Archive for the 'deflation' Category

Hayek, Deflation and Nihilism

In the discussion about my paper on Hayek and intertemporal equilibrium at the HES meeting last month, Harald Hagemann suggested looking at Hansjorg Klausinger’s introductions to the two recently published volumes of Hayek’s Collected Works containing his writings (mostly from the 1920s and 1930s) about business-cycle theory in which he explores how Hayek’s attitude toward equilibrium analysis changed over time. But what I found most interesting in Klausinger’s introduction was his account of Hayek’s tolerant, if not supportive, attitude toward deflation — even toward what Hayek and other Austrians at the time referred to as “secondary deflation.” Some Austrians, notably Gottfried Haberler and Wilhelm Roepke, favored activist “reflationary” policies to counteract, and even reverse, secondary deflation. What did Hayek mean by secondary deflation? Here is how Klausinger (“Introduction” in Collected Works of F. A. Hayek: Business Cycles, Part II, pp. 5-6) explains the difference between primary and secondary deflation:

[A]ccording to Hayek’s theory the crisis is caused by a maladjustment in the structure of production typically initiated by a credit boom, such that the period of production (representing the capitalistic structure of production) is lengthened beyond what can be sustained by the rate of voluntary savings. The necessary reallocation of resources and its consequences give rise to crisis and depression. Thus, the “primary” cause of the crisis is a kind of “capital scarcity” while the depression represents an adjustment process by which the capital structure is adapted.

The Hayekian crisis or upper-turning point of the cycle occurs when banks are no longer willing or able to supply the funds investors need to finance their projects, causing business failures and layoffs of workers. The turning point is associated with distress sales of assets and goods, initiating a deflationary spiral. The collapse of asset prices and sell-off of inventories is the primary deflation, but at some point, the contraction may begin to feed on itself, and the contraction takes on a different character. That is the secondary deflation phase. But it is difficult to identify a specific temporal or analytic criterion by which to distinguish the primary from the secondary deflation.

Roepke and Haberler used the distinction – often referring to “depression”” and “deflation” interchangeably – to denote two phases of the cycle. The primary depression is characterized by the reactions to the disproportionalities of the boom, and accordingly an important cleansing function is ascribed to it; thus it is necessary to allow the primary depression to run its course. In contrast, the secondary depression refers to a self-feeding, cumulative process, not causally connected with the disproportionality that the primary depression is designed to correct. Thus the existence of the secondary depression opens up the possibility of a phase of depression dysfunctional to the economic system, where an expansionist policy might be called for. (Id. p. 6)

Despite conceding that there is a meaningful distinction between a primary and secondary deflation that might justify monetary expansion to counteract the latter, Hayek consistently opposed monetary expansion during the 1930s. The puzzle of Hayek’s opposition to monetary expansion, even at the bottom of the Great Depression, is compounded if we consider his idea of neutral money as a criterion for a monetary policy with no distorting effect on the price system. That idea can be understood in terms of the simple MV=PQ equation. Hayek argued that the proper criterion for neutral money was neither, as some had suggested, a constant quantity of money (M), nor, as others had suggested, a constant price level (P), but constant total spending (MV). But for MV to be constant, M must increase or decrease just enough to offset any change in V, where V represents the percentage of income held by the public in the form of money. Thus, if MV is constant, the quantity of money is increasing or decreasing by just as much as the amount of money the public wants to hold is increasing or decreasing.

The neutral-money criterion led Hayek to denounce the US Federal Reserve for a policy that kept the average level of prices essentially stable from 1922 to 1929, arguing that rapid economic growth should have been accompanied by falling not stable prices, in line with his neutral money criterion. The monetary expansion necessary to keep prices stable, had in Hayek’s view, led to a distortion of relative prices, causing an overextension of the capital structure of production, which was the ultimate cause of the 1929 downturn that triggered the Great Depression. But once the downturn started to accelerate, causing aggregate spending to decline by 50% between 1929 and 1933, Hayek, totally disregarding his own neutral-money criterion, uttered not a single word in protest of a monetary policy that was in flagrant violation of his own neutral money criterion. On the contrary, Hayek wrote an impassioned defense of the insane gold accumulation policy of the Bank of France, which along with the US Federal Reserve was chiefly responsible for the decline in aggregate spending.

In an excellent paper, Larry White has recently discussed Hayek’s pro-deflationary stance in the 1930s, absolving Hayek from responsibility for the policy errors of the 1930s on the grounds that the Federal Reserve Board and the Hoover Administration had been influenced not by Hayek, but by a different strand of pro-deflationary thinking, while pointing out that Hayek’s own theory of monetary policy, had he followed it consistently, would have led him to support monetary expansion during the 1930s to prevent any decline in aggregate spending. White may be correct in saying that policy makers paid little if any attention to Hayek’s pro-deflation policy advice. But Hayek’s policy advice was what it was: relentlessly pro-deflation.

