Archive for the 'gold standard' Category

Samuelson Rules the Seas

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

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

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

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

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

OK, now back to Nick:

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

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

Again, back to Nick:

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

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

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

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

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

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

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

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

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

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

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

Imagining the Gold Standard

The Marginal Revolution University has posted a nice little 10-minute video conversation between Scott Sumner and Larry about the gold standard and fiat money, Scott speaking up for fiat money and Larry weighing in on the side of the gold standard. I thought that both Scott and Larry acquitted themselves admirably, but several of the arguments made by Larry seemed to me to require either correction or elaboration. The necessary corrections or elaborations do not strengthen the defense of the gold standard that Larry presents so capably.

Larry begins with a defense of the gold standard against the charge that it caused the Great Depression. As I recently argued in my discussion of a post on the gold standard by Cecchetti and Schoenholtz, it is a bit of an overreach to argue that the Great Depression was the necessary consequence of trying to restore the international gold standard in the 1920s after its collapse at the start of World War I. Had the leading central banks at the time, the Federal Reserve, the Bank of England, and especially the Bank of France, behaved more intelligently, the catastrophe could have been averted, allowing the economic expansion of the 1920s to continue for many more years, thereby averting subsequent catastrophes that resulted from the Great Depression. But the perverse actions taken by those banks in 1928 and 1929 had catastrophic consequences, because of the essential properties of the gold-standard system. The gold standard was the mechanism that transformed stupidity into catastrophe. Not every monetary system would have been capable of accomplishing that hideous transformation.

So while it is altogether fitting and proper to remind everyone that the mistakes that led to catastrophe were the result of choices made by policy makers — choices not required by any binding rules of central-bank conduct imposed by the gold standard — the deflation caused by the gold accumulation of the Bank of France and the Federal Reserve occurred only because the gold standard makes deflation inevitable if there is a sufficiently large increase in the demand for gold. While Larry is correct that the gold standard per se did not require the Bank of France to embark on its insane policy of gold accumulation, it should at least give one pause that the most fervent defenders of that insane policy were people like Ludwig von Mises, F.A. Hayek, Lionel Robbins, and Charles Rist, who were also the most diehard proponents of maintaining the gold standard after the Great Depression started, even holding up the Bank of France as a role model for other central banks to emulate. (To be fair, I should acknowledge that Hayek and Robbins, to Mises’s consternation, later admitted their youthful errors.)

Of course, Larry would say that under the free-banking system that he favors, there would be no possibility that a central bank like the Bank of France could engage in the sort of ruinous policy that triggered the Great Depression. Larry may well be right, but there is also a non-trivial chance that he’s not. I prefer not to take a non-trivial chance of catastrophe.

Larry, I think, makes at least two other serious misjudgments. First, he argues that the instability of the interwar gold standard can be explained away as the result of central-bank errors – errors, don’t forget, that were endorsed by the most stalwart advocates of the gold standard at the time – and that the relative stability of the pre-World War I gold standard was the result of the absence of the central banks in the US and Canada and some other countries while the central banks in Britain, France and Germany were dutifully following the rules of the game.

As a factual matter, the so-called rules of the game, as I have observed elsewhere (also here), were largely imaginary, and certainly never explicitly agreed upon or considered binding by any monetary authority that ever existed. Moreover, the rules of the game were based on an incorrect theory of the gold standard reflecting the now discredited price-specie-flow mechanism, whereby differences in national price levels under the gold standard triggered gold movements that would be deflationary in countries losing gold and inflationary in countries gaining gold. That is a flatly incorrect understanding of how the international adjustment mechanism worked under the gold standard, because price-level differences large enough to trigger compensatory gold flows are inconsistent with arbitrage opportunities tending to equalize the prices of all tradable goods. And finally, as McCloskey and Zecher demonstrated 40 years ago, the empirical evidence clearly refutes the proposition that gold flows under the gold standard were in any way correlated with national price level differences. (See also this post.) So it is something of a stretch for Larry to attribute the stability of the world economy between 1880 and 1914 either to the absence of central banks in some countries or to the central banks that were then in existence having followed the rules of the game in contrast to the central banks of the interwar period that supposedly flouted those rules.

Focusing on the difference between the supposedly rule-based behavior of central banks under the classical gold standard and the discretionary behavior of central banks in the interwar period, Larry misses the really critical difference between the two periods. The second half of the nineteenth century was a period of peace and stability after the end of the Civil War in America and the short, and one-sided, Franco-Prussian War of 1870. The rapid expansion of the domain of the gold standard between 1870 and 1880 was accomplished relatively easily, but not without significant deflationary pressures that lasted for almost two decades. A gold standard had been operating in Britain and those parts of the world under British control for half a century, and gold had long been, along with silver, one of the two main international monies and had maintained a roughly stable value for at least half a century. Once started, the shift from silver to gold caused a rapid depreciation of silver relative to gold, which itself led the powerful creditor classes in countries still on the silver standard to pressure their governments to shift to gold.

After three and a half decades of stability, the gold standard collapsed almost as soon as World War I started. A non-belligerent for three years, the US alone remained on the gold standard until it prohibited the export of gold upon entry into the war in 1917. But, having amassed an enormous gold hoard during World War I, the US was able to restore convertibility easily after the end of the War. However, gold could not be freely traded even after the war. Restrictions on the ownership and exchange of gold were not eliminated until the early 1920s, so the gold standard did not really function in the US until a free market for gold was restored. But prices had doubled between the start of the war and 1920, while 40% of the world’s gold reserves were held by the US. So it was not the value of gold that determined the value of the U.S. dollar; it was the value of the U.S. dollar — determined by the policy of the Federal Reserve — that determined the value of gold. The kind of system that was operating under the classical gold standard, when gold had a clear known value that had been roughly maintained for half a century or more, did not exist in the 1920s when the world was recreating, essentially from scratch, a new gold standard.

Recreating a gold standard after the enormous shock of World War I was not like flicking a switch. No one knew what the value of gold was or would be, because the value of gold itself depended on a whole range of policy choices that inevitably had to be made by governments and central banks. That was just the nature of the world that existed in the 1920s. You can’t just assume that historical reality away.

Larry would like to think and would like the rest of us to think that it would be easy to recreate a gold standard today. But it would be just as hard to recreate a gold standard today as it was in the 1920s — and just as perilous. As Thomas Aubrey pointed out in a comment on my recent post on the gold standard, Russia and China between them hold about 25% of the world’s gold reserves. Some people complain loudly about Chinese currency manipulation now. How would you like to empower the Chinese and the Russians to manipulate the value of gold under a gold standard?

The problem of recreating a gold standard was beautifully described in 1922 by Dennis Robertson in his short classic Money. I have previously posted this passage, but as Herbert Spencer is supposed to have said, “it is only by repeated and varied iteration that alien conceptions can be forced upon reluctant minds.” So, I will once again let Dennis Robertson have the final word on the gold standard.

We can now resume the main thread of our argument. In a gold standard country, whatever the exact device in force for facilitating the maintenance of the standard, the quantity of money is such that its value and that of a defined weight of gold are kept at an equality with one another. It looks therefore as if we could confidently take a step forward, and say that in such a country the quantity of money depends on the world value of gold. Before the war this would have been a true enough statement, and it may come to be true again in the lifetime of those now living: it is worthwhile therefore to consider what, if it be true, are its implications.

The value of gold in its turn depends on the world’s demand for it for all purposes, and on the quantity of it in existence in the world. Gold is demanded not only for use as money and in reserves, but for industrial and decorative purposes, and to be hoarded by the nations of the East : and the fact that it can be absorbed into or ejected from these alternative uses sets a limit to the possible changes in its value which may arise from a change in the demand for it for monetary uses, or from a change in its supply. But from the point of view of any single country, the most important alternative use for gold is its use as money or reserves in other countries; and this becomes on occasion a very important matter, for it means that a gold standard country is liable to be at the mercy of any change in fashion not merely in the methods of decoration or dentistry of its neighbours, but in their methods of paying their bills. For instance, the determination of Germany to acquire a standard money of gold in the [eighteen]’seventies materially restricted the increase of the quantity of money in England.

But alas for the best made pigeon-holes! If we assert that at the present day the quantity of money in every gold standard country, and therefore its value, depends on the world value of gold, we shall be in grave danger of falling once more into Alice’s trouble about the thunder and the lightning. For the world’s demand for gold includes the demand of the particular country which we are considering; and if that country be very large and rich and powerful, the value of gold is not something which she must take as given and settled by forces outside her control, but something which up to a point at least she can affect at will. It is open to such a country to maintain what is in effect an arbitrary standard, and to make the value of gold conform to the value of her money instead of making the value of her money conform to the value of gold. And this she can do while still preserving intact the full trappings of a gold circulation or gold bullion system. For as we have hinted, even where such a system exists it does not by itself constitute an infallible and automatic machine for the preservation of a gold standard. In lesser countries it is still necessary for the monetary authority, by refraining from abuse of the elements of ‘play’ still left in the monetary system, to make the supply of money conform to the gold position: in such a country as we are now considering it is open to the monetary authority, by making full use of these same elements of ‘play,’ to make the supply of money dance to its own sweet pipings.

Now for a number of years, for reasons connected partly with the war and partly with its own inherent strength, the United States has been in such a position as has just been described. More than one-third of the world’s monetary gold is still concentrated in her shores; and she possesses two big elements of ‘play’ in her system — the power of varying considerably in practice the proportion of gold reserves which the Federal Reserve Banks hold against their notes and deposits (p. 47), and the power of substituting for one another two kinds of common money, against one of which the law requires a gold reserve of 100 per cent and against the other only one of 40 per cent (p. 51). Exactly what her monetary aim has been and how far she has attained it, is a difficult question of which more later. At present it is enough for us that she has been deliberately trying to treat gold as a servant and not as a master.

It was for this reason, and for fear that the Red Queen might catch us out, that the definition of a gold standard in the first section of this chapter had to be so carefully framed. For it would be misleading to say that in America the value of money is being kept equal to the value of a defined weight of gold: but it is true even there that the value of money and the value of a defined weight of gold are being kept equal to one another. We are not therefore forced into the inconveniently paradoxical statement that America is not on a gold standard. Nevertheless it is arguable that a truer impression of the state of the world’s monetary affairs would be given by saying that America is on an arbitrary standard, while the rest of the world has climbed back painfully on to a dollar standard.

HT: J. P. Koning

Golden Misconceptions

The gold standard, as an international institution, existed for less than 40 years, emerging first, and by accident, in England, and more than a century and a half later, spreading by a rapid series of independent, but interrelated, decisions to the United States, Germany, and most of Europe and much of the rest of the world. After its collapse with the outbreak of World War I, reconstruction of the gold standard was thought by many to be a precondition for recreating the stable and prosperous international order that had been brutally demolished by the Great War. But that attempt ended catastrophically when the restoration of the gold standard was subverted by the insane gold-accumulation policy of the Bank of France and the failure of the Federal Reserve and other national monetary authorities to heed the explicit warnings of two of the leading monetary theorists of immediate postwar era, R. G. Hawtrey and Gustav Cassel, that unless the monetary demand for gold was kept from increasing as a result of the resumption of convertibility, a renewed gold standard could trigger a disastrous deflation.

But despite its short, checkered, and not altogether happy, history as an international institution, the gold standard, in its idealized and largely imagined form has retained a kind of nostalgic aura of stability, excellence and grandeur, becoming an idiom for anything that’s the best of its kind. So no, Virginia, there is no Santa Claus, and the gold standard is not the gold standard of monetary systems.

