for prof washington

Economic History Association

Why Did the Bank of Canada Emerge in 1935? Author(s): Michael D. Bordo and Angela Redish Source: The Journal of Economic History, Vol. 47, No. 2, The Tasks of Economic History (Jun., 1987), pp. 405-417 Published by: Cambridge University Press on behalf of the Economic History Association Stable URL: http://www.jstor.org/stable/2122238 Accessed: 21-03-2017 18:33 UTC

REFERENCES Linked references are available on JSTOR for this article: http://www.jstor.org/stable/2122238?seq=1&cid=pdf-reference#references_tab_contents You may need to log in to JSTOR to access the linked references.

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted

digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about

JSTOR, please contact [email protected].

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at

http://about.jstor.org/terms

Cambridge University Press, Economic History Association are collaborating with JSTOR to digitize, preserve and extend access to The Journal of Economic History

This content downloaded from 142.104.160.190 on Tue, 21 Mar 2017 18:33:06 UTC All use subject to http://about.jstor.org/terms

Why Did the Bank of Canada Emerge in 1935?

MICHAEL D. BORDO AND ANGELA REDISH

Three possible explanations for the emergence of the Canadian central bank in

1935 are examined: that it reflected the need of competitive banking systems for

a lender of last resort, that it was necessary to anchor the unregulated Canadian monetary system after abandonment of the gold standard in 1929, and that it was

a response to political rather than purely economic pressures. Evidence from a variety of sources (contemporary statements to a Royal Commission, correspon-

dence of chartered bankers, newspaper reports, academic writings, and estima-

tion of time series econometric models) rejects the first two hypotheses and supports the third.

The Bank of Canada began operations in March 1935, considerably later than the central banks of most other Western industrial

economies. We examine two questions suggested by this event, why did Canada not develop a central bank earlier, and, that given, why did the central bank evolve at all?

The current debate over regulatory reform of the banking system has led to a reexamination of the need for government intervention in the

monetary sector. One of the central issues in the debate is the role of

central banks, and historical evidence on the circumstances leading to their establishment is crucial. Some economists argue that in every case central banks were imposed by revenue-seeking or power-hungry governments, while others argue that central banks, specifically in their role as lender of last resort, evolved naturally from a fractional reserve

banking system.' The relatively late appearance of central banking in Canada suggests

that its experience may shed some light on the debate. We examine

three competing hypotheses concerning the introduction of central

Journal of Economic History, Vol. XLVII, No. 2 (June 1987). ? The Economic History Association. All rights reserved. ISSN 0022-0507.

Michael Bordo is Professor of Economics, College of Business Administration, University of

South Carolina, Columbia, SC 29208; Angela Redish is Assistant Professor, Department of

Economics, University of British Columbia, Vancouver, British Columbia, Canada, V6T 1Y2. They wish to thank Greg Bloss and Shirley Haun for research assistance and the Bank of Nova

Scotia Archives for access to their material. Helpful comments on an earlier draft were supplied by Lance Davis, Steven Easton, Steven Ferris, Debra Glassman, Charles Goodhart, Mark Rush,

Anna Schwartz, Ronald Shearer, Charles Stuart, Dean Taylor, Kenneth White and participants at

the Fourteenth Annual Conference of the Use of Quantitative Methods in Canadian Economic

History. The usual disclaimer applies.

ISee Vera Smith, The Rationale for Central Banking (London, 1936); Friederich Hayek, Denationalization of Money, (London, 1976) for the view that central banks were primarily a response to political and historical forces; and Charles Goodhart, The Evolution of Central Banks:

A Natural Development? (London, 1985) for the natural evolution hypothesis.

405

This content downloaded from 142.104.160.190 on Tue, 21 Mar 2017 18:33:06 UTC All use subject to http://about.jstor.org/terms

406 Bordo and Redish

banking in Canada. The first is that the bank evolved naturally as a

lender of last resort to the fractional reserve banking system. The second is that the bank was introduced to provide an anchor for a largely unregulated monetary system that had just left the certainties of the gold

standard, and the final hypothesis is that the bank's emergence was prompted primarily by political factors independent of the preceding two hypotheses.2 We find most support for the third alternative.

