INTRODUCTION

In a survey of economic history written in the mid 1980s, I wrote that “economic history has had little influence upon and has been relatively little affected by growth theory of the postwar variety” (Crafts (1987, p. 40)). Clearly, growth accounting had been highly influential for measurement purposes but, at that point, for economic historians keen to understand productivity growth in terms of induced innovation or endogenous technological change, economic theory had little to offer, as the review of the well-known Habakkuk debate in David (1975) had made painfully obvious.

Since the mid 1980s, endogenous growth theory has developed very rapidly and has produced a large volume of theoretical research. At the core of these models is the proposition that investment in a broad sense, including human as well as physical capital and the production of new processes and products through research, is central to growth which can be driven on without being halted by diminishing returns.

One branch of endogenous growth theory obtains results by arguing for constant returns to routine investment in broad capital with the production function, Y = AǨ, as in Rebelo (1991). The key to rapid long-run growth is to be found in cultures, institutions, and tax policies which make a high rate of saving optimal. In this “capital-fundamentalist” approach there is no explicit role for total factor productivity (TFP), growth, or technological change. Despite the initial appeal of ideas of this kind, they are not persuasive as models of long-run growth. For example, cross-sectional regression evidence on the growth of GDP across countries (Mankiw, Romer and Weil (1992), Islam (1995)) and on output across British manufacturing sectors (Oulton and O‘Mahony (1994)) suggests that the sum of the exponents on physical and human capital in the production function is less than one and that there are diminishing returns to routine investment in the long run.

INTRODUCTION

Adam Smith ([1776] 1937) argued that the “propensity to truck, barter, and exchange” is in human nature (p. 13) and proceeded to examine how institutions impact the efficiency implications of this tendency. Arguably, institutions impact efficiency since they influence the allocation of resources to and by economic agents and the set of exchange relations that these agents are willing to assume. The diversity of economic environments and institutions utilized throughout history provides a unique source for examining the nature and implications of institutions. Indeed, a distinctive feature of economic history has always been its concentration on the examination of institutions, their origins, natures, and implications.

This chapter provides a brief survey of the three approaches within economic history - the neoclassical (section 1), the new institutional economic history (section 2), and the historical institutional analysis (section 3) - that utilize microeconomic theory for the study of institutions and their efficiency implications. Each of these complementary approaches focuses on different sets of institutions, utilizes different theoretical frameworks to analyze them, and advances different methodologies to integrate theoretical and historical analyses.

Owing to space limitation this chapter concentrates on highlighting the methodology of and interrelations with microeconomic theory adopted by these approaches, and gives some of their insights with respect the study of economic institutions. Since historical analysis is the most recent development in the study of economic institutions through economic history, most of the survey is devoted to this approach.

The phrase “political economy” has come to mean very different things in different places. In political science departments, it generally means the study of how economic forces affect politics. As such, the phrase often has Marxist implications, because of the particular importance that Marxist theory places on economic forces for explaining political events. In economics departments, however, political economy is often taken to mean the study of political forces that affect economic activity. In classical social philosophy, the study of markets was not so separate from the study of government. The phrase “political economy” has come to mean very different things in different places. In political science departments, it generally means the study of how economic forces affect politics. As such, the phrase often has Marxist implications, because of the particular importance that Marxist theory places on economic forces for explaining political events. In economics departments, however, political economy is often taken to mean the study of political forces that affect economic activity.

In classical social philosophy, the study of markets was not so separate from the study of government. The phrase “political economy” was taken from Greek words meaning “housekeeping of city-states,” and it was applied to describe the study of how civilized societies are organized. So the classical goal of political economy was to explain the functioning of all social institutions.

The successful development of price theory forced a separation between the study of markets and the study of government. Price theory describes market competition well, but it cannot be applied to political competition. So a separation of political science from economics was necessary when price theory was the only general analytical methodology in economics. Thus economics has developed around a core analytical methodology, whereas descriptive methodologies have been more dominant in political science.

INTRODUCTION

The success of game theory in the 1980s has revolutionized economics. In addition to optimization and competitive market equilibrium, the concept of Nash equilibrium became a basic analytical tool and a common language of economists in almost all fields. In his famed text book (1948), Paul Samuelson quoted an epigram: “You can make even a parrot into a learned economist; all it must learn are the two words, 'supply' and 'demand.'” But now the parrot needs two more words, “Nash equilibrium,” to be academically correct.

As the game theoretic approach penetrated into many fields, however, some basic problems became apparent. First, it is not clear how players come to play a Nash equilibrium. Although Nash equilibrium was once perceived as the outcome of perfectly rational reasoning, active research in the past decade revealed that common knowledge of rationality only implies rationalizability, which is much weaker than Nash equilibrium. Second, game theoretic models quite often possess multiple equilibria which have markedly different properties. This is in contrast to the general equilibrium model where all equilibria are efficient. Hence in applications of game theory it is vital to pin down which equilibrium is selected. A host of refinements literature tried to solve this problem by defining a stronger notion of rationality than Nash equilibrium assumes, but it was not entirely successful. We are left with a number of new solution concepts, and there seems to be no clear consensus among economists as to which one is right.

