gold standard | Uneasy Money

Archive for the 'gold standard' Category

A New Version of My Paper (With Ron Batchelder) on Hawtrey and Cassel Is Available on SSRN

It’s now over twenty years since my old UCLA buddy (and student of Earl Thompson) Ron Batchelder and I started writing our paper on Ralph Hawtrey and Gustav Cassel entitled “Pre-Keynesian Monetary Theories of the Great Depression: Whatever Happened to Hawtrey and Cassel?” I presented it many years ago at the annual meeting of the History of Economics Society and Ron has presented it over the years at a number of academic workshops. Almost everyone who has commented on it has really liked it. Scott Sumner plugged it on his blog two years ago. Scott’s own very important work on the Great Depression has been a great inspiration for me to continue working on the paper. Doug Irwin has also written an outstanding paper on Gustav Cassel and his early anticipation of the deflationary threat that eventually turned into the Great Depression.

Unfortunately, Ron and I have still not done that last revision to make it the almost-perfect paper that we want it to be. But I have finally made another set of revisions, and I am turning the paper back to Ron for his revisions before we submit it to a journal for publication. In the meantime, I thought that we should make an up-to-date version of the paper available on SSRN as the current version (UCLA working paper #626) on the web dates back to (yikes!) 1991.

Here’s the abstract.

A strictly monetary theory of the Great Depression is generally thought to have originated with Milton Friedman. Designed to counter the Keynesian notion that the Great Depression resulted from instabilities inherent in modern capitalist economies, Friedman’s explanation identified the culprit as an inept Federal Reserve Board. More recent work on the Great Depression suggests that the causes of the Great Depression, rooted in the attempt to restore an international gold standard that had been suspended after World War I started, were more international in scope than Friedman believed. We document that current views about the causes of the Great Depression were anticipated in the 1920s by Ralph Hawtrey and Gustav Cassel who warned that restoring the gold standard risked causing a disastrous deflation unless an increasing international demand for gold could be kept within strict limits. Although their early warnings of potential disaster were validated, and their policy advice after the Depression started was consistently correct, their contributions were later ignored and forgotten. We offer some possible reasons for the remarkable disregard by later economists of the Hawtrey-Cassel monetary explanation of the Great Depression.

More on Bernanke and the Gold Standard

Published March 29, 2012 gold standard , monetary history , monetary policy 16 Comments

Last week I criticized Ben Bernanke’s explanation in a lecture at George Washington University of what’s wrong with the gold standard. I see that Forbes has also been devoting a lot of attention to criticizing what Bernanke had to say about the gold standard, though the criticisms published in Forbes, a pro-gold-standard publication, are different from the ones that I was making.

So let’s have a look at what Brian Domitrovic, a history professor at Sam Houston State University, author of a recent book on supply-side economics, and a member of the advisory board of The Gold Standard Now, an advocacy group promoting the gold standard, had to say.

Domitrovic dismisses most of Bernanke’s criticisms of the gold standard as being trivial and inconsequential.

Whatever criticism there is to be leveled at the gold standard during its halcyon days in the late 19^th and early 20^th centuries, we now know, it is small potatoes. However many panics and bank failures you can point to from 1870 to 1913, the underlying economic reality is that the period saw phenomenal growth year after year, far above the twentieth-century average, and in the context of price oscillations around par that have no like in their modesty in the subsequent century of history.

This sounds like a strong case for the performance of the gold standard, but one has to be careful. Just because the end of the nineteenth century till World War I saw rapid growth, we can’t infer that the gold standard was the cause. The gold standard may just have been lucky to be around at the time. But no serious student of the gold standard has ever argued that it inherently and inevitably must cause financial panics and other monetary dysfunctions, just that it is vulnerable to serious recessions caused by sudden increases in the value of gold.

Domitrovic then reaches for a very questionable historical argument in favor of the gold standard.

Moreover, the silence of the critics about the renewed if modified gold-standard era of 1944-1971, the “Bretton Woods” run of substantial growth and considerable price stability, indicates that it too is innocent of sponsoring an irreducibly faulty monetary system.

I can’t speak on behalf of other critics of the gold standard, but the relevance of 1944-1971 Bretton Woods era to an evaluation of the gold standard is dubious at best. The value of gold was in that period was did not in any sense govern the value of the dollar, the only currency at the time formally convertible into gold. The list of economic agents entitled to demand redemption of dollars from the US was very tightly controlled. There was no free market in gold. The $35 an ounce price was an artifact not a reflection of economic reality, and it is absurd, as well as hypocritical, to regard such a dirigiste set of arrangements as an sort of evidence in favor of the efficacy of a truly operational gold standard.

As a result, Domitrovic contends that Bernanke’s case against the gold standard comes down to one proposition: that it caused the Great Depression. Domitrovic cites Barry Eichengreen’s 1992 book Golden Fetters as the most influential recent study holding the gold standard responsible for the Great Depression.

Eichengreen lays out a case that it was the effort on the part of central banks to defend their currencies’ gold parities from 1929 on that led to the severity of the crisis. The more countries tried to defend their currencies’ values against gold, the more their economies were starved of cash and thus spun into depression; the more nonchalant countries became about gold, the quicker and bigger their recoveries.

