Uneasy Money

For many readers, I am afraid that the reaction to the title of this post will be something like: “and not a moment too soon.” When I started this series two months ago, I didn’t expect it to drag out quite this long, but I have actually enjoyed the process of reading Hawtrey’s Good and Bad Trade carefully enough to be able to explain (or at least try to explain) it to an audience of attentive readers. In the course of the past ten posts, I have actually learned a fair amount about Hawtrey that I had not known before, and a number of questions have arisen that will require further investigation and research. More stuff to keep me busy.

My previous post about financial crises and asset crashes was mainly about chapter 16, which is the final substantive discussion of Hawtrey’s business-cycle theory in the volume. Four more chapters follow, the first three are given over to questions about how government policy affects the business cycle, and finally in the last chapter a discussion about whether changes in the existing monetary system (i.e., the gold standard) might eliminate, or at least reduce, the fluctuations of the business cycle.

Chapter 17 (“Banking and Currency Legislation in Relation to the State of Trade”) actually has little to do with banking and is mainly a discussion of how the international monetary system evolved over the course of the second half of the nineteenth century from a collection of mostly bimetallic standards before 1870 to a nearly universal gold standard, the catalyst for the evolution being the 1870 decision by newly formed German Empire to adopt a gold standard and then proceeded to convert its existing coinage to a gold basis, thereby driving up the world value of gold. As a result, all the countries with bimetallic standards (usually tied to a 15.5 to 1 ratio of silver to gold) to choose between adopting the gold standard and curtailing the unlimited free coinage of silver or tolerating the inflationary effects of Gresham’s Law as overvalued and depreciating silver drove gold out of circulation.

At the end of the chapter, Hawtrey speculates about the possibility that secular inflation might have some tendency to mitigate the effects of the business cycle, comparing the period from 1870 to 1896, characterized by deflation of about 1 to 2% a year, with the period from 1896 to 1913, when inflation was roughly about 1 to 2% a year.

Experience suggests that a scarcity of new gold prolongs the periods of depression and an abundance of new gold shortens them, so that the whole period of a fluctuation is somewhat shorter in the latter circumstances than is the former. (p. 227)

Hawtrey also noted the fact that, despite unlikelihood that long-term price level movements had been correctly foreseen, the period of falling prices from 1870 to 1896 was associated with low long-term interest rates while the period from 1896 to 1913 when prices were rising was associated with high interest rates, thereby anticipating by ten years the famous empirical observation made by the British economist A. W. Gibson of the positive correlation between long-term interest rates and the price level, an observation Keynes called the Gibson’s paradox, which he expounded upon at length in his Treatise on Money.

[T]he price was affected by the experience of investments during the long gold famine when profits had been low for almost a generation, and indeed it may be regarded as the outcome of the experience. In the same way the low prices of securities at the present time are the product of the contrary experience, the great output of gold in the last twenty years having been accompanied by inflated profits. (p. 229)

Chapter 18 (“Taxation in Relation to the State of Trade”) is almost exclusively concerned not with taxation as such but with protective tariffs. The question that Hawtrey considers is whether protective tariffs can reduce the severity of the business cycle. His answer is that unless tariffs are changed during the course of a cycle, there is no reason why they should have any cyclical effect. He then asks whether an increase in the tariff would have any effect on employment during a downturn. His answer is that imposing tariffs or raising existing tariffs, by inducing a gold inflow, and thus permitting a reduction in interest rates, would tend to reduce the adverse effect of a cyclical downturn, but he stops short of advocating such a policy, because of the other adverse effects of the protective tariff, both on the country imposing the tariff and on its neighbors.

Chapter 19 (“Public Finance in Relation to the State of Trade”) is mainly concerned with the effects of the requirements of the government for banking services in making payments to and accepting payments from the public.

Finally, Chapter 20 (“Can Fluctuations Be Prevented?”) addresses a number of proposals for mitigating the effects of the business cycle by means of policy or changes institutional reform. Hawtrey devotes an extended discussion to Irving Fisher’s proposal for a compensated dollar. Hawtrey is sympathetic, in principle, to the proposal, but expressed doubts about its practicality, a) because it did not seem in 1913 that replacing the gold standard was politically possible, b) because Hawtrey doubted that a satisfactory price index could be constructed, and c) because the plan would, at best, only mitigate, not eliminate, cyclical fluctuations.

Hawtrey next turns to the question whether government spending could be timed to coincide with business cycle downturns so that it would offset the reduction in private spending, thereby preventing the overall demand for labor from falling as much as it otherwise would during the downturn. Hawtrey emphatically rejects this idea because any spending by the government on projects would simply displace an equal amount of private spending, leaving total expenditure unchanged.

The underlying principle of this proposal is that the Government should add to the effective demand for labour at the time when the effective private demand of private traders falls off. But [the proposal] appears to have overlooked the fact that the Government by the very fact of borrowing for this expenditure is withdrawing from the investment market savings which would otherwise be applied to the creation of capital. (p. 260)

Thus, already in 1913, Hawtrey formulated the argument later advanced in his famous 1925 paper on “Public Expenditure and the Demand for Labour,” an argument which eventually came to be known as the Treasury view. The Treasury view has been widely condemned, and, indeed, it did overlook the possibility that government expenditure might induce private funds that were being hoarded as cash to be released for spending on investment. This tendency, implied by the interest-elasticity of the demand for money, would prevent government spending completely displacing private spending, as the Treasury view asserted. But as I have observed previously, despite the logical gap in Hawtrey’s argument, the mistake was not as bad as it is reputed to be, because, according to Hawtrey, the decline in private spending was attributable to a high rate of interest, so that the remedy for unemployment is to be found in a reduction in the rate of interest rather than an increase in government spending.

And with that, I think I will give Good and Bad Trade and myself a rest.