Sterilizing Gold Inflows: The Anatomy of a Misconception

In my previous post about Milton Friedman’s problematic distinction between real and pseudo-gold standards, I mentioned that one of the signs that Friedman pointed to in asserting that the Federal Reserve Board in the 1920s was managing a pseudo gold standard was the “sterilization” of gold inflows to the Fed. What Friedman meant by sterilization is that the incremental gold reserves flowing into the Fed did not lead to a commensurate increase in the stock of money held by the public, the failure of the stock of money to increase commensurately with an inflow of gold being the standard understanding of sterilization in the context of the gold standard.

Of course “commensurateness” is in the eye of the beholder. Because Friedman felt that, given the size of the gold inflow, the US money stock did not increase “enough,” he argued that the gold standard in the 1920s did not function as a “real” gold standard would have functioned. Now Friedman’s denial that a gold standard in which gold inflows are sterilized is a “real” gold standard may have been uniquely his own, but his understanding of sterilization was hardly unique; it was widely shared. In fact it was so widely shared that I myself have had to engage in a bit of an intellectual struggle to free myself from its implicit reversal of the causation between money creation and the holding of reserves. For direct evidence of my struggles, see some of my earlier posts on currency manipulation (here, here and here), in which I began by using the concept of sterilization as if it actually made sense in the context of international adjustment, and did not fully grasp that the concept leads only to confusion. In an earlier post about Hayek’s 1932 defense of the insane Bank of France, I did not explicitly refer to sterilization, and got the essential analysis right. Of course Hayek, in his 1932 defense of the Bank of France, was using — whether implicitly or explicitly I don’t recall — the idea of sterilization to defend the Bank of France against critics by showing that the Bank of France was not guilty of sterilization, but Hayek’s criterion for what qualifies as sterilization was stricter than Friedman’s. In any event, it would be fair to say that Friedman’s conception of how the gold standard works was broadly consistent with the general understanding at the time of how the gold standard operates, though, even under the orthodox understanding, he had no basis for asserting that the 1920s gold standard was fraudulent and bogus.

To sort out the multiple layers of confusion operating here, it helps to go back to the classic discussion of international monetary adjustment under a pure gold currency, which was the basis for later discussions of international monetary adjustment under a gold standard (i.e, a paper currency convertible into gold at a fixed exchange rate). I refer to David Hume’s essay “Of the Balance of Trade” in which he argued that there is an equilibrium distribution of gold across different countries, working through a famous thought experiment in which four-fifths of the gold held in Great Britain was annihilated to show that an automatic adjustment process would redistribute the international stock of gold to restore Britain’s equilibrium share of the total world stock of gold.

The adjustment process, which came to be known as the price-specie flow mechanism (PSFM), is widely considered one of Hume’s greatest contributions to economics and to monetary theory. Applying the simple quantity theory of money, Hume argued that the loss of 80% of Britain’s gold stock would mean that prices and wages in Britain would fall by 80%. But with British prices 80% lower than prices elsewhere, Britain would stop importing goods that could now be obtained more cheaply at home than they could be obtained abroad, while foreigners would begin exporting all they could from Britain to take advantage of low British prices. British exports would rise and imports fall, causing an inflow of gold into Britain. But, as gold flowed into Britain, British prices would rise, thereby reducing the British competitive advantage, causing imports to increase and exports to decrease, and consequently reducing the inflow of gold. The adjustment process would continue until British prices and wages had risen to a level equal to that in other countries, thus eliminating the British balance-of-trade surplus and terminating the inflow of gold.

This was a very nice argument, and Hume, a consummate literary stylist, expressed it beautifully. There is only one problem: Hume ignored that the prices of tradable goods (those that can be imported or exported or those that compete with imports and exports) are determined not in isolated domestic markets, but in international markets, so the premise that all British prices, like the British stock of gold, would fall by 80% was clearly wrong. Nevertheless, the disconnect between the simple quantity theory and the idea that the prices of tradable goods are determined in international markets was widely ignored by subsequent writers. Although Adam Smith, David Ricardo, and J. S. Mill avoided the fallacy, but without explicit criticism of Hume, while Henry Thornton, in his great work The Paper Credit of Great Britain, alternately embraced it and rejected it, the Humean analysis, by the end of the nineteenth century, if not earlier, had become the established orthodoxy.

