Archive for the 'Deirdre McCloskey' Category

What’s Wrong with the Price-Specie-Flow Mechanism, Part III: Friedman and Schwartz on the Great US Inflation of 1933

I have been writing recently about two great papers by McCloskey and Zecher (“How the Gold Standard Really Worked” and “The Success of Purchasing Power Parity”) on the gold standard and the price-specie-flow mechanism (PSFM). This post, for the time being at any rate, will be the last in the series. My main topic in this post is the four-month burst of inflation in the US from April through July of 1933, an episode that largely escaped the notice of Friedman and Schwartz in their Monetary History  of the US, an omission criticized by McCloskey and Zecher in their purchasing-power-parity paper. (I will mention parenthetically that the 1933 inflation was noticed and its importance understood by R. G. Hawtrey in the second (1933) edition of his book Trade Depression and the Way Out and by Scott Sumner in his 2015 book The Midas Paradox. Both Hawtrey and Sumner emphasize the importance of the aborted 1933 recovery as have Jalil and Rua in an important recent paper.) In his published comment on the purchasing-power-parity paper, Friedman (pp. 157-62) responded to the critique by McCloskey and Zecher, and I will look carefully at that response below. But before discussing Friedman’s take on the 1933 inflation, I want to make four general comments about the two McCloskey and Zecher papers.

My first comment concerns an assertion made in a couple of places in which they interpret balance-of-payments surpluses or deficits under a fixed-exchange-rate regime as the mechanism by which excess demands for (supplies of) money in one country are accommodated by way of a balance-of-payments surpluses (deficits). Thus, given a fixed exchange rate between country A and country B, if the quantity of money in country A is less than the amount that the public in country A want to hold, the amount of money held in country A will be increased as the public, seeking to add to their cash holdings, collectively spend less than their income, thereby generating an export surplus relative to country B, and inducing a net inflow of country B’s currency into country A to be converted into country A’s currency at the fixed exchange rate. The argument is correct, but it glosses over a subtle point: excess supplies of, and excess demands for, money in this context are not absolute, but comparative. Money flows into whichever country has the relatively larger excess demand for money. Both countries may have an absolute excess supply of money, but the country with the comparatively smaller excess supply of money will nevertheless experience a balance-of-payments surplus and an inflow of cash.

My second comment is that although McCloskey and Zecher are correct to emphasize that the quantity of money in a country operating with a fixed exchange is endogenous, they fail to mention explicitly that, apart from the balance-of-payments mechanism under fixed exchange rates, the quantity of domestically produced inside money is endogenous, because there is a domestic market mechanism that adjusts the amount of inside money supplied by banks to the amount of inside money demanded by the public. Thus, under a fixed-exchange-rate regime, the quantity of inside money and the quantity of outside money are both endogenously determined, the quantity of inside money being determined by domestic forces, and the quantity of outside money determined by international forces operating through the balance-of-payments mechanism.

Which brings me to my third comment. McCloskey and Zecher have a two-stage argument. The first stage is that commodity arbitrage effectively constrains the prices of tradable goods in all countries linked by international trade. Not all commodities are tradable, and even tradable goods may be subject to varying limits — based on varying ratios of transportation costs to value — on the amount of price dispersion consistent with the arbitrage constraint. The second stage of their argument is that insofar as the prices of tradable goods are constrained by arbitrage, the rest of the price system is also effectively constrained, because economic forces constrain all relative prices to move toward their equilibrium values. So if the nominal prices of tradable goods are fixed by arbitrage, the tendency of relative prices between non-tradables and tradables to revert to their equilibrium values must constrain the nominal prices of non-tradable goods to move in the same direction as tradable-goods prices are moving. I don’t disagree with this argument in principle, but it’s subject to at least two qualifications.

First, monetary policy can alter spending patterns; if the monetary authority wishes, it can accumulate the inflow of foreign exchange that results when there is a domestic excess demand for money rather than allow the foreign-exchange inflow to increase the domestic money stock. If domestic money mostly consists of inside money supplied by private banks, preventing an increase in the quantity of inside money may require increasing the legal reserve requirements to which banks are subject. By not allowing the domestic money stock to increase in response to a foreign-exchange inflow, the central bank effectively limits domestic spending, thereby reducing the equilibrium ratio between the prices of non-tradables and tradables. A monetary policy that raises the relative price of tradables to non-tradables was called exchange-rate protection by the eminent Australian economist Max Corden. Although term “currency manipulation” is chronically misused to refer to any exchange-rate depreciation, the term is applicable to the special case in which exchange-rate depreciation is combined with a tight monetary policy thereby sustaining a reduced exchange rate.

Second, Although McCloskey and Zecher are correct that equilibrating forces normally cause the prices of non-tradables to move in the direction toward which arbitrage is forcing the prices of tradables to move, such equilibrating processes need not always operate powerfully. Suppose, to go back to David Hume’s classic thought experiment, the world is on a gold standard and the amount of gold in Britain is doubled while the amount of gold everywhere else is halved, so that the total world stock of gold is unchanged, just redistributed from the rest of the world to Britain. Under the PSFM view of the world, prices instantaneously double in Britain and fall by half in the rest of the world, and it only by seeking bargains in the rest of the world that Britain gradually exports gold to import goods from the rest of the world. Prices gradually fall in Britain and rise in the rest of the world; eventually (and as a first approximation) prices and the distribution of gold revert back to where they were originally. Alternatively, in the arbitrage view of the world, the prices of tradables don’t change, because in the world market for tradables, neither the amount of output nor the amount of gold has changed, so why should the price of tradables change? But if prices of tradables don’t change, does that mean that the prices of non-tradables won’t change? McCloskey and Zecher argue that if arbitrage prevents the prices of tradables from changing, the equilibrium relationship between the prices of tradables and non-tradables will also prevent the prices of non-tradables from changing.

I agree that the equilibrium relationship between the prices of tradables and non-tradables imposes some constraint on the movement of the prices of non-tradables, but the equilibrium relationship between the prices of tradables and non-tradables is not necessarily a constant. If people in Britain suddenly have more gold in their pockets, and they can buy all the tradable goods they want at unchanged prices, they may well increase their demand for non-tradables, causing the prices of British non-tradables to rise relative to the prices of tradables. The terms of trade will shift in Britain’s favor. Nevertheless, it would be very surprising if the price of non-tradables were to double, even momentarily, as the Humean PSFM argument suggests. Just because arbitrage does not strictly constrain the price of non-tradables does not mean that the appropriate default assumption is that the prices of non-tradables would rise by as much as suggested by a naïve quantity-theoretic PSFM extrapolation. Thus, the way to think of the common international price level under a fixed-exchange-rate regime is that the national price levels are linked by arbitrage, so that movements in national price levels are highly — but not necessarily perfectly — correlated.

