Archive for the 'gold standard' Category

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.

 

Explaining Post-Traumatic-Inflation Stress Disorder

Paul Krugman and Steve Waldman having been puzzling of late about why inflation is so viscerally opposed by the dreaded one percent (even more so by the ultra-dreaded 0.01 percent). Here’s how Krugman phrased the conundrum.

One thought I’ve had and written about is that the one percent (or actually the 0.01 percent) like hard money because they’re rentiers. But you can argue that this is foolish — that they have much more to gain from asset appreciation than they have to lose from the small chance of runaway inflation. . . .

But maybe the 1% doesn’t make the connection?

Steve Waldman, however, doesn’t take the one percent — and certainly not the 0.01 percent — for the misguided dunces that Krugman suggests they are. Waldman sees them as the cunning, calculating villains that we all (notwithstanding his politically correct disclaimer that the rich aren’t bad people) know they really are.

Soft money types — I’ve heard the sentiment from Scott Sumner, Brad DeLong, Kevin Drum, and now Paul Krugman — really want to see the bias towards hard money and fiscal austerity as some kind of mistake. I wish that were true. It just isn’t. Aggregate wealth is held by risk averse individuals who don’t individually experience aggregate outcomes. Prospective outcomes have to be extremely good and nearly certain to offset the insecurity soft money policy induces among individuals at the top of the distribution, people who have much more to lose than they are likely to gain.

That’s all very interesting. Are the rich opposed to inflation because they are stupid, or because they are clever? Krugman thinks it’s the former, Waldman the latter. And I agree; it is a puzzle.

But what about the poor and the middle class? Has anyone seen any demonstrations lately by the 99 percent demanding that the Fed increase its inflation target? Did even one Democrat in the Senate – not even that self-proclaimed socialist Bernie Sanders — threaten to vote against confirmation of Janet Yellen unless she promised to raise the Fed’s inflation target? Well, maybe that just shows that the Democrats are as beholden to the one percent as the Republicans, but I suspect that the real reason is because the 99 percent hate inflation just as much as the one percent do. I mean, don’t the 99 percent realize that inflation would increase total output and employment, thereby benefitting ordinary workers generally?

Oh, you say, workers must be afraid that inflation would reduce their real wages. That’s a widely believed factoid about inflation — that inflation is biased against workers, because wages adjust more slowly than other prices to changes in demand. Well, that factoid is not necessarily true, either in theory or in practice. That doesn’t mean that inflation might not be associated with reduced real wages, but if it is, it would mean that inflation is facilitating a market adjustment in real wages that would tend to increase total output and total employment, thereby increasing aggregate wages paid to workers. That is just the sort of tradeoff between a prospective upside from growth-inducing inflation and a perceived downside from inflation redistribution. In other words, the attitudes of the one percent and of the 99 percent toward inflation don’t seem all that different.

And aside from the potential direct output-expanding effect of inflation, there is also the redistributional effect from creditors to debtors. A lot of underwater homeowners could have sold their homes if a 10- or 20-percent increase in the overall price level had kept nominal home prices from falling below nominal mortgage indebtedness. Inflation would have been the simplest and easiest way to avoid a foreclosure crisis and getting stuck in a balance-sheet recession. Why weren’t underwater homeowners out their clamoring for some inflationary relief?

I have not done a historical study, but I cannot think of any successful political movement or campaign that has ever been carried out on a platform of increasing inflation. Even FDR, who saved the country from ruin by taking the US off the gold standard in 1933, did not say that he would do so when running for office.

Nor has anyone ever stated the case against inflation more eloquently than John Maynard Keynes, hardly a spokesman for the interests of rentiers.

Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security but [also] at confidence in the equity of the existing distribution of wealth.

Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become “profiteers,” who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose. (Economic Consequences of the Peace)

One might say that when Keynes wrote this he was still very much of an orthodox Marshallian economist, who only later outgrew his orthodox prejudices when he finally saw the light and wrote the General Theory. But Keynes was actually quite explicit in the General Theory that he favored a monetary policy aiming at price-level stabilization. If Keynes favored inflation it was only in the context of counteracting a massive deflation. Similarly, Ralph Hawtrey, who famously likened opposition to monetary stimulus, out of fear of inflation, during the Great Depression to crying “fire, fire” during Noah’s Flood, favored a monetary regime aiming at stable money wages, a regime that over the long term would generate a gradually falling output price level. So I fail to see why anyone should be surprised that a pro-inflationary policy would be a tough sell even when unemployment is high.

But, in thinking about all this, I believe it may help to distinguish between two types of post-traumatic-inflation stress disorder. One is a kind of instinctual aversion to inflation, which I think is widely shared by people from all kinds of backgrounds, beliefs, and economic status. After arguing and pleading for higher inflation for over three years on this blog, I am a little bit embarrassed to make this admission, but I suffer from this type of post-traumatic-inflation stress disorder myself. I know that it’s weird, but every month when the CPI is announced, and the monthly change is less than 2%, I just get a warm fuzzy feeling inside of me. I know (or at least believe) that people will suffer because inflation is not higher than a measly 2%, but I can’t help getting that feeling of comfort and well-being when I hear that inflation is low. That just seems to be the natural order of things. And I don’t think that I am the only one who feels that way, though I probably suffer more guilt than most for not being able to suppress the feeling.

But there is another kind of post-traumatic-inflation stress disorder. This is a purely intellectual disorder brought on by excessive exposure to extreme libertarian dogmas associated with pop-Austrianism and reading too many (i.e., more than zero) novels by Ayn Rand. Unfortunately, one of the two major political parties seems to have been captured this group of ideologues, and anti-inflationary dogma has become an article of faith rather than a mere disposition. It is one thing to have a disposition or a bias in favor of low inflation; it is altogether different to make anti-inflationism a moral or ideological crusade. I think most people, whether they are in the one percent or the 99 percent are biased in favor of low inflation, but most of them don’t oppose inflation as a moral or ideological imperative. Now it’s true that that the attachment of a great many people to the gold standard before World War I was akin to a moral precept, but at least since the collapse of the gold standard in the Great Depression, most people no longer think about inflation in moral and ideological terms.

