PART 4—
FINANCE

11—
Financial Deregulation and Economic Performance:
An Attempt to Relate European Financial History to Current LDC Issues^[*]

This paper takes off from Diaz-Alejandro (1985). It takes way off. I am unable to comment on capital markets in developing countries, either on that of South Korea where McKinnon (1973) and Shaw (1973) first developed or expressed their criticism of repressed and shallow financial markets, or on those of Latin America in which Diaz-Alejandro (1985) observed that ending repression led to binges of lending that ended in crash. I have a nodding acquaintance with some of the literature, including Fry (1982) on models of repression, and McKinnon and Mathieson (1981) which blamed the disaster in Argentina on mistakes in correcting repression, pointing to the success in Chile. This was just before, as it happened, Chile itself experienced a disastrous boom and bust. I am impressed by the special issue of World Development (Corbo and de Melo, 1985), exploring in considerable depth the experience of Argentina, Chile and Uruguay, but lacking sufficient background am unable to judge the validity of the conclusion of either Vittorio Corbo and Jaime de Melo that the main reason for the eventual failure of the reforms was inconsistencies in policies (p. 864) or that of Michael Bruno that the most important problem for any successful reform is the paths followed in such areas as capital controls, trade controls, financial regulation and fiscal policy (to reduce the inflation tax) (p. 867). The order of reform steps is also judged as critical by McKinnon (1982) and Edwards (1984).

[*] Reprinted from the Journal of Economic Development , vol. 27, nos 1–2 (October 1987), Special Issue on "International Trade, Investment, Macro Policies and History: Essays in Memory of Carlos F. Diaz-Alejandro." The paper benefited from the comments of Rondo Cameron and from the Yale Economics Graduate Club to which it was presented on March 5, 1986.

Lacking sufficient background in financial markets in less developed countries, I choose to approach the problem tangentially, by way of the history of European national capital markets. First, however, I offer to scholars of Latin American and Korean experience the suggestion that what may affect the outcome of deregulation is less the order of various steps than the speed with which they are applied. Bruno makes the point that "the issue of credibility is clearly at the heart of the success or failure of any reform" (Corbo and de Melo, 1985, p. 878). When steps are long foreshadowed and separated by intervals in various fields, markets become stably adjusted to them.

When my Manias, Panics and Crashes (1978a) appeared, an Argentine friend wrote privately that the model beautifully explained the Argentine financial crisis of 1974. In that model an autonomous shock to economic markets opens up new investment opportunities, resulting in a reallocation of investment. It can happen that the first investors in this new set of opportunities are followed by others in a euphoric wave as the second tier sees the first reaping substantial profits. The new direction of investment grows. If an attempt is made to contain the boom by restrictive monetary policy, financial innovation that monetizes unutilized forms of credit may overcome the intended restraint. At some stage, with followers close on the heels of leaders, expectations of continued profitability give way, slowly or rapidly, and some of those who have been moving out of money or monetized credit into real or illiquid financial assets begin to move back into cash. Whether there is a financial crash or not depends partly on the extent of the leveraged speculation and partly on the speed of the reversal of expectations.

The displacement or autonomous shock that may lead to a wave of new and excited investment may be either real or financial. Real shocks come from the start of a war, the end of a war, a bumper crop, a short crop, discoveries as in gold or oil fields, development of a new and pervasive technology — e.g. canals and railroads — or the extension of old technology to a new location, a sudden jump in a pervasive price such as that of oil in late 1973. Financial shocks have included the unexpected success of a sizable loan flotation in a new direction — the Baring indemnity loan of 1817, the Thier rentes of 1871 and 1872, the Dawes loan of 1924, leading in the three cases to new waves of investment, conversion of interest rates on outstanding debt, forcing the holders of the old to look for new outlets to maintain income level, and hence to take greater risks. Such conversions led to investment booms in England and France in the 1820s, as did the Goschen conversion to England in 1888, foreshadowed much earlier. All three led to or were followed by financial crashes. Laws widening the avenues for incorporation can also lead to investment surges, and even the anticipation of laws that may

narrow such avenues. In the 1880s a number of companies went public quickly before an anticipated restriction on converting private companies to public form, and the success of the Guinness public issue in October 1886 was said to act like the crack of the starter's pistol, leading to the issuance of public shares by 86 other breweries (Cottrell, 1980, pp. 169–70).

I am further persuaded that a salient feature of the boom in Third World lending in the 1970s was a sudden lowering of interest rates that took place well before the real shock of the OPEC price hike following the Yom Kippur war of November 1973. The Federal Reserve Board under the chairmanship of Arthur F. Burns undertook to lower interest rates in the United States to help ensure the re-election of Richard Nixon as president of the United States, this at a time when the Bundesbank was maintaining tight money in an effort to control inflation in the Federal Republic of Germany, Inconsistent monetary policies led to a flood of funds from the United States to the intermediating Eurocurrency market where they were borrowed by German business, trying to refund high-cost loans, sold to the Bundesbank and redeposited by the latter in the Eurocurrency market. From a level of $2 billion to $4 billion a year, the "deficit" in the balance of payments of the United States on the liquidity definition rose to $20 billion in 1971 and $30 billion in 1972. The Federal Reserve System overpowered the Bundesbank, world interest rates fell, and Eurocurrency banks set out to find new loan outlets. A bubble in Third World lending took place from what Bacha and Diaz-Alejandro (1982, p. 27) call "the most unregulated market in the world," this well before the first OPEC price rise.

Rather than explore more deeply the possibility that deregulation can of itself provide the autonomous shock that may lead to financial crisis in developing countries, where I lack adequate background, I choose to explore the financial history of some countries in Western Europe to see what light they throw upon the comparative merits of repressed and unrepressed financial markets. The thesis that emerges is that the McKinnon–Shaw contrast between regulated and unregulated markets, with its implication that repression or shallowness come from government intervention and that all laissez-faire markets behave in the same way, is too simple. Participants in unregulated markets can behave in different ways, shaped by their history, national character, and by differing horizons that may change discontinuously, and regulated and unregulated markets can behave in the same ways.

Interest in deregulation today is partly theoretical, rooted in the comeback of neo-classical economic theory, and comes partly from the increase in the speed and reduction in the cost of transport and communication that has enabled investors to scan wider horizons, move

funds with less government hindrance, and more and more escape the writ of national governments with their fixed jurisdictions. The prime example of recent decades, of course, is the Eurocurrency market. The change from banking within nations to supranational banking did not come about through overt deregulation. While some regulation of foreign banking existed in foreign countries, the force limiting banking to national confines was largely custom and limited horizons. One can perhaps maintain that the reluctance of Britain to supervise dollar deposits of branches of American banks in London was a negative sort of deregulation. I argue, to the contrary, that the laissez-faire money and capital markets are not all alike, and that they are shaped by other forces as well as — perhaps more than — government intervention.

Theoretical interest in deregulation is largely based on the belief in the efficiency of free markets. At the limit, it is embodied in the Austrian school of today that would go so far as to shut down central banks, allow anyone or any business to issue money without governmental supervision, and to argue that such a system would approach Pareto-optimality. This extreme belief in laissez-faire rests on a denial that money is a public good, even in the unit-of-account or measuring function, on a conviction that transaction costs for establishing what is good money and what is not are low, and on a disbelief in Gresham's law, or perhaps on a belief in the antithesis of Gresham's law, i.e. that good money drives out bad. It can point in support to one historical episode, to a period from 1000 to 1125 AD when private mints in France and Catalonia competed in issuing good money that sellers would accept (Bisson, 1979). In strong sellers' markets, to be sure, sellers can insist on receiving good money for their wares. Gresham's law works in the normal direction, with bad money driving good money into hoarding or export, when buyers can choose what money they spend and what they keep. Roland Vaubel (1977) maintains in his support of completely deregulated currency that different moneys will have different prices that reflect their relative merits and maintain equilibrium among them. To my mind, however, this destroys their moneyness. Money is the one truly liquid asset which means that it is convertible from one form to another without delay and at a fixed price. Just as fluctuating exchange rates are the denial of international money, so changing prices of the demand liabilities of various money users would imply the absence of national money.

Other historical support for the Austrian school is said to be furnished by Scottish banking history from 1775 to 1845 when the banks were brought under the regulation of the Bank Act of 1845. White's (1984) study of those years claims that bank supervision was unnecessary at the time. Two points can be made. First, the study starts a few years

after a major bank disaster in Scotland, the failure of the Ayr Bank in 1772, and stops short — by almost three decades — of that of the City of Glasgow Bank in 1878, though the latter can perhaps be blamed on the surveillance of London. Second, the Edinburgh banks supervised each other, and the smaller Scottish banks, by accumulations of the notes issued by other banks that were presented for conversion into specie when it was thought that a particular bank was lending too freely. This is the supervisory technique used by the Second Bank of the United States that so disturbed American populists. It is a spontaneous form of central banking. Nor am I disposed to accept White's view that free banking in the Middle West from 1840 to the National Bank Act of 1863, especially wildcat banking in Michigan, would have been successful and stable had it not been for government interference. Some discipline provided from some source seems to be necessary to restrain the inherent tendency of some issuers of money to go too far. A further illustration of self-selected banks as stabilizers in the absence of a central bank is furnished by Sprague's (1968) account of the money-market banks under the National Bank Act preparing to offset the destabilizing activities of country banks as they lend to New York in boom and withdraw funds in time of trouble.

In an insightful aside, in a comparison of financial markets in Argentina, Australia and Canada, Jones (1982) stated that monetary history falls into four classes: the orthodox, the heroic, the populist and the statist. The orthodox consists of the development of institutions to contain the exuberance of lenders, much as the history of the Bank of England from its founding in 1694 to the Bank Act of 1844 and beyond was directed to restraining the country banks, getting control of the note issue, developing techniques of managing interest rates and using open-market operations (Fetter, 1965). The heroic mode stressed breakthroughs, like the establishment of the Société Général de la Belgique in the 1830s or the Crédit Mobilier that Cameron (1961) thought spearheaded the economic development of France and served as a model for developmental banking in Germany, Austria, Italy, Sweden and Spain, where, according to Gerschenkron (1962), banks were necessary to economic development because of the absence of indigenous entrepreneurs. Populist banking history is applicable to the Jackson period in the United States and the veto of the Second Bank of the United States that had tried to restrain wildcat expansion. Jones said that Argentina, Australia and Canada all fell into the statist category, with central banks starting to assist in financing public debt. Note additionally, however, that the Bank of England and the Bank of France were each established during wars to help finance the conflict, and that the National Bank Act of 1863 in the United States had the dual function of correcting the

populism of free banking and helping to finance the Union during the Civil War. As these examples indicate, national financial history is not restricted to one mode but may shift from one to another.

It might be possible to use this taxonomy to categorize the history of money and capital markets. It happens, however, that a thesis dealing with the Italian capital market, and a paper related to it, are at hand (Pagano, 1985a; 1985b) and offer a different schema. Marco Pagano remarks that stock markets originated in different ways in different countries, and that these origins have had long-lasting and pervasive effects. He distinguishes two broad categories: one of stock exchanges founded by free associations of private individuals, as in the Netherlands, Great Britain and the United States, and those that came into existence as a result of government action. The latter class is further divided into two groups, the bourses des banquiers , in which stock-dealing is reserved for bankers and their representatives and trade is regulated by chambers of commerce (Germany, Austria and Switzerland), and the bourses du roi (France, Luxemburg and Spain) which are directly regulated by the central government. The Milan stock exchange, to which Dr Pagano's thesis is directed, is a mixture of the two governmental types, having been influenced by its founding under the Napoleonic occupation of Lombardy, and later affected by a return of the region to Austrian domination. Organized stock exchanges, to be sure, do not encompass the total of money and capital markets, and the Pagano taxonomy might have to be modified if the larger area were being categorized.

The Coase theorem that institutions do not matter except when transaction costs are particularly high might be said to be subject to testing in this financial history. If institutions do not matter, different origins of money and capital markets would presumably make no difference in outcomes, provided that national demands for capital ran roughly parallel. The latter condition cannot, of course, be assumed. Accordingly we proceed to a discussion of the development of money and capital markets in Europe over the last two centuries, up to the 1960s when a number of European international institutions — the Bank for International Settlements (1964), the European Economic Community (EEC) (1966), the Economic Research Group of a consortium of banks from four different countries (1966), and the Committee on Invisible Transactions of the Organization of Economic Cooperation and Development (OECD, 1967; 1968) produced a welter of research material on European capital markets that resulted, however, in virtually no action. The discussion is necessarily sketchy and, in the absence of information on the demand side, inconclusive. Enough is offered, it is hoped, on Amsterdam, England, France, Germany and Italy to suggest that the issue of regulation and deregulation is not critical to performance.

The Amsterdam capital market is said to have been completely unregulated. It was a relative pioneer in developing the public bank as an institution, with 100 percent bullion backing that lowered transaction costs by eliminating the necessity for each merchant to test the money he received (Van Dillen, 1934). Smith (1937, p. 453) asserted that the Bank of Amsterdam had a guilder of specie for every guilder of liability and Van Dillen (1934, p. 109) confirms that in 1760 this was more or less right. In 1780, however, following the troubles of the Dutch East India Company, the Bank loaned its specie to help out that company, at the persuasion of the city of Amsterdam, and went bankrupt in the process. This is a clear case of dysfunctional government intervention.

It was not just in money and banking that the Dutch pioneered. Their finance of trade was highly developed with specialized bill brokers, as was the stock exchange which invested in loans to governments at home and abroad, shares of trading and shipping companies, futures, options, and similar instruments for leveraged speculation called windhandel (trade in air). Dutch speculators gambled heavily in the South Sea and Mississippi bubbles but were shrewd enough to avoid the most obvious swindles of the former, and to sell out at the right moment in the latter, and lost little in the crashes (Wilson, 1941, pp. 72, 107–10). Substantial investments in British securities led to the settlement of a large number of Dutch capitalists in London. But Dutch skill in skating unregulated on the thin ice of the South Sea and Mississippi bubbles in 1720 was not proof against subsequent trouble. In 1763 the de Neufville bank failed after having expanded rapidly with a chain of discounted bills, as described by Smith (1937, pp. 292–300). Similar disaster occurred in 1772 with the failure of Cliffords. Worst of all, the Fourth Anglo-Dutch war in 1780–4 led Dutch investors to shift their foreign lending from Britain to France in time to be wiped out by the French Revolution. Three earlier Anglo-Dutch wars had not interrupted lending to British merchants (Barbour, 1966, p. 130). In the seventeenth century Dutch capitalists were men without a country, even though they had a city, Amsterdam.

Perhaps the most fateful aspect of Dutch money and capital markets, however, was the absence of loans to industry. Demand was doubtless limited. Capital went abroad because it was abundant and cheap. But the merchants and bankers who controlled trade, finance and government were interested in speculating in everything but industry. Tariff protection was kept down in the interest of trade turnover. Taxes were light on trade and incomes, heavy on the cost of living which kept wages high. Money and capital markets were highly unstable, despite the lack of government interference, and provided no stimulus to industry apart from that, like shipbuilding, closely associated with trade.

Britain had the example of the United Provinces to follow in the field

of finance, but behaved otherwise. The Bank of England was founded to assist in funding government debt — a statist pattern — not like the Bank of Amsterdam to reduce transaction costs in trade. The financial revolution that took place after Parliament deposed the Stuarts in favor of the House of Orange in 1688 produced the beginnings of the capital market with trading in government stock, Bank of England shares, South Sea Company shares to add to the existing shares of the East India Company and the Sun Life Assurance (Dickson, 1967). An important feature of the revolution was a smooth and easy transition, as in the Netherlands, from the archaic and expensive system of tax farming and spending of governmental moneys by private bureaus, as contrasted with the traumatic change in France requiring the guillotining of 28 of the financiers and officiers who looked on their offices as private property, salable and inheritable.

From this statist start, the financial history of Britain follows an orthodox path from the middle of the eighteenth century. Local personalized markets for most industry and ships were integrated into the national market in London only slowly. London specialized in trade and insurance, and moved into industry gradually as breweries, railroads, iron and steel reached sizes beyond the capacity of provincial informal dealings. The financial and trading institutions in London — acceptance houses, discount houses, jobbers, brokers, merchant, private and joint-stock banks — divided functions in an evolutionary but highly discriminating way. Country and provincial joint-stock banks were gradually suppressed or merged into a few giant national banks. In the process, banks in areas with excess savings sought to merge with those in the industrial areas that needed funds. In the transition to an integrated national market, Lloyds Bank found that it could not hold its deposit rate steady while having the London interest rate follow Bank Rate, as depositors learned to move funds from London to the provinces, or the reverse, as the two rates diverged (Sayers, 1957, pp. 110, 165, 270).

Widespread local initiative in Britain, however, contravened the Coase theorem in two or possibly three particulars. The first is the Macmillan gap in finance for equity capital between the sum of £ 100,000, less than which could be raised fairly readily in the local port or industrial town, and the £ 1,500,000 required as a capital sum before one could count on selling an issue economically in London. This gap was discovered by the Macmillan Committee in 1931 — hence the name — but it is said to have been a blemish on English capital markets as early as the second half of the nineteenth century. The second was a temporal gap between short- and long-term foreign lending, both highly developed, the one for finance of commodity trade, running usually 90 or 180 days, and the other for long-term government or railroad borrowing of

10 to 20 years. Between were capital exports needed to finance equipment, with terms of five to ten years, for which no private lending agencies sprang into being. The third possible area of market failure was the institutional diversion of British savings to foreign borrowers from potential domestic users (e.g. Lewis, 1978). The debate over this issue cannot be resolved here. The alleged mechanism can be noted, however: the growth of fortunes disassociated from industry, giving rise to a need for trustee-approved bonds, when government finance produced no new borrowing, and the railroad building boom was coming to an end. As private companies sold out to public shareholders, trustees found a dearth of suitable investments at home and went abroad. In this circumstance it is claimed, not without controversy, that British capital markets discriminated against domestic industry in favor of foreign governments and railroads.