But Domitrovic argues that the work of Richard Timberlake – identified by Domitrovic as Milton Friedman’s greatest student in the area of monetary history – to show that there is no evidence “that the Fed was following gold-standard rules or rubrics when it contracted the money supply from 1928 to 1933.”

Gold is nowhere in this story. There’s no evidence that Fed tightening was done in view of any gold-standard requirement, no evidence that gold-market moves pressured the Fed into tightening, no evidence that dwindling gold stocks or the prospect thereof scared the Fed into keeping money extra tight and triggering the Great Contraction.

In fact, the whole while gold was cascading into the Treasury, making it fully possible, indeed mandated, under gold-standard rules (had they been obliged) for the Fed to print money with abandon. Indeed, as Timberlake notes, and this argument is killer, the gold-standard convention had it that all gold was to be monetized by central banks and treasuries in the event of crisis. Here was a crisis, and these institutions stockpiled gold at the expense of money! In sum: the gold standard was inoperative from 1928 to 1933.

The confusions abound. As I pointed out in my earlier post on Bernanke’s problems explaining the gold standard, there is only one rule defining the gold standard: making your currency convertible on demand at a fixed rate into gold or into another currency convertible into gold. References to non-existent “gold-standard rules” obliging the Fed (or any other central bank) to do this or that are irrelevant distractions. No critic of the gold standard and its role in causing the Great Depression ever claimed that the Fed, much less the insane Bank of France, had no choice but to follow the misguided (or insane) policies that they followed. The point is that by following misguided and insane policies that implied a huge increase in the world’s demand for gold, they produced a huge increase in the value of gold which meant that all countries on the gold standard were forced to endure a catastrophic deflation as long as they observed the only rule of the gold standard that is relevant to a discussion of the gold standard, namely the rule that says that the value of your currency must be equal the value of a fixed weight of gold into which you will make your currency freely convertible at a fixed rate. Timberlake is a fine economist and historian, but he unfortunately misinterprets the gold standard as a prescription for a particular set of economic policies, which leads him to make the mistake of suggesting that the gold standard was not operational between 1928 and 1933.

In the 1920s Ralph Hawtrey and Gustav Cassel favored maintaining a version of the gold standard that might have saved the Western Civilization. Unfortunately, at a critical moment their advice was ignored, with disastrous results. Why would we want to restore a system with the potential to produce such a horrible outcome, especially when the people advocating recreating a gold standard from scratch seem to have a very high propensity for cluelessness about what a gold standard actually means and why it went so wrong the last time it was put into effect?

Bernanke Has Trouble Explaining What’s Wrong with the Gold Standard

Published March 23, 2012 gold standard 33 Comments

Ben Bernanke went to George Washington University on Wednesday to give the first of four lectures on about the Federal Reserve System and the financial crisis. Wednesday’s lecture was entitled “Origins of the Federal Reserve: Economic Stability Concerns.” Most of the news coverage and commentary about the lecture seemed to be addressed to Bernanke’s discussion, about mid-way through the 75 minute lecture, of the gold standard and its shortcomings. Bernanke’s intentions were certainly admirable, inasmuch as a foolhardy attempt to restore the gold standard now, four score years after its slow, agonizing, disastrous demise in the early 1930s, would recklessly risk a repetition of that catastrophic episode. Unfortunately, Bernanke did not do a great job of explaining why we ought not give the gold standard one more shot.

Bernanke gave his lecture by going through a power-point presentation consisting of about 50 slides. He got to the gold standard on slide 22 on which he describes the gold standard as “an alternative to a central bank.” That is not quite correct, there having been central banks in existence, notably the Bank of England, under the gold standard. But we can let that pass, because modern-day advocates of the gold standard like to hold up the gold standard as an alternative to central banking. Bernanke provided a couple of further statements describing the workings of the gold standard.

In a gold standard, the value of the currency is fixed in terms of a quantity of gold
The gold standard sets the money supply and price level with limited central bank intervention

Now the first statement is perfectly fine. The gold standard is quintessentially a means by which a unit of account, say the dollar, is defined as a certain weight of gold. In the US from the late 19^th century until 1933, the dollar was defined as a quantity of gold such that an ounce of gold would be worth $20.67. But the second statement is totally wrong. The gold standard, by defining what the value of a dollar is in terms of gold, does nothing to “set” the money supply. (Actually, I don’t know what it means to “set” the money supply, but I am assuming it means something like fixing a particular numerical limit on the number of dollars.) Under the gold standard, the number of dollars in existence depends on how many dollars the public wants to hold given the value of gold. Of course, the value of gold means more than the fixed conversion rate between gold and dollars; it means the purchasing power of gold in terms of all other goods. The more valuable gold is, the fewer dollars people will want to hold at a given conversion rate between the dollar and gold, but the amount of dollars that people will want to hold, not some numerical relationship between gold and dollars, is what determines how many dollars people actually do hold.

Things get even worse (much worse) on the next slide with the heading: “Problems with the gold standard.” Here is what Bernanke has to say about that:

The strength of the gold standard is its greatest weakness too: Because the money supply is determined by the supply of gold, it cannot be adjusted in response to changing economic conditions.

