Archive for December, 2016

Imagining the Gold Standard

The Marginal Revolution University has posted a nice little 10-minute video conversation between Scott Sumner and Larry about the gold standard and fiat money, Scott speaking up for fiat money and Larry weighing in on the side of the gold standard. I thought that both Scott and Larry acquitted themselves admirably, but several of the arguments made by Larry seemed to me to require either correction or elaboration. The necessary corrections or elaborations do not strengthen the defense of the gold standard that Larry presents so capably.

Larry begins with a defense of the gold standard against the charge that it caused the Great Depression. As I recently argued in my discussion of a post on the gold standard by Cecchetti and Schoenholtz, it is a bit of an overreach to argue that the Great Depression was the necessary consequence of trying to restore the international gold standard in the 1920s after its collapse at the start of World War I. Had the leading central banks at the time, the Federal Reserve, the Bank of England, and especially the Bank of France, behaved more intelligently, the catastrophe could have been averted, allowing the economic expansion of the 1920s to continue for many more years, thereby averting subsequent catastrophes that resulted from the Great Depression. But the perverse actions taken by those banks in 1928 and 1929 had catastrophic consequences, because of the essential properties of the gold-standard system. The gold standard was the mechanism that transformed stupidity into catastrophe. Not every monetary system would have been capable of accomplishing that hideous transformation.

So while it is altogether fitting and proper to remind everyone that the mistakes that led to catastrophe were the result of choices made by policy makers — choices not required by any binding rules of central-bank conduct imposed by the gold standard — the deflation caused by the gold accumulation of the Bank of France and the Federal Reserve occurred only because the gold standard makes deflation inevitable if there is a sufficiently large increase in the demand for gold. While Larry is correct that the gold standard per se did not require the Bank of France to embark on its insane policy of gold accumulation, it should at least give one pause that the most fervent defenders of that insane policy were people like Ludwig von Mises, F.A. Hayek, Lionel Robbins, and Charles Rist, who were also the most diehard proponents of maintaining the gold standard after the Great Depression started, even holding up the Bank of France as a role model for other central banks to emulate. (To be fair, I should acknowledge that Hayek and Robbins, to Mises’s consternation, later admitted their youthful errors.)

Of course, Larry would say that under the free-banking system that he favors, there would be no possibility that a central bank like the Bank of France could engage in the sort of ruinous policy that triggered the Great Depression. Larry may well be right, but there is also a non-trivial chance that he’s not. I prefer not to take a non-trivial chance of catastrophe.

Larry, I think, makes at least two other serious misjudgments. First, he argues that the instability of the interwar gold standard can be explained away as the result of central-bank errors – errors, don’t forget, that were endorsed by the most stalwart advocates of the gold standard at the time – and that the relative stability of the pre-World War I gold standard was the result of the absence of the central banks in the US and Canada and some other countries while the central banks in Britain, France and Germany were dutifully following the rules of the game.

As a factual matter, the so-called rules of the game, as I have observed elsewhere (also here), were largely imaginary, and certainly never explicitly agreed upon or considered binding by any monetary authority that ever existed. Moreover, the rules of the game were based on an incorrect theory of the gold standard reflecting the now discredited price-specie-flow mechanism, whereby differences in national price levels under the gold standard triggered gold movements that would be deflationary in countries losing gold and inflationary in countries gaining gold. That is a flatly incorrect understanding of how the international adjustment mechanism worked under the gold standard, because price-level differences large enough to trigger compensatory gold flows are inconsistent with arbitrage opportunities tending to equalize the prices of all tradable goods. And finally, as McCloskey and Zecher demonstrated 40 years ago, the empirical evidence clearly refutes the proposition that gold flows under the gold standard were in any way correlated with national price level differences. (See also this post.) So it is something of a stretch for Larry to attribute the stability of the world economy between 1880 and 1914 either to the absence of central banks in some countries or to the central banks that were then in existence having followed the rules of the game in contrast to the central banks of the interwar period that supposedly flouted those rules.

Focusing on the difference between the supposedly rule-based behavior of central banks under the classical gold standard and the discretionary behavior of central banks in the interwar period, Larry misses the really critical difference between the two periods. The second half of the nineteenth century was a period of peace and stability after the end of the Civil War in America and the short, and one-sided, Franco-Prussian War of 1870. The rapid expansion of the domain of the gold standard between 1870 and 1880 was accomplished relatively easily, but not without significant deflationary pressures that lasted for almost two decades. A gold standard had been operating in Britain and those parts of the world under British control for half a century, and gold had long been, along with silver, one of the two main international monies and had maintained a roughly stable value for at least half a century. Once started, the shift from silver to gold caused a rapid depreciation of silver relative to gold, which itself led the powerful creditor classes in countries still on the silver standard to pressure their governments to shift to gold.

After three and a half decades of stability, the gold standard collapsed almost as soon as World War I started. A non-belligerent for three years, the US alone remained on the gold standard until it prohibited the export of gold upon entry into the war in 1917. But, having amassed an enormous gold hoard during World War I, the US was able to restore convertibility easily after the end of the War. However, gold could not be freely traded even after the war. Restrictions on the ownership and exchange of gold were not eliminated until the early 1920s, so the gold standard did not really function in the US until a free market for gold was restored. But prices had doubled between the start of the war and 1920, while 40% of the world’s gold reserves were held by the US. So it was not the value of gold that determined the value of the U.S. dollar; it was the value of the U.S. dollar — determined by the policy of the Federal Reserve — that determined the value of gold. The kind of system that was operating under the classical gold standard, when gold had a clear known value that had been roughly maintained for half a century or more, did not exist in the 1920s when the world was recreating, essentially from scratch, a new gold standard.

Recreating a gold standard after the enormous shock of World War I was not like flicking a switch. No one knew what the value of gold was or would be, because the value of gold itself depended on a whole range of policy choices that inevitably had to be made by governments and central banks. That was just the nature of the world that existed in the 1920s. You can’t just assume that historical reality away.

Larry would like to think and would like the rest of us to think that it would be easy to recreate a gold standard today. But it would be just as hard to recreate a gold standard today as it was in the 1920s — and just as perilous. As Thomas Aubrey pointed out in a comment on my recent post on the gold standard, Russia and China between them hold about 25% of the world’s gold reserves. Some people complain loudly about Chinese currency manipulation now. How would you like to empower the Chinese and the Russians to manipulate the value of gold under a gold standard?

The problem of recreating a gold standard was beautifully described in 1922 by Dennis Robertson in his short classic Money. I have previously posted this passage, but as Herbert Spencer is supposed to have said, “it is only by repeated and varied iteration that alien conceptions can be forced upon reluctant minds.” So, I will once again let Dennis Robertson have the final word on the gold standard.

We can now resume the main thread of our argument. In a gold standard country, whatever the exact device in force for facilitating the maintenance of the standard, the quantity of money is such that its value and that of a defined weight of gold are kept at an equality with one another. It looks therefore as if we could confidently take a step forward, and say that in such a country the quantity of money depends on the world value of gold. Before the war this would have been a true enough statement, and it may come to be true again in the lifetime of those now living: it is worthwhile therefore to consider what, if it be true, are its implications.

The value of gold in its turn depends on the world’s demand for it for all purposes, and on the quantity of it in existence in the world. Gold is demanded not only for use as money and in reserves, but for industrial and decorative purposes, and to be hoarded by the nations of the East : and the fact that it can be absorbed into or ejected from these alternative uses sets a limit to the possible changes in its value which may arise from a change in the demand for it for monetary uses, or from a change in its supply. But from the point of view of any single country, the most important alternative use for gold is its use as money or reserves in other countries; and this becomes on occasion a very important matter, for it means that a gold standard country is liable to be at the mercy of any change in fashion not merely in the methods of decoration or dentistry of its neighbours, but in their methods of paying their bills. For instance, the determination of Germany to acquire a standard money of gold in the [eighteen]’seventies materially restricted the increase of the quantity of money in England.

But alas for the best made pigeon-holes! If we assert that at the present day the quantity of money in every gold standard country, and therefore its value, depends on the world value of gold, we shall be in grave danger of falling once more into Alice’s trouble about the thunder and the lightning. For the world’s demand for gold includes the demand of the particular country which we are considering; and if that country be very large and rich and powerful, the value of gold is not something which she must take as given and settled by forces outside her control, but something which up to a point at least she can affect at will. It is open to such a country to maintain what is in effect an arbitrary standard, and to make the value of gold conform to the value of her money instead of making the value of her money conform to the value of gold. And this she can do while still preserving intact the full trappings of a gold circulation or gold bullion system. For as we have hinted, even where such a system exists it does not by itself constitute an infallible and automatic machine for the preservation of a gold standard. In lesser countries it is still necessary for the monetary authority, by refraining from abuse of the elements of ‘play’ still left in the monetary system, to make the supply of money conform to the gold position: in such a country as we are now considering it is open to the monetary authority, by making full use of these same elements of ‘play,’ to make the supply of money dance to its own sweet pipings.

