Archive for the 'gold standard' Category

Monetarism and the Great Depression

Last Friday, Scott Sumner posted a diatribe against the IS-LM triggered by a set of slides by Chris Foote of Harvard and the Boston Fed explaining how the effects of monetary policy can be analyzed using the IS-LM framework. What really annoys Scott is the following slide in which Foote compares the “spending (aka Keynesian) hypothesis” and the “money (aka Monetarist) hypothesis” as explanations for the Great Depression. I am also annoyed; whether more annoyed or less annoyed than Scott I can’t say, interpersonal comparisons of annoyance, like interpersonal comparisons of utility, being beyond the ken of economists. But our reasons for annoyance are a little different, so let me try to explore those reasons. But first, let’s look briefly at the source of our common annoyance.

foote_81The “spending hypothesis” attributes the Great Depression to a sudden collapse of spending which, in turn, is attributed to a collapse of consumer confidence resulting from the 1929 stock-market crash and a collapse of investment spending occasioned by a collapse of business confidence. The cause of the collapse in consumer and business confidence is not really specified, but somehow it has to do with the unstable economic and financial situation that characterized the developed world in the wake of World War I. In addition there was, at least according to some accounts, a perverse fiscal response: cuts in government spending and increases in taxes to keep the budget in balance. The latter notion that fiscal policy was contractionary evokes a contemptuous response from Scott, more or less justified, because nominal government spending actually rose in 1930 and 1931 and spending in real terms continued to rise in 1932. But the key point is that government spending in those days was too meager to have made much difference; the spending hypothesis rises or falls on the notion that the trigger for the Great Depression was an autonomous collapse in private spending.

But what really gets Scott all bent out of shape is Foote’s commentary on the “money hypothesis.” In his first bullet point, Foote refers to the 25% decline in M1 between 1929 and 1933, suggesting that monetary policy was really, really tight, but in the next bullet point, Foote points out that if monetary policy was tight, implying a leftward shift in the LM curve, interest rates should have risen. Instead they fell. Moreover, Foote points out that, inasmuch as the price level fell by more than 25% between 1929 and 1933, the real value of the money supply actually increased, so it’s not even clear that there was a leftward shift in the LM curve. You can just feel Scott’s blood boiling:

What interests me is the suggestion that the “money hypothesis” is contradicted by various stylized facts. Interest rates fell.  The real quantity of money rose.  In fact, these two stylized facts are exactly what you’d expect from tight money.  The fact that they seem to contradict the tight money hypothesis does not reflect poorly on the tight money hypothesis, but rather the IS-LM model that says tight money leads to a smaller level of real cash balances and a higher level of interest rates.

To see the absurdity of IS-LM, just consider a monetary policy shock that no one could question—hyperinflation.  Wheelbarrows full of billion mark currency notes. Can we all agree that that would be “easy money?”  Good.  We also know that hyperinflation leads to extremely high interest rates and extremely low real cash balances, just the opposite of the prediction of the IS-LM model.  In contrast, Milton Friedman would tell you that really tight money leads to low interest rates and large real cash balances, exactly what we do see.

Scott is totally right, of course, to point out that the fall in interest rates and the increase in the real quantity of money do not contradict the “money hypothesis.” However, he is also being selective and unfair in making that criticism, because, in two slides following almost immediately after the one to which Scott takes such offense, Foote actually explains that the simple IS-LM analysis presented in the previous slide requires modification to take into account expected deflation, because the demand for money depends on the nominal rate of interest while the amount of investment spending depends on the real rate of interest, and shows how to do the modification. Here are the slides:

foote_83

foote_84Thus, expected deflation raises the real rate of interest thereby shifting the IS curve to the left while leaving the LM curve where it was. Expected deflation therefore explains a fall in both nominal and real income as well as in the nominal rate of interest; it also explains an increase in the real rate of interest. Scott seems to be emotionally committed to the notion that the IS-LM model must lead to a misunderstanding of the effects of monetary policy, holding Foote up as an example of this confusion on the basis of the first of the slides, but Foote actually shows that IS-LM can be tweaked to accommodate a correct understanding of the dominant role of monetary policy in the Great Depression.

The Great Depression was triggered by a deflationary scramble for gold associated with the uncoordinated restoration of the gold standard by the major European countries in the late 1920s, especially France and its insane central bank. On top of this, the Federal Reserve, succumbing to political pressure to stop “excessive” stock-market speculation, raised its discount rate to a near record 6.5% in early 1929, greatly amplifying the pressure on gold reserves, thereby driving up the value of gold, and causing expectations of the future price level to start dropping. It was thus a rise (both actual and expected) in the value of gold, not a reduction in the money supply, which was the source of the monetary shock that produced the Great Depression. The shock was administered without a reduction in the money supply, so there was no shift in the LM curve. IS-LM is not necessarily the best model with which to describe this monetary shock, but the basic story can be expressed in terms of the IS-LM model.

So, you ask, if I don’t think that Foote’s exposition of the IS-LM model seriously misrepresents what happened in the Great Depression, why did I say at beginning of this post that Foote’s slides really annoy me? Well, the reason is simply that Foote seems to think that the only monetary explanation of the Great Depression is the Monetarist explanation of Milton Friedman: that the Great Depression was caused by an exogenous contraction in the US money supply. That explanation is wrong, theoretically and empirically.

What caused the Great Depression was an international disturbance to the value of gold, caused by the independent actions of a number of central banks, most notably the insane Bank of France, maniacally trying to convert all its foreign exchange reserves into gold, and the Federal Reserve, obsessed with suppressing a non-existent stock-market bubble on Wall Street. It only seems like a bubble with mistaken hindsight, because the collapse of prices was not the result of any inherent overvaluation in stock prices in October 1929, but because the combined policies of the insane Bank of France and the Fed wrecked the world economy. The decline in the nominal quantity of money in the US, the great bugaboo of Milton Friedman, was merely an epiphenomenon.

As Ron Batchelder and I have shown, Gustav Cassel and Ralph Hawtrey had diagnosed and explained the causes of the Great Depression fully a decade before it happened. Unfortunately, whenever people think of a monetary explanation of the Great Depression, they think of Milton Friedman, not Hawtrey and Cassel. Scott Sumner understands all this, he’s even written a book – a wonderful (but unfortunately still unpublished) book – about it. But he gets all worked up about IS-LM.

I, on the other hand, could not care less about IS-LM; it’s the idea that the monetary cause of the Great Depression was discovered by Milton Friedman that annoys the [redacted] out of me.

UPDATE: I posted this post prematurely before I finished editing it, so I apologize for any mistakes or omissions or confusing statements that appeared previously or that I haven’t found yet.

The Enchanted James Grant Expounds Eloquently on the Esthetics of the Gold Standard

One of the leading financial journalists of our time, James Grant is obviously a very smart, very well read, commentator on contemporary business and finance. He also has published several highly regarded historical studies, and according to the biographical tag on his review of a new book on the monetary role of gold in the weekend Wall Street Journal, he will soon publish a new historical study of the dearly beloved 1920-21 depression, a study that will certainly be worth reading, if not entirely worth believing. Grant reviewed a new book, War and Gold, by Kwasi Kwarteng, which provides a historical account of the role of gold in monetary affairs and in wartime finance since the 16th century. Despite his admiration for Kwarteng’s work, Grant betrays more than a little annoyance and exasperation with Kwarteng’s failure to appreciate what a many-splendored thing gold really is, deploring the impartial attitude to gold taken by Kwarteng.