In due course, government sought to correct these "gaps." The Export Credit Guarantees Department was established in the 1930s to assist in financing the export of capital equipment. Other specialized agencies have been set up since 1945 to fill the Macmillan gap, including the Industrial and Commercial Finance Corporation, Ship Mortgage Finance, Charterhouse Industrial Development Corporation. Higher death dues gave rise to a new financing need not fully cared for by the private market, so that an Estate Duties Investment Trust was created to forestall unwanted business liquidation upon the death of the entrepreneur. Owing to the troubles of the balance of payments and to help finance priority needs, especially as war approached, new security issues were rationed by government, in the 1930s and after the war, with Commonwealth and foreign borrowers assigned to the end of the queue or stricken from it altogether.

Deregulation may be said to have begun with the establishment of the Eurocurrency market, largely in London and an institution that evolved in Darwinian fashion out of private initiatives rather than governmental intention. This consisted primarily of foreign banks dealing in foreign currencies that the British authorities decided to leave unregulated, or that were regulated, if at all, by the governments and institutions of their home countries. The Eurocurrency market served as the thin end of the wedge for further deregulation. The traditional division of function among London joint-stock banks, discount houses, brokers, jobbers, merchant banks and the few remaining private banks is being torn down, largely for the sake of improving trading in British debt and to finance the privatization of companies nationalized before the present Conservative government took office.

To summarize, money and capital markets in Britain grew up with gaps that the government tried to fill, and evolved in an ossified way that

government, with the help of private financial houses, is now prepared to see changed.

French financial history is centripetal. Various efforts to decentralize the financial structure were initiated in the eighteenth century, largely by foreigners such as John Law of Scotland, and Isaac Panchaud and Jacques Necker of Switzerland, in all cases without success. Attempts to spread banking to the provinces by creating regional note-issuing banks or branches of the Bank of France were advocated by Napoleon I, by the Saint-Simonists, and by provincial bankers and businessmen, but were defeated by the Paris banking establishment of the Bank of France and the Haute Banque. Under Napoleon III, a crypto-Saint-Simonist when in exile and in office until converted to an establishment view, the Pereire brothers were permitted to start the Crédit Mobilier to stimulate public works in France. The government earlier detected gaps in the financial spectrum and created the Crédit Foncier to improve the market for mortgage credit, and in 1860 the Crédit Agricole to lend to farmers. This last found little demand for credit from the countryside and occupied itself, from 1873 to 1876, in lending money on speculative bonds to Egypt.

Large deposit banks were created in France, primarily in the early 1860s. The Comptoir d'Escompte (of 1847) and the Société Générale were founded in Paris. In due course the Crédit Lyonnais (of Lyons) moved its head office to Paris. After the success of the Thiers rentes all banks speculated in government bonds, and by the end of the 1870s, in foreign bonds. Rather than trying to balance the intake of domestic savings and outlet of domestic lending, as British banks had done in merging into national networks, the Crédit Lyonnais concentrated on establishing branches where deposits were abundant and avoiding communities with an urgent demand for loans, and it drew deposits to Paris for investment in speculative foreign issues (Bouvier, 1961, esp. ch. 2). The high-flying Union Générale of Lyons was allowed to collapse in 1882, while the equally or even more speculative Comptoir d'Escompte that had unsuccessfully backed an attempt to corner the world copper market (evocative of the American Bunker Hunt's attempt to corner the silver market nearly a century later) was rescued (Bouvier, 1960). In the twentieth century the Bank of France was accused with some plausibility of having suppressed regional banks in Haute Savoie and Lorraine (Charpenay, 1939).

A special class of banques d'affaires got going in the 1870s but spent the first years of existence speculating in bonds before settling down to lend to industry. This again was focused in Paris with governmental blessing. Among the earliest was the Banque de Paris et des Pays-Bas which grew out of a merger involving a bank started in Holland by the

German exile, Ludwig Bamberger, to lend to France from an offshore location, much as the Eurocurrency market later developed (Zucker, 1975, p. 77).

It is hard to see that there were wide differences between the instability of British and of French finance, despite the decentralization of the one and the centralization of the other. When it came to the allocation of savings, both are accused of favoring foreign borrowers at the expense of domestic, but the point is debatable. The 1960 studies of European capital markets singled out the French, especially, for collecting savings deposits throughout the country into a central Caisse des Dépôts et des Consignations that existed from the early nineteenth century and investing them, now in housing, now in government debt, now in para-statal nationalized bodies in various industries, or in government capital allocation to control investment under the various plans that had been adopted since 1946. In due course first planning and then the program of nationalization under Mitterrand were allowed to fade into obscurity. It is difficult to make a case that the nationalization of banks or centralized government control of credit made a major difference in the way that French credit was allocated from the center.

German money and capital institutions were originally widely diffused because of the country's division before 1870 into a large number of states, principalities, free cities and the like. A group of financiers in Cologne, in Prussia, wanted in the 1850s to start a bank along the lines of the Crédit Mobilier and was refused at locations in Cologne and in Frankfurt am Main. It was forced ultimately to go to Darmstadt in Hesse, across the state border. From an early period, however, German banks were closely tied to industry, not to trade, trade being much less developed than in Holland or England. With unification in 1870, a centripetal process started as banks moved head offices to Berlin. Even from Hamburg, a mercantile city with a Hanseatic tradition of openness to the world and a disdain of Prussian Junkers, the Commerzbank gradually shifted its head office to Berlin, but indirectly after an intermediary move to Frankfurt. The Deutsche Bank, established in 1872 to rival London in foreign-exchange trading, got caught up in the boom that followed the founding of the Reich and loaned predominantly to industry.

The close association of banks and industry in Germany had some gaps. One or two steel companies stayed aloof from intimacy with the leading D-banks (the Deutsche Bank, the Dresdener Bank, the Darmstädter und National Bank) as did the chemical industry as a whole (Riesser, 1911, pp. 721, 741). In the boom of 1870–3 a host of mortgage banks and brokers' banks were started in Germany and in Austria, but melted quickly thereafter. Gerschenkron (1962, pp. 87–9) makes much

of the banks' action in aiding Italy in starting new banks along German lines in the 1890s at the behest of Bismarck. Two things seem to me wrong with this claim: first, that the German banks quickly sold back the shares they bought in the new banks in the first wave of enthusiasm, and the banks ended up by 1900 owned largely in Italy and France (Confalonieri, 1976, ch. i); second, as discussed below, Italian lending to industry after the spurt from 1895 to 1913 proved largely unsuccessful.

Of interest in comparing German and Italian banks, both intimately bound to industry through "mixed" or "industrial" banks that owned industrial shares on their own account, and in the German case voted the shares of their depositors left in their custody, was that when the system broke down in the 1930s, the Germans left it intact while the Italians changed it. Industrial finance under the Nazis was conducted by new instruments invented by government that produced economic recovery that slowly floated the clogged banks (Hardach, 1984). In Italy reform was undertaken, separating "ordinary" from investment banking, as in the Glass—Steagall Act of 1933 in the United States, and providing most finance for industry by a Reconstruction Finance Corporation — the Istituto per la Ricostruzione Italiana (IRI), as in the United States (Ciocca and Toniolo, 1984). In Italy, however, IRI became a permanent institution, whereas in the United States the RFC was metamorphosed into the Defense Plant Corporation during the war but liquidated afterwards.

The Italian capital market has been called "colonized" (Bonelli, 1971, p. 43) or an exercise in the second best (Kindleberger, 1984, p. 11). Prior to the unification of Italy that took place in stages in 1860, 1868 and 1870, the country consisted partly of independent states, but partly of states controlled by or having close relations with outside powers, notably France, Austria and Spain. With unification led by Piedmont, closely allied with France, foreign borrowing in the 1860s was largely in Paris, except for one issue that the French were unwilling to take in 1881 that was shifted to London. Pagano (1985b) notes that in 1854 Italian railway shares were regularly traded in Vienna but not in Milan. Collapse of the banks associated with France in the early 1890s and the creation of new, started from Germany, led to the boom that lasted to 1913, apart from the relapse in 1907. Wartime inflation destroyed any private market for bonds that might have existed, leading personal savers to hold mostly short-term government bonds and bank deposits, while banks accumulated industrial shares along with industrial loans. The interwar history of the capital market includes the failure of only one bank in 1923 when the postwar bubble burst, severe troubles

for others in the stock market crash of 1926, following the appreciation of the lire from 150 to the pound to 90 (the so-called quota novanta ), each forcing the Bank of Italy to take over industrial shares from the mixed banks to save the latter. When 1930 troubles were piled on top of the earlier accumulations, IRI was formed to relieve the Bank of Italy of its burden, and later other state financing funds, IMI and EMI. In today's "dual" Italian economy, multinational business finances itself in the Eurocurrency market, ordinary domestic industry turns to IRI, and small-scale business, especially in the black market that pays no social security or corporate income taxes, relies on internal and parochial informal finance.

It is difficult to claim that the Italian capital market troubles originate in governmental regulation. Rather regulation and the substitution of government for private credit through IRI, EMI and IMI come from a less than Pareto-optimal capital market with roots deep in Italian history. Government is often regarded as an ulcer that debilitates the body economic. It sometimes, however, is an instrument for filling vacuums left by private persons seeking their own interest (Kindleberger, 1978b). In the case of the Italian capital market, I judge that government has been less of a disturbance to private equilibrium and more of a correction of private disequilibria.

I conclude that the issue of financial regulation and deregulation implicit in the McKinnon view of repression is unduly simple. One cannot postulate repressed and unrepressed money and capital markets as if there were only two types. Financial history, national character, evolving institutions and relationships affect both how financial markets will respond to changes in the environment — real, financial, governmental regulation or deregulation — and how efficiently capital markets allocate resources among competing uses. Excitable Dutch, without regulation, will indulge in bubbles, their own or those of others, successfully on occasion, unsuccessfully at other times. In moving from regulation to deregulation — if it be assumed, as is most likely the case, that an economy will do well in an unregulated state most of the time — it is plausible that one should proceed slowly and cautiously, giving expectations, after each step, time to absorb the changes in a quiet way and steady down. There may be some merit in talking about capital markets at length, as was done by the EEC, OECD, BIS, etc., in the 1960s, and then doing nothing beyond letting the Eurocurrency and Eurobond markets move Europe some distance along the road to integration. The present positive steps of deregulation in response to technical change with satellite communication and computers bear careful, perhaps even prayerful, watching.

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12—
Write-Off or Work-Out? A Historical Analysis of Creditor Options^[*]

When loans go "bad" because debtors are encountering difficulties in meeting interest and paying back principal on schedule, the creditor faces a menu of policy options of which the polar ideal types are writing off the bad loans or working them out, that is, keeping the loans on the books at cost in the hope that circumstances will change and make the loans good. This paper discusses the polar extremes, analyzes some of the intermediate cases, and furnishes historical examples. I have confined myself mostly to examples drawn from US and European financial history, which is all that I know.

Write-offs are the classic medicine for bad loans. If the discussion is limited to bank assets, these should be "marked to market" at some regular period — daily, weekly, monthly, quarterly — that is, maintained on the books at cost or market whichever is lower. When the asset has fallen in price below cost, it must be written down on the asset side of the balance sheet, with a corresponding charge against the profit-and-loss statement, where the valuation takes place at intervals when income is calculated, or against capital surplus. Where there are assets for which the market is thin or non-existent, classic therapy calls for writing them down to realistic levels of their present discounted value (PDV), based on the prospects for payment of interest and principal.

When a debtor announces that it cannot or will not pay, there is of course no option, and the loan has to be written off under any conceivable accounting rule. On occasion, subsequent negotiations, perhaps

[*] Paper presented to a Conference on Financial Crises and Crisis-Containing Mechanisms sponsored by the National University of Mexico and Washington University of St Louis, March 9–11, 1987. Published in Spanish as "Cancelación o Revalidación: Un Análisis Histórico de la Opciones del Acreedor," in Carlos Tellos Macías and Clemente Ruiz Durán (eds) (1990), Crisis financiera y mecanismos de contención , Mexico DF: Universidad and Fondacion, pp. 211–31.

with a Council of Foreign Bondholders, will produce resumption of partial debt service and enable the holder of the obligation to get some value from it. In the case of bonds, the debtor may default and then buy up outstanding bonds in the market at derisory prices to clear its own books of debt. But where a debtor insists that it wants to pay, but is for a time unable to do so, or can only pay so much — as with the 10 percent of export proceeds offered by Peru — the choice of write-off or work-out is open — open perhaps to the creditor, or possibly in the case of bank loans, mainly to the bank examiner. Where a bank is subject to examination by several agencies — the Comptroller of the Currency, the Federal Deposit Insurance Corporation (FDIC) and/or the Federal Reserve System — and they disagree, the choice may require negotiation among the parties.

Working out a bad asset calls in the first place for not writing it off, maintaining it on the books at cost, and doing nothing in hopes that the conditions which caused the loan to turn bad will change, making resumption of debt service possible and the loan good again. For Latin American loans today, the hoped-for circumstances include effective policies of austerity in the debtor countries, cutting imports and releasing output for exports — policies undertaken in a determination to maintain debt service and credit standing so that later loans may be obtained to expedite economic growth. In the world beyond the debtor's control at least three conditions are critical to assure work-outs: low interest rates to hold down payments under floating-rate arrangements, sustained prosperity in the developed countries; and successful governmental resistance to demands for protection against debtor-country exports. Note parenthetically that if the probability of achieving each of these three conditions were 1/2, and the three were unrelated (which they are not), the probability of meeting all three would be 1/2 × 1/2 × 1/2, or 1/8. It happens, however, that low interest rates in the developed world would assist in maintaining prosperity, and that sustained prosperity would assist governments in resisting calls for protection, so that the probability of achieving all three is above 1/8, although probably considerably below 1/2.

A fourth condition on which creditors and debtors have difficulty agreeing, and especially different groups in the creditor countries, is more loans. Jacques de la Rosière, erstwhile managing director of the International Monetary Fund (IMF) and James A. Baker, US Secretary of the Treasury, have properly, in my judgment, insisted on more loans to keep the debtor countries growing economically. United States banks are skeptical and reluctant on the basis of the slogan that one should not throw good money after bad. But good money after bad on the right occasions is a highly desirable therapy, whether in poker, bank lending

or lender-of-last-resort operations. World depressions started in 1873, 1896 and 1929 when foreign lending was suddenly cut off, shortly followed by declining imports by the developed world. Each bank, and especially the smaller regional banks which feel no responsibility for general economic conditions and are fully occupied minding their own balance sheets, views lending more when outstanding loans turn sour with acute distaste. This is one of those examples of the fallacy of composition where what is bad for the individual is good for society when all do it together.

Marking to market with write-off of the difference between market and cost is ostensibly called for by the standards of bank examiners, if the discussion is limited to banks as a single class of creditors. In practice, however, examiners typically allow banks to carry loans at book value or cost. Newspaper accounts of December 1986 (see, for example, the New York Times of December 15) mention that more than 400 thrift institutions in the United States are "essentially bankrupt," but are allowed to continue operating because the assets of the Federal Savings and Loan Insurance Corporation (FSLIC), needed to make good depositor losses in the event of failure, have declined to very low levels. One compromise on the part of authorities maintaining surveillance over banks is to allocate particular loans of questionable payout to special categories, such as "problem loans," even while carrying them on the books at book, sometimes limiting the amount of problem loans a bank may be permitted to carry without write-off, or possibly requiring a certain proportion of problem loans to be written off in each income period. Another technique is to impose a ratio of bank capital to total assets, such as 5, 6 or 6 1/2 percent, leaving it up to the bank whether to charge off loans against earnings, obtain more capital, or something of both. If the bank has trouble selling shares to raise its equity capital, it may sell subordinated debentures that qualify as capital because they rank behind deposits and certificates of deposit in the event of liquidation, although ahead of equity.

The highest standard of banking, as noted, calls for writing off bad loans against earnings, or capital and surplus. An outstanding example of a bank following this practice today is the Deutsche Bank of the Federal Republic of Germany, which is known and applauded for having drastically written down its loans to Eastern Europe, perhaps to a point below their true value so that it has acquired hidden reserves in the process.

There is one argument against writing off dubious loans. If the debtor learns that its paper has been written off, its resolve to take strong action to meet debt service as fully as possible may be weakened. The classic example concerns a governmental obligation: German repara-

tions after World War I. When Keynes (1919) asserted that Germany would be unable to pay the large amount of reparations that the Allies were trying to levy at Versailles, the Germans lost interest in trying to pay, if they ever had much. When President Hoover in June 1941 announced a compromise between write-off and work-out — the Hoover moratorium postponing any debt service on both reparations and war debts for one year — it effectively wrote off both sets of obligation entirely, as Germany stopped paying reparations altogether, and the Allies soon followed suit with war debts owed to the United States.

The contrast between write-off and work-out applies not only to bad loans, whether bank or intergovernmental, but also to other cases. After World War II, the United States and the United Kingdom handled an awkward military financial problem in entirely different ways. The problem arose because the military forces, whether through lack of understanding of the consequences of their action or concern that troop morale would otherwise be adversely affected, redeemed at par exchange rates large amounts of inflated German and Japanese currency presented to them for conversion by their own servicemen. These conversions resulted in what was euphemistically called "an excess of foreign currency" but what was more accurately a deficiency of dollars (or sterling) in the troop-pay account. The British brought their accounts into balance by a Parliamentary appropriation of over £100 million, writing off the worthless enemy currency; the United States, on the other hand, took years of taking in dollars from Congressional appropriations for service personnel and occupation civil servants in occupied Germany and Japan, paying out Reichsmarks (later Deutsche-marks) and yen, plus renting quarters and buying goods for post exchanges in enemy currency, and renting and selling them to Allied servicemen and women in dollars. In total, five or six years went by before the enemy currency had been converted into dollars in the extended work-out. The troop-pay account was balanced in foreign exchange, but at the expense of German exports of goods and services, with the enlarged deficit in the German balance of payments made up, in those days, by US Congressional appropriations for non-military purposes such as relief and Marshall Plan aid.

