Archive for the 'Great Depression' Category



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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Great, but Misguided, Benjamin Strong Goes Astray in 1928

In making yet further revisions to our paper on Hawtrey and Cassel, Ron Batchelder and I keep finding interesting new material that sheds new light on the thinking behind the policies that led to the Great Depression. Recently I have been looking at the digital archive of Benjamin Strong’s papers held at the Federal Reserve Bank. Benjamin Strong was perhaps the greatest central banker who ever lived. Milton Friedman, Charles Kindleberger, Irving Fisher, and Ralph Hawtrey – and probably others as well — all believed that if Strong, Governor of the New York Federal Reserve Bank from 1914 to 1928 and effectively the sole policy maker for the entire system, had not died in 1928, the Great Depression would have been avoided entirely or, at least, would have been far less severe and long-lasting. My own view had been that Strong had generally understood the argument of Hawtrey and Cassel about the importance of economizing on gold, and, faced with the insane policy of the Bank of France, would have accommodated that policy by allowing an outflow of gold from the immense US holdings, rather than raise interest rates and induce an inflow of gold into the US in 1929, as happened under his successor, George Harrison.

Having spent some time browsing through the papers, I am sorry — because Strong’s truly remarkable qualities are evident in his papers — to say that the papers also show to my surprise and disappointment that Strong was very far from being a disciple of Hawtrey or Cassel or of any economist, and he seems to have been entirely unconcerned in 1928 about the policy of the Bank of France or the prospect of a deflationary run-up in the value of gold even though his friend Montague Norman, Governor of the Bank of England, was beginning to show some nervousness about “a scramble for gold,” while other observers were warning of a deflationary collapse. I must admit that, at least one reason for my surprise is that I had naively accepted the charges made by various Austrians – most notably Murray Rothbard – that Strong was a money manager who had bought into the dangerous theories of people like Irving Fisher, Ralph Hawtrey and J. M. Keynes that central bankers should manipulate their currencies to stabilize the price level. The papers I have seen show that, far from being a money manager and a price-level stabilizer, Strong expressed strong reservations about policies for stabilizing the price level, and was more in sympathy with the old-fashioned gold standard than with the gold-exchange standard — the paradigm promoted by Hawtrey and Cassel and endorsed at the Genoa Conference of 1922. Rothbard’s selective quotation from the memorandum summarizing Strong’s 1928 conversation with Sir Arthur Salter, which I will discuss below, gives a very inaccurate impression of Strong’s position on money management.

Here are a few of the documents that caught my eye.

On November 28 1927, Montague Norman wrote Strong about their planned meeting in January at Algeciras, Spain. Norman makes the following suggestion:

Perhaps the chief uncertainty or danger which confronts Central Bankers on this side of the Atlantic over the next half dozen years is the purchasing power of gold and the general price level. If not an immediate, it is a very serious question and has been too little considered up to the present. Cassel, as you will remember, has held up his warning finger on many occasions against the dangers of a continuing fall in the price level and the Conference at Genoa as you will remember, suggested that the danger could be met or prevented, by a more general use of the “Gold Exchange Standard”.

This is a very abstruse and complicated problem which personally I do not pretend to understand, the more so as it is based on somewhat uncertain statistics. But I rely for information from the outside about such a subject as this not, as you might suppose, on McKenna or Keynes, but on Sir Henry Strakosch. I am not sure if you know him: Austrian origin: many years in Johannesburg: 20 years in this country: a student of economics: a gold producer with general financial interests: perhaps the main stay in setting up the South African Reserve Bank: a member of the Financial Committee of the League and of the Indian Currency Commission: full of public spirit, genial and helpful . . . and so forth. I have probably told you that if I had been a Dictator he would have been a Director here years ago.

This is a problem to which Strackosch has given much study and it alarms him. He would say that none of us are paying sufficient attention to the possibility of a future fall in prices or are taking precautions to prepare any remedy such as was suggested at Genoa, namely smaller gold reserves through the Gold Exchange Standard, and that you, in the long run, will feel any trouble just as much as the rest of the Central Bankers will feel it.

My suggestion therefore is that it might be helpful if I could persuade Strakoosch too to come to Algeciras for a week: his visit could be quite casual and you would not be committed to any intrigue with him.

I gather from the tone of this letter and from other indications that the demands by the French to convert their foreign exchange to gold were already being made on the Bank of England and were causing some degree of consternation in London, which is why Norman was hoping that Strakosch might persuade Strong that something ought to be done to get the French to moderate their demands on the Bank of England to convert claims on sterling into gold. In the event, Strong met with Strakosch in December (probably in New York, not in Algeciras, without the presence of Norman). Not long thereafter Strong’s health deteriorated, and he took an extended leave from his duties at the bank. On March 27, 1928 Strong sent a letter to Norman outlining the main points of his conversation with Strakosch:

What [Strakosch] told me leads me to believe that he holds the following views:

  • That there is an impending shortage of monetary gold.
  • That there is certain to be a decline in the production by the South African mines.
  • That in consequence there will be a competition for gold between banks of issue which will lead to high discount rates, contracting credit and falling world commodity prices.
  • That Europe is so burdened with debt as to make such a development calamitous, possibly bankrupting some nations.
  • That the remedy is an extensive and formal development of the gold exchange standard.

From the above you will doubtless agree with me that Strakosch is a 100% “quantity” theory man, that he holds Cassel’s views in regard to the world’s gold position, and that he is alarmed at the outlook, just as most of the strict quantity theory men are, and rather expects that the banks of issue can do something about it.

Just as an aside, I will note that Strong is here displaying a rather common confusion, mixing up the quantity theory with a theory about the value of money under a gold standard. It’s a confusion that not only laymen, but also economists such as (to pick out a name almost at random) Milton Friedman, are very prone to fall into.

What he tells me is proposed consists of:

  • A study by the Financial Section of the League [of Nations] of the progress of economic recovery in Europe, which, he asserts, has closely followed progress in the resumption of gold payment or its equivalent.
  • A study of the gold problem, apparently in the perspective of the views of Cassel and others.
  • The submission of the results, with possibly some suggestions of a constructive nature, to a meeting of the heads of the banks of issue. He did not disclose whether the meeting would be a belated “Genoa resolution” meeting or something different.

What I told him appeared to shock him, and it was in brief:

  • That I did not share the fears of Cassel and others as to a gold shortage.
  • That I did not think that the quantity theory of prices, such for instance as Fisher has elaborate, “reduction ad absurdum,” was always dependable if unadulterated!
  • That I thought the gold exchange standard as now developing was hazardous in the extreme if allowed to proceed very much further, because of the duplication of bank liabilities upon the same gold.
  • That I much preferred to see the central banks build up their actual gold metal reserves in their own hands to something like orthodox proportions, and adopt their own monetary and credit policy and execute it themselves.
  • That I thought a meeting of the banks of issue in the immediate future to discuss the particular matter would be inappropriate and premature, until the vicissitudes of the Dawes Plan had developed further.
  • That any formal meeting of the banks of issue, if and when called, should originate among themselves rather than through the League, that the Genoa resolution was certainly no longer operative, and that such formal meeting should confine itself very specifically at the outset first to developing a sound basis of information, and second, to devising improvement in technique in gold practice

I am not at all sure that any formal meeting should be held before another year has elapsed. If it is held within a year or after a year, I am quite certain that it I attended it I could not do so helpfully if it tacitly implied acceptance of the principles set out in the Genoa resolution.

Stratosch is a fine fellow: I like him immensely, but I would feel reluctant to join in discussions where there was likelihood that the views so strongly advocated by Fisher, Cassel, Keynes, Commons, and others would seem likely to prevail. I would be willing at the proper time, if objection were not raised at home, to attend a conference of the banks of issue, if we could agree at the outset upon a simple platform, i.e., that gold is an effective measure of value and medium of exchange. If these two principles are extended, as seems to be in Stratosch’s mind, to mean that a manipulation of gold and credit can be employed as a regulator of prices at all times and under all circumstances, then I fear fundamental differences are inescapable.