My own impression is that most, though not all, supporters of the gold standard are smitten by a kind of romantic, unthinking, and irrational attachment to the idea that the gold standard is a magic formula for recovering a lost golden age. But having said that, I would also add that I actually think that the gold standard, in its brief first run as an international monetary system, did not perform all that badly, and I can even sympathize with the ultimately unsuccessful attempt to restore the gold standard after World War I. I just think that the risks of scrapping our current monetary arrangements and trying to replace them with a gold standard recreated from scratch, over a century after it ceased to function effectively in practice, are far too great to consider it seriously as a practical option.

Not long ago I was chided by Larry White for being unduly harsh in my criticism of the gold standard in my talk at the Mercatus Center conference on Monetary Rules for a Post-Crisis World. I responded to Larry in this post. But I now find myself somewhat exasperated by a post by Stephen Cecchetti and Kermit Schoenholtz on the blog they maintain for their money and banking textbook. I don’t know much about Schoenholtz, but Cecchetti is an economist of the first rank. They clearly share my opposition to gold standard, but I’m afraid that some of their arguments against the gold standard are misguided or misconceived. I don’t write this post just to be critical; it’s only because their arguments reflect common and long-standing misconceptions and misunderstandings that have become part of the received doctrine about the gold standard that those arguments are worth taking the time and effort to criticize.

So let’s start from the beginning of their post, which is actually quite a good beginning. They quote Barry Eichengreen, one of our most eminent economic historians.

“Far from being synonymous with stability, the gold standard itself was the principal threat to financial stability and economic prosperity between the wars.” Barry Eichengreen, Golden Fetters.

That’s certainly true, but notice that the quotation from Eichengreen explicitly refers to the interwar period; it’s not a blanket indictment.

After quoting Eichengreen, Cecchetti and Schoenholtz refer to a lecture delivered by Ben Bernanke when he was still Chairman of the Federal Reserve Board. Quoting this lecture is not a good sign, because back in 2012 after Bernanke gave the lecture, I wrote a post in which I explained why Bernanke had failed to provide a coherent criticism of the gold standard.

In his 2012 lecture Origins and Mission of the Federal Reserve, then-Federal Reserve Board Chair Ben Bernanke identifies four fundamental problems with the gold standard:

  • When the central bank fixes the dollar price of gold, rather than the price of goods we consume, fluctuations in the dollar price of goods replace fluctuations in the market price of gold.
  • Since prices are tied to the amount of money in the economy, which is linked to the supply of gold, inflation depends on the rate that gold is mined.
  • When the gold standard is used at home and abroad, it is an exchange rate policy in which international transactions must be settled in gold.
  • Digging gold out of one hole in the ground (a mine) to put it into another hole in the ground (a vault) wastes resources.

Bernanke’s first statement is certainly correct, but his second statement ignores the fact that the amount of new gold extracted from the earth in a year is only a small fraction of the existing stock of gold. Thus, fluctuations in the value of gold are more likely to be caused by fluctuations in the demand for gold than by fluctuations in supply. The third statement makes as much sense as saying that since the US economy operates on a dollar standard transactions must be settled in hard currency. In fact, the vast majority of legal transactions are settled not by the exchange of currency but by the exchange of abstract claims to currency. There is no reason why, under a gold standard, international transactions could not be settled by abstract claims to gold rather than in physical gold. I agree with the fourth statement.

Consistent with Bernanke’s critique, the evidence shows that both inflation and economic growth were quite volatile under the gold standard. The following chart plots annual U.S. consumer price inflation from 1880, the beginning of the post-Civil War gold standard, to 2015. The vertical blue line marks 1933, the end of the gold standard in the United States. The standard deviation of inflation during the 53 years of the gold standard is nearly twice what it has been since the collapse of the Bretton Woods system in 1973 (denoted in the chart by the vertical red line). That is, even if we include the Great Inflation of the 1970s, inflation over the past 43 years has been more stable than it was under the gold standard. Focusing on the most recent quarter century, the interval when central banks have focused most intently on price stability, then the standard deviation of inflation is less than one-fifth of what it was during the gold standard epoch.

Annual Consumer Price Inflation, 1880 to 2016

gold_standard_vs_dollar_standard

Source: Federal Reserve Bank of Minneapolis.

I am sorry to say this, but comparing the average rate and the variability of inflation under the gold standard (1880-1933) and under a pure dollar standard (1973-2016) is tendentious and misleading, because the 20-year period from 1914 to 1933, a period marked by rapid wartime and post-war inflation and two post-war deflations, was a period when the gold standard either was not functioning at all (1914 to about 1922) or was being unsuccessfully reconstructed. Now it would be one thing to conclude from the failed attempt at reconstruction that a second attempt at reconstruction would be futile and potentially as disastrous as the first attempt, but that doesn’t seem to be what Ceccheti and Schoenholz are arguing. Instead, they include data from 20 years when the gold standard was either not operating at all or was operating dysfunctionally to make an unqualified comparison between the performance of the US economy under the gold standard and under a pure dollar standard. That simplistic comparison conveys almost no useful information.

A fairer comparison would be between the gold standard as it operated between 1880 and 1914 and either the dollar standard of the post-Bretton Woods era (1973 – 2016) or the period from 1991 to 2016 when, according to Cecchetti and Schoenholz, the Fed adopted an explicit or implicit inflation target as its primary policy objective. Changing the gold-standard period in this way reduces the average inflation rate from 0.86% to 0.23% a year and the standard deviation from 5.06% to 2.13%. That comparison is not obviously disadvantageous to the gold standard.

What about economic growth? Again, the gold standard was associated with greater volatility, not less. The following chart plots annual growth as measured by gross national product (gross domestic product only came into common use in the 1991.) The pattern looks quite a bit like that of inflation: the standard deviation of economic growth during the gold-standard era was more than twice that of the period since 1973. And, despite the Great Recession, the past quarter century has been even more stable. To use another, simpler, measure, in the period from 1880 to 1933 there were 15 business cycles identified by the National Bureau of Economic Research. That is, on average there was a recession once every 3½ years. By contrast, since 1972, there have been 7 recessions; one every 6 years.

Annual GNP Growth, 1880-2016

gold_standard_vs_dollar_standard_2

 

Source: FRED and Romer (1986)

Again, this comparison, like the inflation comparison is distorted by the exogenous disruption associated with World War I and its aftermath. Excluding the 1914 to 1933 period from the comparison would make for a far less one-sided comparison than the one presented by Cecchetti and Schoenholtz.

Finally, consider a crude measure of financial stability: the frequency of banking crises. From 1880 to 1933, there were at least 5 full-fledged banking panics: 1893, 1907, 1930, 1931, and 1933. Including the savings and loan crisis of the 1980s, in the past half century, there have been two.

But if we exclude the Great Depression period from the comparison, there were two banking panics under the gold standard and two under the dollar standard. So the performance of the gold standard when it was operating normally was not clearly inferior to the operation of the dollar standard.

So, on every score, the gold standard period was less stable. Prices were less stable; growth was less stable; and the financial system was less stable. Why?

We see six major reasons. First, the gold standard is procyclical. When the economy booms, inflation typically rises. In the absence of a central bank to force the nominal interest rate up, the real interest rate falls, providing a further impetus to activity. In contrast, countercyclical monetary policy—whether based on a Taylor rule or not—would lean against the boom.

I don’t know what the basis is for the factual assertion that high growth under a gold standard is associated with inflation. There were periods of high growth with very low or negative inflation under the gold standard. Periods of mild inflation, owing to a falling real value of gold, perhaps following significant discoveries of previously unknown gold deposits, may have had a marginal stimulative effect under the gold standard, but such episodes were not necessarily periods of economic instability.

At any rate it is not even clear why, if a countericyclical monetary policy were desirable, such a policy could not be conducted under the gold standard by a central bank constrained by an obligation to convert its liabilities into gold on demand. Some gold standard proponents, like Larry White for example, insist that a gold standard could and would function better without a central bank than with a central bank. I am skeptical about that position, but even if it is correct, there is nothing inherent in the idea of a gold standard that is inconsistent with the existence of a central bank that conducts a countercyclical policy, so I don’t understand why Cecchetti and Schoenholtz assert, without argument, that a central bank could not conduct a countercyclical policy under a gold standard.

Second, the gold standard has exchange rate implications. While we do not know for sure, we suspect that current U.S. advocates of a shift to gold are thinking of the case where the United States acts alone (rather than waiting to coordinate a global return to the gold standard). If so, the change would impose unnecessary risks on exporters and importers, their employees and their creditors. To see why, consider the consequences of a move in the global price of gold measured in some other currency, say British pounds. If the pound price of gold changed, but the dollar price of gold did not, the result would be a move in the real dollar-pound exchange rate. That is, unless the dollar prices of U.S. goods and the dollar wages of U.S. workers adjust instantly to offset gold price fluctuations, the real dollar exchange rate changes. In either case, the result would almost surely induce volatility of production, employment, and the debt burden.

If the US monetary policy were governed by a commitment to convert the dollar into gold at a fixed conversion rate, the dollar price of gold would remain constant and exchange rates of the dollar in terms of the pound and other non-gold currencies would fluctuate. We have fluctuating exchange rates now against the pound and other currencies. It is not clear to me why exchange rates would be more volatile under this system than they are currently.

More broadly, a gold standard suffers from some of the same problems as any fixed-exchange rate system. Not only can’t the exchange rate adjust to buffer external shocks, but the commitment invites speculative attacks because it lacks time consistency. Under a gold standard, the scale of the central bank’s liabilities—currency plus reserves—is determined by the gold it has in its vault. Imagine that, as a consequence of an extended downturn, people come to fear a currency devaluation. That is, they worry that the central bank will raise the dollar price of gold. In such a circumstance, it will be natural for investors to take their dollars to the central bank and exchange them for gold. The doubts that motivate such a run can be self-fulfilling: once the central bank starts to lose gold reserves, it can quickly be compelled to raise its dollar price, or to suspend redemption entirely. This is what happened in 1931 to the Bank of England, when it was driven off the gold standard. It happened again in 1992 (albeit with foreign currency reserves rather than gold) when Britain was compelled to abandon its fixed exchange rate.

Cecchetti and Schoenholtz articulate a valid concern, and it is a risk inherent in any gold standard or any monetary system based on trust in a redemption commitment. My only quibble is that Cecchetti and Schoenholtz overrate the importance of gold reserves. Foreign-exchange reserves would do just as well, and perhaps better, than gold reserves, because, unlike gold, foreign-exchange reserves yield interest.

Third, as historians have emphasized, the gold standard helped spread the Great Depression from the United States to the rest of the world. The gold standard was a global arrangement that formed the basis for a virtually universal fixed-exchange rate regime in which international transactions were settled in gold.

Here Cecchetti and Schoenholtz stumble into several interrelated confusions. First, while the gold standard was certainly an international transmission mechanism, the international linkage between national price levels being an essential characteristic of the gold standard, there is no reason to identify the United States as the source of a disturbance that was propagated to the rest of the world. Because the value of gold must be equalized in all countries operating under the gold standard, changes in the value of gold are an international, not a national, phenomenon. Thus, an increase in the demand for gold causing an increase in its value would have essentially the same effects on the world economy irrespective of the geographic location of the increase in the demand for gold. In the 1920s, the goal of reestablishing the gold standard meant restoring convertibility of the leading currencies into gold, so that price levels in all gold standard countries, all reflecting the internationally determined value of gold, were closely aligned.

