Monetarism v. Hawtrey and Cassel

The following is an updated and revised version of the penultimate section of my paper with Ron Batchelder “Pre-Keynesian Theories of the Great Depressison: What Ever Happened to Hawtrey and Cassel?” which I am now preparing for publication. The previous version is available on SSRN.

In the 1950s and early 1960s, empirical studies of the effects of money and monetary policy by Milton Friedman, his students and followers, rehabilitated the idea that monetary policy had significant macroeconomic effects. Most importantly, in research with Anna Schwartz Friedman advanced the seemingly remarkable claim that the chief cause of the Great Depression had been a series of policy mistakes by the Federal Reserve. Although Hawtrey and Cassel, had also implicated the Federal Reserve in their explanation of the Great Depression, they were unmentioned by Friedman and Schwartz or by other Monetarists.[1]

The chief difference between the Monetarist and the Hawtrey-Cassel explanations of the Great Depression is that Monetarists posited a monetary shock (bank failures) specific to the U.S. as the primary, if not sole, cause of the Depression, while Hawtrey and Cassel considered the Depression a global phenomenon reflecting a rapidly increasing international demand for gold, bank failures being merely an incidental and aggravating symptom, specific to the U.S., of a more general monetary disorder.

Arguing that the Great Depression originated in the United States following a typical business-cycle downturn, Friedman and Schwartz (1963) attributed the depth of the downturn not to the unexplained initial shock, but to the contraction of the U.S. money stock caused by the bank failures. Dismissing any causal role for the gold standard in the Depression, Friedman and Schwartz (359-60) acknowledged only its role in propagating, via PSFM, an exogenous, policy-driven, contraction of the U.S. money stock to other gold-standard countries. According to Friedman and Schwartz, the monetary contraction was the cause, and deflation the effect.

But the causation posited by Friedman and Schwartz is the exact opposite of the true causation. Under the gold standard, deflation (i.e., gold appreciation) was the cause and the decline in the quantity of money the effect. Deflation in an international gold standard is not a local phenomenon originating in any single country; it occurs simultaneously in all gold standard countries.

To be sure the banking collapse in the U.S. exacerbated the catastrophe. But the collapse was the localized effect of a more general cause: deflation. Without deflation, neither the unexplained 1929 downturn nor the subsequent banking collapse would have occurred. Nor was an investment boom in the most advanced and most productive economy in the world unsustainable as posited, with no evidence of unsustainability other than the subsequent economic collapse, by the Austrian malinvestment hypothesis.

Friedman and Schwartz based their assertion that the monetary disturbance that caused the Great Depression occurred in the U.S. on the observation that, from 1929 to 1931, gold flowed into, not out of, the U.S. Had the disturbance occurred elsewhere, they argued, gold would have flowed out of, not into, the U. S.

Table 1 shows the half-year changes in U.S., French, and world gold reserves starting in June 1928, when the French monetary law re-establishing the gold standard was enacted.

TABLE 1: Gold Reserves in US, France, and the World June 1928-December 1931 (measured in dollars)
Date World ReservesUS ReservesUS Share (percent)French ReservesFrench Share (percent)
June 19289,7493,73238.31,13611.7
Dec. 192810,0573,74637.21,25412.4
2nd half 1928 change31214-1.11180.7
June 192910,1263,95639.11,43614.2
1st half 1929 change692101.91821.8
Dec. 192910,3363,90037.71,63315.8
2nd half 1929 change210-56-1.41971.6
June 193010,6714,17839.21,72716.2
1st half 1930 change3352781.5940.4
Dec. 193010,9444,22538.72,10019.2
2nd half 1930 change 27347-0.53733.0
June 193111,264459340.82,21219.6
1st half 1931 change3203682.11120.4
Dec. 193111,3234,05135.82,69923.8
2nd half 1931 change59-542-5.04874.2
June 1928-Dec. 1931 change1,574319-2.51,56312.1
Source: H. C. Johnson, Gold, France and the Great Depression

In the three-and-a-half years from June 1928 (when gold convertibility of the franc was restored) to December 1931, gold inflows into France exceeded gold inflows into the United States. The total gold inflow into France during the June 1928 to December 1931 period was $1.563 billion compared to only $319 billion into the United States.

However, much of the difference in the totals stems from the gold outflow from the U.S. into France in the second half of 1931, reflecting fears of a possible U.S. devaluation or suspension of convertibility after Great Britain and other countries suspended the gold standard in September 1931 (Hamilton 2012). From June 1928 through June 1931, the total gold inflow into the U.S. was $861 billion and the total gold inflow into France was $1.076 billion, the U.S. share of total reserves increasing from 38.3 percent to 40.6 percent, while the total French share increased from 11.7 percent to 19.6 percent.[2]

In the first half of 1931, when the first two waves of U.S. bank failures occurred, the increase in U.S. gold reserves exceeded the increase in world gold reserves. The shift by the public from holding bank deposits to holding currency increased reserve requirements, an increase reflected in the gold reserves held by the U.S. The increased U.S. demand for gold likely exacerbated the deflationary pressures affecting all gold-standard countries, perhaps contributing to the failure of the Credit-Anstalt in May 1931 that intensified the European crisis that forced Britain off the gold standard in September.