We argue that by 1935, the Canadian banking system had developed alternative institutions to perform the functions traditionally associated with a central bank. At the same time the Bank of Canada was

considered by its framers to be a complement to, not a substitute for, the gold standard, and we find support for this position in econometric analysis.

I. THE NATURAL EVOLUTION HYPOTHESIS

The traditional approach to the origins of central banking views it as part of the natural evolution of a modern banking system. A competitive

banking system, with bank money convertible into gold or some other dominant (outside) money, will periodically face the problem of runs on individual banks reflecting the public's fear for the solvency of a particular institution. Because the non-bank public is not able to distinguish between the liquidity and solvency of related banks, a liquidity crisis and a banking panic will often follow. Charles Goodhart effectively argues that because of an information asymmetry, a central

bank is necessary to act as lender of last resort and cannot be operated on profit maximizing lines because of potential conflicts of interest between the competitive central bank and other banks in the system.3

Goodhart's explanation for the evolution of central banking in En- gland as well as other European countries is that the first central banks evolved from commercial banks which had the special privilege of being the government's bank. Because of their sound reputation, position as holder of the nation's central gold reserve, ability to obtain economies of pooling reserves through a correspondent banking system, and ability to provide extra cash by rediscounting, such banks evolved into

bankers' banks and lenders of last resort in a liquidity crisis. Once such banks began to perform the role of lender of last resort, "moral hazard" on the part of member banks (following a more risky strategy) provided a rationale for some form of supervision or legislation. Further, Goodhart argues that the conflict between the public functions of such

2 The traditional explanation given for the establishment of the Bank of Canada in the 1930s is the failure of the prevailing set of monetary arrangements to increase the money supply during the Great Depression. See for example, S. R. Noble, "The Monetary Experience of Canada during the Depression," in Arthur Gayer, ed., The Lessons of Monetary Experience (New York, 1937).

3 Goodhart, The Evolution of Central Banks.

This content downloaded from 142.104.160.190 on Tue, 21 Mar 2017 18:33:06 UTC All use subject to http://about.jstor.org/terms

Bank of Canada 407

an institution and satisfying the shareholders made the transition from a

competitive bank to a central bank lengthy and painful.

The counter argument has been put most clearly by Vera Smith who rests the case on the fact that central banks did not, in historical fact,

evolve naturally but were established as favors to the government of the day. Milton Friedman and Anna Schwartz, while agreeing with Smith,

suggest that the case against some form of government role as a lender of last resort is inconclusive.4 While private insurance schemes could handle bank insolvency, federal deposit insurance has been necessary in the United States to allay incipient liquidity crises in the unit banking system.

The structure of the Canadian banking system changed considerably between the emergence of the first chartered bank in 1822 and the 1930s,

but the process of evolution did not result in the introduction of central banking.

At the beginning of the twentieth century the Canadian banking system was comprised of thirty-six competitive fractional reserve banks, each permitted to operate branches nationwide. The banks required a government charter to commence operations and some minimum level of paid-up capital. There were no required reserves, but banks usually kept substantial levels of reserves because the refusal to

convert their notes and demand deposits into specie (or Dominion notes-see below) would result in suspension or forfeit of the charter.

The government's involvement in the monetary sector was through regulation of financial institutions and the issue of convertible and, in part, fiduciary Dominion notes. Dominion notes were legal tender and were generally issued in small denominations for hand-to-hand currency

(the government had a monopoly over the issue of notes of $5 or less) and large denominations (over $10,000) used as reserves by the banks. The government held a fractional reserve against its notes, up to a limit

above which 100 percent reserves were required to be held. (The limit rose from $9 million to $50 million between 1860 and 1930.)

Although Canada had a competitive fractional reserve banking sys- tem throughout the nineteenth century, no central bank evolved.

Virtually all the elements of traditional central banking had emerged by the beginning of the twentieth century, undertaken either by private institutions or directly by the government.

First, the Canadian banking system had developed an efficient (bank notes generally traded at par throughout the country) and elastic note

issue. The Clearing House in Montreal was maintained by the Canadian Bankers' Association (CBA), which in 1901 was recognized by the Bank Act as "an agency for the supervision and control of certain activities of

'Smith, The Rationale; and Milton Friedman and Anna J. Schwartz, "Has Government Any Role in Money?" Journal of Monetary Economics, 17 (Jan. 1986), pp. 37-62.

