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Eureka! Paul Krugman Discovers the Bank of France

Published November 3, 2013 Cassel , currency manipulation , Federal Reserve , gold standard , Great Depression , Hawtrey , monetary history , monetary policy , monetary theory , Paul Krugman 17 Comments
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Trying hard, but not entirely successfully, to contain his astonishment, Paul Krugman has a very good post (“France 1930, Germany 2013) inspired by Doug Irwin’s “very good” paper (see also this shorter version) “Did France Cause the Great Depression?” Here’s Krugman take away from Irwin’s paper.

[Irwin] points out that France, with its undervalued currency, soaked up a huge proportion of the world’s gold reserves in 1930-31, and suggests that France was responsible for about half the global deflation that took place over that period.

The thing is, France itself didn’t do that badly in the early stages of the Great Depression — again thanks to that undervalued currency. In fact, it was less affected than most other advanced countries (pdf) in 1929-31:

Krugman is on the right track here — certainly a hopeful sign — but he misses the distinction between an undervalued French franc, which, despite temporary adverse effects on other countries, would normally be self-correcting under the gold standard, and the explosive increase in demand for gold by the insane Bank of France after the franc was pegged at an undervalued parity against the dollar. Undervaluation of the franc began in December 1926 when Premier Raymond Poincare stabilized its value at about 25 francs to the dollar, the franc having fallen to 50 francs to the dollar in July when Poincare, a former prime minister, had been returned to office to deal with a worsening currency crisis. Undervaluation of the franc would have done no permanent damage to the world economy if the Bank of France had not used the resulting inflow of foreign exchange to accumulate gold, cashing in sterling- and dollar-denominated financial assets for gold. This was a step beyond classic exchange-rate protection (currency manipulation) whereby a country uses a combination of an undervalued exchange rate and a tight monetary policy to keep accumulating foreign-exchange reserves as a way of favoring its export and import-competing industries. Exchange-rate protection may have been one motivation for the French policy, but that objective did not require gold accumulation; it could have been achieved by accumulating foreign exchange reserves without demanding redemption of those reserves in terms of gold, as the Bank of France began doing aggressively in 1927. A more likely motivation for gold accumulation policy of the Bank of France seems to have been French resentment against a monetary system that, from the French perspective, granted a privileged status to the dollar and to sterling, allowing central banks to treat dollar- and sterling-denominated financial assets as official exchange reserves, thereby enabling issuers of dollar and sterling-denominated assets the ability to obtain funds on more favorable terms than issuers of instruments denominated in other currencies.

The world economy was able to withstand the French gold-accumulation policy in 1927-28, because the Federal Reserve was tolerating an outflow of gold, thereby accommodating to some degree the French demand for gold. But after the Fed raised its discount rate to 5% in 1928 and 6% in February 1929, gold began flowing into the US as well, causing gold to start appreciating (in other words, prices to start falling) in world markets by the summer of 1929. But rather than reverse course, the Bank of France and the Fed, despite reductions in their official lending rates, continued pursuing policies that caused huge amounts of gold to flow into the French and US vaults in 1930 and 1931. Hawtrey and Cassel, of course, had warned against such a scenario as early as 1919, and proposed measures to prevent or reverse the looming catastrophe before it took place and after it started, but with little success. For a more complete account of this sad story, and the failure of the economics profession, with a very few notable exceptions, to figure out what happened, see my paper with Ron Batchelder “Pre-Keynesian Monetary Theories of the Great Depression: Whatever Happened to Hawtrey and Cassel?”

As Krugman observes, the French economy did not do so badly in 1929-31, because it was viewed as the most stable, thrifty, and dynamic economy in Europe. But France looked good only because Britain and Germany were in even worse shape. Because France was better off the Britain and Germany, and because its currency was understood to be undervalued, the French franc was considered to be stable, and, thus, unlikely to be devalued. So, unlike sterling, the reichsmark, and the dollar, the franc was not subjected to speculative attacks, becoming instead a haven for capital seeking safety.

Interestingly, Krugman even shows some sympathetic understanding for the plight of the French:

Notice, by the way, that the French weren’t evil or malicious here — they were just adhering to their hard-money ideology in an environment where that had terrible adverse effects on other countries.

Just wondering, would Krugman ever invoke adherence to a hard-money ideology as a mitigating factor in passing judgment on a Republican?

Krugman concludes by comparing Germany today with France in 1930.

Obviously the details are different, but I would argue that Germany is playing a somewhat similar role today — not as drastic, but with less excuse. For Germany is an economic hegemon in a way France never was; it has responsibilities, which it isn’t meeting.

Indeed, there are similarities, but there is a crucial difference in the mechanism by which damage is being inflicted: the world price level in 1930, under the gold standard, was determined by the value of gold. An increase in the demand for gold by central banks necessarily raised the value of gold, causing deflation for all countries either on the gold standard or maintaining a fixed exchange rate against a gold-standard currency. By accumulating gold, nearly quadrupling its gold reserves between 1926 and 1932, the Bank of France was a mighty deflationary force, inflicting immense damage on the international economy. Today, the Eurozone price level does not depend on the independent policy actions of any national central bank, including that of Germany. The Eurozone price level is rather determined by the policy choices of a nominally independent European Central Bank. But the ECB is clearly unable to any adopt policy not approved by the German government and its leader Mrs. Merkel, and Mrs. Merkel has rejected any policy that would raise prices in the Eurozone to a level consistent with full employment. Though the mechanism by which Mrs. Merkel and her government are now inflicting damage on the Eurozone is different from the mechanism by which the insane Bank of France inflicted damage during the Great Depression, the damage is just as pointless and just as inexcusable. But as the damage caused by Mrs. Merkel, in relative terms at any rate, seems somewhat smaller in magnitude than that caused by the insane Bank of France, I would not judge her more harshly than I would the Bank of France — insanity being, in matters of monetary policy, no defense.

HT: ChargerCarl

Hawtrey’s Good and Bad Trade, Part VIII: Credit Money and Banking Systems

Published October 30, 2013 gold standard , Hawtrey , monetary history , monetary policy 7 Comments
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Having argued in chapters 5 through 9 that monetary disturbances could cause significant fluctuations in aggregate expenditure, income, output, and employment, and having argued in chapter 11 that shifts in demand would be unlikely to trigger significant aggregate fluctuations, Hawtrey was satisfied that he had established that monetary disturbances were the most likely cause of such fluctuations. Hawtrey therefore turns his attention in chapter 12 to a consideration of the law and economics of banking and of the two instruments (banknotes and checks) that banks are uniquely able to create. Continuing in this vein in chapter 13, Hawtrey surveys the range of national institutional arrangements then in existence under which banks were then operating.

Hawtrey observes that banks may cause monetary disturbances by providing either too much, or too little, money relative to the amount of money demanded by the public, thereby triggering a cumulative deviation from a point of stability. He then mentions another way in which banks may cause macroeconomic disturbances.

[B]ankers may be tempted to lend imprudently, and when their rashness finds them out, whether they pay the penalty in bankruptcy, or whether they manage to restore their business to a sound footing, in either case a quantity of credit money will have to be annihilated.

Hawtrey characterizes the essence of credit money as the commitment by a banker to pay money on demand “and that the right to obtain money on demand is given in such a form as to be a convenient substitute for cash to the possessor of the right.” For credit money supplied by a bank to be a convenient substitute for cash, the credit money of the bank must be usable and acceptable in payment. Credit money can be made usable and acceptable by way of two instruments: banknotes and checks. Most of chapter 12 is given over to a discussion of the similarities and differences between those two instruments.

A bank-note is a transferable document issued by the banker entitling the holder to obtain on demand a sum specified on its face. The problem of effecting payments is solved by the simple process of handing on the document itself.

Under the cheque system the banker places to his customer’s credit a certain sum, but gives him no transferable documentary evidence of the existence of this sum. But the customer can at any time direct the banker to pay any portion of the money to any third person. The direction is given in writing, and the handing over of the written document or cheque to this third person is, for practical purposes, the equivalent of a payment.

After noting a number of the obvious differences between checks and banknotes, Hawtrey lays down an important principle that in the nineteenth century was denied by the Currency School (who regarded banknotes as uniquely having the status of money and therefore sought quantitative limit on the creation of banknotes but not deposits), but upheld by the Banking School in the famous debates over the Bank Charter Act of 1844.

But for all these differences, there remains the fundamental identity of the right to draw any sum by cheque with the possession of banknotes representing in aggregate value the same sum. Either is simply the possession of so much credit money, and from the point of view of the banker makes the liability to pay that sum on demand. All that has been said in the preceding chapters on the subject of credit money applies impartially to both systems.

And yet in the next breath, Hawtrey seems to acknowledge that, in practice, the principle is not quite so clear cut.

But it does not follow that there are not important practical differences between the two kinds of credit money, even from the point of view from which we are now interested in the subject of banking. The most important of all arise from the fact that notes have a closer resemblance than cheques to cash. Indeed, there is really no hard-and-fast line between cash and notes at all – only a continuous gradation from bullion at one end, through legal tender full-valued coin, legal tender overvalued coin, legal tender inconvertible notes, legal tender convertible notes, finally to convertible notes that are not legal tender.

Ultimately, the points on which Hawtrey lays the most stress in distinguishing banknotes from cheques are that the incentive of a depositor a) to investigate the solvency of his bank is greater than the incentive of the acceptor of a banknote to investigate the solvency of the issuing bank, and b) the incentive of a depositor not to redeem his deposits if there is any question about his banker’s solvency is greater than the incentive of a noteholder not to redeem the banknote if such a question should arise concerning the issuer of a banknote in his possession. These two differential incentives make banknotes an inherently riskier instrument than a bank deposit.

