Archive for the 'David Hume' Category

The Real-Bills Doctrine, the Lender of Last Resort, and the Scope of Banking

Here is another section from my work in progress on the Smithian and Humean traditions in monetary economics. The discussion starts with a comparison of the negative view David Hume took toward banks and the positive view taken by Adam Smith which was also discussed in the previous post on the price-specie-flow mechanism. This section discusses how Smith, despite viewing banks positively, also understood that banks can be a source of disturbances as well as of efficiencies, and how he addressed that problem and how his followers who shared a positive view toward banks addressed the problem. Comments and feedback are welcome and greatly appreciated.

Hume and Smith had very different views about fractional-reserve banking and its capacity to provide the public with the desired quantity of money (banknotes and deposits) and promote international adjustment. The cash created by banks consists of liabilities on themselves that they exchange for liabilities on the public. Liabilities on the public accepted by banks become their assets, generating revenue streams with which banks cover their outlays including obligations to creditors and stockholders.

The previous post focused on the liability side of bank balance sheets, and whether there are economic forces that limit the size of those balance sheets, implying a point of equilibrium bank expansion. Believing that banks have an unlimited incentive to issue liabilities, whose face value exceeds their cost of production, Hume considered banks dangerous and inflationary. Smith disagreed, arguing that although bank money is a less costly alternative to the full-bodied money preferred by Hume, banks don’t create liabilities limitlessly, because, unless those liabilities generate corresponding revenue streams, they will be unable to redeem those liabilities, which their creditors may require of them, at will. To enhance the attractiveness of those liabilities and to increase the demand to hold them, competitive banks promise to convert those liabilities, at a stipulated rate, into an asset whose value they do not control. Under those conditions, banks have neither the incentive nor the capacity to cause inflation.

I turn now to a different topic: whether Smith’s rejection of the idea that banks are systematically biased toward overissuing liabilities implies that banks require no external control or intervention. I begin by briefly referring to Smith’s support of the real-bills doctrine and then extend that discussion to two other issues: the lender of last resort and the scope of banking.

A         Real-Bills Doctrine

I have argued elsewhere that, besides sketching the outlines of Fullarton’s argument for the Law of Reflux, Adam Smith recommended that banks observe a form of the real-bills doctrine, namely that banks issue sight liabilities only in exchange for real commercial bills of short (usually 90-days) duration. Increases in the demand for money cause bank balance sheets to expand; decreases cause them to contract. Unlike Mints (1945), who identified the Law of Reflux with the real-bills doctrine, I suggested that Smith viewed the real-bills doctrine as a pragmatic policy to facilitate contractions in the size of bank balance sheets as required by the reflux of their liabilities. With the discrepancy between the duration of liabilities and assets limited by issuing sight liabilities only in exchange for short-term bills, bank balance sheets would contract automatically thereby obviating, at least in part, the liquidation of longer-term assets at depressed prices.

On this reading, Smith recognized that banking policy ought to take account of the composition of bank balance sheets, in particular, the sort of assets that banks accept as backing for the sight liabilities that they issue. I would also emphasize that on this interpretation, Smith did not believe, as did many later advocates of the doctrine, that lending on the security of real bills is sufficient to prevent the price level from changing. Even if banks have no systematic incentive to overissue their liabilities, unless those liabilities are made convertible into an asset whose value is determined independently of the banks, the value of their liabilities is undetermined. Convertibility is how banks anchor the value of their liabilities, thereby increasing the attractiveness of those liabilities to the public and the willingness of the public to accept and hold them.

But Smith’s support for the real-bills doctrine indicates that, while understanding the equilibrating tendencies of competition on bank operations, he also recognized the inherent instability of banking caused by fluctuations in the value and liquidity of their assets. Smith’s support for the real-bills doctrine addressed one type of instability: the maturity mismatch between banks’ assets and liabilities. But there are other sources of instability, which may require further institutional or policy measures beyond the general laws of property and contract whose application and enforcement, in Smith’s view, generally sufficed for the self-interested conduct of private firms to lead to socially benign outcomes.

In the remainder of this section, I consider two other methods of addressing the vulnerability of bank assets to sudden losses of value: (1) the creation or empowerment of a lender of last resort capable of lending to illiquid, but solvent, banks possessing good security (valuable assets) as collateral against which to borrow, and (2) limits beyond the real-bills doctrine over the permissible activities undertaken by commercial banks.

B         Lender of Last Resort

Although the real-bills doctrine limits the exposure of bank balance sheets to adverse shocks on the value of long-term liabilities, even banks whose liabilities were issued in exchange for short-term real bills of exchange may be unable to meet all demands for redemption in periods of extreme financial distress, when debtors cannot sell their products at the prices they expected and cannot meet their own obligations to their creditors. If banks are called upon to redeem their liabilities, banks may be faced with a choice between depleting their own cash reserves, when they are most needed, or liquidating other assets at substantial, if not catastrophic, losses.

Smith’s version of the real-bills doctrine addressed one aspect of balance-sheet risk, but the underlying problem is deeper and more complicated than the liquidity issue that concerned Smith. The assets accepted by banks in exchange for their liabilities are typically not easily marketable, so if those assets must be shed quickly to satisfy demands for payment, banks’ solvency may be jeopardized by consequent capital losses. Limiting portfolios to short-term assets limits exposure to such losses, but only when the disturbances requiring asset liquidation affect only a relatively small number of banks. As the number of affected banks increases, their ability to counter the disturbance is impaired, as the interbank market for credit starts to freeze up or break down entirely, leaving them unable to offer short-term relief to, or receive it from, other momentarily illiquid banks. It is then that emergency lending by a lender of last resort to illiquid, but possibly still solvent, banks is necessary.

What causes a cluster of expectational errors by banks in exchanging their liabilities for assets supplied by their customers that become less valuable than they were upon acceptance? Are financial crises that result in, or are caused by, asset write downs by banks caused by random clusters of errors by banks, or are there systematic causes of such errors? Does the danger lie in the magnitude of the errors or in the transmission mechanism?

Here, too, the Humean and Smithian traditions seem to be at odds, offering different answers to problems, or, if not answers, at least different approaches to problems. Focusing on the liability side of bank balance sheets, the Humean tradition emphasizes the expansion of bank lending and the consequent creation of banknotes or deposits as the main impulse to macroeconomic fluctuations, a boom-bust or credit cycle triggered by banks’ lending to finance either business investment or consumer spending. Despite their theoretical differences, both Austrian business-cycle theory and Friedmanite Monetarism share a common intellectual ancestry, traceable by way of the Currency School to Hume, identifying the source of business-cycle fluctuations in excessive growth in the quantity of money.

The eclectic Smithian tradition accommodates both monetary and non-monetary business-cycle theories, but balance-sheet effects on banks are more naturally accommodated within the Smithian tradition than the Humean tradition with its focus on the liabilities not the assets of banks. At any rate, more research is necessary before we can decide whether serious financial disturbances result from big expectational errors or from contagion effects.

The Great Depression resulted from a big error. After the steep deflation and depression of 1920-22, followed by a gradual restoration of the gold standard, fears of further deflation were dispelled and steady economic expansion, especially in the United States, resulted. Suddenly in 1929, as France and other countries rejoined the gold standard, the fears voiced by Hawtrey and Cassel that restoring the gold standard could have serious deflationary consequences appeared increasingly more likely to be realized. Real signs of deflation began to appear in the summer of 1929, and in the fall the stock market collapsed. Rather than use monetary policy to counter incipient deflation, policy makers and many economists argued that deflation was part of the solution not the problem. And the Depression came.

It is generally agreed that the 2008 financial crisis that triggered the Little Depression (aka Great Recession) was largely the result of a housing bubble fueled by unsound mortgage lending by banks and questionable underwriting practices in packaging and marketing of mortgage-backed securities. However, although the housing bubble seems to have burst the spring of 2007, the crisis did not start until September 2008.

It is at least possible, as I have argued (Glasner 2018) that, despite the financial fragility caused by the housing bubble and unsound lending practices that fueled the bubble, the crisis could have been avoided but for a reflexive policy tightening by the Federal Reserve starting in 2007 that caused a recession starting in December 2007 and gradually worsening through the summer of 2008. Rather than ease monetary policy as the recession deepened, the Fed, distracted by rising headline inflation owing to rising oil prices that summer, would not reduce its interest-rate target further after March 2008. If my interpretation is correct, the financial crisis of 2008 and the subsequent Little Depression (aka Great Recession) were as much caused by bad monetary policy as by the unsound lending practices and mistaken expectations by lenders.

It is when all agents are cash constrained that a lender of last resort that is able to provide the liquidity that the usual suppliers of liquidity cannot provide, but are instead demanding, is necessary to avoid a systemic breakdown. In 2008, the Fed was unwilling to satisfy demands for liquidity until the crisis had deteriorated to the point of a worldwide collapse. In the nineteenth century, Thornton and Fullarton understood that the Bank of England was uniquely able to provide liquidity in such circumstances, recommending that it lend freely in periods of financial stress.

That policy was not viewed favorably either by Humean supporters of the Currency Principle, opposed to all forms of fractional-reserve banking, or by Smithian supporters of free banking who deplored the privileged central-banking position granted to the Bank of England. Although the Fed in 2008 acknowledged that it was both a national and international lender of last resort, it was tragically slow to take the necessary actions to end the crisis after allowing it to spiral nearly out of control.

While cogent arguments have been made that a free-banking alternative to the lender-of-last-resort services of the Bank of England might have been possible in the nineteenth century,[2] even a free-banking system would require a mechanism for handling periods of financial stress. Free-banking supporters argue that bank clearinghouses have emerged spontaneously in the absence of central banks, and could provide the lender-of-last resort services provided by central banks. But, insofar as bank clearinghouses would take on the lender-of-last-resort function, which involves some intervention and supervision of bank activities by either the clearinghouse or the central bank, the same anticompetitive or cartelistic objections to the provision of lender-of-last-resort services by central banks also would apply to the provision of those services by clearinghouses. So, the tension between libertarian, free-market principles and lender-of-last-resort services would not necessarily be eliminated bank clearinghouses instead of central banks provided those services.

This is an appropriate place to consider Walter Bagehot’s contribution to the lender-of-last-resort doctrine. Building on the work of Thornton and Fullarton, Bagehot formulated the classic principle that, during times of financial distress, the Bank of England should lend freely at a penalty rate to banks on good security. Bagehot, himself, admitted to a certain unease in offering this advice, opining that it was regrettable that the Bank of England achieved a pre-eminent position in the British banking system, so that a decentralized banking system, along the lines of the Scottish free-banking system, could have evolved. But given the historical development of British banking, including the 1844 Bank Charter Act, Bagehot, an eminently practical man, had no desire to recommend radical reform, only to help the existing system operate as smoothly as it could be made to operate.

But the soundness of Bagehot’s advice to lend freely at a penalty rate is dubious. In a financial crisis, the market rate of interest primarily reflects a liquidity premium not an expected real return on capital, the latter typically being depressed in a crisis. Charging a penalty rate to distressed borrowers in a crisis only raises the liquidity premium. Monetary policy ought to aim to reduce, not to increase, that premium. So Bagehot’s advice, derived from a misplaced sense of what is practical and prudent and financially sound, rather than from sound analysis, was far from sound.

Under the gold standard, or under any fixed-exchange-rate regime, a single country has an incentive to raise interest rates above the rates of other countries to prevent a gold outflow or attract an inflow. Under these circumstances, a failure of international cooperation can lead to competitive rate increases as monetary authorities scramble to maintain or increase their gold reserves. In testimony to the Macmillan Commission in 1930, Ralph Hawtrey masterfully described the obligation of a central bank in a crisis. Here is his exchange with the Chairman of the Commission Hugh Macmillan:

MACMILLAN: Suppose . . . without restricting credit . . . that gold had gone out to a very considerable extent, would that not have had very serious consequences on the international position of London?

HAWTREY: I do not think the credit of London depends on any particular figure of gold holding. . . . The harm began to be done in March and April of 1925 [when] the fall in American prices started. There was no reason why the Bank of England should have taken ny action at that time so far as the question of loss of gold is concerned. . . . I believed at the time and I still think that the right treatment would have been to restore the gold standard de facto before it was restored de jure. That is what all the other countries have done. . . . I would have suggested that we should have adopted the practice of always selling gold to a sufficient extent to prevent the exchange depreciating. There would have been no legal obligation to continue convertibility into gold . . . If that course had been adopted, the Bank of England would never have been anxious about the gold holding, they would have been able to see it ebb away to quite a considerable extent with perfect equanimity, . . and might have continued with a 4 percent Bank Rate.

MACMILLAN: . . . the course you suggest would not have been consistent with what one may call orthodox Central Banking, would it?

HAWTREY: I do not know what orthodox Central Banking is.

MACMILLAN: . . . when gold ebbs away you must restrict credit as a general principle?

HAWTREY: . . . that kind of orthodoxy is like conventions at bridge; you have to break them when the circumstances call for it. I think that a gold reserve exists to be used. . . . Perhaps once in a century the time comes when you can use your gold reserve for the governing purpose, provided you have the courage to use practically all of it.

Hawtrey here was echoing Fullarton’s insight that there is no rigid relationship between the gold reserves held by the Bank of England and the total quantity of sight liabilities created by the British banking system. Rather, he argued, the Bank should hold an ample reserve sufficient to satisfy the demand for gold in a crisis when a sudden and temporary demand for gold had to be accommodated. That was Hawtrey’s advice, but not Bagehot’s, whose concern was about banks’ moral hazard and imprudent lending in the expectation of being rescued in a crisis by the Bank of England. Indeed, moral hazard is a problem, but in a crisis it is a secondary problem, when, as Hawtrey explained, alleviating the crisis, not discouraging moral hazard, must be the primary concern of the lender of last resort.

            C         Scope of Banking

Inclined to find remedies for financial distress in structural reforms limiting the types of assets banks accept in exchange for their sight liabilities, Smith did not recommend a lender of last resort.[3] Another method of reducing risk, perhaps more in tune with the Smithian real-bills doctrine than a lender of last resort, is to restrict the activities of banks that issue banknotes and deposits.