This meant that a country with an external deficit — one whose imports exceed its exports — was required to pay the difference by transferring gold to countries with external surpluses. The loss of gold forced the deficit country’s central bank to shrink its balance sheet, reducing the quantity of money and credit in the economy, and driving domestic prices down. Put differently, under a gold standard, countries running external deficits face deflationary pressure. A surplus country’s central bank faced no such pressure, as it could choose whether to convert higher gold stocks into money or not. Put another way, a central bank can have too little gold, but it can never have too much.

Cecchetti and Schonholtz are confusing two distinct questions: a) what determines the common international value of gold? and b) what accounts for second-order deviations between national price levels? The important point is that movements in national price levels under the gold standard were highly correlated because, owing to international arbitrage of tradable goods, the value of gold could not differ substantially between countries on the gold standard. Significant short-run changes in the value of gold had to reflect changes in the total demand for gold because short-run changes in the supply of gold are only a small fraction of the existing stock. To be sure, short-run differences in inflation across countries might reflect special circumstances causing over- or under-valuation of particular currencies relative to one another, but those differences were of a second-order magnitude relative to the sharp worldwide deflation that characterized the Great Depression in which the price levels of all gold-standard countries fell simultaneously. It is always the case that some countries will be running trade deficits and some will be running trade surpluses. At most, that circmstance might explain small differences in relative rates of inflation or deflation across countries; it can’t explain why deflation was rampant across all countries at the same time.

The shock that produced the Great Depression was a shock to the real value of gold which was caused mainly by the gold accumulation policy of the Bank of France. However, the United States, holding about 40 percent of the world’s monetary gold reserves after World War I, could have offset or mitigated the French policy by allowing an outflow of some of its massive gold reserves. Instead, the Fed, in late 1928, raised interest rates yet again to counter what it viewed as unhealthy stock-market speculation, thereby intensifying, rather than mitigating, the deflationary effect of the gold-accumulation policy of the Bank of France. Implicitly, Cecchetti and Schoenholtz assume that the observed gold flows were the result of non-monetary causes, which is to say that gold flows were the result of trade imbalances reflecting purely structural factors, such as national differences in rates of productivity growth, or propensities to save, or demand and supply patterns, over which central banks have little or no influence. But in fact, central banks and monetary authorities based their policies on explicit or implicit goals for their holdings of gold reserves. And the value of gold ultimately reflected the combined effect of the policy decisions taken by all central banks thereby causing a substantial increase in the demand of national monetary authorities to hold gold.

This policy asymmetry helped transmit financial shocks in the United States abroad. By the late 1920s, the major economies had restored the pre-World War I gold standard. At the time, both the United States and France were running external surpluses, absorbing the world’s gold into their central bank vaults.

Cecchetti and Schoneholtz say explicitly “the United States and France were running external surpluses, absorbing the world’s gold into their central bank vaults” as if those surpluses just happened and were unrelated to the monetary policies deliberately adopted by the Bank of France and the Federal Reserve.

But, instead of allowing the gold inflows to expand the quantity of money in their financial systems, authorities in both countries tightened monetary policy to resist booming asset prices and other signs of overheating. The result was catastrophic, compelling deficit countries with gold outflows to tighten their monetary policies even more. As the quantity of money available worldwide shrank, so did the price level, adding to the real burden of debt, and prompting defaults and bank failures virtually around the world.

Cecchetti and Schoenholtz have the causation backwards; it was the tightness of monetary policy that caused gold inflows into France and later into the United States. The gold flows did not precede, but were the result of, already tight monetary policies. Cecchetti and Schoenholtz are implicitly adopting the sterilization model based on the price-specie-flow mechanism in which it is gold flows that cause, or ought to cause, changes in the quantity of money. I debunked the simplistic sterilization idea in this post. But, in fairness, I should acknowledge that Cecchetti and Schoenholz do eventually acknowledge that the demand by central banks to hold gold reserves is what determines actual monetary policy under the gold standard. But despite that acknowledgment, they can’t free themselves from the misconception that it was a reduction in the quantity of money, rather than an increase in the demand for gold, that caused the value of gold to rise in the Great Depression.

Fourth, economists blame the gold standard for sustaining and deepening the Great Depression. What makes this view most compelling is the fact that the sooner a country left the gold standard and regained discretionary control of its monetary policy, the faster it recovered. The contrast between Sweden and France is striking. Sweden left gold in 1931, and by 1936 its industrial production was 14 percent higher than its 1929 level. France waited until 1936 to leave, at which point its industrial production was fully 26 percent below the level just 7 years earlier (see here and here.) Similarly, when the U.S. suspended gold convertibility in March 1933—allowing the dollar to depreciate substantially—the financial and economic impact was immediate: deflation turned to inflation, lowering the real interest rate, boosting asset prices, and triggering one of the most powerful U.S. cyclical upturns (see, for example, Romer).

This is certainly right. My only quibble is that Cecchetti and Schoenholtz do not acknowledge that the Depression was triggered by a rapid increase in the international demand for gold by the world’s central banks in 1928-29, in particular the Bank of France and the Federal Reserve.

Turning to financial stability, the gold standard limits one of the most powerful tools for halting bank panics: the central bank’s authority to act as lender of last resort. It was the absence of this function during the Panic of 1907 that was the primary impetus for the creation of the Federal Reserve System. Yet, under a gold standard, the availability of gold limits the scope for expanding central bank liabilities. Thus, had the Fed been on a strict gold standard in the fall of 2008—when Lehman failed—the constraint on its ability to lend could again have led to a collapse of the financial system and a second Great Depression.

At best, the charge that the gold standard limits the capacity of a central bank to act as a lender of last resort is a serious oversimplification. The ability of a central bank to expand its liabilities is not limited by the gold standard in any way. What limits the ability of the central bank to expand its liabilities are gold-cover requirements such as those enacted by the Bank Charter Act of 1844 which imposed a 100% marginal reserve requirement on the issue of banknotes by the Bank of England beyond a fixed fiduciary issue requiring no gold cover. Subsequent financial crises in 1847, 1857, and 1866 were quelled as soon as the government suspended the relevant provisions of the Bank Charter Act, allowing the Bank of England to increase its note issue and satisfy the exceptional demands for liquidity that led to the crisis in the first place.

Finally, because the supply of gold is finite, the quantity available to the central bank likely will grow more slowly than the real economy. As a result, over long periods—say, a decade or more—we would expect deflation. While (in theory) labor, debt and other contracts can be arranged so that the economy will adjust smoothly to steady, long-term deflation, recent experience (including that with negative nominal interest rates) makes us skeptical.

Whether gold appreciates over the long-term depends on the rate at which the quantity of gold expands over time and the rate of growth of demand for gold over time. It is plausible to expect secular deflation under the gold standard, but it is hardly inevitable. I don’t think that we yet fully understand the conditions under which secular deflation is compatible with full employment. Certainly if we were confident that secular deflation is compatible with full employment, the case for secular deflation would be very compelling.

This brings us back to where we started. Under a gold standard, inflation, growth and the financial system are all less stable. There are more recessions, larger swings in cons umer prices and more banking crises. When things go wrong in one part of the world, the distress will be transmitted more quickly and completely to others. In short, re-creating a gold standard would be a colossal mistake.

These conclusions are based on very limited historical experience, and it is not clear how relevant that experience is for contemporary circumstances. The argument against a gold standard not so much that a gold standard could not in principle operate smoothly and efficiently. It is that, a real gold standard having been abandoned for 80 years, recreating a gold standard would be radical and risky undertaking completely lacking in a plausible roadmap for its execution. The other argument against the gold standard is that insofar as gold would be actually used as a medium of exchange in a recreated gold standard with a modern banking system, the banking system would be subject to the potentially catastrophic risk of a flight to quality in periods of banking instability, leading to a disastrous deflationary increase in the value of gold.

HT: J. P. Koning

Larry White on the Gold Standard and Me

A little over three months ago on a brutally hot day in Washington DC, I gave a talk about a not yet completed paper at the Mercatus Center Conference on Monetary Rules for a Post-Crisis World. The title of my paper was (and still is) “Rules versus Discretion Historically Contemplated.” I hope to post a draft of the paper soon on SSRN.

One of the attendees at the conference was Larry White who started his graduate training at UCLA just after I had left. When I wrote a post about my talk, Larry responded with a post of his own in which he took issue with some of what I had to say about the gold standard, which I described as the first formal attempt at a legislated monetary rule. Actually, in my talk and my paper, my intention was not as much to criticize the gold standard as it was to criticize the idea, which originated after the gold standard had already been adopted in England, of imposing a fixed numerical rule in addition to the gold standard to control the quantity of banknotes or the total stock of money. The fixed mechanical rule was imposed by an act of Parliament, the Bank Charter Act of 1844. The rule, intended to avoid financial crises such as those experienced in 1825 and 1836, actually led to further crises in 1847, 1857 and 1866 and the latter crises were quelled only after the British government suspended those provisions of the Act preventing the Bank of England from increasing the quantity of banknotes in circulation. So my first point was that the fixed quantitative rule made the gold standard less stable than it would otherwise have been.

My second point was that, in the depths of the Great Depression, a fixed rule freezing the nominal quantity of money was proposed as an alternative rule to the gold standard. It was this rule that one of its originators, Henry Simons, had in mind when he introduced his famous distinction between rules and discretion. Simons had many other reasons for opposing the gold standard, but he introduced the famous rules-discretion dichotomy as a way of convincing those supporters of the gold standard who considered it a necessary bulwark against comprehensive government control over the economy to recognize that his fixed quantity rule would be a far more effective barrier than the gold standard against arbitrary government meddling and intervention in the private sector, because the gold standard, far from constraining the conduct of central banks, granted them broad discretionary authority. The gold standard was an ineffective rule, because it specified only the target pursued by the monetary authority, but not the means of achieving the target. In Simons view, giving the monetary authority to exercise discretion over the instruments used to achieve its target granted the monetary authority far too much discretion for independent unconstrained decision making.

My third point was that Henry Simons himself recognized that the strict quantity rule that he would have liked to introduce could only be made operational effectively if the entire financial system were radically restructured, an outcome that he reluctantly concluded was unattainable. However, his student Milton Friedman convinced himself that a variant of the Simons rule could actually be implemented quite easily, and he therefore argued over the course of almost his entire career that opponents of discretion ought to favor the quantity rule that he favored instead of continuing to support a restoration of the gold standard. However, Friedman was badly mistaken in assuming that his modified quantity rule eliminated discretion in the manner that Simons had wanted, because his quantity rule was defined in terms of a magnitude, the total money stock in the hands of the public, which was a target, not, as he insisted, an instrument, the quantity of money held by the public being dependent on choices made by the public, not just on choices made by the monetary authority.

So my criticism of quantity rules can be read as at least a partial defense of the gold standard against the attacks of those who criticized the gold standard for being insufficiently rigorous in controlling the conduct of central banks.

Let me now respond to some of Larry’s specific comments and criticisms of my post.

[Glasner] suggests that perhaps the earliest monetary rule, in the general sense of a binding pre-commitment for a money issuer, can be seen in the redemption obligations attached to banknotes. The obligation was contractual: A typical banknote pledged that the bank “will pay the bearer on demand” in specie. . . .  He rightly remarks that “convertibility was not originally undertaken as a policy rule; it was undertaken simply as a business expedient” without which the public would not have accepted demand deposits or banknotes.