Another extended work-out by United States officials took place in the 1930s when the Treasury stabilization fund bought £1 million sold by the Soviet Union on September 26, 1936 at the time of the Tripartite Monetary Agreement. The purchase took place on a Saturday when the New York exchange market lacked support from London and was thin. Secretary of the Treasury Henry Morgenthau took over the sterling at a price close to $5 per pound, accused the Soviet Union of trying to undermine the financial stability of the world, and insisted that the

Treasury would make a profit on the transaction. It happened that the pound opened at around $4.86 when trading was resumed on Monday and never went above that level in the weeks and months to come. The work-out was accomplished by adding the 1/4 percent service charge on gold transactions, both purchases and sales, to the particular exchange account, making it possible after an extended period to close the account with a profit.

One of the more salient forms of work-out, not widely discussed, is the practice of central banks in keeping foreign-exchange reserves on the books at cost under regimes of flexible exchange rates, rather than marking them to market. Some of the richest central banks in the world, notably the Bundesbank and the Bank of Japan, must have had their capital impaired — a condition under which with strict banking rules they would have had to close their doors as bankrupt — when the dollar declined in 1973–5 and again in 1985–6. Having acquired large quantities of dollars in the course of vain efforts in support of that currency, the decline of the dollar would have occasioned them substantial losses if they had been required to write their exchange reserves down. (They doubtless had at the same time substantial hidden reserves from failing to write gold holdings up to market.) To the extent that economists take notice of the price at which foreign exchange is valued on central-bank books, they regard the issue as unimportant. While a large loss on foreign exchange will matter to a country, it is of minor importance to the central bank. Central banks cannot go bankrupt; losses on foreign exchange can be offset by a claim in local currency against the government, perhaps a notional one if the government does not explicitly agree. This would leave the liability side of the balance sheet unchanged. Central-bank profits go to the government, and so can central-bank losses. The question was regarded as important in the interwar period. The Bank of France in 1926 refused to buy foreign exchange for francs to hold down the currency as it rose until the Poincaré government agreed to make good any possible Bank loss (Moreau, 1954), and the National Bank of Belgium was surprised when the Minister of Finance blithely agreed to take over the Bank's loss in sterling following that currency's depreciation in September 1931 (Van der Wee and Tavernier, 1975).

Between write-offs and work-outs there is an almost infinite variety of compromises. One is to add unpaid interest to the loan, increasing its nominal value and including the interest, though not received, in income for the relevant period. The interest rate can be reduced or capped, with the unpaid portion at the original rate either written off or added to the loan. Interest and/or principal can be rescheduled, perhaps with a period of grace in which the payment on one score, the other, or

both, is cancelled or added to the loan or to payments due later. All these leave the nominal amount of the debt unchanged (or increased), but most lower the PDV. The hurt is felt on the profit-and-loss statement, but not on the balance sheet. The strong propensity to avoid writing down the face value of such bad loans seems to me a form of "debt illusion" on the part of the creditor. I am not clear whether debtors would prefer to keep something like the old terms and write down the principal amount, or whether they are typically happy to participate in the self-deception of the creditor. The Paris Club and the World Bank both avoid writing down the face amount of debt on which service cannot be maintained on the original terms, even when the necessity for change is traceable to the wild extravagance of dictators who are later deposed, notably Sukarno in Indonesia and the assassinated Nkrumah in Ghana. The absence of tangible productive assets to service the loans would seem to justify the write-off of principal amounts, reducing the face amount as well as the PDV of debt service to amounts perhaps near zero, but that ultimate step seems to be regarded as anathema. I conjecture that creditors are fearful that if the book value of loans is written down in one case, other debtors will be more likely to demand negotiation than if debt service is only rescheduled. Such a belief, however, seems hardly rational.

In addition to economic conditions and policies in the debtor and in creditor countries, plus the world economy, the choice between write-off and work-out of bad loans is affected also by the use to which the loan has been put, as the examples of Sukarno and Nkrumah illustrate. To use ideal types again, consumption loans for people at the subsistence level should be written off — in fact assistance to such people or countries should take the form of grants, rather than loans in the first place, whereas funds borrowed for productive purposes presumably create assets and productivity out of which interest and principal can be paid under ordinary circumstances. The evil of usury in Mohammedanism and in Christianity in pre-Aquinas times was based on the ethical duty of those better off to help those in need in periods of adversity, such as famine. To charge interest was to take advantage of the troubles of others, especially of co-religionists. When starving Indian peasants borrowed from moneylenders, they typically had to continue to borrow the interest, adding to the loan, because there was no additional source of income from the loan. The same is often true of gambling debts.

Consumption loans are entirely normal today in rich countries, as households experiencing shortfalls in income or one-time increases in expenditure expect either to earn more or to compress expenditure in future to provide a margin for debt service. Buy now and pay later is the

antithesis of the life-cycle consumption function in which one saves first and dissaves subsequently. The latter model accords with the Calvinist convictions of the Swiss (and the Japanese?), but borrowing for consumption is widely accepted in today's world when there is an expectation that it can be paid for by future austerity or increased earnings. In the subsistence economy of peasants at the margin, no such expectation was rational.

This distinction between consumption loans at the subsistence level and loans for productive projects calls into question a criticism of international lending that is frequently raised in Latin American discussion, i.e. that based on a comparison of new loans and investment with interest on old loans, dividends on direct investment, repayment of principal and depreciation and depletion, that the United States takes more money out of Latin America than it puts in. I have attempted unsuccessfully in the past to scotch this hoary fallacy (see under "Cumulative Lending" in the 1953 to 1973 editions of my International Economics ). The analysis applies well to amortization, depreciation and depletion, but not to interest and dividends which have no connection whatsoever with new investment. If I buy a share of General Motors, the company may urge me to reinvest dividends automatically, but I am free to take them as income and spend them, without any implicit moral obligation to reinvest. It happened in the nineteenth century that Britain reinvested annually amounts more or less equal to its earnings on foreign investment, but except in the case of retained earnings used to expand a given direct investment, or depreciation and depletion used to maintain a given asset, the rough equality of the two flows was fortuitous: moneys earned abroad entered into the income stream in Britain where they were divided between consumption and savings, and savings out of foreign income joined those on domestic income to be divided again between foreign and domestic investment. To expect that an individual, household or country should reinvest the total of its foreign-earned income in the countries where it is earned calls for geometric growth of foreign investment. When famished peasants or losing gamblers fall behind in paying interest and principal on their debts, to be sure, the debt rapidly approaches astronomical amounts.

There is one type of loan on which one legitimately has to borrow the interest, arising in the case of construction projects of long gestation. Suppose a country borrows $100 million at 10 percent a year for a project that will have its first product in five years — the Egyptian High Dam at Aswan, for example. Interest begins the first year, but there is no output with which to pay it. The interest must be borrowed, and the same is the case in years 2, 3, 4 (and possibly 5). The project costs not $100 million but that amount plus compound interest for five years.

Waiting is necessary, and in the circumstances specified, the waiting is productive. The case is sharply different from borrowing for consumption at the subsistence level, when borrowing of the interest is inescapable, too, but unproductive.

Consumption and investment do not comprise the full range of purposes for which individuals, households, firms or countries may wish to borrow. For countries, in particular, borrowing may be undertaken to buy military equipment which is productive only in the sense implied by Adam Smith when be said that defense was greater than opulence. It is not productive of a stream of income that can be used in part to meet debt service. In and after World War I, the United States took a bankerish view of war loans. Calvin Coolidge said of the European allies "They hired the money, didn't they?" meaning that the loans should bear interest and be repaid. In the war-loan negotiations of 1923–6, however, interest rates were set below market rates for most debtors — though not for the United Kingdom — and in working out these rates, account was taken of ability to pay of the separate debtors. In World War II, the Lend-Lease Act left open the question whether advances would be made on the basis of loans or grants, and if loans, on what terms. In the Lend-Lease settlements after the war, the cost of military equipment used up in the war — consumed, so to speak — was written off entirely by the United States, as were supplies consumed by the military and the civilian populations. Goods that survived the war or that emerged from the pipeline after new inputs were halted, were valued in terms of their civilian worth — almost nil for military aircraft for example, but more for food, petroleum products, trucks, military clothing, tenting — and put on a loan basis. The terms were generous, 28 years with a period of grace and below-market rates of interest, the whole, that is, with a PDV well below the nominal amount of debt.

On Christmas Eve 1986, the US Treasury offered to defer interest payments on military loans to Israel, Egypt and 36 other countries, including Spain, Greece, Thailand, Turkey and Korea, citing the United States' interest in the military forces of these countries. The loss was estimated at $3.5 billion in uncollected revenue in the six following years (New York Times , December 25, 1986). It is not clear how much these write-offs were due to ability to pay and how much to the purposes for which the moneys were borrowed. The news account went on to state that the action postponed the need to come to grips with the accumulating American support for economically weak allies, and that it is easier to get loans through Congress than grants. Presumably the tactic is to make loans and reschedule them later should the need arise. It is clear, none the less, that military aid, like consumption loans, produces no direct income from which debt service can be subtracted in the normal manner.

Congressional preference for loans over grants goes back at east to the Marshall Plan experience of 1948–52. Most assistance was made in the form of grants, rather than loans, on the ground that it was needed for consumption and or restocking or reconstruction which would only restore previous levels of income, not raise output. In the event, a number of the receiving countries found themselves experiencing "economic miracles" of extraordinarily high rates of growth from which they would have been able to extract debt service. While it would have been possible to convert loans into grants if economic growth had fallen short of expectation, there was no possibility of replacing grants with loans when the outcome was the reverse. Germany did, to be sure, use some of the surpluses in its national budget and its balance of payments to prepay principal on much, if not all, of the loan portion of its Marshall Plan aid and other advances during the occupation and reconstruction well ahead of the agreed schedule. The PDV of these payments, of course, exceeded that of the original formula.

Apart from pure consumption, military aid and reconstruction assistance, there are difficult cases such as those presented by economic projects where the anticipated results are not realized, whether because of bad judgment to start with — overly ambitious plans that end up building unproductive "monuments," cases of unrelated bad policy that harms the project's prospects — or instances in which circumstances beyond the control and expectations of borrower or lender changed drastically. The collapse of the price of oil in 1982 may or may not be one of this last class, depending upon how euphoric or detached an observer was at the time.

Where the circumstances of the original loan or investment change in ways that cannot reasonably be foreseen, there is a presumption that work-out is a better option than write-off on the assumption that circumstances may change against in unanticipated ways, and for the better. They may, to be sure, continue changing for the worse. For the German loans behind the Iron Curtain, the chances of a massive improvement are perhaps so slight as to warrant write-off rather than work-out. In Third World loans, much depends upon the particular economic outlook, seriously and soberly judged. Commodity prices move with general business conditions, but are also subject to independent influences — coffee (Brazil) to the sizes of harvest and carryovers, oil (Mexico, Venezuela, Peru) to the strength of the OPEC cartel and the course of the Iran-Iraq war, copper (Chile) to the trend of substitution of optic fibers for copper wire.

Decisions by individual banks as to whether to write off or work out bad loans will again depend on particular circumstances. Regional banks may take one view, money-center banks another. Regional banks entered syndicated sovereign bank lending to Third World countries

late, with little experience, relying on the wisdom of the lead banks. In a number of cases, they are disillusioned and anxious to turn their backs on the field. Where holdings are small, they are often prepared to sell off the loans for what little they can bring, write off the rest, and get clear of the field. As I understand it, however, they cannot sell just a portion of their holding and keep the remainder on the books at cost. Just as when a debtor announces it cannot and/or will not pay, writing off a portion of a loan calls to the attention of the lender the real facts of life. If this be true, the market for sovereign bank loans without recourse to the seller in case of default, and especially that provided by direct investors who are sometimes able to arrange to buy foreign debt at a deep discount and exchange it for pesos, cruzeiros or australs for which they promise to hold the investment counterpart for an extended period, is small. Money-center banks with large holdings are unable to take advantage of these quasi-write-off devices since they would have to take charges against income or surplus which would be very large in any one period. The nine leading money-center banks had syndicated sovereign bank loans of close to $60 billion on June 1986, amounting to 130 percent of their capital adjusted to market valuation. This is well down from the peak ratio of 300 percent in 1982 — the decline having been brought about partly through a reduction of the loan volume by almost 10 percent but primarily through a doubling of the banks' market-adjusted capital. The regional banks are especially anxious to work their way out from under Third World loans so as to avoid what the money-center banks have been forced to do by the IMF, and urged to do by the US Treasury — make new loans in the process of working out the old. The attitude of individual banks toward write-offs as opposed to work-outs depends additionally, of course, on their loans in other weak sectors — oil, real estate, farm property — not to mention the pressure of particular bank examiners. The smaller the bank in the United States, however, the more likely its option will be write-off rather than work-out. Since the big banks dominate the statistics, however, work-out is the dominant choice over write-off.

Thus far the discussion has been at the level of banks' loans, on the one hand, and intergovernmental loans (or grants), on the other. There is a third dimension to the problem that merits consideration: the choices made by governments, central banks, and other official bodies when they take over bad loans from commercial banks in acting as lenders of last resort. When a commercial bank gets into difficulty with bad loans, it may or may not be rescued, or, as the Italians say, salvaged. The doctrine of the lender of last resort grew in Britain where the Treasury, the Bank of England or the London money market as a whole, through guarantees of an institution's liabilities, came to the rescue of a bank in

trouble, or perhaps did not. The basis of decision was typically whether the bank's assets were deemed sound in the longer run, once it had gotten past the liquidity crisis. Walter Bagehot rationalized the procedure and propounded the rule that in a crisis the Bank of England should lend freely, without limit, albeit at a penalty rate. The Bank's rule was to lend only on good assets, by which it meant bankers' acceptances with less than two months to run and on two good London names. In practice it was not always "overly nice," lending on mortgages, iron works, copper works, promissory notes, acquiring a West Indian plantation, etc. (Clapham, 1945). Rules do not stand up in crisis. In the Continental Illinois crisis of July 1982, the $100,000 limit on insured deposits of the FDIC had to be abandoned because not to rescue the holders of large deposits and certificates of deposit, many of them foreign, would have given rise to runs on other banks. The FDIC was established in 1934 to head off runs by small depositors who were thought not to have enough financial knowledge and experience to judge the soundness of banks, and should therefore be protected from their ignorance, as a public good. Runs today typically start — for commercial banks at least if not for the thrift institutions — among the knowledgeable, foreign-deposit holders, other commercial banks who will take the CDs of the troubled institution only at high discounts if at all, or who refuse to deal with it in the federal funds market. The public good is less concerned with safety for the little depositor and more with the preventions of runs, no matter how touched off.

When lenders of last resort take over bad loans from commercial banks in trouble, they also have a choice whether to write off or work out. As noted for the FSLIC, something depends upon whether the relevant body has liquid assets — a central bank can, of course, create money — and what its chances are of getting more. In the case of the FSLIC, the opening of the new Congress in January 1987 is expected to bring new funds to restore its capacity for normal operations, but the process involves introducing politics into lender-of-last-resort functions. With commercial banks failing because of foreign loans, the political element would be doubled, foreign policy on top of domestic faultfinding.

One contrast is between the Reconstruction Finance Corporation (RFC) in the United States and the Istituto per la Ricostruzione Industriale (IRI) in Italy, both started in the 1930s to take over bad loans from banks. The loans, to be sure, were domestic. The RFC worked its loans off for the most part during the 1935–7 boomlet, was converted into a Defense Plant Corporation at the time of the war to assist in financing factories and equipment built for defense purposes, and was wound up after World War II by selling off its assets in what

would be known today as "privatization." IRI was started by taking over the bad assets of the Italian "mixed banks," accumulated by the Bank of Italy in the recessions of 1923, 1926 and the early 1930s. The original intention was to work them off, but so difficult did this become that IRI took over the assets, wrote off the debts of the banks, and operated a substantial portion of Italian industry as a major conglomerate or holding company (Toniolo, 1980).

The great depression in Germany saw the failure of one major bank, the Darmstädter und Nationalbank, generally called the Danat. A modern economist asserts that this would be unthinkable today (Irmler, 1976, p. 287). With the ensuing rearmament program under National Socialism, the banks were left alone, not called upon to make new loans for industrial rearmament, with their old bad loans gradually floated by the widespread recovery and the armament program financed by government paper (Hardach, 1984).

The point to be emphasized is the role of the lender of last resort is highly political. When it has to be played internationally, foreign-policy aspects are likely to be mixed with economics. The $1 billion bridging loan from the Federal Reserve System for Mexico in 1982 would probably not have been available for a country with which the United States felt less close. The swap network among the Group of Ten leading financial countries presumably rests on solid expectations of economic capacity to make good the undoing of swaps at the end of six months or the chosen period. It is uncertain, however, whether the United States would extend the swap arrangement to a country with which it was quarreling over foreign-policy matters. We further have the examples of France insisting on political conditions — the cancellation of the Zollunion (customs union proposed between Germany and Austria in the fall of 1930) before it would lend a second time to Austria in June 1931, and Germany scrapping construction of the Panzerkreuzer (pocket battleship) before it would come to its rescue the same month. In September 1965 France refused to join the other members of the swap network in assistance to Britain, ostensibly as a matter of foreign policy after saying "No" to the British request to join the Common Market (Strange, 1976, II, p. 136).

Debtor countries from time to time say they are incapable of following the austerity policies laid down by the IMF and creditor countries or institutions because of domestic political resistance. Balancing the budget or creating a surplus out of which to pay debt service involves levying taxes under circumstances, on occasion, when no group is willing to take its share of the burden. Depreciating the exchange rate to the level needed to produce an export surplus is likely to raise prices, producing, with nominal income unchanged, a cut in real income resisted by what Olson (1982) calls "distributional coalitions."

