Archive for the 'Great Depression' Category

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.

James Grant on Irving Fisher and the Great Depression

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

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

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

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

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

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

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

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

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

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

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

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

What Makes Deflation Good?

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

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

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

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

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

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

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

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

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

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

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

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

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

Eureka! Paul Krugman Discovers the Bank of France

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

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

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

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

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

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

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

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

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

Krugman concludes by comparing Germany today with France in 1930.

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

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

HT: ChargerCarl

A New Paper Shows Just How Right Hawtrey and Cassel Were

I was pleasantly surprised to receive an email a couple of weeks ago from someone I don’t know, a graduate student in economics at George Mason University, James Caton. He sent me a link to a paper (“Good as Gold?: A Quantitative Analysis of Hawtrey and Cassel’s Theory of Gold Demand and the Gold Price Level During the Interwar Period”) that he recently posted on SSRN. Caton was kind enough to credit me and my co-author Ron Batchelder, as well as Doug Irwin (here and here) and Scott Sumner, for reviving interest in the seminal work of Ralph Hawtrey and Gustav Cassel on the interwar gold standard and the key role in causing the Great Depression played by the process of restoring the gold standard after it had been effectively suspended after World War I began.

The thesis independently, but cooperatively, advanced by Hawtrey and Cassel was that under a gold standard, fluctuations in the gold price level were sensitive to variations in the demand for gold reserves by the central banks. The main contribution of Caton’s paper is to provide econometric evidence of the tight correlation between variations in the total gold holdings of the world’s central banks and the gold price level in the period between the end of World War I (1918) to the start of Great Depression (1930-32). Caton uses a variation on a model used by Scott Sumner in his empirical work on the Great Depression to predict changes in the value of gold, and, hence, changes in the gold price level of commodities. If central banks in the aggregate are adding to their gold reserves at a faster rate than the rate at which the total world stock of gold is growing, then gold would be likely to appreciate, and if central banks are adding to their gold reserves at a slower rate than that at which the world stock is growing, then gold would be likely to depreciate.

So from the published sources, Caton constructed a time series of international monetary gold holdings and the total world stock of gold from 1918 to 1932 and regressed the international gold price level on the international gold reserve ratio (the ratio of monetary gold reserves to the total world stock of gold). He used two different measures of the world gold price level, the Sauerback-Statist price index and the gold price of silver. Based on his regressions (calculated in both log-linear and log-quadratic forms and separately for the periods 1918-30, 1918-31, 1918-32), he compared the predicted gold price level against both the Sauerback-Statist price index and the gold price of silver. The chart below shows his result for the log-linear regression estimated over the period 1918-30.

Caton_Regressions

Pretty impressive, if you ask me. Have a look yourself.

Let me also mention that Caton’s results also shed important light on the puzzling behavior of the world price level immediately after the end of World War I. Unlike most wars in which the wartime inflation comes to an abrupt end after the end of the war, inflation actually accelerated after the end of the war. The inflation did not actually stop for almost two years after the end of the war, when a huge deflation set in. Caton shows that the behavior of the price level was largely determined by the declining gold holdings of the Federal Reserve after the war ended. Unnerved by the rapid inflation, the Fed finally changed policy, and began accumulating gold rapidly in 1920 by raising the discount rate to an all-time high of 7 percent. Although no other countries were then on the gold standard, other countries, unwilling, for the most part, to allow their currencies to depreciate too much against the dollar, imported US deflation.

Jim is also a blogger. Check out his blog here.

Update: Thanks to commenter Blue Aurora for pointing out that I neglected to provide a link to Jim Caton’s paper.  Sorry about that. The link is now embedded.

Why Hawtrey and Cassel Trump Friedman and Schwartz

This year is almost two-thirds over, and I still have yet to start writing about one of the two great anniversaries monetary economists are (or should be) celebrating this year. The one that they are already celebrating is the fiftieth anniversary of the publication of The Monetary History of the United States 1867-1960 by Milton Friedman and Anna Schwartz; the one that they should also be celebrating is the 100th anniversary of Good and Bad Trade by Ralph Hawtrey. I am supposed to present a paper to mark the latter anniversary at the Southern Economic Association meetings in November, and I really have to start working on that paper, which I am planning to do by writing a series of posts about the book over the next several weeks.

Good and Bad Trade was Hawtrey’s first publication about economics. He was 34 years old, and had already been working at the Treasury for nearly a decade. Though a Cambridge graduate (in mathematics), Hawtrey was an autodidact in economics, so it is really a mistake to view him as a Cambridge economist. In Good and Bad Trade, he developed a credit theory of money (money as a standard of value in terms of which to discharge debts) in the course of presenting his purely monetary theory of the business cycle, one of the first and most original instances of such a theory. The originality lay in his description of the transmission mechanism by which money — actually the interest rate at which money is lent by banks — influences economic activity, through the planned accumulation or reduction of inventory holdings by traders and middlemen in response to changes in the interest rate at which they can borrow funds. Accumulation of inventories leads to cumulative increases of output and income; reductions in inventories lead to cumulative decreases in output and income. The business cycle (under a gold standard) therefore was driven by changes in bank lending rates in response to changes in lending rate of the central bank. That rate, or Bank Rate, as Hawtrey called it, was governed by the demand of the central bank for gold reserves. A desire to increase gold reserves would call for an increase in Bank Rate, and a willingness to reduce reserves would lead to a reduction in Bank Rate. The basic model presented in Good and Bad Trade was, with minor adjustments and refinements, pretty much the same model that Hawtrey used for the next 60 years, 1971 being the year of his final publication.

