Money, trade, and competition essays in memory of egon sohmen (publications of the egon sohmen foundation)

A Publication of the Egon-Sohmen-Foundation


Herbert Giersch (Ed.)
for the Egon-Sohmen-Foundation

Money, Trade,
and Competition
Essays in Memory
ofEgon Sohmen

With 19 Figures

Springer-Verlag
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Prof. Dr. Herbert Giersch
Past President
Kiel Institute of Wodd Economics
P.O.Box 4309
W-2300 Kiell, FRG

This book was produced with financial support of the
Egon-Sohmen-Foundation

ISBN -13: 978-3-642-77269-6
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Preface

On June 1, 1990, Egon Sohmen would have reached the age of 60 had he
not suffered from a fatal illness. It demanded his death at the early age of
46. If he were still with us, he would playa prominent role in the current
debate on monetary arrangements and on allocation theory, perhaps including environmental issues and urban economics. His contributions are
well remembered by his colleagues and friends, by his former students, and
by many in the economics profession on both sides of the Atlantic. In
extrapolating his great achievements as a scholar and teacher beyond the
time of his death, one is inclined to suppose that Egon Sohmen's name
would figure high on many a list of candidates for honors and awards in
the field of international economics.
For the reconstruction of economics in the German language area Egon
Sohmen was invaluable. Born in Linz (Austria), he studied in Vienna at the
Business School (Hochschule fUr Welthandel, now Wirtscha!tsuniversitiit),

then went to the US as a Fulbright scholar (1953), returned to Europe to
take his doctorate in Tiibingen, Germany, (1954) and crossed the Atlantic
again to teach at MIT (1955-58) where he obtained a Ph.D. (1958) under
Charlie Kindleberger. He might have stayed permanently in the US, continuing a career that he started as Assistant Professor at Yale University
(1958-61), if the US visa provisions had been applied in a more liberal
fashion.
Fortunately for quite a few people in Germany, Egon was offered a chair
at the young Saar University in 1961, after the faculty had been persuaded
to waive the traditional Habilitation requirement. We were glad that he
accepted. It gave us new opportunities to strengthen our ties with MIT
and Yale, with Austrian economists like Gottfried Haberler and Fritz
Machlup, who had become Egon's friends and mentors, with Willy Fellner,
and with the international economists of Egon's age cohort. Many students at the Saar University were deeply impressed by his teachings,
including his later wife, our best female student, and quite a few who now
hold prestigious posts in economics and public life. I can frankly say
without hesitation that Egon's influence was particularly strong among


vi

Preface

those bright collaborators who went along with me in 1964 to establish the
German Economic Expert Council (Sachverstiindigenrat) and who - in
1969 - helped strengthen international economic research at the Kiel
Institute. No economist teaching in Germany would have deserved the
Kiel Institute's Bernhard Harms Prize more than Egon. This acknowledgement must serve as a posthumous substitute.
Egon was not afraid of controversy; perhaps he even liked it. Great
controversies developed in Saarbriicken over the exchange rate issue, with
Wolfgang Stiitzel defending fixed rates, Egon propagating flexibility, and

some -like myself - pondering for a while until circumstances demanded
a system switch in the interest of domestic price level stability. In May
1969, when action was needed, Egon and I drafted a memorandum that
we sent to the government. When we went to the public it aroused a
political turmoil when more than a hundred economics professors in Germany openly joined forces with us. A few months later, exchange rates
became the main issue in the general elections.
In stormy periods, one needs friends with a strong character. Egon was
a true friend. He had an instinctive sense of the needs of others, notably his
family. Without his good advice and the generous financial support he
diverted from his salary as a young professor in his early thirties, much of
the scope for productive human capital formation in the Sohmen family
would have remained unexploited, as I gather from remarks by his sister.
From his brother, Helmut, Egon quickly received high intellectual returns.
Those who have read the preface to the first edition of "Flexible Exchange
Rates" will remember that he thanked his brother for having acted as Dr.
Wong, meaning Jacob Viner's Chinese draftsman who turned out to be an
excellent amateur economist by discovering a mistake in Viner's reasoning
about "Cost Curves and Supply Curves."
It so happened that Helmut Sohmen, as if Egon's reference had had
predictive power, made his way to the top of the world business community in the Chinese cultural and ethnic environment of Hong Kong with
such success that he acquired the means for creating the Egon-SohmenFoundation. Should sociologists have doubts about the viability of the
family in a cosmopolitan environment, they would become more confident
by looking at this example. Egon surely was a father figure, and economics
is now benefiting from it in a roundabout way.
The papers for this memorial conference cover the main areas of Egon's
interest and research during the largest part of his academic life, i.e, exchange rates and adjustment problems; welfare economics and allocation
theory; trade and factor movements; competition and economic growth.
The perspective is international, except for the paper on German monetary
unification, a subject which Egon would have found fascinating.