This content downloaded from 142.104.160.190 on Tue, 21 Mar 2017 18:33:06 UTC All use subject to http://about.jstor.org/terms

408 Bordo and Redish

the banks."5 Second, the nationwide branch system avoided the prob-

lem of seasonal liquidity crises so evident in the United States after the

Civil War, lessening the need for a lender of last resort. Third, the Bank of Montreal (founded in 1817) emerged very early as

the government's bank performing many central bank functions. How-

ever, the Bank of Montreal never evolved into a full-fledged central bank as did the Bank of England (or the government's bank in other

countries) perhaps because of the rivalry of other large Canadian banks (for example, the Royal Bank). Fourth, Canadian banks kept most of

their reserves on "call" in the New York money market. Such outside reserves were used on occasion to satisfy the public's demand for

liquidity, again precluding the need for a central bank. On two occa-

sions, 1907 and 1914, these reserves proved inadequate to prevent a

liquidity crisis and the Government of Canada had to step in to provide adequate reserves.

Fifth, the Finance Act, passed in 1914 to facilitate wartime finance,

provided the chartered banks with a liberal rediscounting facility. This

act included a clause that permitted the issue of unbacked Dominion notes. By pledging appropriate collateral (and this was broadly defined) banks could borrow Dominion notes from the Treasury Board. This

clause, which was extended after the wartime emergency by the Amendment of 1923, provided a discount window/lender of last resort for the Canadian banking system.

II. PROVIDING A SUBSTITUTE FOR THE GOLD STANDARD

The key macroeconomic function for a central bank under the classical gold standard was to maintain convertibility into gold. In Canada, overissue by individual banks was prevented through the operation of the clearing mechanism while convertibility for the system as a whole was maintained through the holding of outside reserves. Discretionary monetary policy (for debt management purposes and to finance the government's bonds) rarely conflicted with the gold standard

constraint and was carried out by the Government of Canada using the Bank of Montreal as its fiscal agent. Thus, under the classical gold standard which prevailed before 1914, there seemed to be little need for a central bank for Canada.6

In 1926 Canada had returned to the gold standard which had been abandoned in November 1914. In December 1928 Canada de facto

suspended the gold standard. The banks "cooperated" with the gov-

'George S. Watts, "The Origins and Background of Central Banking in Canada," Bank of Canada Review (May 1972), p. 18.

6Derek Chisholm, "La Banque de Canada dtait-elle ndcessaire?" L'actualiti 9conomique, 59

(Sept. 1983), pp. 551-74, argues that the Bank of Canada was equally unnecessary in the 1930s,

since the government of Canada had shown that it could manage the Canadian currency both before

and after the suspension of free gold convertibility.

This content downloaded from 142.104.160.190 on Tue, 21 Mar 2017 18:33:06 UTC All use subject to http://about.jstor.org/terms

Bank of Canada 409

ernment by suspending gold exports on their own account and by raising

the price of gold for U.S. banks. Because Dominion notes were de facto inconvertible, the Canadian exchange rate was no longer constrained at

par. On the other hand, and in contrast to the nineteenth-century

suspension of convertibility, internal convertibility was maintained, that is, Canadian banks were still required to convert their notes into

Dominion notes on demand. The informal suspension continued (more

or less) until October 1931 when, following the British suspension of the

gold standard, a formal embargo was placed on gold exports. Conse- quently, one possible rationale for the establishment of a central bank was to provide an anchor to the money supply, the price level, and

hence the exchange rate, in the absence of gold convertibility. A central bank could prevent unregulated profit-maximizing private banks from expanding their money issues without limit.7

There is considerable evidence that this hypothesis is at best incom-

plete. We have argued elsewhere that the suspension of the gold standard did not create an explosion of the price level as a consequence

of profit-maximizing banks expanding their money issues, as suggested by traditional models of inflationary finance. Expectations by the banks

that the gold standard would be resumed at some traditional par constrained the issue of bank money.8 This view is supported by the almost identical deflationary behavior of the Canadian and the U.S.

price level during the period 1929 to 1933, and the tendency of the exchange rate to stay close to par for three years after Canada had left the gold standard.

