Marcus Nunes follows Karl Smith and Russ Roberts in wondering what Edmund Phelps was talking about in his remarks in the second Hayek v. Keynes debate. I have already explained why I find all the Hayek versus Keynes brouhaha pretty annoying, so, relax, I am not going there again. But Marcus did point out that in the first paragraph of Phelps’s remarks, he actually came close to offering the correct diagnosis of the causes of the Great Depression, an increase in the value of gold. Unfortunately, he didn’t quite get the point, the diagnosis independently provided 10 years before the Great Depression by both Ralph Hawtrey and Gustave Cassel. Here’s Phelps:
Keynes was a close observer of the British and American economies in an era in which their depressions were wholly or largely monetary in origin – Britain’s slump in the late 1920s after the price of the British currency was raised in terms of gold, and America’s Great Depression of the 1930s, when the world was not getting growth in the stock of gold to keep pace with productivity growth. In both cases, there was a huge fall of the price level. Major deflation is a telltale symptom of a monetary problem.
What Phelps unfortunately missed was that from 1925 to mid-1929, Great Britain was not in a slump, at least not in his terminology. Unemployment was high, a carryover from the deep recession of 1920-21, and there were some serious structural problems, especially in the labor market. But the overvaluation of the pound that Phelps blames for a non-existent (under his terminology) slump caused only mild deflation. Deflation was mild, because the Federal Reserve, under the direction of the great Benjamin Strong, was aiming at a roughly stable US (and therefore, world) price level. Although there was still deflationary pressure on Britain, the pound being overvalued compared to the dollar, the accommodative Fed policy (condemned by von Mises and Hayek as intolerably inflationary) allowed a gradual diminution of the relative overvaluation of sterling with only mild British deflation. So from 1925 to 1929, the British economy actually grew steadily, while unemployment fell from over 11% in 1925 to just under 10% in 1929.
The problem that caused the Great Depression in America and the rest of the world (or at least that portion of the world that had gone back on the gold standard) was not that the world stock of gold was not growing as fast as productivity was growing – that was a separate long-run problem that Cassel had warned about that had almost nothing to do with the sudden onset of the Great Depression in 1929. The problem was that in 1928 the insane Bank of France started converting its holdings of foreign exchange into gold. As a result, a tsunami of gold, drawn mostly from other central banks, inundated the vaults of the Bank of France, forcing other central banks throughout the world to raise interest rates and to cash in their foreign exchange holdings for gold in a futile effort to stem the tide of gold headed for the vaults of the IBOF.
One central bank, the Federal Reserve, might have prevented the catastrophe, but, the illustrious Benjamin Strong tragically having been incapacitated by illness in early 1928, the incompetent crew replacing Strong kept raising the discount rate in a frenzied attempt to curb stock-market speculation on Wall Street. Instead of accommodating the world demand for gold by allowing an outflow of gold from its swollen reserves — over 40% of total gold reserves held by central banks, the Fed actually was inducing an inflow of gold into the US in 1929.
That Phelps agrees that the 1925-29 period in Britain was characterized by a deficiency of effective demand because the price level was falling slightly, while denying that there is now any deficiency of aggregate demand in the US because prices are rising slightly, though at the slowest rate in 50 years, misses an important distinction, which is that when real interest rates are negative as they are now, an equilibrium with negative inflation is impossible. Forcing down inflation lower than it is now would trigger another financial panic. With positive real interest rates in the late 1920s, the British economy was able to tolerate deflation without imploding. It was only when deflation fell substantially below 1% a year that the British economy, like most of the rest of the world, started to implode.
If Phelps wants to brush up on his Hawtrey and Cassel, a good place to start would be here.
Uneasy Money 
David,
Just as a general point of historical interest, was there actually much geographical movement of physical gold precipitated by the IBOF’s actions? Did the gold ‘inundate their vault’ or did it just nominally change hands? It’s not especially important, I’m just curious.
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I’m intrigued by your comments on 1925-1929. So if its not the overvalued pound, exactly what was causing the “carry over” of unemployment from 1920-1921 so many years later? Why did this get carried over in the UK but not in the US?
That seems like a lot of unemployment to “carry over” and seems to require some explanation… what do you think caused that, if not monetary problems?
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dkuehn, shell out some money on David’s book Free Banking and Monetary Reform, he addresses this.
His explanation is that a rise in the real value of unemployment relief payments rendered British foreign trade unprofitable and reduced employment in the export industries.
Whether David still holds to this theory or has added to it is another question.