Preface

vii

There was no planning behind the allocation of subjects to participants.
It just worked out this way by my calling upon persons who were known
to have been influenced by Egon's teachings and writings in one way
or another and vice versa. No jawboning was necessary to support the
invisible hand. What was left for correction and coordination was mostly
achieved in the free discussion during two pleasant conference days at
Tegernsee in the Bavarian Alps.
The participants enjoyed the presence of the Sohmen family: Egon's wife
and brother, his sister, and sister-in-law. A verbatim record of the discussion would have shown that their intellectual contribution was not minor.
Bob Mundell had unanimous support when he recognized this at the end
of the conference, after having expressed his opinion on the future role of
the Egon-Sohmen-Foundation in the field of international economics.
The Egon Sohmen Memorial Conference was the second symposium
organized by the Egon-Sohmen-Foundation. The first one had taken place
half a year before in Laxenburg, Austria, on "The Economic Transformation of Central and Eastern Europe." The papers were published in 1991
under the title "Towards a Market Economy in Central and Eastern
Europe," edited by Herbert Giersch for the Egon-Sohmen-Foundation
(Berlin: Springer-Verlag). The third symposium was held on "Economic
Evolution and Environmental Concerns" in late summer 1991 in Linz,
Austria, Egon Sohmen's hometown.

Herbert Giersch


Contents

Introduction
Friedrich Schneider

1

Part I: Money and Exchange Rates
Free Minting
Charles P. Kindleberger

11

Profitable Currency Speculation: Service to Users or Destabilizing?
Herbert G. Grubel ........................................

23

Flexible Exchange Rates and Insulation:
A Reexamination
Joachim Fels .............................................

39

An Institutional-Economic Analysis of the Louvre Accord
Rudolf Richter and Udo Schmidt-Mohr ......................

59

The German Monetary Union
Harmen Lehment .........................................

87

Financial Liberalization in Developing Countries
Bela Balassa .............. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..

105

Part II: International Trade
Fiscal Policy and the Theory of International Trade
Robert Mundell ..........................................

125

Wage Agreements and Optimal International Factor Flows
Stephen T. Easton and Ronald W. Jones ......................

151


x

Contents

Protection and Exchange Rates
John S. Chipman .........................................

167

Aggressi ve U nila teralism

Jagdish Bhagwati .........................................

201

Theory and Practice of Commercial Policy: 1945-1990
Anne O. Krueger .........................................

233

Part III: Competition
Welfare Economics, Economic Order, and Competition
Manfred E. Streit .........................................

255

Competition and Economic Growth: The Lessons of East Asia
Wolfgang Kasper .........................................

279

List of Contributors .......................................

305


Introduction
Friedrich Schneider

The thirteen papers in this conference volume cover a wide range of topics.
They can be broadly categorized into three groups. Six of the papers deal

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

Money and Exchange Rates

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


2

Friedrich Schneider

argues that under unregulated free banking, short-term profit seeking will
go much further to destabilize the financial system.
Herbert Grubel's paper with the provocative title "Profitable Currency
Speculation: Service to Users or Destabilizing?" takes up another hotly
debated issue. Grubel critically examines the view of some influential economists that the large variance of exchange rates in the post-Bretton Woods
era can be attributed to widespread destabilizing speculation. He argues
that there is evidence that banks have made consistent profits from speculation and that such speculation has resulted in a stabilization of exchange rates over time in comparison to a situation in which the banks
would not have earned such profits. Grubel admits that some new theories
have generated examples of destabilizing, profitable currency speculation,
but stresses that so far neither direct empirical tests are available nor are
valid empirical results obtainable. The evidence cited in support of the thesis
that speculation is destabilizing is, according to Grubel, not undisputed in
the literature. Therefore, one cannot make a clear case for speculation
leading to destabilizing effects. Grubel mentions another problem that
arises in this context, namely, that up to now no general model explaining
the fluctuations of exchange rates has been developed. If a model of this
type were available, it would then be possible to investigate whether or not
one could observe destabilizing effects. However, Grubel's final conclusion
that currency speCUlation will stabilize exchange rates over time is also an
assumption (made by him) that has not been empirically verified.
Another topic relating to flexible exchange rate theory is tackled by
Joachim Fels in his paper "Flexible Exchange Rates and Insulation: A
Reexamination." The author argues that, contrary to conventional wisdom, the early proponents of flexible exchange rates (such as Milton
Friedman, Egon Sohmen, and Harry Johnson) never believed in the ability
of the system of flexible exchange rates to provide complete and automatic
insulation from all foreign disturbances. However, they stressed that domestic monetary policies would be free to pursue domestic goals under
flexible exchange rates and could, in some circumstances, be employed

to neutralize undesired macroeconomic influences from abroad. After elaborating on the work of the early proponents of flexible exchange rates,
Fels confronts the hypotheses of the early advocates with data from the
post-1973 period of flexible exchange rates. Summarizing his empirical
results, he arrives at two conclusions. First, in the flexible exchange rate
period countries have been able to set their price levels independently
of foreign inflationary or deflationary trends, as was predicted by Milton
Friedman and others. Second, business cycles have been much more synchronized under flexible exchange rates than they were under fixed exchange rates. This result is not in line with the argumentation of the


