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In Praise of Israel Kirzner

Over the holiday weekend, I stumbled across, to my pleasant surprise, the lecture given just a week ago by Israel Kirzner on being awarded the 2015 Hayek medal by the Hayek Gesellschaft in Berlin. The medal, it goes without saying, was richly deserved, because Kirzner’s long career spanning over half a century has produced hundreds of articles and many books elucidating many important concepts in various areas of economics, but especially on the role of competition and entrepreneurship (the title of his best known book) in theory and in practice. A student of Ludwig von Mises, when Mises was at NYU in the 1950s, Kirzner was able to recast and rework Mises’s ideas in a way that made them more accessible and more relevant to younger generations of students than were the didactic and dogmatic pronouncements so characteristic of Mises’s own writings. Not that there wasn’t and still isn’t a substantial market niche in which such didacticism and dogmatism is highly prized, but there are also many for whom those features of the Misesian style don’t go down quite so easily.

But it would be very unfair, and totally wrong, to think of Kirzner as a mere popularizer of Misesian doctrines. Although in his modesty and self-effacement, Kirzner made few, if any, claims of originality for himself, his application of ideas that he learned from, or, having developed them himself, read into, Mises, Kirzner’s contributions in their own way were not at all lacking originality and creativity. In a certain sense, his contribution was, in its own way, entrepreneurial, i.e., taking a concept or an idea or an analytical tool applied in one context and deploying that concept, idea, or tool in another context. It’s worth mentioning that a reverential attitude towards one’s teachers and intellectual forbears is not only very much characteristic of the Talmudic tradition of which Kirzner is also an accomplished master, but it’s also characteristic, or at least used to be, of other scholarly traditions, notably Cambridge, England, where such illustrious students of Alfred Marshall as Frederick Lavington and A. C. Pigou viewed themselves as merely elaborating on doctrines that had already been expounded by Marshall himself, Pigou having famously said of his own voluminous work, “it’s all in Marshall.”

But rather than just extol Kirzner’s admirable personal qualities, I want to discuss what Kirzner said in his Hayek lecture. His main point was to explain how, in his view, the Austrian tradition, just as it seemed to be petering out in the late 1930s and 1940s, evolved from just another variant school of thought within the broader neoclassical tradition that emerged late in the 19th century from the marginal revolution started almost simultaneously around 1870 by William Stanley Jevons in England, Carl Menger in Austria, and Leon Walras in France/Switzerland, into a completely distinct school of thought very much at odds with the neoclassical mainstream. In Kirzner’s view, the divergence between Mises and Hayek on the one hand and the neoclassical mainstream on the other was that Mises and Hayek went further in developing the subjectivist paradigm underlying the marginal-utility theory of value introduced by Jevons, Menger, and Walras in opposition to the physicalist, real-cost, theory of value inherited from Smith, Ricardo, Mill, and other economists of the classical school.

The marginal revolution shifted the focus of economics from the objective physical and technological forces that supposedly determine cost, which, in turn, supposedly determines value, to subjective, not objective, mental states or opinions that characterize preferences, which, in turn, determine value. And, as soon became evident, the new subjective marginalist theory of value implied that cost, at bottom, is nothing other than a foregone value (opportunity cost), so that the classical doctrine that cost determines value has it exactly backwards: it is really value that determines cost (though it is usually a mistake to suppose that in complex systems causation runs in only one direction).

However, as the neoclassical research program evolved, the subjective character of the underlying theory was increasingly de-emphasized, a de-emphasis that was probably driven by two factors: 1) the profoundly paradoxical nature of the idea that value determines cost, not the reverse, and b) the mathematicization of economics and the increasing adoption, in the Walrasian style, of functional representations of utility and production, leading to the construction of models of economic equilibrium that, under appropriate continuity and convexity assumptions, could be shown to have a theoretically determinate and unique solution. The false impression was created that economics was an objective science like physics, and that economics should aim to create objective and deterministic scientific representations (models) of complex economic systems that could then yield quantitatively precise predictions, in the same way that physics produced models of planetary motion yielding quantitatively precise predictions.

What Hayek and Mises objected to was the idea, derived from the functional approach to economic theory, that economics is just a technique of optimization subject to constraints, that all economic problems can be reduced to optimization problems. And it is a historical curiosum that one of the chief contributors to this view of economics was none other than Lionel Robbins in his seminal methodological work An Essay on the Nature and Significance of Economic Science, written precisely during that stage of his career when he came under the profound influence of Mises and Hayek, but before Mises and Hayek adopted the more radically subjective approach that characterizes their views in the late 1930s and 1940s. The critical works are Hayek’s essays reproduced as The Counterrevolution of Science and his essays “Economics and Knowledge,” “The Facts of the Social Sciences,” “The Use of Knowledge in Society,” and “The Meaning of Competition,” all contained in the remarkable volume Individualism and Economic Order.

What neoclassical economists who developed this deterministic version of economic theory, a version wonderfully expounded in Samuelson Foundations of Economic Analysis and ultimately embodied in the Arrow-Debreu general-equilibrium model, failed to see is that the model could not incorporate in an intellectually satisfying or empirically fruitful way the process of economic growth and development. The fundamental characteristic of the Arrow-Debreu model is its perfection. The solution of the model is Pareto-optimal, and cannot be improved upon; the entire unfolding of the model from beginning to end proceeds entirely according to a plan (actually a set of perfectly consistent and harmonious individual plans) with no surprises and no disappointments relative to what was already foreseen and planned — in detail — at the outset. Nothing is learned in the unfolding and execution of those detailed, perfectly harmonious plans that was not already known at the beginning, whatever happens having already been foreseen. If something truly new would have been learned in the course of the unfolding and execution of those plans, the new knowledge would necessarily have been surprising, and a surprise would necessarily have generated some disappointment and caused some revision of a previously formulated plan of action. But that is precisely what the Arrow-Debreu model, in its perfection, disallows. And that is what, from the perspective of Mises, Hayek, and Kirzner, is exactly wrong with the entire development of neoclassical theory for the past 80 years or more.

The specific point of the neoclassical paradigm on which Kirzner has focused his criticism is the inability of the neoclassical paradigm to find a place for the entrepreneur and entrepreneurial activity in its theoretical apparatus. Profit is what is earned by the entrepreneur, but in full general equilibrium, all income is earned by factors of production, so profits have been exhausted and the entrepreneur euthanized.

Joseph Schumpeter, who was torn between his admiration for the Walrasian general equilibrium system and his Austrian education in economics, tried to reintroduce the entrepreneur as the disruptive force behind the process of creative destruction, the role of the entrepreneur being to disrupt the harmonious equilibrium of the Walrasian system by innovating – introducing either new techniques of production or new consumer products. Kirzner, however, though not denying that disruptive Schumpeterian entrepreneurs may come on the scene from time to time, is focused on a less disruptive, but more pervasive and more characteristic type of entrepreneurship, the kind that is on the lookout for – that is alert to – the profit opportunities that are always latent in the existing allocation of resources and the current structure of input and output prices. Prices in some places or at some times may be high relative to other places and other times, so the entrepreneurial maxim is: buy cheap and sell dear.

Not so long ago, someone noticed that used book prices on Amazon are typically lower at the end of the semester or the school year, when students are trying to unload the books that they don’t want to keep, than they are at the beginning of the semester, when students are buying the books that they will have to read in the new semester. By buying the books students are selling at the end of the school year and selling them at the beginning of the school year, the insightful entrepreneur reduces the cost to students of obtaining the books they use during the school year. That bit of insight and alertness is classic Kirznerian entrepreneurship in action; it was rewarded by a profit, but the activity was equilibrating, not disruptive, reducing the spread between prices for the same, or very similar, commodities paid by buyers or received by sellers at different times of the year.

Sometimes entrepreneurship involves recognizing that a resource or a factor of production is undervalued in its current use. Shifting the resource from a relatively low-valued use to a higher-value use generates a profit for the alert entrepreneur. Here, again, the activity is equilibrating not disruptive. And as others start to catch on, the profit earned on the spread between the value of the resource in its old and new uses will be eroded by the competition of copy-cat entrepreneurs and of other entrepreneurs with an even better idea derived from an even more penetrating insight.