My fourth comment is terminological. As Robert Lipsey (pp. 151-56) observes in his published comment about the McCloskey-Zecher paper on purchasing power parity (PPP), when the authors talk about PPP, they usually have in mind the narrower concept of the law of one price which says that commodity arbitrage keeps the prices of the same goods at different locations from deviating by more than the cost of transportation. Thus, a localized increase in the quantity of money at any location cannot force up the price of that commodity at that location by an amount exceeding the cost of transporting that commodity from the lowest cost alternative source of supply of that commodity. The quantity theory of money cannot operate outside the limits imposed by commodity arbitrage. That is the fundamental mistake underlying the PSFM.

PPP is a weaker proposition than the law of one price, refering to the relationship between exchange rates and price indices. If domestic price indices in two locations with different currencies rise by different amounts, PPP says that the expected change in the exchange rate between the two currencies is proportional to relative change in the price indices. But PPP is only an approximate relationship, while the law of one price is, within the constraints of transportation costs, an exact relationship. If all goods are tradable and transportation costs are zero, prices of all commodities sold in both locations will be equal. However, the price indices for the two location will not have the same composition, goods not being produced or consumed in the same proportions in the two locations. Thus, even if all goods sold in both locations sell at the same prices the price indices for the two locations need not change by the same proportions. If the price of a commodity exported by country A goes up relative to the price of the good exported by country B, the exchange rate between the two countries will change even if the law of one price is always satisfied. As I argued in part II of this series on PSFM, it was this terms-of-trade effect that accounted for the divergence between American and British price indices in the aftermath of the US resumption of gold convertibility in 1879. The law of one price can hold even if PPP doesn’t.

With those introductory comments out of the way, let’s now examine the treatment of the 1933 inflation in the Monetary History. The remarkable thing about the account of the 1933 inflation given by Friedman and Schwartz is that they treat it as if it were a non-event. Although industrial production increased by over 45% in a four-month period, accompanied by a 14% rise in wholesale prices, Friedman and Schwartz say almost nothing about the episode. Any mention of the episode is incidental to their description of the longer cyclical movements described in Chapter 9 of the Monetary History entitled “Cyclical Changes, 1933-41.” On p. 493, they observe: “the most notable feature of the revival after 1933 was not its rapidity but its incompleteness,” failing to mention that the increase of over 45% in industrial production from April to July was the largest increase industrial production over any four-month period (or even any 12-month period) in American history. In the next paragraph, Friedman and Schwartz continue:

The revival was initially erratic and uneven. Reopening of the banks was followed by rapid spurt in personal income and industrial production. The spurt was intensified by production in anticipation of the codes to be established under the National Industrial Recovery Act (passed June 16, 1933), which were expected to raise wage rates and prices, and did. (pp. 493-95)

Friedman and Schwartz don’t say anything about the suspension of convertibility by FDR and the devaluation of the dollar, all of which caused wholesale prices to rise immediately and substantially (14% in four months). It is implausible to think that the huge increase in industrial production and in wholesale prices was caused by the anticipation of increased wages and production quotas that would take place only after the NIRA was implemented, i.e., not before August. The reopening of the banks may have had some effect, but it is hard to believe that the effect would have accounted for more than a small fraction of the total increase or that it would have had a continuing effect over a four-month period. In discussing the behavior of prices, Friedman and Schwartz, write matter-of-factly:

Like production, wholesale prices first spurted in early 1933, partly for the same reason – in anticipation of the NIRA codes – partly under the stimulus of depreciation in the foreign exchange value of the dollar. (p. 496)

This statement is troubling for two reasons: 1) it seems to suggest that anticipation of the NIRA codes was at least as important as dollar depreciation in accounting for the rise in wholesale prices; 2) it implies that depreciation of the dollar was no more important than anticipation of the NIRA codes in accounting for the increase in industrial production. Finally, Friedman and Schwartz assess the behavior of prices and output over the entire 1933-37 expansion.

What accounts for the greater rise in wholesale prices in 1933-37, despite a probably higher fraction of the labor force unemployed and of physical capacity unutilized than in the two earlier expansions [i.e., 1879-82, 1897-1900]? One factor, already mentioned, was devaluation with its differential effect on wholesale prices. Another was almost surely the explicit measures to raise prices and wages undertaken with government encouragement and assistance, notably, NIRA, the Guffey Coal Act, the agricultural price-support program, and National Labor Relations Act. The first two were declared unconstitutional and lapsed, but they had some effect while in operation; the third was partly negated by Court decisions and then revised, but was effective throughout the expansion; the fourth, along with the general climate of opinion it reflected, became most important toward the end of the expansion.

There has been much discussion in recent years of a wage-price spiral or price-wage spiral as an explanation of post-World War II price movements. We have grave doubts that autonomous changes in wages and prices played an important role in that period. There seems to us a much stronger case for a wage-price or price-wage spiral interpretation of 1933-37 – indeed this is the only period in the near-century we cover for which such an explanation seems clearly justified. During those years there were autonomous forces raising wages and prices. (p. 498)

McCloskey and Zecher explain the implausibility of the idea that the 1933 burst of inflation (mostly concentrated in the April-July period) that largely occurred before NIRA was passed and almost completely occurred before the NIRA was implemented could be attributed to the NIRA.

The chief factual difficulties with the notion that the official cartels sanctioned by the NRA codes caused a rise in the general price level is that most of the NRA codes were not enacted until after the price rise. Ante hoc ergo non propter hoc. Look at the plot of wholesale prices of 1933 in figure 2.3 (retail prices, including such nontradables as housing, show a similar pattern). Most of the rise occurs in May, June, and July of 1933, but the NIRA was not even passed until June. A law passed, furthermore, is not a law enforced. However eager most businessmen must have been to cooperate with a government intent on forming monopolies, the formation took time. . . .