In addition, the qualitative evidence of statements by contemporaries suggests that they did not see the central bank as an alternative to the international gold standard, but rather as a necessary institution in a

gold standard world. The opinions of the various interest groups are available in the records of the Macmillan Commission. Established by an Order-in-Council (P.C. 1562) on July 31, 1933, the five-man Macmil-

lan Commission investigated the desirability and potential structure of a

central bank in Canada. The commission conducted hearings across Canada before reporting on September 27, 1933, in favor of the

establishment of a central bank, with two dissenting opinions.

The evidence presented to the commission shows that it was widely believed that the suspension of the gold standard was temporary. Jackson Dodds, speaking for the CBA, stated: "It is logical to assume that the gold standard (perhaps with modifications) will be resumed in

'See Milton Friedman, A Program for Monetary Stability (New York, 1959). For the counter argument that competing banks would provide a determinant price level, see Benjamin Klein, "The

Competitive Supply of Money," Journal of Money, Credit and Banking, 6 (Nov. 1974), pp. 423-53. 8 Michael Bordo and Angela Redish, "The Supply of Inconvertible Money in the Absence of a

Central Bank: Canada's Interwar Experience" (unpublished manuscript, University of British

Columbia, 1985).

This content downloaded from 142.104.160.190 on Tue, 21 Mar 2017 18:33:06 UTC All use subject to http://about.jstor.org/terms

410 Bordo and Redish

due time by the great trading nations and that the Dominion would naturally desire to follow suit."9 While Frank Knox, a leading academic

economist, stated:

It may be assumed that sooner or later the major trading countries of the world will have

to come to some agreement as to a common monetary standard and that they will

stabilize their several currencys with respect to each other probably by making them

convertible once more into gold. Supposing this to have taken place Canada's monetary

policy is clearly to join such a group.1

The debate about the need for a central bank therefore focused on the

need for central banking in a gold standard world and the argument that the automatic gold standard of the pre-1914 era had been replaced by a

managed gold standard. Macmillan's report stated his position: "The gold standard was restored in a world which called for continuous direction and cooperation on the part of the various national authori-

ties.11 Indeed the dissenting commissioners stated that while they realized a central bank might be appropriate at some later date, they felt it should wait for the reestablishment of the international gold standard.

Macmillan, on the other hand, argued that the present time was particularly advantageous for establishing the bank, because it would not be subject to the day-to-day discipline of the gold standard until the central bankers had developed some experience.

An empirical analysis of the impact of the establishment of the Bank of Canada on key macroeconomic variables such as the price level, exchange rates, and interest rates can provide indirect evidence of the reasons for the bank's emergence. The hypothesis that the bank was necessary as a substitute for the gold standard implies that the intro- duction of a central bank with the power to control the money supply

would lead to very different price level behavior than under a regime where monetary variables were determined by a private banking sys- tem.

In the absence of sufficient data to estimate a structural model of the

macroeconomy that would permit identification of the channels and magnitude of the bank's impact, time-series models are used to examine the bank's effect on the macroeconomy. The impact of the bank's formation on the level of the money stock itself is difficult to gauge as the definition of such variables as currency in the hands of the public and reserves changed the day the bank began operations. The nature of the demand for reserves was altered by the introduction of a required reserve ratio, and the high-powered money component of currency in

9Royal Commission on Banking and Currency: Evidence [henceforth RCBC], p. 3225. I0RCBC, p. 3063. II Report of the Royal Commission on Banking and Currency in Canada (Ottawa, 1933), p. 59.

This view found support from both bankers and academics. See, for example, the evidence of

T. E. Gregory, (RCBC, p. 2995) and J. A. MacLeod, (RCBC, p. 50).

This content downloaded from 142.104.160.190 on Tue, 21 Mar 2017 18:33:06 UTC All use subject to http://about.jstor.org/terms

Bank of Canada 411

the hands of the public changed from Dominion notes in circulation to

Bank of Canada notes in active circulation.'2 Thus, though the impact of the bank's emergence on monetary variables is of great interest, our

serious doubts about the consistency of the measurement of high-pow- ered money lead us to restrict our analysis to the behavior of such

nominal variables as the price level and exchange rate. We estimate univariate models of the price level and the exchange

rate (data on Canadian interest rates are not available). We also estimate

two multivariate models of the price level in which the independent variables are the U.S. price level and the money stock-variables which

economic theory suggests would affect the price level. In each case, the impact of the formation of the bank is tested by an analysis of the

stability of the regression and by an examination of the regression residuals.