The result is that while the demand of depositors are regulated by the real needs of business, the demands of note-holders are subject to capricious fluctuations which may arise at any time for a loss of confidence in the issuing banks.

Because of the perceived differential in risk associated with banknotes, the creation of banknotes has been subjected to more stringent regulation than the creation of deposits, regulations applying either to the permissible quantity of banknotes issued, or to the requirement that reserves be held against banknotes in the form of particular kinds of assets.

Hawtrey concludes chapter 12 with the following assessment of the role of confidence in a commercial crisis.

It is hardly too much to say that the normal working of the machinery of the money market cannot be understood until the relatively subordinate part played by the impairment of credit, that is to say, by the expectation that banks or other businesses will fail to meet the engagements, is fully realised. A contraction or depression of trade is ordinarily accompanied by a number of failures, especially if it be started by a commercial crisis. But even a crisis cannot be fully explained by a general loss of confidence. A crisis only differs in degree from an ordinary contraction of trade. The manufacture of credit money has so far outstripped the due proportion to the supply of cash that recovery is only possible by means of immediate and drastic steps. The loss of confidence may be very widespread, but it is still only a symptom and not a cause of the collapse.

Hawtrey continues his discussion of banking and credit money in Chapter 13 with a survey of the existing monetary systems in 1913. He begins with the British monetary system, then proceeds to describe the French system, and then the Indian system (which became the prototype for the gold-exchange standard whereby a country could join the gold standard by maintaining a fixed exchange rate against another currency that was fully convertible into gold, e.g., sterling, without engaging in any gold transactions or holding any gold reserves). Hawtrey also gave summary descriptions of the Austria-Hungary and the German monetary systems, before concluding with a lengthier description of the peculiar US monetary system, the only major monetary system then operating without a central bank, as it existed in 1913 just before being drastically changed by the creation of the Federal Reserve System.

.Rather than summarize Hawtrey’s insightful descriptions of the extant monetary systems in 1913 on the eve of the destruction of the classical gold standard, I will close with comments on the following passage in which Hawtrey describes the what was viewed as the responsibility of the central bank at that time.

The responsibility for maintaining the solvency of the banking system as a whole rests almost entirely on the central bank, and the question arises, how is that bank to be guided in exercising that responsibility? How much gold ought to be kept in reserve and how great a change in the amount of the reserve should the central bank acquiesce in before taking steps to correct it?

This is the much discussed gold reserve question. The solution is, of course, a matter of practical experience, upon which it would be useless to dogmatise a priori. The gold reserve of any country is simply a working balance. Like all working balances, however low it falls, it fulfills its function provided it is never exhausted even at the moment of greatest strain. But the moment of greatest strain cannot necessarily be recognized when it comes. In practice, therefore, a standard, more or less arbitrary, is fixed for the gold reserve (e.g., a certain proportion of the liabilities of the central bank), and steps are taken to correct any material departure from the standard chosen. Under this system the standard reserve must be at least of such amount that if it begins to diminish it can stand whatever drain it may be subjected to in the interval before the remedial measures adopted by the central bank have become completely effective.

There are two related issues raised by this passage that are worthy of consideration. Hawtrey’s statement about what constitutes an adequate gold reserve is certainly reasonable; it is also seems cautious inasmuch as he seems to accept that a central bank must never allow its reserve to be exhausted. In other words, the bank must make sure that it in normal times it accumulates a reserve large enough to withstand any conceivable drain on its reserves and to take whatever steps are necessary to protect that reserve once it begins to experience a loss of reserves. That was certainly the dominant view at the time. But Hawtrey eventually came to recommend a different view, which he expressed on many occasions a decade later when he, unlike Keynes, supported the restoration of the international gold standard and supported the decision to restore the prewar dollar-sterling parity. Though supporting that decision, Hawtrey made clear that the decision to restore the gold standard and the prewar dollar-sterling parity should not be considered inviolable. Recognizing the deflationary risks associated with restoring the gold standard and the dollar-sterling parity, Hawtrey.elevated achieving a high level of employment over maintaining the gold standard as the primary duty of the Bank of England. If the two goals were in conflict, it was the gold standard, not high employment, that should yield. The clearest and most dramatic statement of this unorthodox position came in response to questioning by Chairman Hugh Macmillan when Hawtrey testified in 1930 before the Macmillan Committee, when Britain was caught in the downward spiral of the Great Depression. Macmillan asked Hawtrey if the precepts of central banking orthodoxy did not require the Bank of England to take whatever steps were necessary to protect its gold reserve.

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

HAWTREY. I do not think the credit of London depends on any particular figure of gold holding. . . . The harm began to be done in March and April of 1925 [when] the fall in American prices started. There was no reason why the Bank of England should have taken any action at that time so far as the question of loss of gold is concerned. . .

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.

Perhaps Hawtrey already understood the implications of his position in 1913, but a reader of his 1913 statement would not necessarily have grasped the point that he expressed so boldly in 1930.

Hawtrey’s Good and Bad Trade, Part VII: International Adjustment to a Demand Shift

Published October 18, 2013 David Hume , gold standard , Hawtrey , monetary theory , price-specie-flow mechanism 2 Comments
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In this installment, I will provide a very quick overview of Hawtrey’s chapters 10 and 11, and point out a minor defect in his argument about the international adjustment process. Having explained the international adjustment process to a monetary disturbance in chapter 9, Hawtrey uses the next two chapters to give a brief, but highly insightful, account of the process of economic growth, expanding human settlement into new geographic locations, thereby showing an acute sense of the importance of geography and location in economic development, and of the process by which newly extracted gold is exported from gold-producing to gold-importing areas, even though, under the gold standard, the value of gold is the same all over the world (chapter 10). Hawtrey then examines the process of adjustment to a reduction in the demand for a product exported by a particular country. Hawtrey explains the adjustment processes first under the assumption that the exchange rate is allowed to adjust (all countries being assumed to have inconvertible fiat currencies). and, then, under the assumption that all money is convertible into gold and exchange rates are fixed (at least within the limits of gold import and export points).

The analysis is pretty straightforward. Starting from a state of equilibrium, if the worldwide demand for one of country A’s export products (say hats) declines, with the increased expenditure shared among all other commodities, country A will experience a balance-of-payments deficit, requiring a depreciation of the exchange rate of the currency of country exchange against other currencies. In the meantime, country A’s hat producers will have to cut output, thus laying off workers. The workers are unlikely to accept an offer of reduced wages from country A hat producers, correctly reasoning that they may be able to find work elsewhere at close to their old wage. In fact the depreciation of country A’s currency will offer some incentive to country A’s other producers to expand output, eventually reabsorbing the workers laid off by country A’s hat producers. The point is that a demand shift, though leading to a substantial reduction in the output and employment of one industry, does not trigger the wider contraction in economic activity characteristic of cyclical disturbances. Sectoral shifts in demand don’t normally lead to cyclical downturns.

Hawtrey then goes through the analysis under the assumption that all countries are on the gold standard. What happens under the gold standard, according to Hawtrey, is that the balance-of-payments deficit caused by the demand shift requires the export of gold to cover the deficit. The exported gold comes out of the gold reserves held by the banks. When banks see that their gold reserves are diminishing, they in turn raise interest rates as a way of stemming the outflow of gold. The increase in the rate of interest will tend to restrain total spending, which tends to reduce imports and encourage exports. Hawtrey goes through a somewhat abstruse numerical example, which I will spare you, to show how much the internal demand for gold falls as a result of the reduction in demand for country A’s hats. This all seems generally correct.

However, there is one point on which I would take issue with Hawtrey. He writes:

But even so equilibrium is not yet reached. For the export of hats has been diminished by 20 percent, and if the prices ruling in other industries are the same, relatively to those ruling abroad, as before, the imports of those commodities will be unchanged. There must therefore be a further export of gold to lower the general level of prices and so to encourage exports and discourage imports. (pp. 137-38)

Here is an example of the mistaken reasoning that I pointed out in my previous post, a failure to notice that the prices of all internationally traded commodities are fixed by arbitrage (at least as a first approximation) not by the domestic quantity of gold. The export of gold does nothing to reduce the prices of the products of the other industries in country A, which are determined in international markets. Given the internationally determined prices for those goods, equilibrium will have to be restored by the adjustment of wages in country A to make it profitable for country A’s exporting industries and import-competing industries to increase their output, thereby absorbing the workers displaced from country A’s hat industry. As I showed in my previous post, Hawtrey eventually came to understand this point. But in 1913, he had still not freed himself from that misunderstanding originally perpetrated by David Hume in his famous essay “Of the Balance of Trade,” expounding what came to be known as the price-specie-flow mechanism.

Hawtrey’s Good and Bad Trade, Part VI: Monetary Equilibrium under the Gold Standard

Published October 15, 2013 gold standard , Hawtrey , Milton Friedman , purchasing power parity 10 Comments
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In Chapter 9 of Good and Bad Trade, Hawtrey arrives at what he then regarded as the culmination of the earlier purely theoretical discussions of the determination of prices, incomes, and exchange rates under a fiat currency, by positing that the currencies of all countries were uniformly convertible into some fixed weight of gold.

We have shown that the rate of exchange tends to represent simply the ratio of the purchasing power of the two units of currency, and that when this ratio is disturbed, the rate of exchange, subject to certain fluctuations, follows it.