By September 1933, apparently before the approval of most NRA codes — and, judging from the late coming of compulsion, before the effective approval of agricultural codes-three-quarters of the total rise in wholesale prices and more of the total rise in retail food prices from March 1933 to the average of 1934 was complete. On the face of it, at least, the NRA is a poor candidate for a cause of the price rise. It came too late.

What came in time was the depreciation of the dollar, a conscious policy of the Roosevelt administration from the beginning. . . . There was certainly no contemporaneous price rise abroad to explain the 28-percent rise in American wholesale prices (and in retail food prices) between April 1933 and the high point in September 1934. In fact, in twenty-five countries the average rise was only 2.2 percent, with the American rise far and away the largest.

It would appear, in short, that the economic history of 1933 cannot be understood with a model closed to direct arbitrage. The inflation was no gradual working out of price-specie flow; less was it an inflation of aggregate demand. It happened quickly, well before most other New Deal policies (and in particular the NRA) could take effect, and it happened about when and to the extent that the dollar was devalued. By the standard of success in explaining major events, parity here works. (pp. 141-43)

In commenting on the McCloskey-Zecher paper, Friedman responds to their criticism of account of the 1933 inflation presented in the Monetary History. He quibbles about the figure in which McCloskey and Zecher showed that US wholesale prices were highly correlated with the dollar/sterling exchange rate after FDR suspended the dollar’s convertibility into gold in April, complaining that chart leaves the impression that the percentage increase in wholesale prices was as large as the 50% decrease in the dollar/sterling exchange rate, when in fact it was less than a third as large. A fair point, but merely tangential to the main issue: explaining the increase in wholesale prices. The depreciation in the dollar can explain the increase in wholesale prices even if the increase in wholesale prices is not as great as the depreciation of the dollar. Friedman continues:

In any event, as McCloskey and Zecher note, we pointed out in A Monetary History that there was a direct effect of devaluation on prices. However, the existence of a direct effect on wholesale prices is not incompatible with the existence of many other prices, as Moe Abramovitz has remarked, such as non-tradable-goods prices, that did not respond immediately or responded to different forces. An index of rents paid plotted against the exchange rate would not give the same result. An index of wages would not give the same result. (p. 161)

In saying that the Monetary History acknowledged that there was a direct effect of devaluation on prices, Friedman is being disingenuous; by implication at least, the Monetary History suggests that the importance of the NIRA for rising prices and output even in the April to July 1933 period was not inferior to the effect of devaluation on prices and output. Though (belatedly) acknowledging the primary importance of devaluation on wholesale prices, Friedman continues to suggest that factors other than devaluation could have accounted for the rise in wholesale prices — but (tellingly) without referring to the NIRA. Friedman then changes the subject to absence of devaluation effects on the prices of non-tradable goods and on wages. Thus, he is left with no substantial cause to explain the sudden rise in US wholesale prices between April and July 1933 other than the depreciation of the dollar, not the operation of PSFM. Friedman and Schwartz could easily have consulted Hawtrey’s definitive contemporaneous account of the 1933 inflation, but did not do so, referring only once to Hawtrey in the Monetary History (p. 99) in connection with changes by the Bank of England in Bank rate in 1881-82.

Having been almost uniformly critical of Friedman, I would conclude with a word on his behalf. In the context of Great Depression, I think there are good reasons to think that devaluation would not necessarily have had a significant effect on wages and the prices of non-tradables. At the bottom of a downturn, it’s likely that relative prices are far from their equilibrium values. So if we think of devaluation as a mechanism for recovery and restoring an economy to the neighborhood of equilibrium, we would not expect to see prices and wages rising uniformly. So if, for the sake of argument, we posit that real wages were in some sense too high at the bottom of the recession, we would not necessarily expect that a devaluation would cause wages (or the prices of non-tradables) to rise proportionately with wholesale prices largely determined in international markets. Friedman actually notes that the divergence between the increase of wholesale prices and the increase in the implicit price deflator in 1933-37 recovery was larger than in the 1879-82 or the 1897-99 recoveries. The magnitude of the necessary relative price adjustment in the 1933-37 episode may have been substantially greater than it was in either of the two earlier episodes.

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What’s Wrong with the Price-Specie-Flow Mechanism, Part II: Friedman and Schwartz on the 1879 Resumption

Having explained in my previous post why the price-specie-flow mechanism (PSFM) is a deeply flawed mischaracterization of how the gold standard operated, I am now going to discuss two important papers by McCloskey and Zecher that go explain in detail the conceptual and especially the historical shortcomings of PSFM. The first paper (“How the Gold Standard Really Worked”) was published in the 1976 volume edited by Johnson and Frenkel, The Monetary Approach to the Balance of Payments; the second paper, (“The Success of Purchasing Power Parity: Historical Evidence and its Relevance for Macroeconomics”) was published in a 1984 NBER conference volume edited by Schwartz and Bordo, A Retrospective on the Classical Gold Standard 1821-1931. I won’t go through either paper in detail, but I do want to mention their criticisms of The Monetary History of the United States, 1867-1960, by Friedman and Schwartz and Friedman’s published response to those criticisms in the Schwartz-Bordo volume. I also want to register a mild criticism of an error of omission by McCloskey and Zecher in failing to note that, aside from the role of the balance of payments under the gold standard in equilibrating the domestic demand for money with the domestic supply of money, there is also a domestic mechanism for equilibrating the domestic demand for money with the domestic supply; it is only when the domestic mechanism does not operate that the burden for adjustment falls upon the balance of payments. I suspect that McCloskey and Zecher would not disagree that there is a domestic mechanism for equilibrating the demand for money with the supply of money, but the failure to spell out the domestic mechanism is still a shortcoming in these two otherwise splendid papers.

McCloskey and Zecher devote a section of their paper to the empirical anomalies that beset the PSFM.

If the orthodox theories of the gold standard are incorrect, it should be possible to observe signs of strain in the literature when they are applied to the experiences of the late nineteenth century. This is the case. Indeed, in the midst of their difficulties in applying the theories earlier observers have anticipated most of the elements of the alternative theory proposed here.

