Uneasy Money

In my previous post, I explained how the real-bills doctrine originally espoused by Adam Smith was later misunderstood and misapplied as a policy guide for central banking, not, as Smith understood it, as a guide for individual fractional-reserve banks. In his recent book on the history of the Federal Reserve, Robert Hetzel recounts how the Federal Reserve was founded, and to a large extent guided in its early years, by believers in the real-bills doctrine. On top of their misunderstanding of what the real-bills doctrine really meant, they also misunderstood the transformation of the international monetary system from the classical gold standard that had been in effect as an international system from the early 1870s to the outbreak of World War I. Before World War I, no central bank, even the Bank of England, dominant central bank at the time, could determine the international price level shared by all countries on the gold standard. But by the early 1920s, the Federal Reserve System, after huge wartime and postwar gold inflows, held almost half of the world’s gold reserves. Its gold holdings empowered the Fed to control the value of gold, and thereby the price level, not only for itself but for all the other countries rejoining the restored gold standard during the 1920s.

All of this was understood by Hawtrey in 1919 when he first warned that restoring the gold standard after the war could cause catastrophic deflation unless the countries restoring the gold standard agreed to restrain their demands for gold. The cooperation, while informal and imperfect, did moderate the increased demand for gold as over 30 countries rejoined the gold standard in the 1920s until the cooperation broke down in 1928.

Unlike most other Monetarists, especially Milton Friedman and his followers, whose explanatory focus was almost entirely on the US quantity of money rather than on the international monetary conditions resulting from the fraught attempt to restore the international gold standard, Hetzel acknowledges Hawtrey’s contributions and his understanding of the confluence of forces that led to a downturn in the summer of 1929 followed by a stock-market crash in October.

Recounting events during the 1920s and the early stages of the Great Depression, Hetzel mentions or quotes Hawtrey a number of times, for example, crediting (p. 100) both Hawtrey and Gustav Cassel, for “predicting that a return to the gold standard as it existed prior to World War I would destabilize Europe through deflation.” Discussing the Fed’s exaggerated concerns about the inflationary consequences of stock-market spectulation, Hetzel (p. 136) quotes Hawtrey’s remark that the Fed’s dear-money policy, aiming to curb stock-market speculation “stopped speculation by stopping prosperity.” Hetzel (p. 142) also quotes Hawtrey approvingly about the importance of keeping value of money stable and the futility of urging monetary authorities to stabilize the value of money if they believe themselves incapable of doing so. Later (p. 156), Hetzel, calling Hawtrey a lone voice (thereby ignoring Cassel), quotes Hawtrey’s scathing criticism of the monetary authorities for their slow response to the sudden onset of rapid deflation in late 1929 and early 1930, including his remark: “Deflation may become so intense that it is difficult to induce traders to borrow on any terms, and that in that event the only remedy is the purchase of securities by the central bank with a view to directly increase the supply of money.”

In Chapter 9 (entitled “The Great Contraction” in a nod to the corresponding chapter in A Monetary History of the United States by Friedman and Schwartz), Hetzel understandably focuses on Federal Reserve policy. Friedman insisted that the Great Contraction started as a normal business-cycle downturn caused by Fed tightening to quell stock-market speculation that was needlessly exacerbated by the Fed’s failure to stop a collapse of the US money stock precipitated by a series of bank failures in 1930, and was then transmitted to the rest of the world through the fixed-exchange-rate regime of the restored gold standard. Unlike Friedman Hetzel acknowledges the essential role of the gold standard in not only propagating, but in causing, the Great Depression.

But Hetzel leaves the seriously mistaken impression that the international causes and dimensions of the Great Depression (as opposed to the US-centered account advanced by Friedman) was neither known nor understood until the recent research undertaken by such economists as Barry Eichengreen, Peter Temin, Douglas Irwin, Clark Johnson, and Scott Sumner, decades after publication of the Monetary History. What Hetzel leaves unsaid is that the recent work he cites largely rediscoveed the contemporaneous work of Hawtrey and Cassel. While recent research provides further, and perhaps more sophisticated, quantitative confirmation of the Hawtrey-Cassel monetary explanation of the Great Depression, it adds little, if anything, to their broad and deep analytical and historical account of the downward deflationary spiral from 1929 to 1933 and its causes.

In section 9.11 (with the heading “Why Did Learning Prove Impossible?”) Hetzel (p. 187) actually quotes a lengthy passage from Hawtrey (1932, pp. 204-05) describing the widely held view that the stock-market crash and subsequent downturn were the result of a bursting speculative bubble that had been encouraged and sustained by easy-money policies of the Fed and the loose lending practices of the banking system. It was of course a view that Hawtrey rejected, but was quoted by Hetzel to show that contemporary opinion during the Great Depression viewed easy monetary policy as both the cause of the crash and Great Depression, and as powerless to prevent or reverse the downward spiral that followed the bust.

