This may not be the most important news of the day, but for those wishing to immerse themselves in the economics of Hawtrey and Cassel, a newly revised version of my paper with Ron Batchelder “Pre-Keynesian Monetary Explanations of the Great Depression: Whatever Happened to Hawtrey and Cassel?” is now available on SSRN.
The paper has also recently been submitted to a journal for review, so we are hoping that it will finally be published before too long. Wish us luck. Here’s the slightly revised abstract.
A strictly monetary theory of the Great Depression is generally thought to have originated with Milton Friedman. Designed to counter the Keynesian notion that the Depression resulted from instabilities inherent in modern capitalist economies, Friedman’s explanation identified the culprit as an ill-conceived monetary policy pursued by an inept Federal Reserve Board. More recent work on the Depression suggests that the causes of the Depression, rooted in the attempt to restore an international gold standard that had been suspended after World War I started, were more international in scope than Friedman believed. We document that current views about the causes of the Depression were anticipated in the 1920s by Ralph Hawtrey and Gustav Cassel who independently warned that restoring the gold standard risked causing a disastrous deflation unless the resulting increase in the international monetary demand for gold could be limited. Although their early warnings of potential disaster were validated, and their policy advice after the Depression started was consistently correct, their contributions were later ignored or forgotten. This paper explores the possible reasons for the remarkable disregard by later economists of the Hawtrey-Cassel monetary explanation of the Great Depression.
Margaret Thatcher was a great lady, and a great political leader, reversing, by the strength of her character, a ruinous cycle of increasing state control of the British economy imposed in semi-collaboration with the British trade unions. That achievement required not just a change of policy, but a change in the way that the British people thought about the role of the state in organizing and directing economic activity. Mrs. Thatcher’s greatest achievement was not to change this or that policy, but to change the thinking of her countrymen. Leaders who can get others to change their thinking in fundamental ways rarely do so by being subtle; Mrs. Thatcher was not subtle.
Mrs. Thatcher had the great merit of admiring the writings of F. A. Hayek. How well she understood them, I am not in a position to say. But Hayek was a subtle thinker, and I think it is worth considering one instance — a somewhat notorious instance — in which Mrs. Thatcher failed to grasp Hayek’s subtlety. But just to give Mrs. Thatcher her due, it is also worth noting that, though Mrs. Thatcher admired Hayek enormously, she was not at all slavish in her admiration. And so it is only fair to recall that Mrs. Thatcher properly administered a stinging rebuke to Hayek, when he once dared to suggest to her that she could learn from General Pinochet about how to implement pro-market economic reforms.
However, I am sure you will agree that, in Britain with our democratic institutions and the need for a high degree of consent, some of the measures adopted in Chile are quite unacceptable. Our reform must be in line with our traditions and our Constitution. At times the process may seem painfully slow. But I am certain we shall achieve our reforms in our own way and in our own time. Then they will endure.
But Mrs. Thatcher did made the egregious mistake of asserting “there is no such thing as society, just individuals.” Here are two quotations in which the assertion was made.
And, you know, there is no such thing as society. There are individual men and women, and there are families. And no government can do anything except through people, and people must look to themselves first. It’s our duty to look after ourselves and then, also to look after our neighbour. People have got the entitlements too much in mind, without the obligations, because there is no such thing as an entitlement unless someone has first met an obligation.
And,
There is no such thing as society. There is living tapestry of men and women and people and the beauty of that tapestry and the quality of our lives will depend upon how much each of us is prepared to take responsibility for ourselves and each of us prepared to turn round and help by our own efforts those who are unfortunate.
In making that assertion, Mrs. Thatcher may have been inspired by Hayek, who wrote at length about the meaninglessness of the concept of “social justice.” But Hayek’s point was not that “social justice” is meaningless, because there is no such thing as society, but that justice, like democracy, is a concept that has no meaning except as it relates to society, so that adding “social” as a modifier to “justice” or to “democracy” can hardly impart any additional meaning to the concept it is supposed to modify. But the subtlety of Hayek’s reasoning was evidently beyond Mrs. Thatcher’s grasp.
Here’s a wonderful example of Hayek talking about society.
In the last resort we find ourselves constrained to repudiate the ideal of the social concept because it has become the ideal of those who, on principle, deny the existence of a true society and whose longing is for the artificially constructed and the rationally controlled. In this context, it seems to me that a great deal of what today professes to be social is, in the deeper and truer sense of the word, thoroughly and completely anti-social.
Nevertheless, while Mrs. Thatcher undoubtedly made her share of mistakes, on some really important decisions, decisions that really counted for the future of her country, she got things basically right.
While searching for material on the close and multi-faceted relationship between Keynes and Hawtrey which I am now studying and writing about, I came across a remarkable juxtaposition of two reviews in the British economics journal Economica, published by the London School of Economics. Economica was, after the Economic Journal published at Cambridge (and edited for many years by Keynes), probably the most important economics journal published in Britain in the early 1930s. Having just arrived in Britain in 1931 to a spectacularly successful debut with his four lectures at LSE, which were soon published as Prices and Production, and having accepted the offer of a professorship at LSE, Hayek began an intense period of teaching and publishing, almost immediately becoming the chief rival of Keynes. The rivalry had been more or less officially inaugurated when Hayek published the first of his two-part review-essay of Keynes’s recently published Treatise on Money in the August 1931 issue of Economica, followed by Keynes’s ill-tempered reply and Hayek’s rejoinder in the November 1931 issue, with the second part of Hayek’s review appearing in the February 1932 issue.
But interestingly in the same February issue containing the second installment of Hayek’s lengthy review essay, Hayek also published a short (2 pages, 3 paragraphs) review of Hawtrey’s Trade Depression and the Way Out immediately following Hawtrey’s review of Hayek’s Prices and Production in the same issue. So not only was Hayek engaging in controversy with Keynes, he was arguing with Hawtrey as well. The points at issue were similar in the two exchanges, but there may well be more to learn from the lower-key, less polemical, exchange between Hayek and Hawtrey than from the overheated exchange between Hayek and Keynes.
So here is my summary (in reverse order) of the two reviews:
Hayek on Trade Depression and the Way Out.
Hayek, in his usual polite fashion, begins by praising Hawtrey’s theoretical eminence and skill as a clear expositor of his position. (“the rare clarity and painstaking precision of his theoretical exposition and his very exceptional knowledge of facts making anything that comes from his pen well worth reading.”) However, noting that Hawtrey’s book was aimed at a popular rather than a professional audience, Hayek accuses Hawtrey of oversimplification in attributing the depression to a lack of monetary stimulus.
Hayek proceeds in his second paragraph to explain what he means by oversimplification. Hayek agrees that the origin of the depression was monetary, but he disputes Hawtrey’s belief that the deflationary shocks were crucial.
[Hawtrey's] insistence upon the relation between “consumers’ income” and “consumers’ outlay” as the only relevant factor prevents him from seeing the highly important effects of monetary causes upon the capitalistic structure of production and leads him along the paths of the “purchasing power theorists” who see the source of all evil in the insufficiency of demand for consumers goods. . . . Against all empirical evidence, he insists that “the first symptom of contracting demand is a decline in sales to the consumer or final purchaser.” In fact, of course, depression has always begun with a decline in demand, not for consumers’ goods but for capital goods, and the one marked phenomenon of the present depression was that the demand for consumers’ goods was very well maintained for a long while after the crisis occurred.