In Anglophone countries, commercial banking generally evolved as separate and distinct from investment banking. It was only during the Great Depression and the resulting wave of bank failures that the combination of commercial and investment banking was legally prohibited by the Glass-Steagall Act, eventually repealed in 1999. On the Continent, where commercial banking penetrated less deeply into the fabric of economic and commercial life than in Anglophone countries, commercial banking developed more or less along with investment banking in what are called universal banks.

Whether the earlier, and more widespread, adoption of commercial banking in Anglophone countries than on the Continent advanced the idea that no banking institution should provide both commercial- and investment-banking services is not a question about which I offer a conjecture, but it seems a topic worthy of study. The Glass-Steagall Act, which enforced that separation after being breached early in the twentieth century, a breach thought by some to have contributed to US bank failures in the Great Depression, was based on a presumption against combining and investment-banking in a single institution. But even apart from the concerns that led to enactment of Glass-Steagall, limiting the exposure of commercial banks, which supply most of the cash held by the public, to the balance-sheet risk associated with investment-banking activities seems reasonable. Moreover, the adoption of government deposit insurance after the Great Depression as well as banks’ access to the discount window of the central bank may augment the moral hazard induced by deposit insurance and a lender of last resort, offsetting potential economies of scope associated with combining commercial and investment banking.

Although legal barriers to the combination of commercial and investment banking have long been eliminated, proposals for “narrow banking” that would restrict the activities undertaken by commercial banks continue to be made. Two different interpretations of narrow banking – one Smithian and one Humean – are possible.

The Humean concern about banking was that banks are inherently disposed to overissue their liabilities. The Humean response to the concern has been to propose 100-percent reserve banking, a comprehensive extension of the 100-percent marginal reserve requirement on the issue of banknotes imposed by the Bank Charter Act. Such measures could succeed, as some supporters (Simons 1936) came to realize, only if accompanied by a radical change the financial practices and arrangements on which all debt contracts are based. It is difficult to imagine that the necessary restructuring of economic activity would ever be implemented or tolerated.

The Humean concern was dismissed by the Smithian tradition, recognizing that banks, even if unconstrained by reserve requirements, have no incentive to issue liabilities without limit. The Smithian concern was whether banks could cope with balance-sheet risks after unexpected losses in the value of their assets. Although narrow banking proposals are a legitimate and possibly worthwhile response to that concern, the acceptance by central banks of responsibility to act as a lender of last resort and widespread government deposit insurance to dampen contagion effects have taken the question of narrowing or restricting the functions of money-creating banks off the table. Whether a different strategy for addressing the systemic risks associated with banks’ creation of money by relying solely on deposit insurance and a lender of last resort is a question that still deserves thoughtful attention.

On the Price Specie Flow Mechanism

I have been working on a paper tentatively titled “The Smithian and Humean Traditions in Monetary Theory.” One section of the paper is on the price-specie-flow mechanism, about which I wrote last month in my previous post. This section develops the arguments of the previous post at greater length and draws on a number of earlier posts that I’ve written about PSFM as well (e.g., here and here )provides more detailed criticisms of both PSFM and sterilization and provides some further historical evidence to support some of the theoretical arguments. I will be grateful for any comments and feedback.

The tortured intellectual history of the price-specie-flow mechanism (PSFM) received its still classic exposition in a Hume (1752) essay, which has remained a staple of the theory of international adjustment under the gold standard, or any international system of fixed exchange rates. Regrettably, the two-and-a-half-century life span of PSFM provides no ground for optimism about the prospects for progress in what some are pleased to call without irony economic science.

PSFM describes how, under a gold standard, national price levels tend to be equalized, with deviations between the national price levels in any two countries inducing gold to be shipped from the country with higher prices to the one with lower prices until prices are equalized. Premised on a version of the quantity theory of money in which (1) the price level in each country on the gold standard is determined by the quantity of money in that country, and (2) money consists entirely in gold coin or bullion, Hume elegantly articulated a model of disturbance and equilibration after an exogenous change in the gold stock in one country.

Viewing banks as inflationary engines of financial disorder, Hume disregarded banks and the convertible monetary liabilities of banks in his account of PSFM, leaving to others the task of describing the international adjustment process under a gold standard with fractional-reserve banking. The task of devising an institutional framework, within which PSFM could operate, for a system of fractional-reserve banking proved to be problematic and ultimately unsuccessful.

For three-quarters of a century, PSFM served a purely theoretical function. During the Bullionist debates of the first two decades of the nineteenth century, triggered by the suspension of the convertibility of the pound sterling into gold in 1797, PSFM served as a theoretical benchmark not a guide for policy, it being generally assumed that, when convertibility was resumed, international monetary equilibrium would be restored automatically.

However, the 1821 resumption was followed by severe and recurring monetary disorders, leading some economists, who formed what became known as the Currency School, to view PSFM as a normative criterion for ensuring smooth adjustment to international gold flows. That criterion, the Currency Principle, stated that the total currency in circulation in Britain should increase or decrease by exactly as much as the amount of gold flowing into or out of Britain.[1]

The Currency Principle was codified by the Bank Charter Act of 1844. To mimic the Humean mechanism, it restricted, but did not suppress, the right of note-issuing banks in England and Wales, which were allowed to continue issuing notes, at current, but no higher, levels, without holding equivalent gold reserves. Scottish and Irish note-issuing banks were allowed to continue issuing notes, but could increase their note issue only if matched by increased holdings of gold or government debt. In England and Wales, the note issue could increase only if gold was exchanged for Bank of England notes, so that a 100-percent marginal gold reserve requirement was imposed on additional banknotes.

Opposition to the Bank Charter Act was led by the Banking School, notably John Fullarton and Thomas Tooke. Rejecting the Humean quantity-theoretic underpinnings of the Currency School and the Bank Charter Act, the Banking School rejected the quantitative limits of the Bank Charter Act as both unnecessary and counterproductive, because banks, obligated to redeem their liabilities directly or indirectly in gold, issue liabilities only insofar as they expect those liabilities to be willingly held by the public, or, if not, are capable of redeeming any liabilities no longer willingly held. Rather than the Humean view that banks issue banknotes or create deposits without constraint, the Banking School held Smith’s view that banks issue money in a form more convenient to hold and to transact with than metallic money, so that bank money allows an equivalent amount of gold to be shifted from monetary to real (non-monetary) uses, providing a net social savings. For a small open economy, the diversion (and likely export) of gold bullion from monetary to non-monetary uses has negligible effect on prices (which are internationally, not locally, determined).

The quarter century following enactment of the Bank Charter Act showed that the Act had not eliminated monetary disturbances, the government having been compelled to suspend the Act in 1847, 1857 and 1866 to prevent incipient crises from causing financial collapse. Indeed, it was precisely the fear that liquidity might not be forthcoming that precipitated increased demands for liquidity that the Act made it impossible to accommodate. Suspending the Act was sufficient to end the crises with limited intervention by the Bank. [check articles on the crises of 1847, 1857 and 1866.]

It may seem surprising, but the disappointing results of the Bank Charter Act provided little vindication to the Banking School. It led only to a partial, uneasy, and not entirely coherent, accommodation between PSFM doctrine and the reality of a monetary system in which the money stock consists mostly of banknotes and bank deposits issued by fractional-reserve banks. But despite the failure of the Bank Charter Act, PSFM achieved almost canonical status, continuing, albeit with some notable exceptions, to serve as the textbook model of the gold standard.

The requirement that gold flows induce equal changes in the quantity of money within a country into (or from) which gold is flowing was replaced by an admonition that gold flows lead to “appropriate” changes in the central-bank discount rate or an alternative monetary instrument to cause the quantity of money to change in the same direction as the gold flow. While such vague maxims, sometimes described as “the rules of the game,” gave only directional guidance about how to respond to change in gold reserves, their hortatory character, and avoidance of quantitative guidance, allowed monetary authorities latitude to avoid the self-inflicted crises that had resulted from the quantitative limits of the Bank Charter Act.

Nevertheless, the myth of vague “rules” relating the quantity of money in a country to changes in gold reserves, whose observance ensured the smooth functioning of the international gold standard before its collapse at the start of World War I, enshrined PSFM as the theoretical paradigm for international monetary adjustment under the gold standard.

That paradigm was misconceived in four ways that can be briefly summarized.

  • Contrary to PSFM, changes in the quantity of money in a gold-standard country cannot change local prices proportionately, because prices of tradable goods in that country are constrained by arbitrage to equal the prices of those goods in other countries.
  • Contrary to PSFM, changes in local gold reserves are not necessarily caused either by non-monetary disturbances such as shifts in the terms of trade between countries or by local monetary disturbances (e.g. overissue by local banks) that must be reversed or counteracted by central-bank policy.
  • Contrary to PSFM, changes in the national price levels of gold-standard countries were uncorrelated with gold flows, and changes in national price levels were positively, not negatively, correlated.
  • Local banks and monetary authorities exhibit their own demands for gold reserves, demands exhibited by choice (i.e., independent of legally required gold holdings) or by law (i.e., by legally requirement to hold gold reserves equal to some fraction of banknotes issued by banks or monetary authorities). Such changes in gold reserves may be caused by changes in the local demands for gold by local banks and the monetary authorities in one or more countries.

Many of the misconceptions underlying PSFM were identified by Fullarton’s refutation of the Currency School. In articulating the classical Law of Reflux, he established the logical independence of the quantity convertible money in a country from by the quantity of gold reserves held by the monetary authority. The gold reserves held by individual banks, or their deposits with the Bank of England, are not the raw material from which banks create money, either banknotes or deposits. Rather, it is their creation of banknotes or deposits when extending credit to customers that generates a derived demand to hold liquid assets (i.e., gold) to allow them to accommodate the demands of customers and other banks to redeem banknotes and deposits. Causality runs from creating banknotes and deposits to holding reserves, not vice versa.

The misconceptions inherent in PSFM and the resulting misunderstanding of gold flows under the gold standard led to a further misconception known as sterilization: the idea that central banks, violating the obligations imposed by “the rules of the game,” do not allow, or deliberately prevent, local money stocks from changing as their gold holdings change. The misconception is the presumption that gold inflows ought necessarily cause increases in local money stocks. The mechanisms causing local money stocks to change are entirely different from those causing gold flows. And insofar as those mechanisms are related, causality flows from the local money stock to gold reserves, not vice versa.

Gold flows also result when monetary authorities transform their own asset holdings into gold. Notable examples of such transformations occurred in the 1870s when a number of countries abandoned their de jure bimetallic (and de facto silver) standards to the gold standard. Monetary authorities in those countries transformed silver holdings into gold, driving the value of gold up and silver down. Similarly, but with more catastrophic consequences, the Bank of France, in 1928 after France restored the gold standard, began redeeming holdings of foreign-exchange reserves (financial claims on the United States or Britain, payable in gold) into gold. Following the French example, other countries rejoining the gold standard redeemed foreign exchange for gold, causing gold appreciation and deflation that led to the Great Depression.

Rereading the memoirs of this splendid translation . . . has impressed me with important subtleties that I missed when I read the memoirs in a language not my own and in which I am far from completely fluent. Had I fully appreciated those subtleties when Anna Schwartz and I were writing our A Monetary History of the United States, we would likely have assessed responsibility for the international character of the Great Depression somewhat differently. We attributed responsibility for the initiation of a worldwide contraction to the United States and I would not alter that judgment now. However, we also remarked, “The international effects were severe and the transmission rapid, not only because the gold-exchange standard had rendered the international financial system more vulnerable to disturbances, but also because the United States did not follow gold-standard rules.” Were I writing that sentence today, I would say “because the United States and France did not follow gold-standard rules.”

I pause to note for the record Friedman’s assertion that the United States and France did not follow “gold-standard rules.” Warming up to the idea, he then accused them of sterilization.

Benjamin Strong and Emile Moreau were admirable characters of personal force and integrity. But . . .the common policies they followed were misguided and contributed to the severity and rapidity of transmission of the U.S. shock to the international community. We stressed that the U.S. “did not permit the inflow of gold to expand the U.S. money stock. We not only sterilized it, we went much further. Our money stock moved perversely, going down as the gold stock went up” from 1929 to 1931.

Strong and Moreau tried to reconcile two ultimately incompatible objectives: fixed exchange rates and internal price stability. Thanks to the level at which Britain returned to gold in 1925, the U.S. dollar was undervalued, and thanks to the level at which France returned to gold at the end of 1926, so was the French franc. Both countries as a result experienced substantial gold inflows. Gold-standard rules called for letting the stock of money rise in response to the gold inflows and for price inflation in the U.S. and France, and deflation in Britain, to end the over-and under-valuations. But both Strong and Moreau were determined to prevent inflation and accordingly both sterilized the gold inflows, preventing them from providing the required increase in the quantity of money.

Friedman’s discussion of sterilization is at odds with basic theory. Working with a naïve version of PSFM, he imagines that gold flows passively respond to trade balances independent of monetary forces, and that the monetary authority under a gold standard is supposed to ensure that the domestic money stock varies roughly in proportion to its gold reserves. Ignoring the international deflationary dynamic, he asserts that the US money stock perversely declined from 1929 to 1931, while its gold stock increased. With a faltering banking system, the public shifted from holding demand deposits to currency. Gold reserves were legally required against currency, but not against demand deposits, so the shift from deposits to currency entailed an increase gold reserves. To be sure the increased US demand for gold added to upward pressure on value of gold, and to worldwide deflationary pressure. But US gold holdings rose by only $150 million from December 1929 to December 1931 compared with an increase of $1.06 billion in French gold holdings over the same period. Gold accumulation by the US and its direct contribution to world deflation during the first two years of the Depression was small relative to that of France.

Friedman also erred in stating “the common policies they followed were misguided and contributed to the severity and rapidity of transmission of the U.S. shock to the international community.” The shock to the international community clearly originated not in the US but in France. The Fed could have absorbed and mitigated the shock by allowing a substantial outflow of its huge gold reserves, but instead amplified the shock by raising interest rates to nearly unprecedented levels, causing gold to flow into the US.