And here is a third document in a similar vein that is also worth looking at. It is a memorandum written by O. E. Moore (a member of Strong’s staff at the New York Fed) providing a detailed account of the May 25, 1928 conversation between Strong and Sir Arthur Salter, then head of the economic and financial section of the League of Nations, who came to New York to ask for Strong’s cooperation in calling a new conference (already hinted at by Strakosch in his December conversation with Strong) with a view toward limiting the international demand for gold. Salter handed Strong a copy of a report by a committee of the League of Nations warning of the dangers of a steep increase in the value of gold because of increasing demand and a declining production.

Strong responded with a historical rendition of international monetary developments since the end of World War I, pointing out that even before the war was over he had been convinced of the need for cooperation among the world’s central banks, but then adding that he had been opposed to the recommendation of the 1922 Genoa Conference (largely drafted by Hawtrey and Cassel).

Governor Strong had been opposed from the start to the conclusions reached at the Genoa Conference. So far as he was aware, no one had ever been able to show any proof that there was a world shortage of gold or that there was likely to be any such shortage in the near future. . . . He was also opposed to the permanent operation of the gold exchange standard as outlined by the Genoa Conference, because it would mean by virtue of the extensive credits which the exchange standard countries would be holding in the gold centers, that they would be taking away from each of those two centers the control of their own money markets. This was an impossible thing for the Federal Reserve System to accept, so far as the American market was concerned, and in fact it was out of the question for any important country, it seemed to him, to give up entirely the direction of its own market. . . .

As a further aside, I will just observe that Strong’s objection to the gold exchange standard, namely that it permits an indefinite expansion of the money supply, a given base of gold reserves being able to support an unlimited expansion of the quantity of money, is simply wrong as a matter of theory. A country running a balance-of-payments deficit under a gold-exchange standard would be no less subject to the constraint of an external drain, even if it is holding reserves only in the form of instruments convertible into gold rather than actual gold, than it would be if it were operating under a gold standard holding reserves in gold.

Although Strong was emphatic that he could not agree to participate in any conference in which the policies and actions of the US could be determined by the views of other countries, he was open to a purely fact-finding commission to ascertain what the total world gold reserves were and how those were distributed among the different official reserve holding institutions. He also added this interesting caveat:

Governor Strong added that, in his estimation, it was very important that the men who undertook to find the answers to these questions should not be mere theorists who would take issue on controversial points, and that it would be most unfortunate if the report of such a commission should result in giving color to the views of men like Keynes, Cassel, and Fisher regarding an impending world shortage of gold and the necessity of stabilizing the price level. . . .

Governor Strong mentioned that one thing which had made him more wary than ever of the policies advocated by these men was that when Professor Fisher wrote his book on “Stabilizing the Dollar”, he had first submitted the manuscript to him (Governor Strong) and that the proposal made in that original manuscript was to adjust the gold content of the dollar as often as once a week, which in his opinion showed just how theoretical this group of economists were.

Here Strong was displaying the condescending attitude toward academic theorizing characteristic of men of affairs, especially characteristic of brilliant and self-taught men of affairs. Whether such condescension is justified is a question for which there is no general answer. However, it is clear to me that Strong did not have an accurate picture of what was happening in 1928 and what dangers were lying ahead of him and the world in the last few months of his life. So the confidence of Friedman, Kindelberger, Fisher, and Hawtrey in Strong’s surpassing judgment does not seem to me to rest on any evidence that Strong actually understood the situation in 1928 and certainly not that he knew what to do about it. On the contrary he was committed to a policy that was leading to disaster, or at least, was not going to avoid disaster. The most that can be said is that he was at least informed about the dangers, and if he had lived long enough to observe that the dangers about which he had been warned were coming to pass, he would have had the wit and the good sense and the courage to change his mind and take the actions that might have avoided catastrophe. But that possibility is just a possibility, and we can hardly be sure that, in the counterfactual universe in which Strong does not die in 1928, the Great Depression never happened.

Trying to Make Sense of the Insane Policy of the Bank of France and Other Catastrophes

In the almost four years since I started blogging I have occasionally referred to the insane Bank of France or to the insane policy of the Bank of France, a mental disorder that helped cause the deflation that produced the Great Depression. The insane policy began in 1928 when the Bank of France began converting its rapidly growing stockpile of foreign-exchange reserves (i.e., dollar- or sterling-denominated financial instruments) into gold. The conversion of foreign exchange was precipitated by the enactment of a law restoring the legal convertibility of the franc into gold and requiring the Bank of France to hold gold reserves equal to at least 35% of its outstanding banknotes. The law induced a massive inflow of gold into the Bank of France, and, after the Federal Reserve recklessly tightened its policy in an attempt to stamp out stock speculation on Wall Street, thereby inducing an inflow of gold into the US, the one-two punch knocked the world economy into just the deflationary tailspin that Hawtrey and Cassel, had warned would result if the postwar restoration of the gold standard were not managed so as to minimize the increase in the monetary demand for gold.

In making a new round of revisions to our paper on Hawtrey and Cassel, my co-author Ron Batchelder has just added an interesting footnote pointing out that there may have been a sensible rationale for the French gold policy: to accumulate a sufficient hoard of gold for use in case of another war with Germany. In World War I, belligerents withdrew gold coins from circulation, melted them down, and, over the next few years, exported the gold to neutral countries to pay for food and war supplies. That’s how the US, remaining neutral till 1917, wound up with a staggering 40% of the world’s stock of monetary gold reserves after the war. Obsessed with the military threat a re-armed Germany would pose, France insisted that the Versailles Treaty impose crippling reparations payments. The 1926 stabilization of the franc and enactment of the law restoring the gold standard and imposing a 35% reserve requirement on banknotes issued by the Bank of France occurred during the premiership of the staunchly anti-German Raymond Poincaré, a native of Lorraine (lost to Prussia in the war of 1870-71) and President of France during World War I.

A long time ago I wrote a paper “An Evolutionary Theory of the State Monopoly over Money” (which was reworked as chapter two of my book Free Banking and Monetary Reform and was later published in Money and the Nation State) in which, relying on an argument made by Earl Thompson, I suggested that historically the main reason for the nearly ubiquitous state involvement in supplying money was military not monetary: monopoly control over the supply of money enables the sovereign to quickly gain control over resources in war time, thereby giving states in which the sovereign controls the supply of money a military advantage over states in which the sovereign has no such control. Subsequently, Thompson further developed the idea to explain the rise of the gold standard after the Bank of England was founded in 1694, early in the reign of William and Mary, to finance rebuilding of the English navy, largely destroyed by the French in 1690. As explained by Macaulay in his History of England, the Bank of England, by substantially reducing the borrowing costs of the British government, was critical to the survival of the new monarchs in their battle with the Stuarts and Louis XIV. See Thompson’s article “The Gold Standard: Causes and Consequences” in Business Cycles and Depressions: An Encyclopedia (edited by me).

Thompson’s article is not focused on the holding of gold reserves, but on the confidence that the gold standard gave to those lending to the state, especially during a wartime suspension of convertibility, owing to an implicit commitment to restore the gold standard at the prewar parity. The importance of that implicit commitment is one reason why Churchill’s 1925 decision to restore the gold standard at the prewar parity was not necessarily as foolish as Keynes (The Economic Consequences of Mr. Churchill), along with almost all subsequent commentators, judged it to have been. But the postwar depreciation of the franc was so extreme that restoring the convertibility of the franc at the prewar parity became a practical impossibility, and the new parity at which convertibility was restored was just a fifth of its prewar level. Having thus reneged on its implicit commitment to restore the gold standard at the prewar parity, impairing its ability to borrow, France may have felt it had no alternative but to accumulate a ready gold reserve from which to draw when another war against Germany came. This is just theoretical speculation, but it might provide some clues for historical research into the thinking of French politicians and bankers in the late 1920s as they formulated their strategy for rejoining the gold standard.

