Uneasy Money

In Chapter 9 of Good and Bad Trade, Hawtrey arrives at what he then regarded as the culmination of the earlier purely theoretical discussions of the determination of prices, incomes, and exchange rates under a fiat currency, by positing that the currencies of all countries were uniformly convertible into some fixed weight of gold.

We have shown that the rate of exchange tends to represent simply the ratio of the purchasing power of the two units of currency, and that when this ratio is disturbed, the rate of exchange, subject to certain fluctuations, follows it.

But having elucidated this point we can now pass to the much more important case of the international effects of a fluctuation experienced in a country using metal currency common to itself and its neighbours. Practiaclly all the great commercial nations of the world have now adopted gold as their standard of legal tender, and this completely alters the problem. (p. 102)

Ah, what a difference a century makes! At any rate after providing a detailed and fairly painstaking account of the process of international adjustment in response to a loss of gold in one country, explaining how the loss of gold would cause an increase in interest rates in the country that lost gold which would induce lending by other countries to the country experiencing monetary stringency, and tracing out further repercussions on the movement of exchange rates (within the limits set by gold import and export points, reflecting the cost of transporting gold) and domestic price levels, Hawtrey provides the following summary of his analysis

Gold flows from foreign countries ot the area of stringency in response to the high rate of interest, more quickly from the nearer and more slowly from the more distant countries. While this process is at work the rates of interests in foreign countries are raised, more in the nearer and less in the more distant countries. As soon as the bankers’ loans have been brought into the proper proportion to the stock of gold, the rate of interest reverts to the profit rate in the area of stringency, but the influx of gold continues from each foreign country until the average level of prices there has so far fallen that its divergence from the average level of prices in the area of stringency is no longer great enough to cover the cost of sending the gold.

So long as any country is actually exporting gold the rate of interest will there be maintained somewhat above the profit rate, so as to diminish the total amount of bankers’ loans pari passu with the stock of gold.

At the time when the export of gold ceases from any foreign country the rate of exchange in that country on the area of stringency is at the export specie point; and the exchange will remain at this point indefinitely unless some new influence arises to disturb the equilibrium. In fact, the whole economic system will, the absence of such influence, revert to the stable conditions from which it started. (p. 113)

In subsequent writings, Hawtrey modified his account of the adjustment process in an important respect. I have not identified where and when Hawtrey first revised his view of the adjustment process, but, almost twenty years later in his book The Art of Central Banking, there is an exceptionally clear explanation of the defective nature of the account of the international adjustment mechanism provided in Good and Bad Trade. Iin the course of an extended historical discussion of how the Bank of England had used its lending rate as an instrument of policy in the nineteenth and earl twentieth centuries (a discussion later expanded upon in Hawtrey’s A Century of Bank Rate), Hawtrey quoted the following passage from the Cunliffe Report of 1918 recommending that England quickly restore the gold standard at the prewar parity. The passage provides an explanation of how, under the gold standard, the Bank of England, faced with an outflow of its gold reserves, could restore an international equilibrium by raising Bank Rate. The explanation in the Cunliffe Report deploys essentially the same reasoning reflected above in the quotation from p. 113 of Good and Bad Trade.

The raising of the discount rate had the immediate effect of retaining money here which would otherwise have been remitted abroad, and of attracting remittances from abroad to take advantage of the higher rate, thus checking the outflow of gold and even reversing the stream.

If the adverse conditions of the exchanges was due not merely to seasonal fluctuations but to circumstances tending to create a permanently adverse trade balance, it is obvious that the procedure above described would not have been sufficient. It would have resulted in the creation of a volume of short-dated indebtedness to foreign countries, which would have been in the end disastrous to our credit and the position of London as the financial centre of the world. But the raising of the Bank’s discount rate and the steps taken to make it effective in the market necessarily led to a general rise of interest rates and a restriction of credit. New enterprises were therefore postponed, and the demand for constructional materials and other capital goods was lessened. The consequent slackening of employment also diminished the demand for consumable goods, while holders of stocks of commodities carried largely with borrowed money, being confronted with an increase in interest charges, if not with actual difficulty in renewing loans, and with the prospect of falling prices, tended to press their goods on a weak market. The result was a decline in general prices in the home market which, by checking imports and stimulating exports, corrected the adverse trade balance which was the primary cause of the difficulty. (Interim Report of the Cunliffe Committee, sections 4-5)

Hawtrey took strong issue with the version of the adjustment process outlined in the Cunliffe Report, though acknowledging that ithe Cunliffe Report did in some sense reflect the orthodox view of how variations in Bank Rate achieved an international adjustment.