Hayek’s comment seems to me to misinterpret Hawtrey slightly. Hawtrey wrote “a decline in sales to the consumer or final purchaser,” which could refer to a decline in the sales of capital equipment as well as the sales of consumption goods, so Hawtrey’s assertion was not necessarily inconsistent with Hayek’s representation about the stability of consumption expenditure immediately following a cyclical downturn. It would also not be hard to modify Hawtrey’s statement slightly; in an accelerator model, with which Hawtrey was certainly familiar, investment depends on the growth of consumption expenditures, so that a leveling off of consumption, rather than an actual downturn in consumption, would suffice to trigger the downturn in investment which, according to Hayek, was a generally accepted stylized fact characterizing the cyclical downturn.
Hayek continues:
[W]hat Mr. Hawtrey, in common with many other English economists [I wonder whom Hayek could be thinking of], lacks is an adequate basic theory of the factors which affect [the] capitalistic structure of production.
Because of Hawtrey’s preoccupation with the movements of the overall price level, Hayek accuses Hawtrey of attributing the depression solely “to a process of deflation” for which the remedy is credit expansion by the central banks. [Sound familiar?]
[Hawtrey] seems to extend [blame for the depression] on the policy of the Bank of England even to the period before 1929, though according to his own criterion – the rise in the prices of the original factors of production [i.e., wages] – it is clear that, in that period, the trouble was too much credit expansion. “In 1929,” Mr. Hawtrey writes, “when productive activity was at its highest in the United States, wages were 120 percent higher than in 1913, while commodity prices were only 50 percent higher.” Even if we take into account the fact that the greater part of this rise in wages took place before 1921, it is clear that we had much more credit expansion before 1929 than would have been necessary to maintain the world-wage-level. It is not difficult to imagine what would have been the consequences if, during that period, the Bank of England had followed Mr. Hawtrey’s advice and had shown still less reluctance to let go. But perhaps, this would have exposed the dangers of such frankly inflationist advice quicker than will now be the case.
A remarkable passage indeed! To accuse Hawtrey of toleration of inflation, he insinuates that the 50% rise in wages from 1913 to 1929, was at least in part attributable to the inflationary policies Hawtrey was advocating. In fact, I believe that it is clear, though I don’t have easy access to the best data source C. H. Feinstein’s “Changes in Nominal Wages, the Cost of Living, and Real Wages in the United Kingdom over Two Centuries, 1780-1990,” in Labour’s Reward edited by P. Schoillers and V. Zamagni (1995). From 1922 to 1929 the overall trend of nominal wages in Britain was actually negative. Hayek’s reference to “frankly inflationist advice” was not just wrong, but wrong-headed.
Hawtrey on Prices and Production
Hawtrey spends the first two or three pages or so of his review giving a summary of Hayek’s theory, explaining the underlying connection between Hayek and the Bohm-Bawerkian theory of production as a process in time, with the length of time from beginning to end of the production process being a function of the rate of interest. Thus, reducing the rate of interest leads to a lengthening of the production process (average period of production). Credit expansion financed by bank lending is the key cyclical variable, lengthening the period of production, but only temporarily.
The lengthening of the period of production can only take place as long as inflation is increasing, but inflation cannot increase indefinitely. When inflation stops increasing, the period of production starts to contract. Hawtrey explains:
Some intermediate products (“non-specific”) can readily be transferred from one process to another, but others (“specific”) cannot. These latter will no longer be needed. Those who have been using them, and still more those who have producing them, will be thrown out of employment. And here is the “explanation of how it comes about at certain times that some of the existing resources cannot be used.” . . .
The originating cause of the disturbance would therefore be the artificially enhanced demand for producers’ goods arising when the creation of credit in favour of producers supplements the normal flow savings out of income. It is only because the latter cannot last for ever that the reaction which results in under-employment occurs.
But Hawtrey observes that only a small part of the annual capital outlay is applied to lengthening the period of production, capital outlay being devoted mostly to increasing output within the existing period of production, or to enhancing productivity through the addition of new plant and equipment embodying technical progress and new inventions. Thus, most capital spending, even when financed by credit creation, is not associated with any alteration in the period of production. Hawtrey would later introduce the terms capital widening and capital deepening to describe investments that do not affect the period of production and those that do affect it. Nor, in general, are capital-deepening investments the most likely to be adopted in response to a change in the rate of interest.
Similarly, If the rate of interest were to rise, making the most roundabout processes unprofitable, it does not follow that such processes will have to be scrapped.
A piece of equipment may have been installed, of which the yield, in terms of labour saved, is 4 percent on its cost. If the market rate of interest rises to 5 percent, it would no longer be profitable to install a similar piece. But that does not mean that, once installed, it will be left idle. The yield of 4 percent is better than nothing. . . .
When the scrapping of plant is hastened on account of the discovery of some technically improved process, there is a loss not only of interest but of the residue of depreciation allowance that would otherwise have accumulated during its life of usefulness. It is only when the new process promises a very suitable gain in efficiency that premature scrapping is worthwhile. A mere rise in the rate of interest could never have that effect.
But though a rise in the rate of interest is not likely to cause the scrapping of plant, it may prevent the installation of new plant of the kind affected. Those who produce such plant would be thrown out of employment, and it is this effect which is, I think, the main part of Dr. Hayek’s explanation of trade depressions.
But what is the possible magnitude of the effect? The transition from activity to depression is accompanied by a rise in the rate of interest. But the rise in the long-term rate is very slight, and moreover, once depression has set in, the long-term rate is usually lower than ever.
Changes are in any case perpetually occurring in the character of the plant and instrumental goods produced for use in industry. Such changes are apt to throw out of employment any highly specialized capital and labour engaged in the production of plant which becomes obsolete. But among the causes of obsolescence a rise in the rate of interest is certainly one of the least important and over short periods it may safely be said to be quite negligible.
Hawtrey goes on to question Hayek’s implicit assumption that the effects of the depression were an inevitable result of stopping the expansion of credit, an assumption that Hayek disavowed much later, but it was not unreasonable for Hawtrey to challenge Hayek on this point.
It is remarkable that Dr. Hayek does not entertain the possibility of a contraction of credit; he is content to deal with the cessation of further expansion. He maintains that at a time of depression a credit expansion cannot provide a remedy, because if the proportion between the demand for consumers’ goods and the demand for producers’ goods “is distorted by the creation of artificial demand, it must mean that part of the available resources is again led into a wrong direction and a definite and lasting adjustment is again postponed.” But if credit being contracted, the proportion is being distorted by an artificial restriction of demand.
The expansion of credit is assumed to start by chance, or at any rate no cause is suggested. It is maintained because the rise of prices offers temporary extra profits to entrepreneurs. A contraction of credit might equally well be assumed to start, and then to be maintained because the fall of prices inflicts temporary losses on entrepreneurs, and deters them from borrowing. Is not this to be corrected by credit expansion?
