Archive for December, 2020

White and Hogan on Hayek and Cassel on the Causes of the Great Depression

Lawrence White and Thomas Hogan have just published a new paper in the Journal of Economic Behavior and Organization (“Hayek, Cassel, and the origins of the great depression”). Since White is a leading Hayek scholar, who has written extensively on Hayek’s economic writings (e.g., his important 2008 article “Did Hayek and Robbins Deepen the Great Depression?”) and edited the new edition of Hayek’s notoriously difficult volume, The Pure Theory of Capital, when it was published as volume 11 of the Collected Works of F. A. Hayek, the conclusion reached by the new paper that Hayek had a better understanding than Cassel of what caused the Great Depression is not, in and of itself, surprising.

However, I admit to being taken aback by the abstract of the paper:

We revisit the origins of the Great Depression by contrasting the accounts of two contemporary economists, Friedrich A. Hayek and Gustav Cassel. Their distinct theories highlight important, but often unacknowledged, differences between the international depression and the Great Depression in the United States. Hayek’s business cycle theory offered a monetary overexpansion account for the 1920s investment boom, the collapse of which initiated the Great Depression in the United States. Cassel’s warnings about a scarcity gold reserves related to the international character of the downturn, but the mechanisms he emphasized contributed little to the deflation or depression in the United States.

I wouldn’t deny that there are differences between the way the Great Depression played out in the United States and in the rest of the world, e.g., Britain and France, which to be sure, suffered less severely than did the US or, say, Germany. It is both possible, and important, to explore and understand the differential effects of the Great Depression in various countries. I am sorry to say that White and Hogan do neither. Instead, taking at face value the dubious authority of Friedman and Schwartz’s treatment of the Great Depression in the Monetary History of the United States, they assert that the cause of the Great Depression in the US was fundamentally different from the cause of the Great Depression in many or all other countries.

Taking that insupportable premise from Friedman and Schwartz, they simply invoke various numerical facts from the Monetary History as if those facts, in and of themselves, demonstrate what requires to be demonstrated: that the causes of the Great Depression in the US were different from those of the Great Depression in the rest of the world. That assumption vitiated the entire treatment of the Great Depression in the Monetary History, and it vitiates the results that White and Hogan reach about the merits of the conflicting explanations of the Great Depression offered by Cassel and Hayek.

I’ve discussed the failings of Friedman’s treatment of the Great Depression and of other episodes he analyzed in the Monetary History in previous posts (e.g., here, here, here, here, and here). The common failing of all the episodes treated by Friedman in the Monetary History and elsewhere is that he misunderstood how the gold standard operated, because his model of the gold standard was a primitive version of the price-specie-flow mechanism in which the monetary authority determines the quantity of money, which then determines the price level, which then determines the balance of payments, the balance of payments being a function of the relative price levels of the different countries on the gold standard. Countries with relatively high price levels experience trade deficits and outflows of gold, and countries with relatively low price levels experience trade surpluses and inflows of gold. Under the mythical “rules of the game” under the gold standard, countries with gold inflows were supposed to expand their money supplies, so that prices would rise and countries with outflows were supposed to reduce their money supplies, so that prices fall. If countries followed the rules, then an international monetary equilibrium would eventually be reached.

That is the model of the gold standard that Friedman used throughout his career. He was not alone; Hayek and Mises and many others also used that model, following Hume’s treatment in his essay on the balance of trade. But it’s the wrong model. The correct model is the one originating with Adam Smith, based on the law of one price, which says that prices of all commodities in terms of gold are equalized by arbitrage in all countries on the gold standard.

As a first approximation, under the Smithean model, there is only one price level adjusted for different currency parities for all countries on the gold standard. So if there is deflation in one country on the gold standard, there is deflation for all countries on the gold standard. If the rest of the world was suffering from deflation under the gold standard, the US was also suffering from a deflation of approximately the same magnitude as every other country on the gold standard was suffering.

The entire premise of the Friedman account of the Great Depression, adopted unquestioningly by White and Hogan, is that there was a different causal mechanism for the Great Depression in the United States from the mechanism operating in the rest of the world. That premise is flatly wrong. The causation assumed by Friedman in the Monetary History was the exact opposite of the actual causation. It wasn’t, as Friedman assumed, that the decline in the quantity of money in the US was causing deflation; it was the common deflation in all gold-standard countries that was causing the quantity of money in the US to decline.