But having elucidated this point we can now pass to the much more important case of the international effects of a fluctuation experienced in a country using metal currency common to itself and its neighbours. Practiaclly all the great commercial nations of the world have now adopted gold as their standard of legal tender, and this completely alters the problem. (p. 102)

Ah, what a difference a century makes! At any rate after providing a detailed and fairly painstaking account of the process of international adjustment in response to a loss of gold in one country, explaining how the loss of gold would cause an increase in interest rates in the country that lost gold which would induce lending by other countries to the country experiencing monetary stringency, and tracing out further repercussions on the movement of exchange rates (within the limits set by gold import and export points, reflecting the cost of transporting gold) and domestic price levels, Hawtrey provides the following summary of his analysis

Gold flows from foreign countries ot the area of stringency in response to the high rate of interest, more quickly from the nearer and more slowly from the more distant countries. While this process is at work the rates of interests in foreign countries are raised, more in the nearer and less in the more distant countries. As soon as the bankers’ loans have been brought into the proper proportion to the stock of gold, the rate of interest reverts to the profit rate in the area of stringency, but the influx of gold continues from each foreign country until the average level of prices there has so far fallen that its divergence from the average level of prices in the area of stringency is no longer great enough to cover the cost of sending the gold.

So long as any country is actually exporting gold the rate of interest will there be maintained somewhat above the profit rate, so as to diminish the total amount of bankers’ loans pari passu with the stock of gold.

At the time when the export of gold ceases from any foreign country the rate of exchange in that country on the area of stringency is at the export specie point; and the exchange will remain at this point indefinitely unless some new influence arises to disturb the equilibrium. In fact, the whole economic system will, the absence of such influence, revert to the stable conditions from which it started. (p. 113)

In subsequent writings, Hawtrey modified his account of the adjustment process in an important respect. I have not identified where and when Hawtrey first revised his view of the adjustment process, but, almost twenty years later in his book The Art of Central Banking, there is an exceptionally clear explanation of the defective nature of the account of the international adjustment mechanism provided in Good and Bad Trade. Iin the course of an extended historical discussion of how the Bank of England had used its lending rate as an instrument of policy in the nineteenth and earl twentieth centuries (a discussion later expanded upon in Hawtrey’s A Century of Bank Rate), Hawtrey quoted the following passage from the Cunliffe Report of 1918 recommending that England quickly restore the gold standard at the prewar parity. The passage provides an explanation of how, under the gold standard, the Bank of England, faced with an outflow of its gold reserves, could restore an international equilibrium by raising Bank Rate. The explanation in the Cunliffe Report deploys essentially the same reasoning reflected above in the quotation from p. 113 of Good and Bad Trade.

The raising of the discount rate had the immediate effect of retaining money here which would otherwise have been remitted abroad, and of attracting remittances from abroad to take advantage of the higher rate, thus checking the outflow of gold and even reversing the stream.

If the adverse conditions of the exchanges was due not merely to seasonal fluctuations but to circumstances tending to create a permanently adverse trade balance, it is obvious that the procedure above described would not have been sufficient. It would have resulted in the creation of a volume of short-dated indebtedness to foreign countries, which would have been in the end disastrous to our credit and the position of London as the financial centre of the world. But the raising of the Bank’s discount rate and the steps taken to make it effective in the market necessarily led to a general rise of interest rates and a restriction of credit. New enterprises were therefore postponed, and the demand for constructional materials and other capital goods was lessened. The consequent slackening of employment also diminished the demand for consumable goods, while holders of stocks of commodities carried largely with borrowed money, being confronted with an increase in interest charges, if not with actual difficulty in renewing loans, and with the prospect of falling prices, tended to press their goods on a weak market. The result was a decline in general prices in the home market which, by checking imports and stimulating exports, corrected the adverse trade balance which was the primary cause of the difficulty. (Interim Report of the Cunliffe Committee, sections 4-5)

Hawtrey took strong issue with the version of the adjustment process outlined in the Cunliffe Report, though acknowledging that ithe Cunliffe Report did in some sense reflect the orthodox view of how variations in Bank Rate achieved an international adjustment.

This passage expresses very fairly the principle on which the Bank of England had been regulating credit from 1866 to 1914. They embody the art of central banking as it was understood in the half-century preceding the war. In view of the experience which has been obtained, the progress made in theory and the changes which have occurred since 1914, the principles of the art require reconsideration at the present day.

The Cunliffe Committee’s version of the effect of Bank rate upon the trade balance was based on exactly the same Ricardian theory of foreign trade as Horsely Palmer’s. It depended on adjustments of the price level. But the revolutionary changes in the means of communication during the past hundred years have unified markets to such a degree that for any of the commodities which enter regularly into international trade there is practically a single world market and a single world price. That does not mean absolutely identical prices for the same commodity at different places, but prices differing only by the cost of transport from exporting to the importing centres. Local divergences of prices form this standard are small and casual, and are speedily eliminated so long as markets work freely.

In Ricardo’s day, relatively considerable differences of price were possible between distant centres. The merchant could never have up-to-date information at one place of the price quotations at another. When he heard that the price of a commodity at a distant place had been relatively high weeks or months before, he was taking a risk in shipping a cargo thither, because the market might have changes for the worse before the cargo arrived. Under such conditions, it might well be that a substantial difference of price level was required to attract goods from one country to another.

Nevertheless it was fallacious ot explain the adjustment wholly in terms of the price level. There was, even at that time, an approximation to a world price. When the difference of price level attracted goods from one country to another, the effect was to diminish the difference of price level, and probably after an interval to eliminate it altogether (apart from cost of transport). When that occurred, the importing country was suffering an adverse balance, not on account of an excess price level, but on account of an excess demand at the world price level. Whether there be a difference of price level or not, it is this difference of demand that is the fundamental factor.

In Horsely Palmer‘s day the accepted theory was that the rate of discount affected the price level because it affected the amount of note issue and therefore the quantity of currency. That did not mean that the whole doctrine depended on the quantity theory of money. All that had currency so far tended to cause a rise or fall of the price level that any required rise or fall of prices could be secured by an appropriate expansion or contraction of the currency that is a very different thing from saying that the rise or fall of the price level would be exactly proportional to the expansion or contraction of the currency.

But it is not really necessary to introduce the quantity of currency into the analysis at all. What governs demand in any community is the consumers’ income (the total of all incomes expressed in terms of money) and consumers’ outlay (the total of all disbursements out of income, including investment).

The final sentence seems to be somewhat overstated, but in the context of a gold standard, in which the quantity of currency is endogenously determined, the quantity of currency is determined not determining. After noticing that Hawtrey anticipated Cassel in formulating the purchasing power parity doctrine, I looked again at the excellent paper by McCloskey and Zecher “The Success of Purchasing Power Parity” in the NBER volume A Retrospective on the Classical Gold Standard 1821-1931, edited by Bordo and Schwartz, a sequel to their earlier paper, “How the Gold Standard Worked” in The Monetary Approach to the Balance of Payments, edited by Johnson and Frenkel. The paper on purchasing power parity makes some very powerful criticisms of the Monetary History of the United States by Friedman and Schwartz, some of which Friedman responded to in his formal discussion of the paper. But clearly the main point on which McCloskey and Zecher took issue with Friedman and Schwartz was whether an internationally determined price level under the gold standard tightly constrained national price levels regardless of the quantity of local money. McCloskey and Zecher argued that it did, while Friedman and Schwartz maintained that variations in the quantity of national money, even under the gold standard, could have significant effects on prices and nominal income, at least in the short to medium term. As Friedman put it in his comment on McCloskey and Zecher:

[W]hile the quantity of money is ultimately an endogenous variable [under fixed exchange rates], there can be and is much leeway in the short run, before the external forces overwhelm the independent internal effects. And we have repeatedly been surprised in our studies by how much leeway there is and for how long – frequently a number of years.

I’ll let Friedman have the last word on this point, except to note that Hawtrey clearly would have disagreed with him post, at least subsequently to his writing Good and Bad Trade.

Hawtrey’s Good and Bad Trade, Part V: Did Hawtrey Discover PPP?

Published October 8, 2013 Cassel , Hawtrey , monetary theory , purchasing power parity 2 Comments
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The first seven chapters of Hawtrey’s Good and Bad Trade present an admirably succinct exposition of the theory of a fiat monetary system with a banking system that issues a credit money convertible into the fiat money supplied by the government. Hawtrey also explains how cyclical fluctuations in output, employment and prices could arise in such a system, given that the interest rates set by banks in the course of their lending operations inevitably deviate, even if for no more than very short periods of time, from what he calls their natural levels. See the wonderful quotation (from pp. 76-77) in my previous post about the inherent instability of the equilibrium between the market rate set by banks and the natural rate.

In chapter 7, Hawtrey considers an international system of fiat currencies, each one issued by the government of a single country in which only that currency (or credit money convertible into that currency) is acceptable as payment. Hawtrey sets as his objective an explanation of the exchange rates between pairs of such currencies and the corresponding price levels in those countries. In summing up his discussion (pp. 90-93) of what determines the rate of exchange between any two currencies, Hawtrey makes the following observation

Practically, it may be said that the rate of exchange equates the general level of prices of commodities in one country with that in the other. This is of course only approximately true, since the rate of exchange is affected only by those commodities which are or might be transported between the two countries. If one of the two countries is at a disadvantage in the production of commodities which cannot be imported, or indeed in those which can only be imported at a specially heavy cost, the general level of prices, calculated fairly over all commodities, will be higher in that country than in the other. But, subject to this important qualification, the rate of exchange under stable conditions does represent that ratio between the units of currency which makes the price-levels and therefore the purchasing powers of the two units equal. (pp. 92-93)

That, of course, is a terse, but characteristically precise, statement of the purchasing power parity doctrine. What makes it interesting, and possibly noteworthy, is that Hawtrey made it 100 years ago, in 1913, which is five years before Hawtrey’s older contemporary, Gustav Cassel, who is usually credited with having originated the doctrine in 1918 in his paper “Abnormal Deviations in International Exchanges” Economic Journal 28:413-15. Here’s how Cassel put it:

According to the theory of international exchanges which I have tried to develop during the course of the war, the rate of exchange between two countries is primarily determined by the quotient between the internal purchasing power against goods of the money of each country. The general inflation which has taken place during the war has lowered this purchasing power in all countries, though in a very different degree, and the rates of exchanges should accordingly be expected to deviate from their old parity in proportion to the inflation in each country.