On the broadest level it has always been puzzling that the gold standard in its prime worked so smoothly. After all, the mechanism described by Hume, in which an initial divergence in price levels was to be corrected by flows of gold inducing a return to parity, might be expected to work fairly slowly, requiring alterations in the money supply and, more important, in expectations concerning the level and rate of change of prices which would have been difficult to achieve. The actual flows of gold in the late nineteenth century, furthermore, appear too small to play the large role assigned to them. . . . (pp. 361-62)

Later in the same section, they criticize the account given by Friedman and Schwartz of how the US formally adopted the gold standard in 1879 and its immediate aftermath, suggesting that the attempt by Friedman and Schwartz to use PSFM to interpret the events of 1879-81 was unsuccessful.

The behavior of prices in the late nineteenth century has suggested to some observers that the view that it was gold flows that were transmitting price changes from one country to another is indeed flawed. Over a short period, perhaps a year or so, the simple price-specie-flow mechanism predicts an inverse correlation in the price levels of two countries interacting with each other on the gold standard. . . . Yet, as Triffin [The Evolution of the International Monetary System, p. 4] has noted. . . even over a period as brief as a single year, what is impressive is “the overeall parallelism – rather than divergence – of price movements, expressed in the same unit of measurement, between the various trading countries maintaining a minimum degree of freedom of trade and exchange in their international transactions.

Over a longer period of time, of course, the parallelism is consistent with the theory of the price-specie-flow. In fact, one is free to assume that the lags in its mechanism are shorter than a year, attributing the close correlations among national price levels within the same year to a speedy flow of gold and a speedy price change resulting from the flow rather than to direct and rapid arbitrage. One is not free, however, to assume that there were no lags at all; in the price-specie-flow theory inflows of gold must precede increase in prices by at least the number of months necessary for the money supply to adjust to the new gold and for the increased amount of money to have an inflationary effect. The American inflation following the resumption of specie payments in January 1879 is a good example. After examining the annual statistics on gold flows and price levels for the period, Friedman and Schwartz [Monetary History of the United States, 1867-1960, p. 99] concluded that “It would be hard to find a much neater example in history of the classical gold-standard mechanism in operation.” Gold flowed in during 1879, 1880, and 1881 and American prices rose each year. Yet the monthly statistics on American gold flows and price changes tell a very different story. Changes in the Warren and Pearson wholesale price index during 1879-81 run closely parallel month by month with gold flows, rising prices corresponding to net inflows of gold. There is no tendency for prices to lag behind a gold flow and some tendency for them to lead it, suggesting not only the episode is an especially poor example of the price-specie flow theory in operation, but also that it might well be a reasonably good one of the monetary theory. (pp. 365-66)

Now let’s go back and see exactly what Friedman and Schwartz said about the episode in the Monetary History. Here is how they describe the rapid expansion starting with the resumption of convertibility on January 1, 1879:

The initial cyclical expansion from 1879 to 1882 . . . was characterized by an unusually rapid rise in the stock of money and in net national product in both current and constant prices. The stock of money rose by over 50 per cent, net national product in current prices over 35 per cent, and net national product in constant prices nearly 25 per cent. . . . (p. 96)

The initial rapid expansion reflected a combination of favorable physical and financial factors. On the physical side, the preceding contraction had been unusually protracted; once it was over, there tended to be a vigorous rebound; this is a rather typical pattern of reaction. On the financial side, the successful achievement of resumption, by itself, eased pressure on the foreign exchanges and permitted an internal price rise without external difficulties, for two reasons: first, because it eliminated the temporary demand for foreign exchange on the part of the Treasury to build up its gold reserve . . . second because it promoted a growth in U.S. balances held by foreigners and a decline in foreign balances held by U.S. residents, as confidence spread that the specie standard would be maintained and that the dollar would not depreciate again. (p. 97)

The point about financial conditions that Friedman and Schwartz are making is that, in advance of resumption, the US Treasury had been buying gold to increase reserves with which to satisfy potential demands for redemption once convertibility at the official parity was restored. The gold purchases supposedly forced the US price level to drop further (at the official price of gold, corresponding to a $4.86 dollar/sterling exchange rate) than it would have fallen if the Treasury had not been buying gold. (See quotation below from p. 99 of the Monetary History). Their reasoning is that the additional imports of gold ultimately had to be financed by a corresponding export surplus, which required depressing the US price level below the price level in the rest of the world sufficiently to cause a sufficient increase in US exports and decrease of US imports. But the premise that US exports could be increased and US imports could be decreased only by reducing the US price level relative to the rest of the world is unfounded. The incremental export surplus required only that total domestic expenditure be reduced, thereby allowing an incremental increase US exports or reduction in US imports. Reduced US spending would have been possible without any change in US prices. Friedman and Schwartz continue:

These forces were powerfully reinforced by accidents of weather that produced two successive years of bumper crops in the United States and unusually short crops elsewhere. The result was an unprecedentedly high level of exports. Exports of crude foodstuffs, in the years ending June 30, 1889 and 1881, reached levels roughly twice the average of either the preceding or the following year five years. In each year they were higher than in any preceding year, and neither figure was again exceeded until 1892. (pp. 97-98)

This is a critical point, but neither Friedman and Schwartz nor McCloskey and Zecher in their criticism seem to recognize its significance. Crop shortages in the rest of the world must have caused a substantial increase in grain and cotton prices, but Friedman and Schwartz provide no indication of the magnitudes of the price increases. At any rate, the US was then still a largely agricultural economy, so a substantial rise in agricultural prices determined in international markets would imply an increase in an index of US output prices relative to an index of British output prices reflecting both a shifting terms of trade in favor of the US and a higher share of total output accounted for by agricultural products in the US than in Britain. That shift, and the consequent increase in US versus British price levels, required no divergence between prices in the US and in Britain, and could have occurred without operation of the PSFM. Ignoring the terms-of-trade effect after drawing attention to the bumper crops in the US and crop failures elsewhere was an obvious error in the narrative provided by Friedman and Schwartz. With that in mind, let us return to their narrative.

The resulting increased demand for dollars meant that a relatively higher price level in the United States was consistent with equilibrium in the balance of payments.

Friedman and Schwartz are assuming that a demand for dollars under a fixed-exchange-rate regime can be satisfied only by through an incremental adjustment in exports and imports to induce an offsetting flow of dollars. Such a demand for dollars could also be satisfied by way of appropriate banking and credit operations requiring no change in imports and exports, but even if the demand for money is satisfied through an incremental adjustment in the trade balance, the implicit assumption that an adjustment in the trade balance requires an adjustment in relative price levels is totally unfounded; the adjustment in the trade balance can occur with no divergence in prices, such a divergence being inconsistent with the operation of international arbitrage.

