No! God Did Not Create all Slave-Holders Equal

In these troubled times, I find it hard to think and write about economics, so this post will be drawn largely from Abraham Lincoln’s great Cooper Union Speech which helped him gain the Republican nomination for President in 1860. What a difference a century and a half makes!

I am drawn to this speech because we are told that if we take down the statue of Robert E. Lee — a Virginian slave-holder who was once a hero of mine — in Charlottesville, Virginia, that will set us off on a road that will inevitably lead us to take down monuments to George Washington and Thomas Jefferson, who were also Virginian slave-holders. At least that’s what Tucker Carlson said on his show on Fox News on Tuesday night.

On Monday a mob tore down a civil war soldier’s memorial in Durham, North Carolina. Police stood idly by and liberals across the country applauded it. Which statues are next, the president asked today, George Washington, Thomas Jefferson? . . .

Thomas Jefferson indisputably was a great man. He was the author of the Declaration of Independence. Founder of the University of Virginia and maybe, most importantly, the greatest thinker in American political history.

All of us live in his shadow. Unfortunately, however, Jefferson was also a slave holder. That’s real. It’s a moral taint. We ought to remember it.

But to the fanatics on the left it means that Jefferson must be purged from public memory forever. The demands are already coming that we do that.

In 2015, the students at the University of Missouri demanded the removal of a Jefferson statue. Two years ago, on CNN, anchor Ashleigh Banfield suggested the Jefferson Memorial in Washington might have to go. . . .

Now, to be clear, as if it’s necessary, slavery is evil. If you believe in the rights of the individual, it’s actually hard to think of anything worse than slavery.

But let’s be honest. Up until 150 years ago when a group of brave Americans fought and died to finally put an end to it, slavery was the rule, rather than the exception around the world. And had been for thousands of years, sadly.

Plato owned saves, so did Mohammed — peace be upon him.

Many African tribes held slaves and sold them. The Aztecs did, too. Before he liberated Latin America, Simon Bolivar owned slaves.

Slave-holding was so common among the North American Indians that the Cherokee brought their slaves with them on the Trail of Tears. And it wasn’t something they learned from European settlers.

Indians were holding and trading slaves when Christopher Columbus arrived. And by the way, he owned slaves, too.

None of this is a defense of the atrocity of human bondage. And it is an atrocity.

The point however is that if we are going to judge the past by the standards of the present. If we are going to reduce a person’s life to the single worst thing he ever participated in, we had better be prepared for the consequences of that. And here’s why: Forty one of the 56 men who signed the Declaration of Independence held slaves.

James Madison, the father of the Constitution, had a plantation full of slaves.

George Mason, the father of the Bill of Rights, also owned slaves, unfortunately. But does that make what they wrote illegitimate?

Carlson made no mention of George Washington, but others have.

Of course, the argument is sophistical, because it conflates all slave-holders, suggesting that all slave-holders are equal, so that to deny Robert E. Lee and other Confederate heroes the privilege of being immortalized in stone or in bronze would require us, on principle, to consider all other slave-holders equally unworthy of such honor. But here’s the difference: most slave-holders — people like Washington and Jefferson and Madison and Mason — held slaves, because they lived in societies in which slave-holding was condoned and socially acceptable. But not all slave-holders had the audacity to claim that slave-holding was a natural and inalienable right of theirs, for the vindication of which they would go to war against their fellow countrymen to establish a new regime that would preserve, protect and defend that sacred right till the end of time. Not all slave-holders dared to justify their slave-holding as a high principle; it was only those Secessionists who started the Civil War to create the Confederate States of America to uphold a society dedicated to the proposition that some men are divinely entitled to “wring their bread from the sweat of other men’s faces” who entertained that audacious and repugnant conception of their own natural and rightful supremacy.

In his Cooper Union speech (see a marvelous re-enactment of the speech by Sam Waterston here), Lincoln conclusively showed how vast a difference there was between the attitude to slavery of the Founders of the American Republic — including those who owned slaves — and that of the Secessionists who chose to make war rather than allow the Republic to survive.

Herewith are selections from Lincoln’s magnificent address:

In his speech last autumn, at Columbus, Ohio, as reported in “The New-York Times,” Senator Douglas said:

“Our fathers, when they framed the Government under which we live, understood this question just as well, and even better, than we do now.”

I fully indorse this, and I adopt it as a text for this discourse. I so adopt it because it furnishes a precise and an agreed starting point for a discussion between Republicans and that wing of the Democracy headed by Senator Douglas. It simply leaves the inquiry: “What was the understanding those fathers had of the question mentioned?”

What is the frame of government under which we live?

The answer must be: “The Constitution of the United States.” That Constitution consists of the original, framed in 1787, (and under which the present government first went into operation,) and twelve subsequently framed amendments, the first ten of which were framed in 1789.

Who were our fathers that framed the Constitution? I suppose the “thirty-nine” who signed the original instrument may be fairly called our fathers who framed that part of the present Government. It is almost exactly true to say they framed it, and it is altogether true to say they fairly represented the opinion and sentiment of the whole nation at that time. Their names, being familiar to nearly all, and accessible to quite all, need not now be repeated. . . .

What is the question which, according to the text, those fathers understood “just as well, and even better than we do now?”

It is this: Does the proper division of local from federal authority, or anything in the Constitution, forbid our Federal Government to control as to slavery in our Federal Territories?

Upon this, Senator Douglas holds the affirmative, and Republicans the negative. This affirmation and denial form an issue; and this issue – this question – is precisely what the text declares our fathers understood “better than we.” . . .

In 1789, by the first Congress which sat under the Constitution, an act was passed to enforce the Ordinance of ’87, including the prohibition of slavery in the Northwestern Territory. The bill for this act was reported by one of the “thirty-nine,” Thomas Fitzsimmons, then a member of the House of Representatives from Pennsylvania. It went through all its stages without a word of opposition, and finally passed both branches without yeas and nays, which is equivalent to a unanimous passage. In this Congress there were sixteen of the thirty-nine fathers who framed the original Constitution. They were John Langdon, Nicholas Gilman, Wm. S. Johnson, Roger Sherman, Robert Morris, Thos. Fitzsimmons, William Few, Abraham Baldwin, Rufus King, William Paterson, George Clymer, Richard Bassett, George Read, Pierce Butler, Daniel Carroll, James Madison.

This shows that, in their understanding, no line dividing local from federal authority, nor anything in the Constitution, properly forbade Congress to prohibit slavery in the federal territory; else both their fidelity to correct principle, and their oath to support the Constitution, would have constrained them to oppose the prohibition.

Again, George Washington, another of the “thirty-nine,” was then President of the United States, and, as such approved and signed the bill; thus completing its validity as a law, and thus showing that, in his understanding, no line dividing local from federal authority, nor anything in the Constitution, forbade the Federal Government, to control as to slavery in federal territory. . . .

In 1803, the Federal Government purchased the Louisiana country. Our former territorial acquisitions came from certain of our own States; but this Louisiana country was acquired from a foreign nation. In 1804, Congress gave a territorial organization to that part of it which now constitutes the State of Louisiana. New Orleans, lying within that part, was an old and comparatively large city. There were other considerable towns and settlements, and slavery was extensively and thoroughly intermingled with the people. Congress did not, in the Territorial Act, prohibit slavery; but they did interfere with it – take control of it – in a more marked and extensive way than they did in the case of Mississippi. The substance of the provision therein made, in relation to slaves, was:

First. That no slave should be imported into the territory from foreign parts.

Second. That no slave should be carried into it who had been imported into the United States since the first day of May, 1798.

Third. That no slave should be carried into it, except by the owner, and for his own use as a settler; the penalty in all the cases being a fine upon the violator of the law, and freedom to the slave. . . .

The sum of the whole is, that of our thirty-nine fathers who framed the original Constitution, twenty-one – a clear majority of the whole – certainly understood that no proper division of local from federal authority, nor any part of the Constitution, forbade the Federal Government to control slavery in the federal territories; while all the rest probably had the same understanding. Such, unquestionably, was the understanding of our fathers who framed the original Constitution; and the text affirms that they understood the question “better than we.”

But, so far, I have been considering the understanding of the question manifested by the framers of the original Constitution. In and by the original instrument, a mode was provided for amending it; and, as I have already stated, the present frame of “the Government under which we live” consists of that original, and twelve amendatory articles framed and adopted since. Those who now insist that federal control of slavery in federal territories violates the Constitution, point us to the provisions which they suppose it thus violates; and, as I understand, that all fix upon provisions in these amendatory articles, and not in the original instrument. The Supreme Court, in the Dred Scott case, plant themselves upon the fifth amendment, which provides that no person shall be deprived of “life, liberty or property without due process of law;” while Senator Douglas and his peculiar adherents plant themselves upon the tenth amendment, providing that “the powers not delegated to the United States by the Constitution” “are reserved to the States respectively, or to the people.”

Now, it so happens that these amendments were framed by the first Congress which sat under the Constitution – the identical Congress which passed the act already mentioned, enforcing the prohibition of slavery in the Northwestern Territory. Not only was it the same Congress, but they were the identical, same individual men who, at the same session, and at the same time within the session, had under consideration, and in progress toward maturity, these Constitutional amendments, and this act prohibiting slavery in all the territory the nation then owned. The Constitutional amendments were introduced before, and passed after the act enforcing the Ordinance of ’87; so that, during the whole pendency of the act to enforce the Ordinance, the Constitutional amendments were also pending.

The seventy-six members of that Congress, including sixteen of the framers of the original Constitution, as before stated, were pre- eminently our fathers who framed that part of “the Government under which we live,” which is now claimed as forbidding the Federal Government to control slavery in the federal territories.

Is it not a little presumptuous in any one at this day to affirm that the two things which that Congress deliberately framed, and carried to maturity at the same time, are absolutely inconsistent with each other? And does not such affirmation become impudently absurd when coupled with the other affirmation from the same mouth, that those who did the two things, alleged to be inconsistent, understood whether they really were inconsistent better than we – better than he who affirms that they are inconsistent?

It is surely safe to assume that the thirty-nine framers of the original Constitution, and the seventy-six members of the Congress which framed the amendments thereto, taken together, do certainly include those who may be fairly called “our fathers who framed the Government under which we live.” And so assuming, I defy any man to show that any one of them ever, in his whole life, declared that, in his understanding, any proper division of local from federal authority, or any part of the Constitution, forbade the Federal Government to control as to slavery in the federal territories. I go a step further. I defy any one to show that any living man in the whole world ever did, prior to the beginning of the present century, (and I might almost say prior to the beginning of the last half of the present century,) declare that, in his understanding, any proper division of local from federal authority, or any part of the Constitution, forbade the Federal Government to control as to slavery in the federal territories. To those who now so declare, I give, not only “our fathers who framed the Government under which we live,” but with them all other living men within the century in which it was framed, among whom to search, and they shall not be able to find the evidence of a single man agreeing with them.

Now, and here, let me guard a little against being misunderstood. I do not mean to say we are bound to follow implicitly in whatever our fathers did. To do so, would be to discard all the lights of current experience – to reject all progress – all improvement. What I do say is, that if we would supplant the opinions and policy of our fathers in any case, we should do so upon evidence so conclusive, and argument so clear, that even their great authority, fairly considered and weighed, cannot stand; and most surely not in a case whereof we ourselves declare they understood the question better than we.

Some of you delight to flaunt in our faces the warning against sectional parties given by Washington in his Farewell Address. Less than eight years before Washington gave that warning, he had, as President of the United States, approved and signed an act of Congress, enforcing the prohibition of slavery in the Northwestern Territory, which act embodied the policy of the Government upon that subject up to and at the very moment he penned that warning; and about one year after he penned it, he wrote LaFayette that he considered that prohibition a wise measure, expressing in the same connection his hope that we should at some time have a confederacy of free States. . . .

But you will break up the Union rather than submit to a denial of your Constitutional rights.

That has a somewhat reckless sound; but it would be palliated, if not fully justified, were we proposing, by the mere force of numbers, to deprive you of some right, plainly written down in the Constitution. But we are proposing no such thing.

When you make these declarations, you have a specific and well-understood allusion to an assumed Constitutional right of yours, to take slaves into the federal territories, and to hold them there as property. But no such right is specifically written in the Constitution. That instrument is literally silent about any such right. We, on the contrary, deny that such a right has any existence in the Constitution, even by implication.

Your purpose, then, plainly stated, is that you will destroy the Government, unless you be allowed to construe and enforce the Constitution as you please, on all points in dispute between you and us. You will rule or ruin in all events.

This, plainly stated, is your language. Perhaps you will say the Supreme Court has decided the disputed Constitutional question in your favor. Not quite so. But waiving the lawyer’s distinction between dictum and decision, the Court have decided the question for you in a sort of way. The Court have substantially said, it is your Constitutional right to take slaves into the federal territories, and to hold them there as property. When I say the decision was made in a sort of way, I mean it was made in a divided Court, by a bare majority of the Judges, and they not quite agreeing with one another in the reasons for making it; that it is so made as that its avowed supporters disagree with one another about its meaning, and that it was mainly based upon a mistaken statement of fact – the statement in the opinion that “the right of property in a slave is distinctly and expressly affirmed in the Constitution.”

An inspection of the Constitution will show that the right of property in a slave is not “distinctly and expressly affirmed” in it. Bear in mind, the Judges do not pledge their judicial opinion that such right is impliedly affirmed in the Constitution; but they pledge their veracity that it is “distinctly and expressly” affirmed there – “distinctly,” that is, not mingled with anything else – “expressly,” that is, in words meaning just that, without the aid of any inference, and susceptible of no other meaning.

If they had only pledged their judicial opinion that such right is affirmed in the instrument by implication, it would be open to others to show that neither the word “slave” nor “slavery” is to be found in the Constitution, nor the word “property” even, in any connection with language alluding to the things slave, or slavery; and that wherever in that instrument the slave is alluded to, he is called a “person;” – and wherever his master’s legal right in relation to him is alluded to, it is spoken of as “service or labor which may be due,” – as a debt payable in service or labor. Also, it would be open to show, by contemporaneous history, that this mode of alluding to slaves and slavery, instead of speaking of them, was employed on purpose to exclude from the Constitution the idea that there could be property in man.

To show all this, is easy and certain.

When this obvious mistake of the Judges shall be brought to their notice, is it not reasonable to expect that they will withdraw the mistaken statement, and reconsider the conclusion based upon it?

And then it is to be remembered that “our fathers, who framed the Government under which we live” – the men who made the Constitution – decided this same Constitutional question in our favor, long ago – decided it without division among themselves, when making the decision; without division among themselves about the meaning of it after it was made, and, so far as any evidence is left, without basing it upon any mistaken statement of facts.

Under all these circumstances, do you really feel yourselves justified to break up this Government unless such a court decision as yours is, shall be at once submitted to as a conclusive and final rule of political action? But you will not abide the election of a Republican president! In that supposed event, you say, you will destroy the Union; and then, you say, the great crime of having destroyed it will be upon us! That is cool. A highwayman holds a pistol to my ear, and mutters through his teeth, “Stand and deliver, or I shall kill you, and then you will be a murderer!”