Before anti-inflationism became a moral crusade, it was possible for people like Richard Nixon and Ronald Reagan, who were disposed to favor low inflation, to accommodate themselves fairly easily to an annual rate of inflation of 4 percent. Indeed, it was largely because of pressure from Democrats to fight inflation by wage and price controls that Nixon did the unthinkable and imposed wage and price controls on August 15, 1971. Reagan, who had no interest in repeating that colossal blunder, instead fought against Paul Volcker’s desire to bring inflation down below 4 percent for most of his two terms. Of course, one doesn’t know to what extent the current moral and ideological crusade against inflation would survive an accession to power by a Republican administration. It is always easier to proclaim one’s ideological principles when one doesn’t have any responsibility to implement them. But given the current ideological commitment to anti-inflationism, there was never any chance for a pragmatic accommodation that might have used increased inflation as a means of alleviating economic distress.

Hey, Look at Me; I Turned Brad Delong into an Apologist for Milton Friedman

It’s always nice to be noticed, so I can hardly complain if Brad Delong wants to defend Milton Friedman on his blog against my criticism of his paper “Real and Pseudo Gold Standards.” I just find it a little bit rich to see Friedman being defended against my criticism by the arch-Keynesian Brad Delong.

But in the spirit of friendly disagreement in which Brad criticizes my criticism, I shall return the compliment and offer some criticisms of my own of Brad’s valiant effort to defend the indefensible.

So let me try to parse what Brad is saying and see if Brad can help me find sense where before I could find none.

I think that Friedman’s paper has somewhat more coherence than David does. From Milton Friedman’s standpoint (and from John Maynard Keynes’s) you need microeconomic [I think Brad meant to say macroeconomic] stability in order for private laissez-faire to be for the best in the best of possible worlds. Macroeconomic stability is:

  1. stable and predictable paths for total spending, the price level, and interest rates; hence
  2. a stable and predictable path for the velocity of money; hence
  3. (1) then achieved by a stable and predictable path for the money stock; and
  4. if (3) is secured by institutions, then expectations of (3) will generate the possibility of (1) and (2) so that if (3) is actually carried out then eppur si muove

I agree with Brad that macroeconomic stability can be described as a persistent circumstance in which the paths for total spending, the price level, and (perhaps) interest rates are stable and predictable. I also agree that a stable and predictable path for the velocity of money is conducive to macroeconomic stability. But note the difference between saying that the time paths for total spending, the price level and (perhaps) interest rates are stable and predictable and that the time path for the velocity of money is stable and predictable. It is, at least possibly the case, that it is within the power of an enlightened monetary authority to provide, or that it would be possible to construct a monetary regime that could provide, stable and predictable paths for total spending and the price level. Whether it is also possible for a monetary authority or a monetary regime to provide a stable and predictable path for interest rates would depend on the inherent variability in the real rate of interest. It may be that variations in the real rate are triggered by avoidable variations in nominal rates, so that if nominal rates are stabilized, real rates will be stabilized, too. But it may be that real rates are inherently variable and unpredictable. But it is at least plausible to argue that the appropriate monetary policy or monetary regime would result in a stable and predictable path of real and nominal interest rates. However, I find it highly implausible to think that it is within the power of any monetary authority or monetary regime to provide a stable and predictable path for the velocity of money. On the contrary, it seems much more likely that in order to provide stability and predictability in the paths for total spending, the price level, and interest rates, the monetary authority or the monetary regime would have to tolerate substantial variations in the velocity of money associated with changes in the public’s demand to hold money. So the notion that a stable and predictable path for the money stock is a characteristic of macroeconomic stability, much less a condition for monetary stability, strikes me as a complete misconception, a misconception propagated, more than anyone else, by Milton Friedman, himself.

Thus, contrary to Brad’s assertion, a stable and predictable path for the money stock is more likely than not to be a condition not for macroeconomic stability, but of macroeconomic instability. And to support my contention that a stable and predictable path for the money stock is macroeconomically destabilizing, let me quote none other than F. A. Hayek. I quote Hayek not because I think he is more authoritative than Friedman – Hayek having made more than his share of bad macroeconomic policy calls (e.g. his 1932 defense of the insane Bank of France) – but because in his own polite way he simply demolished the fallacy underlying Friedman’s fetish with a fixed rate of growth in the money stock (Full Empoyment at Any Price).

I wish I could share the confidence of my friend Milton Friedman who thinks that one could deprive the monetary authorities, in order to prevent the abuse of their powers for political purposes, of all discretionary powers by prescribing the amount of money they may and should add to circulation in any one year. It seems to me that he regards this as practicable because he has become used for statistical purposes to draw a sharp distinction between what is to be regarded as money and what is not. This distinction does not exist in the real world. I believe that, to ensure the convertibility of all kinds of near-money into real money, which is necessary if we are to avoid severe liquidity crises or panics, the monetary authorities must be given some discretion. But I agree with Friedman that we will have to try and get back to a more or less automatic system for regulating the quantity of money in ordinary times. The necessity of “suspending” Sir Robert Peel’s Bank Act of 1844 three times within 25 years after it was passed ought to have taught us this once and for all.

He was briefer and more pointed in a later comment (Denationalization of Money).

As regards Professor Friedman’s proposal of a legal limit on the rate at which a monopolistic issuer of money was to be allowed to increase the quantity in circulation, I can only say that I would not like to see what would happen if it ever became known that the amount of cash in circulation was approaching the upper limit and that therefore a need for increased liquidity could not be met.

And for good measure, Hayek added this footnote quoting Bagehot:

To such a situation the classic account of Walter Bagehot . . . would apply: “In a sensitive state of the English money market the near approach to the legal limit of reserve would be a sure incentive to panic; if one-third were fixed by law, the moment the banks were close to one-third, alarm would begin and would run like magic.

In other words if 3 is secured by institutions, all hell breaks loose.

But let us follow Brad a bit further in his quixotic quest to make Friedman seem sensible.

Now there are two different institutional setups that can produce (3):

  1. a monetarist central bank committed to targeting a k% growth rate of the money stock via open-market operations; or
  2. a gold standard in which a Humean price-specie flow mechanism leads inflating countries to lose and deflating countries to gain gold, tightly coupled to a banking system in which there is a reliable and stable money multiplier, and thus in which the money stock grows at the rate at which the world’s gold stock grows (plus the velocity trend).

Well, I have just – and not for the first time — disposed of 1, and in my previous post, I have disposed of 2. But having started to repeat myself, why not continue.