Now for a number of years, for reasons connected partly with the war and partly with its own inherent strength, the United States has been in such a position as has just been described. More than one-third of the world’s monetary gold is still concentrated in her shores; and she possesses two big elements of ‘play’ in her system — the power of varying considerably in practice the proportion of gold reserves which the Federal Reserve Banks hold against their notes and deposits (p. 47), and the power of substituting for one another two kinds of common money, against one of which the law requires a gold reserve of 100 per cent and against the other only one of 40 per cent (p. 51). Exactly what her monetary aim has been and how far she has attained it, is a difficult question of which more later. At present it is enough for us that she has been deliberately trying to treat gold as a servant and not as a master.

It was for this reason, and for fear that the Red Queen might catch us out, that the definition of a gold standard in the first section of this chapter had to be so carefully framed. For it would be misleading to say that in America the value of money is being kept equal to the value of a defined weight of gold: but it is true even there that the value of money and the value of a defined weight of gold are being kept equal to one another. We are not therefore forced into the inconveniently paradoxical statement that America is not on a gold standard. Nevertheless it is arguable that a truer impression of the state of the world’s monetary affairs would be given by saying that America is on an arbitrary standard, while the rest of the world has climbed back painfully on to a dollar standard.

HT: J. P. Koning

Why Hayek Was not a Conservative

At the end of his classic treatise The Constitution of Liberty, F. A. Hayek added a postscript entitled “Why I am not a Conservative.” Like everything he wrote, what Hayek has to say about the weaknesses of conservatism can be read with profit even by those who disagree with his arguments. The following passage, for a number of reasons, seems especially apt and relevant now, some 55 years after it was written.

Conservatives feel instinctively that it is new ideas more than anything else that cause change. But, from its point of view rightly, conservatism fears new ideas because it has no distinctive principles of  its own to oppose them; and, by its distrust of theory and its lack of imagination concerning anything except that which experience has already proved, it deprives itself of the weapons needed in the struggle of ideas. Unlike liberalism, with its fundamental belief in the long-range power of ideas, conservatism is bound by the stock of ideas inherited at a given time. And since it does not really believe in the power of argument, its last resort is generally a claim to superior wisdom, based on some self-arrogated superior quality. The difference shows itself most clearly in the different attitudes of the two traditions to the advance of knowledge. Though the liberal certainly does not regard all change as progress, he does regard the advance of knowledge as one of the chief aims of human effort and expects from it the gradual solution of such problems and difficulties as we can hope to solve. Without preferring the new merely because it is new, the liberal is aware that it is of the essence of human achievement that it produces something new; and he is prepared to come to terms with new knowledge, whether he likes its immediate effects or not.

Personally, I find that the most objectionable feature of the conservative attitude is its propensity to reject well-substantiated new knowledge because it dislikes some of the consequences which seem to follow from it – or, to put it bluntly, its obscurantism. I will not deny that scientists as much as others are given to fads and fashions and that we have much reason to be cautious in accepting the conclusions that they draw from their latest theories. But the reasons for our reluctance must themselves be rational and must be kept separate from our regret that the new theories upset our cherished beliefs. I can have little patience with those who oppose, for instance, the theory of evolution or what are called “mechanistic” explanations of the phenomena of life because of certain moral
consequences which at first seem to follow from these theories, and still less with those who regard it as irrelevant or impious to ask certain questions at all. By refusing to face the facts, the conservative only weakens his own position. Frequently the conclusions which rationalist presumption draws from new scientific insights do not at all follow from them. But only by actively taking part in the elaboration of the consequences of new discoveries do we learn whether or not they fit into our world picture and, if so, how. Should our moral beliefs really prove to be dependent on factual assumptions shown to be incorrect, it would hardly be moral to defend them by refusing to acknowledge facts.

Connected with the conservative distrust if the new and the strange is its hostility to internationalism and its proneness to a strident nationalism. Here is another source of its weakness in the struggle of ideas. It cannot alter the fact that the ideas which are changing our civilization respect no boundaries. But refusal to acquaint one’s self with new ideas merely deprives one of the power of effectively countering them when necessary. The growth of ideas is an international process, and only those who fully take part in the discussion will be able to exercise a significant influence. It is no real argument to say that an idea is un-American, or un-German, nor is a mistaken or vicious ideal better for having been conceived by one of our compatriots.

A great deal more might be said about the close connection between conservatism and nationalism, but I shall not dwell on this point because it might be felt that my personal position makes me unable to sympathize with any form of nationalism. I will merely add that it is this nationalistic bias which frequently provides the bridge from conservatism to collectivism: to think in terms of “our” industry or resource is only a short step away from demanding that these national assets be directed in the national interest. But in this respect the Continental liberalism which derives from the French Revolution is little better than conservatism. I need hardly say that nationalism of this sort is something very different from patriotism and that an aversion to nationalism is fully compatible with a
deep attachment to national traditions. But the fact that I prefer and feel reverence for some of the traditions of my society need not be the cause of hostility to what is strange and different.

Only at first foes it seem paradoxical that the anti-internationalism of conservatism is so frequently associated with imperialism. But the more a person dislikes the strange and thinks his own ways superior, the more he tends to regard it as his mission to “civilize” others – not by the voluntary and unhampered intercourse which the liberal favors, but by bringing them the blessings of efficient government. It is significant that here again we frequently find the conservatives joining hands with the socialists against the liberals – not only in England, where the Webbs and their Fabians were outspoken imperialists, or in Germany, where state socialism and colonial expansionism went together and found the support of the same group of “socialists of the chair,” but also in the United States,
where even at the time of the first Roosevelt it could be observed: “the Jingoes and the Social Reformers have gotten together; and have formed a political party, which threatened to capture the Government and use it for their program of Caesaristic paternalism, a danger which now seems to have been averted only by the other parties having adopted their program in a somewhat milder degree and form.”


Golden Misconceptions

The gold standard, as an international institution, existed for less than 40 years, emerging first, and by accident, in England, and more than a century and a half later, spreading by a rapid series of independent, but interrelated, decisions to the United States, Germany, and most of Europe and much of the rest of the world. After its collapse with the outbreak of World War I, reconstruction of the gold standard was thought by many to be a precondition for recreating the stable and prosperous international order that had been brutally demolished by the Great War. But that attempt ended catastrophically when the restoration of the gold standard was subverted by the insane gold-accumulation policy of the Bank of France and the failure of the Federal Reserve and other national monetary authorities to heed the explicit warnings of two of the leading monetary theorists of immediate postwar era, R. G. Hawtrey and Gustav Cassel, that unless the monetary demand for gold was kept from increasing as a result of the resumption of convertibility, a renewed gold standard could trigger a disastrous deflation.

But despite its short, checkered, and not altogether happy, history as an international institution, the gold standard, in its idealized and largely imagined form has retained a kind of nostalgic aura of stability, excellence and grandeur, becoming an idiom for anything that’s the best of its kind. So no, Virginia, there is no Santa Claus, and the gold standard is not the gold standard of monetary systems.

My own impression is that most, though not all, supporters of the gold standard are smitten by a kind of romantic, unthinking, and irrational attachment to the idea that the gold standard is a magic formula for recovering a lost golden age. But having said that, I would also add that I actually think that the gold standard, in its brief first run as an international monetary system, did not perform all that badly, and I can even sympathize with the ultimately unsuccessful attempt to restore the gold standard after World War I. I just think that the risks of scrapping our current monetary arrangements and trying to replace them with a gold standard recreated from scratch, over a century after it ceased to function effectively in practice, are far too great to consider it seriously as a practical option.

Not long ago I was chided by Larry White for being unduly harsh in my criticism of the gold standard in my talk at the Mercatus Center conference on Monetary Rules for a Post-Crisis World. I responded to Larry in this post. But I now find myself somewhat exasperated by a post by Stephen Cecchetti and Kermit Schoenholtz on the blog they maintain for their money and banking textbook. I don’t know much about Schoenholtz, but Cecchetti is an economist of the first rank. They clearly share my opposition to gold standard, but I’m afraid that some of their arguments against the gold standard are misguided or misconceived. I don’t write this post just to be critical; it’s only because their arguments reflect common and long-standing misconceptions and misunderstandings that have become part of the received doctrine about the gold standard that those arguments are worth taking the time and effort to criticize.

