INFLATION AND SWITCHES BETWEEN SPECIE AND PAPER STANDARDS IN SWEDEN 1668 - 1931: A PUBLIC FINANCE...

Scottish Journal of Political Economy. Vol. 43, No. 4. September 1996 6 Scottish Economic Society 1996. Published by Blackwell Publishers Lrd.. 108 Cowley Road, Oxford OX4 I J F . UK and 238 Main Street. Cambridge. MA 02142. USA

INFLATION A N D SWITCHES BETWEEN SPECIE A N D PAPER STANDARDS IN SWEDEN

1 6 6 8 - 1 9 3 1 : A PUBLIC FINANCE INTERPRETATION

Klas Fregert* and Lars Jonung**

ABSTRACT

In this study, the recent literature on the integration offiscal and monetary policy is used to examine the suspensions and resumptions of currency convertibility in Sweden during the period 1668- 1931. We demonstrate that urgent demands for financing of war expenditures forced the Swedish Riksbank to abandon convertibility of its notes in all cases of suspensions prior to 1914. We argue that the suspension periods should be regarded as unexpected lapses into discretion from rule-bound convertibility regimes rather than as part of an optimal ex ante public finance policy. All resumptions of convertibility, except for the resumption of 1924, implied an ex post formal devaluation. All suspensions were illegal, except in 1931 when a constitutional escape clause was invoked.

I INTRODUCTION

Sweden's central bank-Riksbanken, henceforth the Bank- was founded in 1668 and can be considered the world's oldest central bank. According to its Charter, the principal objective of the Bank was to preserve the convertibility of its deposits, later its notes, into specie; yet Sweden experienced five periods with paper money as the main medium of exchange, covering 83 out of the 264 years between 1668 and 1931. Since then Sweden has been on paper standard,' see Table 1. In fact, Sweden was the first country to experiment with monetary policy under paper regimes. The paper standards account for most of the inflation between 1668 and 1931, see Figure 1. The underlying causes of the inflation therefore must be sought in the forces behind the paper standards. In this study, we explain long-nm inflation by examining the circumstances of the suspensions and resumptions of convertibility.*

' Whether Sweden has been on a pure paper standard since 1931 is a question of definition. During the Bretton Woods period 1951-71, the krona was indirectly tied to gold via the dollar. In addition, notes were convertible to gold until 1974 according to the constitution, unless the Parliament freed the Bank from convertibility, which it did yearly from 1931 to 74.

'This issue is closely related to the endogeneity of fixed and flexible exchange rate arrangements as well.

* University of Lund Stockholm School of Economics **

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INFLATION: SPECIE AND PAPER STANDARDS IN SWEDEN 445

TABLE 1 Monetary arrangements 1668-1931

Reason for % change in parity Length of Regime period suspension at resumption suspension (years)

Copper 1668 - 1709 Paper 1709-1719 Copper 1709-1745 Paper 1745-1776

Silver 1777-1788 Paper 1789-1803 Silver 1803-1809 Paper 1809-1834 Silver 1834-1873

Paper 1914-1924

Paper 1931-

Gold 1873-1914

Gold 1924-1931

Panic 0

War Russia 1741-43, Seven Years' War 1756-63 50

WarRussia 1788-90 33

War Russia 1808- 12 62

World War I

Panic

0

11

32

15

26

11

Sources: Jonung (1976. Tables 2 and 4). Nores: The change in parity at resumption i s calculated as the change in the number of weight units of metal per currency unit relative to the old value. (This is the same as the change in the number of currency units per weight unit of the metal relative to the new value.)

1 1732 1752 1772 1792 1812 1832 1852 1872 1892 1912 1932

Figure I . The Swedish price level (1732-1939) and the United Kingdom price level (1750- 1939). Index 1750 = 100, logarithmic scale. Sources: Mitchell (1992).

Our work builds on recent studies of monetary history which rely on insights gained from the integration of fiscal and monetary policy in a public finance perspective, initiated by the rational expectations school. Such a public finance approach has been utilized to explain the inflation history of the 18th and 19th centuries in France and the United Kingdom (Bordo and White, 1993). of 19th century France (Sargent and Velde, 1995). and of 19th century Argentina and the United States (Bordo and Vegh. 1995). The suspensions of 1745, 1789 and 1809 coincided with extraordinary increases in government expenditures and in the Bank's note issue, all initially associated with war. In contrast, after 1834 the

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specie standard was maintained until 1914, when the gold standard was suspended without an immediate cause in a large note issue. The gold standard was restored at the old parity in 1924-the only case of a resumption involving a return to the original parity.

We also consider a recent development in the literature on time inconsistency. Bordo and Kydland (1995) have argued that the gold standard functioned as a contingent rule supporting government borrowing. By adhering to the convertibility rule, except in emergencies, the government can borrow by maintaining a reputation for not defaulting on the debt through inflation. Suspending convertibility in generally accepted crisis periods does not constitute a violation of the rule. Thus the paper periods may not represent discretionary lapses from a simple convertibility rule, but instead may be part of an optimal commitment policy.

The paper is organized as follows. First, some aspects of public finance theory relevant to suspensions and resumptions are reviewed. Next, the monetary and fiscal institutional framework is described. Then the history of suspensions and resumptions 1668- 1931 is recounted, and finally conclusions are drawn. We rely heavily on the five-volume work Sveriges Riksbank 1668-1924, (1918-1931), a scholarly work by economists and political scientist^.^ For the fiscal side we rely on the monumental study by Amark (1961) Sveriges statsfinanser 1718-1809.

11 PUBLIC FINANCE ASPECTS OF SUSPENSION AND RESUMPTIONS

The connection between inflation and war finance has been observed in many countries and has routinely been explained by the need for an inflation tax. This explanation begs the question of why other means of finance were not used, specifically borrowing outside the central bank. Indeed, the argument for tax smoothing suggests that the inflation tax, like other taxes, should not be used to finance temporary expenditure^.^ A suggested explanation is that the govem- ment faced a borrowing constraint.' This is a likely explanation, even for credit- worthy governments, in the short run. However, a borrowing constraint is an incomplete explanation of long-run inflation since central bank loans can be repaid. Indeed, this option was seriously considered in all but the last of the Swedish episodes we examine.6

'Indirectly, we adopt the research methodology recommended by Bordo and Kydland (1995) using 'an exegesis of official views, statements from Parliamentary debates, newspaper editorials and the like'.