Why did Hayek offer policy advice so blatantly contradicted by his own neutral-money criterion? White suggests that the reason was that Hayek viewed deflation as potentially beneficial if it would break the rigidities obstructing adjustments in relative prices. It was the lack of relative-price adjustments that, in Hayek’s view, caused the depression. Here is how Hayek (“The Present State and Immediate Prospects of the Study of Industrial Fluctuations” in Collected Works of F. A. Hayek: Business Cycles, Part II, pp. 171-79) put it:

The analysis of the crisis shows that, once an excessive increase of the capital structure has proved insupportable and has led to a crisis, profitability of production can be restored only by considerable changes in relative prices, reductions of certain stocks, and transfers of the means of production to other uses. In connection with these changes, liquidations of firms in a purely financial sense of the word may be inevitable, and their postponement may possibly delay the process of liquidation in the first, more general sense; but this is a separate and special phenomenon which in recent discussions has been stressed rather excessively at the expense of the more fundamental changes in prices, stocks, etc. (Id. pp. 175-76)

Hayek thus draws a distinction between two possible interpretations of liquidation, noting that widespread financial bankruptcy is not necessary for liquidation in the economic sense, an important distinction. Continuing with the following argument about rigidities, Hayek writes:

A theoretical problem of great importance which needs to be elucidated in this connection is the significance, for this process of liquidation, of the rigidity of prices and wages, which since the great war has undoubtedly become very considerable. There can be little question that these rigidities tend to delay the process of adaptation and that this will cause a “secondary” deflation which at first will intensify the depression but ultimately will help to overcome those rigidities. (Id. p. 176)

It is worth noting that Hayek’s assertion that the intensification of the depression would help to overcome the rigidities is an unfounded and unsupported supposition. Moreover, the notion that increased price flexibility in a depression would actually promote recovery has a flimsy theoretical basis, because, even if an equilibrium does exist in an economy dislocated by severe maladjustments — the premise of Austrian cycle theory — the notion that price adjustments are all that’s required for recovery can’t be proven even under the assumption of Walrasian tatonnement, much less under the assumption of incomplete markets with trading at non-equilibrium prices. The intuitively appealing notion that markets self-adjust is an extrapolation from Marshallian partial-equilibrium analysis in which the disequilibrium of a single market is analyzed under the assumption that all other markets remain in equilibrium. The assumption of approximate macroeconomic equilibrium is a necessary precondition for the partial-equilibrium analysis to show that a single (relatively small) market reverts to equilibrium after a disturbance. In the general case in which multiple markets are simultaneously disturbed from an initial equilibrium, it can’t be shown that price adjustments based on excess demands in individual markets lead to the restoration of equilibrium.

The main problem in this connection, on which opinions are still diametrically opposed, are, firstly, whether this process of deflation is merely an evil which has to be combated, or whether it does not serve a necessary function in breaking these rigidities, and, secondly, whether the persistence of these deflationary tendencies proves that the fundamental maladjustment of prices still exists, or whether, once that process of deflation has gathered momentum, it may not continue long after it has served its initial function. (Id.)

Unable to demonstrate that deflation was not exacerbating economic conditions, Hayek justified tolerating further deflation, as White acknowledged, with the hope that it would break the “rigidities” preventing the relative-price adjustments that he felt were necessary for recovery. Lacking a solid basis in economic theory, Hayek’s support for deflation to break rigidities in relative-price adjustment invites evaluation in ideological terms. Conceding that monetary expansion might increase employment, Hayek may have been disturbed by the prospect that an expansionary monetary policy would be credited for having led to a positive outcome, thereby increasing the chances that inflationary policies would be adopted under less extreme conditions. Hayek therefore appears to have supported deflation as a means to accomplish a political objective – breaking politically imposed and supported rigidities in prices – he did not believe could otherwise be accomplished.

Such a rationale, I am sorry to say, reminds me of Lenin’s famous saying that you can’t make an omelet without breaking eggs. Which is to say, that in order to achieve a desired political outcome, Hayek was prepared to support policies that he had good reason to believe would increase the misery and suffering of a great many people. I don’t accuse Hayek of malevolence, but I do question the judgment that led him to such a conclusion. In Fabricating the Keynesian Revolution, David Laidler described Hayek’s policy stance in the 1930s as extreme pessimism verging on nihilism. But in supporting deflation as a means to accomplish a political end, Hayek clearly seems to have crossed over the line separating pessimism from nihilism.

In fairness to Hayek, it should be noted that he eventually acknowledged and explicitly disavowed his early pro-deflation stance.

I am the last to deny – or rather, I am today the last to deny – that, in these circumstances, monetary counteractions, deliberate attempts to maintain the money stream, are appropriate.

I probably ought to add a word of explanation: I have to admit that I took a different attitude forty years ago, at the beginning of the Great Depression. At that time I believed that a process of deflation of some short duration might break the rigidity of wages which I thought was incompatible with a functioning economy. Perhaps I should have even then understood that this possibility no longer existed. . . . I would no longer maintain, as I did in the early ‘30s, that for this reason, and for this reason only, a short period of deflation might be desirable. Today I believe that deflation has no recognizable function whatever, and that there is no justification for supporting or permitting a process of deflation. (A Discussion with Friedrich A. Von Hayek: Held at the American Enterprise Institute on April 9, 1975, p. 5)

Responding to a question about “secondary deflation” from his old colleague and friend, Gottfried Haberler, Hayek went on to elaborate:

The moment there is any sign that the total income stream may actually shrink, I should certainly not only try everything in my power to prevent it from dwindling, but I should announce beforehand that I would do so in the event the problem arose. . .

You ask whether I have changed my opinion about combating secondary deflation. I do not have to change my theoretical views. As I explained before, I have always thought that deflation had no economic function; but I did once believe, and no longer do, that it was desirable because it could break the growing rigidity of wage rates. Even at that time I regarded this view as a political consideration; I did not think that deflation improved the adjustment mechanism of the market. (Id. pp. 12-13)

I am not sure that Hayek’s characterization of his early views is totally accurate. Although he may indeed have believed that a short period of deflation would be enough to break the rigidities that he found so troublesome, he never spoke out against deflation, even as late as 1932 more than two years the start of deflation at the end of 1929. But on the key point Hayek was perfectly candid: “I regarded this view as a political consideration.”

