Archive for the 'gold standard' Category

A Keynesian Postscript on the Bright and Shining, Dearly Beloved, Depression of 1920-21

In his latest blog post Paul Krugman drew my attention to Keynes’s essay The Great Slump of 1930. In describing the enormity of the 1930 slump, Keynes properly compared the severity of the 1930 slump with the 1920-21 episode, noting that the price decline in 1920-21 was of a similar magnitude to that of 1930. James Grant, in his book on the Greatest Depression, argues that the Greatest Depression was so outstanding, because, in contrast to the Great Depression, there was no attempt by the government in 1920-21 to cushion the blow. Instead, the powers that be just stood back and let the devil take the hindmost.

Keynes had a different take on the difference between the Greatest Depression and the Great Depression:

First of all, the extreme violence of the slump is to be noticed. In the three leading industrial countries of the world—the United States, Great Britain, and Germany—10,000,000 workers stand idle. There is scarcely an important industry anywhere earning enough profit to make it expand—which is the test of progress. At the same time, in the countries of primary production the output of mining and of agriculture is selling, in the case of almost every important commodity, at a price which, for many or for the majority of producers, does not cover its cost. In 1921, when prices fell as heavily, the fall was from a boom level at which producers were making abnormal profits; and there is no example in modern history of so great and rapid a fall of prices from a normal figure as has occurred in the past year. Hence the magnitude of the catastrophe.

In diagnosing what went wrong in the Great Depression, Keynes largely, though not entirely, missed the most important cause of the catastrophe, the appreciation of gold caused by the attempt to restore an international gold standard without a means by which to control the monetary demand for gold of the world’s central banks — most notoriously, the insane Bank of France. Keynes should have paid more attention to Hawtrey and Cassel than he did. But Keynes was absolutely on target in explaining why the world more easily absorbed and recovered from a 40% deflation in 1920-21 than it was able to do in 1929-33.

Thoughts and Details on the Dearly Beloved, Bright and Shining, Depression of 1920-21, of Blessed Memory

Commenter TravisV kindly referred me to a review article by David Frum in the current issue of the Atlantic Monthly of The Deluge by Adam Tooze, an economic history of the First World War, its aftermath, and the rise of America as the first global superpower since the Roman Empire. Frum draws an interesting contrast between Tooze’s understanding of the 1920-21 depression and the analysis of that episode presented in James Grant’s recent paean to the Greatest Depression.

But in thinking about Frum’s article, and especially his comments on Grant, I realized that my own discussion of the 1920-21 depression was not fully satisfactory, and so I have been puzzling for a couple of weeks about my own explanation for the good depression of 1920-21. What follows is a progress report on my thinking.

Here is what Frum says about Grant:

Periodically, attempts have been made to rehabilitate the American leaders of the 1920s. The most recent version, James Grant’s The Forgotten Depression, 1921: The Crash That Cured Itself, was released just two days before The Deluge: Grant, an influential financial journalist and historian, holds views so old-fashioned that they have become almost retro-hip again. He believes in thrift, balanced budgets, and the gold standard; he abhors government debt and Keynesian economics. The Forgotten Depression is a polemic embedded within a narrative, an argument against the Obama stimulus joined to an account of the depression of 1920-21.

As Grant correctly observes, that depression was one of the sharpest and most painful in American history. Total industrial production may have dropped by 30 percent. [According to Industrial Production Index of the Federal Reserve, industrial production dropped by almost 40%, DG] Unemployment spiked at perhaps close to 12 percent (accurate joblessness statistics don’t exist for this period). Overall, prices plummeted at the steepest rate ever recorded—steeper than in 1929-33. Then, after 18 months of extremely hard times, the economy lurched into recovery. By 1923, the U.S. had returned to full employment.

Grant presents this story as a laissez-faire triumph. Wartime inflation was halted. . . . Recovery then occurred naturally, without any need for government stimulus. “The hero of my narrative is the price mechanism, Adam Smith’s invisible hand,” he notes. “In a market economy, prices coordinate human effort. They channel investment, saving and work. High prices encourage production but discourage consumption; low prices do the opposite. The depression of 1920-21 was marked by plunging prices, the malignity we call deflation. But prices and wages fell only so far. They stopped falling when they become low enough to entice consumers into shopping, investors into committing capital and employers into hiring. Through the agency of falling prices and wages, the American economy righted itself.” Reader, draw your own comparisons!

. . .

Grant rightly points out that wars are usually followed by economic downturns. Such a downturn occurred in late 1918-early 1919. “Within four weeks of the … Armistice, the [U.S.] War Department had canceled $2.5 billion of its then outstanding $6 billion in contracts; for perspective, $2.5 billion represented 3.3 percent of the 1918 gross national product,” he observes. Even this understates the shock, because it counts only Army contracts, not Navy ones. The postwar recession checked wartime inflation, and by March 1919, the U.S. economy was growing again.

Here is where the argument needs further clarity and elaboration. But first let me comment parenthetically that there are two distinct kinds of post-war downturns. First, there is an inevitable adjustment whereby productive resources are shifted to accommodate the shift in demand from armaments to civilian products. The reallocation entails the temporary unemployment that is described in familiar search and matching models. Because of the magnitude of the adjustment, these sectoral-adjustment downturns can last for some time, typically two to four quarters. But there is a second and more serious kind of downturn; it can be associated either with an attempt to restore a debased currency to its legal parity, or with the cessation of money printing to finance military expenditures by the government. Either the deflationary adjustment associated with restoring a suspended monetary standard or the disinflationary adjustment associated with the end of a monetary expansion tends to exacerbate and compound the pure resource reallocation problem that is taking place simultaneously.