Sorry, Professor Bernanke, you got that one wrong, too. The money supply is not determined, or set, by the supply of gold, so the money supply is perfectly capable of adjusting to changing economic conditions. What Bernanke probably had in mind was something like the following. Suppose people get nervous for whatever reason about the state of the economy. When they get nervous, they want to increase the amount of money they have on hand rather than tying up their wealth in illiquid form. In such situations, an effective central bank could increase the money supply, providing the public with the added liquidity that they want, thereby allowing the economy to keep functioning, without serious disruption, because the money supply was increased to match the increased demand to hold money. However, if the money supply is fixed, because under a gold standard the amount of money is determined or set by the supply of gold, the only way that the money supply can increase is by obtaining additional gold. But it takes a long time to mine more gold out of the ground, so in the meantime, people will have less money on hand than they want to hold, and the only way they can increase their cash holdings is to spend less. But in the aggregate people can’t increase their holdings of money by reducing their spending; they just reduce money income, forcing prices and output to fall. In other words the gold standard causes a recession.

So why is that wrong? It’s wrong, because under a gold standard, if people want to hold more dollars, more dollars can be created. Yes more dollars can be created out of thin air under a gold standard! The whole point is that any dollars created have to be convertible on demand into gold. Well if people want to hold more dollars, they can be created, and held, just as desired. Given that people want to hold the dollars, not spend them (remember that that was the assumption we just started with), creating additional dollars to be held will not cause an increase in the rate of dollars returned for redemption. So an increase in the demand for money need not cause a recession under the gold standard.

Well, in that case, so what exactly is the problem with the gold standard? There’s only a problem with the gold standard if the increase in the demand for money is associated with an increase in the demand for gold. An increase in the demand for gold over any short period of time implies an increase in the value of gold, because the amount of gold in existence is very large compared to the current rate of production. So an increase in the demand for gold necessarily increases the value of gold, implying that the prices of everything else in terms of gold start to fall. Suddenly falling prices – deflation — reduces money income and output, so there’s a recession. The recession is caused not because the money supply failed to rise — it did rise!–, but because the demand for gold increased.

Why would an increase in the demand for money cause an increase in the demand for gold? There are two possibilities. First, there could be legal reserve requirements, so that whenever the quantity of money is increased more gold has to be held as “backing.” Some (maybe most) people mistakenly believe that the reserve requirement is what constitutes a gold standard. But it’s not; the gold standard is defining the value of a monetary unit as a fixed weight of gold. That definition is consistent with any reserve requirement from zero to 100 percent. The second possibility is that the general feeling of uncertainty that causes people to want to increase their holdings of money also causes them to want to increase their holdings of gold, because they think that the money issued by governments or banks may have become more risky. This may be true under some circumstances, but not necessarily others.

The gold standard may be able to accommodate some increases in the demand for money, but not others. It depends. But historically some episodes in which the demand for money has increased have been associated with increases in the demand for gold. When that happens, watch out! Of course in the Great Depression, it was the demand for gold that increased, even before the demand for money increased, largely because of the monetary policy of the insane Bank of France in 1928-29.

Raising Reserve Requirements

Published March 12, 2012 gold standard , monetary history 13 Comments

In Monday’s Wall Street Journal, Charles Calomiris advocated raising reserve requirements on banks as a pre-emptive strike against gathering inflationary forces inherent in the huge growth in bank reserves since 2008, forces expected by Calomiris to become increasingly powerful in coming months.

The end of credit crunches like the one we’ve just gone through can see dramatic and sudden increases in bank lending. After six years of zero loan growth in the banking system from 1933 to 1939, for example, a sudden shift in the economic climate produced a surge in lending by U.S. banks, and from December 1939 to December 1941 lending grew by roughly 20%.

That is precisely the risk the U.S. faces over the next several years. Given the huge amount of reserves held by banks in excess of their legal requirements—excess reserves today stand at roughly $1.5 trillion—there is the potential for an even more sudden increase in credit and money growth today, accelerating the inflation rate.

By increasing reserve requirements, in effect quarantining a big chunk of those reserves, the Fed, Calomiris believes, could help keep a lid on inflation while it drained reserves from the banking system over a longer time horizon than it might otherwise have.

However, this recommendation flies in the face of a half-century old consensus, dating at least to the Monetary History of the United States by Friedman and Schwartz, that a key factor in causing the 1937-38 downturn, a downturn shorter but almost as sharp as the 1929-33 downturn, was the doubling of reserve requirements in 1936-37. It was thought at the time that since the banking system was then holding very large amounts of excess reserves, raising reserve requirements would entail no tightening of monetary policy, instead just eliminating slack in the system, thereby making it easier to implement monetary policy. Calomiris acknowledges that his proposal resembles the proposal to increase reserve requirements in 1936-37, now viewed as a disastrous mistake, but maintains that the consensus that raising reserve requirements in 1936-37 led to the downturn of 1937-38 is itself mistaken.

In 1936-37 the Fed doubled reserve requirements as an insurance policy against inflation, and some monetary economists have argued that this contributed to the recession of 1937-38. But recent microeconomic analysis of bank reserve holdings by Joseph Mason, David Wheelock and me in a 2011 working paper available from the National Bureau of Economic Research showed that the higher reserve requirements were small relative to the banks’ pre-existing excess reserves and had no effect on interest rates or the availability of credit.