See Mankiw (1987). 'See Bordo and Vegh (1995). 6Another rationale for financing wars with the inflation tax is suggested by Calvo and

Guidotti (1993). If the temporary expenditures are unexpected, a concomitant unexpected inflation works as a capital levy on money balances and government debt. Following such a policy may be ex ante optimal. In this case, a return to the original parity is not called for, in contrast to the claim in Bordo and Kydland (1995). While this idea is worth pursuing, we do not follow it up here. Most of the inflation occurred during longer periods and it appears that most of it was expected.

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However, paying back the loan is a costly affair. First, there is the fiscal cost itself. In the absence of a binding institutional structure, only the fear of a loss of reputation can stop a default and that may well be a weak deterrent.' Second, if money financing leads to inflation, making it a tax on real balances, and the government wants to restore the old parity, repaying the loan requires a deflation. Since deflations are usually associated with losses in output, paying back the loan carries a penalty in excess of the fiscal cost. Furthermore, inflation and deflation as a rule affect the distribution of income and wealth. Various pressure groups will therefore try to influence the design of monetary and fiscal policies.

To understand the historical record and the policies to restore convertibility, it is useful to consider the options with reference to the balance sheets of the central bank and the government. Restoring convertibility at a devalued parity, that is increasing the convertibility rate (currency units per weight unit specie), is tantamount to partially defaulting on the government short-term debt represented by money. If convertibility is restored at the actual, depreciated exchange rate between paper money and specie, the resumption validates the actual default implied by the inflation. To keep the currency convertible at the new rate, the government must stop borrowing from the central bank.

Resuming convertibility at the original parity, or at an appreciated rate relative to the actual parity, requires a proportionate reduction of the high- powered money stock if the demand for real balances, the money multiplier and the foreign price level are constant. To the degree that real balances and the foreign price level are growing, the required reduction is less. Thus, in general, the government must repay some, or all, of its loans made during the suspension to reduce the money stock, or demonetize its debt. This may be done by the government borrowing outside the central bank for a quick resumption, or more gradually by using budget surpluses. The required budget surpluses are the same in both cases. Thus, making the currency convertible at the old parity requires more stringent fiscal measures than if the currency is devalued. For the government to be able to borrow in order to resume parity immediately, it must convince the public that it will run future budget surpluses. The government must prove not only that it will mend its future ways, but also pay for past ways. This will probably require both fiscal and central bank institutional reforms.

Restoring parity also usually requires an increase in the specie reserve ratio, and th s for two reasons. First, the specie reserve will likely have been reduced by a run during the period leading up to the suspension. Second, the specie reserve probably has to be increased beyond its previous level to restore confidence in convertibility. The specie reserve ratio increases in direct proportion to (i) an increase in the convertibility rate (devaluation), (ii) a decrease in the note issue, or (iii) an increase in the amount of specie (in weight units).8 Thus, if it is considered necessary to increase the reserve ratio beyond

'See Bulow and Rogoff (1989). 'The reserve ratio is the convertibility rate (currency units/weight unit) times the amount

of specie (weight units) divided by the note issue (currency units).

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448 KLAS FREGERT AND LARS JONUNG

the combined effect of the increase in the convertibility rate and the decrease in the note issue, specie must be obtained by borrowing (from abroad for example), further increasing the fiscal requirements.

To summarize, a successful resumption requires a coordinated monetary and fiscal policy to make consistent the decisions concerning (i) the resumption rate, (ii) the amount of note reduction, (iii) the present value of future budget surpluses, (iv) fiscal reforms and (v) the necessary specie reserve ratio. For a given resumption rate, a known path of desired real balances (in high powered money), purchasing power parity and a known reserve ratio, the required note reduction and budget surpluses can be calculated from the government budget constraint. The timing of the borrowing is determined by the timing of the resumption: immediate resumption requires borrowing today and paying later. We will describe how uncertainty concerning the actions required arises from not knowing the amount of future real balances and the required reserve ratio.

In MONETARY AND FISCAL INSTITUTIONS

Swedish monetary policy has always been under parliamentary control. Two sets of rules have governed monetary policy: those defining the Parliament as the principal of the Bank with the right to run the Bank as it saw fit, and those defining the commitment to the convertibility of notes and deposits into specie. The tension between these two sets of rules underlies the whole history of the Bank.

The Bank’s Charter of 1668 and the constitutions of 1719 established the Parliament as the owner of the Bank, together with royal pledges not to utilize the Bank.g The Bank’s commitment to convertibility was stated in the first paragraph of the Bank’s Charter from 1668:

We the Parliament, . . . promise . . . , that the person who either deposits money [i.e. specie money] himself or by some event receives a deposit, shall immediately and without exception command them after his own pleasure, no different from him having the same money in his own house, office or store, ... (Banko-ordningen 1668, $1, Sveriges Riksbank 1668-1918 part 1, 1918, bilagor, p. 83).

The preamble of the Charter stated that the Bank was to ‘preserve the proper and right value of the domestic money and hinder and forestall foreign monies’ increase in value’. The whole idea behind making the Parliament the Bank’s

9The legal stipulations for the Bank appeared in four pieces of legislation: the original Charter of 1668 (Bunko-ordningen), the Constitution (Regeringsformen) of 17 19, 1720. 1772, and 1809, amended in 1873 and 1915, the Royal Pledge (Konungaf6rsiikran) of 1672, 1719, 1720, 1751, 1772, 1779 (identical thereafter), and the Riksbank law (Riksbankslugen) of 1830 and 1898. The royal pledge, considered part of the Constitution, in which the King stated his respect of the Parliament as the law-maker, spelled out the Bank’s independence from the King. Charles XI’s pledge of 1672 stated the Bank’s independence in no uncertain terms: ‘The means of the Bank, ..., should neither, not by us or anybody else, in one way or the other be taken; nor at war, by one King or the other or the Government, be confiscated, nor (despite the necessity and distress be ever so large) there take advances and credit.’