Domestic politics plays a role in creditor countries, too. When the lending of last resort is undertaken by a central bank which creates money, there may be an "inflation tax" with a particular incidence. The choices made of which banks are to be rescued and which allowed to fail are likely to evoke criticism. Even when the explicit criterion is the likelihood of further disintermediation or runs, it will be asserted that insiders are taken care of and outsiders are left to their unhappy fate. Rescue of banks gives rise to cries of "bail out," the widespread populist sentiment in the United States resenting the financial community as contrasted with the real economy of farmers and workers. Where institutions like the FDIC, FSLIC, Farm Loan Board and Federal Home Owners' Bank run out of money and it becomes necessary to approach Congress for more, who gets saved on what terms becomes squarely a political question. The issues are legion: how much should be raised by assessment on the banks, and how much provided out of the national budget; whether surpluses of one support institution can be transferred to others in need; whether insurance premiums should be uniform or can be graded in consonance with risks taken by the banks in question; the need for reserves against off-balance-sheet items; with deregulation, whether non-banking institutions trying to break into world finance are favored by regulations and fees levied on banks. The political problems of lenders of last resort in creditor countries are perhaps more complex than those of debtors in another dimension: rescue or bank salvage must be done quickly to halt financial disintermediation or unravelling, and political processes take time to reach consensus.

One close call in the United States was that experienced by the Overseas Private Investment Corporation (OPIC) which would have had to pay out in losses far more than its reserves and foreseeable premium income when the Allende government in Chile took over a number of US-owned direct investments that had been insured against nationalization. To settle the potential claims on it, OPIC would have had to ask Congress for an appropriation. This would have opened up a highly politicized and exquisitely embarrassing debate on direct investment, who benefited from it and the appropriateness of governmental support for risky private enterprise. As it happened, the Allende government was overthrown and the nationalization decrees rescinded before it became finally necessary to pay the claims.

The lender of last resort in the domestic arena typically writes off the bad loans as far as the liquidated or bailed-out bank is concerned but may seek to work out the acquired assets for itself. The Bank of England in 1837 took over the three American so-called "W" banks it had rescued in 1836, but did not get their assets off its books until 1852 (Clapham, 1945, II, p. 157). Where a regional bank today sells

off a foreign loan to a manufacturer who invests the local-currency proceeds, there is a partial write-off by the bank and presumably an extended work-out by the direct investor.

When debtor countries overtly default, US banks with their loans on the books must write them off. If that should render the banks insolvent, they would be taken over by governmental authorities at some level — FDIC, a new RFC, or the Federal Reserve System. Under no circumstances would a major bank be allowed to fail today if it were thought that such failure would lead to a flight into hand-to-hand currency or foreign exchange. The result would be to inject US banking agencies into the process of trying to work out claims on foreign debtors. The political implications are not attractive.

In the circumstances, the US clear hope is that there will not be overt defaults, that US banks will continue to work out their foreign loans, lending more to keep debtor countries growing, writing off bad loans where inescapable, but not at a rate to render them bankrupt. The process looks trying. I suspect it is far more attractive than the alternatives.

References

Clapham, Sir John (1945), The Bank of England: A History , 2 vols, Cambridge: Cambridge University Press.

Hardach, G. (1984), "Banking and Industry in Germany in the Interwar Period, 1919-1939," Journal of European Economic History , vol. 13, no. 2 (special issue), pp. 203-34.

Irmler, Heinrich (1976), "Bankenkrise und Vollbeschäftigungspolitik (1931-1936)," in Bundesbank, ed., Währung und Wirtschaft in Deutschland , Frankfurt am Main: Fritz Knapp.

Keynes, John Maynard (1919), The Economic Consequences of the Peace , London: Macmillan.

Kindleberger, Charles P. (1953), International Economics , Homewood, Ill.: Richard D. Irwin.

Moreau, Emile (1954), Souvenirs d'un gouveneur de la Banque de France: Histoire de la stabilization du franc (1926-1928) , Paris: Editions Génin.

Olson, Mancur (1982), The Rise and Decline of Nations: Economic Growth, Stagflation and Social Rigidities , New Haven, Conn.: Yale University Press.

Strange, Susan (1976) International Monetary Relations , vol. 2 of Andrew Shonfield, ed., International Economic Relations of the Western World , New York: Oxford University Press.

Toniolo, Gianni (1980), L'economia dell' Italia fascista , Rome: Laterza.

Van der Wee, Herman and K. Tavernier (1975), La Banque Nationale de Belgique et l'histoire monétaire entre les deux guerres mondiales , Brussels.

13—
Exchange-Rate Changes and Ratchet Effects: A Historical Perspective^[*]

I have long complained that discussion of the great depression in the United States typically assigns no role whatsoever to the large exchange-rate changes, or to some small ones for that matter, that took place in the period. Two episodes are worth attention: first, the depreciation of the currencies of Argentina, Australia, New Zealand and Uruguay in 1929 and 1930; and second, appreciation of the dollar in the fall of 1931, generally characterized as the depreciation of sterling. I argue that both were seriously deflationary, and that in depression, depreciation is largely neutral while appreciation is deflationary. On the other hand, in the 1970s, appreciation was neutral and depreciation inflationary. In short, it can happen that fluctuating exchange rates affect international prices through a ratchet that works to accentuate inflation in a period of boom, and deflation in periods of depression. It can happen, too, that a change in exchange rates can raise prices partway in the depreciating currency, and lower them partway in appreciating, with no ratchet operating. Economic analysis that supposes that exchange-rate changes always operate in the same fashion, must be modified in the light of historical experience.

The first depression episode perhaps should be classified as a group of small exchange-rate changes rather than large. Shortly after the stockmarket crash of October 1929, first Argentina, then Australia, New Zealand and Uruguay either floated their currencies or depreciated them substantially. There was no direct connection with the stock

[*] A paper presented to a conference held at Brandeis University, December 4–6, 1987, and published in Stephan Gerlach and Peter Petri, eds, The Economics of the Dollar Cycle , Cambridge, Mass.: MIT Press, 1989.

market. These countries normally borrowed capital in London and New York, but had been unable to do so since the spring of 1928 when the stock-market boom began, when investors turned from foreign bonds to equities, and when interest rates rose in response to speculator demands for call money to buy stocks on margin. In the usual case, such a cut-off of long-term borrowing induces a shift to short money, and this response took place in Germany. It happened, however, that the London capital market worked somewhat differently with respect to the dominions and such favored borrowers as Argentina. These countries typically ran substantial bank overdrafts which built up as the deficit on current account ran along and were paid down with the proceeds of long-term borrowing when the lending banks considered that the overdraft was reaching an appropriate limit. When long-term lending was cut off in 1928, the borrowing needed to reduce or wipe out the overdraft was impossible. Given the reluctance of the London banks to enlarge the overdrafts, the central banks of these "regions of recent settlement," as they were called in League of Nations publications, had no choice but to let their currencies depreciate. The fact that this occurred after the stock-market collapse in October 1929 is fortuitous, although if the central banks had been able to hold on a little longer, the recovery of interest rates in New York and London might have enabled long-term debt to be sold in the spring of 1930, when foreign-bond markets briefly recovered and in fact hit new highs. As it happened, Argentina let the peso go in December 1929 and the other three currencies began to depreciate in the first quarter of 1930.

The depreciations of the Argentinian and Uruguayan pesos, and of the Australian and New Zealand pounds are usually thought of in terms of the stated currencies, but can be regarded as a small appreciation of the US and Canadian dollars. They had the effect of softening world prices in dollars for wheat and wool, and the sterling price of butter in London. The price of wheat fell from $1.50 a bushel in June 1929 to $1.05 in June 1930 — and New Zealand butter from 157.0 shillings per hundredweight in London in February 1930 to 135.2 shillings in April of the same year. Both price declines were well in excess of the percentage of depreciation — close to 5 percent at this early stage — commodity prices were generally soft and the appreciation of the US and Canadian dollars and of sterling in terms of the currencies that dominated wheat, wool, and butter markets gave these commodities a push against which resistance was weak.

It should be noted that wheat had not been strikingly affected by the spreading deflation from the stock market to commodities imported into New York that was a serious cause of deflation early in the depression. Wholesale prices fell between August 1929 and September 1930 by 22

percent in Japan, 16 percent in Canada, 15 percent in Great Britain, 14 percent it Italy, and 12 percent in the United States and Germany. I ascribe much of this to the liquidity squeeze of New York banks as they struggled in the crash to meet the consequences of the decline in stock prices for brokers' loans and stopped lending elsewhere. At that time, commodities exported to the United States, and especially to New York, were for the large part shipped on consignment to be sold on arrival to brokers who operated with credit. If credit seized up, the brokers who could not get their usual loans could not undertake their normal buying. The prices of import commodities traded in this way fell between September and December 1929 by as much as 26 percent in rubber, 18 percent in hides, 17 percent in zinc, 15 percent in cocoa, 13 percent in coffee, 10 percent in tin and silk, and 9 percent in copper and lead. An import commodity normally financed by the processing corporation in the United States, sugar, fell only 7 percent, and the export commodity, wheat, only 4 percent over these months. Overall, to be sure, the liquidity squeeze emanating from the stock market was far more important in depressing commodity prices than the limited effective appreciation of the dollars of Canada and the United States, and of sterling. They none the less added a small push against an open door.

Of much greater importance was the appreciation of the dollar and the gold bloc (depreciation of sterling and the sterling bloc) in September 1931. The sterling rate went from $4.86 on September 20 to $3.25 in December at the high for the dollar, a decline for sterling of 30 percent, or an appreciation of the dollar (and gold) of close to 40 percent. Prices did not rise in sterling, but fell in dollars and French francs. Measured from September 1931 to March 1932, prices of internationally traded commodities expressed in dollars behaved as shown in Table 13.1.

Whether prices rise in the depreciating country or fall in the appreciating when substantial change occurs in exchange rates, or fall in between, with some rise in the depreciating and some fall in the

appreciating currencies, depends, of course, on the elasticities. The normal classical assumption of elasticity optimism is that a country is a price-taker for imports and a price-maker in exports, so that the terms of trade go against it when its currency is depreciated. The ultra-classical assumption of such an economist an Frank Graham is that a country is a price-taker for both imports and exports and that an exchange-rate change will leave prices in foreign exchange, and the terms of trade, unchanged. In the British case, however, the terms of trade improved with depreciation — an anti-classical outcome — as Britain in world depression was more of a price-maker in imports, the world depending on its market for primary products more than it depended on world markets for its manufactured exports. It is noteworthy that the elasticities are partly associated with the nature of the commodities concerned, but also very much affected by the state of world markets, whether they are poised on the edge of deflation which makes elasticities of both demand and supply low for price decreases (and high for price increases which were not involved).

It can be argued that the spread between dollar and gold prices, on the one hand, and sterling prices, on the other, was achieved more or less by a part rise in sterling and part decline in dollars and gold. A chart of Australian export prices in Kindleberger (1986, p. 86) shows Australian export prices rising in sterling and Australian currency at the end of 1931, falling in dollars. But the Australian commodities, wheat and wool, behaved differently from the bulk of primary product prices in Table 13.1. The large number of prices falling 23 to 34 percent in dollars makes the case for the ratchet on the down side in depression.

There is something of a mystery why United States prices turned up with the depreciation of the dollar in the spring of 1933, with sterling and gold prices steady rather than pushed further down. In this instance the exogenous depreciation of the exchange rate lifted an index of internationally-traded commodities (Moody's) and of the Dow Jones industrial stock price index at a time when the world economy had not recovered very far from the lows of June 1932. Some commodities doubled in price from March 1933 to June — corn and rubber for example, one an export and the other an import commodity. Hides went from 5.2 cents a pound to 12.2 cents, a rise of 135 percent, as the dollar went from $3.40 to the pound sterling to $4.80. The depreciation was undertaken in response to the Warren and Pearson (1933) study of the relationship between commodity prices and the agio on gold in the greenback period from 1863 to 1879, when again US prices varied with the rate of depreciation and world prices held steady. At that time, however, the United States was much less of a dominant power in the world economy than in 1933.

I lack a satisfactory explanation why British prices held steady when sterling depreciated in 1931 while US prices rose and world prices remained unchanged when the dollar depreciated two years later. One could hypothesize that the world economy had hit bottom via the investment multiplier with gross investment close to zero and net investment strongly negative. It would be hard to claim that the United States was more a price-taker in internationally-traded goods than Britain, although this explanation is probably valid for the period after the Civil War.

Some part of the explanation may lie in the fact that the US exchange rate at par was strongly overvalued — certainly against sterling and the yen — and that letting the exchange rate go lifted a deflationary pressure. Ragnar Nurkse (1949) once wrote that the United States was wrong to depreciate the dollar when the US current account in the balance of payments was in surplus. In early Keynesian analysis it was thought that if a country had a surplus, it meant that its foreign trade was giving a positive stimulus to national income and that it would be a beggar-thy-neighbor type of policy to depreciate. These strictures clearly applied in the 1930s to Japan, which consciously adopted policies of depreciating to undervalued rates to export its unemployment. In the US case, however, it can be argued against Nurkse that the dollar rate had been overvalued, but that the declines in national income and in imports through the national income multiplier were so severe that imports fell more than exports and produced a residual export surplus, with no implication that the exchange rate was undervalued. Depreciation, in other words, relieved strong deflationary pressure on income and prices from the foreign-trade sector, and imparted an upward pressure to prices. But this and other explanations are very much ad hoc , and the divergent behavior in prices between Britain in 1931 and the United States in 1933 remains to be understood.

If we leave aside the 1933 case of the US dollar, it can be said that depreciation in the 1930s left domestic prices in the depreciating country relatively unchanged and put strong downward pressure on prices in those countries where the currency appreciated, producing a ratchet in which an exchange rate that went up and down could be expected to produce a net decline in prices. The ratchet in the 1970s, on the other hand, moved in the opposite direction. If depreciation raises domestic prices and appreciation leaves them unchanged, a currency moving sinusoidally down and up will find prices raised on balance. This is what happened during the 1970s, starting with the depreciation of the dollar in 1971 and the adoption of floating in 1973. Dollar prices rose when the dollar depreciated, and remained unchanged when the dollar recovered.

The ratchet worked in the 1970s on the whole as a market pheno-

menon, based on the circumstance that the world economy operated as a sellers' market, as contrasted with the 1930s when there was a buyers' market. The 1970s were poised on the edge of inflation, whereas the 1930s were strongly deflationary. But the model can be seen with conscious direction behind it if one looks at the Organization of Petroleum Exporting Countries (OPEC) and the price of oil.

Figure 13.1
World-market commodity prices, oil and non-oil, 
compared with the effective exchange rate for the dollar, 
1972–82. (Source: Bank of International Settlements (1982, pp. 40 and 42.)

In November 1973, at the time of the Yom Kippur War, the Arabian members of OPEC embargoed all oil exports to the United States and the Netherlands, which were deemed to be partial to Israel, and reduced all other exports by 25 percent. The price rose sharply to $20 per barrel before settling down at $10. Thereafter if the dollar depreciated, OPEC raised the price in dollars to maintain it in other currencies, such as the Deutschmark, sterling, and the yen. But if the dollar appreciated, the dollar price of Arabian crude was left unchanged, while prices in other currencies necessarily rose as these currencies depreciated against the dollar. The ratchet worked intermittently and with varying degrees of timing. Figure 13.1 shows the two oil shocks of 1973 and 1979 and the inching up of the dollar price of Arabian crude between those episodes when the effective exchange rate for the dollar rose in 1975 and 1978, with no decline in 1974 or 1976 when the dollar fell. The ratchet is much less clearly seen in non-oil prices during the decade: the effective exchange rate for the dollar, measured as a percentage change over four quarters, moves in a sine wave up and down, while world non-oil commodity prices exhibit for the most part price increases over 12 months, except in the recession of 1974 and in 1978.

The belief that prices in general, traded-goods prices and exchange rates behave differently in relation to one another, depending upon whether economic conditions are inflationary or deflationary, has an analogue in the operation of Gresham's law. Most economists summarize Gresham's law as bad money drives out good, i.e. that people spend bad or overvalued money and hoard, melt down or export good or undervalued money. Roland Vaubel's (1977) recommendation of parallel currencies rules out this possibility on the ground that good money may drive out bad. In his opinion, sellers will demand good money and refuse to take money that has been overissued or otherwise become overvalued. The possibility must be admitted. In a study of mints in Spain and France at the beginning of this millennium, Thomas Bisson (1979) cites a case of mints competing to have their coinage accepted and circulated and mints with full-weight coins succeeding over those which issued coins underweight. The usual formulation of Gresham's law as bad money drives out good rests on the belief that the choice of which money is spent rests with the buyer, not the seller, and implies a background of buyers' markets dominating over sellers'. The issue may be complicated in particular cases by laws governing legal tender, money which the law decrees has to be accepted in payment of debts. The general point, however, is that in the circulation of money, as in the relationship between domestic prices and exchange rates, outcomes may depend upon particular circumstances, in the instant cases whether buyers' or sellers' markets prevail.

This brings us to the present. The price of oil collapsed at the end of 1986 as the cartel proved to be unable to agree on sharing production cuts during stable phases of the Iran–Iraq war. The Federal Reserve undertook tight monetary policy from 1982, leading to high interest rates, capital inflow and an appreciation of the dollar that continued unexpectedly, in view of the fundamentals — a substantial budget deficit and a substantial trade deficit — to February 1985. The appreciation of the dollar may have held back inflation in the United States, but it did not lead to deflation. United States prices declined to the end of 1982, rose mildly through mid-1984 and then declined again. Prices in the Federal Republic of Germany rose substantially while the Deutschmark was depreciating in 1983, held steady during 1984, and came down again as the Deutschmark appreciated after February 1985. West German prices seem to have moved up during Deutschmark depreciation and down during appreciation, with US prices relatively steady. There was no ratchet such as took place on the upside during the 1970s or the downside in the 1930s. The historical analysis seems not to have applied, probably because world prices were slipping consistently during the 1980s until early 1987. Commodity schemes such as that for tin and coffee collapsed. The Green revolution and the policies of the European Community in agriculture depressed world food prices. Such a commodity as copper was hurt by the development of optic fibers. With Third World and other primary product prices falling, depreciation of the Deutschmark to 1985 and of the dollar thereafter did not produce the inflationary conditions of the 1970s.