To be sure there was a banking collapse in the US that was exacerbating the catastrophe, but that was an effect of the underlying cause: deflation, not an independent cause. Absent the deflationary collapse, there is no reason to assume that the investment boom in the most advanced and most productive economy in the world after World War I was unsustainable as the Hayekian overinvestment/malinvestment hypothesis posits with no evidence of unsustainability other than the subsequent economic collapse.

So what did cause deflation under the gold standard? It was the rapid increase in the monetary demand for gold resulting from the insane policy of the Bank of France (disgracefully endorsed by Hayek as late as 1932) which Cassel, along with Ralph Hawtrey (whose writings, closely parallel to Cassel’s on the danger of postwar deflation, avoid all of the ancillary mistakes White and Hogan attribute to Cassel), was warning would lead to catastrophe.

It is true that Cassel also believed that over the long run not enough gold was being produced to avoid deflation. White and Hogan spend inordinate space and attention on that issue, because that secular tendency toward deflation is entirely different from the catastrophic effects of the increase in gold demand in the late 1920s triggered by the insane policy of the Bank of France.

The US could have mitigated the effects if it had been willing to accommodate the Bank of France’s demand to increase its gold holdings. Of course, mitigating the effects of the insane policy of the Bank of France would have rewarded the French for their catastrophic policy, but, under the circumstances, some other means of addressing French misconduct would have spared the world incalculable suffering. But misled by an inordinate fear of stock market speculation, the Fed tightened policy in 1928-29 and began accumulating gold rather than accommodate the French demand.

And the Depression came.

A Primer on Say’s Law and Walras’s Law

Say’s Law, often paraphrased as “supply creates its own demand,” is one of oldest “laws” in economics. It is also one of the least understood and most contentious propositions in economics. I am now in the process of revising my current draft of my paper “Say’s Law and the Classical Theory of Depressions,” which surveys and clarifies various interpretations, disputes and misunderstandings about Say’s Law. I thought that a brief update of my section discussing the relationship between Say’s Law and Walras’s Law might make for a useful blogpost. Not only does it discuss the meaning of Say’s Law and its relationship to Walras’s Law, it expands the narrow understanding of Say’s Law and corrects the mistaken view that Say’s Law does not hold in a monetary economy, because, given a demand to hold a pure medium of exchange, real goods may be supplied only to accumulate cash not to obtain real goods and services. IOW, supply may be a demand for cash not for goods. Under this interpretation, Say’s Law is valid only when the economy is in a macro or monetary equilibrium with no excess demand for money.

Here’s my discussion of that logically incorrect belief. (Let me add as a qualification that not only Say’s Law, but Walras’s Law, as I explained elsewhere in my paper, is not valid when there is not a complete set of forward and contingent markets. That’s because to prove Walras’s Law all agents must be optimizing on the same set of prices, whether actual observed prices or expected, but currently unobserved, prices. See also an earlier post about this paper in which I included the relevant excerpt from the paper.)

The argument that a demand to hold cash invalidates Say’s Law, because output may be produced for the purpose of accumulating cash rather than to buy other goods and services is an argument that had been made by nineteenth-century critics of Say’s Law. The argument did not go without response, but the nature and import of the response was not well, or widely, understood, and the criticism was widely credited. Thus, in his early writings on business-cycle theory, F. A. Hayek, making no claim to originality, maintained, matter of factly, that money involves a disconnect between aggregate supply and aggregate demand, describing money as a “loose joint” in the theory of general equilibrium, creating the central theoretical problem to be addressed by business-cycle theory. So, even Hayek in 1927 did not accept the validity of Say’s Law

Oskar Lange (“Say’s Law a Restatement and Criticism”) subsequently formalized the problem, introducing his distinction between Say’s Law and Walras’s Law. Lange defined Walras’s Law as the proposition that the sum of excess demands, corresponding to any price vector announced by a Walrasian auctioneer, must identically equal zero.[1] In a barter model, individual optimization, subject to the budget constraint corresponding to a given price vector, implies that the value of the planned purchases and planned sales by each agent must be exactly equal; if the value of the excess demands of each individual agent is zero the sum of the values of the excess demands of all individuals must also be zero. In a barter model, Walras’s Law and Say’s Law are equivalent: demand is always sufficient to absorb supply.