But in juxtaposing Hawtrey with Friedman and Schwartz, I really don’t mean to highlight Hawtrey’s theory of the business cycle, important though it may be in its own right, but his explanation of the Great Depression. And the important thing to remember about Hawtrey’s explanation for the Great Depression (the same explanation provided at about the same time by Gustav Cassel who deserves equal credit for diagnosing and explaining the problem both prospectively and retrospectively as explained in my paper with Ron Batchelder and by Doug Irwin in this paper) is that he did not regard the Great Depression as a business-cycle episode, i.e., a recurring phenomenon of economic life under a functioning gold standard with a central bank trying to manage its holdings of gold reserves through manipulation of Bank Rate. The typical business-cycle downturn described by Hawtrey was caused by a central bank responding to a drain on its gold reserves (usually because expanding output and income increased the internal monetary demand for gold to be used as hand-to-hand currency) by raising Bank Rate. What happened in the Great Depression was not a typical business-cycle downturn; it was characteristic of a systemic breakdown in the gold standard. In his 1919 article on the gold standard, Hawtrey described the danger facing the world as it faced the task of reconstructing the international gold standard that had been effectively destroyed by World War I.

We have already observed that the displacement of vast quantities of gold from circulation in Europe has greatly depressed the world value of gold in relation to commodities. Suppose that in a few years’ time the gold standard is restored to practically universal use. If the former currency systems are revived, and with them the old demands for gold, both for circulation in coin and for reserves against note issues, the value of gold in terms of commodities will go up. In proportion as it goes up, the difficulty of regaining or maintaining the gold standard will be accentuated. In other words, if the countries which are striving to recover the gold standard compete with one another for the existing supply of gold, they will drive up the world value of gold, and will find themselves burdened with a much more severe task of deflation than they ever anticipated.

And at the present time the situation is complicated by the portentous burden of the national debts. Except for America and this country, none of the principal participants in the war can see clearly the way to solvency. Even we, with taxation at war level, can only just make ends meet. France, Italy, Germany and Belgium have hardly made a beginning with the solution of their financial problems. The higher the value of the monetary unit in which one of these vast debts is calculated, the greater will be the burden on the taxpayers responsible for it. The effect of inflation in swelling the nominal national income is clearly demonstrated by the British income-tax returns, and by the well-sustained consumption of dutiable commodities notwithstanding enormous increases in the rates of duty. Deflation decreases the money yield of the revenue, while leaving the money burden of the debt undiminished. Deflation also, it is true, diminishes the ex-penses of Government, and when the debt charges are small in proportion to the rest, it does not greatly increase the national burdens. But now that the debt charge itself is our main pre-occupation, we may find the continuance of some degree of inflation a necessary condition of solvency.

So 10 years before the downward spiral into the Great Depression began, Hawtrey (and Cassel) had already identified the nature and cause of the monetary dysfunction associated with a mishandled restoration of the international gold standard which led to the disaster. Nevertheless, in their account of the Great Depression, Friedman and Schwartz paid almost no attention to the perverse dynamics associated with the restoration of the gold standard, completely overlooking the role of the insane Bank of France, while denying that the Great Depression was caused by factors outside the US on the grounds that, in the 1929 and 1930, the US was accumulating gold.

We saw in Chapter 5 that there is good reason to regard the 1920-21 contraction as having been initiated primarily in the United States. The initial step – the sharp rise in discount rates in January 1920 – was indeed a consequence of the prior gold outflow, but that in turn reflected the United States inflation in 1919. The rise in discount rates produced a reversal of the gold movements in May. The second step – the rise in discount rates in June 1920 go the highest level in history – before or since [written in 1963] – was a deliberate act of policy involving a reaction stronger than was needed, since a gold inflow had already begun. It was succeeded by a heavy gold inflow, proof positive that the other countries were being forced to adapt to United States action in order to check their loss of gold, rather than the reverse.