Dr. Hayek recognizes no cause of under-employment of the factors of production except a change in the structure of production, a “shortening of the period.” He does not consider the possibility that if, through a credit contraction or for any other reason, less money altogether is spent on intermediate products (capital goods), the factors of production engaged in producing these products will be under-employed.
Hawtrey then discusses the tension between Hayek’s recognition that the sense in which the quantity of money should be kept constant is the maintenance of a constant stream of money expenditure, so that in fact an ideal monetary policy would adjust the quantity of money to compensate for changes in velocity. Nevertheless, Hayek did not feel that it was within the capacity of monetary policy to adjust the quantity of money in such a way as to keep total monetary expenditure constant over the course of the business cycle.
Here are the concluding two paragraphs of Hawtrey’s review:
In conclusion, I feel bound to say that Dr. Hayek has spoiled an original piece of work which might have been an important contribution to monetary theory, by entangling his argument with the intolerably cumbersome theory of capital derived from Jevons and Bohm-Bawerk. This theory, when it was enunciated, was a noteworthy new departure in the metaphysics of political economy. But it is singularly ill-adapted for use in monetary theory, or indeed in any practical treatment of the capital market.
The result has been to make Dr. Hayek’s work so difficult and obscure that it is impossible to understand his little book of 112 pages except at the cost of many hours of hard work. And at the end we are left with the impression, not only that this is not a necessary consequence of the difficulty of the subject, but that he himself has been led by so ill-chosen a method of analysis to conclusions which he would hardly have accepted if given a more straightforward form of expression.
Last week, I did a short post linking to the new draft of my paper with Paul Zimmerman about the Sraffa-Hayek exchange on the natural rate of interest. In the paper, we attempt to assess Sraffa’s criticism in his 1932 review of Prices and Production of Hayek’s use of the idea of a natural rate of interest as well as Hayek’s response, or, perhaps, his lack of response, to Sraffa’s criticism. The issues raised by Sraffa are devilishly tricky, especially because he introduced the unfamiliar terminology of own-rates of interest, later adopted Keynes in chapter 17 of the General Theory in order to express his criticism. The consensus about this debate is that Sraffa got the best of Hayek in this exchange – the natural rate of interest was just one of the issues Sraffa raised, and, in the process, he took Hayek down a peg or two after the startling success that Hayek enjoyed upon his arrival in England, and publication of Prices and Production. In a comment to my post, Greg Ransom questions this conventional version of the exchange, but that’s my story and I’m sticking to it.
What Paul and I do in the paper is to try to understand Sraffa’s criticism of Hayek. It seems to us that the stridency of Sraffa’s attack on Hayek suggests that Sraffa was arguing that Hayek’s conception of a natural rate of interest was somehow incoherent in a barter economy in which there is growth and investment and, thus, changes in relative prices over time, implying that commodity own rates of interest would have differ. If, in a barter economy with growth and savings and investment, there are many own-rates, Sraffa seemed to be saying, it is impossible to identify any one of them as the natural rate of interest. In a later account of the exchange between Sraffa and Hayek, Ludwig Lachmann, a pupil of Hayek, pointed out that, even if there are many own rates in a barter economy, the own rates must, in an intertemporal equilibrium, stand in a unique relationship to each other: the expected net return from holding any asset cannot differ from the expected net return on holding any other asset. That is a condition of equilibrium. If so, it is possible, at least conceptually, to infer a unique real interest rate. That unique real interest rate could be identified with Hayek’s natural rate of interest.
In fact, as we point out in our paper, Irving Fisher in his classic Appreciation and Interest (1896) had demonstrated precisely this point, theoretically extracting the real rate from the different nominal rates of interest corresponding to loans contracted in terms of different assets with different expected rates of price appreciation. Thus, Sraffa did not demonstrate that there was no natural rate of interest. There is a unique real rate of interest in intertemporal equilibrium which corresponds to the Hayekian natural rate. However, what Sraffa could have demonstrated — though had he done so, he would still have been 35 years behind Irving Fisher – is that the unique real rate is consistent with an infinite number of nominal rates provided that those nominal rates reflected corresponding anticipated rate of price appreciation. But, instead, Sraffa argued that there is no unique real rate in intertemporal equilibrium. That was a mistake.
Another interesting (at least to us) point in our paper is that Keynes who, as editor of the Economic Journal, asked Sraffa to review Prices and Production, borrowed Sraffa’s own-rate terminology in chapter 17 of the General Theory, but, instead of following Sraffa’s analysis and arguing that there is no natural rate of interest, Keynes proceeded to derive, using (without acknowledgment) a generalized version of Fisher’s argument of 1896, a unique relationship between commodity own rates, adjusted for expected price changes, and net service yields, such that the expected net returns on all assets would be equalized. From this, Keynes did not conclude, as had Sraffa, that there is no natural rate of interest. Rather, he made a very different argument: that the natural rate of interest is a useless concept, because there are many natural rates each corresponding to a different the level of income and employment, a consideration that Hayek, and presumably Fisher, had avoided by assuming full intertemporal equilibrium. But Keynes never disputed that for any given level of income and employment, there would be a unique real rate to which all commodity own rates had to correspond. Thus, Keynes turned Sraffa’s analysis on its head. And the final point of interest is that even though Keynes, in chapter 17, presented essentially the same analysis of own rates, though in more general terms, that Fisher had presented 40 years earlier, Keynes in chapter 13 explicitly rejected Fisher’s distinction between the real and nominal rates of interest. Go figure.
Bob Murphy wrote a nice paper on the Sraffa-Hayek debate, which I have referred to before on this blog. However, I disagree with him that Sraffa’s criticism of Hayek was correct. In a post earlier this week, he infers, from our statement that, as long as price expectations are correct, any nominal rate is consistent with the unique real natural rate, that we must agree with him that Sraffa was right and Hayek was wrong about the natural rate. I think that Bob is in error on the pure theory here. There is a unique real natural rate in intertemporal equilibrium, and, in principle, the monetary authority could set a money rate equal to that real rate, provided that that nominal rate was consistent with the price expectations held by the public. However, intertemporal equilibrium could be achieved by any nominal interest rate selected by the monetary authority, again provided that the nominal rate chosen was consistent with the price expectations held by the public. In practice, either formulation is very damaging to Hayek’s policy criterion of setting the nominal interest rate equal to the real natural rate. But contrary to Sraffa’s charge, the policy criterion is not incoherent. It is just unworkable, as Hayek formulated it, and, on Hayek’s own theory, the criterion is unnecessary to avoid distorting malinvestments.
I have just uploaded to the SSRN website a new draft of the paper (co-authored with Paul Zimmerman) on Hayek and Sraffa and the natural rate of interest, presented last June at the History of Economics Society conference at Brock University. The paper evolved from an early post on this blog in September 2011. I also wrote about the Hayek-Sraffa controversy in a post in June 2012 just after the HES conference.
