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The Real-Bills Doctrine, the Lender of Last Resort, and the Scope of Banking

Here is another section from my work in progress on the Smithian and Humean traditions in monetary economics. The discussion starts with a comparison of the negative view David Hume took toward banks and the positive view taken by Adam Smith which was also discussed in the previous post on the price-specie-flow mechanism. This section discusses how Smith, despite viewing banks positively, also understood that banks can be a source of disturbances as well as of efficiencies, and how he addressed that problem and how his followers who shared a positive view toward banks addressed the problem. Comments and feedback are welcome and greatly appreciated.

Hume and Smith had very different views about fractional-reserve banking and its capacity to provide the public with the desired quantity of money (banknotes and deposits) and promote international adjustment. The cash created by banks consists of liabilities on themselves that they exchange for liabilities on the public. Liabilities on the public accepted by banks become their assets, generating revenue streams with which banks cover their outlays including obligations to creditors and stockholders.

The previous post focused on the liability side of bank balance sheets, and whether there are economic forces that limit the size of those balance sheets, implying a point of equilibrium bank expansion. Believing that banks have an unlimited incentive to issue liabilities, whose face value exceeds their cost of production, Hume considered banks dangerous and inflationary. Smith disagreed, arguing that although bank money is a less costly alternative to the full-bodied money preferred by Hume, banks don’t create liabilities limitlessly, because, unless those liabilities generate corresponding revenue streams, they will be unable to redeem those liabilities, which their creditors may require of them, at will. To enhance the attractiveness of those liabilities and to increase the demand to hold them, competitive banks promise to convert those liabilities, at a stipulated rate, into an asset whose value they do not control. Under those conditions, banks have neither the incentive nor the capacity to cause inflation.

I turn now to a different topic: whether Smith’s rejection of the idea that banks are systematically biased toward overissuing liabilities implies that banks require no external control or intervention. I begin by briefly referring to Smith’s support of the real-bills doctrine and then extend that discussion to two other issues: the lender of last resort and the scope of banking.

A Real-Bills Doctrine

I have argued elsewhere that, besides sketching the outlines of Fullarton’s argument for the Law of Reflux, Adam Smith recommended that banks observe a form of the real-bills doctrine, namely that banks issue sight liabilities only in exchange for real commercial bills of short (usually 90-days) duration. Increases in the demand for money cause bank balance sheets to expand; decreases cause them to contract. Unlike Mints (1945), who identified the Law of Reflux with the real-bills doctrine, I suggested that Smith viewed the real-bills doctrine as a pragmatic policy to facilitate contractions in the size of bank balance sheets as required by the reflux of their liabilities. With the discrepancy between the duration of liabilities and assets limited by issuing sight liabilities only in exchange for short-term bills, bank balance sheets would contract automatically thereby obviating, at least in part, the liquidation of longer-term assets at depressed prices.

On this reading, Smith recognized that banking policy ought to take account of the composition of bank balance sheets, in particular, the sort of assets that banks accept as backing for the sight liabilities that they issue. I would also emphasize that on this interpretation, Smith did not believe, as did many later advocates of the doctrine, that lending on the security of real bills is sufficient to prevent the price level from changing. Even if banks have no systematic incentive to overissue their liabilities, unless those liabilities are made convertible into an asset whose value is determined independently of the banks, the value of their liabilities is undetermined. Convertibility is how banks anchor the value of their liabilities, thereby increasing the attractiveness of those liabilities to the public and the willingness of the public to accept and hold them.

But Smith’s support for the real-bills doctrine indicates that, while understanding the equilibrating tendencies of competition on bank operations, he also recognized the inherent instability of banking caused by fluctuations in the value and liquidity of their assets. Smith’s support for the real-bills doctrine addressed one type of instability: the maturity mismatch between banks’ assets and liabilities. But there are other sources of instability, which may require further institutional or policy measures beyond the general laws of property and contract whose application and enforcement, in Smith’s view, generally sufficed for the self-interested conduct of private firms to lead to socially benign outcomes.

In the remainder of this section, I consider two other methods of addressing the vulnerability of bank assets to sudden losses of value: (1) the creation or empowerment of a lender of last resort capable of lending to illiquid, but solvent, banks possessing good security (valuable assets) as collateral against which to borrow, and (2) limits beyond the real-bills doctrine over the permissible activities undertaken by commercial banks.

B Lender of Last Resort

Although the real-bills doctrine limits the exposure of bank balance sheets to adverse shocks on the value of long-term liabilities, even banks whose liabilities were issued in exchange for short-term real bills of exchange may be unable to meet all demands for redemption in periods of extreme financial distress, when debtors cannot sell their products at the prices they expected and cannot meet their own obligations to their creditors. If banks are called upon to redeem their liabilities, banks may be faced with a choice between depleting their own cash reserves, when they are most needed, or liquidating other assets at substantial, if not catastrophic, losses.

Smith’s version of the real-bills doctrine addressed one aspect of balance-sheet risk, but the underlying problem is deeper and more complicated than the liquidity issue that concerned Smith. The assets accepted by banks in exchange for their liabilities are typically not easily marketable, so if those assets must be shed quickly to satisfy demands for payment, banks’ solvency may be jeopardized by consequent capital losses. Limiting portfolios to short-term assets limits exposure to such losses, but only when the disturbances requiring asset liquidation affect only a relatively small number of banks. As the number of affected banks increases, their ability to counter the disturbance is impaired, as the interbank market for credit starts to freeze up or break down entirely, leaving them unable to offer short-term relief to, or receive it from, other momentarily illiquid banks. It is then that emergency lending by a lender of last resort to illiquid, but possibly still solvent, banks is necessary.

What causes a cluster of expectational errors by banks in exchanging their liabilities for assets supplied by their customers that become less valuable than they were upon acceptance? Are financial crises that result in, or are caused by, asset write downs by banks caused by random clusters of errors by banks, or are there systematic causes of such errors? Does the danger lie in the magnitude of the errors or in the transmission mechanism?

Here, too, the Humean and Smithian traditions seem to be at odds, offering different answers to problems, or, if not answers, at least different approaches to problems. Focusing on the liability side of bank balance sheets, the Humean tradition emphasizes the expansion of bank lending and the consequent creation of banknotes or deposits as the main impulse to macroeconomic fluctuations, a boom-bust or credit cycle triggered by banks’ lending to finance either business investment or consumer spending. Despite their theoretical differences, both Austrian business-cycle theory and Friedmanite Monetarism share a common intellectual ancestry, traceable by way of the Currency School to Hume, identifying the source of business-cycle fluctuations in excessive growth in the quantity of money.

The eclectic Smithian tradition accommodates both monetary and non-monetary business-cycle theories, but balance-sheet effects on banks are more naturally accommodated within the Smithian tradition than the Humean tradition with its focus on the liabilities not the assets of banks. At any rate, more research is necessary before we can decide whether serious financial disturbances result from big expectational errors or from contagion effects.

The Great Depression resulted from a big error. After the steep deflation and depression of 1920-22, followed by a gradual restoration of the gold standard, fears of further deflation were dispelled and steady economic expansion, especially in the United States, resulted. Suddenly in 1929, as France and other countries rejoined the gold standard, the fears voiced by Hawtrey and Cassel that restoring the gold standard could have serious deflationary consequences appeared increasingly more likely to be realized. Real signs of deflation began to appear in the summer of 1929, and in the fall the stock market collapsed. Rather than use monetary policy to counter incipient deflation, policy makers and many economists argued that deflation was part of the solution not the problem. And the Depression came.

It is generally agreed that the 2008 financial crisis that triggered the Little Depression (aka Great Recession) was largely the result of a housing bubble fueled by unsound mortgage lending by banks and questionable underwriting practices in packaging and marketing of mortgage-backed securities. However, although the housing bubble seems to have burst the spring of 2007, the crisis did not start until September 2008.

It is at least possible, as I have argued (Glasner 2018) that, despite the financial fragility caused by the housing bubble and unsound lending practices that fueled the bubble, the crisis could have been avoided but for a reflexive policy tightening by the Federal Reserve starting in 2007 that caused a recession starting in December 2007 and gradually worsening through the summer of 2008. Rather than ease monetary policy as the recession deepened, the Fed, distracted by rising headline inflation owing to rising oil prices that summer, would not reduce its interest-rate target further after March 2008. If my interpretation is correct, the financial crisis of 2008 and the subsequent Little Depression (aka Great Recession) were as much caused by bad monetary policy as by the unsound lending practices and mistaken expectations by lenders.

It is when all agents are cash constrained that a lender of last resort that is able to provide the liquidity that the usual suppliers of liquidity cannot provide, but are instead demanding, is necessary to avoid a systemic breakdown. In 2008, the Fed was unwilling to satisfy demands for liquidity until the crisis had deteriorated to the point of a worldwide collapse. In the nineteenth century, Thornton and Fullarton understood that the Bank of England was uniquely able to provide liquidity in such circumstances, recommending that it lend freely in periods of financial stress.

That policy was not viewed favorably either by Humean supporters of the Currency Principle, opposed to all forms of fractional-reserve banking, or by Smithian supporters of free banking who deplored the privileged central-banking position granted to the Bank of England. Although the Fed in 2008 acknowledged that it was both a national and international lender of last resort, it was tragically slow to take the necessary actions to end the crisis after allowing it to spiral nearly out of control.

While cogent arguments have been made that a free-banking alternative to the lender-of-last-resort services of the Bank of England might have been possible in the nineteenth century,[2] even a free-banking system would require a mechanism for handling periods of financial stress. Free-banking supporters argue that bank clearinghouses have emerged spontaneously in the absence of central banks, and could provide the lender-of-last resort services provided by central banks. But, insofar as bank clearinghouses would take on the lender-of-last-resort function, which involves some intervention and supervision of bank activities by either the clearinghouse or the central bank, the same anticompetitive or cartelistic objections to the provision of lender-of-last-resort services by central banks also would apply to the provision of those services by clearinghouses. So, the tension between libertarian, free-market principles and lender-of-last-resort services would not necessarily be eliminated bank clearinghouses instead of central banks provided those services.

This is an appropriate place to consider Walter Bagehot’s contribution to the lender-of-last-resort doctrine. Building on the work of Thornton and Fullarton, Bagehot formulated the classic principle that, during times of financial distress, the Bank of England should lend freely at a penalty rate to banks on good security. Bagehot, himself, admitted to a certain unease in offering this advice, opining that it was regrettable that the Bank of England achieved a pre-eminent position in the British banking system, so that a decentralized banking system, along the lines of the Scottish free-banking system, could have evolved. But given the historical development of British banking, including the 1844 Bank Charter Act, Bagehot, an eminently practical man, had no desire to recommend radical reform, only to help the existing system operate as smoothly as it could be made to operate.

But the soundness of Bagehot’s advice to lend freely at a penalty rate is dubious. In a financial crisis, the market rate of interest primarily reflects a liquidity premium not an expected real return on capital, the latter typically being depressed in a crisis. Charging a penalty rate to distressed borrowers in a crisis only raises the liquidity premium. Monetary policy ought to aim to reduce, not to increase, that premium. So Bagehot’s advice, derived from a misplaced sense of what is practical and prudent and financially sound, rather than from sound analysis, was far from sound.

Under the gold standard, or under any fixed-exchange-rate regime, a single country has an incentive to raise interest rates above the rates of other countries to prevent a gold outflow or attract an inflow. Under these circumstances, a failure of international cooperation can lead to competitive rate increases as monetary authorities scramble to maintain or increase their gold reserves. In testimony to the Macmillan Commission in 1930, Ralph Hawtrey masterfully described the obligation of a central bank in a crisis. Here is his exchange with the Chairman of the Commission Hugh Macmillan:

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

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

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

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

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

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

Hawtrey here was echoing Fullarton’s insight that there is no rigid relationship between the gold reserves held by the Bank of England and the total quantity of sight liabilities created by the British banking system. Rather, he argued, the Bank should hold an ample reserve sufficient to satisfy the demand for gold in a crisis when a sudden and temporary demand for gold had to be accommodated. That was Hawtrey’s advice, but not Bagehot’s, whose concern was about banks’ moral hazard and imprudent lending in the expectation of being rescued in a crisis by the Bank of England. Indeed, moral hazard is a problem, but in a crisis it is a secondary problem, when, as Hawtrey explained, alleviating the crisis, not discouraging moral hazard, must be the primary concern of the lender of last resort.

C Scope of Banking

Inclined to find remedies for financial distress in structural reforms limiting the types of assets banks accept in exchange for their sight liabilities, Smith did not recommend a lender of last resort.[3] Another method of reducing risk, perhaps more in tune with the Smithian real-bills doctrine than a lender of last resort, is to restrict the activities of banks that issue banknotes and deposits.

In Anglophone countries, commercial banking generally evolved as separate and distinct from investment banking. It was only during the Great Depression and the resulting wave of bank failures that the combination of commercial and investment banking was legally prohibited by the Glass-Steagall Act, eventually repealed in 1999. On the Continent, where commercial banking penetrated less deeply into the fabric of economic and commercial life than in Anglophone countries, commercial banking developed more or less along with investment banking in what are called universal banks.

Whether the earlier, and more widespread, adoption of commercial banking in Anglophone countries than on the Continent advanced the idea that no banking institution should provide both commercial- and investment-banking services is not a question about which I offer a conjecture, but it seems a topic worthy of study. The Glass-Steagall Act, which enforced that separation after being breached early in the twentieth century, a breach thought by some to have contributed to US bank failures in the Great Depression, was based on a presumption against combining and investment-banking in a single institution. But even apart from the concerns that led to enactment of Glass-Steagall, limiting the exposure of commercial banks, which supply most of the cash held by the public, to the balance-sheet risk associated with investment-banking activities seems reasonable. Moreover, the adoption of government deposit insurance after the Great Depression as well as banks’ access to the discount window of the central bank may augment the moral hazard induced by deposit insurance and a lender of last resort, offsetting potential economies of scope associated with combining commercial and investment banking.

Although legal barriers to the combination of commercial and investment banking have long been eliminated, proposals for “narrow banking” that would restrict the activities undertaken by commercial banks continue to be made. Two different interpretations of narrow banking – one Smithian and one Humean – are possible.

The Humean concern about banking was that banks are inherently disposed to overissue their liabilities. The Humean response to the concern has been to propose 100-percent reserve banking, a comprehensive extension of the 100-percent marginal reserve requirement on the issue of banknotes imposed by the Bank Charter Act. Such measures could succeed, as some supporters (Simons 1936) came to realize, only if accompanied by a radical change the financial practices and arrangements on which all debt contracts are based. It is difficult to imagine that the necessary restructuring of economic activity would ever be implemented or tolerated.