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principal was to protect the safety of the deposits, thus avoiding a repetition of its private predecessor’s failure.” The Charter explicitly prohibited the issue of notes to circulate as a medium of exchange. In 1701, however, the Banking Committee authorized the issue of notes to be used as money, thus overruling the Charter. In 1726, the notes became accepted for tax payments. From then on, the notes quickly began to replace specie, in particular the unwieldy copper plates.

The constitution of 1809, valid until 1974, also guaranteed the convertibility of the Bank’s notes. In 1915, an escape clause was written into the constitution, codifying the unconstitutional suspension in 19 14:

... These notes shall at request be converted to gold according to their inscription; but that the exception, when the consideration of war, danger of war or a severe money crises make it without doubt necessary, may for a certain time be allowed the King and the Parliament together, or if the Parliament is not convened, by the King on the request of the Board of the Riksbank and after consultation with the National Debt office (972 Reger- ingsformen, 1915- 1974).

The governing structure of the Bank has remained largely unchanged until the present. The Bank is led by a non-professional Board, appointed by the Parliament from its own members.” The Parliament supervises the Bank through a Banking Committee.” The committee delegates monetary policy through written instr~ctionsl~ to the Board voted on in Parliament. Initially, banking policy was not voted on by the whole Parliament but by a subcommit- tee, the so called Secret C~mmittee.’~ The nobility, the burghers and the clergy were represented, but the fourth peasants’ estate, was excluded from the Secret Committee and the Banking Committees until 1800.

The period studied covers large swings in the relative power overfrscul policy between the executive and the Parliament. The Parliament increased its power over taxation in the 17th century, but lost virtually all its powers during the despotic regimes of Charles XI and XI1 1682-1718. A complete reversal occurred after the death of Charles XI1 in 1718. According to the constitution of 1720, the Parliament controlled budget and tax policy with complete sover- eignty. The executive, elected and subject to dismissal by the Parliament, carried out the decisions. Formally the King led the executive, but he had virtually no power. The coup d‘ktat of king Gustav I11 in 1772, removed the Parliament’s right to determine the budget, but not its right to tax. The new constitution of 1809-Gustav 111’s son Gustav IV was dethroned that same year-restored the Parliament’s power over the budget and taxation.

lo Palmstruchska Banken. ‘I Riksbanksfullm6ktige. Only very recently have board members been appointed from

“Bankodeputationen 1668- 1772, Bankourskottet 1772- 1971, and after 1971 subsumed in

” Bankoreglementet. ‘4 Sekreta utskottet 1627- 1772.

outside the Parliament.

Finansutskottet.

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To sum up, from 1718 fiscal policy has been controlled by the Parliament, with very little power for the executive with the exception of the period 1772-1809, while monetary policy continuously has been the prerogative of the Parliament since the founding of the Bank in 1668. Thus, for most of the period, monetary and fiscal policy decisions were coordinated through debates within the Parliament while when the executive controlled fiscal policy, coordination was often the outcome of power struggles between the Parliament and the executive.

Iv SUSPENSIONS AND RESUMP~IONS 1668- 1931

The suspension 1709-19'5

During the period 1668-1745 convertible notes gradually evolved as an acceptable means of payment. Depository notes circulated early on as money, in violation of the wishes and the statutes of the Bank. They became common in the 1720s malung an inconvertible paper standard possible. The Bank managed to preserve the convertibility of its deposits, despite the absolutist reign of Charles XI and Charles XI1 until 1709. The Bank had to close in 1709 when news of Charles XII's defeat in the battle of Poltava, deep in Russia, led to a panic. It remained closed until 1718. In the meantime, several conflicts arose between the King and the Bank over reserves, as well as over the King's demands that the Bank issue credit notes to finance his war effort. By and large, the Bank managed to protect its independence through reliance on the Bank Charter. Starting in 1715, the government began to issue IOUs which turned into paper money in great quantities to pay for war finance.16 When peace returned after the Great Nordic War and Charles XII's death in 1718, the Parliament took control over the government. It settled the short-term IOUs by partial payment (i.e. default), created a new office" endowed with earmarked taxes to pay the long-term domestic and foreign debt, and reopened the Bank in 1719.''

The 1745-76 paper standard"

After the death of Charles XI1 in 1718, the Parliament controlled the executive while the King's position was strictly ceremonial. A two-party system devel- oped, with the mercantilist Hat party holding power until 1765. The note issue and ensuing inflation are closely related to the two principal planks of the Hat party: increasing the wealth of the country through support of domestic industry with generous credits, state subsides and protectionism; and reclaiming land lost

"This section builds on Brisman (1918). "The IOUs were issued by Upphandlingsdelegationen 17 16- 19 (mynrrecken),

Konrriburionsrdnrerier 17 12- 19 (Stdndernas obligarioner, myntsedlar), and Starskonrorer 17 15- 19 (I6ningsedlar).

I' Riksys srdnders konror 1719- 1765, a precursor to Riksgdldskontorer founded in 1789. I* See Amark (1961, ch. 12) on the repayment of Charles XII's debts.

The section builds on Montgomery (1920) and Amark (1961, chapter 6). See also I Y

Myhrman (1976).



to Russia in the Great Nordic War. The latter goal resulted in a war with Russia 1741-43 and in participation on the side of France in the Seven Years’ War

The suspension of 1745 and monetary policy until 1756. This suspension was forced by the loss of reserves due to an over-issue used to finance Swedish manufacturers starting in 1738. During the war against Russia 1741-43, government borrowing doubled the note issue. The exchange rate against the silver based Hamburger Banco depreciated continuously from 1738. Due to the high cost of shipping copper, the commodity backing the Swedish currency-daler silvermynt, and the falling real value of copper, the loss of reserves was slow, but in 1745 the Bank was forced to suspend convertibility.

