Archive for February, 2012

Hawtrey on Competitive Devaluation: Bring It On

In a comment on my previous post about Ralph Hawtrey’s discussion of the explosive, but short-lived, recovery triggered by FDR’s 1933 suspension of the gold standard and devaluation of the dollar, Greg Ransom queried me as follows:

Is this supposed to be a lesson in international monetary economics . . . or a lesson in closed economy macroeconomics?

To which I responded:

I don’t understand your question. The two are not mutually exclusive; it could be a lesson in either.

To which Greg replied:

I’m pushing you David to make a clearer and cleaner claim about what sort of monetary disequilibrium you are asserting existed in the 1929-1933 period, is this a domestic disequilibrium or an international disequilibrium — or are these temprary effects any nation could achieve via competitive devaluations of the currency, i.e. improving the terms of international trade via unsustainable temporary monetary policy.

Or are a ping pong of competitive devaluations among nations a pure free lunch?

And if so, why?

You can read my response to Greg in the comment section of my post, but I also mentioned that Hawtrey had addressed the issue of competitive devaluation in Trade Depression and the Way Out, hinting that another post discussing Hawtrey’s views on the subject might be in the offing. So let me turn the floor over to Mr. R. G. Hawtrey.

When Great Britain left the gold standard, deflationary measure were everywhere resorted to. Not only did the Bank of England raise its rate, but the tremendous withdrawals of gold from the United States involved an increase of rediscounts and a rise of rates there, and the gold that reached Europe was immobilized or hoarded. . . .

The consequence was that the fall in the price level continued. The British price level rose in the first few weeks after the suspension of the gold standard, but then accompanied the gold price level in its downward trend. This fall of prices calls for no other explanation than the deflationary measures which had been imposed. Indeed what does demand explanation is the moderation of the fall, which was on the whole not so steep after September 1931 as before.

Yet when the commercial and financial world saw that gold prices were falling rather than sterling prices rising, they evolved the purely empirical conclusion that a depreciation of the pound had no effect in raising the price level, but that it caused the price level in terms of gold and of those currencies in relation to which the pound depreciated to fall.

For any such conclusion there was no foundation. Whenever the gold price level tended to fall, the tendency would make itself felt in a fall in the pound concurrently with the fall in commodities. But it would be quite unwarrantable to infer that the fall in the pound was the cause of the fall in commodities.

On the other hand, there is no doubt that the depreciation of any currency, by reducing the cost of manufacture in the country concerned in terms of gold, tends to lower the gold prices of manufactured goods. . . .

But that is quite a different thing from lowering the price level. For the fall in manufacturing costs results in a greater demand for manufactured goods, and therefore the derivative demand for primary products is increased. While the prices of finished goods fall, the prices of primary products rise. Whether the price level as a whole would rise or fall it is not possible to say a priori, but the tendency is toward correcting the disparity between the price levels of finished products and primary products. That is a step towards equilibrium. And there is on the whole an increase of productive activity. The competition of the country which depreciates its currency will result in some reduction of output from the manufacturing industry of other countries. But this reduction will be less than the increase in the country’s output, for if there were no net increase in the world’s output there would be no fall of prices.

In consequence of the competitive advantage gained by a country’s manufacturers from a depreciation of its currency, any such depreciation is only too likely to meet with recriminations and even retaliation from its competitors. . . . Fears are even expressed that if one country starts depreciation, and others follow suit, there may result “a competitive depreciation” to which no end can be seen.

This competitive depreciation is an entirely imaginary danger. The benefit that a country derives from the depreciation of its currency is in the rise of its price level relative to its wage level, and does not depend on its competitive advantage. If other countries depreciate their currencies, its competitive advantage is destroyed, but the advantage of the price level remains both to it and to them. They in turn may carry the depreciation further, and gain a competitive advantage. But this race in depreciation reaches a natural limit when the fall in wages and in the prices of manufactured goods in terms of gold has gone so far in all the countries concerned as to regain the normal relation with the prices of primary products. When that occurs, the depression is over, and industry is everywhere remunerative and fully employed. Any countries that lag behind in the race will suffer from unemployment in their manufacturing industry. But the remedy lies in their own hands; all they have to do is to depreciate their currencies to the extent necessary to make the price level remunerative to their industry. Their tardiness does not benefit their competitors, once these latter are employed up to capacity. Indeed, if the countries that hang back are an important part of the world’s economic system, the result must be to leave the disparity of price levels partly uncorrected, with undesirable consequences to everybody. . . .