What I have been mainly puzzling over is how to think about the World War I monetary expansion and inflation, especially in the US. From the beginning of World War I in 1914 till the US entered the war in April 1917, the dollar remained fully convertible into gold at the legal gold price of $20.67 an ounce. Nevertheless, there was a huge price inflation in the US prior to April 1917. How was this possible while the US was on the gold standard? It’s not enough to say that a huge influx of gold into the US caused the US money supply to expand, which is the essence of the typical quantity-theoretic explanation of what happened, an explanation that you will find not just in Friedman and Schwartz, but in most other accounts as well.

Why not? Because, as long as the dollar was still redeemable at the official gold price, people could redeem their excess dollars for gold to avoid the inflationary losses incurred by holding dollars. Why didn’t they? In my previous post on the subject, I suggested that it was because gold, too, was depreciating, so that rapid US inflation from 1915 to 1917 before entering the war was a reflection of the underlying depreciation of gold.

But why was gold depreciating? What happened to make gold less valuable? There are two answers. First, a lot of gold was being withdrawn from circulation, as belligerent governments were replacing their gold coins with paper or base metallic coins. But there was a second reason: the private demand for gold was being actively suppressed by governments. Gold could no longer be freely imported or exported. Without easy import and export of gold, the international gold market, a necessary condition for the gold standard, ceased to function. If you lived in the US and were concerned about dollar depreciation, you could redeem your dollars for gold, but you could not easily find anyone else in the world that would pay you more than the official price of $20.67 an ounce, even though there were probably people out there willing to pay you more than that price if you could only find them and circumvent the export and import embargoes to ship the gold to them. After the US entered the war in April 1917, an embargo was imposed on the export of gold from the US, but that was largely just a precaution. Even without an embargo, little gold would have been exported.

So it was at best an oversimplification for me to say in my previous post that the dollar depreciated along with gold during World War I, because there was no market mechanism that reflected or measured the value of gold during World War I. Insofar as the dollar was still being used as a medium of exchange, albeit with many restrictions, it was more correct to say that the value of gold reflected the value of the dollar, than that the value of the dollar reflected the value of gold.

In my previous post, I posited that, owing to the gold-export embargo imposed after US entry into World War I, the dollar actually depreciated by less than gold between April 1917 and the end of the war. I then argued that after full dollar convertibility into gold was restored after the war, the dollar had to depreciate further to match the value of gold. That was an elegant explanation for the anomalous postwar US inflation, but that explanation has a problem: gold was flowing out of the US during the inflation, but if my explanation of the postwar inflation were right, gold should have been flowing into the US as the trade balance turned in favor of the US.

So, much to my regret, I have to admit that my simple explanation, however elegant, of the post-World War I inflation, as an equilibration of the dollar price level with the gold price level, was too simple. So here are some provisional thoughts, buttressed by a bit of empirical research and evidence drawn mainly from two books by W. A. Brown England and the New Gold Standard and The International Gold Standard Reinterpreted 1914-34.

The gold standard ceased to function as an economic system during World War I, because a free market in gold ceased to exist. Nearly two-thirds of all the gold in the world was mined in territories under the partial or complete control of the British Empire (South Africa, Rhodesia, Australia, Canada, and India). Another 15% of the world’s output was mined in the US or its territories. Thus, Britain was in a position, with US support and approval, to completely dominate the world gold market. When the war ended, a gold standard could not begin to function again until a free market in gold was restored. Here is how Brown describes the state of the world gold market (or non-market) immediately after the War.

In March 1919 when the sterling-dollar rate was freed from control, the export of gold was for the first time legally [my emphasis] prohibited. It was therefore still impossible to measure the appreciation or depreciation of any currency in terms of a world price of gold. The price of gold was nowhere determined by world-wide forces. The gold of the European continent was completely shut out of the world’s trade by export embargoes. There was an embargo upon the export of gold from Australia. All the gold exported from the Union of South Africa had still to be sold to the Bank of England at its statutory price. Gold could not be exported from the United States except under government license. All the avenues of approach by which gold from abroad could reach the public in India were effectually closed. The possessors of gold in the United States, South Africa, India, or in England, Spain, or France, could not offer their gold to prospective buyers in competition with one another. The purchasers of gold in these countries did not have access to the world’s supplies, but on the other hand, they were not exposed to foreign competition for the supplies in their own countries, or in the sphere of influence of their own countries.

Ten months after the war ended, on September 12, 1919, many wartime controls over gold having been eliminated, a free market in gold was reestablished in London.

No longer propped up by the elaborate wartime apparatus of controls and supports, the official dollar-sterling exchange rate of $4.76 per pound gave way in April 1919, falling gradually to less than $4 by the end of 1919. With the dollar-sterling exchange rate set free and the dollar was pegged to gold at the prewar parity of $20.67 an ounce, the sterling price of gold and the dollar-sterling exchange rate varied inversely. The US wholesale price index (in current parlance the producer price index) stood at 23.5 in November 1918 when the war ended (compared to 11.6 in July 1914 just before the war began). Between November 1918 and June 1919 the wholesale price index was roughly stable, falling to 23.4, a drop of just 0.4% in seven months. However, the existence of wartime price controls, largely dismantled in the months after the war ended, introduces some noise into the price indices, making price-level estimates and comparisons in the latter stages of the War and its immediate aftermath problematic.

When the US embargo on gold exports was lifted in June 1919, causing a big jump in gold exports in July 1919, wholesale prices shot up nearly 4% to 24.3, and to 24.9 in August, suggesting that lifting the gold export embargo tended to reduce the international value of gold to which the dollar corresponded. Prices dropped somewhat in September when the London gold market was reestablished, perhaps reflecting the impact of pent-up demand for gold suddenly becoming effective. Prices remained stable in October before rising almost 2% in November. Price increases accelerated in December and January, leveled off in February and March, before jumping up in April, the PPI reaching its postwar peak (28.8, a level not reached again till November 1950!) in May 1920.