One interesting wrinkle that occurred to me just as I was making revisions in the paper this week is that Keynes’s treatment of own rates in chapter 17 of the General Theory, which was in an important sense inspired by Sraffa, but, in my view, came to a very different conclusion from Sraffa’s, was actually nothing more than a generalization of Irving Fisher’s analysis of the real and nominal rates of interest, first presented in Fisher’s 1896 book Appreciation and Interest. In his Tract on Monetary Reform, Keynes extended Fisher’s analysis into his theory of covered interest rate arbitrage. What is really surprising is that, despite his reliance on Fisher’s analysis in the Tract and also in the Treatise on Money, Keynes sharply criticized Fisher’s analysis of the nominal and real rates of interest in chapter 13 of the General Theory. (I discussed that difficult passage in the General Theory in this post). That is certainly surprising. But what is astonishing to me is that, after trashing Fisher in chapter 13 of the GT, Keynes goes back to Fisher in chapter 17, giving a generalized restatement of Fisher’s analysis in his discussion of own rates. Am I the first person to have noticed Keynes’s schizophrenic treatment of Fisher in the General Theory?
PS: My revered teacher, the great Armen Alchian passed away yesterday at the age of 98. There have been many tributes to him, such as this one by David Henderson, also a student of Alchian’s, in the Wall Street Journal. I have written about Alchian in the past (here, here, here, here, and here), and I hope to write about Alchian again in the near future. There was none like him; he will be missed terribly.
I never met Ronald Dworkin, and I have not studied his work on legal philosophy carefully, but one essay that he wrote many years ago made a deep impression on me when I read it over 40 years ago as an undergraduate, and I still consider it just about the most profound discussion of law that I ever read. The essay, “Is Law a System of Rules?” (reprinted in The Philosophy of Law) is a refutation of the philosophy of legal positivism, which holds that law is simply the command of a duly authorized sovereign law giver, an idea that was powerfully articulated by Thomas Hobbes and later by Jeremy Bentham.
Legal positivism was developed largely in reaction to theories of natural law, reflected in the work of legal philosophers like Hugo Grotius and Samuel Pufendorf, and in William Blackstone’s famous Commentaries on the Laws of England. The validity of law and the obligation to obey law were derived from the correspondence, even if only imperfect, of positive law to natural law. Blackstone’s Commentaries were largely a form of apologetics aimed at showing how well English law corresponded to the natural law. Jeremy Bentham would have none of this, calling “natural rights” (i.e., the rights derived from natural law) simple nonsense, and “natural and imprescriptible rights” nonsense on stilts.
Legal positivism was first given a systematic exposition by Bentham’s younger contemporary, John Austin, who described law as those commands of a sovereign for which one would be punished if one failed to obey them, the sovereign being he who is habitually obeyed. The twentieth century legal philosopher H. L. A. Hart further refined the doctrine in a definitive treatise, The Concept of Law, in which he argued that law must have a systematic and non-arbitrary structure. Laws are more than commands, but they remain disconnected from any moral principles. Law is not just a set of commands; it is a system of rules, but the rules have no necessary moral content.
As a Rhodes Scholar, Dworkin studied under Hart at Oxford, but he rejected Hart’s view of law. In his paper “Is Law a System of Rules?” Dworkin subjected legal positivism, in the sophisticated version (law as a system of rules) articulated by Hart, to a searching philosophical analysis. When I read Dworkin’s essay, I had already read Hayek’s great work, The Constitution of Liberty, and, while Hayek was visiting UCLA in the 1968-69 academic year, the first draft of his Law, Legislation and Liberty. In both of these works, Hayek had also criticized legal positivism, which he viewed as diametrically opposed to his cherished ideal of the rule of law as a necessary condition of liberty. But his criticism seemed to me not nearly as effective or as interesting as Dworkin’s. Despite disagreeing with Dworkin on a lot of issues, I have, ever since, admired Dworkin as a pre-eminent legal and political philosopher.
Dworkin’s main criticism of the theory that law is a system of rules was that the theory cannot account for the role played by legal principles in informing and guiding judges in deciding actual cases whose outcome is not obvious. Here is how Dworkin, in his essay, described the role of one such principle.
In 1889 a New York court, in the famous case of Riggs v. Palmer had to decide whether an heir named in the will of his grandfather could inherit under that will, even though he had murdered his grandfather to do so. The court began its reasoning with this admission: “It is quite true that statutes regulating the making, proof and effect of wills, and the devolution of property, if literally construed, and if their force and effect can in no way and under no circumstances be controlled or modified, give this property to the murderer.” But the court continued in to note that “all laws as well as all contracts may be controlled in their operation and effect by general, fundamental maxims of the common law. No one shall be permitted to profit by his own fraud, or to take advantage of his own wrong, or to found any claim upon his own iniquity, or acquire property by his own crime.” The murder did not receive his inheritance.
From here Dworkin went on to conduct a rigorous philosophical analysis of the way in which the principle that no one may profit from his own wrong could be understood within the conceptual framework of legal positivism that law is nothing more than a system of rules. In fact, Dworkin argued, rules cannot be applied in a vacuum, there must be principles and standards that provide judges with the resources by which to arrive at judicial decisions in cases where there is not an exact match between the given facts and an applicable rule, cases in which, in the terminology of legal positivism, judges must exercise discretion, as if discretion meant no more than freedom to reach an arbitrary unprincipled decision. Principles govern judicial decisions, but not in the same way that rules do. Rules are binary, on or off; principles are flexible, they have weight, their application requires judgment.
If we take baseball rules as a model, we find that rules of law, like the rule that a will is invalid unless signed by three witnesses, fit the model well. If the requirement of three witnesses is a valid legal rule, then it cannot be that a will has signed by only two witnesses and is valid. . . .
But this is not the way the sample principles in the quotations operated. Even those which look most like rules do not set out legal consequences that follow automatically when the conditions provided are met. We say that our law respects the principle that no man may profit from his own wrong, but we do not mean that the law never permits a man to profit from wrongs he commits. In fact, people most often profit, perfectly legally, from their legal wrongs. . . .
We do not treat these . . . counter-instances . . . as showing that the principle about profiting from one’s own wrongs is not a principle of our legal system, or that it is incomplete and needs qualifying exceptions. We not treat counter-instances as exceptions (at least not exceptions in the way in which a catcher’s dropping the third strike is an exception) because we could not hope to capture these counter-instances simply by a more extended statement of the principle. . . . Listing some of these might sharpen our sense of the principle’s weight, but it would not make for a more accurate or complete statement of the principle. . . .
All that is meant, when we way that a particular principle is a principle of our law, is that the principle is one which officials must take into account, if it is relevant, as a consideration inclining in one direction or another.
Just as an aside, I will observe that this passage and others in Dworkin’s essay make it clear that when Chief Justice Roberts appeared before the Senate Judiciary Committee in 2005 and stated that in his view the job of a judge is calling balls and strikes but not pitching or batting, he was using a distinctly inappropriate, and perhaps misleading, metaphor to describe what it is that a judge, especially an appellate judge, is called upon to do. See Dworkin’s essay on the Roberts hearing in the New York Review of Books.
Although I never met Dworkin, I did correspond with him on a few occasions, once many years ago and more recently exchanging emails with him about various issues — the last time when I sent him a link to this post commenting on the oral argument before the Supreme Court about the Affordable Health Care Act. His responses to me were always cordial and unfailingly polite; I now regret not having saved the letters and the emails. Here are links to obituaries in the New York Times, The Guardian and The Financial Times.