The government’s borrowing from the Bank was sanctioned by the Secret Committee through orders for specific sums. Sealed instructions for emergency loans were added to the budget to be opened by the government when the state was in danger. The Parliament hypothecated the loans by earmarking specific taxes and foreign subsidies for interest payments and amortization.*’ Sealed instructions were added to the budgets of 1739, 1743, and 1747. The seals were all broken and used for new loans, though of fairly small magnitude. The government appears according to its (ex ante) budget, to have run small surpluses (see Figure 3; the figures are, however, misleading for 1741-45 as most of the war expenses occurred outside the budget). The government debt increased, however, which suggests that the actual primary surpluses were too small to service the debt. Thus, new loans had to be raised. Attempts to borrow outside the Bank, domestically and abroad, were made in 1743 but they all failed. Increasing debt and interest payments led the Parliament in 1756 to order a reduction in the interest rate from 6 to 3%, in effect a partial default.

After 1745, the note issue increased mainly due to private lending. This expansionist policy was sanctioned by the Parliament, based in turn on the interests of the leadership of the Bank. According to HallendorfT(l920, p. 283):

The generous loans created a strong bond of economic solidarity between the Bank’s debtors and the party which had opened this source of credits and also had it in their hands to close it or let it flow even more freely. It is no coincidence, that the classes of business, the nobility and the burghers, first began this alliance between politics and private interests and then sought to preserve it as long as possible.

The monetary expansion was facilitated by the popularity of the mercantilist doctrine that the trade deficit was the cause of the depreciated exchange rate. This theory remained popular for two reasons: the absence of official information on the state of the Bank’s lending and the absence of a clear alternative analysis. Full information was only given to the Banking Committee and, sometimes, to the larger Secret Committee.

1757-62.

fOThe emergency loans were first given against IOUs, and then hypothecated by the Parliament.


NO~O lawe d a m 50,000,000 - 45,000,000 .. 40,000,000 .. 35,000,000 .- 30.000.000 .. 25,000,000 .. 20.000.000 .. 15,000,000 ..

O t : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : ' 17 42 44 18 48 50 52 54 58 58 80 62 64 66 68 70 72 74 76 40

9 0 - 80 70 60 50 40

3o 20 10

d r p 10,000,000

8,000.000

6.000.000

4,000,000

2.000.000

..

.- '. '. .. .T .. ..

0 1 : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : ; : '

Real balancer

300 250 m 150 100 50

0 I : . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

17 42 44 46 40 50 a 54 !m 58 80 82 84 66 68 70 72 74 76 40

Figure 2. Monetarv indicators 1740-76. Notes: Currency units are Doler silvermork id s m). Real balances are defined as 1) the real value in goods by taking the ratio of the note issue and the price level in 1740, and 2) the silver value by taking the ratio of the note issue and the exchange rate, defined as the domestic currency price (in mark kopparmynt, m k; 12 m k = 1 d s m) of the silver based Hamburger banco. Sources: Note issue and exchange rate from Sveriges Riksbonk 1668-1918. Bankens tillkomst och verkrornher, part 5 , 193 1. The plans are from Montgomery ( 1920). 0 Scottish Economic Society 1996

d s m 35,000,000 - 30,000,000 - - 25,000,000 .. 20.000.000 .. 15,000,000 .- 10,000,000 .-

17 2224 26 28 30 32 34 38 38 40 42 44 46 48 50 52 54 56 58 80 82 64 66 68 70 72 74 76 20

80,000,000 70,000,000 60,000,000

d o m 20,000,000

15,000,000

10,000,000

5,000,000

Totaldebt1777 x .. .- .- TOUdebt 1764 .

-5,000,000 O I -10,000.000 1


The warfinancing of 1757-60. Between 1757 and 1762 the note issue tripled as a result of the large primary deficits incurred due to Sweden’s involvement in the Seven Years’ War, see Figure 3. Sweden was dragged into the war as a result of a treaty with France incurred in exchange for subsidies. The subsidies were increased to pay for the Swedish troops on the continent but they did not cover the increased expenditures. From 1757 until 1764 the budget showed large primary deficits resulting in a rapid increase in the debt, see Figure 3. The Bank became the war’s principal financier. The budget of 1756 contained a sealed instruction granting the right to borrow further from the Bank with a maximum limit. The Crown (r6det) coaxed the Bank into advancing far more than the stated maximum, a clear constitutional breach. New Bank loans were granted by the new Parliament convened in 1760. Loans from the Bank temporarily stopped in 1761.

Borrowing outside the Bank began in 1757. Most of the non-Bank loans were short-term and the need for long-term finance was great. A proposal for raising a long-term foreign loan in order to pay off the Bank was considered at the Parliament in 1756. The issue was referred to a committee, which reported to the new Parliament in 1760 when the situation had completely changed. The connection between the note issue, the price level and the exchange rate had by then become apparent. The issue now was how to stop a further depreciation by repaying the short-term debt and continuing to finance the war without further reliance on the Bank. The Secret Committee suggested a foreign loan. The situation was delicate since revealing the Crown’s financial position might destroy its credit-worthiness. The Parliament, however, had to agree to stand as guarantor. It was reluctant, in particular the peasants’ estate, and the Secret Committee had to reveal more than it wished to before any action was taken. The subsequent loan negotiations failed, and the government had to continue relying on short-term credits from abroad.

After 1764 the government appears to have had the primary deficit under control, and it may even have run some surpluses. However, it is clear that the surplus created was insufficient to stabilize the debt, which continued to grow. Once again, the debt to the Bank began to grow in 1769. Domestic loans outside the Bank began to increase in 1757. Foreign borrowing turned upwards about the same time. The total debt at the end of 1764 was estimated to have been 55 million daler silvermynt, representing more than three times the Crown’s revenues in 1764, of which 70% were Bank loans and less than 3% were foreign loans. By the end of 1777, the debt had increased to 88 million, of which 34 millions was foreign. The note issue decreased by about 20% between 1765 and 1768, when the Bank was instructed to recall private loans, while the Crown’s debt to the Bank remained constant.

Plans and actions to restore convertibility 1760-77. The debates at the Parliamentary meeting of 1760-62 began the long process that led to the resumption of convertibility in 1776. The Hat party still had the majorities in the three estates governing the Bank but public opinion had turned against their policies, not least because of the disastrous war activities. The previous mercantilist theory that the depreciated exchange rate was due to an unfavour-


INFLATION: SPECIE A N D PAPER STANDARDS IN SWEDEN 455

able trade balance was also generally discredited. The Swedish ‘bullionist’ debate, initiated by the insightful analysis of Pehr Niclas Christiemin in 1761, offered a quantity theory view placing the blame on the overissue of notes.*’ After long discussions on who was accountable for the Bank’s affairs, the Parliament instructed the Bank to stop all new loans to private borrowers. The minority party, the Caps, introduced a plan to restore parity but no decision was taken.

