Archive for the 'gold-exchange standard' Category

Mattei Misjudges Hawtrey

Published December 25, 2023 1920-21 Depression , Clara Mattei , gold standard , gold-exchange standard , Great Depression , Keynes , R. G. Hawtrey , World War I 1 Comment

Clara Mattei, associate professor of economics at the New School for Social Research, recently published a book, The Capital Order: How Economists Invented Austerity and Paved the Way to Fascism, (University of Chicago Press) in which she argues that the fiscal and monetary austerity imposed on Great Britain after World War I to restore the gold standard at the prewar parity of pound to the dollar provided a model for austerity policies imposed by Mussolini in Italy when he took control of the Italian state in the early 1920s. In making her argument, Mattei identifies Hawtrey, Director of Financial Enquiries in the British Treasury for the entire interwar period, as the eminence grise behind the austerity policies implemented by the Treasury and the Bank of England to restore convertibility at the prewar parity.

Mattei’s ideological position is obviously left of center, and her attempt to link British austerity policies during the 1920s with the rise of fascism in Italy furthers her ideological agenda. Although that agenda is not mine, my only interest here is to examine her claim that Hawtrey was the intellectual architect of the austerity policies she deplores. I leave it to others to assess her broader historical claims.

In her introductory chapter, Mattei (p. 10) justifies her attention to Hawtrey, by claiming that his “texts and memoranda . . . would serve as the guidelines for British austerity after World War I,” describing the Treasury officials Sir Basil Blackett and Sir Otto Niemeyer, under whom Hawtrey served, as “working at his side,” as if they were Hawtrey’s subordinates rather than the other way around. At the end of the chapter, Mattei (p. 20) writes: “I was riveted by the evidence of Hawtrey’s persuasion of the other two bureaucrats, and in turn how the two bureaucrats, neither one a trained economist, came to be missionaries in campaigns to export the British austerity agenda to other countries around the globe.” In a later passage (p. 171), she elaborates:

In the face of unrelenting opposition, Niemeyer and Blackett needed solid intellectual grounds to urge the chancellor of the exchequer to move for dear money and drastic cuts in public expenditures. In examining the controllers’ confidential Treasury files—virtually the only direct source of information we have about their economic beliefs—one is struck by the ubiquity and influence of the economist Ralph G. Hawtrey, the primary source of economic knowledge for Blackett and especially for Niemeyer. In fact, there is ample evidence that Hawtreyan economics refined and strengthened the economic stance of the senior Treasury officials, so as to enable the emergence of a full-blown austerity doctrine.

Given her emphasis on the documentary record left by Hawtrey during his nearly three decades as the in-house economist at the Treasury, I would have expected to see more than just the few direct quotations and citations from the voluminous internal memos written by Hawtrey to his Treasury colleagues to which Mattei makes general reference. The references to Hawtrey’s communications with his colleagues provide few specifics, while the more numerous citations to his writings seem to misinterpret, misrepresent or mischaracterize Hawtrey’s theoretical and policy views.

It should also be noted that Mattei’s estimation of Hawtrey’s influence at the Treasury is not shared by other researchers into Hawtrey’s life and career. R. D. C. Black, who wrote an admiring biographical essay on Hawtrey for the British Academy of which Hawtrey became a member in 1935, wrote dismissively of Hawtrey’s influence at the Treasury.

Hawtrey drew up many and varied reports and memoranda on economic and financial matters which are now to be found among the papers of senior Treasury officials of that period, but the impression prevails that they did not receive much attention, and that the Financial Enquiries Branch under Hawtrey was something of a backwater.

R. D. C. Black, “Ralph George Hawtrey, 1879-1975.” In Proceedings of the British Academy, 1977, p. 379.

Susan Howson, in her biographical essay on Hawtrey, believed that Hawtrey was influential eary in his tenure as Director of Financial Enquiries, primarily because of his important role in drafting the financial resolutions for the Genoa Conference of 1922, about which more will be said below, but that his influence declined subsequently. Mattei cites both Black and Howson in her book, but does not engage with their assesment of Hawtrey’s influence at Treasury. Mattei also cites the unpublished doctoral dissertation of Alan Gaukroger on Hawtrey, which focuses specifically on his service as Director of Financial Enquiries at the Treasury, but does not engage with his detailed assement, based on exhaustive reading of relevant Treasury memoranda, of Hawtrey’s influence on his Treasury colleagues and superiors. Here is how Gaukroger characterizes those memoranda:

In the case of Hawtrey, who was to some extent an outsider to the very small and closely knit group of influential policy makers, the written memorandum was his method of attempting to break into, and influence, the powerful central group. . . .

Many of Hawtrey’s memoranda were unsolicited. He produced them because he was critical of some spect of Government policy. In some of these memoranda there is a marked tone of anger. This was particularly apparent during the late 1920s when the United Kingdom had returned to the Gold
Standard and Hawtrey believed that the Bank of England was pursuing a foolish and unnecessarily high interest rate policy. At this time, his memoranda, critical of Bank or even Treasury policy, could, for such a mild-mannered man, be quite savage in tone. Often, his memoranda were produced as a result of a specific request. On a very small number of occasions they were produced as a result of a direct request for guidance, or information, from the Chancellor of the Exchequer. At other times Hawtrey prepared a memorandum as a result of a Parliamentary Question. Often a senior colleague wanted support in reparing a memorandum and would seek to use Hawtrey’s expertise, particularly with regard to currency and foreign exchange. Hawtrey would invariably write an unsolicited memorandum after press criticism of Treasury Policy.

A. Gaukroger, “The Director of Financial Enquiries.” Ph.D. Thesis. University of Huddersfield, 2008, pp. 29-32

In criticizing the austerity doctrines and policies of the British Treasury and the Bank of England in the decade after World War I, Mattei mounts a comprehensive attack on Hawtrey’s views (or what she inaccurately represents to be his views) to which she, unlike other researchers, ascribes immense influence. She begins with the decision to restore the gold standard and the subsequent deflationary policy adopted in the1920-22 period to reverse the wartime and postwar inflations, and subsequently to restore the gold standard at the prewar parity of the pound to the dollar ($4.86). Mattei’s overestimation of Hawtrey’s influence is evidenced by her failure even to mention the 1918 interim report of the Cunliffe Commission (headed by the former Governor of the Bank of England Lord Cunliffe) recommending the prompt restoration of the gold standard in as close a form as possible to the prewar gold standard. Although no precise parity was specified, the goal of minimizing the departure from the prewar gold standard (except for not reintroducing a full-bodied gold coinage) made the prewar parity to the dollar, restored in 1919 to its prewar gold parity of $20.67/ounce, the obvious benchmark for restoration.

Her next object of criticism is Hawtrey’s advocacy of deflation in his 1919 article “The Gold Standard,” to reverse, if only partially, the inflation during and after the war that had cut the purchasing power of the pound by roughly 60%. The inflation, especially the postwar inflation, had been deeply unsettling, and there was undoubtedly strong political pressure on the government to halt the inflation. Although opposed to both inflation and deflation, Hawtrey believed that some deflation was needed to achieve stabilization, especially given that the US, which had restored convertibility of the dollar into gold in June 1919, would likely adopt a deflationary policy.

Mattei cites Hawtrey’s approval of the April 1920 increase in Bank rate by the Bank of England to an unprecedented 7% to break the inflationary spiral then underway. Inflation was quickly tamed, but a brutal deflation followed, while Bank rate remained at 7% for more than 12 months before a half a percent cut in April 1922 with further half-percent cuts at bimonthly intervals till the rate was reduced to 3% in July 1922.

Hawtrey’s support for deflation was less categorical and durable than Mattei claims. Prices having risen much faster than wages since the war started, Hawtrey thought that deflation would cause prices to fall before downward pressure on wages started. (See G. C. Peden, The Treasury and British Public Policy 1906-1959, Oxford: Oxford University Press, p. 154.) Once unemployment increased and wages came under significant downward pressure, Hawtrey began to call for easing of the dear-money policy of the Bank. Montague Norman, Governor of the Bank of England, aware of Hawtrey’s criticisms of Bank of England policy, shared his annoyance with Hawtrey in a letter to his counterpart at the Federal Reserve, Benjamin Strong, mentioning criticism from “a ‘leading light’ of the Treasury [who] made it his particular business to quarrel with the policy of the Treasury and the Bank of England.” (See G. C. Peden, Id. pp. 155-56.) Hawtrey later articulated the basis for his criticism.

In 1920 it was justifiable to keep up Bank rate so long as there was any uncertainty whether inflation had been successfully checked. But even in the late summer of 1920 there was no real doubt that this was so, and by November 1920, it was abundantly clear that the danger was in the opposite direction, and was that of excessive deflation.

Hawtrey, A Century of Bank Rate, London: Longmans, Green and Co., 1938, p. 133.

Mattei further attacks Hawtrey for his central role in the Genoa Conference of 1922, which, besides resolutions on other topics of international concern, adopted resolutions aimed at restoring the international gold standard. As early as in his 1919 article on the gold standard and in his important book Currency and Credit of the same year, Hawtrey was warning urgently that restoring the gold standard could cause severe–possibly disastrous–deflation unless countries rejoining the gold standard cooperated to moderate their demand for gold reserves when setting fixed parities between their currencies and gold.

Hawtrey therefore proposed that countries other than the US and Britain rejoin the gold standard by discharging their obligations in dollars or pound sterling, which were either (in the case of the dollar) already convertible into gold, or (in the case of sterling) likely to be convertible in the future. By freeing national central banks from the need to hold actual gold reserves to discharge their obligations, the Genoa proposals aimed to limit the international demand for gold, thereby moderating or eliminating the deflationary pressure otherwise entailed by restoring the gold standard. Additionally, the resulting demand by central banks to hold sterling-denominated liabilities would ease the pressure on the British balance of payments, thereby making room for the Bank of England to reduce Bank rate.

Ignoring Hawtrey’s anti-deflationary intent in drafting those resolution, Mattei focuses on the legal independence for central banks proposed by the resolutions, intended to insulate them from demands by national governments to print money to fund fiscal deficits, money printing by governments or by banks under government pressure to do so, having been, historically, a primary cause of inflation. Mattei further misrepresents Hawtrey’s call for monetary management to avoid the likely deflationary consequences of an unmanaged restoration of the prewar gold standard as evidence that Hawtrey desired to impose an even more draconian austerity on British workers than an unmanaged restoration of the gold standard would have imposed, thereby imputing to Hawtrey an intention precisely the opposite of what he meant to accomplish.

Mattei equates Hawtrey’s support for central-bank independence in the Genoa Resolutions with hostility to democracy. Quoting from Hawtrey’s 1925 article “Currency and Public Administration,” which, she suggests, betrays a technocratic and anti-democratic mindset that he shared with contemporary Italian theoreticians of fascism, Mattei seizes on the following passage:

The central bank is free to follow the precept: “never explain; never regret; never apologize.” It need make no statement of policy. Critics may rage for nine days, but in face of the silence imposed by tradition they do not keep it up.”

Hawtrey, “Currency and Public Administration” Public Administration 3(3):232-45, 243

Mattei subjects the elitist tone of Hawtrey’s defense of central bank independence to withering criticism, a criticism echoed by her ideological opposite Milton Friedman, but she neglects to quote an important explanatory passage.

The public interest in the broadest sense is profoundly affected by currency administration. Those who deprecate criticism fear an ill-judged pressure at critical times. Experience shows that, whenever an expansion of credit is developing to excess, a formidable opposition arises in the trading world to an increase in bank rate. When on the other hand, business is in a state of depression, no one minds what happens to bank rate. The influence of outside pressure is, therefore, just the contrary to what is required.