To be sure, what the robber demanded of me – my money – was my own; and I had a clear right to keep it; but it was no more my own than my vote is my own; and the threat of death to me, to extort my money, and the threat of destruction to the Union, to extort my vote, can scarcely be distinguished in principle. . . .

A few words now to Republicans. It is exceedingly desirable that all parts of this great Confederacy shall be at peace, and in harmony, one with another. Let us Republicans do our part to have it so. Even though much provoked, let us do nothing through passion and ill temper. Even though the southern people will not so much as listen to us, let us calmly consider their demands, and yield to them if, in our deliberate view of our duty, we possibly can. Judging by all they say and do, and by the subject and nature of their controversy with us, let us determine, if we can, what will satisfy them. . . .

These natural, and apparently adequate means all failing, what will convince them? This, and this only: cease to call slavery wrong, and join them in calling it right. And this must be done thoroughly – done in acts as well as in words. Silence will not be tolerated – we must place ourselves avowedly with them. Senator Douglas’ new sedition law must be enacted and enforced, suppressing all declarations that slavery is wrong, whether made in politics, in presses, in pulpits, or in private. We must arrest and return their fugitive slaves with greedy pleasure. We must pull down our Free State constitutions. The whole atmosphere must be disinfected from all taint of opposition to slavery, before they will cease to believe that all their troubles proceed from us.

I am quite aware they do not state their case precisely in this way. Most of them would probably say to us, “Let us alone, do nothing to us, and say what you please about slavery.” But we do let them alone – have never disturbed them – so that, after all, it is what we say, which dissatisfies them. They will continue to accuse us of doing, until we cease saying.

I am also aware they have not, as yet, in terms, demanded the overthrow of our Free-State Constitutions. Yet those Constitutions declare the wrong of slavery, with more solemn emphasis, than do all other sayings against it; and when all these other sayings shall have been silenced, the overthrow of these Constitutions will be demanded, and nothing be left to resist the demand. It is nothing to the contrary, that they do not demand the whole of this just now. Demanding what they do, and for the reason they do, they can voluntarily stop nowhere short of this consummation. Holding, as they do, that slavery is morally right, and socially elevating, they cannot cease to demand a full national recognition of it, as a legal right, and a social blessing.

Nor can we justifiably withhold this, on any ground save our conviction that slavery is wrong. If slavery is right, all words, acts, laws, and constitutions against it, are themselves wrong, and should be silenced, and swept away. If it is right, we cannot justly object to its nationality – its universality; if it is wrong, they cannot justly insist upon its extension – its enlargement. All they ask, we could readily grant, if we thought slavery right; all we ask, they could as readily grant, if they thought it wrong. Their thinking it right, and our thinking it wrong, is the precise fact upon which depends the whole controversy. Thinking it right, as they do, they are not to blame for desiring its full recognition, as being right; but, thinking it wrong, as we do, can we yield to them? Can we cast our votes with their view, and against our own? In view of our moral, social, and political responsibilities, can we do this?

Wrong as we think slavery is, we can yet afford to let it alone where it is, because that much is due to the necessity arising from its actual presence in the nation; but can we, while our votes will prevent it, allow it to spread into the National Territories, and to overrun us here in these Free States? If our sense of duty forbids this, then let us stand by our duty, fearlessly and effectively. Let us be diverted by none of those sophistical contrivances wherewith we are so industriously plied and belabored – contrivances such as groping for some middle ground between the right and the wrong, vain as the search for a man who should be neither a living man nor a dead man – such as a policy of “don’t care” on a question about which all true men do care – such as Union appeals beseeching true Union men to yield to Disunionists, reversing the divine rule, and calling, not the sinners, but the righteous to repentance – such as invocations to Washington, imploring men to unsay what Washington said, and undo what Washington did.

Neither let us be slandered from our duty by false accusations against us, nor frightened from it by menaces of destruction to the Government nor of dungeons to ourselves. LET US HAVE FAITH THAT RIGHT MAKES MIGHT, AND IN THAT FAITH, LET US, TO THE END, DARE TO DO OUR DUTY AS WE UNDERSTAND IT.

So, Mr. Carlson, before you start opining about slavery again, instead of citing Plato and Muhammed, peace be upon him, why not try reading some of the speeches of the sixteenth President of the United States?

What’s Wrong with the Price-Specie-Flow Mechanism, Part III: Friedman and Schwartz on the Great US Inflation of 1933

I have been writing recently about two great papers by McCloskey and Zecher (“How the Gold Standard Really Worked” and “The Success of Purchasing Power Parity”) on the gold standard and the price-specie-flow mechanism (PSFM). This post, for the time being at any rate, will be the last in the series. My main topic in this post is the four-month burst of inflation in the US from April through July of 1933, an episode that largely escaped the notice of Friedman and Schwartz in their Monetary History  of the US, an omission criticized by McCloskey and Zecher in their purchasing-power-parity paper. (I will mention parenthetically that the 1933 inflation was noticed and its importance understood by R. G. Hawtrey in the second (1933) edition of his book Trade Depression and the Way Out and by Scott Sumner in his 2015 book The Midas Paradox. Both Hawtrey and Sumner emphasize the importance of the aborted 1933 recovery as have Jalil and Rua in an important recent paper.) In his published comment on the purchasing-power-parity paper, Friedman (pp. 157-62) responded to the critique by McCloskey and Zecher, and I will look carefully at that response below. But before discussing Friedman’s take on the 1933 inflation, I want to make four general comments about the two McCloskey and Zecher papers.

My first comment concerns an assertion made in a couple of places in which they interpret balance-of-payments surpluses or deficits under a fixed-exchange-rate regime as the mechanism by which excess demands for (supplies of) money in one country are accommodated by way of a balance-of-payments surpluses (deficits). Thus, given a fixed exchange rate between country A and country B, if the quantity of money in country A is less than the amount that the public in country A want to hold, the amount of money held in country A will be increased as the public, seeking to add to their cash holdings, collectively spend less than their income, thereby generating an export surplus relative to country B, and inducing a net inflow of country B’s currency into country A to be converted into country A’s currency at the fixed exchange rate. The argument is correct, but it glosses over a subtle point: excess supplies of, and excess demands for, money in this context are not absolute, but comparative. Money flows into whichever country has the relatively larger excess demand for money. Both countries may have an absolute excess supply of money, but the country with the comparatively smaller excess supply of money will nevertheless experience a balance-of-payments surplus and an inflow of cash.

My second comment is that although McCloskey and Zecher are correct to emphasize that the quantity of money in a country operating with a fixed exchange is endogenous, they fail to mention explicitly that, apart from the balance-of-payments mechanism under fixed exchange rates, the quantity of domestically produced inside money is endogenous, because there is a domestic market mechanism that adjusts the amount of inside money supplied by banks to the amount of inside money demanded by the public. Thus, under a fixed-exchange-rate regime, the quantity of inside money and the quantity of outside money are both endogenously determined, the quantity of inside money being determined by domestic forces, and the quantity of outside money determined by international forces operating through the balance-of-payments mechanism.

Which brings me to my third comment. McCloskey and Zecher have a two-stage argument. The first stage is that commodity arbitrage effectively constrains the prices of tradable goods in all countries linked by international trade. Not all commodities are tradable, and even tradable goods may be subject to varying limits — based on varying ratios of transportation costs to value — on the amount of price dispersion consistent with the arbitrage constraint. The second stage of their argument is that insofar as the prices of tradable goods are constrained by arbitrage, the rest of the price system is also effectively constrained, because economic forces constrain all relative prices to move toward their equilibrium values. So if the nominal prices of tradable goods are fixed by arbitrage, the tendency of relative prices between non-tradables and tradables to revert to their equilibrium values must constrain the nominal prices of non-tradable goods to move in the same direction as tradable-goods prices are moving. I don’t disagree with this argument in principle, but it’s subject to at least two qualifications.

First, monetary policy can alter spending patterns; if the monetary authority wishes, it can accumulate the inflow of foreign exchange that results when there is a domestic excess demand for money rather than allow the foreign-exchange inflow to increase the domestic money stock. If domestic money mostly consists of inside money supplied by private banks, preventing an increase in the quantity of inside money may require increasing the legal reserve requirements to which banks are subject. By not allowing the domestic money stock to increase in response to a foreign-exchange inflow, the central bank effectively limits domestic spending, thereby reducing the equilibrium ratio between the prices of non-tradables and tradables. A monetary policy that raises the relative price of tradables to non-tradables was called exchange-rate protection by the eminent Australian economist Max Corden. Although term “currency manipulation” is chronically misused to refer to any exchange-rate depreciation, the term is applicable to the special case in which exchange-rate depreciation is combined with a tight monetary policy thereby sustaining a reduced exchange rate.

Second, Although McCloskey and Zecher are correct that equilibrating forces normally cause the prices of non-tradables to move in the direction toward which arbitrage is forcing the prices of tradables to move, such equilibrating processes need not always operate powerfully. Suppose, to go back to David Hume’s classic thought experiment, the world is on a gold standard and the amount of gold in Britain is doubled while the amount of gold everywhere else is halved, so that the total world stock of gold is unchanged, just redistributed from the rest of the world to Britain. Under the PSFM view of the world, prices instantaneously double in Britain and fall by half in the rest of the world, and it only by seeking bargains in the rest of the world that Britain gradually exports gold to import goods from the rest of the world. Prices gradually fall in Britain and rise in the rest of the world; eventually (and as a first approximation) prices and the distribution of gold revert back to where they were originally. Alternatively, in the arbitrage view of the world, the prices of tradables don’t change, because in the world market for tradables, neither the amount of output nor the amount of gold has changed, so why should the price of tradables change? But if prices of tradables don’t change, does that mean that the prices of non-tradables won’t change? McCloskey and Zecher argue that if arbitrage prevents the prices of tradables from changing, the equilibrium relationship between the prices of tradables and non-tradables will also prevent the prices of non-tradables from changing.

I agree that the equilibrium relationship between the prices of tradables and non-tradables imposes some constraint on the movement of the prices of non-tradables, but the equilibrium relationship between the prices of tradables and non-tradables is not necessarily a constant. If people in Britain suddenly have more gold in their pockets, and they can buy all the tradable goods they want at unchanged prices, they may well increase their demand for non-tradables, causing the prices of British non-tradables to rise relative to the prices of tradables. The terms of trade will shift in Britain’s favor. Nevertheless, it would be very surprising if the price of non-tradables were to double, even momentarily, as the Humean PSFM argument suggests. Just because arbitrage does not strictly constrain the price of non-tradables does not mean that the appropriate default assumption is that the prices of non-tradables would rise by as much as suggested by a naïve quantity-theoretic PSFM extrapolation. Thus, the way to think of the common international price level under a fixed-exchange-rate regime is that the national price levels are linked by arbitrage, so that movements in national price levels are highly — but not necessarily perfectly — correlated.

My fourth comment is terminological. As Robert Lipsey (pp. 151-56) observes in his published comment about the McCloskey-Zecher paper on purchasing power parity (PPP), when the authors talk about PPP, they usually have in mind the narrower concept of the law of one price which says that commodity arbitrage keeps the prices of the same goods at different locations from deviating by more than the cost of transportation. Thus, a localized increase in the quantity of money at any location cannot force up the price of that commodity at that location by an amount exceeding the cost of transporting that commodity from the lowest cost alternative source of supply of that commodity. The quantity theory of money cannot operate outside the limits imposed by commodity arbitrage. That is the fundamental mistake underlying the PSFM.

PPP is a weaker proposition than the law of one price, refering to the relationship between exchange rates and price indices. If domestic price indices in two locations with different currencies rise by different amounts, PPP says that the expected change in the exchange rate between the two currencies is proportional to relative change in the price indices. But PPP is only an approximate relationship, while the law of one price is, within the constraints of transportation costs, an exact relationship. If all goods are tradable and transportation costs are zero, prices of all commodities sold in both locations will be equal. However, the price indices for the two location will not have the same composition, goods not being produced or consumed in the same proportions in the two locations. Thus, even if all goods sold in both locations sell at the same prices the price indices for the two locations need not change by the same proportions. If the price of a commodity exported by country A goes up relative to the price of the good exported by country B, the exchange rate between the two countries will change even if the law of one price is always satisfied. As I argued in part II of this series on PSFM, it was this terms-of-trade effect that accounted for the divergence between American and British price indices in the aftermath of the US resumption of gold convertibility in 1879. The law of one price can hold even if PPP doesn’t.

With those introductory comments out of the way, let’s now examine the treatment of the 1933 inflation in the Monetary History. The remarkable thing about the account of the 1933 inflation given by Friedman and Schwartz is that they treat it as if it were a non-event. Although industrial production increased by over 45% in a four-month period, accompanied by a 14% rise in wholesale prices, Friedman and Schwartz say almost nothing about the episode. Any mention of the episode is incidental to their description of the longer cyclical movements described in Chapter 9 of the Monetary History entitled “Cyclical Changes, 1933-41.” On p. 493, they observe: “the most notable feature of the revival after 1933 was not its rapidity but its incompleteness,” failing to mention that the increase of over 45% in industrial production from April to July was the largest increase industrial production over any four-month period (or even any 12-month period) in American history. In the next paragraph, Friedman and Schwartz continue:

The revival was initially erratic and uneven. Reopening of the banks was followed by rapid spurt in personal income and industrial production. The spurt was intensified by production in anticipation of the codes to be established under the National Industrial Recovery Act (passed June 16, 1933), which were expected to raise wage rates and prices, and did. (pp. 493-95)

Friedman and Schwartz don’t say anything about the suspension of convertibility by FDR and the devaluation of the dollar, all of which caused wholesale prices to rise immediately and substantially (14% in four months). It is implausible to think that the huge increase in industrial production and in wholesale prices was caused by the anticipation of increased wages and production quotas that would take place only after the NIRA was implemented, i.e., not before August. The reopening of the banks may have had some effect, but it is hard to believe that the effect would have accounted for more than a small fraction of the total increase or that it would have had a continuing effect over a four-month period. In discussing the behavior of prices, Friedman and Schwartz, write matter-of-factly:

Like production, wholesale prices first spurted in early 1933, partly for the same reason – in anticipation of the NIRA codes – partly under the stimulus of depreciation in the foreign exchange value of the dollar. (p. 496)

This statement is troubling for two reasons: 1) it seems to suggest that anticipation of the NIRA codes was at least as important as dollar depreciation in accounting for the rise in wholesale prices; 2) it implies that depreciation of the dollar was no more important than anticipation of the NIRA codes in accounting for the increase in industrial production. Finally, Friedman and Schwartz assess the behavior of prices and output over the entire 1933-37 expansion.

What accounts for the greater rise in wholesale prices in 1933-37, despite a probably higher fraction of the labor force unemployed and of physical capacity unutilized than in the two earlier expansions [i.e., 1879-82, 1897-1900]? One factor, already mentioned, was devaluation with its differential effect on wholesale prices. Another was almost surely the explicit measures to raise prices and wages undertaken with government encouragement and assistance, notably, NIRA, the Guffey Coal Act, the agricultural price-support program, and National Labor Relations Act. The first two were declared unconstitutional and lapsed, but they had some effect while in operation; the third was partly negated by Court decisions and then revised, but was effective throughout the expansion; the fourth, along with the general climate of opinion it reflected, became most important toward the end of the expansion.