Here is another critical point. Rarely does a new idea come into existence and cause just one change. Every change creates a new and different situation, potentially creating further opportunities to be taken advantage of by other alert and insightful individuals. In an open competitive system, there is no reason why the process of discovery and adaptation should ever come to an end state in which new insights can no longer be made and change is no longer possible.

However, it also the case that knowledge or information is often imperfect and faulty, and that incentives are imperfectly aligned with actual benefits, so that changes can be profitable even though they lead to inferior outcomes. Margarine can be substituted for butter, and transfats for saturated fats. Big mistake. But who knew? And processed carbohydrates can replace fats in low-fat diets. Big mistake. But who knew?

I myself had the pleasure of experiencing first-hand, on a very small scale to be sure, but still in a very inspiring way, this sort of unplanned, serendipitous connection between my stumbling across Kirzner’s Hayek lecture and, then, after starting to write this post a couple of days ago, doing a Google search on Kirzner plus something else (can’t remember what) and seeing a link to Deirdre McCloskey’s paper “A Kirznerian Economic History of the Modern World” in which McCloskey, in somewhat over-the-top style, waxed eloquent about the long and circuitous evolution of her views from the strict neoclassicism in which she was indoctrinated at Harvard and later at Chicago to Kirznerian Austrianism. McCloskey observes in her wonderful paean to Kirzner that growth theory (which is now the core of modern macroeconomics) is utterly incapable of accounting for the historically unique period of economic growth over the past 200 years in what we now refer to as the developed world.

I had faced repeatedly 1964 to 2010 the failure of oomph in the routine, Samuelsonian arguments, such as accumulation inspired by the Protestant ethic, or trade as an engine of growth, or Marxian exploitation, or imperialism as the last stage of capitalism, or factor-biased induced technical change, or Unified Growth Theory. My colleagues at the University of Chicago in the 1970s, Al Harberger and Bob Fogel, pioneered the point that Harberger Triangles of efficiency gain are small (Harberger 1964; Fogel 1965). None of the allocative, capital-accumulation explanations of economic growth since Adam Smith have worked scientifically, which I show in depressing detail in Bourgeois Dignity. None of them have the quantitative force and the distinctiveness to the modern world and the West to explain the Great Fact. No oomph.

What works? Creativity. Innovation. Discovery. The Austrian core. And where did discovery come from? It came from the releasing of the West from ancient constraints on the dignity and liberty of the bourgeoisie, producing an intellectual and engineering explosion of ideas. As the banker and science writer Matt Ridley has recently described it (2010; compare Storr 2008), ideas started breeding, and having baby ideas, who bred further. The liberation of the Jews in the West is a good emblem for the wider story. A people of the book began to be allowed into commercial centers in Holland and then England, and allowed outside the shtetl and the ghetto, and into the universities of Berlin and Manchester. They commenced innovating on a massive, breeding-reactor scale, in good ways (Rothschild, Einstein) and in bad (Marx, Freud).

Ridley explains how the evolutionary biologist Leigh Van Valen proposed in 1973 a Red Queen Hypothesis that would explain why commercial and mechanical ideas, when first allowed to evolve, had to run faster and faster to stay in the same place. Economists would call it the dissipation of initial rents, in the second and third acts of the economic drama. Once breeding ideas were set free in the seventeenth century they created more and more opportunities for Kirznerian alertness. The opportunities were alertly taken up, and persuasively argued for, and at length routinized. The idea of the steam engine had babies with the idea of rails and the idea of wrought iron, and the result was the railroads. The new generation of ideas-in view of the continuing breeding of ideas going on in the background-created by their very routinization still more Kirznerian opportunities. Railroads once they were routine led to Sears, Roebuck and Montgomery Ward. And the routine then created prosperous people, such as my grandfather the freight conductor on the Milwaukee Road or my great-grandfather the postal clerk on the Chicago & Western Indiana or my other great-grandfather who invented the ring on telephones (which extended the telegraph, which itself had made tight scheduling of trains possible). Some became prosperous enough to take up the new ideas, and all became prosperous enough under the Great Fact to buy them. If there was no dissipation of the rents to alertness, and no ultimate gain of income to hoi polloi, no third act, no Red Queen effect, then innovation would not have a justification on egalitarian grounds-as in the historical event it surely did have. The Bosses would engorge all the income, as Ricardo in the early days of the Great Fact had feared. But in the event the discovery of which Kirzner and the Austrian tradition speaks enriched in the third act mainly the poor-your ancestors, and Israel’s, and mine.

It is the growth and diffusion of knowledge (both practical and theoretical, but especially the former), not the accumulation of capital, that accounts for the spectacular economic growth of the past two centuries. So, all praise to the Austrian economist par excellence, Israel Kirzner. But just to avoid any misunderstanding, I will state for the record, that my admiration for Kirzner does not mean that I have gone wobbly on the subject of Austrian Business Cycle Theory, a subject on which Kirzner has been, so far as I know, largely silent — yet further evidence – as if any were needed — of Kirzner’s impeccable judgment.

Mises’s Unwitting Affirmation of the Hawtrey-Cassel Explanation of the Great Depression

In looking up some sources for my previous post on the gold-exchange standard, I checked, as I like to do from time to time, my old copy of The Theory of Money and Credit by Ludwig von Mises. Mises published The Theory of Money and Credit in 1912 (in German of course) when he was about 31 years old, a significant achievement. In 1924 he published a second enlarged edition addressing many issues that became relevant in the aftermath the World War and the attempts then underway to restore the gold standard. So one finds in the 1934 English translation of the 1924 German edition a whole section of Part III, chapter 6 devoted to the Gold-Exchange Standard. I noticed that I had dog-eared the section, which presumably means that when I first read the book I found the section interesting in some way, but I did not write any notes in the margin, so I am not sure what it was that I found interesting. I can’t even remember when I read the book, but there are many passages underlined throughout the book, so I am guessing that I did read it from cover to cover. Luckily, I wrote my name and the year (1971) in which I bought the book on the inside of the front cover, so I am also guessing that I read the book before I became aware of the Hawtrey Cassel explanation of the Great Depression. But it seems clear to me that whatever it was that I found interesting about the section on the gold-exchange standard, it didn’t make a lasting impression on me, because I don’t think that I ever reread that section until earlier this week. So let’s go through Mises’s discussion and see what we find.

Wherever inflation has thrown the monetary system into confusion, the primary aim of currency policy has been to bring the printing presses to a standstill. Once that is done, once it has at last been learned that even the policy of raising the objective exchange-value of money has undesirable consequences, and once it is seen that the chief thing is to stabilize the value of money, then attempts are made to establish a gold-exchange standard as quickly as possible.

This seems to be reference to the World War I inflation and the somewhat surprising post-war inflation of 1919, which caused most countries to want to peg their currencies against the dollar, then the only major country with a currency convertible into gold. Mises continues:

This, for example, is what occurred in Austria at the end of 1922 and since then, at least for the time being, the dollar rate in that country has been fixed. But in existing circumstances, invariability of the dollar rate means invariability of the price of gold also. Thus Austria has a dollar-exchange standard and so, indirectly, a gold-exchange standard. That is the currency system that seems to be the immediate aim in Germany, Poland, Hungary, and many other European countries. Nowadays, European aspirations in the sphere of currency policy are limited to a return to the gold standard. This is quite understandable, for the gold standard previously functioned on the whole satisfactorily; it is true that it did not secure the unattainable ideal of a money with an invariable objective exchange value, but it did preserve the monetary system from the influence of governments and changing policies.

Yet the gold-standard system was already undermined before the war. The first step was the abolition of the physical use of gold in individual payments and the accumulation of the stocks of gold in the vaults of the great banks-of-issue. The next step was the adoption of the practice by a series of States of holding the gold reserves of the central banks-of-issue (or the redemption funds that took their place), not in actual gold, but in various sorts of foreign claims to gold. Thus it came about that the greater part of the stock of gold that was used for monetary purposes was gradually accumulated in a few large banks-of-issue; and so these banks became the central reserve-banks of the world, as previously the central banks-of-issue had become central reserve-banks for individual countries.