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From an article titled “The International Gold Standard and U.S. Monetary Policy from World War I to the New Deal ” by Leland Crabbe, Federal Reserve Bulletin, June, 1989, pp. 423 ff., this data on the gold holdings of the Insane Bank of France (millions of dollars):
1924 710
1925 710
1926 711
1927 954
1928 1,254
1929 1,633
1930 2,099
By December 1932 it had climbed to $3,257 million–4.5 times as large as its 1926 holdings. And there was a corresponding (but not as large) a drop in foreign excnahge holdings, from $850 million in 1927 to $176 million in Decemner, 1932.
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That should be “nearly 3 times as large” for the gold holdings. And whether this represents physical movements of gold or not is unclear, and Crabbe does not address this isssue.
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I really can’t do arithmetic. 4.5 times as large was correct. Sorry.
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Every time I read David on this subject, I become curious about why the IBOF thought it a good idea to convert its foreign exchange holdings into gold. Simply because it was insane? Do we know anything about how the IBOF’s members were selected?
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Will, David touches on this in his book as does Douglas Irwin in his paper on the BoF. In June 1928, France legally went back onto the gold standard. That same legislation forced the BoF to hold gold reserves equal to 35 percent of its liabilities and prohibited it from purchasing anymore foreign exchange.
The BoF’s gold reserve ratio eventually rose to 50% by 1930. Presumably the prohibition against puchasing forex forced the bank to keep adding gold. Why it couldn’t sell gold for say French government debt or commercial paper, I don’t know.
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Richard,Transfers of golds between vaults has been traditionally done using a ‘spot of paint to indicate ownership’ method, rather than physically moving much gold, which of course then only had to be moved at the margin. Much has been made of this by holders of nominalist/credit theory of money thinkers.
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I’m a big fan of that debate between Hayek and Keynes. I tend to be representing the Hayek philosophy. Even though I need to explorer the topic a lot more.
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JP- Thanks for the answer. You seem to like David’s book a lot. Based on any number of “thinking like an economist” pieces I’ve read, I conclude you must be getting kickbacks! I’ll still buy a copy.
If the BoF actions were indeed the product of legislation, I’m not sure we have grounds for declaring insanity. It seems at best we can say, “the insufficiently independent Bank of France (IIBOF)”. The insanity would seem to belong to the French parliament. However, on further reflection, I would guess that this legislative act was the work of whatever right-wing protectionist party France had at the time. So we might impart insanity to them. But then it occurs to me that they were probably supported by the French rentiers of the time. Rentiers might have a rational preference for deflationary busts over inflationary booms. And so, there may be no insanity here, and also — presto! — we finally have a class-conflict theory of why the Great Depression happened.
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Richard, I don’t really have specific knowledge on how transfers of gold were being made, but my guess is that the IBOF really wanted to take physical possession of, as well as legal title to, the gold.
dkuehn, Not sure I understand the comparison between the US and the UK. It was the pound that was overvalued relative to the dollar, so the two situations are not at all comparable. Prices in the UK had to fall relative to prices in the US.
JP, Thanks so much for plugging my book, and I am impressed that you seem to have read it so diligently. My argument about the role of unemployment compensation was based on the article by Dan Benjamin and Levis Kochin in JPE in the late 1970s. My impression is that their argument has stood up reasonably well against critics. I also discussed their argument in my article “Where Keynes Went Wrong” originally published in Encounter.
Donald, Thanks for supplying those numbers.
Will, On the IBOF, read the recent book Lords of Finance by Liaquat Ahamed. For a more scholarly treatment, see The Gold Standard Illusion: France, the Bank of France, and the International Gold Standard by Kenneth Moure.
Andrew, I am not sure when the practice of transferring ownership without transferring the location of gold reserves began, but I think it is of more recent vintage. The concept of gold export and import points would not be relevant if that is all that was happening.
Tas, There’s a lot of reading you’re going to have to do.
Will, No JP is not shilling for me. Actually, I was going to mention in my post the legal obligations imposed on the Bank of France, but I was pressed for time and couldn’t quite figure out how to convey the point in the proper spirit, the proper spirit being that the IBOF was a co-conspirator with the French Parliament in the legislation under which it operated, the IBOF viewed the increase in its gold reserves as the ultimate validation of the correctness and sagacity of its policy and the thrifty and industrious character of the French nation, in much the same self-congratulatory spirit as the Mrs. Merkel and the Germans tirelessly pat themselves on the back for their own rectitude in resisting the seductive siren song of inflation.
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David: Thanks for the book recommendations, and the explanation. The case of Germany reminds me of a line from the Onion: “Where the mistakes of the past come alive!” It is somewhat hopeful that the French seem poised to repudiate this approach. At the very least, it won’t hurt to have a French prime minister who hasn’t been saying rude, sexist things about Ms. Merkel behind her back.
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Will, I see very little that is hopeful in the French elections.
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