Taming the Global Financial Cycle:

Central banks and the sterilization of

capital flows under the Classical

Gold Standard (1890s – 1914)

Center for Financial Studies Lecture Series, 29th January

CFS and Institut für Bank- und Finanzgeschichte

Guillaume Bazot, University Paris 8

Eric Monnet, Paris School of Economics & CEPR

Matthias Morys, University of York

Questions

Can central banks run an autonomous policy in a globalized financial & monetary system?

Today:

trilemma or dilemma? (Obstfeld & Taylor 2004, 2017; Rey 2013, Klein & Shambaugh 2015)

focus on the impact of the US interest rates on other economies (Bruno & Shin 2015, Rey 2013, Miranda-Agrippino & Rey 2018)

can central banks sterilize foreign capital flows or do they have to rely on capital controls? (Aizenman & Glick 2009, Alder & Blanchard 2015)

Eurozone: institutional evolution (capital controls in Cyprus, Greece) and rules vs. discretion

Balance sheet policies since 2008

Classical Gold Standard (1870s-1914)

Bloomfield (1959): sterilization in 11 countries + some forms of capital controls. Contra “rules of the games”.

Sterilization (neutralization): negative correlation between international & domestic assets of the central bank

Contradicts David Hume’s price-specie-flow mechanism

Bloomfield (1963) & Lindert (1967): foreign exchange reserves

Numerous cases studies. FX interventions & sterilization: Drummond (1976)

Chapters in Bordo & Schwartz (1984)

Chapters in Ogren & Oksendal (2012)

Reis (2007), Jobst (2009), Bazot, Bordo & Monnet (2016)

Limits of previous approaches:

Loss of the comparative perspective after Bloomfield & Lindert.

Comparative work focuses on interest rates (Obstfeld & Taylor

2005, Morys 2013, Mitchener & Weidenmier 2015)

What happens to central bank balance sheet?

Analysis of sterilization limited by annual data.

Few peripheral countries

Still a crude definition & measure of sterilization. Suffers from

obvious identification problem: endogeneity + omitted variables

(seasonality & banking crises).

Theory and identification strategy

Consider the BoE rate as exogenous (as in Jorda, Schularick & Taylor 2015, 2019, Bazot, Bordo & Monnet 2016).

[More in the paper on alternative assumptions and discussion of endogeneity]

Standard macro theory (Mundell 1963, Obstfeld & Taylor 2004, Farhi & Werning 2014) provides 4 scenarios

(1) “playing by the rules of the game” – interest rate adjustment

(2) sterilization – expansion of domestic credit

(3) capital controls – prevents reserve drain by allowing xr drop

(4) float – exchange-rate adjustment

Is it possible to group countries as falling into these 4 scenarios?

Reconstruction of balance sheet items

International portfolio

metallic reserves (gold plus silver)

foreign papers (bills of exchange drawn on foreign places)

foreign funds available at banks’ correspondents

Domestic portfolio

discount portfolio of domestic papers

short term advances on securities and other collaterals

Raw data alone suggest that central banking was easier for some (core countries) than others (peripheral countries)

Sources

Monthly balance sheets, 21 central banks (1891-1913.) Very detailed. Discount rates & exchange rates. Countries in and out of the gold standard.

1881. Conference on central bank balance sheets in Rome

Banque de France “research department” created in 1884.

Systematic collection of weekly/monthly/annual balance sheets & reports of foreign central banks. Start in 1891.

Translation, harmonization, documentation of data

Ex: Swedish Riksbank

Plus one peculiar case: U.S. as a gold

standard country without a central bank

U.S. Federal Reserve System only since 1913

Before: U.S. Treasury backs notes in circulation

From 4 key time series we can still reconstruct 3

(domestic portfolio, by design, does not exist in the absence of a cb)

K. Polanyi (1944):“Completely monetarized communities could not have stood the ruinous effects of abrupt changes in the price level necessitated by the maintenance of stable exchanges unless the shock was cushioned by the means of an independent central banking policy. “

Was Polanyi right?