Mises is leaving out a lot here. Many countries were joining gold standard in the last quarter of the 19th century, when the gold standard became an international system. The countries adopting the gold standard did not have a gold coinage; for them to introduce a gold coinage, as Mises apparently would have been wanted, was then prohibitively costly. But gold reserves were still piling up in many central banks because of laws and regulations requiring central banks to hold gold reserves against banknotes. If gold coinages would have been introduced in addition to the gold gold reserves being accumulated as reserves against banknotes, the spread of gold standard through much of the world in the last quarter of the 19th century would have drastically accentuated the deflationary trends that marked most of the period from 1872 to 1896.

The War did not create this development; it merely hastened it a little.

Actually a lot. But we now come to the key passage.

Neither has the development yet reached the stage when all the newly-produced gold that is not absorbed into industrial use flows to a single centre. The Bank of England and the central banks-of-issue of some other States still control large stocks of gold; there are still several of them that take up part of the annual output of gold. Yet fluctuations in the price of gold are nowadays essentially dependent on the policy followed by the Federal Reserve Board. If the United States did not absorb gold to the extent to which it does, the price of gold would fall and the gold-prices of commodities would rise. Since, so long as the dollar represents a fixed quantity of gold, the United States admits the surplus gold and surrenders commodities for gold to an unlimited extent, a rapid fall in the value of gold has hitherto been avoided.

Mises’s explanation here is rather confused, because he neglects to point out that the extent to which gold was flowing into the Federal Reserve was a function, among other things, of the credit policy adopted by the Fed. The higher the interest rate, the more gold would flow into the Fed and, thus, the lower the international price level. Mises makes it sound as if there was a fixed demand for gold by the rest of the world and the US simply took whatever was left over. That was a remarkable misunderstanding on Mises’s part.

But this policy of the United States, which involves considerable sacrifices, might one day be changed. Variations in the price of gold would then occur and this would be bound to give rise in other gold countries to the question of whether it would not be better in order to avoid further rises in prices to dissociate the currency standard from gold.

Note the ambiguous use of the term “price of gold.” The nominal price of gold was fixed by convertibility, so what Mises meant was the real price of gold, with a fixed nominal price. It would have been less ambiguous if the term “value of gold” had been used here and in the rest of the passage instead of “price of gold.” I don’t know if Mises or his translator was at fault.

Just as Sweden attempted for a time to raise the krone above its old gold parity by closing the Mint to gold, so other countries that are now still on the gold standard or intend to return to it might act similarly. This would mean a further drop in the price of gold and a further reduction of the usefulness of gold for monetary purposes. If we disregard the Asiatic demand for money, we might even now without undue exaggeration say that gold has ceased to be a commodity the fluctuations in the price of which are independent of government influence. Fluctuations in the price of gold are nowadays substantially dependent on the behaviour of one government, viz. that of the United States of America.

By George, he’s got it! The value of gold depends mainly on the Fed! Or, to be a bit more exact, on how much gold is being held by the Fed and by the other central banks. The more gold they hold, the more valuable in real terms gold becomes, which means that, with a fixed nominal price of gold, the lower are the prices of all other commodities. The point of the gold-exchange standard was thus to reduce the world’s monetary demand for gold, thereby limiting the tendency of gold to appreciate and for prices in terms of gold to fall. Indeed, Mises here cites in a footnote none other than the villainous John Maynard Keynes himself (Tract on Monetary Reform) where he also argued that after World War I, the value of gold was determined by government policy, especially that of the Federal Reserve. Mises goes on to explain:

All that could not have been foreseen in this result of a long process of development is the circumstance that the fluctuations in the price of gold should have become dependent upon the policy of one government only. That the United States should have achieved such an economic predominance over other countries as it now has, and that it alone of all the countries of great economic importance should have retained the gold standard while the others (England, France, Germany, Russia, and the rest) have at least temporarily abandoned it – that is a consequence of what took place during the War. Yet the matter would not be essentially different if the price of gold was dependent not on the policy of the United States alone, but on those of four or five other governments as well. Those protagonists of the gold-exchange standard who have recommended it as a general monetary system and not merely as an expedient for poor countries, have overlooked this fact. They have not observed that the gold-exchange standard must at last mean depriving gold of that characteristic which is the most important from the point of view of monetary policy – its independence of government influence upon fluctuations in its value. The gold-exchange standard has not been recommended or adopted with the object of dethroning gold. All that Ricardo wanted was to reduce the cost of the monetary system. In many countries which from the last decade of the nineteenth century onward have wished to abandon the silver or credit-money standard, the gold-exchange standard rather than a gold standard with an actual gold currency has been adopted in order to prevent the growth of a new demand for gold from causing a rise in its price and a fall in the gold-prices of commodities. But whatever the motives may have been by which the protagonists of the gold-exchange standard have been led, there can be no doubt concerning the results of its increasing popularity.

If the gold-exchange standard is retained, the question must sooner or later arise as to whether it would not be better to substitute for it a credit-money standard whose fluctuations were more susceptible to control than those of gold. For if fluctuations in the price of gold are substantially dependent on political intervention, it is inconceivable why government policy should still be restricted at all and not given a free hand altogether, since the amount of this restriction is not enough to confine arbitrariness in price policy within narrow limits. The cost of additional gold for monetary purposes that is borne by the whole world might well be saved, for it no longer secures the result of making the monetary system independent of government intervention. If this complete government control is not desired, there remains one alternative only: an attempt must be made to get back from the gold-exchange standard to the actual use of gold again.

Thus, we see that in 1924 none other than the legendary Ludwig von Mises was explaining that the value of gold had come to depend primarily on the policy decisions of the Federal Reserve and the other leading central banks. He also understood that a process of deflation could have terrible consequences if free-market forces were not operating to bring about an adjustment of market prices to the rising value of gold. Recognizing the potentially disastrous consequences of a scramble for gold by the world’s central banks as they rejoined the gold standard, Hawtrey and Cassel called for central-bank cooperation to limit the increase in the demand for gold and to keep the value of gold stable. In 1924, at any rate, Mises, too, recognized that there could be a destabilizing deflationary increase in the demand for gold by central banks. But when the destabilizing deflationary increase actually started to happen in 1927 when the Bank of France began cashing in its foreign-exchange reserves for gold, triggering similar demands by other central banks in the process of adopting the gold standard, the gold standard started collapsing under the weight  of deflation. But, as far as I know, Mises never said a word about the relationship between gold demand and the Great Depression.

Instead, in the mythology of Austrian business-cycle theory, it was all the fault of the demonic Benjamin Strong for reducing the Fed’s discount rate from 5% to 3.5% in 1927 (and back to only 4% in 1928) and of the duplicitous Montagu Norman for reducing Bank Rate from 5% to 4.5% in 1927-28 rather than follow the virtuous example of the Bank of France in abandoning the cursed abomination of the gold-exchange standard.

Gold Standard or Gold-Exchange Standard: What’s the Difference?

In recent posts (here and here) I have mentioned both the gold standard and the gold-exchange standard, a dichotomy that suggests that the two are somehow distinct, and I noted that the Genoa Conference of 1922 produced a set of resolutions designed to ensure that the gold standard, whose restoration was the goal of the conference, would be a gold-exchange standard rather than the traditional pre-World War I gold standard. I also mentioned that the great American central banker Benjamin Strong had stated that he was not particularly fond of the gold-exchange standard favored by the Genoa Resolutions. So there seems to be some substantive difference between a gold standard (of the traditional type) and a gold-exchange standard. Wherein lies the difference? And what, if anything, can we infer from that difference about how the two standards operate?

Let’s begin with some basics. Suppose there’s a pure metallic (gold) currency. All coins that circulate are gold and their value reflects the weight and fineness of the gold, except that the coins are stamped so that they don’t have to be weighed or assayed; they trade at their face value. Inevitably under such systems, there’s a problem with the concurrent circulation of old and worn coins at par with newly minted coins. Because they have the same face value, it is old coins that remain in circulation, while the new coins are hoarded, leading to increasingly overvalued (underweight) coins in circulation. This observation gives rise to Gresham’s Law: bad (i.e., old and worn) money drives out the good (i.e., new full-weight) money. The full-weight coin is the standard, but it tends not to circulate.

