Abstract
The three exchange rate regimes adopted by Italy from 1883 up to the eve of World War I — the gold standard (1883–1893), floating rates (1894–1902), and “gold shadowing” (1903–1911)—produced a puzzling result: formal adherence to the gold standard ended in failure while shadowing the gold standard proved very successful. This paper discusses the main policies underlying Italy’s performance particularly focusing on the strategy of reserve accumulation. It presents a cointegration analysis identifying a distinct co-movement between exchange rate, reserves, and banknotes that holds over the three sub-periods of the sample. Given this long-run relationship, the different performance in each regime is explained by the diversity of policy measures, reflected in the different variables adjusting the system in the various regimes. Italy’s variegated experience during the gold standard provides a valuable lesson about current developments in the international scenario, showing the central role of fundamentals and consistent policies.
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Notes
“If adherence to the rule was evidence of financial rectitude—like the ‘good housekeeping seal of approval’—it would signal that a country followed prudent fiscal and monetary policies and would only temporarily run large fiscal deficits in well-understood emergencies. Monetary authorities then could be depended on to avoid defaulting on externally held debt” (Bordo and Rockoff 1996, 390).
Bordo and Kydland argue that the gold standard was successful as a commitment rule “because it had the virtues of being simple and transparent” (1996, 456). Explaining his preference for a convertible currency instead of an inconvertible currency regulated by keeping the price of bullion in accordance with the mint price, Mill emphasizes “the importance of adhering to a simple principle, intelligible to the most untaught capacity. Everybody can understand convertibility; every one sees that what can be at any moment exchanged for five pounds is worth five pounds. Regulation by the price of bullion is a more complex idea, and does not recommend itself through the same familiar associations” (1848, 546).
As Eichengreen and Flandreau remark: “What pressure existed for the pursuit of other policy goals was exceptional and, ultimately, limited. At the gold standard’s European and North American core, its political, ideological, and economic underpinnings sufficed to sustain the system. When push came to shove and the authorities in these countries had to choose between interest-rate increases to keep the gold standard from collapsing and interest-rate reductions to stimulate production, they never hesitated to opt for the former” (1997, 19).
Obstfeld and Taylor (2003, 262) find that in the inter-war years, in contrast to the gold standard period, countries were punished for running high public debts, which shows the policymakers’ greater room for maneuver during the gold standard.
Using cluster analysis, Garofalo (2005, 23–28) identifies a number of sub-periods within this broad tripartite division of the time span. For the two periods after the 1893 suspension of convertibility, he argues that cluster analysis allows us to distinguish between pure floating and managed floating on the one hand and between soft and crawling pegs on the other.
By far the thickest foreign market for the lira and lira-denominated securities was the Paris stock-exchange. The profile of the lira-sterling exchange rate is, however, not significantly different. Exchange rates are those for the last trading day in each month. Following Fratianni and Spinelli (1997), the gold points have been set at +/−0.5% of the official parity. On the role of the Paris Bourse in setting the price of Italian consols and its influence on the lira exchange rate, see De Cecco (1990), Di Martino (2001), and Tattara (2003).
“To return from paper currency to metallic currency it is therefore worth withdrawing as much paper money as necessary to reduce prices precisely to the level there would have been with metallic currency. And only afterwards can metallic money be substituted for paper money ... . It is deduced that a foreign loan in gold to eliminate inconvertible paper currency is vain and harmful. ... The loan can be useful only after equilibrium has been attained by reducing the quantity of currency or, which comes to the same thing, by increasing trade and industry. What happened in Italy, what is now happening in Austria, and the theory of economic crises, all confirm these theoretical deductions” (Pareto 1894, 157; 169–170).
Distinguishing between a foreign loan and a domestic loan, Fanno (1908, 90–97) points out that while the former increases reserves but does not restrict circulation, the latter does the opposite. By destroying the banknotes paid by subscribers to a domestic loan, the monetary authority can make the agio disappear, although it cannot resume convertibility for which a sizeable reserve is needed. To achieve this objective, the decrease in the stock of paper money must continue until the balance of payments is in surplus. Yet, this policy of sudden deflation may well bring about disruptive shocks to the economy.
Building upon Fanno’s analysis, Enrico Barone, in a chapter eloquently titled “Countries with Rotten Circulation,” also emphasized the central role of fiscal discipline and sound bank portfolios in ending convertibility suspension (1918, 113–25).