In their recent paper, Calomiris, Mason and Wheelock attribute the 1937-38 downturn mainly to a policy of sterilization of gold inflows undertaken by the Treasury starting in early 1937. Scott Sumner has similarly emphasized the sterilization policy as a key factor in causing the downturn by increasing the real value of gold, a deflationary shock in the quasi-gold standard monetary regime of the time, with gold convertibility suspended but with gold still playing a very important role in the international monetary system. Doug Irwin has also attributed the 1937-38 downturn to the gold sterilization policy in his recent paper on the subject, and even Friedman and Schwartz in the Monetary History ascribed about as much importance to gold sterilization as they did to the increase in reserve requirements. So Calomiris’s argument that doubling reserve requirements in 1936-37 was not the cause of the 1937-38 downturn is not quite as far out of the mainstream as it seems at first. Nevertheless, Scott Sumner is very critical of Calomiris’s historical argument about the 1937-38 downturn and about his current policy proposal for launching a pre-emptive strike against the gathering inflationary threat.

Now I must admit that I am not that well-informed about the 1937-38 downturn, more or less accepting at face value what I learned as an undergraduate, second-hand from Friedman and Schwartz, that it was the doubling of reserve requirements that caused the problems. While I have come to reject much of what Friedman and Schwartz had to say about 1929-33, until I read what Scott Sumner wrote in his unpublished work on the Great Depression about the role of gold in the 1937-38 downturn, it never occurred to me that there might be more to the 1937-38 episode than the doubling of reserve requirements. I’m also now aware if Hawtrey wrote anything about the 1937-38 downturn, though it would actually be pretty surprising if he did not. So, I now have something new to think about. How nice.

So here’s the first thing to cross my mind. Doubling reserve requirements increased the demand for reserves by the banking system. Calomiris et al. deny that increasing reserve requirements raised the demand for reserves, relying on regression estimates of the demand for reserves over 1934-35, which they use to simulate the demand for reserves in 1936-37, finding that there is little unexplained residual left to be attributed to the effect of increased reserve requirements. I still don’t understand the argument, so I can’t say that they are wrong. But it seems to me that if doubling reserve requirements did increase the demand for reserves, as I would expect to have happened, the consequence of the excess demand for reserves would be an influx of gold imports, which is just what happened. However, the policy of gold sterilization prevented the banks from increasing their holdings of reserves. The ongoing excess demand for reserves was translated into an ongoing increase in the demand for gold, causing an increase in its value and a drop in prices as long as the dollar price of gold remained stable. Thus, there was an underlying connection between the doubling of reserve requirements and the sterilization policy, a possibility that Calomiris seems to have overlooked.

Brad Delong Likes Bagehot and Minsky Better than Hawtrey and Cassel

Published March 2, 2012 Cassel , gold standard , Hawtrey , Keynes , monetary history 13 Comments

It seems as if Brad DeLong can’t get enough of me, because he just quoted at length from my post about Keynes and Hayek even though he already quoted at length from the same post a month ago. So, even though Brad and I don’t seem to be exactly on the same page, as you can tell from the somewhat snarky title of his most recent post, I take all this attention that he is lavishing on me as evidence that I must be doing something right.

After his long quote from my post, Brad makes the following comment:

As I have said before, IMHO Cassel and Hawtrey see a lot but also miss a lot. The Bagehot-Minsky and the Wicksell-Kahn traditions have a lot to add as well. And Friedman was a very effective popularizer of most of what you can get from Cassel and Hawtrey.

But, as I have said before, those of us who learned this stuff from Blanchard, Dornbusch, Eichengreen, and Kindleberger–who made us read Bagehot, Minsky, Wicksell, Metzler, and company–have a huge intellectual advantage over others.

I left a reply to Brad on his site, (which, as I write this, is still awaiting moderation so I can’t reproduce it here); the main point I made was that Hawtrey (who coined the term “inherent instability of credit”) was not outside the Bagehot-Minsky tradition, or, having invented the fiscal-multiplier analysis before Richard Kahn did (as documented by Robert Dimand), and having relied extensively on the concept of a natural rate of interest in most of his monetary writings, was he outside the Wicksell-Kahn tradition. But, while acknowledged the importance of the two traditions that Brad mentions and Hawtrey’s affinity with those traditions, I maintain that those traditions are not all that relevant to an understanding of the Great Depression, which was not a typical cyclical depression of the kind that those two traditions are primarily concerned with. The Great Depression, unlike “normal” cyclical depressions, was driven by powerful worldwide deflationary impulse associated with the dysfunctional attempt to restore the gold standard as an international system after World War I. Hawtrey and Cassel understood the key role played by the demand for gold in causing the Great Depression. That is why Brad’s reference to Friedman’s popularization “of most of what you can get from Cassel and Hawtrey” is really off the mark. Friedman totally missed the role of the gold standard and the demand for gold in precipitating the Great Depression. And Friedman’s failure — either from ignorance or lack of understanding — to cite the work of Hawtrey and Cassel in any of his writings on the Great Depression was an inexcusable lapse of scholarship.

Daniel Kuehne picks up on Brad’s post with one of his own, defending Keynes against my criticisms of the General Theory. Daniel points out that Keynes was aware of and adopted many of the same criticisms of the policy of the Bank of France that Hawtrey had made. That’s true, but the full picture is more complicated than either Daniel or I have indicated. Perhaps I will try to elaborate on that in a future post.