Before the stock-market decline in October 1987, there were signs that this was changing. Raw material prices rose substantially in many commodities from the fall of 1986 or the early months of 1987 through September. There was fear that if the dollar depreciated still further, it would be highly inflationary, perhaps restoring the ratchet of the 1970s on the up side. The stock-market crash of October 1987 seems to have differed from that of 1929, as I write, in that the liquidity squeeze in the stock market has not been communicated to commodities. Not only has the ratchet model of the 1930s and the 1970s been suspended, but the connection between share prices and commodity prices that played a major role in the 1929 depression is out of action — thus far — as well.

This experience leads me once again to emphasize that in the real world it is necessary to change models frequently. As economists we are trained to look for models which are general, and to distrust ad hoc explanations. At the same time, it is vital to recognize that differences in the initial conditions may require changes of models from those that have functioned well on earlier occasions.

References

Bank for International Settlements (1982), Fifty-second Annual Report, 1st April 1981 to 31st March 1982 , Basle.

Bisson, Thomas N. (1979), Conservation of Coinage, Monetary Exploitation and Restraint in France, Catalonia and Aragon , c.1000-1125 A.D. , Oxford: Clarendon Press.

Kindleberger, Charles P. (1986), The World in Depression, 1929-1939 , revised edn, Berkeley: University of California Press.

Nurkse, Ragnar (1949), "Balance-of-Payments Equilibrium," in American Economic Association, Readings in the Theory of International Trade , Philadelphia: Blakiston, pp. 1-25.

Vaubel, Roland (1977), "Free Currency Competition," Weltwirtschaftliches Archiv , vol. 113, no. 3, pp. 435-59.

Warren, George F. and Frank A. Pearson (1933), Prices , New York: Wiley.

14—
The Panic of 1873^[*]

The panic of 1873 fits somewhat uneasily into a discussion on crashes in the American stock market. In the first place, the panic was international, as many others including those of 1890, 1929 and 1987, have been. The title of this paper might properly be called "The panics of 1873," since there were panics in Vienna and Berlin, as well as in New York. Secondly, the United States end of the troubles was felt in the bond market, more than that for equities, and even in the market for urban building sites, especially in Chicago. These differences or extensions, do not seem to me to be sufficient reason to abandon the study. The panics of 1873, 1890 and 1929 are of particular interest for their international character and because each was followed by fairly deep depression on a global scale. That of 1873 is thus worth reexamination.

The international connections of the crash are of particular interest. National observers repeatedly insist that financial crises within their borders are of purely local origins and consequences. This has been claimed especially for the Overend, Gurney failure in London, and the corso forzoso (forced circulation or abandonment of the silver standard) in Italy, both of 1866, on the one hand, and for the 1890 Baring crisis and its 1893 aftermath in London, Argentina, Turin, Melbourne, New York, and probably also Johannesburg, on the other. The connections among Vienna, Berlin, Frankfurt and New York in 1873 were more

[*] Paper prepared for a Conference on Financial Panics held on October 19, 1988 at the Salomon Brothers Center for the Study of Financial Institutions, New York University, first published in 1990 in Crashes and Panics in Historical Perspective , a Salomon Brothers Center Book.

readily recognized (except by Emden, 1938, p. 183, who claims the Jay Cooke failure to be independent of the Viennese Krach ). Friedman and Schwartz (1963) insist that the 1920–1 and 1929 stock-market crashes originated solely in the United States, pointing to the gold inflows of the periods as proof. But connections between financial markets and macro-economies extend beyond those running solely through money flows. Booms and busts can both be spread by money movements, to be sure, but also by arbitrage in internationally-traded commodities and securities, through the foreign-trade multiplier connecting incomes in two countries through trade between them, and especially by psychological responses in one or more markets to trouble in another. The market (or markets) that follows marks down its prices along with prices in the originating one, shifting both demand and supply curves, if one needs to think in those terms, without transactions between the markets necessarily taking place. Especially of relevance to 1873, one market may precipitate a recession, a depression and even a crash in another by halting lending to it at a time when the earlier recipient had come to depend on a regular inflow. The events of 1873 provide a striking example of a dictum of R.C.O. Matthews (1954, p. 69), applied by him to 1836–9, in the question whether the trouble started in Britain or in the United States: "It is futile to draw any hard-and-fast rule assigning to either country causal primacy in the cycle as a whole or its individual phases."

I start with a model which is perhaps familiar to those who know my book Manias, Panics and Crashes: A Study of Financial Crises (1989). There is a "displacement" or autonomous event or shock that changes investment opportunities. Some old lines of investment may be closed down, but especially some new are opened up. Prices in the new lines rise. Gains are made. More investment follows. The process can cumulate, accelerate, pick up speed, become euphoric, and verge on irrationality. To quote from the Chicago Tribune of April 13, 1890, on the contemporary land boom:

In the ruin of all collapsed booms is to be found the work of men who bought property at prices they knew perfectly well were fictitious, but who were willing to pay such prices simply because they knew that some still greater fool could be depended on to take the property off their hands and leave them with a profit. (Quoted in Hoyt 1933, p. 165)

A stage of "overtrading" or "overshooting" equilibrium levels may be reached. After a time, expectations of continued price rises in the asset weakens and may even be reversed. The period in which expectations are weakening is known as "distress." The expectations that had led to a crescendo of movement out of liquid assets such as money into long-

term or equity assets reverse themselves, gradually or precipitously. If the reversal is precipitous, there is a crash and perhaps a panic.

In this history of manic episodes followed by market collapse it is often clear what the displacement was. The period leading up to 1873, on the other hand, had a great many, making it difficult to rank them in importance. In chronological order they were:

1. The end of the Civil War in the United States.

2. The Prussian—Austrian war of 1866.

3. The Overend, Gurney crash in Britain, again in 1866.

4. The Wunderharvest in wheat in Austria in 1867, a year when the rest of Europe experienced short crops, that gave a life to Austrian railroad traffic and exports.

5. The opening of the Suez canal in 1869.

6. The Franco-Prussian War of 1870–1.

7. The astounding success of the Thier rentes , issued in 1871 and 1872 to recycle the 5-billion-franc indemnity paid by France to Prussia.

8. The Chicago fire of October 1871.

9. The mistake of German monetary authorities in paying out gold coins minted from a portion of the indemnity payment before the silver coins to be withdrawn had been retired.

10. Relaxation of German banking laws.

There were also a number of lesser but still disturbing events:

11. The Crédit Mobilier scandal in the finance of the Erie and Union Pacific railroads.

12. The US claims against Britain for having outfitted and supported the Confederate naval vessel Alabama that preyed on Northern shipping.

13. The Granger movement in the West with farm groups fighting the expanding railroads regarded as avaricious monopolies by legislating limits on the rates charged for handling, storing, and shipping farm products.

Of particular importance in the relations between Europe and the United States was that different countries in Europe participated in the boom at its height in 1872–3 in varying degrees. France was relatively depressed as it sought to raise a portion of the indemnity through taxation. Britain had already been through a railway mania in 1847, with a moderated reprise in 1857, so that it was not caught up in domestic-investment euphoria in the same way as Germany, Austria and Hungary. Moreover, it had just experienced the Overend, Gurney panic of 1866, largely associated with foreign investment in the Mediterranean, especially Egypt and Greece, and in shipping, and was in consequence

wary of investment excitement. Britain functioned in fact to a degree as a balance wheel between central Europe and the United States, absorbing US government and railroad bonds sold by German investors to acquire funds for investment at home (Simon, 1979, pp. 101, 127, 145), and fine-tuning the short-term capital market as the French indemnity transfer took place to a large extent through sterling bills. It did so by frequent changes of the Bank of England discount rate – 24 in 1873 alone.

Foremost among the displacements in 1871–2 in Europe was the payment of the 5-billion-franc indemnity of France to Prussia which the latter shared with other German states as the Reich was founded. Significant monetary changes followed from the payment of 512 million francs in gold and silver, plus the drawing of gold from London with sterling exchange. This part of the payment was connected with German monetary reform, the adoption of the gold standard, and the expansion of the money supply through the issuance of gold coin before calling in the silver, widely noted as a mistake (Åkerman, 1957, p. 341; Wirth, 1968, pp. 456–8; Zucker, 1975, pp. 68–9). In three years the circulation of thalers, later renamed marks, tripled from 254 millions to 762 million (Wirth, 1968, p. 438).

The bulk of the rest of the indemnity was paid off by September 1873 recycling. The French raised two massive bond issues at home (the Thier rentes ) in June 1871 and July 1872 that were subscribed to by French investors, some of whom sold their European securities to acquire the money to do so, and by investors, banks and speculators all over Europe. The real transfer occurred later as French investors reconstituted their portfolios of foreign securities, and foreign purchasers of the rentes sold them to take their profit and repatriated the funds.

The proceeds of the indemnity in Germany were used to pay off the debts of the German states, debts both at home and abroad. One billion marks of German state securities were estimated to have been held in Austria and the redemption of this amount led to a new boom in Austrian railroads. The Austrian railroad system had already been expanded by 16 percent in mileage and 38 percent in traffic between 1864 and 1867, the latter largely the result of the Wunderharvest . The liquidation of German securities led Austrian investors to a new wave of railroad investment that spread to the related industries of iron and steel and rolling stock, and especially to a major expansion in financial institutions, both general banks and a specialized type, the Maklerbank or broker's bank, which loaned to purchasers of securities.

In Germany itself there was a boom in banking, in railroads, and especially in construction. The formation of the Reich with Berlin as its capital attracted large numbers of people to that city and, in due course,

banks that had originated in other places. Along with mixed banks like the Deutsche Bank, formed in 1872 to compete with London in the finance of German foreign trade but inevitably drawn into domestic lending by the boom, there was created a class of so-called Baubanken , or construction banks, that ostensibly financed building but more than anything else financed speculation in building sites. A class of millionaire peasants developed that sold their farm land in the periphery of cities, especially Berlin, and so-called "tent-cities" were built, along with barracks to accommodate the workers that poured in. Rents in Berlin doubled and trebled in a short time, and calculable reality gave way to fantasy (Pinner, 1937, pp. 202–4). Among the foremost of the Baubanken was one Quistorpische Vereins-Bank of Berlin, with 29 subsidiaries in the field of real estate, construction and transport. Its shares went from 191 marks on April 1, 1873, to 25 1/2 marks the following October 10 (ibid, p. 205; Oelssner, 1953, p. 257). After paying out dividends of 20, 30 or 40 percent per annum in 1872 the prices of Baubanken shares fell after September 1873 to 50, 20, 10 or 5 percent of nominal capital (Pinner, 1937, p. 203). In the early years Berlin was called "Chicago on the [River] Spree" (Stern, 1977, p. 161). (I come later to the 1873 real-estate boom in Chicago, the third of five in a century, which evokes Chicago as the standard of real-estate manias (Hoyt, 1933)).

The period from 1871 to 1873 is called the Gründerzeit . For a time I thought this term derived from the founding of the German Reich, as in Reichgründungszeit (Böhme, 1966). It refers, however, to the founding of companies, companies of all kinds but especially of banks (Good, 1984, p. 164). In Austria 1,005 companies with a nominal capital of 5,560 million gulden were chartered between 1867 and 1873, including 175 banks with a nominal capital of 1.4 billion gulden, and 604 industrial firms with nominal capital of 1,337 millions. Many of these never got started, and only 516 with a nominal capital of 1,555 million gulden survived to 1874. In North Germany 265 companies with a nominal capital of 1.2 billion marks were founded in 1871; in Prussia, which made up most of North Germany, 481 firms with a capital of 1.5 billion marks were chartered in 1872, followed in 1873 by 196 companies with a nominal capital of 166 million thalers (Wirth, 1968, pp. 466–71). The data are partial and incomparable. Detailed data for Prussia in 1872 include 49 "Banks and credit institutions," with 345 million marks in capital, and 61 Baubanken with a capital of 227 million.

The boom in the new Reich and in Austria had the usual characteristics: widespread participation in speculative investments; service of distinguished names — largely of nobility — as members of company boards as shills to engender investor confidence; swindles of all kinds.

Wirth (1968, pp. 502–9) observes that there was an epidemic desire to become rich, and that the easy credibility of the public was never greater in any epoch. To get high returns many people "would throw their money out the window." Edmund Lasker, a member of the Prussian House of Delegates from Magdeburg, called attention in February 1873 to a series of scandals in railroad and financing involving German nobility, most notably the Arnim affair, "the most celebrated scandal of the 1870s," involving a professional ambassador to France at the time of the indemnity who was accused of arranging his negotiations so as to affect the stock market in which he had a position. Lasker also denounced collusion in the manipulation of securities between railroad promoters and officials of the Ministry of Commerce (Stern, 1977, pp. 234–42).

Distress appeared in the late summer and early fall of 1872. Wirth (1968, p. 508) observed that the bow was stretched so taut in the fall of 1872 that it threatened to snap. In Austria trade and speculation had been triumphant in 1871 and most of 1872 but at the first sign of trouble railroad securities receded into the background and more speculative bank, construction and industrial companies moved to the foreground. Already in the second half of 1872 textile firms found themselves in difficulty.

In the fall of 1872 the magic word, according to März (1968, p. 172), was the Weltaustellung (World Exhibition) to open on May 1, 1873, in Vienna to celebrate the twenty-fifth anniversary of the accession to the imperial throne of Francis Joseph. Hotels, cafés and places of amusement were built in abundance for the Exhibition which was expected to attract hundreds of thousands of people from all over Europe and to promote widespread prosperity. These hopes were widely exaggerated.

The Creditanstalt pulled back from participation in the market to ready itself to provide help if it were needed (ibid., pp. 177–8) — an action of a major bank getting ready to serve as a lender of next-to-last resort, and paralleling other action by money-center banks at other times, especially the largest New York banks under the National Bank Act (Sprague, 1968, pp. 15, 95, 147, 153, 230, 236–7, 239, 253, 273–4; summarized in Kindleberger, 1989, pp. 188–90), and the action of the New York banks in the spring of 1929 in cutting down brokers' loans to prepare to fill in for "out-of-town banks" and "others" when they withdrew in crisis (Kindleberger, 1986, Table 9, p. 100). Stock-market near-panic broke out in the fall of 1872, and again on April 10, 1873, but the market held on, waiting for the deus ex machina sought in the opening of the Exhibition (Wirth, 1968, p. 519). This period of distress has been called "a silent moratorium" (ibid., p. 508). On May 1, 1873, the Exhibition duly opened. No brilliant success was evident for the first

week and on May 9 the stock market collapsed, one of a series of Black Fridays.

Berlin hung on until September 1873 when it collapsed simultaneously with the failure of Jay Cooke and Co. in Philadelphia and the closing of the New York Stock Exchange. Baubanken continued to lend; prices to rise. The wholesale price level rose from 107 in 1870 (1880 = 100) to 133 in 1872 and 141 in 1873. For industrial materials alone the price level went from 121 in 1870 to 159 in 1872 and 167 in 1873 (by 1879 the two indexes had fallen to 93 and 95, respectively) (Jacobs and Richter, 1935, p. 81). Wirth (1968, p. 513) observed that the writing on the wall should have been clear to all after the revelation of the scandals of Strousberg in 1872, the failure of the Deschauer Bank in Munich, and the Lasker speech of February 1873, but capital continued to be withdrawn from the solid paper of the Reich to be invested in new ventures. Interest rates tightened. In September the bourse collapsed.

The financial crises in Austria and Germany were primarily asset-market phenomena with little or nothing to do with constriction of the money supply (ibid., p. 515). Money in circulation in Austria rose slightly in the second quarter of 1873 (ibid., p. 537). The course of the money supply in Germany in 1873 is too difficult to pin down. Reichsbank figures for gold reserves and circulation do not begin until 1876 (Deutsche Bundesbank, 1976, Sections A and B.1). In 1870, before the founding of the Reichsbank in 1875, there were 38 banks of issue, with notes in circulation rising from 300 million thaler in that year to 450 million in 1872 (Zucker, 1975, p. 78). As already noted, coins in circulation rose from 250 million to three times that amount between 1870 and September 1873. When the last payment on the French indemnity had been paid on September 5, 1873, it is true, the foreign exchanges turned against Germany and it lost several hundred million marks in a few months, says Wirth (1968, p. 459), because Berlin was the dearest city in the world. How much of this occurred before the stock-market crash of September 15 is not evident, but the accounts place no stress on the gold outflow as a precipitant of the collapse. As in Austria, there was no remarkable internal drain.

The relevance of this negative information is to Anna Schwartz's (1986) attempted distinction between "real" and "pseudo" financial crises, echoed by Michael Bordo (1987, p. 3), who calls the former "true" financial crises. Real or true financial crises have bank panics that produce runs out of ordinary money into high-powered money such as bank notes, or, in the circumstances of the development of banking at the time, gold coin. Pseudo-crises do not have such drains. Both Schwartz and Bordo are convinced monetarists, and seem to need to fit financial crises into a monetarist framework. It is not clear that they get

much support from the central European crisis of 1873. Bordo's (1987, pp. 2–3) agreement with Schwartz seems a little forced since a reduction in the money supply is sixth in his list of ten elements of a financial crisis, following behind, presumably in the order of importance although possibly chronologically, a change in expectations, fear of insolvency of financial institutions, attempts to convert real and/or illiquid assets into money, threats to the solvency of commercial banks and other financial institutions, and bank runs.^[1] The crises in Germany, Austria (and the United States) seemed real to contemporaries, conformed to Bordo's elements and Goldsmith's definition, and produced a depression lasting to 1879, even though on Schwartz's monetarist definition it would have to be scored as a pseudo-crisis.