The combined increase in U.S. and French gold reserves was $1.937 billion compared to an increase of only $1.515 billion in total world reserves, indicating that the U.S. and France were drawing reserves either from other central banks or from privately held gold stocks. Clearly, both the U.S. and France were exerting powerful deflationary pressure on the world economy, before and during the downward spiral of the Great Depression.[3]

Deflationary forces were operating directly on prices before the quantity of money adjusted to the decline in prices. In some countries the adjustment of the quantity of money was relatively smooth; in the U.S. it was exceptionally difficult, but, not even in the U.S., was it the source of the disturbance. Hawtrey and Cassel understood that; Friedman did not.

In explaining the sources of his interest in monetary theory and the role of monetary policy, Friedman (1970) pointedly distinguished between the monetary tradition from which his work emerged and the dominant tradition in London circa 1930, citing Robbins’s (1934) Austrian-deflationist book on the Great Depression, while ignoring Hawtrey and Cassel. Friedman linked his work to the Chicago oral tradition, citing a lecture by Jacob Viner (1933) as foreshadowing his own explanation of the Great Depression, attributing the loss of interest in monetary theory and policy by the wider profession to the deflationism of LSE monetary economists. Friedman went on to suggest that the anti-deflationism of the Chicago monetary tradition immunized it against the broader reaction against monetary theory and policy, that the Austro-London pro-deflation bias provoked against monetary theory and policy.

Though perhaps superficially plausible, Friedman’s argument ignores, as he did throughout a half-century of scholarship and research, the contributions of Hawtrey and Cassel and especially their explanation of the Great Depression. Unfortunately, Friedman’s outsized influence on economists trained after the Keynesian Revolution distracted their attention from contributions outside the crude Keynesian-Monetarist dichotomy that shaped his approach to monetary economics.

Eclectics like Hawtrey and Cassel were neither natural sources of authority, nor obvious ideological foils for Friedman to focus upon. Already forgotten, providing neither convenient targets, nor ideological support, Hawtrey and Cassel, could be easily and conveniently ignored.


[1] Meltzer (2001) did mention Hawtrey, but the reference was perfunctory and did not address the substance of his and Cassel’s explanation of the Great Depression.

[2] By far the largest six-month increase in U.S. gold reserves was in the June-December 1931 period coinciding with the two waves of bank failures at the end of 1930 and in March 1931 causing a substantial shift from deposits to currency which required an increase in gold reserves owing to the higher ratio of required gold reserves against currency than against bank deposits.

[3] Fremling (1985) noted that, even during the 1929-31 period, the U.S. share of world gold reserves actually declined. However, her calculation includes the extraordinary outflow of gold from the U.S. in the second half of 1931. The U.S. share of global gold reserves rose from June 1928 to June 1931.

35 Responses to “Monetarism v. Hawtrey and Cassel”


  1. 1 Henry Rech April 2, 2021 at 10:32 am

    David,

    As has been your practice when discussing gold and the Great Depression, you focus solely on the accumulation of gold by the US and France in the late 1920s. Of course, you are not the only commentator on the Great Depression that does. It seems to be de rigueur.

    After providing the gold reserves figures you go on to intimate that this was the cause of great financial dislocation and the major cause of the Great Depression.

    As I have pointed out several times to you over the last few years, the French accumulation appears to be accounted for by new gold production of the period.

    The main losers of gold in the period were the agricultural producing countries, including Japan, whose trade balances had collapsed. (Agricultural product prices had been falling, mainly due to the huge increases in agricultural production fostered by the technological innovations of the early 1920s.)

    The Europeans did not lose gold during this period, in fact gold holdings increased in the main economies. The loser in Europe was Germany owing to its war reparations obligations.

    British gold holdings were relatively stable until 1931 when speculation regarding a possible devaluation of sterling destabilized gold.

    So where was the great monetary destabilization caused by US and French gold accumulation?

    There was no doubt that the US and French gold accumulation pressured the world monetary system. There was no doubt that the Gold Standard was deflationary – it had worked in this way since the early 1920s. It was not solely a feature of the late 1920s.

    The collapse of Credit Anstalt had probably more to do with the politics of the German reparations.