However, even if the motivation for France’s gold accumulation was not simply a miserly desire to hold ever larger piles of shiny gold ingots in the vaults of the Banque de France, but was a precautionary measure against the possibility of a future war with Germany – and we know only too well that the fear was not imaginary – it is important to understand that, in the end, it was almost certainly the French policy of gold accumulation that paved the way for Hitler’s rise to power and all that entailed. Without the Great Depression and the collapse of the German economy, Hitler might well have remained an outcast on the margins of German politics.

The existence of a legitimate motivation for the insane policy of the Bank of France cannot excuse the failure to foresee the all too predictable consequences of that policy – consequences laid out plainly by Hawtrey and Cassel already in 1919-20, and reiterated consistently over the ensuing decade. Nor does the approval of that policy by reputable, even eminent, economists, who simply failed to understand how the gold standard worked, absolve those who made the wrong decisions of responsibility for their mistaken decisions. They were warned about the consequences of their actions, and chose to disregard the warnings.

All of this is sadly reminiscent of the 2003 invasion of Iraq. I don’t agree with those who ascribe evil motives to the Bush administration for invading Iraq, though there seems little doubt that the WMD issue was largely pretextual. But that doesn’t mean that Bush et al. didn’t actually believe that Saddam had WMD. More importantly, I think that Bush et al. sincerely thought that invading Iraq and deposing Saddam Hussein would, after the supposed defeat of Al Qaeda and the Taliban in Afghanistan, establish a benign American dominance in the region, as World War II had done in Japan and Western Europe.

The problem is not, as critics like to say, that Bush et al. lied us into war; the problem is that they stupidly fooled themselves into thinking that they could just invade Iraq, unseat Saddam Hussein, and that their job would be over. They fooled themselves even though they had been warned in advance that Iraq was riven by internal ethnic, sectarian, religious and political divisions. Brutally suppressed by Hussein and his Ba’athist regime, those differences were bound to reemerge once the regime was dismantled. When General Eric Shinseki’s testified before Congress that hundreds of thousands of American troops would be needed to maintain peace and order after Hussein was ousted, Paul Wolfowitz and Donald Rumsfeld could only respond with triumphalist ridicule at the idea that more troops would be required to maintain law and order in Iraq after Hussein was deposed than were needed to depose him. The sophomoric shallowness of the response to Shinseki by those that planned the invasion still shocks and appalls.

It’s true that, after the Republican loss in the 2006 Congressional elections, Bush, freeing himself from the influence of Dick Cheney and replacing Donald Rumsfeld with Robert Gates as Secretary of Defense, and Gen. George Casey with Gen. David Petraeus as commander of US forces in Iraq, finally adopted the counter-insurgency strategy (aka the “surge”) so long resisted by Cheney and Rumsfeld, thereby succeeding in putting down the Sunni/Al-Qaeda/Baathist insurgency and in bringing the anti-American Shi’ite militias to heel. I wrote about the success of the surge in December 2007 when that provisional military success was still controversial. But, as General Petraeus conceded, the ultimate success of the counter-insurgency strategy depended on implementing a political strategy to reconcile the different elements of Iraqi society to their government. We now know that even in 2008 Premier Nouri al-Maliki, who had been installed as premier with the backing of the Bush administration, was already reversing the limited steps taken during the surge to achieve accommodation between Iraqi Sunnis and Shi’ites, while consolidating his Shi’ite base by reconciling politically with the pro-Iranian militants he had put down militarily.

The failure of the Iraqi government to consolidate and maintain the gains made in 2007-08 has been blamed on Obama’s decision to withdraw all American forces from Iraq after the status of forces agreement signed by President Bush and Premier al-Maliki in December 2008 expired at the end of 2011. But preserving the gains made in 2007-08 depended on a political strategy to reconcile the opposing ethnic and sectarian factions of Iraqi society. The Bush administration could not implement such a strategy with 130,000 troops still in Iraq at the end of 2008, and the sovereign Iraqi government in place, left to its own devices, had no interest in pursuing such a strategy. Perhaps keeping a larger US presence in Iraq for a longer time would have kept Iraq from falling apart as fast as it has, but the necessary conditions for a successful political outcome were never in place.

So even if the motivation for the catastrophic accumulation of gold by France in the 1928-29 was merely to prepare itself to fight, if need be, another war against Germany, the fact remains that the main accomplishment of the gold-accumulation policy was to bring to power a German regime far more dangerous and threatening than the one that would have otherwise confronted France. And even if the motivation for the catastrophic invasion of Iraq in 2003 was to defeat and discredit Islamic terrorism, the fact remains that the invasion, just as Osama bin Laden had hoped, was to create the conditions in which Islamic terrorism could grow into a worldwide movement, attracting would-be jihadists to a growing number of local conflicts across the world. Although bin Laden was eventually killed in his Pakistani hideout, the invasion of Iraq led to rise of an even more sophisticated, more dangerous, and more threatening opponent than the one the invasion was intended to eradicate. Just as a misunderstanding of the gold standard led to catastrophe in 1928-29, the misconception that the threat of terrorism can be eliminated by military means has been leading us toward catastrophe since 2003. When will we learn?

PS Despite some overlap between what I say above and what David Henderson said in this post, I am not a libertarian or a non-interventionist.

Repeat after Me: Inflation’s the Cure not the Disease

Last week Martin Feldstein triggered a fascinating four-way exchange with a post explaining yet again why we still need to be worried about inflation. Tony Yates responded first with an explanation of why money printing doesn’t work at the zero lower bound (aka liquidity trap), leading Paul Krugman to comment wearily about the obtuseness of all those right-wingers who just can’t stop obsessing about the non-existent inflation threat when, all along, it was crystal clear that in a liquidity trap, printing money is useless.

I’m still not sure why relatively moderate conservatives like Feldstein didn’t find all this convincing back in 2009. I get, I think, why politics might predispose them to see inflation risks everywhere, but this was as crystal-clear a proposition as I’ve ever seen. Still, even if you managed to convince yourself that the liquidity-trap analysis was wrong six years ago, by now you should surely have realized that Bernanke, Woodford, Eggertsson, and, yes, me got it right.

But no — it’s a complete puzzle. Maybe it’s because those tricksy Fed officials started paying all of 25 basis points on reserves (Japan never paid such interest). Anyway, inflation is just around the corner, the same way it has been all these years.

Which surprisingly (not least to Krugman) led Brad DeLong to rise to Feldstein’s defense (well, sort of), pointing out that there is a respectable argument to be made for why even if money printing is not immediately effective at the zero lower bound, it could still be effective down the road, so that the mere fact that inflation has been consistently below 2% since the crash (except for a short blip when oil prices spiked in 2011-12) doesn’t mean that inflation might not pick up quickly once inflation expectations pick up a bit, triggering an accelerating and self-sustaining inflation as all those hitherto idle balances start gushing into circulation.