At every moment the real parity between two countries is represented by this quotient between the purchasing power of the money in the one country and the other. I propose to call this parity “the purchasing power parity.” As long as anything like free movement of merchandise and a somewhat comprehensive trade between two countries takes place, the actual rate of exchange cannot deviate very much from this purchasing power parity. (p. 413)

Hawtrey proceeds, in the rest of the chapter, to explain how international relationships would be affected by a contraction in the currency of one country. The immediate effects would be the same as those described in the case of a single closed economy. However, in an international system, the effects of a contraction in one country would create opportunities for international transactions, both real and financial, that would involve both countries in the adjustment to the initial monetary disturbance originating in one of them.

Hawtrey sums up the discussion about the adjustment to a contraction of the currency of one country as follows:

From the above description, which is necessarily rather complicated, it will be seen that the mutual influence of two areas with independent currency systems is on the whole not very great Indeed, the only important consequence to either of a contraction of currency in the other, is the tendency for the first to lend money to the second in order to get the benefit of the high rate of interest. This hastens the movement towards ultimate equilibrium in the area of stringency. At the same time it would raise the rate of interest slightly in the other country But as this rise in the rate of interest is due to an enhanced demand for loans, it will not have the effect of diminishing the total stock of bankers’ money. (p. 99)

He concludes the chapter with a refinement of the purchasing power parity doctrine.

It is important to notice that as soon as the assumption of stable conditions is abandoned the rate of exchange ceases to represent the ratio of the purchasing powers of the two units of currency which it relates. A difference between the rates of interest in the two countries concerned displaces the rate of exchange from its normal position of equality with this ratio, in the same direction as if the purchasing power of the currency with the higher rate of interest had been increased. Such a divergence between the rates of interest would only occur in case of some financial disturbance, and though such disturbances, great or small, are bound to be frequent, the ratio of purchasing powers may still be taken (subject to the qualification previously explained) to be the normal significance of the rate of exchange. (p. 101)

Hawtrey’s Good and Bad Trade, Part IV: The Inherent Instability of Credit

Published October 4, 2013 Hawtrey , monetary theory , Uncategorized 6 Comments

I don’t have a particularly good memory for specific facts or of books and articles that I have read, even ones that I really enjoyed or thought were very important. If I am lucky, I can remember on or two highlights or retain some general idea of what the book or article was about. So I often find myself surprised when reading something for the second time when I come across a passage that I had forgotten and experience the shock and awe of discovery while knowing, and perhaps even remembering, that I had read this all before once upon a time. That is just the experience I had when reading chapter 7 (“Origination of Monetary Disturbances in an Isolated Community”) of Good and Bad Trade. I think that I read Good and Bad Trade for the first time in the spring of 2009. On the whole, I would say that I was less impressed with it than I was with some other books of his that I had read (especially The Art of Central Banking and The Gold Standard in Theory and Practice), but reading chapter 7 a second time really enhanced my appreciation for how insightful Hawtrey was and how well he explained the underlying causes for what he called, in one of his great phrases “the inherent instability of credit.” He starts of chapter 7 with the following deceptively modest introductory paragraphs.

In the last two chapters we have postulated a perfectly arbitrary change in the quantity of legal tender currency in circulation. However closely the consequences traced from such an arbitrary change may correspond with the phenomena we have set out to explain, we have accomplished nothing till we have shown that causes which will lead to those consequences actually occur. . . .

At the present stage, however it is already possible to make a preliminary survey of the causes of fluctuations with the advantage of an artificial simplification of the problem. And at the outset it must be recognized that arbitrary changes in the quantity of legal tender currency in circulation cannot be of much practical importance. Such changes rarely occur. . . .

But what we are looking for is the origination of changes not necessarily in the quantity of legal tender currency but in the quantity of purchasing power, which is based on the quantity of credit money. . . . For example, if the banker suddenly came to the conclusion that the proportion of reserves to liabilities previously maintained was too low, and decided to increase, this would necessitate a reduction in deposits exactly similar to the reduction which in the last chapter we supposed them to make in consequence of a reduction in the actual stock of legal tender currency. Or there might casual variations in their reserves. These reserves simply consist of that portion of the existing supply of cash [i.e., currency] which happens for the moment not to be in the pockets, tills, cashboxes, etc., of the public. The amount of money which any individual carries about with him at any time is largely a matter of chance, and consequently there may very well be variations in the cash in circulation and therefore contrary variations in the reserves, which are really in the nature of casual variations . . . (pp. 73-74)

After explaining that the amount of cash (i.e., currency) held by the public tends to fluctuate cyclically because increasing employment and increasing wage payments involve an increasing demand for currency (most workers having been paid with currency not by check, and certainly not by electronic transfer, in the nineteenth and early twentieth centuries), so that banks would generally tend to experience declining reserves over the course of the business cycle, Hawtrey offered another reason why banks would be subject to cyclical disturbances affecting their reserve position.

[W]henever the prevailing rate of profit deviates from the rate of interest charged on loans the discrepancy between them at once tends to be enlarged. If trade is for the moment stable and the market rate of interest is equal to the profit rate, and if we suppose that by any cause the profit rate is slightly increased, there will be an increased demand for loans at the existing market rate. But this increased demand for loans leads to an increase in the aggregate amount of purchasing power, which in turn still further increases the profit rate. This process will continue with ever accelerated force until the bankers intervene to save their reserves by raising the rate of interest up to and above the now enhanced profit rate. A parallel phenomenon occurs when the profit rate, through some chance cause, drops below the market rate; the consequent curtailment of loans and so of purchasing power leads at once to a greater and growing fall in profits, until the bankers intervene by reducing the rate of interest. It appears, therefore, that the equilibrium which the bankers have to maintain in fixing the rate of interest is essentially “unstable,” in the sense that if the rate of interest deviates from its proper value by any amount, however small, the deviation will tend to grow greater and greater until steps are taken to correct it. This of itself shows that the money market must be subject to fluctuations. A flag in a steady breeze could theoretically remain in equilibrium if it were spread out perfectly flat in the exact direction of the breeze. But it can be shown mathematically that that position is “unstable,” that if the flag deviates from it to any extent, however small, it will tend to deviate further. Consequently the flag flaps. (pp. 76-77)

Hawtrey also mentions other economic forces tending to amplify fluctuations, forces implicated in the general phenomenon of credit.

Credit money is composed of the obligations of bankers, and if a banker cannot meet his obligations the credit money dependent upon him is wholly or partly destroyed. Again, against his obligations the banker holds equivalent assets, together with a margin. These assets are composed chiefly of two items, legal tender currency and loans to traders. The solvency of the banker will depend largely on the reality of these assets, and the value of the loans will depend in turn on the solvency of the borrowers. (p. 77)

Hawtrey describes one of the principal assets held by English commercial banks in his day, the mercantile bill, with which a dealer or wholesaler making an order from a manufacturer obligates himself to pay for the ordered merchandise upon delivery at some fixed time, say 120 days, after the order is placed. The IOU of the dealer, the bill, can be immediately presented by the manufacturer to his banker who will then advance the funds to the manufacturer with which to cover the costs of producing the order for the dealer. When the order is filled four months hence, the dealer will pay for the order and the manufacturer will then be able to discharge his obligation to his banker.

The whole value of the manufacturer’s efforts in producing the goods depends upon there being an effective demand for them when they are completed. It is only because the dealer anticipates that this effective demand for them will be forthcoming that he gives the manufacturer the order. The dealer, in fact, is taking the responsibility of saying how £10,000 worth of the productive capacity of the country shall be employed. The manufacturer, in accepting the order, and the banker in discounting the bill, are both endorsing the opinion of the dealer. The whole transaction is based ultimately on an expectation of a future demand, which must be more or less speculative. But the banker is doubly insured against the risk. Both the dealer and the manufacturer are men of substance. If the dealer cannot dispose of the goods for £10,000, he is prepared to bear the loss himself. He expects some of his ventures to fail, and others to bring him more than he counted on. Take the rough with the smooth he will probably make a profit. . . . And if the dealer becomes insolvent, there is still the manufacturer to save the banker from loss. . . . Where bills are not used a banker may lend on the sole credit of a dealer or manufacturer, relying on the value of the business to which he lends as the ultimate security for the loan.

Now if a contraction of credit money occurs, the consequent slackening of demand, and fall in the prices of commodities, will lead to a widespread disappointment of dealers’ expectations. At such a time the weakest dealers are likely to be impaired. An individual or company in starting a manufacturing business would usually add to the capital they can provide themselves, further sums borrowed in the form of debentures secured on the business and yielding a fixed rate of interest. . . . But when the general level of prices is falling, the value of the entire business will be falling also, while the debenture and other liabilities, being expressed in money, will remain unchanged. . . . [D]uring the period of falling prices, the expenses of production resist the downward tendency, and the profits are temporarily diminished and may be entirely obliterated or turned into an actual loss. A weak business cannot bear the strain, and being unable to pay its debenture interest and having no further assets on which to borrow, it will fail. If it is not reconstructed but ceases operations altogether, that will of course contribute to the general diminution of output. Its inability to meet its engagements will at the same time inflict loss on the banks. But at present we are considering credit, and credit depends on the expectation of future solvency. A business which is believed to be weak will have difficulty in borrowing, because bankers fear that it may fail. At a time of contracting trade the probability of any given business failing will be increased. At the same time the probability of any particular venture for which it may desire to borrow resulting in a loss instead of a profit will likewise be increased. Consequently at such a time credit will be impaired, but this will be the consequence, not the cause of the contracting trade. (pp. 79-80)

Finally, Hawtrey directs our attention to the credit of bankers.