There are two points to make about the Humean price-specie-flow mechanism. First, it makes no sense, as Samuelson showed in his classic 1980 paper, inasmuch as it violates arbitrage conditions which do not allow the prices of tradable commodities to differ by more than the costs of transport. The Humean price-specie-flow mechanism presumes that the local domestic price levels are determined by local money supplies (either gold or convertible into gold), but that is simply not possible if arbitrage conditions obtain. There is no price-specie-flow mechanism under the gold standard, there is simply a movement of money sufficient to eliminate excess demands or supplies of money at the constant internationally determined price level. Domestic money supplies are endogenous and prices are (from the point of view of the monetary system) exogenously determined by the value of gold and the exchange rates of the local currencies in terms of gold. There is therefore no stable money multiplier at the level of a national currency (gold or convertible into gold). Friedman’s conception a pure [aka real] gold standard was predicated on a fallacy, namely the price-specie-flow mechanism. No gold standard in history ever operated as Friedman supposed that it operated. There were a few attempts to impose by statutory requirement a 100% (or sometime lower) marginal reserve requirement on banknotes, but that was statutory intervention, not a gold standard, which, at any operational level, is characterized by a fixed exchange rate between gold and the local currency with no restriction on the ability of economic agents to purchase gold at the going market price. the market price, under the gold standard, always equaling (or very closely approximating) the legal exchange rate between gold and the local currency.

Friedman calls (2) a “pure gold standard”. Anything else that claims to be a gold standard is and must be a “pseudo gold standard”. It might be a pseudo gold standard either because something disrupts the Humean price-specie flow mechanism–the “rules of the game” are not obeyed–so that deficit countries do not reliably lose and surplus countries do not reliably gain gold. It might be a pseudo gold standard because the money multiplier is not reliable and stable–because the banking system does not transparently and rapidly transmute a k% shift in the stock of gold into a k% shift in the money stock.

Friedman’s calling (2) “a pure [real] gold standard,” because it actualizes the Humean price-specie-flow-mechanism simply shows that Friedman understood neither the gold standard nor the price-specie-flow mechanism. The supposed rules of the game were designed to make the gold standard function in a particular way. In fact, the evidence shows that the classical gold standard in operation from roughly 1880 to 1914 operated with consistent departures from the “rules of the game.” What allows us to call the monetary regime in operation from 1880 to 1914 a gold standard is not that the rules of the game were observed but that the value of local currencies corresponded to the value of the gold with which they could be freely exchanged at the legal parities. No more and no less. And even Friedman was unwilling to call the gold standard in operation from 1880 to 1914 a pseudo gold standard, because if that was a pseudo-gold standard, there never was a real gold standard. So he was simply talking nonsense when he asserted that during the 1920s there a pseudo gold standard in operation even though gold was freely exchangeable for local currencies at the legal exchange rates.

Or, in short, to Friedman a gold standard is only a real gold standard if it produces a path for the money stock that is a k% rule. Anything else is a pseudo gold standard.

Yes! And that is what Friedman said, and it is absurd. And I am sure that Harry Johnson must have told him so.

The purpose of the paper, in short, is a Talmudic splitting-of-hairs. The point is to allow von Mises and Rueff and their not-so-deep-thinking latter-day followers (paging Paul Ryan! Paging Benn Steil! Paging Charles Koch! Paging Rand Paul!) to remain in their cloud-cuckoo-land of pledging allegiance to the gold standard as a golden calf while at the same time walling them off from and keeping them calm and supportive as the monetarist central bank does its job of keeping our fiat-money system stable by making Say’s Law true enough in practice.

As such, it succeeds admirably.

Or, at least, I think it does…

Have I just given an unconvincing Straussian reading of Friedman–that he knows what he is doing, and that what he is doing is leaving the theoretical husk to the fanatics von Mises and Rueff while keeping the rational kernel for himself, and making the point that a gold standard is a good monetary policy only if it turns out to mimic a good monetarist fiat-money standard policy? That his apparent confusion is simply a way of accomplishing those two tasks without splitting Mont Pelerin of the 1960s into yet more mutually-feuding camps?

I really sympathize with Brad’s effort to recruit Friedman into the worthy cause of combating nonsense. But you can’t combat nonsense with nonsense.

 

Sterilizing Gold Inflows: The Anatomy of a Misconception

In my previous post about Milton Friedman’s problematic distinction between real and pseudo-gold standards, I mentioned that one of the signs that Friedman pointed to in asserting that the Federal Reserve Board in the 1920s was managing a pseudo gold standard was the “sterilization” of gold inflows to the Fed. What Friedman meant by sterilization is that the incremental gold reserves flowing into the Fed did not lead to a commensurate increase in the stock of money held by the public, the failure of the stock of money to increase commensurately with an inflow of gold being the standard understanding of sterilization in the context of the gold standard.

Of course “commensurateness” is in the eye of the beholder. Because Friedman felt that, given the size of the gold inflow, the US money stock did not increase “enough,” he argued that the gold standard in the 1920s did not function as a “real” gold standard would have functioned. Now Friedman’s denial that a gold standard in which gold inflows are sterilized is a “real” gold standard may have been uniquely his own, but his understanding of sterilization was hardly unique; it was widely shared. In fact it was so widely shared that I myself have had to engage in a bit of an intellectual struggle to free myself from its implicit reversal of the causation between money creation and the holding of reserves. For direct evidence of my struggles, see some of my earlier posts on currency manipulation (here, here and here), in which I began by using the concept of sterilization as if it actually made sense in the context of international adjustment, and did not fully grasp that the concept leads only to confusion. In an earlier post about Hayek’s 1932 defense of the insane Bank of France, I did not explicitly refer to sterilization, and got the essential analysis right. Of course Hayek, in his 1932 defense of the Bank of France, was using — whether implicitly or explicitly I don’t recall — the idea of sterilization to defend the Bank of France against critics by showing that the Bank of France was not guilty of sterilization, but Hayek’s criterion for what qualifies as sterilization was stricter than Friedman’s. In any event, it would be fair to say that Friedman’s conception of how the gold standard works was broadly consistent with the general understanding at the time of how the gold standard operates, though, even under the orthodox understanding, he had no basis for asserting that the 1920s gold standard was fraudulent and bogus.

To sort out the multiple layers of confusion operating here, it helps to go back to the classic discussion of international monetary adjustment under a pure gold currency, which was the basis for later discussions of international monetary adjustment under a gold standard (i.e, a paper currency convertible into gold at a fixed exchange rate). I refer to David Hume’s essay “Of the Balance of Trade” in which he argued that there is an equilibrium distribution of gold across different countries, working through a famous thought experiment in which four-fifths of the gold held in Great Britain was annihilated to show that an automatic adjustment process would redistribute the international stock of gold to restore Britain’s equilibrium share of the total world stock of gold.