Perhaps that is so, because criticism is confined to financial and trading circles. When credits is expanding, traders want to borrow, and resent any measures which makes borrowing more difficult or more expensive. When business is depressed, they do not want to borrow. In neither case are they impelled to look beyond their own affairs to the effect of credit on the public interest.

Id.

It is interesting that Hawtrey would have written as he did in 1925 given his own recent experience in criticizing the dear money policy generally followed by the Bank of England since 1921 when the Bank of England steadfastly refused to lower Bank rate despite his own repeated pleas for rate reductions and criticisms of the Bank’s refusal to respond to those pleas.

In his lengthy and insightful doctoral dissertation about Hawtrey’s tenure at the Treasury, Alan Gaukroger, relying far more intensively and extensively than Mattei on the documentary record of Hawtrey’s tenure, discusses a Treasury Memorandum written by Hawtrey on December 5, 1925 soon after Bank of England raised Bank rate back to 5% after briefly reducing it to 4% immediately after restoration of the prewar parity with dollar in April.

The raising of the Bank rate to 5% is nothing less than a national disaster. That dear money causes unemployment is a proposition which ought not to admit of dispute. Not only is it the generally accepted opinion of theoretical economists, but it was well recognised by practical financiers and men of business before economists paid much attention to it.

Gaukroger, p. 194

Gaukroger (p. 193) also reports, relying on a recorded interview of Hawtrey conducted by Alexander Cairncross in 1965, that upon hearing the news that Bank rate had been raised back to 5%, Hawtrey went directly to Niemeyer’s office to express his fury at the news he had just heard, only to find, after he had begun denouncing the increase, that Montagu Norman himself had been seated in Niemeyer’s office behind the door he had just opened. Direct communication between Hawtrey and Norman never resumed.

Gaukroger also reports that Hawtrey’s view was dismissed not only by the Bank of England but by his superior Otto Niemeyer and by Niemeyer’s deputy Sir Frederick Leith-Ross, who invidiously compared Hawtrey in opposing an increase in Bank rate to Rudolf Havenstein, President of the German Reichsbank during the German hyperinflation of 1923.

As already mentioned, Mattei accuses Hawtrey of having harbored a deflationary bias owing to a belief that a credit economy is inherently predisposed toward inflation, a tendency that must be counteracted by restrictive monetary policy.

Mattei’s accusation of deflationary bias rests on a misunderstanding of Hawtrey’s monetary theory. In Hawtrey’s theory, if banks create too much credit, the result is inflation; if they create too little, the result is deflation. No endogenous mechanism keeps credit creation by banks on a stable non-inflationary, non-deflationary path. Once inflation or deflation sets in, a cumulative process leads to continuing, even accelerating, inflation or deflation. To achieve stability, an exogenous stabilizing mechanism, like a metallic standard or a central bank, is needed to constrain or stimulate, albeit imperfectly, credit creation by the banking system. It was only in the special conditions after World War I and the collapse of the prewar gold standard, which had been centered in London, that Hawtrey believed a limited deflation would be useful in pursuing the generally accepted goal of restoring the prewar gold standard. But the postwar deflation was far more extreme than the deflation contemplated, much less endorsed, by Hawtrey.

Mattei infers from Hawtrey’s support for deflation to reverse the postwar inflation, that he regarded inflation as a greater and more dangerous threat than inflation, without acknowledging that he regarded the 1920-22 deflation as excessive and unjustified. She also cites his endorsement of restoring convertibility of the pound at the prewar ($4.86) parity against the dollar, despite the deflationary implications of that restoration, as further evidence of Hawtrey’s approval of deflation. But Mattei ignores Hawtrey’s repeated arguments that, given the high rate of unemployment in Britain, there was ample room, even after restoration of the prewar parity, for the Bank of England to have reduced Bank rate to promote increased output and employment.

The advance of Bank rate to 5% in March 1925 supervened on a condition of things which promised to bring the pound sterling to par with the dollar without any effort at all. Credit was expanding and the price level in the United States, which may be taken as indicating the price level in terms of gold, was rising. This expansive tendency came abruptly to an end. The rediscount rate, it is true, was raised in New York, but only to 3.5%, and till 1928 the American Federal Reserve Bank adhered to moderate rediscount rates and a policy of credit relaxation. The deflationary tendency in the gold standard world was due to the continuance of dear money in London. In British industry unemployment remained practically undiminished.

Hawtrey, A Century of Bank Rate, London: Longmans, Green and Co., 1938, pp. 137-38

While Mattei acknowledges that Hawtrey favored easing monetary policy after the restoration of the prewar parity, she minimizes its significance by citing Hawtrey’s recommendation to increase Bank rate in 1939 from the 2% rate at which it had been pegged since July 1932. But by 1940 British inflation had risen above 10%, substantiating Hawtrey’s fear, with Britain about to enter into World War II, of renewed inflation.

Mattei even imputes a sinister motivation to Hawtrey’s opposition to inflation, suggesting that he blamed inflation on the moral turpitude of workers lacking the self-discipline to save any of their incomes rather than squander it all on wasteful purchases of alcohol and tobacco, in contrast to the virtuous habits of the bourgeoisie and the upper classes who saved a substantial portion of their incomes. In doing so, Mattei, in yet another misunderstanding and mischaracterization, mistakenly attributes an over-consumption theory of inflation to Hawtrey. The consumption habits of the working class are irrelevant to Hawtrey’s theory of income and prices in which total income is determined solely by the amount of credit created by the banking system.

If substantial idle resources are available, a reduced lending rate encourages retail and wholesale businesses and traders to increase their holdings of inventories by increasing orders to manufacturers who then increase output, thereby generating increased income which, in turn, leads to increased purchases of consumer and capital goods. The increase in output and income causes a further increase the desired holdings of inventories by businesses and traders, initiating a further round of increases in orders to manufacturers so that further increases in output and income are constrained by the limits of capacity, whereupon further reductions in lending rates would cause inflation rather than increased output.

While the composition of output between investment goods and consumption goods is governed, in Hawtrey’s theory, by the savings habits of households, the level of total output and income and the rate of inflation or deflation are determined entirely by the availability of credit. It was precisely on this theoretical basis that Hawtrey denied that increased public spending would increase output and employment during a depression unless that spending was financed by credit expansion (money creation); if financed by taxation or by borrowing, the public spending would simply reduce private spending by an equal amount. Mattei recognized the point in connection with public spending in her discussion of Hawtrey’s famous articulation of the Treasury View (see Hawtrey, “Public Expenditure and the Demand for Labour,”), but failed to recognize the same theoretical argument in the context of spending on consumption versus spending on investment.

I close this post with a quotation from Hawtrey’s Trade Depression and the Way Out, 2nd edition, a brilliant exposition of his monetary theory and its application to the problem of inadequate aggregate demand, a problem, as Keynes himself admitted, that he dealt with before Keynes had addressed it. I choose a passage from the last section, entitled “The Fear of Inflation,” of the penultimate chapter. Evidently, Mattei has not studied this book (which she does not cite or refer to). Otherwise, I cannot imagine how she could have written about Hawtrey in her book in the way that she did.

The fears that efforts to expand credit will be defeated in one way or anotherby the pessimism of traders are not wholly irrational. But that pessimism is no more than an obstacle to be overcome. And the much more usual view is that inflationary measures take effect only too easily

The real obstacle to measures of credit expansion is not the fear that they will not be effective, but the fear that they will. [author’s emphasis]

Yet what can be more irrational that that fear? The term inflation is very loosely used; sometimes it means any expansion of the currency or of bank credit, or any such expansion not covered by metallic reserves; sometimes it means an issue of currency by way of advances to the Government or else an issue backed by Government securities. But whatever the precise measures classed as inflationary may be, their common characteristic and the sole source of danger attributed to them is that they tend to bring about an enlargement of demand and a consequent rise of prices. And an enlargement of demand is the essential condition of recovery. To warnthe world against inflation is to warn it against economic revival.

If the economic system of the world had adjusted itself to the existing price level, there would be good reason to object to a renewed change. Inflation is rightly condemned, because it means an arbitrary change in the value of money in terms of wealth. But deflation equally means an arbitrary change in the value of money. The reason why inflation is more condemned and feared is that it is apt to appear convenient and attractive to financiers in difficulties. The consequences of deflation are so disastrous and the difficulties of carrying it out so great that no one thinks it necessary to attach any stigma to it. And since from time to time deflation has to be applied as a corrective of inflation, it is given the status of an austere and painful virtue.

But essentially it is not a virtue at all, and when it is wantonly imposed on the world, not as a corrective of inflation but as a departure from a pre-existing state of equilibrium, it ought to be regarded as a crime against humanity. [my emphasis]

Just as deflation may be needed as a corrective to an inflation to which the economic system has not adjusted itself, so at the present time inflation is needed as a corrective to deflation. If the monetary affairs of the world were wisely governed, both inflation and deflation would be avoided, or at any rate quickly corrected in their initial stages. Perhaps the ideal of monetary stability will be achieved in the future. But to start stereotyping conditions in which prices are utterly out of equilibrium with wages and debts, and with one another, would be to start the new polcy under impossible conditions.

The dread of inflation has been greatly accentuated by the experiences of the years following the war, when so many countries found that the monetary situation got completely out of control. The vicisous circle of inflation gained such power that it wrecked both the tax system and the investment market; it cut off all the normal resources for meeting public expenditure, and left Governments to subsist on issues of paper money. No country would willingly endure such a situation.

But that kind of monetary collapse does not come easily or suddenly. There is, I believe, no case in history in which inflation has got out of hand in less that three years. [author’s emphasis] . . .

The fear that one slip from parity means a fall into the abyss is entirely without foundation. Especially is that so when deflation is raging. The first impact of a monetary expansion is then felt rather in increased output than in higher prices. It is only when industry has become fully employed that the vicious circle of inflation is joined and prices begin to rise.

Ralph Hawtrey, Part 1: An Overview of his Career

Published October 28, 2023 Alfred Marshall , Clara Elizabeth Mattei , David Ricardo , gold standard , gold-exchange standard , Great Depression , Keynes , Milton Friedman , R. G. Hawtrey , Robert Hetzel , Winston Churchill 18 Comments
Tags: ,

One of my goals when launching this blog in 2011 was to revive interest in the important, but unfortunately neglected and largely forgotten, contributions to monetary and macroeconomic theory of Ralph Hawtrey. Two important books published within the last year have focused attention on Ralph Hawtrey: The Federal Reserve: A New History by Robert Hetzel, and The Capital Order by Clara Elizabeth Mattei.

While Hetzel’s discussion of Hawtrey’s monetary theory of the Great Depression is generally positive, it criticizes him for discounting, unlike Milton Friedman, the efficacy of open-market operations in reviving aggregate demand. But Hetzel’s criticism relies on an incomplete reading of Hawtrey’s discussions of open-market operations. Mattei’s criticism of Hawtrey is very different from Hetzel’s narrow technical criticism. Mattei is clearly deeply hostile to Hawtrey, portraying him as the grey eminence behind the austerity policies of the British Treasury and the Bank of England in the 1920s both before and after Britain restored the prewar gold standard. Mattei holds Hawtrey uniquely responsible for providing the intellectual rationale for the fiscal and monetary policies that ruthlessly tolerated high unemployment to suppress inflation and hold down wages.