Towards the middle of the nineteenth century, there was a famous series of controversies over the Bank Charter Act of 1844, in which two groups of economists the Currency School in support and the Banking School in opposition argued about the key provisions of the Act: to centralize the issue of Banknotes in Great Britain within the Bank of England and to prohibit the Bank of England from issuing additional banknotes, beyond the fixed quantity of “unbacked” notes (i.e. without gold cover) already in circulation, unless the additional banknotes were issued in exchange for a corresponding amount of gold coin or bullion. In other words, the Bank Charter Act imposed a 100% marginal reserve requirement on the issue of additional banknotes by the Bank of England, thereby codifying what was then known as the Currency Principle, the idea being that the fluctuation in the total quantity of Banknotes ought to track exactly the Humean mechanism in which the quantity of money in circulation changes pound for pound with the import or export of gold.

The doctrinal history of the controversies about the Bank Charter Act are very confused, and I have written about them at length in several papers (this, this, and this) and in my book on free banking, so I don’t want to go over that ground again here. But until the advent of the monetary approach to the balance of payments in the late 1960s and early 1970s, the thinking of the economics profession about monetary adjustment under the gold standard was largely in a state of confusion, the underlying fallacy of PSFM having remained largely unrecognized. One of the few who avoided the confusion was R. G. Hawtrey, who had anticipated all the important elements of the monetary approach to the balance of payments, but whose work had been largely forgotten in the wake of the General Theory.

Two important papers changed the landscape. The first was a 1976 paper by Donald McCloskey and Richard Zecher “How the Gold Standard Really Worked” which explained that a whole slew of supposed anomalies in the empirical literature on the gold standard were easily explained if the Humean PSFM was disregarded. The second was Paul Samuelson’s 1980 paper “A Corrected Version of Hume’s Equilibrating Mechanisms for International Trade,” showing that the change in relative price levels — the mechanism whereby international monetary equilibrium is supposedly restored according to PSFM — is irrelevant to the adjustment process when arbitrage constraints on tradable goods are effective. The burden of the adjustment is carried by changes in spending patterns that restore desired asset holdings to their equilibrium levels, independently of relative-price-level effects. Samuelson further showed that even when, owing to the existence of non-tradable goods, there are relative-price-level effects, those effects are irrelevant to the adjustment process that restores equilibrium.

What was missing from Hume’s analysis was the concept of a demand to hold money (or gold). The difference between desired and actual holdings of cash imply corresponding changes in expenditure, and those changes in expenditure restore equilibrium in money (gold) holdings independent of any price effects. Lacking any theory of the demand to hold money (or gold), Hume had to rely on a price-level adjustment to explain how equilibrium is restored after a change in the quantity of gold in one country. Hume’s misstep set monetary economics off on a two-century detour, avoided by only a relative handful of economists, in explaining the process of international adjustment.

So historically there have been two paradigms of international adjustment under the gold standard: 1) the better-known, but incorrect, Humean PSFM based on relative-price-level differences which induce self-correcting gold flows that, in turn, are supposed to eliminate the price-level differences, and 2) the not-so-well-known, but correct, arbitrage-monetary-adjustment theory. Under the PSFM, the adjustment can occur only if gold flows give rise to relative-price-level adjustments. But, under PSFM, for those relative-price-level adjustments to occur, gold flows have to change the domestic money stock, because it is the quantity of domestic money that governs the domestic price level.

That is why if you believe, as Milton Friedman did, in PSFM, sterilization is such a big deal. Relative domestic price levels are correlated with relative domestic money stocks, so if a gold inflow into a country does not change its domestic money stock, the necessary increase in the relative price level of the country receiving the gold inflow cannot occur. The “automatic” adjustment mechanism under the gold standard has been blocked, implying that if there is sterilization, the gold standard is rendered fraudulent.