My contention is that the US price level after World War I largely reflected the state of the world gold market, and the state of the world gold market was mainly determined by the direction and magnitude of gold flows into or out of the US. From the War’s end in November 1918 till the embargo on US gold exports was lifted the following July, the gold market was insulated from the US. The wartime controls imposed on the world gold market were gradually being dismantled, but until the London gold market reopened in September 1919, allowing gold to move to where it was most highly valued, there was no such thing as a uniform international value of gold to which the dollar had to correspond.

My understanding of the postwar US inflation and the subsequent deflation is based on the close relationship between monetary policy and the direction and magnitude of gold flows. Under a gold standard, and given the demand to hold the liabilities of a central bank, a central bank typically controlled the amount of gold reserves it held by choosing the interest rate at which it would lend. The relationship between the central-bank lending rate and its holdings of reserves is complex, but the reserve position of a central bank was reliably correlated with the central-bank lending rate, as Hawtrey explained and documented in his Century of Bank Rate. So the central bank lending rate can be thought of as the means by which a central bank operating under a gold standard made its demand for gold reserves effective.

The chart below shows monthly net gold flows into the US from January 1919 through June 1922. Inflows (outflows) correspond to positive (negative) magnitudes measured on left vertical axis; the PPI is measured on the right vertical axis. From January 1919 to June 1920, prices were relatively high and rising, while gold was generally flowing out of the US. From July 1920 till June 1921, prices fell sharply while huge amounts of gold were flowing into the US. Prices hit bottom in June, and gold inflows gradually tapered off in the second half of 1921.

gold_imports_2The correlation is obviously very far from perfect; I have done a number of regressions trying to explain movements in the PPI from January 1919 to June 1922, and the net monthly inflow of gold into the US consistently accounts for roughly 25% of the monthly variation in the PPI, and I have yet to find any other variable that is reliably correlated with the PPI over that period. Of course, I would be happy to receive suggestions about other variables that might be correlated with price level changes. Here’s the simplest regression result.

y = -4.41e-10 NGOLDIMP, 41 observations, t = -3.99, r-squared = .285, where y is the monthly percentage change in the PPI, and NGOLDIMP is net monthly gold imports into the US.

The one part of the story that still really puzzles me is that deflation bottomed out in June 1921, even though monthly gold inflows remained strong throughout the spring and summer of 1921 before tapering off in the autumn. Perhaps there was a complicated lag structure in the effects of gold inflows on prices that might be teased out of the data, but I don’t see it. And adding lagged variables does little if anything to improve the fit of the regression.

I want to make two further points about the dearly beloved 1920-21 depression. Let me go to the source and quote from James Grant himself waxing eloquent in the Wall Street Journal about the beguiling charms of the wonderful 1920-21 experience.

In the absence of anything resembling government stimulus, a modern economist may wonder how the depression of 1920-21 ever ended. Oddly enough, deflation turned out to be a tonic. Prices—and, critically, wages too—were allowed to fall, and they fell far enough to entice consumers, employers and investors to part with their money. Europeans, noticing that America was on the bargain counter, shipped their gold across the Atlantic, where it swelled the depression-shrunken U.S. money supply. Shares of profitable and well-financed American companies changed hands at giveaway valuations.

The first point to make is that Grant has the causation backwards; it was the flow of gold into the US that caused deflation by driving up the international value of gold and forcing down prices in terms of gold. The second point to make is that Grant completely ignores the brutal fact that the US exported its deflation to Europe and most of the rest of the world. Indeed, because Europe and much of the rest of the world were aiming to rejoin the gold standard, which effectively meant going on a dollar standard at the prewar dollar parity, and because, by 1920, almost every other currency was at a discount relative to the prewar dollar parity, the rest of the world had to endure a far steeper deflation than the US did in order to bring their currencies back to the prewar parity against the dollar. So the notion that US deflation lured eager bargain-hunting Europeans to flock to the US to spend their excess cash would be laughable, if it weren’t so pathetic. Even when the US recovery began in the summer of 1921, almost everywhere else prices were still falling, and output and employment contractin.

This can be seen by looking at the exchange rates of European countries against the dollar, normalizing the February 1920 exchange rates as 100. In February 1921, here are the exchange rates. (Source W. A. Brown The International Gold Standard Reinterpreted 1914-34, Table 29)

UK 114.6

France 101.8

Switzerland 99.3

Denmark 124.4

Belgium 103.6

Sweden 119.6

Holland 94.9

Italy 81.6

Norway 102.8

Spain 84.9

And in 1922, the exchange rates for every country had risen against the dollar (peak month noted in parentheses), implying steeper deflation in each of those countries in 1921 than in the US.

UK (June) 134.3

France (April) 131.1

Switzerland (February) 118.5

Denmark (June) 145.4

Belgium (April) 117.7

Sweden (March) 140.6

Holland (April) 105.2

Italy (April) 119.6

Norway (May) 106.8

Spain (February) 94.9

As David Frum emphasizes, the damage inflicted by the bright and shining depression of 1920-21 was not confined to the US, it exacted an even greater price on the already devastated European continent, thereby setting the stage, in conjunction with the draconian reparations imposed by the Treaty of Versailles and the war debts that the US insisted on collecting, preferably in gold, not imports, from its allies, first for the great German hyperinflation and then the Great Depression. And we all know what followed.

So, yes, by all means, let us all raise our glasses and toast the dearly beloved, bright and shining, depression of 1920-21, of blessed memory, the greatest depression ever. May we never see its like again.