Exasperatingly, the author, a University of Cambridge Ph. D. in history and a British parliamentarian, refuses to render historical judgment. He doesn’t exactly decry the world’s descent into “too big to fail” banking, occult-style central banking and tiny, government-issued interest rates. Neither does he precisely support those offenses against wholesome finance. He is neither for the dematerialized, non-gold dollar nor against it. He is a monetary Hamlet.

He does, at least, ask: “Why gold?” I would answer: “Because it’s money, or used to be money, and will likely one day become money again.” The value of gold is inherent, not conferred by governments. Its supply tends to grow by 1% to 2% a year, in line with growth in world population. It is nice to look at and self-evidently valuable.

Evidently, Mr. Grant’s enchantment with gold has led him into incoherence. Is gold money or isn’t it? Obviously not — at least not if you believe that definitions ought to correspond to reality rather than to Platonic ideal forms. Sensing that his grip on reality may be questionable, he tries to have it both ways. If gold isn’t money now, it likely will become money again — “one day.” For sure, gold used to be money, but so did cowerie shells, cattle, and at least a dozen other substances. How does that create any presumption that gold is likely to become money again?

Then we read: “The value of gold is inherent.” OMG! And this from a self-proclaimed Austrian! Has he ever heard of the “subjective theory of value?” Mr. Grant, meet Ludwig von Mises.

Value is not intrinsic, it is not in things. It is within us. (Human Action p. 96)

If value “is not in things,” how can anything be “self-evidently valuable?”

Grant, in his emotional attachment to gold, feels obligated to defend the metal against any charge that it may have been responsible for human suffering.

Shelley wrote lines of poetry to protest the deflation that attended Britain’s return to the gold standard after the Napoleonic wars. Mr. Kwarteng quotes them: “Let the Ghost of Gold / Take from Toil a thousandfold / More than e’er its substance could / In the tyrannies of old.” The author seems to agree with the poet.

Grant responds to this unfair slur against gold:

I myself hold the gold standard blameless. The source of the postwar depression was rather the decision of the British government to return to the level of prices and wages that prevailed before the war, a decision it enforced through monetary means (that is, by reimposing the prewar exchange rate). It was an error that Britain repeated after World War I.

This is a remarkable and fanciful defense, suggesting that the British government actually had a specific target level of prices and wages in mind when it restored the pound to its prewar gold parity. In fact, the idea of a price level was not yet even understood by most economists, let alone by the British government. Restoring the pound to its prewar parity was considered a matter of financial rectitude and honor, not a matter of economic fine-tuning. Nor was the choice of the prewar parity the only reason for the ruinous deflation that followed the postwar resumption of gold payments. The replacement of paper pounds with gold pounds implied a significant increase in the total demand for gold by the world’s leading economic power, which implied an increase in the total world demand for gold, and an increase in its value relative to other commodities, in other words deflation. David Ricardo foresaw the deflationary consequences of the resumption of gold payments, and tried to mitigate those consequences with his Proposals for an Economical and Secure Currency, designed to limit the increase in the monetary demand for gold. The real error after World War I, as Hawtrey and Cassel both pointed out in 1919, was that the resumption of an international gold standard after gold had been effectively demonetized during World War I would lead to an enormous increase in the monetary demand for gold, causing a worldwide deflationary collapse. After the Napoleonic wars, the gold standard was still a peculiarly British institution, the rest of the world then operating on a silver standard.

Grant makes further extravagant and unsupported claims on behalf of the gold standard:

The classical gold standard, in service roughly from 1815 to 1914, was certainly imperfect. What it did deliver was long-term price stability. What the politics of the gold-standard era delivered was modest levels of government borrowing.

The choice of 1815 as the start of the gold standard era is quite arbitrary, 1815 being the year that Britain defeated Napoleonic France, thereby setting the stage for the restoration of the golden pound at its prewar parity. But the very fact that 1815 marked the beginning of the restoration of the prewar gold parity with sterling shows that for Britain the gold standard began much earlier, actually 1717 when Isaac Newton, then master of the mint, established the gold parity at a level that overvalued gold, thereby driving silver out of circulation. So, if the gold standard somehow ensures that government borrowing levels are modest, one would think that borrowing by the British government would have been modest from 1717 to 1797 when the gold standard was suspended. But the chart below showing British government debt as a percentage of GDP from 1692 to 2010 shows that British government debt rose rapidly over most of the 18th century.

uk_national_debtGrant suggests that bad behavior by banks is mainly the result of abandonment of the gold standard.

Progress is the rule, the Whig theory of history teaches, but the old Whigs never met the new bankers. Ordinary people live longer and Olympians run faster than they did a century ago, but no such improvement is evident in our monetary and banking affairs. On the contrary, the dollar commands but 1/1,300th of an ounce of gold today, as compared with the 1/20th of an ounce on the eve of World War I. As for banking, the dismal record of 2007-09 would seem inexplicable to the financial leaders of the Model T era. One of these ancients, Comptroller of the Currency John Skelton Williams, predicted in 1920 that bank failures would soon be unimaginable. In 2008, it was solvency you almost couldn’t imagine.

Once again, the claims that Mr. Grant makes on behalf of the gold standard simply do not correspond to reality. The chart below shows the annual number of bank failures in every years since 1920.

bank_failures

Somehow, Mr. Grant somehow seems to have overlooked what happened between 1929 and 1932. John Skelton Williams obviously didn’t know what was going to happen in the following decade. Certainly no shame in that. I am guessing that Mr. Grant does know what happened; he just seems too bedazzled by the beauty of the gold standard to care.

Monetary Theory on the Neo-Fisherite Edge

The week before last, Noah Smith wrote a post “The Neo-Fisherite Rebellion” discussing, rather sympathetically I thought, the contrarian school of monetary thought emerging from the Great American Heartland, according to which, notwithstanding everything monetary economists since Henry Thornton have taught, high interest rates are inflationary and low interest rates deflationary. This view of the relationship between interest rates and inflation was advanced (but later retracted) by Narayana Kocherlakota, President of the Minneapolis Fed in a 2010 lecture, and was embraced and expounded with increased steadfastness by Stephen Williamson of Washington University in St. Louis and the St. Louis Fed in at least one working paper and in a series of posts over the past five or six months (e.g. here, here and here). And John Cochrane of the University of Chicago has picked up on the idea as well in two recent blog posts (here and here). Others seem to be joining the upstart school as well.

The new argument seems simple: given the Fisher equation, in which the nominal interest rate equals the real interest rate plus the (expected) rate of inflation, a central bank can meet its inflation target by setting a fixed nominal interest rate target consistent with its inflation target and keeping it there. Once the central bank sets its target, the long-run neutrality of money, implying that the real interest rate is independent of the nominal targets set by the central bank, ensures that inflation expectations must converge on rates consistent with the nominal interest rate target and the independently determined real interest rate (i.e., the real yield curve), so that the actual and expected rates of inflation adjust to ensure that the Fisher equation is satisfied. If the promise of the central bank to maintain a particular nominal rate over time is believed, the promise will induce a rate of inflation consistent with the nominal interest-rate target and the exogenous real rate.

The novelty of this way of thinking about monetary policy is that monetary theorists have generally assumed that the actual adjustment of the price level or inflation rate depends on whether the target interest rate is greater or less than the real rate plus the expected rate. When the target rate is greater than the real rate plus expected inflation, inflation goes down, and when it is less than the real rate plus expected inflation, inflation goes up. In the conventional treatment, the expected rate of inflation is momentarily fixed, and the (expected) real rate variable. In the Neo-Fisherite school, the (expected) real rate is fixed, and the expected inflation rate is variable. (Just as an aside, I would observe that the idea that expectations about the real rate of interest and the inflation rate cannot occur simultaneously in the short run is not derived from the limited cognitive capacity of economic agents; it can only be derived from the limited intellectual capacity of economic theorists.)