Although Hetzel is familiar enough with Hawtrey’s writings to know that he believed that the Great Depression had been caused by misguided monetary stringency, Hetzel is perplexed by the long failure to recognize that the Great Depression was caused by mistaken monetary policy. Hetzel (p. 189) quotes Friedman’s solution to the puzzle:

It was believed [in the Depression] . . . that monetary policy had been tried and had been found wanting. In part that view reflected the natural tendency for the monetary authorities to blame other forces for the terrible economic events that were occurring. The people who run monetary policy are human beings, even as you and I, and a common human characteristic is that if anything bad happens it is somebody else’s fault.

Friedman, The Counter-revolution in Monetary Theory. London: Institute for Economic Affairs, p. 12.

To which Hetzel, as if totally unaware of Hawtrey and Cassel, adds: “Nevertheless, no one even outside the Fed [my emphasis] mounted a sustained, effective attack on monetary policy as uniformly contractionary in the Depression.”

Apparently further searching for a solution, Hetzel in Chapter twelve (“Contemporary Critics in the Depression”), provides a general overview of contemporary opinion about the causes of the Depression, focusing on 14 economists—all Americans, except for Joseph Schumpeter (arriving at Harvard in 1932), Gottfried Haberler (arriving at Harvard in 1936), Hawtrey and Cassel. Although acknowledging the difficulty of applying the quantity theory to a gold-standard monetary regime, especially when international in scope, Hetzel classifies them either as proponents or opponents of the quantity theory. Remarkably, Hetzel includes Hawtrey among those quantity theorists who “lacked a theory attributing money to the behavior of the Fed rather than to the commercial banking system” and who “lacked a monetary explanation of the Depression highlighting the role of the Fed as opposed to the maladjustment of relative prices.” Only one economist, Laughlin Currie, did not, in Hetzel’s view, lack those two theories.

Hetzel then briefly describes the views of each of the 14 economists: first opponents and then proponents of the quantity theory. He begins his summary of Hawtrey’s views with a favorable assessment of Hawtrey’s repeated warnings as early as 1919 that, unless the gold standard were restored in a way that did not substantially increase the demand for gold, a severe deflation would result.

Despite having already included Hawtrey among those lacking “a theory attributing money to the behavior of the Fed rather than to the commercial banking system,” Hetzel (p. 281-82) credits Hawtrey with having “almost alone among his contemporaries advanced the idea that central banks can create money,” quoting from Hawtrey’s The Art of Central Banking.

Now the central bank has the power of creating money. If it chooses to buy assets of any kind, it assumes corresponding liabilities and its liabilities, whether notes or deposits, are money. . . . When they [central banks] buy, they create money, and place it in the hands of the sellers. There must ultimately be a limit to the amount of money that the sellers will hold idle, and it follows that by this process the vicious cycle of deflation can always be broken, however great the stagnation of business and the reluctance of borrowers may be.

Hawtrey, The Art of Central Banking: London: Frank Cass, 1932 [1962], p. 172

Having already quoted Hawtrey’s explicit assertion that central banks can create money, Hetzel struggles to justify classifying Hawtrey among those denying that central banks can do so, by quoting later statements that, according to Hetzel, show that Hawtrey doubted that central banks could cause a recovery from depression, and “accepted the . . . view that central banks had tried to stimulate the economy, and . . . no longer mentioned the idea of central banks creating money.”

Efforts have been made over and over again to induce that expansion of demand which is the essential condition of a revival of activity. In the United States, particularly, cheap money, open-market purchases, mounting cash reserves, public works, budget deficits . . . in fact the whole apparatus of inflation has been applied, and inflation has not supervened.

Hawtrey, “The Credit Deadlock” in A. D. Gayer, ed., The Lessons of Monetary Experience, New York: Farrar & Rhinehart, p. 141.

Hetzel here confuses the two distinct and different deficiencies supposedly shared by quantity theorists other than Laughlin Currie: “[lack] of a theory attributing money to the . . . Fed rather than to the commercial banking system” and “[lack] of a monetary explanation of the Depression highlighting the role of the Fed as opposed to the maladjustment of relative prices.” Explicitly mentioning open-market purchases, Hawtrey obviously did not withdraw the attribution of money to the behavior of the Fed. It’s true that he questioned whether the increase in the money stock resulting from open-market purchases had been effective, but that would relate only to Hetzel’s second criterion–lack of a monetary explanation of the Depression highlighting the role of the Fed as opposed to the maladjustment of relative prices—not the first.

But even the relevance of the second criterion to Hawtrey is dubious, because Hawtrey explained both the monetary origins of the Depression and the ineffectiveness of the monetary response to the downturn, namely the monetary response having been delayed until the onset of a credit deadlock. The possibility of a credit deadlock doesn’t negate the underlying monetary theory of the Depression; it only suggests an explanation of why the delayed monetary expansion didn’t trigger a recovery as strong as a prompt expansion would have.