There has been much discussion in recent years of a wage-price spiral or price-wage spiral as an explanation of post-World War II price movements. We have grave doubts that autonomous changes in wages and prices played an important role in that period. There seems to us a much stronger case for a wage-price or price-wage spiral interpretation of 1933-37 – indeed this is the only period in the near-century we cover for which such an explanation seems clearly justified. During those years there were autonomous forces raising wages and prices. (p. 498)

McCloskey and Zecher explain the implausibility of the idea that the 1933 burst of inflation (mostly concentrated in the April-July period) that largely occurred before NIRA was passed and almost completely occurred before the NIRA was implemented could be attributed to the NIRA.

The chief factual difficulties with the notion that the official cartels sanctioned by the NRA codes caused a rise in the general price level is that most of the NRA codes were not enacted until after the price rise. Ante hoc ergo non propter hoc. Look at the plot of wholesale prices of 1933 in figure 2.3 (retail prices, including such nontradables as housing, show a similar pattern). Most of the rise occurs in May, June, and July of 1933, but the NIRA was not even passed until June. A law passed, furthermore, is not a law enforced. However eager most businessmen must have been to cooperate with a government intent on forming monopolies, the formation took time. . . .

By September 1933, apparently before the approval of most NRA codes — and, judging from the late coming of compulsion, before the effective approval of agricultural codes-three-quarters of the total rise in wholesale prices and more of the total rise in retail food prices from March 1933 to the average of 1934 was complete. On the face of it, at least, the NRA is a poor candidate for a cause of the price rise. It came too late.

What came in time was the depreciation of the dollar, a conscious policy of the Roosevelt administration from the beginning. . . . There was certainly no contemporaneous price rise abroad to explain the 28-percent rise in American wholesale prices (and in retail food prices) between April 1933 and the high point in September 1934. In fact, in twenty-five countries the average rise was only 2.2 percent, with the American rise far and away the largest.

It would appear, in short, that the economic history of 1933 cannot be understood with a model closed to direct arbitrage. The inflation was no gradual working out of price-specie flow; less was it an inflation of aggregate demand. It happened quickly, well before most other New Deal policies (and in particular the NRA) could take effect, and it happened about when and to the extent that the dollar was devalued. By the standard of success in explaining major events, parity here works. (pp. 141-43)

In commenting on the McCloskey-Zecher paper, Friedman responds to their criticism of account of the 1933 inflation presented in the Monetary History. He quibbles about the figure in which McCloskey and Zecher showed that US wholesale prices were highly correlated with the dollar/sterling exchange rate after FDR suspended the dollar’s convertibility into gold in April, complaining that chart leaves the impression that the percentage increase in wholesale prices was as large as the 50% decrease in the dollar/sterling exchange rate, when in fact it was less than a third as large. A fair point, but merely tangential to the main issue: explaining the increase in wholesale prices. The depreciation in the dollar can explain the increase in wholesale prices even if the increase in wholesale prices is not as great as the depreciation of the dollar. Friedman continues:

In any event, as McCloskey and Zecher note, we pointed out in A Monetary History that there was a direct effect of devaluation on prices. However, the existence of a direct effect on wholesale prices is not incompatible with the existence of many other prices, as Moe Abramovitz has remarked, such as non-tradable-goods prices, that did not respond immediately or responded to different forces. An index of rents paid plotted against the exchange rate would not give the same result. An index of wages would not give the same result. (p. 161)

In saying that the Monetary History acknowledged that there was a direct effect of devaluation on prices, Friedman is being disingenuous; by implication at least, the Monetary History suggests that the importance of the NIRA for rising prices and output even in the April to July 1933 period was not inferior to the effect of devaluation on prices and output. Though (belatedly) acknowledging the primary importance of devaluation on wholesale prices, Friedman continues to suggest that factors other than devaluation could have accounted for the rise in wholesale prices — but (tellingly) without referring to the NIRA. Friedman then changes the subject to absence of devaluation effects on the prices of non-tradable goods and on wages. Thus, he is left with no substantial cause to explain the sudden rise in US wholesale prices between April and July 1933 other than the depreciation of the dollar, not the operation of PSFM. Friedman and Schwartz could easily have consulted Hawtrey’s definitive contemporaneous account of the 1933 inflation, but did not do so, referring only once to Hawtrey in the Monetary History (p. 99) in connection with changes by the Bank of England in Bank rate in 1881-82.

Having been almost uniformly critical of Friedman, I would conclude with a word on his behalf. In the context of Great Depression, I think there are good reasons to think that devaluation would not necessarily have had a significant effect on wages and the prices of non-tradables. At the bottom of a downturn, it’s likely that relative prices are far from their equilibrium values. So if we think of devaluation as a mechanism for recovery and restoring an economy to the neighborhood of equilibrium, we would not expect to see prices and wages rising uniformly. So if, for the sake of argument, we posit that real wages were in some sense too high at the bottom of the recession, we would not necessarily expect that a devaluation would cause wages (or the prices of non-tradables) to rise proportionately with wholesale prices largely determined in international markets. Friedman actually notes that the divergence between the increase of wholesale prices and the increase in the implicit price deflator in 1933-37 recovery was larger than in the 1879-82 or the 1897-99 recoveries. The magnitude of the necessary relative price adjustment in the 1933-37 episode may have been substantially greater than it was in either of the two earlier episodes.

Hayek, Deflation and Nihilism: A Popperian Postscript

In my previous post about Hayek’s support for deflationary monetary policy in the early 1930s, I wrote that Hayek’s support for deflation in the hope that it would break rigidities (he thought) were blocking the relative-price adjustments whereby self-correcting market forces would induce a spontaneous recovery from the Great Depression reminded me of the epigram attributed to Lenin: “you can’t make an omelet without breaking eggs.” I actually believed that that was a line that I had seen Karl Popper use somewhere. But in searching unsuccessfully for that quotation in Popper, I did find the following passage in Popper’s autobiography (Unended Quest), which seems to me to be worth reproducing. Popper describes the circumstances that led him while still a teenager to renounce his youthful Marxism.

The incident that turned me against communism, and that soon led me away from Marxism altogether, was one of the most important incidents in my life. It happened shortly before my seventeenth birthday. In Vienna, shooting broke out during a demonstration by unarmed young socialists who, instigated by the communists, tried to help some communists to escape who were under arrest in the central police station in Vienna. Several young socialist and communist workers were killed. I was horrified and shocked by the brutality of the police, but also by myself. For I felt that as a Marxist I bore part of the responsibility for the tragedy – at least in principle. Marxist theory demands that the class struggle be intensified, in order to speed up the coming of socialism. Its thesis is that although the revolution may claim some victims, capitalism is claiming more victims than the whole socialist revolution.

That was the Marxist theory – part of so-called “scientific socialism”. I now asked myself whether such a calculation could ever be supported by “science”. The whole experience, and especially this question, produced in me a life-long revulsion of feeling.

Communism is a creed which promises to bring about a better world. It claims to be based on knowledge: knowledge of the laws of historical development. I still hoped for a better world, a less violent and more just world, but I questioned whether I really knew – whether what I thought was knowledge was perhaps not more than mere pretence. I had, of course, read some Marx and Engels – but had I really understood it? Had I examined it critically, as anybody should do before he accepts a creed which justifies its means by a somewhat distant end?

I was shocked to have to admit to myself that not only had I accepted a complex theory somewhat uncritically, but that I had also actually noticed quite a bit of what was wrong, in the theory as well as in the practice of communism. But I had repressed this – partly out of loyalty to my friends, partly out of loyalty to “the cause”, and partly because there is a mechanism of getting oneself more and more deeply involved: once one has sacrificed one’s intellectual conscience over a minor point one does not wish to give in too easily; one wishes to justify the self-sacrifice by convincing oneself of the fundamental goodness of the cause, which is seen to outweigh any little moral or intellectual compromise that may be required. With every such moral or intellectual sacrifice one gets more deeply involved. One becomes ready to back one’s moral or intellectual investments in the cause with further investments. It is like being eager to throw good money after bad.

I saw how this mechanism had been working in my case, and I was horrified. I also saw it at work in others, especially my communist friends. And the experience enabled me to understand later many things which otherwise I would not have understood.

I had accepted a dangerous creed uncritically, dogmatically. The reaction made me first a sceptic; then it led me, though only for a very short time, to react against all rationalism. (As I found later, this is a typical reaction of a disappointed Marxist.)

By the time I was seventeen I had become an anti-Marxist. I realized the dogmatic character of the creed, and its incredible intellectual arrogance. It was a terrible thing to arrogate to oneself a kind of knowledge which made it a duty to risk  the lives of other people for an uncritically accepted dogma or for a dream which might turn out not to be realizable. (pp. 32-34)

Popper’s description of the process whereby emotional investment in a futile, but seemingly noble, cause leads to moral self-corruption is both chilling and frighteningly familiar to anyone paying attention to the news.

Hayek, Deflation and Nihilism

In the discussion about my paper on Hayek and intertemporal equilibrium at the HES meeting last month, Harald Hagemann suggested looking at Hansjorg Klausinger’s introductions to the two recently published volumes of Hayek’s Collected Works containing his writings (mostly from the 1920s and 1930s) about business-cycle theory in which he explores how Hayek’s attitude toward equilibrium analysis changed over time. But what I found most interesting in Klausinger’s introduction was his account of Hayek’s tolerant, if not supportive, attitude toward deflation — even toward what Hayek and other Austrians at the time referred to as “secondary deflation.” Some Austrians, notably Gottfried Haberler and Wilhelm Roepke, favored activist “reflationary” policies to counteract, and even reverse, secondary deflation. What did Hayek mean by secondary deflation? Here is how Klausinger (“Introduction” in Collected Works of F. A. Hayek: Business Cycles, Part II, pp. 5-6) explains the difference between primary and secondary deflation:

[A]ccording to Hayek’s theory the crisis is caused by a maladjustment in the structure of production typically initiated by a credit boom, such that the period of production (representing the capitalistic structure of production) is lengthened beyond what can be sustained by the rate of voluntary savings. The necessary reallocation of resources and its consequences give rise to crisis and depression. Thus, the “primary” cause of the crisis is a kind of “capital scarcity” while the depression represents an adjustment process by which the capital structure is adapted.

The Hayekian crisis or upper-turning point of the cycle occurs when banks are no longer willing or able to supply the funds investors need to finance their projects, causing business failures and layoffs of workers. The turning point is associated with distress sales of assets and goods, initiating a deflationary spiral. The collapse of asset prices and sell-off of inventories is the primary deflation, but at some point, the contraction may begin to feed on itself, and the contraction takes on a different character. That is the secondary deflation phase. But it is difficult to identify a specific temporal or analytic criterion by which to distinguish the primary from the secondary deflation.

Roepke and Haberler used the distinction – often referring to “depression”” and “deflation” interchangeably – to denote two phases of the cycle. The primary depression is characterized by the reactions to the disproportionalities of the boom, and accordingly an important cleansing function is ascribed to it; thus it is necessary to allow the primary depression to run its course. In contrast, the secondary depression refers to a self-feeding, cumulative process, not causally connected with the disproportionality that the primary depression is designed to correct. Thus the existence of the secondary depression opens up the possibility of a phase of depression dysfunctional to the economic system, where an expansionist policy might be called for. (Id. p. 6)

Despite conceding that there is a meaningful distinction between a primary and secondary deflation that might justify monetary expansion to counteract the latter, Hayek consistently opposed monetary expansion during the 1930s. The puzzle of Hayek’s opposition to monetary expansion, even at the bottom of the Great Depression, is compounded if we consider his idea of neutral money as a criterion for a monetary policy with no distorting effect on the price system. That idea can be understood in terms of the simple MV=PQ equation. Hayek argued that the proper criterion for neutral money was neither, as some had suggested, a constant quantity of money (M), nor, as others had suggested, a constant price level (P), but constant total spending (MV). But for MV to be constant, M must increase or decrease just enough to offset any change in V, where V represents the percentage of income held by the public in the form of money. Thus, if MV is constant, the quantity of money is increasing or decreasing by just as much as the amount of money the public wants to hold is increasing or decreasing.

The neutral-money criterion led Hayek to denounce the US Federal Reserve for a policy that kept the average level of prices essentially stable from 1922 to 1929, arguing that rapid economic growth should have been accompanied by falling not stable prices, in line with his neutral money criterion. The monetary expansion necessary to keep prices stable, had in Hayek’s view, led to a distortion of relative prices, causing an overextension of the capital structure of production, which was the ultimate cause of the 1929 downturn that triggered the Great Depression. But once the downturn started to accelerate, causing aggregate spending to decline by 50% between 1929 and 1933, Hayek, totally disregarding his own neutral-money criterion, uttered not a single word in protest of a monetary policy that was in flagrant violation of his own neutral money criterion. On the contrary, Hayek wrote an impassioned defense of the insane gold accumulation policy of the Bank of France, which along with the US Federal Reserve was chiefly responsible for the decline in aggregate spending.

In an excellent paper, Larry White has recently discussed Hayek’s pro-deflationary stance in the 1930s, absolving Hayek from responsibility for the policy errors of the 1930s on the grounds that the Federal Reserve Board and the Hoover Administration had been influenced not by Hayek, but by a different strand of pro-deflationary thinking, while pointing out that Hayek’s own theory of monetary policy, had he followed it consistently, would have led him to support monetary expansion during the 1930s to prevent any decline in aggregate spending. White may be correct in saying that policy makers paid little if any attention to Hayek’s pro-deflation policy advice. But Hayek’s policy advice was what it was: relentlessly pro-deflation.

Why did Hayek offer policy advice so blatantly contradicted by his own neutral-money criterion? White suggests that the reason was that Hayek viewed deflation as potentially beneficial if it would break the rigidities obstructing adjustments in relative prices. It was the lack of relative-price adjustments that, in Hayek’s view, caused the depression. Here is how Hayek (“The Present State and Immediate Prospects of the Study of Industrial Fluctuations” in Collected Works of F. A. Hayek: Business Cycles, Part II, pp. 171-79) put it:

The analysis of the crisis shows that, once an excessive increase of the capital structure has proved insupportable and has led to a crisis, profitability of production can be restored only by considerable changes in relative prices, reductions of certain stocks, and transfers of the means of production to other uses. In connection with these changes, liquidations of firms in a purely financial sense of the word may be inevitable, and their postponement may possibly delay the process of liquidation in the first, more general sense; but this is a separate and special phenomenon which in recent discussions has been stressed rather excessively at the expense of the more fundamental changes in prices, stocks, etc. (Id. pp. 175-76)

Hayek thus draws a distinction between two possible interpretations of liquidation, noting that widespread financial bankruptcy is not necessary for liquidation in the economic sense, an important distinction. Continuing with the following argument about rigidities, Hayek writes:

A theoretical problem of great importance which needs to be elucidated in this connection is the significance, for this process of liquidation, of the rigidity of prices and wages, which since the great war has undoubtedly become very considerable. There can be little question that these rigidities tend to delay the process of adaptation and that this will cause a “secondary” deflation which at first will intensify the depression but ultimately will help to overcome those rigidities. (Id. p. 176)

It is worth noting that Hayek’s assertion that the intensification of the depression would help to overcome the rigidities is an unfounded and unsupported supposition. Moreover, the notion that increased price flexibility in a depression would actually promote recovery has a flimsy theoretical basis, because, even if an equilibrium does exist in an economy dislocated by severe maladjustments — the premise of Austrian cycle theory — the notion that price adjustments are all that’s required for recovery can’t be proven even under the assumption of Walrasian tatonnement, much less under the assumption of incomplete markets with trading at non-equilibrium prices. The intuitively appealing notion that markets self-adjust is an extrapolation from Marshallian partial-equilibrium analysis in which the disequilibrium of a single market is analyzed under the assumption that all other markets remain in equilibrium. The assumption of approximate macroeconomic equilibrium is a necessary precondition for the partial-equilibrium analysis to show that a single (relatively small) market reverts to equilibrium after a disturbance. In the general case in which multiple markets are simultaneously disturbed from an initial equilibrium, it can’t be shown that price adjustments based on excess demands in individual markets lead to the restoration of equilibrium.