The heretical views expressed by Williamson and Cochrane and earlier by Kocherlakota have understandably elicited scorn and derision from conventional monetary theorists, whether Keynesian, New Keynesian, Monetarist or Market Monetarist. (Williamson having appropriated for himself the New Monetarist label, I regrettably could not preserve an appropriate symmetry in my list of labels for monetary theorists.) As a matter of fact, I wrote a post last December challenging Williamson’s reasoning in arguing that QE had caused a decline in inflation, though in his initial foray into uncharted territory, Williamson was actually making a narrower argument than the more general thesis that he has more recently expounded.

Although deep down, I have no great sympathy for Williamson’s argument, the counterarguments I have seen leave me feeling a bit, shall we say, underwhelmed. That’s not to say that I am becoming a convert to New Monetarism, but I am feeling that we have reached a point at which certain underlying gaps in monetary theory can’t be concealed any longer. To explain what I mean by that remark, let me start by reviewing the historical context in which the ruling doctrine governing central-bank operations via adjustments in the central-bank lending rate evolved. The primary (though historically not the first) source of the doctrine is Henry Thornton in his classic volume The Nature and Effects of the Paper Credit of Great Britain.

Even though Thornton focused on the policy of the Bank of England during the Napoleonic Wars, when Bank of England notes, not gold, were legal tender, his discussion was still in the context of a monetary system in which paper money was generally convertible into either gold or silver. Inconvertible banknotes – aka fiat money — were the exception not the rule. Gold and silver were what Nick Rowe would call alpha money. All other moneys were evaluated in terms of gold and silver, not in terms of a general price level (not yet a widely accepted concept). Even though Bank of England notes became an alternative alpha money during the restriction period of inconvertibility, that situation was generally viewed as temporary, the restoration of convertibility being expected after the war. The value of the paper pound was tracked by the sterling price of gold on the Hamburg exchange. Thus, Ricardo’s first published work was entitled The High Price of Bullion, in which he blamed the high sterling price of bullion at Hamburg on an overissue of banknotes by the Bank of England.

But to get back to Thornton, who was far more concerned with the mechanics of monetary policy than Ricardo, his great contribution was to show that the Bank of England could control the amount of lending (and money creation) by adjusting the interest rate charged to borrowers. If banknotes were depreciating relative to gold, the Bank of England could increase the value of their notes by raising the rate of interest charged on loans.

The point is that if you are a central banker and are trying to target the exchange rate of your currency with respect to an alpha currency, you can do so by adjusting the interest rate that you charge borrowers. Raising the interest rate will cause the exchange value of your currency to rise and reducing the interest rate will cause the exchange value to fall. And if you are operating under strict convertibility, so that you are committed to keep the exchange rate between your currency and an alpha currency at a specified par value, raising that interest rate will cause you to accumulate reserves payable in terms of the alpha currency, and reducing that interest rate will cause you to emit reserves payable in terms of the alpha currency.

So the idea that an increase in the central-bank interest rate tends to increase the exchange value of its currency, or, under a fixed-exchange rate regime, an increase in the foreign exchange reserves of the bank, has a history at least two centuries old, though the doctrine has not exactly been free of misunderstanding or confusion in the course of those two centuries. One of those misunderstandings was about the effect of a change in the central-bank interest rate, under a fixed-exchange rate regime. In fact, as long as the central bank is maintaining a fixed exchange rate between its currency and an alpha currency, changes in the central-bank interest rate don’t affect (at least as a first approximation) either the domestic money supply or the domestic price level; all that changes in the central-bank interest rate can accomplish is to change the bank’s holdings of alpha-currency reserves.

It seems to me that this long well-documented historical association between changes in the central-bank interest rates and the exchange value of currencies and the level of private spending is the basis for the widespread theoretical presumption that raising the central-bank interest rate target is deflationary and reducing it is inflationary. However, the old central-bank doctrine of the Bank Rate was conceived in a world in which gold and silver were the alpha moneys, and central banks – even central banks operating with inconvertible currencies – were beta banks, because the value of a central-bank currency was still reckoned, like the value of inconvertible Bank of England notes in the Napoleonic Wars, in terms of gold and silver.

In the Neo-Fisherite world, central banks rarely peg exchange rates against each other, and there is no longer any outside standard of value to which central banks even nominally commit themselves. In a world without the metallic standard of value in which the conventional theory of central banking developed, do the propositions about the effects of central-bank interest-rate setting still obtain? I am not so sure that they do, not with the analytical tools that we normally deploy when thinking about the effects of central-bank policies. Why not? Because, in a Neo-Fisherite world in which all central banks are alpha banks, I am not so sure that we really know what determines the value of this thing called fiat money. And if we don’t really know what determines the value of a fiat money, how can we really be sure that interest-rate policy works the same way in a Neo-Fisherite world that it used to work when the value of money was determined in relation to a metallic standard? (Just to avoid misunderstanding, I am not – repeat NOT — arguing for restoring the gold standard.)

Why do I say that we don’t know what determines the value of fiat money in a Neo-Fisherite world? Well, consider this. Almost three weeks ago I wrote a post in which I suggested that Bitcoins could be a massive bubble. My explanation for why Bitcoins could be a bubble is that they provide no real (i.e., non-monetary) service, so that their value is totally contingent on, and derived from (or so it seems to me, though I admit that my understanding of Bitcoins is partial and imperfect), the expectation of a positive future resale value. However, it seems certain that the resale value of Bitcoins must eventually fall to zero, so that backward induction implies that Bitcoins, inasmuch as they provide no real service, cannot retain a positive value in the present. On this reasoning, any observed value of a Bitcoin seems inexplicable except as an irrational bubble phenomenon.

Most of the comments I received about that post challenged the relevance of the backward-induction argument. The challenges were mainly of two types: a) the end state, when everyone will certainly stop accepting a Bitcoin in exchange, is very, very far into the future and its date is unknown, and b) the backward-induction argument applies equally to every fiat currency, so my own reasoning, according to my critics, implies that the value of every fiat currency is just as much a bubble phenomenon as the value of a Bitcoin.

My response to the first objection is that even if the strict logic of the backward-induction argument is inconclusive, because of the long and uncertain duration of the time elapse between now and the end state, the argument nevertheless suggests that the value of a Bitcoin is potentially very unsteady and vulnerable to sudden collapse. Those are not generally thought to be desirable attributes in a medium of exchange.

My response to the second objection is that fiat currencies are actually quite different from Bitcoins, because fiat currencies are accepted by governments in discharging the tax liabilities due to them. The discharge of a tax liability is a real (i.e. non-monetary) service, creating a distinct non-monetary demand for fiat currencies, thereby ensuring that fiat currencies retain value, even apart from being accepted as a medium of exchange.

That, at any rate, is my view, which I first heard from Earl Thompson (see his unpublished paper, “A Reformulation of Macroeconomic Theory” pp. 23-25 for a derivation of the value of fiat money when tax liability is a fixed proportion of income). Some other pretty good economists have also held that view, like Abba Lerner, P. H. Wicksteed, and Adam Smith. Georg Friedrich Knapp also held that view, and, in his day, he was certainly well known, but I am unable to pass judgment on whether he was or wasn’t a good economist. But I do know that his views about money were famously misrepresented and caricatured by Ludwig von Mises. However, there are other good economists (Hal Varian for one), apparently unaware of, or untroubled by, the backward induction argument, who don’t think that acceptability in discharging tax liability is required to explain the value of fiat money.