Introduction

There are many salient characteristics of the Italian monetary history of the 1920s and 1930s. First of all, the purchasing power of the Italian lira was lower at home than on the international markets. This problem emerged slowly between 1922 and 1924, then exploded in the subsequent two years. For the most part, this situation was inherited from the war as it stemmed from the process of normalising both domestic and international monetary relations. The authorities also faced difficulties in dealing with an obsolete industrial and financial structure existing at the end of the war. Second, the authorities initially reacted to the lira collapse by launching a monetary stabilisation program, but then went much further and aimed at a fundamental restructuring of the industrial system. Thus, from 1926 to 1936, the authorities tried to harmonise monetary policy, industrial restructuring and the resumption of the process of capital accumulation.

This chapter consists of five major parts. We begin with a comparison of the Italian economy and the economies of the United Kingdom and the United States. Then, we analyse the causes of domestic inflation and lira depreciation from 1922 to 1926.

In this chapter we intend to draw general conclusions and lessons that emanate from our History. Six themes emerge from our work, themes which are not entirely unique to the Italian experience. Space and knowledge prevent us from pointing to similarities and dissimilarities between Italy and other countries. So, as a next best solution, we invite the economic historian and monetary economist of other countries to make the appropriate comparisons.

First theme: What is money?

At the time of political unification, people had a preference for money in the form of gold and silver coins. Paper notes were imperfect substitutes for metal coins. There were historical and political reasons for this relative distrust of paper money. Paper money was a newcomer to the market, making money holders reluctant to use it. The negative ‘network’ effect was reinforced by a deep suspicion that paper money was more prone to depreciation than gold or silver. Confidence in paper money derives from confidence in those institutions and governments that directly affect the purchasing power of money. The political history of Italy, with its century-old regional turmoil, did not inspire in money holders the trust necessary to make paper notes perfectly equivalent to metal coins.

The several banks of issue did not have a nation-wide branch network; consequently, their liabilities were regarded with some suspicion outside their local markets. It was only after Italy's exit from the gold standard that paper notes, both those issued by the government and those by the banks, gained wider acceptance. Similarly, bank deposits were very undeveloped at the time of political unification.

This study deals with the monetary history of Italy from 1861 to 1991, a span of 131 years. An earlier version of the History was published in 1991 in Italian by Mondadori. This version differs from the Italian version in two respects: it is temporally longer in that we treat the 1980s, whereas the Italian version stops in 1980; and it is more compact, having eliminated many historical details that we judged to be of lesser interest to an Englishspeaking audience.

Several reasons inspired us to write this History. First, traditionally the economic history of Italy is ‘told’ without reference to a specific interpretative framework. When a framework is used, the preference is for microeconomics rather than macroeconomics. That is, Italian economic history emphasises ‘real’ aspects in preference to nominal and monetary aspects, which are the proper domain of macroeconomics. Hence, we felt that this book would fill a vacuum. We did not want to fill this vacuum by going to the opposite extreme of interpreting the Italian monetary history through the looking glass of a single model. While our interpretation is monetarist on balance, we are not wedded to a single model. Our purpose is to interpret monetary history with reference to alternative economic models.

The second reason involves the quality of the monetary debate and the state of monetary policy in Italy. After the ‘high’ point of the 1950s, the following years were marked by deterioration both in debate and policy. From a theoretical viewpoint, the concept of money lost its importance and was substituted by the fuzzier concept of domestic credit.

Introduction

The world war shattered the domestic and international mechanisms which for two decades gave Italy monetary stability, both in absolute terms and in relation to the rest of the world. Between 1914 and 1920, the inflation rate, measured in terms of the national income price deflator, rose progressively from zero per cent in 1914 to 34.7 per cent in 1920 (figure 1.2). Over the same period, the lira price of the pound climbed from 25.3 to 77.5.

This chapter deals with the evolution and consequences of macroeconomic policy during the war. With regard to the first aspect, we shall emphasise fiscal policy as this appeared to be the dominant and destabilising impulse. We shall then examine monetary policy by illustrating the limits of funding the massive increase in government spending through additional taxes or the placement of public debt. With respect to the second aspect, we shall focus on the process of internal and external depreciation of the lira.

As usually happens when the economy is in a state of emergency, during the period Italy resorted to policies of direct control of domestic prices and exchange rates. Consequently, we shall attempt to assess both the effectiveness of such policies (during and immediately after the war) and their possible side effects.

Introduction

Two important events give a distinctive character to the last 40 years of the History. First, between the sixties and seventies and, again, between the seventies and eighties, the monetary regime went through two drastic changes, which involved the formulation of the intermediate and final objectives of monetary policy. Second, during the eighties, BI was no longer submissive to the political system. Consequently, for the first time and for a long period afterwards, monetary policy was in conflict with fiscal policy.