This harrowing episode seems worth recalling now, as the U.S. Senate is about to make decisions about the future of the highly imperfect American health care system, and many are explicitly advocating taking steps calculated to make the system (or substantial parts of it) implode or enter a “death spiral” for the express purpose of achieving a political/ideological objective. Policy-making and nihilism are a toxic mix, as we learned in the 1930s with such catastrophic results. Do we really need to be taught that lesson again?

Thoughts and Details on the Dearly Beloved, Bright and Shining, Depression of 1920-21, of Blessed Memory

Commenter TravisV kindly referred me to a review article by David Frum in the current issue of the Atlantic Monthly of The Deluge by Adam Tooze, an economic history of the First World War, its aftermath, and the rise of America as the first global superpower since the Roman Empire. Frum draws an interesting contrast between Tooze’s understanding of the 1920-21 depression and the analysis of that episode presented in James Grant’s recent paean to the Greatest Depression.

But in thinking about Frum’s article, and especially his comments on Grant, I realized that my own discussion of the 1920-21 depression was not fully satisfactory, and so I have been puzzling for a couple of weeks about my own explanation for the good depression of 1920-21. What follows is a progress report on my thinking.

Here is what Frum says about Grant:

Periodically, attempts have been made to rehabilitate the American leaders of the 1920s. The most recent version, James Grant’s The Forgotten Depression, 1921: The Crash That Cured Itself, was released just two days before The Deluge: Grant, an influential financial journalist and historian, holds views so old-fashioned that they have become almost retro-hip again. He believes in thrift, balanced budgets, and the gold standard; he abhors government debt and Keynesian economics. The Forgotten Depression is a polemic embedded within a narrative, an argument against the Obama stimulus joined to an account of the depression of 1920-21.

As Grant correctly observes, that depression was one of the sharpest and most painful in American history. Total industrial production may have dropped by 30 percent. [According to Industrial Production Index of the Federal Reserve, industrial production dropped by almost 40%, DG] Unemployment spiked at perhaps close to 12 percent (accurate joblessness statistics don’t exist for this period). Overall, prices plummeted at the steepest rate ever recorded—steeper than in 1929-33. Then, after 18 months of extremely hard times, the economy lurched into recovery. By 1923, the U.S. had returned to full employment.

Grant presents this story as a laissez-faire triumph. Wartime inflation was halted. . . . Recovery then occurred naturally, without any need for government stimulus. “The hero of my narrative is the price mechanism, Adam Smith’s invisible hand,” he notes. “In a market economy, prices coordinate human effort. They channel investment, saving and work. High prices encourage production but discourage consumption; low prices do the opposite. The depression of 1920-21 was marked by plunging prices, the malignity we call deflation. But prices and wages fell only so far. They stopped falling when they become low enough to entice consumers into shopping, investors into committing capital and employers into hiring. Through the agency of falling prices and wages, the American economy righted itself.” Reader, draw your own comparisons!

. . .

Grant rightly points out that wars are usually followed by economic downturns. Such a downturn occurred in late 1918-early 1919. “Within four weeks of the … Armistice, the [U.S.] War Department had canceled $2.5 billion of its then outstanding $6 billion in contracts; for perspective, $2.5 billion represented 3.3 percent of the 1918 gross national product,” he observes. Even this understates the shock, because it counts only Army contracts, not Navy ones. The postwar recession checked wartime inflation, and by March 1919, the U.S. economy was growing again.

Here is where the argument needs further clarity and elaboration. But first let me comment parenthetically that there are two distinct kinds of post-war downturns. First, there is an inevitable adjustment whereby productive resources are shifted to accommodate the shift in demand from armaments to civilian products. The reallocation entails the temporary unemployment that is described in familiar search and matching models. Because of the magnitude of the adjustment, these sectoral-adjustment downturns can last for some time, typically two to four quarters. But there is a second and more serious kind of downturn; it can be associated either with an attempt to restore a debased currency to its legal parity, or with the cessation of money printing to finance military expenditures by the government. Either the deflationary adjustment associated with restoring a suspended monetary standard or the disinflationary adjustment associated with the end of a monetary expansion tends to exacerbate and compound the pure resource reallocation problem that is taking place simultaneously.

What I have been mainly puzzling over is how to think about the World War I monetary expansion and inflation, especially in the US. From the beginning of World War I in 1914 till the US entered the war in April 1917, the dollar remained fully convertible into gold at the legal gold price of $20.67 an ounce. Nevertheless, there was a huge price inflation in the US prior to April 1917. How was this possible while the US was on the gold standard? It’s not enough to say that a huge influx of gold into the US caused the US money supply to expand, which is the essence of the typical quantity-theoretic explanation of what happened, an explanation that you will find not just in Friedman and Schwartz, but in most other accounts as well.

Why not? Because, as long as the dollar was still redeemable at the official gold price, people could redeem their excess dollars for gold to avoid the inflationary losses incurred by holding dollars. Why didn’t they? In my previous post on the subject, I suggested that it was because gold, too, was depreciating, so that rapid US inflation from 1915 to 1917 before entering the war was a reflection of the underlying depreciation of gold.