Turning to Hawtrey’s discussion of the brief, but powerful, revival that began almost immediately after FDR suspended the gold standard and raised the dollar gold price (i.e., direct monetary stimulus) upon taking office, Hetzel (Id.) misrepresents Hawtrey as saying that the problem was pessimism not contractionary monetary policy; Hawtrey actually attributed the weakening of the recovery to “an all-round increase of costs” following enactment of the National Industrial Recovery Act, that dissipated “expectations of profit on which the movement had been built.” In modern terminology it would be described as a negative supply-side shock.

In a further misrepresentation, Hetzel writes (p. 282), “despite the isolated reference above to ‘creating money,’ Hawtrey understood the central bank as operating through its influence on financial intermediation, with the corollary that in depression a lack of demand for funds would limit the ability of the central bank to stimulate the economy.” Insofar as that reference was isolated, the isolation was due to Hetzel’s selectivity, not Hawtrey’s understanding of the capacity of a central bank. Hawtrey undoubtedly wrote more extensively about the intermediation channel of monetary policy than about open-market purchases, inasmuch as it was through the intermediation channel that, historically, monetary policy had operated. But as early as 1925, Hawtrey wrote in his paper “Public Expenditure and the Demand for Labour”:

It is conceivable that . . . a low bank rate by itself might be found to be an insufficient restorative. But the effect of a low bank rate can be reinforced by purchase of securities on the part of the central bank in the open market.

Although Hawtrey was pessimistic that a low bank rate could counter a credit deadlock, he never denied the efficacy of open-market purchases. Hetzel cites the first (1931) edition of Hawtrey’s Trade Depression and the Way Out, to support his contention that “Hawtrey (1931, 24) believed that in the Depression ‘cheap money’ failed to revive the economy.” In the cited passage, Hawtrey observed that between 1844 and 1924 Bank rate had never fallen below 2% while in 1930 the New York Fed discount rate fell to 2.5% in June 1930, to 2% in December and to 1.5% in May 1931.

Apparently, Hetzel neglected to read the passage (pp. 30-31) (though he later quotes a passage on p. 32) in the next chapter (entitled “Deadlock in the Credit Market”), or he would not have cited the passage on p. 24 to show that Hawtrey denied that monetary policy could counter the Depression.

A moderate trade depression can be cured by cheap money. The cure will be prompter if a low Bank rate is reinforced by purchases of securities in the open market by the Central Bank. But so long as the depression is moderate, low rates will of themselves suffice to stimulate borrowing.

On the other hand, if the depression is very severe, enterprise will be killed. It is possible that no rate of interest, however low, will tempt dealers to buy goods. Even lending money without interest would not help if the borrower anticipated a loss on every conceivable use . . . of the money. In that case the purchase of securities by the Central Bank, which is otherwise no more than a useful reinforcement of the low Bank rate, hastening the progress of revival, becomes an essential condition of the revival beginning at all. By buying securities the Central Bank creates money [my emphasis], which appears in the form of deposits credited to the banks whose customers have sold the securities. The banks can thus be flooded with idle money, and given . . . powerful inducement to find additional borrowers.

Something like this situation occurred in the years 1894-96. The trade reaction which began after 1891 was disastrously aggravated by the American crisis of 1893. Enterprise seemed . . . absolutely dead. Bank rate was reduced to 2% in February 1894, and remained continuously at that rate for 2.5 years.

The Bank of England received unprecedented quantities of gold, and yet added to its holdings of Government securities. Its deposits rose to a substantially higher total than was ever reached either before or after, till the outbreak of war in 1914. Nevertheless, revival was slow. The fall of prices was not stopped till 1896. But by that time the unemployment percentage, which had exceeded 10% in the winter of 1893, had fallen to 3.3%.

Hawtrey, Trade Depression and the Way Out. London: Longmans, Green and Company, 1931.

This passage was likely written in mid-1931, the first edition having been published in September 1931. In the second edition published two years later, Hawtrey elaborated on the conditions in 1931 discussed in the first edition. Describing the context of the monetary policy of the Bank of England in 1930, Hawtrey wrote:

For some time the gold situation had been a source of anxiety in London. The inflow of “distress gold” was only a stop-gap defence against the apparently limitless demands of France and the United States. When it failed, and the country lost £20,000,000 of gold in three months, the Bank resorted to restrictive measures.

Bank rate was not raised, but the Government securities in the Banking Department were reduced from £52,000,000 in the middle of January 1931 to £28,000,000 at the end of March. That was the lowest figure since August 1928. The 3% bank rate became “effective,” the market rate on 3-months bills rising above 2.5%. Here was a restrictive open market policy, designed to curtail the amount of idle money in the banking system.