I wouldn’t characterize the contract in quite the way Glasner does, however, as a “monetary rule to govern the operation of a monetary system.” In a system with many banks of issue, the redemption contract on any one bank’s notes was a commitment from that bank to the holders of those notes only, without anyone intending it as a device to govern the operation of the entire system. The commitment that governs a single bank ipso facto governs an entire monetary system only when that single bank is a central bank, the only bank allowed to issue currency and the repository of the gold reserves of ordinary commercial banks.

It’s hard to write a short description of a system that covers all possible permutations in the system. While I think Larry is correct in noting the difference between the commitment made by any single bank to convert – on demand — its obligations into gold and the legal commitment imposed on an entire system to maintain convertibility into gold, the historical process was rather complicated, because both silver and gold coins circulating in Britain. So the historical fact that British banks were making their obligations convertible into gold was the result of prior decisions that had been made about the legal exchange rate between gold and silver coins, decisions which overvalued gold and undervalued silver, causing full bodied silver coins to disappear from circulation. Given a monetary framework shaped by the legal gold/silver parity established by the British mint, it was inevitable that British banks operating within that framework would make their banknotes convertible into gold not silver.

Under a gold standard with competitive plural note-issuers (a free banking system) holding their own reserves, by contrast, the operation of the monetary system is governed by impersonal market forces rather than by any single agent. This is an important distinction between the properties of a gold standard with free banking and the properties of a gold standard managed by a central bank. The distinction is especially important when it comes to judging whether historical monetary crises and depressions can be accurately described as instances where “the gold standard failed” or instead where “central bank management of the monetary system failed.”

I agree that introducing a central bank into the picture creates the possibility that the actions of the central bank will have a destabilizing effect. But that does not necessarily mean that the actions of the central bank could not also have a stabilizing effect compared to how a pure free-banking system would operate under a gold standard.

As the author of Free Banking and Monetary Reform, Glasner of course knows the distinction well. So I am not here telling him anything he doesn’t know. I am only alerting readers to keep the distinction in mind when they hear or read “the gold standard” being blamed for financial instability. I wish that Glasner had made it more explicit that he is talking about a system run by the Bank of England, not the more automatic type of gold standard with free banking.

But in my book, I did acknowledge that there inherent instabilities associated with a gold standard. That’s why I proposed a system that would aim at stabilizing the average wage level. Almost thirty years on, I have to admit to having my doubts whether that would be the right target to aim for. And those doubts make me more skeptical than I once was about adopting any rigid monetary rule. When it comes to monetary rules, I fear that the best is the enemy of the good.

Glasner highlights the British Parliament’s legislative decision “to restore the convertibility of banknotes issued by the Bank of England into a fixed weight of gold” after a decades-long suspension that began during the Napoleonic wars. He comments:

However, the widely held expectations that the restoration of convertibility of banknotes issued by the Bank of England into gold would produce a stable monetary regime and a stable economy were quickly disappointed, financial crises and depressions occurring in 1825 and again in 1836.

Left unexplained is why the expectations were disappointed, why the monetary regime remained unstable. A reader who hasn’t read Glasner’s other blog entries on the gold standard might think that he is blaming the gold standard as such.

Actually I didn’t mean to blame anyone for the crises of 1825 and 1836. All I meant to do was a) blame the Currency School for agitating for a strict quantitative rule governing the total quantity of banknotes in circulation to be imposed on top of the gold standard, b) point out that the rule that was enacted when Parliament passed the Bank Charter Act of 1844 failed to prevent subsequent crises in 1847, 1857 and 1866, and c) that the crises ended only after the provisions of the Bank Charter Act limiting the issue of banknotes by the Bank of England had been suspended.

My own view is that, because the monopoly Bank of England’s monopoly was not broken up, even with convertibility acting as a long-run constraint, the Bank had the power to create cyclical monetary instability and occasionally did so by (unintentionally) over-issuing and then having to contract suddenly as gold flowed out of its vault — as happened in 1825 and again in 1836. Because the London note-issue was not decentralized, the Bank of England did not experience prompt loss of reserves to rival banks (adverse clearings) as soon as it over-issued. Regulation via the price-specie-flow mechanism (external drain) allowed over-issue to persist longer and grow larger. Correction came only with a delay, and came more harshly than continuous intra-London correction through adverse clearings would have. Bank of England mistakes boggled the entire financial system. It was central bank errors and not the gold standard that disrupted monetary stability after 1821.

Here, I think, we do arrive at a basic theoretical disagreement, because I don’t accept that the price-specie-flow mechanism played any significant role in the international adjustment process. National price levels under the gold standard were positively correlated to a high degree, not negatively correlated, as implied by the price-specie-flow mechanism. Moreover, the Bank Charter Act imposed a fixed quantitative limit on the note issue of all British banks and the Bank of England in particular, so the overissue of banknotes by the Bank of England could not have been the cause of the post-1844 financial crises. If there was excessive credit expansion, it was happening through deposit creation by a great number of competing deposit-creating banks, not the overissue of banknotes by the Bank of England.

This hypothesis about the source of England’s cyclical instability is far from original with me. It was offered during the 1821-1850 period by a number of writers. Some, like Robert Torrens, were members of the Currency School and offered the Currency Principle as a remedy. Others, like James William Gilbart, are better classified as members of the Free Banking School because they argued that competition and adverse clearings would effectively constrain the Bank of England once rival note issuers were allowed in London. Although they offered different remedies, these writers shared the judgment that the Bank of England had over-issued, stimulating an unsustainable boom, then was eventually forced by gold reserve losses to reverse course, instituting a credit crunch. Because Glasner elides the distinction between free banking and central banking in his talk and blog post, he naturally omits the third side in the Currency School-Banking School-Free Banking School debate.

And my view is that Free Bankers like Larry White overestimate the importance of note issue in a banking system in which deposits were rapidly overtaking banknotes as the primary means by which banks extended credit. As Henry Simons, himself, recognized this shift from banknotes to bank deposits was itself stimulated, at least in part, by the Bank Charter Act, which made the extension of credit via banknotes prohibitively costly relative to expansion by deposit creation.

Later in his blog post, Glasner fairly summarizes how a gold standard works when a central bank does not subvert or over-ride its automatic operation:

Given the convertibility commitment, the actual quantity of the monetary instrument that is issued is whatever quantity the public wishes to hold.

But he then immediately remarks:

That, at any rate, was the theory of the gold standard. There were — and are – at least two basic problems with that theory. First, making the value of money equal to the value of gold does not imply that the value of money will be stable unless the value of gold is stable, and there is no necessary reason why the value of gold should be stable. Second, the behavior of a banking system may be such that the banking system will itself destabilize the value of gold, e.g., in periods of distress when the public loses confidence in the solvency of banks and banks simultaneously increase their demands for gold. The resulting increase in the monetary demand for gold drives up the value of gold, triggering a vicious cycle in which the attempt by each to increase his own liquidity impairs the solvency of all.

These two purported “basic problems” prompt me to make two sets of comments:

1 While it is true that the purchasing power of gold was not perfectly stable under the classical gold standard, perfection is not the relevant benchmark. The purchasing power of money was more stable under the classical gold standard than it has been under fiat money standards since the Second World War. Average inflation rates were closer to zero, and the price level was more predictable at medium to long horizons. Whatever Glasner may have meant by “necessary reason,” there certainly is a theoretical reason for this performance: the economics of gold mining make the purchasing power of gold (ppg) mean-reverting in the face of monetary demand and supply shocks. An unusually high ppg encourages additional gold mining, until the ppg declines to the normal long-run value determined by the flow supply and demand for gold. An unusually low ppg discourages mining, until the normal long-run ppg is restored. It is true that permanent changes in the gold mining cost conditions can have a permanent impact on the long-run level of the ppg, but empirically such shocks were smaller than the money supply variations that central banks have produced.

2 The behavior of the banking system is indeed critically important for short-run stability. Instability wasn’t a problem in all countries, so we need to ask why some banking systems were unstable or panic-prone, while others were stable. The US banking system was panic prone in the late 19th century while the Canadian system was not. The English system was panic-prone while the Scottish system was not. The behavioral differences were not random or mere facts of nature, but grew directly from differences in the legal restrictions constraining the banks. The Canadian and Scottish systems, unlike the US and English systems, allowed their banks to adequately diversify, and to respond to peak currency demands, thus allowed banks to be more solvent and more liquid, and thus avoided loss of confidence in the banks. The problem in the US and England was not the gold standard, or a flaw in “the theory of the gold standard,” but ill-conceived legal restrictions that weakened the banking systems.

Larry makes two good points, but I doubt that they are very important in practice. The problem with the value of gold is that there is a very long time lag before the adjustment in the rate of output of new gold will cause the value of gold to revert back to its normal level. The annual output of gold is only about 3 percent of the total stock of gold. If the monetary demand for gold is large relative to the total stock and that demand is unstable, the swing in the overall demand for gold can easily dominate the small resulting change in the annual rate of output. So I do not have much confidence that the mean-reversion characteristic of the purchasing power of gold to be of much help in the short or even the medium term. I also agree with Larry that the Canadian and Scottish banking systems exhibited a lot more stability than the neighboring US and English banking systems. That is an important point, but I don’t think it is decisive. It’s true that there were no bank failures in Canada in the Great Depression. But the absence of bank failures, while certainly a great benefit, did not prevent Canada from suffering a downturn of about the same depth and duration as the US did between 1929 and 1933. The main cause of the Great Depression was the deflation caused by the appreciation of the value of gold. The deflation caused bank failures when banks were small and unstable and did not cause bank failures when banks were large and diversified. But the deflation  was still wreaking havoc on the rest of the economy even though banks weren’t failing.

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

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

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

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

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

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

However, the widely held expectations that the restoration of convertibility of banknotes issued by the Bank of England into gold would produce a stable monetary regime and a stable economy were quickly disappointed, financial crises and depressions occurring in 1825 and again in 1836. To explain the occurrence of these unexpected financial crises and periods of severe economic distress, a group of monetary theorists advanced a theory based on David Hume’s discussion of the price-specie-flow mechanism in his essay “Of the Balance of Trade,” in which he explained the automatic tendency toward equilibrium in the balance of trade and stocks of gold and precious metals among nations. Hume carried out his argument in terms of a fully metallic (gold) currency, and, in other works, Hume decried the tendency of banks to issue banknotes to excess, thereby causing inflation and economic disturbances.

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

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

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

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

So British monetary history in the first half of the nineteenth century provides us with two paradigms of monetary rules. The first is a price rule in which the value of a monetary instrument is maintained at a level above its cost of production by way of a convertibility commitment. Given the convertibility commitment, the actual quantity of the monetary instrument that is issued is whatever quantity the public wishes to hold. That, at any rate, was the theory of the gold standard. There were – and are – at least two basic problems with that theory. First, making the value of money equal to the value of gold does not imply that the value of money will be stable unless the value of gold is stable, and there is no necessary reason why the value of gold should be stable. Second, the behavior of a banking system may be such that the banking system will itself destabilize the value of gold, e.g., in periods of distress when the public loses confidence in the solvency of banks and banks simultaneously increase their demands for gold. The resulting increase in the monetary demand for gold drives up the value of gold, triggering a vicious cycle in which the attempt by each to increase his own liquidity impairs the solvency of all.

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

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

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

What’s Wrong with Monetarism?