Nor do I think that Thompson’s tax-acceptability theory of the value of money can stand entirely on its own, because it implies a kind of saw-tooth time profile of the price level, so that a fiat currency, earning no liquidity premium, would actually be appreciating between peak tax collection dates, and depreciating immediately following those dates, a pattern not obviously consistent with observed price data, though I do recall that Thompson used to claim that there is a lot of evidence that prices fall just before peak tax-collection dates. I don’t think that anyone has ever tried to combine the tax-acceptability theory with the empirical premise that currency (or base money) does in fact provide significant liquidity services. That, it seems to me, would be a worthwhile endeavor for any eager young researcher to undertake.

What does all of this have to do with the Neo-Fisherite Rebellion? Well, if we don’t have a satisfactory theory of the value of fiat money at hand, which is what another very smart economist Fischer Black – who, to my knowledge never mentioned the tax-liability theory — thought, then the only explanation of the value of fiat money is that, like the value of a Bitcoin, it is whatever people expect it to be. And the rate of inflation is equally inexplicable, being just whatever it is expected to be. So in a Neo-Fisherite world, if the central bank announces that it is reducing its interest-rate target, the effect of the announcement depends entirely on what “the market” reads into the announcement. And that is exactly what Fischer Black believed. See his paper “Active and Passive Monetary Policy in a Neoclassical Model.”

I don’t say that Williamson and his Neo-Fisherite colleagues are correct. Nor have they, to my knowledge, related their arguments to Fischer Black’s work. What I do say (indeed this is a problem I raised almost three years ago in one of my first posts on this blog) is that existing monetary theories of the price level are unable to rule out his result, because the behavior of the price level and inflation seems to depend, more than anything else, on expectations. And it is far from clear to me that there are any fundamentals in which these expectations can be grounded. If you impose the rational expectations assumption, which is almost certainly wrong empirically, maybe you can argue that the central bank provides a focal point for expectations to converge on. The problem, of course, is that in the real world, expectations are all over the place, there being no fundamentals to force the convergence of expectations to a stable equilibrium value.

In other words, it’s just a mess, a bloody mess, and I do not like it, not one little bit.

Did Raising Interest Rates under the Gold Standard Really Increase Aggregate Demand?

I hope that I can write this quickly just so people won’t think that I’ve disappeared. I’ve been a bit under the weather this week, and the post that I’ve been working on needs more attention and it’s not going to be ready for a few more days. But the good news, from my perspective at any rate, is that Scott Sumner, as he has done so often in the past, has come through for me by giving me something to write about. In his most recent post at his second home on Econlog, Scott writes the following:

I recently did a post pointing out that higher interest rates don’t reduce AD.  Indeed even higher interest rates caused by a decrease in the money supply don’t reduce AD. Rather the higher rates raise velocity, but that effect is more than offset by the decrease in the money supply.

Of course that’s not the way Keynesians typically look at things.  They believe that higher interest rates actually cause AD to decrease.  Except under the gold standard. Back in 1988 Robert Barsky and Larry Summers wrote a paper showing that higher interest rates were expansionary when the dollar was pegged to gold.  Now in fairness, many Keynesians understand that higher interest rates are often associated with higher levels of AD.  But Barsky and Summers showed that the higher rates actually caused AD to increase.  Higher nominal rates increase the opportunity cost of holding gold. This reduces gold demand, and thus lowers its value.  Because the nominal price of gold is fixed under the gold standard, the only way for the value of gold to decrease is for the price level to increase. Thus higher interest rates boost AD and the price level.  This explains the “Gibson Paradox.”

Very clever on Scott’s part, and I am sure that he will have backfooted a lot of Keynesians. There’s just one problem with Scott’s point, which is that he forgets that an increase in interest rates by the central bank under the gold standard corresponds to an increase in the demand of the central bank for gold, which, as Scott certainly knows better than almost anyone else, is deflationary. What Barsky and Summers were talking about when they were relating interest rates to the value of gold was movements in the long-term interest rate (the yield on consols), not in central-bank lending rate (the rate central banks charge for overnight or very short-dated loans to other banks). As Hawtrey showed in A Century of Bank Rate, the yield on consols was not closely correlated with Bank Rate. So not only is Scott looking at the wrong interest rate (for purposes of his argument), he is – and I don’t know how to phrase this delicately – reasoning from a price change. Ouch!

James Grant on Irving Fisher and the Great Depression

In the past weekend edition (January 4-5, 2014) of the Wall Street Journal, James Grant, financial journalist, reviewed (“Great Minds, Failed Prophets”) Fortune Tellers by Walter A. Friedman, a new book about the first generation of economic forecasters, or business prophets. Friedman tells the stories of forecasters who became well-known and successful in the 1920s: Roger Babson, John Moody, the team of Carl J. Bullock and Warren Persons, Wesley Mitchell, and the great Irving Fisher. I haven’t read the book, but, judging from the Grant’s review, I am guessing it’s a good read.

Grant is a gifted, erudite and insightful journalist, but unfortunately his judgment is often led astray by a dogmatic attachment to Austrian business cycle theory and the gold standard, which causes him to make an absurd identification of Fisher’s views on how to stop the Great Depression with the disastrous policies of Herbert Hoover after the stock market crash.

Though undoubtedly a genius, Fisher was not immune to bad ideas, and was easily carried away by his enthusiasms. He was often right, but sometimes he was tragically wrong. His forecasting record and his scholarship made him perhaps the best known American economist in the 1920s, and a good case could be made that he was the greatest economist who ever lived, but his reputation was destroyed when, on the eve of the stock market crash, he commented “stock prices have reached what looks like a permanently high plateau.” For a year, Fisher insisted that stock prices would rebound (which they did in early 1930, recovering most of their losses), but the recovery in stock prices was short-lived, and Fisher’s public reputation never recovered.

Certainly, Fisher should have been more alert to the danger of a depression than he was. Working with a monetary theory similar to Fisher’s, both Ralph Hawtrey and Gustav Cassel foresaw the deflationary dangers associated with the restoration of the gold standard and warned against the disastrous policies of the Bank of France and the Federal Reserve in 1928-29, which led to the downturn and the crash. What Fisher thought of the warnings of Hawtrey and Cassel I don’t know, but it would be interesting and worthwhile for some researcher to go back and look for Fisher’s comments on Hawtrey and Cassel before or after the 1929 crash.

So there is no denying that Fisher got something wrong in his forecasts, but we (or least I) still don’t know exactly what his mistake was. This is where Grant’s story starts to unravel. He discusses how, under the tutelage of Wesley Mitchell, Herbert Hoover responded to the crash by “[summoning] the captains of industry to the White House.”

So when stocks crashed in 1929, Hoover, as president, summoned the captains of industry to the White House. Profits should bear the brunt of the initial adjustment to the downturn, he said. Capital-spending plans should go forward, if not be accelerated. Wages must not be cut, as they had been in the bad old days of 1920-21. The executives shook hands on it.

In the wake of this unprecedented display of federal economic activism, Wesley Mitchell, the economist, said: “While a business cycle is passing over from a phase of expansion to the phase of contraction, the president of the United States is organizing the economic forces of the country to check the threatened decline at the start, if possible. A more significant experiment in the technique of balance could not be devised than the one which is being performed before our very eyes.”

The experiment in balance ended in monumental imbalance. . . . The laissez-faire depression of 1920-21 was over and done within 18 months. The federally doctored depression of 1929-33 spanned 43 months. Hoover failed for the same reason that Babson, Moody and Fisher fell short: America’s economy is too complex to predict, much less to direct from on high.