After correctly noting the incompatibility between fixed exchange rates and internal price stability, Friedman contradicts himself by asserting that, in seeking to stabilize their internal price levels, Strong and Moreau violated the gold-standard “rules,” as if it were rules, not arbitrage, that constrain national price to converge toward a common level under a gold standard.

Friedman’s assertion that, after 1925, the dollar was undervalued and sterling overvalued was not wrong. But he misunderstood the consequences of currency undervaluation and overvaluation under the gold standard, a confusion stemming from the underlying misconception, derived from PSFM, that foreign exchange rates adjust to balance trade flows, so that, in equilibrium, no country runs a trade deficit or trade surplus.

Thus, in Friedman’s view, dollar undervaluation and sterling overvaluation implied a US trade surplus and British trade deficit, causing gold to flow from Britain to the US. Under gold-standard “rules,” the US money stock and US prices were supposed to rise and the British money stock and British prices were supposed to fall until undervaluation and overvaluation were eliminated. Friedman therefore blamed sterilization of gold inflows by the Fed for preventing the necessary increase in the US money stock and price level to restore equilibrium. But, in fact, from 1925 through 1928, prices in the US were roughly stable and prices in Britain fell slightly. Violating gold-standard “rules” did not prevent the US and British price levels from converging, a convergence driven by market forces, not “rules.”

The stance of monetary policy in a gold-standard country had minimal effect on either the quantity of money or the price level in that country, which were mainly determined by the internationally determined value of gold. What the stance of national monetary policy determines under the gold standard is whether the quantity of money in the country adjusts to the quantity demanded by a process of domestic monetary creation or withdrawal or by the inflow or outflow of gold. Sufficiently tight domestic monetary policy restricting the quantify of domestic money causes a compensatory gold inflow increasing the domestic money stock, while sufficiently easy money causes a compensatory outflow of gold reducing the domestic money stock. Tightness or ease of domestic monetary policy under the gold standard mainly affected gold and foreign-exchange reserves, and, only minimally, the quantity of domestic money and the domestic price level.

However, the combined effects of many countries simultaneously tightening monetary policy in a deliberate, or even inadvertent, attempt to accumulate — or at least prevent the loss — of gold reserves could indeed drive up the international value of gold through a deflationary process affecting prices in all gold-standard countries. Friedman, even while admitting that, in his Monetary History, he had understated the effect of the Bank of France on the Great Depression, referred only the overvaluation of sterling and undervaluation of the dollar and franc as causes of the Great Depression, remaining oblivious to the deflationary effects of gold accumulation and appreciation.

It was thus nonsensical for Friedman to argue that the mistake of the Bank of France during the Great Depression was not to increase the quantity of francs in proportion to the increase of its gold reserves. The problem was not that the quantity of francs was too low; it was that the Bank of France prevented the French public from collectively increasing the quantity of francs that they held except by importing gold.

Unlike Friedman, F. A. Hayek actually defended the policy of the Bank of France, and denied that the Bank of France had violated “the rules of the game” after nearly quadrupling its gold reserves between 1928 and 1932. Under his interpretation of those “rules,” because the Bank of France increased the quantity of banknotes after the 1928 restoration of convertibility by about as much as its gold reserves increased, it had fully complied with the “rules.” Hayek’s defense was incoherent; under its legal obligation to convert gold into francs at the official conversion rate, the Bank of France had no choice but to increase the quantity of francs by as much as its gold reserves increased.

That eminent economists like Hayek and Friedman could defend, or criticize, the conduct of the Bank of France during the Great Depression, because the Bank either did, or did not, follow “the rules of the game” under which the gold standard operated, shows the uselessness and irrelevance of the “rules of the game” as a guide to policy. For that reason alone, the failure of empirical studies to find evidence that “the rules of the game” were followed during the heyday of the gold standard is unsurprising. But the deeper reason for that lack of evidence is that PSFM, whose implementation “the rules of the game” were supposed to guarantee, was based on a misunderstanding of the international-adjustment mechanism under either the gold standard or any fixed-exchange-rates system.

Despite the grip of PSFM over most of the profession, a few economists did show a deeper understanding of the adjustment mechanism. The idea that the price level in terms of gold directly constrained the movements of national price levels across countries was indeed recognized by writers as diverse as Keynes, Mises, and Hawtrey who all pointed out that the prices of internationally traded commodities were constrained by arbitrage and that the free movement of capital across countries would limit discrepancies in interest rates across countries attached to the gold standard, observations that had already been made by Smith, Thornton, Ricardo, Fullarton and Mill in the classical period. But, until the Monetary Approach to the Balance of Payments became popular in the 1970s, only Hawtrey consistently and systematically deduced the implications of those insights in analyzing both the Great Depression and the Bretton Woods system of fixed, but adjustable, exchange rates following World War II.

The inconsistencies and internal contradictions of PSFM were sometimes recognized, but usually overlooked, by business-cycle theorists when focusing on the disturbing influence of central banks, perpetuating mistakes of the Humean Currency School doctrine that attributed cyclical disturbances to the misbehavior of local banking systems that were inherently disposed to overissue their liabilities.

Graeber Against Economics

David Graeber’s vitriolic essay “Against Economics” in the New York Review of Books has generated responses from Noah Smith and Scott Sumner among others. I don’t disagree with much that Noah or Scott have to say, but I want to dig a little deeper than they did into some of Graeber’s arguments, because even though I think he is badly misinformed on many if not most of the subjects he writes about, I actually have some sympathy for his dissatisfaction with the current state of economics. Graeber wastes no time on pleasantries.

There is a growing feeling, among those who have the responsibility of managing large economies, that the discipline of economics is no longer fit for purpose. It is beginning to look like a science designed to solve problems that no longer exist.

A serious polemicist should avoid blatant mischaracterizations, exaggerations and cheap shots, and should be well-grounded in the object of his critique, thereby avoiding criticisms that undermine his own claims to expertise. I grant that  Graeber has some valid criticisms to make, even agreeing with him, at least in part, on some of them. But his indiscriminate attacks on, and caricatures of, all neoclassical economics betrays a superficial understanding of that discipline.

Graeber begins by attacking what he considers the misguided and obsessive focus on inflation by economists.

A good example is the obsession with inflation. Economists still teach their students that the primary economic role of government—many would insist, its only really proper economic role—is to guarantee price stability. We must be constantly vigilant over the dangers of inflation. For governments to simply print money is therefore inherently sinful.

Every currency unit, or banknote issued by a central bank, now in circulation, as Graeber must know, has been “printed.” So to say that economists consider it sinful for governments to print money is either a deliberate falsehood, or an emotional rhetorical outburst, as Graeber immediately, and apparently unwittingly, acknowledges!

If, however, inflation is kept at bay through the coordinated action of government and central bankers, the market should find its “natural rate of unemployment,” and investors, taking advantage of clear price signals, should be able to ensure healthy growth. These assumptions came with the monetarism of the 1980s, the idea that government should restrict itself to managing the money supply, and by the 1990s had come to be accepted as such elementary common sense that pretty much all political debate had to set out from a ritual acknowledgment of the perils of government spending. This continues to be the case, despite the fact that, since the 2008 recession, central banks have been printing money frantically [my emphasis] in an attempt to create inflation and compel the rich to do something useful with their money, and have been largely unsuccessful in both endeavors.

Graeber’s use of the ambiguous pronoun “this” beginning the last sentence of the paragraph betrays his own confusion about what he is saying. Central banks are printing money and attempting to “create” inflation while supposedly still believing that inflation is a menace and printing money is a sin. Go figure.

We now live in a different economic universe than we did before the crash. Falling unemployment no longer drives up wages. Printing money does not cause inflation. Yet the language of public debate, and the wisdom conveyed in economic textbooks, remain almost entirely unchanged.

Again showing an inadequate understanding of basic economic theory, Graeber suggests that, in theory if not practice, falling unemployment should cause wages to rise. The Philips Curve, upon which Graeber’s suggestion relies, represents the empirically observed negative correlation between the rate of average wage increase and the rate of unemployment. But correlation does not imply causation, so there is no basis in economic theory to assert that falling unemployment causes the rate of increase in wages to accelerate. That the empirical correlation between unemployment and wage increases has not recently been in evidence provides no compelling reason for changing textbook theory.

From this largely unfounded and attack on economic theory – a theory which I myself consider, in many respects, inadequate and unreliable – Graeber launches a bitter diatribe against the supposed hegemony of economists over policy-making.

Mainstream economists nowadays might not be particularly good at predicting financial crashes, facilitating general prosperity, or coming up with models for preventing climate change, but when it comes to establishing themselves in positions of intellectual authority, unaffected by such failings, their success is unparalleled. One would have to look at the history of religions to find anything like it.

The ability to predict financial crises would be desirable, but that cannot be the sole criterion for whether economics has advanced our understanding of how economic activity is organized or what effects policy changes have. (I note parenthetically that many economists defensively reject the notion that economic crises are predictable on the grounds that if economists could predict a future economic crisis, those predictions would be immediately self-fulfilling. This response, of course, effectively disproves the idea that economists could predict that an economic crisis would occur in the way that astronomers predict solar eclipses. But this response slays a strawman. The issue is not whether economists can predict future crises, but whether they can identify conditions indicating an increased likelihood of a crisis and suggest precautionary measures to reduce the likelihood that a potential crisis will occur. But Graeber seems uninterested in or incapable of engaging the question at even this moderate level of subtlety.)

In general, I doubt that economists can make more than a modest contribution to improved policy-making, and the best that one can hope for is probably that they steer us away from the worst potential decisions rather than identifying the best ones. But no one, as far as I know, has yet been burned at the stake by a tribunal of economists.

To this day, economics continues to be taught not as a story of arguments—not, like any other social science, as a welter of often warring theoretical perspectives—but rather as something more like physics, the gradual realization of universal, unimpeachable mathematical truths. “Heterodox” theories of economics do, of course, exist (institutionalist, Marxist, feminist, “Austrian,” post-Keynesian…), but their exponents have been almost completely locked out of what are considered “serious” departments, and even outright rebellions by economics students (from the post-autistic economics movement in France to post-crash economics in Britain) have largely failed to force them into the core curriculum.

I am now happy to register agreement with something that Graeber says. Economists in general have become overly attached to axiomatic and formalistic mathematical models that create a false and misleading impression of rigor and mathematical certainty. In saying this, I don’t dispute that mathematical modeling is an important part of much economic theorizing, but it should not exclude other approaches to economic analysis and discourse.

As a result, heterodox economists continue to be treated as just a step or two away from crackpots, despite the fact that they often have a much better record of predicting real-world economic events. What’s more, the basic psychological assumptions on which mainstream (neoclassical) economics is based—though they have long since been disproved by actual psychologists—have colonized the rest of the academy, and have had a profound impact on popular understandings of the world.

That heterodox economists have a better record of predicting economic events than mainstream economists is an assertion for which Graeber offers no evidence or examples. I would not be surprised if he could cite examples, but one would have to weigh the evidence surrounding those examples before concluding that predictions by heterodox economists were more accurate than those of their mainstream counterparts.

Graeber returns to the topic of monetary theory, which seems a particular bugaboo of his. Taking the extreme liberty of holding up Mrs. Theresa May as a spokesperson for orthodox economics, he focuses on her definitive 2017 statement that there is no magic money tree.

The truly extraordinary thing about May’s phrase is that it isn’t true. There are plenty of magic money trees in Britain, as there are in any developed economy. They are called “banks.” Since modern money is simply credit, banks can and do create money literally out of nothing, simply by making loans. Almost all of the money circulating in Britain at the moment is bank-created in this way.

What Graeber chooses to ignore is that banks do not operate magically; they make loans and create deposits in seeking to earn profits; their decisions are not magical, but are oriented toward making profits. Whether they make good or bad decisions is debatable, but the debate isn’t about a magical process; it’s a debate about theory and evidence. Graeber describe how he thinks that economists think about how banks create money, correctly observing that there is a debate about how that process works, but without understanding those differences or their significance.

Economists, for obvious reasons, can’t be completely oblivious to the role of banks, but they have spent much of the twentieth century arguing about what actually happens when someone applies for a loan. One school insists that banks transfer existing funds from their reserves, another that they produce new money, but only on the basis of a multiplier effect). . . Only a minority—mostly heterodox economists, post-Keynesians, and modern money theorists—uphold what is called the “credit creation theory of banking”: that bankers simply wave a magic wand and make the money appear, secure in the confidence that even if they hand a client a credit for $1 million, ultimately the recipient will put it back in the bank again, so that, across the system as a whole, credits and debts will cancel out. Rather than loans being based in deposits, in this view, deposits themselves were the result of loans.

The one thing it never seemed to occur to anyone to do was to get a job at a bank, and find out what actually happens when someone asks to borrow money. In 2014 a German economist named Richard Werner did exactly that, and discovered that, in fact, loan officers do not check their existing funds, reserves, or anything else. They simply create money out of thin air, or, as he preferred to put it, “fairy dust.”

Graeber is right that economists differ in how they understand banking. But the simple transfer-of-funds view, a product of the eighteenth century, was gradually rejected over the course of the nineteenth century; the money-multiplier view largely superseded it, enjoying a half-century or more of dominance as a theory of banking, still remains a popular way for introductory textbooks to explain how banking works, though it would be better if it were decently buried and forgotten. But since James Tobin’s classic essay “Commercial banks as creators of money” was published in 1963, most economists who have thought carefully about banking have concluded that the amount of deposits created by banks corresponds to the quantity of deposits that the public, given their expectations about the future course of the economy and the future course of prices, chooses to hold. The important point is that while a bank can create deposits without incurring more than the negligible cost of making a book-keeping, or an electronic, entry in a customer’s account, the creation of a deposit is typically associated with a demand by the bank to hold either reserves in its account with the Fed or to hold some amount of Treasury instruments convertible, on very short notice, into reserves at the Fed.