D.H. Robertson on Why the Gold Standard after World War I Was Really a Dollar Standard

In a recent post, I explained how the Depression of 1920-21 was caused by Federal Reserve policy that induced a gold inflow into the US thereby causing the real value of gold to appreciate. The appreciation of gold implied that, measured in gold, prices for most goods and services had to fall. Since the dollar was equal to a fixed weight of gold, dollar prices also had to fall, and insofar as other countries kept their currencies from depreciating against the dollar, prices in terms of other currencies were also falling. So in 1920-21, pretty much the whole world went into a depression along with the US. The depression stopped in late 1921 when the Fed decided to allowed interest rates to fall sufficiently to stop the inflow of gold into the US, thereby halting the appreciation of gold.

As an addendum to my earlier post, I reproduce here a passage from D. H. Robertson’s short classic, one of the Cambridge Economic Handbooks, entitled Money, originally published 92 years ago in 1922. I first read the book as an undergraduate – I think when I took money and banking from Ben Klein – which would have been about 46 years ago. After seeing Nick Rowe’s latest post following up on my post, I remembered that it was from Robertson that I first became aware of the critical distinction between a small country on the gold standard and a large country on the gold standard. So here is Dennis Robertson from chapter IV (“The Gold Standard”), section 6 (“The Value of Money and the Value of Gold”) (pp. 65-67):

We can now resume the main thread of our argument. In a gold standard country, whatever the exact device in force for facilitating the maintenance of the standard, the quantity of money is such that its value and that of a defined weight of gold are kept at an equality with one another. It looks therefore as if we could confidently take a step forward, and say that in such a country the quantity of money depends on the world value of gold. Before the war this would have been a true enough statement, and it may come to be true again in the lifetime of those now living: it is worthwhile therefore to consider what, if it be true, are its implications.

The value of gold in its turn depends on the world’s demand for it for all purposes, and on the quantity of it in existence in the world. Gold is demanded not only for use as money and in reserves, but for industrial and decorative purposes, and to be hoarded by the nations of the East : and the fact that it can be absorbed into or ejected from these alternative uses sets a limit to the possible changes in its value which may arise from a change in the demand for it for monetary uses, or from a change in its supply. But from the point of view of any single country, the most important alternative use for gold is its use as money or reserves in other countries; and this becomes on occasion a very important matter, for it means that a gold standard country is liable to be at the mercy of any change in fashion not merely in the methods of decoration or dentistry of its neighbours, but in their methods of paying their bills. For instance, the determination of Germany to acquire a standard money of gold in the [eighteen]’seventies materially restricted the increase of the quantity of money in England.

But alas for the best made pigeon-holes! If we assert that at the present day the quantity of money in every gold standard country, and therefore its value, depends on the world value of gold, we shall be in grave danger of falling once more into Alice’s trouble about the thunder and the lightning. For the world’s demand for gold includes the demand of the particular country which we are considering; and if that country be very large and rich and powerful, the value of gold is not something which she must take as given and settled by forces outside her control, but something which up to a point at least she can affect at will. It is open to such a country to maintain what is in effect an arbitrary standard, and to make the value of gold conform to the value of her money instead of making the value of her money conform to the value of gold. And this she can do while still preserving intact the full trappings of a gold circulation or gold bullion system. For as we have hinted, even where such a system exists it does not by itself constitute an infallible and automatic machine for the preservation of a gold standard. In lesser countries it is still necessary for the monetary authority, by refraining from abuse of the elements of ‘play’ still left in the monetary system, to make the supply of money conform to the gold position: in such a country as we are now considering it is open to the monetary authority, by making full use of these same elements of ‘play,’ to make the supply of money dance to its own sweet pipings.

Now for a number of years, for reasons connected partly with the war and partly with its own inherent strength, the United States has been in such a position as has just been described. More than one-third of the world’s monetary gold is still concentrated in her shores; and she possesses two big elements of ‘play’ in her system — the power of varying considerably in practice the proportion of gold reserves which the Federal Reserve Banks hold against their notes and deposits (p. 47), and the power of substituting for one another two kinds of common money, against one of which the law requires a gold reserve of 100 per cent and against the other only one of 40 per cent (p. 51). Exactly what her monetary aim has been and how far she has attained it, is a difficult question of which more later. At present it is enough for us that she has been deliberately trying to treat gold as a servant and not as a master.

It was for this reason, and for fear that the Red Queen might catch us out, that the definition of a gold standard in the first section of this chapter had to be so carefully framed. For it would be misleading to say that in America the value of money is being kept equal to the value of a defined weight of gold: but it is true even there that the value of money and the value of a defined weight of gold are being kept equal to one another. We are not therefore forced into the inconveniently paradoxical statement that America is not on a gold standard. Nevertheless it is arguable that a truer impression of the state of the world’s monetary affairs would be given by saying that America is on an arbitrary standard, while the rest of the world has climbed back painfully on to a dollar standard.

The Nearly Forgotten Dearly Beloved 1920-21 Depression Yet Again; Or, Never Reason from a Quantity Change

The industrious James Grant recently published a book about the 1920-21 Depression. It has received enthusiastic reviews in the Wall Street Journal and Barron’s, was the subject of an admiring column by Washington Post columnist Robert J. Samuelson, and was celebrated at a Cato Institute panel discussion, luncheon, and book-signing event. The Cato extravaganza elicited a dismissive blog post by Barkley Rosser which was linked to by Paul Krugman on his blog. The Rosser/Krugman tandem provoked an unhappy reply on the Free Banking blog from George Selgin who chaired the Cato panel discussion. And the 1920-21 Depression is now the latest hot topic in the econblogosphere.

I am afraid that there are multiple layers of errors and confusion that are being mixed up and compounded in this discussion, errors and confusion derived from basic misunderstandings about how the gold standard operated that have been plaguing the economics profession and the financial world for about two and a half centuries. If you want to understand how the gold standard worked, what you have to read is the book by Ralph Hawtrey entitled – drum roll, please – The Gold Standard.

Here are the basic things you need to know about the gold standard.