“That was the period [1883–97] ... that, by abusing credit, excessive trust in our own forces, mistakes and aberrations which would be shocking today, prepared for the sad days to follow inasmuch as easy credit brought about the establishment of new industries and all sorts of speculations heavily fueled and vigorously encouraged by cheap capital. Grandiose designs and grandiose public works, railways, and other projects undertaken by the government, were the sorry example that dragged provincial and city councils and private citizens to push individual and collective activities to the limit while, on the other hand, the ever growing defense needs created by an insecure political situation in Europe obliged the government to reach levels of expenditures far exceeding the nation’s tax potential” (De Cecco 1990, 782).
A new Bank Act was passed after which the Bank of Italy was reorganized, giving the government a prominent role in appointing the bank’s management and supervising its operation. Two new large commercial banks were created to fill the void left by those that had failed in 1893.
Praising the shrewd conduct of Bonaldo Stringher, at the helm of the Bank of Italy from 1900 to 1930, Corbino noted that, in carrying out his successful monetary stabilization, Stringher had “the help and political support of men like Giolitti, Sonnino, and Luzzatti all of whom had the profound conviction that it was necessary to consider the period of weaknesses and banking adventures as definitively closed and look at the monetary system as a means to foster the country’s economic growth, provided that it was used without artifice and political interference” (1938, 389).
In the 1897–1913 period, the ratio of debt to GDP fell from 128.0 to 77.2 per cent and the share of foreign debt from 22.2 to 9.5 per cent (Francese and Pace 2008). As early as 1903 a foreign observer, the French economist Arthur Raffalovich, remarked: “Italy ... , with precise measures and secure methods that could be taken as a model, brought the exchange rate to its definitive level. The Italian government has spoken little, knowing that in monetary policy the less discussion the better. It has persevered with tenacity to improve the public finances. For his part, the skillful Director General of the Bank of Italy was able to mend past faults, sacrificing the popularity that he would have won from the Bank’s shareholders by increasing the dividend for a more substantial result. Success has crowned this resolute and truly patriotic conduct and it is not without legitimate pride that we can see that today the lira is equal to the franc, i.e. it is worth gold” (quoted in Corbino 1938, 391).
“All this was fortunately reflected in the price of foreign exchange. Financial and economic factors together with the steady improvement of banks’ circulation, soon determined the disappearance of the agio. The psychological element contributed powerfully and rapidly to this result while at other times, it contributed instead to keeping the exchange rate too high. ” (Banca d’Italia 1903, 7–8).
The series in graph 2 are in thousands of lire. The reserve requirement rose from 33 to 40 per cent in August 1893. The banks were allowed, however, to use up to 7% of their issue of notes to discount foreign bills labelled in a convertible foreign currency. In 1895 their deposits in foreign banks and their holdings of foreign sovereign bonds payable in gold were considered akin to specie reserves. Figure 2 shows a conservative 40 per cent gold coverage requirement from 1893 onwards.
These objectives were clearly stated from the very beginning. The growth in reserves had the “double aim of increasing the ratio between the metallic guarantee and the value of bills in circulation, and making a greater amount of exchange media available to the market, widening the paper circulation entirely covered by specie and thus independent of the normal limit of circulation. In short, in increasing measure, a part of our bills has been given the function of deposit certificates of gold purchased abroad in order to better satisfy the new needs of the national economy” (Banca d’Italia 1903, 13).
Additive outliers introduce a moving average component with a negative coefficient into the residuals of standard unit root test estimates which, in turn, inflates the size of the test and brings about over-rejection of the null of non-stationarity.
Additive outliers may also distort inference on cointegration rank in finite samples. Following the interpolation strategy suggested by Nielsen (2004), the outlying observations are eliminated and replaced by an average of the respective adjoining data. The smoothed time series will then be used in the cointegration analysis below.
Non-metallic reserves, equal to zero in the first sub-period, went up to 20 per cent of total reserves in 1900 and then progressively decreased to 7 per cent in 1913.
For examples in the literature, see Lettau and Ludvigson (2004) among many others.
We follow Urbain (1995) and base the choice of the VECM order on the absence of serial correlation of the residuals.