Graeber seems to think that there is something fundamental at stake for the whole of macroeconomics in the question whether deposits created loans or loans create deposits. I agree that it’s an important question, but not as significant as Graeber believes. But aside from that nuance, what’s remarkable is that Graeber actually acknowledges that the weight of professional opinion is on the side that says that loans create deposits. He thus triumphantly cites a report by Bank of England economists that correctly explained that banks create money and do so in the normal course of business by making loans.

Before long, the Bank of England . . . rolled out an elaborate official report called “Money Creation in the Modern Economy,” replete with videos and animations, making the same point: existing economics textbooks, and particularly the reigning monetarist orthodoxy, are wrong. The heterodox economists are right. Private banks create money. Central banks like the Bank of England create money as well, but monetarists are entirely wrong to insist that their proper function is to control the money supply.

Graeber, I regret to say, is simply exposing the inadequacy of his knowledge of the history of economics. Adam Smith in The Wealth of Nations explained that banks create money who, in doing so, saved the resources that would have been wasted on creating additional gold and silver. Subsequent economists from David Ricardo through Henry Thornton, J. S. Mill and R. G. Hawtrey were perfectly aware that banks can supply money — either banknotes or deposits — at less than the cost of mining and minting new coins, as they extend their credit in making loans to borrowers. So what is at issue, Graeber to the contrary notwithstanding, is not a dispute between orthodoxy and heterodoxy.

In fact, central banks do not in any sense control the money supply; their main function is to set the interest rate—to determine how much private banks can charge for the money they create.

Central banks set a rental price for reserves, thereby controlling the quantity of reserves into which bank deposits are convertible that is available to the economy. One way to think about that quantity is that the quantity of reserves along with the aggregate demand to hold reserves determines the exchange value of reserves and hence the price level; another way to think about it is that the interest rate or the implied policy stance of the central bank helps to determine the expectations of the public about the future course of the price level which is what determines – within some margin of error or range – what the future course of the price level will turn out to be.

Almost all public debate on these subjects is therefore based on false premises. For example, if what the Bank of England was saying were true, government borrowing didn’t divert funds from the private sector; it created entirely new money that had not existed before.

This is just silly. Funds may or may not be diverted from the private sector, but the total available resources to society is finite. If the central bank creates additional money, it creates additional claims to those resources and the creation of additional claims to resources necessarily has an effect on the prices of inputs and of outputs.

One might have imagined that such an admission would create something of a splash, and in certain restricted circles, it did. Central banks in Norway, Switzerland, and Germany quickly put out similar papers. Back in the UK, the immediate media response was simply silence. The Bank of England report has never, to my knowledge, been so much as mentioned on the BBC or any other TV news outlet. Newspaper columnists continued to write as if monetarism was self-evidently correct. Politicians continued to be grilled about where they would find the cash for social programs. It was as if a kind of entente cordiale had been established, in which the technocrats would be allowed to live in one theoretical universe, while politicians and news commentators would continue to exist in an entirely different one.

Even if we stipulate that this characterization of what the BBC and newspaper columnists believe is correct, what we would have — at best — is a commentary on the ability of economists to communicate their understanding of how the economy works to the intelligentsia that communicates to ordinary citizens. It is not in and of itself a commentary on the state of economic knowledge, inasmuch as Graeber himself concedes that most economists don’t accept monetarism. And that has been the case, as Noah Smith pointed out in his Bloomberg column on Graeber, since the early 1980s when the Monetarist experiment in trying to conduct monetary policy by controlling the monetary aggregates proved entirely unworkable and had to be abandoned as it was on the verge of precipitating a financial crisis.

Only after this long warmup decrying the sorry state of contemporary economic theory does Graeber begin discussing the book under review Money and Government by Robert Skidelsky.

What [Skidelsky] reveals is an endless war between two broad theoretical perspectives. . . The crux of the argument always seems to turn on the nature of money. Is money best conceived of as a physical commodity, a precious substance used to facilitate exchange, or is it better to see money primarily as a credit, a bookkeeping method or circulating IOU—in any case, a social arrangement? This is an argument that has been going on in some form for thousands of years. What we call “money” is always a mixture of both, and, as I myself noted in Debt (2011), the center of gravity between the two tends to shift back and forth over time. . . .One important theoretical innovation that these new bullion-based theories of money allowed was, as Skidelsky notes, what has come to be called the quantity theory of money (usually referred to in textbooks—since economists take endless delight in abbreviations—as QTM).

But these two perspectives are not mutually exclusive, and, depending on time, place, circumstances, and the particular problem that is the focus of attention, either of the two may be the appropriate paradigm for analysis.

The QTM argument was first put forward by a French lawyer named Jean Bodin, during a debate over the cause of the sharp, destablizing price inflation that immediately followed the Iberian conquest of the Americas. Bodin argued that the inflation was a simple matter of supply and demand: the enormous influx of gold and silver from the Spanish colonies was cheapening the value of money in Europe. The basic principle would no doubt have seemed a matter of common sense to anyone with experience of commerce at the time, but it turns out to have been based on a series of false assumptions. For one thing, most of the gold and silver extracted from Mexico and Peru did not end up in Europe at all, and certainly wasn’t coined into money. Most of it was transported directly to China and India (to buy spices, silks, calicoes, and other “oriental luxuries”), and insofar as it had inflationary effects back home, it was on the basis of speculative bonds of one sort or another. This almost always turns out to be true when QTM is applied: it seems self-evident, but only if you leave most of the critical factors out.

In the case of the sixteenth-century price inflation, for instance, once one takes account of credit, hoarding, and speculation—not to mention increased rates of economic activity, investment in new technology, and wage levels (which, in turn, have a lot to do with the relative power of workers and employers, creditors and debtors)—it becomes impossible to say for certain which is the deciding factor: whether the money supply drives prices, or prices drive the money supply.

As a matter of logic, if the value of money depends on the precious metals (gold or silver) from which coins were minted, the value of money is necessarily affected by a change in the value of the metals used to coin money. Because a large increase in the stock of gold and silver, as Graeber concedes, must reduce the value of those metals, subsequent inflation then being attributable, at least in part, to the gold and silver discoveries even if the newly mined gold and silver was shipped mainly to privately held Indian and Chinese hoards rather than minted into new coins. An exogenous increase in prices may well have caused the quantity of credit money to increase, but that is analytically distinct from the inflationary effect of a reduced value of gold or silver when, as was the case in the sixteenth century, money is legally defined as a specific weight of gold or silver.

Technically, this comes down to a choice between what are called exogenous and endogenous theories of money. Should money be treated as an outside factor, like all those Spanish dubloons supposedly sweeping into Antwerp, Dublin, and Genoa in the days of Philip II, or should it be imagined primarily as a product of economic activity itself, mined, minted, and put into circulation, or more often, created as credit instruments such as loans, in order to meet a demand—which would, of course, mean that the roots of inflation lie elsewhere?

There is no such choice, because any theory must posit certain initial conditions and definitions, which are given or exogenous to the analysis. How the theory is framed and which variables are treated as exogenous and which are treated as endogenous is a matter of judgment in light of the problem and the circumstances. Graeber is certainly correct that, in any realistic model, the quantity of money is endogenously, not exogenously, determined, but that doesn’t mean that the value of gold and silver may not usefully be treated as exogenous in a system in which money is defined as a weight of gold or silver.

To put it bluntly: QTM is obviously wrong. Doubling the amount of gold in a country will have no effect on the price of cheese if you give all the gold to rich people and they just bury it in their yards, or use it to make gold-plated submarines (this is, incidentally, why quantitative easing, the strategy of buying long-term government bonds to put money into circulation, did not work either). What actually matters is spending.

Graeber is talking in circles, failing to distinguish between the quantity theory of money – a theory about the value of a pure medium of exchange with no use except to be received in exchange — and a theory of the real value of gold and silver when money is defined as a weight of gold or silver. The value of gold (or silver) in monetary uses must be roughly equal to its value in non-monetary uses. which is determined by the total stock of gold and the demand to hold gold or to use it in coinage or for other uses (e.g., jewelry and ornamentation). An increase in the stock of gold relative to demand must reduce its value. That relationship between price and quantity is not the same as QTM. The quantity of a metallic money will increase as its value in non-monetary uses declines. If there is literally an unlimited demand for newly mined gold to be immediately sent unused into hoards, Graeber’s argument would be correct. But the fact that much of the newly mined gold initially went into hoards does not mean that all of the newly mined gold went into hoards.

In sum, Graeber is confused between the quantity theory of money and a theory of a commodity money used both as money and as a real commodity. The quantity theory of money of a pure medium of exchange posits that changes in the quantity of money cause proportionate changes in the price level. Changes in the quantity of a real commodity also used as money have nothing to do with the quantity theory of money.

Relying on a dubious account of the history of monetary theory by Skidelsky, Graeber blames the obsession of economists with the quantity theory for repeated monetary disturbances starting with the late 17th century deflation in Britain when silver appreciated relative to gold causing prices measured in silver to fall. Graeber thus fails to see that under a metallic money, real disturbances do have repercussion on the level of prices, repercussions having nothing to do with an exogenous prior change in the quantity of money.

According to Skidelsky, the pattern was to repeat itself again and again, in 1797, the 1840s, the 1890s, and, ultimately, the late 1970s and early 1980s, with Thatcher and Reagan’s (in each case brief) adoption of monetarism. Always we see the same sequence of events:

(1) The government adopts hard-money policies as a matter of principle.

(2) Disaster ensues.

(3) The government quietly abandons hard-money policies.

(4) The economy recovers.

(5) Hard-money philosophy nonetheless becomes, or is reinforced as, simple universal common sense.

There is so much indiscriminate generalization here that it is hard to know what to make of it. But the conduct of monetary policy has always been fraught, and learning has been slow and painful. We can and must learn to do better, but blanket condemnations of economics are unlikely to lead to better outcomes.

How was it possible to justify such a remarkable string of failures? Here a lot of the blame, according to Skidelsky, can be laid at the feet of the Scottish philosopher David Hume. An early advocate of QTM, Hume was also the first to introduce the notion that short-term shocks—such as Locke produced—would create long-term benefits if they had the effect of unleashing the self-regulating powers of the market:

Actually I agree that Hume, as great and insightful a philosopher as he was and as sophisticated an economic observer as he was, was an unreliable monetary theorist. And one of the reasons he was led astray was his unwarranted attachment to the quantity theory of money, an attachment that was not shared by his close friend Adam Smith.

Ever since Hume, economists have distinguished between the short-run and the long-run effects of economic change, including the effects of policy interventions. The distinction has served to protect the theory of equilibrium, by enabling it to be stated in a form which took some account of reality. In economics, the short-run now typically stands for the period during which a market (or an economy of markets) temporarily deviates from its long-term equilibrium position under the impact of some “shock,” like a pendulum temporarily dislodged from a position of rest. This way of thinking suggests that governments should leave it to markets to discover their natural equilibrium positions. Government interventions to “correct” deviations will only add extra layers of delusion to the original one.

I also agree that focusing on long-run equilibrium without regard to short-run fluctuations can lead to terrible macroeconomic outcomes, but that doesn’t mean that long-run effects are never of concern and may be safely disregarded. But just as current suffering must not be disregarded when pursuing vague and uncertain long-term benefits, ephemeral transitory benefits shouldn’t obscure serious long-term consequences. Weighing such alternatives isn’t easy, but nothing is gained by denying that the alternatives exist. Making those difficult choices is inherent in policy-making, whether macroeconomic or climate policy-making.

Although Graeber takes a valid point – that a supposed tendency toward an optimal long-run equilibrium does not justify disregard of an acute short-term problem – to an extreme, his criticism of the New Classical approach to policy-making that replaced the flawed mainstream Keynesian macroeconomics of the late 1970s is worth listening to. The New Classical approach self-consciously rejected any policy aimed at short-run considerations owing to a time-inconsistency paradox was based almost entirely on the logic of general-equilibrium theory and an illegitimate methodological argument rejecting all macroeconomic theories not rigorously deduced from the unarguable axiom of optimizing behavior by rational agents (and therefore not, in the official jargon, microfounded) as unscientific and unworthy of serious consideration in the brave New Classical world of scientific macroeconomics.

It’s difficult for outsiders to see what was really at stake here, because the argument has come to be recounted as a technical dispute between the roles of micro- and macroeconomics. Keynesians insisted that the former is appropriate to studying the behavior of individual households or firms, trying to optimize their advantage in the marketplace, but that as soon as one begins to look at national economies, one is moving to an entirely different level of complexity, where different sorts of laws apply. Just as it is impossible to understand the mating habits of an aardvark by analyzing all the chemical reactions in their cells, so patterns of trade, investment, or the fluctuations of interest or employment rates were not simply the aggregate of all the microtransactions that seemed to make them up. The patterns had, as philosophers of science would put it, “emergent properties.” Obviously, it was necessary to understand the micro level (just as it was necessary to understand the chemicals that made up the aardvark) to have any chance of understand the macro, but that was not, in itself, enough.

As an aisde, it’s worth noting that the denial or disregard of the possibility of any emergent properties by New Classical economists (of which what came to be known as New Keynesian economics is really a mildly schismatic offshoot) is nicely illustrated by the un-self-conscious alacrity with which the representative-agent approach was adopted as a modeling strategy in the first few generations of New Classical models. That New Classical theorists now insist that representative agency is not an essential to New Classical modeling is true, but the methodologically reductive nature of New Classical macroeconomics, in which all macroeconomic theories must be derived under the axiom of individually maximizing behavior except insofar as specific “frictions” are introduced by explicit assumption, is essential. (See here, here, and here)

The counterrevolutionaries, starting with Keynes’s old rival Friedrich Hayek . . . took aim directly at this notion that national economies are anything more than the sum of their parts. Politically, Skidelsky notes, this was due to a hostility to the very idea of statecraft (and, in a broader sense, of any collective good). National economies could indeed be reduced to the aggregate effect of millions of individual decisions, and, therefore, every element of macroeconomics had to be systematically “micro-founded.”