We have already seen that the banker’s estimate of the proper proportion of his reserve to his liabilities is almost entirely empirical, and that an arbitrary change in the proportion which he thinks fit to maintain between them will carry with it an increase or decrease, as the case may be, in the available amount of purchasing power in the community. If a banker really underestimates the proper amount of reserve, and does not correct his estimate, he may find himself at a moment of strain with his reserve rapidly melting away and no prospect of the process coming to an end before the reserve is exhausted. His natural remedy is to borrow from other banks; but this he can only do if they believe his position to be sound. If they will not lend, he must try to curtail his loans. But if has been lending imprudently, he will find that on his refusing to renew loans the borrowers will in some cases become bankrupt and his money will be lost. It is just when a banker has been lending imprudently that his fellow-bankers will refuse to lend to him, and thus the same mistake cuts him off simultaneously from the two possible remedies. (pp. 81-82)

Interestingly, though he explains how it is possible that credit may become unstable, leading to cumulative fluctuations in economic activity, Hawtrey concludes this chapter by arguing that without changes in aggregate purchasing power (which, in Hawtrey’s terminology, means the total quantity of fiat and credit money). The problem with that formulation is that what Hawtrey has just shown is that the quantity of credit money fluctuates with the state of credit, so to say that economic activity will not fluctuate much if aggregate purchasing power is held stable is to beg the question. The quantity of credit money will not remain stable unless credit remains stable, and if credit is unstable, which is what Hawtrey has just shown, the quantity of credit money will not remain stable.

Hawtrey’s Good and Bad Trade, Part III: Banking and Interest Rates

Published October 1, 2013 Hawtrey , monetary theory , natural rate of interest 11 Comments
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In my previous installment in this series, I began discussing Hawtrey’s analysis of a banking system that creates credit money convertible into a pure fiat money. I noted what seem to me to be defects in Hawtrey’s analysis, mainly related to his incomplete recognition of all the incentives governing banks when deciding how much money to create by making loans. Nevertheless, it is worth following Hawtrey, even with the gap, as he works his way through his analysis .

But, before we try to follow Hawtrey, it will be helpful to think about where he is heading. In his analysis of a pure fiat money system, all — actually not quite all, but almost all — of the analytical work was done by considering how a difference between the amount of fiat money people want to hold and the greater or lesser amount that they actually do hold is resolved. If they hold less money than they want, total spending decreases as people try (unsuccessfully in the aggregate) to build up their cash balances, and if they hold more money than they want, spending increases as people try (unsuccessfully in the aggregate) to part with their excess cash hoaldings. Reaching a new equilibrium entails an adjustment of the ratio of total spending to the stock of fiat money that characterized the initial equilibrium. There may be an interest rate in such an economy, but a change in the interest rate plays no part in the adjustment process that restores equilibrium after a monetary shock (i.e., a change in the stock of fiat money). Hawtrey aims to compare (and contrast) this adjustment process with the adjustment process to a change in the quantity of fiat money when not all money is fiat money — when there is also credit money (created by banks and convertible into fiat money) circulating along with fiat money.

In analyzing a monetary disturbance to a credit-money system, Hawtrey takes as his starting point a banking system in equilibrium, with banks and individuals holding just the amount of currency, reserves and deposits that they want to hold. He then posits a reduction in the total stock of currency.

The first effect of the contraction of the currency is that the working balance of cash in the hands of individual members of the community will be diminished. The precise proportion in which this diminution is shared between bankers and other people does not matter, for those who have banking accounts will quickly draw out enough cash to restore their working balances. As soon as this process is completed we have two effects; first, that the greater part, indeed practically the whole, of the currency withdrawn comes out of the banks’ reserves, and secondly, that the total amount of purchasing power in the community (i.e., currency in circulation plus bank balances) is diminished by the amount of currency withdrawn. One consequence of the existence of a banking system is that a given diminution in the stock of currency produces at this stage much less than a proportional diminution in the total of purchasing power. (pp. 58-59)

Hawtrey goes on to explain this point with a numerical example. Suppose total purchasing power (i.e., the sum of currency plus deposits) were £1 billion of which £250 million were currency and £750 million deposits. If the stock of currency were reduced by 10%, the amount of currency would fall to £225 million, with total stock of purchasing power falling to £975 million. (Note by the way, that Hawtrey’s figure for total purchasing power, or the total stock of money, does not correspond to the usual definition of the money stock in which only currency held by the public, not by the banking system, are counted.) At any rate, the key point for Hawtrey is that under a fiat currency with a banking system, the percentage decrease (10%) in the stock of currency is not equal to the percentage decrease in the total stock of money (2.5%), so that a 10% reduction in the stock of currency, unlike the pure fiat currency case, would not force down the price level by 10% (at least, not without introducing other variables into the picture). Having replenished their holdings of currency by converting deposits into currency, the total cash holdings of the public are only slightly (2.5%) less than the amount they would like to hold, so that only a 2.5% reduction in total spending would seem to be necessary to restore the kind of monetary equilibrium on which Hawtrey was focused in discussing the pure fiat money case. A different sort of disequilibrium involving a different adjustment process had to be added to his analytical landscape.

The new disequilibrium introduced by Hawtrey was that between the amount of currency held by the banks as reserves against their liabilities (deposits) and the amount of currency that they are actually holding. Thus, even though banks met the demands of their depositors to replenish the fiat currency that, by assumption, had been taken from their existing cash balances, that response by the banks, while (largely) eliminating one disequilibrium, also created another one: the banks now find that their reserves, given the amount of liabilities (deposits) on their balance sheets, are less than they would like them to be. Hawtrey is thus positing the existence of a demand function by the banks to hold reserves, a function that depends on the amount of liabilities that they create. (Like most banking theorists, Hawtrey assumes that the functional relationship between bank deposits and banks’ desired reserves is proportional, but there are obviously economies of scale in holding reserves, so that the relationship between bank deposits and desired reserves is certainly less than proportional.) The means by which banks can replenish their reserves, according to Hawtrey, again following traditional banking theory, is to raise the interest rate that they charge borrowers. Here, again, Hawtrey was not quite on the mark, overlooking the possibility that banks could offer to pay interest (or to increase the rate that they were already paying on deposits) as a way of reducing the tendency of depositors to withdraw deposits in exchange for currency.

The special insight brought by Hawtrey to this analysis is that a particular group of entrepreneurs (traders and merchants), whose largest expense is the interest paid on advances from banks to finance their holdings of inventories, are highly sensitive to variations in the bank lending rate, and adjust the size of their inventories accordingly. And since it is the manufacturers to whom traders and merchants are placing orders, the output of factories is necessarily sensitive to the size of the inventories that merchants and traders are trying to hold. Thus, if banks, desiring to replenish their depleted reserves held against deposits, raise interest rates on loans, it will immediately reduce the size of inventories that merchants and traders want to hold, causing them to diminish their orders to manufacturers. But as manufacturers reduce output in response to diminished orders from merchants, the incomes of employees and others providing services and materials to the manufacturers will also fall, so that traders and merchants will find that they are accumulating inventories because their sales to dealers and retailers are slackening, offsetting the effect of their diminished orders to manufacturers, and, in turn, causing merchants and traders to reduce further their orders from manufacturers.

As this process works itself out, prices and output will tend to fall (at least relative to trend), so that traders and merchants will gradually succeed in reducing their indebtedness to the banks, implying that the total deposits created by the banking system will decrease. As their deposit liabilities decline, the amount of reserves that the banks would like to hold declines as well, so that gradually this adjustment process will restore an equilibrium between the total quantity of reserves demanded by the banking system and the total quantity of reserves that is made available to the banks (i.e., the total quantity of currency minus the amount of currency that the public chooses to hold as cash). However, the story does not end with the restoration of equilibrium for the banking system. Despite equilibrium in the banking system, total spending, output, and employment will have fallen from their original equilibrium levels. Full equilibrium will not be restored until prices and wages fall enough to make total spending consistent with a stock of currency 10% less than it was in the original equilibrium. Thus, in the end, it turns out that a 10% reduction in the quantity of currency in a monetary system with both fiat money and credit money will cause a 10% reduction in the price level when a new equilibrium is reached. However, the adjustment process by which a new equilibrium is reached, involving changes not only in absolute prices and wages, but in interest rates, is more complicated than the adjustment process in a pure fiat money system.

Hawtrey summed up his analysis in terms of three interest rates. First, the natural rate “which represented the actual labour-saving value of capital at the level of capitalisation reached by industry. This ratio of labour saved per annum to labour expended on first cost is a physical property of the capital actually in use, and under perfectly stable monetary conditions is equal to the market rate of interest.” Second the market rate which “diverges from the natural rate according to the tendency of prices. When prices are rising them market rate is higher, and when falling lower, than the natural rate, and this divergence is due to the fat that the actual profits of business show under those conditions corresponding movements.” Third, there is the profit rate, “which represents the true profits of business prevailing for the time being,” and does not necessarily coincide with the market rate.

The market rate is in fact the bankers’ rate, and is greater or less than the profit rate, according as the bankers wish to discourage or encourage borrowing. . . .

Consequently, for the banker’s purposes, a “high” rate of interest is one which is above the profit rate, and it is only when the rate of interest is equal to the profit rate that there is no tendency towards either an increase or decrease in temporary borrowing. In any of the three cases the rate of interest may be either above or below the natural rate. If the natural rate is 4% and the profit rate in consequence is only 2%, a market rate of 3% is “high,” and will result in a curtailment of borrowing. If prices are rising and the profit rate is 6%, a market rate of 5% is “low,” and will be compatible with an increased borrowing.