That argument drew a slightly dyspeptic response from Krugman who again pointed out, as had Tony Yates, that at the zero lower bound, the demand for cash is virtually unlimited so that there is no tendency for monetary expansion to raise prices, as if DeLong did not already know that. For some reason, Krugman seems unwilling to accept the implication of the argument in his own 1998 paper that he cites frequently: that for an increase in the money stock to raise the price level – note that there is an implicit assumption that the real demand for money does not change – the increase must be expected to be permanent. (I also note that the argument had been made almost 20 years earlier by Jack Hirshleifer, in his Fisherian text on capital theory, Capital Interest and Investment.) Thus, on Krugman’s own analysis, the effect of an increase in the money stock is expectations-dependent. A change in monetary policy will be inflationary if it is expected to be inflationary, and it will not be inflationary if it is not expected to be inflationary. And Krugman even quotes himself on the point, referring to

my call for the Bank of Japan to “credibly promise to be irresponsible” — to make the expansion of the base permanent, by committing to a relatively high inflation target. That was the main point of my 1998 paper!

So the question whether the monetary expansion since 2008 will ever turn out to be inflationary depends not on an abstract argument about the shape of the LM curve, but about the evolution of inflation expectations over time. I’m not sure that I’m persuaded by DeLong’s backward induction argument – an argument that I like enough to have used myself on occasion while conceding that the logic may not hold in the real word – but there is no logical inconsistency between the backward-induction argument and Krugman’s credibility argument; they simply reflect different conjectures about the evolution of inflation expectations in a world in which there is uncertainty about what the future monetary policy of the central bank is going to be (in other words, a world like the one we inhabit).

Which brings me to the real point of this post: the problem with monetary policy since 2008 has been that the Fed has credibly adopted a 2% inflation target, a target that, it is generally understood, the Fed prefers to undershoot rather than overshoot. Thus, in operational terms, the actual goal is really less than 2%. As long as the inflation target credibly remains less than 2%, the argument about inflation risk is about the risk that the Fed will credibly revise its target upwards.

With the both Wickselian natural real and natural nominal short-term rates of interest probably below zero, it would have made sense to raise the inflation target to get the natural nominal short-term rate above zero. There were other reasons to raise the inflation target as well, e.g., providing debt relief to debtors, thereby benefitting not only debtors but also those creditors whose debtors simply defaulted.

Krugman takes it for granted that monetary policy is impotent at the zero lower bound, but that impotence is not inherent; it is self-imposed by the credibility of the Fed’s own inflation target. To be sure, changing the inflation target is not a decision that we would want the Fed to take lightly, because it opens up some very tricky time-inconsistency problems. However, in a crisis, you may have to take a chance and hope that credibility can be restored by future responsible behavior once things get back to normal.

In this vein, I am reminded of the 1930 exchange between Hawtrey and Hugh Pattison Macmillan, chairman of the Committee on Finance and Industry, when Hawtrey, testifying before the Committee, suggested that the Bank of England reduce Bank Rate even at the risk of endangering the convertibility of sterling into gold (England eventually left the gold standard a little over a year later)

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.

Of course the best evidence for the effectiveness of monetary policy at the zero lower bound was provided three years later, in April 1933, when FDR suspended the gold standard in the US, causing the dollar to depreciate against gold, triggering an immediate rise in US prices (wholesale prices rising 14% from April through July) and the fastest real recovery in US history (industrial output rising by over 50% over the same period). A recent paper by Andrew Jalil and Gisela Rua documents this amazing recovery from the depths of the Great Depression and the crucial role that changing inflation expectations played in stimulating the recovery. They also make a further important point: that by announcing a price level target, FDR both accelerated the recovery and prevented expectations of inflation from increasing without limit. The 1933 episode suggests that a sharp, but limited, increase in the price-level target would generate a faster and more powerful output response than an incremental increase in the inflation target. Unfortunately, after the 2008 downturn we got neither.

Maybe it’s too much to expect that an unelected central bank would take upon itself to adopt as a policy goal a substantial increase in the price level. Had the Fed announced such a goal after the 2008 crisis, it would have invited a potentially fatal attack, and not just from the usual right-wing suspects, on its institutional independence. Price stability, is after all, part of dual mandate that Fed is legally bound to pursue. And it was FDR, not the Fed, that took the US off the gold standard.

But even so, we at least ought to be clear that if monetary policy is impotent at the zero lower bound, the impotence is not caused by any inherent weakness, but by the institutional and political constraints under which it operates in a constitutional system. And maybe there is no better argument for nominal GDP level targeting than that it offers a practical and civilly reverent way of allowing monetary policy to be effective at the zero lower bound.

A New Paper on the Short, But Sweet, 1933 Recovery Confirms that Hawtrey and Cassel Got it Right

In a recent post, the indispensable Marcus Nunes drew my attention to a working paper by Andrew Jalil of Occidental College and Gisela Rua of the Federal Reserve Board. The paper is called “Inflation Expectations and Recovery from the Depression in 1933: Evidence from the Narrative Record. “ Subsequently I noticed that Mark Thoma had also posted the abstract on his blog.

 Here’s the abstract:

This paper uses the historical narrative record to determine whether inflation expectations shifted during the second quarter of 1933, precisely as the recovery from the Great Depression took hold. First, by examining the historical news record and the forecasts of contemporary business analysts, we show that inflation expectations increased dramatically. Second, using an event-studies approach, we identify the impact on financial markets of the key events that shifted inflation expectations. Third, we gather new evidence—both quantitative and narrative—that indicates that the shift in inflation expectations played a causal role in stimulating the recovery.

There’s a lot of new and interesting stuff in this paper even though the basic narrative framework goes back almost 80 years to the discussion of the 1933 recovery in Hawtrey’s Trade Depression and The Way Out. The paper highlights the importance of rising inflation (or price-level) expectations in generating the recovery, which started within a few weeks of FDR’s inauguration in March 1933. In the absence of direct measures of inflation expectations, such as breakeven TIPS spreads, that are now available, or surveys of consumer and business expectations, Jalil and Rua document the sudden and sharp shift in expectations in three different ways.

First, they show document that there was a sharp spike in news coverage of inflation in April 1933. Second, they show an expectational shift toward inflation by a close analysis of the economic reporting and commentary in the Economist and in Business Week, providing a fascinating account of the evolution of FDR’s thinking and how his economic policy was assessed in the period between the election in November 1932 and April 1933 when the gold standard was suspended. Just before the election, the Economist observed

No well-informed man in Wall Street expects the outcome of the election to make much real difference in business prospects, the argument being that while politicians may do something to bring on a trade slump, they can do nothing to change a depression into prosperity (October 29, 1932)

 On April 22, 1933, just after FDR took the US of the gold standard, the Economist commented

As usual, Wall Street has interpreted the policy of the Washington Administration with uncanny accuracy. For a week or so before President Roosevelt announced his abandonment of the gold standard, Wall Street was “talking inflation.”

 A third indication of increasing inflation is drawn from the five independent economic forecasters which all began predicting inflation — some sooner than others  — during the April-May time frame.

Jalil and Rua extend the important work of Daniel Nelson whose 1991 paper “Was the Deflation of 1929-30 Anticipated? The Monetary Regime as Viewed by the Business Press” showed that the 1929-30 downturn coincided with a sharp drop in price level expectations, providing powerful support for the Hawtrey-Cassel interpretation of the onset of the Great Depression.

Besides persuasive evidence from multiple sources that inflation expectations shifted in the spring of 1933, Jalil and Rua identify 5 key events or news shocks that focused attention on a changing policy environment that would lead to rising prices.

1 Abandonment of the Gold Standard and a Pledge by FDR to Raise Prices (April 19)

2 Passage of the Thomas Inflation Amendment to the Farm Relief Bill by the Senate (April 28)

3 Announcement of Open Market Operations (May 24)

4 Announcement that the Gold Clause Would Be Repealed and a Reduction in the New York Fed’s Rediscount Rate (May 26)

5 FDR’s Message to the World Economic Conference Calling for Restoration of the 1926 Price Level (June 19)

Jalil and Rua perform an event study and find that stock prices rose significantly and the dollar depreciated against gold and pound sterling after each of these news shocks. They also discuss the macreconomic effects of shift in inflation expectations, showing that a standard macro model cannot account for the rapid 1933 recovery. Further, they scrutinize the claim by Friedman and Schwartz in their Monetary History of the United States that, based on the lack of evidence of any substantial increase in the quantity of money, “the economic recovery in the half-year after the panic owed nothing to monetary expansion.” Friedman and Schwartz note that, given the increase in prices and the more rapid increase in output, the velocity of circulation must have increased, without mentioning the role of rising inflation expectations in reducing that amount of cash (relative to income) that people wanted to hold.