Hawtrey on Competitive Devaluation: Bring It On

Published February 28, 2012 gold standard , Hawtrey , inflation , monetary history , monetary policy , monetary theory 18 Comments

In a comment on my previous post about Ralph Hawtrey’s discussion of the explosive, but short-lived, recovery triggered by FDR’s 1933 suspension of the gold standard and devaluation of the dollar, Greg Ransom queried me as follows:

Is this supposed to be a lesson in international monetary economics . . . or a lesson in closed economy macroeconomics?

To which I responded:

I don’t understand your question. The two are not mutually exclusive; it could be a lesson in either.

To which Greg replied:

I’m pushing you David to make a clearer and cleaner claim about what sort of monetary disequilibrium you are asserting existed in the 1929-1933 period, is this a domestic disequilibrium or an international disequilibrium — or are these temprary effects any nation could achieve via competitive devaluations of the currency, i.e. improving the terms of international trade via unsustainable temporary monetary policy.

Or are a ping pong of competitive devaluations among nations a pure free lunch?

And if so, why?

You can read my response to Greg in the comment section of my post, but I also mentioned that Hawtrey had addressed the issue of competitive devaluation in Trade Depression and the Way Out, hinting that another post discussing Hawtrey’s views on the subject might be in the offing. So let me turn the floor over to Mr. R. G. Hawtrey.

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.

In consequence of the competitive advantage gained by a country’s manufacturers from a depreciation of its currency, any such depreciation is only too likely to meet with recriminations and even retaliation from its competitors. . . . Fears are even expressed that if one country starts depreciation, and others follow suit, there may result “a competitive depreciation” to which no end can be seen.

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)

So yes, Greg, competitive devaluation is a free lunch. Bring it on.

Hawtrey on the Short but Sweet 1933 Recovery

Published February 23, 2012 gold standard , Hawtrey , inflation , monetary policy 29 Comments

Here’s another little gem (pp. 65-66) from Ralph Hawtrey’s Trade Depression and the Way Out. He discusses the amazing revival of business in the depth of the Great Depression triggered by FDR’s suspension of the gold standard in March 1933 immediately after taking office. Despite the suspension of the gold standard, there was period of uncertainty lasting over a month because it was not clear whether FDR would trigger a devaluation and the Treasury Department was issuing licenses to export gold preventing the dollar from depreciating in the foreign exchange markets. It was not until April 19 that the Secretary of the Treasury declined to issue any more licenses.

A license was a device for sustaining the value of the dollar. It was an instrument of torture designed to inflict further distress on a suffering nation. The pen refused to write the signature. No licenses were to be granted.

At once the dollar fell. The discount soon exceeded 10%. The suspension of the gold standard had become a reality.

The impulse given towards the revival of industry was instantaneous. It was like the magic change of spirit that seized the Allied line at Waterloo late in the afternoon, when there passed through the French ranks the terrible murmur “the Guard is giving way,” and the cohesion of their onset was at last loosened. . . . The eagles (258 grains, nine-tenths fine) were in full retreat.

Manufacturers pressed forward to fulfill a stream of orders such as they had not known for years. Wheat and corn, cotton, silk and wool, non-ferrous metals, rubber, almost every primary product found increased sales at higher prices. The steel industry, which at one time in March had been working at 15% of capacity rose in three months to 59%. The consumption of rubber in June exceeded the highest monthly totals of 1929. The index of manufacturing production, which relapsed from 66 in September 1932 to 57 in March 1933, advanced to 99 in July 1933, the highest since May 1930. The index of factory employment rose from 56.6 in March to 70.1 in July, and that of factory payrolls from 36.9 to 49.9. The Department of Labour Price Index rose from 59.8 in February 1933 to 69.7 on the 22^nd July, the Farm Products group rising in the same period from 40.9 to 62.7.

This revival was a close parallel to that which occurred in Great Britain after the suspension of the gold standard in September 1931. On that occasion bank rate was put up to 6%, and renewed deflation and depression followed. In the United States, on the other hand, not only was cheap money continued (the 3% rediscount rate in New York being completely ineffective), but wide and unprecedented powers were conferred on the President with a view to a policy of inflation being carried out. . . .

For a month the depreciation of the dollar had no other source than in the minds of the market. The Administration quite clearly and certainly intended the dollar to fall, and every one dealing in the market was bound to take account of that intention. Towards the end of May the Federal Reserve Banks began to buy securities. By the end of June they had increased their holding of Government securities from $1,837,000,000 to $1,998,000,000, and the dollar was at a discount of more than 20%. The New York rediscount rate was reduced from 3% to 2.5% on the 26^th May, and even the lower rate remained completely ineffective.

In July, however, the open market purchases slackened off. And other circumstances contributed to check the progress of depreciation. . . . Above all, on the 20^th July, a plan for applying the minimum wages and maximum hours of the National Industrial Recovery Act throughout the whole range of American industry and trade without delay was put forward by the Administration. Profits were threatened.

The discount on the dollar had reached 30% on the 10^th July, but, from the 20^th July, it met with a rapid and serious reaction. There were fluctuations, but the discount did not again touch 30% till the middle of September. And the recovery of business was likewise interrupted.

There was some tendency to regard the policy of minimum wages and maximum hours as an alternative to monetary depreciation as a remedy for the depression.