The adjustment process, which came to be known as the price-specie flow mechanism (PSFM), is widely considered one of Hume’s greatest contributions to economics and to monetary theory. Applying the simple quantity theory of money, Hume argued that the loss of 80% of Britain’s gold stock would mean that prices and wages in Britain would fall by 80%. But with British prices 80% lower than prices elsewhere, Britain would stop importing goods that could now be obtained more cheaply at home than they could be obtained abroad, while foreigners would begin exporting all they could from Britain to take advantage of low British prices. British exports would rise and imports fall, causing an inflow of gold into Britain. But, as gold flowed into Britain, British prices would rise, thereby reducing the British competitive advantage, causing imports to increase and exports to decrease, and consequently reducing the inflow of gold. The adjustment process would continue until British prices and wages had risen to a level equal to that in other countries, thus eliminating the British balance-of-trade surplus and terminating the inflow of gold.

This was a very nice argument, and Hume, a consummate literary stylist, expressed it beautifully. There is only one problem: Hume ignored that the prices of tradable goods (those that can be imported or exported or those that compete with imports and exports) are determined not in isolated domestic markets, but in international markets, so the premise that all British prices, like the British stock of gold, would fall by 80% was clearly wrong. Nevertheless, the disconnect between the simple quantity theory and the idea that the prices of tradable goods are determined in international markets was widely ignored by subsequent writers. Although Adam Smith, David Ricardo, and J. S. Mill avoided the fallacy, but without explicit criticism of Hume, while Henry Thornton, in his great work The Paper Credit of Great Britain, alternately embraced it and rejected it, the Humean analysis, by the end of the nineteenth century, if not earlier, had become the established orthodoxy.

Towards the middle of the nineteenth century, there was a famous series of controversies over the Bank Charter Act of 1844, in which two groups of economists the Currency School in support and the Banking School in opposition argued about the key provisions of the Act: to centralize the issue of Banknotes in Great Britain within the Bank of England and to prohibit the Bank of England from issuing additional banknotes, beyond the fixed quantity of “unbacked” notes (i.e. without gold cover) already in circulation, unless the additional banknotes were issued in exchange for a corresponding amount of gold coin or bullion. In other words, the Bank Charter Act imposed a 100% marginal reserve requirement on the issue of additional banknotes by the Bank of England, thereby codifying what was then known as the Currency Principle, the idea being that the fluctuation in the total quantity of Banknotes ought to track exactly the Humean mechanism in which the quantity of money in circulation changes pound for pound with the import or export of gold.

The doctrinal history of the controversies about the Bank Charter Act are very confused, and I have written about them at length in several papers (this, this, and this) and in my book on free banking, so I don’t want to go over that ground again here. But until the advent of the monetary approach to the balance of payments in the late 1960s and early 1970s, the thinking of the economics profession about monetary adjustment under the gold standard was largely in a state of confusion, the underlying fallacy of PSFM having remained largely unrecognized. One of the few who avoided the confusion was R. G. Hawtrey, who had anticipated all the important elements of the monetary approach to the balance of payments, but whose work had been largely forgotten in the wake of the General Theory.

Two important papers changed the landscape. The first was a 1976 paper by Donald McCloskey and Richard Zecher “How the Gold Standard Really Worked” which explained that a whole slew of supposed anomalies in the empirical literature on the gold standard were easily explained if the Humean PSFM was disregarded. The second was Paul Samuelson’s 1980 paper “A Corrected Version of Hume’s Equilibrating Mechanisms for International Trade,” showing that the change in relative price levels — the mechanism whereby international monetary equilibrium is supposedly restored according to PSFM — is irrelevant to the adjustment process when arbitrage constraints on tradable goods are effective. The burden of the adjustment is carried by changes in spending patterns that restore desired asset holdings to their equilibrium levels, independently of relative-price-level effects. Samuelson further showed that even when, owing to the existence of non-tradable goods, there are relative-price-level effects, those effects are irrelevant to the adjustment process that restores equilibrium.

What was missing from Hume’s analysis was the concept of a demand to hold money (or gold). The difference between desired and actual holdings of cash imply corresponding changes in expenditure, and those changes in expenditure restore equilibrium in money (gold) holdings independent of any price effects. Lacking any theory of the demand to hold money (or gold), Hume had to rely on a price-level adjustment to explain how equilibrium is restored after a change in the quantity of gold in one country. Hume’s misstep set monetary economics off on a two-century detour, avoided by only a relative handful of economists, in explaining the process of international adjustment.

So historically there have been two paradigms of international adjustment under the gold standard: 1) the better-known, but incorrect, Humean PSFM based on relative-price-level differences which induce self-correcting gold flows that, in turn, are supposed to eliminate the price-level differences, and 2) the not-so-well-known, but correct, arbitrage-monetary-adjustment theory. Under the PSFM, the adjustment can occur only if gold flows give rise to relative-price-level adjustments. But, under PSFM, for those relative-price-level adjustments to occur, gold flows have to change the domestic money stock, because it is the quantity of domestic money that governs the domestic price level.

That is why if you believe, as Milton Friedman did, in PSFM, sterilization is such a big deal. Relative domestic price levels are correlated with relative domestic money stocks, so if a gold inflow into a country does not change its domestic money stock, the necessary increase in the relative price level of the country receiving the gold inflow cannot occur. The “automatic” adjustment mechanism under the gold standard has been blocked, implying that if there is sterilization, the gold standard is rendered fraudulent.

But we now know that that is not how the gold standard works. The point of gold flows was not to change relative price levels. International adjustment required changes in domestic money supplies to be sure, but, under the gold standard, changes in domestic money supplies are essentially unavoidable. Thus, in his 1932 defense of the insane Bank of France, Hayek pointed out that the domestic quantity of money had in fact increased in France along with French gold holdings. To Hayek, this meant that the Bank of France was not sterilizing the gold inflow. Friedman would have said that, given the gold inflow, the French money stock ought to have increased by a far larger amount than it actually did.

Neither Hayek nor Friedman understood what was happening. The French public wanted to increase their holdings of money. Because the French government imposed high gold reserve requirements (but less than 100%) on the creation of French banknotes and deposits, increasing holdings of money required the French to restrict their spending sufficiently to create a balance-of-trade surplus large enough to induce the inflow of gold needed to satisfy the reserve requirements on the desired increase in cash holdings. The direction of causation was exactly the opposite of what Friedman thought. It was the desired increase in the amount of francs that the French wanted to hold that (given the level of gold reserve requirements) induced the increase in French gold holdings.