So let’s start from the beginning of their post, which is actually quite a good beginning. They quote Barry Eichengreen, one of our most eminent economic historians.

“Far from being synonymous with stability, the gold standard itself was the principal threat to financial stability and economic prosperity between the wars.” Barry Eichengreen, Golden Fetters.

That’s certainly true, but notice that the quotation from Eichengreen explicitly refers to the interwar period; it’s not a blanket indictment.

After quoting Eichengreen, Cecchetti and Schoenholtz refer to a lecture delivered by Ben Bernanke when he was still Chairman of the Federal Reserve Board. Quoting this lecture is not a good sign, because back in 2012 after Bernanke gave the lecture, I wrote a post in which I explained why Bernanke had failed to provide a coherent criticism of the gold standard.

In his 2012 lecture Origins and Mission of the Federal Reserve, then-Federal Reserve Board Chair Ben Bernanke identifies four fundamental problems with the gold standard:

  • When the central bank fixes the dollar price of gold, rather than the price of goods we consume, fluctuations in the dollar price of goods replace fluctuations in the market price of gold.
  • Since prices are tied to the amount of money in the economy, which is linked to the supply of gold, inflation depends on the rate that gold is mined.
  • When the gold standard is used at home and abroad, it is an exchange rate policy in which international transactions must be settled in gold.
  • Digging gold out of one hole in the ground (a mine) to put it into another hole in the ground (a vault) wastes resources.

Bernanke’s first statement is certainly correct, but his second statement ignores the fact that the amount of new gold extracted from the earth in a year is only a small fraction of the existing stock of gold. Thus, fluctuations in the value of gold are more likely to be caused by fluctuations in the demand for gold than by fluctuations in supply. The third statement makes as much sense as saying that since the US economy operates on a dollar standard transactions must be settled in hard currency. In fact, the vast majority of legal transactions are settled not by the exchange of currency but by the exchange of abstract claims to currency. There is no reason why, under a gold standard, international transactions could not be settled by abstract claims to gold rather than in physical gold. I agree with the fourth statement.

Consistent with Bernanke’s critique, the evidence shows that both inflation and economic growth were quite volatile under the gold standard. The following chart plots annual U.S. consumer price inflation from 1880, the beginning of the post-Civil War gold standard, to 2015. The vertical blue line marks 1933, the end of the gold standard in the United States. The standard deviation of inflation during the 53 years of the gold standard is nearly twice what it has been since the collapse of the Bretton Woods system in 1973 (denoted in the chart by the vertical red line). That is, even if we include the Great Inflation of the 1970s, inflation over the past 43 years has been more stable than it was under the gold standard. Focusing on the most recent quarter century, the interval when central banks have focused most intently on price stability, then the standard deviation of inflation is less than one-fifth of what it was during the gold standard epoch.

Annual Consumer Price Inflation, 1880 to 2016


Source: Federal Reserve Bank of Minneapolis.

I am sorry to say this, but comparing the average rate and the variability of inflation under the gold standard (1880-1933) and under a pure dollar standard (1973-2016) is tendentious and misleading, because the 20-year period from 1914 to 1933, a period marked by rapid wartime and post-war inflation and two post-war deflations, was a period when the gold standard either was not functioning at all (1914 to about 1922) or was being unsuccessfully reconstructed. Now it would be one thing to conclude from the failed attempt at reconstruction that a second attempt at reconstruction would be futile and potentially as disastrous as the first attempt, but that doesn’t seem to be what Ceccheti and Schoenholz are arguing. Instead, they include data from 20 years when the gold standard was either not operating at all or was operating dysfunctionally to make an unqualified comparison between the performance of the US economy under the gold standard and under a pure dollar standard. That simplistic comparison conveys almost no useful information.

A fairer comparison would be between the gold standard as it operated between 1880 and 1914 and either the dollar standard of the post-Bretton Woods era (1973 – 2016) or the period from 1991 to 2016 when, according to Cecchetti and Schoenholz, the Fed adopted an explicit or implicit inflation target as its primary policy objective. Changing the gold-standard period in this way reduces the average inflation rate from 0.86% to 0.23% a year and the standard deviation from 5.06% to 2.13%. That comparison is not obviously disadvantageous to the gold standard.

What about economic growth? Again, the gold standard was associated with greater volatility, not less. The following chart plots annual growth as measured by gross national product (gross domestic product only came into common use in the 1991.) The pattern looks quite a bit like that of inflation: the standard deviation of economic growth during the gold-standard era was more than twice that of the period since 1973. And, despite the Great Recession, the past quarter century has been even more stable. To use another, simpler, measure, in the period from 1880 to 1933 there were 15 business cycles identified by the National Bureau of Economic Research. That is, on average there was a recession once every 3½ years. By contrast, since 1972, there have been 7 recessions; one every 6 years.

Annual GNP Growth, 1880-2016



Source: FRED and Romer (1986)

Again, this comparison, like the inflation comparison is distorted by the exogenous disruption associated with World War I and its aftermath. Excluding the 1914 to 1933 period from the comparison would make for a far less one-sided comparison than the one presented by Cecchetti and Schoenholtz.

Finally, consider a crude measure of financial stability: the frequency of banking crises. From 1880 to 1933, there were at least 5 full-fledged banking panics: 1893, 1907, 1930, 1931, and 1933. Including the savings and loan crisis of the 1980s, in the past half century, there have been two.

But if we exclude the Great Depression period from the comparison, there were two banking panics under the gold standard and two under the dollar standard. So the performance of the gold standard when it was operating normally was not clearly inferior to the operation of the dollar standard.

So, on every score, the gold standard period was less stable. Prices were less stable; growth was less stable; and the financial system was less stable. Why?

We see six major reasons. First, the gold standard is procyclical. When the economy booms, inflation typically rises. In the absence of a central bank to force the nominal interest rate up, the real interest rate falls, providing a further impetus to activity. In contrast, countercyclical monetary policy—whether based on a Taylor rule or not—would lean against the boom.

I don’t know what the basis is for the factual assertion that high growth under a gold standard is associated with inflation. There were periods of high growth with very low or negative inflation under the gold standard. Periods of mild inflation, owing to a falling real value of gold, perhaps following significant discoveries of previously unknown gold deposits, may have had a marginal stimulative effect under the gold standard, but such episodes were not necessarily periods of economic instability.

At any rate it is not even clear why, if a countericyclical monetary policy were desirable, such a policy could not be conducted under the gold standard by a central bank constrained by an obligation to convert its liabilities into gold on demand. Some gold standard proponents, like Larry White for example, insist that a gold standard could and would function better without a central bank than with a central bank. I am skeptical about that position, but even if it is correct, there is nothing inherent in the idea of a gold standard that is inconsistent with the existence of a central bank that conducts a countercyclical policy, so I don’t understand why Cecchetti and Schoenholtz assert, without argument, that a central bank could not conduct a countercyclical policy under a gold standard.

Second, the gold standard has exchange rate implications. While we do not know for sure, we suspect that current U.S. advocates of a shift to gold are thinking of the case where the United States acts alone (rather than waiting to coordinate a global return to the gold standard). If so, the change would impose unnecessary risks on exporters and importers, their employees and their creditors. To see why, consider the consequences of a move in the global price of gold measured in some other currency, say British pounds. If the pound price of gold changed, but the dollar price of gold did not, the result would be a move in the real dollar-pound exchange rate. That is, unless the dollar prices of U.S. goods and the dollar wages of U.S. workers adjust instantly to offset gold price fluctuations, the real dollar exchange rate changes. In either case, the result would almost surely induce volatility of production, employment, and the debt burden.

If the US monetary policy were governed by a commitment to convert the dollar into gold at a fixed conversion rate, the dollar price of gold would remain constant and exchange rates of the dollar in terms of the pound and other non-gold currencies would fluctuate. We have fluctuating exchange rates now against the pound and other currencies. It is not clear to me why exchange rates would be more volatile under this system than they are currently.

More broadly, a gold standard suffers from some of the same problems as any fixed-exchange rate system. Not only can’t the exchange rate adjust to buffer external shocks, but the commitment invites speculative attacks because it lacks time consistency. Under a gold standard, the scale of the central bank’s liabilities—currency plus reserves—is determined by the gold it has in its vault. Imagine that, as a consequence of an extended downturn, people come to fear a currency devaluation. That is, they worry that the central bank will raise the dollar price of gold. In such a circumstance, it will be natural for investors to take their dollars to the central bank and exchange them for gold. The doubts that motivate such a run can be self-fulfilling: once the central bank starts to lose gold reserves, it can quickly be compelled to raise its dollar price, or to suspend redemption entirely. This is what happened in 1931 to the Bank of England, when it was driven off the gold standard. It happened again in 1992 (albeit with foreign currency reserves rather than gold) when Britain was compelled to abandon its fixed exchange rate.