The test is meant to assess if the full sample estimate is contained in the space spanned by the recursive α i estimates. Formally the hypotheses tested are \( {H_{0{\alpha_i}}}:\quad \widehat{\alpha } \in sp({\alpha_i}),\;i = {T_0},...,T \), where \( \widehat{\alpha } \) is the full sample cointegration vector estimate and T 0 is the January 1883–December 1885 base period. The last recursive estimation is equal to the full sample one. The null is thus that the cointegration vector α estimate at each recursive iteration is not statistically different from the full sample one, which has the lowest sample variance. It is asymptotically distributed here as a χ 2 with m(n-m) degrees of freedom.
Neither the “known cointegration vector” stability test nor the LR tests for weak exogeneity are affected by the normalization of the cointegrating vector.
We test to see if any of the variables in X t is weakly exogenous with respect to α, i.e. if it does not adjust to the long run disequilibrium error. Formally, we test the null \( {H_0}:\quad {\beta_{ij}} = 0,j = 1,...,m \) and i = 1,...,n, where m = 1 is the number of cointegration relationships and n = 3 is the number of variables in X t . The test is asymptotically χ 2 distributed with m degrees of freedom.
Drawing attention to the influence of political factors, Obstfeld and Taylor stress the same point: “[I]f we seek lessons from the past, our results have some implications for today’s attempts to gain capital market credibility through the use of pegged exchange rates. It is clear that the post-World War One political developments that rendered interwar exchange-rate commitments less credible have not receded in the meantime. Thus, policymakers should not expect to gain market credibility even through seemingly irrevocable exchange rate commitments. In the absence of robust fundamentals and complementary economic and institutional reforms, efforts to forswear discretionary exchange rate changes are of questionable value” (2003, 266). The central role of credibility is definitely reflected in the effectiveness of capital mobility. During the gold standard, capital movements were a major stabilizing factor because the exchange rate risk was virtually nil. From the inter-war years onward, the waiving of key rules weakened credibility and capital flows became a major source of instability. Hence, the “analytical mystery” stressed by Bayoumi and Eichengreen, contrasting the stability of the gold standard with subsequent fixed exchange rate regimes (see the beginning of Section 2 above), is accounted for by the changed nature of the monetary system.
Bordo and Flandreau emphasize the similarity of the problems affecting peripheral countries. “If going on gold was so costly for the periphery, one may wonder why a number of countries nonetheless sought to stick to gold. We argue that this choice rested on something quite similar to the current fear-of-floating dilemma. If fixing was quite painful under the gold standard for many of the peripheral countries, floating could be just as deadly as today. This was due to pervasive problems of currency mismatch arising from the inability, for underdeveloped borrowing countries, to issue foreign debts in their own currency” (2003, 436).
This twofold objective of reserve policy was clearly stated by Stringher (see footnote 16). In a recent paper, Obstfeld et al. (2008) trace back this hypothesis to Thornton and Keynes, corroborating it with panel data analysis covering the 1980–2004 years and 134 countries.
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Acknowledgements
The authors are grateful to Barry Eichengreen, Marc Flandreau, Franco Spinelli, two anonymous referees, and the editor of this journal for their comments on a previous version of the paper, to Sandra Natoli for superb research assistance. The usual disclaimer applies.
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Appendix
Appendix
The data set spans the 1883–1911 time period and is obtained from the following sources
Monthly frequency
Italian lira-French franc exchange rate
Historical archive of the Bank of Italy, ASBI, Banca d’Italia, Studi. Pratt. N. 390. Fasc. 1, 1941.
Metallic and foreign reserves
De Mattia (1967)
Banknotes
De Mattia (1990)
Yearly frequency
Percentage of public debt serviced in gold
Flandreau and Zumer (2004), http://www.eh.net/databases/finance/
Exports
Flandreau and Zumer (2004), http://www.eh.net/databases/finance/
Yield on the Government bonds of Argentina, Austria-Hungary, Greece, Italy, Portugal, Russia, and Spain
Flandreau and Zumer (2004), http://www.eh.net/databases/finance/
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Cesarano, F., Cifarelli, G. & Toniolo, G. Exchange Rate Regimes and Reserve Policy: The Italian Lira, 1883–1911. Open Econ Rev 23, 253–275 (2012). https://doi.org/10.1007/s11079-010-9182-0
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DOI: https://doi.org/10.1007/s11079-010-9182-0