Pending the rise in prices, it led to a large inflow of gold. The estimated stock of gold in the United States rose from $210 million on June 30, 1879, to $439 million on June 30, 1881.

The first sentence is difficult to understand. Having just asserted that there was a rise in US prices, why do Friedman and Schwartz now suggest that the rise in prices has not yet occurred? Presumably, the antecedent of the pronoun “it” is the demand for dollars, but why is the demand for dollars conditioned on a rise in prices? There are any number of reasons why there could have been an inflow of gold into the United States. (Presumably, higher than usual import demand could have led to a temporary drawdown of accumulated liquid assets, e.g., gold, in other countries to finance their unusually high grain imports. Moreover, the significant wealth transfer associated with a sharply improving terms of trade in favor of the US would have led to an increased demand for gold, either for real or monetary uses. More importantly, as banks increased the amount of deposits and banknotes they were supplying to the public, the demand of banks to hold gold reserves would have also increased.)

In classical gold-standard fashion, the inflow of gold helped produce an expansion in the stock of money and in prices. The implicit price index for the U.S. rose 10 per cent from 1879 to 1882 while a general index of British prices was roughly constant, so that the price level in the United States relative to that in Britain rose from 89.1 to 96.1. In classical gold-standard fashion, also, the outflow of gold from other countries produced downward pressure on their stock of money and their prices.

To say that the inflow of gold helped produce an expansion in the stock of money and in prices is simply to invoke the analytically empty story that gold reserves are lent out to the public, because the gold is sitting idle in bank vaults just waiting to be put to active use. But gold doesn’t just wind up sitting in a bank vault for no reason. Banks demand it for a purpose; either they are legally required to hold the gold or they find it more useful or rewarding to hold gold than to hold alternative assets. Banks don’t create liabilities payable in gold because they are holding gold; they hold gold because they create liabilities payable in gold; creating liabilities legally payable in gold may entail a legal obligation to hold gold reserves, or create a prudential incentive to keep some gold on hand. The throw-away references made by Friedman and Schwartz to “classical gold-standard fashion” is just meaningless chatter, and the divergence between the US and the British price indexes between 1879 and 1882 is attributable to a shift in the terms of trade of which the flow of gold from Britain to the US was the effect not the cause.

The Bank of England reserve in the Banking Department declined by nearly 40 percent from mid-1879 to mid-1881. In response, Bank rate was raised by steps from 2.5 per cent in April 1881 to 6 per cent in January 1882. The resulting effects on both prices and capital movements contributed to the cessation of the gold outflow to the U.S., and indeed, to its replacement by a subsequent inflow from the U.S. . . . (p. 98)

The only evidence about the U.S. gold stock provided by Friedman and Schwartz is an increase from $210 million to $439 million between June 30, 1879 to June 30, 1881. They juxtapose that with a decrease in the gold stock held by the Bank of England between mid-1879 and mid-1881, and an increase in Bank rate from 2.5% to 6%. Friedman and Schwartz cite Hawtrey’s Century of Bank Rate as the source for this fact (the only citation of Hawtrey in the Monetary History). But the increase in Bank rate from 2.5% did not begin till April 28, 1881, Bank rate having fluctuated between 2 and 3% from January 1878 to April 1881, two years and three months after the resumption. Discussing the fluctuations in the gold reserve of the Bank England in 1881, Hawtrey states:

The exports of gold had abated in the earlier part of the year, but set in again in August, and Bank rate was raised to 4 per cent. On the 6th of October it was put up to 5 per cent and on the 30th January, 1882, to 6.

The exports of gold had been accentuated in consequence of the crisis in Paris in January, 1882, resulting from the failure of the Union Generale. The loss of gold by export stopped almost immediately after the rise to 6 per cent. In fact the importation into the United States was ceasing, in consequence partly of the silver legislation which went far to satisfy the need for currency with silver certificates. (p. 102)

So it’s not at all clear from the narrative provided by Friedman and Schwartz to what extent the Bank of England, in raising Bank rate in 1881, was responding to the flow of gold to the United States, and they certainly do not establish that price-level changes between 1879 to 1881 reflected monetary, rather than real, forces. Here is how Friedman and Schwartz conclude their discussion of the effects of the resumption of US gold convertibility.

These gold movements and those before resumption have contrasting economic significance. As mentioned in the preceding chapter, the inflow into the U.S. before resumption was deliberately sought by the Treasury and represented an increased demand for foreign exchange. It required a surplus in the balance of payments sufficient to finance the gold inflow. The surplus could be generated only by a reduction in U.S. prices relative to foreign prices or in the price of the U.S. dollar relative to foreign currencies and was, in fact, generated by a relative reduction in U.S. prices. The gold inflow was, as it were, the active element to which the rest of the balance of payments adjusted.

This characterization of the pre-resumption deflationary process is certainly correct insofar as refers to the necessity of a deflation in US dollar prices for the dollar to appreciate to allow convertibility into gold at the 1861 dollar price of gold and dollar/sterling exchange rate. It is not correct insofar as it suggests that beyond the deflation necessary to restore purchasing power parity, a further incremental deflation was required to finance the Treasury’s demand for foreign exchange

After resumption, on the other hand, the active element was the increased demand for dollars resulting largely from the crop situation. The gold inflow was a passive reaction which temporarily filled the gap in payments. In its absence, there would have had to be an appreciation of the dollar relative to other currencies – a solution ruled out by the fixed exchange rate under the specie standard – or a more rapid [sic! They meant “less rapid”] rise in internal U.S. prices. At the same time, the gold inflow provided the basis and stimulus for an expansion in the stock of money and thereby a rise in internal prices at home and downward pressure on the stock of money and price abroad sufficient to bring an end to the necessity for large gold inflows. (p. 99)

This explanation of the causes of gold movements is not correct. The crop situation was a real, not a monetary, disturbance. We would now say that there was a positive supply shock in the US and a negative supply shock in the rest of the world, causing the terms of trade to shift in favor of the US. The resulting gold inflow reflected an increased US demand for gold induced by rapid economic growth and the improved terms of trade and a reduced demand to hold gold elsewhere to finance a temporary excess demand for grain. The monetary demand for gold would have also increased as a result of an increasing domestic demand for money. An increased demand for money could induce an inflow of gold to be minted into coin or to be held as legally required reserves for banknotes or to be held as bank reserves for deposits. The rapid increase in output and income, fueled in part by the positive supply shock and the improving terms of trade, would normally be expected to increase the demand to hold money. If the gold inflow was the basis, or the stimulus, for an expansion of the money stock, then increases in the gold stock should have preceded increases in the money stock. But as I am going to show, Friedman himself later provided evidence showing that in this episode the money stock at first increased more rapidly than the gold stock. And just as price increases and money expansion in the US were endogenous responses to real shocks in output and the terms of trade, adjustments in the stock of money and prices abroad were not the effects of monetary disturbances but endogenous monetary adjustments to real disturbances.