But in a model in which agents hold cash, which they use when transacting, they may supply real goods in order to add to their cash holdings. Because individual agents may seek to change their cash holdings, Lange argued that the equivalence between Walras’s Law and Say’s Law in a barter model does not carry over to a model in which agents hold money. Say’s Law cannot hold in such an economy unless excess demands in the markets for real goods sum to zero. But if agents all wish to add to their holdings of cash, their excess demand for cash will be offset by an excess supply of goods, which is precisely what Say’s Law denies.

It is only when an equilibrium price vector is found at which the excess demand in each market is zero that Say’s Law is satisfied. Say’s Law, according to Lange, is a property of a general equilibrium, not a necessary property of rational economic conduct, as Say and his contemporaries and followers had argued. When our model is extended from a barter to a monetary setting, Say’s Law must be restated in the generalized form of Walras’s Law. But, unlike Say’s Law, Walras’s Law does not exclude the possibility of an aggregate excess supply of all goods. Aggregate demand can be deficient, and it can result in involuntary unemployment.

At bottom, this critique of Say’s Law depends on the assumption that the quantity of money is exogenously fixed, so that individuals can increase or decrease their holdings of money only by spending either less or more than their incomes. However, as noted above, if there is a market mechanism that allows an increased demand for cash balances to elicit an increased quantity of cash balances, so that the public need not reduce expenditures to finance additions to their holdings of cash, Lange’s critique may not invalidate Say’s Law.

A competitive monetary system based on convertibility into gold or some other asset[2] has precisely this property. In particular, with money privately supplied by a set of traders (let’s call them banks), money is created when a bank accepts a money-backing asset (IOU) supplied by a customer in exchange for issuing its liability (a banknote or a deposit), which is widely acceptable as a medium of exchange. As first pointed out by Thompson (1974), Lange’s analytical oversight was to assume that in a Walrasian model with n real goods and money, there are only (n+1) goods or assets. In fact, there are really (n+2) goods or assets; there are n real goods and two monetary assets (i.e., the money issued by the bank and the money-backing asset accepted by the bank in exchange for the money that it issues). Thus, an excess demand for money need not, as Lange assumed, be associated with, or offset by, an excess supply of real commodities; it may be offset by a supply of money-backing assets supplied by those seeking to increase their cash holdings.

Properly specifying the monetary model relevant to macroeconomic analysis eliminates a misconception that afflicted monetary and macroeconomic theory for a very long time, and provides a limited rehabilitation of Say’s Law. But that rehabilitation doesn’t mean that all would be well if we got rid of central banks, abandoned all countercyclical policies and let private banks operate without restrictions. None of those difficult and complicated questions can be answered by invoking or rejecting Say’s Law.

[1] Excess supplies are recorded as negative excess demands.

[2] The classical economists generally regarded gold or silver as the appropriate underlying asset into which privately issued monies would be convertible, but the possibility of a fiat standard was not rejected on analytical principle.

Bitcoin Doesn’t Rule

Look out, bitcoin’s back. After the first bitcoin bubble burst almost exactly three years ago on December 15, 2017, when bitcoin hit its previous all-time high of over $19,600, bitcoin lost more than 80% its value, falling to less than $3200 on December 14, 2018. It gradually recovered, more than doubling its value (to over $7000) by December 13, 2019 and reached a new all-time high today at $20,872.

Bitcoin’s remarkable recovery is again sparking senseless talk by its more extreme promoters that it  will soon transform the world monetary system leading the collapse of fiat currencies and a flight to bitcoin to escape the hyperinflationary collapse of worthless unbacked fiat currencies. This is nonsense, as I have explained at length in a number of previous posts (e.g., here, here, and here) at even greater length in a forthcoming paper, a draft of which is available here.

In this post, I offer a summary of my argument about why bitcoin, despite its success as a speculative asset, is intrinsically unsuited to be a widely used medium of exchange, let alone a dominant currency. Indeed, success as a speculative asset is precisely what disqualifies it as anything more than a niche medium of exchange.