But why was gold depreciating? What happened to make gold less valuable? There are two answers. First, a lot of gold was being withdrawn from circulation, as belligerent governments were replacing their gold coins with paper or base metallic coins. But there was a second reason: the private demand for gold was being actively suppressed by governments. Gold could no longer be freely imported or exported. Without easy import and export of gold, the international gold market, a necessary condition for the gold standard, ceased to function. If you lived in the US and were concerned about dollar depreciation, you could redeem your dollars for gold, but you could not easily find anyone else in the world that would pay you more than the official price of $20.67 an ounce, even though there were probably people out there willing to pay you more than that price if you could only find them and circumvent the export and import embargoes to ship the gold to them. After the US entered the war in April 1917, an embargo was imposed on the export of gold from the US, but that was largely just a precaution. Even without an embargo, little gold would have been exported.

So it was at best an oversimplification for me to say in my previous post that the dollar depreciated along with gold during World War I, because there was no market mechanism that reflected or measured the value of gold during World War I. Insofar as the dollar was still being used as a medium of exchange, albeit with many restrictions, it was more correct to say that the value of gold reflected the value of the dollar, than that the value of the dollar reflected the value of gold.

In my previous post, I posited that, owing to the gold-export embargo imposed after US entry into World War I, the dollar actually depreciated by less than gold between April 1917 and the end of the war. I then argued that after full dollar convertibility into gold was restored after the war, the dollar had to depreciate further to match the value of gold. That was an elegant explanation for the anomalous postwar US inflation, but that explanation has a problem: gold was flowing out of the US during the inflation, but if my explanation of the postwar inflation were right, gold should have been flowing into the US as the trade balance turned in favor of the US.

So, much to my regret, I have to admit that my simple explanation, however elegant, of the post-World War I inflation, as an equilibration of the dollar price level with the gold price level, was too simple. So here are some provisional thoughts, buttressed by a bit of empirical research and evidence drawn mainly from two books by W. A. Brown England and the New Gold Standard and The International Gold Standard Reinterpreted 1914-34.

The gold standard ceased to function as an economic system during World War I, because a free market in gold ceased to exist. Nearly two-thirds of all the gold in the world was mined in territories under the partial or complete control of the British Empire (South Africa, Rhodesia, Australia, Canada, and India). Another 15% of the world’s output was mined in the US or its territories. Thus, Britain was in a position, with US support and approval, to completely dominate the world gold market. When the war ended, a gold standard could not begin to function again until a free market in gold was restored. Here is how Brown describes the state of the world gold market (or non-market) immediately after the War.

In March 1919 when the sterling-dollar rate was freed from control, the export of gold was for the first time legally [my emphasis] prohibited. It was therefore still impossible to measure the appreciation or depreciation of any currency in terms of a world price of gold. The price of gold was nowhere determined by world-wide forces. The gold of the European continent was completely shut out of the world’s trade by export embargoes. There was an embargo upon the export of gold from Australia. All the gold exported from the Union of South Africa had still to be sold to the Bank of England at its statutory price. Gold could not be exported from the United States except under government license. All the avenues of approach by which gold from abroad could reach the public in India were effectually closed. The possessors of gold in the United States, South Africa, India, or in England, Spain, or France, could not offer their gold to prospective buyers in competition with one another. The purchasers of gold in these countries did not have access to the world’s supplies, but on the other hand, they were not exposed to foreign competition for the supplies in their own countries, or in the sphere of influence of their own countries.

Ten months after the war ended, on September 12, 1919, many wartime controls over gold having been eliminated, a free market in gold was reestablished in London.

No longer propped up by the elaborate wartime apparatus of controls and supports, the official dollar-sterling exchange rate of $4.76 per pound gave way in April 1919, falling gradually to less than $4 by the end of 1919. With the dollar-sterling exchange rate set free and the dollar was pegged to gold at the prewar parity of $20.67 an ounce, the sterling price of gold and the dollar-sterling exchange rate varied inversely. The US wholesale price index (in current parlance the producer price index) stood at 23.5 in November 1918 when the war ended (compared to 11.6 in July 1914 just before the war began). Between November 1918 and June 1919 the wholesale price index was roughly stable, falling to 23.4, a drop of just 0.4% in seven months. However, the existence of wartime price controls, largely dismantled in the months after the war ended, introduces some noise into the price indices, making price-level estimates and comparisons in the latter stages of the War and its immediate aftermath problematic.

When the US embargo on gold exports was lifted in June 1919, causing a big jump in gold exports in July 1919, wholesale prices shot up nearly 4% to 24.3, and to 24.9 in August, suggesting that lifting the gold export embargo tended to reduce the international value of gold to which the dollar corresponded. Prices dropped somewhat in September when the London gold market was reestablished, perhaps reflecting the impact of pent-up demand for gold suddenly becoming effective. Prices remained stable in October before rising almost 2% in November. Price increases accelerated in December and January, leveled off in February and March, before jumping up in April, the PPI reaching its postwar peak (28.8, a level not reached again till November 1950!) in May 1920.

My contention is that the US price level after World War I largely reflected the state of the world gold market, and the state of the world gold market was mainly determined by the direction and magnitude of gold flows into or out of the US. From the War’s end in November 1918 till the embargo on US gold exports was lifted the following July, the gold market was insulated from the US. The wartime controls imposed on the world gold market were gradually being dismantled, but until the London gold market reopened in September 1919, allowing gold to move to where it was most highly valued, there was no such thing as a uniform international value of gold to which the dollar had to correspond.