The main problem in this connection, on which opinions are still diametrically opposed, are, firstly, whether this process of deflation is merely an evil which has to be combated, or whether it does not serve a necessary function in breaking these rigidities, and, secondly, whether the persistence of these deflationary tendencies proves that the fundamental maladjustment of prices still exists, or whether, once that process of deflation has gathered momentum, it may not continue long after it has served its initial function. (Id.)

Unable to demonstrate that deflation was not exacerbating economic conditions, Hayek justified tolerating further deflation, as White acknowledged, with the hope that it would break the “rigidities” preventing the relative-price adjustments that he felt were necessary for recovery. Lacking a solid basis in economic theory, Hayek’s support for deflation to break rigidities in relative-price adjustment invites evaluation in ideological terms. Conceding that monetary expansion might increase employment, Hayek may have been disturbed by the prospect that an expansionary monetary policy would be credited for having led to a positive outcome, thereby increasing the chances that inflationary policies would be adopted under less extreme conditions. Hayek therefore appears to have supported deflation as a means to accomplish a political objective – breaking politically imposed and supported rigidities in prices – he did not believe could otherwise be accomplished.

Such a rationale, I am sorry to say, reminds me of Lenin’s famous saying that you can’t make an omelet without breaking eggs. Which is to say, that in order to achieve a desired political outcome, Hayek was prepared to support policies that he had good reason to believe would increase the misery and suffering of a great many people. I don’t accuse Hayek of malevolence, but I do question the judgment that led him to such a conclusion. In Fabricating the Keynesian Revolution, David Laidler described Hayek’s policy stance in the 1930s as extreme pessimism verging on nihilism. But in supporting deflation as a means to accomplish a political end, Hayek clearly seems to have crossed over the line separating pessimism from nihilism.

In fairness to Hayek, it should be noted that he eventually acknowledged and explicitly disavowed his early pro-deflation stance.

I am the last to deny – or rather, I am today the last to deny – that, in these circumstances, monetary counteractions, deliberate attempts to maintain the money stream, are appropriate.

I probably ought to add a word of explanation: I have to admit that I took a different attitude forty years ago, at the beginning of the Great Depression. At that time I believed that a process of deflation of some short duration might break the rigidity of wages which I thought was incompatible with a functioning economy. Perhaps I should have even then understood that this possibility no longer existed. . . . I would no longer maintain, as I did in the early ‘30s, that for this reason, and for this reason only, a short period of deflation might be desirable. Today I believe that deflation has no recognizable function whatever, and that there is no justification for supporting or permitting a process of deflation. (A Discussion with Friedrich A. Von Hayek: Held at the American Enterprise Institute on April 9, 1975, p. 5)

Responding to a question about “secondary deflation” from his old colleague and friend, Gottfried Haberler, Hayek went on to elaborate:

The moment there is any sign that the total income stream may actually shrink, I should certainly not only try everything in my power to prevent it from dwindling, but I should announce beforehand that I would do so in the event the problem arose. . .

You ask whether I have changed my opinion about combating secondary deflation. I do not have to change my theoretical views. As I explained before, I have always thought that deflation had no economic function; but I did once believe, and no longer do, that it was desirable because it could break the growing rigidity of wage rates. Even at that time I regarded this view as a political consideration; I did not think that deflation improved the adjustment mechanism of the market. (Id. pp. 12-13)

I am not sure that Hayek’s characterization of his early views is totally accurate. Although he may indeed have believed that a short period of deflation would be enough to break the rigidities that he found so troublesome, he never spoke out against deflation, even as late as 1932 more than two years the start of deflation at the end of 1929. But on the key point Hayek was perfectly candid: “I regarded this view as a political consideration.”

This harrowing episode seems worth recalling now, as the U.S. Senate is about to make decisions about the future of the highly imperfect American health care system, and many are explicitly advocating taking steps calculated to make the system (or substantial parts of it) implode or enter a “death spiral” for the express purpose of achieving a political/ideological objective. Policy-making and nihilism are a toxic mix, as we learned in the 1930s with such catastrophic results. Do we really need to be taught that lesson again?

What’s Wrong with the Price-Specie-Flow Mechanism, Part II: Friedman and Schwartz on the 1879 Resumption

Having explained in my previous post why the price-specie-flow mechanism (PSFM) is a deeply flawed mischaracterization of how the gold standard operated, I am now going to discuss two important papers by McCloskey and Zecher that go explain in detail the conceptual and especially the historical shortcomings of PSFM. The first paper (“How the Gold Standard Really Worked”) was published in the 1976 volume edited by Johnson and Frenkel, The Monetary Approach to the Balance of Payments; the second paper, (“The Success of Purchasing Power Parity: Historical Evidence and its Relevance for Macroeconomics”) was published in a 1984 NBER conference volume edited by Schwartz and Bordo, A Retrospective on the Classical Gold Standard 1821-1931. I won’t go through either paper in detail, but I do want to mention their criticisms of The Monetary History of the United States, 1867-1960, by Friedman and Schwartz and Friedman’s published response to those criticisms in the Schwartz-Bordo volume. I also want to register a mild criticism of an error of omission by McCloskey and Zecher in failing to note that, aside from the role of the balance of payments under the gold standard in equilibrating the domestic demand for money with the domestic supply of money, there is also a domestic mechanism for equilibrating the domestic demand for money with the domestic supply; it is only when the domestic mechanism does not operate that the burden for adjustment falls upon the balance of payments. I suspect that McCloskey and Zecher would not disagree that there is a domestic mechanism for equilibrating the demand for money with the supply of money, but the failure to spell out the domestic mechanism is still a shortcoming in these two otherwise splendid papers.

McCloskey and Zecher devote a section of their paper to the empirical anomalies that beset the PSFM.

If the orthodox theories of the gold standard are incorrect, it should be possible to observe signs of strain in the literature when they are applied to the experiences of the late nineteenth century. This is the case. Indeed, in the midst of their difficulties in applying the theories earlier observers have anticipated most of the elements of the alternative theory proposed here.

On the broadest level it has always been puzzling that the gold standard in its prime worked so smoothly. After all, the mechanism described by Hume, in which an initial divergence in price levels was to be corrected by flows of gold inducing a return to parity, might be expected to work fairly slowly, requiring alterations in the money supply and, more important, in expectations concerning the level and rate of change of prices which would have been difficult to achieve. The actual flows of gold in the late nineteenth century, furthermore, appear too small to play the large role assigned to them. . . . (pp. 361-62)

Later in the same section, they criticize the account given by Friedman and Schwartz of how the US formally adopted the gold standard in 1879 and its immediate aftermath, suggesting that the attempt by Friedman and Schwartz to use PSFM to interpret the events of 1879-81 was unsuccessful.

The behavior of prices in the late nineteenth century has suggested to some observers that the view that it was gold flows that were transmitting price changes from one country to another is indeed flawed. Over a short period, perhaps a year or so, the simple price-specie-flow mechanism predicts an inverse correlation in the price levels of two countries interacting with each other on the gold standard. . . . Yet, as Triffin [The Evolution of the International Monetary System, p. 4] has noted. . . even over a period as brief as a single year, what is impressive is “the overeall parallelism – rather than divergence – of price movements, expressed in the same unit of measurement, between the various trading countries maintaining a minimum degree of freedom of trade and exchange in their international transactions.

Over a longer period of time, of course, the parallelism is consistent with the theory of the price-specie-flow. In fact, one is free to assume that the lags in its mechanism are shorter than a year, attributing the close correlations among national price levels within the same year to a speedy flow of gold and a speedy price change resulting from the flow rather than to direct and rapid arbitrage. One is not free, however, to assume that there were no lags at all; in the price-specie-flow theory inflows of gold must precede increase in prices by at least the number of months necessary for the money supply to adjust to the new gold and for the increased amount of money to have an inflationary effect. The American inflation following the resumption of specie payments in January 1879 is a good example. After examining the annual statistics on gold flows and price levels for the period, Friedman and Schwartz [Monetary History of the United States, 1867-1960, p. 99] concluded that “It would be hard to find a much neater example in history of the classical gold-standard mechanism in operation.” Gold flowed in during 1879, 1880, and 1881 and American prices rose each year. Yet the monthly statistics on American gold flows and price changes tell a very different story. Changes in the Warren and Pearson wholesale price index during 1879-81 run closely parallel month by month with gold flows, rising prices corresponding to net inflows of gold. There is no tendency for prices to lag behind a gold flow and some tendency for them to lead it, suggesting not only the episode is an especially poor example of the price-specie flow theory in operation, but also that it might well be a reasonably good one of the monetary theory. (pp. 365-66)

Now let’s go back and see exactly what Friedman and Schwartz said about the episode in the Monetary History. Here is how they describe the rapid expansion starting with the resumption of convertibility on January 1, 1879:

The initial cyclical expansion from 1879 to 1882 . . . was characterized by an unusually rapid rise in the stock of money and in net national product in both current and constant prices. The stock of money rose by over 50 per cent, net national product in current prices over 35 per cent, and net national product in constant prices nearly 25 per cent. . . . (p. 96)

The initial rapid expansion reflected a combination of favorable physical and financial factors. On the physical side, the preceding contraction had been unusually protracted; once it was over, there tended to be a vigorous rebound; this is a rather typical pattern of reaction. On the financial side, the successful achievement of resumption, by itself, eased pressure on the foreign exchanges and permitted an internal price rise without external difficulties, for two reasons: first, because it eliminated the temporary demand for foreign exchange on the part of the Treasury to build up its gold reserve . . . second because it promoted a growth in U.S. balances held by foreigners and a decline in foreign balances held by U.S. residents, as confidence spread that the specie standard would be maintained and that the dollar would not depreciate again. (p. 97)

The point about financial conditions that Friedman and Schwartz are making is that, in advance of resumption, the US Treasury had been buying gold to increase reserves with which to satisfy potential demands for redemption once convertibility at the official parity was restored. The gold purchases supposedly forced the US price level to drop further (at the official price of gold, corresponding to a $4.86 dollar/sterling exchange rate) than it would have fallen if the Treasury had not been buying gold. (See quotation below from p. 99 of the Monetary History). Their reasoning is that the additional imports of gold ultimately had to be financed by a corresponding export surplus, which required depressing the US price level below the price level in the rest of the world sufficiently to cause a sufficient increase in US exports and decrease of US imports. But the premise that US exports could be increased and US imports could be decreased only by reducing the US price level relative to the rest of the world is unfounded. The incremental export surplus required only that total domestic expenditure be reduced, thereby allowing an incremental increase US exports or reduction in US imports. Reduced US spending would have been possible without any change in US prices. Friedman and Schwartz continue:

These forces were powerfully reinforced by accidents of weather that produced two successive years of bumper crops in the United States and unusually short crops elsewhere. The result was an unprecedentedly high level of exports. Exports of crude foodstuffs, in the years ending June 30, 1889 and 1881, reached levels roughly twice the average of either the preceding or the following year five years. In each year they were higher than in any preceding year, and neither figure was again exceeded until 1892. (pp. 97-98)

This is a critical point, but neither Friedman and Schwartz nor McCloskey and Zecher in their criticism seem to recognize its significance. Crop shortages in the rest of the world must have caused a substantial increase in grain and cotton prices, but Friedman and Schwartz provide no indication of the magnitudes of the price increases. At any rate, the US was then still a largely agricultural economy, so a substantial rise in agricultural prices determined in international markets would imply an increase in an index of US output prices relative to an index of British output prices reflecting both a shifting terms of trade in favor of the US and a higher share of total output accounted for by agricultural products in the US than in Britain. That shift, and the consequent increase in US versus British price levels, required no divergence between prices in the US and in Britain, and could have occurred without operation of the PSFM. Ignoring the terms-of-trade effect after drawing attention to the bumper crops in the US and crop failures elsewhere was an obvious error in the narrative provided by Friedman and Schwartz. With that in mind, let us return to their narrative.

The resulting increased demand for dollars meant that a relatively higher price level in the United States was consistent with equilibrium in the balance of payments.

Friedman and Schwartz are assuming that a demand for dollars under a fixed-exchange-rate regime can be satisfied only by through an incremental adjustment in exports and imports to induce an offsetting flow of dollars. Such a demand for dollars could also be satisfied by way of appropriate banking and credit operations requiring no change in imports and exports, but even if the demand for money is satisfied through an incremental adjustment in the trade balance, the implicit assumption that an adjustment in the trade balance requires an adjustment in relative price levels is totally unfounded; the adjustment in the trade balance can occur with no divergence in prices, such a divergence being inconsistent with the operation of international arbitrage.

Pending the rise in prices, it led to a large inflow of gold. The estimated stock of gold in the United States rose from $210 million on June 30, 1879, to $439 million on June 30, 1881.

The first sentence is difficult to understand. Having just asserted that there was a rise in US prices, why do Friedman and Schwartz now suggest that the rise in prices has not yet occurred? Presumably, the antecedent of the pronoun “it” is the demand for dollars, but why is the demand for dollars conditioned on a rise in prices? There are any number of reasons why there could have been an inflow of gold into the United States. (Presumably, higher than usual import demand could have led to a temporary drawdown of accumulated liquid assets, e.g., gold, in other countries to finance their unusually high grain imports. Moreover, the significant wealth transfer associated with a sharply improving terms of trade in favor of the US would have led to an increased demand for gold, either for real or monetary uses. More importantly, as banks increased the amount of deposits and banknotes they were supplying to the public, the demand of banks to hold gold reserves would have also increased.)

In classical gold-standard fashion, the inflow of gold helped produce an expansion in the stock of money and in prices. The implicit price index for the U.S. rose 10 per cent from 1879 to 1882 while a general index of British prices was roughly constant, so that the price level in the United States relative to that in Britain rose from 89.1 to 96.1. In classical gold-standard fashion, also, the outflow of gold from other countries produced downward pressure on their stock of money and their prices.