In the case we are now considering we assumed the disturbance to be a departure from perfectly stable conditions, in which the market rate of interest would be identical with the “natural” rate. On the contraction of the currency occurring the bankers raised the market rate above the natural rate. But at the same time the fall of prices began, and there must consequently be a fall of the profit rate below the natural rate. As we now see, the market rate may actually fall below the natural rate, and so long as it remains above the profit rate it will still be a “high” rate of interest.

When the restoration of the bank reserves is completed the market rate will drop down to equality with the profit rate, and they will remain equal to one another and below the natural rate until the fall of prices has gone far enough to re-establish equilibrium. (pp. 66-67)

Although it seems to me that Hawtrey, in focusing exclusively on the short-term lending rate of banks to explain the adjustment of the banking system to a disturbance, missed an important aspect of the overall picture (i.e., the deposit rate), Hawtrey did explain the efficacy of a traditional tool of monetary policy, the short-term lending rate of the banking system (the idea of a central bank having not yet been introduced at this stage of Hawtrey’s exposition). And he did so while avoiding the logical gap in the standard version of the natural-rate-market-rate theory as developed by both Thornton and Wicksell (see section 3 of my paper on Ricardo and Thornton here) explaining why changes in the bank rate could affect aggregate demand without assuming, as do conventional descriptions of the adjustment process, that the system was adjusting to an excess demand for or an excess supply of bank deposits.

Hawtrey’s Good and Bad Trade: Part II

Published September 24, 2013 Hawtrey , James Tobin , John Fullarton , Knut Wicksell , monetary theory , natural rate of interest 21 Comments
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Here I am again back at you finally with another installment in my series on Hawtrey’s Good and Bad Trade. In my first installment I provided some background on Hawtrey and a quick overview of the book, including a mention of the interesting fact (brought to my attention by David Laidler) that Hawtrey used the term “effective demand” in pretty much the same way that Keynes, some 20 years later, would use it in the General Theory.

In this post, I want to discuss what I consider the highlights of the first six chapters. The first chapter is a general introduction to the entire volume laying out the basic premise of the book, which is that the business cycle, understood as recurring fluctuations in the level of employment, is the result of monetary disturbances that lead to alternating phases of expansion and contraction. It is relatively easy for workers to find employment in expansions, but more difficult to do so in contractions. From the standpoint of the theory of economic equilibrium, the close correlation between employment and nominal income over the business cycle is somewhat paradoxical, because, according to the equilibrium theory, the allocation of resources is governed by relative, not absolute, prices. In the theory of equilibrium, a proportional increase or decrease in all prices should have no effect on employment. To explain the paradox, Hawtrey relies on the rigidity of some prices, and especially wages, an empirical fact that, Hawtrey believed, was an essential aspect of any economic system, and a necessary condition for the cyclicality of output and employment.

In Hawtrey’s view, economic expansions and contractions are caused by variations in effective demand, which he defines as total money income. (For reasons I discussed about a year and a half ago, I prefer to define “effective demand” as total money expenditure.) What determines effective demand, according to Hawtrey, is the relationship between the amount of money people are holding and the amount that they would, on average over time, like to hold. The way to think about the amount of money that people would like to hold is to imagine that there is some proportion of their annual income that people aim to hold in the form of cash.

The relationship between the amount of cash being held and the amount that people would like to hold depends on the nature of the monetary system. Hawtrey considers two types of monetary system: one type (discussed in chapter 2) is a pure fiat money system in which all money is issued by government; the other (discussed in chapter 3) is a credit system in which money is also created by banks by promising to redeem, on demand, their obligations (either deposits or negotiable banknotes) for fiat money. Credit money is issued by banks in exchange for a variety of assets, usually the untraded IOUs of borrowers.

In a pure fiat money system, effective demand depends chiefly on the amount of fiat money that people want to hold and on the amount of fiat money created by the government, fiat money being the only money available. A pure fiat money system, Hawtrey understood, was just the sort of system in which the propositions of the quantity theory of money would obtain at least in the medium to long run.

[I]f the adjustment [to a reduction in the quantity of money] could be made entirely by a suitable diminution of wages and salaries, accompanied by a corresponding diminution of prices, the commercial community could be placed forthwith in a new position of equilibrium, in which the output would continue unchanged, and distribution would only be modified by the apportionment of a somewhat larger share of the national product to the possessors of interest, rent, and other kinds of fixed incomes. In fact, the change in the circulating medium is merely a change in the machinery of distribution, and a change, moreover, which, once made, does not impair the effectiveness of that machinery. If the habits of the community are adapted without delay to the change, the production of wealth will continue unabated. If customary prices resist the change, the adjustment, which is bound to come sooner or later, will only be forced upon the people by the pressure of distress. (p. 41)

In a fiat money system, if the public have less money than they would like to hold their only recourse is to attempt to reduce their expenditures relative to their receipts, either offering more in exchange, which tends to depress prices or reducing their purchases, making it that much more difficult for anyone to increase sales except by reducing prices. The problem is that in a fiat system the amount of money is what it is, so that if one person manages to increase his holdings of money by increasing sales relative to purchases, his increase in cash balances must have be gained at the expense of someone else. With a fixed amount of fiat money in existence, the public as a whole cannot increase their holdings of cash, so equilibrium can be restored only by reducing the quantity of money demanded. But the reduction in the amount of money that people want to hold cannot occur unless income in money terms goes down. Money income can go down only if total output in real terms, or if the price level, falls. With nominal income down, people, wanting to hold some particular share of their nominal income in the form of money, will be content with a smaller cash balance than they were before, and will stop trying to increase their cash balances by cutting their expenditure. Because some prices — and especially wages — tend to be sticky, Hawtrey felt that it was inevitable that the adjustment to reduction in the amount of fiat money would cause both real income and prices to fall.

Although Hawtrey correctly perceived that the simple quantity theory would not, even in theory, hold precisely for a credit system, his analysis of the credit system was incomplete inasmuch as he did not fully take into account the factors governing the public’s choice between holding credit money as opposed to fiat money or the incentives of the banking system to create credit money. That theory was not worked out till James Tobin did so 50 years later (another important anniversary worthy of note), though John Fullarton made an impressive start in his great work on the subject in 1844, a work Hawtrey must have been familiar with, but, to my knowledge, never discussed in detail.

In such a banking system there is no necessary connexion between the total of the deposits and the amount of coin which has been paid to the banks. A banker may at any time grant a customer a loan by simply adding to the balance standing to the customer’s credit in the books of the bank. No cash passes, but the customer acquires the right, during the currency of the loan, to draw cheques on the bank up to the amount lent. When the period of the loan expires, if the customer has a large enough balance to his credit, the loan can be repaid without any cash being employed, the amount of the loan being simply deducted from the balance. So long as the loan is outstanding it represents a clear addition to the available stock of “money,” in the sense of purchasing power. It is “money” in the the sense which will play, in a community possessing banks, the same part as money in the stricter sense of legal tender currency would play in the fictitious bankless community whose commercial conditions we previously have been considering. This is the most distinctive feature of the banking system, that between the stock of legal tender currency and the trading community there is interposed an intermediary, the banker, who can, if he wishes, create money out of nothing. (PP. 56-57)

This formulation is incomplete, inasmuch as it leaves the decision of the banker about how much money to create unconstrained by the usual forces of marginal revenue and marginal cost that supposedly determine the decisions of other profit-seeking businessmen. Hawtrey is not oblivious to the problem, but does not advance the analysis as far as he might have.

We have now to find out how this functionary uses his power and under what limitations he works. Something has already been said of the contingencies for which he must provide. Whenever he grants a loan and thereby creates money, he must expect a certain portion of this money to be applied sooner or later, to purposes for which legal tender currency is necessary. Sums will be drawn out from time to time to be spent either in wages or in small purchases, and the currency so applied will take a little time to find its way back to the banks. Large purchases will be paid for by cheque, involving a mere transfer of credit from one banking account to another, but the recipient of the cheque may wish to apply it ot the payment of wages, etc. Thus the principal limitation upon the banker’s freedom to create money is that he must have a reserve to meet the fresh demands for cash to which the creation of new money may lead. (Id.)

This is a very narrow view, apparently assuming that there is but one banker and that the only drain on the reserves of the banker is the withdrawal of currency by depositors. The possibility that recipients of cheques drawn on one bank may prefer to hold those funds in a different bank so that the bank must pay a competitive rate of interest on its deposits to induce its deposits to be held rather than those of another bank is not considered.

In trade a seller encourages or discourages buyers by lowering or raising his prices. So a banker encourages or discourages borrowers by lowering or raising the rate of interest. (p.58)

Again, Hawtrey only saw half the picture. The banker is setting two rates: the rate that he charges borrowers and the rate that he pays to depositors. It is the spread between those two rates that determines the marginal revenue from creating another dollar of deposits. Given that marginal revenue, the banker must form some estimate of the likely cost associated with creating another dollar of deposits (an estimate that depends to a large degree on expectations that may or may not be turn out to be correct), and it is the comparison between the marginal revenue from creating additional deposits with the expected cost of creating additional deposits that determines whether a bank wants to expand or contract its deposits.

Of course, the incomplete analysis of the decision making of the banker is not just Hawtrey’s, it is characteristic of all Wicksellian natural-rate theories. However, in contrast to other versions of the natural-rate genre, Hawtrey managed to avoid the logical gap in those theories: the failure to see that it is the spread between the lending and the deposit rates, not the difference between the lending rate and the natural rate, that determines whether banks are trying to expand or contract. But that is a point that I will have to come back to in the next installment in this series in which I will try to follow through the main steps of Hawtrey’s argument about how a banking system adjusts to a reduction in the quantity of fiat money (aka legal tender currency or base money) is reduced. That analysis, which hinges on the role of merchants and traders whose holding of inventories of goods is financed by borrowing from the banks, was a critical intellectual innovation of Hawtrey’s and was the key to his avoidance of the Wicksellian explanatory gap.