In my previous post, I suggested that Stephen Williamson’s views about the incapacity of monetary policy to reduce unemployment, and his fears that monetary expansion would simply lead to higher inflation and a repeat of the bad old days the 1970s when inflation and unemployment spun out of control, follow from a theoretical presumption that the US economy is now operating (as it almost always does) in the neighborhood of equilibrium. This does not seem right to me, but it is the sort of deep theoretical assumption (e.g., like the rationality of economic agents) that is not subject to direct empirical testing. It is part of what the philosopher Imre Lakatos called the hard core of a (in this case Williamson’s) scientific research program. Whatever happens, Williamson will process the observed facts in terms of a theoretical paradigm in which prices adjust and markets clear. No other way of viewing reality makes sense, because Williamson cannot make any sense of it in terms of the theoretical paradigm or world view to which he is committed. I actually have some sympathy with that way of looking at the world, but not because I think it’s really true; it’s just the best paradigm we have at the moment. But I don’t want to follow that line of thought too far now, but who knows, maybe another time.
A good illustration of how Williamson understands his paradigm was provided by blogger J. P. Koning in his comment on my previous post copying the following quotation from a post written by Williamson a couple of years on his blog.
In other cases, as in the link you mention, there are people concerned about disequilibrium phenomena. These approaches are or were popular in Europe – I looked up Benassy and he is still hard at work. However, most of the mainstream – and here I’m including New Keynesians – sticks to equilibrium economics. New Keynesian models may have some stuck prices and wages, but those models don’t have to depart much from standard competitive equilibrium (or, if you like, competitive equilibrium with monopolistic competition). In those models, you have to determine what a firm with a stuck price produces, and that is where the big leap is. However, in terms of determining everything mathematically, it’s not a big deal. Equilibrium economics is hard enough as it is, without having to deal with the lack of discipline associated with “disequilibrium.” In equilibrium economics, particularly monetary equilibrium economics, we have all the equilibria (and more) we can handle, thanks.
I actually agree that departing from the assumption of equilibrium can involve a lack of discipline. Market clearing is a very powerful analytical tool, and to give it up without replacing it with an equally powerful analytical tool leaves us theoretically impoverished. But Williamson seems to suggest (or at least leaves ambiguous) that there is only one kind of equilibrium that can be handled theoretically, namely a fully optimal general equilibrium with perfect foresight (i.e., rational expectations) or at least with a learning process leading toward rational expectations. But there are other equilibrium concepts that preserve market clearing, but without imposing, what seems to me, the unreasonable condition of rational expectations and (near) optimality.
In particular, there is the Hicksian concept of a temporary equilibrium (inspired by Hayek’s discussion of intertemporal equilibrium) which allows for inconsistent expectations by economic agents, but assumes market clearing based on supply and demand schedules reflecting those inconsistent expectations. Nearly 40 years ago, Earl Thompson was able to deploy that equilibrium concept to derive a sub-optimal temporary equilibrium with Keynesian unemployment and a role for countercyclical monetary policy in minimizing inefficient unemployment. I have summarized and discussed Thompson’s model previously in some previous posts (here, here, here, and here), and I hope to do a few more in the future. The model is hardly the last word, but it might at least serve as a starting point for thinking seriously about the possibility that not every state of the economy is an optimal equilibrium state, but without abandoning market clearing as an analytical tool.
Once again, I find myself slightly behind the curve, with Scott Sumner (and again, and again, and again, and again), Nick Rowe and Bill Woolsey out there trying to face down an onslaught of Austrians rallying under the dreaded banner (I won’t say what color) of Cantillon Effects. At this point, the best I can do is some mopping up by making a few general observations about the traditional role of Cantillon Effects in Austrian business cycle theory and how that role squares with the recent clamor about Cantillon Effects.
Scott got things started, as he usually does, with a post challenging an Austrian claim that the Federal Reserve favors the rich because its injections of newly printed money enter the economy at “specific points,” thereby conferring unearned advantages on those lucky or well-connected few into whose hands those crisp new dollar bills hot off the printing press first arrive. The fortunate ones who get to spend the newly created money before the fresh new greenbacks have started on their inflationary journey through the economy are able to buy stuff at pre-inflation prices, while the poor suckers further down the chain of transactions triggered by the cash infusion must pay higher prices before receiving any of the increased spending. Scott’s challenge provoked a fierce Austrian counterattack from commenters on his blog and from not-so-fierce bloggers like Bob Murphy. As is often the case, the discussion (or the shouting) produced no clear outcome, each side confidently claiming vindication. Scott and Nick argued that any benefits conferred on first recipients of cash would be attributable to the fiscal impact of the Fed’s actions (e.g., purchasing treasury bonds with new money rather than helicopter distribution), with Murphy et al. arguing that distinctions between the fiscal and monetary effects of Fed operations are a dodge. No one will be surprised when I say that Scott and Nick got the better of the argument.
But there are a couple of further points that I would like to bring up about Cantillon effects. It seems to me that the reason Cantillon effects were thought to be of import by the early Austrian theorists like Hayek was that they had a systematic theory of the distribution or the incidence of those effects. Merely to point out that such effects exist and redound to the benefits of some lucky individuals would have been considered a rather trivial and pointless exercise by Hayek. Hayek went to great lengths in the 1930s to spell out a theory of how the creation of new money resulting in an increase in total expenditure would be associated with a systematic and (to the theorist) predictable change in relative prices between consumption goods and capital goods, a cheapening of consumption goods relative to capital goods causing a shift in the composition of output in favor of capital goods. Hayek then argued that such a shift in the composition of output would be induced by the increase in capital-goods prices relative to consumption-goods prices, the latter shift, having been induced by a monetary expansion that could not (for reasons I have discussed in previous posts, e.g., here) be continued indefinitely, eventually having to be reversed. This reversal was identified by Hayek with the upper-turning point of the business cycle, because it would trigger a collapse of the capital-goods industries and a disruption of all the production processes dependent on a continued supply of those capital goods.
Hayek’s was an interesting theory, because it identified a particular consequence of monetary expansion for an important sector of the economy, providing an explanation of the economic mechanism and a prediction about the direction of change along with an explanation of why the initial change would eventually turn out to be unsustainable. The theory could be right or wrong, but it involved a pretty clear-cut set of empirical implications. But the point to bear in mind is that this went well beyond merely saying that in principle there would be some gainers and some losers as the process of monetary expansion unfolds.
What accounts for the difference between the empirically rich theory of systematic Cantillon Effects articulated by Hayek over 80 years ago and the empirically trivial version on which so much energy was expended over the past few days on the blogosphere? I think that the key difference is that in Hayek’s cycle theory, it is the banks that are assumed somehow or other to set an interest rate at which they are willing to lend, and this interest rate may or may not be consistent with the constant volume of expenditure that Hayek thought (albeit with many qualifications) was ideal criterion of the neutral monetary policy which he favored. A central bank might or might not be involved in the process of setting the bank rate, but the instrument of monetary policy was (depending on circumstances) the lending rate of the banks, or, alternatively, the rate at which the central bank was willing lending to banks by rediscounting the assets acquired by banks in lending to their borrowers.