The Humean concern was dismissed by the Smithian tradition, recognizing that banks, even if unconstrained by reserve requirements, have no incentive to issue liabilities without limit. The Smithian concern was whether banks could cope with balance-sheet risks after unexpected losses in the value of their assets. Although narrow banking proposals are a legitimate and possibly worthwhile response to that concern, the acceptance by central banks of responsibility to act as a lender of last resort and widespread government deposit insurance to dampen contagion effects have taken the question of narrowing or restricting the functions of money-creating banks off the table. Whether a different strategy for addressing the systemic risks associated with banks’ creation of money by relying solely on deposit insurance and a lender of last resort is a question that still deserves thoughtful attention.

On the Price Specie Flow Mechanism

Published January 30, 2021 Bank of France , David Hume , gold standard , Great Depression , Hawtrey , Hayek , Ludwig von Mises , Milton Friedman , price-specie-flow mechanism , sterilization 14 Comments

I have been working on a paper tentatively titled “The Smithian and Humean Traditions in Monetary Theory.” One section of the paper is on the price-specie-flow mechanism, about which I wrote last month in my previous post. This section develops the arguments of the previous post at greater length and draws on a number of earlier posts that I’ve written about PSFM as well (e.g., here and here )provides more detailed criticisms of both PSFM and sterilization and provides some further historical evidence to support some of the theoretical arguments. I will be grateful for any comments and feedback.

The tortured intellectual history of the price-specie-flow mechanism (PSFM) received its still classic exposition in a Hume (1752) essay, which has remained a staple of the theory of international adjustment under the gold standard, or any international system of fixed exchange rates. Regrettably, the two-and-a-half-century life span of PSFM provides no ground for optimism about the prospects for progress in what some are pleased to call without irony economic science.

PSFM describes how, under a gold standard, national price levels tend to be equalized, with deviations between the national price levels in any two countries inducing gold to be shipped from the country with higher prices to the one with lower prices until prices are equalized. Premised on a version of the quantity theory of money in which (1) the price level in each country on the gold standard is determined by the quantity of money in that country, and (2) money consists entirely in gold coin or bullion, Hume elegantly articulated a model of disturbance and equilibration after an exogenous change in the gold stock in one country.

Viewing banks as inflationary engines of financial disorder, Hume disregarded banks and the convertible monetary liabilities of banks in his account of PSFM, leaving to others the task of describing the international adjustment process under a gold standard with fractional-reserve banking. The task of devising an institutional framework, within which PSFM could operate, for a system of fractional-reserve banking proved to be problematic and ultimately unsuccessful.

For three-quarters of a century, PSFM served a purely theoretical function. During the Bullionist debates of the first two decades of the nineteenth century, triggered by the suspension of the convertibility of the pound sterling into gold in 1797, PSFM served as a theoretical benchmark not a guide for policy, it being generally assumed that, when convertibility was resumed, international monetary equilibrium would be restored automatically.

However, the 1821 resumption was followed by severe and recurring monetary disorders, leading some economists, who formed what became known as the Currency School, to view PSFM as a normative criterion for ensuring smooth adjustment to international gold flows. That criterion, the Currency Principle, stated that the total currency in circulation in Britain should increase or decrease by exactly as much as the amount of gold flowing into or out of Britain.[1]

The Currency Principle was codified by the Bank Charter Act of 1844. To mimic the Humean mechanism, it restricted, but did not suppress, the right of note-issuing banks in England and Wales, which were allowed to continue issuing notes, at current, but no higher, levels, without holding equivalent gold reserves. Scottish and Irish note-issuing banks were allowed to continue issuing notes, but could increase their note issue only if matched by increased holdings of gold or government debt. In England and Wales, the note issue could increase only if gold was exchanged for Bank of England notes, so that a 100-percent marginal gold reserve requirement was imposed on additional banknotes.

Opposition to the Bank Charter Act was led by the Banking School, notably John Fullarton and Thomas Tooke. Rejecting the Humean quantity-theoretic underpinnings of the Currency School and the Bank Charter Act, the Banking School rejected the quantitative limits of the Bank Charter Act as both unnecessary and counterproductive, because banks, obligated to redeem their liabilities directly or indirectly in gold, issue liabilities only insofar as they expect those liabilities to be willingly held by the public, or, if not, are capable of redeeming any liabilities no longer willingly held. Rather than the Humean view that banks issue banknotes or create deposits without constraint, the Banking School held Smith’s view that banks issue money in a form more convenient to hold and to transact with than metallic money, so that bank money allows an equivalent amount of gold to be shifted from monetary to real (non-monetary) uses, providing a net social savings. For a small open economy, the diversion (and likely export) of gold bullion from monetary to non-monetary uses has negligible effect on prices (which are internationally, not locally, determined).

The quarter century following enactment of the Bank Charter Act showed that the Act had not eliminated monetary disturbances, the government having been compelled to suspend the Act in 1847, 1857 and 1866 to prevent incipient crises from causing financial collapse. Indeed, it was precisely the fear that liquidity might not be forthcoming that precipitated increased demands for liquidity that the Act made it impossible to accommodate. Suspending the Act was sufficient to end the crises with limited intervention by the Bank. [check articles on the crises of 1847, 1857 and 1866.]

It may seem surprising, but the disappointing results of the Bank Charter Act provided little vindication to the Banking School. It led only to a partial, uneasy, and not entirely coherent, accommodation between PSFM doctrine and the reality of a monetary system in which the money stock consists mostly of banknotes and bank deposits issued by fractional-reserve banks. But despite the failure of the Bank Charter Act, PSFM achieved almost canonical status, continuing, albeit with some notable exceptions, to serve as the textbook model of the gold standard.

The requirement that gold flows induce equal changes in the quantity of money within a country into (or from) which gold is flowing was replaced by an admonition that gold flows lead to “appropriate” changes in the central-bank discount rate or an alternative monetary instrument to cause the quantity of money to change in the same direction as the gold flow. While such vague maxims, sometimes described as “the rules of the game,” gave only directional guidance about how to respond to change in gold reserves, their hortatory character, and avoidance of quantitative guidance, allowed monetary authorities latitude to avoid the self-inflicted crises that had resulted from the quantitative limits of the Bank Charter Act.

Nevertheless, the myth of vague “rules” relating the quantity of money in a country to changes in gold reserves, whose observance ensured the smooth functioning of the international gold standard before its collapse at the start of World War I, enshrined PSFM as the theoretical paradigm for international monetary adjustment under the gold standard.

That paradigm was misconceived in four ways that can be briefly summarized.

Contrary to PSFM, changes in the quantity of money in a gold-standard country cannot change local prices proportionately, because prices of tradable goods in that country are constrained by arbitrage to equal the prices of those goods in other countries.
Contrary to PSFM, changes in local gold reserves are not necessarily caused either by non-monetary disturbances such as shifts in the terms of trade between countries or by local monetary disturbances (e.g. overissue by local banks) that must be reversed or counteracted by central-bank policy.
Contrary to PSFM, changes in the national price levels of gold-standard countries were uncorrelated with gold flows, and changes in national price levels were positively, not negatively, correlated.
Local banks and monetary authorities exhibit their own demands for gold reserves, demands exhibited by choice (i.e., independent of legally required gold holdings) or by law (i.e., by legally requirement to hold gold reserves equal to some fraction of banknotes issued by banks or monetary authorities). Such changes in gold reserves may be caused by changes in the local demands for gold by local banks and the monetary authorities in one or more countries.

Many of the misconceptions underlying PSFM were identified by Fullarton’s refutation of the Currency School. In articulating the classical Law of Reflux, he established the logical independence of the quantity convertible money in a country from by the quantity of gold reserves held by the monetary authority. The gold reserves held by individual banks, or their deposits with the Bank of England, are not the raw material from which banks create money, either banknotes or deposits. Rather, it is their creation of banknotes or deposits when extending credit to customers that generates a derived demand to hold liquid assets (i.e., gold) to allow them to accommodate the demands of customers and other banks to redeem banknotes and deposits. Causality runs from creating banknotes and deposits to holding reserves, not vice versa.

The misconceptions inherent in PSFM and the resulting misunderstanding of gold flows under the gold standard led to a further misconception known as sterilization: the idea that central banks, violating the obligations imposed by “the rules of the game,” do not allow, or deliberately prevent, local money stocks from changing as their gold holdings change. The misconception is the presumption that gold inflows ought necessarily cause increases in local money stocks. The mechanisms causing local money stocks to change are entirely different from those causing gold flows. And insofar as those mechanisms are related, causality flows from the local money stock to gold reserves, not vice versa.

Gold flows also result when monetary authorities transform their own asset holdings into gold. Notable examples of such transformations occurred in the 1870s when a number of countries abandoned their de jure bimetallic (and de facto silver) standards to the gold standard. Monetary authorities in those countries transformed silver holdings into gold, driving the value of gold up and silver down. Similarly, but with more catastrophic consequences, the Bank of France, in 1928 after France restored the gold standard, began redeeming holdings of foreign-exchange reserves (financial claims on the United States or Britain, payable in gold) into gold. Following the French example, other countries rejoining the gold standard redeemed foreign exchange for gold, causing gold appreciation and deflation that led to the Great Depression.

Rereading the memoirs of this splendid translation . . . has impressed me with important subtleties that I missed when I read the memoirs in a language not my own and in which I am far from completely fluent. Had I fully appreciated those subtleties when Anna Schwartz and I were writing our A Monetary History of the United States, we would likely have assessed responsibility for the international character of the Great Depression somewhat differently. We attributed responsibility for the initiation of a worldwide contraction to the United States and I would not alter that judgment now. However, we also remarked, “The international effects were severe and the transmission rapid, not only because the gold-exchange standard had rendered the international financial system more vulnerable to disturbances, but also because the United States did not follow gold-standard rules.” Were I writing that sentence today, I would say “because the United States and France did not follow gold-standard rules.”

I pause to note for the record Friedman’s assertion that the United States and France did not follow “gold-standard rules.” Warming up to the idea, he then accused them of sterilization.

Benjamin Strong and Emile Moreau were admirable characters of personal force and integrity. But . . .the common policies they followed were misguided and contributed to the severity and rapidity of transmission of the U.S. shock to the international community. We stressed that the U.S. “did not permit the inflow of gold to expand the U.S. money stock. We not only sterilized it, we went much further. Our money stock moved perversely, going down as the gold stock went up” from 1929 to 1931.

Strong and Moreau tried to reconcile two ultimately incompatible objectives: fixed exchange rates and internal price stability. Thanks to the level at which Britain returned to gold in 1925, the U.S. dollar was undervalued, and thanks to the level at which France returned to gold at the end of 1926, so was the French franc. Both countries as a result experienced substantial gold inflows. Gold-standard rules called for letting the stock of money rise in response to the gold inflows and for price inflation in the U.S. and France, and deflation in Britain, to end the over-and under-valuations. But both Strong and Moreau were determined to prevent inflation and accordingly both sterilized the gold inflows, preventing them from providing the required increase in the quantity of money.

Friedman’s discussion of sterilization is at odds with basic theory. Working with a naïve version of PSFM, he imagines that gold flows passively respond to trade balances independent of monetary forces, and that the monetary authority under a gold standard is supposed to ensure that the domestic money stock varies roughly in proportion to its gold reserves. Ignoring the international deflationary dynamic, he asserts that the US money stock perversely declined from 1929 to 1931, while its gold stock increased. With a faltering banking system, the public shifted from holding demand deposits to currency. Gold reserves were legally required against currency, but not against demand deposits, so the shift from deposits to currency entailed an increase gold reserves. To be sure the increased US demand for gold added to upward pressure on value of gold, and to worldwide deflationary pressure. But US gold holdings rose by only $150 million from December 1929 to December 1931 compared with an increase of $1.06 billion in French gold holdings over the same period. Gold accumulation by the US and its direct contribution to world deflation during the first two years of the Depression was small relative to that of France.

Friedman also erred in stating “the common policies they followed were misguided and contributed to the severity and rapidity of transmission of the U.S. shock to the international community.” The shock to the international community clearly originated not in the US but in France. The Fed could have absorbed and mitigated the shock by allowing a substantial outflow of its huge gold reserves, but instead amplified the shock by raising interest rates to nearly unprecedented levels, causing gold to flow into the US.

After correctly noting the incompatibility between fixed exchange rates and internal price stability, Friedman contradicts himself by asserting that, in seeking to stabilize their internal price levels, Strong and Moreau violated the gold-standard “rules,” as if it were rules, not arbitrage, that constrain national price to converge toward a common level under a gold standard.

Friedman’s assertion that, after 1925, the dollar was undervalued and sterling overvalued was not wrong. But he misunderstood the consequences of currency undervaluation and overvaluation under the gold standard, a confusion stemming from the underlying misconception, derived from PSFM, that foreign exchange rates adjust to balance trade flows, so that, in equilibrium, no country runs a trade deficit or trade surplus.

Thus, in Friedman’s view, dollar undervaluation and sterling overvaluation implied a US trade surplus and British trade deficit, causing gold to flow from Britain to the US. Under gold-standard “rules,” the US money stock and US prices were supposed to rise and the British money stock and British prices were supposed to fall until undervaluation and overvaluation were eliminated. Friedman therefore blamed sterilization of gold inflows by the Fed for preventing the necessary increase in the US money stock and price level to restore equilibrium. But, in fact, from 1925 through 1928, prices in the US were roughly stable and prices in Britain fell slightly. Violating gold-standard “rules” did not prevent the US and British price levels from converging, a convergence driven by market forces, not “rules.”

The stance of monetary policy in a gold-standard country had minimal effect on either the quantity of money or the price level in that country, which were mainly determined by the internationally determined value of gold. What the stance of national monetary policy determines under the gold standard is whether the quantity of money in the country adjusts to the quantity demanded by a process of domestic monetary creation or withdrawal or by the inflow or outflow of gold. Sufficiently tight domestic monetary policy restricting the quantify of domestic money causes a compensatory gold inflow increasing the domestic money stock, while sufficiently easy money causes a compensatory outflow of gold reducing the domestic money stock. Tightness or ease of domestic monetary policy under the gold standard mainly affected gold and foreign-exchange reserves, and, only minimally, the quantity of domestic money and the domestic price level.

However, the combined effects of many countries simultaneously tightening monetary policy in a deliberate, or even inadvertent, attempt to accumulate — or at least prevent the loss — of gold reserves could indeed drive up the international value of gold through a deflationary process affecting prices in all gold-standard countries. Friedman, even while admitting that, in his Monetary History, he had understated the effect of the Bank of France on the Great Depression, referred only the overvaluation of sterling and undervaluation of the dollar and franc as causes of the Great Depression, remaining oblivious to the deflationary effects of gold accumulation and appreciation.