UPDATE: (05/06): In an email Richard Lipsey has chided me for seeming to endorse the notion that 1970s stagflation refuted Keynesian economics. Lipsey rightly points out that by introducing inflation expectations into the Phillips Curve or the Aggregate Supply Curve, a standard Keynesian model is perfectly capable of explaining stagflation, so that it is simply wrong to suggest that 1970s stagflation constituted an empirical refutation of Keynesian theory. So my statement in the penultimate paragraph that the k-percent rule

was empirically demolished in the 1980s in a failure even more embarrassing than the stagflation failure of Keynesian economics.

should be amended to read “the supposed stagflation failure of Keynesian economics.”

Brad DeLong recently did a post (“The Disappearance of Monetarism”) referencing an old (apparently unpublished) paper of his following up his 2000 article (“The Triumph of Monetarism”) in the Journal of Economic Perspectives. Paul Krugman added his own gloss on DeLong on Friedman in a post called “Why Monetarism Failed.” In the JEP paper, DeLong argued that the New Keynesian policy consensus of the 1990s was built on the foundation of what DeLong called “classic monetarism,” the analytical core of the doctrine developed by Friedman in the 1950s and 1960s, a core that survived the demise of what he called “political monetarism,” the set of factual assumptions and policy preferences required to justify Friedman’s k-percent rule as the holy grail of monetary policy.

In his follow-up paper, DeLong balanced his enthusiasm for Friedman with a bow toward Keynes, noting the influence of Keynes on both classic and political monetarism, arguing that, unlike earlier adherents of the quantity theory, Friedman believed that a passive monetary policy was not the appropriate policy stance during the Great Depression; Friedman famously held the Fed responsible for the depth and duration of what he called the Great Contraction, because it had allowed the US money supply to drop by a third between 1929 and 1933. This was in sharp contrast to hard-core laissez-faire opponents of Fed policy, who regarded even the mild and largely ineffectual steps taken by the Fed – increasing the monetary base by 15% – as illegitimate interventionism to obstruct the salutary liquidation of bad investments, thereby postponing the necessary reallocation of real resources to more valuable uses. So, according to DeLong, Friedman, no less than Keynes, was battling against the hard-core laissez-faire opponents of any positive action to speed recovery from the Depression. While Keynes believed that in a deep depression only fiscal policy would be effective, Friedman believed that, even in a deep depression, monetary policy would be effective. But both agreed that there was no structural reason why stimulus would necessarily counterproductive; both rejected the idea that only if the increased output generated during the recovery was of a particular composition would recovery be sustainable.

Indeed, that’s why Friedman has always been regarded with suspicion by laissez-faire dogmatists who correctly judged him to be soft in his criticism of Keynesian doctrines, never having disputed the possibility that “artificially” increasing demand – either by government spending or by money creation — in a deep depression could lead to sustainable economic growth. From the point of view of laissez-faire dogmatists that concession to Keynesianism constituted a total sellout of fundamental free-market principles.

Friedman parried such attacks on the purity of his free-market dogmatism with a counterattack against his free-market dogmatist opponents, arguing that the gold standard to which they were attached so fervently was itself inconsistent with free-market principles, because, in virtually all historical instances of the gold standard, the monetary authorities charged with overseeing or administering the gold standard retained discretionary authority allowing them to set interest rates and exercise control over the quantity of money. Because monetary authorities retained substantial discretionary latitude under the gold standard, Friedman argued that a gold standard was institutionally inadequate and incapable of constraining the behavior of the monetary authorities responsible for its operation.

The point of a gold standard, in Friedman’s view, was that it makes it costly to increase the quantity of money. That might once have been true, but advances in banking technology eventually made it easy for banks to increase the quantity of money without any increase in the quantity of gold, making inflation possible even under a gold standard. True, eventually the inflation would have to be reversed to maintain the gold standard, but that simply made alternative periods of boom and bust inevitable. Thus, the gold standard, i.e., a mere obligation to convert banknotes or deposits into gold, was an inadequate constraint on the quantity of money, and an inadequate systemic assurance of stability.

In other words, if the point of a gold standard is to prevent the quantity of money from growing excessively, then, why not just eliminate the middleman, and simply establish a monetary rule constraining the growth in the quantity of money. That was why Friedman believed that his k-percent rule – please pardon the expression – trumped the gold standard, accomplishing directly what the gold standard could not accomplish, even indirectly: a gradual steady increase in the quantity of money that would prevent monetary-induced booms and busts.

Moreover, the k-percent rule made the monetary authority responsible for one thing, and one thing alone, imposing a rule on the monetary authority prescribing the time path of a targeted instrument – the quantity of money – over which the monetary authority has direct control: the quantity of money. The belief that the monetary authority in a modern banking system has direct control over the quantity of money was, of course, an obvious mistake. That the mistake could have persisted as long as it did was the result of the analytical distraction of the money multiplier: one of the leading fallacies of twentieth-century monetary thought, a fallacy that introductory textbooks unfortunately continue even now to foist upon unsuspecting students.

The money multiplier is not a structural supply-side variable, it is a reduced-form variable incorporating both supply-side and demand-side parameters, but Friedman and other Monetarists insisted on treating it as if it were a structural — and a deep structural variable at that – supply variable, so that it no less vulnerable to the Lucas Critique than, say, the Phillips Curve. Nevertheless, for at least a decade and a half after his refutation of the structural Phillips Curve, demonstrating its dangers as a guide to policy making, Friedman continued treating the money multiplier as if it were a deep structural variable, leading to the Monetarist forecasting debacle of the 1980s when Friedman and his acolytes were confidently predicting – over and over again — the return of double-digit inflation because the quantity of money was increasing for most of the 1980s at double-digit rates.

So once the k-percent rule collapsed under an avalanche of contradictory evidence, the Monetarist alternative to the gold standard that Friedman had persuasively, though fallaciously, argued was, on strictly libertarian grounds, preferable to the gold standard, the gold standard once again became the default position of laissez-faire dogmatists. There was to be sure some consideration given to free banking as an alternative to the gold standard. In his old age, after winning the Nobel Prize, F. A. Hayek introduced a proposal for direct currency competition — the elimination of legal tender laws and the like – which he later developed into a proposal for the denationalization of money. Hayek’s proposals suggested that convertibility into a real commodity was not necessary for a non-legal tender currency to have value – a proposition which I have argued is fallacious. So Hayek can be regarded as the grandfather of crypto currencies like the bitcoin. On the other hand, advocates of free banking, with a few exceptions like Earl Thompson and me, have generally gravitated back to the gold standard.

So while I agree with DeLong and Krugman (and for that matter with his many laissez-faire dogmatist critics) that Friedman had Keynesian inclinations which, depending on his audience, he sometimes emphasized, and sometimes suppressed, the most important reason that he was unable to retain his hold on right-wing monetary-economics thinking is that his key monetary-policy proposal – the k-percent rule – was empirically demolished in a failure even more embarrassing than the stagflation failure of Keynesian economics. With the k-percent rule no longer available as an alternative, what’s a right-wing ideologue to do?

Anyone for nominal gross domestic product level targeting (or NGDPLT for short)?

What’s so Bad about the Gold Standard?

Last week Paul Krugman argued that Ted Cruz is more dangerous than Donald Trump, because Trump is merely a protectionist while Cruz wants to restore the gold standard. I’m not going to weigh in on the relative merits of Cruz and Trump, but I have previously suggested that Krugman may be too dismissive of the possibility that the Smoot-Hawley tariff did indeed play a significant, though certainly secondary, role in the Great Depression. In warning about the danger of a return to the gold standard, Krugman is certainly right that the gold standard was and could again be profoundly destabilizing to the world economy, but I don’t think he did such a good job of explaining why, largely because, like Ben Bernanke and, I am afraid, most other economists, Krugman isn’t totally clear on how the gold standard really worked.

Here’s what Krugman says:

[P]rotectionism didn’t cause the Great Depression. It was a consequence, not a cause – and much less severe in countries that had the good sense to leave the gold standard.

That’s basically right. But I note for the record, to spell out the my point made in the post I alluded to in the opening paragraph that protectionism might indeed have played a role in exacerbating the Great Depression, making it harder for Germany and other indebted countries to pay off their debts by making it more difficult for them to exports required to discharge their obligations, thereby making their IOUs, widely held by European and American banks, worthless or nearly so, undermining the solvency of many of those banks. It also increased the demand for the gold required to discharge debts, adding to the deflationary forces that had been unleashed by the Bank of France and the Fed, thereby triggering the debt-deflation mechanism described by Irving Fisher in his famous article.

Which brings us to Cruz, who is enthusiastic about the gold standard – which did play a major role in spreading the Depression.

Well, that’s half — or maybe a quarter — right. The gold standard did play a major role in spreading the Depression. But the role was not just major; it was dominant. And the role of the gold standard in the Great Depression was not just to spread it; the role was, as Hawtrey and Cassel warned a decade before it happened, to cause it. The causal mechanism was that in restoring the gold standard, the various central banks linking their currencies to gold would increase their demands for gold reserves so substantially that the value of gold would rise back to its value before World War I, which was about double what it was after the war. It was to avoid such a catastrophic increase in the value of gold that Hawtrey drafted the resolutions adopted at the 1922 Genoa monetary conference calling for central-bank cooperation to minimize the increase in the monetary demand for gold associated with restoring the gold standard. Unfortunately, when France officially restored the gold standard in 1928, it went on a gold-buying spree, joined in by the Fed in 1929 when it raised interest rates to suppress Wall Street stock speculation. The huge accumulation of gold by France and the US in 1929 led directly to the deflation that started in the second half of 1929, which continued unabated till 1933. The Great Depression was caused by a 50% increase in the value of gold that was the direct result of the restoration of the gold standard. In principle, if the Genoa Resolutions had been followed, the restoration of the gold standard could have been accomplished with no increase in the value of gold. But, obviously, the gold standard was a catastrophe waiting to happen.

The problem with gold is, first of all, that it removes flexibility. Given an adverse shock to demand, it rules out any offsetting loosening of monetary policy.

That’s not quite right; the problem with gold is, first of all, that it does not guarantee that value of gold will be stable. The problem is exacerbated when central banks hold substantial gold reserves, which means that significant changes in the demand of central banks for gold reserves can have dramatic repercussions on the value of gold. Far from being a guarantee of price stability, the gold standard can be the source of price-level instability, depending on the policies adopted by individual central banks. The Great Depression was not caused by an adverse shock to demand; it was caused by a policy-induced shock to the value of gold. There was nothing inherent in the gold standard that would have prevented a loosening of monetary policy – a decline in the gold reserves held by central banks – to reverse the deflationary effects of the rapid accumulation of gold reserves, but, the insane Bank of France was not inclined to reverse its policy, perversely viewing the increase in its gold reserves as evidence of the success of its catastrophic policy. However, once some central banks are accumulating gold reserves, other central banks inevitably feel that they must take steps to at least maintain their current levels of reserves, lest markets begin to lose confidence that convertibility into gold will be preserved. Bad policy tends to spread. Krugman seems to have this possibility in mind when he continues:

Worse, relying on gold can easily have the effect of forcing a tightening of monetary policy at precisely the wrong moment. In a crisis, people get worried about banks and seek cash, increasing the demand for the monetary base – but you can’t expand the monetary base to meet this demand, because it’s tied to gold.

But Krugman is being a little sloppy here. If the demand for the monetary base – meaning, presumably, currency plus reserves at the central bank — is increasing, then the public simply wants to increase their holdings of currency, not spend the added holdings. So what stops the the central bank accommodate that demand? Krugman says that “it” – meaning, presumably, the monetary base – is tied to gold. What does it mean for the monetary base to be “tied” to gold? Under the gold standard, the “tie” to gold is a promise to convert the monetary base, on demand, at a specified conversion rate.