A univariate model of the Canadian price level was estimated using

monthly seasonally adjusted price data.'3 Box-Jenkins methods identi- fied the following estimating equation as the appropriate univariate model: 14

PF - = - a (P, - Pt2) + Et

where Et is a white noise error term. The estimated value of a was 0.48

with a t-statistic of 6.98.

The objective of the estimation is to examine whether the evolution of

the price series changed after the introduction of the Bank of Canada.

The first test examines the structural stability of the equation. Three

potential structural breaks are examined: January 1929, when Canada suspended gold convertibility, March 1933, when the United States

suspended gold convertibility, and March 1935. If the Bank of Canada had created a new monetary regime the equation should have a

structural break in 1935. Chow tests for the three periods show that the

null hypothesis of no break should be accepted for each of the three

periods.

An alternative method of determining the stability of the regression is to examine the regression residuals and to find those residuals that have

a disproportionate influence on the estimated model. Figure la presents

12 The active circulation of Bank of Canada notes in March 1935 was double the Dominion notes in the hands of the public in February 1935, which we attribute primarily to a change in

measurement rather than a doubling of currency holdings.

13 The data sources are as follows: Canadian wholesale price index-Prices and Price Indexes, Dominion Bureau of Statistics, Canada; the exchange rate-monthly average noon buying rate for

the Canadian dollar in New York from U.S. Board of Governors of the Federal Reserve, Federal

Reserve Bulletin; U.S. wholesale price index-Department of Commerce, Statistical Abstract of

the U.S., Washington; MI and M2-calculated from the returns published in the Canada Gazette

(available from the authors on request). All data were seasonally adjusted using the SAS X- 11

program.

4 George E. P. Box and Gwilym M. Jenkins, Time Series Analysis (San Francisco, 1976).

This content downloaded from 142.104.160.190 on Tue, 21 Mar 2017 18:33:06 UTC All use subject to http://about.jstor.org/terms

412 Bordo and Redish

-1 2 16 AA4 93 13 1940

a) PRICE

1926 1928 1930 1932 1924 1936 1939 1940

4 e

1928 1928 1930 1932 1934 1936 1938 1940

,1, 7 , . . . . . . . . , . . . . . ;. . . . . . . . . . . . . . . , ,.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

O - ' It kt ^ ^^A ^ _ K .A AA I

0 v -1vAVAV vV-QVA - AVi

. v ,,,,,,, ..- .,... 4c) US PRICE

1926 1928 1930 1932 1934 1939 1939 1940

1 vA V - ;%,- A'F A IGA U 1 stuenti VV"rd s _th model.'VV Ifv th foraio- of v ~~~~~~~~. . . ,. . . . . . . . . . . . . . . . . . . . . . . . . . .. . . ... . . . , V . . . . . . . . . . .... . . . . . . . . . . . . . . . . . . . . . . . . . . ........... ..... ........ 4 d) Ml

1926 1928 1930 1932 Ags4 13 a93d 19S e 1940

1.. 7 . . . . . . . . . . . . . . . . . . . . . . . .

fr t marks t pb . k o A th l Aate t the

mars th beinn of Wrd arI. Th abec fainfcn

1926 1928 1030 1932 1@i4 1 93 6 1913 19' 0

FIGURE I

REGRESSION RESIDUALS

the "studentized" residuals for the model."s If the formation of the Bank of Canada altered the monetary regime, then the month when the bank began business or when the bill establishing the bank was passed (June 1934) would have a studentized residual greater than 1.97 in absolute value. In the equation for the entire period, four residuals are significant: July 1929, July 1933, August 1933, and September 1939. The first date marks the peak of the business cycle in the late twenties; the months of 1933 are part of the brief hiatus from March 1933 to January 1934 when the gold price of the U.S. dollar fluctuated; the last date marks the beginning of World War II. The absence of a significant

15 One interpretation of the "studentized" residuals is as follows: If the regression were rerun with a dummy variable for the ith observation, the t-statistic on the coefficient of the dummy

variable would be the same as the "studentized" residual for that observation. See David A.