By a “medium of exchange,” I mean a good or instrument readily accepted in exchange by agents even if they don’t value the non-monetary services provided by that good or instrument in the expectation that other agents will be accepted in exchange at a reasonably predictable value close to its current value. After a good begins to function as a medium of exchange, its value may rise above the value it would have had if it were demanded only for the real services it provides, but arbitrage ensures that the value of a medium of exchange will be equalized in all uses, monetary or and real, so the expected value of a medium of exchange will not vary as a result of the intended use for which it is acquired.

By a “pure medium of exchange” I mean a good or instrument providing no non-monetary services and therefore demanded solely on account of its expected future resale value. The analysis of the value of a pure medium of exchange seems to hinge on three different factors affecting its expected future resale value: (1) backward induction, (2) tax liability, and (3) network effects.

Backward induction refers to the influence of a predictable future state on the present. If agents all foresee a future event that influence of that future event, however distant, must rebound backward towards the present. Thus, the certainty that a pure medium of exchange must lose its value once no one is willing to accept in exchange, its predictable loss of value must deprive it of value immediately, because no one will want to be the last person to accept it.

Backward induction is used routinely in formal exchange and game-theoretic models, but its relevance is often disputed when the certainty and the timing of the last period is unclear. In that environment, people seem more willing to assume that there will always be someone else around who will accept the medium of exchange at a positive value. Even so, backward induction at least suggests that the value of any pure medium of exchange is sensitive to expectational shocks, making a pure medium of exchange a potentially unstable pillar of an economic system.

Tax liability refers to the acceptability of a medium of exchange to discharge tax liabilities to the government. Acceptability to discharge a stream of future tax liabilities imposed by the government can maintain a positive value for a pure medium of exchange even if the backward induction argument is otherwise compelling. However, acceptability to discharge tax payments is routinely extended to government issued, or government sanctioned, fiat currencies but never to privately issued cryptocurrencies.

Network effects result from the property of some goods that their usefulness is contingent on and enhanced by the extent to which the good is used by other people. Think of the difference between a refrigerator and a telephone. Clearly, the desirability of and the demand for a medium of exchange increases with the number of other people using that medium of exchange. Additionally, as more people use any given medium of exchange, the cost to any individual user of switching to another medium of exchange than that used by the network of users of which that user is a part increases.

Network effects are important for many reasons, but for purposes of this discussion, network effects are particularly important because they provide another explanation than the tax-liability argument for why backward induction need not drive the value of a pure medium of exchange to zero. If a new medium of exchange provides some exchange service superior to, or not provided at all by, the service provided by the existing, more widely used, medium of exchange, and it attracts even a small network of users that take advantage of that service, a demand for the continued use of the alternative medium of exchange may be created. If the switching cost associated with adopting another medium of exchange and foregoing the unique service provided by the new medium of exchange is sufficiently high, current users of the new medium of exchange may persist in use of the new medium of exchange despite its predictable future loss of value.

Thus, even though it provides no current real services, and even though its current value is drawn entirely from its expected future value, bitcoin may have succeeded in providing a niche medium of exchange service for transactions in which one or both parties have a strong desire or need for anonymity. The underlying blockchain technology is thought to provide such assurance to those transacting with bitcoins. At least for now, this niche service seems to serve a small network of users better than any available alternative, and the current costs of switching to an alternative medium of exchange providing similar assurance of anonymity may be prohibitive. That network effect, combined with high switching cost, may be sufficient to prevent backward induction from driving the value of bitcoins down to zero, as might otherwise seem likely.

While this argument suggests that bitcoin will not soon disappear, the hopes of its promoters and supporters for continued appreciation to result in the collapse of fiat currencies and their replacement by bitcoin and possibly other cryptocurrencies seem destined for disappointment. Expectations of rapid appreciation do not attract new uses into the network of users of a medium of exchange. On the contrary, as implicitly recognized by the familiar proposition (now known as Gresham’s Law) that bad money drives out the good, the expectation of rapid appreciation deters, rather than attracts, traders from using the appreciating (good) money in exchange, encouraging instead the use of the alternative (bad) money whose value is expected to be comparatively stable. Centuries, if not millenia, of monetary experience have demonstrated the wisdom of this proposition over and over again.

The very success of bitcoin as a speculative asset turns out to be the kiss of death for its chances of ever displacing the dollar as the dominant currency in the world.


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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