Cecchetti and Schoenholtz articulate a valid concern, and it is a risk inherent in any gold standard or any monetary system based on trust in a redemption commitment. My only quibble is that Cecchetti and Schoenholtz overrate the importance of gold reserves. Foreign-exchange reserves would do just as well, and perhaps better, than gold reserves, because, unlike gold, foreign-exchange reserves yield interest.

Third, as historians have emphasized, the gold standard helped spread the Great Depression from the United States to the rest of the world. The gold standard was a global arrangement that formed the basis for a virtually universal fixed-exchange rate regime in which international transactions were settled in gold.

Here Cecchetti and Schoenholtz stumble into several interrelated confusions. First, while the gold standard was certainly an international transmission mechanism, the international linkage between national price levels being an essential characteristic of the gold standard, there is no reason to identify the United States as the source of a disturbance that was propagated to the rest of the world. Because the value of gold must be equalized in all countries operating under the gold standard, changes in the value of gold are an international, not a national, phenomenon. Thus, an increase in the demand for gold causing an increase in its value would have essentially the same effects on the world economy irrespective of the geographic location of the increase in the demand for gold. In the 1920s, the goal of reestablishing the gold standard meant restoring convertibility of the leading currencies into gold, so that price levels in all gold standard countries, all reflecting the internationally determined value of gold, were closely aligned.

This meant that a country with an external deficit — one whose imports exceed its exports — was required to pay the difference by transferring gold to countries with external surpluses. The loss of gold forced the deficit country’s central bank to shrink its balance sheet, reducing the quantity of money and credit in the economy, and driving domestic prices down. Put differently, under a gold standard, countries running external deficits face deflationary pressure. A surplus country’s central bank faced no such pressure, as it could choose whether to convert higher gold stocks into money or not. Put another way, a central bank can have too little gold, but it can never have too much.

Cecchetti and Schonholtz are confusing two distinct questions: a) what determines the common international value of gold? and b) what accounts for second-order deviations between national price levels? The important point is that movements in national price levels under the gold standard were highly correlated because, owing to international arbitrage of tradable goods, the value of gold could not differ substantially between countries on the gold standard. Significant short-run changes in the value of gold had to reflect changes in the total demand for gold because short-run changes in the supply of gold are only a small fraction of the existing stock. To be sure, short-run differences in inflation across countries might reflect special circumstances causing over- or under-valuation of particular currencies relative to one another, but those differences were of a second-order magnitude relative to the sharp worldwide deflation that characterized the Great Depression in which the price levels of all gold-standard countries fell simultaneously. It is always the case that some countries will be running trade deficits and some will be running trade surpluses. At most, that circmstance might explain small differences in relative rates of inflation or deflation across countries; it can’t explain why deflation was rampant across all countries at the same time.

The shock that produced the Great Depression was a shock to the real value of gold which was caused mainly by the gold accumulation policy of the Bank of France. However, the United States, holding about 40 percent of the world’s monetary gold reserves after World War I, could have offset or mitigated the French policy by allowing an outflow of some of its massive gold reserves. Instead, the Fed, in late 1928, raised interest rates yet again to counter what it viewed as unhealthy stock-market speculation, thereby intensifying, rather than mitigating, the deflationary effect of the gold-accumulation policy of the Bank of France. Implicitly, Cecchetti and Schoenholtz assume that the observed gold flows were the result of non-monetary causes, which is to say that gold flows were the result of trade imbalances reflecting purely structural factors, such as national differences in rates of productivity growth, or propensities to save, or demand and supply patterns, over which central banks have little or no influence. But in fact, central banks and monetary authorities based their policies on explicit or implicit goals for their holdings of gold reserves. And the value of gold ultimately reflected the combined effect of the policy decisions taken by all central banks thereby causing a substantial increase in the demand of national monetary authorities to hold gold.

This policy asymmetry helped transmit financial shocks in the United States abroad. By the late 1920s, the major economies had restored the pre-World War I gold standard. At the time, both the United States and France were running external surpluses, absorbing the world’s gold into their central bank vaults.

Cecchetti and Schoneholtz say explicitly “the United States and France were running external surpluses, absorbing the world’s gold into their central bank vaults” as if those surpluses just happened and were unrelated to the monetary policies deliberately adopted by the Bank of France and the Federal Reserve.

But, instead of allowing the gold inflows to expand the quantity of money in their financial systems, authorities in both countries tightened monetary policy to resist booming asset prices and other signs of overheating. The result was catastrophic, compelling deficit countries with gold outflows to tighten their monetary policies even more. As the quantity of money available worldwide shrank, so did the price level, adding to the real burden of debt, and prompting defaults and bank failures virtually around the world.

Cecchetti and Schoenholtz have the causation backwards; it was the tightness of monetary policy that caused gold inflows into France and later into the United States. The gold flows did not precede, but were the result of, already tight monetary policies. Cecchetti and Schoenholtz are implicitly adopting the sterilization model based on the price-specie-flow mechanism in which it is gold flows that cause, or ought to cause, changes in the quantity of money. I debunked the simplistic sterilization idea in this post. But, in fairness, I should acknowledge that Cecchetti and Schoenholz do eventually acknowledge that the demand by central banks to hold gold reserves is what determines actual monetary policy under the gold standard. But despite that acknowledgment, they can’t free themselves from the misconception that it was a reduction in the quantity of money, rather than an increase in the demand for gold, that caused the value of gold to rise in the Great Depression.

Fourth, economists blame the gold standard for sustaining and deepening the Great Depression. What makes this view most compelling is the fact that the sooner a country left the gold standard and regained discretionary control of its monetary policy, the faster it recovered. The contrast between Sweden and France is striking. Sweden left gold in 1931, and by 1936 its industrial production was 14 percent higher than its 1929 level. France waited until 1936 to leave, at which point its industrial production was fully 26 percent below the level just 7 years earlier (see here and here.) Similarly, when the U.S. suspended gold convertibility in March 1933—allowing the dollar to depreciate substantially—the financial and economic impact was immediate: deflation turned to inflation, lowering the real interest rate, boosting asset prices, and triggering one of the most powerful U.S. cyclical upturns (see, for example, Romer).

This is certainly right. My only quibble is that Cecchetti and Schoenholtz do not acknowledge that the Depression was triggered by a rapid increase in the international demand for gold by the world’s central banks in 1928-29, in particular the Bank of France and the Federal Reserve.

Turning to financial stability, the gold standard limits one of the most powerful tools for halting bank panics: the central bank’s authority to act as lender of last resort. It was the absence of this function during the Panic of 1907 that was the primary impetus for the creation of the Federal Reserve System. Yet, under a gold standard, the availability of gold limits the scope for expanding central bank liabilities. Thus, had the Fed been on a strict gold standard in the fall of 2008—when Lehman failed—the constraint on its ability to lend could again have led to a collapse of the financial system and a second Great Depression.

At best, the charge that the gold standard limits the capacity of a central bank to act as a lender of last resort is a serious oversimplification. The ability of a central bank to expand its liabilities is not limited by the gold standard in any way. What limits the ability of the central bank to expand its liabilities are gold-cover requirements such as those enacted by the Bank Charter Act of 1844 which imposed a 100% marginal reserve requirement on the issue of banknotes by the Bank of England beyond a fixed fiduciary issue requiring no gold cover. Subsequent financial crises in 1847, 1857, and 1866 were quelled as soon as the government suspended the relevant provisions of the Bank Charter Act, allowing the Bank of England to increase its note issue and satisfy the exceptional demands for liquidity that led to the crisis in the first place.

Finally, because the supply of gold is finite, the quantity available to the central bank likely will grow more slowly than the real economy. As a result, over long periods—say, a decade or more—we would expect deflation. While (in theory) labor, debt and other contracts can be arranged so that the economy will adjust smoothly to steady, long-term deflation, recent experience (including that with negative nominal interest rates) makes us skeptical.

Whether gold appreciates over the long-term depends on the rate at which the quantity of gold expands over time and the rate of growth of demand for gold over time. It is plausible to expect secular deflation under the gold standard, but it is hardly inevitable. I don’t think that we yet fully understand the conditions under which secular deflation is compatible with full employment. Certainly if we were confident that secular deflation is compatible with full employment, the case for secular deflation would be very compelling.