To say that the inflow of gold helped produce an expansion in the stock of money and in prices is simply to invoke the analytically empty story that gold reserves are lent out to the public, because the gold is sitting idle in bank vaults just waiting to be put to active use. But gold doesn’t just wind up sitting in a bank vault for no reason. Banks demand it for a purpose; either they are legally required to hold the gold or they find it more useful or rewarding to hold gold than to hold alternative assets. Banks don’t create liabilities payable in gold because they are holding gold; they hold gold because they create liabilities payable in gold; creating liabilities legally payable in gold may entail a legal obligation to hold gold reserves, or create a prudential incentive to keep some gold on hand. The throw-away references made by Friedman and Schwartz to “classical gold-standard fashion” is just meaningless chatter, and the divergence between the US and the British price indexes between 1879 and 1882 is attributable to a shift in the terms of trade of which the flow of gold from Britain to the US was the effect not the cause.

The Bank of England reserve in the Banking Department declined by nearly 40 percent from mid-1879 to mid-1881. In response, Bank rate was raised by steps from 2.5 per cent in April 1881 to 6 per cent in January 1882. The resulting effects on both prices and capital movements contributed to the cessation of the gold outflow to the U.S., and indeed, to its replacement by a subsequent inflow from the U.S. . . . (p. 98)

The only evidence about the U.S. gold stock provided by Friedman and Schwartz is an increase from $210 million to $439 million between June 30, 1879 to June 30, 1881. They juxtapose that with a decrease in the gold stock held by the Bank of England between mid-1879 and mid-1881, and an increase in Bank rate from 2.5% to 6%. Friedman and Schwartz cite Hawtrey’s Century of Bank Rate as the source for this fact (the only citation of Hawtrey in the Monetary History). But the increase in Bank rate from 2.5% did not begin till April 28, 1881, Bank rate having fluctuated between 2 and 3% from January 1878 to April 1881, two years and three months after the resumption. Discussing the fluctuations in the gold reserve of the Bank England in 1881, Hawtrey states:

The exports of gold had abated in the earlier part of the year, but set in again in August, and Bank rate was raised to 4 per cent. On the 6th of October it was put up to 5 per cent and on the 30th January, 1882, to 6.

The exports of gold had been accentuated in consequence of the crisis in Paris in January, 1882, resulting from the failure of the Union Generale. The loss of gold by export stopped almost immediately after the rise to 6 per cent. In fact the importation into the United States was ceasing, in consequence partly of the silver legislation which went far to satisfy the need for currency with silver certificates. (p. 102)

So it’s not at all clear from the narrative provided by Friedman and Schwartz to what extent the Bank of England, in raising Bank rate in 1881, was responding to the flow of gold to the United States, and they certainly do not establish that price-level changes between 1879 to 1881 reflected monetary, rather than real, forces. Here is how Friedman and Schwartz conclude their discussion of the effects of the resumption of US gold convertibility.

These gold movements and those before resumption have contrasting economic significance. As mentioned in the preceding chapter, the inflow into the U.S. before resumption was deliberately sought by the Treasury and represented an increased demand for foreign exchange. It required a surplus in the balance of payments sufficient to finance the gold inflow. The surplus could be generated only by a reduction in U.S. prices relative to foreign prices or in the price of the U.S. dollar relative to foreign currencies and was, in fact, generated by a relative reduction in U.S. prices. The gold inflow was, as it were, the active element to which the rest of the balance of payments adjusted.

This characterization of the pre-resumption deflationary process is certainly correct insofar as refers to the necessity of a deflation in US dollar prices for the dollar to appreciate to allow convertibility into gold at the 1861 dollar price of gold and dollar/sterling exchange rate. It is not correct insofar as it suggests that beyond the deflation necessary to restore purchasing power parity, a further incremental deflation was required to finance the Treasury’s demand for foreign exchange

After resumption, on the other hand, the active element was the increased demand for dollars resulting largely from the crop situation. The gold inflow was a passive reaction which temporarily filled the gap in payments. In its absence, there would have had to be an appreciation of the dollar relative to other currencies – a solution ruled out by the fixed exchange rate under the specie standard – or a more rapid [sic! They meant “less rapid”] rise in internal U.S. prices. At the same time, the gold inflow provided the basis and stimulus for an expansion in the stock of money and thereby a rise in internal prices at home and downward pressure on the stock of money and price abroad sufficient to bring an end to the necessity for large gold inflows. (p. 99)

This explanation of the causes of gold movements is not correct. The crop situation was a real, not a monetary, disturbance. We would now say that there was a positive supply shock in the US and a negative supply shock in the rest of the world, causing the terms of trade to shift in favor of the US. The resulting gold inflow reflected an increased US demand for gold induced by rapid economic growth and the improved terms of trade and a reduced demand to hold gold elsewhere to finance a temporary excess demand for grain. The monetary demand for gold would have also increased as a result of an increasing domestic demand for money. An increased demand for money could induce an inflow of gold to be minted into coin or to be held as legally required reserves for banknotes or to be held as bank reserves for deposits. The rapid increase in output and income, fueled in part by the positive supply shock and the improving terms of trade, would normally be expected to increase the demand to hold money. If the gold inflow was the basis, or the stimulus, for an expansion of the money stock, then increases in the gold stock should have preceded increases in the money stock. But as I am going to show, Friedman himself later provided evidence showing that in this episode the money stock at first increased more rapidly than the gold stock. And just as price increases and money expansion in the US were endogenous responses to real shocks in output and the terms of trade, adjustments in the stock of money and prices abroad were not the effects of monetary disturbances but endogenous monetary adjustments to real disturbances.

Let’s now turn to the second McCloskey-Zecher paper in which they returned to the 1879 resumption of gold convertibility by the US.

In an earlier paper (1976, p. 367) we reviewed the empirical anomalies in the price-specie-flow mechanism. For instance, we argued that Milton Friedman and Anna Schwartz misapplied the mechanism to an episode in American history. The United States went back on the gold standard in January 1879 at the pre-Civil War parity. The American price level was too low for the parity, allegedly setting the mechanism in motion. Over the next three years, Friedman and Schwartz argued from annual figures, gold flowed in and the price level rose just as Hume would have had it. They conclude (1963, p. 99) that “it would be hard to find a much neater example in history of the classical gold-standard mechanism in operation.” On the contrary, however, we believe it seems much more like an example of purchasing-power parity and the monetary approach than of the Humean mechanism. In the monthly statistics (Friedman and Schwartz confined themselves to annual data), there is no tendency for price rises to follow inflows of gold, as they should in the price-specie-flow mechanism; if anything, there is a slight tendency for price rises to precede inflows of gold, as they would if arbitrage were shortcutting the mechanism and leaving Americans with higher prices directly and a higher demand for gold. Whether or not the episode is a good example of the monetary theory, it is a poor example of the price-specie-flow mechanism. (p. 126)

Milton Friedman, a discussant at the conference at which McCloskey and Zecher presented their paper, submitted his amended remarks about the paper which were published in the volume along with comments of the other discussant, Robert E. Lipsey, and a transcript of the discussion of the paper by those in attendance. Here is Friedman’s response.

[McCloskey and Zecher] quote our statement that “it would be hard to find a much neater example in history of the classical gold-standard mechanism in operation” (p. 99). Their look at that episode on the basis of monthly data is interesting and most welcome, but on closer examination it does not, contrary to their claims, contradict our interpretation of the episode. McCloskey and Zecher compare price rises to inflows of gold, concluding, “In the monthly statistics … there is no tendency for price rises to follow inflows of gold . . . ; if anything, there is a slight tendency for price rises to precede inflows of gold, as they would if arbitrage were shortcutting the mechanism.”

Their comparison is the wrong one for determining whether prices were reacting to arbitrage rather than reflecting changes in the quantity of money. For that purpose the relevant comparison is with the quantity of money. Gold flows are relevant only as a proxy for the quantity of money. (p. 159)

I don’t understand this assertion at all. Gold flows are not simply a proxy for the quantity of money, because the whole premise of the PSFM is, as he and Schwartz assert in the Monetary History, that gold flows provide the “basis and stimulus for” an increase in the quantity of money.

If we compare price rises with changes in the quantity of money directly, a very different picture emerges than McCloskey and Zecher draw (see table C2.1). Our basic estimates of the quantity of money for this period are for semiannual dates, February and August. Resumption took effect on 1 January 1879. From August 1878 to February 1879, the money supply declined a trifle, continuing a decline that had begun in 1875 in final preparation for resumption. From February 1879 to August 1879, the money supply rose sharply, according to our estimates, by 15 percent. The Warren-Pearson monthly wholesale price index fell in the first half of 1879, reflecting the earlier decline in the money stock. It started its sharp rise in September 1879, or at least seven months later than the money supply.

Again, I don’t understand Friedman’s argument. The quantity of money began to rise after the resumption. In fact, Friedman’s own data show that in the six months from February to August of 1879, the quantity of money rose by 14.8% and the gold stock by 10.6%, without any effect on the price level. Friedman asserts that the price level only started to increase in September 8 or 9 months after the resumption in January. But it seems quite plausible that the fall harvest would have been the occasion for the effects of crop failures on grain prices to begin to make themselves felt on wholesale prices. So Friedman’s own evidence undercuts his argument that the increase in the quantity of money was what was driving the increase in US prices.

As to gold, the total stock of gold, as well as gold held by the Treasury, had been rising since 1877 as part of the preparation for resumption. But it had been rising at the expense of other components of high-powered money, which actually fell slightly. However, the decline in the money stock before 1879 had been due primarily to a decline in the deposit-currency ratio and the deposit-reserve ratio. After successful resumption, both ratios rose, which enabled the stock of money to rise despite no initial increase in gold flows. The large step-up in gold inflows in the fall of 1879, to which McCloskey and Zecher call attention, was mostly absorbed in raising the fraction of high-powered money in the form of gold rather than in speeding up monetary growth.

I agree with Friedman that the rapid increase in gold flows starting the fall of 1879 probably had little to do with the increase in the US price level, that increase reflecting primarily the terms-of-trade effect of rising agricultural prices, not a divergence between prices in the US and prices elsewhere in the world.  But that does not justify Friedman’s self-confident reiteration of the conclusion reached in the Monetary History that it would be hard to find a much neater example in history of the classical gold standard mechanism in operation. On the contrary, I see no evidence at all that “the classical gold standard mechanism” aka PSFM had anything to do with the behavior of prices after the resumption.

What’s Wrong with the Price-Specie-Flow Mechanism? Part I

The tortured intellectual history of the price-specie-flow mechanism (PSFM), which received its classic exposition in an essay (“Of the Balance of Trade”) by David Hume about 275 years ago is not a history that, properly understood, provides solid grounds for optimism about the chances for progress in what we, somewhat credulously, call economic science. In brief, the price-specie-flow mechanism asserts that, under a gold or commodity standard, deviations between the price levels of those countries on the gold standard induce gold to be shipped from countries where prices are relatively high to countries where prices are relatively low, the gold flows continuing until price levels are equalized. Hence, the compound adjective “price-specie-flow,” signifying that the mechanism is set in motion by price-level differences that induce gold (specie) flows.

The PSFM is thus premised on a version of the quantity theory of money in which price levels in each country on the gold standard are determined by the quantity of money circulating in that country. In his account, Hume assumed that money consists entirely of gold, so that he could present a scenario of disturbance and re-equilibration strictly in terms of changes in the amount of gold circulating in each country. Inasmuch as Hume held a deeply hostile attitude toward banks, believing them to be essentially inflationary engines of financial disorder, subsequent interpretations of the PSFM had to struggle to formulate a more general theoretical account of international monetary adjustment to accommodate the presence of the fractional-reserve banking so detested by Hume and to devise an institutional framework that would facilitate operation of the adjustment mechanism under a fractional-reserve-banking system.

In previous posts on this blog (e.g., here, here and here) a recent article on the history of the (misconceived) distinction between rules and discretion, I’ve discussed the role played by the PSFM in one not very successful attempt at monetary reform, the English Bank Charter Act of 1844. The Bank Charter Act was intended to ensure the maintenance of monetary equilibrium by reforming the English banking system so that it would operate the way Hume described it in his account of the PSFM. However, despite the failings of the Bank Charter Act, the general confusion about monetary theory and policy that has beset economic theory for over two centuries has allowed PSFM to retain an almost canonical status, so that it continues to be widely regarded as the basic positive and normative model of how the classical gold standard operated. Using the PSFM as their normative model, monetary “experts” came up with the idea that, in countries with gold inflows, monetary authorities should reduce interest rates (i.e., lending rates to the banking system) causing monetary expansion through the banking system, and, in countries losing gold, the monetary authorities should do the opposite. These vague maxims described as the “rules of the game,” gave only directional guidance about how to respond to an increase or decrease in gold reserves, thereby avoiding the strict numerical rules, and resulting financial malfunctions, prescribed by the Bank Charter Act.

In his 1932 defense of the insane gold-accumulation policy of the Bank of France, Hayek posited an interpretation of what the rules of the game required that oddly mirrored the strict numerical rules of the Bank Charter Act, insisting that, having increased the quantity of banknotes by about as much its gold reserves had increased after restoration of the gold convertibility of the franc, the Bank of France had done all that the “rules of the game” required it to do. In fairness to Hayek, I should note that decades after his misguided defense of the Bank of France, he was sharply critical of the Bank Charter Act. At any rate, the episode indicates how indefinite the “rules of the game” actually were as a guide to policy. And, for that reason alone, it is not surprising that evidence that the rules of the game were followed during the heyday of the gold standard (roughly 1880 to 1914) is so meager. But the main reason for the lack of evidence that the rules of the game were actually followed is that the PSFM, whose implementation the rules of the game were supposed to guarantee, was a theoretically flawed misrepresentation of the international-adjustment mechanism under the gold standard.

Until my second year of graduate school (1971-72), I had accepted the PSFM as a straightforward implication of the quantity theory of money, endorsed by such luminaries as Hayek, Friedman and Jacob Viner. I had taken Axel Leijonhufvud’s graduate macro class in my first year, so in my second year I audited Earl Thompson’s graduate macro class in which he expounded his own unique approach to macroeconomics. One of the first eye-opening arguments that Thompson made was to deny that the quantity theory of money is relevant to an economy on the gold standard, the kind of economy (allowing for silver and bimetallic standards as well) that classical economics, for the most part, dealt with. It was only after the Great Depression that fiat money was widely accepted as a viable system for the long-term rather than a mere temporary wartime expedient.

What determines the price level for a gold-standard economy? Thompson’s argument was simple. The value of gold is determined relative to every other good in the economy by exactly the same forces of supply and demand that determine relative prices for every other real good. If gold is the standard, or numeraire, in terms of which all prices are quoted, then the nominal price of gold is one (the relative price of gold in terms of itself). A unit of currency is specified as a certain quantity of gold, so the price level measure in terms of the currency unit varies inversely with the value of gold. The amount of money in such an economy will correspond to the amount of gold, or, more precisely, to the amount of gold that people want to devote to monetary, as opposed to real (non-monetary), uses. But financial intermediaries (banks) will offer to exchange IOUs convertible on demand into gold for IOUs of individual agents. The IOUs of banks have the property that they are accepted in exchange, unlike the IOUs of individual agents which are not accepted in exchange (not strictly true as bills of exchange have in the past been widely accepted in exchange). Thus, the amount of money (IOUs payable on demand) issued by the banking system depends on how much money, given the value of gold, the public wants to hold; whenever people want to hold more money than they have on hand, they obtain additional money by exchanging their own IOUs – not accepted in payment — with a bank for a corresponding amount of the bank’s IOUs – which are accepted in payment.