Let’s now turn to the second McCloskey-Zecher paper in which they returned to the 1879 resumption of gold convertibility by the US.

In an earlier paper (1976, p. 367) we reviewed the empirical anomalies in the price-specie-flow mechanism. For instance, we argued that Milton Friedman and Anna Schwartz misapplied the mechanism to an episode in American history. The United States went back on the gold standard in January 1879 at the pre-Civil War parity. The American price level was too low for the parity, allegedly setting the mechanism in motion. Over the next three years, Friedman and Schwartz argued from annual figures, gold flowed in and the price level rose just as Hume would have had it. They conclude (1963, p. 99) that “it would be hard to find a much neater example in history of the classical gold-standard mechanism in operation.” On the contrary, however, we believe it seems much more like an example of purchasing-power parity and the monetary approach than of the Humean mechanism. In the monthly statistics (Friedman and Schwartz confined themselves to annual data), there is no tendency for price rises to follow inflows of gold, as they should in the price-specie-flow mechanism; if anything, there is a slight tendency for price rises to precede inflows of gold, as they would if arbitrage were shortcutting the mechanism and leaving Americans with higher prices directly and a higher demand for gold. Whether or not the episode is a good example of the monetary theory, it is a poor example of the price-specie-flow mechanism. (p. 126)

Milton Friedman, a discussant at the conference at which McCloskey and Zecher presented their paper, submitted his amended remarks about the paper which were published in the volume along with comments of the other discussant, Robert E. Lipsey, and a transcript of the discussion of the paper by those in attendance. Here is Friedman’s response.

[McCloskey and Zecher] quote our statement that “it would be hard to find a much neater example in history of the classical gold-standard mechanism in operation” (p. 99). Their look at that episode on the basis of monthly data is interesting and most welcome, but on closer examination it does not, contrary to their claims, contradict our interpretation of the episode. McCloskey and Zecher compare price rises to inflows of gold, concluding, “In the monthly statistics … there is no tendency for price rises to follow inflows of gold . . . ; if anything, there is a slight tendency for price rises to precede inflows of gold, as they would if arbitrage were shortcutting the mechanism.”

Their comparison is the wrong one for determining whether prices were reacting to arbitrage rather than reflecting changes in the quantity of money. For that purpose the relevant comparison is with the quantity of money. Gold flows are relevant only as a proxy for the quantity of money. (p. 159)

I don’t understand this assertion at all. Gold flows are not simply a proxy for the quantity of money, because the whole premise of the PSFM is, as he and Schwartz assert in the Monetary History, that gold flows provide the “basis and stimulus for” an increase in the quantity of money.

If we compare price rises with changes in the quantity of money directly, a very different picture emerges than McCloskey and Zecher draw (see table C2.1). Our basic estimates of the quantity of money for this period are for semiannual dates, February and August. Resumption took effect on 1 January 1879. From August 1878 to February 1879, the money supply declined a trifle, continuing a decline that had begun in 1875 in final preparation for resumption. From February 1879 to August 1879, the money supply rose sharply, according to our estimates, by 15 percent. The Warren-Pearson monthly wholesale price index fell in the first half of 1879, reflecting the earlier decline in the money stock. It started its sharp rise in September 1879, or at least seven months later than the money supply.

Again, I don’t understand Friedman’s argument. The quantity of money began to rise after the resumption. In fact, Friedman’s own data show that in the six months from February to August of 1879, the quantity of money rose by 14.8% and the gold stock by 10.6%, without any effect on the price level. Friedman asserts that the price level only started to increase in September 8 or 9 months after the resumption in January. But it seems quite plausible that the fall harvest would have been the occasion for the effects of crop failures on grain prices to begin to make themselves felt on wholesale prices. So Friedman’s own evidence undercuts his argument that the increase in the quantity of money was what was driving the increase in US prices.

As to gold, the total stock of gold, as well as gold held by the Treasury, had been rising since 1877 as part of the preparation for resumption. But it had been rising at the expense of other components of high-powered money, which actually fell slightly. However, the decline in the money stock before 1879 had been due primarily to a decline in the deposit-currency ratio and the deposit-reserve ratio. After successful resumption, both ratios rose, which enabled the stock of money to rise despite no initial increase in gold flows. The large step-up in gold inflows in the fall of 1879, to which McCloskey and Zecher call attention, was mostly absorbed in raising the fraction of high-powered money in the form of gold rather than in speeding up monetary growth.

I agree with Friedman that the rapid increase in gold flows starting the fall of 1879 probably had little to do with the increase in the US price level, that increase reflecting primarily the terms-of-trade effect of rising agricultural prices, not a divergence between prices in the US and prices elsewhere in the world.  But that does not justify Friedman’s self-confident reiteration of the conclusion reached in the Monetary History that it would be hard to find a much neater example in history of the classical gold standard mechanism in operation. On the contrary, I see no evidence at all that “the classical gold standard mechanism” aka PSFM had anything to do with the behavior of prices after the resumption.

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.

In Praise of Israel Kirzner

Over the holiday weekend, I stumbled across, to my pleasant surprise, the lecture given just a week ago by Israel Kirzner on being awarded the 2015 Hayek medal by the Hayek Gesellschaft in Berlin. The medal, it goes without saying, was richly deserved, because Kirzner’s long career spanning over half a century has produced hundreds of articles and many books elucidating many important concepts in various areas of economics, but especially on the role of competition and entrepreneurship (the title of his best known book) in theory and in practice. A student of Ludwig von Mises, when Mises was at NYU in the 1950s, Kirzner was able to recast and rework Mises’s ideas in a way that made them more accessible and more relevant to younger generations of students than were the didactic and dogmatic pronouncements so characteristic of Mises’s own writings. Not that there wasn’t and still isn’t a substantial market niche in which such didacticism and dogmatism is highly prized, but there are also many for whom those features of the Misesian style don’t go down quite so easily.