Hayek’s role in the microfoundations movement is important, but his position was more sophisticated and less methodologically doctrinaire than that of the New Classical macroeconomists, if for no other reason than that Hayek didn’t believe that macroeconomics should, or could, be derived from general-equilibrium theory. His criticism, like that of economists like Clower and Leijonhufvud, of Keynesian macroeconomics for being insufficiently grounded in microeconomic principles, was aimed at finding microeconomic arguments that could explain and embellish and modify the propositions of Keynesian macroeconomic theory. That is the sort of scientific – not methodological — reductivism that Hayek’s friend Karl Popper advocated: a theoretical and empirical challenge of reducing a higher level theory to its more fundamental foundations, e.g., when physicists and chemists search for theoretical breakthroughs that allow the propositions of chemistry to be reduced to more fundamental propositions of physics. The attempt to reduce chemistry to underlying physical principles is very different from a methodological rejection of all chemistry that cannot be derived from underlying deep physical theories.

There is probably more than a grain of truth in Graeber’s belief that there was a political and ideological subtext in the demand for microfoundations by New Classical macroeconomists, but the success of the microfoundations program was also the result of philosophically unsophisticated methodological error. How to apportion the share of blame going to mistaken methodology, professional and academic opportunism, and a hidden political agenda is a question worthy of further investigation. The easy part is to identify the mistaken methodology, which Graeber does. As for the rest, Graeber simply asserts bad faith, but with little evidence.

In Graeber’s comprehensive condemnation of modern economics, the efficient market hypothesis, being closely related to the rational-expectations hypothesis so central to New Classical economics, is not spared either. Here again, though I share and sympathize with his disdain for EMH, Graeber can’t resist exaggeration.

In other words, we were obliged to pretend that markets could not, by definition, be wrong—if in the 1980s the land on which the Imperial compound in Tokyo was built, for example, was valued higher than that of all the land in New York City, then that would have to be because that was what it was actually worth. If there are deviations, they are purely random, “stochastic” and therefore unpredictable, temporary, and, ultimately, insignificant.

Of course, no one is obliged to pretend that markets could not be wrong — and certainly not by a definition. The EMH simply asserts that the price of an asset reflects all the publicly available information. But what EMH asserts is certainly not true in many or even most cases, because people with non-public information (or with superior capacity to process public information) may affect asset prices, and such people may profit at the expense of those less knowledgeable or less competent in anticipating price changes. Moreover, those advantages may result from (largely wasted) resources devoted to acquiring and processing information, and it is those people who make fortunes betting on the future course of asset prices.

Graeber then quotes Skidelsky approvingly:

There is a paradox here. On the one hand, the theory says that there is no point in trying to profit from speculation, because shares are always correctly priced and their movements cannot be predicted. But on the other hand, if investors did not try to profit, the market would not be efficient because there would be no self-correcting mechanism. . .

Secondly, if shares are always correctly priced, bubbles and crises cannot be generated by the market….

This attitude leached into policy: “government officials, starting with [Fed Chairman] Alan Greenspan, were unwilling to burst the bubble precisely because they were unwilling to even judge that it was a bubble.” The EMH made the identification of bubbles impossible because it ruled them out a priori.

So the apparent paradox that concerns Skidelsky and Graeber dissolves upon (only a modest amount of) further reflection. Proper understanding and revision of the EMH makes it clear that bubbles can occur. But that doesn’t mean that bursting bubbles is a job that can be safely delegated to any agency, including the Fed.

Moreover, the housing bubble peaked in early 2006, two and a half years before the financial crisis in September 2008. The financial crisis was not unrelated to the housing bubble, which undoubtedly added to the fragility of the financial system and its vulnerability to macroeconomic shocks, but the main cause of the crisis was Fed policy that was unnecessarily focused on a temporary blip in commodity prices persuading the Fed not to loosen policy in 2008 during a worsening recession. That was a scenario similar to the one in 1929 when concern about an apparent stock-market bubble caused the Fed to repeatedly tighten money, raising interest rates, thereby causing a downturn and crash of asset prices triggering the Great Depression.

Graeber and Skidelsky correctly identify some of the problems besetting macroeconomics, but their indiscriminate attack on all economic theory is unlikely to improve the situation. A pity, because a focused and sophisticated critique of economics than they have served up has never been more urgently needed than it is now to enable economists to perform the modest service to mankind of which they might be capable.

What’s Wrong with the Price-Specie-Flow Mechanism? Part I

The tortured intellectual history of the price-specie-flow mechanism (PSFM), which received its classic exposition in an essay (“Of the Balance of Trade”) by David Hume about 275 years ago is not a history that, properly understood, provides solid grounds for optimism about the chances for progress in what we, somewhat credulously, call economic science. In brief, the price-specie-flow mechanism asserts that, under a gold or commodity standard, deviations between the price levels of those countries on the gold standard induce gold to be shipped from countries where prices are relatively high to countries where prices are relatively low, the gold flows continuing until price levels are equalized. Hence, the compound adjective “price-specie-flow,” signifying that the mechanism is set in motion by price-level differences that induce gold (specie) flows.

The PSFM is thus premised on a version of the quantity theory of money in which price levels in each country on the gold standard are determined by the quantity of money circulating in that country. In his account, Hume assumed that money consists entirely of gold, so that he could present a scenario of disturbance and re-equilibration strictly in terms of changes in the amount of gold circulating in each country. Inasmuch as Hume held a deeply hostile attitude toward banks, believing them to be essentially inflationary engines of financial disorder, subsequent interpretations of the PSFM had to struggle to formulate a more general theoretical account of international monetary adjustment to accommodate the presence of the fractional-reserve banking so detested by Hume and to devise an institutional framework that would facilitate operation of the adjustment mechanism under a fractional-reserve-banking system.

In previous posts on this blog (e.g., here, here and here) a recent article on the history of the (misconceived) distinction between rules and discretion, I’ve discussed the role played by the PSFM in one not very successful attempt at monetary reform, the English Bank Charter Act of 1844. The Bank Charter Act was intended to ensure the maintenance of monetary equilibrium by reforming the English banking system so that it would operate the way Hume described it in his account of the PSFM. However, despite the failings of the Bank Charter Act, the general confusion about monetary theory and policy that has beset economic theory for over two centuries has allowed PSFM to retain an almost canonical status, so that it continues to be widely regarded as the basic positive and normative model of how the classical gold standard operated. Using the PSFM as their normative model, monetary “experts” came up with the idea that, in countries with gold inflows, monetary authorities should reduce interest rates (i.e., lending rates to the banking system) causing monetary expansion through the banking system, and, in countries losing gold, the monetary authorities should do the opposite. These vague maxims described as the “rules of the game,” gave only directional guidance about how to respond to an increase or decrease in gold reserves, thereby avoiding the strict numerical rules, and resulting financial malfunctions, prescribed by the Bank Charter Act.

In his 1932 defense of the insane gold-accumulation policy of the Bank of France, Hayek posited an interpretation of what the rules of the game required that oddly mirrored the strict numerical rules of the Bank Charter Act, insisting that, having increased the quantity of banknotes by about as much its gold reserves had increased after restoration of the gold convertibility of the franc, the Bank of France had done all that the “rules of the game” required it to do. In fairness to Hayek, I should note that decades after his misguided defense of the Bank of France, he was sharply critical of the Bank Charter Act. At any rate, the episode indicates how indefinite the “rules of the game” actually were as a guide to policy. And, for that reason alone, it is not surprising that evidence that the rules of the game were followed during the heyday of the gold standard (roughly 1880 to 1914) is so meager. But the main reason for the lack of evidence that the rules of the game were actually followed is that the PSFM, whose implementation the rules of the game were supposed to guarantee, was a theoretically flawed misrepresentation of the international-adjustment mechanism under the gold standard.

Until my second year of graduate school (1971-72), I had accepted the PSFM as a straightforward implication of the quantity theory of money, endorsed by such luminaries as Hayek, Friedman and Jacob Viner. I had taken Axel Leijonhufvud’s graduate macro class in my first year, so in my second year I audited Earl Thompson’s graduate macro class in which he expounded his own unique approach to macroeconomics. One of the first eye-opening arguments that Thompson made was to deny that the quantity theory of money is relevant to an economy on the gold standard, the kind of economy (allowing for silver and bimetallic standards as well) that classical economics, for the most part, dealt with. It was only after the Great Depression that fiat money was widely accepted as a viable system for the long-term rather than a mere temporary wartime expedient.

What determines the price level for a gold-standard economy? Thompson’s argument was simple. The value of gold is determined relative to every other good in the economy by exactly the same forces of supply and demand that determine relative prices for every other real good. If gold is the standard, or numeraire, in terms of which all prices are quoted, then the nominal price of gold is one (the relative price of gold in terms of itself). A unit of currency is specified as a certain quantity of gold, so the price level measure in terms of the currency unit varies inversely with the value of gold. The amount of money in such an economy will correspond to the amount of gold, or, more precisely, to the amount of gold that people want to devote to monetary, as opposed to real (non-monetary), uses. But financial intermediaries (banks) will offer to exchange IOUs convertible on demand into gold for IOUs of individual agents. The IOUs of banks have the property that they are accepted in exchange, unlike the IOUs of individual agents which are not accepted in exchange (not strictly true as bills of exchange have in the past been widely accepted in exchange). Thus, the amount of money (IOUs payable on demand) issued by the banking system depends on how much money, given the value of gold, the public wants to hold; whenever people want to hold more money than they have on hand, they obtain additional money by exchanging their own IOUs – not accepted in payment — with a bank for a corresponding amount of the bank’s IOUs – which are accepted in payment.

Thus, the simple monetary theory that corresponds to a gold standard starts with a value of gold determined by real factors. Given the public’s demand to hold money, the banking system supplies whatever quantity of money is demanded by the public at a price level corresponding to the real value of gold. This monetary theory is a theory of an ideal banking system producing a competitive supply of money. It is the basic monetary paradigm of Adam Smith and a significant group of subsequent monetary theorists who formed the Banking School (and also the Free Banking School) that opposed the Currency School doctrine that provided the rationale for the Bank Charter Act. The model is highly simplified and based on assumptions that aren’t necessarily fulfilled always or even at all in the real world. The same qualification applies to all economic models, but the realism of the monetary model is certainly open to question.

So under the ideal gold-standard model described by Thompson, what was the mechanism of international monetary adjustment? All countries on the gold standard shared a common price level, because, under competitive conditions, prices for any tradable good at any two points in space can deviate by no more than the cost of transporting that product from one point to the other. If geographic price differences are constrained by transportation costs, then the price effects of an increased quantity of gold at any location cannot be confined to prices at that location; arbitrage spreads the price effect at one location across the whole world. So the basic premise underlying the PSFM — that price differences across space resulting from any disturbance to the equilibrium distribution of gold would trigger equilibrating gold shipments to equalize prices — is untenable; price differences between any two points are always constrained by the cost of transportation between those points, whatever the geographic distribution of gold happens to be.

Aside from the theoretical point that there is a single world price level – actually it’s more correct to call it a price band reflecting the range of local price differences consistent with arbitrage — that exists under the gold standard, so that the idea that local prices vary in proportion to the local money stock is inconsistent with standard price theory, Thompson also provided an empirical refutation of the PSFM. According to the PSFM, when gold is flowing into one country and out of another, the price levels in the two countries should move in opposite directions. But the evidence shows that price-level changes in gold-standard countries were highly correlated even when gold flows were in the opposite direction. Similarly, if PSFM were correct, cyclical changes in output and employment should have been correlated with gold flows, but no such correlation between cyclical movements and gold flows is observed in the data. It was on this theoretical foundation that Thompson built a novel — except that Hawtrey and Cassel had anticipated him by about 50 years — interpretation of the Great Depression as a deflationary episode caused by a massive increase in the demand for gold between 1929 and 1933, in contrast to Milton Friedman’s narrative that explained the Great Depression in terms of massive contraction in the US money stock between 1929 and 1933.

Thompson’s ideas about the gold standard, which he had been working on for years before I encountered them, were in the air, and it wasn’t long before I encountered them in the work of Harry Johnson, Bob Mundell, Jacob Frenkel and others at the University of Chicago who were then developing what came to be known as the monetary approach to the balance of payments. Not long after leaving UCLA in 1976 for my first teaching job, I picked up a volume edited by Johnson and Frenkel with the catchy title The Monetary Approach to the Balance of Payments. I studied many of the papers in the volume, but only two made a lasting impression, the first by Johnson and Frenkel “The Monetary Approach to the Balance of Payments: Essential Concepts and Historical Origins,” and the last by McCloskey and Zecher, “How the Gold Standard Really Worked.” Reinforcing what I had learned from Thompson, the papers provided a deeper understanding of the relevant history of thought on the international-monetary-adjustment  mechanism, and the important empirical and historical evidence that contradicts the PSFM. I also owe my interest in Hawtrey to the Johnson and Frenkel paper which cites Hawtrey repeatedly for many of the basic concepts of the monetary approach, especially the existence of a single arbitrage-constrained international price level under the gold standard.

When I attended the History of Economics Society Meeting in Toronto a couple of weeks ago, I had the  pleasure of meeting Deirdre McCloskey for the first time. Anticipating that we would have a chance to chat, I reread the 1976 paper in the Johnson and Frenkel volume and a follow-up paper by McCloskey and Zecher (“The Success of Purchasing Power Parity: Historical Evidence and Its Implications for Macroeconomics“) that appeared in a volume edited by Michael Bordo and Anna Schwartz, A Retrospective on the Classical Gold Standard. We did have a chance to chat and she did attend the session at which I talked about Friedman and the gold standard, but regrettably the chat was not a long one, so I am going to try to keep the conversation going with this post, and the next one in which I will discuss the two McCloskey and Zecher papers and especially the printed comment to the later paper that Milton Friedman presented at the conference for which the paper was written. So stay tuned.

