Archive for the 'monetary history' Category

Milton Friedman’s Dumb Rule

Josh Hendrickson discusses Milton Friedman’s famous k-percent rule on his blog, using Friedman’s rule as a vehicle for an enlightening discussion of the time-inconsistency problem so brilliantly described by Fynn Kydland and Edward Prescott in a classic paper published 36 years ago. Josh recognizes that Friedman’s rule is imperfect. At any given time, the k-percent rule is likely to involve either an excess demand for cash or an excess supply of cash, so that the economy would constantly be adjusting to a policy induced macroeconomic disturbance. Obviously a less restrictive rule would allow the monetary authorities to achieve a better outcome. But Josh has an answer to that objection.

The k-percent rule has often been derided as a sub-optimal policy. Suppose, for example, that there was an increase in money demand. Without a corresponding increase in the money supply, there would be excess money demand that even Friedman believed would cause a reduction in both nominal income and real economic activity. So why would Friedman advocate such a policy?

The reason Friedman advocated the k-percent rule was not because he believed that it was the optimal policy in the modern sense of phrase, but rather that it limited the damage done by activist monetary policy. In Friedman’s view, shaped by his empirical work on monetary history, central banks tended to be a greater source of business cycle fluctuations than they were a source of stability. Thus, the k-percent rule would eliminate recessions caused by bad monetary policy.

That’s a fair statement of why Friedman advocated the k-percent rule. One of Friedman’s favorite epigrams was that one shouldn’t allow the best to be the enemy of the good, meaning that the pursuit of perfection is usually not worth it. Perfection is costly, and usually merely good is good enough. That’s generally good advice. Friedman thought that allowing the money supply to expand at a moderate rate (say 3%) would avoid severe deflationary pressure and avoid significant inflation, allowing the economy to muddle through without serious problems.

But behind that common-sense argument, there were deeper, more ideological, reasons for the k-percent rule. The k-percent rule was also part of Friedman’s attempt to provide a libertarian/conservative alternative to the gold standard, which Friedman believed was both politically impractical and economically undesirable. However, the gold standard for over a century had been viewed by supporters of free-market liberalism as a necessary check on government power and as a bulwark of liberty. Friedman, desiring to offer a modern version of the case for classical liberalism (which has somehow been renamed neo-liberalism), felt that the k-percent rule, importantly combined with a regime of flexible exchange rates, could serve as an ideological substitute for the gold standard.

To provide a rationale for why the k-percent rule was preferable to simply trying to stabilize the price level, Friedman had to draw on a distinction between the aims of monetary policy and the instruments of monetary policy. Friedman argued that a rule specifying that the monetary authority should stabilize the price level was too flexible, granting the monetary authority too much discretion in its decision making.

The price level is not a variable over which the monetary authority has any direct control. It is a target not an instrument. Specifying a price-level target allows the monetary authority discretion in its choice of instruments to achieve the target. Friedman actually made a similar argument about the gold standard in a paper called “Real and Pseudo Gold Standards.” The price of gold is a target, not an instrument. The monetary authority can achieve its target price of gold with more than one policy. Unless you define the rule in terms of the instruments of the central bank, you have not taken away the discretionary power of the monetary authority. In his anti-discretionary zeal, Friedman believed that he had discovered an argument that trumped advocates of the gold standard .

Of course there was a huge problem with this argument, though Friedman was rarely called on it. The money supply, under any definition that Friedman ever entertained, is no more an instrument of the monetary authority than the price level. Most of the money instruments included in any of the various definitions of money Friedman entertained for purposes of his k-percent rule are privately issued. So Friedman’s claim that his rule would eliminate the discretion of the monetary authority in its use of instrument was clearly false. Now, one might claim that when Friedman originally advanced the rule in his Program for Monetary Stability, the rule was formulated the context of a proposal for 100-percent reserves. However, the proposal for 100-percent reserves would inevitably have to identify those deposits subject to the 100-percent requirement and those exempt from the requirement. Once it is possible to convert the covered deposits into higher yielding uncovered deposits, monetary policy would not be effective if it controlled only the growth of deposits subject to a 100-percent reserve requirement.