Introduction

3

early proponents. Hence the author discusses several explanations for
the observed synchronization of business cycles in the post-1973 period.
He concludes that the increase in international synchronization can be
explained by the growing integration among countries, which was reinforced by the move to general floating, and by the high degree of synchronization of short-term monetary policies under flexible exchange rates.
It is not only important to analyze the consequences offlexible exchange
rate regimes but also to go a step further and to subject the institutional arrangements themselves, and in particular the contractual relations
that characterize them, to economic analysis. Rudolf Richter and Udo
Schmidt-Mohr provide such an analysis in their paper "An InstitutionalEconomic Analysis of the Louvre Accord." They undertake their analysis
of exchange rate regimes from the contractual viewpoint of institutional
and especially transaction costs economics, which allows them to examine
reality as it is observed, without the usual claim that reality does not fit
into the economic model. The authors find that the transaction cost
approach provides economic rationales for the observation that a world
currency exists under an international paper standard together with flexible exchange rates and for the apparent "invalidity" of the purchasing
power parity theory as indicated by long periods of over- and undershooting in exchange rates. As the approach of this paper takes into
account the actual policy measures in the given institutional frame, it
permits a rational basis to be provided for a relationship that seems "very

dirty, when viewed through neoclassical spectacles" (quoted from Richter
and Schmidt-Mohr) and it permits this relationship to be discussed. The
advantage of the analytical style of the institutional economics is that such
an approach makes it possible to discuss complex organizational forms
using concepts such as bounded rationality, ex post opportunism, and
transaction costs.
The next paper, "The German Monetary Union" by Harmen Lehment,
deals with the introduction of the West German Deutsche mark as the
single German currency. Lehment begins with a short description of the
main events, discussions, and decisions accompanying the path towards
the German monetary union, and then analyzes the basic issues of the
German currency unification and its main implications. The author concludes that the German montary, economic, and social union can be seen
as a historically unique event because it aimed at transforming a socialist
economy into a market economy within a period of only a few months. A
monetary union of this kind is unlikely to increase the DM inflation risk
because the uncertainty about the East German money demand is relatively small due to the fact that the economic and monetary weight of East
Germany is only roughly 10 percent of the West German level. Further-


4

Friedrich Schneider

more, the author points out that the German monetary union did not
come about as the result of economic reasoning, but rather as the result
of a specific German political and economic situation. Lehment's paper
provides a set of economic facts and some preliminary conclusions about
the functioning of a suddenly installed monetary union, and hence can
be seen as describing a "field experiment" for the planned West European
monetary union.

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

Part II:

International Trade

In his paper "Fiscal Policy and the Theory ofInternational Trade," Robert
Mundell integrates major aspects of fiscal policy into the theory of international trade, employing classical assumptions such as that the purchasing
power parity theory is valid and that fiscal policy is perfectly anticipated
by the economic agents. Mundell reaches the conclusion that the effect
of fiscal policy on interest rates and on the exchange rate is much more
strongly determined by the decision of a government to spend now or in
future periods than it is by the way government spending is financed.
Moreover, the author presents the result that a country can put the entire
burden of domestic government spending on the rest of the world and that
retaliation from the affected country(ies) might only be able to counteract
such a result if it (they) at least has (have) the same economic power.
Then the author drops the assumption that the rest of the world acts in a
monolithic way and divides the rest of the world into partner and rival

countries. The author derives the result that usually some countries are
positively affected by a country's fiscal policy, whereas other countries are
hurt. An example for such a situation is the fiscal policy of the United
States (a net borrower since 1975), which increased government spending


Introduction

5

in the eighties and worsened its financial terms of trade, thereby benefiting
some trading partners. However, as pointed out by Mundell, it harmed
other borrowers, such as the less developed countries and some European
countries. Mundell further stresses that even though the benefits to the
lenders, i.e., Japan and Germany, were larger in a narrow sense than
the losses to the borrowers, it could not be argued that the rest of the
world was better off in a wider sense unless compensatory transfers from
the lending countries to the others had in fact been made. In his paper,
Mundell not only demonstrates how closely fiscal policy is currently related to international trade, he also states that the more countries are
linked to each other by trade flows, the more severe the consequences of
the fiscal policy of a major country are on other countries.
The next paper, "Wage Agreements and Optimal International Factor
Flows," is by Stephen Easton and Ronald Jones. They investigate the
nature of the response of the home demand for foreign labor to the level
of the minimum wages stipulated by the source country when capital is
more or less immobile between countries. Additionally, the authors consider the case that capitalists invest abroad, and the possibility that capital
might flow towards the low-rate-of-return home country as a part of a
buyout strategy offoreign factors. Further, the authors consider the impact
of various wage agreements on real incomes at home as well as in foreign
countries. Easton and Jones stress the argument that in the theory of

international trade one should analyze not only the gains that goods trade
allows when relative prices differ among countries but also the gains from
factor movements in response to differences in factor payments that are
not merely a reflection of asymmetric skill levels. This paper provides some
theoretical insight into the effects of the large-scale migration we are
observing, especially within Europe.
In the paper entitled "Protection and Exchange Rates," John Chipman
focuses on the relation between exchange rates and trade restrictions.
Chipman begins with a critical survey of the literature on the relationship
between protection and exchange rates. He then develops two models to
study the effect on the exchange rate of a change in a tariff or export tax
(or subsidy), obtaining the result that both an import tariff and an export
subsidy will bring about a currency appreciation. Chipman admits that the
trouble with this approach is the difficulty in interpreting the meaning of
strictly separable trade preferences. He chooses an alternative approach
and uses more direct trade-demand functions. He differenciates between
two states of the world: one in which two countries produce all three
commodities (two tradable and one nontradable) with only two factors of
production, and one in which all three commodities are produced with
three or more factors of production. While the results for Case 1 are