This brings us back to where we started. Under a gold standard, inflation, growth and the financial system are all less stable. There are more recessions, larger swings in cons umer prices and more banking crises. When things go wrong in one part of the world, the distress will be transmitted more quickly and completely to others. In short, re-creating a gold standard would be a colossal mistake.

These conclusions are based on very limited historical experience, and it is not clear how relevant that experience is for contemporary circumstances. The argument against a gold standard not so much that a gold standard could not in principle operate smoothly and efficiently. It is that, a real gold standard having been abandoned for 80 years, recreating a gold standard would be radical and risky undertaking completely lacking in a plausible roadmap for its execution. The other argument against the gold standard is that insofar as gold would be actually used as a medium of exchange in a recreated gold standard with a modern banking system, the banking system would be subject to the potentially catastrophic risk of a flight to quality in periods of banking instability, leading to a disastrous deflationary increase in the value of gold.

HT: J. P. Koning

The Trump Rally

David Beckworth has a recent post about the Trump stock-market rally. Just before the election I had a post in which I pointed out that the stock market seemed to be dreading the prospect of a Trump victory, based on the strong positive correlation between movements in the dollar value of the Mexican peso and the S&P 500, though, in response to a comment by one of my readers, I did partially walk back my argument. As the initial returns and exit polls briefly seemed to be pointing toward a Clinton victory, the correlation between the peso and the S&P 500 (futures) seemed to be very strong and getting stronger, and after the returns started to point increasingly toward a Trump victory, the strong correlation between the peso and the S&P 500 remained all too evident, showing a massive decline in both the peso and the S&P 500. But what seemed like a Trump panic was suddenly broken, when Mrs. Clinton phoned Trump to concede and Trump appeared to claim victory with a relatively restrained and conciliatory statement that calmed the worst fears about a messy transition and the potential for serious political instability. The survival of a Republican majority in the Senate was perhaps viewed as a further positive sign and strengthened hopes for business-friendly changes in the US corporate and personal taxes. The earlier losses in S&P 500 futures were reversed even without any recovery in the peso.

So what explains the turnaround in the reaction of the stock market to Trump’s victory? Here’s David Beckworth:

I have a new piece in The Hill where I argue markets are increasingly seeing the Trump shock as an inflection point for the U.S. economy:

It seems the U.S. economy is finally poised for robust economic growth, something that has been missing for the past eight years. Such strong economic growth is expected to cause the demand for credit to increase and the supply of savings to decline

Though this is not the main point, I will just register my disagreement with David’s version of how interest rates are determined, which essentially restates the “loanable-funds” theory of interest determination, which is often described as the orthodox alternative to the Keynesian liquidity preference theory of interest rates. I disagree that it is the alternative to the Keynesian theory. I think that is a very basic misconception perpetrated by macroeconomists with either a regrettable memory lapse or an insufficient understanding of, the Fisherian theory of interest rates. In the Fisherian theory interest rates are implicit in the intertemporal structure of all prices, they are therefore not determined in any single market, as asserted by the loanable-funds theory, any more than the price level is determined in any single market. The way to think about interest-rate determination is to ask the following question: at what structure of interest rates would holders of long-lived assets be content to continue holding the existing stock of assets? Current savings and current demand for credit are an epiphenomenon of interest-rate determination, not a determinant of interest rates — with the caveat that every factor that influences the intertemporal structure of prices is one of the myriad determinants of interest rates.

Together, these forces are naturally pushing interest rates higher. The Fed’s interest rate hike today is simply piggybacking on this new reality.

If “these forces” is interpreted in the way I have suggested in my above comment on David’s previous sentence, then I would agree with this sentence.

Here are some charts that document this upbeat economic outlook as seen from the treasury market. The first one shows the treasury market’s implicit inflation forecast (or “breakeven inflation”) and real interest rate at the 10-year horizon. These come from TIPs and have their flaws, but they provide a good first approximation to knowing what the bond market is thinking. In this case, both the real interest rate and expected inflation rate are rising. This implies the market expects both higher real economic growth and higher inflation. The two may be related–the higher expected inflation may be a reflection of higher expected nominal demand growth causing real growth. The higher real growth expectations are also probably being fueled by Trump’s supply-side reforms.


I agree that the rise in real interest rates may reflect improved prospects for economic growth, and that the rising TIPS spread may reflect expectations of at least a small rise in inflation towards the Fed’s largely rhetorical 2-percent target. And I concur that a higher inflation rate could be one of the causes of improving implicit forecasts of economic growth. However, I am not so sure that expectations of rising inflation and supply-side reforms are the only explanations for rising real interest rates.

What “reforms” is Trump promising? I’m not sure actually, but here is a list of possibilities: 1) reducing and simplifying corporate tax rates, 2) reducing and simplifying personal tax rates, 3) deregulation, 4) tougher enforcement of immigration laws, 5) deportation of an undetermined number of illegal immigrants, 6) aggressively protectionist international trade policies.

I think that there is a broad consensus in favor of reducing corporate tax rates. Not only is the 35% marginal rate on corporate profits very high compared to the top corporate set by other countries, the interest deduction is a perverse incentive favoring debt rather than equity financing. As I pointed out in a post five years ago, Hyman Minsky, one of the favorite economists of the left, was an outspoken opponent of corporate income taxation in general, precisely because it encourages debt rather than equity financing. I think that the Obama administration would have been happy to propose reducing the corporate tax rate as part of a broader budget deal, but no broader deal with the Republican majority in Congress was possible, and a simple reduction of the corporate tax rate would have been difficult for Obama to sell to his own political base without offering them something that could be described as reducing inequality. So cutting the top corporate tax rate would almost certainly be a good thing (but subject to qualification by the arguments in the next paragraph), and expectations of a reduction in the top corporate rate would tend to raise stock prices, though the effect on stock prices would be moderated by increased issues of new corporate stock.

Reducing and simplifying corporate and personal tax rates seems like a good thing, but there’s at least one problem. Not all earnings of taxable income is socially productive. Lots of earned income is generated by completely, or partially, unproductive activities associated with private gains that exceed social gains. I have written in the past about how unproductive many types of information gathering and knowledge production is (e.g., here, here, here, and here). Much of this activity enables the person who acquires knowledge or information to gain an information advantage over people with whom he transacts, so the private return to the acquisition of such knowledge is greater than the social gain, because the gain to one party to the trade comes not from an increase in output but by way of a transfer from the other less-informed party to the transaction.

The same is true — to a somewhat lesser extent, but the basic tendency is the same – of activity aimed at the discovery of knew knowledge over which an intellectual property right can be exercised for a substantial length of time. The ability to extract monopoly rents over newly discovered knowledge is likely to confer a private gain on the discoverer greater than the social gain accruing from the discovery, because the first discoverer to acquire exclusive rights can extract the full value of the discovery even though the marginal benefit accruing to the discovery is only the value of the new knowledge over the elapsed time between the moment of the discovery and the moment when the discovery would have been made, perhaps soon afterwards, by someone else. In general, there is a whole range of income accruing to a variety of winner-takes-all activities in which the private gain to the winner greatly exceeds the social gain. A low marginal rate of income taxation increases the incentive to engage in such socially wasteful winner-takes-all activities.

Deregulation can be a good thing when it undermines monopolistic price-fixing and legally imposed entry barriers entrenching incumbent suppliers. A lot of regulation has historically been of this type. But although it is convenient for libertarian ideologues to claim that monopoly enhancement or entrenchment characterizes all government regulation, I doubt that most current regulations are for this purpose. A lot of regulation is aimed at preventing dishonest or misleading business practices or environmental pollution or damage to third-parties. So as an empirical matter, I don’t think we can say whether a reduction in regulation will have a net positive or a net negative effect on society. Nevertheless, regulation probably does reduce the overall earnings of corporations, so that a reduction in regulation will tend to raise stock prices. If it becomes easier for corporations to emit harmful pollution into the atmosphere and into our rivers, lakes and oceans, the reductions in private costs enjoyed by the corporations will be capitalized into their stock prices while the increase in social costs will be borne in a variety of ways by all individuals in the country or the world. Insofar as stock prices have risen since Trump’s election because of expectations of a roll back in regulation, it is not clear to me at least whether that reflects an increase in net social welfare or a capitalization of the value of enhanced rights to engage in socially harmful conduct.

The possible effects of changes in immigration laws, in the enforcement of immigration laws and in trade policies seem to me far too murky at this point even to speculate upon. I would just observe that insofar as the stock market has capitalized the effects of Trump’s supposed supply-side reforms, those reforms would have tended to reduce, not increase, inflation expectations. So it does not seem likely to me that whatever increase in stock prices we have seen so far reflects a pure supply-side effect.