Jalil and Rua also offer a very insightful explanation for the remarkably rapid recovery in the April-July period, suggesting that the commitment to raise prices back to their 1926 levels encouraged businesses to hasten their responses to the prospect of rising prices, because prices would stop rising after they reached their target level.

The literature on price-level targeting has shown that, relative to inflation targeting, this policy choice has the advantage of removing more uncertainty in terms of the future level of prices. Under price-level targeting, inflation depends on the relationship between the current price level and its target. Inflation expectations will be higher the lower is the current price level. Thus, Roosevelt’s commitment to a price-level target caused market participants to expect inflation until prices were back at that higher set target.

A few further comments before closing. Jalil and Rua have a brief discussion of whether other factors besides increasing inflation expectations could account for the rapid recovery. The only factor that they mention as an alternative is exit from the gold standard. This discussion is somewhat puzzling inasmuch as they already noted that exit from the gold standard was one of five news shocks (and by all odds the important one) in causing the increase in inflation expectations. They go on to point out that no other country that left the gold standard during the Great Depression experienced anywhere near as rapid a recovery as did the US. Because international trade accounted for a relatively small share of the US economy, they argue that the stimulus to production by US producers of tradable goods from a depreciating dollar would not have been all that great. But that just shows that the macroeconomic significance of abandoning the gold standard was not in shifting the real exchange rate, but in raising the price level. The fact that the US recovery after leaving the gold standard was so much more powerful than it was in other countries is because, at least for a short time, the US sought to use monetary policy aggressively to raise prices, while other countries were content merely to stop the deflation that the gold standard had inflicted on them, but made no attempt to reverse the deflation that had already occurred.

Jalil and Rua conclude with a discussion of possible explanations for why the April-July recovery seemed to peter out suddenly at the end of July. They offer two possible explanations. First passage of the National Industrial Recovery Act in July was a negative supply shock, and second the rapid recovery between April and July persuaded FDR that further inflation was no longer necessary, with actual inflation and expected inflation both subsiding as a result. These are obviously not competing explanations. Indeed the NIRA may have itself been another reason why FDR no longer felt inflation was necessary, as indicated by this news story in the New York Times

The government does not contemplate entering upon inflation of the currency at present and will issue cheaper money only as a last resort to stimulate trade, according to a close adviser of the President who discussed financial policies with him this week. This official asserted today that the President was well satisfied with the business improvement and the government’s ability to borrow money at cheap rates. These are interpreted as good signs, and if the conditions continue as the recovery program broadened, it was believed no real inflation of the currency would be necessary. (“Inflation Putt Off, Officials Suggest,” New York Times, August 4, 1933)

If only . . .

Milton Friedman, Monetarism, and the Great and Little Depressions

Brad Delong has a nice little piece bashing Milton Friedman, an activity that, within reasonable limits, I consider altogether commendable and like to engage in myself from time to time (see here, here, here, here, here , here, here, here, here and here). Citing Barry Eichengreen’s recent book Hall of Mirrors, Delong tries to lay the blame for our long-lasting Little Depression (aka Great Recession) on Milton Friedman and his disciples whose purely monetary explanation for the Great Depression caused the rest of us to neglect or ignore the work of Keynes and Minsky and their followers in explaining the Great Depression.

According to Eichengreen, the Great Depression and the Great Recession are related. The inadequate response to our current troubles can be traced to the triumph of the monetarist disciples of Milton Friedman over their Keynesian and Minskyite peers in describing the history of the Great Depression.

In A Monetary History of the United States, published in 1963, Friedman and Anna Jacobson Schwartz famously argued that the Great Depression was due solely and completely to the failure of the US Federal Reserve to expand the country’s monetary base and thereby keep the economy on a path of stable growth. Had there been no decline in the money stock, their argument goes, there would have been no Great Depression.

This interpretation makes a certain kind of sense, but it relies on a critical assumption. Friedman and Schwartz’s prescription would have worked only if interest rates and what economists call the “velocity of money” – the rate at which money changes hands – were largely independent of one another.

What is more likely, however, is that the drop in interest rates resulting from the interventions needed to expand the country’s supply of money would have put a brake on the velocity of money, undermining the proposed cure. In that case, ending the Great Depression would have also required the fiscal expansion called for by John Maynard Keynes and the supportive credit-market policies prescribed by Hyman Minsky.

I’m sorry, but I find this criticism of Friedman and his followers just a bit annoying. Why? Well, there are a number of reasons, but I will focus on one: it perpetuates the myth that a purely monetary explanation of the Great Depression originated with Friedman.

Why is it a myth? Because it wasn’t Friedman who first propounded a purely monetary theory of the Great Depression. Nor did the few precursors, like Clark Warburton, that Friedman ever acknowledged. Ralph Hawtrey and Gustav Cassel did — 10 years before the start of the Great Depression in 1919, when they independently warned that going back on the gold standard at the post-World War I price level (in terms of gold) — about twice the pre-War price level — would cause a disastrous deflation unless the world’s monetary authorities took concerted action to reduce the international monetary demand for gold as countries went back on the gold standard to a level consistent with the elevated post-War price level. The Genoa Monetary Conference of 1922, inspired by the work of Hawtrey and Cassel, resulted in an agreement (unfortunately voluntary and non-binding) that, as countries returned to the gold standard, they would neither reintroduce gold coinage nor keep their monetary reserves in the form of physical gold, but instead would hold reserves in dollar or (once the gold convertibility of sterling was restored) pound-denominated assets. (Ron Batchelder and I have a paper discussing the work of Hawtrey and Casssel on the Great Depression; Doug Irwin has a paper discussing Cassel.)

After the short, but fierce, deflation of 1920-21 (see here and here), when the US (about the only country in the world then on the gold standard) led the world in reducing the price level by about a third, but still about two-thirds higher than the pre-War price level, the Genoa system worked moderately well until 1928 when the Bank of France, totally defying the Genoa Agreement, launched its insane policy of converting its monetary reserves into physical gold. As long as the US was prepared to accommodate the insane French gold-lust by permitting a sufficient efflux of gold from its own immense holdings, the Genoa system continued to function. But in late 1928 and 1929, the Fed, responding to domestic fears about a possible stock-market bubble, kept raising interest rates to levels not seen since the deflationary disaster of 1920-21. And sure enough, a 6.5% discount rate (just shy of the calamitous 7% rate set in 1920) reversed the flow of gold out of the US, and soon the US was accumulating gold almost as rapidly as the insane Bank of France was.

This was exactly the scenario against which Hawtrey and Cassel had been warning since 1919. They saw it happening, and watched in horror while their warnings were disregarded as virtually the whole world plunged blindly into a deflationary abyss. Keynes had some inkling of what was going on – he was an old friend and admirer of Hawtrey and had considerable regard for Cassel – but, for reasons I don’t really understand, Keynes was intent on explaining the downturn in terms of his own evolving theoretical vision of how the economy works, even though just about everything that was happening had already been foreseen by Hawtrey and Cassel.