6

Friedrich Schneider

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

The next paper by Jagdish Bhagwati is entitled "Aggressive Unilateralism." He discusses the various measures the United States has taken
against countries like Brazil, Japan, and India because it feels that these
countries conduct unfair trade. The US attempts to deal with the effects of
unfair trade by arguing that these trading partners more or less secretly
subsidize industries in their countries by using various measures. These
measures result in lower prices than the prices that would have resulted
in a perfectly competitive situation. The US then exerts massive pressure
on these countries in order to force them to either abolish this type of
subsidy (in a very broad sense) or to come to "voluntary agreements"
about trade restrictions. Bhagwati provides an analysis of the various
stages in this highly interactive game. He is critical of the actions of the US
and he concludes that agressive unilateralism has no place in a world
trading regime reflecting the rule of law and the necessary symmetry of
rights and obligations, such as the GAIT.
Anne Krueger's survey paper, "Theory and Practice of Commercial
Policy: 1945-1990," concludes Part II of this volume. Krueger begins by
describing a few "realities." One such reality is that most economists, on
the one hand, believe that free trade is optimal, while politicians, on the
other hand, quite often act in accordance with the opposite belief. These
realities have resulted in new ideas like the political economy of commercial policy, which is still in a developing stage. Krueger argues that earlier
theories of commercial policy assumed that governments attempt to maximize a social welfare function and that politicians understand the principle
of comparative advantage. Using a political economic framework, public
choice economists seek to explain government behavior in a positive way,
whereby the motives and outcomes of commercial policy may significantly
diverge from those that would result from policies adopted to maximize a
social welfare function. Krueger briefly reviews the GATT Agreements and
the evolution of trade policies among developed countries. She concludes
that decision makers (governments) apparently have not attempted to
maximize social welfare and that research should focus on the political
determinants of levels of protection. This leads to the approach of the

political economy of protectionism, which argues that under certain conditions protection may be favorable for a government (e.g., to win an election
by guaranteeing high employment due to protectionist short-term policy).
Krueger also analyzes the theories underlying commercial policy in developing countries. She shows that here, too, a political economy approach


Introduction

7

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

Part III:

Competition

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

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


Part I
Money and Exchange Rates


Free Minting
Charles P. Kindleberger*

It is tempting as we honor the memory of Egon Sohmen to speculate
on how he would have reacted to the current interest in "free banking."
He was, of course, Austrian by birth, and the advocates of free banking
are sometimes lumped together as the "Austrian School." He was, moreover, a fierce proponent of flexible exchange rates, and an opponent of

fixed rates, strongly believing that exchange rates unaffected by intervention of monetary authorities would work smoothly - a view he might have
modified had he lived to observe the rise of the dollar in the free market
from 1982 to February 1985, its decline in the two subsequent years, and
the gyrations since. If one had any faith in revealed preference, there would
seem to have developed a revealed preference in governments for intervention after the disenchantment with free floating - not successful intervention perhaps, but some modest stability preferred to chaotic over- and
undershooting.
It is possible to advocate flexible exchange rates but hold back from free
banking, as does Milton Friedman. Egon Sohmen was in that camp, rather
than an adherent of the Austrian school, which advocates both flexible
exchange rates and free banking. Like Friedman, he may have wanted to
abolish central banks, to be sure, while insisting on strict control of the
money supply that requires some sort of government intervention or regulation. Friedman differed, as it happened, from Henry Simons, a Chicago
monetarist, who would enforce 100 percent reserve money by making
all capital apart from money take the form of equity in an effort to restrict
the issue of private debt that could be used as money substitutes (1967). To
go as far as Simons in restricting the money supply, would go too far in
Friedman's view in government intervention in private behavior. Sadly we
do not know Egon Sohmen's view on this further point.
• I am grateful for leads to the literature on free banking to Eugene N. White, and on the
Kipper- und Wipperzeit to Christopher Friedrichs, Geoffrey Parker, and to Wolfram Fischer,
who generously provided me with xerox copies of a great many articles in local German
state historical periodicals impossible to obtain in Cambridge, Massachusetts.