I’ll address the inaccuracies in Hetzel’s discussion of Hawtrey and especially in Mattei’s deeply flawed misrepresentations of Hawtrey in future posts. In this post, I provide an overview of Hawtrey’s career drawn from papers I’ve written (two of which were co-authored by my friend Ron Batchelder) about Hawtrey included in my recent book, Studies in the History of Monetary Theory: Controversies and Clarifications (Chapters 10-14)

Ralph George Hawtrey, born in 1879, two years before his friend, fellow Cambridge man and Apostle, John Maynard Keynes, with whom he often disagreed, was in the 1920s and early 1930s almost as well-known as, and perhaps even more influential, at least among economists and policy-makers, than Keynes. Despite their Cambridge educations and careers in economics, as undergraduates, they both concentrated on mathematics[1] and philosophy and were deeply influenced by the Cambridge philosopher, G. E. Moore. Neither formally studied economics under Alfred Marshall.[2]

Perhaps the last autodidact to make significant contributions to economic theory, Hawtrey began his study of economics only when preparing for the civil-service exam at the Treasury. Hawtrey’s Cambridge background, his friendship with Keynes, and the similarities between his own monetary theories and those of Marshall, Keynes and other Cambridge economists contributed to the widespread impression that Hawtrey had ties to the Cambridge school of economics, a connection Hawtrey denied. Hawtrey’s powerful analytical mind, his command of monetary history and deep and wide knowledge of monetary and business institutions, acquired by dint of intense independent study, led to a rapid rise in the Treasury bureaucracy, eventually becoming Director of Economic Studies in 1919, a position he held until he retired from the Treasury in 1945.

Coincidentally, both Hawtrey and Keynes published their first books in 1913, Keynes writing about the reform of the Indian Currency system (Indian Currency and Finance) and Hawtrey propounding his monetary theory of the business cycle (Good and Bad Trade). A more substantive coincidence in their first books is that they both described a gold-exchange standard (resurrecting an idea described almost a century earlier by Ricardo in his Proposals for an Economical and Secure Currency) in which gold coins do not circulate and the central bank holds reserves, not in gold, but in foreign exchange denominated in currencies legally convertible into gold.

The trajectory of Hawtrey’s carrier (like Keynes’s) was sharply upward after publication of his first book. Hawtrey’s reputation was further enhanced by important academic articles about the history of monetary institutions and the gold standard. Those studies were incorporated in Hawtrey’s most important work on monetary economics, Currency and Credit published in 1919, a profound treatise on monetary economics in which his deep theoretical insights were deployed to shed light on important events and developments in the history of monetary institutions. A resounding success, the volume becoming a standard work routinely assigned to students of money and banking for over a decade, establishing Hawtrey as one of the most widely read and frequently cited economists in the 1920s and even the 1930s.

Although Keynes, by virtue of his celebrated book The Economic Consequences of the Peace became one of the most prominent public figures in Britain in the immediate postwar period, Hawtrey’s reputation among economists and policy makers likely overshadowed Keynes’s in the early 1920s. That distinction is exemplified by their roles at the 1922 Genoa Conference on postwar international cooperation and reconstruction.

In his writings about postwar monetary reconstruction, Hawtrey emphasized the necessity for international cooperation to restore international gold standard lest an uncoordinated restoration by individual countries with countries seeking to accumulate gold, thereby causing gold to appreciate and prices in terms of gold to fall. It was Hawtrey’s warnings, echoed independently by the Swedish economist Gustav Cassel, that caused the Treasury to recommend that planning for a coordinated restoration of the gold standard be included in agenda of the Genoa Conference.

While Hawtrey was the intellectual inspiration for including restoration of gold standard on the agenda of the Genoa Conference, Keynes’s role at Genoa was journalistic, serving as a correspondent for the Manchester Guardian. Keynes criticized the plan to reestablish an international gold standard even in the form of a gold-exchange standard that he and Hawtrey had described a decade earlier. Keynes observed that there was then only one nation with an effective gold standard, the United States. Conjecturing that the US, holding 40% of the world’s gold reserves, would likely choose to divest itself of at least part of its gold hoard, causing gold depreciation, Keynes argued that rejoining the gold standard would mean importing inflation from the United States. Keynes therefore recommended that Britain to adopt an independent monetary policy detached from gold to achieve a stable domestic price level. 

But after it became clear that the US had no intention of unburdening itself of its huge gold holdings, Keynes reversed his rationale for opposing restoration of the gold standard. Given the depreciation of sterling against the dollar during and after World War I, the goal of restoring the prewar dollar-sterling parity of $4.86/pound would require Britain to endure even more deflation than it had already suffered following the sharp US deflation of 1920-21.

When Winston Churchill, appointed Chancelor of the Exchequer in the new Conservative Government, announced in November 1924 that he would restore the gold standard at the prewar parity by April 1925, the pound appreciated against the dollar. But the market exchange rate with the dollar remained 10% below the prewar parity. Keynes began arguing against restoring the prewar parity because a further 10% deflation would impose an unacceptable hardship on an economy that had not recovered from the effects of the recession and high unemployment caused by earlier deflation.

After personally consulting Keynes in person about his argument against restoring the prewar parity, Churchill also invited Hawtrey to hear his argument in favor of restoring the prewar parity. Hawtrey believed that doing so would bolster London’s position as the preeminent international financial center. But he also urged that, to avoid the dire consequences that Keynes warned would follow restoration of the prewar parity, the Bank of England reduce Bank Rate to promote economic expansion and employment. Given the unique position of London as the center of international finance, Hawtrey was confident that the Bank of England could ease its monetary policy and that the Federal Reserve and other central banks would ease their policies as well, thereby allowing the gold standard to be restored without significant deflation.

Supported by his Treasury advisers including Hawtrey, Churchill restored the gold standard at the prewar dollar parity in April 1925, causing Keynes to publish his brutal critique of that decision in his pamphlet The Economic Consequences of Mr. Churchill. While the consequences were perhaps not as dire as Keynes had predicted, they were less favorable than Hawtrey had hoped, the Bank of England refusing to reduce Bank Rate below 5% as Hawtrey had urged. At any rate, after a brief downturn in the latter part of 1925, the British economy did expand moderately from 1926 through early 1929 with unemployment declining slightly before Britain, along with the rest of the world, plunged into the Great Depression in the second half of 1929.

Keynes and Hawtrey again came into indirect opposition in the 1929 general election campaign, when Lloyd George, leader of the Liberal Party, proposed a program of public works to increase employment. In rejecting Lloyd George’s proposal, Churchill cited the “traditional Treasury view” that public spending simply displaced an equal amount of private spending, merely shifting spending from the private to the public sector without increasing total output and employment.

The source of “the traditional Treasury” view” was Hawtrey, himself, who had made the argument at length in a 1925 article in the Economic Journal which he had previously made in less detail in Good and Bad Trade. Replying to Churchill, Keynes and Hubert Henderson co-authored a pamphlet Can Lloyd George Do It supporting Lloyd George’s proposal and criticizing the Treasury View.

Keynes and Hawtrey confronted each other in person when Hawtrey testified before the Macmillan Committee investigating the causes of high unemployment. As a member of the Committee, Keynes questioned Hawtrey about his argument that the Bank of England could have countered rising unemployment by reducing Bank Rate, seemingly exposing an inconsistency in Hawtrey’s responses to his questions. But, when considered in light of Hawtrey’s assumption that a reduction in Bank Rate by the Bank of England would have led to Federal Reserve and other central banks to reduce their interest rates rather than absorb further inflows of gold, the inconsistency is resolved (see this post for further explanation).

Although Hawtrey had warned of the dreadful consequences of restoring the gold standard without coordination among central bank to avoid rapid accumulation of gold reserves, his warnings were disregarded when France returned to the gold standard in 1927 and began rapidly increasing its gold reserves in 1928. Hawtrey’s association with the Treasury view fostered the misimpression that, despite his unheeded advocacy of reducing Bank Rate to reduce unemployment, Hawtrey was oblivious to, or unconcerned by, the problem of unemployment. While Keynes often tried out new ideas, as he did with his neo-Wicksellian theory of the business cycle in his Treatise on Money only to abandon it in response to criticism and the changing economic environment of the Great Depression before writing his General Theory of Interest, Income and Money, Hawtrey stuck to the same basic theory developed in his first two books.

While his output of new publications in the 1930s did not flag, Hawtrey’s reputation among economists and his influence in the Treasury gradually declined, especially after publication of Keynes’s General Theory as the attention of economists was increasingly occupied by an effort to comprehend and assimilate it into the received body of economic theory. By the time he retired from the Treasury in 1945 to become Professor of International Economics at the Royal Institute for International Affairs, Hawtrey was no longer at the cutting edge of the economics profession, and his work gradually fell from the view of younger economists.

Nevertheless, for the next two decades as he advanced to old age, Hawtrey continued to publish important works, mostly, but not exclusively concerning the conduct of British monetary policy, especially his lonely criticism of Britain’s 1947 devaluation of the pound. Elaborating on arguments advanced in his early writings, Hawtrey anticipated much of what would become known as the monetary approach to the balance of payments.

Given his monetary explanation of the Great Depression, it might have been expected that Monetarists, especially Milton Friedman, who, in the early 1950s, began his effort to develop a monetary theory of the Great Depression as an alternative to the Keynesian theory of a sudden decline in animal spirits that caused a stock-market crash and a drop in investment spending from which the private economy could not recover on its own, would have found Hawtrey’s explanation of the causes of the Great Depression to be worth their attention. However, one would search for Hawtrey’s name almost in vain in Friedman’s writings in general, and in his writings on the Great Depression, in particular. Certainly there was no recognition in the Monetarist literature on the Great Depression that a monetary theory of the Great Depression had actually been advanced by Hawtrey as the Great Depression was unfolding or that Hawtrey had warned in advance of the danger of the catastrophic deflation that would result from an uncoordinated restoration of the gold standard.

Years after Friedman’s magnum opus The Monetary History of the US was published, various researchers, including Peter Temin, Barry Eichengreen, Ben Bernanke, Kenneth Mouré, Clark Johnson, Scott Sumner, and Ronald Batchelder and I, recognized the critical importance of the newly restored gold standard in causing the Great Depression. While most of the later authors cited Hawtrey’s writings, the full extent of Hawtrey’s contributions that fully anticipated all the major conclusions of the later research remains generally unrecognized in most of the recent literature on the Great Depression, while Friedman’s very flawed account of the Great Depression continues to be regarded by most economists and financial historians as authoritative if not definitive.

In a future post, I’ll discuss Hetzel’s account of Hawtrey’s explanation of the Great Depression. Unlike earlier Monetarists who ignored Hawtrey’s explanation entirely, Hetzel does credit Hawtrey with having provided a coherent explanation of the causes of the Great Depression, without acknowledging the many respects in which Hawtrey’s explanation is more complete and more persuasive than Friedman’s. He also argues that Friedman provided a better account of the recovery than Hawtrey, because Friedman, unlike Hawtrey, recognized the effectiveness of open-market operations which Hawtrey maintained would be ineffective in initiating a recovery in situations of what Hawtrey called credit deadlock.

In another post, I’ll discuss the highly critical, and I believe tendentious, treatment by Clara Elizabeth Mattei, of Hawtrey’s supposed role in devising and rationalizing the austerity policies of the British Treasury in the 1920s up to and including the Great Depression.

[1] While Keynes was an accomplished mathematician who wrote an important philosophical and mathematical work A Treatise on Probability praised extravagantly by Bertrand Russell, Hawtrey’s mathematical skills were sufficiently formidable to have drawn the attention of Russell who included a footnote in his Principia Mathematica replying to a letter from Hawtrey.