More than a quarter of a century after the fact, and after the Keynesian Revolution in macroeconomics was well established, along came Friedman, woefully ignorant of pre-Keynesian monetary theory, but determined to show that the Keynesian explanation for the Great Depression was wrong and unnecessary. So Friedman came up with his own explanation of the Great Depression that did not even begin until December 1930 when the Fed allowed the Bank of United States to fail, triggering, in Friedman’s telling, a wave of bank failures that caused the US money supply to decline by a third by 1933. Rather than see the Great Depression as a global phenomenon caused by a massive increase in the world’s monetary demand for gold, Friedman portrayed it as a largely domestic phenomenon, though somehow linked to contemporaneous downturns elsewhere, for which the primary explanation was the Fed’s passivity in the face of contagious bank failures. Friedman, mistaking the epiphenomenon for the phenomenon itself, ignorantly disregarded the monetary theory of the Great Depression that had already been worked out by Hawtrey and Cassel and substituted in its place a simplistic, dumbed-down version of the quantity theory. So Friedman reinvented the wheel, but did a really miserable job of it.

A. C. Pigou, Alfred Marshall’s student and successor at Cambridge, was a brilliant and prolific economic theorist in his own right. In his modesty and reverence for his teacher, Pigou was given to say “It’s all in Marshall.” When it comes to explaining the Great Depression, one might say as well “it’s all in Hawtrey.”

So I agree that Delong is totally justified in criticizing Friedman and his followers for giving such a silly explanation of the Great Depression, as if it were, for all intents and purposes, made in the US, and as if the Great Depression didn’t really start until 1931. But the problem with Friedman is not, as Delong suggests, that he distracted us from the superior insights of Keynes and Minsky into the causes of the Great Depression. The problem is that Friedman botched the monetary theory, even though the monetary theory had already been worked out for him if only he had bothered to read it. But Friedman’s interest in the history of monetary theory did not extend very far, if at all, beyond an overrated book by his teacher Lloyd Mints A History of Banking Theory.

As for whether fiscal expansion called for by Keynes was necessary to end the Great Depression, we do know that the key factor explaining recovery from the Great Depression was leaving the gold standard. And the most important example of the importance of leaving the gold standard is the remarkable explosion of output in the US beginning in April 1933 (surely before expansionary fiscal policy could take effect) following the suspension of the gold standard by FDR and an effective 40% devaluation of the dollar in terms of gold. Between April and July 1933, industrial production in the US increased by 70%, stock prices nearly doubled, employment rose by 25%, while wholesale prices rose by 14%. All that is directly attributable to FDR’s decision to take the US off gold, and devalue the dollar (see here). Unfortunately, in July 1933, FDR snatched defeat from the jaws of victory (or depression from the jaws of recovery) by starting the National Recovery Administration, whose stated goal was (OMG!) to raise prices by cartelizing industries and restricting output, while imposing a 30% increase in nominal wages. That was enough to bring the recovery to a virtual standstill, prolonging the Great Depression for years.

I don’t say that the fiscal expansion under FDR had no stimulative effect in the Great Depression or that the fiscal expansion under Obama in the Little Depression had no stimulative effect, but you can’t prove that monetary policy is useless just by reminding us that Friedman liked to assume (as if it were a fact) that the demand for money is highly insensitive to changes in the rate of interest. The difference between the rapid recovery from the Great Depression when countries left the gold standard and the weak recovery from the Little Depression is that leaving the gold standard had an immediate effect on price-level expectations, while monetary expansion during the Little Depression was undertaken with explicit assurances by the monetary authorities that the 2% inflation target – in the upper direction, at any rate — was, and would forever more remain, sacred and inviolable.

A Keynesian Postscript on the Bright and Shining, Dearly Beloved, Depression of 1920-21

In his latest blog post Paul Krugman drew my attention to Keynes’s essay The Great Slump of 1930. In describing the enormity of the 1930 slump, Keynes properly compared the severity of the 1930 slump with the 1920-21 episode, noting that the price decline in 1920-21 was of a similar magnitude to that of 1930. James Grant, in his book on the Greatest Depression, argues that the Greatest Depression was so outstanding, because, in contrast to the Great Depression, there was no attempt by the government in 1920-21 to cushion the blow. Instead, the powers that be just stood back and let the devil take the hindmost.

Keynes had a different take on the difference between the Greatest Depression and the Great Depression:

First of all, the extreme violence of the slump is to be noticed. In the three leading industrial countries of the world—the United States, Great Britain, and Germany—10,000,000 workers stand idle. There is scarcely an important industry anywhere earning enough profit to make it expand—which is the test of progress. At the same time, in the countries of primary production the output of mining and of agriculture is selling, in the case of almost every important commodity, at a price which, for many or for the majority of producers, does not cover its cost. In 1921, when prices fell as heavily, the fall was from a boom level at which producers were making abnormal profits; and there is no example in modern history of so great and rapid a fall of prices from a normal figure as has occurred in the past year. Hence the magnitude of the catastrophe.

In diagnosing what went wrong in the Great Depression, Keynes largely, though not entirely, missed the most important cause of the catastrophe, the appreciation of gold caused by the attempt to restore an international gold standard without a means by which to control the monetary demand for gold of the world’s central banks — most notoriously, the insane Bank of France. Keynes should have paid more attention to Hawtrey and Cassel than he did. But Keynes was absolutely on target in explaining why the world more easily absorbed and recovered from a 40% deflation in 1920-21 than it was able to do in 1929-33.

Misunderstanding Reserve Currencies and the Gold Standard

In Friday’s Wall Street Journal, Lewis Lehrman and John Mueller argue for replacing the dollar as the world’s reserve currency with gold. I don’t know Lewis Lehrman, but almost 30 years ago, when I was writing my book Free Banking and Monetary Reform, which opposed restoring the gold standard, I received financial support from the Lehrman Institute where I gave a series of seminars discussing several chapters of my book. A couple of those seminars were attended by John Mueller, who was then a staffer for Congressman Jack Kemp. But despite my friendly feelings for Lehrman and Mueller, I am afraid that they badly misunderstand how the gold standard worked and what went wrong with the gold standard in the 1920s. Not surprisingly, that misunderstanding carries over into their comments on current monetary arrangements.

Lehrman and Mueller begin by discussing the 1922 Genoa Conference, a conference largely inspired by the analysis of Ralph Hawtrey and Gustav Cassel of post-World War I monetary conditions, and by their proposals for restoring an international gold standard without triggering a disastrous deflation in the process of doing so, the international price level in terms of gold having just about doubled relative to the pre-War price level.

The 1922 Genoa conference, which was intended to supervise Europe’s post-World War I financial reconstruction, recommended “some means of economizing the use of gold by maintaining reserves in the form of foreign balances”—initially pound-sterling and dollar IOUs. This established the interwar “gold exchange standard.”

Lehrman and Mueller then cite the view of the gold exchange standard expressed by the famous French economist Jacques Rueff, of whom Lehrman is a fervent admirer.

A decade later Jacques Rueff, an influential French economist, explained the result of this profound change from the classical gold standard. When a foreign monetary authority accepts claims denominated in dollars to settle its balance-of-payments deficits instead of gold, purchasing power “has simply been duplicated.” If the Banque de France counts among its reserves dollar claims (and not just gold and French francs)—for example a Banque de France deposit in a New York bank—this increases the money supply in France but without reducing the money supply of the U.S. So both countries can use these dollar assets to grant credit. “As a result,” Rueff said, “the gold-exchange standard was one of the major causes of the wave of speculation that culminated in the September 1929 crisis.” A vast expansion of dollar reserves had inflated the prices of stocks and commodities; their contraction deflated both.

This is astonishing. Lehrman and Mueller do not identify the publication of Rueff that they are citing, but I don’t doubt the accuracy of the quotation. What Rueff is calling for is a 100% marginal reserve requirement. Now it is true that under the Bank Charter Act of 1844, Great Britain had a 100% marginal reserve requirement on Bank of England notes, but throughout the nineteenth century, there was an shift from banknotes to bank deposits, so the English money supply was expanding far more rapidly than English gold reserves. The kind of monetary system that Rueff was talking about, in which the quantity of money in circulation, could not increase by more than the supply of gold, never existed. Money was being created under the gold standard without an equal amount of gold being held in reserve.