Question: why would that promise to convert have prevented the central bank from increasing the monetary base? Answer: it would not and did not. Since, by assumption, the public is demanding more currency to hold, there is no reason why the central bank could not safely accommodate that demand. Of course, there would be a problem if the public feared that the central bank might not continue to honor its convertibility commitment and that the price of gold would rise. Then there would be an internal drain on the central bank’s gold reserves. But that is not — or doesn’t seem to be — the case that Krugman has in mind. Rather, what he seems to mean is that the quantity of base money is limited by a reserve ratio between the gold reserves held by the central bank and the monetary base. But if the tie between the monetary base and gold that Krugman is referring to is a legal reserve requirement, then he is confusing the legal reserve requirement with the gold standard, and the two are simply not the same, it being entirely possible, and actually desirable, for the gold standard to function with no legal reserve requirement – certainly not a marginal reserve requirement.

On top of that, a slump drives interest rates down, increasing the demand for real assets perceived as safe — like gold — which is why gold prices rose after the 2008 crisis. But if you’re on a gold standard, nominal gold prices can’t rise; the only way real prices can rise is a fall in the prices of everything else. Hello, deflation!

Note the implicit assumption here: that the slump just happens for some unknown reason. I don’t deny that such events are possible, but in the context of this discussion about the gold standard and its destabilizing properties, the historically relevant scenario is when the slump occurred because of a deliberate decision to raise interest rates, as the Fed did in 1929 to suppress stock-market speculation and as the Bank of England did for most of the 1920s, to restore and maintain the prewar sterling parity against the dollar. Under those circumstances, it was the increase in the interest rate set by the central bank that amounted to an increase in the monetary demand for gold which is what caused gold appreciation and deflation.

Competitive Devaluation Plus Monetary Expansion Does Create a Free Lunch

I want to begin this post by saying that I’m flattered by, and grateful to, Frances Coppola for the first line of her blog post yesterday. But – and I note that imitation is the sincerest form of flattery – I fear I have to take issue with her over competitive devaluation.

Frances quotes at length from a quotation from Hawtrey’s Trade Depression and the Way Out that I used in a post I wrote almost four years ago. Hawtrey explained why competitive devaluation in the 1930s was – and in my view still is – not a problem (except under extreme assumptions, which I will discuss at the end of this post). Indeed, I called competitive devaluation a free lunch, providing her with a title for her post. Here’s the passage that Frances quotes:

This competitive depreciation is an entirely imaginary danger. The benefit that a country derives from the depreciation of its currency is in the rise of its price level relative to its wage level, and does not depend on its competitive advantage. If other countries depreciate their currencies, its competitive advantage is destroyed, but the advantage of the price level remains both to it and to them. They in turn may carry the depreciation further, and gain a competitive advantage. But this race in depreciation reaches a natural limit when the fall in wages and in the prices of manufactured goods in terms of gold has gone so far in all the countries concerned as to regain the normal relation with the prices of primary products. When that occurs, the depression is over, and industry is everywhere remunerative and fully employed. Any countries that lag behind in the race will suffer from unemployment in their manufacturing industry. But the remedy lies in their own hands; all they have to do is to depreciate their currencies to the extent necessary to make the price level remunerative to their industry. Their tardiness does not benefit their competitors, once these latter are employed up to capacity. Indeed, if the countries that hang back are an important part of the world’s economic system, the result must be to leave the disparity of price levels partly uncorrected, with undesirable consequences to everybody. . . .

The picture of an endless competition in currency depreciation is completely misleading. The race of depreciation is towards a definite goal; it is a competitive return to equilibrium. The situation is like that of a fishing fleet threatened with a storm; no harm is done if their return to a harbor of refuge is “competitive.” Let them race; the sooner they get there the better. (pp. 154-57)

Here’s Frances’s take on Hawtrey and me:

The highlight “in terms of gold” is mine, because it is the key to why Glasner is wrong. Hawtrey was right in his time, but his thinking does not apply now. We do not value today’s currencies in terms of gold. We value them in terms of each other. And in such a system, competitive devaluation is by definition beggar-my-neighbour.

Let me explain. Hawtrey defines currency values in relation to gold, and advertises the benefit of devaluing in relation to gold. The fact that gold is the standard means there is no direct relationship between my currency and yours. I may devalue my currency relative to gold, but you do not have to: my currency will be worth less compared to yours, but if the medium of account is gold, this does not matter since yours will still be worth the same amount in terms of gold. Assuming that the world price of gold remains stable, devaluation therefore principally affects the DOMESTIC price level.  As Hawtrey says, there may additionally be some external competitive advantage, but this is not the principal effect and it does not really matter if other countries also devalue. It is adjusting the relationship of domestic wages and prices in terms of gold that matters, since this eventually forces down the price of finished goods and therefore supports domestic demand.

Conversely, in a floating fiat currency system such as we have now, if I devalue my currency relative to yours, your currency rises relative to mine. There may be a domestic inflationary effect due to import price rises, but we do not value domestic wages or the prices of finished goods in terms of other currencies, so there can be no relative adjustment of wages to prices such as Hawtrey envisages. Devaluing the currency DOES NOT support domestic demand in a floating fiat currency system. It only rebalances the external position by making imports relatively more expensive and exports relatively cheaper.

This difference is crucial. In a gold standard system, devaluing the currency is a monetary adjustment to support domestic demand. In a floating fiat currency system, itis an external adjustment to improve competitiveness relative to other countries.

Actually, Frances did not quote the entire passage from Hawtrey that I reproduced in my post, and Frances would have done well to quote from, and to think carefully about, what Hawtrey said in the paragraphs preceding the ones she quoted. Here they are:

When Great Britain left the gold standard, deflationary measure were everywhere resorted to. Not only did the Bank of England raise its rate, but the tremendous withdrawals of gold from the United States involved an increase of rediscounts and a rise of rates there, and the gold that reached Europe was immobilized or hoarded. . . .

The consequence was that the fall in the price level continued. The British price level rose in the first few weeks after the suspension of the gold standard, but then accompanied the gold price level in its downward trend. This fall of prices calls for no other explanation than the deflationary measures which had been imposed. Indeed what does demand explanation is the moderation of the fall, which was on the whole not so steep after September 1931 as before.

Yet when the commercial and financial world saw that gold prices were falling rather than sterling prices rising, they evolved the purely empirical conclusion that a depreciation of the pound had no effect in raising the price level, but that it caused the price level in terms of gold and of those currencies in relation to which the pound depreciated to fall.

For any such conclusion there was no foundation. Whenever the gold price level tended to fall, the tendency would make itself felt in a fall in the pound concurrently with the fall in commodities. But it would be quite unwarrantable to infer that the fall in the pound was the cause of the fall in commodities.

On the other hand, there is no doubt that the depreciation of any currency, by reducing the cost of manufacture in the country concerned in terms of gold, tends to lower the gold prices of manufactured goods. . . .

But that is quite a different thing from lowering the price level. For the fall in manufacturing costs results in a greater demand for manufactured goods, and therefore the derivative demand for primary products is increased. While the prices of finished goods fall, the prices of primary products rise. Whether the price level as a whole would rise or fall it is not possible to say a priori, but the tendency is toward correcting the disparity between the price levels of finished products and primary products. That is a step towards equilibrium. And there is on the whole an increase of productive activity. The competition of the country which depreciates its currency will result in some reduction of output from the manufacturing industry of other countries. But this reduction will be less than the increase in the country’s output, for if there were no net increase in the world’s output there would be no fall of prices.

So Hawtrey was refuting precisely the argument raised  by Frances. Because the value of gold was not stable after Britain left the gold standard and depreciated its currency, the deflationary effect in other countries was mistakenly attributed to the British depreciation. But Hawtrey points out that this reasoning was backwards. The fall in prices in the rest of the world was caused by deflationary measures that were increasing the demand for gold and causing prices in terms of gold to continue to fall, as they had been since 1929. It was the fall in prices in terms of gold that was causing the pound to depreciate, not the other way around

Frances identifies an important difference between an international system of fiat currencies in which currency values are determined in relationship to each other in foreign exchange markets and a gold standard in which currency values are determined relative to gold. However, she seems to be suggesting that currency values in a fiat money system affect only the prices of imports and exports. But that can’t be so, because if the prices of imports and exports are affected, then the prices of the goods that compete with imports and exports must also be affected. And if the prices of tradable goods are affected, then the prices of non-tradables will also — though probably with a lag — eventually be affected as well. Of course, insofar as relative prices before the change in currency values were not in equilibrium, one can’t predict that all prices will adjust proportionately after the change.

To make the point in more abstract terms, the principle of purchasing power parity (PPP) operates under both a gold standard and a fiat money standard, and one can’t just assume that the gold standard has some special property that allows PPP to hold, while PPP is somehow disabled under a fiat currency system. Absent an explanation of why PPP doesn’t hold in a floating fiat currency system, the assertion that devaluing a currency (i.e., driving down the exchange value of one currency relative to other currencies) “is an external adjustment to improve competitiveness relative to other countries” is baseless.

I would also add a semantic point about this part of Frances’s argument:

We do not value today’s currencies in terms of gold. We value them in terms of each other. And in such a system, competitive devaluation is by definition beggar-my-neighbour.

Unfortunately, Frances falls into the common trap of believing that a definition actually tell us something about the real word, when in fact a definition tell us no more than what meaning is supposed to be attached to a word. The real world is invariant with respect to our definitions; our definitions convey no information about reality. So for Frances to say – apparently with the feeling that she is thereby proving her point – that competitive devaluation is by definition beggar-my-neighbour is completely uninformative about happens in the world; she is merely informing us about how she chooses to define the words she is using.

Frances goes on to refer to this graph taken from Gavyn Davies in the Financial Times, concerning a speech made by Stanley Fischer about research done by Fed staff economists showing that the 20% appreciation in the dollar over the past 18 months has reduced the rate of US inflation by as much as 1% and is projected to cause US GDP in three years to be about 3% lower than it would have been without dollar appreciation.Gavyn_Davies_Chart

Frances focuses on these two comments by Gavyn. First:

Importantly, the impact of the higher exchange rate does not reverse itself, at least in the time horizon of this simulation – it is a permanent hit to the level of GDP, assuming that monetary policy is not eased in the meantime.

And then:

According to the model, the annual growth rate should have dropped by about 0.5-1.0 per cent by now, and this effect should increase somewhat further by the end of this year.

Then, Frances continues:

But of course this assumes that the US does not ease monetary policy further. Suppose that it does?

The hit to net exports shown on the above graph is caused by imports becoming relatively cheaper and exports relatively more expensive as other countries devalue. If the US eased monetary policy in order to devalue the dollar support nominal GDP, the relative prices of imports and exports would rebalance – to the detriment of those countries attempting to export to the US.

What Frances overlooks is that by easing monetary policy to support nominal GDP, the US, aside from moderating or reversing the increase in its real exchange rate, would have raised total US aggregate demand, causing US income and employment to increase as well. Increased US income and employment would have increased US demand for imports (and for the products of American exporters), thereby reducing US net exports and increasing aggregate demand in the rest of the world. That was Hawtrey’s argument why competitive devaluation causes an increase in total world demand. Francis continues with a description of the predicament of the countries affected by US currency devaluation:

They have three choices: they respond with further devaluation of their own currencies to support exports, they impose import tariffs to support their own balance of trade, or they accept the deflationary shock themselves. The first is the feared “competitive devaluation” – exporting deflation to other countries through manipulation of the currency; the second, if widely practised, results in a general contraction of global trade, to everyone’s detriment; and you would think that no government would willingly accept the third.