It was thus nonsensical for Friedman to argue that the mistake of the Bank of France during the Great Depression was not to increase the quantity of francs in proportion to the increase of its gold reserves. The problem was not that the quantity of francs was too low; it was that the Bank of France prevented the French public from collectively increasing the quantity of francs that they held except by importing gold.

Unlike Friedman, F. A. Hayek actually defended the policy of the Bank of France, and denied that the Bank of France had violated “the rules of the game” after nearly quadrupling its gold reserves between 1928 and 1932. Under his interpretation of those “rules,” because the Bank of France increased the quantity of banknotes after the 1928 restoration of convertibility by about as much as its gold reserves increased, it had fully complied with the “rules.” Hayek’s defense was incoherent; under its legal obligation to convert gold into francs at the official conversion rate, the Bank of France had no choice but to increase the quantity of francs by as much as its gold reserves increased.

That eminent economists like Hayek and Friedman could defend, or criticize, the conduct of the Bank of France during the Great Depression, because the Bank either did, or did not, follow “the rules of the game” under which the gold standard operated, shows the uselessness and irrelevance of the “rules of the game” as a guide to policy. For that reason alone, the failure of empirical studies to find evidence that “the rules of the game” were followed during the heyday of the gold standard is unsurprising. But the deeper reason for that lack of evidence is that PSFM, whose implementation “the rules of the game” were supposed to guarantee, was based on a misunderstanding of the international-adjustment mechanism under either the gold standard or any fixed-exchange-rates system.

Despite the grip of PSFM over most of the profession, a few economists did show a deeper understanding of the adjustment mechanism. The idea that the price level in terms of gold directly constrained the movements of national price levels across countries was indeed recognized by writers as diverse as Keynes, Mises, and Hawtrey who all pointed out that the prices of internationally traded commodities were constrained by arbitrage and that the free movement of capital across countries would limit discrepancies in interest rates across countries attached to the gold standard, observations that had already been made by Smith, Thornton, Ricardo, Fullarton and Mill in the classical period. But, until the Monetary Approach to the Balance of Payments became popular in the 1970s, only Hawtrey consistently and systematically deduced the implications of those insights in analyzing both the Great Depression and the Bretton Woods system of fixed, but adjustable, exchange rates following World War II.

The inconsistencies and internal contradictions of PSFM were sometimes recognized, but usually overlooked, by business-cycle theorists when focusing on the disturbing influence of central banks, perpetuating mistakes of the Humean Currency School doctrine that attributed cyclical disturbances to the misbehavior of local banking systems that were inherently disposed to overissue their liabilities.

White and Hogan on Hayek and Cassel on the Causes of the Great Depression

Published December 26, 2020 gold standard , Great Depression , Gustav Cassel , Hayek , Larry White , Milton Friedman , price-specie-flow mechanism , R. G. Hawtrey 23 Comments
Tags: Thomas Hogan

Lawrence White and Thomas Hogan have just published a new paper in the Journal of Economic Behavior and Organization (“Hayek, Cassel, and the origins of the great depression”). Since White is a leading Hayek scholar, who has written extensively on Hayek’s economic writings (e.g., his important 2008 article “Did Hayek and Robbins Deepen the Great Depression?”) and edited the new edition of Hayek’s notoriously difficult volume, The Pure Theory of Capital, when it was published as volume 11 of the Collected Works of F. A. Hayek, the conclusion reached by the new paper that Hayek had a better understanding than Cassel of what caused the Great Depression is not, in and of itself, surprising.

However, I admit to being taken aback by the abstract of the paper:

We revisit the origins of the Great Depression by contrasting the accounts of two contemporary economists, Friedrich A. Hayek and Gustav Cassel. Their distinct theories highlight important, but often unacknowledged, differences between the international depression and the Great Depression in the United States. Hayek’s business cycle theory offered a monetary overexpansion account for the 1920s investment boom, the collapse of which initiated the Great Depression in the United States. Cassel’s warnings about a scarcity gold reserves related to the international character of the downturn, but the mechanisms he emphasized contributed little to the deflation or depression in the United States.

I wouldn’t deny that there are differences between the way the Great Depression played out in the United States and in the rest of the world, e.g., Britain and France, which to be sure, suffered less severely than did the US or, say, Germany. It is both possible, and important, to explore and understand the differential effects of the Great Depression in various countries. I am sorry to say that White and Hogan do neither. Instead, taking at face value the dubious authority of Friedman and Schwartz’s treatment of the Great Depression in the Monetary History of the United States, they assert that the cause of the Great Depression in the US was fundamentally different from the cause of the Great Depression in many or all other countries.

Taking that insupportable premise from Friedman and Schwartz, they simply invoke various numerical facts from the Monetary History as if those facts, in and of themselves, demonstrate what requires to be demonstrated: that the causes of the Great Depression in the US were different from those of the Great Depression in the rest of the world. That assumption vitiated the entire treatment of the Great Depression in the Monetary History, and it vitiates the results that White and Hogan reach about the merits of the conflicting explanations of the Great Depression offered by Cassel and Hayek.

I’ve discussed the failings of Friedman’s treatment of the Great Depression and of other episodes he analyzed in the Monetary History in previous posts (e.g., here, here, here, here, and here). The common failing of all the episodes treated by Friedman in the Monetary History and elsewhere is that he misunderstood how the gold standard operated, because his model of the gold standard was a primitive version of the price-specie-flow mechanism in which the monetary authority determines the quantity of money, which then determines the price level, which then determines the balance of payments, the balance of payments being a function of the relative price levels of the different countries on the gold standard. Countries with relatively high price levels experience trade deficits and outflows of gold, and countries with relatively low price levels experience trade surpluses and inflows of gold. Under the mythical “rules of the game” under the gold standard, countries with gold inflows were supposed to expand their money supplies, so that prices would rise and countries with outflows were supposed to reduce their money supplies, so that prices fall. If countries followed the rules, then an international monetary equilibrium would eventually be reached.

That is the model of the gold standard that Friedman used throughout his career. He was not alone; Hayek and Mises and many others also used that model, following Hume’s treatment in his essay on the balance of trade. But it’s the wrong model. The correct model is the one originating with Adam Smith, based on the law of one price, which says that prices of all commodities in terms of gold are equalized by arbitrage in all countries on the gold standard.

As a first approximation, under the Smithean model, there is only one price level adjusted for different currency parities for all countries on the gold standard. So if there is deflation in one country on the gold standard, there is deflation for all countries on the gold standard. If the rest of the world was suffering from deflation under the gold standard, the US was also suffering from a deflation of approximately the same magnitude as every other country on the gold standard was suffering.

The entire premise of the Friedman account of the Great Depression, adopted unquestioningly by White and Hogan, is that there was a different causal mechanism for the Great Depression in the United States from the mechanism operating in the rest of the world. That premise is flatly wrong. The causation assumed by Friedman in the Monetary History was the exact opposite of the actual causation. It wasn’t, as Friedman assumed, that the decline in the quantity of money in the US was causing deflation; it was the common deflation in all gold-standard countries that was causing the quantity of money in the US to decline.

To be sure there was a banking collapse in the US that was exacerbating the catastrophe, but that was an effect of the underlying cause: deflation, not an independent cause. Absent the deflationary collapse, there is no reason to assume that the investment boom in the most advanced and most productive economy in the world after World War I was unsustainable as the Hayekian overinvestment/malinvestment hypothesis posits with no evidence of unsustainability other than the subsequent economic collapse.

So what did cause deflation under the gold standard? It was the rapid increase in the monetary demand for gold resulting from the insane policy of the Bank of France (disgracefully endorsed by Hayek as late as 1932) which Cassel, along with Ralph Hawtrey (whose writings, closely parallel to Cassel’s on the danger of postwar deflation, avoid all of the ancillary mistakes White and Hogan attribute to Cassel), was warning would lead to catastrophe.

It is true that Cassel also believed that over the long run not enough gold was being produced to avoid deflation. White and Hogan spend inordinate space and attention on that issue, because that secular tendency toward deflation is entirely different from the catastrophic effects of the increase in gold demand in the late 1920s triggered by the insane policy of the Bank of France.

The US could have mitigated the effects if it had been willing to accommodate the Bank of France’s demand to increase its gold holdings. Of course, mitigating the effects of the insane policy of the Bank of France would have rewarded the French for their catastrophic policy, but, under the circumstances, some other means of addressing French misconduct would have spared the world incalculable suffering. But misled by an inordinate fear of stock market speculation, the Fed tightened policy in 1928-29 and began accumulating gold rather than accommodate the French demand.

And the Depression came.

An Austrian Tragedy

Published May 24, 2020 Alfred Marshall , Carl Menger , E. v. Bohm-Bawerk , expectations , general equilibrium , Great Depression , Hayek , Irving Fisher , IS-LM , Israel Kirzner , Joseph Schumpeter , Keynes , Leon Walras , Ludwig Lachmann , Ludwig von Mises , macroeconomics , neoclassical synthesis , New Classical macroeconomics , New Keynesians , Old Keynesians , Oskar Morgensterm , rational expectations , rational expectations equilibrium , representative agent , Walrasian equilibrium 32 Comments
Tags: Fritz Machlup, Gottfried Haberler, Murray Rothbard, W. S. Jevons

It was hardly predictable that the New York Review of Books would take notice of Marginal Revolutionaries by Janek Wasserman, marking the susquicentenial of the publication of Carl Menger’s Grundsätze (Principles of Economics) which, along with Jevons’s Principles of Political Economy and Walras’s Elements of Pure Economics ushered in the marginal revolution upon which all of modern economics, for better or for worse, is based. The differences among the three founding fathers of modern economic theory were not insubstantial, and the Jevonian version was largely superseded by the work of his younger contemporary Alfred Marshall, so that modern neoclassical economics is built on the work of only one of the original founders, Leon Walras, Jevons’s work having left little impression on the future course of economics.

Menger’s work, however, though largely, but not totally, eclipsed by that of Marshall and Walras, did leave a more enduring imprint and a more complicated legacy than Jevons’s — not only for economics, but for political theory and philosophy, more generally. Judging from Edward Chancellor’s largely favorable review of Wasserman’s volume, one might even hope that a start might be made in reassessing that legacy, a process that could provide an opportunity for mutually beneficial interaction between long-estranged schools of thought — one dominant and one marginal — that are struggling to overcome various conceptual, analytical and philosophical problems for which no obvious solutions seem available.

In view of the failure of modern economists to anticipate the Great Recession of 2008, the worst financial shock since the 1930s, it was perhaps inevitable that the Austrian School, a once favored branch of economics that had made a specialty of booms and busts, would enjoy a revival of public interest.

The theme of Austrians as outsiders runs through Janek Wasserman’s The Marginal Revolutionaries: How Austrian Economists Fought the War of Ideas, a general history of the Austrian School from its beginnings to the present day. The title refers both to the later marginalization of the Austrian economists and to the original insight of its founding father, Carl Menger, who introduced the notion of marginal utility—namely, that economic value does not derive from the cost of inputs such as raw material or labor, as David Ricardo and later Karl Marx suggested, but from the utility an individual derives from consuming an additional amount of any good or service. Water, for instance, may be indispensable to humans, but when it is abundant, the marginal value of an extra glass of the stuff is close to zero. Diamonds are less useful than water, but a great deal rarer, and hence command a high market price. If diamonds were as common as dewdrops, however, they would be worthless.

Menger was not the first economist to ponder . . . the “paradox of value” (why useless things are worth more than essentials)—the Italian Ferdinando Galiani had gotten there more than a century earlier. His central idea of marginal utility was simultaneously developed in England by W. S. Jevons and on the Continent by Léon Walras. Menger’s originality lay in applying his theory to the entire production process, showing how the value of capital goods like factory equipment derived from the marginal value of the goods they produced. As a result, Austrian economics developed a keen interest in the allocation of capital. Furthermore, Menger and his disciples emphasized that value was inherently subjective, since it depends on what consumers are willing to pay for something; this imbued the Austrian school from the outset with a fiercely individualistic and anti-statist aspect.

Menger’s unique contribution is indeed worthy of special emphasis. He was more explicit than Jevons or Walras, and certainly more than Marshall, in explaining that the value of factors of production is derived entirely from the value of the incremental output that could be attributed (or imputed) to their services. This insight implies that cost is not an independent determinant of value, as Marshall, despite accepting the principle of marginal utility, continued to insist – famously referring to demand and supply as the two blades of the analytical scissors that determine value. The cost of production therefore turns out to be nothing but the value the output foregone when factors are used to produce one output instead of the next most highly valued alternative. Cost therefore does not determine, but is determined by, equilibrium price, which means that, in practice, costs are always subjective and conjectural. (I have made this point in an earlier post in a different context.) I will have more to say below about the importance of Menger’s specific contribution and its lasting imprint on the Austrian school.

Menger’s Principles of Economics, published in 1871, established the study of economics in Vienna—before then, no economic journals were published in Austria, and courses in economics were taught in law schools. . . .

The Austrian School was also bound together through family and social ties: [his two leading disciples, [Eugen von] Böhm-Bawerk and Friedrich von Wieser [were brothers-in-law]. [Wieser was] a close friend of the statistician Franz von Juraschek, Friedrich Hayek’s maternal grandfather. Young Austrian economists bonded on Alpine excursions and met in Böhm-Bawerk’s famous seminars (also attended by the Bolshevik Nikolai Bukharin and the German Marxist Rudolf Hilferding). Ludwig von Mises continued this tradition, holding private seminars in Vienna in the 1920s and later in New York. As Wasserman notes, the Austrian School was “a social network first and last.”

After World War I, the Habsburg Empire was dismantled by the victorious Allies. The Austrian bureaucracy shrank, and university placements became scarce. Menger, the last surviving member of the first generation of Austrian economists, died in 1921. The economic school he founded, with its emphasis on individualism and free markets, might have disappeared under the socialism of “Red Vienna.” Instead, a new generation of brilliant young economists emerged: Schumpeter, Hayek, and Mises—all of whom published best-selling works in English and remain familiar names today—along with a number of less well known but influential economists, including Oskar Morgenstern, Fritz Machlup, Alexander Gerschenkron, and Gottfried Haberler.

Two factual corrections are in order. Menger outlived Böhm-Bawerk, but not his other chief disciple von Wieser, who died in 1926, not long after supervising Hayek’s doctoral dissertation, later published in 1927, and, in 1933, translated into English and published as Monetary Theory and the Trade Cycle. Moreover, a 16-year gap separated Mises and Schumpeter, who were exact contemporaries, from Hayek (born in 1899) who was a few years older than Gerschenkron, Haberler, Machlup and Morgenstern.

