Indian Currency and Finance (1913): The Role of Institutions
Keynes was in the India Office for less than two years. He not only wrote the first version of his fellowship dissertation in that time but also closely studied the peculiarities of India’s financial system.
His analysis in the resulting book, Indian Currency and Finance (hereafter ICF, Keynes 1913 [1971]), established his method of theorizing from the known facts - not the usual procedure in economics, then as (even more) now. Although the book reads as a coherent whole, once Keynes was invited to participate in the Royal Commission on Indian Finance and Currency, it was sent to print without some of its intended chapters, in order to establish the book’s independence from the Commission’s deliberations.India’s gold standard was effectively based on sterling, and the system functioned differently from the gold standard in Britain also because of their different financial institutions and real economies. The emphasis on institutional factors that characterizes ICF is only equalled in Keynes’s later work on commodity markets, but we would argue that institutional knowledge is at the back of his mind at all times and can be detected in his later theoretical propositions, for example, the theory of liquidity preference and the causal priority of investment over saving.
The most striking difference in the system’s operation arose from the strong seasonal fluctuations in interest rates in India, driven by the variable liquidity needs of her agricultural economic base. India at that time had no central bank but was entirely dependent on London for its liquidity. Before the advent of rapid communication, the time lost in the transfer of funds from London cost interest, which India could ill afford. Keynes recommended that India have its own central bank, which would issue paper money to accommodate seasonal liquidity needs while maintaining its currency’s gold parity. This possibility of using credit to alleviate the gold standard’s rigidity and to economize on the expense of minting and shipping precious metal recommended the gold-exchange standard to Keynes as a future system more generally. The existing one-to-one relationship between gold reserves and the supply of currency in a “proper” gold standard led to instability; a managed currency would be better.
Keynes’s objection to the gold standard went beyond its unnecessary rigidity. The conventional wisdom was that the second half of the nineteenth century was a wonderful age of stability and prosperity and that the gold standard was largely responsible for its success. A return to gold was seen as the best hope of recapturing prosperity. Keynes argued for the opposite causality: that the apparent success of the gold standard as an international payments system depended on the particular historical circumstances of the period, which were unlikely to be repeated in the post-war world economy.