[2] Keynes, however, the son of John Neville Keynes, a Cambridge philosopher and economist, had a personal connection to Marshall apart from his formal studies at Cambridge. Rather than pursue graduate studies, Hawtrey chose a career in the civil service, first at the Admiralty and soon thereafter at the Treasury.

Gabriel Mathy and I Discuss the Gold Standard and the Great Depression

Published June 28, 2021 Bank of France , Gabriel Mathy , gold , gold standard , gold-exchange standard , Great Depression , R. G. Hawtrey , Uncategorized 16 Comments

Sometimes you get into a Twitter argument when you least expect to. It was after 11pm two Saturday nights ago when I saw this tweet by Gabriel Mathy (@gabriel_mathy)

Friedman says if there had been no Fed, there would have been no Depression. That’s certainly wrong, even if your position is that the Fed did little to nothing to mitigate the Depression (which is reasonable IMO)

Chiming in, I thought to reinforce Mathy’s criticism of Friedman, I tweeted the following:

Friedman totally misunderstood the dynamics of the Great Depression, which was driven by increasing demand for gold after 1928, in particular by the Bank of France and by the Fed. He had no way of knowing what the US demand for gold would have been if there had not been a Fed

I got a response from Mathy that I really wasn’t expecting who tweeted with seeming annoyance

There already isn’t enough gold to back the gold standard by the end of World War I, it’s just a matter of time until a negative shock large enough sent the world into a downward spiral (my emphasis). Just took a few years after resumption of the gold standard in most countries in the mid-20s. (my emphasis)

I didn’t know exactly what to make of Mathy’s assertion that there wasn’t enough gold by the end of World War I. The gold standard was effectively abandoned at the outset of WWI and the US price level was nearly double the prewar US price level after the postwar inflation of 1919. Even after the deflation of 1920-21, US prices were still much higher in 1922 than they were in 1914. Gold production fell during World War I, but gold coins had been withdrawn from circulation and replaced with paper or token coins. The idea that there is a fixed relationship between the amount of gold and the amount of money, especially after gold coinage had been eliminated, has no theoretical basis.

So I tweeted back:

The US holdings of gold after WWI were so great that Keynes in his Tract on Monetary Reform [argued] that the great danger of a postwar gold standard was inflation because the US would certainly convert its useless holding of gold for something more useful

To which Mathy responded

The USA is not the only country though. The UK had to implement tight monetary policies to back the gold standard, and eventually had to leave the gold standard. As did the USA in 1931. The Great Depression is a global crisis.

Mathy’s response, I’m afraid, is completely wrong. Of course, the Great Depression is a global crisis. It was a global crisis, because, under the (newly restored) gold standard, the price level in gold-standard countries was determined internationally. And, holding 40% of the world’s monetary reserves of gold at the end of World War I, the US, the largest and most dynamic economy in the world, was clearly able to control, as Keynes understood, the common international price level for gold-standard countries.

The tight monetary policy imposed on the UK resulted from its decision to rejoin the gold standard at the prewar dollar parity. Had the US followed a modestly inflationary monetary policy, allowing an outflow of gold during the 1920s rather than inducing an inflow, deflation would not have been imposed on the UK.

But instead of that response, I replied as follows:

The US didn’t leave till 1933 when FDR devalued. I agree that individual countries, worried about losing gold, protected their reserves by raising interest rates. Had they all reduced rates together, the conflict between individual incentives and common interest could have been avoided.

Mathy then kept the focus on the chronology of the Great Depression, clarifying that he meant that in 1931 the US, like the UK, tightened monetary policy to remain on the gold standard, not that the US, like the UK, also left the gold standard in 1931:

The USA tightens in 1931 to stay on the gold standard. And this sets off a wave of bank failures.

Fair enough, but once the situation deteriorated after the crash and the onset of deflation, the dynamics of the financial crisis made managing the gold standard increasingly difficult, given the increasingly pessimistic expectations conditioned by deepening economic contraction and deflation. While an easier US monetary policy in the late 1920s might have avoided the catastrophe and preserved the gold standard, an easier monetary policy may, at some point, have become inconsistent with staying on the gold standard.

So my response to Mathy was more categorical than was warranted.

Again, the US did not have to tighten in 1931 to stay on the gold standard. I agree that the authorities might have sincerely thought that they needed to tighten to stay on the gold standard, but they were wrong if that’s what they thought.

Mathy was having none of it, unleashing a serious snark attack

You know better I guess, despite collapsing free gold amidst a massive speculative attack

What I ought to have said is that the gold standard was not worth saving if doing so entailed continuing deflation. If I understand him, Mathy believes that deflation after World War I was inevitable and unavoidable, because there wasn’t enough gold to sustain the gold standard after World War I. I was arguing that if there was a shortage of gold, it was because of the policies followed, often in compliance with legal gold-cover requirements, that central banks, especially the Bank of France, which started accumulating gold rapidly in 1928, and the Fed, which raised interest rates to burst a supposed stock-market bubble, were following. But as I point out below, the gold accumulation by the Bank of France far exceeded what was mandated by legal gold-cover requirements.

My point is that the gold shortage that Mathy believes doomed the gold standard was not preordained; it could have been mitigated by policies to reduce, or reverse, gold accumulation. France could have rejoined the gold standard without accumulating enormous quantities of gold in 1928-29, and the Fed did not have to raise interest rates in 1928-29, attracting additional gold to its own already massive holdings just as France was rapidly accumulating gold.

When France formally rejoined the gold standard in July 1928, the gold reserves of the Bank of France were approximately equal to its foreign-exchange holdings and its gold-reserve ratio was 39.5% slightly above the newly established legal required ratio of 35%. In subsequent years, the gold reserves of the Bank of France steadily increased while foreign exchange reserves declined. At the close of 1929, the gold-reserve ratio of the Bank of France stood at 47.3%, while its holdings of foreign exchange hardly changed. French gold holdings increased in 1930 by slightly more than in 1929, with foreign-exchange holdings almost constant; the French gold-reserve ratio at the end of 1930 was 53.2%. The 1931 increase in French gold reserves, owing to a 20% drop in foreign-exchange holdings, was even larger than in 1930, raising the gold-reserve ratio to 60.5% at the end of 1931.

Once deflation and the Great Depression started late in 1929, deteriorating rapidly in 1930, salvaging the gold standard became increasingly unlikely, with speculators becoming increasingly alert to the possibility of currency devaluation or convertibility suspension. Speculation against a pegged exchange rate is not always a good bet, but it’s rarely a bad one, any change in the pegged rate being almost surely in the direction that speculators are betting on. 

But, it was still at least possible that, if gold-cover requirements for outstanding banknotes and bank reserves were relaxed or suspended, central banks could have caused a gold outflow sufficient to counter the deflationary expectations then feeding speculative demands for gold. Gold does not have many non-monetary uses, so a significant release of gold from idle central-bank reserves might have caused gold to depreciate relative to other real assets, thereby slowing, or even reversing, deflation.

Of course, deflation would not have stopped unless the deflationary expectations fueling speculative demands for gold were reversed. Different expectational responses would have led to different outcomes. More often than not, inflationary and deflationary expectations are self-fulfilling. Because expectations tend to be mutually interdependent – my inflationary expectations reinforce your inflationary expectations and vice versa — the notion of rational expectation in this context borders on the nonsensical, making outcomes inherently unpredictable. Reversing inflationary or deflationary expectations requires policy credibility and a willingness by policy makers to take policy actions – even or especially painful ones — that demonstrate their resolve.

In 1930 Ralph Hawtrey testified to the Macmillan Committee on Finance and Industry, he recommended that the Bank of England reduce interest rates to counter the unemployment and deflation. That testimony elicited the following exchange between Hugh Pattison Macmillan, the chairman of the Committee and Hawtrey:

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

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

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

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

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

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

Hawtrey’s argument lay behind this response of mine to Mathy:

What else is a gold reserve is for? That’s like saying you can’t fight a fire because you’ll drain the water tank. But I agree that by 1931 there was no point in defending the gold standard and the US should have made clear the goal was reflation to the 1926 price level as FDR did in 1933.

Mathy responded:

If the Fed cuts discount rates to 0%, capital outflow will eventually exhaust gold reserves. So do you recommend a massive OMO in 1929? What specifically is the plan?

In 1927, the Fed reduced its discount rate to 3.5%; in February 1928, it was raised the rate to 4%. The rate was raised again in August 1928 and to 6% in September 1929. The only reason the Fed raised interest rates in 1928 was a misguided concern with rising stock prices. A zero interest rate was hardly necessary in 1929, nor were massive open-market operations. Had the Fed kept its interest rate at 4%, and the Bank of France not accumulated gold rapidly in 1928-29, the history of the world might well have followed a course much different from the one actually followed.

In another exchange, Mathy pointed to the 1920s adoption of the gold-exchange standard rather than a (supposedly) orthodox version of the gold standard as evidence that there wasn’t enough gold to support the gold standard after World War I. (See my post on the difference between the gold standard and the gold-exchange standard.)

Mathy: You seem to be implying there was plentiful free gold [i.e., gold held by central banks in excess of the amount required by legal gold-cover requirements] in the world after WW1 so that gold was not a constraint. How much free gold to you reckon there was?

Glasner: All of it was free. Legal reserve requirements soaked up much but nearly all the free gold

Mathy: All of it was not free, and countries suffered speculative attacks before their real or perceived minimum backings of gold were reached

Glasner: All of it would have been free but for the legal reserve requirements. Of course countries were subject to speculative attacks, when the only way for a country to avoid deflation was to leave the gold standard.

Mathy: You keep asserting an abundance of free gold, so let’s see some numbers. The lack of free gold led to the gold exchange standard where countries would back currencies with other currencies (themselves only partially backed by gold) because there wasn’t enough gold.

Glasner: The gold exchange standard was a rational response to the WWI inflation and post WWI deflation and it could have worked well if it had not been undermined by the Bank of France and gold accumulation by the US after 1928.

Mathy: Both you and [Douglas] Irwin assume that the gold inflows into France are the result of French policy. But moving your gold to France, a country committed to the gold standard, is exactly what a speculative attack on another currency at risk of leaving the gold standard looks like.

Mathy: What specific policies did the Bank if France implement in 1928 that caused gold inflows? We can just reason from accounting identities, assuming that international flows to France are about pull factors from France rather than push factors from abroad.

Mathy: So lay out your counterfactual- how much gold should the US and France have let go abroad, and how does this prevent the Depression?

Glasner: The increase in gold monetary holdings corresponds to a higher real value of gold. Under the gold standard that translates into [de]flation. Alternatively, to prevent gold outflows central banks raised rates which slowed economic activity and led to deflation.

Mathy: So give me some numbers. What does the Fed do specifically in 1928 and what does France do specifically in 1928 that avoid the debacle of 1929. You can take your time, pick this up Monday.

Mathy: The UK was suffering from high unemployment before 1928 because there wasn’t enough gold in the system. The Bank of England had been able to draw gold “from the moon” with a higher bank rate. After WW1, this was no longer possible.

Glasner: Unemployment in the UK steadily fell after 1922 and continued falling till ’29. With a fixed exchange rate against the $, and productivity in the US rising faster than in the UK, the UK needed more US inflation than it got to reach full employment. That has nothing to do with what happened after 1929.

Mathy: UK unemployment rises 1925-1926 actually, that’s incorrect and it’s near double digits throughout the 1920s. That’s not good at all and the problems start long before 1928.