The picture of an endless competition in currency depreciation is completely misleading. The race of depreciation is towards a definite goal; it is a competitive return to equilibrium. The situation is like that of a fishing fleet threatened with a storm; no harm is done if their return to a harbor of refuge is “competitive.” Let them race; the sooner they get there the better. (pp. 154-57)

So yes, Greg, competitive devaluation is a free lunch. Bring it on.

More on Inflation and Recovery

David Pearson, a regular and very acute commenter on this blog, responded with the following comment to my recent post about the remarkable 1933 recovery triggered by FDR’s devaluation of the dollar a month after taking office.

Here is a chart [reproduced below] showing the 12-mo. change in a broad range of CPI components. IMO, FDR would have been quite happy with this performance following 1933. The question is, if the Fed eased to produce 4-5% inflation, as MM’s recommend, what would each of these components look like, and how would that affect l.t. household real wage growth expectations? In turn, what impact would that have on current real household spending?

I inferred from David’s comment and the chart to which he provided a link that he believes that recent inflation has been distorting relative prices, and that he worries that increasing inflation would amplify the relative-price distortions. I thought that it would be useful to track the selected components in this chart more than one year back, so I created another chart showing the average rate of change in the CPI and in the selected components from January 2008 to January 2010 along side the changes from January 2011 to January 2012. There seems to be some inverse correlation between the rate of price increase in a component in the 2008-10 period and the price increase in 2011. Of the 6 components that increased by less than 1% per year in the 2008-10 period, four increased in 2011 by 4.7% or more in 2011, the remaining components increasing by 4.4% or less in 2011. So the rapid increases in some components in 2011 may simply reflect a reversion to a more normal pattern of relative prices.

I agree that inflation is not neutral. There are relative price effects; some prices adjust faster than others, but I don’t think we know enough about the process of price adjustment in the real world to be able to say that overall inflation in conditions of high unemployment amplifies relative distortions. What we do know is that even after a pickup in inflation in 2011, inflation expectations remain low (though somewhat higher than last summer) and real interest rates are negative or nearly negative at up to a 10-year time horizon. Negative real interest rates are an expectational phenomenon, reflecting the extremely pessimistic outlook of investors. Increasing future price-level expectations is one way – I think the best way — to improve the investment outlook for businesses. We are in an expectational trap, not a liquidity trap, and an increase in price-level expectations would generate a cycle of increased investment and output and income and entrepreneurial optimism that will be self-sustaining. Say’s Law in action; supply creates its own demand.

In a more recent comment on the same post, David Pearson worries that insofar as inflation would tend to reduce real wages, it will cause wage earners and households to cut back on consumption, thereby counteracting any stimulus to investment by business from expectations of rising prices. To the extent that expectations of future wage growth fall, workers may also revise downward their reservation wages, so, even if David is right, the effect on employment is not clear. But I doubt that short-term changes in the inflation rate cause significant changes in expectations of future wage and income growth which are dependent on a variety of micro factors peculiar to individual workers and their own particular circumstances. As usual David makes a good argument for his point of view, but I am not persuaded. But then I don’t suppose that I have persuaded him either.

Hawtrey on the Short but Sweet 1933 Recovery

Here’s another little gem (pp. 65-66) from Ralph Hawtrey’s Trade Depression and the Way Out. He discusses the amazing revival of business in the depth of the Great Depression triggered by FDR’s suspension of the gold standard in March 1933 immediately after taking office. Despite the suspension of the gold standard, there was period of uncertainty lasting over a month because it was not clear whether FDR would trigger a devaluation and the Treasury Department was issuing licenses to export gold preventing the dollar from depreciating in the foreign exchange markets. It was not until April 19 that the Secretary of the Treasury declined to issue any more licenses.