1 The gold standard operates by creating an equivalence between a currency unit and a fixed amount of gold.

2 The gold standard does not require gold to circulate as money in the form of coins. That was historically the case, but a gold standard can function with no gold coins or even gold certificates.

3 The value of a currency unit and the value of a corresponding weight of gold are necessarily equalized by arbitrage.

4 Equality between a currency unit and a corresponding weight of gold does not necessarily show the direction of causality; the currency unit may determine the value of gold, not the other way around. In other words, making gold the standard of value for currency affects the demand for gold which affects the value of gold. Decisions made by monetary authorities under the gold standard necessarily affect the value of gold, so a gold standard does not somehow make the value of money independent of monetary policy.

5 When more than one country is on a gold standard, the countries share a common price level, because the value of gold is determined in an international market.

Keeping those basics in mind, let’s quickly try to understand what was going on in 1920 when the Fed decided to raise its discount rate to the then unprecedented level of 7 percent. But the situation in 1920 was the outcome of the previous six years of World War I that effectively destroyed the gold standard as a functioning institution, even though its existence was in some sense still legally recognized.

Under the gold standard, gold was the ultimate way of discharging international debts. In World War I, belligerents had to pay for imports with gold, thus governments amassed all available gold with which to pay for the imports required to support the war effort. Gold coins were melted down and converted to bullion so the gold could be exported. For a private citizen in a belligerent country to demand that the national currency unit be converted to gold would be considered an unpatriotic if not a treasonous act. So the gold standard ceased to function in belligerent countries. In non-belligerent countries, which were busy exporting to the belligerents, the result was a massive inflow of gold, causing a spectacular increase in the amount of gold held by the US Treasury between 1914 and 1917. Other non-belligerents like Sweden and Switzerland experienced similar inflows.

Quantity theorists and Monetarists like Milton Friedman habitually misinterpret the wartime inflation, and attributing the inflation to an inflow of gold that increased the money supply, thereby perpetrating the price-specie-flow-mechanism fallacy. What actually happened was that the huge demonetization of gold coins by the belligerents and their export of large quantities of gold to non-belligerent countries in which a free market in gold continued to operate drove down the value of gold. A falling value of gold under a gold standard logically implies rising prices for all other goods and services. Rising prices increased the nominal demand for money, which more or less automatically caused a corresponding adjustment in the quantity of money. A rising price level caused the quantity of money to increase, not the other way around.

In 1917, just before the US entered the war, the US, still effectively on a gold standard as gold flowed into the Treasury, had experienced a drastic inflation, like all other gold standard countries, because gold was rapidly losing value, as it was being demonetized and exported by the belligerent countries. But when the US entered the war in 1917, the US, like other belligerents, suspended operation of the gold standard, thereby accelerating the depreciation of gold, forcing the few remaining countries on the gold standard to suspend the gold standard to avoid runaway inflation. Inflationary pressure in the US did increase after entry into the war, but the war-induced fiat inflation, to some extent suppressed or disguised by price controls, was actually slower than inflation in terms of gold.

When the war ended, the US went back on the gold standard by again making the dollar convertible into gold at the legal parity. Doing so meant that the US price level in terms of dollars was below the notional (no currency any longer being convertible into gold) world price level in terms of gold. In other belligerent countries, notably Britain, France and Germany, inflation in terms of their national currencies exceeded gold inflation, requiring them to deflate even to restore the legal parity in terms of gold.  Thus, the US was the only country in the world that was both willing and able to return to the gold standard at the prewar parity. Sweden and Switzerland could have done so, but preferred to avoid the inflationary consequences of a return to the gold standard.

Once the dollar convertibility into gold was restored, arbitrage forced the US price level to rise to so that it would equal the gold price level. The excess of the gold price level over the US price level level explains the anomalous post-war inflation – everyone knows that prices are supposed to fall, not rise, when a war ends — in the US. The rest of the world, then, had to choose between accepting US inflation, by keeping their currencies pegged to the dollar, or allowing their currencies to appreciate against the dollar. The anomalous post-war inflation was caused by the reequilibration of the US price level to the gold price levels, not, as commonly supposed, by Fed inexperience or incompetence.

To stop the post-war inflation, the Fed could have simply abandoned the gold standard, or it could have revalued the dollar in terms of gold, by reducing the official dollar price of gold. (I ignore the minor detail that the official dollar price of gold was then determined by statute.) Instead, the Fed — whether knowingly or not I can’t say – chose to increase the value of gold. The method by which it did so was to raise its discount rate, thereby making it easier to obtain dollars by selling gold to the Treasury than to borrow from the Fed. The flood of gold into the Treasury in 1920-21 succeeded in taking a huge amount of gold out of private and public hands, thus driving up the real value of gold, and forcing down the gold price level. That’s when the brutal deflation of 1920-21 started. At some point, the Fed and the Treasury decided that they had had enough, having amassed about 40% of the world’s gold reserves, and began reducing the discount rate, thereby slowing the inflow of gold into the US, and stopping its appreciation. And that’s when and how the dearly beloved, but quite dreadful, depression of 1920-21 came to an end.

Misunderstanding Reserve Currencies and the Gold Standard

In Friday’s Wall Street Journal, Lewis Lehrman and John Mueller argue for replacing the dollar as the world’s reserve currency with gold. I don’t know Lewis Lehrman, but almost 30 years ago, when I was writing my book Free Banking and Monetary Reform, which opposed restoring the gold standard, I received financial support from the Lehrman Institute where I gave a series of seminars discussing several chapters of my book. A couple of those seminars were attended by John Mueller, who was then a staffer for Congressman Jack Kemp. But despite my friendly feelings for Lehrman and Mueller, I am afraid that they badly misunderstand how the gold standard worked and what went wrong with the gold standard in the 1920s. Not surprisingly, that misunderstanding carries over into their comments on current monetary arrangements.