We can stipulate that Hoover’s attempt to keep prices and wages from falling in the face of a massive deflationary shock did not aid the recovery, but neither did it cause the Depression; the deflationary shock did. The deflationary shock was the result of the failed attempt to restore the gold standard and the insane policies of the Bank of France, which might have been counteracted, but were instead reinforced, by the Federal Reserve.

Before closing, Grant turns back to Fisher, recounting, with admiration, Fisher’s continuing scholarly achievements despite the loss of his personal fortune in the crash and the collapse of his public reputation.

Though sorely beset, Fisher produced one of his best known works in 1933, the essay called “The Debt-Deflation Theory of Great Depressions,” in which he observed that plunging prices made debts unsupportable. The way out? Price stabilization, the very policy that Hoover had championed.

Grant has it totally wrong. Hoover acquiesced in, even encouraged, the deflationary policies of the Fed, and never wavered in his commitment to the gold standard. His policy of stabilizing prices and wages was largely ineffectual, because you can’t control the price level by controlling individual prices. Fisher understood the difference between controlling individual prices and controlling the price level. It is Grant, not Fisher, who resembles Hoover in failing to grasp that essential distinction.

What Makes Deflation Good?

Earlier this week, there was a piece in the Financial Times by Michael Heise, chief economist at Allianz SE, arguing that the recent dip in Eurozone inflation to near zero is not a sign of economic weakness, but a sign of recovery reflecting increased competitiveness in the Eurozone periphery. Scott Sumner identified a systematic confusion on Heise’s part between aggregate demand and aggregate supply, so that without any signs that rapidly falling Eurozone inflation has been accompanied by an acceleration of anemic growth in Eurozone real GDP, it is absurd to attribute falling inflation to a strengthening economy. There’s not really much more left to say about Heise’s piece after Scott’s demolition, but, nevertheless, sifting through the rubble, I still want to pick up on the distinction that Heise makes between good deflation and bad deflation.

Nonetheless, bank lending has been on the retreat, bankruptcies have soared and disposable incomes have fallen. This is the kind of demand shock that fosters bad deflation: a financial crisis causes aggregate demand to shrink faster than supply, resulting in falling prices.

However, looking through the lens of aggregate supply, the difficulties of the eurozone’s periphery bear only a superficial resemblance to those plaguing Japan. In this case, falling prices are the result of a supply shock, through improved productivity or real wage reduction.

Low inflation or even deflation is testament to the fact that (painful) adjustment through structural reforms is finally working.

In other words, deflation associated with a financial crisis, causing liquidation of assets and forced sales of inventories, thereby driving down prices and engendering expectations of continuing price declines, is bad. However, the subsequent response to that deflationary shock – the elimination of production inefficiencies and the reduction of wages — is not bad, but good. Both responses to the initial deflationary contraction in aggregate demand correspond to a rightward shift of the aggregate supply curve, thereby tending to raise aggregate output and employment even while tending to causes a further reduction in the price level or the inflation rate.

It is also interesting to take note of the peculiar euphemism for cutting money wages adopted by Heise: internal devaluation. As he puts it:

The eurozone periphery is regaining competitiveness via internal devaluation. This could even be called “good deflation.”

Now in ordinary usage, the term “devaluation” signifies a reduction in the pegged value of one currency in terms of another. When a country devalues its currency, it is usually because that country is running a trade deficit for which foreign lenders are unwilling to provide financing. The cause of the trade deficit is that the country’s tradable-goods sector is not profitable enough to expand to the point that the trade deficit is brought into balance, or close enough to balance to be willingly financed by foreigners. To make expansion of its tradable-goods sector profitable, the country may resort to currency devaluation, raising the prices of exports and imports in terms of the domestic currency. With unchanged money wages, the increase in the prices of exports and imports makes expansion of the country’s tradable-goods sector profitable, thereby reducing or eliminating the trade deficit. What Heise means by “internal devaluation” in contrast to normal devaluation is a reduction in money wages, export and import prices being held constant at the fixed exchange.

There is something strange, even bizarre, about Heise’s formulation, because what he is saying amounts to this: a deflation is good insofar as it reduces money wages. So Heise’s message, delivered in an obscure language, apparently of his own creation, is that the high and rising unemployment of the past five years in the Eurozone is finally causing money wages to fall. Therefore, don’t do anything — like shift to an easier monetary policy — that would stop those blessed reductions in money wages. Give this much to Herr Heise, unlike American critics of quantitative easing who pretend to blame it for causing real-wage reductions by way of the resulting inflation, he at least is honest enough to criticize monetary expansion for preventing money (and real) wages from falling, though he has contrived a language in which to say this without being easily understood.

Actually there is a historical precedent for the kind of good deflation Heise appears to favor. It was undertaken by Heinrich Bruning, Chancellor of the Weimar Republic from 1930 to 1932, when, desperate to demonstrate Germany’s financial rectitude (less than a decade after the hyperinflation of 1923) he imposed, by emergency decree, draconian wage reductions aimed at increasing Germany’s international competitiveness, while remaining on the gold standard. The evidence does not suggest that the good deflation and internal devaluation adopted by Bruning’s policy of money-wage cuts succeeded in ending the depression. And internal devaluation was certainly not successful enough to keep Bruning’s government in office, its principal effect being to increase support for Adolph Hitler, who became Chancellor within less than nine months after Bruning’s government fell.

This is not to say that nominal wages should never be reduced, but the idea that nominal wage cuts could serve as the means to reverse an economic contraction has little, if any, empirical evidence to support it. A famous economist who supported deflation in the early 1930s believing that it would facilitate labor market efficiencies and necessary cuts in real wages, subsequently retracted his policy advice, admitting that he had been wrong to think that deflation would be an effective instrument to overcome rigidities in labor markets. His name? F. A. Hayek.

So there is nothing good about the signs of deflation that Heise sees. They are simply predictable follow-on effects of the aggregate demand shock that hit the Eurozone after the 2008 financial crisis, subsequently reinforced by the monetary policy of the European Central Bank, reflecting the inflation-phobia of the current German political establishment. Those effects, delayed responses to the original demand shock, do not signal a recovery.

What, then, would distinguish good deflation from bad deflation? Simple. If observed deflation were accompanied by a significant increase in output, associated with significant growth in labor productivity and increasing employment (indicating increasing efficiency or technological progress), we could be confident that the deflation was benign, reflecting endogenous economic growth rather than macroeconomic dysfunction. Whenever output prices are falling without any obvious signs of real economic growth, falling prices are a clear sign of economic dysfunction. If prices are falling without output rising, something is wrong — very wrong — and it needs fixing.

Eureka! Paul Krugman Discovers the Bank of France

Trying hard, but not entirely successfully, to contain his astonishment, Paul Krugman has a very good post (“France 1930, Germany 2013) inspired by Doug Irwin’s “very good” paper (see also this shorter version) “Did France Cause the Great Depression?” Here’s Krugman take away from Irwin’s paper.

[Irwin] points out that France, with its undervalued currency, soaked up a huge proportion of the world’s gold reserves in 1930-31, and suggests that France was responsible for about half the global deflation that took place over that period.