But, as Hawtrey showed, competitive devaluation is not a problem. Depreciating your currency cushions the fall in nominal income and aggregate demand. If aggregate demand is kept stable, then the increased output, income, and employment associated with a falling exchange rate will spill over into a demand for the exports of other countries and an increase in the home demand for exportable home products. So it’s a win-win situation.

However, the Fed has permitted passive monetary tightening over the last eighteen months, and in December 2015 embarked on active monetary tightening in the form of interest rate rises. Davies questions the rationale for this, given the extraordinary rise in the dollar REER and the growing evidence that the US economy is weakening. I share his concern.

And I share his concern, too. So what are we even arguing about? Equally troubling is how passive tightening has reduced US demand for imports and for US exportable products, so passive tightening has negative indirect effects on aggregate demand in the rest of the world.

Although currency depreciation generally tends to increase the home demand for imports and for exportables, there are in fact conditions when the general rule that competitive devaluation is expansionary for all countries may be violated. In a number of previous posts (e.g., this, this, this, this and this) about currency manipulation, I have explained that when currency depreciation is undertaken along with a contractionary monetary policy, the terms-of-trade effect predominates without any countervailing effect on aggregate demand. If a country depreciates its exchange rate by intervening in foreign-exchange markets, buying foreign currencies with its own currency, thereby raising the value of foreign currencies relative to its own currency, it is also increasing the quantity of the domestic currency in the hands of the public. Increasing the quantity of domestic currency tends to raise domestic prices, thereby reversing, though probably with a lag, the effect on the currency’s real exchange rate. To prevent the real-exchange rate from returning to its previous level, the monetary authority must sterilize the issue of domestic currency with which it purchased foreign currencies. This can be done by open-market sales of assets by the cental bank, or by imposing increased reserve requirements on banks, thereby forcing banks to hold the new currency that had been created to depreciate the home currency.

This sort of currency manipulation, or exchange-rate protection, as Max Corden referred to it in his classic paper (reprinted here), is very different from conventional currency depreciation brought about by monetary expansion. The combination of currency depreciation and tight money creates an ongoing shortage of cash, so that the desired additional cash balances can be obtained only by way of reduced expenditures and a consequent export surplus. Since World War II, Japan, Germany, Taiwan, South Korea, and China are among the countries that have used currency undervaluation and tight money as a mechanism for exchange-rate protectionism in promoting industrialization. But exchange rate protection is possible not only under a fiat currency system. Currency manipulation was also possible under the gold standard, as happened when the France restored the gold standard in 1928, and pegged the franc to the dollar at a lower exchange rate than the franc had reached prior to the restoration of convertibility. That depreciation was accompanied by increased reserve requirements on French banknotes, providing the Bank of France with a continuing inflow of foreign exchange reserves with which it was able to pursue its insane policy of accumulating gold, thereby precipitating, with a major assist from the high-interest rate policy of the Fed, the deflation that turned into the Great Depression.

Sumner on the Demand for Money, Interest Rates and Barsky and Summers

Scott Sumner had two outstanding posts a couple of weeks ago (here and here) discussing the relationship between interest rates and NGDP, making a number of important points, which I largely agree with, even though I have some (mostly semantic) quibbles about the details. I especially liked how in the second post he applied the analysis of Robert Barsky and Larry Summers in their article about Gibson’s Paradox under the gold standard to recent monetary experience. The two posts are so good and cover such a wide range of topics that the best way for me to address them is by cutting and pasting relevant passages and commenting on them.

Scott begins with the equation of exchange MV = PY. I personally prefer the Cambridge version (M = kPY) where k stands for the fraction of income that people hold as cash, thereby making it clear that the relevant concept is how much money want to hold, not that mysterious metaphysical concept called the velocity of circulation V (= 1/k). With attention focused on the decision about how much money to hold, it is natural to think of the rate of interest as the opportunity cost of holding non-interest-bearing cash balances. When the rate of interest rate rises, the desired holdings of non-interest-bearing cash tend to fall; in other words k falls (and V rises). With unchanged M, the equation is satisfied only if PY increases. So the notion that a reduction in interest rates, in and of itself, is expansionary is based on a misunderstanding. An increase in the amount of money demanded is always contractionary. A reduction in interest rates increases the amount of money demanded (if money is non-interest-bearing). A reduction in interest rates is therefore contractionary (all else equal).

Scott suggests some reasons why this basic relationship seems paradoxical.

Sometimes, not always, reductions in interest rates are caused by an increase in the monetary base. (This was not the case in late 2007 and early 2008, but it is the case on some occasions.) When there is an expansionary monetary policy, specifically an exogenous increase in M, then when interest rates fall, V tends to fall by less than M rises. So the policy as a whole causes NGDP to rise, even as the specific impact of lower interest rates is to cause NGDP to fall.

To this I would add that, as discussed in my recent posts about Keynes and Fisher, Keynes in the General Theory seemed to be advancing a purely monetary theory of the rate of interest. If Keynes meant that the rate of interest is determined exclusively by monetary factors, then a falling rate of interest is a sure sign of an excess supply of money. Of course in the Hicksian world of IS-LM, the rate of interest is simultaneously determined by both equilibrium in the money market and an equilibrium rate of total spending, but Keynes seems to have had trouble with the notion that the rate of interest could be simultaneously determined by not one, but two, equilibrium conditions.

Another problem is the Keynesian model, which hopelessly confuses the transmission mechanism. Any Keynesian model with currency that says low interest rates are expansionary is flat out wrong.

But if Keynes believed that the rate of interest is exclusively determined by money demand and money supply, then the only possible cause of a low or falling interest rate is the state of the money market, the supply side of which is always under the control of the monetary authority. Or stated differently, in the Keynesian model, the money-supply function is perfectly elastic at the target rate of interest, so that the monetary authority supplies whatever amount of money is demanded at that rate of interest. I disagree with the underlying view of what determines the rate of interest, but given that theory of the rate of interest, the model is not incoherent and doesn’t confuse the transmission mechanism.

That’s probably why economists were so confused by 2008. Many people confuse aggregate demand with consumption. Thus they think low rates encourage people to “spend” and that this n somehow boosts AD and NGDP. But it doesn’t, at least not in the way they assume. If by “spend” you mean higher velocity, then yes, spending more boosts NGDP. But we’ve already seen that lower interest rates don’t boost velocity, rather they lower velocity.

But, remember that Keynes believed that the interest rate can be reduced only by increasing the quantity of money, which nullifies the contractionary effect of a reduced interest rate.

Even worse, some assume that “spending” is the same as consumption, hence if low rates encourage people to save less and consume more, then AD will rise. This is reasoning from a price change on steroids! When you don’t spend you save, and saving goes into investment, which is also part of GDP.

But this is reasoning from an accounting identity. The question is what happens if people try to save. The Keynesian argument is that the attempt to save will be self-defeating; instead of increased saving, there is reduced income. Both scenarios are consistent with the accounting identity. The question is which causal mechanism is operating? Does an attempt to increase saving cause investment to increase, or does it cause income to go down? Seemingly aware of the alternative scenario, Scott continues:

Now here’s were amateur Keynesians get hopelessly confused. They recall reading something about the paradox of thrift, about planned vs. actual saving, about the fact that an attempt to save more might depress NGDP, and that in the end people may fail to save more, and instead NGDP will fall. This is possible, but even if true it has no bearing on my claim that low rates are contractionary.

Just so. But there is not necessarily any confusion; the issue may be just a difference in how monetary policy is implemented. You can think of the monetary authority as having a choice in setting its policy in terms of the quantity of the monetary base, or in terms of an interest-rate target. Scott characterizes monetary policy in terms of the base, allowing the interest rate to adjust; Keynesians characterize monetary policy in terms of an interest-rate target, allowing the monetary base to adjust. The underlying analysis should not depend on how policy is characterized. I think that this is borne out by Scott’s next paragraph, which is consistent with a policy choice on the part of the Keynesian monetary authority to raise interest rates as needed to curb aggregate demand when aggregate demand is excessive.

To see the problem with this analysis, consider the Keynesian explanations for increases in AD. One theory is that animal spirits propel businesses to invest more. Another is that consumer optimism propels consumers to spend more. Another is that fiscal policy becomes more expansionary, boosting the budget deficit. What do all three of these shocks have in common? In all three cases the shock leads to higher interest rates. (Use the S&I diagram to show this.) Yes, in all three cases the higher interest rates boost velocity, and hence ceteris paribus (i.e. fixed monetary base) the higher V leads to more NGDP. But that’s not an example of low rates boosting AD, it’s an example of some factor boosting AD, and also raising interest rates.

In the Keynesian terminology, the shocks do lead to higher rates, but only because excessive aggregate demand, caused by animal spirits, consumer optimism, or government budget deficits, has to be curbed by interest-rate increases. The ceteris paribus assumption is ambiguous; it can be interpreted to mean holding the monetary base constant or holding the interest-rate target constant. I don’t often cite Milton Friedman as an authority, but one of his early classic papers was “The Marshallian Demand Curve” in which he pointed out that there is an ambiguity in what is held constant along the demand curve: prices of other goods or real income. You can hold only one of the two constant, not both, and you get a different demand curve depending on which ceteris paribus assumption you make. So the upshot of my commentary here is that, although Scott is right to point out that the standard reasoning about how a change in interest rates affects NGDP implicitly assumes that the quantity of money is changing, that valid point doesn’t refute the standard reasoning. There is an inherent ambiguity in specifying what is actually held constant in any ceteris paribus exercise. It’s good to make these ambiguities explicit, and there might be good reasons to prefer one ceteris paribus assumption over another, but a ceteris paribus assumption isn’t a sufficient basis for rejecting a model.

Now just to be clear, I agree with Scott that, as a matter of positive economics, the interest rate is not fully under the control of the monetary authority. And one reason that it’s not  is that the rate of interest is embedded in the entire price system, not just a particular short-term rate that the central bank may be able to control. So I don’t accept the basic Keynesian premise that monetary authority can always make the rate of interest whatever it wants it to be, though the monetary authority probably does have some control over short-term rates.

Scott also provides an analysis of the effects of interest on reserves, and he is absolutely correct to point out that paying interest on reserves is deflationary.

I will just note that near the end of his post, Scott makes a comment about living “in a Ratex world.” WADR, I don’t think that ratex is at all descriptive of reality, but I will save that discussion for another time.

Scott followed up the post about the contractionary effects of low interest rates with a post about the 1988 Barsky and Summers paper.

Barsky and Summers . . . claim that the “Gibson Paradox” is caused by the fact that low interest rates are deflationary under the gold standard, and that causation runs from falling interest rates to deflation. Note that there was no NGDP data for this period, so they use the price level rather than NGDP as their nominal indicator. But their basic argument is identical to mine.

The Gibson Paradox referred to the tendency of prices and interest rates to be highly correlated under the gold standard. Initially some people thought this was due to the Fisher effect, but it turns out that prices were roughly a random walk under the gold standard, and hence the expected rate of inflation was close to zero. So the actual correlation was between prices and both real and nominal interest rates. Nonetheless, the nominal interest rate is the key causal variable in their model, even though changes in that variable are mostly due to changes in the real interest rate.