Lehrman and Mueller begin by discussing the 1922 Genoa Conference, a conference largely inspired by the analysis of Ralph Hawtrey and Gustav Cassel of post-World War I monetary conditions, and by their proposals for restoring an international gold standard without triggering a disastrous deflation in the process of doing so, the international price level in terms of gold having just about doubled relative to the pre-War price level.

The 1922 Genoa conference, which was intended to supervise Europe’s post-World War I financial reconstruction, recommended “some means of economizing the use of gold by maintaining reserves in the form of foreign balances”—initially pound-sterling and dollar IOUs. This established the interwar “gold exchange standard.”

Lehrman and Mueller then cite the view of the gold exchange standard expressed by the famous French economist Jacques Rueff, of whom Lehrman is a fervent admirer.

A decade later Jacques Rueff, an influential French economist, explained the result of this profound change from the classical gold standard. When a foreign monetary authority accepts claims denominated in dollars to settle its balance-of-payments deficits instead of gold, purchasing power “has simply been duplicated.” If the Banque de France counts among its reserves dollar claims (and not just gold and French francs)—for example a Banque de France deposit in a New York bank—this increases the money supply in France but without reducing the money supply of the U.S. So both countries can use these dollar assets to grant credit. “As a result,” Rueff said, “the gold-exchange standard was one of the major causes of the wave of speculation that culminated in the September 1929 crisis.” A vast expansion of dollar reserves had inflated the prices of stocks and commodities; their contraction deflated both.

This is astonishing. Lehrman and Mueller do not identify the publication of Rueff that they are citing, but I don’t doubt the accuracy of the quotation. What Rueff is calling for is a 100% marginal reserve requirement. Now it is true that under the Bank Charter Act of 1844, Great Britain had a 100% marginal reserve requirement on Bank of England notes, but throughout the nineteenth century, there was an shift from banknotes to bank deposits, so the English money supply was expanding far more rapidly than English gold reserves. The kind of monetary system that Rueff was talking about, in which the quantity of money in circulation, could not increase by more than the supply of gold, never existed. Money was being created under the gold standard without an equal amount of gold being held in reserve.

The point of the gold exchange standard, after World War I, was to economize on the amount of gold held by central banks as they rejoined the gold standard to prevent a deflation back to the pre-War price level. Gold had been demonetized over the course of World War I as countries used gold to pay for imports, much of it winding up in the US before the US entered the war. If all the demonetized gold was remonetized, the result would be a huge rise in the value of gold, in other words, a huge, catastrophic, deflation.

Nor does the notion that the gold-exchange standard was the cause of speculation that culminated in the 1929 crisis have any theoretical or evidentiary basis. Interest rates in the 1920s were higher than they ever were during the heyday of the classical gold standard from about 1880 to 1914. Prices were not rising faster in the 1920s than they did for most of the gold standard era, so there is no basis for thinking that speculation was triggered by monetary causes. Indeed, there is no basis for thinking that there was any speculative bubble in the 1920s, or that even if there was such a bubble it was triggered by monetary expansion. What caused the 1929 crash was not the bursting of a speculative bubble, as taught by the popular mythology of the crash, it was caused by the sudden increase in the demand for gold in 1928 and 1929 resulting from the insane policy of the Bank of France and the clueless policy of the Federal Reserve after ill health forced Benjamin Strong to resign as President of the New York Fed.

Lehrman and Mueller go on to criticize the Bretton Woods system.

The gold-exchange standard’s demand-duplicating feature, based on the dollar’s reserve-currency role, was again enshrined in the 1944 Bretton Woods agreement. What ensued was an unprecedented expansion of official dollar reserves, and the consumer price level in the U.S. and elsewhere roughly doubled. Foreign governments holding dollars increasingly demanded gold before the U.S. finally suspended gold payments in 1971.

The gold-exchange standard of the 1920s was a real gold standard, but one designed to minimize the monetary demand for gold by central banks. In the 1920s, the US and Great Britain were under a binding obligation to convert dollars or pound sterling on demand into gold bullion, so there was a tight correspondence between the value of gold and the price level in any country maintaining a fixed exchange rate against the dollar or pound sterling. Under Bretton Woods, only the US was obligated to convert dollars into gold, but the obligation was largely a fiction, so the tight correspondence between the value of gold and the price level no longer obtained.

The economic crisis of 2008-09 was similar to the crisis that triggered the Great Depression. This time, foreign monetary authorities had purchased trillions of dollars in U.S. public debt, including nearly $1 trillion in mortgage-backed securities issued by two government-sponsored enterprises, Fannie Mae and Freddie Mac. The foreign holdings of dollars were promptly returned to the dollar market, an example of demand duplication. This helped fuel a boom-and-bust in foreign markets and U.S. housing prices. The global excess credit creation also spilled over to commodity markets, in particular causing the world price of crude oil (which is denominated in dollars) to spike to $150 a barrel.

There were indeed similarities between the 1929 crisis and the 2008 crisis. In both cases, the world financial system was made vulnerable because there was a lot of bad debt out there. In 2008, it was subprime mortgages, in 1929 it was reckless borrowing by German local governments and the debt sold to refinance German reparations obligations under the Treaty of Versailles. But in neither episode did the existence of bad debt have anything to do with monetary policy; in both cases tight monetary policy precipitated a crisis that made a default on the bad debt unavoidable.

Lehrman and Mueller go on to argue, as do some Keynesians like Jared Bernstein, that the US would be better off if the dollar were not a reserve currency. There may be disadvantages associated with having a reserve currency – disadvantages like those associated with having a large endowment of an exportable natural resource, AKA the Dutch disease – but the only way for the US to stop having a reserve currency would be to take a leaf out of the Zimbabwe hyperinflation playbook. Short of a Zimbabwean hyperinflation, the network externalities internalized by using the dollar as a reserve currency are so great, that the dollar is likely to remain the world’s reserve currency for at least a millennium. Of course, the flip side of the Dutch disease is at that there is a wealth transfer from the rest of the world to the US – AKA seignorage — in exchange for using the dollar.