When the currency consists entirely of full-weight gold coins, it is redundant to speak of a gold standard. The term “gold standard” has significance only if the coin represents a value greater than the value of its actual metallic content. When underweight coins can circulate at par, because they are easily exchangeable for coins of full weight, the coinage is up to standard. If coins don’t circulate at par, the coinage is debased; it is substandard.

Despite the circulation of gold coins for millenia, the formal idea of a gold standard did not come into being until the eighteenth century, when, because the English mint was consistently overvaluing gold at a ratio relative to silver of approximately 15.5 to 1, while on the Continent, the gold-silver ratio was about 15 to 1, inducing an influx of gold into England. The pound sterling had always been a silver coin, like the shilling (20 shillings in a pound), but by the end of the 17th century, debasement of the silver coinage led to the hoarding and export of full weight silver coins. In the 17th century, the British mint had begun coining a golden guinea, originally worth a pound, but, subsequently, reflecting the premium on gold, guineas traded in the market at a premium.

In 1717, the master of the mint — a guy named Isaac Newton who, in his youth, had made something of a name for himself as a Cambridge mathematician — began to mint a golden pound at a mint price of £3 17 shillings and 10.5 pence (12 pence in a shilling) for an ounce of gold. The mint stopped minting guineas, which continued to circulate, and had an official value of 21 shillings (£1 1s.). In theory the pound remained a weight of silver, but in practice the pound had become a golden coin whose value was determined by the mint price chosen by that Newton guy.

Meanwhile the Bank of England based in London and what were known as country banks (because they operated outside the London metro area) as well as the Scottish banks operating under the Scottish legal regime that was retained after the union of England with Scotland, were all issuing banknotes denominated in sterling, meaning that they were convertible into an equivalent value of metallic (now golden) pounds. So legally the banks were operating under a pound standard not a gold standard. The connection to gold was indirect, reflecting the price at which Isaac Newton had decided that the mint would coin gold into pounds, not a legal definition of the pound.

The pound did not become truly golden until Parliament passed legislation in 1819 (The Resumption Act) after the Napoleonic Wars. The obligation of banks to convert their notes into coinage was suspended in 1797, and Bank of England notes were made legal tender. With the indirect link between gold and paper broken, the value of gold in terms of inconvertible pounds rose above the old mint price. Anticipating the resumption of gold payments, David Ricardo in 1816 penned what he called Proposals for an Economical and Secure Currency in which he proposed making all banknotes convertible into a fixed weight of gold, while reducing the metallic content of the coinage to well below their face value. By abolishing the convertibility of banknotes into gold coin, but restricting the convertibility of bank notes to gold bullion, Ricardo was proposing what is called a gold-bullion standard, as opposed to a gold-specie standard when banknotes are convertible into coin. Ricardo reasoned that by saving the resources tied up in a gold coinage, his proposal would make the currency economical, and, by making banknotes convertible into gold, his proposals would ensure that the currency was secure. Evidently too radical for the times, Ricardo’s proposals did not gain acceptance, and a gold coinage was brought back into circulation at the Newtonian mint price.

But as Keynes observed in his first book on economics Indian Currency and Finance published in 1913 just before the gold standard collapsed at the start of World War I, gold coinage was not an important feature of the gold standard as it operated in its heday.

A gold standard is the rule now in all parts of the world; but a gold currency is the exception. The “sound currency” maxims of twenty or thirty years ago are still often repeated, but they have not been successful, nor ought they to have been, in actually influencing affairs. I think that I am right in saying that Egypt is now the only country in the world in which actual gold coins are the principle medium of exchange.

The reasons for this change are easily seen. It has been found that the expense of a gold circulation is insupportable, and that large economics can be safely effected by the use of some cheaper substitute; and it has been found further that gold in the pockets of the people is not in the least available at a time of crisis or to meet a foreign drain. For these purposes the gold resources of a country must be centralized.

This view has long been maintained by economists. Ricardo’s proposals for a sound and economical currency were based on the principle of keeping gold out of actual circulation. Mill argued that “gold wanted for exportation is almost invariably drawn from the reserves of banks, and is never likely to be taken from the outside circulation while the banks remain solvent.” . . .

A preference for a tangible gold currency is no longer more than a relic of a time when Governments were less trustworthy in these matters than they are now, and when it was the fashion to imitate uncritically the system which had been established in England and had seemed to work so well during the second quarter of the nineteenth century. (pp. 71-73)

Besides arguing against the wastefulness of a gold coinage, Keynes made a further argument about the holding of gold reserves as a feature of the gold standard, namely that, as a matter of course, there are economic incentives (already recognized by Ricardo almost a century earlier) for banks to economize on their holdings of gold reserves with which to discharge their foreign obligations by holding foreign debt instruments which also serve to satisfy foreign claims upon themselves while also generating a pecuniary return. A decentralized informal clearinghouse evolved over the course of the nineteenth century, in which banks held increasing amounts of foreign instruments with which to settle mutual claims upon each other, thereby minimizing the need for actual gold shipments to settle claims. Thus, for purposes of discharging foreign indebtedness, the need for banks to hold gold reserves became less urgent. The holding of foreign-exchange reserves and the use of those reserves to discharge foreign obligations as they came due is the defining characteristic of what was known as the gold-exchange standard.

To say that the Gold-Exchange Standard merely carries somewhat further the currency arrangements which several European countries have evolved during the last quarter of a century is not, of course, to justify it. But if we see that the Gold-Exchange Standard is not, in the currency world of to-day, anomalous, and that it is in the main stream of currency evolution, we shall have a wider experience, on which to draw in criticising it, and may be in a better position to judge of its details wisely. Much nonsense is talked about a gold standard’s properly carrying a gold currency with it. If we mean by a gold currency a state of affairs in which gold is the principal or even, in the aggregate, a very important medium of exchange, no country in the world has such a thing. [fn. Unless it be Egypt.] Gold is an international, but not a local currency. The currency problem of each country is to ensure that they shall run no risk of being unable to put their hands on international currency when they need it, and to waste as small a proportion of their resources on holdings of actual gold as is compatible with this. The proper solution for each country must be governed by the nature of its position in the international money market and of its relations to the chief financial centres, and by those national customs in matters of currency which it may be unwise to disturb. It is as an attempt to solve this problem that the Gold Exchange Standard ought to be judged. . . .

The Gold-Exchange Standard arises out of the discovery that, so long as gold is available for payments of international indebtedness at an approximately constant rate in terms of the national currency, it is a matter of comparative indifference whether it actually forms the national currency.

The Gold-Exchange Standard may be said to exist when gold does not circulate in a country to an appreciable extent, when the local currency is not necessarily redeemable in gold, but when the Government or Central Bank makes arrangements for the provision of foreign remittances in gold at a fix, ed maximum rate in terms of the local currency, the reserves necessary to provide these remittances being kept to a considerable extent abroad. . . .

Its theoretical advantages were first set forth by Ricardo at the time of the Bullionist Controversy. He laid it down that a currency is in its most perfect state when it consists of a cheap material, but having an equal value with the gold it professes to represent; and he suggested that convertibility for the purposes of the foreign exchanges should be ensured by the tendering on demand of gold bars (not coin) in exchange for notes, — so that gold might be available for purposes of export only, and would be prevented from entering into the internal circulation of the country. (pp. 29-31)

The Gold-Exchange Standard in the form in which it has been adopted in India is justly known as the Lindsay scheme. It was proposed and advocated from the earliest discussions, when the Indian currency problem first became prominent, by Mr. A. M. Lindsay, Deputy-Secretary of the Bank of Bengal, who always maintained that “they must adopt my scheme despite themselves.” His first proposals were made in 1876 and 1878. They were repeated in 1885 and again in 1892, when he published a pamphlet entitled Ricardo’s Exchange Remedy. Finally he explained his views in detail to the Committee of 1898.

Lindsay’s scheme was severely criticized both by Government officials and leading financiers. Lord Farrer described it as “far too clever for the ordinary English mind with its ineradicable prejudice for an immediately tangible gold backing of all currencies.” Lord Rothschild, Sir John Lubbock (Lord Avebury), Sir Samuel Montagu (the late Lord Swythling) all gave evidence before the Committee that any system without a visible gold currency would be looked on with distrust. Mr. Alfred de Rothschild went so far as to say that “in fact a gold standard without a gold currency seemed to him an utter impossibility.” Financiers of this type will not admit the feasibility of anything until it has been demonstrated to them by practical experience. (pp. 34-35)

Finally, as to the question of what difference, aside from convenience, does it make whether a country operates on a full-fledged honest to goodness gold standard or a cheap imitation gold-exchange standard, I conclude with another splendid quotation from Keynes.