In his chapter on monetary policy in The Constitution of Liberty, F. A. Hayek effectively punctured Friedman’s argument that a monetary authority could operate effectively without some discretion in its use of instruments to execute a policy aimed at some agreed upon policy goal. It is a category error to equate the discretion of the monetary authority in the choice of its policy instruments with the discretion of the government in applying coercive sanctions against the persons and property of private individuals. It is true that Hayek later modified his views about central banks, but that change in his views was at least in part attributable to a misunderstanding. Hayek erroneoulsy believed that his discovery that competition in the supply of money is possible without driving the value of money down to zero meant that competitive banks would compete to create an alternative monetary standard that would be superior to the existing standard legally established by the monetary authority. His conclusion did not follow from his premise.

In a previous post, I discussed how Hayek also memorably demolished Friedman’s argument that, although the k-percent rule might not be the theoretically best rule, it would at least be a good rule that would avoid the worst consequences of misguided monetary policies producing either deflation or inflation. John Taylor, accepting the Hayek Prize from the Manhattan Institute, totally embarrassed himself by flagarantly misunderstanding what Hayek was talking about. Here are the two relevant passages from Hayek. The first from his pamphlet, Full Employment at any Price?

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

Hayek in the Denationalization of Money, Hayek was more direct:

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

And in a footnote, Hayek added.

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

So Friedman’s k-percent rule was dumb, really dumb. It was dumb, because it induced expectations that made it unsustainable. As Hayek observed, not only was the theory clear, but it was confirmed by the historical evidence from the nineteenth century. Unfortunately, it had to be reconfirmed one more time in 1982 before the Fed abandoned its own misguided attempt to implement a modified version of the Friedman rule.

George Selgin Relives the Sixties

Just two days before the 50th anniversary of the assassination of John Kennedy, George Selgin offered an ironic endorsement of raising the inflation target, as happened during the Kennedy Administration, in order to reduce unemployment.

[T]his isn’t the first time that we’ve been in a situation like the present one. There was at least one other occasion when the U.S. economy, having been humming along nicely with the inflation rate of 2% and an unemployment rate between 5% and 6%, slid into a recession. Eventually the unemployment rate was 7%, the inflation rate was only 1%, and the federal funds rate was within a percentage point of the zero lower bound. Fortunately for the American public, some well-placed (mostly Keynesian) economists came to the rescue, by arguing that the way to get unemployment back down was to aim for a higher inflation rate: a rate of about 4% a year, they figured, should suffice to get the unemployment rate down to 4%–a much lower rate than anyone dares to hope for today.

I’m puzzled and frustrated because, that time around, the Fed took the experts’ advice and it worked like a charm. The federal funds rate quickly achieved lift-off (within a year it had risen almost 100 basis points, from 1.17% to 2.15%). Before you could say “investment multiplier” the inflation and unemployment numbers were improving steadily. Within a few years inflation had reached 4%, and unemployment had declined to 4%–just as those (mostly Keynesian) experts had predicted.

So why are these crazy inflation hawks trying to prevent us from resorting again to a policy that worked such wonders in the past? Do they just love seeing all those millions of workers without jobs? Or is it simply that they don’t care about job

Oh: I forgot to say what past recession I’ve been referring to. It was the recession of 1960-61. The desired numbers were achieved by 1967. I can’t remember exactly what happened after that, though I’m sure it all went exactly as those clever theorists intended.