A license was a device for sustaining the value of the dollar. It was an instrument of torture designed to inflict further distress on a suffering nation. The pen refused to write the signature. No licenses were to be granted.

At once the dollar fell. The discount soon exceeded 10%. The suspension of the gold standard had become a reality.

The impulse given towards the revival of industry was instantaneous. It was like the magic change of spirit that seized the Allied line at Waterloo late in the afternoon, when there passed through the French ranks the terrible murmur “the Guard is giving way,” and the cohesion of their onset was at last loosened. . . . The eagles (258 grains, nine-tenths fine) were in full retreat.

Manufacturers pressed forward to fulfill a stream of orders such as they had not known for years. Wheat and corn, cotton, silk and wool, non-ferrous metals, rubber, almost every primary product found increased sales at higher prices. The steel industry, which at one time in March had been working at 15% of capacity rose in three months to 59%. The consumption of rubber in June exceeded the highest monthly totals of 1929. The index of manufacturing production, which relapsed from 66 in September 1932 to 57 in March 1933, advanced to 99 in July 1933, the highest since May 1930. The index of factory employment rose from 56.6 in March to 70.1 in July, and that of factory payrolls from 36.9 to 49.9. The Department of Labour Price Index rose from 59.8 in February 1933 to 69.7 on the 22nd July, the Farm Products group rising in the same period from 40.9 to 62.7.

This revival was a close parallel to that which occurred in Great Britain after the suspension of the gold standard in September 1931. On that occasion bank rate was put up to 6%, and renewed deflation and depression followed. In the United States, on the other hand, not only was cheap money continued (the 3% rediscount rate in New York being completely ineffective), but wide and unprecedented powers were conferred on the President with a view to a policy of inflation being carried out. . . .

For a month the depreciation of the dollar had no other source than in the minds of the market. The Administration quite clearly and certainly intended the dollar to fall, and every one dealing in the market was bound to take account of that intention. Towards the end of May the Federal Reserve Banks began to buy securities. By the end of June they had increased their holding of Government securities from $1,837,000,000 to $1,998,000,000, and the dollar was at a discount of more than 20%. The New York rediscount rate was reduced from 3% to 2.5% on the 26th May, and even the lower rate remained completely ineffective.

In July, however, the open market purchases slackened off. And other circumstances contributed to check the progress of depreciation. . . . Above all, on the 20th July, a plan for applying the minimum wages and maximum hours of the National Industrial Recovery Act throughout the whole range of American industry and trade without delay was put forward by the Administration. Profits were threatened.

The discount on the dollar had reached 30% on the 10th July, but, from the 20th July, it met with a rapid and serious reaction. There were fluctuations, but the discount did not again touch 30% till the middle of September. And the recovery of business was likewise interrupted.

There was some tendency to regard the policy of minimum wages and maximum hours as an alternative to monetary depreciation as a remedy for the depression.

It’s instructive to compare Hawtrey’s account of the effects of the devaluation of April 1933 with the treatment by Friedman and Schwartz in their Monetary History of the US (pp. 462-69) which treats the devaluation as a minor event. A subsequent discussion pp. 493-98 fails to draw attention to the remarkable recovery triggered over night by the devaluation of the dollar, and inexplicably singles out a second-order effect – increased production in anticipation of cost increases imposed by the anticipated enactment of the National Industrial Recovery Act – while ignoring the direct effect of enhanced profitability resulting from the depreciation of the dollar.

The revival was initially erratic and uneven. Reopening of the banks was followed by a rapid spurt in personal income and industrial production (see Chart 37). 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. A relapse in the second half of 1933 was followed by another spurt in early 1934 and then a further relapse. A sustained and reasonably continuous rise in income and production did not get under way until late 1934.

This is an example of how Friedman’s obsession with the quantity theory, meaning that the quantity of money was always the relevant policy variable blinded him from recognizing that devaluation of the dollar in and of itself could raise the price level and provide the stimulus to profits and economic activity necessary to lift the economy from the depths of a depression.  The name Hawtrey appears only once in the Monetary History in a footnote on p. 99 citing Hawtrey’s A Century of Bank Rate in connection with the use of Bank rate by the Bank of England to manage its reserve position.  Cassel is not cited once.  To my knowledge, Friedman did not cite Hawtrey in any of his works on the Great Depression.