But before we pass to these several features of the Indian system, it will be worth while to emphasise two respects in which this system is not peculiar. In the first place a system, in which the rupee is maintained at 1s. 4d. by regulation, does not affect the level of prices differently from the way in which it would be affected by a system in which the rupee was a gold coin worth 1s 4d., except in a very indirect and unimportant way to be explained in a moment. So long as the rupee is worth 1s. 4d. in gold, no merchant or manufacturer considers of what material it is made when he fixes the price of his product. The indirect effect on prices, due to the rupee’s being silver, is similar to the effect of the use of any medium of exchange, such as cheques or notes, which economises the use of gold. If the use of gold is economised in any country, gold throughout the world is less valuable – gold prices, that is to say, are higher. But as this effect is shared by the whole world, the effect on prices in any country of economies in the use of gold made by that country is likely to be relatively slight. In short, a policy which led to a greater use of gold in India would tend, by increasing the demand for gold in the world’s markets, somewhat to lower the level of world prices as measured in gold; but it would not cause any alteration worth considering in the relative rates of exchange of Indian and non-Indian commodities.

In the second place, although it is true that the maintenance of the rupee at or near 1s. 4d. is due to regulation, it is not true, when once 1s. 4d. rather than some other gold value has been determined, that the volume of currency in circulation depends in the least upon the policy of the Government or the caprice of an official. This part of the system is as perfectly automatic as in any other country. (pp. 11-13)

The Great, but Misguided, Benjamin Strong Goes Astray in 1928

In making yet further revisions to our paper on Hawtrey and Cassel, Ron Batchelder and I keep finding interesting new material that sheds new light on the thinking behind the policies that led to the Great Depression. Recently I have been looking at the digital archive of Benjamin Strong’s papers held at the Federal Reserve Bank. Benjamin Strong was perhaps the greatest central banker who ever lived. Milton Friedman, Charles Kindleberger, Irving Fisher, and Ralph Hawtrey – and probably others as well — all believed that if Strong, Governor of the New York Federal Reserve Bank from 1914 to 1928 and effectively the sole policy maker for the entire system, had not died in 1928, the Great Depression would have been avoided entirely or, at least, would have been far less severe and long-lasting. My own view had been that Strong had generally understood the argument of Hawtrey and Cassel about the importance of economizing on gold, and, faced with the insane policy of the Bank of France, would have accommodated that policy by allowing an outflow of gold from the immense US holdings, rather than raise interest rates and induce an inflow of gold into the US in 1929, as happened under his successor, George Harrison.

Having spent some time browsing through the papers, I am sorry — because Strong’s truly remarkable qualities are evident in his papers — to say that the papers also show to my surprise and disappointment that Strong was very far from being a disciple of Hawtrey or Cassel or of any economist, and he seems to have been entirely unconcerned in 1928 about the policy of the Bank of France or the prospect of a deflationary run-up in the value of gold even though his friend Montague Norman, Governor of the Bank of England, was beginning to show some nervousness about “a scramble for gold,” while other observers were warning of a deflationary collapse. I must admit that, at least one reason for my surprise is that I had naively accepted the charges made by various Austrians – most notably Murray Rothbard – that Strong was a money manager who had bought into the dangerous theories of people like Irving Fisher, Ralph Hawtrey and J. M. Keynes that central bankers should manipulate their currencies to stabilize the price level. The papers I have seen show that, far from being a money manager and a price-level stabilizer, Strong expressed strong reservations about policies for stabilizing the price level, and was more in sympathy with the old-fashioned gold standard than with the gold-exchange standard — the paradigm promoted by Hawtrey and Cassel and endorsed at the Genoa Conference of 1922. Rothbard’s selective quotation from the memorandum summarizing Strong’s 1928 conversation with Sir Arthur Salter, which I will discuss below, gives a very inaccurate impression of Strong’s position on money management.

Here are a few of the documents that caught my eye.

On November 28 1927, Montague Norman wrote Strong about their planned meeting in January at Algeciras, Spain. Norman makes the following suggestion:

Perhaps the chief uncertainty or danger which confronts Central Bankers on this side of the Atlantic over the next half dozen years is the purchasing power of gold and the general price level. If not an immediate, it is a very serious question and has been too little considered up to the present. Cassel, as you will remember, has held up his warning finger on many occasions against the dangers of a continuing fall in the price level and the Conference at Genoa as you will remember, suggested that the danger could be met or prevented, by a more general use of the “Gold Exchange Standard”.

This is a very abstruse and complicated problem which personally I do not pretend to understand, the more so as it is based on somewhat uncertain statistics. But I rely for information from the outside about such a subject as this not, as you might suppose, on McKenna or Keynes, but on Sir Henry Strakosch. I am not sure if you know him: Austrian origin: many years in Johannesburg: 20 years in this country: a student of economics: a gold producer with general financial interests: perhaps the main stay in setting up the South African Reserve Bank: a member of the Financial Committee of the League and of the Indian Currency Commission: full of public spirit, genial and helpful . . . and so forth. I have probably told you that if I had been a Dictator he would have been a Director here years ago.

This is a problem to which Strackosch has given much study and it alarms him. He would say that none of us are paying sufficient attention to the possibility of a future fall in prices or are taking precautions to prepare any remedy such as was suggested at Genoa, namely smaller gold reserves through the Gold Exchange Standard, and that you, in the long run, will feel any trouble just as much as the rest of the Central Bankers will feel it.

My suggestion therefore is that it might be helpful if I could persuade Strakoosch too to come to Algeciras for a week: his visit could be quite casual and you would not be committed to any intrigue with him.

I gather from the tone of this letter and from other indications that the demands by the French to convert their foreign exchange to gold were already being made on the Bank of England and were causing some degree of consternation in London, which is why Norman was hoping that Strakosch might persuade Strong that something ought to be done to get the French to moderate their demands on the Bank of England to convert claims on sterling into gold. In the event, Strong met with Strakosch in December (probably in New York, not in Algeciras, without the presence of Norman). Not long thereafter Strong’s health deteriorated, and he took an extended leave from his duties at the bank. On March 27, 1928 Strong sent a letter to Norman outlining the main points of his conversation with Strakosch:

What [Strakosch] told me leads me to believe that he holds the following views:

  • That there is an impending shortage of monetary gold.
  • That there is certain to be a decline in the production by the South African mines.
  • That in consequence there will be a competition for gold between banks of issue which will lead to high discount rates, contracting credit and falling world commodity prices.
  • That Europe is so burdened with debt as to make such a development calamitous, possibly bankrupting some nations.
  • That the remedy is an extensive and formal development of the gold exchange standard.

From the above you will doubtless agree with me that Strakosch is a 100% “quantity” theory man, that he holds Cassel’s views in regard to the world’s gold position, and that he is alarmed at the outlook, just as most of the strict quantity theory men are, and rather expects that the banks of issue can do something about it.

Just as an aside, I will note that Strong is here displaying a rather common confusion, mixing up the quantity theory with a theory about the value of money under a gold standard. It’s a confusion that not only laymen, but also economists such as (to pick out a name almost at random) Milton Friedman, are very prone to fall into.

What he tells me is proposed consists of:

  • A study by the Financial Section of the League [of Nations] of the progress of economic recovery in Europe, which, he asserts, has closely followed progress in the resumption of gold payment or its equivalent.
  • A study of the gold problem, apparently in the perspective of the views of Cassel and others.
  • The submission of the results, with possibly some suggestions of a constructive nature, to a meeting of the heads of the banks of issue. He did not disclose whether the meeting would be a belated “Genoa resolution” meeting or something different.