All the surviving members or associates of the Austrian school wound up either in the US or Britain after World War II, and Hayek, who had taken a position in London in 1931, moved to the US in 1950, taking a position in the Committee on Social Thought at the University of Chicago after having been refused a position in the economics department. Through the intervention of wealthy sponsors, Mises obtained an academic appointment of sorts at the NYU economics department, where he succeeded in training two noteworthy disciples ~~who wrote dissertations under his tutelage~~, Murray Rothbard and Israel Kirzner. (Kirzner wrote his dissertation under Mises at NYU, but Rothbard did his graduate work at Colulmbia.) Schumpeter, Haberler and Gerschenkron eventually took positions at Harvard, while Machlup (with some stops along the way) and Morgenstern made their way to Princeton. However, Hayek’s interests shifted from pure economic theory to deep philosophical questions. While Machlup and Haberler continued to work on economic theory, the Austrian influence on their work after World War II was barely recognizable. Morgenstern and Schumpeter made major contributions to economics, but did not hide their alienation from the doctrines of the Austrian School.

So there was little reason to expect that the Austrian School would survive its dispersal when the Nazis marched unopposed into Vienna in 1938. That it did survive is in no small measure due to its ideological usefulness to anti-socialist supporters who provided financial support to Hayek, enabling his appointment to the Committee on Social Thought at the University of Chicago, and Mises’s appointment at NYU, and other forms of research support to Hayek, Mises and other like-minded scholars, as well as funding the Mont Pelerin Society, an early venture in globalist networking, started by Hayek in 1947. Such support does not discredit the research to which it gave rise. That the survival of the Austrian School would probably not have been possible without the support of wealthy benefactors who anticipated that the Austrians would advance their political and economic interests does not invalidate the research thereby enabled. (In the interest of transparency, I acknowledge that I received support from such sources for two books that I wrote.)

Because Austrian School survivors other than Mises and Hayek either adapted themselves to mainstream thinking without renouncing their earlier beliefs (Haberler and Machlup) or took an entirely different direction (Morgenstern), and because the economic mainstream shifted in two directions that were most uncongenial to the Austrians: Walrasian general-equilibrium theory and Keynesian macroeconomics, the Austrian remnant, initially centered on Mises at NYU, adopted a sharply adversarial attitude toward mainstream economic doctrines.

Despite its minute numbers, the lonely remnant became a house divided against itself, Mises’s two outstanding NYU disciples, Murray Rothbard and Israel Kirzner, holding radically different conceptions of how to carry on the Austrian tradition. An extroverted radical activist, Rothbard was not content just to lead a school of economic thought, he aspired to become the leader of a fantastical anarchistic revolutionary movement to replace all established governments under a reign of private-enterprise anarcho-capitalism. Rothbard’s political radicalism, which, despite his Jewish ancestry, even included dabbling in Holocaust denialism, so alienated his mentor, that Mises terminated all contact with Rothbard for many years before his death. Kirzner, self-effacing, personally conservative, with no political or personal agenda other than the advancement of his own and his students’ scholarship, published hundreds of articles and several books filling 10 thick volumes of his collected works published by the Liberty Fund, while establishing a robust Austrian program at NYU, training many excellent scholars who found positions in respected academic and research institutions. Similar Austrian programs, established under the guidance of Kirzner’s students, were started at other institutions, most notably at George Mason University.

One of the founders of the Cato Institute, which for nearly half a century has been the leading avowedly libertarian think tank in the US, Rothbard was eventually ousted by Cato, and proceeded to set up a rival think tank, the Ludwig von Mises Institute, at Auburn University, which has turned into a focal point for extreme libertarians and white nationalists to congregate, get acquainted, and strategize together.

Isolation and marginalization tend to cause a subspecies either to degenerate toward extinction, to somehow blend in with the members of the larger species, thereby losing its distinctive characteristics, or to accentuate its unique traits, enabling it to find some niche within which to survive as a distinct sub-species. Insofar as they have engaged in economic analysis rather than in various forms of political agitation and propaganda, the Rothbardian Austrians have focused on anarcho-capitalist theory and the uniquely perverse evils of fractional-reserve banking.

Rejecting the political extremism of the Rothbardians, Kirznerian Austrians differentiate themselves by analyzing what they call market processes and emphasizing the limitations on the knowledge and information possessed by actual decision-makers. They attribute this misplaced focus on equilibrium to the extravagantly unrealistic and patently false assumptions of mainstream models on the knowledge possessed by economic agents, which effectively make equilibrium the inevitable — and trivial — conclusion entailed by those extreme assumptions. In their view, the focus of mainstream models on equilibrium states with unrealistic assumptions results from a preoccupation with mathematical formalism in which mathematical tractability rather than sound economics dictates the choice of modeling assumptions.

Skepticism of the extreme assumptions about the informational endowments of agents covers a range of now routine assumptions in mainstream models, e.g., the ability of agents to form precise mathematical estimates of the probability distributions of future states of the world, implying that agents never confront decisions about which they are genuinely uncertain. Austrians also object to the routine assumption that all the information needed to determine the solution of a model is the common knowledge of the agents in the model, so that an existing equilibrium cannot be disrupted unless new information randomly and unpredictably arrives. Each agent in the model having been endowed with the capacity of a semi-omniscient central planner, solving the model for its equilibrium state becomes a trivial exercise in which the optimal choices of a single agent are taken as representative of the choices made by all of the model’s other, semi-omnicient, agents.

Although shreds of subjectivism — i.e., agents make choices based own preference orderings — are shared by all neoclassical economists, Austrian criticisms of mainstream neoclassical models are aimed at what Austrians consider to be their insufficient subjectivism. It is this fierce commitment to a robust conception of subjectivism, in which an equilibrium state of shared expectations by economic agents must be explained, not just assumed, that Chancellor properly identifies as a distinguishing feature of the Austrian School.

Menger’s original idea of marginal utility was posited on the subjective preferences of consumers. This subjectivist position was retained by subsequent generations of the school. It inspired a tradition of radical individualism, which in time made the Austrians the favorite economists of American libertarians. Subjectivism was at the heart of the Austrians’ polemical rejection of Marxism. Not only did they dismiss Marx’s labor theory of value, they argued that socialism couldn’t possibly work since it would lack the means to allocate resources efficiently.

The problem with central planning, according to Hayek, is that so much of the knowledge that people act upon is specific knowledge that individuals acquire in the course of their daily activities and life experience, knowledge that is often difficult to articulate – mere intuition and guesswork, yet more reliable than not when acted upon by people whose livelihoods depend on being able to do the right thing at the right time – much less communicate to a central planner.

Chancellor attributes Austrian mistrust of statistical aggregates or indices, like GDP and price levels, to Austrian subjectivism, which regards such magnitudes as abstractions irrelevant to the decisions of private decision-makers, except perhaps in forming expectations about the actions of government policy makers. (Of course, this exception potentially provides full subjectivist license and legitimacy for macroeconomic theorizing despite Austrian misgivings.) Observed statistical correlations between aggregate variables identified by macroeconomists are dismissed as irrelevant unless grounded in, and implied by, the purposeful choices of economic agents.

But such scruples about the use of macroeconomic aggregates and inferring causal relationships from observed correlations are hardly unique to the Austrian school. One of the most important contributions of the 20th century to the methodology of economics was an article by T. C. Koopmans, “Measurement Without Theory,” which argued that measured correlations between macroeconomic variables provide a reliable basis for business-cycle research and policy advice only if the correlations can be explained in terms of deeper theoretical or structural relationships. The Nobel Prize Committee, in awarding the 1975 Prize to Koopmans, specifically mentioned this paper in describing Koopmans’s contributions. Austrians may be more fastidious than their mainstream counterparts in rejecting macroeconomic relationships not based on microeconomic principles, but they aren’t the only ones mistrustful of mere correlations.

Chancellor cites mistrust about the use of statistical aggregates and price indices as a factor in Hayek’s disastrous policy advice warning against anti-deflationary or reflationary measures during the Great Depression.

Their distrust of price indexes brought Austrian economists into conflict with mainstream economic opinion during the 1920s. At the time, there was a general consensus among leading economists, ranging from Irving Fisher at Yale to Keynes at Cambridge, that monetary policy should aim at delivering a stable price level, and in particular seek to prevent any decline in prices (deflation). Hayek, who earlier in the decade had spent time at New York University studying monetary policy and in 1927 became the first director of the Austrian Institute for Business Cycle Research, argued that the policy of price stabilization was misguided. It was only natural, Hayek wrote, that improvements in productivity should lead to lower prices and that any resistance to this movement (sometimes described as “good deflation”) would have damaging economic consequences.

The argument that deflation stemming from economic expansion and increasing productivity is normal and desirable isn’t what led Hayek and the Austrians astray in the Great Depression; it was their failure to realize the deflation that triggered the Great Depression was a monetary phenomenon caused by a malfunctioning international gold standard. Moreover, Hayek’s own business-cycle theory explicitly stated that a neutral (stable) monetary policy ought to aim at keeping the flow of total spending and income constant in nominal terms while his policy advice of welcoming deflation meant a rapidly falling rate of total spending. Hayek’s policy advice was an inexcusable error of judgment, which, to his credit, he did acknowledge after the fact, though many, perhaps most, Austrians have refused to follow him even that far.

Considered from the vantage point of almost a century, the collapse of the Austrian School seems to have been inevitable. Hayek’s long-shot bid to establish his business-cycle theory as the dominant explanation of the Great Depression was doomed from the start by the inadequacies of the very specific version of his basic model and his disregard of the obvious implication of that model: prevent total spending from contracting. The promising young students and colleagues who had briefly gathered round him upon his arrival in England, mostly attached themselves to other mentors, leaving Hayek with only one or two immediate disciples to carry on his research program. The collapse of his research program, which he himself abandoned after completing his final work in economic theory, marked a research hiatus of almost a quarter century, with the notable exception of publications by his student, Ludwig Lachmann who, having decamped in far-away South Africa, labored in relative obscurity for most of his career.

The early clash between Keynes and Hayek, so important in the eyes of Chancellor and others, is actually overrated. Chancellor, quoting Lachmann and Nicholas Wapshott, describes it as a clash of two irreconcilable views of the economic world, and the clash that defined modern economics. In later years, Lachmann actually sought to effect a kind of reconciliation between their views. It was not a conflict of visions that undid Hayek in 1931-32, it was his misapplication of a narrowly constructed model to a problem for which it was irrelevant.

Although the marginalization of the Austrian School, after its misguided policy advice in the Great Depression and its dispersal during and after World War II, is hardly surprising, the unwillingness of mainstream economists to sort out what was useful and relevant in the teachings of the Austrian School from what is not was unfortunate not only for the Austrians. Modern economics was itself impoverished by its disregard for the complexity and interconnectedness of economic phenomena. It’s precisely the Austrian attentiveness to the complexity of economic activity — the necessity for complementary goods and factors of production to be deployed over time to satisfy individual wants – that is missing from standard economic models.

That Austrian attentiveness, pioneered by Menger himself, to the complementarity of inputs applied over the course of time undoubtedly informed Hayek’s seminal contribution to economic thought: his articulation of the idea of intertemporal equilibrium that comprehends the interdependence of the plans of independent agents and the need for them to all fit together over the course of time for equilibrium to obtain. Hayek’s articulation represented a conceptual advance over earlier versions of equilibrium analysis stemming from Walras and Pareto, and even from Irving Fisher who did pay explicit attention to intertemporal equilibrium. But in Fisher’s articulation, intertemporal consistency was described in terms of aggregate production and income, leaving unexplained the mechanisms whereby the individual plans to produce and consume particular goods over time are reconciled. Hayek’s granular exposition enabled him to attend to, and articulate, necessary but previously unspecified relationships between the current prices and expected future prices.

Moreover, neither mainstream nor Austrian economists have ever explained how prices are adjust in non-equilibrium settings. The focus of mainstream analysis has always been the determination of equilibrium prices, with the implicit understanding that “market forces” move the price toward its equilibrium value. The explanatory gap has been filled by the mainstream New Classical School which simply posits the existence of an equilibrium price vector, and, to replace an empirically untenable tâtonnement process for determining prices, posits an equally untenable rational-expectations postulate to assert that market economies typically perform as if they are in, or near the neighborhood of, equilibrium, so that apparent fluctuations in real output are viewed as optimal adjustments to unexplained random productivity shocks.

Alternatively, in New Keynesian mainstream versions, constraints on price changes prevent immediate adjustments to rationally expected equilibrium prices, leading instead to persistent reductions in output and employment following demand or supply shocks. (I note parenthetically that the assumption of rational expectations is not, as often suggested, an assumption distinct from market-clearing, because the rational expectation of all agents of a market-clearing price vector necessarily implies that the markets clear unless one posits a constraint, e.g., a binding price floor or ceiling, that prevents all mutually beneficial trades from being executed.)

Similarly, the Austrian school offers no explanation of how unconstrained price adjustments by market participants is a sufficient basis for a systemic tendency toward equilibrium. Without such an explanation, their belief that market economies have strong self-correcting properties is unfounded, because, as Hayek demonstrated in his 1937 paper, “Economics and Knowledge,” price adjustments in current markets don’t, by themselves, ensure a systemic tendency toward equilibrium values that coordinate the plans of independent economic agents unless agents’ expectations of future prices are sufficiently coincident. To take only one passage of many discussing the difficulty of explaining or accounting for a process that leads individuals toward a state of equilibrium, I offer the following as an example:

All that this condition amounts to, then, is that there must be some discernible regularity in the world which makes it possible to predict events correctly. But, while this is clearly not sufficient to prove that people will learn to foresee events correctly, the same is true to a hardly less degree even about constancy of data in an absolute sense. For any one individual, constancy of the data does in no way mean constancy of all the facts independent of himself, since, of course, only the tastes and not the actions of the other people can in this sense be assumed to be constant. As all those other people will change their decisions as they gain experience about the external facts and about other people’s actions, there is no reason why these processes of successive changes should ever come to an end. These difficulties are well known, and I mention them here only to remind you how little we actually know about the conditions under which an equilibrium will ever be reached.

In this theoretical muddle, Keynesian economics and the neoclassical synthesis were abandoned, because the key proposition of Keynesian economics was supposedly the tendency of a modern economy toward an equilibrium with involuntary unemployment while the neoclassical synthesis rejected that proposition, so that the supposed synthesis was no more than an agreement to disagree. That divided house could not stand. The inability of Keynesian economists such as Hicks, Modigliani, Samuelson and Patinkin to find a satisfactory (at least in terms of a preferred Walrasian general-equilibrium model) rationalization for Keynes’s conclusion that an economy would likely become stuck in an equilibrium with involuntary unemployment led to the breakdown of the neoclassical synthesis and the displacement of Keynesianism as the dominant macroeconomic paradigm.