George has the general trajectory of the story more or less right, but the details and the timing are a bit off. Unemployment rose to 7% in the first half of 1961, and inflation was 1% or less. So reducing the Fed funds rate certainly worked, real GDP rising at not less than a 6.8% annual rate for four consecutive quarters starting with the second quarter of 1961, unemployment falling to 5.5 in the first quarter of 1962. In the following 11 quarters till the end of 1964, there were only three quarters in which the annual growth of GDP was less than 3.9%. The unemployment rate at the end of 1964 had fallen just below 5 percent and inflation was still well below 2%. It was only in 1965, that we see the beginings of an inflationary boom, real GDP growing at about a 10% annual rate in three of the next five quarters, and 8.4% and 5.6% in the other two quarters, unemployment falling to 3.8% by the second quarter of 1966, and inflation reaching 3% in 1966. Real GDP growth did not exceed 4% in any quarter after the first quarter of 1966, which suggests that the US economy had reached or exceeded its potential output, and unemployment had fallen below its natural rate.

In fact, recognizing the inflationary implications of the situation, the Fed shifted toward tighter money late in 1965, the Fed funds rate rising from 4% in late 1965 to nearly 6% in the summer of 1966. But the combination of tighter money and regulation-Q ceilings on deposit interest rates caused banks to lose deposits, producing a credit crunch in August 1966 and a slowdown in both real GDP growth in the second half of 1966 and the first half of 1967. With the economy already operating at capacity, subsequent increases in aggregate demand were reflected in rising inflation, which reached 5% in the annus horribilis 1968.

Cleverly suggesting that the decision to use monetary expansion, and an implied higher tolerance for inflation, to reduce unemployment from the 7% rate to which it had risen in 1961 was the ultimate cause of the high inflation of the late 1960s and early 1970s, and, presumably, the stagflation of the mid- and late-1970s, George is inviting his readers to conclude that raising the inflation target today would have similarly disastrous results.

Well, that strikes me as quite an overreach. Certainly one should not ignore the history to which George is drawing our attention, but I think it is possible (and plausible) to imagine a far more benign course of events than the one that played itself out in the 1960s and 1970s. The key difference is that the ceilings on deposit interest rates that caused a tightening of monetary policy in 1966 to produce a mini-financial crisis, forcing the 1966 Fed to abandon its sensible monetary tightening to counter inflationary pressure, are no longer in place.

Nor should we forget that some of the inflation of the 1970s was the result of supply-side shocks for which some monetary expansion (and some incremental price inflation) was an optimal policy response. The disastrous long-term consequences of Nixon’s wage and price controls should not be attributed to the expansionary monetary policy of the early 1960s.

As Mark Twain put it so well:

We should be careful to get out of an experience only the wisdom that is in it and stop there lest we be like the cat that sits down on a hot stove lid. She will never sit down on a hot stove lid again and that is well but also she will never sit down on a cold one anymore.

Eureka! Paul Krugman Discovers the Bank of France

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

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

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

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

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

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

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

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

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

Krugman concludes by comparing Germany today with France in 1930.

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

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

HT: ChargerCarl

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

Friedman’s Dictum

In his gallant, but in my opinion futile, attempts to defend Milton Friedman against the scandalous charge that Friedman was, gasp, a Keynesian, if not in his policy prescriptions, at least in his theoretical orientation, Scott Sumner has several times referred to the contrast between the implication of the IS-LM model that expansionary monetary policy implies a reduced interest rate, and Friedman’s oft-repeated dictum that high interest rates are a sign of easy money, and low interest rates a sign of tight money. This was a very clever strategic and rhetorical move by Scott, because it did highlight a key difference between Keynesian and Monetarist ideas while distracting attention from the overlap between Friedman and Keynesians on the basic analytics of nominal-income determination.

Alghough I agree with Scott that Friedman’s dictum that high interest rates distinguishes him from Keynes and Keynesian economists, I think that Scott leaves out an important detail: Friedman’s dictum also distinguishes him from just about all pre-Keynesian monetary economists. Keynes did not invent the terms “dear money” and “cheap money.” Those terms were around for over a century before Keynes came on the scene, so Keynes and the Keynesians were merely reflecting the common understanding of all (or nearly all) economists that high interest rates were a sign of “dear” or “tight” money, and low interest rates a sign of “cheap” or “easy” money. For example, in his magisterial A Century of Bank Rate, Hawtrey actually provided numerical bounds on what constituted cheap or dear money in the period he examined, from 1844 to 1938. Cheap money corresponded to a bank rate less than 3.5% and dear money to a bank rate over 4.5%, 3.5 to 4.5% being the intermediate range.