In this chapter, we deal with the years 1950 to 1969, during which monetary policy was tailored to a longer-term strategy, at least in the first decade; was able to guarantee an almost absolute price stability; and contributed to regular and sustained economic development. Chapter 8 will examine the seventies during which monetary policy privileged the short over the long horizon; was not only incapable of counteracting domestic and international shocks, but was in itself a cause of instability; and contributed to an inflationary process that had no precedents in peacetime. The monetary authorities did not pursue price stability; instead they favoured employment as its primary target. Furthermore, they acquiesced to a regime of fiscal dominance by developing a new intermediate objective that gave virtually absolute priority to government lending. Chapter 9 deals with the eighties and will give insight into the nature of the second drastic change, a counterrevolution which produced a number of innovations in the conflict of monetary policy, but most significantly gave the monetary authorities independence from the fiscal authorities.

We begin with an analysis of the evolution of some key variables to underscore the structural break at the end of the sixties.

Introduction

This chapter deals with the evolution of Italian monetary policy during the period from the political unification of the country to the eve of the First World War. Particular attention is given to the evolution of the legislation governing the activities of banks of issue, the monetary system, and the monetary relations with the rest of the world. As a result, the core of this chapter deals with the motivating factors and the practical repercussions of important new legislation passed in 1866, 1868, 1874, 1880, and 1893. We also emphasise the model of monetary policy adopted by the most important banks of issue in the country.

In view of the length of the period analysed, we shall deal separately with the two sub-periods 1861–96 and 1897–1913, in the hope that this demarcation will facilitate the reading of this chapter. Of course, we could have divided the period differently. Initially, in fact, we had considered 1893, the year when the Bank of Italy was formed, as the dividing line between the two sub-periods; but, as will be readily evident later, we have subsequently concluded that 1893 was not a significant year with respect to structural changes in monetary policy, nor did it bring specific new ideas with regard to real variables and the business cycle.

This book has been in the making for well over a decade, with each one of us interspersing monetary history with other subjects. An Italian version was published in 1991 by Mondadori. The English version is considerably shorter but has a longer horizon in that it covers the eighties up to the September 1992 currency crisis.

We owe our gratitude to many people who have read parts of our work throughout the years. The ones we cannot fail to mention are: Beniamino Andreatta, Michael Bordo, Karl Brunner, Filippo Cesarano, Paul de Grauwe, Renato de Mattia, Enzo Grilli, Gualberto Gualerni, David Laidler, Thomas Mayer, Allan Meltzer, Stefano Micossi, Manfred J.M. Neumann, Fabrizio Onida, Luigi Pasinetti, Mario Sarcinelli, Paolo Savona, Anna Schwartz, Luigi Spaventa, Richard Sylla, Paolo Sylos Labini, Vito Tanzi, Jürgen von Hagen, and Elmus Wicker. We thank Ralph Vonghia for competent translation.

Parts of the book were presented at Indiana University, University of Brescia, Catholic University of Louvain, the London School of Economics, University of Western Ontario, Board of Governors of the Federal Reserve System, Banca d'ltalia, International Monetary Fund, Konstanz Seminar on Monetary Theory and Policy, University of Cagliari, University of Venice, Bocconi University, University of Rome- Tor Vergata, the NBER Money Workshop, University of Trento, and ISPE.

We are grateful for financial support received from the Banca Credito Agrario Bresciano; and the juries of the Scanno Prize (1991) and the St. Vincent Prize (1992) for having deemed us worthy of their first prizes for the Italian volume.

A history of Italian monetary policy from 1861 to 1991 is a history of the Bank of Italy, the country's central bank, and its relations with the government and with other banks that serve the public. Readers of this volume will find a narrative and analytical study of the internal and external events that shaped that history. Rather than summarise what the authors have themselves done so well, let me comment on how the Bank of Italy compares with other central banks.

No two central banks are alike in structure and culture. Each bears the impress of its history. In some respects the Bank of Italy's history makes it unique. A law of 1894 required it to have a branch in each of the country's 95 provinces with a total of 99 which included two branches in Rome and Milan and one in Naples. The branches, however, are organised in 14 regional groupings, which are comparable with the 12 Federal Reserve districts, with which they share similar responsibilities for supervision of local banks, and the provision of currency and cheque clearing. Like the Federal Reserve Banks the Bank of Italy is not owned by the government. Its shareholders are banks and insurance companies.

The Bank of Italy High Council, comparable with the Federal Reserve's Open Market Committee, determines policy. It chooses the Governor subject to government approval. He can hold the office for long periods since there is no prescribed term. The Council includes the governor, who is chairman, and 13 members with no active political ties whom the shareholder banks choose to represent the regions. They serve for three years.