    While you have at various times referred to the undervaluation of the Franc you virtually ignore the other side of the coin – the Pound’s overvaluation. In his testimony before the Macmillan Committee, Hawtrey admitted that the setting of British interest rates at a higher level than necessary, in defence of the Pound, was the cause of deflation in world prices. It even lead to the British accumulating gold in some years along with the US and France during the late 1920s.

    Your singular focus on US and France leads you to over-exaggeration of the causes of the Great Depression.

  2. 2 Henry Rech April 2, 2021 at 10:58 am

    David,

    You mention Flemling’s paper of 1985.

    While she disagreed with Friedman/Schwartz on international monetary transmission, she concluded that it was possible that “the United States could have prevented or mitigated the world-wide depression through appropriate monetary policies.”

    The causes of the Great Depression are not as plain as you make out.

  3. 3 David Glasner April 2, 2021 at 11:06 am

    You seem to think that Fleming’s remark is somehow inconsistent with my position. I think Fleming and I are in perfect accord.

  4. 4 Henry Rech April 2, 2021 at 11:37 am

    David,

    I wasn’t saying that.

    Just adding to the idea that the Great Depression was not just about US and French gold accumulation.

  5. 5 David Glasner April 2, 2021 at 1:15 pm

    I don’t disagree with that either. But the US and France were the chief culprits.

  6. 6 Henry Rech April 2, 2021 at 3:48 pm

    “But the US and France were the chief culprits.”

    But of what?

    It’s not as if the other major economies of the world lost mountains of gold during the period of interest, in fact, they gained gold.

    The gold heading towards the US and France can be accounted for by new gold production and the gold sucked from the agricultural exporters (Australia, Brazil, Canada etc.) because their trade accounts collapsed.

    No-one looks at these facts.

  7. 7 Henry Rech April 2, 2021 at 5:24 pm

    Take a look at the trend in interest rates in the relevant period up to the crisis in Sterling, as at June of the years from 1927 to 1930 and April 1931, in various countries (using various instruments as reported in the US Federal Reserve Bulletins of the era – where ranges are shown in the original statistics, the lower figure is taken).

    US – NY Fed Res dis. rate – 3.5, 5, 5 (peaked at 6.25 in Oct/Nov), 3, 1.5

    UK – 3 months bankers acceptances – 4.34, 3.82, 5.32, 2.31, 2.58

    France – private discount rate – 2.25, 2.9, 3.5, 3.5, 2.57

    Germany – private discount rate – 5.39, 6.59, 7.5, 3.58, 4.65

    Netherlands – private discount rate – 3.57, 4.18, 5.3, 1.89, 1.5

    Switzerland – private discount rate – 3.42, 3.4, 3.26, 2.06, 1.06

    Italy – private discount rate – 7.6, 5.25, 6.75, 5.5, 5.48

    Belgium – private discount rate – 4.17, 4.27, 3.94, 2.78, 2.25

    Austria – private discount rate – 5 2/3, 5 11/16, 7 3/16, 4 1/2, 3 7/8

    Hungary – prime commercial paper – 7, 7 1/8, 8 3/4, 5 1/2, 5 1/2 (March)

    Sweden – 3 month loans – 4, 4, 4 1/2, 3 1/2, 3

    Japan – discounted bills – 6.57, 4.38, 5.48, 5.48, 5.29 (March)

    The rates generally peak in the years 1928 and 1929 and thereafter declined.

    US and French gold accumulation proceeded well into 1931. If the gold accumulation by the US and France was pressuring the finances of other major industrial countries it would be expected to see interest rates continue to rise across the spectrum. They did not.

    The general peaking of rates in 1928/1929 coincide with the tightening of the policy rate in the US and declined as the US policy rate fell thereafter.

  8. 8 viennacapitalist April 7, 2021 at 2:49 am

    David,
    you write that deflation caused by a rise in gold caused the money supply to contract.
    Just what was the cause of such as sudden rise in gold’s value?

    The reserve demand by the bank of france?

    This is unplausible under fractional reseve banking prevailing at the time, i.e. a fractional reserve system can easily adjust to this type of demand shifts (leaving aside certain limiting cases).

    As you yourself write, reserves of the Fed did not decline as the French were accumulating gold, which means that US banks were under no obligation to contract, yet we know that the depresson, albeit global, was most severe in the US…

    The question remains unanswered in your post:
    Why did the depression start, and was most severe, in the US which never lost gold to France?

    The Austrians would say that it is because the preceeding boom had been most pronounced in the US…(although I agree that unsustainability is not adequately defined)…

  9. 9 Frank Restly April 8, 2021 at 10:02 am

    Vienna Capitalist,

    Here is one explanation based on Irving Fisher’s debt deflation analysis of the Great Depression.