But it would be very unfair, and totally wrong, to think of Kirzner as a mere popularizer of Misesian doctrines. Although in his modesty and self-effacement, Kirzner made few, if any, claims of originality for himself, his application of ideas that he learned from, or, having developed them himself, read into, Mises, Kirzner’s contributions in their own way were not at all lacking originality and creativity. In a certain sense, his contribution was, in its own way, entrepreneurial, i.e., taking a concept or an idea or an analytical tool applied in one context and deploying that concept, idea, or tool in another context. It’s worth mentioning that a reverential attitude towards one’s teachers and intellectual forbears is not only very much characteristic of the Talmudic tradition of which Kirzner is also an accomplished master, but it’s also characteristic, or at least used to be, of other scholarly traditions, notably Cambridge, England, where such illustrious students of Alfred Marshall as Frederick Lavington and A. C. Pigou viewed themselves as merely elaborating on doctrines that had already been expounded by Marshall himself, Pigou having famously said of his own voluminous work, “it’s all in Marshall.”

But rather than just extol Kirzner’s admirable personal qualities, I want to discuss what Kirzner said in his Hayek lecture. His main point was to explain how, in his view, the Austrian tradition, just as it seemed to be petering out in the late 1930s and 1940s, evolved from just another variant school of thought within the broader neoclassical tradition that emerged late in the 19th century from the marginal revolution started almost simultaneously around 1870 by William Stanley Jevons in England, Carl Menger in Austria, and Leon Walras in France/Switzerland, into a completely distinct school of thought very much at odds with the neoclassical mainstream. In Kirzner’s view, the divergence between Mises and Hayek on the one hand and the neoclassical mainstream on the other was that Mises and Hayek went further in developing the subjectivist paradigm underlying the marginal-utility theory of value introduced by Jevons, Menger, and Walras in opposition to the physicalist, real-cost, theory of value inherited from Smith, Ricardo, Mill, and other economists of the classical school.

The marginal revolution shifted the focus of economics from the objective physical and technological forces that supposedly determine cost, which, in turn, supposedly determines value, to subjective, not objective, mental states or opinions that characterize preferences, which, in turn, determine value. And, as soon became evident, the new subjective marginalist theory of value implied that cost, at bottom, is nothing other than a foregone value (opportunity cost), so that the classical doctrine that cost determines value has it exactly backwards: it is really value that determines cost (though it is usually a mistake to suppose that in complex systems causation runs in only one direction).

However, as the neoclassical research program evolved, the subjective character of the underlying theory was increasingly de-emphasized, a de-emphasis that was probably driven by two factors: 1) the profoundly paradoxical nature of the idea that value determines cost, not the reverse, and b) the mathematicization of economics and the increasing adoption, in the Walrasian style, of functional representations of utility and production, leading to the construction of models of economic equilibrium that, under appropriate continuity and convexity assumptions, could be shown to have a theoretically determinate and unique solution. The false impression was created that economics was an objective science like physics, and that economics should aim to create objective and deterministic scientific representations (models) of complex economic systems that could then yield quantitatively precise predictions, in the same way that physics produced models of planetary motion yielding quantitatively precise predictions.

What Hayek and Mises objected to was the idea, derived from the functional approach to economic theory, that economics is just a technique of optimization subject to constraints, that all economic problems can be reduced to optimization problems. And it is a historical curiosum that one of the chief contributors to this view of economics was none other than Lionel Robbins in his seminal methodological work An Essay on the Nature and Significance of Economic Science, written precisely during that stage of his career when he came under the profound influence of Mises and Hayek, but before Mises and Hayek adopted the more radically subjective approach that characterizes their views in the late 1930s and 1940s. The critical works are Hayek’s essays reproduced as The Counterrevolution of Science and his essays “Economics and Knowledge,” “The Facts of the Social Sciences,” “The Use of Knowledge in Society,” and “The Meaning of Competition,” all contained in the remarkable volume Individualism and Economic Order.

What neoclassical economists who developed this deterministic version of economic theory, a version wonderfully expounded in Samuelson Foundations of Economic Analysis and ultimately embodied in the Arrow-Debreu general-equilibrium model, failed to see is that the model could not incorporate in an intellectually satisfying or empirically fruitful way the process of economic growth and development. The fundamental characteristic of the Arrow-Debreu model is its perfection. The solution of the model is Pareto-optimal, and cannot be improved upon; the entire unfolding of the model from beginning to end proceeds entirely according to a plan (actually a set of perfectly consistent and harmonious individual plans) with no surprises and no disappointments relative to what was already foreseen and planned — in detail — at the outset. Nothing is learned in the unfolding and execution of those detailed, perfectly harmonious plans that was not already known at the beginning, whatever happens having already been foreseen. If something truly new would have been learned in the course of the unfolding and execution of those plans, the new knowledge would necessarily have been surprising, and a surprise would necessarily have generated some disappointment and caused some revision of a previously formulated plan of action. But that is precisely what the Arrow-Debreu model, in its perfection, disallows. And that is what, from the perspective of Mises, Hayek, and Kirzner, is exactly wrong with the entire development of neoclassical theory for the past 80 years or more.

The specific point of the neoclassical paradigm on which Kirzner has focused his criticism is the inability of the neoclassical paradigm to find a place for the entrepreneur and entrepreneurial activity in its theoretical apparatus. Profit is what is earned by the entrepreneur, but in full general equilibrium, all income is earned by factors of production, so profits have been exhausted and the entrepreneur euthanized.

Joseph Schumpeter, who was torn between his admiration for the Walrasian general equilibrium system and his Austrian education in economics, tried to reintroduce the entrepreneur as the disruptive force behind the process of creative destruction, the role of the entrepreneur being to disrupt the harmonious equilibrium of the Walrasian system by innovating – introducing either new techniques of production or new consumer products. Kirzner, however, though not denying that disruptive Schumpeterian entrepreneurs may come on the scene from time to time, is focused on a less disruptive, but more pervasive and more characteristic type of entrepreneurship, the kind that is on the lookout for – that is alert to – the profit opportunities that are always latent in the existing allocation of resources and the current structure of input and output prices. Prices in some places or at some times may be high relative to other places and other times, so the entrepreneurial maxim is: buy cheap and sell dear.