But this doesn’t mean, as Hayek argued, that the insane Bank of France was not wreaking havoc on the international monetary system. By advocating a banking law that imposed very high gold reserve requirements and by insisting on redeeming almost all of its non-gold foreign exchange reserves into gold bullion, the insane Bank of France, along with the clueless Federal Reserve, generated a huge increase in the international monetary demand for gold, which was the proximate cause of the worldwide deflation that began in 1929 and continued till 1933. The problem was not a misalignment between relative price levels, which is sterilization supposedly causes; the problem was a worldwide deflation that afflicted all countries on the gold standard, and was avoidable only by escaping from the gold standard.

At any rate, the concept of sterilization does nothing to enhance our understanding of that deflationary process. And whatever defects there were in the way that central banks were operating under the gold standard in the 1920s, the concept of sterilization averts attention from the critical problem which was the increasing demand of the world’s central banks, especially the Bank of France and the Federal Reserve, for gold reserves.

Real and Pseudo Gold Standards: Could Friedman Tell the Difference?

One of the first academic papers by Milton Friedman that I read was “Real and Pseudo Gold Standards.” It’s an interesting paper presented to the Mont Pelerin Society in September 1961 and published in the Journal of Law and Economics in October 1961. That it was published in the Journal of Law and Economics, then edited by Friedman’s colleague at Chicago (and fellow Mont Pelerin member) Ronald Coase, is itself interesting, that estimable journal hardly being an obvious place to publish research on monetary economics. But the point of the paper was not to advance new theoretical insights about monetary theory, though he did provide a short preview of his critique of Fed policy in the 1920-21 Depression and in the Great Depression that he and Anna Schwartz would make in their soon to be published Monetary History of the United States, but to defend Friedman’s pro-fiat money position as a respectable alternative among the libertarians and classical liberals with whom Friedman had allied himself in the Mont Pelerin Society.

Although many members of the Mont Pelerin Society, including Hayek himself, as well as Friedman, Fritz Machlup and Lionel Robbins no longer supported the gold standard, their reasons for doing so were largely pragmatic, believing that whatever its virtues, the gold standard was no longer a realistic or even a desirable option as a national or an international monetary system. But there was another, perhaps more numerous, faction within the Mont Pelerin Society and the wider libertarian/ classical-liberal community, that disdained any monetary system other than the gold standard. The intellectual leader of this group was of course the soul of intransigence, the unyieldingly stubborn Ludwig von Mises, notably supported by the almost equally intransigent French economist Jacques Rueff, whose attachment to gold was so intense that Charles de Gaulle, another in a long line of French politicians enchanted by the yellow metal, had chosen Rueff as his personal economic adviser.

What Friedman did in this essay was not to engage with von Mises on the question of the gold standard; Friedman was realistic enough to understand that one could not reason with von Mises, who anyway regarded Friedman, as he probably did most of the members of the Mont Pelerin Society, as hardly better than a socialist. Instead, his strategy was to say that there is only one kind of real gold standard – presumably the kind favored by von Mises, whose name went unmentioned by Friedman, anything else being a pseudo-gold standard — in reality, nothing but a form of price fixing in which the government sets the price of gold and manages the gold market to prevent the demand for gold from outstripping the supply. While Friedman acknowledged that a real gold standard could be defended on strictly libertarian grounds, he argued that a pseudo-gold standard could not, inasmuch as it requires all sorts of market interventions, especially restrictions on the private ownership of gold that were then in place. What Friedman was saying, in effect, to the middle group in the Mont Pelerin Society was the only alternatives for liberals and libertarians were a gold standard of the Mises type or his preference: a fiat standard with flexible exchange rates.

Here is how he put it:

It is vitally important for the preservation and promotion of a free society that we recognize the difference between a real and pseudo gold standard. War aside, nothing that has occurred in the past half-century has, in my view, done more weaken and undermine the public’s faith in liberal principles than the pseudo gold standard that has intermittently prevailed and the actions that have been taken in its name. I believe that those of us who support it in the belief that it either is or will tend to be a real gold standard are mistakenly fostering trends the outcome of which they will be among the first to deplore.

This is a sweeping charge, so let me document it by a few examples which will incidentally illustrate the difference between a real and a pseudo gold standard before turning to an explicit discussion of the difference.

So what were Friedman’s examples of a pseudo gold standard? He offered five. First, US monetary policy after World War I, in particular the rapid inflation of 1919 and the depression of 1920-21. Second, US monetary policy in the 1920s and the British return to gold. Third, US monetary policy in the 1931-33 period. Fourth the U.S. nationalization of gold in 1934. And fifth, the International Monetary Fund and post-World War II exchange-rate policy.

Just to digress for a moment, I will admit that when I first read this paper as an undergraduate I was deeply impressed by his introductory statement, but found much of the rest of the paper incomprehensible. Still awestruck by Friedman, who, I then believed, was the greatest economist alive, I attributed my inability to follow what he was saying to my own intellectual shortcomings. So I have to admit to taking a bit of satisfaction in now being able to demonstrate that Friedman literally did not know what he was talking about.

US Monetary Policy after World War I

Friedman’s discussion of monetary policy after WWI begins strangely as if he were cutting and pasting from another source without providing any background to the discussion. I suspected that he might have cut and pasted from the Monetary History, but that turned out not to be the case. However, I did find that this paragraph (and probably a lot more] was included in testimony he gave to the Joint Economic Committee.

Nearly half of the monetary expansion in the United States came after the end of the war, thanks to the acquiescence of the Federal Reserve System in the Treasury’s desire to avoid a fall in the price of government securities. This expansion, with its accompanying price inflation, led to an outflow of gold despite the great demand for United States goods from a war-ravaged world and despite the departure of most countries from any fixed parity between their currencies and either gold or the dollar.

Friedman, usually a very careful writer, refers to “half of the monetary expansion” without identifying in any way “the monetary expansion” that he is referring to, leaving it to the reader to conjecture whether he is talking about the monetary expansion that began with the start of World War I in 1914 or the monetary expansion that began with US entry into the war in 1917 or the monetary expansion associated with some other time period. Friedman then goes on to describe the transition from inflation to deflation.

Beginning in late 1919, then more sharply in January 1920 and May 1920, the Federal Reserve System took vigorous deflationary steps that produced first a slackening of the growth of money and then a sharp decline. These brought in their train a collapse in wholesale prices and a severe economic contraction. The near halving of wholesale prices in a twelve month period was by all odds the most rapid price decline ever experienced in the United States before or since. It was not of course confined to the United States but spread to all countries whose money was linked to the dollar either by having a fixed price in terms of gold or by central bank policies directed at maintaining rigid or nearly rigid exchange rates.