The way Hayek’s theory works is through an unobservable natural interest rate that would, if it were chosen by the banks, generate a constant rate of total spending. There is, however, no market mechanism guaranteeing that the lending rate selected by the banks (with or without the involvement of a central bank) coincides with the ideal but unobservable natural rate. Deviations of the banks’ lending rate from the natural rate cause Cantillon Effects involving relative-price distortions, thereby misdirecting resources from capital-goods industries to consumption-goods industries, or vice versa. But the specific Cantillon effect associated with Hayek’s theory presumes that the banking system has the power to determine the interest rates at which borrowing and lending take place for the entire economy. This presumption is nowhere ot my knowledge justified, and it does not seem to me that the presumption is even remotely justifiable unless one accepts the very narrow theory of interest known as the loanable-funds theory. According to the loanable-funds theory, the rate of interest is that rate which equates the demand for funds to be borrowed with the supply of funds available to be lent. However, if one views the rate of interest (in the sense of the entire term structure of interest rates) as being determined in the process by which the entire existing stock of capital assets is valued (i.e., the price for each asset at which it would be willingly held by just one economic agent) those valuations being mutually consistent only when the expected net cash flows attached to each asset are discounted at the equilibrium term structure and equilibrium risk premia. Given that comprehensive view of asset valuations and interest-rate determination, the notion that banks (with or without a central bank) have any substantial discretion in choosing interest rates is hard to take seriously. And to the extent that banks have any discretion over lending rates, it is concentrated at the very short end of the term structure. I really can’t tell what she meant, but it is at least possible that Joan Robinson was alluding to this idea when, in her own uniquely charming way, she criticized Hayek’s argument in Prices and Production.
I very well remember Hayek’s visit to Cambridge on his way to the London School. He expounded his theory and covered a black board with his triangles. The whole argument, as we could see later, consisted in confusing the current rate of investment with the total stock of capital goods, but we could not make it out at the time. The general tendency seemed to be to show that the slump was caused by [excessive] consumption. R. F. Kahn, who was at that time involved in explaining that the multiplier guaranteed that saving equals investment, asked in a puzzled tone, “Is it your view that if I went out tomorrow and bought a new overcoat, that would increase unemploy- ment?”‘ “Yes,” said Hayek, “but,” pointing to his triangles on the board, “it would take a very long mathematical argument to explain why.”
At any rate, if interest rates are determined comprehensively in all the related markets for existing stocks of physical assets, not in flow markets for current borrowing and lending, Hayek’s notion that the banking system can cause significant Cantillon effects via its control over interest rates is hard to credit. There is perhaps some room to alter very short-term rates, but longer-term rates seem impervious to manipulation by the banking system except insofar as inflation expectations respond to the actions of the banking system. But how does one derive a Cantillon Effect from a change in expected inflation? Cantillon Effects may or may not exist, but unless they are systematic, predictable, and unsustainable, they have little relevance to the study of business cycles.
A new book by Angus Burgin about the role of F. A. Hayek and Milton Friedman and the Mont Pelerin Society (an organization of free-market economists plus some scholars in other disciplines founded by Hayek and later headed by Friedman) in resuscitating free-market capitalism as a political ideal after its nineteenth-century version had been discredited by the twin catastrophes of the Great War and the Great Depression was the subject of an interesting and in many ways insightful review by Robert Solow in the latest New Republic. Despite some unfortunate memory lapses and apologetics concerning his own errors and those of his good friend and colleague Paul Samuelson in their assessments of the of efficiency of central planning, thereby minimizing the analytical contributions of Hayek and Friedman, Solow does a good job of highlighting the complexity and nuances of Hayek’s thought — a complexity often ignored not only by Hayek’s critics but by many of his most vocal admirers — and of contrasting Hayek’s complexity and nuance with Friedman’s rhetorically and strategically compelling, but intellectually dubious, penchant for simplification.
First, let’s get the apologetics out of the way. Tyler Cowen pounced on this comment by Solow:
The MPS [Mont Pelerin Society] was no more influential inside the economics profession. There were no publications to be discussed. The American membership was apparently limited to economists of the Chicago School and its scattered university outposts, plus a few transplanted Europeans. “Some of my best friends” belonged. There was, of course, continuing research and debate among economists on the good and bad properties of competitive and noncompetitive markets, and the capacities and limitations of corrective regulation. But these would have gone on in the same way had the MPS not existed. It has to be remembered that academic economists were never optimistic about central planning. Even discussion about the economics of some conceivable socialism usually took the form of devising institutions and rules of behavior that would make a socialist economy function like a competitive market economy (perhaps more like one than any real-world market economy does). Maybe the main function of the MPS was to maintain the morale of the free-market fellowship.
And one of Tyler’s commenters unearthed this gem from Samuelson’s legendary textbook:
The Soviet economy is proof that, contrary to what many skeptics had earlier believed, a socialist command economy can function and even thrive.
Tyler also dug up this nugget from the classic paper by Sameulson and Solow on the Phillips Curve (but see this paper by James Forder for some revisionist history about the Samuelson-Solow paper):
We have not here entered upon the important question of what feasible institutional reforms might be introduced to lessen the degree of disharmony between full employment and price stability. These could of course involve such wide-ranging issues as direct price and wage controls, antiunion and antitrust legislation, and a host of other measures hopefully designed to move the American Phillips’ curves downward and to the left.
But actually, Solow was undoubtedly right that the main function of the MPS was morale-building! Plus networking. Nothing to be sneered at, and nothing to apologize for. The real heavy lifting was done in the 51 weeks of the year when the MPS was not in session.
Anyway, enough score settling, because Solow does show a qualified, but respectful, appreciation for Hayek’s virtues as an economist, scholar, and social philosopher, suggesting that there was a Good Hayek, who struggled to reformulate a version of liberalism that transcended the inadequacies (practical and theoretical) that doomed the laissez-faire liberalism of the nineteenth century, and a Bad Hayek, who engaged in a black versus white polemical struggle with “socialists of all parties.” The trope strikes me as a bit unfair, but Hayek could sometimes be injudicious in his policy pronouncements, or in his off-the-cuff observations and remarks. Despite his natural reserve, Hayek sometimes indulged in polemical exaggeration. The appetite for rhetorical overkill was especially hard for Hayek to resist when the topic of discussion was J. M. Keynes, the object of both Hayek’s admiration and his disdain. Hayek seemingly could not help but caricature Keynes in a way calculated to make him seem both ridiculous and irresistible. Have a look.
So I would not dispute that Hayek occasionally committed rhetorical excesses when wearing his policy-advocate hat. And there were some other egregious lapses on Hayek’s part like his unqualified support for General Pinochet, reflecting perhaps a Quixotic hope that somewhere there was a benevolent despot waiting to be persuaded to implement Hayek’s ideas for a new liberal political constitution in which the principle of the separation of powers would be extended to separate the law-making powers of the legislative body from the governing powers of the representative assembly.
But Solow exaggerates by characterizing the Road to Serfdom as an example of the Bad Hayek, despite acknowledging that the Road to Serfdom was very far from advocating a return to nineteenth-century laissez-faire. What Solow finds troubling is thesis that
the standard regulatory interventions in the economy have any inherent tendency to snowball into “serfdom.” The correlations often run the other way. Sixty-five years later, Hayek’s implicit prediction is a failure, rather like Marx’s forecast of the coming “immiserization of the working class.”