    Suppose you are a farmer with a mortgage on your farm that you pay a nominal interest rate on. Suppose the prices that you receive on your crops start falling – what do you do to ensure that you are able to make your mortgage payments? You could plant more crops hoping that the excess supply you are creating doesn’t drive prices further down or you could plant fewer crops hoping that prices you are receiving for your crops rise enough to still make your mortgage payments.

    But you are not the only farmer. As a for instance, There are two hundred thousand other farmers spread across the nation that are faced with the same dilemma.

    Now suppose that 190,000 of those farmers with mortgages (uncoordinated with each other) decide to plant more crops hoping that prices stabilize, but instead prices fall faster making debt service more difficult for each farming trying to service his / her own debts. This process was exacerbated by the tariffs put in place under President Hoover as global markets for US agricultural crops shrunk.

    This description doesn’t explain how the deflation first began, but instead tries to explain how the process accelerates.

    This scenario led to the passage of the Agricultural Adjustment Act in 1933 under President Franklin Delano Roosevelt.

    “The Austrians would say that it is because the preceeding boom had been most pronounced in the US…(although I agree that unsustainability is not adequately defined)…”

    The sustainability of credit at that time was in large part a function of new gold discoveries. Even with fractional reserve banking, gold placed a limit on the amount of new loans / money that could be created.

  10. 10 viennacapitalist April 12, 2021 at 1:44 am

    @ Frank,
    Thank you.
    Unfortunately, Fisher’s description doesn’t explain anything, i..e it leaves out the most important thing: why do all these faermers err in their future estimate of demand? And they seem to err in one direction…

    In a competitive market (many farmers) those with good judgement as to future demand/price conditions cancell the negative effect from those with bad judgement. The lucky ones should be roughly equal to the unlucky ones (that is what you see absent a boom or depression)…
    So why do so many farmers have debt they cannot serve?
    Because they were induced by false price signals (interest rate, underwriting conditions ) to expand collectively…
    Fisher describes the historical process, doesn’t explain the phenomenon, though…

    As for tariffs:
    I am very sympathetic to nonmonetary explainations of depression(severity), but would focus on the monetary factors first…

  11. 11 Frank Restly April 12, 2021 at 7:36 am

    ViennaCapitalist,

    “Thank you. Unfortunately, Fisher’s description doesn’t explain anything, i..e it leaves out the most important thing: why do all these farmers err in their future estimate of demand? And they seem to err in one direction…”

    Prices fall (generally speaking) when supply exceeds demand. So suppose demand was growing by 3% per year BUT supply (courtesy of productivity improvements such as motorized farm equipment) was growing by 6% per year. Prices still fall even though demand is growing.

    That is why farmers AND economists err – because they only look at demand. It’s not that farmers err in their future estimate of demand, they err in their estimate of future production relative to future demand.

    Can an individual farmer predict into the future about the invention of motorized farm equipment or government actions?

    “In a competitive market (many farmers) those with good judgement as to future demand/price conditions cancel the negative effect from those with bad judgement.”

    What is meant by good judgement?

    We are talking about predictions of both future supply and future demand.

    If I am a farmer and I see demand growing by 3% per year (as per my example) I am going to try to increase my output by 3% per year.

    What I don’t know about is my farmer neighbor 50 miles away that just purchased a motorized combine harvester that enables him to increase output 9% per year.

    What I don’t know about is my federal government is going to kill demand for my goods overseas by initiating tariffs.

    “The lucky ones should be roughly equal to the unlucky ones (that is what you see absent a boom or depression)…”

    It has nothing to do with luck. It has everything to do with how monetary and fiscal policy are implemented even to this day.

  12. 12 Henry Rech. April 12, 2021 at 8:13 am

    VC,

    “……but would focus on the monetary factors first”

    Why?

    Look how steeply the Dow Jones rose through the course of the 1920s as a result of the technology investment boom that was underway. It wasn’t called the “Roaring Twenties” for nothing. This technology investment boom was all pervasive and unsustainable. The Fed, wanting to quell the boom, began to increase interest rates in 1928. This eventually took the heat out of the markets in a big way, as we all know. The markets were ripe for a pull back.

    In the background, was also the tight UK monetary policy designed to defend the pound at its old parity. The UK, at that stage, was still a powerful force in the world economy.

    The collapse was a huge shock and was followed by credit restriction and a collapse in spending. The effects of this shock reverberated all the way into 1932 by which time the Dow Jones had lost 90% of its value.This was a “real” phenomenon, not monetary, but with an initial monetary cause.

    It seems every problematic trend in the world economy – the collapse of output and prices – began in earnest in 1929.

    Many would say the other (monetary) factor was the shortage of gold. It could be argued there was no shortage of gold in the late 1920s. Cassel and Kitchin had previously calculated, that to sustain the gold standard, new gold production had to increase at around 3% pa. This was mostly the case. There was no shortage of gold.