Uneasy Money Marks the Centenary of Hawtrey’s Good and Bad Trade

Published September 10, 2013 David Laidler , Hawtrey , Keynes 9 Comments
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As promised, I am beginning a series of posts about R. G. Hawtrey’s book Good and Bad Trade, published 100 years ago in 1913. Good and Bad Trade was not only Hawtrey’s first book on economics, it was his first publication of any kind on economics, and only his second publication of any kind, the first having been an article on naval strategy written even before his arrival at Cambridge as an undergraduate. Perhaps on the strength of that youthful publication, Hawtrey’s first position, after having been accepted into the British Civil Service, was in the Admiralty, but he soon was transferred to the Treasury where he remained for over forty years till 1947.

Though he was a Cambridge man, Hawtrey had studied mathematics and philosophy at Cambridge. He was deeply influenced by the Cambridge philosopher G. E. Moore, an influence most clearly evident in one of Hawtrey’s few works of economics not primarily concerned with monetary theory, history or policy, The Economic Problem. Hawtrey’s mathematical interests led him to a correspondence with another Cambridge man, Bertrand Russell, which Russell refers to in his Principia Mathematica. However, Hawtrey seems to have had no contact with Alfred Marshall or any other Cambridge economist. Indeed, the only economist mentioned by Hawtrey in Good and Bad Trade was none other than Irving Fisher, whose distinction between the real and nominal rates of interest Hawtrey invokes in chapter 5. So Hawtrey was clearly an autodidact in economics. It is likely that Hawtrey’s self-education in economics started after his graduation from Cambridge when he was studying for the Civil Service entrance examination, but it seems likely that Hawtrey continued an intensive study of economics even afterwards, for although Hawtrey was not in the habit of engaging in lengthy discussions of earlier economists, his sophisticated familiarity with the history of economics and of economic history is quite unmistakable. Nevertheless, it is a puzzle that Hawtrey uses the term “natural rate of interest” to signify more or less the same idea that Wicksell had when he used the term, but without mentioning Wicksell.

In his introductory chapter, Hawtrey lays out the following objective:

My present purposed is to examine certain elements in the modern economic organization of the world, which appear to be intimately connected with [cyclical] fluctuations. I shall not attempt to work back from a precise statistical analysis of the fluctuations which the world has experienced to the causes of all the phenomena disclosed by such analysis. But I shall endeavor to show what the effects of certain assumed economic causes would be, and it will, I think, be found that these calculated effects correspond very closely with the observed features of the fluctuations.

The general result up to which I hope to work is that the fluctuations are due to disturbances in the available stock of “money” – the term “money” being take to cover every species of purchasing power available for immediate use, both legal tender money and credit money, whether in the form of coin, notes, or deposits at banks. (p. 3)

In the remainder of this post, I will present a quick overview of the entire book, and, then, as a kind of postscript to my earlier series of posts on Hawtrey and Keynes, I will comment on the fact that it seems quite clear that it was Hawtrey who invented the term “effective demand,” defining it in a way that does not appear significantly different from the meaning that Keynes attached to it.

Hawtrey posits that the chief problem associated with the business cycle is that workers are unable to earn an income with which to sustain themselves during business-cycle contractions. The source of this problem in Hawtrey’s view is some sort of malfunction in the monetary system, even though money, when considered from the point of view of an equilibrium, seems unimportant, inasmuch as any set of absolute prices would work just as well as another, provided that relative prices were consistent with equilibrium.

In chapter 2, Hawtrey explains the idea of a demand for money and how this demand for money, together with any fixed amount of inconvertible paper money will determine the absolute level of prices and the relationship between the total amount of money in nominal terms and the total amount of income.

In chapter 3, Hawtrey introduces the idea of credit money and banks, and the role of a central bank.

In chapter 4, Hawtrey discusses the organization of production, the accumulation of capital, and the employment of labor, explaining the matching circular flows: expenditure on goods and services, the output of goods and services, and the incomes accruing from that output.

Having laid the groundwork for his analysis, Hawtrey in chapter 5 provides an initial simplified analysis of the effects of a monetary disturbance in an isolated economy with no banking system.

Hawtrey continues the analysis in chapter 6 with a discussion of a monetary disturbance in an isolated economy with a banking system.

In chapter 7, Hawtrey discusses how a monetary disturbance might actually come about in an isolated community.

In chapter 8, Hawtrey extends the discussion of the previous three chapters to an open economy connected to an international system.

In chapter 9, Hawtrey drops the assumption of an inconvertible paper money and introduces an international metallic system (corresponding to the international gold standard then in operation).

Having completed his basic model of the business cycle, Hawtrey, in chapter 10, introduces other sources of change, e.g., population growth and technological progress, and changes in the supply of gold.

In chapter 11, Hawtrey drops the assumption of the previous chapters that there are no forces leading to change in relative prices among commodities.

In chapter 12, Hawtrey enters into a more detailed analysis of money, credit and banking, and, in chapter 13, he describes international differences in money and banking institutions.

In chapters 14 and 15, Hawtrey traces out the sources and effects of international cyclical disturbances.

In chapter 16, Hawtey considers financial crises and their relationship to cyclical phenomena.

In chapter 17, Hawtrey discusses banking and currency legislation and their effects on the business cycle.

Chapters 18 and 19 are devoted to taxation and public finance.

Finally in chapter 20, Hawtrey poses the question whether cyclical fluctuations can be prevented.

After my series on Hawtrey and Keynes, I condensed those posts into a paper which, after further revision, I hope will eventually appear in the forthcoming Elgar Companion to Keynes. After I sent it to David Laidler for comments, he pointed out to me that I had failed to note that it was actually Hawtrey who, in Good and Bad Trade, introduced the term “effective demand.”

The term makes its first appearance in chapter 1 (p. 4).

The producers of commodities depend, for their profits and for the means of paying wages and other expenses, upon the money which they receive for the finished commodities. They supply in response to a demand, but only to an effective demand. A want becomes an effective demand when the person who experiences the want possesses (and can spare) the purchasing power necessary ot meet the price of the thing which will satisfy it. A man may want a hat, but if he has no money [i.e., income or wealth] he cannot buy it, and his want does not contribute to the effective demand for hats.

Then at the outset of chapter 2 (p. 6), Hawtrey continues:

The total effective demand for all finished commodities in any community is simply the aggregate of all money incomes. The same aggregate represents also the total cost of production of all finished commodities.

Once again, Hawtrey, in chapter 4 (pp. 32-33), returns to the concept of effective demand

It was laid down that the total effective demand for all commodities si simply the aggregate of all incomes, and that the same aggregate represents the total cost of production of all commodities.

Hawtrey attributed fluctuations in employment to fluctuations in effective demand inasmuch as wages and prices would not adjust immediately to a change in total spending.

Here is how Keynes defines aggregate demand in the General Theory (p. 55)

[T]he effective demand is simply the aggregate income or (proceeds) which the entrepreneurs expect to receive, inclusive of the income which they will hand on to the other factors of production, from the amount of current employment which they decide to give. The aggregate demand function relates various hypothetical quantities of employment to the proceeds which their outputs are expected to yield; and the effective demand is the point on the aggregate demand function which becomes effective because, taken in conjunction with the conditions of supply, it corresponds to the level of employment which maximizes the entrepreneur’s expectation of profit.

So Keynes in the General Theory obviously presented an analytically more sophisticated version of the concept of effective demand than Hawtrey did over two decades earlier, having expressed the idea in terms of entrepreneurial expectations of income and expenditure and specifying a general functional relationship (aggregate demand) between employment and expected income. Nevertheless, the basic idea is still very close to Hawtrey’s. Interestingly, Hawtrey never asserted a claim of priority on the concept, whether it was because of his natural reticence or because he was unhappy with how Keynes made use of the idea, or perhaps some other reason, I would not venture to say. But perhaps others would like to weigh in with some speculations of their own.

Why Hawtrey and Cassel Trump Friedman and Schwartz

Published August 21, 2013 Cassel , endogenous money , gold standard , Great Depression , Hawtrey , Milton Friedman , monetary policy , monetary theory 36 Comments
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This year is almost two-thirds over, and I still have yet to start writing about one of the two great anniversaries monetary economists are (or should be) celebrating this year. The one that they are already celebrating is the fiftieth anniversary of the publication of The Monetary History of the United States 1867-1960 by Milton Friedman and Anna Schwartz; the one that they should also be celebrating is the 100th anniversary of Good and Bad Trade by Ralph Hawtrey. I am supposed to present a paper to mark the latter anniversary at the Southern Economic Association meetings in November, and I really have to start working on that paper, which I am planning to do by writing a series of posts about the book over the next several weeks.

Good and Bad Trade was Hawtrey’s first publication about economics. He was 34 years old, and had already been working at the Treasury for nearly a decade. Though a Cambridge graduate (in mathematics), Hawtrey was an autodidact in economics, so it is really a mistake to view him as a Cambridge economist. In Good and Bad Trade, he developed a credit theory of money (money as a standard of value in terms of which to discharge debts) in the course of presenting his purely monetary theory of the business cycle, one of the first and most original instances of such a theory. The originality lay in his description of the transmission mechanism by which money — actually the interest rate at which money is lent by banks — influences economic activity, through the planned accumulation or reduction of inventory holdings by traders and middlemen in response to changes in the interest rate at which they can borrow funds. Accumulation of inventories leads to cumulative increases of output and income; reductions in inventories lead to cumulative decreases in output and income. The business cycle (under a gold standard) therefore was driven by changes in bank lending rates in response to changes in lending rate of the central bank. That rate, or Bank Rate, as Hawtrey called it, was governed by the demand of the central bank for gold reserves. A desire to increase gold reserves would call for an increase in Bank Rate, and a willingness to reduce reserves would lead to a reduction in Bank Rate. The basic model presented in Good and Bad Trade was, with minor adjustments and refinements, pretty much the same model that Hawtrey used for the next 60 years, 1971 being the year of his final publication.