It’s instructive to compare Hawtrey’s account of the effects of the devaluation of April 1933 with the treatment by Friedman and Schwartz in their Monetary History of the US (pp. 462-69) which treats the devaluation as a minor event. A subsequent discussion pp. 493-98 fails to draw attention to the remarkable recovery triggered over night by the devaluation of the dollar, and inexplicably singles out a second-order effect – increased production in anticipation of cost increases imposed by the anticipated enactment of the National Industrial Recovery Act – while ignoring the direct effect of enhanced profitability resulting from the depreciation of the dollar.

The revival was initially erratic and uneven. Reopening of the banks was followed by a rapid spurt in personal income and industrial production (see Chart 37). The spurt was intensified by production in anticipation of the codes to be established under the National Industrial Recovery Act (passed June 16, 1933), which were expected to raise wage rates and prices, and did. A relapse in the second half of 1933 was followed by another spurt in early 1934 and then a further relapse. A sustained and reasonably continuous rise in income and production did not get under way until late 1934.

This is an example of how Friedman’s obsession with the quantity theory, meaning that the quantity of money was always the relevant policy variable blinded him from recognizing that devaluation of the dollar in and of itself could raise the price level and provide the stimulus to profits and economic activity necessary to lift the economy from the depths of a depression. The name Hawtrey appears only once in the Monetary History in a footnote on p. 99 citing Hawtrey’s A Century of Bank Rate in connection with the use of Bank rate by the Bank of England to manage its reserve position. Cassel is not cited once. To my knowledge, Friedman did not cite Hawtrey in any of his works on the Great Depression.

Hawtrey on the Interwar Gold Standard

Published February 22, 2012 gold standard , Hawtrey , monetary history , monetary policy 37 Comments

I just got a copy of Ralph Hawtrey’s Trade Depression and the Way Out (1933 edition, an expanded version of the first, 1931, edition published three days before England left the gold standard). Just flipping through the pages, I found the following tidbit on p. 9.

The banking system of the world, as it was functioning in 1929, was regulated by the gold standard. Formerly the gold standard used to mean the use of money made of gold. Gold coin was used as a hand-to-hand medium of payment. Nowadays the gold standard means in most countries the use of money convertible into gold. The central bank is required to exchange paper money into gold and gold into paper money at a fixed rate. The currency of any gold-standard country is convertible into gold, and the gold is convertible into the currency of any other gold-standard country. Thus the currencies of any two gold-standard countries are convertible into one another at no greater cost than is involved in sending gold from one country to the other.

Thus, for Hawtrey, the key formal difference between the interwar and the prewar gold standards was that gold coins were did not circulate as hand-to-hand money in the interwar gold standard (hence the reference to gold exchange standard), gold coins having been withdrawn almost universally from circulation during World War I to enable the belligerent governments to control the monetary reserves they needed to obtain war supplies. A huge fraction of the demonetized gold coins wound up in the possession of the United States government or the Federal Reserve Bank of New York in payment for US exports, though an even greater amount of US exports were financed by loans to the allies. By war’s end, the US had accumulated a staggering 40% of the world’s monetary gold reserves. Many people casually distinguish between the prewar and the interwar gold standards without specifying what exactly accounts for the difference. There is no reason to think that the absence of gold coinage makes any significant difference in how the gold standard operated. David Ricardo, as committed a defender of the gold standard as ever lived, had proposed abolishing gold coinage (to be replaced entirely by convertible banknotes and token coins) in his 1816 Proposals for an Economical and Secure Currency. Thanks to the demonetization of gold coins during World War I, there was a huge increase in the world’s total stock of gold reserves in the hands of the central banks. Exactly how that affected the subsequent operation of the gold standard is never made clear. There may have been increased obstacles placed on the redemption of gold or the exchange of different currencies, but that is just conjecture on my part.

Back to Hawtrey:

Gold is a commodity with other uses than as money. But it would be a mistake to suppose that it therefore provides an independent standard of value. The industrial demand for gold throughout the world is insignificant in comparison with the demand for it as money. It is only a fraction of the annual output, and the annual output is only about 4% of the total stock held by the central banks and currency authorities of the world in their reserves. The market for gold consists of the purchases of the central banks from the mines and from one another. It is by their action that the value of gold in terms of other forms of wealth is determined.

The key point which bears repeating again and again is that under a gold standard, there is no assurance that the value of money will be stable in the absence of action taken by the monetary authorities to maintain its value. If a gold standard were to be restored, I have no idea how the demand for gold would be affected. The value of gold (in the short to intermediate run and perhaps even the long run) depends, more than anything, on the demand for gold. Gold is now a speculative asset; people hold gold now because they for some reason (unfathomable to me) believe that it will appreciate over time. If the value of gold were fixed in nominal terms by way of a gold standard, would people continue to demand gold in anticipation that its price would rise? Perhaps, but I don’t think so. And what do supporters of the gold standard believe that governments and monetary authorities, which now hold about almost 20% of existing gold stocks, ought to be done with those reserves? Do they think that governments and public agencies ought to continue to hold gold simply to stabilize the value of gold? Is that how the free market is supposed to determine the value of money?

Am I Being Unfair to the Gold Standard?

Published February 12, 2012 Cassel , gold standard , Hawtrey , Hayek , monetary policy , monetary theory 38 Comments

Kurt Schuler takes me (among others) to task in a thoughtful post on the Free-Banking blog for being too harsh in my criticisms of the gold standard, in particular in blaming the gold standard for the Great Depression, when it was really the misguided policies of central banks that were at fault.