    Was there a mal-distribution of gold? David and many others would yes. But the numbers show that while the US and France markedly increased their gold reserves during the late 1920s, the industrial countries of Europe increased their gold holdings. The only countries to lose gold were the large agricultural exporters (Australia, Canada, Brazil etc.) and Japan. These countries lost gold because their trade balances were in a mess.

    If the dire world economic situation of the late 1920s was the result of monetary factors, why is it that the world economy continued to deteriorate in the face of the substantial and sustained easing of world interest rates?

  13. 13 Frank Restly April 12, 2021 at 9:53 am

    Henry,

    “This technology investment boom was all pervasive and unsustainable.”

    Because?? Some Austrian said so??

    “If the dire world economic situation of the late 1920s was the result of monetary factors, why is it that the world economy continued to deteriorate in the face of the substantial and sustained easing of world interest rates?”

    The easing of short term interest rates does nothing for the borrower if he / she is locked into a long term fixed rate borrowing agreement. I don’t believe that adjustable rate mortgages (ARMs) existed back them.

  14. 14 Henry Rech April 12, 2021 at 2:18 pm

    Frank,

    “Because?? Some Austrian said so??”

    No Austrians, just plain fact.

    The development of the vacuum tube opened a new era of radio communications and entertainment as did the development of the film industry. The development of the internal combustion engine opened a new era of transport and travel and mechanization. The development of aeronautics contributed to this new era of transport and travel. Mass production had revolutionized industrial methods. Industrialized chemistry brought its own raft of new products. So many new horizons of economic potential were now apparent. Einstein’s General Theory of Relativity and the nascent Quantum Mechanics Theory had blasted science on to an elevated plain. The 1920s would have been completely unrecognizable to anyone stepping into the new century in 1901, just 20 years previously.

    “The easing of short term interest rates does nothing…”

    You focus on a narrow aspect. The fact is there was a general easing of monetary conditions in the late 1920s.

    You raised Fisher’s debt deflation theory above. You have answered your point yourself.

    The debt question is more of a real phenomenon that it is monetary. It impacts directly on spending capacity and plans/expectations.

  15. 15 viennacapitalist April 13, 2021 at 2:00 am

    @ Frank,
    …That is why farmers AND economists err – because they only look at demand. It’s not that farmers err in their future estimate of demand, they err in their estimate of future production relative to future demand….

    have to disagree here, entrepreneurs do try to take supply conditions into account. In a commodity business (farming) you would do this by guesstimating the wheather, inventories, etc.) of course: the individual farmer will be wrong, but typically these things cancell each other out (which is why we do not see depressions that oftern..). I see this happening constantly in every commodity market I follow…

    …If I am a farmer and I see demand growing by 3% per year (as per my example) I am going to try to increase my output by 3% per year.
    What I don’t know about is my farmer neighbor 50 miles away that just purchased a motorized combine harvester that enables him to increase output 9% per year….

    It is not so easy to increase your demand and buy a combine harvester. Someone has to lend you the money, to buy more land and equipment.
    You might be an optimistt, but the bank director has to agree with your forecast and believe that loaning you the money is the best use of his funds. And in our example he is not just lending to one farmer, but to many of them. – again…This collective error in judgement -because rare – is what needs to be explained, not the fact that producitivty will cause prices to fall…

    I do not say that tariffs did not play a role, however, I do believe there is a monetary effect which I wantet to focus on.

  16. 16 viennacapitalist April 13, 2021 at 2:05 am

    @ Henry,
    I am not sure as to what point you are trying to make. I do not ignore non-monetary factors. I explicitly write that I believe them to be generally underappreciateted in explaining the GD.

    Increases in productivity, i.e. the natural interest rate, are indeed needed to ignite the sort of lending that starts the boom bust cycle….(if you accept this theory)

  17. 17 Henry Rech April 13, 2021 at 4:37 am

    VC,

    “I do not ignore non-monetary factors.”

    I misunderstood you – it sounded as if you were only looking to monetary factors.

    “Increases in productivity, i.e. the natural interest rate, are indeed needed to ignite the sort of lending that starts the boom bust cycle…”

    I don’t know I would exactly put it that way but I guess that is a reasonable way to look at it and the part I don’t get is your reference to the natural rate of interest.