The thing is, France itself didn’t do that badly in the early stages of the Great Depression — again thanks to that undervalued currency. In fact, it was less affected than most other advanced countries (pdf) in 1929-31:

Krugman is on the right track here — certainly a hopeful sign — but he misses the distinction between an undervalued French franc, which, despite temporary adverse effects on other countries, would normally be self-correcting under the gold standard, and the explosive increase in demand for gold by the insane Bank of France after the franc was pegged at an undervalued parity against the dollar. Undervaluation of the franc began in December 1926 when Premier Raymond Poincare stabilized its value at about 25 francs to the dollar, the franc having fallen to 50 francs to the dollar in July when Poincare, a former prime minister, had been returned to office to deal with a worsening currency crisis. Undervaluation of the franc would have done no permanent damage to the world economy if the Bank of France had not used the resulting inflow of foreign exchange to accumulate gold, cashing in sterling- and dollar-denominated financial assets for gold. This was a step beyond classic exchange-rate protection (currency manipulation) whereby a country uses a combination of an undervalued exchange rate and a tight monetary policy to keep accumulating foreign-exchange reserves as a way of favoring its export and import-competing industries. Exchange-rate protection may have been one motivation for the French policy, but that objective did not require gold accumulation; it could have been achieved by accumulating foreign exchange reserves without demanding redemption of those reserves in terms of gold, as the Bank of France began doing aggressively in 1927. A more likely motivation for gold accumulation policy of the Bank of France seems to have been French resentment against a monetary system that, from the French perspective, granted a privileged status to the dollar and to sterling, allowing central banks to treat dollar- and sterling-denominated financial assets as official exchange reserves, thereby enabling issuers of dollar and sterling-denominated assets the ability to obtain funds on more favorable terms than issuers of instruments denominated in other currencies.

The world economy was able to withstand the French gold-accumulation policy in 1927-28, because the Federal Reserve was tolerating an outflow of gold, thereby accommodating to some degree the French demand for gold. But after the Fed raised its discount rate to 5% in 1928 and 6% in February 1929, gold began flowing into the US as well, causing gold to start appreciating (in other words, prices to start falling) in world markets by the summer of 1929. But rather than reverse course, the Bank of France and the Fed, despite reductions in their official lending rates, continued pursuing policies that caused huge amounts of gold to flow into the French and US vaults in 1930 and 1931. Hawtrey and Cassel, of course, had warned against such a scenario as early as 1919, and proposed measures to prevent or reverse the looming catastrophe before it took place and after it started, but with little success. For a more complete account of this sad story, and the failure of the economics profession, with a very few notable exceptions, to figure out what happened, see my paper with Ron Batchelder “Pre-Keynesian Monetary Theories of the Great Depression: Whatever Happened to Hawtrey and Cassel?”

As Krugman observes, the French economy did not do so badly in 1929-31, because it was viewed as the most stable, thrifty, and dynamic economy in Europe. But France looked good only because Britain and Germany were in even worse shape. Because France was better off the Britain and Germany, and because its currency was understood to be undervalued, the French franc was considered to be stable, and, thus, unlikely to be devalued. So, unlike sterling, the reichsmark, and the dollar, the franc was not subjected to speculative attacks, becoming instead a haven for capital seeking safety.

Interestingly, Krugman even shows some sympathetic understanding for the plight of the French:

Notice, by the way, that the French weren’t evil or malicious here — they were just adhering to their hard-money ideology in an environment where that had terrible adverse effects on other countries.

Just wondering, would Krugman ever invoke adherence to a hard-money ideology as a mitigating factor in passing judgment on a Republican?

Krugman concludes by comparing Germany today with France in 1930.

Obviously the details are different, but I would argue that Germany is playing a somewhat similar role today — not as drastic, but with less excuse. For Germany is an economic hegemon in a way France never was; it has responsibilities, which it isn’t meeting.

Indeed, there are similarities, but there is a crucial difference in the mechanism by which damage is being inflicted: the world price level in 1930, under the gold standard, was determined by the value of gold. An increase in the demand for gold by central banks necessarily raised the value of gold, causing deflation for all countries either on the gold standard or maintaining a fixed exchange rate against a gold-standard currency. By accumulating gold, nearly quadrupling its gold reserves between 1926 and 1932, the Bank of France was a mighty deflationary force, inflicting immense damage on the international economy. Today, the Eurozone price level does not depend on the independent policy actions of any national central bank, including that of Germany. The Eurozone price level is rather determined by the policy choices of a nominally independent European Central Bank. But the ECB is clearly unable to any adopt policy not approved by the German government and its leader Mrs. Merkel, and Mrs. Merkel has rejected any policy that would raise prices in the Eurozone to a level consistent with full employment. Though the mechanism by which Mrs. Merkel and her government are now inflicting damage on the Eurozone is different from the mechanism by which the insane Bank of France inflicted damage during the Great Depression, the damage is just as pointless and just as inexcusable. But as the damage caused by Mrs. Merkel, in relative terms at any rate, seems somewhat smaller in magnitude than that caused by the insane Bank of France, I would not judge her more harshly than I would the Bank of France — insanity being, in matters of monetary policy, no defense.

HT: ChargerCarl

Hawtrey’s Good and Bad Trade, Part VIII: Credit Money and Banking Systems

Having argued in chapters 5 through 9 that monetary disturbances could cause significant fluctuations in aggregate expenditure, income, output, and employment, and having argued in chapter 11 that shifts in demand would be unlikely to trigger significant aggregate fluctuations, Hawtrey was satisfied that he had established that monetary disturbances were the most likely cause of such fluctuations. Hawtrey therefore turns his attention in chapter 12 to a consideration of the law and economics of banking and of the two instruments (banknotes and checks) that banks are uniquely able to create. Continuing in this vein in chapter 13, Hawtrey surveys the range of national institutional arrangements then in existence under which banks were then operating.

Hawtrey observes that banks may cause monetary disturbances by providing either too much, or too little, money relative to the amount of money demanded by the public, thereby triggering a cumulative deviation from a point of stability. He then mentions another way in which banks may cause macroeconomic disturbances.

[B]ankers may be tempted to lend imprudently, and when their rashness finds them out, whether they pay the penalty in bankruptcy, or whether they manage to restore their business to a sound footing, in either case a quantity of credit money will have to be annihilated.

Hawtrey characterizes the essence of credit money as the commitment by a banker to pay money on demand “and that the right to obtain money on demand is given in such a form as to be a convenient substitute for cash to the possessor of the right.” For credit money supplied by a bank to be a convenient substitute for cash, the credit money of the bank must be usable and acceptable in payment. Credit money can be made usable and acceptable by way of two instruments: banknotes and checks. Most of chapter 12 is given over to a discussion of the similarities and differences between those two instruments.

A bank-note is a transferable document issued by the banker entitling the holder to obtain on demand a sum specified on its face. The problem of effecting payments is solved by the simple process of handing on the document itself.

Under the cheque system the banker places to his customer’s credit a certain sum, but gives him no transferable documentary evidence of the existence of this sum. But the customer can at any time direct the banker to pay any portion of the money to any third person. The direction is given in writing, and the handing over of the written document or cheque to this third person is, for practical purposes, the equivalent of a payment.

After noting a number of the obvious differences between checks and banknotes, Hawtrey lays down an important principle that in the nineteenth century was denied by the Currency School (who regarded banknotes as uniquely having the status of money and therefore sought quantitative limit on the creation of banknotes but not deposits), but upheld by the Banking School in the famous debates over the Bank Charter Act of 1844.

But for all these differences, there remains the fundamental identity of the right to draw any sum by cheque with the possession of banknotes representing in aggregate value the same sum. Either is simply the possession of so much credit money, and from the point of view of the banker makes the liability to pay that sum on demand. All that has been said in the preceding chapters on the subject of credit money applies impartially to both systems.

And yet in the next breath, Hawtrey seems to acknowledge that, in practice, the principle is not quite so clear cut.