There’s a lot to unpack here, and I will try to at least touch on the main points. Mathy questions whether there was enough free gold available in the 1920s, while also acknowledging that the gold-exchange standard was instituted in the 1920s precisely to avoid the demands on monetary gold reserves that would result from restoring gold coinage and imposing legal gold-cover requirements on central-bank liabilities. So, if free-gold reserves were insufficient before the Great Depression, it was because of the countries that restored the gold standard and also imposed legal gold-cover requirements, notably the French Monetary Law enacted in June 1928 that imposed a minimum 35% gold-cover requirement when convertibility of the franc was restored.

It’s true that there were speculative movements of gold into France when there were fears that countries might devalue their currencies or suspend gold convertibility, but those speculative movements did not begin until late 1930 or 1931.

Two aspects of the French restoration of gold convertibility should be mentioned. First, France pegged the dollar/franc exchange rate at $0.0392, with the intention of inducing a current-account surplus and a gold inflow. Normally that inflow would have been transitory as French prices and wages rose to the world level. But the French Monetary Law allowed the creation of new central-bank liabilities only in exchange for gold or foreign exchange convertible into gold. So French demand for additional cash balances could be satisfied only insofar as total spending in France was restricted sufficiently to ensure an inflow of gold or convertible foreign exchange. Hawtrey explained this brilliantly in Chapter two of The Art of Central Banking.

Mathy suggests that the gold-standard was adopted by countries without enough gold to operate a true gold standard, which he thinks proves that there wasn’t enough free gold available. What resort to the gold-exchange standard shows is that countries without enough gold were able to join the gold standard without first incurring the substantial cost of accumulating (either by direct gold purchases or by inducing large amounts of gold inflows by raising domestic interest rates); it does not prove that the gold-exchange standard system was inherently unstable.

Why did some countries restoring the gold standard not have enough gold? First, much of the world’s stock of gold reserves had been shipped to the US during World War I when countries were importing food, supplies and war material from the US paid with gold, or, promising to repay after the war, on credit. Second, wartime and immediate postwar inflation required increased quantities of cash to conduct transactions and satisfy liquidity demands. Third, legislated gold-cover requirements in the US, and later in France and other countries rejoining the gold standard, obligated monetary authorities to accumulate gold.

Those gold-cover requirements, forcing countries to accumulate additional gold to satisfy any increased demand by the public for cash, were an ongoing, and unnecessary, cause of rising demand for gold reserves as countries rejoined the gold standard in the 1920s, imparting an inherent deflationary bias to the gold standard. The 1922 Genoa Accords attempted to cushion this deflationary bias by allowing countries to rejoin the gold standard without making their own currencies directly convertible into gold, but by committing themselves to a fixed exchange rate against those currencies – at first the dollar and subsequently pound sterling – that were directly convertible into gold. But the accords were purely advisory and provided no effective mechanism to prevent the feared increase in the monetary demand for gold. And the French never intended to rejoin the gold standard except by making the franc convertible directly into gold.

Mathy asks how much gold I think that the French and the US should have let go to avoid the Great Depression. This is an impossible question to answer, because French gold accumulation in 1928-29, combined with increased US interest rates in 1928-29, which caused a nearly equivalent gold inflow into the US, triggered deflation in the second half of 1929 that amplified deflationary expectations, causing a stock market crash, a financial crisis and ultimately the Great Depression. Once deflation got underway, the measures needed to calm the crisis and reverse the downturn became much more extreme than those that would have prevented the downturn in the first place.

Had the Fed kept its discount rate at 3.5 to 4 percent, had France not undervalued the franc in setting its gold peg, and had France created a mechanism for domestic credit expansion instead of making an increase in the quantity of francs impossible except through a current account surplus, and had the Bank of France been willing to accumulate foreign exchange instead of requiring its foreign-exchange holdings to be redeemed for gold, the crisis would not have occurred.

Here are some quick and dirty estimates of the effect of French policy on the availability of free gold. In July 1928 when France rejoined the gold standard and enacted the Monetary Law drafted by the Bank of France, the notes and demand deposits against which the Bank was required to gold reserves totaled almost ff76 billion (=$2.98 billion). French gold holdings in July 1928 were then just under ff30 billion (=$1.17 billion), implying a reserve ratio of 39.5%. (See the discussion above.)

By the end of 1931, the total of French banknotes and deposits against which the Bank of France was required to hold gold reserves was almost ff114 billion (=$4.46 billion). French gold holdings at the end of 1931 totaled ff68.9 billion (=$2.7 billion), implying a gold-reserve ratio of 60.5%. If the French had merely maintained the 40% gold-reserve ratio of 1928, their gold holdings in 1931 would have been approximately ff45 billion (=$1.7 billion).

Thus, from July 1929 to December 1931, France absorbed $1 billion of gold reserves that would have otherwise been available to other central banks or made available for use in non-monetary applications. The idea that free gold was a constraint on central bank policy is primarily associated with the period immediately before and after the British suspension of the gold standard in September 1931, which occasioned speculative movements of gold from the US to France to avoid a US suspension of the gold standard or a devaluation. From January 1931 through August 1931, the gold holdings of the Bank of France increased by just over ff3 billion (=$78 million). From August to December of 1931 French gold holdings increased by ff10.3 billion (=$404 million).

So, insofar as a lack of free gold was a constraint on US monetary expansion via open market purchases in 1931, which is the only time period when there is a colorable argument that free gold was a constraint on the Fed, it seems highly unlikely that that constraint would have been binding had the Bank of France not accumulated an additional $1 billion of gold reserves (over and above the increased reserves necessary to maintain the 40% gold-reserve ratio of July 1928) after rejoining the gold standard. Of course, the claim that free gold was a binding constraint on Fed policy in the second half of 1931 is far from universally accepted, and I consider the claim to be pretextual.

Finally, I concede that my assertion that unemployment fell steadily in Britain after the end of the 1920-22 depression was not entirely correct. Unemployment did indeed fall substantially after 1922, but remained around 10 percent in 1924 — there are conflicting estimates based on different assumptions about how to determine whom to count as unemployed — when the pound began appreciating before the restoration of the prewar parity. Unemployment continued rising rise until 1926, but remained below the 1922 level. Unemployment then fell substantially in 1926-27, but rose again in 1928 (as gold accumulation by France and the US led to a rise in Bank rate), without reaching the 1926 level. Unemployment fell slightly in 1929 and was less than the 1924 level before the crash. See Eichengreen “Unemployment in Interwar Britain.”

I agree that unemployment had been a serious problem in Britain before 1928. But that wasn’t because sufficient gold was lacking in the system. Unemployment was a British problem caused by an overvalued exchange rate; it was not a systemic gold-standard problem.

Before World War I, when the gold standard was largely a sterling standard (just as the postwar gold standard became a dollar standard), the Bank of England had been able to “draw gold from the moon” by raising Bank rate. But the gold that had once been in the moon moved to the US during World War I. What Britain required was a US discount rate low enough to raise the world price level, thereby reducing deflationary pressure on Britain caused by overvaluation of sterling. Instead of keeping the discount rate at 3.5 – 4%, and allowing an outflow of gold, the Fed increased its discount rate, inducing a gold inflow and triggering a worldwide deflationary catastrophe. Between 1929 to 1931, British unemployment nearly doubled because of that catastrophe, not because Britain didn’t have enough gold. The US had plenty of gold and suffered equally from the catastrophe.

Hu McCulloch Figures out (More or Less) the Great Depression

Published August 29, 2018 deflation , gold standard , gold-exchange standard , Great Depression , Gustav Cassel , Hawtrey , Houston McCulloch , Keynes , Winston Churchill 6 Comments

Last week Houston McCulloch, one of the leading monetary economists of my generation, posted an  insightful and thoughtful discussion of the causes of the Great Depression with which I largely, though not entirely, agree. Although Scott Sumner has already commented on Hu’s discussion, I also wanted to weigh in with some of my comments. Here is how McCulloch sets up his discussion.

Understanding what caused the Great Depression of 1929-39 and why it persisted so long has been fairly characterized by Ben Bernanke as the “Holy Grail of Macroeconomics.” The fear that the financial crisis of 2008 would lead to a similar Depression induced the Fed to use its emergency powers to bail out failing firms and to more than quadruple the monetary base, while Congress authorized additional bailouts and doubled the national debt. Could the Great Recession have taken a similar turn had these extreme measures not been taken?

Economists have often blamed the Depression on U.S. monetary policy or financial institutions.  Friedman and Schwartz (1963) famously argued that a spontaneous wave of runs against fragile fractional reserve banks led to a rise in the currency/deposit ratio. The Fed failed to offset the resulting fall in the money multiplier with base expansion, leading to a disastrous 24% deflation from 1929 to 1933. Through the short-run Phillips curve effect (Friedman 1968), this in turn led to a surge in unemployment to 22.5% by 1932.

The Debt-Deflation theory of Irving Fisher, and later Ben Bernanke (1995), takes the deflation as given, and blames the severity of the disruption on the massive bankruptcies that were caused by the increased burden of nominal indebtedness.  Murray Rothbard (1963) uses the “Austrian” business cycle theory of Ludwig von Mises and F.A. Hayek to blame the downturn on excessive domestic credit expansion by the Fed during the 1920s that disturbed the intertemporal structure of production (cf. McCulloch 2014).

My own view, after pondering the problem for many decades, is that indeed the Depression was monetary in origin, but that the ultimate blame lies not with U.S. domestic monetary and financial policy during the 1920s and 30s. Rather, the massive deflation was an inevitable consequence of Europe’s departure from the gold standard during World War I —  and its bungled and abrupt attempt to return to gold in the late 1920s.

I agree with every word of this introductory passage, so let’s continue.

In brief, the departure of the European belligerents from gold in 1914 massively reduced the global demand for gold, leading to the inflation of prices in terms of gold — and, therefore, in terms of currencies like the U.S. dollar which were convertible to gold at a fixed parity. After the war, Europe initially postponed its return to gold, leading to a plateau of high prices during the 1920s that came to be perceived as the new normal. In the late 1920s, there was a scramble to return to the pre-war gold standard, with the inevitable consequence that commodity prices — in terms of gold, and therefore in terms of the dollar — had to return to something approaching their 1914 level.

The deflation was thus inevitable, but was made much more harmful by its postponement and then abruptness. In retrospect, the UK could have returned to its pre-war parity with far less pain by emulating the U.S. post-Civil War policy of freezing the monetary base until the price level gradually fell to its pre-war level. France should not have over-devalued the franc, and then should have monetized its gold influx rather than acting as a global gold sink. Gold reserve ratios were unnecessarily high, especially in France.

Here is where I start to quibble a bit with Hu, mainly about the importance of Britain’s 1925 resumption of convertibility at the prewar parity with the dollar. Largely owing to Keynes’s essay “The Economic Consequences of Mr. Churchill,” in which Keynes berated Churchill for agreeing to the demands of the City and to the advice of the British Treasury advisers (including Ralph Hawtrey), on whom he relied despite Keynes’s attempt to convince him otherwise, to quickly resume gold convertibility at the prewar dollar parity, warning of the devastating effects of the subsequent deflation on British industry and employment, much greater significance has been attributed to the resumption of convertibility than it actually had on the subsequent course of events. Keynes’s analysis of the deflationary effect of the resumption was largely correct, but the effect turned out to be milder than he anticipated. Britain had already undergone a severe deflation in the early 1920s largely as a result of the American deflation. Thus by 1925, Britain had already undergone nearly 5 years of continuous deflation that brought the foreign exchange value of sterling to within 10 percent of the prewar dollar parity. The remaining deflation required to enable sterling to appreciate another 10 percent was not trivial, but by 1925 most of the deflationary pain had already been absorbed. Britain was able to sustain further mild deflation for the next four years till mid-1929 even as the British economy grew and unemployment declined gradually. The myth that Britain was mired in a continuous depression after the resumption of convertibility in 1925 has no basis in the evidence. Certainly, a faster recovery would have been desirable, and Hawtrey consistently criticized the Bank of England for keeping Bank Rate at 5% even with deflation in the 1-2% range.