My understanding of the postwar US inflation and the subsequent deflation is based on the close relationship between monetary policy and the direction and magnitude of gold flows. Under a gold standard, and given the demand to hold the liabilities of a central bank, a central bank typically controlled the amount of gold reserves it held by choosing the interest rate at which it would lend. The relationship between the central-bank lending rate and its holdings of reserves is complex, but the reserve position of a central bank was reliably correlated with the central-bank lending rate, as Hawtrey explained and documented in his Century of Bank Rate. So the central bank lending rate can be thought of as the means by which a central bank operating under a gold standard made its demand for gold reserves effective.

The chart below shows monthly net gold flows into the US from January 1919 through June 1922. Inflows (outflows) correspond to positive (negative) magnitudes measured on left vertical axis; the PPI is measured on the right vertical axis. From January 1919 to June 1920, prices were relatively high and rising, while gold was generally flowing out of the US. From July 1920 till June 1921, prices fell sharply while huge amounts of gold were flowing into the US. Prices hit bottom in June, and gold inflows gradually tapered off in the second half of 1921.

gold_imports_2The correlation is obviously very far from perfect; I have done a number of regressions trying to explain movements in the PPI from January 1919 to June 1922, and the net monthly inflow of gold into the US consistently accounts for roughly 25% of the monthly variation in the PPI, and I have yet to find any other variable that is reliably correlated with the PPI over that period. Of course, I would be happy to receive suggestions about other variables that might be correlated with price level changes. Here’s the simplest regression result.

y = -4.41e-10 NGOLDIMP, 41 observations, t = -3.99, r-squared = .285, where y is the monthly percentage change in the PPI, and NGOLDIMP is net monthly gold imports into the US.

The one part of the story that still really puzzles me is that deflation bottomed out in June 1921, even though monthly gold inflows remained strong throughout the spring and summer of 1921 before tapering off in the autumn. Perhaps there was a complicated lag structure in the effects of gold inflows on prices that might be teased out of the data, but I don’t see it. And adding lagged variables does little if anything to improve the fit of the regression.

I want to make two further points about the dearly beloved 1920-21 depression. Let me go to the source and quote from James Grant himself waxing eloquent in the Wall Street Journal about the beguiling charms of the wonderful 1920-21 experience.

In the absence of anything resembling government stimulus, a modern economist may wonder how the depression of 1920-21 ever ended. Oddly enough, deflation turned out to be a tonic. Prices—and, critically, wages too—were allowed to fall, and they fell far enough to entice consumers, employers and investors to part with their money. Europeans, noticing that America was on the bargain counter, shipped their gold across the Atlantic, where it swelled the depression-shrunken U.S. money supply. Shares of profitable and well-financed American companies changed hands at giveaway valuations.

The first point to make is that Grant has the causation backwards; it was the flow of gold into the US that caused deflation by driving up the international value of gold and forcing down prices in terms of gold. The second point to make is that Grant completely ignores the brutal fact that the US exported its deflation to Europe and most of the rest of the world. Indeed, because Europe and much of the rest of the world were aiming to rejoin the gold standard, which effectively meant going on a dollar standard at the prewar dollar parity, and because, by 1920, almost every other currency was at a discount relative to the prewar dollar parity, the rest of the world had to endure a far steeper deflation than the US did in order to bring their currencies back to the prewar parity against the dollar. So the notion that US deflation lured eager bargain-hunting Europeans to flock to the US to spend their excess cash would be laughable, if it weren’t so pathetic. Even when the US recovery began in the summer of 1921, almost everywhere else prices were still falling, and output and employment contractin.

This can be seen by looking at the exchange rates of European countries against the dollar, normalizing the February 1920 exchange rates as 100. In February 1921, here are the exchange rates. (Source W. A. Brown The International Gold Standard Reinterpreted 1914-34, Table 29)

UK 114.6

France 101.8

Switzerland 99.3

Denmark 124.4

Belgium 103.6

Sweden 119.6

Holland 94.9

Italy 81.6

Norway 102.8

Spain 84.9

And in 1922, the exchange rates for every country had risen against the dollar (peak month noted in parentheses), implying steeper deflation in each of those countries in 1921 than in the US.

UK (June) 134.3

France (April) 131.1

Switzerland (February) 118.5

Denmark (June) 145.4

Belgium (April) 117.7

Sweden (March) 140.6

Holland (April) 105.2

Italy (April) 119.6

Norway (May) 106.8

Spain (February) 94.9

As David Frum emphasizes, the damage inflicted by the bright and shining depression of 1920-21 was not confined to the US, it exacted an even greater price on the already devastated European continent, thereby setting the stage, in conjunction with the draconian reparations imposed by the Treaty of Versailles and the war debts that the US insisted on collecting, preferably in gold, not imports, from its allies, first for the great German hyperinflation and then the Great Depression. And we all know what followed.

So, yes, by all means, let us all raise our glasses and toast the dearly beloved, bright and shining, depression of 1920-21, of blessed memory, the greatest depression ever. May we never see its like again.

The Nearly Forgotten Dearly Beloved 1920-21 Depression Yet Again; Or, Never Reason from a Quantity Change

The industrious James Grant recently published a book about the 1920-21 Depression. It has received enthusiastic reviews in the Wall Street Journal and Barron’s, was the subject of an admiring column by Washington Post columnist Robert J. Samuelson, and was celebrated at a Cato Institute panel discussion, luncheon, and book-signing event. The Cato extravaganza elicited a dismissive blog post by Barkley Rosser which was linked to by Paul Krugman on his blog. The Rosser/Krugman tandem provoked an unhappy reply on the Free Banking blog from George Selgin who chaired the Cato panel discussion. And the 1920-21 Depression is now the latest hot topic in the econblogosphere.