This is a common interpretation of Hayek’s thesis in the Road to Serfdom. And it is true that Hayek did intimate that piecemeal social engineering (to borrow a phrase coined by Hayek’s friend Karl Popper) created tendencies, which, if not held in check by strict adherence to liberal principles, could lead to comprehensive central planning. But that argument is a different one from the main argument of the Road to Serfdom that comprehensive central planning could be carried out effectively only by a government exercising unlimited power over individuals. And there is no empirical evidence that refutes Hayek’s main thesis.
A few years ago, in perhaps his last published article, Paul Samuelson wrote a brief historical assessment of Hayek, including personal recollections of their mostly friendly interactions and of one not so pleasant exchange they had in Hayek’s old age, when Hayek wrote to Samuelson demanding that Samuelson retract the statement in his textbook (essentially the same as the one made by Solow) that the empirical evidence, showing little or no correlation between economic and political freedom, refutes the thesis of the Road to Serfdom that intervention leads to totalitarianism. Hayek complained that this charge misrepresented what he had argued in the Road to Serfdom. Observing that Hayek, with whom he had long been acquainted, never previously complained about the passage, Samuelson explained that he tried to placate Hayek with an empty promise to revise the passage, attributing Hayek’s belated objection to the irritability of old age and a bad heart. Whether Samuelson’s evasive response to Hayek was an appropriate one is left as an exercise for the reader.
Defenders of Hayek expressed varying degrees of outrage at the condescending tone taken by Samuelson in his assessment of Hayek. I think that they were overreacting. Samuelson, an academic enfant terrible if there ever was one, may have treated his elders and peers with condescension, but, speaking from experience, I can testify that he treated his inferiors with the utmost courtesy. Samuelson was not dismissing Hayek, he was just being who he was.
The question remains: what was Hayek trying to say in the Road to Serfdom, and in subsequent works? Well, believe it or not, he was trying to say many things, but the main thesis of the Road to Serfdom was clearly what he always said it was: comprehensive central planning is, and always will be, incompatible with individual and political liberty. Samuelson and Solow were not testing Hayek’s main thesis. None of the examples of interventionist governments that they cite, mostly European social democracies, adopted comprehensive central planning, so Hayek’s thesis was not refuted by those counterexamples. Samuelson once acknowledged “considerable validity . . . for the nonnovel part [my emphasis] of Hayek’s warning” in the Road to Serfdom: “controlled socialist societies are rarely efficient and virtually never freely democratic.” Presumably Samuelson assumed that Hayek must have been saying something more than what had previously been said by other liberal economists. After all, if Hayek were saying no more than that liberty and democracy are incompatible with comprehensive central planning, what claim to originality could Hayek have been making? None.
Yep, that’s exactly right; Hayek was not making any claim to originality in the Road to Serfdom. But sometimes old truths have to be restated in a new and more persuasive form than that in which they were originally stated. That was especially the case in the early 1940s when collectivism and planning were widely viewed as the wave of the future, and even so thoroughly conservative and so eminent an economic theorist as Joseph Schumpeter could argue without embarrassment that there was no practical or theoretical reason why socialist central planning could not be implemented. And besides, the argument that every intervention leads to another one until the market system becomes paralyzed was not invented by Hayek either, having been made by Ludwig von Mises some twenty years earlier, and quite possibly by other writers before that. So even the argument that Samuelson tried to pin on Hayek was not really novel either.
To be sure, Hayek’s warning that central planning would inevitably lead to totalitarianism was not the only warning he made in the Road to Serfdom, but conceptually distinct arguments should not be conflated. Hayek clearly wanted to make the argument that an unprincipled policy of economic interventions was dangerous, because interventions introduce distortions that beget further interventions, producing a cumulative process of ever-more intrusive interventions, thereby smothering market forces and eventually sapping the productive capacity of the free enterprise system. That is an argument about how it is possible to stumble into central planning without really intending to do so. Hayek clearly believed in that argument, often invoking it in tandem with, or as a supplement to, his main argument about the incompatibility of central planning with liberty and democracy. Despite the undeniable tendency for interventions to create pressure (for both political and economic reasons) to adopt additional interventions, Hayek clearly overestimated the power of that tendency, failing to understand, or at least to take sufficient account of, the countervailing political forces resisting further interventions. So although Hayek was right that no intellectual principle enables one to say “so much intervention and not a drop more,” there could still be a kind of (messy) democratic political equilibrium that effectively limits the extent to which new interventions can be piled on top of old ones. That surely was a significant gap in Hayek’s too narrow, and overly critical, view of how the democratic political process operates.
That said, I think that Solow came close to getting it right in this paragraph:
THE GOOD HAYEK was not happy with the reception of The Road to Serfdom. He had not meant to provide a manifesto for the far right. Careless readers ignored his rejection of unqualified laissez-faire, and the fact that he reserved a useful, limited economic role for government. He had not actually claimed that the descent into serfdom was inevitable. There is no reason to doubt Hayek’s sincerity in this (although the Bad Hayek occasionally made other appearances). Perhaps he would be appalled at the thought of a Congress full of Tea Party Hayekians. But it was his book, after all. The fact that natural allies such as Knight and moderates such as Viner thought that he had overreached suggests that the Bad Hayek really was there in the text.
But not exactly right. Hayek was not totally good. Who is? Hayek made mistakes. Let he who is without sin cast the first stone. Frank Knight didn’t like the Road to Serfdom. But as Solow, himself, observed earlier in his review, Knight was a curmudgeon, and had previously crossed swords with Hayek over arcane issues of capital theory. So any inference from Knight’s reaction to the Road to Serfdom must be taken with a large grain of salt. And one might also want to consider what Schumpeter said about Hayek in his review of the Road to Serfdom, criticizing Hayek for “politeness to a fault,” because Hayek would “hardly ever attribute to opponents anything beyond intellectual error.” Was the Bad Hayek really there in the text? Was it really “not a good book?” The verdict has to be: unproven.
PS In his review, Solow expressed a wish for a full list of the original attendees at the founding meeting of the Mont Pelerin Society. Hayek included the list as a footnote to his “Opening Address to a Conference at Mont Pelerin” published in his Studies in Philosophy, Politics and Economics. There is a slightly different list of original members in Wikipedia.
Maurice Allais, Paris
Carlo Antoni, Rome
Hans Barth, Zurich
Karl Brandt, Stanford, Calif.
John Davenport, New York
Stanley R. Dennison, Cambridge
Walter Eucken, Freiburg i. B.