Data are weekly or monthly depending on the country. We collect monthly (end of the month)

Checked to be consistent with Lindert (1967), Morys (2013) and others

Discount rates also from Bank of France archives and Morys (2013)

Exchange rates on London, Berlin/Hamburg/Frankfurt, Paris, from Morys (2013) and Schneider et al. (1991, 1994)

We construct series of international (metallic reserves, foreign bills, foreign funds) & domestic portfolio (discounts, advances on securities)

Special case of mortgage loans

4 groups of countries

Gold standard

Core

Gold standard

Periphery

Off gold standard Gold standard countries

without a central bank

Germany, France,

Netherlands,

Belgium, Austria-

Hungary (since

1896)

Norway, Sweden,

Denmark, Finland,

Romania (until

11/1912), Japan (after

10/1897), Russia

(starting 01/1897),

Italy (01/1903-

09/1911), Bulgaria

(01/1906-09/1912),

Serbia (07/1909-

09/1912), Greece

(starting 01/1910)

Portugal, Spain, Austria

(before 1896), Russia

(before 01/1897), Italy

(before 01/1903; after

09/1911), Greece (before

01/1910), Bulgaria (Before

01/1906; after 09/1012),

Serbia (before 07/1909;

after 09/1912) Romania

(after 11/1912)

United States

Core country: liquid forex market, debt issued in domestic currency, mature money market

Classification consistent with the literature: Flandreau and Zumer 2004, Flandreau & Jobst

2005, Morys 2013, Mitchener and Weidenmier 2015

Local projections

Jorda (2005), Ramey (2016), Jorda, Schularick and Taylor (2018, 2019), Barnichon & Brownlees (2018)

Well suited for a panel with heterogeneous effects across groups

𝑦𝑖,𝑡+ℎ𝑘 = 𝛼𝑖 + 𝑐𝑜𝑟𝑒 𝑖𝑛 𝐺𝑆𝑡−1 × 𝛷ℎ 𝐿 𝑌𝑡−1 + 𝛽𝑎,ℎ∆𝑟𝑡

𝐵𝑜𝐸

+𝑝𝑒𝑟𝑖𝑝ℎ𝑒𝑟𝑦 𝑖𝑛 𝐺𝑆𝑡−1 × 𝛷ℎ 𝐿 𝑌𝑡−1 + 𝛽𝑏,ℎ∆𝑟𝑡𝐵𝑜𝐸

+𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔𝑡−1 × 𝛷ℎ 𝐿 𝑌𝑡−1 + 𝛽𝑐,ℎ∆𝑟𝑡𝐵𝑜𝐸 + 𝜀ℎ,𝑖𝑡

Timing restriction: BoE rate affects contemporaneously other countries

Consistent with end of the month values and evidence about rate changes (Lindert 1969)

Matching four theoretical scenarios to

actual gold standard monetary policy

#1: “playing by the rules of the game”: interest rate adjustment

Group 4 (g. st. countries w/o central bank) come closest

Polanyi was right!

#2: Sterilisation: expansion of domestic credit

Group 1 (core g. st. countries)

“luxury version” of the gold standard

#3: Capital controls:

Group 2 (peripheral g. st. countries)

Lack monetary policy credibility and mature domestic money markets

#4: Floating

Group 3

Findings supportive of trilemma not dilemma

Conclusions Focus on balance sheets rather than interest rates only

No central bank followed the rules of the game – but countries without a central bank (U.S.) were forced to do so

Having a central bank allowed countries much lower interest rate fluctuations

Central banks as shelter from the vagaries of international financial markets

Yet different patterns: sterilization in the core; imperfect convertibility in the periphery.

Many ways to “round the corner of the trilemma” (cf. Klein&Shambaugh 2015)

Gold standard was more flexible than acknowledged

The system allowed for institutional adaption (cf. Morys 2013)

Will we see similar process in EMU (or have we already)?

Endogeneity

Omitted variables and reverse causality

Arguments based on historical narrative (relative

frequency & central bank meeting schedule)

Omitted variables: include variables for global cycle(s) in

prices, economic or financial activity

Reverse causality: exogenous measure of English

monetary policy based on Lennard (2018)

Specific case of the US: measure of English monetary

policy unaffected by events emanating in the US based on

Green (2018)