Belsley, Edwin Kuh, and Roy E. Welsch, Regression Diagnostics (New York, 1980), p. 20.

This content downloaded from 142.104.160.190 on Tue, 21 Mar 2017 18:33:06 UTC All use subject to http://about.jstor.org/terms

Bank of Canada 413

residual in March 1935 (or in June 1934) provides evidence that the Bank

of Canada had little effect on macroeconomic variables.

Similar analysis was conducted for the behavior of the exchange rate between the Canadian dollar and the U.S. dollar. The data again did not

reject the hypothesis that the equation was stable throughout the period.

The results of the influence tests are shown in Figure lb. All the

significant residuals (other than that for September 1939) lie within the period from September 1931 to November 1933, when the normal relationship between the pound and the U.S. dollar was disrupted, while

there is no evidence of a change in the relationship in March 1935.

The third model is a multivariate model including lagged and contem- poraneous U.S. price level terms as well as lagged Canadian price level terms as determinants of the Canadian price level. Since the Canadian

dollar was very close to par with the U.S. dollar for the period July 1926 to September 1939 (with the exception of the period October 1931 to March 1933), we would expect Canadian prices to be strongly correlated with U.S. prices. Furthermore, since Canada had many of the features

of a small open economy, we would expect the world price level to be exogenous for the Canadian economy. The independent variables of the estimating equation were the contemporaneous U.S. price level and six

lags of the Canadian price level and of the U.S. price level. 16 The Chow tests suggest a structural break only in March 1933 and the analysis of the residuals (Figure ic) again show no significant residual in March

1935.

Finally a multivariate model in which the current price level depends on lagged prices and lagged and contemporaneous money stock is estimated separately with Ml and M2.17 We use the same methodology to determine lag length as in the previous model, and twelve lagged

values of the dependent variable and six of the money stock variable are

included. When the M2 definition of money is used, the results are quite

similar to those of the other models. The only structural break occurs in March 1933, and again there is no significant residual in March 1935 (Figure le).

When the Ml definition of money is employed, no structural break is found in January 1929 or March 1933, although there is a structural break in March 1935. We suspect that this break reflects the change in reporting techniques of the currency-in-the-hands-of-the-public compo-

nent of high-powered money discussed above. We therefore reestim-

ated the model using as the monetary variable Ml less the high-powered currency component. In this model the hypothesis of structural stability

16 The lag lengths were determined by the method of Frederic S. Mishkin, A Rational Expectations Approach to Macroeconometrics (Chicago, 1983), p. 22.

17 MI comprises Dominion notes in the hands of the public, chartered bank notes in circulation, plus public (including provincial government) demand deposits. M2 includes MI and notice

deposits.

This content downloaded from 142.104.160.190 on Tue, 21 Mar 2017 18:33:06 UTC All use subject to http://about.jstor.org/terms

414 Bordo and Redish

could not be rejected. The studentized residuals are similar to those for M2 (see Figure Id).

Despite the one anomalous significant residual in the Ml model, the battery of tests largely supports the conclusion that the introduction of the Bank of Canada did not alter the money supply process in Canada and did not affect the evolution of the key nominal variables in the economy.

The annual reports of the governor of the bank (1935-1939) suggest that the result was not unintentional. In the first annual report the governor described the functions of the bank and how they were being implemented.'8 The five functions listed were: to manage domestic credit, to manage the exchange rate, to advise the government, to

cooperate with other central banks, and to manage the bank rate. The bank, however, took a rather agnostic approach to these activities. After admitting that, since the Canadian dollar was inconvertible, the bank could control the level of domestic credit, the governor argued that the objective of such control was the level of income, which "can grow and does grow without any definite connection between such growth and a growth in bank deposits or notes in circulation."'9

With respect to the exchange rate, the governor noted that "the Canadian dollar has exhibited a remarkable tendency, when not at

parity with the pound or U.S. dollar to take up an intermediate position."20 But he took no credit for the level of the exchange rate and rather attributed it to institutional arrangements: "The existence of so many Canadian bonds payable in 2 or 3 currencies . . . has had a tendency to restrict fluctuations."'2' Finally, with respect to the bank rate: "It is quite out of touch with Treasury Bill rates, but this fact is not at present of any significance."22

The governor's report reflects more concern with the housekeeping details of the transfer to the bank of various activities previously managed by the government (the issue of currency, and the manage- ment of the government debt) than with macroeconomic objectives. This is consistent with our econometric analysis which finds that the formation of the bank had virtually no macroeconomic impact.