I am more inclined to believe that the recent increases in stock prices and inflation expectations reflect expectations that Trump will fulfill his commitments to conduct irresponsible fiscal policies generating increased budget deficits, which the Republican majorities in Congress will now meekly accept and dutifully applaud, and that Trump will be able either to cajole or intimidate enough officials at the Federal Reserve to accommodate those policies or will appoint enough willing accomplices to the Fed to overcome the opposition of the current FOMC.

Larry White on the Gold Standard and Me

A little over three months ago on a brutally hot day in Washington DC, I gave a talk about a not yet completed paper at the Mercatus Center Conference on Monetary Rules for a Post-Crisis World. The title of my paper was (and still is) “Rules versus Discretion Historically Contemplated.” I hope to post a draft of the paper soon on SSRN.

One of the attendees at the conference was Larry White who started his graduate training at UCLA just after I had left. When I wrote a post about my talk, Larry responded with a post of his own in which he took issue with some of what I had to say about the gold standard, which I described as the first formal attempt at a legislated monetary rule. Actually, in my talk and my paper, my intention was not as much to criticize the gold standard as it was to criticize the idea, which originated after the gold standard had already been adopted in England, of imposing a fixed numerical rule in addition to the gold standard to control the quantity of banknotes or the total stock of money. The fixed mechanical rule was imposed by an act of Parliament, the Bank Charter Act of 1844. The rule, intended to avoid financial crises such as those experienced in 1825 and 1836, actually led to further crises in 1847, 1857 and 1866 and the latter crises were quelled only after the British government suspended those provisions of the Act preventing the Bank of England from increasing the quantity of banknotes in circulation. So my first point was that the fixed quantitative rule made the gold standard less stable than it would otherwise have been.

My second point was that, in the depths of the Great Depression, a fixed rule freezing the nominal quantity of money was proposed as an alternative rule to the gold standard. It was this rule that one of its originators, Henry Simons, had in mind when he introduced his famous distinction between rules and discretion. Simons had many other reasons for opposing the gold standard, but he introduced the famous rules-discretion dichotomy as a way of convincing those supporters of the gold standard who considered it a necessary bulwark against comprehensive government control over the economy to recognize that his fixed quantity rule would be a far more effective barrier than the gold standard against arbitrary government meddling and intervention in the private sector, because the gold standard, far from constraining the conduct of central banks, granted them broad discretionary authority. The gold standard was an ineffective rule, because it specified only the target pursued by the monetary authority, but not the means of achieving the target. In Simons view, giving the monetary authority to exercise discretion over the instruments used to achieve its target granted the monetary authority far too much discretion for independent unconstrained decision making.

My third point was that Henry Simons himself recognized that the strict quantity rule that he would have liked to introduce could only be made operational effectively if the entire financial system were radically restructured, an outcome that he reluctantly concluded was unattainable. However, his student Milton Friedman convinced himself that a variant of the Simons rule could actually be implemented quite easily, and he therefore argued over the course of almost his entire career that opponents of discretion ought to favor the quantity rule that he favored instead of continuing to support a restoration of the gold standard. However, Friedman was badly mistaken in assuming that his modified quantity rule eliminated discretion in the manner that Simons had wanted, because his quantity rule was defined in terms of a magnitude, the total money stock in the hands of the public, which was a target, not, as he insisted, an instrument, the quantity of money held by the public being dependent on choices made by the public, not just on choices made by the monetary authority.

So my criticism of quantity rules can be read as at least a partial defense of the gold standard against the attacks of those who criticized the gold standard for being insufficiently rigorous in controlling the conduct of central banks.

Let me now respond to some of Larry’s specific comments and criticisms of my post.

[Glasner] suggests that perhaps the earliest monetary rule, in the general sense of a binding pre-commitment for a money issuer, can be seen in the redemption obligations attached to banknotes. The obligation was contractual: A typical banknote pledged that the bank “will pay the bearer on demand” in specie. . . .  He rightly remarks that “convertibility was not originally undertaken as a policy rule; it was undertaken simply as a business expedient” without which the public would not have accepted demand deposits or banknotes.

I wouldn’t characterize the contract in quite the way Glasner does, however, as a “monetary rule to govern the operation of a monetary system.” In a system with many banks of issue, the redemption contract on any one bank’s notes was a commitment from that bank to the holders of those notes only, without anyone intending it as a device to govern the operation of the entire system. The commitment that governs a single bank ipso facto governs an entire monetary system only when that single bank is a central bank, the only bank allowed to issue currency and the repository of the gold reserves of ordinary commercial banks.

It’s hard to write a short description of a system that covers all possible permutations in the system. While I think Larry is correct in noting the difference between the commitment made by any single bank to convert – on demand — its obligations into gold and the legal commitment imposed on an entire system to maintain convertibility into gold, the historical process was rather complicated, because both silver and gold coins circulating in Britain. So the historical fact that British banks were making their obligations convertible into gold was the result of prior decisions that had been made about the legal exchange rate between gold and silver coins, decisions which overvalued gold and undervalued silver, causing full bodied silver coins to disappear from circulation. Given a monetary framework shaped by the legal gold/silver parity established by the British mint, it was inevitable that British banks operating within that framework would make their banknotes convertible into gold not silver.

Under a gold standard with competitive plural note-issuers (a free banking system) holding their own reserves, by contrast, the operation of the monetary system is governed by impersonal market forces rather than by any single agent. This is an important distinction between the properties of a gold standard with free banking and the properties of a gold standard managed by a central bank. The distinction is especially important when it comes to judging whether historical monetary crises and depressions can be accurately described as instances where “the gold standard failed” or instead where “central bank management of the monetary system failed.”

I agree that introducing a central bank into the picture creates the possibility that the actions of the central bank will have a destabilizing effect. But that does not necessarily mean that the actions of the central bank could not also have a stabilizing effect compared to how a pure free-banking system would operate under a gold standard.

As the author of Free Banking and Monetary Reform, Glasner of course knows the distinction well. So I am not here telling him anything he doesn’t know. I am only alerting readers to keep the distinction in mind when they hear or read “the gold standard” being blamed for financial instability. I wish that Glasner had made it more explicit that he is talking about a system run by the Bank of England, not the more automatic type of gold standard with free banking.

But in my book, I did acknowledge that there inherent instabilities associated with a gold standard. That’s why I proposed a system that would aim at stabilizing the average wage level. Almost thirty years on, I have to admit to having my doubts whether that would be the right target to aim for. And those doubts make me more skeptical than I once was about adopting any rigid monetary rule. When it comes to monetary rules, I fear that the best is the enemy of the good.

Glasner highlights the British Parliament’s legislative decision “to restore the convertibility of banknotes issued by the Bank of England into a fixed weight of gold” after a decades-long suspension that began during the Napoleonic wars. He comments:

However, the widely held expectations that the restoration of convertibility of banknotes issued by the Bank of England into gold would produce a stable monetary regime and a stable economy were quickly disappointed, financial crises and depressions occurring in 1825 and again in 1836.

Left unexplained is why the expectations were disappointed, why the monetary regime remained unstable. A reader who hasn’t read Glasner’s other blog entries on the gold standard might think that he is blaming the gold standard as such.

Actually I didn’t mean to blame anyone for the crises of 1825 and 1836. All I meant to do was a) blame the Currency School for agitating for a strict quantitative rule governing the total quantity of banknotes in circulation to be imposed on top of the gold standard, b) point out that the rule that was enacted when Parliament passed the Bank Charter Act of 1844 failed to prevent subsequent crises in 1847, 1857 and 1866, and c) that the crises ended only after the provisions of the Bank Charter Act limiting the issue of banknotes by the Bank of England had been suspended.

My own view is that, because the monopoly Bank of England’s monopoly was not broken up, even with convertibility acting as a long-run constraint, the Bank had the power to create cyclical monetary instability and occasionally did so by (unintentionally) over-issuing and then having to contract suddenly as gold flowed out of its vault — as happened in 1825 and again in 1836. Because the London note-issue was not decentralized, the Bank of England did not experience prompt loss of reserves to rival banks (adverse clearings) as soon as it over-issued. Regulation via the price-specie-flow mechanism (external drain) allowed over-issue to persist longer and grow larger. Correction came only with a delay, and came more harshly than continuous intra-London correction through adverse clearings would have. Bank of England mistakes boggled the entire financial system. It was central bank errors and not the gold standard that disrupted monetary stability after 1821.