But it does not follow that there are not important practical differences between the two kinds of credit money, even from the point of view from which we are now interested in the subject of banking. The most important of all arise from the fact that notes have a closer resemblance than cheques to cash. Indeed, there is really no hard-and-fast line between cash and notes at all – only a continuous gradation from bullion at one end, through legal tender full-valued coin, legal tender overvalued coin, legal tender inconvertible notes, legal tender convertible notes, finally to convertible notes that are not legal tender.

Ultimately, the points on which Hawtrey lays the most stress in distinguishing banknotes from cheques are that the incentive of a depositor a) to investigate the solvency of his bank is greater than the incentive of the acceptor of a banknote to investigate the solvency of the issuing bank, and b) the incentive of a depositor not to redeem his deposits if there is any question about his banker’s solvency is greater than the incentive of a noteholder not to redeem the banknote if such a question should arise concerning the issuer of a banknote in his possession. These two differential incentives make banknotes an inherently riskier instrument than a bank deposit.

The result is that while the demand of depositors are regulated by the real needs of business, the demands of note-holders are subject to capricious fluctuations which may arise at any time for a loss of confidence in the issuing banks.

Because of the perceived differential in risk associated with banknotes, the creation of banknotes has been subjected to more stringent regulation than the creation of deposits, regulations applying either to the permissible quantity of banknotes issued, or to the requirement that reserves be held against banknotes in the form of particular kinds of assets.

Hawtrey concludes chapter 12 with the following assessment of the role of confidence in a commercial crisis.

It is hardly too much to say that the normal working of the machinery of the money market cannot be understood until the relatively subordinate part played by the impairment of credit, that is to say, by the expectation that banks or other businesses will fail to meet the engagements, is fully realised. A contraction or depression of trade is ordinarily accompanied by a number of failures, especially if it be started by a commercial crisis. But even a crisis cannot be fully explained by a general loss of confidence. A crisis only differs in degree from an ordinary contraction of trade. The manufacture of credit money has so far outstripped the due proportion to the supply of cash that recovery is only possible by means of immediate and drastic steps. The loss of confidence may be very widespread, but it is still only a symptom and not a cause of the collapse.

Hawtrey continues his discussion of banking and credit money in Chapter 13 with a survey of the existing monetary systems in 1913. He begins with the British monetary system, then proceeds to describe the French system, and then the Indian system (which became the prototype for the gold-exchange standard whereby a country could join the gold standard by maintaining a fixed exchange rate against another currency that was fully convertible into gold, e.g., sterling, without engaging in any gold transactions or holding any gold reserves). Hawtrey also gave summary descriptions of the Austria-Hungary and the German monetary systems, before concluding with a lengthier description of the peculiar US monetary system, the only major monetary system then operating without a central bank, as it existed in 1913 just before being drastically changed by the creation of the Federal Reserve System.

.Rather than summarize Hawtrey’s insightful descriptions of the extant monetary systems in 1913 on the eve of the destruction of the classical gold standard, I will close with comments on the following passage in which Hawtrey describes the what was viewed as the responsibility of the central bank at that time.

The responsibility for maintaining the solvency of the banking system as a whole rests almost entirely on the central bank, and the question arises, how is that bank to be guided in exercising that responsibility? How much gold ought to be kept in reserve and how great a change in the amount of the reserve should the central bank acquiesce in before taking steps to correct it?

This is the much discussed gold reserve question. The solution is, of course, a matter of practical experience, upon which it would be useless to dogmatise a priori. The gold reserve of any country is simply a working balance. Like all working balances, however low it falls, it fulfills its function provided it is never exhausted even at the moment of greatest strain. But the moment of greatest strain cannot necessarily be recognized when it comes. In practice, therefore, a standard, more or less arbitrary, is fixed for the gold reserve (e.g., a certain proportion of the liabilities of the central bank), and steps are taken to correct any material departure from the standard chosen. Under this system the standard reserve must be at least of such amount that if it begins to diminish it can stand whatever drain it may be subjected to in the interval before the remedial measures adopted by the central bank have become completely effective.

There are two related issues raised by this passage that are worthy of consideration. Hawtrey’s statement about what constitutes an adequate gold reserve is certainly reasonable; it is also seems cautious inasmuch as he seems to accept that a central bank must never allow its reserve to be exhausted. In other words, the bank must make sure that it in normal times it accumulates a reserve large enough to withstand any conceivable drain on its reserves and to take whatever steps are necessary to protect that reserve once it begins to experience a loss of reserves. That was certainly the dominant view at the time. But Hawtrey eventually came to recommend a different view, which he expressed on many occasions a decade later when he, unlike Keynes, supported the restoration of the international gold standard and supported the decision to restore the prewar dollar-sterling parity. Though supporting that decision, Hawtrey made clear that the decision to restore the gold standard and the prewar dollar-sterling parity should not be considered inviolable. Recognizing the deflationary risks associated with restoring the gold standard and the dollar-sterling parity, Hawtrey.elevated achieving a high level of employment over maintaining the gold standard as the primary duty of the Bank of England. If the two goals were in conflict, it was the gold standard, not high employment, that should yield. The clearest and most dramatic statement of this unorthodox position came in response to questioning by Chairman Hugh Macmillan when Hawtrey testified in 1930 before the Macmillan Committee, when Britain was caught in the downward spiral of the Great Depression. Macmillan asked Hawtrey if the precepts of central banking orthodoxy did not require the Bank of England to take whatever steps were necessary to protect its gold reserve.

MACMILLAN. Suppose . . . without restricting credit . . . that gold had gone out to a very considerable extent, would that not have had very serious consequences on the international position of London?

HAWTREY. I do not think the credit of London depends on any particular figure of gold holding. . . . The harm began to be done in March and April of 1925 [when] the fall in American prices started. There was no reason why the Bank of England should have taken any action at that time so far as the question of loss of gold is concerned. . .

MACMILLAN. . . . the course you suggest would not have been consistent with what one may call orthodox Central Banking, would it?

HAWTREY. I do not know what orthodox Central Banking is.

MACMILLAN. . . . when gold ebbs away you must restrict credit as a general principle?

HAWTREY. . . . that kind of orthodoxy is like conventions at bridge; you have to break them when the circumstances call for it. I think that a gold reserve exists to be used. . . . Perhaps once in a century the time comes when you can use your gold reserve for the governing purpose, provided you have the courage to use practically all of it.

Perhaps Hawtrey already understood the implications of his position in 1913, but a reader of his 1913 statement would not necessarily have grasped the point that he expressed so boldly in 1930.

Hawtrey’s Good and Bad Trade, Part VII: International Adjustment to a Demand Shift

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.

Hawtrey’s Good and Bad Trade, Part VI: Monetary Equilibrium under the Gold Standard

In Chapter 9 of Good and Bad Trade, Hawtrey arrives at what he then regarded as the culmination of the earlier purely theoretical discussions of the determination of prices, incomes, and exchange rates under a fiat currency, by positing that the currencies of all countries were uniformly convertible into some fixed weight of gold.

We have shown that the rate of exchange tends to represent simply the ratio of the purchasing power of the two units of currency, and that when this ratio is disturbed, the rate of exchange, subject to certain fluctuations, follows it.