But we now know that that is not how the gold standard works. The point of gold flows was not to change relative price levels. International adjustment required changes in domestic money supplies to be sure, but, under the gold standard, changes in domestic money supplies are essentially unavoidable. Thus, in his 1932 defense of the insane Bank of France, Hayek pointed out that the domestic quantity of money had in fact increased in France along with French gold holdings. To Hayek, this meant that the Bank of France was not sterilizing the gold inflow. Friedman would have said that, given the gold inflow, the French money stock ought to have increased by a far larger amount than it actually did.

Neither Hayek nor Friedman understood what was happening. The French public wanted to increase their holdings of money. Because the French government imposed high gold reserve requirements (but less than 100%) on the creation of French banknotes and deposits, increasing holdings of money required the French to restrict their spending sufficiently to create a balance-of-trade surplus large enough to induce the inflow of gold needed to satisfy the reserve requirements on the desired increase in cash holdings. The direction of causation was exactly the opposite of what Friedman thought. It was the desired increase in the amount of francs that the French wanted to hold that (given the level of gold reserve requirements) induced the increase in French gold holdings.

But this doesn’t mean, as Hayek argued, that the insane Bank of France was not wreaking havoc on the international monetary system. By advocating a banking law that imposed very high gold reserve requirements and by insisting on redeeming almost all of its non-gold foreign exchange reserves into gold bullion, the insane Bank of France, along with the clueless Federal Reserve, generated a huge increase in the international monetary demand for gold, which was the proximate cause of the worldwide deflation that began in 1929 and continued till 1933. The problem was not a misalignment between relative price levels, which is sterilization supposedly causes; the problem was a worldwide deflation that afflicted all countries on the gold standard, and was avoidable only by escaping from the gold standard.

At any rate, the concept of sterilization does nothing to enhance our understanding of that deflationary process. And whatever defects there were in the way that central banks were operating under the gold standard in the 1920s, the concept of sterilization averts attention from the critical problem which was the increasing demand of the world’s central banks, especially the Bank of France and the Federal Reserve, for gold reserves.

9 Responses to “Sterilizing Gold Inflows: The Anatomy of a Misconception”


  1. 1 Lorenzo from Oz September 2, 2014 at 11:52 pm

    Beautifully clear post, thank you.

  2. 4 Kurt Schuler September 10, 2014 at 6:50 pm

    What was the Price Revolution of the 16th century if not a case of the price-specie-flow process? Hume’s analysis seems quite appropriate to the conditions that existed until the mid 19th century. In his day, It took nearly two weeks to go from London to Edinburgh and nearly half a year to go from London to Sydney, and information moved no faster. The McCloskey-Zecher and Samuelson papers assume a degree of rapid coordination across markets that was not the case until the advent of the telegraph.

  3. 5 Lorenzo from Oz September 10, 2014 at 10:30 pm

    Kurt Schüler. Steam-driven transport (railways and steamships) were the key thing. If you can’t move the goods relatively cheaply, the telegraph won’t make much of a difference. But that just moves your point back a bit, to the 1820s and onwards. Still decades after Hume wrote his essay.

  4. 6 David Glasner September 11, 2014 at 9:51 am

    Kurt, I don’t understand the relevance of the Price Revolution of the 16th century to my argument. I never suggested that an increase in the supply of gold would not depress the value of gold, thereby raising all prices in terms of gold. So that’s not an issue here. The price-specie-flow mechanism is not a theory of the value of gold; it is a theory of relative movements in local price levels responding to or triggering relative movements in gold between different locations. I think that the historical evidence shows that local price level movements under the gold standard were positively not negatively correlated as PSFM would suggest. Now it’s true that in Hume’s day, international markets were not well integrated. Nevertheless, Hume explicitly talks about international competition for tradable products. So, while I agree that the forces of international arbitrage were certainly weaker in the 18th century than they were in the 19th century, they were not absent either, and Hume simply ignored them in one part of his argument even though he recognizes them in another. Adam Smith, who was clearly aware of the Humean analysis, having cited it in his Lectures, avoids it in the Wealth of Nations, an omission that Viner thought was one of the great mysteries in the history of economics. It’s no mystery, of course, if Smith rejected Hume’s analysis, as David Laidler and I have both argued.