That is a fair description of what happened after the Fed took vigorous deflationary steps, notably raising its discount rate to 6%. What Friedman neglects to point out is that there was no international gold standard (real or pseudo) immediately after the war, because only the United States was buying and selling gold at a legally established gold parity. Friedman then goes on to compare the pseudo gold standard under which the US was then operating with what would have happened under a real gold standard.

Under a real gold standard, the large inflow of gold up to the entry of the United States into the war would have produced a price rise to the end of the war similar to that actually experienced.

Now, aside from asserting that under a real gold standard, gold is used as money, and that under a pseudo gold standard, government is engaged in fixing the price of gold, Friedman has not told us how to distinguish between a real and a pseudo gold standard. So it is certainly fair to ask whether in the passage just quoted Friedman meant that the gold standard under which the US was operating when there was a large inflow of gold before entering the war was real or pseudo. His use of the subjunctive verb “would have produced” suggests that he believed that the gold standard was pseudo, not real. But then he immediately says that, under the real gold standard, the “price rise to the end of the war” would have been “similar to that actually experienced.” So take your pick.

Evidently, the difference between a real and a pseudo gold standard became relevant only after the war was over.

But neither the postwar rise nor the subsequent collapse would have occurred. Instead, there would have been an earlier and milder price decline as the belligerent nations returned to a peacetime economy. The postwar increase in the stock of money occurred only because the Reserve System had been given discretionary power to “manage” the stock of money, and the subsequent collapse occurred only because this power to manage the money had been accompanied by gold reserve requirements as one among several masters the System was instructed to serve.

That’s nice, but Friedman has not even suggested, much less demonstrated in any way, how all of this is related to the difference between a real and a pseudo gold standard. Was there any postwar restriction on the buying or selling of gold by private individuals? Friedman doesn’t say. All he can come up with is the idea that the Fed had been given “discretionary power to ‘manage’ the stock of money.” Who gave the Fed this power? And how was this power exercised? He refers to gold reserve requirements, but gold reserve requirements – whether they were a good idea or not is not my concern here — existed before the Fed came into existence.

If the Fed had unusual powers after World War I, those powers were not magically conferred by some unidentified entity, but by the circumstance that the US had accumulated about 40% of the world’s monetary gold reserves during World War I, and was the only country, after the war, that was buying and selling gold freely at a fixed price ($20.67 an ounce). The US was therefore in a position to determine the value of gold either by accumulating more gold or by allowing an efflux of gold from its reserves. Whether the US was emitting or accumulating gold depended on the  interest-rate policy of the Federal Reserve. It is true that the enormous control the US then had over the value of gold was a unique circumstance in world history, but the artificial and tendentious distinction between a real and a pseudo gold standard has absolutely nothing to do with the inflation in 1919 or the deflation in 1920-21.

US Monetary Policy in the 1920s and Britain’s Return to Gold

In the next section Friedman continues his critical review of Fed policy in the 1920s, defending the Fed against the charge (a staple of Austrian Business Cycle Theory and other ill-informed and misguided critics) that it fueled a credit boom during the 1920s. On the contrary, Friedman shows that Fed policy was generally on the restrictive side.

I do not myself believe that the 1929-33 contraction was an inevitable result of the monetary policy of the 1920s or even owed much to it. What was wrong was the policy followed from 1929 to 1933. . . . But internationally, the policy was little short of catastrophic. Much has been made of Britain’s mistake in returning to gold in 1925 at a parity that overvalued the pound. I do not doubt that this was a mistake – but only because the United States was maintaining a pseudo gold standard. Had the United States been maintaining a real gold standard, the stock of money would have risen more in the United States than it did, prices would have been stable or rising instead of declining, the United States would have gained less gold or lost some, and the pressure on the pound would have been enormously eased. As it was by sterilizing gold, the United States forced the whole burden of adapting to gold movements on other countries. When, in addition, France adopted a pseudo gold standard at a parity that undervalued the franc and proceeded also to follow a gold sterilization policy, the combined effect was to make Britain’s position untenable.

This is actually a largely coherent paragraph, more or less correctly diagnosing the adverse consequences of an overly restrictive policy adopted by the Fed for most of the 1920s. What is not coherent is the attempt to attribute policy choices of which Friedman (and I) disapprove to the unrealness of the gold standard. There was nothing unreal about the gold standard as it was operated by the Fed in the 1920s. The Fed stood ready to buy and sell gold at the official price, and Friedman does not even suggest that there was any lapse in that commitment.

So what was the basis for Friedman’s charge that the 1920s gold standard was fake or fraudulent? Friedman says that if there had been a real, not a pseudo, gold standard, “the stock of money would have risen more in the United States than it did, prices would have been stable or rising instead of declining,” and the US “would have gained less gold or lost some.” That this did not happen, Friedman attributes to a “gold sterilization policy” followed by the US. Friedman is confused on two levels. First, he seems to believe that the quantity of money in the US was determined by the Fed. However, under a fixed-exchange-rate regime, the US money supply was determined endogenously via the balance of payments. What the Fed could determine by setting its interest rate was simply whether gold would flow into or out of US reserves. The level of US prices was determined by the internationally determined value of gold. Whether gold was flowing into or out of US reserves, in turn, determined the value of gold was rising or falling, and, correspondingly, whether prices in terms of gold were falling or rising. If the Fed had set interest rates somewhat lower than they did, gold would have flowed out of US reserves, the value of gold would have declined and prices in terms of gold would have risen, thereby easing deflationary pressure on Great Britain occasioned by an overvalued sterling-dollar exchange rate. I have no doubt that the Fed was keeping its interest rate too high for most of the 1920s, but why a mistaken interest-rate policy implies a fraudulent gold standard is not explained. Friedman, like his nemesis von Mises, simply asserted his conclusion or his definition, and expected his listeners and readers to nod in agreement.

US Monetary Policy in the 1931-33 Period

In this section Friedman undertakes his now familiar excoriation of Fed inaction to alleviate the banking crises that began in September 1931 and continued till March 1933. Much, if not all, of Friedman’s condemnation of the Fed is justified, though his failure to understand the international nature of the crisis caused him to assume that the Fed could have prevented a deflation caused by a rising value of gold simply by preventing bank failures. There are a number of logical gaps in that argument, and Friedman failed to address them, simply assuming that US prices were determined by the US money stock even though the US was still operating on the gold standard and the internationally determined value of gold was rising.

But in condemning the Fed’s policy in failing to accommodate an internal drain at the first outbreak of domestic banking crises in September 1931, Friedman observes:

Prior to September 1931, the System had been gaining gold, the monetary gold stock was at an all-time high, and the System’s gold reserve ratio was far above its legal minimum – a reflection of course of its not having operated in accordance with a real gold standard.