I am afraid that there are multiple layers of errors and confusion that are being mixed up and compounded in this discussion, errors and confusion derived from basic misunderstandings about how the gold standard operated that have been plaguing the economics profession and the financial world for about two and a half centuries. If you want to understand how the gold standard worked, what you have to read is the book by Ralph Hawtrey entitled – drum roll, please – The Gold Standard.

Here are the basic things you need to know about the gold standard.

1 The gold standard operates by creating an equivalence between a currency unit and a fixed amount of gold.

2 The gold standard does not require gold to circulate as money in the form of coins. That was historically the case, but a gold standard can function with no gold coins or even gold certificates.

3 The value of a currency unit and the value of a corresponding weight of gold are necessarily equalized by arbitrage.

4 Equality between a currency unit and a corresponding weight of gold does not necessarily show the direction of causality; the currency unit may determine the value of gold, not the other way around. In other words, making gold the standard of value for currency affects the demand for gold which affects the value of gold. Decisions made by monetary authorities under the gold standard necessarily affect the value of gold, so a gold standard does not somehow make the value of money independent of monetary policy.

5 When more than one country is on a gold standard, the countries share a common price level, because the value of gold is determined in an international market.

Keeping those basics in mind, let’s quickly try to understand what was going on in 1920 when the Fed decided to raise its discount rate to the then unprecedented level of 7 percent. But the situation in 1920 was the outcome of the previous six years of World War I that effectively destroyed the gold standard as a functioning institution, even though its existence was in some sense still legally recognized.

Under the gold standard, gold was the ultimate way of discharging international debts. In World War I, belligerents had to pay for imports with gold, thus governments amassed all available gold with which to pay for the imports required to support the war effort. Gold coins were melted down and converted to bullion so the gold could be exported. For a private citizen in a belligerent country to demand that the national currency unit be converted to gold would be considered an unpatriotic if not a treasonous act. So the gold standard ceased to function in belligerent countries. In non-belligerent countries, which were busy exporting to the belligerents, the result was a massive inflow of gold, causing a spectacular increase in the amount of gold held by the US Treasury between 1914 and 1917. Other non-belligerents like Sweden and Switzerland experienced similar inflows.

Quantity theorists and Monetarists like Milton Friedman habitually misinterpret the wartime inflation, and attributing the inflation to an inflow of gold that increased the money supply, thereby perpetrating the price-specie-flow-mechanism fallacy. What actually happened was that the huge demonetization of gold coins by the belligerents and their export of large quantities of gold to non-belligerent countries in which a free market in gold continued to operate drove down the value of gold. A falling value of gold under a gold standard logically implies rising prices for all other goods and services. Rising prices increased the nominal demand for money, which more or less automatically caused a corresponding adjustment in the quantity of money. A rising price level caused the quantity of money to increase, not the other way around.

In 1917, just before the US entered the war, the US, still effectively on a gold standard as gold flowed into the Treasury, had experienced a drastic inflation, like all other gold standard countries, because gold was rapidly losing value, as it was being demonetized and exported by the belligerent countries. But when the US entered the war in 1917, the US, like other belligerents, suspended operation of the gold standard, thereby accelerating the depreciation of gold, forcing the few remaining countries on the gold standard to suspend the gold standard to avoid runaway inflation. Inflationary pressure in the US did increase after entry into the war, but the war-induced fiat inflation, to some extent suppressed or disguised by price controls, was actually slower than inflation in terms of gold.

When the war ended, the US went back on the gold standard by again making the dollar convertible into gold at the legal parity. Doing so meant that the US price level in terms of dollars was below the notional (no currency any longer being convertible into gold) world price level in terms of gold. In other belligerent countries, notably Britain, France and Germany, inflation in terms of their national currencies exceeded gold inflation, requiring them to deflate even to restore the legal parity in terms of gold.  Thus, the US was the only country in the world that was both willing and able to return to the gold standard at the prewar parity. Sweden and Switzerland could have done so, but preferred to avoid the inflationary consequences of a return to the gold standard.

Once the dollar convertibility into gold was restored, arbitrage forced the US price level to rise to so that it would equal the gold price level. The excess of the gold price level over the US price level level explains the anomalous post-war inflation – everyone knows that prices are supposed to fall, not rise, when a war ends — in the US. The rest of the world, then, had to choose between accepting US inflation, by keeping their currencies pegged to the dollar, or allowing their currencies to appreciate against the dollar. The anomalous post-war inflation was caused by the reequilibration of the US price level to the gold price levels, not, as commonly supposed, by Fed inexperience or incompetence.

To stop the post-war inflation, the Fed could have simply abandoned the gold standard, or it could have revalued the dollar in terms of gold, by reducing the official dollar price of gold. (I ignore the minor detail that the official dollar price of gold was then determined by statute.) Instead, the Fed — whether knowingly or not I can’t say – chose to increase the value of gold. The method by which it did so was to raise its discount rate, thereby making it easier to obtain dollars by selling gold to the Treasury than to borrow from the Fed. The flood of gold into the Treasury in 1920-21 succeeded in taking a huge amount of gold out of private and public hands, thus driving up the real value of gold, and forcing down the gold price level. That’s when the brutal deflation of 1920-21 started. At some point, the Fed and the Treasury decided that they had had enough, having amassed about 40% of the world’s gold reserves, and began reducing the discount rate, thereby slowing the inflow of gold into the US, and stopping its appreciation. And that’s when and how the dearly beloved, but quite dreadful, depression of 1920-21 came to an end.