The parliamentary meeting of 1765 with a Cap majority, began an inquiry into both the management of the Bank back to 1738 and the government budget. The inquiry made the situation of the Bank and the Crown public knowledge. The Parliament accused the former and current Board of gross mismanagement and of having intermingled the Crown’s and the Bank’s business. The lending, which had led to the inconvertibility decision 1745, was deemed illegal since it violated the Bank’s original Charter. The debates and actions against the Board were unusually harsh and revengeful. The actions had clear long-term effects establishing the accountability of the Board and the need to maintain the originally intended separation between the finances of the Crown and those of the Bank.

A secret plan to restore parity was accepted by the Secret Committee in 1765. Resumption at the old parity was more or less taken for granted, though some were arguing for devaluation, both in 1762 and 1765. The plan had four elements: first, revocation of the overissue through a recall of both private and government loans, second, an increase in the reserves of silver through foreign loans, hoped for French subsidies and sales of copper reserves for silver, third, interventions in the foreign exchange market to appreciate the Krona against the Hamburger Banco with a plan stipulating a gradual appreciation over six years according to a pre-set, secret schedule; and fourth and finally, a change to a silver standard at resumption.

The plan contained an elaborate calculation of the necessary revocation of the note issue according to a pre-set schedule. The calculated plan for the note issue, the exchange rate, and the real value of the note issue is shown in Figure 2. Real balances in notes were planned to decrease through the exchange of notes for specie. The plan hinged on the government being able to reduce the note issue through budget surpluses. The plan led to a rapid fall in the exchange rate in expectation of restored convertibility, see Figure 2. The nominal appreciation led to a real appreciation and a fall in exports. A deflation followed, hurting

”See Eagly (1971). The actual evolution 1740-59, however, appears inconsistent with the simple quantity theory based on fixed velocity. While the price level and the exchange rate follow qualitatively the note issue, they increased less than the note issue as real balances roughly quadrupled. See Figure 2. Some of the increase is probably due to a gradual crowding out of specie, but it is highly unlikely that it was one-to-one, as paper already from 1726 had begun to replace the unwieldy copper plates. It is also unlikely that growth in real GDP and population can explain the quadrupling. Hence, seignorage (= inflation tax + change in real balances) was only in part paid as an inflation tax. Potentially, the government’s tax backing, through hypothecating specific taxes to the Bank, may have been partly credible. The change in real balances as the key implication of the tax-backing theory is stressed by McCallum (1992).

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both debtors and domestic industry.22 Debtors, property speculators, entrep- reneurs and exporters agitated for a change in monetary policy. The government put pressure on the Board to abandon the plan but it refused, citing instructions from the previous Parliament-their principal. In 1768, however, the Board was forced to advance money to the government by a threat of default on government bonds for which the Bank stood as guarantor.

A second plan was devised in 1769, when a new Parliament met to deal with the deflation crises.23 This plan, detailed in a secret instruction to the Board, preserved the goal of full resumption with a change to silver but it redefined the goal to allow for a fall in the relative price of copper to silver. Instead of 36 marks per Hamburger banco, the new rate was to be 48. The method of achieving the goal, however, was changed. The intention was to strengthen the exchange rate through sterilized intervention with the help of foreign loans. The government would thereby not only be absolved from amortizing its debt to the Bank, but it would also receive new loans. The plan quickly failed. Foreign loan negotiations collapsed and the note issue continued to increase beyond the plan. With new loans, it appeared that the exchange rate could be stabilized but now at a higher level than intended-60 instead of 5 5 , indicating a strong relationship between the note issue and the exchange rate.

A third plan was devised at the Parliamentary meeting in 1771-72. It aimed at a devaluation to 60 marks per Hamburger banco. Several arguments for such a devaluation were advanced. First, the costs of resumption at full parity, which had become apparent during the crisis were not considered worth the loss of the ‘credit’ of the Bank. The Secret Committee put the issue squarely:

About the concern that the Bank would lose its credit if the notes are not realized at their full value, the Secret committee has found it more probable, that its credit would be strengthened through a realization, albeit at less than full parity; since one who pays something ought to have more credit than one who pays nothing, and one who voluntarily enters a contract, ought not to promise more than he with safety can keep, whereupon credit mainly depends on. Statement by Sekreru utskottet, 14 July, 1772, after Schwerin (1 828, p. 204).

Second, the uncertainty over when and at what rate parity would be restored created large swings in the exchange rate which spoke for a quick resumption. Third, a devaluation would upset relations between lenders and borrowers established during the period with a decreased value of money.

The Banking committee’s plan, however, was never voted on, due to the coup d ‘ h t of August 1772 by King Gustav 111. The King imposed an agreement with the Parliament concerning his rights and then dissolved it. The

”The depth of the recession in 1767-68 is suggested by the following figures of percentage declines from Montgomery (1920, p. 63): yearly copper production 36, pig iron 34, iron exports 13, textile machines in use 19.

2’Ironically, the old Board was dismissed for having carried out the previous Parliament’s instructions.


INFLATION: SPECIE A N D PAPER STANDARDS IN SWEDEN 457

agreement included a pledge that the Board would follow the King’s instructions, with the proviso that the instructions were in accord with the Charter of the Bank. Thus the Bank’s safety and strength could be maintained. The Parliament thus left resumption in the hands of the King and his Minister of Finance, Liljencrantz. Liljencrantz’s plan was to increase the specie reserve of the Bank through foreign loans and to repay some of the Crown’s loans in specie. When enough specie had been collected, the existing notes were to be convertible either to new Riksdaler notes (the new currency unit), or to silver coins. At the same time the Crown’s Bank debts would be considered settled. The Bank was also ordered to cany out interventions in the foreign exchange market to stabilize the exchange rate. It succeeded in establishing a rate of about 70 marks in 1775-76, effectively turning the monetary system into a silver exchange standard even before full convertibility was restored in 1777. The plans were repeatedly discussed with the Board which voiced strong misgivings about its feasibility. The Board believed that the measures to strengthen the specie reserve were insufficient in view of the outstanding note issue and the suggested convertibility rate but it was overruled. In November 1776, the King declared that from January 1 , 1777, the notes denominated in copper would be convertible to silver at a rate corresponding to the devalued rate of 70 marks per Hamburger banco.