Again Friedman is saying that the criterion for identifying whether the gold standard is real or fraudulent is whether policy makers make the correct policy decision, if they make a mistake, it means that the gold standard in operation is no longer a real gold standard; it has become a pseudo gold standard.

The System had ample reserves to meet the gold outflow without difficulty and without resort to deflationary measures. And both its own earlier policy and the classical gold-standard rules as enshrined by Bagehot called for its doing so: the gold outflow was strictly speculative and motivated by fear that the United States would go off gold; the outflow had no basis in any trade imbalance; it would have exhausted itself promptly if all demands had been met.

Thus, Friedman, who just three pages earlier had asserted that the gold standard became a pseudo gold standard when the managers of the Federal Reserve System were given discretionary powers to manage the stock of money, now suggests that a gold standard can also be made a pseudo gold standard if the monetary authority fails to exercise its discretionary powers.

US Nationalization of Gold in 1934

The nationalization of gold by FDR effectively ended the gold standard in the US. Nevertheless, Friedman was so enamored of the distinction between real and pseudo gold standards that he tried to portray US monetary arrangements after the nationalization of gold as a pseudo gold standard even though the gold standard had been effectively nullified. But at least, the distinction between what is real and what is fraudulent about the gold standard is now based on an objective legal and institutional fact: the general right to buy gold from (or sell gold to) the government at a fixed price whenever government offices are open for business. Similarly after World War II, only the US government had any legal obligation to sell gold at the official price, but there was only a very select group of individuals and governments who were entitled to buy gold from the US government. Even to call such an arrangement a pseudo gold standard seems like a big stretch, but there is nothing seriously wrong with calling it a pseudo gold standard. But I have no real problem with Friedman’s denial that there was a true gold standard in operation after the nationalization of gold in 1934.

I would also agree that there really was not a gold standard in operation after the US entered World War I, because the US stopped selling gold after the War started. In fact, a pseudo gold standard is a good way to characterize the status of the gold standard during World War I, because the legal price of gold was not changed in any of the belligerent countries, but it was understood that for a private citizen to try to redeem currency for gold at the official price would be considered a reprehensible act, something almost no one was willing to do. But to assert, as Friedman did, that even when the basic right to buy gold at the official price was routinely exercised, a real gold standard was not necessarily in operation, is simply incoherent, or sophistical. Take your pick.

Misunderstanding (Totally!) Competitive Currency Devaluations

Before becoming Governor of the Resesrve Bank of India, Raghuram Rajan professor was Professor of Finance at the University of Chicago Business School. Winner of the Fischer Black Prize in 2003, he is the author numerous articles in leading academic journals in economics and finance, and co-author (with Luigi Zingales) of a well-regarded book Saving Capitalism from the Capitalists that had some valuable insights about financial-market dysfunction. He is obviously no slouch.

Unfortunately, based on recent reports, Goverenor Rajan is, despite his impressive resume and academic credentials, as Marcus Nunes pointed out on his blog, totally clueless about the role of monetary policy and the art of central banking in combating depressions. Here is the evidence provided by none other than the Wall Street Journal, a newspaper whose editorial page espouses roughly the same view as Rajan, summarizing Rajan’s remarks.

Reserve Bank of India Governor Raghuram Rajan warned Wednesday that the global economy bears an increasing resemblance to its condition in the 1930s, with advanced economies trying to pull out of the Great Recession at each other’s expense.

The difference: competitive monetary policy easing has now taken the place of competitive currency devaluations as the favored tool for playing a zero-sum game that is bound to end in disaster. Now, as then, “demand shifting” has taken the place of “demand creation,” the Indian policymaker said.

A clear symptom of the major imbalances crippling the world’s financial market is the over valuation of the euro, Mr. Rajan said.

The euro-zone economy faces problems similar to those faced by developing economies, with the European Central Bank’s “very, very accommodative stance” having a reduced impact due to the ultra-loose monetary policies being pursued by other central banks, including the Federal Reserve, the Bank of Japan and the Bank of England.

The notion that competitive currency devaluations in the Great Depression were a zero-sum game is fallacy, an influential fallacy to be sure, but a fallacy nonetheless. And because it is – and was — so influential, it is a highly dangerous fallacy. There is indeed a similarity between the current situation and the 1930s, but the similarity is not that monetary ease is a zero-sum game that merely “shifts,” but does not “create,” demand; the similarity is that the fallacious notion that monetary ease does not create demand is still so prevalent.

The classic refutation of the fallacy that monetary ease only shifts, but does not create, demand was provided on numerous occasions by R. G. Hawtrey. Almost two and a half years ago, I quoted a particularly cogent passage from Hawtrey’s Trade Depression and the Way Out (2nd edition, 1933) in which he addressed the demand-shift fallacy. Hawtrey refuted the fallacy in responding to those who were arguing that Britain’s abandonment of the gold standard in September 1931 had failed to stimulate the British economy, and had damaged the world economy, because prices continued falling after Britain left the gold standard. Hawtrey first discussed the reasons for the drop in the world price level after Britain gave up the gold standard.

When Great Britain left the gold standard, deflationary measures were everywhere resorted to. Not only did the Bank of England raise its rate, but the tremendous withdrawals of gold from the United States involved an increase of rediscounts and a rise of rates there, and the gold that reached Europe was immobilized or hoarded. . . .

In other words, Britain’s departure from the gold standard led to speculation that the US would follow Britain off the gold standard, implying an increase in the demand to hoard gold before the anticipated increase in its dollar price. That is a typical reaction under the gold standard when the probability of a devaluation is perceived to have risen. By leaving gold, Britain increased the perceived probability that other countries, and especially the US, would also leave the gold standard.

The consequence was that the fall in the price level continued [because an increase in the demand to hold gold (for any reason including speculation on a future increase in the nominal price of gold) must raise the current value of gold relative to all other commodities which means that the price of other commodities in terms of gold must fall -- DG]. The British price level rose in the first few weeks after the suspension of the gold standard [because the value of the pound was falling relative to gold, implying that prices in terms of pounds rose immediately after Britain left gold -- DG], but then accompanied the gold price level in its downward trend [because after the initial fall in the value of the pound relative to gold, the pound stabilized while the real value of gold continued to rise -- DG]. This fall of prices calls for no other explanation than the deflationary measures which had been imposed [alarmed at the rapid fall in the value of gold, the Bank of England raised interest rates to prevent further depreciation in sterling -- DG]. Indeed what does demand explanation is the moderation of the fall, which was on the whole not so steep after September 1931 as before.