Hawtrey on the Interwar Gold Standard

I just got a copy of Ralph Hawtrey’s Trade Depression and the Way Out (1933 edition, an expanded version of the first, 1931, edition published three days before England left the gold standard). Just flipping through the pages, I found the following tidbit on p. 9.

The banking system of the world, as it was functioning in 1929, was regulated by the gold standard. Formerly the gold standard used to mean the use of money made of gold. Gold coin was used as a hand-to-hand medium of payment. Nowadays the gold standard means in most countries the use of money convertible into gold. The central bank is required to exchange paper money into gold and gold into paper money at a fixed rate. The currency of any gold-standard country is convertible into gold, and the gold is convertible into the currency of any other gold-standard country. Thus the currencies of any two gold-standard countries are convertible into one another at no greater cost than is involved in sending gold from one country to the other.

Thus, for Hawtrey, the key formal difference between the interwar and the prewar gold standards was that gold coins were did not circulate as hand-to-hand money in the interwar gold standard (hence the reference to gold exchange standard), gold coins having been withdrawn almost universally from circulation during World War I to enable the belligerent governments to control the monetary reserves they needed to obtain war supplies. A huge fraction of the demonetized gold coins wound up in the possession of the United States government or the Federal Reserve Bank of New York in payment for US exports, though an even greater amount of US exports were financed by loans to the allies. By war’s end, the US had accumulated a staggering 40% of the world’s monetary gold reserves. Many people casually distinguish between the prewar and the interwar gold standards without specifying what exactly accounts for the difference. There is no reason to think that the absence of gold coinage makes any significant difference in how the gold standard operated. David Ricardo, as committed a defender of the gold standard as ever lived, had proposed abolishing gold coinage (to be replaced entirely by convertible banknotes and token coins) in his 1816 Proposals for an Economical and Secure Currency. Thanks to the demonetization of gold coins during World War I, there was a huge increase in the world’s total stock of gold reserves in the hands of the central banks. Exactly how that affected the subsequent operation of the gold standard is never made clear. There may have been increased obstacles placed on the redemption of gold or the exchange of different currencies, but that is just conjecture on my part.

Back to Hawtrey:

Gold is a commodity with other uses than as money. But it would be a mistake to suppose that it therefore provides an independent standard of value. The industrial demand for gold throughout the world is insignificant in comparison with the demand for it as money. It is only a fraction of the annual output, and the annual output is only about 4% of the total stock held by the central banks and currency authorities of the world in their reserves. The market for gold consists of the purchases of the central banks from the mines and from one another. It is by their action that the value of gold in terms of other forms of wealth is determined.

The key point which bears repeating again and again is that under a gold standard, there is no assurance that the value of money will be stable in the absence of action taken by the monetary authorities to maintain its value. If a gold standard were to be restored, I have no idea how the demand for gold would be affected. The value of gold (in the short to intermediate run and perhaps even the long run) depends, more than anything, on the demand for gold. Gold is now a speculative asset; people hold gold now because they for some reason (unfathomable to me) believe that it will appreciate over time. If the value of gold were fixed in nominal terms by way of a gold standard, would people continue to demand gold in anticipation that its price would rise? Perhaps, but I don’t think so. And what do supporters of the gold standard believe that governments and monetary authorities, which now hold about almost 20% of existing gold stocks, ought to be done with those reserves?  Do they think that governments and public agencies ought to continue to hold gold simply to stabilize the value of gold? Is that how the free market is supposed to determine the value of money?

Lars Christensen on the Eurozone Crisis RIP

UPDATE:  In my enthusiasm and haste to plug Lars Chritensen’s post on the possible end of the Eurozone crisis, I got carried away and conflated two separate effects.  The dollar’s appreciation against from July to September was associated with a steep drop in inflation expectations, the TIPS spread fallling from about 2.4% in July to about 1.7% on 10-year Treasuries.  The dollar rose against the euro from July to September from the exchange rate moving from the $1.42 to $1.45 range in early July to the $1.35 to $1.38 range in September.  From September to December, inflation expectations rose modestly, the TIPS spread on 10-year Treasuries recovering to about 1.9%.  It has only been since December that the dollar has been appreciating against the euro even as inflation expectations have risen to over 2% as reflected by the TIPS spread on 10-year Treasuries.  The actual data are thus more consistent with Lars’s take on the Eurozone crisis than suggested by my original comment  .Sorry for that slip-up on my part.