The resumption had two parts: a cancellation of the government’s debt to the Bank, with a partial payment and fiscal reforms to avoid future borrowing. Taxes were increased in real terms by translating taxes expressed in the old currency Daler silvermynr to Riksdaler according to the pre- 1745 relationship between the two currencies. Thus the erosion of tax revenues during the paper period, due to the fixed tax rates in Daler silvermynt combined with the inflation, was reversed. New administrative procedures for tax collections also were introduced. As part of the deal with the Bank, revenues ear-marked for the Bank would be returned to the Crown. Reforms on the expenditure side were long-run. Government offices were to be automatically suspended when the holder retired and re-evaluated, and liquor production was to be made a government monopoly. The chronic government deficits, even increasing during 1773- 1776, initially disappeared, see Figure 3. Convertibility was successfully established with the new notes being accepted by the public and no run occurring on the Bank.

The parallel paper and specie standards I 789-180324

Once convertibility was successfully restored in 1776, the principal goal became its maintenance. The Board’s resolve to maintain convertibility was strongly backed by the Parliament through the instructions of 1778. Ironically, the Bank’s determination to protect convertibility turned out be its undoing. The next Russian war in 1788 brought a new parallel paper currency issued by the newly

%This section builds on Hallendoff (1920), Heckscher (1949). h a r k (1961, ch. 6) and AhlstrGm (1989).

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established Swedish National Debt Office2’ under the Parliament, so called Riksguldssedlar (Treasury notes) that largely replaced the Bank’s notes in circulation. 26

The Board’s position was so strong that the government (now led by the King) never seriously attempted to use the Bank for war finance. Previous attempts to extract loans had failed. The Bank had now succeeded in establishing a reputation for independence and convertibility. The strange solution of a parallel currency, also guaranteed by the Parliament, appears to have been made possible by the division of the Parliament into one fraction among the peasants’ estate loyal to the King, with the three estates which controlled the Banking Committee forming a majority against the King.

As planned, the new notes, initially issued as interest-bearing bonds, were quickly accepted as a means of payments. As observed in many other instances, paper money drove specie money from circulation. See Figure 4. Prices also quickly began to be quoted in Treasury notes.*’ The Bank maintained its convertibility, but its notes were no longer used and it was excluded from monetary policy decisions until 1803.

The war with Russia ended in 1790. Since the Crown continued to be plagued by bad finances, the issue of Treasury notes continued, see Figures 4 and 5 . The Parliament of 1791-92 took no decision, the question being postponed until the next Parliament’s meeting in 1800. This session was convened by the King for the explicit purpose of making the Treasury notes convertible. It was decided that the Treasury notes would be redeemed at a devalued rate of one sixth (163%). that is lower than the actual depreciation. See Figure 4. The Bank was instructed to exchange two thirds of the Treasury notes for conversion into the Bank’s notes at a devalued rate; the rest were to be exchanged for ten-year bonds to be paid for by future taxes. The Banking Committee argued for the devaluation on equity grounds: new lenders and money holders should not profit from an increase in the value of the Treasury notes. They also argued against full repayment on the ground that the additional taxes would be too onerous. The plan called for an increase in the specie reserve which in part would be paid for by a two-year capital levy.28 A resolution was passed by the three estates leaving the final decision to the King.

In 1803 the final devaluation rate for the Riksdaler riksguld was established by the King at 50%, that is, each Riksdaler riksguld was set equal to 2/3 Riksdaler bunco. Thus the process was speeded up by a devaluation greater than planned by the Parliament. The specie reserve was increased in part by the capital levy, paid in silver.29 The decision was clearly unconstitutional, since

RiksgUldskontorer. = A contemporary parallel are the assignats issued by the French Republic. ”This is not self-evident from the existing official price records (markegdngsraror), but

$f Keynes (1923, ch. 2) on a capital levy as an alternative to devaluation. 29The largest part of the increase in the specie reserve came from an unexpected revenue

boon to the Crown: The Swedish colony Wismar in Pomerania was rented to Mecklenburg- Schwerin for 100 years.

has rsuasively been argued to be the case by Ahlstr6m (1974, ch. 2).



Index 1777-100 W T

Prlce level

o 4 : : : : : : : : H : : : : tt: ; : : : : t+t+w: : : : : : n: ; : : : : : : : : : : : : :-

rate Bank and Treasury Notes

skMbbco External exchange rate rdr spMb bco

0

Figure 4. Monetary indicators 1776- 1834. Sources: See Figure 2. Internal exchange rate from J6rberg (1972, Table IV:2).



rdr 12,000,000

10,000,000

8,000,000

6,000,000

4,000,000

2,000.000

0

9,000,000 - 8,000,000 - - 7,000,000 - - 6,000,000 .- 5,000,000 .- 4,000,000 .- 3,000,000 .. 2,000,000 - _ 1,000,000 - - Total delkit

Primerydowt 0 3 : : : : : :::"""'"''''"'::::: ::-

r r

rdr Domestic debt, including central bank deM

20,000,000 18,000,000 16,000,000 14,000,000

,..- --. . 10,000,000 8,000,000 6,000,000 4,000,000 '- .--' 2.000.000

'.. . .-• 'L ... . Foreigndebt

0 -: : : : : :*

Figure 5. Fiscal indicators 1776- 1834. Sources: See Figure 3. Debt: Amark (1961, Tables 64,66,67,68).

one estate, the nobility, had not granted this right to the King. The Board was reprimanded by the Parliament's Bank auditors in 1806, and by the next Parliament's Banking Committee, for not having protested, but no further measures were taken.