Lehrman and Mueller are aware of the seignorage accruing to the supplier of a reserve currency, but confuse the collection of seignorage with the benefit to the world as a whole of minimizing the use of gold as the reserve currency. This leads them to misunderstand the purpose of the Genoa agreement, which they mistakenly attribute to Keynes, who actually criticized the agreement in his Tract on Monetary Reform.

This was exactly what Keynes and other British monetary experts promoted in the 1922 Genoa agreement: a means by which to finance systemic balance-of-payments deficits, forestall their settlement or repayment and put off demands for repayment in gold of Britain’s enormous debts resulting from financing World War I on central bank and foreign credit. Similarly, the dollar’s “exorbitant privilege” enabled the U.S. to finance government deficit spending more cheaply.

But we have since learned a great deal that Keynes did not take into consideration. As Robert Mundell noted in “Monetary Theory” (1971), “The Keynesian model is a short run model of a closed economy, dominated by pessimistic expectations and rigid wages,” a model not relevant to modern economies. In working out a “more general theory of interest, inflation, and growth of the world economy,” Mr. Mundell and others learned a great deal from Rueff, who was the master and professor of the monetary approach to the balance of payments.

The benefit from supplying the resource that functions as the world’s reserve currency will accrue to someone, that is the “exorbitant privilege” to which Lehrman and Mueller refer. But It is not clear why it would be better if the privilege accrued to owners of gold instead of to the US Treasury. On the contrary, the potential for havoc associated with reinstating gold as the world’s reserve currency dwarfs the “exorbitant privilege.” Nor is the reference to Keynes relevant to the discussion, the Keynesian model described by Mundell being the model of the General Theory, which was certainly not the model that Keynes was working with at the time of the Genoa agreement in which Keynes’s only involvement was as an outside critic.

As for Rueff, staunch defender of the insane policy of the Bank of France in 1932, he was an estimable scholar, but, luckily, his influence was much less than Lehrman and Mueller suggest.

Is Insanity Breaking out in Switzerland?

The other day, I saw this item on Bloomberg.com “1500 Tons of Gold on the Line in Swiss Vote Buy Back Bullion.” Have a look:

There are people in Switzerland who resent that the country sold away much of its gold last decade. They may be a splinter group of Swiss politics, but they’re a persistent bunch.

And if they get their way in a referendum this month, these voters will make their presence known to gold traders around the world.

The proposal from the “Save Our Swiss Gold” proponents is simple: Force the central bank to build its bullion position up to at least 20 percent of total assets from 8 percent today. Holding 522 billion Swiss francs ($544 billion) of assets in its coffers, the Swiss National Bank would have to buy at least 1,500 tons of gold, costing about $56.3 billion at current prices, to get to the required threshold by 2019.

Those purchases, equal to about 7 percent of annual global demand, would trigger an 18 percent rally, giving a lift to gold bulls who’ve suffered 32 percent losses in the past two years, Bank of America Corp. estimates. With polls showing voters split before the Nov. 30 referendum, the SNB and national government are warning that such a move could undermine efforts to prevent the franc from surging against the euro and erode the bank’s annual dividend distribution to regional governments.

There they go again. The gold bugs are rallying to prop up the gold-price bubble with mandated purchases of the useless yellow metal so that it can be locked up to lie idle and inert in the vaults of the Swiss National Bank. How insane is that?

But wait! There is method to their madness.

A “yes” victory means Switzerland would face buying the metal at prices that quadrupled since it began selling more than half its reserves in 2000. The move would make the SNB the world’s third-biggest holder of gold. The initiative would also force the central bank to repatriate the 30 percent of its gold held abroad in the U.K. and Canada and bar it from ever selling bullion again.

With 1,040 metric tons, Switzerland is already the seventh-largest holder of gold by country, International Monetary Fund data show. According to UBS, a change in the law may force the SNB to buy about 1,500 tons, while ABN Amro Group NV and Societe Generale SA estimate the need at closer to 1,800 tons.

The SNB’s assets have expanded by more than a third in the past three years because of currency interventions to enforce a minimum exchange rate of 1.20 per euro. As of August, just under 8 percent of its assets were in gold, compared with a ratio of 15 percent for Germany‘s Bundesbank.

Many people get all bent out of shape at the mere mention of bailing out the banks and Wall Street, but those same people don’t seem to mind bailing out all those hedge funds and gold investment trusts, as well as all the individual investors, egged on by the Peter Schiffs of the world and by the sleazy characters advertising on Fox News and talk radio, who recklessly jumped on the gold bandwagon at the height of the gold bubble from 2008 to 2011.

Gold price tanking? No problemo. Just get the central banks to start buying all the gold now being dumped into the market by people who have finally realized that it’s time to cut their losses before prices fall even further. The price of gold having fallen by almost 20% from its 2014 high, a central-bank rescue operation looks awfully attractive to a lot of desperate people. Even better, the rescue operation can be dressed up and packaged as if it were the quintessence of monetary virtue, merely requiring central banks to hold gold backing for the paper money they issue.

Of course, this referendum, even if passed by Swiss electorate, is less than half as insane as the Monetary Law enacted in 1928, at the urging of the Bank of France, by the French Parliament, a law requiring the Bank to hold gold equal to at least 35% of its outstanding note issue. The Bank in its gold frenzy went way beyond its legal obligation to accumulate gold. The proposed Swiss Law is less than half as insane as the French Monetary Law of 1928, because in 1928 France and much of the rest of the world were either on the gold standard or about to rejoin the gold standard, so that increasing the demand for gold meant forcing the world into the deflationary death spiral that turned into the Great Depression. The most that the proposed Swiss Law could do is force Switzerland into a deflationary spiral.