1II. THE POLITICAL FORCES

Canada's central bank was not intended to replace the gold standard, and it was not considered a necessary part of a fractional reserve banking system. The emergence of the Bank of Canada, we believe,

18 Bank of Canada, Annual Report of the Governor of the Bank of Canada (Ottawa, 1935). '9Ibid., p. 12.

20Ibid., p. 13. 21 Ibid.

22 Ibid., p. 16.

This content downloaded from 142.104.160.190 on Tue, 21 Mar 2017 18:33:06 UTC All use subject to http://about.jstor.org/terms

Bank of Canada 415

reflected a conjuncture of political imperatives. Domestically, in an environment where traditional trust in the beneficial nature of the

market system was eroding and a spirit of nationalism was rising,

political pressure was mounting to halt the deflation which was fre- quently blamed on the concentrated banking industry. Internationally,

monetary cooperation was said to depend on a system of central banks. The demand for inflation, while clearly important, is rather ambigu-

ous. The popular demand is succinctly expressed in an article in Maclean's Magazine:

The point which our bankers seem to miss is that what the Canadian people want in a

central bank is not to supply the other banks with rediscount facilities which they already have or to save us from future panics, [as, it is previously noted, U.S.

experience shows they do not] but they do want an institution that will effectually

control the whole of the money and credit of the nation, now under the control of the

other banks and which will somehow be able to make that money and credit available

in sufficient volume wherever legitimately needed, and on terms much more fair and

equitable than at present.23

The ambiguity arises because there was no stated desire to abandon the

gold standard. In addition, the deflation and the stability of the Canadian dollar were clearly phenomena not opposed by the Canadian govern-

ment, and it should have been clear that a central bank would not

diverge from such a policy. Government representatives had frequently

stated that the dollar would not be depreciated, although a monetary

expansion was attempted in late 1932 by forcing the banks to borrow

under the Finance Act. The new borrowing was primarily used to pay

off older borrowings and had little inflationary impact. The government

continued to refuse to undertake the direct inflationary policies of either

increasing the flat limit on Dominion notes or reducing the gold backing

of notes beneath the limit.

The demand for inflation was often not separated from attacks on the

monopoly power of the banking system. In 1930 there were only ten

banks and of these three owned 75 percent of industry assets. The CBA

provided a forum for explicit collusion and the collusion was admitted

on occasion in such areas as western branch closures.24 In the Parlia-

ment, opposition members complained that "farmers were innocent

victims of the policy of deflation instituted by the banks."25 These attacks came at the same time as more general attacks on the

efficacy of the market system. Historian Donald Creighton noted that

"A fairly large and increasing number of Canadians were rapidly reaching the conclusion that positive action by the state must remedy

23 Maclean's Magazine, 1 July 1933. 24 Vancouver Province, 30 Dec. 1935. 25 Milton L. Stokes, The Bank of Canada (Toronto, 1939), p. 62.

This content downloaded from 142.104.160.190 on Tue, 21 Mar 2017 18:33:06 UTC All use subject to http://about.jstor.org/terms

416 Bordo and Redish

the admitted weakness of economic liberalism."26 The political mani-

festation of this sentiment was the Cooperative Commonwealth Feder- ation (CCF), a socialist party, created in 1932 which had by 1934

become the official opposition in the Provincial governments of Ontario

and Saskatchewan. A central platform of the CCF was the nationaliza-

tion of all financial institutions. Schemes for increased government intervention also appeared from the right-the Social Credit party founded on the doctrines of Major Douglas, and the Bloc Populaire, a proto-fascist party, in Quebec.