Well, I must say that Kurt is a persuasive guy, and he makes a strong case for the gold standard. And, you know, the gold standard really wasn’t fatally flawed, and if the central banks at the time had followed better policies, the gold standard might not have imploded in the way that it did in the early 1930s. So, I have to admit that Kurt is right; the Great Depression was not the inevitable result of the gold standard. If the world’s central banks had not acted so unwisely – in other words, if they had followed the advice of Hawtrey and Cassel about limiting the monetary demand for gold — if the Bank of France had not gone insane, if Benjamin Strong, Governor of the New York Federal Reserve Bank, then the de facto policy-making head of the entire Federal Reserve System, had not taken ill in 1928 and been replaced by the ineffectual George L. Harrison, the Great Depression might very well have been avoided.

So was I being unfair to the gold standard? OK, yes, I admit it, I was being unfair. Gold standard, you really weren’t as bad as I said you were. The Great Depression was really not all your fault. There, I’m sorry if I hurt your feelings. But, do I want to see you restored? No way! At least not while the people backing you are precisely those who, like Hayek, in his 1932 lament for the gold standard defending the insane Bank of France against accusations that it caused the Great Depression, hold Hawtrey and Cassel responsible for the policies that caused the Great Depression. If those are the ideas motivating your backers to want to restore you as a monetary standard, I find the prospect of your restoration pretty scary — as in terrifying.

Now, Kurt suggests that people Ron Paul are not so scary, because all Ron Paul means when he says he wants to restore the gold standard is that the Federal Reserve System be abolished. With no central bank, it will be left up to the market to determine what will serve as money. Here is how Kurt describes what would happen.

If people want the standard to be gold, that’s what free banks will offer to attract their business. But if people want the standard to be silver, copper, a commodity basket, seashells, or cellphone minutes, that’s what free banks will offer. Or if they want several standards side by side, the way that multiple computer operating systems exist side by side, appealing to different niches, that’s what free banks will offer. A pure free banking system would also give people the opportunity to change standards at any time. Historically, though, many free banking systems have used the gold standard, and it is quite possible that gold would re-emerge against other competitors as the generally preferred standard.

Now that’s pretty scary – as in terrifying – too. As I suggested in arecent post, the reason that people in some places, like London, for instance, seem to agree readily on what constitutes money, even without the operation of legal tender laws, is that there are huge advantages to standardization. Economists call these advantages network effects, or network externalities. The demand to use a certain currency increases as other people use it, just as the demand to use a computer operating system or a web browser increases as the number of people already using it increases. Abolishing the dollar as we know it, which is what Kurt’s scenario sounds like to me, would annihilate the huge network effects associated with using the dollar, thereby forcing us to go through an uncertain process of indefinite length to recapture those network effects without knowing how or where the process would end up. If we did actually embark on such a process, there is indeed some chance, perhaps a good chance, that it would lead in the end to a gold standard.

Would a gold standard associated with a system of free banking — without the disruptive interference of central banks — work well? There are strong reasons to doubt that it would. For starters, we have no way of knowing what the demand of such banks to hold gold reserves would be. We also have no way of knowing what would happen to the gold holdings of the US government if the Federal Reserve were abolished. Would the US continue to hold gold reserves if it went out of the money creation business? I have no idea. Thus, the future value of gold in a free-banking system is thus completely unpredictable. What we do know is that under a fractional reserve system, the demand for reserves by the banking system tends to be countercyclical, going up in recessions and going down in expansions. But what tends to cause recessions is an increase in the demand of the public to hold money. So the natural cyclical path of a free-banking system under a gold standard would be an increasing demand for money in recessions, associated with an increasing monetary demand for gold by banks as reserves, causing an increase in the value of gold and a fall in prices. Recessions are generally characterized by declining real interest rates produced by depressed profit expectations. Declining real interest rates increase the demand for an asset like gold under the gold standard with a fixed nominal value, so both the real and the monetary demand for gold would increase in recessions, causing recessions to be deflationary. Recessions with falling asset prices and rising unemployment and, very likely, an increasing number of non-performing loans would impair the profitability and liquidity of banks, perhaps threatening the solvency of at least some banks as well, thereby inducing holders of bank notes and bank deposits to try to shift from holding bank notes and bank deposits to holding gold.

A free-banking system based on a gold standard is thus likely to be subject to a shift in demand from holding bank money to holding gold, when it is least able to accommodate such a shift, making a free-banking system based on a gold standard potentially vulnerable to a the sort of vicious deflationary cycle that characterized the Great Depression. The only way out of such a cycle would be to suspend convertibility. Such suspensions might or might not be tolerated, but it is not at all clear whether or how a mechanism to trigger such a suspension could be created. Insofar as such suspensions were expected, the mere anticipation of a liquidity problem might be sufficient to trigger a shift in demand away from holding bank money toward holding gold, thereby forcing a suspension of convertibility. Chronic suspensions of convertibility would tend to undermine convertibility.

In short, there is a really serious problem inherent in any banking system in which the standard is itself a medium of exchange. The very fact that gold is money means that, in any fractional reserve system based on gold, there is an inherent tendency for the system to implode when there is a loss of confidence in bank money that causes a shift in demand from bank money to gold. In principle, what would be most desirable is a system in which the monetary standard is not itself money. Alternatively, the monetary standard could be an asset whose supply may be increased without limit to meet an increase in demand, an asset like, you guessed it, Federal Reserve notes and reserves. But that very defect is precisely what makes the Ron Pauls of this world think that the gold standard is such a wonderful idea. And that is a scary — as in terrifying — thought.