12

Charles P. Kindleberger

Free banking in developed countries is difficult to judge by contemporary experience, since there is none. Its advocates resort either to theory,
as Friedrich A. Hayek (1976) and Roland Vaubel (1984) do, to economic

history in the cases of Lawrence White (1984) and Eugene White (1990), or
both (especially Selgin 1988). The theory rests on the belief that banks will
work to gain acceptance for the (note or) deposit liabilities they issue, and
will themselves restrict their amount. Banks that overissue will find their
deposits discounted in the market. In this view, good money drives out
bad, the opposite of the widely believed version of Gresham's law. Vaubel
defends his position by claiming that Gresham's law in the ordinary view
depends on fixed rates of conversion between different forms of money,
whereas his model allows for the money of one bank to vary in price
against the monies of others. But money is the one asset with a fixed price
in terms of itself, and when the deposits of Bank A vary in price with those
of Bank B, there is a problem whether one can call either of them money
in a true sense, as opposed to non-interest- or interest-bearing securities.
Under the 1860 National Bank Act in the United States, with no central
bank, and on those occasions when the Treasury did not take over the role
of lender of last resort, panics gave rise to the issuance of certificates
by local clearinghouses - a system that Friedman has defended. Selgin,
moreover, makes the clearinghouse a central institution for restraining
banks from overissue (1988, pp. 28-9, 136, 137, etc.). During monetary
troubles under the National Bank Act, the notes issued by the separate
clearinghouses went to premia and discounts as wide as $10, $15, and $20
per $1,000 against New York, and of course possibly wider premia and
discounts against one another (Sprague 1910, pp. 203 ff, 291 ff). In these
circumstances it can be said that there was local money, but no national
money. A system of free banking in a single country would appear to
represent a flexible exchange network rather than a currency area.
It may happen theoretically that good money drives out bad, and as
noted below this has occurred on occasion when the debasement of an
existing money has gone so far that no one is willing to accept it and some
new medium of exchange is required. I have hypothesized that normally

bad money drives out good because the buyer chooses what money he
or she will spend; in ordinary times buyers' markets prevail and buyers
choose the currency in which the purchase is made. In this view, in sellers'
markets, when goods are scarce, the seller could claim and gain the right
to determine the currency of the bargain. But this is theory, with no
historical agreement on when buyers' markets become sellers' markets and
vice versa. A book on minting in parts of France and Spain in medieval
times notes that many contracts specified the kind of currency to be used
in fairly general terms: "best coin," "good coin," "money of legitimate


Free Minting

13

weight," or mancuses (a coin) "of the best gold," "alternative payment in
fine silver." In one area at a given time, it was exceptional "to designate
payment in unspecified deniers or sous" (Bisson 1979, pp. 63-4, 67, 73-4,
79, 83). The history in which these phrases appear is largely devoted to
minting as a service to the public, when debasement was rife and money
was "conserved" or "confirmed" as good coin mainly by public payments
to the King, prince, lord, or other minter to dissuade him from debasing
his coinage, as was the general practice.
I offer a few paragraphs on modern history before turning to an episode
in the currency disorders of early modern times in the German states, an
episode that I find illuminating.
The history of so-called "free banking" in the United States is not
relevant to the present discussion, since while there was free entry into
banking, banking itself was regulated. From the Free Banking law of New
York State of 1838 until the National Bank Act of 1860, many states

adopted laws providing for "free banking." In all of them, however, the
group starting a bank had to deposit specified securities with the state
treasury up to the amount of the notes issued, dollar for dollar (Ng 1988).
Wildcat banking occurred in Indiana and New Jersey under their laws
because of mistakes made in the lists of securities eligible for deposit
(Rockoff 1975, pp. 141-68). Ng claims on the basis of a great deal of
evidence that this free-banking era failed to lower bank profits significantly, so that the freedom did not greatly increase entry.
I disregard this US experience and turn to other historical episodes
involving Scottish banking between 1772 and 1845 (L. White 1984), and
the caisses patriotiques of the French revolution (E.N. White 1990).
The L. White book on free banking in Scotland between 1772 and 1845
has evoked a considerable literature. The basic question is whether it was
in fact entirely free, or whether there were some limitations on banks in
issuing notes. For one thing, three major banks exercised an informal
control akin to central-bank surveillance in collecting the notes of each
other and of smaller banks, and presenting them for conversion into
coin or Bank of England notes when it was suspected that a particular
bank was leaning toward overissue (Checkland 1975). The Second Bank of
the United States behaved in the same fashion from its establishment until
1836, when President Andrew Jackson vetoed the renewal of its charter
(Hammond 1957), ushering in the brief period of wildcat banking in Michigan before the "free-banking" period from 1838 to 1860. Secondly, with
respect to the Scottish experience, the success of free banking is disputed
on the ground that unlimited liability of the owners of banks exercised a
restraining influence on overissue. Lawrence White's study starts after the
failure of the Ayr bank in 1772, which ruined its stockholders, many of