Here, I think, we do arrive at a basic theoretical disagreement, because I don’t accept that the price-specie-flow mechanism played any significant role in the international adjustment process. National price levels under the gold standard were positively correlated to a high degree, not negatively correlated, as implied by the price-specie-flow mechanism. Moreover, the Bank Charter Act imposed a fixed quantitative limit on the note issue of all British banks and the Bank of England in particular, so the overissue of banknotes by the Bank of England could not have been the cause of the post-1844 financial crises. If there was excessive credit expansion, it was happening through deposit creation by a great number of competing deposit-creating banks, not the overissue of banknotes by the Bank of England.

This hypothesis about the source of England’s cyclical instability is far from original with me. It was offered during the 1821-1850 period by a number of writers. Some, like Robert Torrens, were members of the Currency School and offered the Currency Principle as a remedy. Others, like James William Gilbart, are better classified as members of the Free Banking School because they argued that competition and adverse clearings would effectively constrain the Bank of England once rival note issuers were allowed in London. Although they offered different remedies, these writers shared the judgment that the Bank of England had over-issued, stimulating an unsustainable boom, then was eventually forced by gold reserve losses to reverse course, instituting a credit crunch. Because Glasner elides the distinction between free banking and central banking in his talk and blog post, he naturally omits the third side in the Currency School-Banking School-Free Banking School debate.

And my view is that Free Bankers like Larry White overestimate the importance of note issue in a banking system in which deposits were rapidly overtaking banknotes as the primary means by which banks extended credit. As Henry Simons, himself, recognized this shift from banknotes to bank deposits was itself stimulated, at least in part, by the Bank Charter Act, which made the extension of credit via banknotes prohibitively costly relative to expansion by deposit creation.

Later in his blog post, Glasner fairly summarizes how a gold standard works when a central bank does not subvert or over-ride its automatic operation:

Given the convertibility commitment, the actual quantity of the monetary instrument that is issued is whatever quantity the public wishes to hold.

But he then immediately remarks:

That, at any rate, was the theory of the gold standard. There were — and are – at least two basic problems with that theory. First, making the value of money equal to the value of gold does not imply that the value of money will be stable unless the value of gold is stable, and there is no necessary reason why the value of gold should be stable. Second, the behavior of a banking system may be such that the banking system will itself destabilize the value of gold, e.g., in periods of distress when the public loses confidence in the solvency of banks and banks simultaneously increase their demands for gold. The resulting increase in the monetary demand for gold drives up the value of gold, triggering a vicious cycle in which the attempt by each to increase his own liquidity impairs the solvency of all.

These two purported “basic problems” prompt me to make two sets of comments:

1 While it is true that the purchasing power of gold was not perfectly stable under the classical gold standard, perfection is not the relevant benchmark. The purchasing power of money was more stable under the classical gold standard than it has been under fiat money standards since the Second World War. Average inflation rates were closer to zero, and the price level was more predictable at medium to long horizons. Whatever Glasner may have meant by “necessary reason,” there certainly is a theoretical reason for this performance: the economics of gold mining make the purchasing power of gold (ppg) mean-reverting in the face of monetary demand and supply shocks. An unusually high ppg encourages additional gold mining, until the ppg declines to the normal long-run value determined by the flow supply and demand for gold. An unusually low ppg discourages mining, until the normal long-run ppg is restored. It is true that permanent changes in the gold mining cost conditions can have a permanent impact on the long-run level of the ppg, but empirically such shocks were smaller than the money supply variations that central banks have produced.

2 The behavior of the banking system is indeed critically important for short-run stability. Instability wasn’t a problem in all countries, so we need to ask why some banking systems were unstable or panic-prone, while others were stable. The US banking system was panic prone in the late 19th century while the Canadian system was not. The English system was panic-prone while the Scottish system was not. The behavioral differences were not random or mere facts of nature, but grew directly from differences in the legal restrictions constraining the banks. The Canadian and Scottish systems, unlike the US and English systems, allowed their banks to adequately diversify, and to respond to peak currency demands, thus allowed banks to be more solvent and more liquid, and thus avoided loss of confidence in the banks. The problem in the US and England was not the gold standard, or a flaw in “the theory of the gold standard,” but ill-conceived legal restrictions that weakened the banking systems.

Larry makes two good points, but I doubt that they are very important in practice. The problem with the value of gold is that there is a very long time lag before the adjustment in the rate of output of new gold will cause the value of gold to revert back to its normal level. The annual output of gold is only about 3 percent of the total stock of gold. If the monetary demand for gold is large relative to the total stock and that demand is unstable, the swing in the overall demand for gold can easily dominate the small resulting change in the annual rate of output. So I do not have much confidence that the mean-reversion characteristic of the purchasing power of gold to be of much help in the short or even the medium term. I also agree with Larry that the Canadian and Scottish banking systems exhibited a lot more stability than the neighboring US and English banking systems. That is an important point, but I don’t think it is decisive. It’s true that there were no bank failures in Canada in the Great Depression. But the absence of bank failures, while certainly a great benefit, did not prevent Canada from suffering a downturn of about the same depth and duration as the US did between 1929 and 1933. The main cause of the Great Depression was the deflation caused by the appreciation of the value of gold. The deflation caused bank failures when banks were small and unstable and did not cause bank failures when banks were large and diversified. But the deflation  was still wreaking havoc on the rest of the economy even though banks weren’t failing.

A Primer on Equilibrium

After my latest post about rational expectations, Henry from Australia, one of my most prolific commenters, has been engaging me in a conversation about what assumptions are made – or need to be made – for an economic model to have a solution and for that solution to be characterized as an equilibrium, and in particular, a general equilibrium. Equilibrium in economics is not always a clearly defined concept, and it can have a number of different meanings depending on the properties of a given model. But the usual understanding is that the agents in the model (as consumers or producers) are trying to do as well for themselves as they can, given the endowments of resources, skills and technology at their disposal and given their preferences. The conversation was triggered by my assertion that rational expectations must be “compatible with the equilibrium of the model in which those expectations are embedded.”

That was the key insight of John Muth in his paper introducing the rational-expectations assumption into economic modelling. So in any model in which the current and future actions of individuals depend on their expectations of the future, the model cannot arrive at an equilibrium unless those expectations are consistent with the equilibrium of the model. If the expectations of agents are incompatible or inconsistent with the equilibrium of the model, then, since the actions taken or plans made by agents are based on those expectations, the model cannot have an equilibrium solution.

Now Henry thinks that this reasoning is circular. My argument would be circular if I defined an equilibrium to be the same thing as correct expectations. But I am not so defining an equilibrium. I am saying that the correctness of expectations by all agents implies 1) that their expectations are mutually consistent, and 2) that, having made plans, based on their expectations, which, by assumption, agents felt were the best set of choices available to them given those expectations, if the expectations of the agents are realized, then they would not regret the decisions and the choices that they made. Each agent would be as well off as he could have made himself, given his perceived opportunities when the decision were made. That the correctness of expectations implies equilibrium is the consequence of assuming that agents are trying to optimize their decision-making process, given their available and expected opportunities. If all expected opportunities are correctly foreseen, then all decisions will have been the optimal decisions under the circumstances. But nothing has been said that requires all expectations to be correct, or even that it is possible for all expectations to be correct. If an equilibrium does not exist, and just because you can write down an economic model, it does not mean that a solution to the model exists, then the sweet spot where all expectations are consistent and compatible is just a blissful fantasy. So a logical precondition to showing that rational expectations are even possible is to prove that an equilibrium exists. There is nothing circular about the argument.

Now the key to proving the existence of a general equilibrium is to show that the general equilibrium model implies the existence of what mathematicians call a fixed point. A fixed point is said to exist when there is a mapping – a rule or a function – that takes every point in a convex compact set of points and assigns that point to another point in the same set. A convex, compact set has two important properties: 1) the line connecting any two points in the set is entirely contained within the boundaries of the set, and 2) there are no gaps between any two points in set. The set of points in a circle or a rectangle is a convex compact set; the set of points contained in the Star of David is not a convex set. Any two points in the circle will be connected by a line that lies completely within the circle; the points at adjacent edges of a Star of David will be connected by a line that lies entirely outside the Star of David.

If you think of the set of all possible price vectors for an economy, those vectors – each containing a price for each good or service in the economy – could be mapped onto itself in the following way. Given all the equations describing the behavior of each agent in the economy, the quantity demanded and supplied of each good could be calculated, giving us the excess demand (the difference between amount demand and supplied) for each good. Then the price of every good in excess demand would be raised, the price of every good in negative excess demand would be reduced, and the price of every good with zero excess demand would be held constant. To ensure that the mapping was taking a point from a given convex set onto itself, all prices could be normalized so that they would have the property that the sum of all the individual prices would always equal 1. The fixed point theorem ensures that for a mapping from one convex compact set onto itself there must be at least one fixed point, i.e., at least one point in the set that gets mapped onto itself. The price vector corresponding to that point is an equilibrium, because, given how our mapping rule was defined, a point would be mapped onto itself if and only if all excess demands are zero, so that no prices changed. Every fixed point – and there may be one or more fixed points – corresponds to an equilibrium price vector and every equilibrium price vector is associated with a fixed point.