PS Here is are links to Thompson’s essential papers on monetary theory, “The Theory of Money and Income Consistent with Orthodox Value Theory” and “A Reformulation of Macroeconomic Theory” about which I have written several posts in the past. And here is a link to my paper “A Reinterpretation of Classical Monetary Theory” showing that Earl’s ideas actually captured much of what classical monetary theory was all about.

Samuelson Rules the Seas

I think Nick Rowe is a great economist; I really do. And on top of that, he recently has shown himself to be a very brave economist, fearlessly claiming to have shown that Paul Samuelson’s classic 1980 takedown (“A Corrected Version of Hume’s Equilibrating Mechanisms for International Trade“) of David Hume’s classic 1752 articulation of the price-specie-flow mechanism (PSFM) (“Of the Balance of Trade“) was all wrong. Although I am a great admirer of Paul Samuelson, I am far from believing that he was error-free. But I would be very cautious about attributing an error in pure economic theory to Samuelson. So if you were placing bets, Nick would certainly be the longshot in this match-up.

Of course, I should admit that I am not an entirely disinterested observer of this engagement, because in the early 1970s, long before I discovered the Samuelson article that Nick is challenging, Earl Thompson had convinced me that Hume’s account of PSFM was all wrong, the international arbitrage of tradable-goods prices implying that gold movements between countries couldn’t cause the relative price levels of those countries in terms of gold to deviate from a common level, beyond the limits imposed by the operation of international commodity arbitrage. And Thompson’s reasoning was largely restated in the ensuing decade by Jacob Frenkel and Harry Johnson (“The Monetary Approach to the Balance of Payments: Essential Concepts and Historical Origins”) and by Donald McCloskey and Richard Zecher (“How the Gold Standard Really Worked”) both in the 1976 volume on The Monetary Approach to the Balance of Payments edited by Johnson and Frenkel, and by David Laidler in his essay “Adam Smith as a Monetary Economist,” explaining why in The Wealth of Nations Smith ignored his best friend Hume’s classic essay on PSFM. So the main point of Samuelson’s takedown of Hume and the PSFM was not even original. What was original about Samuelson’s classic article was his dismissal of the rationalization that PSFM applies when there are both non-tradable and tradable goods, so that national price levels can deviate from the common international price level in terms of tradables, showing that the inclusion of tradables into the analysis serves only to slow down the adjustment process after a gold-supply shock.

So let’s follow Nick in his daring quest to disprove Samuelson, and see where that leads us.

Assume that durable sailing ships are costly to build, but have low (or zero for simplicity) operating costs. Assume apples are the only tradeable good, and one ship can transport one apple per year across the English Channel between Britain and France (the only countries in the world). Let P be the price of apples in Britain, P* be the price of apples in France, and R be the annual rental of a ship, (all prices measured in gold), then R=ABS(P*-P).

I am sorry to report that Nick has not gotten off to a good start here. There cannot be only tradable good. It takes two tango and two to trade. If apples are being traded, they must be traded for something, and that something is something other than apples. And, just to avoid misunderstanding, let me say that that something is also something other than gold. Otherwise, there couldn’t possibly be a difference between the Thompson-Frenkel-Johnson-McCloskey-Zecher-Laidler-Samuelson critique of PSFM and the PSFM. We need at least three goods – two real goods plus gold – providing a relative price between the two real goods and two absolute prices quoted in terms of gold (the numeraire). So if there are at least two absolute prices, then Nick’s equation for the annual rental of a ship R must be rewritten as follows R=ABS[P(A)*-P(A)+P(SE)*-P(SE)], where P(A) is the price of apples in Britain, P(A)* is the price of apples in France, P(SE) is the price of something else in Britain, and P(SE)* is the price of that same something else in France.

OK, now back to Nick:

In this model, the Law of One Price (P=P*) will only hold if the volume of exports of apples (in either direction) is unconstrained by the existing stock of ships, so rentals on ships are driven to zero. But then no ships would be built to export apples if ship rentals were expected to be always zero, which is a contradiction of the Law of One Price because arbitrage is impossible without ships. But an existing stock of ships represents a sunk cost (sorry) and they keep on sailing even as rentals approach zero. They sail around Samuelson’s Iceberg model (sorry) of transport costs.

This is a peculiar result in two respects. First, it suggests, perhaps inadvertently, that the law of price requires equality between the prices of goods in every location when in fact it only requires that prices in different locations not differ by more than the cost of transportation. The second, more serious, peculiarity is that with only one good being traded the price difference in that single good between the two locations has to be sufficient to cover the cost of building the ship. That suggests that there has to be a very large price difference in that single good to justify building the ship, but in fact there are at least two goods being shipped, so it is the sum of the price differences of the two goods that must be sufficient to cover the cost of building the ship. The more tradable goods there are, the smaller the price differences in any single good necessary to cover the cost of building the ship.

Again, back to Nick:

Start with zero exports, zero ships, and P=P*. Then suppose, like Hume, that some of the gold in Britain magically disappears. (And unlike Hume, just to keep it simple, suppose that gold magically reappears in France.)

Uh-oh. Just to keep it simple? I don’t think so. To me, keeping it simple would mean looking at one change in initial conditions at a time. The one relevant change – the one discussed by Hume – is a reduction in the stock of gold in Britain. But Nick is looking at two changes — a reduced stock of gold in Britain and an increased stock of gold in France — simultaneously. Why does it matter? Because the key point at issue is whether a national price level – i.e, Britain’s — can deviate from the international price level. In Nick’s two-country example, there should be one national price level and one international price level, which means that the only price level subject to change as a result of the change in initial conditions should be, as in Hume’s example, the British price level, while the French price level – representing the international price level – remained constant. In a two-country model, this can only be made plausible by assuming that France is large compared to Britain, so that a loss of gold could potentially affect the British price level without changing the French price level. Once again back to Nick.

The price of apples in Britain drops, the price of apples in France rises, and so the rent on a ship is now positive because you can use it to export apples from Britain to France. If that rent is big enough, and expected to stay big long enough, some ships will be built, and Britain will export apples to France in exchange for gold. Gold will flow from France to Britain, so the stock of gold will slowly rise in Britain and slowly fall in France, and the price of apples will likewise slowly rise in Britain and fall in France, so ship rentals will slowly fall, and the price of ships (the Present Value of those rents) will eventually fall below the cost of production, so no new ships will be built. But the ships already built will keep on sailing until rentals fall to zero or they rot (whichever comes first).

So notice what Nick has done. Instead of confronting the Thompson-Frenkel-Johnson-McCloseky-Zecher-Laidler-Samuelson critique of Hume, which asserts that a world price level determines the national price level, Nick has simply begged the question by not assuming that the world price of gold, which determines the world price level, is constant. Instead, he posits a decreased value of gold in France, owing to an increased French stock of gold, and an increased value of gold in Britain, owing to a decreased British stock of gold, and then conflating the resulting adjustment in the value gold with the operation of commodity arbitrage. Why Nick thinks his discussion is relevant to the Thompson-Frenkel-Johnson-McCloseky-Zecher-Laidler-Samuelson critique escapes me.

The flow of exports and hence the flow of specie is limited by the stock of ships. And only a finite number of ships will be built. So we observe David Hume’s price-specie flow mechanism playing out in real time.

This bugs me. Because it’s all sorta obvious really.

Yes, it bugs me, too. And, yes, it is obvious. But why is it relevant to the question under discussion, which is whether there is an international price level in terms of gold that constrains movements in national price levels in countries in which gold is the numeraire. In other words, if there is a shock to the gold stock of a small open economy, how much will the price level in that small open economy change? By the percentage change in the stock of gold in that country – as Hume maintained – or by the minisicule percentage change in the international stock of gold, gold prices in the country that has lost gold being constrained from changing by more than allowed by the cost of arbitrage operations? Nick’s little example is simply orthogonal to the question under discussion.

I skip Nick’s little exegetical discussion of Hume’s essay and proceed to what I think is the final substantive point that Nick makes.

Prices don’t just arbitrage themselves. Even if we take the limit of my model, as the cost of building ships approaches zero, we need to explain what process ensures the Law of One Price holds in equilibrium. Suppose it didn’t…then people would buy low and sell high… know the rest.

There are different equilibrium conditions being confused here. The equilibrium arbitrage conditions are not same as the equilibrium conditions for international monetary equilibrium. Arbitrage conditions for individual commodities can hold even if the international distribution of gold is not in equilibrium. So I really don’t know what conclusion Nick is alluding to here.

But let me end on what I hope is a conciliatory and constructive note. As always, Nick is making an insightful argument, even if it is misplaced in the context of Hume and PSFM. And the upshot of Nick’s argument is that transportation costs are a function of the dispersion of prices, because, as the incentive to ship products to capture arbitrage profits increases, the cost of shipping will increase as arbitragers bid up the value of resources specialized to the processes of transporting stuff. So the assumption that the cost of transportation can be treated as a parameter is not really valid, which means that the constraints imposed on national price level movements are not really parametric, they are endongenously determined within an appropriately specified general equilibrium model. If Nick is willing to settle for that proposition, I don’t think that our positions are that far apart.

Where Do Monetary Rules Come From and How Do They Work?

In my talk last week at the Mercatus Conference on Monetary Rules for a Post-Crisis World, I discussed how monetary rules and the thinking about monetary rules have developed over time. The point that I started with was that monetary rules become necessary only when the medium of exchange has a value that exceeds the cost of producing the medium of exchange. You don’t need a monetary rule if money is a commodity; people just trade stuff for stuff; it’s not barter, because everyone accepts one real commodity, making that commodity the medium of exchange. But there’s no special rule governing the monetary system beyond the rules that govern all forms of exchange. the first monetary rule came along only when something worth more than its cost of production was used as money. This might have happened when people accepted minted coins at face value, even though the coins were not full-bodied. But that situation was not a stable equilibrium, because eventually Gresham’s Law kicks in, and the bad money drives out the good, so that the value of coins drops to their metallic value rather than their face value. So no real monetary rule was operating to control the value of coinage in situations where the coinage was debased.

So the idea of an actual monetary rule to govern the operation of a monetary system only emerged when banks started to issue banknotes. Banknotes having a negligible cost of production, a value in excess of that negligible cost could be imparted to those essentially worthless banknotes only by banks undertaking a commitment — a legally binding obligation — to make those banknotes redeemable (convertible) for a fixed weight of gold or silver or some other valuable material whose supply was not under the control of the bank itself. This convertibility commitment can be thought of as a kind of rule, but convertibility was not originally undertaken as a policy rule; it was undertaken simply as a business expedient; it was the means by which banks could create a demand for the banknotes that they wanted to issue to borrowers so that they could engage in the profitable business of financial intermediation.

It was in 1797, during the early stages of the British-French wars after the French Revolution, when, the rumor of a French invasion having led to a run on Bank of England notes, the British government prohibited the Bank of England from redeeming its banknotes for gold, and made banknotes issued by the Bank of England legal tender. The subsequent premium on gold in Continental commodity markets in terms of sterling – what was called the high price of bullion – led to a series of debates which engaged some of the finest economic minds in Great Britain – notably David Ricardo and Henry Thornton – over the causes and consequences of the high price of bullion and, if a remedy was in fact required, the appropriate policy steps to be taken to administer that remedy.

There is a vast literature on the many-sided Bullionist debates as they are now called, but my only concern here is with the final outcome of the debates, which was the appointment of a Parliamentary Commission, which included none other than the great Henry Thornton, himself, and two less renowned colleagues, William Huskisson and Francis Horner, who collaborated to write a report published in 1811 recommending the speedy restoration of convertibility of Bank of England notes. The British government and Parliament were unwilling to follow the recommendation while war with France was ongoing, however, there was a broad consensus in favor of the restoration of convertibility once the war was over.

After Napoleon’s final defeat in 1815, the process of restoring convertibility was begun with the intention of restoring the pre-1797 conversion rate between banknotes and gold. Parliament in fact enacted a statute defining the pound sterling as a fixed weight of gold. By 1819, the value of sterling had risen to its prewar level, and in 1821 the legal obligation of the Bank of England to convert its notes into gold was reinstituted. So the first self-consciously adopted monetary rule was the Parliamentary decision to restore the convertibility of banknotes issued by the Bank of England into a fixed weight of gold.

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. To explain the occurrence of these unexpected financial crises and periods of severe economic distress, a group of monetary theorists advanced a theory based on David Hume’s discussion of the price-specie-flow mechanism in his essay “Of the Balance of Trade,” in which he explained the automatic tendency toward equilibrium in the balance of trade and stocks of gold and precious metals among nations. Hume carried out his argument in terms of a fully metallic (gold) currency, and, in other works, Hume decried the tendency of banks to issue banknotes to excess, thereby causing inflation and economic disturbances.

So the conclusion drawn by these monetary theorists was that the Humean adjustment process would work smoothly only if gold shipments into Britain or out of Britain would result in a reduction or increase in the quantity of banknotes exactly equal to the amount of gold flowing into or out of Britain. It was the failure of the Bank of England and the other British banks to follow the Currency Principle – the idea that the total amount of currency in the country should change by exactly the same amount as the total quantity of gold reserves in the country – that had caused the economic crises and disturbances marking the two decades since the resumption of convertibility in 1821.

Those advancing this theory of economic fluctuations and financial crises were known as the Currency School and they succeeded in persuading Sir Robert Peel, the Prime Minister to support legislation to require the Bank of England and the other British Banks to abide by the Currency Principle. This was done by capping the note issue of all banks other than the Bank of England at existing levels and allowing the Bank of England to increase its issue of banknotes only upon deposit of a corresponding quantity of gold bullion. The result was in effect to impose a 100% marginal reserve requirement on the entire British banking system. Opposition to the Currency School largely emanated from what came to be known as the Banking School, whose most profound theorist was John Fullarton who formulated the law of reflux, which focused attention on the endogenous nature of the issue of banknotes by commercial banks. According to Fullarton and the Banking School, the issue of banknotes by the banking system was not a destabilizing and disequilibrating disturbance, but a response to the liquidity demands of traders and dealers. Once these liquidity demands were satisfied, the excess banknotes, returning to the banks in the ordinary course of business, would be retired from circulation unless there was a further demand for liquidity from some other source.