There were, in addition, more subtle political pressures. The Cana- dian government had been a party to the International Financial

Conference in Brussels in 1920 which had issued a statement urging all countries without a central bank to establish one. More recently the

World Monetary and Economic Conference in 1933 had stated that all developed countries without a central bank should create one to

facilitate monetary cooperation and recovery. In an article analyzing the need for a central bank, Queen's University economists had stressed

the need for a central bank to send representatives to world monetary

conferences: "There are few countries . . . more vitally interested in international cooperation in the monetary and economic fields than

Canada and yet we lack any institution which would permit effective participation in such cooperation." 27

The establishment of the bank was also part of a more general program to create sovereign institutions. It was not until 1931 that

Canada's independence from Britain was solidified by the Statute of Westminster, which gave her Dominion status, and authority over her own external affairs.28 In laying the foundation for a national airline, Prime Minister Bennett remarked: "The Americans can fly on their side of the line but we are quite capable of doing all the flying in or over Canada.' 29 The Canadian Radio Broadcasting Commission was also established in 1932. Speaking in December 1933, Bennett stated that he

had decided in December 1931, after Britain left gold, to establish a central bank:

I learned to my surprise that there was no direct means of settling international balances between Canada and London, that the only medium was New York, and the value of the Canadian dollar would have to be determined in Wall Street. I made up my mind then and there that this country was going to have a central bank because there must be some financial institution that can with authority do business for the whole of the Dominion

with the other nations of the World. If Canada was to be financially independent there

26 Donald Creighton, Canada's First Century (Toronto, 1970), p. 215.

27 Department of Political and Economic Science, Queen's University, "The Proposal for a Central Bank," Queen's Quarterly, 40 (Aug. 1933), p. 439.

28 We would like to thank historian Fred Armstrong at the University of Western Ontario for pointing out this argument.

29 Cited in Creighton, Canada's First Century, p. 215.

This content downloaded from 142.104.160.190 on Tue, 21 Mar 2017 18:33:06 UTC All use subject to http://about.jstor.org/terms

Bank of Canada 417

had to be a means of determining balances, of settling international accounts; and a central bank would furnish this.30

Whether or not Bennett was speaking with hindsight, there is consid- erable evidence that the decision to introduce a central bank was made before the Macmillan Commission handed down its report. Bryce states that W. C. Clark "agreed to become deputy minister of finance [in late

1932] only when he had found out that the Prime Minister was prepared to accept in principle the establishment of a central bank for Canada.' '31 Indeed, the appointment of Lord Macmillan (a staunch advocate of

central banking) as head of the commission left little doubt about the

outcome of the investigation. The president of the CBA, writing in August to a colleague, stated: "Confidentially, I think it was decided before Lord Macmillan left London that some kind of a central

organization should be established in Canada.' 32 One week after the Macmillan Commission handed down its report, Prime Minister Bennett announced that he would introduce a bill to establish a central bank, "to regulate credit and currency in the best interests of the economic life of

the nation, to control and protect the external value of the national

monetary unit and to mitigate by its influence fluctuations in the general level of production, trade, prices and employment."33

IV. CONCLUSION

Examination of the available evidence has led us to reject the hypotheses that the Bank of Canada's emergence merely reflected evolutionary necessity or the need to anchor a monetary system cast adrift by the suspension of the gold standard. The qualitative evidence suggests that the emergence of the Bank of Canada reflected political, rather than economic, imperatives. Domestically, the government

needed to be seen as taking active measures in response to the

Depression. The reduced faith in the omnipotence of the market system, coupled with public hostility towards the banking system, meant that the introduction of a central bank was politically popular. Internation- ally, foreign governments and international organizations were urging nations to create central banks to facilitate international monetary cooperation. It was these factors rather than strict economic efficiency that prompted the establishment of the Canadian central bank.

30 Cited in Stokes, Bank of Canada, p. 65. 31 Robert B. Bryce, Maturing in Hard Times (Montreal, 1986), p. 82. 32 Letter from J. A. MacLeod to Hector MacInnes 25 Aug. 1933. Archives of the Bank of Nova

Scotia. B.N.S. docs Sec.#8, File 3. Earlier in August, a newspaper report stated that Eastern financial circles were taking it for granted that a central bank would be created and that the banks would lose their rights to note issue. Vancouver Sun, 11 Aug. 1933.

33 Statues of Canada, 1934, "An Act to Incorporate the Bank of Canada," 24-25, George V, chap. 43, preamble.

This content downloaded from 142.104.160.190 on Tue, 21 Mar 2017 18:33:06 UTC All use subject to http://about.jstor.org/terms