The point of the gold exchange standard, after World War I, was to economize on the amount of gold held by central banks as they rejoined the gold standard to prevent a deflation back to the pre-War price level. Gold had been demonetized over the course of World War I as countries used gold to pay for imports, much of it winding up in the US before the US entered the war. If all the demonetized gold was remonetized, the result would be a huge rise in the value of gold, in other words, a huge, catastrophic, deflation.

Nor does the notion that the gold-exchange standard was the cause of speculation that culminated in the 1929 crisis have any theoretical or evidentiary basis. Interest rates in the 1920s were higher than they ever were during the heyday of the classical gold standard from about 1880 to 1914. Prices were not rising faster in the 1920s than they did for most of the gold standard era, so there is no basis for thinking that speculation was triggered by monetary causes. Indeed, there is no basis for thinking that there was any speculative bubble in the 1920s, or that even if there was such a bubble it was triggered by monetary expansion. What caused the 1929 crash was not the bursting of a speculative bubble, as taught by the popular mythology of the crash, it was caused by the sudden increase in the demand for gold in 1928 and 1929 resulting from the insane policy of the Bank of France and the clueless policy of the Federal Reserve after ill health forced Benjamin Strong to resign as President of the New York Fed.

Lehrman and Mueller go on to criticize the Bretton Woods system.

The gold-exchange standard’s demand-duplicating feature, based on the dollar’s reserve-currency role, was again enshrined in the 1944 Bretton Woods agreement. What ensued was an unprecedented expansion of official dollar reserves, and the consumer price level in the U.S. and elsewhere roughly doubled. Foreign governments holding dollars increasingly demanded gold before the U.S. finally suspended gold payments in 1971.

The gold-exchange standard of the 1920s was a real gold standard, but one designed to minimize the monetary demand for gold by central banks. In the 1920s, the US and Great Britain were under a binding obligation to convert dollars or pound sterling on demand into gold bullion, so there was a tight correspondence between the value of gold and the price level in any country maintaining a fixed exchange rate against the dollar or pound sterling. Under Bretton Woods, only the US was obligated to convert dollars into gold, but the obligation was largely a fiction, so the tight correspondence between the value of gold and the price level no longer obtained.

The economic crisis of 2008-09 was similar to the crisis that triggered the Great Depression. This time, foreign monetary authorities had purchased trillions of dollars in U.S. public debt, including nearly $1 trillion in mortgage-backed securities issued by two government-sponsored enterprises, Fannie Mae and Freddie Mac. The foreign holdings of dollars were promptly returned to the dollar market, an example of demand duplication. This helped fuel a boom-and-bust in foreign markets and U.S. housing prices. The global excess credit creation also spilled over to commodity markets, in particular causing the world price of crude oil (which is denominated in dollars) to spike to $150 a barrel.

There were indeed similarities between the 1929 crisis and the 2008 crisis. In both cases, the world financial system was made vulnerable because there was a lot of bad debt out there. In 2008, it was subprime mortgages, in 1929 it was reckless borrowing by German local governments and the debt sold to refinance German reparations obligations under the Treaty of Versailles. But in neither episode did the existence of bad debt have anything to do with monetary policy; in both cases tight monetary policy precipitated a crisis that made a default on the bad debt unavoidable.

Lehrman and Mueller go on to argue, as do some Keynesians like Jared Bernstein, that the US would be better off if the dollar were not a reserve currency. There may be disadvantages associated with having a reserve currency – disadvantages like those associated with having a large endowment of an exportable natural resource, AKA the Dutch disease – but the only way for the US to stop having a reserve currency would be to take a leaf out of the Zimbabwe hyperinflation playbook. Short of a Zimbabwean hyperinflation, the network externalities internalized by using the dollar as a reserve currency are so great, that the dollar is likely to remain the world’s reserve currency for at least a millennium. Of course, the flip side of the Dutch disease is at that there is a wealth transfer from the rest of the world to the US – AKA seignorage — in exchange for using the dollar.

Lehrman and Mueller are aware of the seignorage accruing to the supplier of a reserve currency, but confuse the collection of seignorage with the benefit to the world as a whole of minimizing the use of gold as the reserve currency. This leads them to misunderstand the purpose of the Genoa agreement, which they mistakenly attribute to Keynes, who actually criticized the agreement in his Tract on Monetary Reform.

This was exactly what Keynes and other British monetary experts promoted in the 1922 Genoa agreement: a means by which to finance systemic balance-of-payments deficits, forestall their settlement or repayment and put off demands for repayment in gold of Britain’s enormous debts resulting from financing World War I on central bank and foreign credit. Similarly, the dollar’s “exorbitant privilege” enabled the U.S. to finance government deficit spending more cheaply.

But we have since learned a great deal that Keynes did not take into consideration. As Robert Mundell noted in “Monetary Theory” (1971), “The Keynesian model is a short run model of a closed economy, dominated by pessimistic expectations and rigid wages,” a model not relevant to modern economies. In working out a “more general theory of interest, inflation, and growth of the world economy,” Mr. Mundell and others learned a great deal from Rueff, who was the master and professor of the monetary approach to the balance of payments.

The benefit from supplying the resource that functions as the world’s reserve currency will accrue to someone, that is the “exorbitant privilege” to which Lehrman and Mueller refer. But It is not clear why it would be better if the privilege accrued to owners of gold instead of to the US Treasury. On the contrary, the potential for havoc associated with reinstating gold as the world’s reserve currency dwarfs the “exorbitant privilege.” Nor is the reference to Keynes relevant to the discussion, the Keynesian model described by Mundell being the model of the General Theory, which was certainly not the model that Keynes was working with at the time of the Genoa agreement in which Keynes’s only involvement was as an outside critic.

As for Rueff, staunch defender of the insane policy of the Bank of France in 1932, he was an estimable scholar, but, luckily, his influence was much less than Lehrman and Mueller suggest.

Is Insanity Breaking out in Switzerland?

The other day, I saw this item on Bloomberg.com “1500 Tons of Gold on the Line in Swiss Vote Buy Back Bullion.” Have a look:

There are people in Switzerland who resent that the country sold away much of its gold last decade. They may be a splinter group of Swiss politics, but they’re a persistent bunch.

And if they get their way in a referendum this month, these voters will make their presence known to gold traders around the world.

The proposal from the “Save Our Swiss Gold” proponents is simple: Force the central bank to build its bullion position up to at least 20 percent of total assets from 8 percent today. Holding 522 billion Swiss francs ($544 billion) of assets in its coffers, the Swiss National Bank would have to buy at least 1,500 tons of gold, costing about $56.3 billion at current prices, to get to the required threshold by 2019.

Those purchases, equal to about 7 percent of annual global demand, would trigger an 18 percent rally, giving a lift to gold bulls who’ve suffered 32 percent losses in the past two years, Bank of America Corp. estimates. With polls showing voters split before the Nov. 30 referendum, the SNB and national government are warning that such a move could undermine efforts to prevent the franc from surging against the euro and erode the bank’s annual dividend distribution to regional governments.

There they go again. The gold bugs are rallying to prop up the gold-price bubble with mandated purchases of the useless yellow metal so that it can be locked up to lie idle and inert in the vaults of the Swiss National Bank. How insane is that?

But wait! There is method to their madness.

A “yes” victory means Switzerland would face buying the metal at prices that quadrupled since it began selling more than half its reserves in 2000. The move would make the SNB the world’s third-biggest holder of gold. The initiative would also force the central bank to repatriate the 30 percent of its gold held abroad in the U.K. and Canada and bar it from ever selling bullion again.