But perhaps the way out of the muddle is to abandon the idea that a systemic tendency toward equilibrium is a property of an economic system, and, instead, to recognize that equilibrium is, as Hayek suggested, a contingent, not a necessary, property of a complex economy. Ludwig Lachmann, cited by Chancellor for his remark that the early theoretical clash between Hayek and Keynes was a conflict of visions, eventually realized that in an important sense both Hayek and Keynes shared a similar subjectivist conception of the crucial role of individual expectations of the future in explaining the stability or instability of market economies. And despite the efforts of New Classical economists to establish rational expectations as an axiomatic equilibrating property of market economies, that notion rests on nothing more than arbitrary methodological fiat.

Chancellor concludes by suggesting that Wasserman’s characterization of the Austrians as marginalized is not entirely accurate inasmuch as “the Austrians’ view of the economy as a complex, evolving system continues to inspire new research.” Indeed, if economics is ever to find a way out of its current state of confusion, following Lachmann in his quest for a synthesis of sorts between Keynes and Hayek might just be a good place to start from.

My Paper “Hayek, Deflation, Gold, and Nihilism” Is now Available on SSRN

Published March 28, 2020 deflation , gold , gold standard , Great Depression Leave a Comment
Tags: Robert Leeson

I contributed a chapter entitled “Hayek, Deflation, Gold and Nihilism” to volume 13 of Hayek: A Collaborative Biography edited by Robert Leeson and published in 2018 by Palgrave Macmillan.

I have posted a preliminary draft of that chapter on SSRN. Here is the abstract.

In Hayek’s early writings on business cycle theory and the Great Depression he argued that business cycle downturns including the steep downturn of 1929-31 were caused by unsustainable elongations of capital structure of the economy resulting from bank-financed investment in excess of voluntary saving. Because monetary expansion was the cause of the crisis, Hayek argued that monetary expansion was an inappropriate remedy to cure the deflation and high unemployment caused by the crisis. He therefore recommended allowing the Depression to take its course until the distortions that led to the downturn could be corrected by market forces. However, this view of the Depression was at odds with Hayek’s own neutral money criterion which implied that prices should fall during expansions and rise during contractions so that nominal spending would remain more or less constant over the cycle. Although Hayek strongly favored allowing prices to fall in the expansion, he did not follow the logic of his own theory in favoring generally increasing prices during the contraction. This paper explores the reasons for Hayek’s reluctance to follow the logic of his own theory in his early policy recommendations. The key factors responsible for his early policy recommendations seem to be his attachment to the gold standard and the seeming necessity for countries to accept deflation to maintain convertibility and his hope or expectation that deflation would overwhelm the price rigidities that he believed were obstructing the price mechanism from speeding a recovery. By 1935 Hayek’s attachment to the gold standard was starting to weaken, and in later years he openly acknowledged that he had been mistaken not to favor policy measures, including monetary expansion, designed to stabilize total spending.

Dr. Shelton Remains Outspoken: She Should Have Known Better

Published July 11, 2019 currency manipulation , gold standard , Great Depression , Judy Shelton , Uncategorized 5 Comments
Tags: Smoot-Hawley tariff

I started blogging in July 2011, and in one of my first blogposts I discussed an article in the now defunct Weekly Standard by Dr. Judy Shelton entitled “Gold Standard or Bust.” I wrote then:

I don’t know, and have never met Dr. Shelton, but she has been a frequent op-ed contributor to the Wall Street Journal and various other publications of a like ideological orientation for 20 years or more, invariably advocating a return to the gold standard. In 1994, she published a book Money Meltdown touting the gold standard as a cure for all our monetary ills.

I was tempted to provide a line-by-line commentary on Dr. Shelton’s Weekly Standard piece, but it would be tedious and churlish to dwell excessively on her deficiencies as a wordsmith or lapses from lucidity.

So I was not very impressed by Dr. Shelton then. I have had occasion to write about her again a few times since, and I cannot report that I have detected any improvement in the lucidity of her thought or the clarity of her exposition.

Aside from, or perhaps owing to, her infatuation with the gold standard, Dr. Shelton seems to have developed a deep aversion to what is commonly, and usually misleadingly, known as currency manipulation. Using her modest entrepreneurial skills as a monetary-policy pundit, Dr. Shelton has tried to use the specter of currency manipulation as a talking point for gold-standard advocacy. So, in 2017 Dr. Shelton wrote an op-ed about currency manipulation for the Wall Street Journal that was so woefully uninformed and unintelligible, that I felt obligated to write a blogpost just for her, a tutorial on the ABCs of currency manipulation, as I called it then. Here’s an excerpt from my tutorial:

[i]t was no surprise to see in Tuesday’s Wall Street Journal that monetary-policy entrepreneur Dr. Judy Shelton has written another one of her screeds promoting the gold standard, in which, showing no awareness of the necessary conditions for currency manipulation, she assures us that a) currency manipulation is a real problem and b) that restoring the gold standard would solve it.

Certainly the rules regarding international exchange-rate arrangements are not working. Monetary integrity was the key to making Bretton Woods institutions work when they were created after World War II to prevent future breakdowns in world order due to trade. The international monetary system, devised in 1944, was based on fixed exchange rates linked to a gold-convertible dollar.

No such system exists today. And no real leader can aspire to champion both the logic and the morality of free trade without confronting the practice that undermines both: currency manipulation.

Ahem, pray tell, which rules relating to exchange-rate arrangements does Dr. Shelton believe are not working? She doesn’t cite any. And, what, on earth does “monetary integrity” even mean, and what does that high-minded, but totally amorphous, concept have to do with the rules of exchange-rate arrangements that aren’t working?

Dr. Shelton mentions “monetary integrity” in the context of the Bretton Woods system, a system based — well, sort of — on fixed exchange rates, forgetting – or choosing not — to acknowledge that, under the Bretton Woods system, exchange rates were also unilaterally adjustable by participating countries. Not only were they adjustable, but currency devaluations were implemented on numerous occasions as a strategy for export promotion, the most notorious example being Britain’s 30% devaluation of sterling in 1949, just five years after the Bretton Woods agreement had been signed. Indeed, many other countries, including West Germany, Italy, and Japan, also had chronically undervalued currencies under the Bretton Woods system, as did France after it rejoined the gold standard in 1926 at a devalued rate deliberately chosen to ensure that its export industries would enjoy a competitive advantage.

The key point to keep in mind is that for a country to gain a competitive advantage by lowering its exchange rate, it has to prevent the automatic tendency of international price arbitrage and corresponding flows of money to eliminate competitive advantages arising from movements in exchange rates. If a depreciated exchange rate gives rise to an export surplus, a corresponding inflow of foreign funds to finance the export surplus will eventually either drive the exchange rate back toward its old level, thereby reducing or eliminating the initial depreciation, or, if the lower rate is maintained, the cash inflow will accumulate in reserve holdings of the central bank. Unless the central bank is willing to accept a continuing accumulation of foreign-exchange reserves, the increased domestic demand and monetary expansion associated with the export surplus will lead to a corresponding rise in domestic prices, wages and incomes, thereby reducing or eliminating the competitive advantage created by the depressed exchange rate. Thus, unless the central bank is willing to accumulate foreign-exchange reserves without limit, or can create an increased demand by private banks and the public to hold additional cash, thereby creating a chronic excess demand for money that can be satisfied only by a continuing export surplus, a permanently reduced foreign-exchange rate creates only a transitory competitive advantage.

I don’t say that currency manipulation is not possible. It is not only possible, but we know that currency manipulation has been practiced. But currency manipulation can occur under a fixed-exchange rate regime as well as under flexible exchange-rate regimes, as demonstrated by the conduct of the Bank of France from 1926 to 1935 while it was operating under a gold standard. And the most egregious recent example of currency manipulation was undertaken by the Chinese central bank when it effectively pegged the yuan to the dollar at a fixed rate. Keeping its exchange rate fixed against the dollar was precisely the offense that the currency-manipulation police accused the Chinese of committing.

I leave it to interested readers to go back and finish the rest of my tutorial for Dr. Shelton. And if you read carefully and attentively, you are likely to understand the concept of currency manipulation a lot more clearly than when you started.

Alas, it’s obvious that Dr. Shelton has either not read or not understood the tutorial I wrote for her, because, in her latest pronouncement on the subject she covers substantially the same ground as she did two years ago, with no sign of increased comprehension of the subject on which she expounds with such misplaced self-assurance. Here are some samples of Dr. Shelton’s conceptual confusion and historical ignorance.

History can be especially informative when it comes to evaluating the relationship between optimal economic performance and monetary regimes. In the 1930s, for example, the “beggar thy neighbor” tactic of devaluing currencies against gold to gain a trade export advantage hampered a global economic recovery.

Beggar thy neighbor policies were indeed adopted by the United States, but they were adopted first in the 1922 (the Fordney-McCumber Act) and again in 1930 (Smoot-Hawley Act) when the US was on the gold standard with the value of the dollar pegged at $~~4.86~~ $20.67 for an ounce of gold. The Great Depression started in late 1929, but the stock market crash of 1929 may have been in part precipitated by fears that the Smoot-Hawley Act would be passed by Congress and signed into law by President Hoover.

At any rate, exchange rates among most major countries were pegged to either gold or the dollar until September 1931 when Britain suspended the convertibility of the pound into gold. The Great Depression was the result of a rapid deflation caused by gold accumulation by central banks as they rejoined the gold standard that had been almost universally suspended during World War I. Countries that remained on the gold standard during the Great Depression were condemned to suffer deflation as gold became ever more valuable in real terms, so that currency depreciation against gold was the only pathway to recovery. Thus, once convertibility was suspended and the pound allowed to depreciate, the British economy stopped contracting and began a modest recovery with slowly expanding output and employment.

The United States, however, kept the dollar pegged to its ~~$4.86~~ $20.67 an ounce parity with gold until April 1933, when FDR saved the American economy by suspending convertibility and commencing a policy of deliberate reflation (i.e. inflation to restore the 1926 price level). An unprecedented expansion of output, employment and income accompanied the rise in prices following the suspension of the gold standard. Currency depreciation was the key to recovery from, not the cause of, depression.

Having exposed her ignorance of the causes of the Great Depression, Dr. Shelton then begins a descent into her confusion about the subject of currency manipulation, about which I had tried to tutor her, evidently without success.

The absence of rules aimed at maintaining a level monetary playing field invites currency manipulation that could spark a backlash against the concept of free trade. Countries engaged in competitive depreciation undermine the principles of genuine competition, and those that have sought to participate in good faith in the global marketplace are unfairly penalized by the monetary sleight of hand executed through central banks.

Currency manipulation is possible only under specific conditions. A depreciating currency is not normally a manipulated currency. Currencies fluctuate in relative values for many different reasons, but if prices adjust in rough proportion to the change in exchange rates, the competitive positions of the countries are only temporarily affected by the change in exchange rates. For a country to gain a sustained advantage for its export and import-competing industries by depreciating its exchange rate, it must adopt a monetary policy that consistently provides less cash than the public demands or needs to satisfy its liquidity needs, forcing the public to obtain the desired cash balances through a balance-of-payments surplus and an inflow of foreign-exchange reserves into the country’s central bank or treasury.

U.S. leadership is necessary to address this fundamental violation of free-trade practices and its distortionary impact on free-market outcomes. When the United States’ trading partners engage in currency manipulation, it is not competing — it’s cheating.

That is why it is vital to weigh the implications of U.S. monetary policy on the dollar’s exchange-rate value against other currencies. Trade and financial flows can be substantially altered by speculative market forces responding to the public comments of officials at the helm of the European Central Bank, the Bank of Japan or the People’s Bank of China — with calls for “additional stimulus” alerting currency players to impending devaluation policies.

Dr. Shelton here reveals a comprehensive misunderstanding of the difference between a monetary policy that aims to stimulate economic activity in general by raising the price level or increasing the rate of inflation to stimulate expenditure and a policy of monetary restraint that aims to raise the relative price of domestic export and import-competing products relative to the prices of domestic non-tradable goods and services, e.g., new homes and apartments. It is only the latter combination of tight monetary policy and exchange-rate intervention to depreciate a currency in foreign-exchange markets that qualifies as currency manipulation.

And, under that understanding, it is obvious that currency manipulation is possible under a fixed-exchange-rate system, as France did in the 1920s and 1930s, and as most European countries and Japan did in the 1950s and early 1960s under the Bretton Woods system so well loved by Dr. Shelton.

In the 1950s and early 1960s, the US dollar was chronically overvalued. The situation was not remediated until the 1960s under the Kennedy administration when consistently loose monetary policy by the Fed made currency manipulation so costly for the Germans and Japanese that they revalued their currencies upward to avoid the inflationary consequences of US monetary expansion.

And then, in a final flourish, Dr. Shelton puts her ignorance of what happened in the Great Depression on public display with the following observation.

When currencies shift downward against the dollar, it makes U.S. exports more expensive for consumers in other nations. It also discounts the cost of imported goods compared with domestic U.S. products. Downshifting currencies against the dollar has the same punishing impact as a tariff. That is why, as in the 1930s during the Great Depression, currency devaluation prompts retaliatory tariffs.

The retaliatory tariffs were imposed in response to the US tariffs that preceded the or were imposed at the outset of the Great Depression in 1930. The devaluations against gold promoted economic recovery, and were accompanied by a general reduction in tariff levels under FDR after the US devalued the dollar against gold and the remaining gold standard currencies. Whereof she knows nothing, thereof Dr. Shelton would do better to remain silent.

Friedman and Schwartz, Eichengreen and Temin, Hawtrey and Cassel

Published January 23, 2019 Douglas Irwin , gold standard , Great Depression , Gustav Cassel , Milton Friedman , R. G. Hawtrey , Ron Batchelder 38 Comments

Barry Eichengreen and Peter Temin are two of the great economic historians of our time, writing, in the splendid tradition of Charles Kindleberger, profound and economically acute studies of the economic and financial history of the nineteenth and early twentieth centuries. Most notably they have focused on periods of panic, crisis and depression, of which by far the best-known and most important episode is the Great Depression that started late in 1929, bottomed out early in 1933, but lingered on for most of the 1930s, and they are rightly acclaimed for having emphasized and highlighted the critical role of the gold standard in the Great Depression, a role largely overlooked in the early Keynesian accounts of the Great Depression. Those accounts identified a variety of specific shocks, amplified by the volatile entrepreneurial expectations and animal spirits that drive, or dampen, business investment, and further exacerbated by inherent instabilities in market economies that lack self-stabilizing mechanisms for maintaining or restoring full employment.