What I told him appeared to shock him, and it was in brief:

  • That I did not share the fears of Cassel and others as to a gold shortage.
  • That I did not think that the quantity theory of prices, such for instance as Fisher has elaborate, “reduction ad absurdum,” was always dependable if unadulterated!
  • That I thought the gold exchange standard as now developing was hazardous in the extreme if allowed to proceed very much further, because of the duplication of bank liabilities upon the same gold.
  • That I much preferred to see the central banks build up their actual gold metal reserves in their own hands to something like orthodox proportions, and adopt their own monetary and credit policy and execute it themselves.
  • That I thought a meeting of the banks of issue in the immediate future to discuss the particular matter would be inappropriate and premature, until the vicissitudes of the Dawes Plan had developed further.
  • That any formal meeting of the banks of issue, if and when called, should originate among themselves rather than through the League, that the Genoa resolution was certainly no longer operative, and that such formal meeting should confine itself very specifically at the outset first to developing a sound basis of information, and second, to devising improvement in technique in gold practice

I am not at all sure that any formal meeting should be held before another year has elapsed. If it is held within a year or after a year, I am quite certain that it I attended it I could not do so helpfully if it tacitly implied acceptance of the principles set out in the Genoa resolution.

Stratosch is a fine fellow: I like him immensely, but I would feel reluctant to join in discussions where there was likelihood that the views so strongly advocated by Fisher, Cassel, Keynes, Commons, and others would seem likely to prevail. I would be willing at the proper time, if objection were not raised at home, to attend a conference of the banks of issue, if we could agree at the outset upon a simple platform, i.e., that gold is an effective measure of value and medium of exchange. If these two principles are extended, as seems to be in Stratosch’s mind, to mean that a manipulation of gold and credit can be employed as a regulator of prices at all times and under all circumstances, then I fear fundamental differences are inescapable.

And here is a third document in a similar vein that is also worth looking at. It is a memorandum written by O. E. Moore (a member of Strong’s staff at the New York Fed) providing a detailed account of the May 25, 1928 conversation between Strong and Sir Arthur Salter, then head of the economic and financial section of the League of Nations, who came to New York to ask for Strong’s cooperation in calling a new conference (already hinted at by Strakosch in his December conversation with Strong) with a view toward limiting the international demand for gold. Salter handed Strong a copy of a report by a committee of the League of Nations warning of the dangers of a steep increase in the value of gold because of increasing demand and a declining production.

Strong responded with a historical rendition of international monetary developments since the end of World War I, pointing out that even before the war was over he had been convinced of the need for cooperation among the world’s central banks, but then adding that he had been opposed to the recommendation of the 1922 Genoa Conference (largely drafted by Hawtrey and Cassel).

Governor Strong had been opposed from the start to the conclusions reached at the Genoa Conference. So far as he was aware, no one had ever been able to show any proof that there was a world shortage of gold or that there was likely to be any such shortage in the near future. . . . He was also opposed to the permanent operation of the gold exchange standard as outlined by the Genoa Conference, because it would mean by virtue of the extensive credits which the exchange standard countries would be holding in the gold centers, that they would be taking away from each of those two centers the control of their own money markets. This was an impossible thing for the Federal Reserve System to accept, so far as the American market was concerned, and in fact it was out of the question for any important country, it seemed to him, to give up entirely the direction of its own market. . . .

As a further aside, I will just observe that Strong’s objection to the gold exchange standard, namely that it permits an indefinite expansion of the money supply, a given base of gold reserves being able to support an unlimited expansion of the quantity of money, is simply wrong as a matter of theory. A country running a balance-of-payments deficit under a gold-exchange standard would be no less subject to the constraint of an external drain, even if it is holding reserves only in the form of instruments convertible into gold rather than actual gold, than it would be if it were operating under a gold standard holding reserves in gold.

Although Strong was emphatic that he could not agree to participate in any conference in which the policies and actions of the US could be determined by the views of other countries, he was open to a purely fact-finding commission to ascertain what the total world gold reserves were and how those were distributed among the different official reserve holding institutions. He also added this interesting caveat:

Governor Strong added that, in his estimation, it was very important that the men who undertook to find the answers to these questions should not be mere theorists who would take issue on controversial points, and that it would be most unfortunate if the report of such a commission should result in giving color to the views of men like Keynes, Cassel, and Fisher regarding an impending world shortage of gold and the necessity of stabilizing the price level. . . .

Governor Strong mentioned that one thing which had made him more wary than ever of the policies advocated by these men was that when Professor Fisher wrote his book on “Stabilizing the Dollar”, he had first submitted the manuscript to him (Governor Strong) and that the proposal made in that original manuscript was to adjust the gold content of the dollar as often as once a week, which in his opinion showed just how theoretical this group of economists were.

Here Strong was displaying the condescending attitude toward academic theorizing characteristic of men of affairs, especially characteristic of brilliant and self-taught men of affairs. Whether such condescension is justified is a question for which there is no general answer. However, it is clear to me that Strong did not have an accurate picture of what was happening in 1928 and what dangers were lying ahead of him and the world in the last few months of his life. So the confidence of Friedman, Kindelberger, Fisher, and Hawtrey in Strong’s surpassing judgment does not seem to me to rest on any evidence that Strong actually understood the situation in 1928 and certainly not that he knew what to do about it. On the contrary he was committed to a policy that was leading to disaster, or at least, was not going to avoid disaster. The most that can be said is that he was at least informed about the dangers, and if he had lived long enough to observe that the dangers about which he had been warned were coming to pass, he would have had the wit and the good sense and the courage to change his mind and take the actions that might have avoided catastrophe. But that possibility is just a possibility, and we can hardly be sure that, in the counterfactual universe in which Strong does not die in 1928, the Great Depression never happened.

Trying to Make Sense of the Insane Policy of the Bank of France and Other Catastrophes

In the almost four years since I started blogging I have occasionally referred to the insane Bank of France or to the insane policy of the Bank of France, a mental disorder that helped cause the deflation that produced the Great Depression. The insane policy began in 1928 when the Bank of France began converting its rapidly growing stockpile of foreign-exchange reserves (i.e., dollar- or sterling-denominated financial instruments) into gold. The conversion of foreign exchange was precipitated by the enactment of a law restoring the legal convertibility of the franc into gold and requiring the Bank of France to hold gold reserves equal to at least 35% of its outstanding banknotes. The law induced a massive inflow of gold into the Bank of France, and, after the Federal Reserve recklessly tightened its policy in an attempt to stamp out stock speculation on Wall Street, thereby inducing an inflow of gold into the US, the one-two punch knocked the world economy into just the deflationary tailspin that Hawtrey and Cassel, had warned would result if the postwar restoration of the gold standard were not managed so as to minimize the increase in the monetary demand for gold.

In making a new round of revisions to our paper on Hawtrey and Cassel, my co-author Ron Batchelder has just added an interesting footnote pointing out that there may have been a sensible rationale for the French gold policy: to accumulate a sufficient hoard of gold for use in case of another war with Germany. In World War I, belligerents withdrew gold coins from circulation, melted them down, and, over the next few years, exported the gold to neutral countries to pay for food and war supplies. That’s how the US, remaining neutral till 1917, wound up with a staggering 40% of the world’s stock of monetary gold reserves after the war. Obsessed with the military threat a re-armed Germany would pose, France insisted that the Versailles Treaty impose crippling reparations payments. The 1926 stabilization of the franc and enactment of the law restoring the gold standard and imposing a 35% reserve requirement on banknotes issued by the Bank of France occurred during the premiership of the staunchly anti-German Raymond Poincaré, a native of Lorraine (lost to Prussia in the war of 1870-71) and President of France during World War I.

A long time ago I wrote a paper “An Evolutionary Theory of the State Monopoly over Money” (which was reworked as chapter two of my book Free Banking and Monetary Reform and was later published in Money and the Nation State) in which, relying on an argument made by Earl Thompson, I suggested that historically the main reason for the nearly ubiquitous state involvement in supplying money was military not monetary: monopoly control over the supply of money enables the sovereign to quickly gain control over resources in war time, thereby giving states in which the sovereign controls the supply of money a military advantage over states in which the sovereign has no such control. Subsequently, Thompson further developed the idea to explain the rise of the gold standard after the Bank of England was founded in 1694, early in the reign of William and Mary, to finance rebuilding of the English navy, largely destroyed by the French in 1690. As explained by Macaulay in his History of England, the Bank of England, by substantially reducing the borrowing costs of the British government, was critical to the survival of the new monarchs in their battle with the Stuarts and Louis XIV. See Thompson’s article “The Gold Standard: Causes and Consequences” in Business Cycles and Depressions: An Encyclopedia (edited by me).