Check out this fascinating post by Lars Christensen on how the Eurozone Crisis (not to be confused with the Greek Debt Crisis) came to an end last July.  The key to understanding what happened is that on July 1 the dollar/euro exchange rate was $1.4508/euro.  Yesterday it was about $1.32/euro.  The appreciation of the dollar would have been a disaster for the US and the rest of the world, except for the fact that inflation expectations in the US have increased, not decreased, since July (even as measured inflation — both headline and core — has fallen).  Ever since 2008, US inflation expectations and the dollar/euro exchange rate have been positively correlated (i.e., increased inflation expectations in the US have been associated with a falling value of the dollar relative to the euro).  Since July US inflation expectations have increased while the dollar has appreciated against the euro.

HT:  Lars Christensen and Marcus Nunes

Counterfeiting and American Monetary History

In the November 10, 2011 issue of the New York Review of Books, Gordon Wood, professor emeritus of history at Brown University, reviews a new book by Ben Tarnoff Moneymakers: The Wicked Lives and Surprising Adventures of Three Notorious Counterfeiters. I found the second paragraph of Wood’s essay, especially arresting.

Almost from the beginning of American history Americans have relied on paper money. Indeed, the Massachusetts Bay Colony in 1690 was the first government in the Western world to print paper currency in order to pay its debts. Although this paper money was not redeemable in specie, the Massachusetts government did accept it in payment for taxes. Because Americans were always severely short of gold and silver, the commercial benefits of such paper soon became obvious. Not only the thirteen British colonies, but following the Revolution the new states and the Continental Congress all came to rely on the printing of paper money to pay most of their bills. By the early nineteenth century hundreds of banks throughout the country were issuing notes that passed as money. No place in the world had more paper money flying about than did America. By the time the federal government began regulating the money supply during the Civil War, there were more than ten thousand different kinds of notes circulating in the United States.

Note the explicit reference to the role of making paper money acceptable in payment for taxes as condition for the success of the paper money printed by the Massachusetts government even though the money was not redeemable in specie.

Wood goes on to recount the important role that counterfeiters played in American history focusing on the stories of the three “heroes” of Tarnoff’s book to illustrate the ways in which counterfeiters actually served the public interest by providing access to paper money that banks were not willing or able to provide, an observation that will resonate deeply with our own esteemed Benjamin Cole, who has loudly proclaimed the benefits of monetary expansion, even if accomplished by counterfeiting.

Another important point that I found extremely interesting comes toward the end of Wood’s piece.

The golden age of American counterfeiting came to an end during the Civil War. In 1862 the United States made paper money printed by the national government legal tender. This “bold expansion of federal sovereignty,” says Tarnoff, “represented nothing less than a revolution in American finance.” The National Currency Act of 1863 followed, and a tax on the notes of state banks put them out of business. The United States had become a new nation. “The war produced something unimaginable: a federal monopoly on paper currency. . . .Never before in American history,” says Tarnoff, “had the power to make paper money been held by a single authority.”

Counterfeiter felt the effects immediately. With a single national currency people no longer had to sift through thousands of different bills trying to distinguish the genuine from the fake. But an agency to detect and arrest counterfeiters was still needed, and in 1865 the Treasury Department created the US Secret Service, which soon severely cut down the number of counterfeiters and counterfeit notes. At the time of the Civil War one third or more of the paper money in circulation had been fraudulent; by the time the Federal Reserve System was established in 1913, counterfeit bills made up less than on thousandth of one percent of the paper money supply.

Obviously, centralizing the issue of bank notes greatly increases the incentive of the monopoly issuer to enforce its property rights and eliminate counterfeiting. With a decentralized supply of bank notes, individual banks have relatively little incentive to seek or undertake enforcement action against counterfeiters who are more likely to counterfeit someone else’s notes than their own. In his first great book on monetary theory, Good and Bad Trade, Ralph Hawtrey cited the reduced costs of identifying counterfeit notes as the principal advantage in suppressing free competition in the issue of banknotes.