  18. 18 viennacapitalist April 13, 2021 at 7:28 am

    @ Henry
    As Wicksell (indeed Tooke before him) theorized (then taken over by the Austrians):
    the absolute level of interest is less important than the relationship betwenn the natural rate (unobservable) and the bank, i.e. market rate. This relationship determines whether fiduciary media expand or contract…
    What is the natural rate?
    It is the marginal return on real capital, i.e. the outlook for profits.
    When you have positive productivity shock the natural rate rises (under certain circumstances taking into account leads and lags).
    If the bank rate (and voluntary savings) doesn’t rise accordingly what you get is a boom…

  19. 19 Frank Restly April 13, 2021 at 2:15 pm

    Vienna Capitalist,

    “What is the natural rate of interest?”
    “It is the marginal return on real capital.”

    https://en.wikipedia.org/wiki/Capital_(economics)

    “In economics, capital consists of human-created assets that can enhance one’s power to perform economically useful work. For example, a stone arrowhead is capital for a hunter-gatherer who can use it as a hunting instrument; similarly, roads are capital for inhabitants of a city. Capital is distinct from land and other non-renewable resources in that it can be increased by human labor, and does not include certain durable goods like homes and personal automobiles that are not used in the production of saleable goods and services. Adam Smith defined capital as that part of man’s stock which he expects to afford him revenue. In economic models, capital is an input in the production function.”

    Nope, the natural rate of interest is the returns on time, not “real capital”.

    This can be seen in the units used for any rate of interest, such and such percent per month or such and such percent per year.

    If we all lived forever, then the natural rate of interest would be ZERO regardless of the returns on real capital.

    It is time that is the precious resource (each of us are only given a fixed amount of it) not “real capital”.

  20. 20 viennacapitalist April 14, 2021 at 12:51 am

    @ Frank
    There are several definitions, which is confusing, I know. Natural rate in a money economy and barter economy are best kept separated…

    You are referring to time preference As Bawerk showed, market interest rates are simultaneoulsy detemined by productivity (related to RoA) and time preference….

    I have reffered to the definition used by Wicksell to describe the workings of a money (as opposed to barter) economiy…. (he and most other economists, at the time, settlet for this definition – including Hayek and Mises after long debates, hence the confusion)

    Why did Economists introduce the natural rate?
    Because they observed in the 19th century that lending might be subdued DESPITE low interest rates and abundant reserves.
    Wicksell explained this puzzle by introducing the natural rate, i.e. basically the outlook for profits.
    It is really simple (and logical):
    No good profit opportunities for businessmen (for whatever reason), no new lending, indeed volumes might (and did) even contract (deflation)…

  21. 21 viennacapitalist April 14, 2021 at 12:54 am

    @ Frank
    another point. Real capital does not yield a return per se.
    If you invest in a country with no property rights (say one day before a communist takeover) or with a high degree of revolutionary violence, then your real capital would yield a (certain) loss….

  22. 22 Henry Rech April 14, 2021 at 10:08 am

    VC,

    You responded to me:

    “It is the marginal return on real capital, i.e. the outlook for profits.”

    You responded to Frank:

    “Nope, the natural rate of interest is the returns on time, not “real capital”.”

    Are these two statements consistent?

  23. 23 Frank Restly April 14, 2021 at 6:57 pm

    Henry,

    Two slightly different world views here.

    VC describes the natural rate of interest as the marginal return on real capital. I responded that the natural rate of interest is the returns on time, not “real capital.”

    I feel that defining interest as the returns on time is a broader more encompassing definition.

    The two statements are not inconsistent if one minor modification is made to VC’s statement:

    “The natural rate of interest is the marginal return on real capital over time.”

    We need the time variable to properly define any interest rate. Suppose that some company doubles it’s real output over five years. Now suppose that another company (producing the same goods) doubles it’s real output over 30 years.

    Both have doubled output, but the rate of return on real capital is higher for the first company. An economy full of companies like the first one will have a higher natural rate of interest than an economy full of companies like the second.

    There are enterprises that benefit from productivity improvements through technological innovation but where profitability is a secondary goal – things like medical care, education, etc.

    There are enterprises where the primary “real capital” is the human mind – literature, music, artistic works, etc – not the tools that are used to create such works.

  24. 24 viennacapitalist April 15, 2021 at 1:42 am

    @ Henry
    Frank’s last comment is spot on.

    BTW, this part was not written by me:
    Nope, the natural rate of interest is the returns on time, not “real capital”.”

  25. 25 Henry Rech April 15, 2021 at 2:38 am

    VC,

    My apologies.

  26. 26 Frank Restly April 25, 2021 at 2:25 am

    VC,

    “@ Frank, There are several definitions, which is confusing, I know. Natural rate in a money economy and barter economy are best kept separated…”

    What should be said is that natural rate in a credit based monetary economy and natural rate in a barter economy should be kept separated.

    Numerous real goods have served as “money” over time (gold, silver, sea shells, large stone tablets, etc.) even in barter economies.

    The important part is to distinguish between interest charged in a lender / borrower arrangement and interest charged in a trade separated by time.

    In a borrower / lender arrangement, the good that is lent out must also be returned in kind.

    Obviously when a bank lends me $1000 in twenties or hundreds, they don’t expect me to return the exact same twenties or hundreds because currency is fungible.