Thompson’s article is not focused on the holding of gold reserves, but on the confidence that the gold standard gave to those lending to the state, especially during a wartime suspension of convertibility, owing to an implicit commitment to restore the gold standard at the prewar parity. The importance of that implicit commitment is one reason why Churchill’s 1925 decision to restore the gold standard at the prewar parity was not necessarily as foolish as Keynes (The Economic Consequences of Mr. Churchill), along with almost all subsequent commentators, judged it to have been. But the postwar depreciation of the franc was so extreme that restoring the convertibility of the franc at the prewar parity became a practical impossibility, and the new parity at which convertibility was restored was just a fifth of its prewar level. Having thus reneged on its implicit commitment to restore the gold standard at the prewar parity, impairing its ability to borrow, France may have felt it had no alternative but to accumulate a ready gold reserve from which to draw when another war against Germany came. This is just theoretical speculation, but it might provide some clues for historical research into the thinking of French politicians and bankers in the late 1920s as they formulated their strategy for rejoining the gold standard.

However, even if the motivation for France’s gold accumulation was not simply a miserly desire to hold ever larger piles of shiny gold ingots in the vaults of the Banque de France, but was a precautionary measure against the possibility of a future war with Germany – and we know only too well that the fear was not imaginary – it is important to understand that, in the end, it was almost certainly the French policy of gold accumulation that paved the way for Hitler’s rise to power and all that entailed. Without the Great Depression and the collapse of the German economy, Hitler might well have remained an outcast on the margins of German politics.

The existence of a legitimate motivation for the insane policy of the Bank of France cannot excuse the failure to foresee the all too predictable consequences of that policy – consequences laid out plainly by Hawtrey and Cassel already in 1919-20, and reiterated consistently over the ensuing decade. Nor does the approval of that policy by reputable, even eminent, economists, who simply failed to understand how the gold standard worked, absolve those who made the wrong decisions of responsibility for their mistaken decisions. They were warned about the consequences of their actions, and chose to disregard the warnings.

All of this is sadly reminiscent of the 2003 invasion of Iraq. I don’t agree with those who ascribe evil motives to the Bush administration for invading Iraq, though there seems little doubt that the WMD issue was largely pretextual. But that doesn’t mean that Bush et al. didn’t actually believe that Saddam had WMD. More importantly, I think that Bush et al. sincerely thought that invading Iraq and deposing Saddam Hussein would, after the supposed defeat of Al Qaeda and the Taliban in Afghanistan, establish a benign American dominance in the region, as World War II had done in Japan and Western Europe.

The problem is not, as critics like to say, that Bush et al. lied us into war; the problem is that they stupidly fooled themselves into thinking that they could just invade Iraq, unseat Saddam Hussein, and that their job would be over. They fooled themselves even though they had been warned in advance that Iraq was riven by internal ethnic, sectarian, religious and political divisions. Brutally suppressed by Hussein and his Ba’athist regime, those differences were bound to reemerge once the regime was dismantled. When General Eric Shinseki’s testified before Congress that hundreds of thousands of American troops would be needed to maintain peace and order after Hussein was ousted, Paul Wolfowitz and Donald Rumsfeld could only respond with triumphalist ridicule at the idea that more troops would be required to maintain law and order in Iraq after Hussein was deposed than were needed to depose him. The sophomoric shallowness of the response to Shinseki by those that planned the invasion still shocks and appalls.

It’s true that, after the Republican loss in the 2006 Congressional elections, Bush, freeing himself from the influence of Dick Cheney and replacing Donald Rumsfeld with Robert Gates as Secretary of Defense, and Gen. George Casey with Gen. David Petraeus as commander of US forces in Iraq, finally adopted the counter-insurgency strategy (aka the “surge”) so long resisted by Cheney and Rumsfeld, thereby succeeding in putting down the Sunni/Al-Qaeda/Baathist insurgency and in bringing the anti-American Shi’ite militias to heel. I wrote about the success of the surge in December 2007 when that provisional military success was still controversial. But, as General Petraeus conceded, the ultimate success of the counter-insurgency strategy depended on implementing a political strategy to reconcile the different elements of Iraqi society to their government. We now know that even in 2008 Premier Nouri al-Maliki, who had been installed as premier with the backing of the Bush administration, was already reversing the limited steps taken during the surge to achieve accommodation between Iraqi Sunnis and Shi’ites, while consolidating his Shi’ite base by reconciling politically with the pro-Iranian militants he had put down militarily.

The failure of the Iraqi government to consolidate and maintain the gains made in 2007-08 has been blamed on Obama’s decision to withdraw all American forces from Iraq after the status of forces agreement signed by President Bush and Premier al-Maliki in December 2008 expired at the end of 2011. But preserving the gains made in 2007-08 depended on a political strategy to reconcile the opposing ethnic and sectarian factions of Iraqi society. The Bush administration could not implement such a strategy with 130,000 troops still in Iraq at the end of 2008, and the sovereign Iraqi government in place, left to its own devices, had no interest in pursuing such a strategy. Perhaps keeping a larger US presence in Iraq for a longer time would have kept Iraq from falling apart as fast as it has, but the necessary conditions for a successful political outcome were never in place.

So even if the motivation for the catastrophic accumulation of gold by France in the 1928-29 was merely to prepare itself to fight, if need be, another war against Germany, the fact remains that the main accomplishment of the gold-accumulation policy was to bring to power a German regime far more dangerous and threatening than the one that would have otherwise confronted France. And even if the motivation for the catastrophic invasion of Iraq in 2003 was to defeat and discredit Islamic terrorism, the fact remains that the invasion, just as Osama bin Laden had hoped, was to create the conditions in which Islamic terrorism could grow into a worldwide movement, attracting would-be jihadists to a growing number of local conflicts across the world. Although bin Laden was eventually killed in his Pakistani hideout, the invasion of Iraq led to rise of an even more sophisticated, more dangerous, and more threatening opponent than the one the invasion was intended to eradicate. Just as a misunderstanding of the gold standard led to catastrophe in 1928-29, the misconception that the threat of terrorism can be eliminated by military means has been leading us toward catastrophe since 2003. When will we learn?

PS Despite some overlap between what I say above and what David Henderson said in this post, I am not a libertarian or a non-interventionist.

Optimistic Thoughts about Productivity Growth and Secular Stagnation

The world, for all kinds of reasons, seems to be in a rather deplorable state, and the trendlines are not necessarily pointed in the right direction either. I won’t go through the whole, or even a partial, list of what is depressing me these days, but there is one topic that comes up a lot in the economics blogosphere, secular stagnation, about which I can conjure up some reasons for optimism.

What a lot of people are depressed about is the unusually low rate of growth in labor productivity that we have seen in the current recovery from the Little Depression. Although the rate of job creation has picked up over the past 15 months or so, averaging over 200,000 new jobs a month, the minimal increases in labor productivity mean that output growth has been much slower than usually observed in previous recoveries from steep downturns. The slow increase in labor productivity and the corresponding weakness of the recovery have been widely cited as evidence that we have entered into an era of secular stagnation.

I don’t deny that secular stagnation is a reasonable inference to be drawn from the persistently low increases in labor productivity during this recovery, but it does seem to me that a less depressing, though perhaps partial, explanation for low productivity growth may be available. My suggestion is that the 2008-09 downturn was associated with major sectoral shifts that caused an unusually large reallocation of labor from industries like construction and finance to other industries so that an unusually large number of workers have had to find new jobs doing work different from what they were doing previously. In many recessions, laid-off workers are either re-employed at their old jobs or find new jobs doing basically the same work that they had been doing at their old jobs. When workers transfer from one job to another similar job, there is little reason to expect a decline in their productivity after they are re-employed, but when workers are re-employed doing something very different from what they did before, a significant drop in their productivity in their new jobs is likely, though there may instances when, as workers gain new skills and experience in their new jobs, their productivity will rise rapidly.