14

Charles P. Kindleberger

them Glaswegian "tobacco lords" (merchants who had become rich from
the Maryland tobacco trade) who were obliged to sell their vast estates to
make good the liabilities to depositors for which they were jointly and
severally liable (Carr, Glied, and Mathewson 1989). The three leading
banks that acted informally as a central bank in checking note issue,
among themselves and by others - the Bank of Scotland, Royal Bank of
Scotland, and the British Linen Company (all chartered by the Scottish
Parliament) - did have limited liability. Others did not. White is aware
of the limited-liability question but dismisses it as unimportant on the
ground that when limited liability became available in 1862, the other
banks did not adopt it immediately. Ng argues the contrary. The issue
need not delay us, since both the note conversion practices of the three
leading banks and unlimited liability make the case different from current
proposals for free banking with no government regulation and only the
general laws of limited liability.
Public acceptance of the notes issued in the 1790s by the caisses
patriotiques of France fits my analysis of good money driving out bad
when the bad money - in this case the assignats - becomes completely
worthless. This is really not good money driving out bad, but some kind
of money being sucked into the vacuum created by the collapse of existing
money. It is not currency competition so much as the tendency of any
system without money to create one, for example, the cigarette money of
Allied prisoner-of-war camps in World War II. Another example is furnished by the rentenmark issued by the Rentenbank, which was created in
Germany in the fall of 1923 when the mark became worthless. This has
been cited as evidence that good money can drive out bad, by Vaubel (in
a private letter), and by Bernholz (1989). The currency troubles of the early
seventeenth century furnish more examples of new monies being created
to fill the void left by collapse of the bad, but I have difficulty in regarding
these cases as upsetting the ordinary interpretation of Gresham's law.

In this paper, I propose to examine another case, the so-called Kipperund Wipperzeit in Germany which spilled over into parts of Europe more
widely, mainly in 1619-1623 at the outset of the Thirty Years' War. Minting in the Holy Roman Empire was not legally free. A series of sixteenthcentury ordinances laid down the numbers of mints allowed to each "Circle," the weight and fineness of various coins, provisions for coin testing,
oaths for mint masters, and the like. They were widely disregarded. One of
the more authoritative historians of the period blames the depreciation
and inflation on the weakness of the Imperial organization and control
(Opel 1866). I shall start by sketching the institutional background.
The Holy Roman Empire was a "holding company" for a congeries
of political units varying in size from the substantial, like Austria, Branden-


Free Minting

15

berg, and Bavaria, through principalities, duchies, states ruled by counts,
bishoprics, imperial cities, and Hanseatic cities, down to small cities. They
were joined for monetary purposes with neighboring units into "Circles,"
often following ancient tribal boundaries like those of Swabia, Franconia,
Westphalia, or such kingdoms as Burgundy. The Holy Roman Empire
laid down the rules for minting, and for testing to see that the rules were
obeyed. With the Reformation accomplished and the Counter-Reformation that culminated in the Thirty Years' War (from 1618 to 1648) looming
on the horizon, the reigning authorities - nobility, church officials, city
authorities, and even the Emperor - saw the need for more revenue to raise
and equip their armies, largely of mercenaries, and to strengthen fortifications. Tax systems were rudimentary. It was difficult to increase domain
rents in periods of bad harvest. One relatively easy means of acquiring
revenue was to debase the currency, extracting greater seignorage.
There are several interesting aspects to the debasement. First, it was
confined to subsidiary coins. Gold coins and the silver thaler (reichsthaler)
were not debased, although they disappeared into hoards. The reichstaler
functioned in effect as a unit of account, against which to measure the

depreciation of the lesser coins, most of which were originally silver. Merchants who used thalers and higher coins, and the mint owners or leasers,
ended up with great fortunes in hoards, while the lower classes, using
subsidiary coin, except for peasants living largely in the "natural" economy, were ruined, along with those on fixed incomes, like government
officials, clerics, teachers, creditors repaid in debased coins, and political
units without mints that collected taxes in depreciated money. Second,
debasement in one political unit spread across state boundaries in "mosaic
Germany," and over German borders into Poland and Denmark, indeed
creating what was called a "commercial," as opposed to a monetary, crisis
in Britain (Supple 1959). The degree of debasement differed from Circle to
Circle, although it was generally greater in the upper (southern) Circles,
and less in the lower ones, including the Hanseatic cities (Opel 1866,
p. 231). Third, the crisis built up slowly long before the outbreak of the
Thirty Years' War - from at least 1600 - and rose to panic proportions in
Upper Saxony before the war had reached its territory. Moreover, stabilization was worked out with some difficulty in 1622 and achieved in 1623,
decades before the end of the war, differing in this respect from the German
inflations after World War I and II (Gaettens 1982, p. 91).
The mechanism for the spread of debasement was Gresham's law, bad
money driving out good, and involved the activities of princes, mints,
exchangers, and the common people. Adam Smith has described how
small states are porous in monetary terms, with foreign coins circulating
widely. He may have exaggerated the ability of Britain and France to