Yet when the commercial and financial world saw that gold prices were falling rather than sterling prices rising, they evolved the purely empirical conclusion that a depreciation of the pound had no effect in raising the price level, but that it caused the price level in terms of gold and of those currencies in relation to which the pound depreciated to fall.

Here Hawtrey identified precisely the demand-shift fallacy evidently now subscribed to by Governor Rajan. In other words, when Britain left the gold standard, Britain did nothing to raise the international level of prices, which, under the gold standard, is the level of prices measured in terms of gold. Britain may have achieved a slight increase in its own domestic price level, but only by imposing a corresponding reduction in the price level measured in terms of gold. Let’s see how Hawtrey demolishes the fallacy.

For any such conclusion there was no foundation. Whenever the gold price level tended to fall, the tendency would make itself felt in a fall in the pound concurrently with the fall in commodities. [Hawtrey is saying that if the gold price level fell, while the sterling price level remained constant, the value of sterling would also fall in terms of gold. -- DG] But it would be quite unwarrantable to infer that the fall in the pound was the cause of the fall in commodities.

On the other hand, there is no doubt that the depreciation of any currency, by reducing the cost of manufacture in the country concerned in terms of gold, tends to lower the gold prices of manufactured goods. . . . [In other words, the cost of production of manufactured goods, which include both raw materials – raw materials often being imported -- and capital equipment and labor, which generally are not mobile, is unlikely to rise as much in percentage terms as the percentage depreciation in the currency. -- DG]

But that is quite a different thing from lowering the price level. For the fall in manufacturing costs results in a greater demand for manufactured goods, and therefore the derivative demand for primary products is increased. [That is to say, if manufactured products become relatively cheaper as the currency depreciates, the real quantity of manufactured goods demanded will increase, and the real quantity of inputs used to produce the increased quantity of manufactured goods must also increase. -- DG] While the prices of finished goods fall, the prices of primary products rise. Whether the price level as a whole would rise or fall it is not possible to say a priori, but the tendency is toward correcting the disparity between the price levels of finished products and primary products. That is a step towards equilibrium. And there is on the whole an increase of productive activity. The competition of the country which depreciates its currency will result in some reduction of output from the manufacturing industry of other countries. But this reduction will be less than the increase in the country’s output, for if there were no net increase in the world’s output there would be no fall of prices. [Thus, even though there is some demand shifting toward the country that depreciates its currency because its products become relatively cheaper than the products of non-depreciating currencies, the cost reduction favoring the output of the country with a depreciating currency could not cause an overall reduction in prices elsewhere if total output had not increased. -- DG]

Hawtrey then articulates the policy implication of the demand-shift fallacy.

In consequence of the competitive advantage gained by a country’s manufacturers from a depreciation of its currency, any such depreciation is only too likely to meet with recriminations and even retaliation from its competitors. . . . Fears are even expressed that if one country starts depreciation, and others follow suit, there may result “a competitive depreciation” to which no end can be seen.

This competitive depreciation is an entirely imaginary danger. The benefit that a country derives from the depreciation of its currency is in the rise of its price level relative to its wage level, and does not depend on its competitive advantage. [There is a slight ambiguity here, because Hawtrey admitted above that there is a demand shift. But there is also an increase in demand, and it is the increase in demand, associated with a rise of its price level relative to its wage level, which does not depend on a competitive advantage associated with a demand shift. -- DG] If other countries depreciate their currencies, its competitive advantage is destroyed, but the advantage of the price level remains both to it and to them. They in turn may carry the depreciation further, and gain a competitive advantage. But this race in depreciation reaches a natural limit when the fall in wages and in the prices of manufactured goods in terms of gold has gone so far in all the countries concerned as to regain the normal relation with the prices of primary products. When that occurs, the depression is over, and industry is everywhere remunerative and fully employed. Any countries that lag behind in the race will suffer from unemployment in their manufacturing industry. But the remedy lies in their own hands; all they have to do is to depreciate their currencies to the extent necessary to make the price level remunerative to their industry. Their tardiness does not benefit their competitors, once these latter are employed up to capacity. Indeed, if the countries that hang back are an important part of the world’s economic system, the result must be to leave the disparity of price levels partly uncorrected, with undesirable consequences to everybody. . . .

The picture of an endless competition in currency depreciation is completely misleading. The race of depreciation is towards a definite goal; it is a competitive return to equilibrium. The situation is like that of a fishing fleet threatened with a storm; no harm is done if their return to a harbor of refuge is “competitive.” Let them race; the sooner they get there the better. (pp. 154-57)

Hawtrey’s analysis of competitive depreciation can be further elucidated by reconsidering it in the light of Max Corden’s classic analysis of exchange-rate protection, which I have discussed several times on this blog (here, here, and here). Corden provided a deep analysis of the conditions under which exchange-rate depreciation confers a competitive advantage. For internationally traded commodities, it is hard to see how any advantage can be derived from currency manipulation. A change in the exchange rate would be rapidly offset by corresponding changes in the prices of the relevant products. However, factors of production like labor, land, and capital equipment, tend to be immobile so their prices in the local currency don’t necessarily adjust immediately to changes in exchange rate of the local currency. Hawtrey was clearly assuming that labor and capital are not tradable so that international arbitrage does not induce immediate adjusments in their prices. Also, Hawtrey’s analysis begins from a state of disequilibrirum, while Corden’s starts from equilibrium, a very important difference.

However, even if prices of non-tradable commodities and factors of production don’t immediately adjust to exchange-rate changes, there is another mechanism operating to eliminate any competitive advantage, which is that the inflow of foreign-exchange reserves into a country with an undervalued currency (and, thus, a competitive advantage) will normally induce monetary expansion in that country, thereby raising the prices of non-tradables and factors of production. What Corden showed was that a central bank willing to tolerate a sufficiently large expansion in its foreign-reserve holdings could keep its currency undervalued, thereby maintaining a competitive advantage for its country in world markets.

But the corollary to Corden’s analysis is that to gain competitive advantage from currency depreciation requires the central bank to maintain monetary stringency (a chronic excess demand for money thus requiring a corresponding export surplus) and a continuing accumulation of foreign exchange reserves. If central banks are pursuing competitive monetary easing, which Governor Rajan likens to competitive exchange-rate depreciation aimed at shifting, not expanding, total demand, he is obviously getting worked up over nothing, because Corden demonstrated 30 years ago that a necessary condition for competitive exchange-rate depreciation is monetary tightness, not monetary ease.

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.


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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