Take the period just leading up to the Great Depression, when Britain returned to the gold standard in 1925. The Bank of England kept its bank rate over 5% almost continuously until well into 1930. Meanwhile the discount rate of the Federal Reserve System from 1925 to late 1928 was between 3.5 and 5%, the increase in the discount rate in 1928 to 5% representing a decisive shift toward tight money that helped drive the world economy into the Great Depression. We all know – and certainly no one better than Scott – that, in the late 1920s, the bank rate was an absolutely reliable indicator of the stance of monetary policy. So what are we to make of Friedman’s dictum?

I think that the key point is that traditional notions of central banking – the idea of “cheap” or “dear” money – were arrived at during the nineteenth century when almost all central banks were operating either in terms of a convertible (gold or silver or bimetallic) standard or with reference to such a standard, so that the effect of monetary policy on prices could be monitored by observing the discount of the currency relative to gold or silver. In other words, there was an international price level in terms of gold (or silver), and the price level of every country could be observed by looking at the relationship of its currency to gold (or silver). As long as convertibility was maintained between a currency and gold (or silver), the price level in terms of that currency was fixed.

If a central bank changed its bank rate, as long as convertibility was maintained (and obviously most changes in bank rate occurred with no change in convertibility), the effect of the change in bank rate was not reflected in the country’s price level (which was determined by convertibility). So what was the point of a change in bank rate under those circumstances? Simply for the central bank to increase or decrease its holding of reserves (usually gold or silver). By increasing bank rate, the central bank would accumulate additional reserves, and, by decreasing bank rate, it would reduce its reserves. A “dear money” policy was the means by which a central bank could add to its reserve and an “easy money” policy was the means by which it could disgorge reserves.

So the idea that a central bank operating under a convertible standard could control its price level was based on a misapprehension — a widely held misapprehension to be sure — but still a mistaken application of the naive quantity theory of money to a convertible monetary standard. Nevertheless, although the irrelevance of bank rate to the domestic price level was not always properly understood in the nineteenth century – economists associated with the Currency School were especially confused on this point — the practical association between interest rates and the stance of monetary policy was well understood, which is why all monetary theorists in the nineteenth and early twentieth centuries agreed that high interest rates were a sign of dear money and low interest rates a sign of cheap money. Keynes and the Keynesians were simply reflecting the conventional wisdom.

Now after World War II, when convertibility was no longer a real constraint on the price level (despite the sham convertibility of the Bretton Woods system), it was a true innovation of Friedman to point out that the old association between dear (cheap) money and high (low) interest rates was no longer a reliable indicator of the stance of monetary policy. However, as a knee-jerk follower of the Currency School – the 3% rule being Friedman’s attempt to adapt the Bank Charter Act of 1844 to a fiat currency, and with equally (and predictably) lousy results – Friedman never understood that under the gold standard, it is the price level which is fixed and the money supply that is endogenously determined, which is why much of the Monetary History, especially the part about the Great Depression (not, as Friedman called it, “Contraction,” erroneously implying that the change in the quantity of money was the cause, rather than the effect, of the deflation that characterized the Great Depression) is fundamentally misguided owing to its comprehensive misunderstanding of the monetary adjustment mechanism under a convertible standard.

PS This is written in haste, so there may be some errors insofar as I relying on my memory without checking my sources. I am sure that readers will correct my lapses of memory

PPS I also apologize for not responding to recent comments, I will try to rectify that transgression over the next few days.