16

Charles P. KindJeberger

control their own money (certainly if the remarks were meant to apply
to the first half of the sixteenth century), but he understood exactly that
juridical units with limited territory traded with their neighbors on an

extensive scale and used foreign as well as domestic coins, without being
exposed to the transactions costs of exchanging foreign for domestic
money, or the converse, on every transaction. One nineteenth-century
writer referred to the "monetary pathology of border regions" (munzkranke
Grenzlande) (Opel 1866, p. 216). As late as 1816 at least seventy coins from Holland, France, Belgium, and various German states - circulated in
the Rhineland, while Prussian coins were rarely seen (Tilly 1966, p. 20).
"The shortage of small coin suitable for paying wages was perhaps the
most serious problem of all. Through the 1840s, at least, manufacturing
areas in the Rhineland were supplying themselves with a motley collection
of small silver and copper coins from all over Western Europe" (ibid., p.
22). Conversions were made from the coins of one country to another
under these circumstances by means of a unit of account - often an
"imaginary money" in that it was not actually coined, but a unit that
required some sophistication in handling (Einaudi 1936, pp. 242-43). Even
today, it is suspected that $180 billion in US currency issued in excess of
estimated normal needs in the United States circulates largely abroad,
in the drug trade, other illegal traffic, and as parallel currency in countries
with currency troubles (The New York Times, 1990).
It is difficult in the literature on the Kipper- und Wipperzeit to determine
exactly where the debasement of the wide variety of subsidiary coins
originated. On one showing, the bad money started pouring into southern
Germany from Italy and Switzerland with the entry point at Lindau on
Lake Constance (Schottle 1922-24, pp. 70-80). The same account, however, mentioned that the counterfeiting of the Upper Rhine Circle that
included Strassburg, was particularly aggravating to the southern circles
of Bavaria, Swabia, and Franconia. The important point, however, is
that wherever it started it spread from one state or city to the adjoining
territories.
The mechanism ran as follows: a prince, elector, duke, count, abbot,
bishop, or whoever needed more funds, would seek to increase his seignorage by a slight debasement. The numbers of mints grew, some officially
owned by the state, some leased to private individuals against payment to

the state authority or authorities. With rentals, the mint operator added
his profit to that of the seigneur. Mter a time, counterfeiting added to the
debasement. Light coins would be taken abroad and exchanged for heavier
coins, either at fairs or in exchange booths set up in cities and towns. The
good coins would be brought back to the original mint for recoinage into
a greater nominal value of debased coins. In due course, the neighboring


Free Minting

17

territory found it necessary to take steps to stop the loss of its circulating
medium. One such defense was to debase its own coins. Thus the debasement and counterfeiting spread from one state to another, crossing
into Poland (Bogucka 1975) and elsewhere. The debasement in Bohemia
accelerated in 1622 after the Emperor leased minting rights for Bohemia,
Moravia, and Lower Austria to a consortium for 6 million gulden a year.
In the first two months before a great decline in confidence in the coins
occurred, the consortium minted 30 million gulden of new coin, and in
the next ten months twelve million gulden (Klima 1978). Klima insists
that the Bohemian inflation of 1621-23 was unconnected (his emphasis)
with the general European economic situation of the time, calling attention
to the particular features of the Czech situation, such as the uprising of the
Protestant estates and their defeat and confiscation by the Catholic forces.
It is difficult, however, to accept such a conclusion when everywhere else
on the Continent debasement was spreading, and, as Klima himself says
(ibid., p. 376), light foreign coins were penetrating Bohemia.
Most ofthe literature on the Kipper- und Wipperzeit is restricted to given
states and Circles, with the richest detail available for Upper and Lower
Saxony (Redlich 1972; Wuttke 1916; Opel 1866). An attempt had been

made by the Emperor in 1603 and 1604 to limit the number of mints to
four to a Circle (except for states with silver mines), but the effort was
opposed by the Lower Saxon Circle, in which there were six existing mints
in Bremen, Hamburg, Lubeck, Rostock, Brunswick, and Magdeburg. This
allowed other towns with minting privileges to establish further ones, and
even encouraged those without privileges to follow suit (Gaettens 1982,
p. 75). In Brunswick, where 17 mints had existed in 1620, there were 40 in
all by 1623, including a converted convent with 300 to 400 workers (Langer
1978, p. 80). The Duke of Weimar leased out 10 mints at 600-800 gulden
weekly (Opel 1866, p. 224).
The imperial ordinance providing for mint assayers in each Circle, and
Coin Testing Days, fell by the wayside. One General Assayer, Rentzsch,
observed that the debasement was particularly acute in the Upper Saxon
Circle and that some mints kept supplies of good groschen on hand to
show the Assayer on his periodic visits (Wuttke 1916, p. 136).
Numerous measures were undertaken to halt the cross-border traffic in
good and bad coin - good out and bad in, but to little effect. Especially on
market days, it was impossible to halt the carts and examine packages.
Some towns and principalities tried jawboning, warning the lower classes
against the exchangers, who often included lawyers, doctors, Jews, and
even women; forbidding transactions of money against money, as opposed
to money against goods (Opel 1866, p. 224); and threatening the exchangers with punishment ranging from confiscation of the coins and all