That would be too bad for Switzerland, but probably not such a big deal for the rest of the world. If the Swiss want to lock up 1500 tons of gold in the vaults of their central bank, well, it’s their sovereign right to go insane. Luckily, the rest of the world has figured out how to have a monetary system in which the gyrations of the hyper-volatile gold price can no longer ruin the lives of many hundreds of millions, if not billions, of people.

Just How Infamous Was that Infamous Open Letter to Bernanke?

There’s been a lot of comment recently about the infamous 2010 open letter to Ben Bernanke penned by an assorted group of economists, journalists, and financiers warning that the Fed’s quantitative easing policy would cause inflation and currency debasement.

Critics of that letter (e.g., Paul Krugman and Brad Delong) have been having fun with the signatories, ridiculing them for what now seems like a chicken-little forecast of disaster. Those signatories who have responded to inquiries about how they now feel about that letter, notably Cliff Asness and Nial Ferguson, have made two arguments: 1) the letter was just a warning that QE was creating a risk of inflation, and 2) despite the historically low levels of inflation since the letter was written, the risk that inflation could increase as a result of QE still exists.

For the most part, critics of the open letter have focused on the absence of inflation since the Fed adopted QE, the critics characterizing the absence of inflation despite QE as an easily predictable outcome, a straightforward implication of basic macroeconomics, which it was ignorant or foolish of the signatories to have ignored. In particular, the signatories should have known that, once interest rates fall to the zero lower bound, the demand for money becoming highly elastic so that the public willingly holds any amount of money that is created, monetary policy is rendered ineffective. Just as a semantic point, I would observe that the term “liquidity trap” used to describe such a situation is actually a slight misnomer inasmuch as the term was coined to describe a situation posited by Keynes in which the demand for money becomes elastic above the zero lower bound. So the assertion that monetary policy is ineffective at the zero lower bound is actually a weaker claim than the one Keynes made about the liquidity trap. As I have suggested previously, the current zero-lower-bound argument is better described as a Hawtreyan credit deadlock than a Keynesian liquidity trap.

Sorry, but I couldn’t resist the parenthetical history-of-thought digression; let’s get back to that infamous open letter.

Those now heaping scorn on signatories to the open letter are claiming that it was obvious that quantitative easing would not increase inflation. I must confess that I did not think that that was the case; I believed that quantitative easing by the Fed could indeed produce inflation. And that’s why I was in favor of quantitative easing. I was hoping for a repeat of what I have called the short but sweat recovery of 1933, when, in the depths of the Great Depression, almost immediately following the worst financial crisis in American history capped by a one-week bank holiday announced by FDR upon being inaugurated President in March 1933, the US economy, propelled by a 14% rise in wholesale prices in the aftermath of FDR’s suspension of the gold standard and 40% devaluation of the dollar, began the fastest expansion it ever had, industrial production leaping by 70% from April to July, and the Dow Jones average more than doubling. Unfortunately, FDR spoiled it all by getting Congress to pass the monumentally stupid National Industrial Recovery Act, thereby strangling the recovery with mandatory wage increases, cost increases, and regulatory ceilings on output as a way to raise prices. Talk about snatching defeat from the jaws of victory!

Inflation having worked splendidly as a recovery strategy during the Great Depression, I have believed all along that we could quickly recover from the Little Depression if only we would give inflation a chance. In the Great Depression, too, there were those that argued either that monetary policy is ineffective – “you can’t push on a string” — or that it would be calamitous — causing inflation and currency debasement – or, even both. But the undeniable fact is that inflation worked; countries that left the gold standard recovered, because once currencies were detached from gold, prices could rise sufficiently to make production profitable again, thereby stimulating multiplier effects (aka supply-side increases in resource utilization) that fueled further economic expansion. And oh yes, don’t forget providing badly needed relief to debtors, relief that actually served the interests of creditors as well.

So my problem with the open letter to Bernanke is not that the letter failed to recognize the existence of a Keynesian liquidity trap or a Hawtreyan credit deadlock, but that the open letter viewed inflation as the problem when, in my estimation at any rate, inflation is the solution.

Now, it is certainly possible that, as critics of the open letter maintain, monetary policy at the zero lower bound is ineffective. However, there is evidence that QE announcements, at least initially, did raise inflation expectations as reflected in TIPS spreads. And we also know (see my paper) that for a considerable period of time (from 2008 through at least 2012) stock prices were positively correlated with inflation expectations, a correlation that one would not expect to observe under normal circumstances.

So why did the huge increase in the monetary base during the Little Depression not cause significant inflation even though monetary policy during the Great Depression clearly did raise the price level in the US and in the other countries that left the gold standard? Well, perhaps the success of monetary policy in ending the Great Depression could not be repeated under modern conditions when all currencies are already fiat currencies. It may be that, starting from an interwar gold standard inherently biased toward deflation, abandoning the gold standard created, more or less automatically, inflationary expectations that allowed prices to rise rapidly toward levels consistent with a restoration of macroeconomic equilibrium. However, in the current fiat money system in which inflation expectations have become anchored to an inflation target of 2 percent or less, no amount of money creation can budge inflation off its expected path, especially at the zero lower bound, and especially when the Fed is paying higher interest on reserves than yielded by short-term Treasuries.

Under our current inflation-targeting monetary regime, the expectation of low inflation seems to have become self-fulfilling. Without an explicit increase in the inflation target or the price-level target (or the NGDP target), the Fed cannot deliver the inflation that could provide a significant economic stimulus. So the problem, it seems to me, is not that we are stuck in a liquidity trap; the problem is that we are stuck in an inflation-targeting monetary regime.

 


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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