But in juxtaposing Hawtrey with Friedman and Schwartz, I really don’t mean to highlight Hawtrey’s theory of the business cycle, important though it may be in its own right, but his explanation of the Great Depression. And the important thing to remember about Hawtrey’s explanation for the Great Depression (the same explanation provided at about the same time by Gustav Cassel who deserves equal credit for diagnosing and explaining the problem both prospectively and retrospectively as explained in my paper with Ron Batchelder and by Doug Irwin in this paper) is that he did not regard the Great Depression as a business-cycle episode, i.e., a recurring phenomenon of economic life under a functioning gold standard with a central bank trying to manage its holdings of gold reserves through manipulation of Bank Rate. The typical business-cycle downturn described by Hawtrey was caused by a central bank responding to a drain on its gold reserves (usually because expanding output and income increased the internal monetary demand for gold to be used as hand-to-hand currency) by raising Bank Rate. What happened in the Great Depression was not a typical business-cycle downturn; it was characteristic of a systemic breakdown in the gold standard. In his 1919 article on the gold standard, Hawtrey described the danger facing the world as it faced the task of reconstructing the international gold standard that had been effectively destroyed by World War I.

We have already observed that the displacement of vast quantities of gold from circulation in Europe has greatly depressed the world value of gold in relation to commodities. Suppose that in a few years’ time the gold standard is restored to practically universal use. If the former currency systems are revived, and with them the old demands for gold, both for circulation in coin and for reserves against note issues, the value of gold in terms of commodities will go up. In proportion as it goes up, the difficulty of regaining or maintaining the gold standard will be accentuated. In other words, if the countries which are striving to recover the gold standard compete with one another for the existing supply of gold, they will drive up the world value of gold, and will find themselves burdened with a much more severe task of deflation than they ever anticipated.

And at the present time the situation is complicated by the portentous burden of the national debts. Except for America and this country, none of the principal participants in the war can see clearly the way to solvency. Even we, with taxation at war level, can only just make ends meet. France, Italy, Germany and Belgium have hardly made a beginning with the solution of their financial problems. The higher the value of the monetary unit in which one of these vast debts is calculated, the greater will be the burden on the taxpayers responsible for it. The effect of inflation in swelling the nominal national income is clearly demonstrated by the British income-tax returns, and by the well-sustained consumption of dutiable commodities notwithstanding enormous increases in the rates of duty. Deflation decreases the money yield of the revenue, while leaving the money burden of the debt undiminished. Deflation also, it is true, diminishes the ex-penses of Government, and when the debt charges are small in proportion to the rest, it does not greatly increase the national burdens. But now that the debt charge itself is our main pre-occupation, we may find the continuance of some degree of inflation a necessary condition of solvency.

So 10 years before the downward spiral into the Great Depression began, Hawtrey (and Cassel) had already identified the nature and cause of the monetary dysfunction associated with a mishandled restoration of the international gold standard which led to the disaster. Nevertheless, in their account of the Great Depression, Friedman and Schwartz paid almost no attention to the perverse dynamics associated with the restoration of the gold standard, completely overlooking the role of the insane Bank of France, while denying that the Great Depression was caused by factors outside the US on the grounds that, in the 1929 and 1930, the US was accumulating gold.

We saw in Chapter 5 that there is good reason to regard the 1920-21 contraction as having been initiated primarily in the United States. The initial step – the sharp rise in discount rates in January 1920 – was indeed a consequence of the prior gold outflow, but that in turn reflected the United States inflation in 1919. The rise in discount rates produced a reversal of the gold movements in May. The second step – the rise in discount rates in June 1920 go the highest level in history – before or since [written in 1963] – was a deliberate act of policy involving a reaction stronger than was needed, since a gold inflow had already begun. It was succeeded by a heavy gold inflow, proof positive that the other countries were being forced to adapt to United States action in order to check their loss of gold, rather than the reverse.

The situation in 1929 was not dissimilar. Again, the initial climactic event – the stock market crash – occurred in the United States. The series of developments which started the stock of money on its accelerated downward course in late 1930 was again predominantly domestic in origin. It would be difficult indeed to attribute the sequence of bank failures to any major current influence from abroad. And again, the clinching evidence that the Unites States was in the van of the movement and not a follower is the flow of gold. If declines elsewhere were being transmitted to the United States, the transmission mechanism would be a balance of payments deficit in the United States as a result of a decline in prices and incomes elsewhere relative to prices and incomes in the United States. That decline would lead to a gold outflow from the United States which, in turn, would tend – if the United States followed gold-standard rules – to lower the stock of money and thereby income and prices in the United States. However, the U.S. gold stock rose during the first two years of the contraction and did not decline, demonstrating as in 1920 that other countries were being forced adapt to our monetary policies rather than the reverse. (p. 360)

Amazingly, Friedman and Schwartz made no mention of the accumulation of gold by the insane Bank of France, which accumulated almost twice as much gold in 1929 and 1930 as did the US. In December 1930, the total monetary gold reserves held by central banks and treasuries had increased to $10.94 billion from $10.06 billion in December 1928 (a net increase of $.88 billion), France’s gold holdings increased by $.85 billion while the holdings of the US increased by $.48 billion, Friedman and Schwartz acknowledge that the increase in the Fed’s discount rate to 6.5% in early 1929 may have played a role in triggering the downturn, but, lacking an international perspective on the deflationary implications of a rapidly tightening international gold market, they treated the increase as a minor misstep, leaving the impression that the downturn was largely unrelated to Fed policy decisions, let alone those of the IBOF. Friedman and Schwartz mention the Bank of France only once in the entire Monetary History. When discussing the possibility that France in 1931 would withdraw funds invested in the US money market, they write: “France was strongly committed to staying on gold, and the French financial community, the Bank of France included, expressed the greatest concern about the United States’ ability and intention to stay on the gold standard.” (p. 397)

So the critical point in Friedman’s narrative of the Great Depression turns out to be the Fed’s decision to allow the Bank of United States to fail in December 1930, more than a year after the stock-market crash, almost a year-and-a-half after the beginning of the downturn in the summer of 1929, almost two years after the Fed raised its discount rate to 6.5%, and over two years after the Bank of France began its insane policy of demanding redemption in gold of much of its sizeable holdings of foreign exchange. Why was a single bank failure so important? Because, for Friedman, it was all about the quantity of money. As a result Friedman and Schwartz minimize the severity of the early stages of the Depression, inasmuch as the quantity of money did not begin dropping significantly until 1931. It is because the quantity of money did not drop in 1928-29, and fell only slightly in 1930 that Friedman and Schwartz did not attribute the 1929 downturn to strictly monetary causes, but rather to “normal” cyclical factors (whatever those might be), perhaps somewhat exacerbated by an ill-timed increase in the Fed discount rate in early 1929. Let’s come back once again to the debate about monetary theory between Friedman and Fischer Black, which I have mentioned in previous posts, after Black arrived at Chicago in 1971.

“But, Fischer, there is a ton of evidence that money causes prices!” Friedman would insist. “Name one piece,” Fischer would respond. The fact that the measured money supply moves in tandem with nominal income and the price level could mean that an increase in money causes prices to rise, as Friedman insisted, but it could also mean that an increase in prices causes the quantity of money to rise, as Fischer thought more reasonable. Empirical evidence could not decide the case. (Mehrling, Fischer Black and the Revolutionary Idea of Finance, p. 160)

So Black obviously understood the possibility that, at least under some conditions, it was possible for prices to change exogenously and for the quantity of money to adjust endogenously to the exogenous change in prices. But Friedman was so ideologically committed to the quantity-theoretic direction of causality from the quantity of money to prices that he would not even consider an alternative, and more plausible, assumption about the direction of causality when the value of money is determined by convertibility into a constant amount of gold.

This obliviousness to the possibility that prices, under convertibility, could change independently of the quantity of money is probably the reason that Friedman and Schwartz also completely overlooked the short, but sweet, recovery of 1933 following FDR’s suspension of the gold standard in March 1933, when, over the next four months, the dollar depreciated by about 20% in terms of gold, and the producer price index rose by almost 15% as industrial production rose by 70% and stock prices doubled, before the recovery was aborted by the enactment of the NIRA, imposing, among other absurdities, a 20% increase in nominal wages. All of this was understood and explained by Hawtrey in his voluminous writings on the Great Depression, but went unmentioned in the Monetary History.

Not only did Friedman get both the theory and the history wrong, he made a bad move from his own ideological perspective, inasmuch as, according to his own narrative, the Great Depression was not triggered by a monetary disturbance; it was just that bad monetary-policy decisions exacerbated a serious, but not unusual, business-cycle downturn that had already started largely on its own. According to the Hawtrey-Cassel explanation, the source of the crisis was a deflation caused by the joint decisions of the various central banks — most importantly the Federal Reserve and the insane Bank of France — that were managing the restoration of the gold standard after World War I. The instability of the private sector played no part in this explanation. This is not to say that stability of the private sector is entailed by the Hawtrey-Cassel explanation, just that the explanation accounts for both the downturn and the subsequent prolonged deflation and high unemployment, with no need for an assumption, one way or the other, about the stability of the private sector.

Of course, whether the private sector is stable is itself a question too complicated to be answered with a simple yes or no. It is one thing for a car to be stable if it is being steered on a paved highway; it is quite another for the car to be stable if driven into a ditch.

About Me

David Glasner
Washington, DC

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

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

Follow me on Twitter @david_glasner

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