The suspension in 1809 and the resumption in 183430

Sweden became involved in the Napoleonic wars when Russia attacked Finland in 1808. Finland was then part of Sweden but it was ceded to Russia in 1809. As a result the Crown’s finances quickly deteriorated. Initially, the war expenses were paid with a small loan from the Bank, in accordance with the Board’s previous instructions for emergencies, and with British subsidies. The King imposed a war tax, a right given to him by the 1772 constitution. As it took time to collect the new taxes and the other funds were quickly exhausted, new means had to be found. The Bank was used in a way that circumvented the Parliament’s instructions against further government borrowing. According to the conversion plan of 1803, Treasury notes were to be received and killed by the Treasury in exchange for a deposit at the Bank (which also happened as seen in Figure 4). Now the Treasury used the right to use deposits at the Bank, but without collecting and killing any Treasury notes, as supposed. Thereby the total note issue increased rapidly as seen in Figure 4.

The rapid increase in the note issue led to inflation and a depreciation of the exchange rate. The ensuing drain of silver from the Bank forced it to close its silver window. In 1809 convertibility was effectively suspended though it was not until 1818 that the Parliament made it official. In the meantime, a very limited conversion took place through rationing. This extremely limited conversion can be interpreted as an attempt to delude the public, but the ad hoc character perhaps also signaled that the suspension ought to be seen as a temporary expedient.

The suspension took the Board by surprise; as late as the end of 1808, it considered the silver reserves adequate and the restored convertibility safe. The decision to suspend was taken by the Bank’s employees, and not until 1810 was the decision formally made by the Board which then informed the Banking Committee. It appears that all the parties responsible for the Bank accepted the suspension as a fait accompli, forced on the Bank by the war, despite its dubious constitutionality.

This suspension lasted for 25 years. Plans to restore convertibility were discussed at every parliamentary meeting. At the sessions of 1810, 1812, 1815, the issue was how and when, but not if, convertibility at the old parity should be restored. In 1810 it was decided that loans to the Crown would be repaid with interest according to a preset schedule. The Banking Committee felt that once it was decided to pay back the loans, the value of money would be preserved. The amortization of the debt would eventually restore the note issue and the reserve ratio which would insure the public of the ‘credit’ of the money. The observed depreciation would soon disappear and convertibility could be restored. The note issue was seen as a loan to be repaid by future taxes and which need not decrease the value of money. This is exactly what the modem proponents of tax- backed money theories claim.

To restore convertibility, it was felt that a reserve ratio of well over 50% was necessary to create enough confidence to avoid a panic. The increase in the

mThis section builds on Ahlstrom (1989), Brisman (1931) and Pettersson (1989).

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reserve ratio was to be achieved through repayments from the Crown to decrease the note issue and through simultaneous silver purchases. Since a quick deflation was to be avoided, the process had to be gradual.

The measures to increase taxes turned out to be inadequate and the note issue remained roughly constant, not only for the next few years, but until convertibility was restored, see Figure 4. The plan to reduce the note issue, however, was official policy until the Parliamentary meeting of 1823. At the meeting of 1812, no further measures for the Bank were taken in view of the post-Napoleonic-war recession and the perceived lack of credit and high interest rate^.^' The bad times continued and in 1815, the Parliament decided to keep the note issue constant, putting the recall of notes on hold until better times. A proposal for devaluation and restored convertibility was presented at the 1818 session but no action was taken.

By the next meeting of 1823. general opinion had swung completely in favour of devaluation and a quick return to convertibility. The Banking Committee referred to the danger of large disruptions that would occur in the case of a deflation. A new plan was devised with devaluation at the current rate implied by the exchange rate against the silver based Hamburger banco. The principal motive according to the Banking Committee’s inquiry, was the uncertainty created by the paper standard which led to high nominal interest rates.

After some modifications the plan was accepted by the Parliament and it eventually became the basis of the resumption of 1834 at a devalued parity of 2 and 2/3 new Riksdaler per old Riksdaler in specie (62.5% devaluation). The resumption process dragged on because it was felt that the silver reserves were inadequate. The King intervened by calling a new Parliament in 1834 which agreed to begin convertibility immediately without further increasing the silver reserve.

The World War I temporary paper standard: full r e s ~ m p t i o n ~ ~

The 1914-24 suspension period stands in contrast to the three earlier ones in several respects: its beginning: an external war in which Sweden was not involved, its duration: a comparatively short period one of ten years (or eight de facto), and its termination: resumption at the old parity. The suspension thus was not related to the state of government finances. The Bank suspended the convertibility of its notes to gold on 2 August, 1914 and later in the Fall of 1914 gold exports were prohibited. This unconstitutional suspension led to a change

’I It was, however, decided that 2/3 of the foreign debt should be defaulted on, in regard of the losses to the Swedish Crown and citizens abroad in the Napoleonic wars, see Figure 5. The rest of the foreign debt was paid in 1815 by a loan to the Swedish government from the King, Charles XIV Johan. The King’s money emanated from the former French colony Guadeloupe which had been given to Sweden in 1813 by the United Kingdom. In 1815, the United Kingdom gave back the colony to France with Sweden’s agreement. In exchange, the United Kingdom reimbursed the King personally, in view of the losses to the King implied by the new constitution of 1809.

’*This section builds on Heckscher (1926).



in the constitution in 1915 with the escape clause quoted in Section III being added. The suspension was clearly seen originally as a temporary step as the general belief was that the war would be of short duration.

The gold standard was reinstated temporarily at the beginning of 1916 with notes convertible to gold. By this time, however, the Swedish exchange rate had appreciated relative to the pre-war parity which made it profitable to exchange gold, obtained from countries still on gold, for Swedish notes The Bank requested and received the right to suspend convertibility of gold to notes which in theory made it possible for Sweden to avoid importing inflation from the gold countries. Still inflation continued at a rate higher than in the gold ~ o u n t r i e s . ~ ~ Thus the gold standard was not fully suspended since the right to convert notes to gold was maintained and still constitutionally guaranteed.