The US Federal Reserve was somewhat accommodative in the 1925-28 period, but could have easily been even more accommodative. As McCulloch correctly notes it was really France, which undervalued the franc when it restored convertibility in 1928, and began accumulating gold in record quantities that became the primary destabilizing force in the world economy. Britain was largely an innocent bystander.

However, given that the U.S. had a fixed exchange rate relative to gold and no control over Europe’s misguided policies, it was stuck with importing the global gold deflation — regardless of its own domestic monetary policies. The debt/deflation problem undoubtedly aggravated the Depression and led to bank failures, which in turn increased the currency/deposit ratio and compounded the situation. However, a substantial portion of the fall in the U.S. nominal money stock was to be expected as a result of the inevitable deflation — and therefore was the product, rather than the primary cause, of the deflation. The anti-competitive policies of the Hoover years and FDR’s New Deal (Rothbard 1963, Ohanian 2009) surely aggravated and prolonged the Depression, but were not the ultimate cause.

Actually, the Fed, holding 40% of the world’s gold reserves in 1929, could have eased pressure on the world gold market by allowing an efflux of gold to accommodate the French demand for gold. However, instead of taking an accommodative stance, the Fed, seized by dread of stock-market speculation, kept increasing short-term interest rates, thereby attracting gold into the United States instead of allowing gold to flow out, increasing pressure on the world gold market and triggering the latent deflationary forces that until mid-1929 had been kept at bay. Anti-competitive policies under Hoover and under FDR were certainly not helpful, but those policies, as McCulloch recognizes, did not cause the collapse of output between 1929 and 1933.

Contemporary economists Ralph Hawtrey, Charles Rist, and Gustav Cassel warned throughout the 1920s that substantial deflation, in terms of gold and therefore the dollar, would be required to sustain a return to anything like the 1914 gold standard.[1]  In 1928, Cassel actually predicted that a global depression was imminent:

The post-War superfluity of gold is, however, of an entirely temporary character, and the great problem is how to meet the growing scarcity of gold which threatens the world both from increased demand and from diminished supply. We must solve this problem by a systematic restriction of the monetary demand for gold. Only if we succeed in doing this can we hope to prevent a permanent fall in the general price level and a prolonged and world-wide depression which would inevitably be connected with such a fall in prices [as quoted by Johnson (1997, p. 55)].

As early as 1919 both Hawtrey and Cassel had warned that a global depression would follow an attempt to restore the gold standard as it existed before World War I. To avoid such a deflation it was necessary to limit the increase in the monetary demand for gold. Hawtrey and Cassel therefore proposed shifting to a gold exchange standard in which gold coinage would not be restored and central banks would hold non-gold foreign exchange reserves rather than gold bullion. The 1922 Genoa Resolutions were largely inspired by the analysis of Hawtrey and Cassel, and those resolutions were largely complied with until France began its insane gold accumulation policy in 1928 just as the Fed began tightening monetary policy to suppress stock-market speculation, thereby triggering, more or less inadvertently, an almost equally massive inflow of gold into the US. (On Hawtrey and Cassel, see my paper with Ron Batchelder.)

McCulloch has a very interesting discussion of the role of the gold standard as a tool of war finance, which reminds me of Earl Thompson’s take on the gold standard, (“Gold Standard: Causes and Consequences”) that Earl contributed to a volume I edited, Business Cycles and Depressions: An Encyclopedia. To keep this post from growing inordinately long, and because it’s somewhat tangential to McCulloch’s larger theme, I won’t comment on that part of McCulloch’s discussion.

The Gold Exchange Standard

After the war, in order to stay on gold at $20.67 an ounce, with Europe off gold, the U.S. had to undo its post-1917 inflation. The Fed achieved this by raising the discount rate on War Bonds, beginning in late 1919, inducing banks to repay their corresponding loans. The result was a sharp 16% fall in the price level from 1920 to 1922. Unemployment rose from 3.0% in 1919 to 8.7% in 1921. However, nominal wages fell quickly, and unemployment was back to 4.8% by 1923, where it remained until 1929.[3]

The 1920-22 deflation thus brought the U.S. price level into equilibrium, but only in a world with Europe still off gold. Restoring the full 1914 gold standard would have required going back to approximately the 1914 value of gold in terms of commodities, and therefore the 1914 U.S. price level, after perhaps extrapolating for a continuation of the 1900-1914 “gold inflation.”

This is basically right except that I don’t think it makes sense to refer to the US price level as being in equilibrium in 1922. Holding 40% of the world’s monetary gold reserves, the US was in a position to determine the value of gold at whatever level it wanted. To call the particular level at which the US decided to stabilize the value of gold in 1922 an equilibrium is not based on any clear definition of equilibrium that I can identify.

However, the European countries did not seriously try to get back on gold until the second half of the 1920s. The Genoa Conference of 1922 recognized that prices were too high for a full gold standard, but instead tried to put off the necessary deflation with an unrealistic “Gold Exchange Standard.” Under that system, only the “gold center” countries, the U.S. and UK, would hold actual gold reserves, while other central banks would be encouraged to hold dollar or sterling reserves, which in turn would only be fractionally backed by gold. The Gold Exchange Standard sounded good on paper, but unrealistically assumed that the rest of the world would permanently kowtow to the financial supremacy of New York and London.

There is an argument to be made that the Genoa Resolutions were unrealistic in the sense that they assumed that countries going back on the gold standard would be willing to forego the holding of gold reserves to a greater extent than they were willing to. But to a large extent, this was the result of systematically incorrect ideas about how the gold standard worked before World War I and how the system could work after World War I, not of any inherent or necessary properties of the gold standard itself. Nor was the assumption that the rest of the world would permanently kowtow to the financial supremacy of New York and London all that unrealistic when considered in the light of how readily, before World War I, the rest of the world kowtowed to the financial supremacy of London.

In 1926, under Raymond Poincaré, France stabilized the franc after a 5:1 devaluation. However, it overdid the devaluation, leaving the franc undervalued by about 25%, according to The Economist (Johnson 1997, p. 131). Normally, under the specie flow mechanism, this would have led to a rapid accumulation of international reserves accompanied by monetary expansion and inflation, until the price level caught up with purchasing power parity. But instead, the Banque de France sterilized the reserve influx by reducing its holdings of government and commercial credit, so that inflation did not automatically stop the reserve inflow. Furthermore, it often cashed dollar and sterling reserves for gold, again contrary to the Gold Exchange Standard.  The Banking Law of 1928 made the new exchange rate, as well as the gold-only policy, official. By 1932, French gold reserves were 80% of currency and sight deposits (Irwin 2012), and France had acquired 28.4% of world gold reserves — even though it accounted for only 6.6% of world manufacturing output (Johnson 1997, p. 194). This “French Gold Sink” created even more deflationary pressure on gold, and therefore dollar prices, than would otherwise have been expected.

Here McCulloch is unintentionally displaying some of the systematically incorrect ideas about how the gold standard worked that I referred to above. McCulloch is correct that the franc was substantially undervalued when France restored convertibility in 1928. But under the gold standard, the French price level would automatically adjust to the world price level regardless of what happened to the French money supply. However, the Bank of France, partly because it was cashing in the rapidly accumulating foreign exchange reserves for gold as French exports were rising and its imports falling given the low internal French price level, and partly because it was legally barred from increasing the supply of banknotes by open-market operations, was accumulating gold both actively and passively. With no mechanism for increasing the quantity of banknotes in France, a balance of payment of surplus was the only mechanism by which an excess demand for money could be accommodated. It was not an inflow of gold that was being sterilized (sterilization being a misnomer reflecting a confusion about the direction of causality) it was the lack of any domestic mechanism for increasing the quantity of banknotes that caused an inflow of gold. Importing gold was the only means by which an excess domestic demand for banknotes could be satisfied.

The Second Post-War Deflation

By 1931, French gold withdrawals forced Germany to adopt exchange controls, and Britain to give up convertibility altogether. However, these countries did not then disgorge their remaining gold, but held onto it in the hopes of one day restoring free convertibility. Meanwhile, after having been burned by the Bank of England’s suspension, the “Gold Bloc” countries — Belgium, Netherlands and Switzerland — also began amassing gold reserves in earnest, raising their share of world gold reserves from 4.2% in June 1930 to 11.1% two years later (Johnson 1997, p. 194). Despite the dollar’s relatively strong position, the Fed also contributed to the problem by raising its gold coverage ratio to over 75% by 1930, well in excess of the 40% required by law (Irwin 2012, Fig. 5).

The result was a second post-war deflation as the value of gold, and therefore of the dollar, in terms of commodities, abruptly caught up with the greatly increased global demand for gold. The U.S. price level fell 24.0% between 1929 and 1933, with deflation averaging 6.6% per year for 4 years in a row. Unemployment shot up to 22.5% by 1932.

By 1933, the U.S. price level was still well above its 1914 level. However, if the “gold inflation” of 1900-1914 is extrapolated to 1933, as in Figure 3, the trend comes out to almost the 1933 price level. It therefore appears that the U.S. price level, if not its unemployment rate, was finally near its equilibrium under a global gold standard with the dollar at $20.67 per ounce, and that further deflation was probably unnecessary.[4]

Once again McCulloch posits an equilibrium price level under a global gold standard. The mistake is in assuming that there is a fixed monetary demand for gold, which is an assumption completely without foundation. The monetary demand for gold is not fixed. The greater the monetary demand for gold the higher the equilibrium real value of gold and the lower the price level in terms of gold. The equilibrium price level is a function of the monetary demand for gold.

The 1929-33 deflation was much more destructive than the 1920-22 deflation, in large part because it followed a 7-year “plateau” of relatively stable prices that lulled the credit and labor markets into thinking that the higher price level was the new norm — and that gave borrowers time to accumulate substantial nominal debt. In 1919-1920, on the other hand, the newly elevated price level seemed abnormally high and likely to come back down in the near future, as it had after 1812 and 1865.

This is correct, and I fully agree.

How It Could Have been Different

In retrospect, the UK could have successfully gotten itself back on gold with far less disruption simply by emulating the U.S. post-Civil War policy of freezing the monetary base at its war-end level, and then letting the economy grow into the money supply with a gradual deflation. This might have taken 14 years, as in the U.S. between 1865-79, or even longer, but it would have been superior to the economic, social, and political turmoil that the UK experienced. After the pound rose to its pre-war parity of $4.86, the BOE could have begun gradually buying gold reserves with new liabilities and even redeeming those liabilities on demand for gold, subject to reserve availability. Once reserves reached say 20% of its liabilities, it could have started to extend domestic credit to the government and the private sector through the banks, while still maintaining convertibility. Gold coins could even have been circulated, as demanded.

Again, I reiterate that, although the UK resumption was more painful for Britain than it need have been, the resumption had little destabilizing effect on the international economy. The UK did not have a destabilizing effect on the world economy until the September 1931 crisis that caused Britain to leave the gold standard.

If the UK and other countries had all simply devalued in proportion to their domestic price levels at the end of the war, they could have returned to gold quicker, and with less deflation. However, given that a country’s real demand for money — and therefore its demand for real gold reserves — depends only on the real size of the economy and its net gold reserve ratio, such policies would not have reduced the ultimate global demand for gold or lessened the postwar deflation in countries that remained on gold at a fixed parity.