Before going on, I ought to make an important observation that is often ignored. The mathematical proof of the existence of an equilibrium doesn’t prove that the economy operates at an equilibrium, or even that the equilibrium could be identified under the mapping rule described (which is a kind of formalization of the Walrasian tatonnement process). The mapping rule doesn’t guarantee that you would ever discover a fixed point in any finite amount of iterations. Walras thought the price adjustment rule of raising the prices of goods in excess demand and reducing prices of goods in excess supply would converge on the equilibrium price vector. But the conditions under which you can prove that the naïve price-adjustment rule converges to an equilibrium price vector turn out to be very restrictive, so even though we can prove that the competitive model has an equilibrium solution – in other words the behavioral, structural and technological assumptions of the model are coherent, meaning that the model has a solution, the model has no assumptions about how prices are actually determined that would prove that the equilibrium is ever reached. In fact, the problem is even more daunting than the previous sentence suggest, because even Walrasian tatonnement imposes an incredibly powerful restriction, namely that no trading is allowed at non-equilibrium prices. In practice there are almost never recontracting provisions allowing traders to revise the terms of their trades once it becomes clear that the prices at which trades were made were not equilibrium prices.

I now want to show how price expectations fit into all of this, because the original general equilibrium models were either one-period models or formal intertemporal models that were reduced to single-period models by assuming that all trading for future delivery was undertaken in the first period by long-lived agents who would eventually carry out the transactions that were contracted in period 1 for subsequent consumption and production. Time was preserved in a purely formal, technical way, but all economic decision-making was actually concluded in the first period. But even though the early general-equilibrium models did not encompass expectations, one of the extraordinary precursors of modern economics, Augustin Cournot, who was way too advanced for his contemporaries even to comprehend, much less make any use of, what he was saying, had incorporated the idea of expectations into the solution of his famous economic model of oligopolistic price setting.

The key to oligopolistic pricing is that each oligopolist must take into account not just consumer demand for his product, and his own production costs; he must consider as well what actions will be taken by his rivals. This is not a problem for a competitive producer (a price-taker) or a pure monopolist. The price-taker simply compares the price at which he can sell as much as he wants with his production costs and decides how much it is worthwhile to produce by comparing his marginal cost to price ,and increases output until the marginal cost rises to match the price at which he can sell. The pure monopolist, if he knows, as is assumed in such exercises, or thinks he knows the shape of the customer demand curve, selects the price and quantity combination on the demand curve that maximizes total profit (corresponding to the equality of marginal revenue and marginal cost). In oligopolistic situations, each producer must take into account how much his rivals will sell, or what prices they will set.

It was by positing such a situation and finding an analytic solution, that Cournot made a stunning intellectual breakthrough. In the simple duopoly case, Cournot posited that if the duopolists had identical costs, then each could find his optimal price conditional on the output chosen by the other. This is a simple profit-maximization problem for each duopolist, given a demand curve for the combined output of both (assumed to be identical, so that a single price must obtain for the output of both) a cost curve and the output of the other duopolist. Thus, for each duopolist there is a reaction curve showing his optimal output given the output of the other. See the accompanying figure.cournot

If one duopolist produces zero, the optimal output for the other is the monopoly output. Depending on what the level of marginal cost is, there is some output by either of the duopolists that is sufficient to make it unprofitable for the other duopolist to produce anything. That level of output corresponds to the competitive output where price just equals marginal cost. So the slope of the two reaction functions corresponds to the ratio of the monopoly output to the competitive output, which, with constant marginal cost is 2:1. Given identical costs, the two reaction curves are symmetric and the optimal output for each, given the expected output of the other, corresponds to the intersection of the two reaction curves, at which both duopolists produce the same quantity. The combined output of the two duopolists will be greater than the monopoly output, but less than the competitive output at which price equals marginal cost. With constant marginal cost, it turns out that each duopolist produces one-third of the competitive output. In the general case with n oligoplists, the ratio of the combined output of all n firms to the competitive output equals n/(n+1).

Cournot’s solution corresponds to a fixed point where the equilibrium of the model implies that both duopolists have correct expectations of the output of the other. Given the assumptions of the model, if the duopolists both expect the other to produce an output equal to one-third of the competitive output, their expectations will be consistent and will be realized. If either one expects the other to produce a different output, the outcome will not be an equilibrium, and each duopolist will regret his output decision, because the price at which he can sell his output will differ from the price that he had expected. In the Cournot case, you could define a mapping of a vector of the quantities that each duopolist had expected the other to produce and the corresponding planned output of each duopolist. An equilibrium corresponds to a case in which both duopolists expected the output planned by the other. If either duopolist expected a different output from what the other planned, the outcome would not be an equilibrium.

We can now recognize that Cournot’s solution anticipated John Nash’s concept of an equilibrium strategy in which player chooses a strategy that is optimal given his expectation of what the other player’s strategy will be. A Nash equilibrium corresponds to a fixed point in which each player chooses an optimal strategy based on the correct expectation of what the other player’s strategy will be. There may be more than one Nash equilibrium in many games. For example, rather than base their decisions on an expectation of the quantity choice of the other duopolist, the two duopolists could base their decisions on an expectation of what price the other duopolist would set. In the constant-cost case, this choice of strategies would lead to the competitive output because both duopolists would conclude that the optimal strategy of the other duopolist would be to charge a price just sufficient to cover his marginal cost. This was the alternative oligopoly model suggested by another French economist J. L. F. Bertrand. Of course there is a lot more to be said about how oligopolists strategize than just these two models, and the conditions under which one or the other model is the more appropriate. I just want to observe that assumptions about expectations are crucial to how we analyze market equilibrium, and that the importance of these assumptions for understanding market behavior has been recognized for a very long time.

But from a macroeconomic perspective, the important point is that expected prices become the critical equilibrating variable in the theory of general equilibrium and in macroeconomics in general. Single-period models of equilibrium, including general-equilibrium models that are formally intertemporal, but in which all trades are executed in the initial period at known prices in a complete array of markets determining all future economic activity, are completely sterile and useless for macroeconomics except as a stepping stone to analyzing the implications of imperfect forecasts of future prices. If we want to think about general equilibrium in a useful macroeconomic context, we have to think about a general-equilibrium system in which agents make plans about consumption and production over time based on only the vaguest conjectures about what future conditions will be like when the various interconnected stages of their plans will be executed.

Unlike the full Arrow-Debreu system of complete markets, a general-equilibrium system with incomplete markets cannot be equilibrated, even in principle, by price adjustments in the incomplete set of present markets. Equilibration depends on the consistency of expected prices with equilibrium. If equilibrium is characterized by a fixed point, the fixed point must be mapping of a set of vectors of current prices and expected prices on to itself. That means that expected future prices are as much equilibrating variables as current market prices. But expected future prices exist only in the minds of the agents, they are not directly subject to change by market forces in the way that prices in actual markets are. If the equilibrating tendencies of market prices in a system of complete markets are very far from completely effective, the equilibrating tendencies of expected future prices may not only be non-existent, but may even be potentially disequilibrating rather than equilibrating.

The problem of price expectations in an intertemporal general-equilibrium system is central to the understanding of macroeconomics. Hayek, who was the father of intertemporal equilibrium theory, which he was the first to outline in a 1928 paper in German, and who explained the problem with unsurpassed clarity in his 1937 paper “Economics and Knowledge,” unfortunately did not seem to acknowledge its radical consequences for macroeconomic theory, and the potential ineffectiveness of self-equilibrating market forces. My quarrel with rational expectations as a strategy of macroeconomic analysis is its implicit assumption, lacking any analytical support, that prices and price expectations somehow always adjust to equilibrium values. In certain contexts, when there is no apparent basis to question whether a particular market is functioning efficiently, rational expectations may be a reasonable working assumption for modelling observed behavior. However, when there is reason to question whether a given market is operating efficiently or whether an entire economy is operating close to its potential, to insist on principle that the rational-expectations assumption must be made, to assume, in other words, that actual and expected prices adjust rapidly to their equilibrium values allowing an economy to operate at or near its optimal growth path, is simply, as I have often said, an exercise in circular reasoning and question begging.

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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