That Keynesian vision of an unstable market economy vulnerable to episodic, but prolonged, lapses from full-employment was vigorously, but at first unsuccessfully, disputed by advocates of free-market economics. It wasn’t until Milton Friedman provided an alternative narrative explaining the depth and duration of the Great Depression, that the post-war dominance of Keynesian theory among academic economists seriously challenged. Friedman’s alternative narrative of the Great Depression was first laid out in the longest chapter (“The Great Contraction”) of his magnum opus, co-authored with Anna Schwartz, A Monetary History of the United States. In Friedman’s telling, the decline in the US money stock was the critical independent causal factor that directly led to the decline in prices, output, and employment. The contraction in the quantity of money was not caused by the inherent instability of free-market capitalism, but, owing to a combination of incompetence and dereliction of duty, by the Federal Reserve.

In the Monetary History of the United States, all the heavy lifting necessary to account for both secular and cyclical movements in the price level, output and employment is done by, supposedly exogenous, changes in the nominal quantity of money, Friedman having considered it to be of the utmost significance that the largest movements in both the quantity of money, and in prices, output and employment occurred during the Great Depression. The narrative arc of the Monetary History was designed to impress on the mind of the reader the axiomatic premise that monetary authority has virtually absolute control over the quantity of money which served as the basis for inferring that changes in the quantity of money are what cause changes in prices, output and employment.

Friedman’s treatment of the gold standard (which I have discussed here, here and here) was both perfunctory and theoretically confused. Unable to reconcile the notion that the monetary authority has absolute control over the nominal quantity of money with the proposition that the price level in any country on the gold standard cannot deviate from the price levels of other gold standard countries without triggering arbitrage transactions that restore the equality between the price levels of all gold standard countries, Friedman dodged the inconsistency repeatedly invoking his favorite fudge factor: long and variable lags between changes in the quantity of money and changes in prices, output and employment. Despite its vacuity, the long-and-variable-lag dodge allowed Friedman to ignore the inconvenient fact that the US price level in the Great Depression did not and could not vary independently of the price levels of all other countries then on the gold standard.

I’ll note parenthetically that Keynes himself was also responsible for this unnecessary and distracting detour, because the General Theory was written almost entirely in the context of a closed economy model with an exogenously determined quantity of money, thereby unwittingly providing with a useful tool with which to propagate his Monetarist narrative. The difference of course is that Keynes, as demonstrated in his brilliant early works, Indian Currency and Finance and A Tract on Monetary Reform and the Economic Consequences of Mr. Churchill, had a correct understanding of the basic theory of the gold standard, an understanding that, owing to his obsessive fixation on the nominal quantity of money, eluded Friedman over his whole career. Why Keynes, who had a perfectly good theory of what was happening in the Great Depression available to him, as it was to others, was diverted to an unnecessary, but not uninteresting, new theory is a topic that I wrote about a very long time ago here, though I’m not so sure that I came up with a good or even adequate explanation.

So it does not speak well of the economics profession that it took nearly a quarter of a century before the basic internal inconsistency underlying Friedman’s account of the Great Depression was sufficiently recognized to call for an alternative theoretical account of the Great Depression that placed the gold standard at the heart of the narrative. It was Peter Temin and Barry Eichengreen, both in their own separate works (e.g., Lessons of the Great Depression by Temin and Golden Fetters by Eichengreen) and in an important paper they co-authored and published in 2000 to remind both economists and historians how important a role the gold standard must play in any historical account of the Great Depression.

All credit is due to Temin and Eichengreen for having brought to the critical role of the gold standard in the Great Depression to the attention of economists who had largely derived their understanding of what had caused the Great Depression from either some variant of the Keynesian narrative or of Friedman’s Monetarist indictment of the Federal Reserve System. But it’s unfortunate that neither Temin nor Eichnegreen gave sufficient credit to either R. G. Hawtrey or to Gustav Cassel for having anticipated almost all of their key findings about the causes of the Great Depression. And I think that what prevented Eichengreen and Temin from realizing that Hawtrey in particular had anticipated their explanation of the Great Depression by more than half a century was that they did not fully grasp the key theoretical insight underlying Hawtrey’s explanation of the Great Depression.

That insight was that the key to understanding the common world price level in terms of gold under a gold standard is to think in terms of a given world stock of gold and to think of total world demand to hold gold consisting of real demands to hold gold for commercial, industrial and decorative uses, the private demand to hold gold as an asset, and the monetary demand for gold to be held either as a currency or as a reserve for currency. The combined demand to hold gold for all such purposes, given the existing stock of gold, determines a real relative price of gold in terms of all other commodities. This relative price when expressed in terms of a currency unit that is convertible into gold corresponds to an equivalent set of commodity prices in terms of those convertible currency units.

This way of thinking about the world price level under the gold standard was what underlay Hawtrey’s monetary analysis and his application of that analysis in explaining the Great Depression. Given that the world output of gold in any year is generally only about 2 or 3 percent of the existing stock of gold, it is fluctuations in the demand for gold, of which the monetary demand for gold in the period after the outbreak of World War I was clearly the least stable, that causes short-term fluctuations in the value of gold. Hawtrey’s efforts after the end of World War I were therefore focused on the necessity to stabilize the world’s monetary demands for gold in order to avoid fluctuations in the value of gold as the world moved toward the restoration of the gold standard that then seemed, to most monetary and financial experts and most monetary authorities and political leaders, to be both inevitable and desirable.

In the opening pages of Golden Fetters, Eichengreen beautifully describes backdrop against which the attempt to reconstitute the gold standard was about to made after World War I.

For more than a quarter of a century before World War I, the gold standard provided the framework for domestic and international monetary relations. . . The gold standard had been a remarkably efficient mechanism for organizing financial affairs. No global crises comparable to the one that began in 1929 had disrupted the operation of financial markets. No economic slump had so depressed output and employment.

The central elements of this system were shattered by . . . World War I. More than a decade was required to complete their reconstruction. Quickly it became evident that the reconstructed gold standard was less resilient that its prewar predecessor. As early as 1929 the new international monetary system began to crumble. Rapid deflation forced countries to producing primary commodities to suspend gold convertibility and depreciate their currencies. Payments problems spread next to the industrialized world. . . Britain, along with United State and France, one of the countries at the center of the international monetary system, was next to experience a crisis, abandoning the gold standard in the autumn of 1931. Some two dozen countries followed suit. The United States dropped the gold standard in 1933; France hung on till the bitter end, which came in 1936.

The collapse of the international monetary system is commonly indicted for triggering the financial crisis that transformed a modes economic downturn gold standard into an unprecedented slump. So long as the gold standard was maintained, it is argued, the post-1929 recession remained just another cyclical contraction. But the collapse of the gold standard destroyed confidence in financial stability, prompting capital flight which undermined the solvency of financial institutions. . . Removing the gold standard, the argument continues, further intensified the crisis. Having suspended gold convertibility, policymakers manipulated currencies, engaging in beggar thy neighbor depreciations that purportedly did nothing to stimulate economic recovery at home while only worsening the Depression abroad.

The gold standard, then, is conventionally portrayed as synonymous with financial stability. Its downfall starting in 1929 is implicated in the global financial crisis and the worldwide depression. A central message of this book is that precisely the opposite was true. (Golden Fetters, pp. 3-4).

That is about as clear and succinct and accurate a description of the basic facts leading up to and surrounding the Great Depression as one could ask for, save for the omission of one important causal factor: the world monetary demand for gold.

Eichengreen was certainly not unaware of the importance of the monetary demand for gold, and in the pages that immediately follow, he attempts to fill in that part of the story, adding to our understanding of how the gold standard worked by penetrating deeply into the nature and role of the expectations that supported the gold standard, during its heyday, and the difficulty of restoring those stabilizing expectations after the havoc of World War I and the unexpected post-war inflation and subsequent deep 1920-21 depression. Those stabilizing expectations, Eichengreen argued, were the result of the credibility of the commitment to the gold standard and the international cooperation between governments and monetary authorities to ensure that the international gold standard would be maintained notwithstanding the occasional stresses and strains to which a complex institution would inevitably be subjected.

The stability of the prewar gold standard was instead the result of two very different factors: credibility and cooperation. Credibility is the confidence invested by the public in the government’s commitment to a policy. The credibility of the gold standard derived from the priority attached by governments to the maintenance of to the maintenance of balance-of-payments equilibrium. In the core countries – Britain, France and Germany – there was little doubt that the authorities would take whatever steps were required to defend the central bank’s gold reserves and maintain the convertibility of the currency into gold. If one of these central banks lost gold reserves and its exchange rate weakened, fund would flow in from abroad in anticipation of the capital gains investors in domestic assets would reap once the authorities adopted measures to stem reserve losses and strengthen the exchange rate. . . The exchange rate consequently strengthened on its own, and stabilizing capital flows minimized the need for government intervention. The very credibility of the official commitment to gold meant that this commitment was rarely tested. (p. 5)

But credibility also required cooperation among the various countries on the gold standard, especially the major countries at its center, of which Britain was the most important.

Ultimately, however, the credibility of the prewar gold standard rested on international cooperation. When the stabilizing speculation and domestic intervention proved incapable of accommodating a disturbance, the system was stabilized through cooperation among governments and central banks. Minor problems could be solved by tacit cooperation, generally achieved without open communication among the parties involved. . . Under such circumstances, the most prominent central bank, the Bank of England, signaled the need for coordinated action. When it lowered its discount rate, other central banks usually responded in kind. In effect, the Bank of England provided a focal point for the harmonization of national monetary policies. . .

Major crises in contrast typically required different responses from different countries. The country losing gold and threatened by a convertibility crisis had to raise interest rates to attract funds from abroad; other countries had to loosen domestic credit conditions to make funds available to the central bank experiencing difficulties. The follow-the-leader approach did not suffice. . . . Such crises were instead contained through overt, conscious cooperation among central banks and governments. . . Consequently, the resources any one country could draw on when its gold parity was under attack far exceeded its own reserves; they included the resources of the other gold standard countries. . . .

What rendered the commitment to the gold standard credible, then, was that the commitment was international, not merely national. That commitment was achieved through international cooperation. (pp. 7-8)

Eichengreen uses this excellent conceptual framework to explain the dysfunction of the newly restored gold standard in the 1920s. Because of the monetary dislocation and demonetization of gold during World War I, the value of gold had fallen to about half of its prewar level, thus to reestablish the gold standard required not only restoring gold as a currency standard but also readjusting – sometimes massively — the prewar relative values of the various national currency units. And to prevent the natural tendency of gold to revert to its prewar value as gold was remonetized would require an unprecedented level of international cooperation among the various countries as they restored the gold standard. Thus, the gold standard was being restored in the 1920s under conditions in which neither the credibility of the prewar commitment to the gold standard nor the level of international cooperation among countries necessary to sustain that commitment was restored.

An important further contribution that Eichengreen, following Temin, brings to the historical narrative of the Great Depression is to incorporate the political forces that affected and often determined the decisions of policy makers directly into the narrative rather than treat those decisions as being somehow exogenous to the purely economic forces that were controlling the unfolding catastrophe.

The connection between domestic politics and international economics is at the center of this book. The stability of the prewar gold standard was attributable to a particular constellation of political as well as economic forces. Similarly, the instability of the interwar gold standard is explicable in terms of political as well as economic changes. Politics enters at two levels. First, domestic political pressures influence governments’ choices of international economic policies. Second, domestic political pressures influence the credibility of governments’ commitments to policies and hence their economic effects. . . (p. 10)

The argument, in a nutshell, is that credibility and cooperation were central to the smooth operation of the classical gold standard. The scope for both declined abruptly with the intervention of World War I. The instability of the interwar gold standard was the inevitable result. (p. 11)

Having explained and focused attention on the necessity for credibility and cooperation for a gold standard to function smoothly, Eichengreen then begins his introductory account of how the lack of credibility and cooperation led to the breakdown of the gold standard that precipitated the Great Depression, starting with the structural shift after World War I that made the rest of the world highly dependent on the US as a source of goods and services and as a source of credit, rendering the rest of the world chronically disposed to run balance-of-payments deficits with the US, deficits that could be financed only by the extension of credit by the US.

[I]f U.S. lending were interrupted, the underlying weakness of other countries’ external positions . . . would be revealed. As they lost gold and foreign exchange reserves, the convertibility of their currencies into gold would be threatened. Their central banks would be forced to restrict domestic credit, their fiscal authorities to compress public spending, even if doing so threatened to plunge their economies into recession.

This is what happened when U.S. lending was curtailed in the summer of 1928 as a result of increasingly stringent Federal Reserve monetary policy. Inauspiciously, the monetary contraction in the United States coincided with a massive flow of gold to France, where monetary policy was tight for independent reasons. Thus, gold and financial capital were drained by the United States and France from other parts of the world. Superimposed on already weak foreign balances of payments, these events provoked a greatly magnified monetary contraction abroad. In addition they caused a tightening of fiscal policies in parts of Europe and much of Latin America. This shift in policy worldwide, and not merely the relatively modest shift in the United States, provided the contractionary impulse that set the stage for the 1929 downturn. The minor shift in American policy had such dramatic effects because of the foreign reaction it provoked through its interactions with existing imbalances in the pattern of international settlements and with the gold standard constraints. (pp. 12-13)

Eichengreen then makes a rather bold statement, with which, despite my agreement with, and admiration for, everything he has written to this point, I would take exception.

This explanation for the onset of the Depression, which emphasizes concurrent shifts in economic policy in the Unites States and abroad, the gold standard as the connection between them, and the combined impact of U.S. and foreign economic policies on the level of activity, has not previously appeared in the literature. Its elements are familiar, but they have not been fit together into a coherent account of the causes of the 1929 downturn. (p. 13)

I don’t think that Eichengreen’s claim of priority for his explanation of the onset of the 1929 downturn can be defended, though I certainly wouldn’t suggest that he did not arrive at his understanding of what caused the Great Depression largely on his own. But it is abundantly clear from reading the writings of Hawtrey and Cassel starting as early as 1919, that the basic scenario outlined by Eichengreen was clearly spelled out by Hawtrey and Cassel well before the Great Depression started, as papers by Ron Batchelder and me and by Doug Irwin have thoroughly documented. Undoubtedly Eichengreen has added a great deal of additional insight and depth and done important quantitative and documentary empirical research to buttress his narrative account of the causes of the Great Depression, but the basic underlying theory has not changed.

Eichengreen is not unaware of Hawtrey’s contribution and in a footnote to the last quoted paragraph, Eichengreen writes as follows.