Since gold is a durable good with a fixed price, the nominal interest rate is the opportunity cost of holding that good. A lower nominal rate tends to increase the demand for gold, for both monetary and non-monetary purposes.  And an increased demand for gold is deflationary (and also reduces NGDP.)

Very insightful on Scott’s part to see the connection between the Barsky and Summers analysis and the standard theory of the demand for money. I had previously thought about the Barsky and Summers discussion simply as a present-value problem. The present value of any durable asset, generating a given expected flow of future services, must vary inversely with the interest rate at which those future services are discounted. Since the future price level under the gold standard was expected to be roughly stable, any change in nominal interest rates implied a change in real interest rates. The value of gold, like other durable assets, varied inversely with nominal interest rate. But with the nominal value of gold fixed by the gold standard, changes in the value of gold implied a change in the price level, an increased value of gold being deflationary and a decreased value of gold inflationary. Scott rightly observes that the same idea can be expressed in the language of monetary theory by thinking of the nominal interest rate as the cost of holding any asset, so that a reduction in the nominal interest rate has to increase the demand to own assets, because reducing the cost of holding an asset increases the demand to own it, thereby raising its value in exchange, provided that current output of the asset is small relative to the total stock.

However, the present-value approach does have an advantage over the opportunity-cost approach, because the present-value approach relates the value of gold or money to the entire term structure of interest rates, while the opportunity-cost approach can only handle a single interest rate – presumably the short-term rate – that is relevant to the decision to hold money at any given moment in time. In simple models of the IS-LM ilk, the only interest rate under consideration is the short-term rate, or the term-structure is assumed to have a fixed shape so that all interest rates are equally affected by, or along with, any change in the short-term rate. The latter assumption of course is clearly unrealistic, though Keynes made it without a second thought. However, in his Century of Bank Rate, Hawtrey showed that between 1844 and 1938, when the gold standard was in effect in Britain (except 1914-25 and 1931-38) short-term rates and long-term rates often moved by significantly different magnitudes and even in opposite directions.

Scott makes a further interesting observation:

The puzzle of why the economy does poorly when interest rates fall (such as during 2007-09) is in principle just as interesting as the one Barsky and Summers looked at. Just as gold was the medium of account during the gold standard, base money is currently the medium of account. And just as causation went from falling interest rates to higher demand for gold to deflation under the gold standard, causation went from falling interest rates to higher demand for base money to recession in 2007-08.

There is something to this point, but I think Scott may be making too much of it. Falling interest rates in 2007 may have caused the demand for money to increase, but other factors were also important in causing contraction. The problem in 2008 was that the real rate of interest was falling, while the Fed, fixated on commodity (especially energy) prices, kept interest rates too high given the rapidly deteriorating economy. With expected yields from holding real assets falling, the Fed, by not cutting interest rates any further between April and October of 2008, precipitated a financial crisis once inflationary expectations started collapsing in August 2008, the expected yield from holding money dominating the expected yield from holding real assets, bringing about a pathological Fisher effect in which asset values had to collapse for the yields from holding money and from holding assets to be equalized.

Under the gold standard, the value of gold was actually sensitive to two separate interest-rate effects – one reflected in the short-term rate and one reflected in the long-term rate. The latter effect is the one focused on by Barsky and Summers, though they also performed some tests on the short-term rate. However, it was through the short-term rate that the central bank, in particular the Bank of England, the dominant central bank during in the pre-World War I era, manifested its demand for gold reserves, raising the short-term rate when it was trying to accumulate gold and reducing the short-term rate when it was willing to reduce its reserve holdings. Barsky and Summers found the long-term rate to be more highly correlated with the price level than the short-term rate. I conjecture that the reason for that result is that the long-term rate is what captures the theoretical inverse relationship between the interest rate and the value of a durable asset, while the short-term rate would be negatively correlated with the value of gold when (as is usually the case) it moves together with the long-term rate but may sometimes be positively correlated with the value of gold (when the central bank is trying to accumulate gold) and thereby tightening the world market for gold. I don’t know if Barsky and Summers ran regressions using both long-term and short-term rates, but using both long-term and short-term rates in the same regression might have allowed them to find evidence of both effects in the data.

PS I have been too busy and too distracted of late to keep up with comments on earlier posts. Sorry for not responding promptly. In case anyone is still interested, I hope to respond to comments over the next few days, and to post and respond more regularly than I have been doing for the past few weeks.

Eric Rauchway on the Gold Standard

Commenter TravisV recently flagged for me a New York Times review of a new book by Eric Rauchway, Professor of History at the University of California at Davis. The book is called Money Makers: How Roosevelt and Keynes Ended the Depression, Defeated Fascism, and Secured a Prosperous Peace, a history of how FDR, with a bit of encouragement, but no real policy input, from J. M. Keynes, started a recovery from the Great Depression in 1933 by taking the US off the gold standard and devaluing the dollar, and later, with major input from Keynes, was instrumental in creating the post-World War II monetary system which was the result of the historic meeting at Bretton Woods, New Hampshire in 1944.

I had only just learned of Rauchway a week or so before the Times reviewed his book when I read his op-ed piece in the New York Times (“Why Republicans Still Love the Gold Standard” 11/13/15), warning about the curious (and ominous) infatuation that many Republican candidates for President seem to have with the gold standard, an infatuation forthrightly expressed by Ted Cruz in a recent debate among the Republican candidates for President. Rauchway wrote:

In Tuesday’s Republican presidential debate, Senator Ted Cruz reintroduced an idea that had many viewers scratching their heads and nearly all economists pulling out their hair. Mr. Cruz advocated a return to the gold standard — that is, tying the value of a dollar to a set amount of gold — because, he said, it produced prosperity under the Bretton Woods system and it helped “workingmen and -women.”

Mr. Cruz is confused about history and economics. The framers of Bretton Woods specifically designed their new international monetary system not to be a gold standard because they believed gold-based currency was largely responsible for the Great Depression. Their system, named for the New Hampshire town hosting the 1944 international conference that created it, was not a gold standard but “the exact opposite,” according to John Maynard Keynes, one of the system’s principal designers. Under Bretton Woods, nations were not obliged to set monetary policy according to how much gold they had, but rather according to their economic needs.

I thought that Rauchway made an excellent point in distinguishing between the actual gold standard and the Bretton Wood monetary system, in which the price of gold was nominally fixed at $35 dollars an ounce. But Bretton Woods system was very far from being a true gold standard, because the existence of a gold standard is predicated on the existence of a free market in gold, so that gold can be freely bought and sold by anyone at the official price. Under Bretton Woods, however, the market was tightly controlled, and US citizens could not legally own gold, except for industrial or commercial purposes, while the international gold market was under the strict control of the international monetary authorities. The only purchasers to whom the Fed was obligated to sell gold at the official price were other central banks, and it was understood that any request to purchase gold from the US monetary authority beyond what the US government thought appropriate would be considered a hostile act. The only foreign government willing to make such requests was the French government under de Gaulle, who took obvious pleasure in provoking the Anglo-Saxons whenever possible.

If Senator Cruz were a little older, or a little better read, or a little more scrupulous in his historical pronouncements, he might have been deterred from identifying the Bretton Woods system with the gold standard, because in the 1950s and 1960s right-wing supporters of the gold standard – I mean people like Ludwig von Mises and Henry Hazlitt — regarded the Bretton Woods as a dreadful engine of inflation, regarding the Bretton Woods system as a sham, embodying only the form, but not the substance, of the gold standard. It was only in the late 1970s that right-wingers began making nostalgic references to Bretton Woods, the very system that they had spent the previous 25 or 30 years denouncing as an abhorrent scheme for currency debasement.

But I stopped nodding my head in agreement with Rauchway when I reached the fifth paragraph of his piece.

Under a gold standard, the amount of gold a nation holds in bank vaults determines how much of its money circulates. If a nation’s gold stock increases through trade, for example, the country issues more currency. Likewise, if its gold stock decreases, it issues less.

Oh dear! Rauchway, like so many others, gets the gold standard all wrong, even though he started off correctly by saying that the gold standard ties “the value of a dollar to a set amount of gold.”

Here’s the point. Given a demand for some product, say, apples, if you can set the quantity of apples, while allowing everyone to trade that fixed amount freely, the equilibrium price for applies will be the price at which the amount demanded exactly matches the fixed quantity available to the market. Alternatively, if you set the price of apples, and can supply exactly as many apples as are demanded, the equilibrium quantity will be whatever quantity is demanded at the fixed price.

The gold standard operates by fixing the price of currency at a certain value in terms of gold (or stated equivalently, defining the currency unit as representing a fixed quantity of gold). The amount of currency under a gold standard is therefore whatever quantity of currency is demanded at the fixed price. That is very different from saying that a gold standard operates by placing a limit on the amount of currency that can be created. It is, to be sure, possible to place a limit on the quantity of currency by imposing a legal gold-reserve requirement on currency issued. But even then, it’s not the amount of reserves that limits the amount of currency; it’s the amount of currency that determines how much gold is held in reserve. Such requirements have existed under a gold standard, but those requirements do not define a gold standard, which is the legal equivalence established between currency and a corresponding amount of gold. A gold-reserve requirement is rather a condition imposed upon the gold standard, not the gold standard itself. Whether reserve requirements are good or bad, wise or unwise, is debatable. But it is a category mistake to confuse the defining characteristic of the gold standard with a separate condition imposed upon the gold standard.

I thought about responding to Rauchway’s erroneous characterization of the gold standard after seeing his op-ed piece, but it didn’t seem quite important enough to make the correction until TravisV pointed me to the review of his new book, which is largely about the gold standard. But then I thought that perhaps Rauchway had just expressed himself sloppily in the Times op-ed, mistakenly trying to convey a somewhat complicated and unfamiliar idea in more easily understood terms. So, without a copy of his book handy, I did a little on-line research, looking up some of the recent – and mostly favorable — reviews of the book. And, to my dismy, I found the following statement in a review in the Economist:

More important, says Mr Rauchway, in 1933 he [FDR] took America off the gold standard, a system whereby the amount of dollars in circulation was determined by the country’s gold reserves.

I am assuming that the reviewer for the Economist did not make this up on his own and is accurately conveying Mr. Rauchway’s understanding of how the gold standard operated. But just to be sure, I checked a few other online reviews, and I found this one by the indefatigable John Tamny in Real Clear Markets. Tamny is listed as editor of Real Clear Markets, which makes sense, because I can’t understand how else his seemingly interminable review of over 4200 words could have gotten published. Luckily for me, I didn’t have to go through the entire review before finding the following comment:

Rauchway lauds FDR for leaving a gold standard that in Rauchway’s words limited money creation to a ratio informed by the “amount of shiny yellow metal a nation had on hand,” but the problem here is that Rauchway’s analysis is spectacularly untrue. As monetary expert Nathan Lewis explained it recently about the U.S. gold standard,

A gold standard system is not, and has never been, a system that “fixes the supply of money to the supply of gold.” Absolutely not. A gold standard system is what I call a fixed-value system. The value of the currency – not the quantity – is linked to gold, for example at 23.2 troy grains of gold per dollar ($20.67/ounce).

It’s too bad that Rauchway had to be corrected by John Tamny and Nathan Lewis, but it is what it is. And don’t forget, even F. A. Hayek and Milton Friedman couldn’t figure out how the gold standard worked. But still, despite its theoretical shortcomings, it seems more than likely that Rauchway’s book is worth reading.

PS Further discussion of GOP nostalgia for the gold standard in today’s New York Times


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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