This is an important point. Devaluation was a way of avoiding an overvalued currency and the relative deflation that a single country needed to undergo. But the main problem facing the world in restoring the gold standard was not the relative deflation of countries with overvalued currencies but the absolute deflation associated with an increased world demand for gold across all countries. Indeed, it was France, the country that did devalue that was the greatest source of increased demand for gold owing to its internal monetary policies based on a perverse gold standard ideology.

In fact, the problem was not that gold was “undervalued” (as Johnson puts it) or that there was a “shortage” of gold (as per Cassel and others), but that the price level in terms of gold, and therefore dollars, was simply unsustainably high given Europe’s determination to return to gold. In any event, it was inconceivable that the U.S. would have devalued in 1922, since it had plenty of gold, had already corrected its price level to the world situation with the 1920-22 deflation, and did not have the excuse of a banking crisis as in 1933.

I think that this is totally right. It was not the undervaluation of individual currencies that was the problem, it was the increase in the demand for gold associated with the simultaneous return of many countries to the gold standard. It is also a mistake to confuse Cassel’s discussion of gold shortage, which he viewed as a long-term problem, with the increase in gold demand associated with returning to the gold standard which was the cause of sudden deflation starting in 1929 as a result of the huge increase in gold demand by the Bank of France, a phenomenon that McCulloch mentions early on in his discussion but does not refer to again.

Mises’s Unwitting Affirmation of the Hawtrey-Cassel Explanation of the Great Depression

Published July 3, 2015 Bank of France , Federal Reserve , gold standard , gold-exchange standard , Great Depression , Ludwig von Mises 12 Comments
Tags: ,

In looking up some sources for my previous post on the gold-exchange standard, I checked, as I like to do from time to time, my old copy of The Theory of Money and Credit by Ludwig von Mises. Mises published The Theory of Money and Credit in 1912 (in German of course) when he was about 31 years old, a significant achievement. In 1924 he published a second enlarged edition addressing many issues that became relevant in the aftermath the World War and the attempts then underway to restore the gold standard. So one finds in the 1934 English translation of the 1924 German edition a whole section of Part III, chapter 6 devoted to the Gold-Exchange Standard. I noticed that I had dog-eared the section, which presumably means that when I first read the book I found the section interesting in some way, but I did not write any notes in the margin, so I am not sure what it was that I found interesting. I can’t even remember when I read the book, but there are many passages underlined throughout the book, so I am guessing that I did read it from cover to cover. Luckily, I wrote my name and the year (1971) in which I bought the book on the inside of the front cover, so I am also guessing that I read the book before I became aware of the Hawtrey Cassel explanation of the Great Depression. But it seems clear to me that whatever it was that I found interesting about the section on the gold-exchange standard, it didn’t make a lasting impression on me, because I don’t think that I ever reread that section until earlier this week. So let’s go through Mises’s discussion and see what we find.

Wherever inflation has thrown the monetary system into confusion, the primary aim of currency policy has been to bring the printing presses to a standstill. Once that is done, once it has at last been learned that even the policy of raising the objective exchange-value of money has undesirable consequences, and once it is seen that the chief thing is to stabilize the value of money, then attempts are made to establish a gold-exchange standard as quickly as possible.

This seems to be reference to the World War I inflation and the somewhat surprising post-war inflation of 1919, which caused most countries to want to peg their currencies against the dollar, then the only major country with a currency convertible into gold. Mises continues:

This, for example, is what occurred in Austria at the end of 1922 and since then, at least for the time being, the dollar rate in that country has been fixed. But in existing circumstances, invariability of the dollar rate means invariability of the price of gold also. Thus Austria has a dollar-exchange standard and so, indirectly, a gold-exchange standard. That is the currency system that seems to be the immediate aim in Germany, Poland, Hungary, and many other European countries. Nowadays, European aspirations in the sphere of currency policy are limited to a return to the gold standard. This is quite understandable, for the gold standard previously functioned on the whole satisfactorily; it is true that it did not secure the unattainable ideal of a money with an invariable objective exchange value, but it did preserve the monetary system from the influence of governments and changing policies.

Yet the gold-standard system was already undermined before the war. The first step was the abolition of the physical use of gold in individual payments and the accumulation of the stocks of gold in the vaults of the great banks-of-issue. The next step was the adoption of the practice by a series of States of holding the gold reserves of the central banks-of-issue (or the redemption funds that took their place), not in actual gold, but in various sorts of foreign claims to gold. Thus it came about that the greater part of the stock of gold that was used for monetary purposes was gradually accumulated in a few large banks-of-issue; and so these banks became the central reserve-banks of the world, as previously the central banks-of-issue had become central reserve-banks for individual countries.

Mises is leaving out a lot here. Many countries were joining gold standard in the last quarter of the 19th century, when the gold standard became an international system. The countries adopting the gold standard did not have a gold coinage; for them to introduce a gold coinage, as Mises apparently would have been wanted, was then prohibitively costly. But gold reserves were still piling up in many central banks because of laws and regulations requiring central banks to hold gold reserves against banknotes. If gold coinages would have been introduced in addition to the gold gold reserves being accumulated as reserves against banknotes, the spread of gold standard through much of the world in the last quarter of the 19th century would have drastically accentuated the deflationary trends that marked most of the period from 1872 to 1896.

The War did not create this development; it merely hastened it a little.

Actually a lot. But we now come to the key passage.

Neither has the development yet reached the stage when all the newly-produced gold that is not absorbed into industrial use flows to a single centre. The Bank of England and the central banks-of-issue of some other States still control large stocks of gold; there are still several of them that take up part of the annual output of gold. Yet fluctuations in the price of gold are nowadays essentially dependent on the policy followed by the Federal Reserve Board. If the United States did not absorb gold to the extent to which it does, the price of gold would fall and the gold-prices of commodities would rise. Since, so long as the dollar represents a fixed quantity of gold, the United States admits the surplus gold and surrenders commodities for gold to an unlimited extent, a rapid fall in the value of gold has hitherto been avoided.

Mises’s explanation here is rather confused, because he neglects to point out that the extent to which gold was flowing into the Federal Reserve was a function, among other things, of the credit policy adopted by the Fed. The higher the interest rate, the more gold would flow into the Fed and, thus, the lower the international price level. Mises makes it sound as if there was a fixed demand for gold by the rest of the world and the US simply took whatever was left over. That was a remarkable misunderstanding on Mises’s part.

But this policy of the United States, which involves considerable sacrifices, might one day be changed. Variations in the price of gold would then occur and this would be bound to give rise in other gold countries to the question of whether it would not be better in order to avoid further rises in prices to dissociate the currency standard from gold.

Note the ambiguous use of the term “price of gold.” The nominal price of gold was fixed by convertibility, so what Mises meant was the real price of gold, with a fixed nominal price. It would have been less ambiguous if the term “value of gold” had been used here and in the rest of the passage instead of “price of gold.” I don’t know if Mises or his translator was at fault.

Just as Sweden attempted for a time to raise the krone above its old gold parity by closing the Mint to gold, so other countries that are now still on the gold standard or intend to return to it might act similarly. This would mean a further drop in the price of gold and a further reduction of the usefulness of gold for monetary purposes. If we disregard the Asiatic demand for money, we might even now without undue exaggeration say that gold has ceased to be a commodity the fluctuations in the price of which are independent of government influence. Fluctuations in the price of gold are nowadays substantially dependent on the behaviour of one government, viz. that of the United States of America.

By George, he’s got it! The value of gold depends mainly on the Fed! Or, to be a bit more exact, on how much gold is being held by the Fed and by the other central banks. The more gold they hold, the more valuable in real terms gold becomes, which means that, with a fixed nominal price of gold, the lower are the prices of all other commodities. The point of the gold-exchange standard was thus to reduce the world’s monetary demand for gold, thereby limiting the tendency of gold to appreciate and for prices in terms of gold to fall. Indeed, Mises here cites in a footnote none other than the villainous John Maynard Keynes himself (Tract on Monetary Reform) where he also argued that after World War I, the value of gold was determined by government policy, especially that of the Federal Reserve. Mises goes on to explain:

All that could not have been foreseen in this result of a long process of development is the circumstance that the fluctuations in the price of gold should have become dependent upon the policy of one government only. That the United States should have achieved such an economic predominance over other countries as it now has, and that it alone of all the countries of great economic importance should have retained the gold standard while the others (England, France, Germany, Russia, and the rest) have at least temporarily abandoned it – that is a consequence of what took place during the War. Yet the matter would not be essentially different if the price of gold was dependent not on the policy of the United States alone, but on those of four or five other governments as well. Those protagonists of the gold-exchange standard who have recommended it as a general monetary system and not merely as an expedient for poor countries, have overlooked this fact. They have not observed that the gold-exchange standard must at last mean depriving gold of that characteristic which is the most important from the point of view of monetary policy – its independence of government influence upon fluctuations in its value. The gold-exchange standard has not been recommended or adopted with the object of dethroning gold. All that Ricardo wanted was to reduce the cost of the monetary system. In many countries which from the last decade of the nineteenth century onward have wished to abandon the silver or credit-money standard, the gold-exchange standard rather than a gold standard with an actual gold currency has been adopted in order to prevent the growth of a new demand for gold from causing a rise in its price and a fall in the gold-prices of commodities. But whatever the motives may have been by which the protagonists of the gold-exchange standard have been led, there can be no doubt concerning the results of its increasing popularity.

If the gold-exchange standard is retained, the question must sooner or later arise as to whether it would not be better to substitute for it a credit-money standard whose fluctuations were more susceptible to control than those of gold. For if fluctuations in the price of gold are substantially dependent on political intervention, it is inconceivable why government policy should still be restricted at all and not given a free hand altogether, since the amount of this restriction is not enough to confine arbitrariness in price policy within narrow limits. The cost of additional gold for monetary purposes that is borne by the whole world might well be saved, for it no longer secures the result of making the monetary system independent of government intervention. If this complete government control is not desired, there remains one alternative only: an attempt must be made to get back from the gold-exchange standard to the actual use of gold again.

Thus, we see that in 1924 none other than the legendary Ludwig von Mises was explaining that the value of gold had come to depend primarily on the policy decisions of the Federal Reserve and the other leading central banks. He also understood that a process of deflation could have terrible consequences if free-market forces were not operating to bring about an adjustment of market prices to the rising value of gold. Recognizing the potentially disastrous consequences of a scramble for gold by the world’s central banks as they rejoined the gold standard, Hawtrey and Cassel called for central-bank cooperation to limit the increase in the demand for gold and to keep the value of gold stable. In 1924, at any rate, Mises, too, recognized that there could be a destabilizing deflationary increase in the demand for gold by central banks. But when the destabilizing deflationary increase actually started to happen in 1927 when the Bank of France began cashing in its foreign-exchange reserves for gold, triggering similar demands by other central banks in the process of adopting the gold standard, the gold standard started collapsing under the weight  of deflation. But, as far as I know, Mises never said a word about the relationship between gold demand and the Great Depression.

Instead, in the mythology of Austrian business-cycle theory, it was all the fault of the demonic Benjamin Strong for reducing the Fed’s discount rate from 5% to 3.5% in 1927 (and back to only 4% in 1928) and of the duplicitous Montagu Norman for reducing Bank Rate from 5% to 4.5% in 1927-28 rather than follow the virtuous example of the Bank of France in abandoning the cursed abomination of the gold-exchange standard.

Gold Standard or Gold-Exchange Standard: What’s the Difference?