Just How Infamous Was that Infamous Open Letter to Bernanke?

There’s been a lot of comment recently about the infamous 2010 open letter to Ben Bernanke penned by an assorted group of economists, journalists, and financiers warning that the Fed’s quantitative easing policy would cause inflation and currency debasement.

Critics of that letter (e.g., Paul Krugman and Brad Delong) have been having fun with the signatories, ridiculing them for what now seems like a chicken-little forecast of disaster. Those signatories who have responded to inquiries about how they now feel about that letter, notably Cliff Asness and Nial Ferguson, have made two arguments: 1) the letter was just a warning that QE was creating a risk of inflation, and 2) despite the historically low levels of inflation since the letter was written, the risk that inflation could increase as a result of QE still exists.

For the most part, critics of the open letter have focused on the absence of inflation since the Fed adopted QE, the critics characterizing the absence of inflation despite QE as an easily predictable outcome, a straightforward implication of basic macroeconomics, which it was ignorant or foolish of the signatories to have ignored. In particular, the signatories should have known that, once interest rates fall to the zero lower bound, the demand for money becoming highly elastic so that the public willingly holds any amount of money that is created, monetary policy is rendered ineffective. Just as a semantic point, I would observe that the term “liquidity trap” used to describe such a situation is actually a slight misnomer inasmuch as the term was coined to describe a situation posited by Keynes in which the demand for money becomes elastic above the zero lower bound. So the assertion that monetary policy is ineffective at the zero lower bound is actually a weaker claim than the one Keynes made about the liquidity trap. As I have suggested previously, the current zero-lower-bound argument is better described as a Hawtreyan credit deadlock than a Keynesian liquidity trap.

Sorry, but I couldn’t resist the parenthetical history-of-thought digression; let’s get back to that infamous open letter.

Those now heaping scorn on signatories to the open letter are claiming that it was obvious that quantitative easing would not increase inflation. I must confess that I did not think that that was the case; I believed that quantitative easing by the Fed could indeed produce inflation. And that’s why I was in favor of quantitative easing. I was hoping for a repeat of what I have called the short but sweat recovery of 1933, when, in the depths of the Great Depression, almost immediately following the worst financial crisis in American history capped by a one-week bank holiday announced by FDR upon being inaugurated President in March 1933, the US economy, propelled by a 14% rise in wholesale prices in the aftermath of FDR’s suspension of the gold standard and 40% devaluation of the dollar, began the fastest expansion it ever had, industrial production leaping by 70% from April to July, and the Dow Jones average more than doubling. Unfortunately, FDR spoiled it all by getting Congress to pass the monumentally stupid National Industrial Recovery Act, thereby strangling the recovery with mandatory wage increases, cost increases, and regulatory ceilings on output as a way to raise prices. Talk about snatching defeat from the jaws of victory!

Inflation having worked splendidly as a recovery strategy during the Great Depression, I have believed all along that we could quickly recover from the Little Depression if only we would give inflation a chance. In the Great Depression, too, there were those that argued either that monetary policy is ineffective – “you can’t push on a string” — or that it would be calamitous — causing inflation and currency debasement – or, even both. But the undeniable fact is that inflation worked; countries that left the gold standard recovered, because once currencies were detached from gold, prices could rise sufficiently to make production profitable again, thereby stimulating multiplier effects (aka supply-side increases in resource utilization) that fueled further economic expansion. And oh yes, don’t forget providing badly needed relief to debtors, relief that actually served the interests of creditors as well.

So my problem with the open letter to Bernanke is not that the letter failed to recognize the existence of a Keynesian liquidity trap or a Hawtreyan credit deadlock, but that the open letter viewed inflation as the problem when, in my estimation at any rate, inflation is the solution.

Now, it is certainly possible that, as critics of the open letter maintain, monetary policy at the zero lower bound is ineffective. However, there is evidence that QE announcements, at least initially, did raise inflation expectations as reflected in TIPS spreads. And we also know (see my paper) that for a considerable period of time (from 2008 through at least 2012) stock prices were positively correlated with inflation expectations, a correlation that one would not expect to observe under normal circumstances.

So why did the huge increase in the monetary base during the Little Depression not cause significant inflation even though monetary policy during the Great Depression clearly did raise the price level in the US and in the other countries that left the gold standard? Well, perhaps the success of monetary policy in ending the Great Depression could not be repeated under modern conditions when all currencies are already fiat currencies. It may be that, starting from an interwar gold standard inherently biased toward deflation, abandoning the gold standard created, more or less automatically, inflationary expectations that allowed prices to rise rapidly toward levels consistent with a restoration of macroeconomic equilibrium. However, in the current fiat money system in which inflation expectations have become anchored to an inflation target of 2 percent or less, no amount of money creation can budge inflation off its expected path, especially at the zero lower bound, and especially when the Fed is paying higher interest on reserves than yielded by short-term Treasuries.

Under our current inflation-targeting monetary regime, the expectation of low inflation seems to have become self-fulfilling. Without an explicit increase in the inflation target or the price-level target (or the NGDP target), the Fed cannot deliver the inflation that could provide a significant economic stimulus. So the problem, it seems to me, is not that we are stuck in a liquidity trap; the problem is that we are stuck in an inflation-targeting monetary regime.