18

Charles P. Kindleberger

the exchanges' goods to mutilation (cutting off a hand), death, and burning
at the stake. At the height of the inflation set in motion by the debasement

and the ultimate refusal of producers to sell for the debased money, riots
broke out in various cities, involving several hundred participants and
ending in deaths of some rioters. The populace blamed the mint masters
and the exchangers, especially the Jews, but most historians writing on
the subject denounce the princes, dukes, counts, abbots, city authorities,
and the like that sought to increase their incomes by further seignorage.
One account suggests, however, that the traffic of the period lacked sufficient means of exchange in the light of a protracted monetary famine and
inadequate development of credit and banks (Opel 1866, p. 222).
One defense against debased currency was the establishment of deposit
banks. These received deposits of coin that was assayed and weighed, and
a receipt was issued for a specific amount. The system had developed
slowly in Spain and Italy (Usher 1943), but made its way north when the
Bank of Amsterdam was established in the early stages of the Kipper- und
Wipperzeit. The proposal was put forward in 1606 and the Bank opened
its doors in 1609. A second Dutch bank was established along the same
lines at Middleburg in Holland in 1616, two more at Hamburg and Venice
in 1619, and two further ones at Delft and Nuremberg in 1621, at the
height of the debasement. The Swabian Circle proposed the establishment
of a bank of deposit in the fall of 1619, but the project was altered to make
it a fund to buy silver in Genoa to induce the local mint to overcome the
shortage in southern Germany (Schottle 1922-24, p. 85). The Bank of
Amsterdam started as a 100 percent reserve bank, with the costs defrayed
by a small charge on transactions, later took on the role of an exchange
bank (wisselbank) to monopolize the discharge of bills of exchange in
international trade over a certain sum, and ultimately, a century and a half
later, made loans to the city of Amsterdam, which was making good the
losses of the Dutch East India Company, and was bankrupted. Its start,
and that of those that followed up to 1621, was to provide an acceptable
means of payment during the monetary disorders.
On other than a local level, effective stabilization for distant trade,

however, had to wait for acute inflation and a virtually complete breakdown of trade and payments. The working classes and others who had
been exploited in the early stages of debasement, giving up their good
coins for progressively worse ones, finally proved unwilling to accept them
where they had any choice. Goods stopped coming to the market, as in the
spring of 1947 in the western zones of Germany. Government accounts
could no longer be kept (Friedrichs 1979). Children played with "tinsel
money" in the street (Langer 1978, p. 30). The reichstaler, which had risen
in price from 1 fl 12 kreuzer (out of 60 to a florin or gulden) in 1596 (on


Free Minting

19

average, with considerable variance among regions, and thus far inadequately studied) to 1 fl32 krz in 1618, reached 2 fl20 krz at the end of 1620,
6 fl30 krz in December 1621, and 10 fl in March 1622 (Shaw 1895, p. 103).
The variance was wide: In Leipzig, for example, the reichstaler was worth
9 to 12 gulden in September 1623, in Gotha, 15 gulden in June 1622. In
Nurnberg it went from 13 gulden 30 krz in January 1622 to 16 gulden 30
krz in February ofthe same year (Opel 1866, p. 233).
The stabilization process, during the early stages of the Thirty Years'
War, as already noted, took place slowly and piecemeal. It started in 1619,
as the northern cities, which centuries before had been linked in a Wendish
monetary union, tried to organize to halt the debasement and restore
the currency to its old basis. Similar efforts were pursued in the South
among the Swabian, Franconian, and Bavarian Circles. A number of mints
stopped producing debased coins in 1622 when it proved impossible to get
the populace to accept them. Gradually stabilization was achieved piecemeal, and spread. When the process was well along, in June 1623, the
Elector of Saxony appointed a commission to make recommendations on
currency policy. This commission furnished him a 26-page memorandum

the next day, outlining a return to the Imperial Ordinance of 1559, a step
taken shortly thereafter, including the reinstitution of the Mint Testing
Days, which had been allowed to lapse for five years (Gaettens 1978,
pp. 92-3). Shaw states that a great imperial deputation was convened in
1623 to establish the final return to the Augsburg Ordinance of 1559,
but this is not treated in the German histories that I have seen. Opel lists
the various ordinances bringing back the standards of the Augsburg Ordinance, one in September 1621, 10 in 1622, 10 in 1623, and the last, the
first action of the Emperor Ferdinand II, in February 1624 (Opel 1866,
pp.261-2).
All accounts of the process emphasize that while there were safeguards
that sought to prevent currency debasement -limitation of mints, oaths of
mint masters, Coin Testing Days, prohibitions against coin traffic, official
assayers, and the like - they were essentially unenforced and in the case of
traffic unenforceable. While most histories, moreover, lay the blame on
the rulers of the states and cities, Opel (1866), whose account is said to
be "surprisingly reliable" (Redlich 1972, p. 10, note), is virtually alone
in observing that growing trade created a shortage of coins - comparable
to the bullion famine of the fifteenth century (Day 1978) - and especially
in the "limitless domination of Territorialismus in trade" (schrankenlose
Herrschaft des Territorialismus im Verkehrsleben) (1866, p. 266). In a long
passage he excoriates the battle of all against all, cities trying to increase
their profits at the expense of their neighbors, the lack of territorial organization and of strong central authority. There was, he claimed, too much