The Humean analysis, abstracting from any notion of a demand for liquidity, was therefore no guide to the appropriate behavior of the quantity of banknotes. Imposing a 100% marginal reserve requirement on the supply of banknotes would make it costly for traders and dealers to satisfy their demands for liquidity in times of financial stress; rather than eliminate monetary disturbances, the statutory enactment of the Currency Principle would be an added source of financial disturbance and disorder.

With the support of Robert Peel and his government, the arguments of the Currency School prevailed, and the Bank Charter Act was enacted in 1844. In 1847, despite the hopes of its supporters that an era of financial tranquility would follow, a new financial crisis occurred, and the crisis was not quelled until the government suspended the Bank Charter Act, thereby enabling the Bank of England to lend to dealers and traders to satisfy their demands for liquidity. Again in 1857 and in 1866, crises occurred which could not be brought under control before the government suspended the Bank Charter Act.

So British monetary history in the first half of the nineteenth century provides us with two paradigms of monetary rules. The first is a price rule in which the value of a monetary instrument is maintained at a level above its cost of production by way of a convertibility commitment. Given the convertibility commitment, the actual quantity of the monetary instrument that is issued is whatever quantity the public wishes to hold. 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.

The second rule is a quantity rule in which the gold standard is forced to operate in a way that prevents the money supply from adjusting freely to variations in the demand for money. Such a rule makes sense only if one ignores or denies the possibility that the demand for money can change suddenly and unpredictably. The quantity rule is neither necessary nor sufficient for the gold standard or any monetary standard to operate. In fact, it is an implicit assertion that the gold standard or any metallic standard cannot operate, the operation of profit-seeking private banks and their creation of banknotes and deposits being inconsistent with the maintenance of a gold standard. But this is really a demand for abolition of the gold standard in which banknotes and deposits draw their value from a convertibility commitment and its replacement by a pure gold currency in which there is no distinction between gold and banknotes or deposits, banknotes and deposits being nothing more than a receipt for an equivalent physical amount of gold held in reserve. That is the monetary system that the Currency School aimed at achieving. However, imposing the 100% reserve requirement only on banknotes, they left deposits unconstrained, thereby paving the way for a gradual revolution in the banking practices of Great Britain between 1844 and about 1870, so that by 1870 the bulk of cash held in Great Britain was held in the form of deposits not banknotes and the bulk of business transactions in Britain were carried out by check not banknotes.

So Milton Friedman was working entirely within the Currency School monetary tradition, formulating a monetary rule in terms of a fixed quantity rather than a fixed price. And, in ultimately rejecting the gold standard, Friedman was merely following the logic of the Currency School to its logical conclusion, because what ultimately matters is the quantity rule not the price rule. For the Currency School, the price rule was redundant, a fifth wheel; the real work was done by the 100% marginal reserve requirement. Friedman therefore saw the gold standard as an unnecessary and even dangerous distraction from the ultimate goal of keeping the quantity of money under strict legal control.

It is in the larger context of Friedman’s position on 100% reserve banking, of which he remained an advocate until he shifted to the k-percent rule in the early 1960s, that his anomalous description of the classical gold standard of late nineteenth century till World War I as a pseudo-gold standard can be understood. What Friedman described as a real gold standard was a system in which only physical gold and banknotes and deposits representing corresponding holdings of physical gold circulate as media of exchange. But this is not a gold standard that has ever existed, so what Friedman called a real gold standard was actually just the gold standard of his hyperactive imagination.

Did David Hume Discover the Vertical Phillips Curve?

In my previous post about Nick Rowe and Milton Friedman, I pointed out to Nick Rowe that Friedman (and Phelps) did not discover the argument that the long-run Phillips Curve, defined so that every rate of inflation is correctly expected, is vertical. The argument I suggested can be traced back at least to Hume. My claim on Hume’s behalf was based on my vague recollection that Hume distinguished between the effect of a high price level and a rising price level, a high price level having no effect on output and employment, while a rising price level increases output and employment.

Scott Sumner offered the following comment, leaving it as an exercise for the reader to figure out what he meant by “didn’t quite get there.”:

As you know Friedman is one of the few areas where we disagree. Here I’ll just address one point, the expectations augmented Phillips Curve. Although I love Hume, he didn’t quite get there, although he did discuss the simple Phillips Curve.

I wrote the following response to Scott referring to the quote that I was thinking of without quoting it verbatim (because I couldn’t remember where to find it):

There is a wonderful quote by Hume about how low prices or high prices are irrelevant to total output, profits and employment, but that unexpected increases in prices are a stimulus to profits, output, and employment. I’ll look for it, and post it.

Nick Rowe then obligingly provided the quotation I was thinking of (but not all of it):

Here, to my mind, is the “money quote” (pun not originally intended) from David Hume’s “Of Money”:

“From the whole of this reasoning we may conclude, that it is of no manner of consequence, with regard to the domestic happiness of a state, whether money be in a greater or less quantity. The good policy of the magistrate consists only in keeping it, if possible, still encreasing; because, by that means, he keeps alive a spirit of industry in the nation, and encreases the stock of labour, in which consists all real power and riches.”

The first sentence is fine. But the second sentence is very clearly a problem.

Was it Friedman who said “we have only advanced one derivative since Hume”?

OK, so let’s see the whole relevant quotation from Hume’s essay “Of Money.”

Accordingly we find, that, in every kingdom, into which money begins to flow in greater abundance than formerly, everything takes a new face: labour and industry gain life; the merchant becomes more enterprising, the manufacturer more diligent and skilful, and even the farmer follows his plough with greater alacrity and attention. This is not easily to be accounted for, if we consider only the influence which a greater abundance of coin has in the kingdom itself, by heightening the price of Commodities, and obliging everyone to pay a greater number of these little yellow or white pieces for everything he purchases. And as to foreign trade, it appears, that great plenty of money is rather disadvantageous, by raising the price of every kind of labour.

To account, then, for this phenomenon, we must consider, that though the high price of commodities be a necessary consequence of the encrease of gold and silver, yet it follows not immediately upon that encrease; but some time is required before the money circulates through the whole state, and makes its effect be felt on all ranks of people. At first, no alteration is perceived; by degrees the price rises, first of one commodity, then of another; till the whole at last reaches a just proportion with the new quantity of specie which is in the kingdom. In my opinion, it is only in this interval or intermediate situation, between the acquisition of money and rise of prices, that the encreasing quantity of gold and silver is favourable to industry. When any quantity of money is imported into a nation, it is not at first dispersed into many hands; but is confined to the coffers of a few persons, who immediately seek to employ it to advantage. Here are a set of manufacturers or merchants, we shall suppose, who have received returns of gold and silver for goods which they sent to CADIZ. They are thereby enabled to employ more workmen than formerly, who never dream of demanding higher wages, but are glad of employment from such good paymasters. If workmen become scarce, the manufacturer gives higher wages, but at first requires an encrease of labour; and this is willingly submitted to by the artisan, who can now eat and drink better, to compensate his additional toil and fatigue.

He carries his money to market, where he, finds everything at the same price as formerly, but returns with greater quantity and of better kinds, for the use of his family. The farmer and gardener, finding, that all their commodities are taken off, apply themselves with alacrity to the raising more; and at the same time can afford to take better and more cloths from their tradesmen, whose price is the same as formerly, and their industry only whetted by so much new gain. It is easy to trace the money in its progress through the whole commonwealth; where we shall find, that it must first quicken the diligence of every individual, before it encrease the price of labour. And that the specie may encrease to a considerable pitch, before it have this latter effect, appears, amongst other instances, from the frequent operations of the FRENCH king on the money; where it was always found, that the augmenting of the numerary value did not produce a proportional rise of the prices, at least for some time. In the last year of LOUIS XIV, money was raised three-sevenths, but prices augmented only one. Corn in FRANCE is now sold at the same price, or for the same number of livres, it was in 1683; though silver was then at 30 livres the mark, and is now at 50. Not to mention the great addition of gold and silver, which may have come into that kingdom since the former period.

From the whole of this reasoning we may conclude, that it is of no manner of consequence, with regard to the domestic happiness of a state, whether money be in a greater or less quantity. The good policy of the magistrate consists only in keeping it, if possible, still encreasing; because, by that means, he keeps alive a spirit of industry in the nation, and encreases the stock of labour, in which consists all real power and riches. A nation, whose money decreases, is actually, at that time, weaker and more miserable than another nation, which possesses no more money, but is on the encreasing hand. This will be easily accounted for, if we consider, that the alterations in the quantity of money, either on one side or the other, are not immediately attended with proportionable alterations in the price of commodities. There is always an interval before matters be adjusted to their new situation; and this interval is as pernicious to industry, when gold and silver are diminishing, as it is advantageous when these metals are encreasing. The workman has not the same employment from the manufacturer and merchant; though he pays the same price for everything in the market. The farmer cannot dispose of his corn and cattle; though he must pay the same rent to his landlord. The poverty, and beggary, and sloth, which must ensue, are easily foreseen.

So Hume understands that once-and-for-all increases in the stock of money and in the price level are neutral, and also that in the transition from one price level to another, there will be a transitory effect on output and employment. However, when he says that the good policy of the magistrate consists only in keeping it, if possible, still increasing; because, by that means, he keeps alive a spirit of industry in the nation, he seems to be suggesting that the long-run Phillips Curve is actually positively sloped, thus confirming Milton Friedman (and Nick Rowe and Scott Sumner) in saying that Hume was off by one derivative.

While I think that is a fair reading of Hume, it is not the only one, because Hume really was thinking in terms of price levels, not rates of inflation. The idea that a good magistrate would keep the stock of money increasing could not have meant that the rate of inflation would indefinitely continue at a particular rate, only that the temporary increase in the price level would be extended a while longer. So I don’t think that Hume would ever have imagined that there could be a steady predicted rate of inflation lasting for an indefinite period of time. If he could have imagined a steady rate of inflation, I think he would have understood the simple argument that, once expected, the steady rate of inflation would not permanently increase output and employment.

At any rate, even if Hume did not explicitly anticipate Friedman’s argument for a vertical long-run Phillips Curve, certainly there many economists before Friedman who did. I will quote just one example from a source (Hayek’s Constitution of Liberty) that predates Friedman by about eight years. There is every reason to think that Friedman was familiar with the source, Hayek having been Friedman’s colleague at the University of Chicago between 1950 and 1962. The following excerpt is from p. 331 of the 1960 edition.

Inflation at first merely produces conditions in which more people make profits and in which profits are generally larger than usual. Almost everything succeeds, there are hardly any failures. The fact that profits again and again prove to be greater than had been expected and that an unusual number of ventures turn out to be successful produces a general atmosphere favorable to risk-taking. Even those who would have been driven out of business without the windfalls caused by the unexpected general rise in prices are able to hold on and to keep their employees in the expectation that they will soon share in the general prosperity. This situation will last, however, only until people begin to expect prices to continue to rise at the same rate. Once they begin to count on prices being so many per cent higher in so many months’ time, they will bid up the prices of the factors of production which determine the costs to a level corresponding to the future prices they expect. If prices then rise no more than had been expected, profits will return to normal, and the proportion of those making a profit also will fall; and since, during the period of exceptionally large profits, many have held on who would otherwise have been forced to change the direction of their efforts, a higher proportion than usual will suffer losses.

The stimulating effect of inflation will thus operate only so long as it has not been foreseen; as soon as it comes to be foreseen, only its continuation at an increased rate will maintain the same degree of prosperity. If in such a situation price rose less than expected, the effect would be the same as that of unforeseen deflation. Even if they rose only as much as was generally expected, this would no longer provide the expectational stimulus but would lay bare the whole backlog of adjustments that had been postponed while the temporary stimulus lasted. In order for inflation to retain its initial stimulating effect, it would have to continue at a rate always faster than expected.

This was certainly not the first time that Hayek made the same argument. See his Studies in Philosophy Politics and Economics, p. 295-96 for a 1958 version of the argument. Is there any part of Friedman’s argument in his 1968 essay (“The Role of Monetary Policy“) not contained in the quote from Hayek? Nor is there anything to indicate that Hayek thought he was making an argument that was not already familiar. The logic is so obvious that it is actually pointless to look for someone who “discovered” it. If Friedman somehow gets credit for making the discovery, it is simply because he was the one who made the argument at just the moment when the rest of the profession happened to be paying attention.

What Is Free Banking All About?

I notice that there has been a bit of a dustup lately about free banking, triggered by two posts by Izabella Kaminska, first on FTAlphaville followed by another on her own blog. I don’t want to get too deeply into the specifics of Kaminska’s posts, save to correct a couple of factual misstatements and conceptual misunderstandings (see below). At any rate, George Selgin has a detailed reply to Kaminska’s errors with which I mostly agree, and Scott Sumner has scolded her for not distinguishing between sensible free bankers, e.g., Larry White, George Selgin, Kevin Dowd, and Bill Woolsey, and the anti-Fed, gold-bug nutcases who, following in the footsteps of Ron Paul, have adopted free banking as a slogan with which to pursue their anti-Fed crusade.

Now it just so happens that, as some readers may know, I wrote a book about free banking, which I began writing almost 30 years ago. The point of the book was not to call for a revolutionary change in our monetary system, but to show that financial innovations and market forces were causing our modern monetary system to evolve into something like the theoretical model of a free banking system that had been worked out in a general sort of way by some classical monetary theorists, starting with Adam Smith, who believed that a system of private banks operating under a gold standard would supply as much money as, but no more money than, the public wanted to hold. In other words, the quantity of money produced by a system of competing banks, operating under convertibility, could be left to take care of itself, with no centralized quantitative control over either the quantity of bank liabilities or the amount of reserves held by the banking system.

So I especially liked the following comment by J. V. Dubois to Scott’s post

[M]y thing against free banking is that we actually already have it. We already have private banks issuing their own monies directly used for transactions – they are called bank accounts and debit/credit cards. There are countries like Sweden where there are now shops that do not accept physical cash (only bank monies) – a policy actively promoted government, if you can believe it.