But having elucidated this point we can now pass to the much more important case of the international effects of a fluctuation experienced in a country using metal currency common to itself and its neighbours. Practiaclly all the great commercial nations of the world have now adopted gold as their standard of legal tender, and this completely alters the problem. (p. 102)

Ah, what a difference a century makes! At any rate after providing a detailed and fairly painstaking account of the process of international adjustment in response to a loss of gold in one country, explaining how the loss of gold would cause an increase in interest rates in the country that lost gold which would induce lending by other countries to the country experiencing monetary stringency, and tracing out further repercussions on the movement of exchange rates (within the limits set by gold import and export points, reflecting the cost of transporting gold) and domestic price levels, Hawtrey provides the following summary of his analysis

Gold flows from foreign countries ot the area of stringency in response to the high rate of interest, more quickly from the nearer and more slowly from the more distant countries. While this process is at work the rates of interests in foreign countries are raised, more in the nearer and less in the more distant countries. As soon as the bankers’ loans have been brought into the proper proportion to the stock of gold, the rate of interest reverts to the profit rate in the area of stringency, but the influx of gold continues from each foreign country until the average level of prices there has so far fallen that its divergence from the average level of prices in the area of stringency is no longer great enough to cover the cost of sending the gold.

So long as any country is actually exporting gold the rate of interest will there be maintained somewhat above the profit rate, so as to diminish the total amount of bankers’ loans pari passu with the stock of gold.

At the time when the export of gold ceases from any foreign country the rate of exchange in that country on the area of stringency is at the export specie point; and the exchange will remain at this point indefinitely unless some new influence arises to disturb the equilibrium. In fact, the whole economic system will, the absence of such influence, revert to the stable conditions from which it started. (p. 113)

In subsequent writings, Hawtrey modified his account of the adjustment process in an important respect. I have not identified where and when Hawtrey first revised his view of the adjustment process, but, almost twenty years later in his book The Art of Central Banking, there is an exceptionally clear explanation of the defective nature of the account of the international adjustment mechanism provided in Good and Bad Trade. Iin the course of an extended historical discussion of how the Bank of England had used its lending rate as an instrument of policy in the nineteenth and earl twentieth centuries (a discussion later expanded upon in Hawtrey’s A Century of Bank Rate), Hawtrey quoted the following passage from the Cunliffe Report of 1918 recommending that England quickly restore the gold standard at the prewar parity. The passage provides an explanation of how, under the gold standard, the Bank of England, faced with an outflow of its gold reserves, could restore an international equilibrium by raising Bank Rate. The explanation in the Cunliffe Report deploys essentially the same reasoning reflected above in the quotation from p. 113 of Good and Bad Trade.

The raising of the discount rate had the immediate effect of retaining money here which would otherwise have been remitted abroad, and of attracting remittances from abroad to take advantage of the higher rate, thus checking the outflow of gold and even reversing the stream.

If the adverse conditions of the exchanges was due not merely to seasonal fluctuations but to circumstances tending to create a permanently adverse trade balance, it is obvious that the procedure above described would not have been sufficient. It would have resulted in the creation of a volume of short-dated indebtedness to foreign countries, which would have been in the end disastrous to our credit and the position of London as the financial centre of the world. But the raising of the Bank’s discount rate and the steps taken to make it effective in the market necessarily led to a general rise of interest rates and a restriction of credit. New enterprises were therefore postponed, and the demand for constructional materials and other capital goods was lessened. The consequent slackening of employment also diminished the demand for consumable goods, while holders of stocks of commodities carried largely with borrowed money, being confronted with an increase in interest charges, if not with actual difficulty in renewing loans, and with the prospect of falling prices, tended to press their goods on a weak market. The result was a decline in general prices in the home market which, by checking imports and stimulating exports, corrected the adverse trade balance which was the primary cause of the difficulty. (Interim Report of the Cunliffe Committee, sections 4-5)

Hawtrey took strong issue with the version of the adjustment process outlined in the Cunliffe Report, though acknowledging that ithe Cunliffe Report did in some sense reflect the orthodox view of how variations in Bank Rate achieved an international adjustment.

This passage expresses very fairly the principle on which the Bank of England had been regulating credit from 1866 to 1914. They embody the art of central banking as it was understood in the half-century preceding the war. In view of the experience which has been obtained, the progress made in theory and the changes which have occurred since 1914, the principles of the art require reconsideration at the present day.

The Cunliffe Committee’s version of the effect of Bank rate upon the trade balance was based on exactly the same Ricardian theory of foreign trade as Horsely Palmer’s. It depended on adjustments of the price level. But the revolutionary changes in the means of communication during the past hundred years have unified markets to such a degree that for any of the commodities which enter regularly into international trade there is practically a single world market and a single world price. That does not mean absolutely identical prices for the same commodity at different places, but prices differing only by the cost of transport from exporting to the importing centres. Local divergences of prices form this standard are small and casual, and are speedily eliminated so long as markets work freely.

In Ricardo’s day, relatively considerable differences of price were possible between distant centres. The merchant could never have up-to-date information at one place of the price quotations at another. When he heard that the price of a commodity at a distant place had been relatively high weeks or months before, he was taking a risk in shipping a cargo thither, because the market might have changes for the worse before the cargo arrived. Under such conditions, it might well be that a substantial difference of price level was required to attract goods from one country to another.

Nevertheless it was fallacious ot explain the adjustment wholly in terms of the price level. There was, even at that time, an approximation to a world price. When the difference of price level attracted goods from one country to another, the effect was to diminish the difference of price level, and probably after an interval to eliminate it altogether (apart from cost of transport). When that occurred, the importing country was suffering an adverse balance, not on account of an excess price level, but on account of an excess demand at the world price level. Whether there be a difference of price level or not, it is this difference of demand that is the fundamental factor.

In Horsely Palmer‘s day the accepted theory was that the rate of discount affected the price level because it affected the amount of note issue and therefore the quantity of currency. That did not mean that the whole doctrine depended on the quantity theory of money. All that had currency so far tended to cause a rise or fall of the price level that any required rise or fall of prices could be secured by an appropriate expansion or contraction of the currency that is a very different thing from saying that the rise or fall of the price level would be exactly proportional to the expansion or contraction of the currency.

But it is not really necessary to introduce the quantity of currency into the analysis at all. What governs demand in any community is the consumers’ income (the total of all incomes expressed in terms of money) and consumers’ outlay (the total of all disbursements out of income, including investment).

The final sentence seems to be somewhat overstated, but in the context of a gold standard, in which the quantity of currency is endogenously determined, the quantity of currency is determined not determining. After noticing that Hawtrey anticipated Cassel in formulating the purchasing power parity doctrine, I looked again at the excellent paper by McCloskey and Zecher “The Success of Purchasing Power Parity” in the NBER volume A Retrospective on the Classical Gold Standard 1821-1931, edited by Bordo and Schwartz, a sequel to their earlier paper, “How the Gold Standard Worked” in The Monetary Approach to the Balance of Payments, edited by Johnson and Frenkel. The paper on purchasing power parity makes some very powerful criticisms of the Monetary History of the United States by Friedman and Schwartz, some of which Friedman responded to in his formal discussion of the paper. But clearly the main point on which McCloskey and Zecher took issue with Friedman and Schwartz was whether an internationally determined price level under the gold standard tightly constrained national price levels regardless of the quantity of local money. McCloskey and Zecher argued that it did, while Friedman and Schwartz maintained that variations in the quantity of national money, even under the gold standard, could have significant effects on prices and nominal income, at least in the short to medium term. As Friedman put it in his comment on McCloskey and Zecher:

[W]hile the quantity of money is ultimately an endogenous variable [under fixed exchange rates], there can be and is much leeway in the short run, before the external forces overwhelm the independent internal effects. And we have repeatedly been surprised in our studies by how much leeway there is and for how long – frequently a number of years.

I’ll let Friedman have the last word on this point, except to note that Hawtrey clearly would have disagreed with him post, at least subsequently to his writing Good and Bad Trade.


About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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