Thus, the simple monetary theory that corresponds to a gold standard starts with a value of gold determined by real factors. Given the public’s demand to hold money, the banking system supplies whatever quantity of money is demanded by the public at a price level corresponding to the real value of gold. This monetary theory is a theory of an ideal banking system producing a competitive supply of money. It is the basic monetary paradigm of Adam Smith and a significant group of subsequent monetary theorists who formed the Banking School (and also the Free Banking School) that opposed the Currency School doctrine that provided the rationale for the Bank Charter Act. The model is highly simplified and based on assumptions that aren’t necessarily fulfilled always or even at all in the real world. The same qualification applies to all economic models, but the realism of the monetary model is certainly open to question.

So under the ideal gold-standard model described by Thompson, what was the mechanism of international monetary adjustment? All countries on the gold standard shared a common price level, because, under competitive conditions, prices for any tradable good at any two points in space can deviate by no more than the cost of transporting that product from one point to the other. If geographic price differences are constrained by transportation costs, then the price effects of an increased quantity of gold at any location cannot be confined to prices at that location; arbitrage spreads the price effect at one location across the whole world. So the basic premise underlying the PSFM — that price differences across space resulting from any disturbance to the equilibrium distribution of gold would trigger equilibrating gold shipments to equalize prices — is untenable; price differences between any two points are always constrained by the cost of transportation between those points, whatever the geographic distribution of gold happens to be.

Aside from the theoretical point that there is a single world price level – actually it’s more correct to call it a price band reflecting the range of local price differences consistent with arbitrage — that exists under the gold standard, so that the idea that local prices vary in proportion to the local money stock is inconsistent with standard price theory, Thompson also provided an empirical refutation of the PSFM. According to the PSFM, when gold is flowing into one country and out of another, the price levels in the two countries should move in opposite directions. But the evidence shows that price-level changes in gold-standard countries were highly correlated even when gold flows were in the opposite direction. Similarly, if PSFM were correct, cyclical changes in output and employment should have been correlated with gold flows, but no such correlation between cyclical movements and gold flows is observed in the data. It was on this theoretical foundation that Thompson built a novel — except that Hawtrey and Cassel had anticipated him by about 50 years — interpretation of the Great Depression as a deflationary episode caused by a massive increase in the demand for gold between 1929 and 1933, in contrast to Milton Friedman’s narrative that explained the Great Depression in terms of massive contraction in the US money stock between 1929 and 1933.

Thompson’s ideas about the gold standard, which he had been working on for years before I encountered them, were in the air, and it wasn’t long before I encountered them in the work of Harry Johnson, Bob Mundell, Jacob Frenkel and others at the University of Chicago who were then developing what came to be known as the monetary approach to the balance of payments. Not long after leaving UCLA in 1976 for my first teaching job, I picked up a volume edited by Johnson and Frenkel with the catchy title The Monetary Approach to the Balance of Payments. I studied many of the papers in the volume, but only two made a lasting impression, the first by Johnson and Frenkel “The Monetary Approach to the Balance of Payments: Essential Concepts and Historical Origins,” and the last by McCloskey and Zecher, “How the Gold Standard Really Worked.” Reinforcing what I had learned from Thompson, the papers provided a deeper understanding of the relevant history of thought on the international-monetary-adjustment  mechanism, and the important empirical and historical evidence that contradicts the PSFM. I also owe my interest in Hawtrey to the Johnson and Frenkel paper which cites Hawtrey repeatedly for many of the basic concepts of the monetary approach, especially the existence of a single arbitrage-constrained international price level under the gold standard.

When I attended the History of Economics Society Meeting in Toronto a couple of weeks ago, I had the  pleasure of meeting Deirdre McCloskey for the first time. Anticipating that we would have a chance to chat, I reread the 1976 paper in the Johnson and Frenkel volume and a follow-up paper by McCloskey and Zecher (“The Success of Purchasing Power Parity: Historical Evidence and Its Implications for Macroeconomics“) that appeared in a volume edited by Michael Bordo and Anna Schwartz, A Retrospective on the Classical Gold Standard. We did have a chance to chat and she did attend the session at which I talked about Friedman and the gold standard, but regrettably the chat was not a long one, so I am going to try to keep the conversation going with this post, and the next one in which I will discuss the two McCloskey and Zecher papers and especially the printed comment to the later paper that Milton Friedman presented at the conference for which the paper was written. So stay tuned.

PS Here is are links to Thompson’s essential papers on monetary theory, “The Theory of Money and Income Consistent with Orthodox Value Theory” and “A Reformulation of Macroeconomic Theory” about which I have written several posts in the past. And here is a link to my paper “A Reinterpretation of Classical Monetary Theory” showing that Earl’s ideas actually captured much of what classical monetary theory was all about.

What Is This Thing Called “Currency Manipulation?”

Over the past few years, I have written a number of posts (e.g., here, here and here) posing — and trying to answer — the question: what is this strange thing called “currency manipulation?” I have to admit that I was actually moderately pleased with myself for having applied ideas developed by the eminent Australian international-trade and monetary economist Max Corden in a classic paper called “Exchange Rate Protection.” Unfortunately, my efforts don’t seem to have pleased – even minimally – Scott Sumner who, in a recent post in his Econlog blog, takes me to task for applying the term to China.

Now I get why Scott doesn’t like the term “currency manipulation.” The term is thrown around indiscriminately all the time as if its meaning were obvious. But the meaning is far from obvious. The term is also an invitation for demagogic abuse, which is another reason for being wary about using it.

A country can peg its exchange rate in terms of some other currency, or allow its exchange rate against all other currencies to float, or it can do a little of both, seeking to influence its exchange rate intermittently depending upon a variety of factors and objectives. A pegged exchange rate may be called a form of intervention (which is not — repeat not —  a synonym for “manipulation”), but if the monetary authority takes its currency peg seriously, it makes the currency peg the overriding determinant of its monetary policy. It is not the only element of its monetary policy, because the monetary authority has another policy objective that it can pursue simultaneously, namely, its holdings of foreign-exchange reserves. If the monetary authority adopts a tight monetary policy, it gains reserves, and if it adopts a loose policy it loses reserves. What constrains a monetary authority with a fixed-exchange rate in loosening policy is the amount of reserves that it is prepared to forego to maintain that exchange rate, and what constrains the monetary authority in tightening its policy is the interest income that must forego in accumulating non-interest-bearing, or low-interest-bearing, foreign-exchange reserves.

What distinguishes “currency manipulation” from mere “currency intervention?” Borrowing Max Corden’s idea of exchange-rate protection, I argued in previous posts that currency manipulation occurs when, in order to favor its tradable-goods sector (i.e., exporting and import-competing industries), a monetary authority (like the Bank of France in 1928) chooses an undervalued currency peg corresponding to a low real exchange rate, or intervenes in currency markets to reduce its nominal exchange rate, while tightening monetary policy to slow down the rise of domestic prices that normally follows a reduced nominal exchange rate. Corden points out that, as a protectionist strategy, exchange-rate protection is inferior to simply raising tariffs on imports or subsidizing exports. However, if international agreements make it difficult to raise tariffs and subsidize exports, exchange-rate protection may become the best available protectionist option.

In his post, “Nominal exchange rates, real exchange rates and protectionism,” Sumner denies that the idea of currency manipulation, and, presumably, the idea of exchange-rate protection make any sense. Here’s what Scott has to say:

The three concepts mentioned in the title of the post are completely unrelated to each other. So unrelated that the subjects ought not even be taught in the same course. The nominal exchange rate is a monetary concept. Real exchange rates belong in course on the real side of macro, perhaps including public finance. And protectionism belongs in a (micro) trade course.

The nominal exchange rate is the relative price of two monies. It’s determined by the monetary policies of the two countries in question. It plays no role in trade.

Scott often cites sticky prices as an important assumption of macroeconomics, so I don’t understand why he thinks that the nominal exchange rate has no effect on trade. If prices do not all instantaneously adjust to a change in the nominal exchange rate, changes in nominal exchange rates are also changes in real exchange rates until prices adjust fully to the new exchange rate.

Protectionism is a set of policies (such as tariffs and quotas) that drives a wedge between domestic and foreign prices. Protectionist policies reduce both imports and exports. They might also slightly affect the current account balance, but that’s a second order effect.

A protectionist policy causes resources from the non-tradable-goods sector to shift to the tradable-goods sector, favoring some domestic producers and disfavoring others, as well as favoring workers specialized to the tradable-goods sector. Whether it affects the trade balance depends on how the policy is implemented, so I agree that raising tariffs doesn’t automatically affect the trade balance. To determine whether and how the trade balance is affected, one has to make further assumptions about the distributional effects of the policy and about the budgetary and monetary policies accompanying the policy. Causation can go in either direction from real exchange rate to trade balance or from trade balance to real exchange rate.

In the following quotation, Scott ignores the relationship between the real exchange rate and the relative pricesof tradables and non-tradables. Protectionist policies, by increasing the relative price of tradables to non-tradables, shift resources from the non-tradable-goods to the tradable-goods sector. That’s the sense in which, contrary to Scott’s assertion, a low real-exchange rate makes enhances the competitiveness of one country relative to other countries. The cost of production in the domestic tradable-goods sector is reduced relative to the price of tradable goods, making the tradable-goods sector more competitive in the markets in which domestic producers compete with foreign producers. I don’t say that increasing the competitiveness of the domestic tradable-goods sector is a good idea, but it is not meaningless to talk about international competitiveness.

Real exchange rates influence the trade balance. When there is a change in either domestic saving or domestic investment, the real exchange rate must adjust to produce an equivalent change in the current account balance. A policy aimed at a bigger current account surplus is not “protectionist”, as it does not generally reduce imports and exports, nor does it drive a wedge between domestic and foreign prices. It affects the gap between imports and exports. . . .

A low real exchange rate is sometimes called a “competitive advantage”, although the concept has absolutely nothing to do with either competition or advantages. It’s simply a reflection of an imbalance between domestic saving and domestic investment. These imbalances also occur within countries, and no one ever worries about regional “deficits”. But for some odd reason at the national level they become a cause for concern. Some of this is based on the mercantilist fallacy that exports are good and imports are bad.

This is where Scott turns his attention to me.

Here’s David Glasner:

Currency manipulation has become a favorite bugbear of critics of both monetary policy and trade policy. Some claim that countries depress their exchange rates to give their exporters an unfair advantage in foreign markets and to insulate their domestic producers from foreign competition. Others claim that using monetary policy as a way to stimulate aggregate demand is necessarily a form of currency manipulation, because monetary expansion causes the currency whose supply is being expanded to depreciate against other currencies, making monetary expansion, ipso facto, a form of currency manipulation.

As I have already explained in a number of posts (e.g., here, here, and here) a theoretically respectable case can be made for the possibility that currency manipulation can be used as a form of covert protectionism without imposing either tariffs, quotas or obviously protectionist measures to favor the producers of one country against their foreign competitors.

I disagree with this. There is no theoretically respectable case for the argument that currency manipulation can be used as protectionism. But I would go much further; there is no intellectually respectable definition of currency manipulation.

Well, my only response is that I consider Max Corden to be just about the most theoretically-respectable economist alive. So let me quote at length from Corden’s essay “Macroeconomic and Industrial Policies” reprinted in his volume Protection, Growth and Trade (pp. 288-301)

There is clearly a relationship between macroeconomic policy and industrial policy on the foreign trade side. . . . The nominal exchange rate is an instrument of macroeconomic policy, while tariffs, import quotas, export subsidies and taxes and voluntary export restraints can all be regarded as instruments of industrial policy. Yet an exchange-rate change can have “industrial” effects. It therefore seems useful to clarify the relationship between exchange-rate policy and the various micro or industrial-policy instruments.

The first step is to distinguish a nominal from a real exchange-rate change and to introduce the concept of “exchange-rate protection. . . . If the exchange rate depreciates to the same extent as all costs and prices are rising (relative to costs and prices in other countries) there may be no real change at all. The nominal exchange rate is a monetary phenomenon, and it is possible that it is no more than that. A monetary authority may engineer a nominal devaluation designed to raise the domestic currency prices of exports and import-competing goods, and hence to benefit these industries. But if nominal wages quickly rise to compensate for the higher tradable-goods prices, no real effects – no rises in the absolute and relative profitability of tradable-goods industries – will remain. Monetary policy can influence the nominal-exchange rate, and possibly can even maintain it at a fixed value, but it cannot necessarily affect the real exchange rate. The real exchange rate refers to the relative price of tradable and non-tradable goods. While its absolute value is difficult to measure because of the ambiguity of the distinction between tradable and non-tradable goods, changes in it are usually – and reasonably – measured or indicated by relating changes in the nominal exchange rate to changes in some index of domestic prices or costs, or possibly to the average nominal wage level. This is sometimes called an index of competitiveness.

A nominal devaluation will devalue the real exchange rate if there is some rigidity or sluggishness either in the prices of non-tradables or in nominal wages. The nominal devaluation will then raise the prices of tradables relative to wage costs and to labour-intensive non-tradables. Thus it protects tradables. This is “exchange-rate protection”. It protects the whole group of tradables relative to non-tradables. It will tnd ot shift resources into tradables out of non-tradables and domestic demand in the opposite direction. If at the same time macroeconomic policy ensures a demand-supply balance for non-tradables – hence decreasing aggregate demand (absorption) in real terms appropriately – a balance of payments surplus (or at least a lesser deficit than before) will result. This refers to the balance of payments on current account since the concurrent fiscal and monetary policies can have varying effects on private capital inflow.

If the motive for the real devaluation was to protect tradables, then the current account surplus will be only a by-product, leading ot more accumulation of foreign exchange reserves than the country’s monetary authority really wanted. Alternatively, if the motive for the real devaluation was to build up the foreign-exchange reserves – or to stop their decline – then the protection of tradables will be the by-product.

The main point to make is that a real exchange-rate change has effects on the relative and absolute profitability of different industries, a real devaluation favouring tradables relative to non-tradables, and a real appreciation the opposite. A nominal exchange-rate change can thus serve an industrial-policy purpose, provided it can be turned into a real exchange-rate change and that the incidental effects on the balance of payments are accepted.

This does not mean that it is an optimal form of industrial policy. . . . [P]rotection policy could be directed more precisely to the industries to be protected, avoiding the by-product effect of an undesired balance-of-payments surplus; and in any case it can be argued that defensive protection policy is unlikely to be optimal, positive adjustment policy being preferable. Nevertheless, it is not difficult to find examples of countries that have practiced exchange-rate protection, if implicitly. They have intervened in the foreign-exchange market to prevent an appreciation of the exchange rate that might otherwise have taken place – or at least, they have “leaned against the wind.” – not because they really wanted to build up foreign-exchange reserves, but because they wanted to protect their tradable-goods industries – usually mainly their export industries.