Between May 1930 and January 1931, the drain of gold to France and the United States had not caused any active measures of credit restriction. Even in that period credit relaxation had been less consistent and whole-hearted than it might have been. In the years 1894-96 the 2% bank rate was almost continuously ineffective, the market rate in 1895 averaging less than 1%. In 1930 the market rate never fell below 2%.

So, notwithstanding Hetzel’s suggestion to contrary, Hawtrey clearly did not believe that the failure of easy-money policy to promote a recovery in 1930-31 showed that monetary policy is necessarily ineffective in a deep depression; it showed that the open-market purchases of central banks had been too timid. Hawtrey made this point explicitly in the second edition (1933, p. 141) of Trade Depression and the Way Out:

When . . . expanding currency and expanding bank deposits do not bring revival, it is sometimes contended that it is no use creating additional credit, because it will not circulate, but will merely be added to the idle balances. And without doubt it ought not to be taken for granted that every addition to the volume of bank balances will necessarily and automatically be accompanied by a proportional addition to demand.

But people do not have an unlimited desire to hold idle balances. Because they already hold more than usual, it does not follow that they are willing to hold more still. And if in the first instance a credit expansion seems to do no more than swell balances without increasing demand, further expansion is bound ultimately to reach a point at which demand responds.

Trying to bolster his argument that Hawtrey conceded the inability of monetary policy to promote recovery from the Depression, Hetzel quotes from Hawtrey’s writings in 1937 and 1938. In his 1937 paper on “The Credit Deadlock,” Hawtrey considered the Fisher equation breaking down the nominal rate of interest into a real rate of interest (corresponding to the expected real rate of return on capital) and expected inflation. Hawtrey explored the theoretical possibility that agents’ expectations could become so pessimistic that the expected rate of deflation would exceed the expected rate of return on capital, so that holding money became more profitable than any capital investment; no investments would be forthcoming in such an economy, which would then descend into the downward deflationary spiral that Hawtrey called a credit deadlock.

In those circumstances, monetary policy couldn’t break the credit deadlock unless the pessimistic expectations preventing capital investments from being made were dispelled. In his gloss on the Fisher equation, a foundational proposition of monetary theory, Hawtrey didn’t deny that a central bank could increase the quantity of money via open-market operations; he questioned whether increasing the quantity of money could sufficiently increase spending and output to restore full employment if pessimistic expectations were not dispelled. Hawtrey’s argument was purely theoretical, but he believed it at least possible that the weak recovery from the Great Depression in the 1930s, even after abandonment of the gold standard and the widespread shift to easy money, had been dampened by entrepreneurial pessimism.

Hetzel also quotes two passages from Hawtrey’s 1938 volume A Century of Bank Rate to show that Hawtrey believed easy money was incapable of inducing increased investment spending and expanded output by business once pessimism and credit deadlock took hold. But those passages refer only to the inefficacy of reductions in bank rate, not of open-market purchases.

Hetzel (p. 283-84) then turns to a broad summary criticism of Hawtrey’s view of the Great Depression.

With no conception of the price system as the organizing principle behind the behavior of the economy, economists invented disequilibrium theories in which the psychology of businessmen and investors (herd behavior) powered cyclical fluctuations. The concept of the central bank causing recessions by interfering with the price system lay only in the future. Initially, Hawtrey found encouraging the Fed’s experiment in the 1920s with open market operations and economic stabilization. By the time Hawtrey wrote in 1938, it appeared evident that the experiment had failed.

Hetzel again mischaracterizes Hawtrey who certainly did not lack a conception of the price system as the organizing principle behind the behavior of the economy, and, unless Hetzel is prepared to repudiate the Fisher equation and the critical role it assigns to expectations of future prices as an explanation of macroeconomic fluctuations, it is hard to understand how the pejorative references psychology and herd behavior have any relevance to Hawtrey. And Hetzel’s suggestion that Hawtrey did not hold central banks responsible for recessions after Hetzel had earlier (p. 136) quoted Hawtrey’s statement that dear money had stopped speculation by stopping prosperity seems puzzling indeed.

Offering faint praise to Hawtrey, Hetzel calls him “especially interesting because of his deep and sophisticated knowledge of central banking,” whose “failure to understand the Great Depression as caused by an unremittingly contractionary monetary policy [is also] especially interesting.” Unfortunately, the only failure of understanding I can find in that sentence is Hetzel’s.

Hetzel concludes his summary of Hawtrey’s contribution to the understanding of the Great Depression with the observation that correction of the misperception that, in the Great Depression, a policy of easy money by the Fed had failed lay in the distant monetarist future. That dismissive observation about Hawtrey’s contribution is a misperception whose corretion I hope does not lie in the distant future.