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| External monetary shocks and financial stability: An empirical evidence from the Silver Act |
| LI Jianan, CHEN Li, ZHOU Yinggang
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| School of Economics/Wang Yanan Institute for Studies in Economics, Xiamen University |
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Abstract At present, the monetary policy cycle of major developed countries in Europe and the United States is frequently changed, which constitutes an external currency shock on the emerging economies with limited room for policy maneuver. The negative impact of external monetary shocks on domestic financial stability has attracted increasing attention, although the academic community has theoretically discussed the spillover effect of central countries' monetary policies on other economies and the significance of developing countries' proactive policies to offset external shocks and maintain financial stability. However, due to the endogeneity of money supply under the credit standard, it is difficult to accurately answer this question from the angle of causal identification. Nevertheless, China in the 1930s provided us with a rare opportunity to observe and answer this question at the institutional level. By collecting the information on customs imports, city prices, bank finance and so on in modern China, this paper studies the causal effect of external monetary shock on financial stability by using the impact of the US Silver Act of 1934, and analyzes the role of China's free banking system in coping with the crisis.
In the early 1930s, China was the only major country in the world that used the silver standard system, and its silver stock and total money supply were controlled by the balance of payments and the international silver price. At the same time, China had no substantive central bank, forming a banking system that resembled a "free banking system." As the previous silver price downturn hurt the interests of the seven silver producing states in the United States, under the promotion of these silver interest groups, the Roosevelt government promulgated the Silver Act in June 1934, authorizing the Treasury Department to buy silver from the international market at a high price, resulting in an increase of 70 percent in the international silver price in less than a year. The Silver Act had a significant impact on China under the silver standard, including a large outflow of silver and deflation. However, scholars, including Milton Friedman and Thomas Sargent, held opposing views on the actual impact of the Silver Act and the role of the free banking system. Contrary to the monetarist view, economists such as Sargent argued that China's deflation at the time was only the result of international arbitrage, and China's real economy was not greatly affected.
In order to re-examine the impact of the Silver Act, an exogenous monetary tightening shock, on China's financial economy in modern times from a micro perspective, we manually collected and sorted out the available data of China's urban prices, customs imports, bank finance, real economy, etc. These data come from the statistics of the Chinese old customs, the National Bank Yearbook compiled by the Bank of China, the industrial survey of the Nanking National Government and other authoritative archival materials at that time. We construct an index to measure the shock intensity of the Silver Act based on China's silver standard monetary system and commercial banks' currency issuance system .Through the exogenous shock of the Silver Act and the analysis of the price indices of major Chinese cities, we find that, in addition to controlling the impact of international price arbitrage, the monetary tightening has led to a significant decline in prices and deflation, as well as a shortage of liquidity in the interbank market. Concerned about tight market liquidity and rising risks, banks have reduced the size of their loans and reduced their support for the real economy. This means that the monetary tightening shock has a negative impact on the stability of the financial system and macro liquidity.
In addition to the direct impact on the financial system, the Silver Act also had a significant negative impact on the real economy. Under the tightening shock, the number of new enterprises and the area of real estate construction have declined significantly, suggesting that external monetary shocks not only affect the price level, but also have significant actual effects. At the same time, the analysis of the free banking system shows that the free banking system under the absence of the central bank cannot resolve the negative impact of external currency shocks in time. This also means that it is important to ensure the flexibility of the monetary policy of the central bank to cope with the impact of external monetary shocks.
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Received: 06 September 2023
Published: 01 August 2024
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