The situation in 1929 was not dissimilar. Again, the initial climactic event – the stock market crash – occurred in the United States. The series of developments which started the stock of money on its accelerated downward course in late 1930 was again predominantly domestic in origin. It would be difficult indeed to attribute the sequence of bank failures to any major current influence from abroad. And again, the clinching evidence that the Unites States was in the van of the movement and not a follower is the flow of gold. If declines elsewhere were being transmitted to the United States, the transmission mechanism would be a balance of payments deficit in the United States as a result of a decline in prices and incomes elsewhere relative to prices and incomes in the United States. That decline would lead to a gold outflow from the United States which, in turn, would tend – if the United States followed gold-standard rules – to lower the stock of money and thereby income and prices in the United States. However, the U.S. gold stock rose during the first two years of the contraction and did not decline, demonstrating as in 1920 that other countries were being forced adapt to our monetary policies rather than the reverse. (p. 360)

Amazingly, Friedman and Schwartz made no mention of the accumulation of gold by the insane Bank of France, which accumulated almost twice as much gold in 1929 and 1930 as did the US. In December 1930, the total monetary gold reserves held by central banks and treasuries had increased to $10.94 billion from $10.06 billion in December 1928 (a net increase of $.88 billion), France’s gold holdings increased by $.85 billion while the holdings of the US increased by $.48 billion, Friedman and Schwartz acknowledge that the increase in the Fed’s discount rate to 6.5% in early 1929 may have played a role in triggering the downturn, but, lacking an international perspective on the deflationary implications of a rapidly tightening international gold market, they treated the increase as a minor misstep, leaving the impression that the downturn was largely unrelated to Fed policy decisions, let alone those of the IBOF. Friedman and Schwartz mention the Bank of France only once in the entire Monetary History. When discussing the possibility that France in 1931 would withdraw funds invested in the US money market, they write: “France was strongly committed to staying on gold, and the French financial community, the Bank of France included, expressed the greatest concern about the United States’ ability and intention to stay on the gold standard.” (p. 397)

So the critical point in Friedman’s narrative of the Great Depression turns out to be the Fed’s decision to allow the Bank of United States to fail in December 1930, more than a year after the stock-market crash, almost a year-and-a-half after the beginning of the downturn in the summer of 1929, almost two years after the Fed raised its discount rate to 6.5%, and over two years after the Bank of France began its insane policy of demanding redemption in gold of much of its sizeable holdings of foreign exchange. Why was a single bank failure so important? Because, for Friedman, it was all about the quantity of money. As a result Friedman and Schwartz minimize the severity of the early stages of the Depression, inasmuch as the quantity of money did not begin dropping significantly until 1931. It is because the quantity of money did not drop in 1928-29, and fell only slightly in 1930 that Friedman and Schwartz did not attribute the 1929 downturn to strictly monetary causes, but rather to “normal” cyclical factors (whatever those might be), perhaps somewhat exacerbated by an ill-timed increase in the Fed discount rate in early 1929. Let’s come back once again to the debate about monetary theory between Friedman and Fischer Black, which I have mentioned in previous posts, after Black arrived at Chicago in 1971.

“But, Fischer, there is a ton of evidence that money causes prices!” Friedman would insist. “Name one piece,” Fischer would respond. The fact that the measured money supply moves in tandem with nominal income and the price level could mean that an increase in money causes prices to rise, as Friedman insisted, but it could also mean that an increase in prices causes the quantity of money to rise, as Fischer thought more reasonable. Empirical evidence could not decide the case. (Mehrling, Fischer Black and the Revolutionary Idea of Finance, p. 160)

So Black obviously understood the possibility that, at least under some conditions, it was possible for prices to change exogenously and for the quantity of money to adjust endogenously to the exogenous change in prices. But Friedman was so ideologically committed to the quantity-theoretic direction of causality from the quantity of money to prices that he would not even consider an alternative, and more plausible, assumption about the direction of causality when the value of money is determined by convertibility into a constant amount of gold.

This obliviousness to the possibility that prices, under convertibility, could change independently of the quantity of money is probably the reason that Friedman and Schwartz also completely overlooked the short, but sweet, recovery of 1933 following FDR’s suspension of the gold standard in March 1933, when, over the next four months, the dollar depreciated by about 20% in terms of gold, and the producer price index rose by almost 15% as industrial production rose by 70% and stock prices doubled, before the recovery was aborted by the enactment of the NIRA, imposing, among other absurdities, a 20% increase in nominal wages. All of this was understood and explained by Hawtrey in his voluminous writings on the Great Depression, but went unmentioned in the Monetary History.

Not only did Friedman get both the theory and the history wrong, he made a bad move from his own ideological perspective, inasmuch as, according to his own narrative, the Great Depression was not triggered by a monetary disturbance; it was just that bad monetary-policy decisions exacerbated a serious, but not unusual, business-cycle downturn that had already started largely on its own. According to the Hawtrey-Cassel explanation, the source of the crisis was a deflation caused by the joint decisions of the various central banks — most importantly the Federal Reserve and the insane Bank of France — that were managing the restoration of the gold standard after World War I. The instability of the private sector played no part in this explanation. This is not to say that stability of the private sector is entailed by the Hawtrey-Cassel explanation, just that the explanation accounts for both the downturn and the subsequent prolonged deflation and high unemployment, with no need for an assumption, one way or the other, about the stability of the private sector.

Of course, whether the private sector is stable is itself a question too complicated to be answered with a simple yes or no. It is one thing for a car to be stable if it is being steered on a paved highway; it is quite another for the car to be stable if driven into a ditch.


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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