The sources of the war inflation were a hotly disputed question during the whole war but it was not until the Spring of 1920 that the issue of resumption began to be debated among policy makers. The starting point was a newspaper article by Eli Heckscher in March 1920 urging the public to convert their notes to gold. He pointed at a potential arbitrage profit in case the gold export prohibition was lifted since the Krona now stood 44% below its gold parity against the gold-dollar. Heckscher's article started a run for gold on the Bank. The Bank asked the Parliament for and received relief from the obligation to convert its notes into gold, thus leaving the issue unresolved. When the government extended the relief from convertibility in September 1920, the Minister of Finance also announced the government's intention to restore the old parity. Similar statements were repeated when inconvertibility was extended until convertibility (with the right to export gold) was finally restored in April 1924.

Even though the constitution was honoured through the resumption of 1924. there was a considerable opposition and uncertainty over the proper course of action; the constitution could be changed or the escape clause could be invoked repeatedly to the point where the constitutional guarantee became meaningless. The latter alternative is what happened after 193 1.

Support for resumption was far from unanimous. First, the resumption implied a sharp deflation in Sweden due to a higher inflation rate in Sweden during the war than in the gold countries. This deflation led to massive unemployment starting in 1920 which in turn fueled opposition by industrialists and representatives of labour. Second, the resumption of the gold parity and the dollar-krona exchange rate had no clear implication for the price level. It was widely felt that the United States determined the real gold value and hence the price level for the countries that choose to go back on the gold standard. The uncertainty surrounding the future of the international gold standard reduced its reputation as a regulator of price levels and exchange rates. Most Swedish economists, however, supported a restored parity. The overriding argument was the automaticity and non-political nature of the gold standard whose reputation

"This was possible due first to the real appreciation and nominal appreciation of the Krona, and later when the Krona depreciated below the gold panty to the gold export prohibition.



should be maintained by restoring the old parity. This argument was strengthened by the Bank’s poor record during the suspension.

The World War I experience in Sweden supports the view of the gold standard as a contingent rule written into the constitution. The gold standard survived but its reputation had been marred both in the public’s mind because of the high deflation cost and formally by the introduction of the constitutional escape clause. Thus the road to future suspensions was paved.

The 1931 suspension

The Bank was forced to declare the suspension of the gold standard in September 193 1, one week after Britain suspended. A severe drain of foreign reserves due mainly to foreign investors who sold their Swedish assets left the Bank no other option. This suspension stands in contrast to the previous ones in several respects. First, it was only the second case of a genuine speculative attack since the Bank was founded (the first one occurred in 1709). The intervening suspensions were caused either by an initial overissue of notes or, as in 1914, was made pre-emptively. Second, the suspension was constitutional since it occurred in response to a ‘severe money crises’ in accord with the constitutional amendment of 1915. Third, it was followed by the declaration of a new norm replacing convertibility.

In conjunction with the suspension, the Minister of Finance declared that Sweden would follow a price stabilization rule: ‘Monetary policy should with all possible means preserve the internal purchasing power of money’. But also that ‘a return to gold should be sought after, as soon as the pre-conditions for this are at hand.’ The new norm was successful, first, in that the imported deflation was halted, and second, in that the price level was stable for the rest of the decade.34 Since the gold standard was never restored, the escape clause had to be invoked each year until the constitution was changed in 1974.

The demise of the international gold standard during the 1930s and the Bretton Woods arrangement after World War I1 explains ex post why it was never restored. To determine how the resumption of the gold standard was perceived ex anre is more difficult. A clear statement of the economists’ point of view on the gold standard question is available.” In the Fall of 1931, the Bank sent a questionnaire to three senior economists, Gustav Cassel. David Davidson and Eli Heckscher. It inquired about the proper conduct of monetary policy in the short and in the long run.

Cassel and Davidson welcomed the suspension since it isolated Sweden from the international deflation. All of them ruled out a quick return to gold and they agreed that the short-term goal should be price stabilization. The long-term goal should be a return to fixed exchange rates; whether to gold would depend on the international gold standard. If there was to be a return to gold, all agreed that it should occur at the current rate as implied by the exchange rate to other gold

34 See Jonung ( 1979a). 3J See Jonung (1979b).



countries. The economists’ reaction indicates that a temporary suspension, with a return to the old parity, was unrealistic. It is also difficult to imagine much popular support for a return that would imply a deflation. Thus the old gold parity probably also gradually lost relevance in the minds of the public ex ante.

V CONCLUSION

We have examined the suspensions and resumptions of the convertibility of notes circulating as a medium of exchange from the founding of the Bank in the late 17th century until the early 1930s when the commodity standard was abandoned permanently. We have drawn a number of conclusions.

(i) There has been a strong, but variable and less than full, commitment to convertibility. Fiscal demands and panics have undermined convertibility, but the attractiveness of convertibility has been a strong opposing force, except after 1931. An indicator of the varying strength of the commitment is the length of the five paper periods which have varied from 10 to 31 years.

(ii) A legal commitment to convertibility has not been a sufficient commitment mechanism. Convertibility has been abandoned in two ways. First, by suspending the convertibility of Bank notes in violation of the Charter in 1745-76 and in violation of the constitution in 1809-34 and 1914-15. Second, by issuing paper money outside the Bank in 1716-18 and

(iii) By implication of conclusion 1, the commitment to convertibility has been a strong constraint on fiscal policy, but not strong enough to rule out inflation finance.

(iv) There has been a weak commitment to a return to the original parity after suspension. The attraction of the old parity was insufficient to cause a return to convertibility, except in 1924.

(v) The proximate cause of paper money has been either panics or fiscal crises. The causes for not restoring the old parity (i. e. default) have been political forces opposing increased taxation and deflation.

(vi) Only the 1914-22 period may be said to constitute an instance of the gold standard serving as a contingent rule in the sense of Bordo and Kydland (1995). The contemporary debates and the failed attempts to go back to the old parity indicate that the moves from specie to paper money were regarded as mistakes.

17 89 - 1 803.

ACKNOWLEDGEMENTS

The authors are grateful for helpful comments by Goran Ahlstrom, Michael D. Bordo, Alessandro Missale, Casey B. Mulligan, Lars Pettersson, Lars G. Sandberg and participants at the First Brescia conference on monetary history and monetary thought, May 1995.

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Date of receipt of final manuscript: June 1996.


INFLATION AND SWITCHES BETWEEN SPECIE AND PAPER STANDARDS IN SWEDEN 1668 - 1931: A PUBLIC FINANCE...

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