This passage expresses very fairly the principle on which the Bank of England had been regulating credit from 1866 to 1914. They embody the art of central banking as it was understood in the half-century preceding the war. In view of the experience which has been obtained, the progress made in theory and the changes which have occurred since 1914, the principles of the art require reconsideration at the present day.

The Cunliffe Committee’s version of the effect of Bank rate upon the trade balance was based on exactly the same Ricardian theory of foreign trade as Horsely Palmer’s. It depended on adjustments of the price level. But the revolutionary changes in the means of communication during the past hundred years have unified markets to such a degree that for any of the commodities which enter regularly into international trade there is practically a single world market and a single world price. That does not mean absolutely identical prices for the same commodity at different places, but prices differing only by the cost of transport from exporting to the importing centres. Local divergences of prices form this standard are small and casual, and are speedily eliminated so long as markets work freely.

In Ricardo’s day, relatively considerable differences of price were possible between distant centres. The merchant could never have up-to-date information at one place of the price quotations at another. When he heard that the price of a commodity at a distant place had been relatively high weeks or months before, he was taking a risk in shipping a cargo thither, because the market might have changes for the worse before the cargo arrived. Under such conditions, it might well be that a substantial difference of price level was required to attract goods from one country to another.

Nevertheless it was fallacious ot explain the adjustment wholly in terms of the price level. There was, even at that time, an approximation to a world price. When the difference of price level attracted goods from one country to another, the effect was to diminish the difference of price level, and probably after an interval to eliminate it altogether (apart from cost of transport). When that occurred, the importing country was suffering an adverse balance, not on account of an excess price level, but on account of an excess demand at the world price level. Whether there be a difference of price level or not, it is this difference of demand that is the fundamental factor.

In Horsely Palmer‘s day the accepted theory was that the rate of discount affected the price level because it affected the amount of note issue and therefore the quantity of currency. That did not mean that the whole doctrine depended on the quantity theory of money. All that had currency so far tended to cause a rise or fall of the price level that any required rise or fall of prices could be secured by an appropriate expansion or contraction of the currency that is a very different thing from saying that the rise or fall of the price level would be exactly proportional to the expansion or contraction of the currency.

But it is not really necessary to introduce the quantity of currency into the analysis at all. What governs demand in any community is the consumers’ income (the total of all incomes expressed in terms of money) and consumers’ outlay (the total of all disbursements out of income, including investment).

The final sentence seems to be somewhat overstated, but in the context of a gold standard, in which the quantity of currency is endogenously determined, the quantity of currency is determined not determining. After noticing that Hawtrey anticipated Cassel in formulating the purchasing power parity doctrine, I looked again at the excellent paper by McCloskey and Zecher “The Success of Purchasing Power Parity” in the NBER volume A Retrospective on the Classical Gold Standard 1821-1931, edited by Bordo and Schwartz, a sequel to their earlier paper, “How the Gold Standard Worked” in The Monetary Approach to the Balance of Payments, edited by Johnson and Frenkel. The paper on purchasing power parity makes some very powerful criticisms of the Monetary History of the United States by Friedman and Schwartz, some of which Friedman responded to in his formal discussion of the paper. But clearly the main point on which McCloskey and Zecher took issue with Friedman and Schwartz was whether an internationally determined price level under the gold standard tightly constrained national price levels regardless of the quantity of local money. McCloskey and Zecher argued that it did, while Friedman and Schwartz maintained that variations in the quantity of national money, even under the gold standard, could have significant effects on prices and nominal income, at least in the short to medium term. As Friedman put it in his comment on McCloskey and Zecher:

[W]hile the quantity of money is ultimately an endogenous variable [under fixed exchange rates], there can be and is much leeway in the short run, before the external forces overwhelm the independent internal effects. And we have repeatedly been surprised in our studies by how much leeway there is and for how long – frequently a number of years.

I’ll let Friedman have the last word on this point, except to note that Hawtrey clearly would have disagreed with him post, at least subsequently to his writing Good and Bad Trade.