Wood closes by noting that most of the $900 billion of Federal Reserve Notes in circulation in 2010 (now well over $1 trillion) are thought to be held outside the US. The amount of gold held in bullion or coins by private citizens is estimated to be 16% of the total of gold in existence in2008. The current stock of gold in all forms is about 170,000 metric tons. So about 25,000 metric tons of gold may now be privately held. At $1700 an ounce, private gold holdings are thus worth about $1.3 trillion. I don’t know how much of this is held outside the US, but I suspect it is much more than a half. Let’s assume it’s a round number like $1 trillion. Then the amount of privately held gold outside the US is about twice the amount of privately held Federal Reserve notes. However, holding Federal Reserve Notes is not the only way that people can hold dollars abroad. They can also hold euro dollar accounts, which are time deposits denominated in dollars held in offshore (outside the US) banks. No one knows what the volume of such accounts is, because it is basically an unregulated market outside the reach of US regulatory authority and pretty much left unregulated by foreign governments. But estimates of the size of euro dollar accounts (which may be denominated in other currencies, but are overwhelmingly denominate in dollars) are probably far more than $1 trillion. So based on the revealed preferences of legally unconstrained choices, the dollar seems to be way, way more popular than gold.

Japan’s 2-Decade Experiment with Fiscal Austerity (or Stimulus) and -0.3% Annual NGDP Growth

UPDATE:  Thanks to Scott Sumner who alerted me in his comment below that I had not properly checked the data for Japanese GDP on the St. Louis Fed website.  There was one series covering real GDP annually from 1960 to 2010 and another quarterly series from 1994 to 2011, which is what I used.  The second series was listed as GDP, so I assumed that it meant nominal GDP.  But when I checked after reading Scott’s comment, I found that indeed it was real GDP as well.  Then using a separate series for the GDP deflator I calculated nominal GDP.  I make corrections in the post below and have modified the title of the post accordingly.

Peter Tasker has an excellent op-ed (“Europe can learn from Japan’s austerity endgame”) in Monday’s Financial Times, pointing out that Japan for the last two decades has been pursuing the kind of fiscal austerity program now being urged on Europe to combat their debt crisis.

When Japan’s bubble economy imploded in the early 1990s, public finances were in surplus and government debt was a mere 20 percent of gross domestic product. Twenty years on, the government is running a yawning deficit and gross public debt as swollen to a sumo-sized 200 percent of GDP.

Fiscal austerity did not begin immediately, but “Japan’s experiment with Keynesian-style public works programmes” ended in 1997. The public works programs did not promote a significant recovery, but in the six years from 1992 to 1997, real GDP at least managed to grow at a feeble 1.3% annual rate. But in the two years after austerity began — public works spending being cut back and the consumption tax raised, real GDP fell by 2.1% (1998) and 0.1% (1999). Despite fiscal austerity after 1997, the budgetary situation steadily deteriorated, government outlays rising as percentage of GDP while tax revenues are 5% lower as a percentage of GDP than in 1988 when the consumption tax was introduced.

Tasker also asserts observes that Japan’s nominal GDP is now lower than it was in 1992. The data on the St. Louis Fed website do not seem to bear out that claim. According to the St. Louis Fed data, nominal real GDP in the third quarter of 2011 was 13.1% higher than in the first quarter of 1994, which is the starting point for the St. Louis Fed data series of Japanese nominal GDP.  Nominal GDP over the same period fell by 5.2%.  Thus, over the 17.5 years for which the St. Louis Fed reports Japanese NGDP, the average annual rate of growth of NGDP has been 0.74 -0.3%. That is the future the Eurozone countries are looking at unless the European Central Bank is willing to take aggressive steps to ensure that nominal GDP growth is at least 5% a year for the foreseeable future. An increase in Japanese NGDP growth wouldn’t be such a bad idea either.  As I have observed before (also here and here), the European debt crisis is really an NGDP crisis.

About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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