Federal Reserve Bank of Richmond Economic Quarterly
"This is a story that illustrates the interrelationship between economic history and economic thought: more precisely, between monetary history and monetary thought. So let me begin with a very brief discussion of the relevant history.
In 1879, the United States returned to the gold standard from which it had departed at the time of the Civil War. This took place in a period in which “a combination of events, including a slowing of the rate of increase of the world’s stock of gold, the adoption of the gold standard by a widening circle of countries, and a rapid increase in aggregate economic output, produced a secular decline ˙.. in the world price level measured in gold˙...” (Friedman and Schwartz 1963, p. 91; for further details, see Friedman 1990, and Laidler 1991, pp. 49–50). The specific situation thus generated in the United States was described by Irving Fisher (1913c, p. 27) in the following words: “For a quarter of a century—from 1873 to 1896—the dollar increased in purchasing power and caused a prolonged depression of trade, culminating in the political upheaval which led to the free silver campaign of 1896, when the remedy proposed was worse than the disease.” This was, of course, the campaign which climaxed with William J. Bryan’s famous “cross of gold” speech in the presidential election of 1896. Fisher’s view of this campaign reflected the fact that it called for the unlimited coinage of silver at a mint price far higher than its market value, a policy that would have led to a tremendous increase in the quantity of money and the consequent generation of strong inflationary pressures..."
1. THE PLAN: RATIONALE AND DETAILS.....
2. THE PLAN: CRITIQUE
3. THE RECEPTION BY THE PROFESSION
"More stress should be laid, however, than Professor Fisher does, on
the fact that the plan can work out its results only through its effects on
the quantity of coined gold ˙... The consequences on prices [of an increase
in the gold content of the dollar] will be precisely the same as those of diminished
production or limited coinage. Professor Fisher seems to expect a
closer connection. His analysis implies, almost states in terms, that prices will
accommodate themselves at once or very promptly to the bullion equivalent
of the coined dollar; that as the bullion required for the dollar increases, prices
will fall quasi-automatically in proportion; and that as the bullion equivalent
lessens, prices will be correspondingly affected at once. Now, no one has stated
more clearly and explicitly than Professor Fisher himself, in his Purchasing
Power of Money, the grounds for maintaining that the connection between the
bullion equivalent in the coined dollar and prices will work out its effects
solely through changes in quantity. He has shown that the connection between
the quantity of coined money and general prices is by no means a close one.
It is not only loose and uncertain, but we are much in the dark concerning
the degree of looseness and uncertainty. Economists should be very chary of
prediction in such matters, and Professor Fisher makes predictions which the
event might greatly falsify. (1913, pp. 402–3; italics in original) "
4. THE HIGH POINT OF THE COMPENSATED DOLLAR
"Under the “indefinite-reserve” system the only inflow and outflow of
[gold] certificates would be through the deposit and withdrawal of gold, just
as at present; whereas under the “definite-reserve” system there would be,
in addition, an inflow and outflow of certificates through special issues or
cancellations to keep the total outstanding volume of certificates in tune with
the gold reserve ˙...
The “definite” system would act more promptly to stabilize the price
level than would the “indefinite,” because, for one reason, the change in the
circulation would be more prompt. The instant any change in the dollar’s
weight is made there is a change in the number of dollars of the reserve, and
the volume of certificates is readjusted to this changed reserve immediately.
Under the “indefinite” system, on the other hand, the circulation would be
affected somewhat more slowly and only as the flow of gold deposits and
withdrawals became changed. (ibid., pp. 129–31)"
5. THE DECLINE OF THE COMPENSATED DOLLAR
6. CONCLUDING OBSERVATIONS
"In the extensive literature on price stabilization that has developed since the early 1980s, there are frequent references to Fisher’s compensated dollar plan, and to his 1920 Stabilizing the Dollar in particular. But sometimes this name is taken in vain. Thus Philip Cagan’s 1987 paper on “A Compensated Dollar: Better or More Likely than Gold” suggests (inter alia) preserving the purchasing power of money, not by stabilizing the price level, but by issuing indexed money (i.e., money whose nominal value changes equiproportionately with the price index), which would become “the primary medium of exchange” (ibid., p. 272). As I have, however, shown elsewhere (Patinkin 1993, pp. 122–24), and as illustrated by the Israeli experience of the early 1980s, an economy whose money supply is mostly indexed will generate a frictionless inflationary process, which will accordingly continue indefinitely at indeterminate rates..."