  5. 7 Kurt Schuler September 12, 2014 at 7:50 pm

    The relevance of the Price Revolution is this: Silver discovered at Potosi leads to high price levels at Potosi. Silver is shipped from Potosi to Spain, where the price level rises, and from there has a ripple effect in raising prices across Europe as silver diffuses across the continent. The process takes months or years. This as I understand is price-specie-flow. In contrast, both McCloskey-Zecher and Samuelson start explicitly from an assumption (not a historical description, mind you, but simply an assumption) that markets were well integrated and that prices change quickly. Yes, by 1880 markets were pretty well integrated, but about 1740, when Hume wrote his essay, the degree of isolation between, say, Europe and its colonies was substantial, with news taking months to transmit. The isolation was even more severe about 200 years prior when Potosi was founded and more severe still in previous centuries. Hence it seems to me that Hume stands up better than you or the authors you cite think, because he has in mind one set of operating circumstances, while you and they have in mind another.

  6. 8 David Glasner September 13, 2014 at 7:52 pm

    Kurt, Thanks for your clarification. Here is how I would look at it If you start with a big increase in gold concentrated in an isolated location like Potosi, you will observe a substantial increase in gold prices in that single location before gold starts to be exported. The observed adjustment process will indeed resemble the price-specie-flow mechanism. Hume was not talking about a change in the gold supply in an isolated location; he was talking about a change in the gold supply in the leading trading nation in the world. So it’s not obvious to me that the Potosi paradigm fits Hume’s thought experiment better than the Samuelson-McCloskey-Zecher paradigm. Obviously, neither paradigm is an exact fit to the circumstances of 1752 (I believe that was when he published his Political Discourses.

    By coincidence, I received in the mail today a copy of International Financial Policy: Essays in Honor of Jacques Polak, which contains an essay by Robert Mundell, “The Quantity Theory of Money in an Open Economy,” which, in the course of an off-line exchange about this post, David Laidler suggested I look at.

    Here is what Mundell has to say on p. 498

    “The preceding analysis has been characterized by two assumptions that need to be modified. First, it applies to an open economy a theory of prices strictly applicable only to a closed economy; the postulate that the price level rise in response to an excess supply of money, as it would in an isolated economy, needs to be modified to allow for arbitrage whenever the domestic price level rises above its equilibrium level. [Actually, this is not quite right, the arbitrage constrains the prices of individual commodities, not the overall price level, which is not subject to an arbitrage constraint, being merely a statistical artifact.] This was precisely the criticism levied at Hume by his friend James Oswald prior to the publication of Hume’s essay on the balance of trade; Hume promised to amend his draft to make clear that prices would not rise to as great an extent if part of the money was at once spent on imports.”

    Mundell added in a footnote

    “Hume’s final draft is tantalizingly ambiguous and has led to considerable controversy. . . . There are two basic issues: (1) Was Hume aware of the possibility that a fortuitous increase in the money supply could be eliminated without price changes? and (2) which type of price changes did Hume have in mind?

    “Consider the first issue. In an early version of his exposition of the adjustment process, Hume puts the entire burden of adjustment on a change in prices; see his letter to Montesquieu in Rotwein’s 1955 edition of Hume. This letter supports Samuelson’s 1989 interpretation that at that time Hume was guilty of ignoring expenditure effects at unchanged prices. In the later correspondence with Oswald, Hume goes part way toward correcting his omission, and in his published essay, he advances from error to tantalizing ambiguity. . . .

    “Hume thought the prices of some commodities would have to change. Because Hume accepted the law of one price, Viner interpreted Hume’s price changes to mean changes in the terms of trade. . . . Collery . . . rejected Viner’s interpretation as ‘so silly that its wide acceptance must forever remain one of the puzzles in the history of economic thought.”


  1. 1 Hey, Look at Me; I Turned Brad Delong into an Apologist for Milton Friedman | Uneasy Money Trackback on September 7, 2014 at 9:18 pm

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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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