There are now even financial products like Xapo Debit Card that automatically converts all payments received on your account into non-monetary assets (with Xapo it is bitcoins) and back into monies when you use the card for payment. There is a very healthy international bank money market so no matter what money you personally use, you can travel all around the world and pay comfortably without ever seeing or touching official local government currency.

In opposition to the Smithian school of thought, there was the view of Smith’s close friend David Hume, who famously articulated what became known as the Price-Specie-Flow Mechanism, a mechanism that Smith wisely omitted from his discussion of international monetary adjustment in the Wealth of Nations, despite having relied on PSFM with due acknowledgment of Hume, in his Lectures on Jurisprudence. In contrast to Smith’s belief that there is a market mechanism limiting the competitive issue of convertible bank liabilities (notes and deposits) to the amount demanded by the public, Hume argued that banks were inherently predisposed to overissue their liabilities, the liabilities being issuable at almost no cost, so that private banks, seeking to profit from the divergence between the face value of their liabilities and the cost of issuing them, were veritable engines of inflation.

These two opposing views of banks later morphed into what became known almost 70 years later as the Banking and Currency Schools. Taking the Humean position, the Currency School argued that without quantitative control over the quantity of banknotes issued, the banking system would inevitably issue an excess of banknotes, causing overtrading, speculation, inflation, a drain on the gold reserves of the banking system, culminating in financial crises. To prevent recurring financial crises, the Currency School proposed a legal limit on the total quantity of banknotes beyond which limit, additional banknotes could be only be issued (by the Bank of England) in exchange for an equivalent amount of gold at the legal gold parity. Taking the Smithian position, the Banking School argued that there were market mechanisms by which any excess liabilities created by the banking system would automatically be returned to the banking system — the law of reflux. Thus, as long as convertibility obtained (i.e., the bank notes were exchangeable for gold at the legal gold parity), any overissue would be self-correcting, so that a legal limit on the quantity of banknotes was, at best, superfluous, and, at worst, would itself trigger a financial crisis.

As it turned out, the legal limit on the quantity of banknotes proposed by the Currency School was enacted in the Bank Charter Act of 1844, and, just as the Banking School predicted, led to a financial crisis in 1847, when, as soon as the total quantity of banknotes approached the legal limit, a sudden precautionary demand for banknotes led to a financial panic that was subdued only after the government announced that the Bank of England would incur no legal liability for issuing banknotes beyond the legal limit. Similar financial panics ensued in 1857 and 1866, and they were also subdued by suspending the relevant statutory limits on the quantity of banknotes. There were no further financial crises in Great Britain in the nineteenth century (except possibly for a minicrisis in 1890), because bank deposits increasingly displaced banknotes as the preferred medium of exchange, the quantity of bank deposits being subject to no statutory limit, and because the market anticipated that, in a crisis, the statutory limit on the quantity of banknotes would be suspended, so that a sudden precautionary demand for banknotes never materialized in the first place.

Let me pause here to comment on the factual and conceptual misunderstandings in Kaminska’s first post. Discussing the role of the Bank of England in the British monetary system in the first half of the nineteenth century, she writes:

But with great money-issuance power comes great responsibility, and more specifically the great temptation to abuse that power via the means of imprudent money-printing. This fate befell the BoE — as it does most banks — not helped by the fact that the BoE still had to compete with a whole bunch of private banks who were just as keen as it to issue money to an equally imprudent degree.

And so it was that by the 1840s — and a number of Napoleonic Wars later — a terrible inflation had begun to grip the land.

So Kaminska seems to have fallen for the Humean notion that banks are inherently predisposed to overissue and, without some quantitative restraint on their issue of liabilities, are engines of inflation. But, as the law of reflux teaches us, this is not true, especially when banks, as they inevitably must, make their liabilities convertible on demand into some outside asset whose supply is not under their control. After 1821, the gold standard having been officially restored in England, the outside asset was gold. So what was happening to the British price level after 1821 was determined not by the actions of the banking system (at least to a first approximation), but by the value of gold which was determined internationally. That’s the conceptual misunderstanding that I want to correct.

Now for the factual misunderstanding. The chart below shows the British Retail Price Index between 1825 and 1850. The British price level was clearly falling for most of the period. After falling steadily from 1825 to about 1835, the price level rebounded till 1839, but it prices again started to fall reaching a low point in 1844, before starting another brief rebound and rising sharply in 1847 until the panic when prices again started falling rapidly.


From a historical perspective, the outcome of the implicit Smith-Hume disagreement, which developed into the explicit dispute over the Bank Charter Act of 1844 between the Banking and Currency Schools, was highly unsatisfactory. Not only was the dysfunctional Bank Charter Act enacted, but the orthodox view of how the gold standard operates was defined by the Humean price-specie-flow mechanism and the Humean fallacy that banks are engines of inflation, which made it appear that, for the gold standard to function, the quantity of money had to be tied rigidly to the gold reserve, thereby placing the burden of adjustment primarily on countries losing gold, so that inflationary excesses would be avoided. (Fortunately, for the world economy, gold supplies increased fairly rapidly during the nineteenth century, the spread of the gold standard meant that the monetary demand for gold was increasing faster than the supply of gold, causing gold to appreciate for most of the nineteenth century.)

When I set out to write my book on free banking, my intention was to clear up the historical misunderstandings, largely attributable to David Hume, surrounding the operation of the gold standard and the behavior of competitive banks. In contrast to the Humean view that banks are inherently inflationary — a view endorsed by quantity theorists of all stripes and enshrined in the money-multiplier analysis found in every economics textbook — that the price level would go to infinity if banks were not constrained by a legal reserve requirement on their creation of liabilities, there was an alternative view that the creation of liabilities by the banking system is characterized by the same sort of revenue and cost considerations governing other profit-making enterprises, and that the equilibrium of a private banking system is not that value of money is driven down to zero, as Milton Friedman, for example, claimed in his Program for Monetary Stability.

The modern discovery (or rediscovery) that banks are not inherently disposed to debase their liabilities was made by James Tobin in his classic paper “Commercial Banks and Creators of Money.” Tobin’s analysis was extended by others (notably Ben Klein, Earl Thompson, and Fischer Black) to show that the standard arguments for imposing quantitative limits on the creation of bank liabilities were unfounded, because, even with no legal constraints, there are economic forces limiting their creation of liabilities. A few years after these contributions, F. A. Hayek also figured out that there are competitive forces constraining the creation of liabilities by the banking system. He further developed the idea in a short book Denationalization of Money which did much to raise the profile of the idea of free banking, at least in some circles.

If there is an economic constraint on the creation of bank liabilities, and if, accordingly, the creation of bank liabilities was responsive to the demands of individuals to hold those liabilities, the Friedman/Monetarist idea that the goal of monetary policy should be to manage the total quantity of bank liabilities so that it would grow continuously at a fixed rate was really dumb. It was tried unsuccessfully by Paul Volcker in the early 1980s, in his struggle to bring inflation under control. It failed for precisely the reason that the Bank Charter Act had to be suspended periodically in the nineteenth century: the quantitative limit on the growth of the money supply itself triggered a precautionary demand to hold money that led to a financial crisis. In order to avoid a financial crisis, the Volcker Fed constantly allowed the monetary aggregates to exceed their growth targets, but until Volcker announced in the summer of 1982 that the Fed would stop paying attention to the aggregates, the economy was teetering on the verge of a financial crisis, undergoing the deepest recession since the Great Depression. After the threat of a Friedman/Monetarist financial crisis was lifted, the US economy almost immediately began one of the fastest expansions of the post-war period.

Nevertheless, for years afterwards, Friedman and his fellow Monetarists kept warning that rapid growth of the monetary aggregates meant that the double-digit inflation of the late 1970s and early 1980s would soon return. So one of my aims in my book was to use free-banking theory – the idea that there are economic forces constraining the issue of bank liabilities and that banks are not inherently engines of inflation – to refute the Monetarist notion that the key to economic stability is to make the money stock grow at a constant 3% annual rate of growth.

Another goal was to explain that competitive banks necessarily have to select some outside asset into which to make their liabilities convertible. Otherwise those liabilities would have no value, or at least so I argued, and still believe. The existence of what we now call network effects forces banks to converge on whatever assets are already serving as money in whatever geographic location they are trying to draw customers from. Thus, free banking is entirely consistent with an already existing fiat currency, so that there is no necessary link between free banking and a gold (or other commodity) standard. Moreover, if free banking were adopted without abolishing existing fiat currencies and legal tender laws, there is almost no chance that, as Hayek argued, new privately established monetary units would arise to displace the existing fiat currencies.

My final goal was to suggest a new way of conducting monetary policy that would enhance the stability of a free banking system, proposing a monetary regime that would ensure the optimum behavior of prices over time. When I wrote the book, I had been convinced by Earl Thompson that the optimum behavior of the price level over time would be achieved if an index of nominal wages was stabilized. He proposed accomplishing this objective by way of indirect convertibility of the dollar into an index of nominal wages by way of a modified form of Irving Fisher’s compensated dollar plan. I won’t discuss how or why that goal could be achieved, but I am no longer convinced of the optimality of stabilizing an index of nominal wages. So I am now more inclined toward nominal GDP level targeting as a monetary policy regime than the system I proposed in my book.

But let me come back to the point that I think J. V. Dubois was getting at in his comment. Historically, idea of free banking meant that private banks should be allowed to issue bank notes of their own (with the issuing bank clearly identified) without unreasonable regulations, restrictions or burdens not generally applied to other institutions. During the period when private banknotes were widely circulating, banknotes were a more prevalent form of money than bank deposits. So in the 21st century, the right of banks to issue hand to hand circulating banknotes is hardly a crucial issue for monetary policy. What really matters is the overall legal and regulatory framework under which banks operate.

The term “free banking” does very little to shed light on most of these issues. For example, what kind of functions should banks perform? Should commercial banks also engage in investment banking? Should commercial bank liabilities be ensured by the government, and if so under what terms, and up to what limits? There are just a couple of issues; there are many others. And they aren’t necessarily easily resolved by invoking the free-banking slogan. When I was writing, I meant by “free banking” a system in which the market determined the total quantity of bank liabilities. I am still willing to use “free banking” in that sense, but there are all kinds of issues concerning the asset side of bank balance sheets that also need to be addressed, and I don’t find it helpful to use the term free banking to address those issues.

Sterilizing Gold Inflows: The Anatomy of a Misconception

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Hawtrey’s Good and Bad Trade, Part VII: International Adjustment to a Demand Shift

In this installment, I will provide a very quick overview of Hawtrey’s chapters 10 and 11, and point out a minor defect in his argument about the international adjustment process. Having explained the international adjustment process to a monetary disturbance in chapter 9, Hawtrey uses the next two chapters to give a brief, but highly insightful, account of the process of economic growth, expanding human settlement into new geographic locations, thereby showing an acute sense of the importance of geography and location in economic development, and of the process by which newly extracted gold is exported from gold-producing to gold-importing areas, even though, under the gold standard, the value of gold is the same all over the world (chapter 10). Hawtrey then examines the process of adjustment to a reduction in the demand for a product exported by a particular country. Hawtrey explains the adjustment processes first under the assumption that the exchange rate is allowed to adjust (all countries being assumed to have inconvertible fiat currencies). and, then, under the assumption that all money is convertible into gold and exchange rates are fixed (at least within the limits of gold import and export points).

The analysis is pretty straightforward. Starting from a state of equilibrium, if the worldwide demand for one of country A’s export products (say hats) declines, with the increased expenditure shared among all other commodities, country A will experience a balance-of-payments deficit, requiring a depreciation of the exchange rate of the currency of country exchange against other currencies. In the meantime, country A’s hat producers will have to cut output, thus laying off workers. The workers are unlikely to accept an offer of reduced wages from country A hat producers, correctly reasoning that they may be able to find work elsewhere at close to their old wage. In fact the depreciation of country A’s currency will offer some incentive to country A’s other producers to expand output, eventually reabsorbing the workers laid off by country A’s hat producers. The point is that a demand shift, though leading to a substantial reduction in the output and employment of one industry, does not trigger the wider contraction in economic activity characteristic of cyclical disturbances. Sectoral shifts in demand don’t normally lead to cyclical downturns.

Hawtrey then goes through the analysis under the assumption that all countries are on the gold standard. What happens under the gold standard, according to Hawtrey, is that the balance-of-payments deficit caused by the demand shift requires the export of gold to cover the deficit. The exported gold comes out of the gold reserves held by the banks. When banks see that their gold reserves are diminishing, they in turn raise interest rates as a way of stemming the outflow of gold. The increase in the rate of interest will tend to restrain total spending, which tends to reduce imports and encourage exports. Hawtrey goes through a somewhat abstruse numerical example, which I will spare you, to show how much the internal demand for gold falls as a result of the reduction in demand for country A’s hats. This all seems generally correct.

However, there is one point on which I would take issue with Hawtrey. He writes:

But even so equilibrium is not yet reached. For the export of hats has been diminished by 20 percent, and if the prices ruling in other industries are the same, relatively to those ruling abroad, as before, the imports of those commodities will be unchanged. There must therefore be a further export of gold to lower the general level of prices and so to encourage exports and discourage imports. (pp. 137-38)

Here is an example of the mistaken reasoning that I pointed out in my previous post, a failure to notice that the prices of all internationally traded commodities are fixed by arbitrage (at least as a first approximation) not by the domestic quantity of gold. The export of gold does nothing to reduce the prices of the products of the other industries in country A, which are determined in international markets. Given the internationally determined prices for those goods, equilibrium will have to be restored by the adjustment of wages in country A to make it profitable for country A’s exporting industries and import-competing industries to increase their output, thereby absorbing the workers displaced from country A’s hat industry. As I showed in my previous post, Hawtrey eventually came to understand this point. But in 1913, he had still not freed himself from that misunderstanding originally perpetrated by David Hume in his famous essay “Of the Balance of Trade,” expounding what came to be known as the price-specie-flow mechanism.

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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