Uneasy Money

In my post last Monday, I suggseted that Hayek’s attachment to the gold standard led him to recommend a policy of deflation during the Great Depression even though his own neutral-money policy criterion of stabilizing aggregate monetary expenditure would have implied aggressive monetary expansion during the Great Depression. Forced to choose between two conflicting principles, Hayek made the wrong choice, opting for defense of the gold standard rather than for stabilizing nominal GDP. He later changed his views, disavowing support for the gold standard as early as 1943 in a paper (“A Commodity Reserve Currency”) in the Economic Journal (reprinted as chapter 10 of Individualism and Economic Order) and reaffirming his opposition to the gold standard in The Constitution of Liberty (p. 335). I cited his 1932 paper “the Fate of the Gold Standard” translated from the original German and republished in his collected works and quoted his opening paragraph lamenting that Britain had abandoned the gold standard because (in September 1931 as the Great Depression was rapidly spiraling downward) Britain found the discipline of the gold standard “irksome.”

I also referred to Hayek’s defense of what I called “the insane French policy of gold accumulation.” I did not want to burden readers of an already long post with further quotations from Hayek’s article, so I just left it there without giving another quotation. But I think it may be worth analyzing what Hayek wrote, not because I want to make Hayek look bad, but because his defense of the Bank of France betrays a basic misunderstanding of the theory of international monetary adjustment and how the gold standard worked that is characteristic of many discussions of the gold standard.

Here is what Hayek wrote (F. A. Hayek, The Collected Works of F. A. Hayek, Good Money, Part 1, p. 160).

The accusation that France systematically hoarded gold seems at first sight to be more likely to be correct [than the charge that the US Federal Reserve had been hoarding gold, an accusation dismissed in the previous paragraph]. France did pursue an extremely cautious foreign policy after the franc stabilized at a level which considerably undervalued it with respect to its domestic purchasing power, and prevented an expansion of credit proportional to the amount of gold coming in. Nevertheless, France did not prevent her monetary circulation from increasing by the very same amount as that of the gold inflow – and this alone is necessary for the gold standard to function.

Hayek made a fundamental error here, assuming that a small open economy (which France could be considered to have been in the late 1920s) had control over its money supply and its price level under the gold standard. The French price level, once France pegged the franc to the dollar in 1926 at $0.0392/franc, was no longer under the control of French monetary authorities, commodity arbitrage requiring commodity prices quoted in francs to equal commodity prices quoted in dollars adjusted for the fixed dollar/franc parity. The equalization was not perfect, because not all commodities enter into international trade and because there are differences between similar products sold in different countries that preclude full price equalization. But there are strict limits on how much national price levels could diverge under a gold standard. Similarly, the money supply in a country on the gold standard could not be controlled by the monetary authority of that country, because if people in that country wanted to hold more money than the monetary authority made available, they could increase their holdings of money by increasing exports or decreasing imports, thereby generating an inflow of gold, which could be converted into banknotes or deposits.

So Hayek’s observation that France did not prevent her monetary circulation from increasing by the very same amount as that of the gold inflow means only that the Bank of France refused to increase the French money supply at all (or even attempted to decrease it), forcing the French to increase their holdings of cash by acquiring gold through an export surplus. Hayek’s statement thus betrays a total misunderstanding of what “is necessary for the gold standard to function.” All that was necessary was that France maintain a fixed parity between the dollar and the franc, not that the Bank of France achieve a particular change in the money supply governed by the amount that its holdings of gold had changed. Hayek wrongly assumed that the French monetary authorities had control over the French money supply and that the inflow of gold was somehow determined by real forces independent of French monetary conditions. But it was just the opposite. The French money supply increased because the French wanted to increase the amount of cash balances they were holding. The only question was whether the French banking system would be allowed by the Bank of France to accommodate the French demand for money by increasing the French money supply, or whether the desired increase in the money supply would be permitted only through gold imports generated by an export surplus. Refusing to allow the French money supply to increase except through the importation of gold meant that the increase in the French demand for money was transformed into an equivalent increase in French (and, hence, the world) demand for gold, thereby driving up the value of gold, the proximate source of the deflation that produced the Great Depression.

As I said, this misconception of money supply adjustment under the gold standard was not unique to Hayek.  In some ways it is characteristic of many orthodox treatments of the gold standard and it can be traced back at least to the British Currency School of the 1830 and 1840s, if not even further back to David Hume in the 18th century.  Milton Friedman was similarly misguided in many of his discussions of the gold standard and international adjustment, especially in his discussion of the Great Depression in his Monetary History of the United States.  Ralph Hawtrey, as usual, got it right.  But the analysis was much later articulated in more conventional model by Harry Johnson and his associates in their development of the monetary approach to the balance of payments.