Erich Eyck, Oxford
Milton Friedman, Chicago
H. D. Gideonse, Brooklyn
F. D. Graham, Princeton
F. A. Harper, Irvington-on-Hudson, NY
Henry Hazlitt, New York
T. J. B. Hoff, Oslo
Albert Hunold, Zurich
Bertrand de Jouvenal, Chexbres, Vaud
Carl Iversen, Copenhagen
John Jewkes, Manchester
F. H. Knight, Chicgao
Fritz Machlup, Buffalo
L. B. Miller, Detroit
Ludwig von Mises, New York
Felix Morely, Washington, DC
Michael Polanyi, Manchester
Karl R. Popper, London
William E. Rappard, Geneva
L. E. Read, Irvington-on-Hudson, NY
Lionel Robbins, London
Wilhelm Roepke, Geneva
George J. Stigler, Providence, RI
Herbert Tingsten, Stockholm
Fracois Trevoux, Lyon
V. O. Watts, Irvington-on-Hudson, NY
C. V. Wedgewood, London
In addition, Hayek included the names of others invited but unable to attend who joined MPS as original members
My previous post on currency manipulation elicited some excellent comments and responses, helping me, I hope, to gain a better understanding of the subject than I started with. What seemed to me the most important point to emerge from the comments was that the Chinese central bank (PBC) imposes high reserve requirements on banks creating deposits. Thus, the creation of deposits by the Chinese banking system implies a derived demand for reserves that must be held with the PBC either to satisfy the legal reserve requirement or to satisfy the banks’ own liquidity demand for reserves. Focusing directly on the derived demand of the banking system to hold reserves is a better way to think about whether the Chinese are engaging in currency manipulation and sterilization than the simple framework of my previous post. Let me try to explain why.
In my previous post, I argued that currency manipulation is tantamount to the sterilization of foreign cash inflows triggered by the export surplus associated with an undervalued currency. Thanks to an undervalued yuan, Chinese exporters enjoy a competitive advantage in international markets, the resulting export surplus inducing an inflow of foreign cash to finance that surplus. But neither that surplus, nor the undervaluation of the yuan that underlies it, is sustainable unless the inflow of foreign cash is sterilized. Otherwise, the cash inflow, causing a corresponding increase in the Chinese money supply, would raise the Chinese price level until the competitive advantage of Chinese exporters was eroded. Sterilization, usually conceived of as open-market sales of domestic assets held by the central bank, counteracts the automatic increase in the domestic money supply and in the domestic price level caused by the exchange of domestic for foreign currency. But this argument implies (or, at least, so I argued) that sterilization is not occurring unless the central bank is running down its holdings of domestic assets to offset the increase in its holdings of foreign exchange. So I suggested that, unless the Chinese central holdings of domestic assets had been falling, it appeared that the PBC was not actually engaging in sterilization. Looking at balance sheets of the PBC since 1999, I found that 2009 was the only year in which the holdings of domestic assets by the PBC actually declined. So I tentatively concluded that there seemed to be no evidence that, despite its prodigious accumulation of foreign exchange reserves, the PBC had been sterilizing inflows of foreign cash triggered by persistent Chinese export surpluses.
Somehow this did not seem right, and I now think that I understand why not. The answer is that reserve requirements imposed by the PBC increase the demand for reserves by the Chinese banking system. (See here.) The Chinese reserve requirements on the largest banks were until recently as high as 21.5% of deposits (apparently the percentage is the same for both time deposits and demand deposits). The required reserve ratio is the highest in the world. Thus, if Chinese banks create 1 million yuan in deposits, they are required to hold approximately 200,000 yuan in reserves at the PBC. That 200,000 increase in reserves must come from somewhere. If the PBC does not create those reserves from domestic credit, the only way that they can be obtained by the banks (in the aggregate) is by obtaining foreign exchange with which to satisfy their requirement. So given a 20% reserve requirement, unless the PBC undertakes net purchases of domestic assets equal to at least 200,000 yuan, it is effectively sterilizing the inflows of foreign exchange. So in my previous post, using the wrong criterion for determining whether sterilization was taking place, I had it backwards. The criterion for whether sterilization has occurred is whether bank reserves have increased over time by a significantly greater percentage than the increase in the domestic asset holdings of the PBC, not, as I had thought, whether those holdings of the PBC have declined.
In fact it is even more complicated than that, because the required-reserve ratio has fluctuated over time, the required-reserve ratio having roughly tripled between 2001 and 2010, so that the domestic asset holdings of the PBC would have had to increase more than proportionately to the increase in reserves to avoid effective sterilization. Given that the reserves held by banking system with the PBC at the end of 2010 were almost 8 times as large as they had been at the end of 2001, while the required reserve ratio over the period roughly tripled, the domestic asset holdings of the PBC should have increased more than twice as fast as bank reserves over the same period, an increase of, say, 20-fold, if not more. In the event, the domestic asset holdings of the PBC at the end of 2010 were just 2.2 times greater than they were at the end of 2001, so the inference of effective sterilization seems all but inescapable.
Why does the existence of reserve requirements mean that, unless the domestic asset holdings of the central bank increase at least as fast as reserves, sterilization is taking place? The answer is that the existence of a reserve requirement means that an increase in deposits implies a roughly equal percentage increase in reserves. If the additional reserves are not forthcoming from domestic sources, the domestic asset holdings of the central bank not having increased as fast as did required reserves, the needed reserves can be obtained from abroad only by way of an export surplus. Thus, an increase in the demand of the public to hold deposits cannot be accommodated unless the required reserves can be obtained from some source. If the central bank does not make the reserves available by purchasing domestic assets, then the only other mechanism by which the increased demand for deposits can be accommodated is through an export surplus, the surplus being achieved by restricting domestic spending, thereby increasing exports and reducing imports. The economic consequences of the central bank not purchasing domestic assets when required reserves increase are the same as if the central bank sold some of its holdings of domestic assets when required reserves were unchanged.
The more general point is that one cannot assume that the inflow of foreign exchange corresponding to an export surplus is determined solely by the magnitude of domestic currency undervaluation. It is also a function of monetary policy. The tighter is monetary policy, the larger the export surplus, the export surplus serving as the mechanism by which the public increases their holdings of cash. Unfortunately, most discussions treat the export surplus as if it were determined solely by the exchange rate, making it seem as if an easier monetary policy would have little or no effect on the export surplus.
The point is similar to one I made almost a year ago when I criticized F. A. Hayek’s 1932 defense of the monetary policy of the insane Bank of France. Hayek acknowledged that the gold holdings of the Bank of France had increased by a huge amount in the late 1920s and early 1930s, but, nevertheless, absolved the Bank of France of any blame for the Great Depression, because the quantity of money in France had increased by as much as the increase in gold reserves of the Bank of France. To Hayek this meant that the Bank of France had done “all that was necessary for the gold standard to function.” This was a complete misunderstanding on Hayek’s part of how the gold standard operated, because what the Bank of France had done was to block every mechanism for increasing the quantity of money in France except the importation of gold. If the Bank of France had not embarked on its insane policy of gold accumulation, the quantity of money in France would have been more or less the same as it turned out to be, but France would have imported less gold, alleviating the upward pressure being applied to the real value of gold, or stated equivalently alleviating the downward pressure on the prices of everything else, a pressure largely caused by insane French policy of gold accumulation.
The consequences of the Chinese sterilization policy for the world economy are not nearly as disastrous as those of the French gold accumulation from 1928 to 1932, because the Chinese policy does not thereby impose deflation on any other country. The effects of Chinese sterilization and currency manipulation are more complex than those of French gold accumulation. I’ll try to at least make a start on analyzing those effects in an upcoming post addressing the comments of Scott Sumner on my previous post.
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.