Ludwig von Mises and the Great Depression

Published February 10, 2012 Cassel , gold standard , Hawtrey , Hayek , monetary history , monetary theory 54 Comments

Many thanks to gliberty who just flagged for me a piece by Mark Spitznagel in today’s (where else?) Wall Street Journal about how Ludwig von Mises, alone among the economists of his day, foresaw the coming of the Great Depression, refusing the offer of a high executive position at the Kredit-Anstalt, Austria’s most important bank, in the summer of 1929, because, as he put it to his fiancée (whom he did not marry till 1938 just before escaping the Nazis), “a great crash is coming, and I don’t want my name in any way connected with it.” Just how going to work for the Kredit Anstalt would have led to Mises’s name being associated with the crash (the result, in Mises’s view, of the inflationary policy of the US Federal Reserve) is left unclear. But it’s such a nice story.

Ludwig von Mises was an extremely well-read and diligent economist, who had some extraordinary insights into economics and business and politics. As a result he made some important contributions to economics, most important the discovery that idea of a fully centrally planned economy is not just an impossibility, it is incoherent. He made other contributions to economics as well, but that insight, perhaps also perceived by Max Weber, was first spelled out and explained by Mises in his book Socialism. That contribution alone is enough to ensure Mises an honorable place in the history of economic thought.

Mises also perceived how the monetary theory of Knut Wicksell, based on a distinction between a market and a natural rate of interest, could be combined with the Austrian theory of capital, developed by his teacher Eugen von Bohm-Bawerk into a theory of business cycles. Von Mises is therefore justly credited with being the father of Austrian business-cycle theory. His own development of the theory was somewhat sketchy, and it was his student F. A. Hayek, who made the great intellectual effort of trying to work out the detailed steps in the argument by which monetary expansion would alter the structure of capital and production, leading to a crisis when the monetary expansion was halted or reversed.

Relying on their newly developed theory of business cycles, Mises and Hayek warned in the late 1920s that the decision of the Federal Reserve to reduce interest rates in 1927, when it appeared that the US economy could be heading into a recession, would distort the structure of production and lead eventually to an even worse downturn than the one the Fed avoided in 1927. That was the basis for Mises’s “prediction” of a “crash” ahead of the Great Depression.

Of course, as I have pointed out previously, Mises and Hayek were not the only ones to have predicted that there could be a downturn. R.G. Hawtrey and Gustav Cassel had been warning about that danger since 1919, should an international return to the gold standard not be managed properly, failing to prevent a rapid deflationary increase in the international monetary demand for gold. When the insane Bank of France began accumulating gold at a breathtaking rate in 1928, and the US reversed its monetary stance in late 1928 and itself began accumulating gold, Hawtrey and Cassel recognized the potential for disaster and warned of the disastrous consequences of the change in Federal Reserve policy.

So Mises and Hayek were not alone in their prediction of a crash; Hawtrey and Cassel were also warning of a looming disaster, and were doing so on the basis of a theory that was both more obvious and more relevant to the situation than theory with which Mises and Hayek were working, a theory that, even giving it the benefit of every doubt, could not possibly have predicted a downturn even remotely approaching the severity of the 1929-31 downturn. Indeed, as I have also pointed out, the irrelevance of the Mises and Hayek “explanation” of the Great Depression is perfectly illustrated by Hayek’s 1932 defense of the insane Bank of France, showing a complete misunderstanding of the international adjustment mechanism and the disastrous consequences of the gold accumulation policy of the insane Bank of France.

Mr. Spitznagel laments that the economics profession somehow ignored Ludwig von Mises. Actually, they didn’t. Some of the greatest economists of the twentieth century were lapsed believers in the Austrian business-cycle theory. A partial list would include, Mises’s own students, Gottfried Haberler and Fritz Machlup; it would include Hayek’s dear friend and colleague, Lionel Robbins who wrote a book on the Great Depression eloquently explaining it in terms of the Austrian theory in a way that even Mises might have approved, a book that Robbins later repudiated and refused to allow to be reprinted in his lifetime (but you can order a new edition here); it would include Hayek’s students, Nobel Laureate J.R. Hicks, Nicholas Kaldor, Abba Lerner, G.L.S. Shackle, and Ludwig Lachmann (who sought a third way incorporating elements of Keynesian and Austrian theory). Hayek himself modified his early views in important ways and admitted that he had given bad policy advice in the 1930s. The only holdout was Mises himself, joined in later years after his arrival in America by a group of more doctrinaire (with at least one notable exception) disciples than Mises had found in Vienna in the 1920s and 1930s. The notion that Austrian theory was ignored by the economics profession and has only lately been rediscovered is just the sort of revisionist history that one tends to find on a lot of wacko Austro-libertarian websites like Lewrockwell.org. Apparently the Wall Street Journal editorial page is providing another, marginally more respectable, venue for such nonsense. Rupert, you’re doing a heckuva job.

« Previous Page — Next Page »

About Me

David Glasner
Washington, DC

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

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

Follow me on Twitter @david_glasner

Uneasy Money