    We can say the same thing about a lot of goods – ounce of gold, silver – bushel of wheat, apples, corn – ton of lumber, iron, salt – with a uniform measuring stick / set of scales, many goods can be considered fungible.

    In a trade separated by time (for instance I give you $100 now for a couple of bushels of apples a year from now), there is a rate of interest applied as well. You see it in the spread between spot and futures markets.

    In a credit based monetary economy consisting of apples and dollars as the only two goods, there are a couple of interest rates:

    1. Dollars now for dollars in the future (%D) – Borrower / lender arrangement
    2. Apples now for apples in the future (%A) – Borrower / lender arrangement
    3. Dollars now for apples in the future (%DA) – Trade arrangement

    The “real” rate of interest %A is equal to the nominal rate of interest %D minus the inflation rate %DA.

    The “real” rate of interest is not directly observed since in a credit based monetary economy, individuals borrow money under #1 and then buy goods under #3 without resorting to apples now for apples later lending arrangements.

  27. 27 Frank Restly May 27, 2021 at 5:08 am

    The question you need to ask yourself is why would the real interest rate ever go negative?

    That means that in my example above – %A is negative.

    Why would anyone pay more apples now for fewer apples in the future?

  28. 28 viennacapitalist May 31, 2021 at 3:45 am

    @ Frank
    why would it go negative?

    assume you are facing an comunist takeover tommorrow, i..e you are facing expropriation?

    what is your marginal expected real return on capital in that scenario?

    How much demand for investment loans is there going to be in that case?

    Who can pay you, your desired positive real interest rate?

    There would never be capital consumption of the expected real natural rate of interest is positive (unless you have a super high timer preference society)

  29. 29 Frank Restly June 2, 2021 at 10:37 am

    Viennacapitalist,

    “Why would it go negative?”
    “What is your marginal expected real return on capital in that scenario?”

    The answer is that I am forced / coerced to lend my apples even when my expected real return on those apples is negative. (See central bank financed wars, bank bailouts, extended unemployment benefits, among other numerous examples).

    “Who can pay you, your desired positive real interest rate?”

    Someone who can take the seeds from my apples that I lend, plant apple trees, and harvest the new apples.

    “There would never be capital consumption if the expected real natural rate of interest is positive.”

    ??? Huh ??? As long as marginal returns on investment (particularly the after tax variety) exceed the real natural rate (expected or otherwise), then there most definitely will be capital consumption.

  30. 30 viennacapitalist June 2, 2021 at 11:25 pm

    @ Frank

    Not sure you got my point.
    I did not assume forced lending, I assumed a negative marginal return on capital, via expropriation (say, a 100 percent tax rate on profits)
    In that scenario, NOBODY will lend, because nobody will ask for funds…..

    I repeat: in that scenario, there is nobody who will take your seed and plant an apple tree (whose fruit will not belong to him anyway) and therefore NOBODY who will pay you sour time preference – that’s what you call a marginally negative return on capital. Capital consumption occurs, as it is more rational to shrink (get poorer) than to grow (effort without reward)…

    You asked my for an example for negative natural rates (where nobody will lend or plant a seed corn) and I gave you an (extreme) one – we even have historical examples for that…
    .
    You are confusing equilibrium conditions with disequilibrium, as well as the natural rate with time preference (they are not the same)
    Yes, in equilibrium the marginal return on capital (natural rate) and the time preference that determine savings are equal that’s when they coincide. The world, however, is never at equilibrium, as every Austrian should know…

    This is also evident in your last paragrhaph. Capital consumption occurs (on average, of course) when the expected marginal return on capital is BELOW the MARKET interest rate.
    The marginal return on capital and the natural rate (both unobservable) are the same thing (as defined by Wicksel, to whom Mises and Hayek refer)…

  31. 31 Frank Restly June 3, 2021 at 4:35 am

    Viennacapitalist,

    “Not sure you got my point.”

    I didn’t realize there was a point to be had. Your post was a list of questions.

    “I did not assume forced lending…”

    That’s fine, but forced lending is the answer to my question – “Why would the real interest rate ever go negative?”

    “I assumed a negative marginal return on capital, via expropriation (say, a 100 percent tax rate on profits). In that scenario, NOBODY will lend, because nobody will ask for funds….. ”

    And that is fine as well – but in the United States we don’t have a 100% tax rate of profits. We DO have forced / coerced lending. See primary dealer banks / FOMC.

    “Capital consumption occurs, as it is more rational to shrink (get poorer) than to grow (effort without reward)…”

    No, capital consumption occurs because of depreciation – most goods that are produced are eventually going to malfunction, corrode, and deteriorate. That will happen IRREGARDLESS of time preference or the marginal return on capital. The person I am lending apples to will consume some of the apples he grows lest he starves, dies, and turns to dust. The apples themselves will eventually do the same.