Scott again quotes me and then comments:

And the most egregious recent example of currency manipulation was undertaken by the Chinese central bank when it effectively pegged the yuan to the dollar at a fixed rate. Keeping its exchange rate fixed against the dollar was precisely the offense that the currency-manipulation police accused the Chinese of committing.

Because currency manipulation does not exist as a coherent concept, I don’t see any evidence that the Chinese did it. But if I am wrong and it does exist, then it surely refers to the real exchange rate, not the nominal rate. Thus the fact that the nominal value of the Chinese yuan was pegged for a period of time has no relevance to whether the currency was being “manipulated”. The real value of the yuan was appreciating.

One cannot conclude that an appreciating yuan means that China was not manipulating its currency. As I pointed out above, and as Corden explains, exchange-rate protection is associated with the accumulation of foreign-exchange reserves by the central bank. There is an ambiguity in interpreting the motivation of the central bank that is accumulating foreign-exchange reserves. Is it accumulating because it wants to increase the amount of reserves in its vaults, or are the increased holdings merely an unwelcome consequence of a policy being pursued for other reasons? In either case, the amount of foreign-exchange reserves a central bank is willing to hold is not unlimited. When the pile of reserves gets high enough, the policy causing accumulation may start to change, implying that the real exchange rate will start to rise.

The dollar was pegged to gold from 1879 to 1933, and yet I don’t think the US government was “manipulating” the exchange rate. And if it was, it was not by fixing the gold price peg, it would have been by depreciating the real value of the dollar via policies that increased national saving, or reduced national investment, in order to run a current account surplus. In my view it is misleading to call policies that promote national saving “currency manipulation”, and even more so to put that label on just a subset of pro-saving policies.

As in the case of the Bank of France after 1928, with a fixed exchange rate, whether a central bank is guilty of currency manipulation depends on whether the initial currency peg was chosen with a view toward creating a competitive advantage for the country’s tradable-goods sector. That was clearly an important motivation when the Bank of France chose the conversion rate between gold and the franc. I haven’t studied the choice of the dollar peg to gold in 1879.

If economists want to use the term ‘currency manipulation’, then they first need to define the term. I have not seen any definitions that make any sense.

I’m hoping that Corden’s definition works for Scott. It does for me.

The 2017 History of Economics Society Conference in Toronto

I arrived in Toronto last Thursday for the History of Economics Society Meeting at the University of Toronto (Trinity College to be exact) to give talks on Friday about two papers, one of which (“Hayek and Three Equilibrium Concepts: Sequential, Temporary and Rational Expectations”) I have been posting over the past few weeks on this blog (here, here, here, here, and here). I want to thank those of you who have posted your comments, which have been very helpful, and apologize for not responding to the more recent comments. The other paper about which I gave a talk was based on a post from three of years ago (“Real and Pseudo Gold Standards: Did Friedman Know the Difference?”) on which one of the sections of that paper was based.

Here I am talking about Friedman.

Here are the abstracts of the two papers:

“Hayek and Three Equilibrium Concepts: Sequential, Temporary, and Rational Expectations”

Almost 40 years ago, Murray Milgate (1979) drew attention to the neglected contribution of F. A. Hayek to the concept of intertemporal equilibrium, which had previously been associated with Erik Lindahl and J. R. Hicks. Milgate showed that although Lindahl had developed the concept of intertemporal equilibrium independently, Hayek’s original 1928 contribution was published before Lindahl’s and that, curiously, Hicks in Value and Capital had credited Lindahl with having developed the concept despite having been Hayek’s colleague at LSE in the early 1930s and having previously credited Hayek for the idea of intertemporal equilibrium. Aside from Milgate’s contribution, few developments of the idea of intertemporal equilibrium have adequately credited Hayek’s contribution. This paper attempts to compare three important subsequent developments of that idea with Hayek’s 1937 refinement of the key idea of his 1928 paper. In non-chronological order, the three developments of interest are: 1) Radner’s model of sequential equilibrium with incomplete markets as an alternative to the Arrow-Debreu-McKenzie model of full equilibrium with complete markets; 2) Hicks’s temporary equilibrium model, and 3) the Muth-Lucas rational expectations model. While Hayek’s 1937 treatment most closely resembles Radner’s sequential equilibrium model, which Radner, echoing Hayek, describes as an equilibrium of plans, prices, and price expectations, Hicks’s temporary equilibrium model seems to be the natural development of Hayek’s approach. The Muth-Lucas rational-expectations model, however, develops the concept of intertemporal equilibrium in a way that runs counter to the fundamental Hayekian insight about the nature of intertemporal equilibrium

“Milton Friedman and the Gold Standard”

Milton Friedman discussed the gold standard in a number of works. His two main discussions of the gold standard appear in a 1951 paper on commodity-reserve currencies and in a 1961 paper on real and pseudo gold standards. In the 1951 paper, he distinguished between a gold standard in which only gold or warehouse certificates to equivalent amounts of gold circulated as a medium of exchange and one in which mere fiduciary claims to gold also circulated as media of exchange. Friedman called the former a strict gold standard and the latter as a partial gold standard. In the later paper, he distinguished between a gold standard in which gold is used as money, and a gold standard in which the government merely fixes the price of gold, dismissing the latter as a “pseudo” gold standard. In this paper, I first discuss the origin for the real/partial distinction, an analytical error, derived from David Hume via the nineteenth-century Currency School, about the incentives of banks to overissue convertible claims to base money, which inspired the Chicago plan for 100-percent reserve banking. I then discuss the real/pseudo distinction and argue that it was primarily motivated by the ideological objective of persuading libertarian and classical-liberal supporters of the gold standard to support a fiat standard supplemented by the k-percent quantity rule that Friedman was about to propose.

And here is my concluding section from the Friedman paper:

Milton Friedman’s view of the gold standard was derived from his mentors at the University Chicago, an inheritance that, in a different context, he misleadingly described as the Chicago oral tradition. The Chicago view of the gold standard was, in turn, derived from the English Currency School of the mid-nineteenth century, which successfully promoted the enactment of the Bank Charter Act of 1844, imposing a 100-percent marginal reserve requirement on the banknotes issued by the Bank of England, and served as a model for the Chicago Plan for 100-percent-reserve banking. The Currency School, in turn, based its proposals for reform on the price-specie-flow analysis of David Hume (1742).

The pure quantity-theoretic lineage of Friedman’s views of the gold standard and the intellectual debt that he owed to the Currency School and the Bank Charter Act disposed him to view the gold standard as nothing more than a mechanism for limiting the quantity of money. If the really compelling purpose and justification of the gold standard was to provide a limitation on the capacity of a government or a monetary authority to increase the quantity of money, then there was nothing special or exceptional about the gold standard.

I have no interest in exploring the reasons why supporters of, and true believers in, the gold standard feel a strong ideological or emotional attachment to that institution, and even if I had such an interest, this would not be the place to enter into such an exploration, but I conjecture that the sources of that attachment to the gold standard go deeper than merely to provide a constraint on the power of the government to increase the quantity of money.

But from Friedman’s quantity-theoretical perspective, if the primary virtue of the gold standard was that it served to limit the ability of the government to increase the quantity of money, if another institution could perform that service, it would serve just as well as the gold standard. The lesson that Friedman took from the efforts of the Currency School to enact the Bank Charter Act was that the gold standard, on its own, did not provide a sufficient constraint on the ability of private banks to increase the quantity of money. Otherwise, the 100-percent marginal reserve requirement of the Bank Charter Act would have been unnecessary.

Now if the gold standard could not function well without additional constraints on the quantity of money, then obviously the constraint on the quantity of money that really matters is not the gold standard itself, but the 100-percent marginal reserve requirement imposed on the banking system. But if the relevant constraint on the quantity of money is the 100 percent marginal reserve requirement, then the gold standard is really just excess baggage.

That was the view of Henry Simons and the other authors of the Chicago Plan. For a long time, Friedman accepted the Chicago Plan as the best prescription for monetary stability, but at about the time that he was writing his paper on real and pseudo gold standards, Friedman was frcoming to position that a k-percent rule would be a superior alternative to the old Chicago Plan. His paper on Pseudo gold standards for the Mont Pelerin Society was his initial attempt to persuade his libertarian and classical-liberal friends and colleagues to reconsider their support for the gold standard and prepare the ground for the k-percent rule that he was about to offer. But in his ideological enthusiasm he, in effect, denied the reality of the historical gold standard.

Aside from the getting to talk about my papers, the other highlights of the HES meeting for me included the opportunity to renew a very old acquaintance with the eminent Samuel Hollander whom I met about 35 years ago at the first History of Economics Society meeting that I ever attended and making the acquaintance for the first time with the eminent Deidre McCloskey who was at both of my sessions and with the eminent E. Roy Weintraub who has been doing important research on my illustrious cousin Abraham Wald, the first one to prove the existence of a competitive equilibrium almost 20 years before Arrow, Debreu and McKenzie came up with their proofs. Doing impressive and painstaking historical research Weintraub found a paper, long thought to have been lost in which Wald, using the fixed-point theorem that Arrow, Debreu and McKenzie had independently used in their proofs, gave a more general existence proof than he had provided in his published existence proofs, clearly establishing Wald’s priority over Arrow, Debreu and McKenzie in proving the existence of general equilibrium.

HT: Rebeca Betancourt

 

Hayek and Rational Expectations

In this, my final, installment on Hayek and intertemporal equilibrium, I want to focus on a particular kind of intertemporal equilibrium: rational-expectations equilibrium. In his discussions of intertemporal equilibrium, Roy Radner assigns a meaning to the term “rational-expectations equilibrium” very different from the meaning normally associated with that term. Radner describes a rational-expectations equilibrium as the equilibrium that results when some agents are able to make inferences about the beliefs held by other agents when observed prices differ from what they had expected prices to be. Agents attribute the differences between observed and expected prices to information held by agents better informed than themselves, and revise their own expectations accordingly in light of the information that would have justified the observed prices.

In the early 1950s, one very rational agent, Armen Alchian, was able to figure out what chemicals were being used in making the newly developed hydrogen bomb by identifying companies whose stock prices had risen too rapidly to be explained otherwise. Alchian, who spent almost his entire career at UCLA while also moonlighting at the nearby Rand Corporation, wrote a paper for Rand in which he listed the chemicals used in making the hydrogen bomb. When people at the Defense Department heard about the paper – the Rand Corporation was started as a think tank largely funded by the Department of Defense to do research that the Defense Department was interested in – they went to Alchian, confiscated and destroyed the paper. Joseph Newhard recently wrote a paper about this episode in the Journal of Corporate Finance. Here’s the abstract:

At RAND in 1954, Armen A. Alchian conducted the world’s first event study to infer the fuel material used in the manufacturing of the newly-developed hydrogen bomb. Successfully identifying lithium as the fusion fuel using only publicly available financial data, the paper was seen as a threat to national security and was immediately confiscated and destroyed. The bomb’s construction being secret at the time but having since been partially declassified, the nuclear tests of the early 1950s provide an opportunity to observe market efficiency through the dissemination of private information as it becomes public. I replicate Alchian’s event study of capital market reactions to the Operation Castle series of nuclear detonations in the Marshall Islands, beginning with the Bravo shot on March 1, 1954 at Bikini Atoll which remains the largest nuclear detonation in US history, confirming Alchian’s results. The Operation Castle tests pioneered the use of lithium deuteride dry fuel which paved the way for the development of high yield nuclear weapons deliverable by aircraft. I find significant upward movement in the price of Lithium Corp. relative to the other corporations and to DJIA in March 1954; within three weeks of Castle Bravo the stock was up 48% before settling down to a monthly return of 28% despite secrecy, scientific uncertainty, and public confusion surrounding the test; the company saw a return of 461% for the year.

Radner also showed that the ability of some agents to infer the information on which other agents are causing prices to differ from the prices that had been expected does not necessarily lead to an equilibrium. The process of revising expectations in light of observed prices may not converge on a shared set of expectations of the future based on commonly shared knowledge.

So rather than pursue Radner’s conception of rational expectations, I will focus here on the conventional understanding of “rational expectations” in modern macroeconomics, which is that the price expectations formed by the agents in a model should be consistent with what the model itself predicts that those future prices will be. In this very restricted sense, I believe rational expectations is a very important property that any model ought to have. It simply says that a model ought to have the property that if one assumes that the agents in a model expect the equilibrium predicted by the model, then, given those expectations, the solution of the model will turn out to be the equilibrium of the model. This property is a consistency and coherence property that any model, regardless of its substantive predictions, ought to have. If a model lacks this property, there is something wrong with the model.

But there is a huge difference between saying that a model should have the property that correct expectations are self-fulfilling and saying that agents are in fact capable of predicting the equilibrium of the model. Assuming the former does not entail the latter. What kind of crazy model would have the property that correct expectations are not self-fulfilling? I mean think about: a model in which correct expectations are not self-fulfilling is a nonsense model.

But demanding that a model not spout out jibberish is very different from insisting that the agents in the model necessarily have the capacity to predict what the equilibrium of the model will be. Rational expectations in the first sense is a minimal consistency property of an economic model; rational expectations in the latter sense is an empirical assertion about the real world. You can make such an assumption if you want, but you can’t claim that it is a property of the real world. Whether it is a property of the real world is a matter of fact, not a matter of methodological fiat. But methodological fiat is what rational expectations has become in macroeconomics.

In his 1937 paper on intertemporal equilibrium, Hayek was very clear that correct expectations are logically implied by the concept of an equilibrium of plans extending through time. But correct expectations are not a necessary, or even descriptively valid, characteristic of reality. Hayek also conceded that we don’t even have an explanation in theory of how correct expectations come into existence. He merely alluded to the empirical observation – perhaps not the most accurate description of empirical reality in 1937 – that there is an observed general tendency for markets to move toward equilibrium, implying that over time expectations do tend to become more accurate.

It is worth pointing out that when the idea of rational expectations was introduced by John Muth in the early 1960s, he did so in the context of partial-equilibrium models in which the rational expectation in the model was the rational expectation of the equilibrium price in a paraticular market. The motivation for Muth to introduce the idea of a rational expectation was idea of a cobweb cycle in which producers simply assume that the current price will remain at whatever level currently prevails. If there is a time lag between production, as in agricultural markets between the initial application of inputs and the final yield of output, it is easy to generate an alternating sequence of boom and bust, with current high prices inducing increased output in the following period, driving prices down, thereby inducing low output and high prices in the next period and so on.

Muth argued that rational producers would not respond to price signals in a way that led to consistently mistaken expectations, but would base their price expectations on more realistic expectations of what future prices would turn out to be. In his microeconomic work on rational expectations, Muth showed that the rational-expectation assumption was a better predictor of observed prices than the assumption of static expectations underlying the traditional cobweb-cycle model. So Muth’s rational-expectations assumption was based on a realistic conjecture of how real-world agents would actually form expectations. In that sense, Muth’s assumption was consistent with Hayek’s conjecture that there is an empirical tendency for markets to move toward equilibrium.