The theme of my work on the 1930s and on financial crises generally is that when there is no lender of last resort to halt the collapse of banking institutions they lead to extended depression (Kindleberger, 1986, ch. 14; 1989, ch. 10). In 1931 the lenders of last resort, the United States and France, were too little and too late. In the 1890 Baring crisis, the position was belatedly saved by the rapidly-rising production of gold in South Africa, but only after financial crises in Australia and the United States in 1893 and a depression that extended to 1896. In 1873, a feeble effort was made to staunch the wound to the financial system in Austria: a support fund (Aushilfsfond ) of 20 million gulden was established, with the national bank contributing 5 million, the state 3 million and the Creditanstalt 2 million to be lent on solid securities. Suspension of the Bank Act, on the analogy of Bank of England action in 1847, 1857 and 1866, was discussed on Sunday, May 11, 1873, and put into effect the next day, but the limit to the issuance of uncovered gulden notes was set at 100 million, a limit that violated the Bagehot prescription that the lender of last resort should lend freely. März (1968, p. 179) comments that the suspension of the Bank Act was awkward in meeting the needs of the moment because the crisis was due to overproduction, not to a scarcity of money.

Money shrank after Black Friday. In October, following the German crash, it became apparent that the Bodenkreditanstalt and its associated banks were in trouble. This time the government helped on a more generous scale because much of the lending by the group had been on domain lands (owned by the emperor) and was regarded abroad as equivalent to government debt. März (1968, p. 181) hints that the greater governmental energy in saving this banking group may have been the consequence of the felt need to protect highly-placed persons who had gambled with the Bankverein's money (ibid., p. 181). The lender-of-last resort function tends as a rule to raise the insider — outsider problem of who should be saved, an inescapable political aspect.

In a passage that evokes the plight of the thrift institutions in

California and the southwest United States today, März (1968, p. 179) observes that the Creditanstalt tried (in vain) to rescue the Baubanken , including among its tools the device of merging them.

Lender-of-last-resort steps in Germany were virtually excluded by the transitions getting under way from the thirty-odd principalities and free cities to the Reich, from 38 banks of issue — although only one of them, the Prussian National Bank, was of any size — to the Reichsbank which opened its doors in 1876. There was also the clumsily handled transition from bimetalism to the gold standard. Transitions, it is generally recognized, make decisive action in crises difficult. In the great depression in the United States there were three such, from the monetary leadership of the Federal Reserve Bank of New York to that of the Federal Reserve Board in Washington, from the retiring president, Herbert Hoover, to Roosevelt who was elected in November 1932 but took office only six months later, and from the international economic leadership of Britain, which yielded it in the summer of 1932, to that of the United States which picked up the burden piecemeal between 1936 and perhaps the Lend-Lease Act of 1941 or the Marshall Plan of 1947. In addition to the major transitions in Germany, there were financial innovations that confused matters — continuous legislation with regard to coinage, the retirement of small notes and of foreign coins (Borchardt, 1976, pp. 6ff.), and financial deregulation which stimulated the formation of the Baubanken . Innovation in banking tends to be underpriced, according to the Cross Report (Bank for International Settlements, 1986, ch. 10), and to lead to what Adam Smith and the classical economists call "overtrading." The German economy was suffused with vigor partly as a consequence of the founding of the German empire, and eventually pulled itself out of the slump. It is hard to find in the literature, however, a recognition of the role of the lender of last resort.

One tragic aspect of the German depression from 1873 to 1879 is that it turned German public opinion against liberalism (Lambi, 1963, ch. vi). Some observers attribute the shift of Bismarck's trade policy from one of low tariffs to the notorious tariff of rye and iron to this shift. Agriculture, in particular, had not been helped by the boom, except for peasants around cities, and was prepared to desert free trade when its exports gave way to import competition from new lands. In addition, the depression gave rise to a wave of anti-Semitism on the ground that Jewish speculators had been prominent among the beneficiaries on the boom, and among the swindlers (ibid., p. 84; Good, 1984, p. 163).

Connections between economic conditions in Germany and Austria and those in the United States went back to the end of the Civil War in 1865. Central Europe was depressed from 1866 to 1869, partly as a

result of the Prussian war against Austria, and this, combined with recovery in the United States, produced a large-scale movement of capital westward to New York from Cologne, Berlin and especially Frankfurt. Matthew Simon (1979) estimates the total capital inflow into the United States from June 1865 to June 1873 as roughly $1 billion, starting relatively slowly at about $100 million a year, picking up to $175 million in 1869 and reaching a peak of $259 million in 1872, before declining to $114 million in 1873 and $100 million in each of 1874 and 1875 (all fiscal years, ended June 30).

Most of this investment up to 1870 was in US government bonds issued during and after the war, notably the 5-20s (5 percent, 20-year bonds) issued in 1862, 1865 and 1867. Immediately after the war these bonds fell in price to very low levels and were bought speculatively. Later, as the US government ran sizable budget surpluses from 1866 to 1871 and reduced its gross debt from $2.7 billion at the end of fiscal 1865 to $2.3 billion six years later, and the gold agio declined from a high of 185 percent in 1865 to 25 percent in 1869–70 and 11 percent in 1874–5, there were assured opportunities for gain (Simon, 1979, pp. 34, 113). The flow from central Europe slowed down in 1866 with the Prussian attack on Austria, and again in July 1870 at the outbreak of the Franco-Prussian War. Panics such as Overend, Gurney and war scares produce two effects on capital movements, according to Simon (1979, p. 92): capital flight which stimulated the purchase of American securities; and building up cash on hand, "the liquidity motive," to be ready for any eventuality, that leads to selling foreign assets. Which motive dominates in a given situation may depend on other factors. From 1866 to 1869 depression in Europe resulted in a greater outflow than the mobilization of cash (ibid., p. 97). In 1870, however, the liquidity motive prevailed (ibid., p. 101). The rise in the prices of US government bonds and the possibilities of a boom in railroad also played a part in the earlier period, a pull as opposed to a push. In 1870 the disturbed market in Europe meant that the US Treasury's attempt to refinance outstanding debt by issuing $200 million of 10-5s, $300 million of 15-4 1/2s and $1 billion of 30-4s, resulted in failure (ibid., p. 105).

The proceeds of bonds sold by US investors to Europe or redeemed by the US government were largely invested in US railroads, pushing their way west. The railroad network expanded rapidly after the Civil War, from 35,000 miles at the end of 1865 to 53,000 miles five years later, and 70,500 miles at the end of 1873 (Bureau of Census, 1949, p. 200).

Jay Cooke and Co. got its financial start by a major innovation in the marketing of US war bonds in aggressive domestic sales campaigns designed to appeal to mass support rather than merely established

financial circles. His success did not make him a favorite of established bankers like Drexel in Philadelphia and Morgan in New York. Like the Pereire brothers in France who failed in 1868, he was an "active" banker, rather than a passive one like the Drexels, Morgans and Rothschilds in Paris (Gras, 1936, p. xi; Larson, 1936, pp. 86–7, 433). The financial history of the nineteenth century is sometimes written in terms of bankers' quarrels, and the distinction between active and passive bankers is echoed in the current controversy whether bankers lending to the Third World in the 1970s were "loan pushers" or "wall flowers, waiting to be asked to dance" (Darity and Horn, 1988).

Cooke's success in marketing US government bonds at home meant that he was late in moving in two other directions, in selling bonds abroad and in entering the market for railroad bonds. When he did move in the latter direction, the eastern railroads such as the Baltimore and Ohio banked by the Brown Brothers, the Chesapeake and Ohio by Alexander Brown, and the Pennsylvania by Drexel already had established connections, as did some newer lines — the Rock Island (Henry Clews), the Union Pacific (the Ciscos) and the Central Pacific (Fisk and Hatch) (Larson, 1936, pp. 245, 257). In addition the Central Pacific and the Union Pacific had governmental subsidies (ibid., p. 259). Like latecomers in many businesses, Jay Cooke was forced to take what was left over, and palpably more risky in his case, the Northern Pacific. This led westward from Duluth, Minnesota, through sparsely settled country. It was hoped to sell land from the abundant grant as the lines reached further west, though the terms would produce little cash, and to sell more bonds in the United States and in Germany as progress was made. Land offices were opened in Germany, Holland and Scandinavia in the hope of attracting settlers. But selling Northern Pacific bonds proved slow, especially when Missouri Pacific bonds through more settled territory were available at around $90 and Union Pacific at $84. European investors held US railroad bonds in considerable disrepute, especially after the Erie and Union Pacific Crédit Mobilier scandals of 1868 and 1872. Cooke failed to enlist the support in Europe of the Rothschilds or Bleichröder, and was forced to form a connection with a new house, Budge, Schill & Co. of Frankfurt. When the Franco-Prussian war broke out the prospect of selling Northern Pacific bonds in Germany evaporated.

Cooke had many other troubles: an absentee president of the line who incautiously bought supplies with cash well in advance of need rather than inducing suppliers to grant long credits or accept bonds. His brother Henry, who ran the Washington lobbying office, lived high and was a drain. Substantial investments in advertising and support of newspapers in Europe failed to pay off in the light of US railroad

scandals. Bit by bit, Jay Cooke and Co. found itself advancing capital to the Northern Pacific for construction. In the fall of 1872 the London partner, Fahnestock, observed that it was cruel to the depositors to use their money to support Northern Pacific bonds, and that the railroad should go to the market to borrow at any price. The near-panic in the market of September 1872 made this impossible. Both Northern Pacific and Southern Pacific pushed for Congressional subsidy of $40,000 a mile, but the scandals in Erie and the Union Pacific made Congress leery.

The scramble to keep Northern Pacific and Jay Cooke and Co. afloat lasted until September 1873, when the storm broke in the second week. The Granger movement in the West attacked railroad rates. Money was tight as funds were withdrawn from the East to finance an early heavy harvest. The New York Warehouse and Security Company suspended on September 8. Formed to lend on grain and other farm produce, like Jay Cooke it had been induced into lending to the Missouri, Kansas and Texas railroad. On September 13 the banking house Kenyon, Cox & Co. failed as a result of endorsing a note of the Canada Southern railroad for $1.5 million which the latter could not pay. Jay Cooke and Co. closed its doors on September 18, and Fisk and Hatch the next day (Black Friday), followed by the Union Trust Company and the National Bank of the Commonwealth on Saturday, September 20. The stock market was closed that day and remained so for ten days, a move later agreed to have been mistaken in so far as it induced a panic withdrawal of brokers' loans in October 1929 for fear of a closing of the exchange. The Commercial and Financial Chronicle of September 20, 1873, blamed the crash on the excessive tightness of the money market that prevailed without interruption from September 1872 to May 1873, making it impossible for railroad companies to borrow on bonds and leading several banking houses negotiating large railroad loans or intimately connected with the building of the roads to become responsible by endorsement of loans or by borrowing on call loans collateralized by railroad securities. "In this delicate situation, the equilibrium was liable to be violently disturbed" (quoted in Sprague, 1968, p. 36). The newspaper account makes no reference to the decline in foreign lending from Europe, but it is clear that the tightness of money rates in the market from September 1872 to the following May is associated with the decline in foreign funds.

The collapse of the bond and stock market in New York in September 1873 also put paid to the land boom in Chicago. Public participation in land buying, according to Hoyt (1933, p. 100), began about 1868 when many cases of large profits made in land since 1861 became common knowledge. In 1871 one writer claimed that every other man and every

fourth woman had an investment in lots. The Chicago fire of October 8, 1871 destroyed 17,450 of the 60,000 homes in the city, but the fire accentuated rather than slowed down the growth of the city, with a year of "hectic borrowing" from the East, and the spending of $40 million for new construction (ibid., p. 102). Population in a belt within three to five miles of the center grew from 8,000 in 1860 to 55,000 in 1870 and nearly 100,000 in 1873. Land prices went from $500 to $10,000 an acre between 1865 and 1873 in the fashionable residential area of the South Side, and some land near the village of Hyde Park from $100 an acre to $15,000 (ibid., pp. 107–9). The euphoric aspect of the boom and the dangerous position of land speculators in the summer of 1873 is described by Hoyt (1933, p. 117) in terms of

municipal extravagance, excessive outlays on magnificent business blocks built at high cost on borrowed money, lavish expenditure on street improvements in sections where they were not required, overextended subdivision activity, and a disproportionately large amount of real estate purchases on small down payments — all these had been the result of the extreme optimism of the times.

In the summer of 1873, the upward movement of land values stopped as a consequence of limited cash resources of prospective buyers as wages fell. Moreover, Hoyt (1933, ch. XIV) comments, as land values cease to rise the desire to purchase it falls off sharply as expectations of a fall replace those of a rise. There was a lull in activity from May to September 1873 when the Jay Cooke failure was make known, and then a collapse in land values and building prices.

At first on such occasions that occurred in 1837, 1857, 1873, 1893 and 1929, the stock-market crash shatters the hopes of gain, but has no other result. Debts contracted to purchase land or buildings are for a term, not on demand. There has been no short selling, and no forced liquidation. Owners of real estate, indeed, tend to congratulate themselves that they escaped more lightly than the owners of stocks or of defaulted bonds. There follows, however, a process of attrition (ibid., p. 400). The decline of industry lowers prices. Unemployment induces recent arrivals to return to the country. Gross income from rentals declines sharply, but expenses of interest and taxes remain the same. Landholders retain their ownership until the constant attrition of interest charges, taxes and penalties or the inability to renew mortgages brings foreclosures that squeeze out the equities above the mortgage. Hoyt (1933, pp. 119, 124) comments that it takes about four or five years to complete this process and thoroughly to deflate land values. The process often cripples banks. In Chicago in 1933, 163 out of 200 banks suspended, and a footnote (Hoyt, 1933, p. 401) observes that real estate

was the largest single factor in the failure of 4,800 banks in the period 1930–3.

It would be useful to have a comparable study of land values in Berlin and Vienna in the years after the crash of 1873. I call attention to the spread of deflation from the bond and stock market in New York to the market for real estate in Chicago, as it may furnish food for thought about the delayed effects of the October 19, 1987 decline in the stock market on the markets for office buildings, condominia, shopping malls, hotels and the like, including especially luxury housing. There is, of course, the major difference that real estate today has built-in lenders of last resort in the Federal Deposit Insurance Corporation and the Federal Savings and Loan Insurance Corporation, troubled as those institutions are.

References

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Borchardt, Knut (1976), "Währungs- und Finanzpolitik von der Reichsgründung bis zum 1. Weltkrieg," in Deutsche Bundesbank, Währung und Wirtschaft in Deutschland, 1876-1975 , Frankfurt am Main: Fritz Knapp.

Bordo, Michael D. (1987), "Financial Crises: Lessons from History," unpublished paper presented to the 5th Garderen Conference on International Finance, Erasmus Universiteit, Rotterdam.

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Darity, William Jr. and Bobbie L. Horn (1988), The Loan Pushers: The Role of Commercial Banks in the International Debt Crisis , Cambridge, Mass.: Ballinger.

Deutsche Bundesbank (1976), Deutsches Geld- und Bankwesen in Zahlen, 1876-1975 , Frankfurt am Main: Fritz Knapp.

Emden, Paul H. (1938), Money Powers of Europe of the Nineteenth and Twentieth Centuries , London: Sampson, Low, Marston & Co.

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Gras, N.S.B. (1936), "Editor's Introduction" to Henrietta M. Larson, Jay Cooke, Private Banker , Cambridge, Mass.: Harvard University Press.

Hoyt, Homer (1933), One Hundred Years of Land Values in Chicago: The Relationship of the Growth of Chicago to the Rise in Its Land Values, 1830-1933 , Chicago: University of Chicago Press.

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Larson, Henrietta M. (1936), Jay Cooke, Private Banker , Cambridge, Mass.: Harvard University Press.

März, Eduard (1968), Österreichische Industrie- und Bankpolitik in der Zeit Franz Joseph I. am Beispiel der k. k. priv. Österreischischen Creditanstalt für Handel und Gewerbe , Vienna: Europa.

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15—
Capital Flight: A Historical Perspective^[*]

It is difficult — perhaps impossible — to make a rigorous definition of capital flight for the purpose of devising policies to cope with it. Do we restrict cases to domestic capital sent abroad, or should foreign capital precipitously pulled out of a country be included? What about the capital that emigrants take with them, or send ahead of them, especially when the people involved are being persecuted — Huguenots from France following the revocation of the Edict of Nantes in 1685, noble émigrés after the French Revolution of 1789 and especially the Reign of Terror in 1793, German Jews or Jews in the countries neighboring Germany during the decade of National Socialism? Does it make a difference whether the emigration is likely to be permanent or temporary, to the extent that one can tell ex ante ? And what about the cases where there is no net export of capital, but capital is sent abroad to be returned to the country as foreign investment — French investors buying bonds of the Chemin de Fer du Nord issued in London in the 1840s (Platt, 1984, ch. 2), or Argentinian investors buying their country's own securities issued in London both before 1914 and in the 1920s? Is there a valid distinction to be made between capital that is expatriated on a long-term basis for fear of confiscatory taxation, and domestic speculation against the national currency through buying

[*] Published as Chapter 2 of Donald R. Lessard and John Williamson, eds, Capital Flight and Third World Debt , Washington, DC: Institute for International Economics, 1987, the proceeds of a conference held at the Institute in October 1986. The paper was written when I was a United Nations University scholar at the World Institute for Development Economic Research (WIDER) in Helsinki in the summer of 1986. I express gratitude to WIDER for their support, and to Carl-Ludwig Holtfrerich and Eric S. Schubert for helpful comments on an earlier draft.

foreign exchange that is ostensibly interested in short-term profits? The distinctions are elusive, and it is not clear how much they matter to the questions of how to prevent capital flight or to attract it back, except perhaps in the case of refugees escaping persecution who manage to take some or all of their capital with them.