    “You asked my for an example for negative natural rates (where nobody will lend or plant a seed corn) and I gave you an (extreme) one – we even have historical examples for that…”

    When nobody lends, a natural rate of interest doesn’t exist at all – the term becomes meaningless. I asked for an example of where lending does occur at a negative real rate of interest – and the only example I can point to is forced / coerced lending.

    “Capital consumption occurs (on average, of course) when the expected marginal return on capital is BELOW the MARKET interest rate.”

    No, capital consumption occurs primarily because all individuals must consume to survive and most goods deteriorate / depreciate over time.

    Additionally, you are forgetting about equity. The person I am lending apples to can instead obtain apples to start an orchard by selling equity claims against the future production from that orchard. The person operating the orchard can then either consume (eat) excess apple production OR use the excess to grow additional apples IRREGARDLESS of the market interest rate.

  32. 32 Henry Rech June 3, 2021 at 3:07 pm

    “The person I am lending apples to can instead obtain apples to start an orchard by selling equity claims against the future production from that orchard.”

    Now I know where the term “seed capital” came from. 🙂

  33. 33 viennacapitalist June 4, 2021 at 1:29 am

    @ Frank,,

    There is no forced lending in the US, nor in Europe. Nobody is pointing a gun at the corporations and households to lever up and buy houses – The incentives are there, yes, but definitively no forced lending…

    I used a 100 percent tax rate as a thought experiment (albeit one that has already happened) – that’s what you do in economics Austrian and otherwise. In practice it is a continuum. Increasing costs of doing business (regulations, taxes, etc.) definitevely have the potential to render the marginal return on capital negative..

    Depreciation is not the explaination for capital consumption. As you write, deprecdiation occurs anyway, hence cannot explain periods of capital consumption and build up. You have to explain why capital is NOT REPLACED in one scenario and IS replaced in another. Please think through my statement above…

    The natural rate is unobservable (I repeat), and it, of course also applies to equity financing.
    Faced with increasing costs of doing business, equity owners might decide not to reinvest depreciation and rather consume their seed corn – it has happened in the past and, I believe, it is happening now…

    Most important concepts for you to take away:
    The natural rate is (typically) defined as the expected (therefore unobservable) MARGINAL RETURN ON CAPITAL….

    The natural rate is UNOBSERVABLE and not necessariily equal to the marktet rate (althhoug one might try to infer it from market rates)

    Depreciation is NOT the reason for capital consumption, rather, and more precisely,, a negattive expected return on investment adjusted for risk and timer preference is….

    And: our current system doesn’t feature forced lending, rather it can best be described by incentivizing people to take out loans (as crazy as that is)…

  34. 34 Frank Restly June 4, 2021 at 7:41 am

    Viennacapitalist,

    I tried this post once with active hyperlinks but it appears to have been rejected. Add https:// to the wikipedia and economicshelp links below.

    – There is no forced lending in the US, nor in Europe.
    – And: our current system doesn’t feature forced lending…

    Yes, forced / coerced lending does happen in the United States – see:

    en.wikipedia.org/wiki/Primary_dealer

    This is why government bond auctions never fail – irrespective of the interest rate.

    – Depreciation is not the explanation for capital consumption.
    – Depreciation is NOT the reason for capital consumption, rather, and more precisely,, a negative expected return on investment adjusted for risk and time preference is….

    Yes it is. If I built a machine and the machine lasted forever, why would I ever build a replacement? Or if I plant an apple tree and it lives forever, why would I ever need to replace the apple tree (re-invest my capital)?
    See:

    http://www.economicshelp.org/blog/glossary/capital-consumption/

    Definition of Capital Consumption

    This is the loss of capital equipment due to depreciation. Depreciation can occur due to the machines wearing out, getting lost or breaking down. Capital can also become obsolete through advances in technology.

    Capital consumption can also occur due to a shift in demand. E.g. rise in demand for computers made the investment in producing typewriters obsolete.

    In my description above, I neglected to include obsolescence – my mistake. My machine may last and operate for 100 years, but better technology may make my machine obsolete in 30 years.

    – Most important concepts for you to take away:
    The natural rate is (typically) defined as the expected (therefore unobservable) marginal return on capital OVER TIME.

    We went over this once already. It is time that is the limiting factor.
    You, I, a machine, an apple tree will last / live on for a fixed amount of time.
    If we all lived forever and all goods were persistent then capital consumption would fall to zero.

  35. 35 Frank Restly June 9, 2021 at 7:34 pm

    Viennacapitalist,

    In the movie “Interstellar”, there are some great lines. Included among those is this comment by Anne Hathaway’s character Dr. Amelia Brand:

    “We need to think of time as a resource, like oxygen and food.”


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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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