So while Muth’s introduction of the rational-expectations hypothesis was an empirically progressive theoretical innovation, extending rational-expectations into the domain of macroeconomics has not been empirically progressive, rational expectations models having consistently failed to generate better predictions than macro-models using other expectational assumptions. Instead, a rational-expectations axiom has been imposed as part of a spurious methodological demand that all macroeconomic models be “micro-founded.” But the deeper point – a point that Hayek understood better than perhaps anyone else — is that there is a huge difference in kind between forming rational expectations about a single market price and forming rational expectations about the vector of n prices on the basis of which agents are choosing or revising their optimal intertemporal consumption and production plans.

It is one thing to assume that agents have some expert knowledge about the course of future prices in the particular markets in which they participate regularly; it is another thing entirely to assume that they have knowledge sufficient to forecast the course of all future prices and in particular to understand the subtle interactions between prices in one market and the apparently unrelated prices in another market. The former kind of knowledge is knowledge that expert traders might be expected to have; the latter kind of knowledge is knowledge that would be possessed by no one but a nearly omniscient central planner, whose existence was shown by Hayek to be a practical impossibility.

Standard macroeconomic models are typically so highly aggregated that the extreme nature of the rational-expectations assumption is effectively suppressed. To treat all output as a single good (which involves treating the single output as both a consumption good and a productive asset generating a flow of productive services) effectively imposes the assumption that the only relative price that can ever change is the wage, so that all but one future relative prices are known in advance. That assumption effectively assumes away the problem of incorrect expectations except for two variables: the future price level and the future productivity of labor (owing to the productivity shocks so beloved of Real Business Cycle theorists). Having eliminated all complexity from their models, modern macroeconomists, purporting to solve micro-founded macromodels, simply assume that there is but one or at most two variables about which agents have to form their rational expectations.

Four score years since Hayek explained how challenging the notion of intertemporal equilibrium really is and the difficulties inherent in explaining any empirical tendency toward intertempral equilibrium, modern macroeconomics has succeeded in assuming all those difficulties out of existence. Many macroeconomists feel rather proud of what modern macroeconomics has achieved. I am not quite as impressed as they are.

Hayek and Temporary Equilibrium

In my three previous posts (here, here, and here) about intertemporal equilibrium, I have been emphasizing that the defining characteristic of an intertemporal equilibrium is that agents all share the same expectations of future prices – or at least the same expectations of those future prices on which they are basing their optimizing plans – over their planning horizons. At a given moment at which agents share the same expectations of future prices, the optimizing plans of the agents are consistent, because none of the agents would have any reason to change his optimal plan as long as price expectations do not change, or are not disappointed as a result of prices turning out to be different from what they had been expected to be.

The failure of expected prices to be fulfilled would therefore signify that the information available to agents in forming their expectations and choosing optimal plans conditional on their expectations had been superseded by newly obtained information. The arrival of new information can thus be viewed as a cause of disequilibrium as can any difference in information among agents. The relationship between information and equilibrium can be expressed as follows: differences in information or differences in how agents interpret information leads to disequilibrium, because those differences lead agents to form differing expectations of future prices.

Now the natural way to generalize the intertemporal equilibrium model is to allow for agents to have different expectations of future prices reflecting their differences in how they acquire, or in how they process, information. But if agents have different information, so that their expectations of future prices are not the same, the plans on which agents construct their subjectively optimal plans will be inconsistent and incapable of implementation without at least some revisions. But this generalization seems incompatible with the equilibrium of optimal plans, prices and price expectations described by Roy Radner, which I have identified as an updated version of Hayek’s concept of intertemporal equilibrium.

The question that I want to explore in this post is how to reconcile the absence of equilibrium of optimal plans, prices, and price expectations, with the intuitive notion of market clearing that we use to analyze asset markets and markets for current delivery. If markets for current delivery and for existing assets are in equilibrium in the sense that prices are adjusting in those markets to equate demand and supply in those markets, how can we understand the idea that  the optimizing plans that agents are seeking to implement are mutually inconsistent?

The classic attempt to explain this intermediate situation which partially is and partially is not an equilibrium, was made by J. R. Hicks in 1939 in Value and Capital when he coined the term “temporary equilibrium” to describe a situation in which current prices are adjusting to equilibrate supply and demand in current markets even though agents are basing their choices of optimal plans to implement over time on different expectations of what prices will be in the future. The divergence of the price expectations on the basis of which agents choose their optimal plans makes it inevitable that some or all of those expectations won’t be realized, and that some, or all, of those agents won’t be able to implement the optimal plans that they have chosen, without at least some revisions.

In Hayek’s early works on business-cycle theory, he argued that the correct approach to the analysis of business cycles must be analyzed as a deviation by the economy from its equilibrium path. The problem that he acknowledged with this approach was that the tools of equilibrium analysis could be used to analyze the nature of the equilibrium path of an economy, but could not easily be deployed to analyze how an economy performs once it deviates from its equilibrium path. Moreover, cyclical deviations from an equilibrium path tend not to be immediately self-correcting, but rather seem to be cumulative. Hayek attributed the tendency toward cumulative deviations from equilibrium to the lagged effects of monetary expansion which cause cumulative distortions in the capital structure of the economy that lead at first to an investment-driven expansion of output, income and employment and then later to cumulative contractions in output, income, and employment. But Hayek’s monetary analysis was never really integrated with the equilibrium analysis that he regarded as the essential foundation for a theory of business cycles, so the monetary analysis of the cycle remained largely distinct from, if not inconsistent with, the equilibrium analysis.

I would suggest that for Hayek the Hicksian temporary-equilibrium construct would have been the appropriate theoretical framework within which to formulate a monetary analysis consistent with equilibrium analysis. Although there are hints in the last part of The Pure Theory of Capital that Hayek was thinking along these lines, I don’t believe that he got very far, and he certainly gave no indication that he saw in the Hicksian method the analytical tool with which to weave the two threads of his analysis.

I will now try to explain how the temporary-equilibrium method makes it possible to understand  the conditions for a cumulative monetary disequilibrium. I make no attempt to outline a specifically Austrian or Hayekian theory of monetary disequilibrium, but perhaps others will find it worthwhile to do so.

As I mentioned in my previous post, agents understand that their price expectations may not be realized, and that their plans may have to be revised. Agents also recognize that, given the uncertainty underlying all expectations and plans, not all debt instruments (IOUs) are equally reliable. The general understanding that debt – promises to make future payments — must be evaluated and assessed makes it profitable for some agents to specialize in in debt assessment. Such specialists are known as financial intermediaries. And, as I also mentioned previously, the existence of financial intermediaries cannot be rationalized in the ADM model, because, all contracts being made in period zero, there can be no doubt that the equilibrium exchanges planned in period zero will be executed whenever and exactly as scheduled, so that everyone’s promise to pay in time zero is equally good and reliable.

For our purposes, a particular kind of financial intermediary — banks — are of primary interest. The role of a bank is to assess the quality of the IOUs offered by non-banks, and select from the IOUs offered to them those that are sufficiently reliable to be accepted by the bank. Once a prospective borrower’s IOU is accepted, the bank exchanges its own IOU for the non-bank’s IOU. No non-bank would accept a non-bank’s IOU, at least not on terms as favorable as those on which the bank offers in accepting an IOU. In return for the non-bank IOU, the bank credits the borrower with a corresponding amount of its own IOUs, which, because the bank promises to redeem its IOUs for the numeraire commodity on demand, is generally accepted at face value.

Thus, bank debt functions as a medium of exchange even as it enables non-bank agents to make current expenditures they could not have made otherwise if they can demonstrate to the bank that they are sufficiently likely to repay the loan in the future at agreed upon terms. Such borrowing and repayments are presumably similar to the borrowing and repayments that would occur in the ADM model unmediated by any financial intermediary. In assessing whether a prospective borrower will repay a loan, the bank makes two kinds of assessments. First, does the borrower have sufficient income-earning capacity to generate enough future income to make the promised repayments that the borrower would be committing himself to make? Second, should the borrower’s future income, for whatever reason, turn out to be insufficient to finance the promised repayments, does the borrower have collateral that would allow the bank to secure repayment from the collateral offered as security? In making both kinds of assessments the bank has to form an expectation about the future — the future income of the borrower and the future value of the collateral.

In a temporary-equilibrium context, the expectations of future prices held by agents are not the same, so the expectations of future prices of at least some agents will not be accurate, and some agents won’tbe able to execute their plans as intended. Agents that can’t execute their plans as intended are vulnerable if they have incurred future obligations based on their expectations of future prices that exceed their repayment capacity given the future prices that are actually realized. If they have sufficient wealth — i.e., if they have asset holdings of sufficient value — they may still be able to repay their obligations. However, in the process they may have to sell assets or reduce their own purchases, thereby reducing the income earned by other agents. Selling assets under pressure of obligations coming due is almost always associated with selling those assets at a significant loss, which is precisely why it usually preferable to finance current expenditure by borrowing funds and making repayments on a fixed schedule than to finance the expenditure by the sale of assets.

Now, in adjusting their plans when they observe that their price expectations are disappointed, agents may respond in two different ways. One type of adjustment is to increase sales or decrease purchases of particular goods and services that they had previously been planning to purchase or sell; such marginal adjustments do not fundamentally alter what agents are doing and are unlikely to seriously affect other agents. But it is also possible that disappointed expectations will cause some agents to conclude that their previous plans are no longer sustainable under the conditions in which they unexpectedly find themselves, so that they must scrap their old plans replacing them with completely new plans instead. In the latter case, the abandonment of plans that are no longer viable given disappointed expectations may cause other agents to conclude that the plans that they had expected to implement are no longer profitable and must be scrapped.

When agents whose price expectations have been disappointed respond with marginal adjustments in their existing plans rather than scrapping them and replacing them with new ones, a temporary equilibrium with disappointed expectations may still exist and that equilibrium may be reached through appropriate price adjustments in the markets for current delivery despite the divergent expectations of future prices held by agents. Operation of the price mechanism may still be able to achieve a reconciliation of revised but sub-optimal plans. The sub-optimal temporary equilibrium will be inferior to the allocation that would have resulted had agents all held correct expectations of future prices. Nevertheless, given a history of incorrect price expectations and misallocations of capital assets, labor, and other factors of production, a sub-optimal temporary equilibrium may be the best feasible outcome.

But here’s the problem. There is no guarantee that, when prices turn out to be very different from what they were expected to be, the excess demands of agents will adjust smoothly to changes in current prices. A plan that was optimal based on the expectation that the price of widgets would be $500 a unit may well be untenable at a price of $120 a unit. When realized prices are very different from what they had been expected to be, those price changes can lead to discontinuous adjustments, violating a basic assumption — the continuity of excess demand functions — necessary to prove the existence of an equilibrium. Once output prices reach some minimum threshold, the best response for some firms may be to shut down, the excess demand for the product produced by the firm becoming discontinuous at the that threshold price. The firms shutting down operations may be unable to repay loans they had obligated themselves to repay based on their disappointed price expectations. If ownership shares in firms forced to cease production are held by households that have predicated their consumption plans on prior borrowing and current repayment obligations, the ability of those households to fulfill their obligations may be compromised once those firms stop paying out the expected profit streams. Banks holding debts incurred by firms or households that borrowers cannot service may find that their own net worth is reduced sufficiently to make the banks’ own debt unreliable, potentially causing a breakdown in the payment system. Such effects are entirely consistent with a temporary-equilibrium model if actual prices turn out to be very different from what agents had expected and upon which they had constructed their future consumption and production plans.

Sufficiently large differences between expected and actual prices in a given period may result in discontinuities in excess demand functions once prices reach critical thresholds, thereby violating the standard continuity assumptions on which the existence of general equilibrium depends under the fixed-point theorems that are the lynchpin of modern existence proofs. C. J. Bliss made such an argument in a 1983 paper (“Consistent Temporary Equilibrium” in the volume Modern Macroeconomic Theory edited by  J. P. Fitoussi) in which he also suggested, as I did above, that the divergence of individual expectations implies that agents will not typically regard the debt issued by other agents as homogeneous. Bliss therefore posited the existence of a “Financier” who would subject the borrowing plans of prospective borrowers to an evaluation process to determine if the plan underlying the prospective loan sought by a borrower was likely to generate sufficient cash flow to enable the borrower to repay the loan. The role of the Financier is to ensure that the plans that firms choose are based on roughly similar expectations of future prices so that firms will not wind up acting on price expectations that must inevitably be disappointed.

I am unsure how to understand the function that Bliss’s Financier is supposed to perform. Presumably the Financier is meant as a kind of idealized companion to the Walrasian auctioneer rather than as a representation of an actual institution, but the resemblance between what the Financier is supposed to do and what bankers actually do is close enough to make it unclear to me why Bliss chose an obviously fictitious character to weed out business plans based on implausible price expectations rather than have the role filled by more realistic characters that do what their real-world counterparts are supposed to do. Perhaps Bliss’s implicit assumption is that real-world bankers do not constrain the expectations of prospective borrowers sufficiently to suggest that their evaluation of borrowers would increase the likelihood that a temporary equilibrium actually exists so that only an idealized central authority could impose sufficient consistency on the price expectations to make the existence of a temporary equilibrium likely.

But from the perspective of positive macroeconomic and business-cycle theory, explicitly introducing banks that simultaneously provide an economy with a medium of exchange – either based on convertibility into a real commodity or into a fiat base money issued by the monetary authority – while intermediating between ultimate borrowers and ultimate lenders seems to be a promising way of modeling a dynamic economy that sometimes may — and sometimes may not — function at or near a temporary equilibrium.

We observe economies operating in the real world that sometimes appear to be functioning, from a macroeconomic perspective, reasonably well with reasonably high employment, increasing per capita output and income, and reasonable price stability. At other times, these economies do not function well at all, with high unemployment and negative growth, sometimes with high rates of inflation or with deflation. Sometimes, these economies are beset with financial crises in which there is a general crisis of solvency, and even apparently solvent firms are unable to borrow. A macroeconomic model should be able to account in some way for the diversity of observed macroeconomic experience. The temporary equilibrium paradigm seems to offer a theoretical framework capable of accounting for this diversity of experience and for explaining at least in a very general way what accounts for the difference in outcomes: the degree of congruence between the price expectations of agents. When expectations are reasonably consistent, the economy is able to function at or near a temporary equilibrium which is likely to exist. When expectations are highly divergent, a temporary equilibrium may not exist, and even if it does, the economy may not be able to find its way toward the equilibrium. Price adjustments in current markets may be incapable of restoring equilibrium inasmuch as expectations of future prices must also adjust to equilibrate the economy, there being no market mechanism by which equilibrium price expectations can be adjusted or restored.

This, I think, is the insight underlying Axel Leijonhufvud’s idea of a corridor within which an economy tends to stay close to an equilibrium path. However if the economy drifts or is shocked away from its equilibrium time path, the stabilizing forces that tend to keep an economy within the corridor cease to operate at all or operate only weakly, so that the tendency for the economy to revert back to its equilibrium time path is either absent or disappointingly weak.

The temporary-equilibrium method, it seems to me, might have been a path that Hayek could have successfully taken in pursuing the goal he had set for himself early in his career: to reconcile equilibrium-analysis with a theory of business cycles. Why he ultimately chose not to take this path is a question that, for now at least, I will leave to others to try to answer.


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. 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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