The closest precedents lie in the work of the British economists Lionel Robbins and Ralph Hawtrey, in the writings of German historians concerned with the causes of their economy’s precocious slump, and in Temin (1989). Robbins (1934) hinted at many of the mechanism emphasized here but failed to develop the argument fully. Hawtrey emphasized how the contractionary shift in U.S. monetary policy, superimposed on an already weak British balance of payments position, forced a draconian contraction on the Bank of England, plunging the world into recession. See Hawtrey (1933), especially chapter 2. But Hawtrey’s account focused almost entirely on the United States and the United Kingdom, neglecting the reaction of other central banks, notably the Bank of France, whose role was equally important. (p. 13, n. 17)

Unfortunately, this footnote neither clarifies nor supports Eichengreen’s claim of priority for his account of the role of the gold standard in the Great Depression. First, the bare citation of Robbins’s 1934 book The Great Depression is confusing at best, because Robbins’s explanation of the cause of the Great Depression, which he himself later disavowed, is largely a recapitulation of the Austrian business-cycle theory that attributed the downturn to a crisis caused by monetary expansion by the Fed and the Bank of England. Eichengreen correctly credits Hawtrey for attributing the Great Depression, in almost diametric opposition to Robbins, to contractionary monetary policy by the Fed and the Bank of England, but then seeks to distinguish Hawtrey’s explanation from his own by suggesting that Hawtrey neglected the role of the Bank of France.

Eichengreen mentions Hawtrey’s account of the Great Depression in his 1933 book, Trade Depression and the Way Out, 2^nd edition. I no longer have a copy of that work accessible to me, but in the first edition of this work published in 1931, Hawtrey included a brief section under the heading “The Demand for Gold as Money since 1914.”

[S]ince 1914 arbitrary changes in monetary policy and in the demand for gold as money have been greater and more numerous than ever before. Frist came the general abandonment of the gold standard by the belligerent countries in favour of inconvertible paper, and the release of hundreds of millions of gold. By 1920 the wealth value of gold had fallen to two-fifths of what it had been in 1913. The United States, which was almost alone at that time in maintaining a gold standard, thereupon started contracting credit and absorbing gold on a vast scale. In June 1924 the wealth value of gold was seventy per cent higher than at its lowest point in 1920, and the amount of gold held for monetary purposes in the United States had grown from $2,840,000,000 in 1920 to $4,488,000,000.

Other countries were then beginning to return to the gold standard, Gemany in 1924, England in 1925, besides several of the smaller countries of Europe. In the years 1924-8 Germany absorbed over £100,000,000 of gold. France stabilized her currency in 1927 and re-established the gold standard in 1928, and absorbed over £60,000,000 in 1927-8. But meanwhile, the Unitd States had been parting with gold freely and her holding had fallen to $4,109,000,000 in June 1928. Large as these movements had been, they had not seriously disturbed the world value of gold. . . .

But from 1929 to the present time has been a period of immense and disastrous instability. France has added more than £200,000,000 to her gold holding, and the United Statesmore than $800,000,000. In the two and a half years the world’s gold output has been a little over £200,000,000, but a part of this been required for the normal demands of industry. The gold absorbed by France and America has exceeded the fresh supply of gold for monetary purposes by some £200,000,000.

This has had to be wrung from other countries, and much o of it has come from new countries such as Australia, Argentina and Brazil, which have been driven off the gold standard and have used their gold reserves to pay their external liabilities, such as interest on loans payable in foreign currencies. (pp. 20-21)

The idea that Hawtrey neglected the role of the Bank of France is clearly inconsistent with the work that Eichengreen himself cites as evidence for that neglect. Moreover in Hawtrey’s 1932 work, The Art of Central Banking, his first chapter is entitled “French Monetary Policy” which directly addresses the issues supposedly neglected by Hawtrey. Here is an example.

I am inclined therefore to say that while the French absorption of gold in the period from January 1929 to May 1931 was in fact one of the most powerful causes of the world depression, that is only because it was allowed to react an unnecessary degree upon the monetary policy of other countries. (p. 38)

In his foreward to the 1962 reprinting of his volume, Hawtrey mentions his chapter on French Monetary Policy in a section under the heading “Gold and the Great Depression.”

Conspicuous among countries accumulating reserves foreign exchange was France. Chapter 1 of this book records how, in the course of stabilizing the franc in the years 1926-8, the Bank of France accumulated a vast holding of foreign exchange [i.e., foreign bank liabilities payable in gold], and in the ensuing years proceeded to liquidate it [for gold]. Chapter IV . . . shows the bearing of the French absorption of gold upon the starting of the great depression of the 1930s. . . . The catastrophe foreseen in 1922 [!] had come to pass, and the moment had come to point to the moral. The disaster was due to the restoration of the gold standard without any provision for international cooperation to prevent undue fluctuations in the purchasing power of gold. (pp. xiv-xv)

Moreover, on p. 254 of Golden Fetters, Eichengreen himself cites Hawtrey as one of the “foreign critics” of Emile Moreau, Governor of the Bank of France during the 1920s and 1930s “for failing to build “a structure of credit” on their gold imports. By failing to expand domestic credit and to repel gold inflows, they argued, the French had violated the rules of the gold standard game.” In the same paragraph Eichengreen also cites Hawtrey’s recommendation that the Bank of France change its statutes to allow for the creation of domestically supplied money and credit that would have obviated the need for continuing imports of gold.

Finally, writers such as Clark Johnson and Kenneth Mouré, who have written widely respected works on French monetary policy during the 1920s and 1930s, cite Hawtrey extensively as one of the leading contemporary critics of French monetary policy.

PS I showed Barry Eichengreen a draft of this post a short while ago, and he agrees with my conclusion that Hawtrey, and presumably Cassel also, had anticipated the key elements of his explanation of how the breakdown of the gold standard, resulting largely from the breakdown of international cooperation, was the primary cause of the Great Depression. I am grateful to Barry for his quick and generous response to my query.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Gold Exchange Standard

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

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

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

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

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

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

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

The Second Post-War Deflation

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

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

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

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

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

This is correct, and I fully agree.

How It Could Have been Different

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

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

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

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

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

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

Milton Friedman and How not to Think about the Gold Standard, France, Sterilization and the Great Depression

Published November 13, 2017 Bank of France , David Beckworth , Douglas Irwin , Emile Moreau , Federal Reserve , gold standard , Great Depression , Gustav Cassel , Milton Friedman , price-specie-flow mechanism , R. G. Hawtrey , rules of the game , sterilization 33 Comments

Last week I listened to David Beckworth on his excellent podcast Macro Musings, interviewing Douglas Irwin. I don’t think I’ve ever met Doug, but we’ve been in touch a number of times via email. Doug is one of our leading economic historians, perhaps the foremost expert on the history of US foreign-trade policy, and he has just published a new book on the history of US trade policy, Clashing over Commerce. As you would expect, most of the podcast is devoted to providing an overview of the history of US trade policy, but toward the end of the podcast, David shifts gears and asks Doug about his work on the Great Depression, questioning Doug about two of his papers, one on the origins of the Great Depression (“Did France Cause the Great Depression?”), the other on the 1937-38 relapse into depression, (“Gold Sterlization and the Recession of 1937-1938“) just as it seemed that the US was finally going to recover fully from the catastrophic 1929-33 downturn.

Regular readers of this blog probably know that I hold the Bank of France – and its insane gold accumulation policy after rejoining the gold standard in 1928 – primarily responsible for the deflation that inevitably led to the Great Depression. In his paper on France and the Great Depression, Doug makes essentially the same argument pointing out that the gold reserves of the Bank of France increased from about 7% of the world stock of gold reserves to about 27% of the world total in 1932. So on the substance, Doug and I are in nearly complete agreement that the Bank of France was the chief culprit in this sad story. Of course, the Federal Reserve in late 1928 and 1929 also played a key supporting role, attempting to dampen what it regarded as reckless stock-market speculation by raising interest rates, and, as a result, accumulating gold even as the Bank of France was rapidly accumulating gold, thereby dangerously amplifying the deflationary pressure created by the insane gold-accumulation policy of the Bank of France.

Now I would not have taken the time to write about this podcast just to say that I agreed with what Doug and David were saying about the Bank of France and the Great Depression. What prompted me to comment about the podcast were two specific remarks that Doug made. The first was that his explanation of how France caused the Great Depression was not original, but had already been provided by Milton Friedman, Clark Johnson, and Scott Sumner. I agree completely that Clark Johnson and Scott Sumner wrote very valuable and important books on the Great Depression and provided important new empirical findings confirming that the Bank of France played a very malign role in creating the deflationary downward spiral that was the chief characteristic of the Great Depression. But I was very disappointed in Doug’s remark that Friedman had been the first to identify the malign role played by the Bank of France in precipitating the Great Depression. Doug refers to the foreward that Friedman wrote for the English translation of the memoirs of Emile Moreau the Governor of the Bank of France from 1926 to 1930 (The Golden Franc: Memoirs of a Governor of the Bank of France: The Stabilization of the Franc (1926-1928). Moreau was a key figure in the stabilization of the French franc in 1926 after its exchange rate had fallen by about 80% against the dollar between 1923 and 1926, particularly in determining the legal exchange rate at which the franc would be pegged to gold and the dollar, when France officially rejoined the gold standard in 1928.

That Doug credits Friedman for having – albeit belatedly — grasped the role of the Bank of France in causing the Great Depression, almost 30 years after attributing the Depression in his Monetary History of the United States, almost entirely to policy mistakes mistakes by the Federal Reserve in late 1930 and early 1931 is problematic for two reasons. First, Doug knows very well that both Gustave Cassel and Ralph Hawtrey correctly diagnosed the causes of the Great Depression and the role of the Bank of France during – and even before – the Great Depression. I know that Doug knows this well, because he wrote this paper about Gustav Cassel’s diagnosis of the Great Depression in which he notes that Hawtrey made essentially the same diagnosis of the Depression as Cassel did. So, not only did Friedman’s supposed discovery of the role of the Bank of France come almost 30 years after publication of the Monetary History, it was over 60 years after Hawtrey and Cassel had provided a far more coherent account of what happened in the Great Depression and of the role of the Bank of France than Friedman provided either in the Monetary History or in his brief foreward to the translation of Moreau’s memoirs.

That would have been bad enough, but a close reading of Friedman’s foreward shows that even though, by 1991 when he wrote that foreward, he had gained some insight into the disruptive and deflationary influence displayed exerted by the Bank of France, he had an imperfect and confused understanding of the transmission mechanism by which the actions of the Bank of France affected the rest of the world, especially the countries on the gold standard. I have previously discussed in a 2015 post, what I called Friedman’s cluelessness about the insane policy of the Bank of France. So I will now quote extensively from my earlier post and supplement with some further comments:

Friedman’s foreward to Moreau’s memoir is sometimes cited as evidence that he backtracked from his denial in the Monetary History that the Great Depression had been caused by international forces, Friedman insisting that there was actually nothing special about the initial 1929 downturn and that the situation only got out of hand in December 1930 when the Fed foolishly (or maliciously) allowed the Bank of United States to fail, triggering a wave of bank runs and bank failures that caused a sharp decline in the US money stock. According to Friedman it was only at that point that what had been a typical business-cycle downturn degenerated into what he liked to call the Great Contraction. Let me now quote Friedman’s 1991 acknowledgment that the Bank of France played some role in causing the Great Depression.

Rereading the memoirs of this splendid translation . . . has impressed me with important subtleties that I missed when I read the memoirs in a language not my own and in which I am far from completely fluent. Had I fully appreciated those subtleties when Anna Schwartz and I were writing our A Monetary History of the United States, we would likely have assessed responsibility for the international character of the Great Depression somewhat differently. We attributed responsibility for the initiation of a worldwide contraction to the United States and I would not alter that judgment now. However, we also remarked, “The international effects were severe and the transmission rapid, not only because the gold-exchange standard had rendered the international financial system more vulnerable to disturbances, but also because the United States did not follow gold-standard rules.” Were I writing that sentence today, I would say “because the United States and France did not follow gold-standard rules.”

I find this minimal adjustment by Friedman of his earlier position in the Monetary History totally unsatisfactory. Why do I find it unsatisfactory? To begin with, Friedman makes vague references to unnamed but “important subtleties” in Moreau’s memoir that he was unable to appreciate before reading the 1991 translation. There was nothing subtle about the gold accumulation being undertaken by the Bank of France; it was massive and relentless. The table below is constructed from data on official holdings of monetary gold reserves from December 1926 to June 1932 provided by Clark Johnson in his important book Gold, France, and the Great Depression, pp. 190-93. In December 1926 France held $711 million in gold or 7.7% of the world total of official gold reserves; in June 1932, French gold holdings were $3.218 billion or 28.4% of the world total. [I omit a table of world monetary gold reserves from December 1926 to June 1932 included in my earlier post.]

What was it about that policy that Friedman didn’t get? He doesn’t say. What he does say is that he would not alter his previous judgment that the US was responsible “for the initiation of a worldwide contraction.” The only change he would make would be to say that France, as well as the US, contributed to the vulnerability of the international financial system to unspecified disturbances, because of a failure to follow “gold-standard rules.” I will just note that, as I have mentioned many times on this blog, references to alleged “gold standard rules” are generally not only unhelpful, but confusing, because there were never any rules as such to the gold standard, and what are termed “gold-standard rules” are largely based on a misconception, derived from the price-specie-flow fallacy, of how the gold standard actually worked.

New Comment. And I would further add that references to the supposed gold-standard rules are confusing, because, in the misguided tradition of the money multiplier, the idea of gold-standard rules of the game mistakenly assumes that the direction of causality between monetary reserves and bank money (either banknotes or bank deposits) created either by central banks or commercial banks goes from reserves to money. But bank reserves are held, because banks have created liabilities (banknotes and deposits) which, under the gold standard, could be redeemed either directly or indirectly for “base money,” e.g., gold under the gold standard. For prudential reasons, or because of legal reserve requirements, national monetary authorities operating under a gold standard held gold reserves in amounts related — in some more or less systematic fashion, but also depending on various legal, psychological and economic considerations — to the quantity of liabilities (in the form of banknotes and bank deposits) that the national banking systems had created. I will come back to, and elaborate on, this point below. So the causality runs from money to reserves, not, as the price-specie-flow mechanism and the rules-of-the-game idea presume, from reserves to money. Back to my earlier post:

So let’s examine another passage from Friedman’s forward, and see where that takes us.

Another feature of Moreau’s book that is most fascinating . . . is the story it tells of the changing relations between the French and British central banks. At the beginning, with France in desperate straits seeking to stabilize its currency, [Montagu] Norman [Governor of the Bank of England] was contemptuous of France and regarded it as very much of a junior partner. Through the accident that the French currency was revalued at a level that stimulated gold imports, France started to accumulate gold reserves and sterling reserves and gradually came into the position where at any time Moreau could have forced the British off gold by withdrawing the funds he had on deposit at the Bank of England. The result was that Norman changed from being a proud boss and very much the senior partner to being almost a supplicant at the mercy of Moreau.