The Golden Constant My Eye

John Tamny, whose economic commentary I usually take with multiple grains of salt, writes an op-ed about the price of gold in today’s Wall Street Journal, a publication where the probability of reading nonsense is dangerously high. Amazingly, Tamny writes that the falling price of gold is a good sign for the US economy. “The recent decline in the price of gold, ” Tamny informs us, “is cause for cautious optimism.” What’s this? A sign that creeping sanity is infiltrating the editorial page of the Wall Street Journal? Is the Age of Enlightenment perhaps dawning in America?

Um, not so fast. After all, we are talking about the Wall Street Journal editorial page. Yep, it turns out that Tamny is indeed up to his old tricks again.

The precious metal has long been referred to as “the golden constant” for its steady value. An example is the skyrocketing price of gold in the 1970s, which didn’t so much signal a spike in gold’s value as it showed the decline of the dollar in which it was priced. If gold’s constancy as a measure of value is doubted, consider oil: In 1971 an ounce of gold at $35 bought 15 barrels, in 1981 an ounce of gold at $480 similarly bought 15 barrels, and today an ounce once again buys a shade above 15.

OMG! The golden constant! Gold was selling for about $35 an ounce in 1970 rose to nearly $900 an ounce in 1980, fell to about $250 an ounce in about 2001, rose back up to almost $1900 in 2011 and is now below $1400, and Mr. Tamny thinks that the value of gold is constant. Give me a break. Evidently, Mr. Tamny attaches deep significance to the fact that the value of gold relative to the value of a barrel of oil was roughly 15 barrels of oil per ounce in 1971, and again in 1981, and now, once again, is at roughly 15 barrels per ounce, though he neglects to inform us whether the significance is economic or mystical.

So I thought that I would test the constancy of this so-called relationship by computing the implied exchange rate between oil and gold since April 1968 when the gold price series maintained by the Federal Reserve Bank of St. Louis begins. The chart below, derived from the St. Louis Fed, plots the monthly average of the number of barrels of oil per ounce of gold from April 1968 (when it was a bit over 12) through March 2013 (when it was about 17). But as the graph makes clear the relative price  of gold to oil has been fluctuating wildly over the past 45 years, hitting a low of 6.6 barrels of oil per ounce of gold in June 2008, and a high of 33.8 barrels of oil per ounce of gold in July 1973. And this graph is based on monthly averages; plotting the daily fluctuations would show an even greater amplitude.

barrels_of_oil_per_ounce_of_goldDo Mr. Tamny and his buddies at the Wall Street Journal really expect people to buy this nonsense? This is what happens to your brain when you are obsessed with gold. If you think that the US and the world economies have been on a wild ride these past five years, imagine what it would have been like if the US or the world price level had been fluctuating as the relative price of gold in terms of oil has been fluctuating over the same time period. And don’t even think about what would have happened over the past 45 years under Mr. Tamny’s ideal, constant, gold-based monetary standard.

Let’s get this straight. The value of gold is entirely determined by speculation. The current value of gold has no relationship — none — to the value of the miniscule current services gold now provides. It is totally dependent on the obviously not very well-informed expectations of people like Mr. Tamny.

Gold indeed had a relatively stable value over long periods of time when there was a gold standard, but that was largely due to fortuitous circumstances, not the least of which was the behavior of national central banks that would accumulate gold or give up gold as needed to prevent the value of gold from fluctuating as wildly as it otherwise would have. When, as a result of the First World War, gold was largely demonetized, prices were no longer tied to gold. Then, in the 1920s, when the world tried to restore the gold standard, it was beyond the capacity of the world’s central banks to recreate the gold standard in such a way that their actions smoothed the inevitable fluctuations in the value of gold. Instead, their actions amplified fluctuations in the value of the gold, and the result was the greatest economic catastrophe the world had seen since the Black Death. To suggest another restoration of the gold standard in the face of such an experience is sheer lunacy. But, as members of at least one of our political parties can inform you, just in case you have been asleep for the past decade or so, the lunatic fringe can sometimes transform itself . . . into the lunatic mainstream.


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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