In his article on capital flight at the depth of the great depression, Machlup (1932) left the inference that capital flight was unimportant provided that the monetary authorities pursued proper policies. If the authorities refused to accommodate the attempt to raise liquid funds at home, capital flight would raise interest rates, lower prices and start a transfer process automatically. Difficulty might be encountered if the funds were not invested abroad but hoarded, since transfer is assisted by expansion in the receiving country as well as contraction in the sending. Machlup recognized that the deflation in the sending country might have serious consequences in bank failures and the like, but at the time professed an Austrian view of macro-economic policy that blamed the troubles of any bank in difficulty from falling prices on its own misuse of credit.^[1]

I started to write this paper as a series of historical episodes, concentrating on the following cases:

France

• 1685 (and earlier) to 1700: revocation of the Edict of Nantes.

• 1720: safeguarding the profits of the Mississippi bubble.

• 1789–97: capital flight from the French Revolution, the assignats , and the Terror, and the return.

• French purchases of French bonds issued in London in the 1840s.

• The speculative attack against the franc in 1924 and the successful "squeeze."

• The 1926 Poincaré stabilization following the extreme depreciation of May–June 1926.

• The 1936 middle-class strike against the Front Populaire.

• The 1968 middle-class strike against the Accord de Grenelle.

• The 1981–2 middle-class strike against the Mitterrand socialist campaign of nationalization.

Italy

• 1866 and the onset of the corso forzoso that was finally halted in 1881.

• Foreign-exchange controls of the 1930s.

• The 1961–3 flight of banknotes smuggled into Switzerland, representing a middle-class strike against the nationalization of the electricity industry.

Germany

• The outflow of German capital during the hyperinflation of 1919–23.

• 1931 outflow leading to the Standstill Agreement.

• Foreign-exchange control with the death penalty for evasion in the 1930s.

Latin America

• Some comments on international financial intermediation through Latino purchases of bonds issued abroad for Latin American account.

• One or two comments on the present capital outflow.

After an extended false start, I changed to an analytical approach. Before presenting it in outline, I note that my background is in European financial history, and I lack all but the most superficial knowledge of Latin American capital flight. One should further observe that there are no English or Scandinavian episodes of an outstanding nature to draw on, despite speculation against sterling at various times through leads and lags and the purchase of Kaffirs in London and their sale in Johannesburg.

The analytical outline conforms to taxonomies of the means of capital escaping a country, on the one hand, and of measures to prevent it or entice it back, on the other. The outflow of flight capital can be financed by the following means:

• Outflow of specie, especially important regarding the Huguenots, safeguarding the profits on the Mississippi bubble, the émigrés of the French Revolution, and in the outflow from Italy in 1866.

• Real transfer, through deflation; through the export and sale of valuables or in hyperinflation short-circuiting the exchange market by shipping goods abroad directly and retaining the proceeds; and through exchange depreciation, particularly relevant to France in the 1920s.

• Various types of countervailing inflow, including: governmental borrowing abroad (the case where domestic investors subscribe to foreign issues of their government or major domestic borrowers may not qualify as capital flight, but in any event arises from somewhat similar motivation); loss of foreign-exchange reserves; central-bank borrowing; monetary constriction at home to raise interest rates and attract a capital inflow; depreciation of the currency, leading to foreign speculative purchases betting on revaluation; dumping of currency in foreign markets purchased by foreigners for speculation or use.

While these various means of financing a capital outflow are analytically distinct, they may, of course, occur together, either simultaneously or in

series. The price-specie-flow mechanism, for example, in principle starts with an outflow of specie that leads to deflation.

The taxonomy of measures to prevent capital flight or entice it back overlaps to some degree with the means of financing it. For example, deflation helps finance real transfer of capital exports, and at the same time, by making it more expensive, tends to cut it off. Again, the various measures are in many cases possible complements as well as substitutes.

The following alternatives are available to the country losing the capital:

• Ignore it. It sometimes pays to let a movement based upon a swing of sentiment burn out, holding various policies steady. This is especially relevant to the intermediation cases — the French buying bonds issued by french entities in London, or Argentinian investors buying Argentinian bonds issued abroad. The intermediary function of the foreign-bond underwriter often leads, after learning, to direct dealing.

• Deflate through monetary and fiscal measures to the extent possible within political constraints, and lengthen the term structure of government debt to lock in possible flight capital and entice that abroad back through high yields. The French government's inability to refund at long term the short bons de le défense nationale in the 1920s was the key weakness in its weaponry.

• Use exchange-rate policy, including: holding the rate, with own funds or swaps, or both; devalue to a credible rate and exhibit determination to hold it; with own or borrowed funds run the rate up to "squeeze" those with a short position, as in the 1924 French operation and the US dollar action of October 1978; impose exchange control with prohibitions or a multiple exchange-rate system, possibly with separate rates for the current and the capital accounts (though these are virtually impossible to operate even when backed by the death penalty, and certainly not without inspection of mail and regulation of credit terms on trade and service transactions that are difficult of public acceptance).

• Implement a monetary reform of sufficient scope and determination to win credibility, for example, the replacement of the mark by the Rentenmark and then the Reichsmark in 1923 and 1924.

Receiving countries have also sought to repel hot money from abroad by a variety of expedients:

• They may allow the currency to appreciate. The classic instance is the rise of the pound sterling to a high of well over $5.00 in 1936 to divert French capital from London to New York.

• They may set special reserve requirements against foreign bank deposits, a technique developed especially by Switzerland and the Federal Republic of Germany.

• They may threaten to report foreign owners of capital to their home governments. This is not only unattractive commercially, but is readily frustrated by the use of domestic nominees.

• The usual tactic is to ignore the influx and regard the problem as one for the authorities in the country from which the capital comes. In the "Golden Avalanche" of 1937, stimulated by the prospect of a reduction of the US gold price, the American authorities hung on, until the likelihood of a policy change vanished with the September recession.

• Other means of limiting inflows of capital through reporting mechanisms have been explored, especially in such cases as communications companies where foreign investment is limited by law (for example, ITT in the 1930s), or where the Securities and Exchange Commission (SEC) rules call for the identification of individual holders with more than 5 percent of the stock of a given company. Such regulations are difficult and probably impossible to apply generally.

Financing Capital Flight Mainly through Specie

It is perhaps only of antiquarian interest to explore the three French cases of capital flight in the seventeenth and eighteenth centuries with a somewhat primitive monetary system, but some interesting points emerge. The revocation of the Edict of Nantes, it will be recalled, took place in 1685 but was foreshadowed several years earlier by a policy of quartering dragoons on Protestants who refused to abjure and embrace Catholicism. A short, sharp outflow of capital took place, mainly in the form of coin, but also in jewelry and plate, wine, and bills of exchange bought from Catholic bankers in all large cities, from government agents in Paris and elsewhere, from the Swiss in Lyons and from foreign diplomatic representatives in France (Scoville, 1960, p. 296). Scoville's discussion of the "Effects of the Revocation on Finance and Agriculture" gives a great deal of anecdotal detail concerning individual escapes with and without valuables, but is unable to pin down an estimated loss between the extreme estimates of 1 billion livres (say £40 million) and a derisorily low figure of 5 million or 1.25 million livres, depending upon whether the emigrants amounted to 200,000 persons at 25 livres a head or 50,000 (ibid., p. 291). Other estimates are offered of 150 million livres, and, by a scholar whom Scoville characterizes as less

cautious, 360 million. Incidentally, Scoville accepts the estimate of approximately 200,000 emigrants out of a total of 2 million Protestants, divided roughly between 40,000 to 50,000 to England, 50,000 to 75,000 to Holland, and to Switzerland (largely Geneva) 60,000 gross and 25,000 net,^[2] with others to Germany, Ireland and overseas (ibid., pp. 120–7). Louis XIV made an attempt to bring back the sailors among these numbers to strengthen the French navy, but I do not see that any systematic attempt was made to woo others. Many remained in close touch with their 1,800,000 coreligionists who had abjured, mostly insincerely.

Some evidence concerning the loss of specie is available in the receiving countries. The London mint is reported to have coined 960,000 louis d'or (of 23 livres or approximately one pound sterling each) as a consequence of the influx (ibid., pp. 292, 299). In the early eighteenth century, the Huguenots contributed some 10 percent of the wealth of Britain in the funded debt of England and Bank of England shares, having wider and deeper financial experience gained from dealing in rentes (Carter, 1975, esp. ch. 7). The annual figures available for the Bank of Amsterdam for January 31 show an increase in deposits — for the most part specie — from 5.17 million guilders (approximately £465,000) in 1676 to 8.28 million guilders in 1681, 12.71 million guilders in 1689 and a peak of 16.75 million guilders in 1699. Assuming, for the sake of argument, that the Bank of Amsterdam's dealings with other customers than French canceled out, and that the increase of 11.58 million guilders or over 23 million livres was entirely due to the Huguenots, the amount was about £1 million or roughly the same as the louis d'or minted in London (Van Dillen, 1964, p. 119). In any event, refugee funds were said to inundate the Dutch market and led to financiers begging for borrowers at 2 percent (Scoville, 1960, p. 292).

France was depressed for three decades at the end of the reign of Louis XIV, but neither Scoville nor other writers are ready to ascribe the major blame to the revocation of the Edict of Nantes, citing, in addition, the two wars fought after 1685 against the British and bad harvests. In an early passage, Scoville states that the revocation "may well have been responsible for the long depression" (ibid., p. 129). At the end of his intensive study, however, he notes that there is not enough evidence to estimate how much the loss of specie was responsible (ibid., p. 446) and concludes that it did much less harm than most historians of the nineteenth and twentieth centuries believed (ibid., p. 446). Another channel for harm, of course, was the loss of skilled artisans in glass, silk, and paper.

The Mississippi bubble was a "system" promoted by John Law to achieve prosperity in France through the issue of paper money that

additionally bid up the price of the shares of the Compagnie d'Occident operating in the French colony of Louisiana through which the Mississippi River flowed, along with other places world-wide. The Compagnie, under John Law's aggressive push, also took over a series of monopolies in France. Initially, the Banque Générale was restricted in note issue. In 1717 it gave way to the Banque Royale, which was not. Frenzied speculation in shares of the Compagnie by French investors and by hordes of foreigners who flocked to Paris drove the price from an initial value of about 200 livres, when the moribund company was reformed, to 500 in early 1719, when Law offered to buy them at that price, to 1,000 in early September, and 5,000 later in the month, from which they rose to 10,000 in November, 15,000 at the end of the year, and nearly 20,000 at the peak early in 1720 (Carswell, 1960, p. 93). These prices are, however, open to considerable question. Eric S. Schubert (1986, Table 3.1, p. 131) has compiled prices of Compagnie des Indes stock from the daily London press from October 1719 to April 1720 which show them rising from 1,000 percent of par (500 livres) or 5,000 livres to 2,000 percent or 10,000 livres on December 9, 1719, and again on April 9, 1720.

Major profit-taking by the "anti-system" — French merchants and bankers who were opposed to Law — began in the fall of 1719, although Chaussinand-Nogaret (1970, p. 143) cites a company formed in July 1718 to transfer money to Cadiz by way of Amsterdam. Keeping profits in notes was risky because they were depreciating, and even buying real property in France — although many including John Law did — was dangerous since most financial troubles in France, and ends of reigns, had been followed by Chambres de Justice in which excess profits — what we would perhaps call today "undue enrichment" — were examined and fined or confiscated. The problem was to get foreign assets or specie abroad. Lüthy (1959, p. 347) notes that most complicated schemes with forward markets and the like proved illusory either because of the failure of the counter-parties, the cancellation of paper money and bank accounts, or the disastrous decline of the exchange for those who tried to shift their profits abroad late. The rate (ostensibly on Swiss francs) fell from 290 in March 1720 to between 1,200 and 1,300 at the end of September (ibid., p. 367). As an example of the difficulties faced by some, Swiss bankers and merchants in Lyons complained that they were "forced to receive in paper and pay in specie, a thing which one does not practice either at Tunis or Algiers" (ibid., p. 344).

Some did get specie out despite the facts that the Swiss frontier was closed for three months because of plague in Marseilles, and that silver, more readily available than gold, was too heavy. Various routes were used for shipment of specie, including Leghorn and Genoa, as a means

of sending it to Amsterdam and London (ibid., p. 369). Lüthy (ibid.) tells of the triumphs of one Jacques Huber, who won large profits speculating successively in the Mississippi bubble, the South Sea bubble and in the stock of the Dutch East India Company, each time telling his agents that he wanted to remit espèces sonnantes (money that would ring on the table). Mackay's (1980, p. 29) colorful account of the Mississippi scheme, written in 1852, has one Vermelet, a jobber, procuring gold and silver coin to the extent of nearly 1 million livres and taking it in a cart, covered with hay and cow dung, across the border into Belgium and ultimately Amsterdam, he dressed as a peasant. On one unspecific report, there was said to be a sudden doubling of the creditors of the Bank (Chaussinand-Nogaret, 1970, p. 172).

I can find no account of a return flow of capital to France after the liquidation of the Mississippi bubble. There was first a Chamber of Justice (called Visa II, Visa I having been the settlement after the death of Louis XIV) in which local ill-gotten gains were fined in whole or in part, although those with political protection, including a number who had used their profits to buy offices , were spared (Chaussinand-Nogaret, 1970, pp. 138, 149). Economic recovery had been proceeding from 1717, with the inflationary impact of the Mississippi bubble offsetting any deflationary impact of the loss of specie. After the Visa, there was some gain in confidence, it would appear, from the slim evidence furnished by the decline in deposits of the Bank of Amsterdam, which fell from 28.89 million guilders on January 31, 1721, to 15.24 million in 1727. Of particular importance was the fixing of the price of gold in France in 1726, following the similar action of Britain in 1717. France remained on the bimetallic standard, with wartime interruptions, until 1885 when the shift was made to gold, but adjustments in the bimetallic ratio were made entirely in the silver price, and the gold price, officially, was unchanged until 1928. As a further remark, it may be noted that, unlike the revocation of the Edict of Nantes, the Mississippi bubble did not involve extraordinary emigration.

The French Revolution

The French Revolution produced another flight of capital accompanied by emigration. Again for information it is necessary to look outside France. The class composition of some 87 percent of the 17,000 executed inside France has been studied by Greer (1935). Six and one-half percent were clergy, 8 percent were nobles, and 14 percent upper class according to a necessarily arbitrary categorization. The percentages of émigrés in these classes were doubtless much higher, as the peasants and

laborers executed for their part in the counter-revolutionary movement in the Vendée, or the artisans of the uprising against the Revolution in Lyons, did not have significant émigré counterparts. The clergy did not bring much money with them, judging by their poverty in England, which required support from the British government, and the nobles spent what they took out freely until they, too, required subventions (Weiner, 1960). But the movement of specie to Britain beginning in 1789 picked up with the assignats and the Reign of Terror. The mint that normally received £650,000 a year acquired £3 3/4 million in 1793 and 1794 (Hawtrey, 1919, p. 261).

Seen from England, the mass of refugee money pouring into the Bank of England from France between 1789 and 1791 led to a rapid increase in the number of note-issuing country banks, and financed the canal mania (Ashton, 1959, p. 168). The panic of 1793 when the canal bubble collapsed occurred despite a continued inflow. But after the end of the Terror following the fall of Robespierre in July 1794 and the collapse of the assignats , a return movement of specie to France took place to provide some means of payment. The assignats survived somewhat longer in Paris than in the countryside, where they were refused. Even in Paris, however, prices began to be quoted in gold. Hawtrey notes that there was an enormous profit to be made on importing gold, as the premium on the louis d'or in the fall of 1795 was 20 percent higher than the premium on foreign bills (ibid., pp. 247–8). The Bank of England gold stock was also drained by British government expenditures during the war, and declined from £6 3/4 million in August 1794 to £2 1/2 million in December 1796 and £1 million in February 1797 (ibid., p. 258). With the panic engendered by a trivial military incident, the Bank of England suspended payment of its notes in coin — a suspension that lasted until 1819.

The Corso Forzoso

The Italian incident of 1866 was perhaps less capital flight by Italians than a halt to French lending and an attempt to repatriate advances to Italy that led to some Italian outflow and abandonment of the silver standard following a heavy outpouring of specie. Part of the occasion was the crisis in northern Europe caused by Prussian mobilization against Austria, the Overend, Gurney crisis, and a French banking liquidity crisis caused by the collapse of cotton prices following the close of the Civil War. There had also been an internal Italian railroad and other public works boom, loosely financed. The outpouring of silver contributed to the troubles of that metal which ended in the abandon-

ment of bimetallism everywhere. Of particular interest is that fiscal and monetary policy was orthodox, exchange depreciation moderate, and by 1881 the lira was reestablished at the old parity with a stabilization loan and a return flow of capital.

Real Transfer: Through Deflation

This is the therapy that Machlup (1932) prescribed for capital flight. Moreover, he and Viner thought that the success of the German payment of reparations after 1928 until breakdown in 1931 showed how malleable the balance of payments was in response to an "abnormal" capital transfer such as reparations or capital flight (Machlup, 1950; Viner, 1952, p. 182). Machlup finally recanted on the ground that the political price — the breakdown of the Weimar Republic and the coming of National Socialism — was too high (Machlup, 1980, pp. 128–31).

Deflation is strong medicine not only in terms of the possibility of political breakdown. It may be institutionally difficult or impossible. French fiscal policy was strongly contractionary in so far as the deficit was wiped out and replaced with a small surplus in the period to 1925, but it was impossible for the authorities to follow up with the appropriate debt policy. They were, that is, unable to lock in French capitalists with their short-term bons de la défense nationale by refunding them into long-term bonds that would halt the capital outflow by driving bond prices down, and interest rates up, every time wealth-holders tried to liquidate bonds to get money with which to buy foreign exchange. Each week a sizable amount of short-term bonds became due, and the market could insist on obtaining cash for these. A fiscal program of running substantial surpluses to pay off debt was impossible, given the widespread resistance to heavier taxes. The alternative was exchange depreciation, discussed below, which effected the real transfer of capital flight.