Published July 1, 2015 David Ricardo , gold standard , gold-exchange standard , Keynes 27 Comments
Tags:

In recent posts (here and here) I have mentioned both the gold standard and the gold-exchange standard, a dichotomy that suggests that the two are somehow distinct, and I noted that the Genoa Conference of 1922 produced a set of resolutions designed to ensure that the gold standard, whose restoration was the goal of the conference, would be a gold-exchange standard rather than the traditional pre-World War I gold standard. I also mentioned that the great American central banker Benjamin Strong had stated that he was not particularly fond of the gold-exchange standard favored by the Genoa Resolutions. So there seems to be some substantive difference between a gold standard (of the traditional type) and a gold-exchange standard. Wherein lies the difference? And what, if anything, can we infer from that difference about how the two standards operate?

Let’s begin with some basics. Suppose there’s a pure metallic (gold) currency. All coins that circulate are gold and their value reflects the weight and fineness of the gold, except that the coins are stamped so that they don’t have to be weighed or assayed; they trade at their face value. Inevitably under such systems, there’s a problem with the concurrent circulation of old and worn coins at par with newly minted coins. Because they have the same face value, it is old coins that remain in circulation, while the new coins are hoarded, leading to increasingly overvalued (underweight) coins in circulation. This observation gives rise to Gresham’s Law: bad (i.e., old and worn) money drives out the good (i.e., new full-weight) money. The full-weight coin is the standard, but it tends not to circulate.

When the currency consists entirely of full-weight gold coins, it is redundant to speak of a gold standard. The term “gold standard” has significance only if the coin represents a value greater than the value of its actual metallic content. When underweight coins can circulate at par, because they are easily exchangeable for coins of full weight, the coinage is up to standard. If coins don’t circulate at par, the coinage is debased; it is substandard.

Despite the circulation of gold coins for millenia, the formal idea of a gold standard did not come into being until the eighteenth century, when, because the English mint was consistently overvaluing gold at a ratio relative to silver of approximately 15.5 to 1, while on the Continent, the gold-silver ratio was about 15 to 1, inducing an influx of gold into England. The pound sterling had always been a silver coin, like the shilling (20 shillings in a pound), but by the end of the 17th century, debasement of the silver coinage led to the hoarding and export of full weight silver coins. In the 17th century, the British mint had begun coining a golden guinea, originally worth a pound, but, subsequently, reflecting the premium on gold, guineas traded in the market at a premium.

In 1717, the master of the mint — a guy named Isaac Newton who, in his youth, had made something of a name for himself as a Cambridge mathematician — began to mint a golden pound at a mint price of £3 17 shillings and 10.5 pence (12 pence in a shilling) for an ounce of gold. The mint stopped minting guineas, which continued to circulate, and had an official value of 21 shillings (£1 1s.). In theory the pound remained a weight of silver, but in practice the pound had become a golden coin whose value was determined by the mint price chosen by that Newton guy.

Meanwhile the Bank of England based in London and what were known as country banks (because they operated outside the London metro area) as well as the Scottish banks operating under the Scottish legal regime that was retained after the union of England with Scotland, were all issuing banknotes denominated in sterling, meaning that they were convertible into an equivalent value of metallic (now golden) pounds. So legally the banks were operating under a pound standard not a gold standard. The connection to gold was indirect, reflecting the price at which Isaac Newton had decided that the mint would coin gold into pounds, not a legal definition of the pound.

The pound did not become truly golden until Parliament passed legislation in 1819 (The Resumption Act) after the Napoleonic Wars. The obligation of banks to convert their notes into coinage was suspended in 1797, and Bank of England notes were made legal tender. With the indirect link between gold and paper broken, the value of gold in terms of inconvertible pounds rose above the old mint price. Anticipating the resumption of gold payments, David Ricardo in 1816 penned what he called Proposals for an Economical and Secure Currency in which he proposed making all banknotes convertible into a fixed weight of gold, while reducing the metallic content of the coinage to well below their face value. By abolishing the convertibility of banknotes into gold coin, but restricting the convertibility of bank notes to gold bullion, Ricardo was proposing what is called a gold-bullion standard, as opposed to a gold-specie standard when banknotes are convertible into coin. Ricardo reasoned that by saving the resources tied up in a gold coinage, his proposal would make the currency economical, and, by making banknotes convertible into gold, his proposals would ensure that the currency was secure. Evidently too radical for the times, Ricardo’s proposals did not gain acceptance, and a gold coinage was brought back into circulation at the Newtonian mint price.

But as Keynes observed in his first book on economics Indian Currency and Finance published in 1913 just before the gold standard collapsed at the start of World War I, gold coinage was not an important feature of the gold standard as it operated in its heday.

A gold standard is the rule now in all parts of the world; but a gold currency is the exception. The “sound currency” maxims of twenty or thirty years ago are still often repeated, but they have not been successful, nor ought they to have been, in actually influencing affairs. I think that I am right in saying that Egypt is now the only country in the world in which actual gold coins are the principle medium of exchange.

The reasons for this change are easily seen. It has been found that the expense of a gold circulation is insupportable, and that large economics can be safely effected by the use of some cheaper substitute; and it has been found further that gold in the pockets of the people is not in the least available at a time of crisis or to meet a foreign drain. For these purposes the gold resources of a country must be centralized.

This view has long been maintained by economists. Ricardo’s proposals for a sound and economical currency were based on the principle of keeping gold out of actual circulation. Mill argued that “gold wanted for exportation is almost invariably drawn from the reserves of banks, and is never likely to be taken from the outside circulation while the banks remain solvent.” . . .

A preference for a tangible gold currency is no longer more than a relic of a time when Governments were less trustworthy in these matters than they are now, and when it was the fashion to imitate uncritically the system which had been established in England and had seemed to work so well during the second quarter of the nineteenth century. (pp. 71-73)

Besides arguing against the wastefulness of a gold coinage, Keynes made a further argument about the holding of gold reserves as a feature of the gold standard, namely that, as a matter of course, there are economic incentives (already recognized by Ricardo almost a century earlier) for banks to economize on their holdings of gold reserves with which to discharge their foreign obligations by holding foreign debt instruments which also serve to satisfy foreign claims upon themselves while also generating a pecuniary return. A decentralized informal clearinghouse evolved over the course of the nineteenth century, in which banks held increasing amounts of foreign instruments with which to settle mutual claims upon each other, thereby minimizing the need for actual gold shipments to settle claims. Thus, for purposes of discharging foreign indebtedness, the need for banks to hold gold reserves became less urgent. The holding of foreign-exchange reserves and the use of those reserves to discharge foreign obligations as they came due is the defining characteristic of what was known as the gold-exchange standard.

To say that the Gold-Exchange Standard merely carries somewhat further the currency arrangements which several European countries have evolved during the last quarter of a century is not, of course, to justify it. But if we see that the Gold-Exchange Standard is not, in the currency world of to-day, anomalous, and that it is in the main stream of currency evolution, we shall have a wider experience, on which to draw in criticising it, and may be in a better position to judge of its details wisely. Much nonsense is talked about a gold standard’s properly carrying a gold currency with it. If we mean by a gold currency a state of affairs in which gold is the principal or even, in the aggregate, a very important medium of exchange, no country in the world has such a thing. [fn. Unless it be Egypt.] Gold is an international, but not a local currency. The currency problem of each country is to ensure that they shall run no risk of being unable to put their hands on international currency when they need it, and to waste as small a proportion of their resources on holdings of actual gold as is compatible with this. The proper solution for each country must be governed by the nature of its position in the international money market and of its relations to the chief financial centres, and by those national customs in matters of currency which it may be unwise to disturb. It is as an attempt to solve this problem that the Gold Exchange Standard ought to be judged. . . .

The Gold-Exchange Standard arises out of the discovery that, so long as gold is available for payments of international indebtedness at an approximately constant rate in terms of the national currency, it is a matter of comparative indifference whether it actually forms the national currency.

The Gold-Exchange Standard may be said to exist when gold does not circulate in a country to an appreciable extent, when the local currency is not necessarily redeemable in gold, but when the Government or Central Bank makes arrangements for the provision of foreign remittances in gold at a fix, ed maximum rate in terms of the local currency, the reserves necessary to provide these remittances being kept to a considerable extent abroad. . . .

Its theoretical advantages were first set forth by Ricardo at the time of the Bullionist Controversy. He laid it down that a currency is in its most perfect state when it consists of a cheap material, but having an equal value with the gold it professes to represent; and he suggested that convertibility for the purposes of the foreign exchanges should be ensured by the tendering on demand of gold bars (not coin) in exchange for notes, — so that gold might be available for purposes of export only, and would be prevented from entering into the internal circulation of the country. (pp. 29-31)

The Gold-Exchange Standard in the form in which it has been adopted in India is justly known as the Lindsay scheme. It was proposed and advocated from the earliest discussions, when the Indian currency problem first became prominent, by Mr. A. M. Lindsay, Deputy-Secretary of the Bank of Bengal, who always maintained that “they must adopt my scheme despite themselves.” His first proposals were made in 1876 and 1878. They were repeated in 1885 and again in 1892, when he published a pamphlet entitled Ricardo’s Exchange Remedy. Finally he explained his views in detail to the Committee of 1898.

Lindsay’s scheme was severely criticized both by Government officials and leading financiers. Lord Farrer described it as “far too clever for the ordinary English mind with its ineradicable prejudice for an immediately tangible gold backing of all currencies.” Lord Rothschild, Sir John Lubbock (Lord Avebury), Sir Samuel Montagu (the late Lord Swythling) all gave evidence before the Committee that any system without a visible gold currency would be looked on with distrust. Mr. Alfred de Rothschild went so far as to say that “in fact a gold standard without a gold currency seemed to him an utter impossibility.” Financiers of this type will not admit the feasibility of anything until it has been demonstrated to them by practical experience. (pp. 34-35)

Finally, as to the question of what difference, aside from convenience, does it make whether a country operates on a full-fledged honest to goodness gold standard or a cheap imitation gold-exchange standard, I conclude with another splendid quotation from Keynes.

But before we pass to these several features of the Indian system, it will be worth while to emphasise two respects in which this system is not peculiar. In the first place a system, in which the rupee is maintained at 1s. 4d. by regulation, does not affect the level of prices differently from the way in which it would be affected by a system in which the rupee was a gold coin worth 1s 4d., except in a very indirect and unimportant way to be explained in a moment. So long as the rupee is worth 1s. 4d. in gold, no merchant or manufacturer considers of what material it is made when he fixes the price of his product. The indirect effect on prices, due to the rupee’s being silver, is similar to the effect of the use of any medium of exchange, such as cheques or notes, which economises the use of gold. If the use of gold is economised in any country, gold throughout the world is less valuable – gold prices, that is to say, are higher. But as this effect is shared by the whole world, the effect on prices in any country of economies in the use of gold made by that country is likely to be relatively slight. In short, a policy which led to a greater use of gold in India would tend, by increasing the demand for gold in the world’s markets, somewhat to lower the level of world prices as measured in gold; but it would not cause any alteration worth considering in the relative rates of exchange of Indian and non-Indian commodities.

In the second place, although it is true that the maintenance of the rupee at or near 1s. 4d. is due to regulation, it is not true, when once 1s. 4d. rather than some other gold value has been determined, that the volume of currency in circulation depends in the least upon the policy of the Government or the caprice of an official. This part of the system is as perfectly automatic as in any other country. (pp. 11-13)

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.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner

Archives

Enter your email address to follow this blog and receive notifications of new posts by email.

Join 3,272 other subscribers
Follow Uneasy Money on WordPress.com