In addition, the number of long-term unemployed (27 weeks or more) since the 2000-09 downturn has been unusually high. Workers who remain unemployed for an extended period of time tend to suffer an erosion of skills, causing their productivity to drop when they are re-employed even if they are able to find a new job in their old occupation. It seems likely that the percentage of long-term unemployed workers that switch occupations is larger than the percentage of short-term unemployed workers that switch occupations, so the unusually high rate of long-term unemployment has probably had a doubly negative effect on labor productivity.

I would even hazard a guess that the low rate of productivity growth in the 1970s may have also, at least in part, been skills-related, though for somewhat different reasons. The 1970s were a period of rapid growth in the labor force because of an influx of women and baby boomers, which continued throughout the 1980s. The influx of first-time workers into the labor force may have had something to do with slowdown in productivity growth in the 1970s and 1980s compared to the 1950s and 1960s, though the increase in the absolute size of the labor force was also a factor in holding down the rate of productivity growth. When the labor-force participation rate peaked in the 1990s, the rate of productivity growth increased.

I am not a labor economist, but a quick internet search seems to indicate that a strong empirical connection between labor-force composition and productivity growth has not been found. But another factor, the increase in energy prices, also had a skills aspect, the adjustment to increased energy prices having led to the adoption of new technologies and new methods of production that presumably required new skills different from those that workers had previously acquired. And the new technologies adopted in response to a sudden increase in energy prices had to go through a period of implementation and debugging and improvement during which measured productivity likely declined. Technological transformations require many workers to learn new skills and adapt to new technologies. The time spent learning how to do new things in new ways and figuring out how to do them better and more efficiently may have caused the measured productivity of such workers to drop, thereby slowing down the overall rate of productivity growth.

At any rate, if the anomalous decline in productivity in the expansion following the 2008-09 downturn has been caused, even if only in part, by a loss of skills by workers who were induced to change jobs or occupations or who experienced long periods of unemployment, that decline in unlikely to be permanent, so that the rate of productivity growth and the rate of growth in real GDP can be expected to pick up somewhat over time. Stagnation may therefore not be as long-lasting as some people fear.

Maybe that’s not such a great reason for optimism, but for now at least, it’s the best that I can muster.

Repeat after Me: Inflation’s the Cure not the Disease

Last week Martin Feldstein triggered a fascinating four-way exchange with a post explaining yet again why we still need to be worried about inflation. Tony Yates responded first with an explanation of why money printing doesn’t work at the zero lower bound (aka liquidity trap), leading Paul Krugman to comment wearily about the obtuseness of all those right-wingers who just can’t stop obsessing about the non-existent inflation threat when, all along, it was crystal clear that in a liquidity trap, printing money is useless.

I’m still not sure why relatively moderate conservatives like Feldstein didn’t find all this convincing back in 2009. I get, I think, why politics might predispose them to see inflation risks everywhere, but this was as crystal-clear a proposition as I’ve ever seen. Still, even if you managed to convince yourself that the liquidity-trap analysis was wrong six years ago, by now you should surely have realized that Bernanke, Woodford, Eggertsson, and, yes, me got it right.

But no — it’s a complete puzzle. Maybe it’s because those tricksy Fed officials started paying all of 25 basis points on reserves (Japan never paid such interest). Anyway, inflation is just around the corner, the same way it has been all these years.

Which surprisingly (not least to Krugman) led Brad DeLong to rise to Feldstein’s defense (well, sort of), pointing out that there is a respectable argument to be made for why even if money printing is not immediately effective at the zero lower bound, it could still be effective down the road, so that the mere fact that inflation has been consistently below 2% since the crash (except for a short blip when oil prices spiked in 2011-12) doesn’t mean that inflation might not pick up quickly once inflation expectations pick up a bit, triggering an accelerating and self-sustaining inflation as all those hitherto idle balances start gushing into circulation.

That argument drew a slightly dyspeptic response from Krugman who again pointed out, as had Tony Yates, that at the zero lower bound, the demand for cash is virtually unlimited so that there is no tendency for monetary expansion to raise prices, as if DeLong did not already know that. For some reason, Krugman seems unwilling to accept the implication of the argument in his own 1998 paper that he cites frequently: that for an increase in the money stock to raise the price level – note that there is an implicit assumption that the real demand for money does not change – the increase must be expected to be permanent. (I also note that the argument had been made almost 20 years earlier by Jack Hirshleifer, in his Fisherian text on capital theory, Capital Interest and Investment.) Thus, on Krugman’s own analysis, the effect of an increase in the money stock is expectations-dependent. A change in monetary policy will be inflationary if it is expected to be inflationary, and it will not be inflationary if it is not expected to be inflationary. And Krugman even quotes himself on the point, referring to

my call for the Bank of Japan to “credibly promise to be irresponsible” — to make the expansion of the base permanent, by committing to a relatively high inflation target. That was the main point of my 1998 paper!

So the question whether the monetary expansion since 2008 will ever turn out to be inflationary depends not on an abstract argument about the shape of the LM curve, but about the evolution of inflation expectations over time. I’m not sure that I’m persuaded by DeLong’s backward induction argument – an argument that I like enough to have used myself on occasion while conceding that the logic may not hold in the real word – but there is no logical inconsistency between the backward-induction argument and Krugman’s credibility argument; they simply reflect different conjectures about the evolution of inflation expectations in a world in which there is uncertainty about what the future monetary policy of the central bank is going to be (in other words, a world like the one we inhabit).

Which brings me to the real point of this post: the problem with monetary policy since 2008 has been that the Fed has credibly adopted a 2% inflation target, a target that, it is generally understood, the Fed prefers to undershoot rather than overshoot. Thus, in operational terms, the actual goal is really less than 2%. As long as the inflation target credibly remains less than 2%, the argument about inflation risk is about the risk that the Fed will credibly revise its target upwards.

With the both Wickselian natural real and natural nominal short-term rates of interest probably below zero, it would have made sense to raise the inflation target to get the natural nominal short-term rate above zero. There were other reasons to raise the inflation target as well, e.g., providing debt relief to debtors, thereby benefitting not only debtors but also those creditors whose debtors simply defaulted.

Krugman takes it for granted that monetary policy is impotent at the zero lower bound, but that impotence is not inherent; it is self-imposed by the credibility of the Fed’s own inflation target. To be sure, changing the inflation target is not a decision that we would want the Fed to take lightly, because it opens up some very tricky time-inconsistency problems. However, in a crisis, you may have to take a chance and hope that credibility can be restored by future responsible behavior once things get back to normal.

In this vein, I am reminded of the 1930 exchange between Hawtrey and Hugh Pattison Macmillan, chairman of the Committee on Finance and Industry, when Hawtrey, testifying before the Committee, suggested that the Bank of England reduce Bank Rate even at the risk of endangering the convertibility of sterling into gold (England eventually left the gold standard a little over a year later)

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.

Of course the best evidence for the effectiveness of monetary policy at the zero lower bound was provided three years later, in April 1933, when FDR suspended the gold standard in the US, causing the dollar to depreciate against gold, triggering an immediate rise in US prices (wholesale prices rising 14% from April through July) and the fastest real recovery in US history (industrial output rising by over 50% over the same period). A recent paper by Andrew Jalil and Gisela Rua documents this amazing recovery from the depths of the Great Depression and the crucial role that changing inflation expectations played in stimulating the recovery. They also make a further important point: that by announcing a price level target, FDR both accelerated the recovery and prevented expectations of inflation from increasing without limit. The 1933 episode suggests that a sharp, but limited, increase in the price-level target would generate a faster and more powerful output response than an incremental increase in the inflation target. Unfortunately, after the 2008 downturn we got neither.

Maybe it’s too much to expect that an unelected central bank would take upon itself to adopt as a policy goal a substantial increase in the price level. Had the Fed announced such a goal after the 2008 crisis, it would have invited a potentially fatal attack, and not just from the usual right-wing suspects, on its institutional independence. Price stability, is after all, part of dual mandate that Fed is legally bound to pursue. And it was FDR, not the Fed, that took the US off the gold standard.

But even so, we at least ought to be clear that if monetary policy is impotent at the zero lower bound, the impotence is not caused by any inherent weakness, but by the institutional and political constraints under which it operates in a constitutional system. And maybe there is no better argument for nominal GDP level targeting than that it offers a practical and civilly reverent way of allowing monetary policy to be effective at the zero lower bound.

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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