With 1,040 metric tons, Switzerland is already the seventh-largest holder of gold by country, International Monetary Fund data show. According to UBS, a change in the law may force the SNB to buy about 1,500 tons, while ABN Amro Group NV and Societe Generale SA estimate the need at closer to 1,800 tons.

The SNB’s assets have expanded by more than a third in the past three years because of currency interventions to enforce a minimum exchange rate of 1.20 per euro. As of August, just under 8 percent of its assets were in gold, compared with a ratio of 15 percent for Germany‘s Bundesbank.

Many people get all bent out of shape at the mere mention of bailing out the banks and Wall Street, but those same people don’t seem to mind bailing out all those hedge funds and gold investment trusts, as well as all the individual investors, egged on by the Peter Schiffs of the world and by the sleazy characters advertising on Fox News and talk radio, who recklessly jumped on the gold bandwagon at the height of the gold bubble from 2008 to 2011.

Gold price tanking? No problemo. Just get the central banks to start buying all the gold now being dumped into the market by people who have finally realized that it’s time to cut their losses before prices fall even further. The price of gold having fallen by almost 20% from its 2014 high, a central-bank rescue operation looks awfully attractive to a lot of desperate people. Even better, the rescue operation can be dressed up and packaged as if it were the quintessence of monetary virtue, merely requiring central banks to hold gold backing for the paper money they issue.

Of course, this referendum, even if passed by Swiss electorate, is less than half as insane as the Monetary Law enacted in 1928, at the urging of the Bank of France, by the French Parliament, a law requiring the Bank to hold gold equal to at least 35% of its outstanding note issue. The Bank in its gold frenzy went way beyond its legal obligation to accumulate gold. The proposed Swiss Law is less than half as insane as the French Monetary Law of 1928, because in 1928 France and much of the rest of the world were either on the gold standard or about to rejoin the gold standard, so that increasing the demand for gold meant forcing the world into the deflationary death spiral that turned into the Great Depression. The most that the proposed Swiss Law could do is force Switzerland into a deflationary spiral.

That would be too bad for Switzerland, but probably not such a big deal for the rest of the world. If the Swiss want to lock up 1500 tons of gold in the vaults of their central bank, well, it’s their sovereign right to go insane. Luckily, the rest of the world has figured out how to have a monetary system in which the gyrations of the hyper-volatile gold price can no longer ruin the lives of many hundreds of millions, if not billions, of people.

Just How Infamous Was that Infamous Open Letter to Bernanke?

There’s been a lot of comment recently about the infamous 2010 open letter to Ben Bernanke penned by an assorted group of economists, journalists, and financiers warning that the Fed’s quantitative easing policy would cause inflation and currency debasement.

Critics of that letter (e.g., Paul Krugman and Brad Delong) have been having fun with the signatories, ridiculing them for what now seems like a chicken-little forecast of disaster. Those signatories who have responded to inquiries about how they now feel about that letter, notably Cliff Asness and Nial Ferguson, have made two arguments: 1) the letter was just a warning that QE was creating a risk of inflation, and 2) despite the historically low levels of inflation since the letter was written, the risk that inflation could increase as a result of QE still exists.

For the most part, critics of the open letter have focused on the absence of inflation since the Fed adopted QE, the critics characterizing the absence of inflation despite QE as an easily predictable outcome, a straightforward implication of basic macroeconomics, which it was ignorant or foolish of the signatories to have ignored. In particular, the signatories should have known that, once interest rates fall to the zero lower bound, the demand for money becoming highly elastic so that the public willingly holds any amount of money that is created, monetary policy is rendered ineffective. Just as a semantic point, I would observe that the term “liquidity trap” used to describe such a situation is actually a slight misnomer inasmuch as the term was coined to describe a situation posited by Keynes in which the demand for money becomes elastic above the zero lower bound. So the assertion that monetary policy is ineffective at the zero lower bound is actually a weaker claim than the one Keynes made about the liquidity trap. As I have suggested previously, the current zero-lower-bound argument is better described as a Hawtreyan credit deadlock than a Keynesian liquidity trap.

Sorry, but I couldn’t resist the parenthetical history-of-thought digression; let’s get back to that infamous open letter.

Those now heaping scorn on signatories to the open letter are claiming that it was obvious that quantitative easing would not increase inflation. I must confess that I did not think that that was the case; I believed that quantitative easing by the Fed could indeed produce inflation. And that’s why I was in favor of quantitative easing. I was hoping for a repeat of what I have called the short but sweat recovery of 1933, when, in the depths of the Great Depression, almost immediately following the worst financial crisis in American history capped by a one-week bank holiday announced by FDR upon being inaugurated President in March 1933, the US economy, propelled by a 14% rise in wholesale prices in the aftermath of FDR’s suspension of the gold standard and 40% devaluation of the dollar, began the fastest expansion it ever had, industrial production leaping by 70% from April to July, and the Dow Jones average more than doubling. Unfortunately, FDR spoiled it all by getting Congress to pass the monumentally stupid National Industrial Recovery Act, thereby strangling the recovery with mandatory wage increases, cost increases, and regulatory ceilings on output as a way to raise prices. Talk about snatching defeat from the jaws of victory!

Inflation having worked splendidly as a recovery strategy during the Great Depression, I have believed all along that we could quickly recover from the Little Depression if only we would give inflation a chance. In the Great Depression, too, there were those that argued either that monetary policy is ineffective – “you can’t push on a string” — or that it would be calamitous — causing inflation and currency debasement – or, even both. But the undeniable fact is that inflation worked; countries that left the gold standard recovered, because once currencies were detached from gold, prices could rise sufficiently to make production profitable again, thereby stimulating multiplier effects (aka supply-side increases in resource utilization) that fueled further economic expansion. And oh yes, don’t forget providing badly needed relief to debtors, relief that actually served the interests of creditors as well.

So my problem with the open letter to Bernanke is not that the letter failed to recognize the existence of a Keynesian liquidity trap or a Hawtreyan credit deadlock, but that the open letter viewed inflation as the problem when, in my estimation at any rate, inflation is the solution.

Now, it is certainly possible that, as critics of the open letter maintain, monetary policy at the zero lower bound is ineffective. However, there is evidence that QE announcements, at least initially, did raise inflation expectations as reflected in TIPS spreads. And we also know (see my paper) that for a considerable period of time (from 2008 through at least 2012) stock prices were positively correlated with inflation expectations, a correlation that one would not expect to observe under normal circumstances.

So why did the huge increase in the monetary base during the Little Depression not cause significant inflation even though monetary policy during the Great Depression clearly did raise the price level in the US and in the other countries that left the gold standard? Well, perhaps the success of monetary policy in ending the Great Depression could not be repeated under modern conditions when all currencies are already fiat currencies. It may be that, starting from an interwar gold standard inherently biased toward deflation, abandoning the gold standard created, more or less automatically, inflationary expectations that allowed prices to rise rapidly toward levels consistent with a restoration of macroeconomic equilibrium. However, in the current fiat money system in which inflation expectations have become anchored to an inflation target of 2 percent or less, no amount of money creation can budge inflation off its expected path, especially at the zero lower bound, and especially when the Fed is paying higher interest on reserves than yielded by short-term Treasuries.

Under our current inflation-targeting monetary regime, the expectation of low inflation seems to have become self-fulfilling. Without an explicit increase in the inflation target or the price-level target (or the NGDP target), the Fed cannot deliver the inflation that could provide a significant economic stimulus. So the problem, it seems to me, is not that we are stuck in a liquidity trap; the problem is that we are stuck in an inflation-targeting monetary regime.

 


About Me

David Glasner
Washington, DC

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

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