What’s wrong with this passage? Well, Friedman was correct about the change in the relative positions of Norman and Moreau from 1926 to 1928, but to say that it was an accident that the French currency was revalued at a level that stimulated gold imports is completely — and in this case embarrassingly — wrong, and wrong in two different senses: one strictly factual, and the other theoretical. First, and most obviously, the level at which the French franc was stabilized — 125 francs per pound — was hardly an accident. Indeed, it was precisely the choice of the rate at which to stabilize the franc that was a central point of Moreau’s narrative in his memoir . . . , the struggle between Moreau and his boss, the French Premier, Raymond Poincaré, over whether the franc would be stabilized at that rate, the rate insisted upon by Moreau, or the prewar parity of 25 francs per pound. So inquiring minds can’t help but wonder what exactly did Friedman think he was reading?

The second sense in which Friedman’s statement was wrong is that the amount of gold that France was importing depended on a lot more than just its exchange rate; it was also a function of a) the monetary policy chosen by the Bank of France, which determined the total foreign-exchange holdings held by the Bank of France, and b) the portfolio decisions of the Bank of France about how, given the exchange rate of the franc and given the monetary policy it adopted, the resulting quantity of foreign-exchange reserves would be held.

I referred to Friedman’s foreward in which he quoted from his own essay “Should There Be an Independent Monetary Authority?” contrasting the personal weakness of W. P. G. Harding, Governor of the Federal Reserve in 1919-20, with the personal strength of Moreau. Quoting from Harding’s memoirs in which he acknowledged that his acquiescence in the U.S. Treasury’s desire to borrow at “reasonable” interest rates caused the Board to follow monetary policies that ultimately caused a rapid postwar inflation

Almost every student of the period is agreed that the great mistake of the Reserve System in postwar monetary policy was to permit the money stock to expand very rapidly in 1919 and then to step very hard on the brakes in 1920. This policy was almost surely responsible for both the sharp postwar rise in prices and the sharp subsequent decline. It is amusing to read Harding’s answer in his memoirs to criticism that was later made of the policies followed. He does not question that alternative policies might well have been preferable for the economy as a whole, but emphasizes the treasury’s desire to float securities at a reasonable rate of interest, and calls attention to a then-existing law under which the treasury could replace the head of the Reserve System. Essentially he was saying the same thing that I heard another member of the Reserve Board say shortly after World War II when the bond-support program was in question. In response to the view expressed by some of my colleagues and myself that the bond-support program should be dropped, he largely agreed but said ‘Do you want us to lose our jobs?’

The importance of personality is strikingly revealed by the contrast between Harding’s behavior and that of Emile Moreau in France under much more difficult circumstances. Moreau formally had no independence whatsoever from the central government. He was named by the premier, and could be discharged at any time by the premier. But when he was asked by the premier to provide the treasury with funds in a manner that he considered inappropriate and undesirable, he flatly refused to do so. Of course, what happened was that Moreau was not discharged, that he did not do what the premier had asked him to, and that stabilization was rather more successful.

Now, if you didn’t read this passage carefully, in particular the part about Moreau’s threat to resign, as I did not the first three or four times that I read it, you might not have noticed what a peculiar description Friedman gives of the incident in which Moreau threatened to resign following a request “by the premier to provide the treasury with funds in a manner that he considered inappropriate and undesirable.” That sounds like a very strange request for the premier to make to the Governor of the Bank of France. The Bank of France doesn’t just “provide funds” to the Treasury. What exactly was the request? And what exactly was “inappropriate and undesirable” about that request?

I have to say again that I have not read Moreau’s memoir, so I can’t state flatly that there is no incident in Moreau’s memoir corresponding to Friedman’s strange account. However, Jacques Rueff, in his preface to the 1954 French edition (translated as well in the 1991 English edition), quotes from Moreau’s own journal entries how the final decision to stabilize the French franc at the new official parity of 125 per pound was reached. And Friedman actually refers to Rueff’s preface in his foreward! Let’s read what Rueff has to say:

The page for May 30, 1928, on which Mr. Moreau set out the problem of legal stabilization, is an admirable lesson in financial wisdom and political courage. I reproduce it here in its entirety with the hope that it will be constantly present in the minds of those who will be obliged in the future to cope with French monetary problems.

“The word drama may sound surprising when it is applied to an event which was inevitable, given the financial and monetary recovery achieved in the past two years. Since July 1926 a balanced budget has been assured, the National Treasury has achieved a surplus and the cleaning up of the balance sheet of the Bank of France has been completed. The April 1928 elections have confirmed the triumph of Mr. Poincaré and the wisdom of the ideas which he represents. . . . Under such conditions there is nothing more natural than to stabilize the currency, which has in fact already been pegged at the same level for the last eighteen months.

“But things are not quite that simple. The 1926-28 recovery restored confidence to those who had actually begun to give up hope for their country and its capacity to recover from the dark hours of July 1926. . . . perhaps too much confidence.

“Distinguished minds maintained that it was possible to return the franc to its prewar parity, in the same way as was done with the pound sterling. And how tempting it would be to thereby cancel the effects of the war and postwar periods and to pay back in the same currency those who had lent the state funds which for them often represented an entire lifetime of unremitting labor.

“International speculation seemed to prove them right, because it kept changing its dollars and pounds for francs, hoping that the franc would be finally revalued.

“Raymond Poincaré, who was honesty itself and who, unlike most politicians, was truly devoted to the public interest and the glory of France, did, deep in his heart, agree with those awaiting a revaluation.

“But I myself had to play the ungrateful role of representative of the technicians who knew that after the financial bloodletting of the past years it was impossible to regain the original parity of the franc.

“I was aware, as had already been determined by the Committee of Experts in 1926, that it was impossible to revalue the franc beyond certain limits without subjecting the national economy to a particularly painful re-adaptation. If we were to sacrifice the vital force of the nation to its acquired wealth, we would put at risk the recovery we had already accomplished. We would be, in effect, preparing a counter-speculation against our currency that would come within a rather short time.

“Since the parity of 125 francs to one pound has held for long months and the national economy seems to have adapted itself to it, it should be at this rate that we stabilize without further delay.

“This is what I had to tell Mr. Poincaré at the beginning of June 1928, tipping the scales of his judgment with the threat of my resignation.” [my emphasis, DG]

So what this tells me is that the very act of personal strength that so impressed Friedman . . . was not about some imaginary “inappropriate” request made by Poincaré (“who was honesty itself”) for the Bank to provide funds to the treasury, but about whether the franc should be stabilized at 125 francs per pound, a peg that Friedman asserts was “accidental.” Obviously, it was not “accidental” at all, but . . . based on the judgment of Moreau and his advisers . . . as attested to by Rueff in his preface.

Just to avoid misunderstanding, I would just say here that I am not suggesting that Friedman was intentionally misrepresenting any facts. I think that he was just being very sloppy in assuming that the facts actually were what he rather cluelessly imagined them to be.

Before concluding, I will quote again from Friedman’s foreword:

Benjamin Strong and Emile Moreau were admirable characters of personal force and integrity. But in my view, the common policies they followed were misguided and contributed to the severity and rapidity of transmission of the U.S. shock to the international community. We stressed that the U.S. “did not permit the inflow of gold to expand the U.S. money stock. We not only sterilized it, we went much further. Our money stock moved perversely, going down as the gold stock went up” from 1929 to 1931. France did the same, both before and after 1929.

Strong and Moreau tried to reconcile two ultimately incompatible objectives: fixed exchange rates and internal price stability. Thanks to the level at which Britain returned to gold in 1925, the U.S. dollar was undervalued, and thanks to the level at which France returned to gold at the end of 1926, so was the French franc. Both countries as a result experienced substantial gold inflows.

New Comment. Actually, between December 1926 and December 1928, US gold reserves decreased by almost $350 million while French gold reserves increased by almost $550 million, suggesting that factors other than whether the currency peg was under- or over-valued determined the direction in which gold was flowing.

Gold-standard rules called for letting the stock of money rise in response to the gold inflows and for price inflation in the U.S. and France, and deflation in Britain, to end the over-and under-valuations. But both Strong and Moreau were determined to prevent inflation and accordingly both sterilized the gold inflows, preventing them from providing the required increase in the quantity of money. The result was to drain the other central banks of the world of their gold reserves, so that they became excessively vulnerable to reserve drains. France’s contribution to this process was, I now realize, much greater than we treated it as being in our History.

New Comment. I pause here to insert the following diatribe about the mutually supporting fallacies of the price-specie-flow mechanism, the rules of the game under the gold standard, and central-bank sterilization expounded on by Friedman, and, to my surprise and dismay, assented to by Irwin and Beckworth. Inflation rates under a gold standard are, to a first approximation, governed by international price arbitrage so that prices difference between the same tradeable commodities in different locations cannot exceed the cost of transporting those commodities between those locations. Even if not all goods are tradeable, the prices of non-tradeables are subject to forces bringing their prices toward an equilibrium relationship with the prices of tradeables that are tightly pinned down by arbitrage. Given those constraints, monetary policy at the national level can have only a second-order effect on national inflation rates, because the prices of non-tradeables that might conceivably be sensitive to localized monetary effects are simultaneously being driven toward equilibrium relationships with tradeable-goods prices.

The idea that the supposed sterilization policies about which Friedman complains had anything to do with the pursuit of national price-level targets is simply inconsistent with a theoretically sound understanding of how national price levels were determined under the gold standard. The sterilization idea mistakenly assumes that, under the gold standard, the quantity of money in any country is what determines national price levels and that monetary policy in each country has to operate to adjust the quantity of money in each country to a level consistent with the fixed-exchange-rate target set by the gold standard.

Again, the causality runs in the opposite direction; under a gold standard, national price levels are, as a first approximation, determined by convertibility, and the quantity of money in a country is whatever amount of money that people in that country want to hold given the price level. If the quantity of money that the people in a country want to hold is supplied by the national monetary authority or by the local banking system, the public can obtain the additional money they demand exchanging their own liabilities for the liabilities of the monetary authority or the local banks, without having to reduce their own spending in order to import the gold necessary to obtain additional banknotes from the central bank. And if the people want to get rid of excess cash, they can dispose of the cash through banking system without having to dispose of it via a net increase in total spending involving an import surplus. The role of gold imports is to fill in for any deficiency in the amount of money supplied by the monetary authority and the local banks, while gold exports are a means of disposing of excess cash that people are unwilling to hold. France was continually importing gold after the franc was stabilized in 1926 not because the franc was undervalued, but because the French monetary system was such that the additional cash demanded by the public could not be created without obtaining gold to be deposited in the vaults of the Bank of France. To describe the Bank of France as sterilizing gold imports betrays a failure to understand the imports of gold were not an accidental event that should have triggered a compensatory policy response to increase the French money supply correspondingly. The inflow of gold was itself the policy and the result that the Bank of France deliberately set out to implement. If the policy was to import gold, then calling the policy gold sterilization makes no sense, because, the quantity of money held by the French public would have been, as a first approximation, about the same whatever policy the Bank of France followed. What would have been different was the quantity of gold reserves held by the Bank of France.

To think that sterilization describes a policy in which the Bank of France kept the French money stock from growing as much as it ought to have grown is just an absurd way to think about how the quantity of money was determined under the gold standard. But it is an absurdity that has pervaded discussion of the gold standard, for almost two centuries. Hawtrey, and, two or three generations later, Earl Thompson, and, independently Harry Johnson and associates (most notably Donald McCloskey and Richard Zecher in their two important papers on the gold standard) explained the right way to think about how the gold standard worked. But the old absurdities, reiterated and propagated by Friedman in his Monetary History, have proven remarkably resistant to basic economic analysis and to straightforward empirical evidence. Now back to my critique of Friedman’s foreward.

These two paragraphs are full of misconceptions; I will try to clarify and correct them. First Friedman refers to “the U.S. shock to the international community.” What is he talking about? I don’t know. Is he talking about the crash of 1929, which he dismissed as being of little consequence for the subsequent course of the Great Depression, whose importance in Friedman’s view was certainly far less than that of the failure of the Bank of United States? But from December 1926 to December 1929, total monetary gold holdings in the world increased by about $1 billion; while US gold holdings declined by nearly $200 million, French holdings increased by $922 million over 90% of the increase in total world official gold reserves. So for Friedman to have even suggested that the shock to the system came from the US and not from France is simply astonishing.

Friedman’s discussion of sterilization lacks any coherent theoretical foundation, because, working with the most naïve version of the price-specie-flow mechanism, he imagines that flows of gold are entirely passive, and that the job of the monetary authority under a gold standard was to ensure that the domestic money stock would vary proportionately with the total stock of gold. But that view of the world ignores the possibility that the demand to hold money in any country could change. Thus, Friedman, in asserting that the US money stock moved perversely from 1929 to 1931, going down as the gold stock went up, misunderstands the dynamic operating in that period. The gold stock went up because, with the banking system faltering, the public was shifting their holdings of money balances from demand deposits to currency. Legal reserves were required against currency, but not against demand deposits, so the shift from deposits to currency necessitated an increase in gold reserves. To be sure the US increase in the demand for gold, driving up its value, was an amplifying factor in the worldwide deflation, but total US holdings of gold from December 1929 to December 1931 rose by $150 million compared with an increase of $1.06 billion in French holdings of gold over the same period. So the US contribution to world deflation at that stage of the Depression was small relative to that of France.

Friedman is correct that fixed exchange rates and internal price stability are incompatible, but he contradicts himself a few sentences later by asserting that Strong and Moreau violated gold-standard rules in order to stabilize their domestic price levels, as if it were the gold-standard rules rather than market forces that would force domestic price levels into correspondence with a common international level. Friedman asserts that the US dollar was undervalued after 1925 because the British pound was overvalued, presuming with no apparent basis that the US balance of payments was determined entirely by its trade with Great Britain. As I observed above, the exchange rate is just one of the determinants of the direction and magnitude of gold flows under the gold standard, and, as also pointed out above, gold was generally flowing out of the US after 1926 until the ferocious tightening of Fed policy at the end of 1928 and in 1929 caused a sizable inflow of gold into the US in 1929.

However, when, in the aggregate, central banks were tightening their policies, thereby tending to accumulate gold, the international gold market would come under pressure, driving up the value of gold relative goods, thereby causing deflationary pressure among all the gold standard countries. That is what happened in 1929, when the US started to accumulate gold even as the insane Bank of France was acting as a giant international vacuum cleaner sucking in gold from everywhere else in the world. Friedman, even as he was acknowledging that he had underestimated the importance of the Bank of France in the Monetary History, never figured this out. He was obsessed, instead with relatively trivial effects of overvaluation of the pound, and undervaluation of the franc and the dollar. Talk about missing the forest for the trees.

Hayek, Deflation and Nihilism

Published July 23, 2017 deflation , Great Depression , Hansjorg Klausinger , Hayek , Larry White , secondary deflation 20 Comments
Tags: David Laidler, Gottried Haberler, Wilhelm Roepke

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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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

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