What Makes Deflation Good?

Earlier this week, there was a piece in the Financial Times by Michael Heise, chief economist at Allianz SE, arguing that the recent dip in Eurozone inflation to near zero is not a sign of economic weakness, but a sign of recovery reflecting increased competitiveness in the Eurozone periphery. Scott Sumner identified a systematic confusion on Heise’s part between aggregate demand and aggregate supply, so that without any signs that rapidly falling Eurozone inflation has been accompanied by an acceleration of anemic growth in Eurozone real GDP, it is absurd to attribute falling inflation to a strengthening economy. There’s not really much more left to say about Heise’s piece after Scott’s demolition, but, nevertheless, sifting through the rubble, I still want to pick up on the distinction that Heise makes between good deflation and bad deflation.

Nonetheless, bank lending has been on the retreat, bankruptcies have soared and disposable incomes have fallen. This is the kind of demand shock that fosters bad deflation: a financial crisis causes aggregate demand to shrink faster than supply, resulting in falling prices.

However, looking through the lens of aggregate supply, the difficulties of the eurozone’s periphery bear only a superficial resemblance to those plaguing Japan. In this case, falling prices are the result of a supply shock, through improved productivity or real wage reduction.

Low inflation or even deflation is testament to the fact that (painful) adjustment through structural reforms is finally working.

In other words, deflation associated with a financial crisis, causing liquidation of assets and forced sales of inventories, thereby driving down prices and engendering expectations of continuing price declines, is bad. However, the subsequent response to that deflationary shock – the elimination of production inefficiencies and the reduction of wages — is not bad, but good. Both responses to the initial deflationary contraction in aggregate demand correspond to a rightward shift of the aggregate supply curve, thereby tending to raise aggregate output and employment even while tending to causes a further reduction in the price level or the inflation rate.

It is also interesting to take note of the peculiar euphemism for cutting money wages adopted by Heise: internal devaluation. As he puts it:

The eurozone periphery is regaining competitiveness via internal devaluation. This could even be called “good deflation.”

Now in ordinary usage, the term “devaluation” signifies a reduction in the pegged value of one currency in terms of another. When a country devalues its currency, it is usually because that country is running a trade deficit for which foreign lenders are unwilling to provide financing. The cause of the trade deficit is that the country’s tradable-goods sector is not profitable enough to expand to the point that the trade deficit is brought into balance, or close enough to balance to be willingly financed by foreigners. To make expansion of its tradable-goods sector profitable, the country may resort to currency devaluation, raising the prices of exports and imports in terms of the domestic currency. With unchanged money wages, the increase in the prices of exports and imports makes expansion of the country’s tradable-goods sector profitable, thereby reducing or eliminating the trade deficit. What Heise means by “internal devaluation” in contrast to normal devaluation is a reduction in money wages, export and import prices being held constant at the fixed exchange.

There is something strange, even bizarre, about Heise’s formulation, because what he is saying amounts to this: a deflation is good insofar as it reduces money wages. So Heise’s message, delivered in an obscure language, apparently of his own creation, is that the high and rising unemployment of the past five years in the Eurozone is finally causing money wages to fall. Therefore, don’t do anything — like shift to an easier monetary policy — that would stop those blessed reductions in money wages. Give this much to Herr Heise, unlike American critics of quantitative easing who pretend to blame it for causing real-wage reductions by way of the resulting inflation, he at least is honest enough to criticize monetary expansion for preventing money (and real) wages from falling, though he has contrived a language in which to say this without being easily understood.

Actually there is a historical precedent for the kind of good deflation Heise appears to favor. It was undertaken by Heinrich Bruning, Chancellor of the Weimar Republic from 1930 to 1932, when, desperate to demonstrate Germany’s financial rectitude (less than a decade after the hyperinflation of 1923) he imposed, by emergency decree, draconian wage reductions aimed at increasing Germany’s international competitiveness, while remaining on the gold standard. The evidence does not suggest that the good deflation and internal devaluation adopted by Bruning’s policy of money-wage cuts succeeded in ending the depression. And internal devaluation was certainly not successful enough to keep Bruning’s government in office, its principal effect being to increase support for Adolph Hitler, who became Chancellor within less than nine months after Bruning’s government fell.

This is not to say that nominal wages should never be reduced, but the idea that nominal wage cuts could serve as the means to reverse an economic contraction has little, if any, empirical evidence to support it. A famous economist who supported deflation in the early 1930s believing that it would facilitate labor market efficiencies and necessary cuts in real wages, subsequently retracted his policy advice, admitting that he had been wrong to think that deflation would be an effective instrument to overcome rigidities in labor markets. His name? F. A. Hayek.

So there is nothing good about the signs of deflation that Heise sees. They are simply predictable follow-on effects of the aggregate demand shock that hit the Eurozone after the 2008 financial crisis, subsequently reinforced by the monetary policy of the European Central Bank, reflecting the inflation-phobia of the current German political establishment. Those effects, delayed responses to the original demand shock, do not signal a recovery.

What, then, would distinguish good deflation from bad deflation? Simple. If observed deflation were accompanied by a significant increase in output, associated with significant growth in labor productivity and increasing employment (indicating increasing efficiency or technological progress), we could be confident that the deflation was benign, reflecting endogenous economic growth rather than macroeconomic dysfunction. Whenever output prices are falling without any obvious signs of real economic growth, falling prices are a clear sign of economic dysfunction. If prices are falling without output rising, something is wrong — very wrong — and it needs fixing.

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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