Uneasy Money

In this installment, I will provide a very quick overview of Hawtrey’s chapters 10 and 11, and point out a minor defect in his argument about the international adjustment process. Having explained the international adjustment process to a monetary disturbance in chapter 9, Hawtrey uses the next two chapters to give a brief, but highly insightful, account of the process of economic growth, expanding human settlement into new geographic locations, thereby showing an acute sense of the importance of geography and location in economic development, and of the process by which newly extracted gold is exported from gold-producing to gold-importing areas, even though, under the gold standard, the value of gold is the same all over the world (chapter 10). Hawtrey then examines the process of adjustment to a reduction in the demand for a product exported by a particular country. Hawtrey explains the adjustment processes first under the assumption that the exchange rate is allowed to adjust (all countries being assumed to have inconvertible fiat currencies). and, then, under the assumption that all money is convertible into gold and exchange rates are fixed (at least within the limits of gold import and export points).

The analysis is pretty straightforward. Starting from a state of equilibrium, if the worldwide demand for one of country A’s export products (say hats) declines, with the increased expenditure shared among all other commodities, country A will experience a balance-of-payments deficit, requiring a depreciation of the exchange rate of the currency of country exchange against other currencies. In the meantime, country A’s hat producers will have to cut output, thus laying off workers. The workers are unlikely to accept an offer of reduced wages from country A hat producers, correctly reasoning that they may be able to find work elsewhere at close to their old wage. In fact the depreciation of country A’s currency will offer some incentive to country A’s other producers to expand output, eventually reabsorbing the workers laid off by country A’s hat producers. The point is that a demand shift, though leading to a substantial reduction in the output and employment of one industry, does not trigger the wider contraction in economic activity characteristic of cyclical disturbances. Sectoral shifts in demand don’t normally lead to cyclical downturns.

Hawtrey then goes through the analysis under the assumption that all countries are on the gold standard. What happens under the gold standard, according to Hawtrey, is that the balance-of-payments deficit caused by the demand shift requires the export of gold to cover the deficit. The exported gold comes out of the gold reserves held by the banks. When banks see that their gold reserves are diminishing, they in turn raise interest rates as a way of stemming the outflow of gold. The increase in the rate of interest will tend to restrain total spending, which tends to reduce imports and encourage exports. Hawtrey goes through a somewhat abstruse numerical example, which I will spare you, to show how much the internal demand for gold falls as a result of the reduction in demand for country A’s hats. This all seems generally correct.

However, there is one point on which I would take issue with Hawtrey. He writes:

But even so equilibrium is not yet reached. For the export of hats has been diminished by 20 percent, and if the prices ruling in other industries are the same, relatively to those ruling abroad, as before, the imports of those commodities will be unchanged. There must therefore be a further export of gold to lower the general level of prices and so to encourage exports and discourage imports. (pp. 137-38)

Here is an example of the mistaken reasoning that I pointed out in my previous post, a failure to notice that the prices of all internationally traded commodities are fixed by arbitrage (at least as a first approximation) not by the domestic quantity of gold. The export of gold does nothing to reduce the prices of the products of the other industries in country A, which are determined in international markets. Given the internationally determined prices for those goods, equilibrium will have to be restored by the adjustment of wages in country A to make it profitable for country A’s exporting industries and import-competing industries to increase their output, thereby absorbing the workers displaced from country A’s hat industry. As I showed in my previous post, Hawtrey eventually came to understand this point. But in 1913, he had still not freed himself from that misunderstanding originally perpetrated by David Hume in his famous essay “Of the Balance of Trade,” expounding what came to be known as the price-specie-flow mechanism.