Deflation at home may also raise interest rates to such an extent that, given the appropriate expectations, flight capital is attracted back. In the process, some continuing capital flight may be transferred by a countervailing return flow, discussed below. The conditions to assure credibility are doubtless stringent: the establishment of confidence in the stability of money, the budget, the exchange rate, plus the possibility of the one-way option that the currency can only appreciate.

Deflation may be the orthodox neoclassical remedy. It is one, however, that calls for a great many necessary conditions and it is difficult to think of a clear-cut example of its implementation. The

Poincaré stabilization of July 1926, for example, lowered taxes on the upper-income groups rather than raised them.

Real Transfer: Through Direct Export of Valuables or Other Merchandise

It was mentioned earlier in connection with the Huguenots and the émigrés that escapees took valuables with them, along with specie. Valuables may also be dumped at home to get currency for transfer through the exchanges: Tiffany's moved from selling paste jewelry to real diamonds when the price of the latter fell precipitously in Paris after the fall of the Orleanist monarchy in 1848.

The more interesting case, however, is that, when a currency is breaking down in hyperinflation and virtually infinite depreciation, the exchanges may be short-circuited by those exporting capital abroad. Goods are bought at home, shipped and sold abroad, with the proceeds retained in foreign currency. This was notably true of Germany in 1922 and 1923. The later development of foreign-exchange control, of course, tries to frustrate this method of escape by requiring exporters to turn in the receipts of foreign sales. Underinvoicing of exports and overinvoicing of imports provide one means of evading such control.

Real Transfer: Through Exchange Depreciation

Typically an attempt is made to prevent capital exports by letting the exchange rate go. This may lead to speculative purchases of the currency — a countervailing inflow, such as occurred in Germany before about June 1922. Or, if it does not, the depreciation as capital pushes abroad is apt to lead to undervaluation of the exchange rate and an export surplus, such as occurred after June 1922. (The statement rejects the McCloskey and Zecher 1976 notion that purchasing-power parity is always automatically achieved.)

Other classic cases in point are the French depreciation of the 1920s, the capital flight of 1936 reacting against the Front Populaire of socialist Premier Blum, and the French outflow in the fall of 1968. Each of these was halted by devaluation to a lower level that provided profits to returning capital, requiring the rate to be set at levels, and accompanied by measures, that inspired confidence that the rate would be held. In the instant cases these were the Poincaré stabilization of July 1926, the Tripartite Monetary Agreement of September 1936, and the August 1969 devaluation agreed to by Germany.

Exchange depreciation raises the question of a possible squeeze to reverse the expectations of speculators and capital exporters. The classic instance is probably the squeeze engineered by Lazard Frères for the French government in March and April 1924, with the help of a stabilization loan from J.P. Morgan and Company in the amount of $100 million. The details have been written up by Phillippe (1931). Initially the squeeze was put into effect when the franc was 123 to the dollar. This rate was held with difficulty in the first week of the operation, after which the level was raised to 84.45 on March 19, 78.10 on March 24, and 61 at the end of April. At this last rate the authorities stopped buying francs and sold them to the badly beaten shorts — French, German, Dutch, and Austrian — who had to repay borrowed francs. The short-term gain was lost over time, however, as a left-wing government won election in June 1924, and measures to stabilize the position judged adequate by the market were not taken. The rate sagged to between 80 and 85 in June, and the decline resumed thereafter until it reached a low of 249 in early July 1926 just before the Poincaré stabilization.

Other squeezes against short speculation on the part of investors, though perhaps not involving capital flight, have been put in place by Italy in 1964, the United Kingdom in 1976, and the United States on October 31, 1978.

Countervailing Inflow: Purchase of Local Bonds in Foreign Capital Markets

As already noted, this is not a net export of capital so much as a search for an intermediary in order to lend to one's own government or nationals. It can be a natural stage in the education of investors and the acquisition of trust in their national borrowers. Platt (1984), for example, observes that most estimates of UK nineteenth-century lending are too high because they fail to take account of the extent to which investors in the borrowing countries acquired bonds issued in London; while the investors wanted to invest at home, they wanted to do so by means of obligations that the local government or borrower would hold in higher esteem than those owed locally, and perhaps wanted the added liquidity that a bond traded on an international market would command. He noted initially that the bonds issued in London for the Chemin de Fer du Nord in the 1840s were largely bought by the French. It is well known that Argentinian and Brazilian investors bought Argentinian and Brazilian bonds, respectively, issued in London and Paris. As the New York market gradually started to issue bonds for European borrowers after World War II, substantial percentages of

these were bought by investors in the issuing countries (Kindleberger, 1971).

Platt makes the point that many borrowing countries have a lot of capital at home to invest at home but prefer to do it through the intermediation of investment bankers abroad. Whether this should be called capital flight depends, of course, on what happens next: whether it is followed, as in the French 1840 case, by the development of a French capital market which obviated the necessity for such intermediation, or whether distrust of domestic creditors grows and intermediation is followed by true capital flight.

Countervailing Inflow: Loss of Foreign-Exchange Reserves

The revocation of the Edict of Nantes, the expatriation of Mississippi bubble profits, and the flight of capital during the French Revolution occurred before central banks had been established on the Continent. After the establishment of central banks, capital flight could still be effected through gold losses, and in addition, where the central bank held foreign exchange in its reserves, with a loss of foreign exchange. It is perhaps stretching matters to call this a countervailing capital inflow, although technically such is the case. The issue is clearer where monetary authorities borrow abroad, a subject we are about to discuss, but it frequently happens that the loss of foreign-exchange reserves or gold is an early means of accommodating capital flight, followed, after the flight has proceeded for some time, by borrowing.

Countervailing Inflow: Official Borrowing Abroad

The monetary authorities can borrow abroad in a variety of ways: through swaps in the case of the Group of Ten (G10), through selling foreign exchange forward, through arranging for parastatal bodies to borrow abroad rather than at home and sell the proceeds to the authorities.

A classic swap case occurred in the Italian lira in 1963 following the nationalization of the electricity-generating industry and a middle-class strike that took the form of capital flight. The Italian authorities chose to meet the crisis not by depreciating the currency, which would have raised domestic prices in irreversible fashion, but by entering into swaps, primarily with the US government. This seems to me to have been wise. The irritation of the Italian capitalists did not last long when

they learned that the socialist terms for compensation were generous — overgenerous, as a number of mainstream economists told me. By financing the outflow and hanging on, the position was restored — although again in the long run the inflation was not cured, and the exchange rate ultimately declined.

The French have gotten themselves into a bind, in my judgment, by holding on to their gold and borrowing foreign exchange through such parastatal bodies as Electricité de France to meet balance-of-payments losses and capital flight in 1968–9 and again as a response to the Mitterrand policy of nationalization in 1981. Gold is illiquid today if attempt be made to sell it in large amount. While the French dollar debt has been reduced in real terms by the fall of the dollar and the easing of interest rates, the overall position remains unstable.

Countervailing Inflow: Through Macroeconomic Policy

Deflation to attract private inflows through higher interest rates and depreciation to attract capital inflow through speculation may be discussed together since their possibilities of success turn on similar criteria. The relevant instances are provided by Germany. In the 1920s, exchange depreciation up to June 1922 encouraged a sufficient speculative capital inflow to finance reparation payments, the current-account deficit, and some unestimated volume of capital flight. The inflow was based on inelastic expectations, the belief, that is, that the mark would one day return to par. There are many estimates of the amount of capital that flowed to Germany in 1919–23 and 1924–31 (Holtfrerich, 1977; 1980; 1986; Schuker, 1978), amounts said to be larger than American assistance to Germany under the Marshall Plan after World War II, but no reliable estimates of how much capital the Germans managed to export in the period before the Dawes Plan. At French insistence, a committee parallel to the Dawes Committee had been appointed under McKenna to determine the amount of capital exported by Germany, just as, at the time of standstill in 1931, a Layton Committee was established alongside the Wiggin Standstill Committee for the same purpose. It is clear on theoretical grounds that after the shift in expectations from inelastic to elastic, usually ascribed to June 1922, when the American holders of marks and German securities tried to liquidate them, that German mark holders were on the same side of the market. But it is not readily estimated how much capital flight by Germans took place before that time. Schuker (1978, p. 350) says that German exporters left their foreign earnings abroad, just as Holtfrerich (1986, p. 286) notes that the earlier movement in the other direction

consisted partly of American exporters leaving the mark proceeds of sales in German banks waiting for the price to rise.

The central point is expectations. Higher interest rates and exchange depreciation will each attract foreign capital and help provide the counterpart of capital flight to the extent that they inspire confidence that the authorities are in full command and have every intention of restoring the position in the case of higher interest rates, and of appreciating the currency in the case of depreciation. Holtfrerich writes me that the return flow of German capital to Germany in the spring of 1924 was owing to tight money on the part of the Reichsbank. This forced business to repatriate hoarded exchange, especially after the establishment of the Golddiskontbank by Schacht strengthened confidence in the long-term stability of the currency, all this even before the adoption of the Dawes Plan. He went on to say that the stringent requirements of the Dawes Plan strengthened confidence still more and assisted that return movement. When such confidence is absent, however, and expectations are inelastic, raising interest rates leads to increased flight by foreigners and domestic holders alike, and the same is true in the case of depreciation.

Countervailing Inflow: Dumping of Currency Abroad

One method of capital flight is to buy foreign currency. In 1940 in Switzerland, I met a man who had arranged to receive five $100 bills from New York each week, which he sold for about $650. He then sent $500 back by draft each week and lived on the difference. A large capital inflow to the United States — outflow from Europe — took place through currency movements reported by banks, but more — much more — contributed to the residual debit in the US balance of payments through covert mail exports of US currency, and through purchases of currency through intermediaries in New York that were hidden in safe-deposit boxes. The counterpart of this US inflow, to the extent it was reported, was European capital flight, i.e. the increase in European holdings of US currency.

In addition to buying currency at home, capital can be exported by selling domestic currency abroad. Various German, Italian, and especially Russian foreign-exchange controls were evaded by smuggling currency abroad and selling it — in Amsterdam and Zurich for the Reichsmark in the Nazi period, in Helsinki and Istanbul for the ruble. The countervailing party that bought the currency in the foreign market effected the capital outflow. If no one had bought it, the price would have gone to zero. There is, of course, no evidence on the point but the supposition is that most of it was bought to be smuggled back, for

example to pay for German exports. One anecdotal suggestion is that the British secret service was a substantial demander of Reichsmark currency in Amsterdam.

A further anecdote is of interest because of the echoes it conveys of the export of the capital of Huguenots after the revocation of the Edict of Nantes through "Catholic bankers, government agents in Paris . . . and foreign diplomatic representatives" (Scoville, 1960, p. 296) the perfection of markets that made the prices of estates in London vary with South Sea stock at the time of the South Sea and Mississippi bubbles (Carswell, 1960, p. 159), and of real estate in Geneva move in consonance with the notes of the Banque Royale (Lüthy, 1959, p. 364). In (I believe) 1937, on a train from Amsterdam to Paris, Emile Despres fell into conversation with a man who said his business had been getting capital out of Germany. There were, he said, three methods. One could buy a Reichsbank official and get sterling in London; this was expensive but sure. Or one could bribe a bank clerk to get currency for deposits in large amounts, and get it out of Germany through the pouches of diplomatic officers of a number of small states. Or one could smuggle it out by train. The risk – return payoffs by each method were related, and what was especially notable was that when there was a coup by the German authorities that temporarily blocked one method the cost of using the others rose. An analogous result materialized in the Italian export of capital to Switzerland in 1963: highway robbers gathered along the main road from Milan to Lugano to prey on those exporting capital in bundles of banknotes disguised as packages of butter (Die Zeit , October 15, 1963). Some part of the countervailing reflow of these notes to Italy, according to a tax accountant I interviewed in Milan in 1972, came from Italian companies repatriating "black cash" accumulated abroad through overinvoicing to get it back on their books to make good losses. These appeared as foreign purchases of the company's newly issued shares.

Means to Contain Capital Flight or to Entice It Back

Only a few loose ends remain to cover the list set forth above, since many of the options have already been covered in connection with the means of financing the outflow, notably: ignoring, deflating, depreciating, stabilizing at a devalued rate, operating a squeeze with or without stabilization loans, and, implicitly, monetary reform. A word or two may be useful, however, on forward operations, foreign-exchange control, and steps that might be taken abroad. I happen not to be sanguine about any of them.

It has been suggested by Keynes and others, notably John Spraos

(1959), that central banks need not lose gold or foreign exchange, since they can create the equivalent by selling foreign exchange forward, roll the contract over as it matures, and keep going virtually to infinity. A domestic holder of, say, sterling, who wants protection against depreciation, can in capital flight either demand dollars – I write as if the system were one of a movable peg – or be content with a contract to be provided with dollars against sterling at a set price in the future. The subject merits extensive exposition for which space is lacking. In short, however, it may be said that when the market believes that the authorities' commitments to deliver foreign exchange are likely to exceed their available reserves, the market may be unwilling to renew its forward engagements by rolling them forward, and demand fulfilment (Spraos, 1969). This is broadly what happened in Britain in 1967. Again, the question turns on credibility.

Exchange control is another subject deserving extended treatment. Systems differ markedly in their approaches, whether they use prohibitions and enforced collection, differentiation by price, or some combination. All are porous to greater or lesser degree, depending to a considerable extent on the elusive concept of national character. Thus Britain in the 1950s managed to develop a wide spread between ordinary sterling and security sterling, whereas in France and Belgium the spread between current-account and capital-account foreign exchange never diverged beyond a few percent before being contained by arbitrage. As the Despres anecdote in the previous section indicates, moreover, even the death penalty in Germany – an efficient country in policing transactions – failed to make the system of control tight. As a rough guess, I have suggested that at one extreme Germany might restrain 95 percent of the attempts to evade foreign-exchange controls whereas a typical Latin country might achieve success only in the range of 60–75 percent. In times of war or other national emergency that pulls a country together, the ratio rises.

The point of exchange control, of course, is to prevent the public from buying in the cheapest market and selling in the dearest. It attempts to override basic economic incentives.

A particularly instructive example of the futility of halfhearted exchange control is US experience in the 1960s with the interest equalization tax, Gore Amendment, Voluntary Credit Restraint Program, and Mandatory Control Program. The administration tried to prevent capital outflow one conduit at a time, when the US capital market was tied to markets abroad through many. As each link was cut off, the flow was diverted to others.

In the postwar period, Switzerland and Germany have at various times tried to keep out foreign funds by requiring banks to maintain

special reserves against foreign deposits. The best-known example is the German Bardepot . I am not a deep student of the experience, but I think it was, on the whole, only partially successful. Nominees can be used to disguise foreign ownership, although there are risks that the fiduciary will fail to live up to commitments.

My own rather thin files from the period when I was working at the Federal Reserve Bank of New York include two memoranda addressed to Mr Sproul, one with E. Despres, of June 28, 1937, entitled "Would American and British Support for the Franc bring French Capital Home?" and one with E.G. Collado, dated April 18, 1938, on "Hot Money." The first is a little bizarre, as the purpose of inducing capital repatriation to France was to induce the French authorities to buy gold and relieve some of the pressure on the United States from the "Golden Avalanche." The critical issue, it was stated, was whether French capital abroad was primarily a hedge against further depreciation or restrictions, or was held chiefly because of fear of expropriation. The conclusion was that the former was the primary motive, and that a US–UK announcement of an intention to stabilize the French currency would be effective in inducing capital repatriation.

The Kindleberger–Collado memorandum explored the possibility of limiting the capital inflow to the United States by taxation, thought to be unenforceable, and various means of limiting the inflow through short-term banking funds, such as a requirement of 80 percent to 100 percent reserves, taxes, widening of the gold points, and a lowering of the gold price. All but some widening of the gold points were rejected. A new method was proposed, simple in theory but deemed complex in practice, to limit foreign purchases of US securities, so as to create two prices after the limit was reached, one for foreign-held shares, and another lower one for those in American hands. The proposal came from recognition that this had already happened to ITT stock, because of limitations on foreign ownership of US communications. As I reread the memorandum now, however, I have the feeling that youthful optimism won out over practicality.

The Crucial Condition for Capital Repatriation

The historical record indicates that the crucial aspect inducing repatriation after capital flight is a return of confidence – confidence in the capacity of the country to maintain the exchange rate, in the safety of capital, in economic recovery. This criterion makes it unlikely, in my judgment, that capital repatriation will take place gradually over a long period of time, as contemplated, for example, in the report of the Inter-

American Dialogue (1986). This report argues (p. 12) that Latin American recovery depends on an inflow of $20 billion a year, made up of $12 billion a year from the commercial banks, $4 billion from the multilateral agencies, $1 billion to $1.5 billion each from foreign direct investment and bilateral lending, and $1 billion to $2 billion in recaptured flight capital. This estimate of the return of flight capital, which the report considers "a reasonable goal" is too little if confidence is restored, and algebraically far too high if it is not, since the capital flight will continue. If I may quote once more from my files, a contribution of January 12, 1937 to a Federal Reserve Bank of New York Research Department collection, on "Some General Implications of Recent Currency Developments," laid heavy emphasis on the restoration of confidence. Such restoration, it was thought, might precede or follow renewed domestic investment and economic recovery (in France), but excluded further depreciation of the franc. The same conclusion is central to Michael Bruno's (1985, p. 868) judgment about stabilization of the monies of the Latin American Southern Cone, i.e. the necessity of building "credible expectations." This essentially means that short-run measures in the foreign-exchange market, such as a stabilization or a squeeze, must be buttressed by long-run macro-economic stabilization that is seen to be politically supportable. It is quite an order.

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