Not so long ago, someone noticed that used book prices on Amazon are typically lower at the end of the semester or the school year, when students are trying to unload the books that they don’t want to keep, than they are at the beginning of the semester, when students are buying the books that they will have to read in the new semester. By buying the books students are selling at the end of the school year and selling them at the beginning of the school year, the insightful entrepreneur reduces the cost to students of obtaining the books they use during the school year. That bit of insight and alertness is classic Kirznerian entrepreneurship in action; it was rewarded by a profit, but the activity was equilibrating, not disruptive, reducing the spread between prices for the same, or very similar, commodities paid by buyers or received by sellers at different times of the year.

Sometimes entrepreneurship involves recognizing that a resource or a factor of production is undervalued in its current use. Shifting the resource from a relatively low-valued use to a higher-value use generates a profit for the alert entrepreneur. Here, again, the activity is equilibrating not disruptive. And as others start to catch on, the profit earned on the spread between the value of the resource in its old and new uses will be eroded by the competition of copy-cat entrepreneurs and of other entrepreneurs with an even better idea derived from an even more penetrating insight.

Here is another critical point. Rarely does a new idea come into existence and cause just one change. Every change creates a new and different situation, potentially creating further opportunities to be taken advantage of by other alert and insightful individuals. In an open competitive system, there is no reason why the process of discovery and adaptation should ever come to an end state in which new insights can no longer be made and change is no longer possible.

However, it also the case that knowledge or information is often imperfect and faulty, and that incentives are imperfectly aligned with actual benefits, so that changes can be profitable even though they lead to inferior outcomes. Margarine can be substituted for butter, and transfats for saturated fats. Big mistake. But who knew? And processed carbohydrates can replace fats in low-fat diets. Big mistake. But who knew?

I myself had the pleasure of experiencing first-hand, on a very small scale to be sure, but still in a very inspiring way, this sort of unplanned, serendipitous connection between my stumbling across Kirzner’s Hayek lecture and, then, after starting to write this post a couple of days ago, doing a Google search on Kirzner plus something else (can’t remember what) and seeing a link to Deirdre McCloskey’s paper “A Kirznerian Economic History of the Modern World” in which McCloskey, in somewhat over-the-top style, waxed eloquent about the long and circuitous evolution of her views from the strict neoclassicism in which she was indoctrinated at Harvard and later at Chicago to Kirznerian Austrianism. McCloskey observes in her wonderful paean to Kirzner that growth theory (which is now the core of modern macroeconomics) is utterly incapable of accounting for the historically unique period of economic growth over the past 200 years in what we now refer to as the developed world.

I had faced repeatedly 1964 to 2010 the failure of oomph in the routine, Samuelsonian arguments, such as accumulation inspired by the Protestant ethic, or trade as an engine of growth, or Marxian exploitation, or imperialism as the last stage of capitalism, or factor-biased induced technical change, or Unified Growth Theory. My colleagues at the University of Chicago in the 1970s, Al Harberger and Bob Fogel, pioneered the point that Harberger Triangles of efficiency gain are small (Harberger 1964; Fogel 1965). None of the allocative, capital-accumulation explanations of economic growth since Adam Smith have worked scientifically, which I show in depressing detail in Bourgeois Dignity. None of them have the quantitative force and the distinctiveness to the modern world and the West to explain the Great Fact. No oomph.

What works? Creativity. Innovation. Discovery. The Austrian core. And where did discovery come from? It came from the releasing of the West from ancient constraints on the dignity and liberty of the bourgeoisie, producing an intellectual and engineering explosion of ideas. As the banker and science writer Matt Ridley has recently described it (2010; compare Storr 2008), ideas started breeding, and having baby ideas, who bred further. The liberation of the Jews in the West is a good emblem for the wider story. A people of the book began to be allowed into commercial centers in Holland and then England, and allowed outside the shtetl and the ghetto, and into the universities of Berlin and Manchester. They commenced innovating on a massive, breeding-reactor scale, in good ways (Rothschild, Einstein) and in bad (Marx, Freud).

Ridley explains how the evolutionary biologist Leigh Van Valen proposed in 1973 a Red Queen Hypothesis that would explain why commercial and mechanical ideas, when first allowed to evolve, had to run faster and faster to stay in the same place. Economists would call it the dissipation of initial rents, in the second and third acts of the economic drama. Once breeding ideas were set free in the seventeenth century they created more and more opportunities for Kirznerian alertness. The opportunities were alertly taken up, and persuasively argued for, and at length routinized. The idea of the steam engine had babies with the idea of rails and the idea of wrought iron, and the result was the railroads. The new generation of ideas-in view of the continuing breeding of ideas going on in the background-created by their very routinization still more Kirznerian opportunities. Railroads once they were routine led to Sears, Roebuck and Montgomery Ward. And the routine then created prosperous people, such as my grandfather the freight conductor on the Milwaukee Road or my great-grandfather the postal clerk on the Chicago & Western Indiana or my other great-grandfather who invented the ring on telephones (which extended the telegraph, which itself had made tight scheduling of trains possible). Some became prosperous enough to take up the new ideas, and all became prosperous enough under the Great Fact to buy them. If there was no dissipation of the rents to alertness, and no ultimate gain of income to hoi polloi, no third act, no Red Queen effect, then innovation would not have a justification on egalitarian grounds-as in the historical event it surely did have. The Bosses would engorge all the income, as Ricardo in the early days of the Great Fact had feared. But in the event the discovery of which Kirzner and the Austrian tradition speaks enriched in the third act mainly the poor-your ancestors, and Israel’s, and mine.

It is the growth and diffusion of knowledge (both practical and theoretical, but especially the former), not the accumulation of capital, that accounts for the spectacular economic growth of the past two centuries. So, all praise to the Austrian economist par excellence, Israel Kirzner. But just to avoid any misunderstanding, I will state for the record, that my admiration for Kirzner does not mean that I have gone wobbly on the subject of Austrian Business Cycle Theory, a subject on which Kirzner has been, so far as I know, largely silent — yet further evidence – as if any were needed — of Kirzner’s impeccable judgment.


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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