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How Monetary Policy Works

These are exciting times. Europe is in disarray, unable to cope with a crisis requiring adjustments in relative prices, wages, and incomes that have been rendered impossible by a monetary policy that has produced almost no growth in nominal GDP in the Eurozone since 2008, placing an intolerable burden on the Eurozone’s weakest economies. The required monetary easing by the European Central Bank is unacceptable to Germany, so the process of disintegration continues. The US, showing signs of gradual recovery in the winter and early spring, remains too anemic to shake off the depressing effects of the worsening situation in Europe. With US fiscal policy effectively stalemated until after the election, the only policy-making institution still in play is the Federal Open Market Committee (FOMC) of the Federal Reserve. The recent track record of the FOMC can hardly inspire much confidence in its judgment, but it’s all we’ve got. Yesterday’s stock market rally shows that the markets, despite many earlier disappointments, have still not given up on the FOMC. But how many more disappointments can they withstand?

In today’s Financial Times, Peter Fisher (head of fixed income at BlackRock) makes the case (“Fed would risk diminishing returns with further ‘QE'”) against a change in policy by the Fed. Fisher lists four possible policy rationales for further easing of monetary policy by the Fed: 1) the “bank liquidity” rationale, 2) the “asset price” rationale, 3) the “credit channel” rationale, and 4) the “radical monetarist” rationale.

Fisher dismisses 1), because banks are awash in excess reserves from previous bouts of monetary easing. I agree, and that’s why the Fed should stop paying banks interest on reserves. He dismisses 2) because earlier bouts of monetary easing raised asset prices but had only very limited success in stimulating increased output.

While [the Fed] did drive asset prices higher for a few months, there was little follow-through in economic activity in 2011. This approach provides little more than a bridging operation and the question remains: a bridge to what?

This is not a persuasive critique. Increased asset prices reflected a partial recovery in expectations of future growth in income and earnings. A credible monetary policy with a clearly articulated price level of NGDP target would have supported expectations of higher growth than the anemic growth since 2009, in which asset prices would have risen correspondingly higher, above the levels in 2007, which we have still not reached again.

Fisher rejects 3), the idea “that if the Fed holds down long-term interest rates it will stimulate private credit creation and, thus, economic expansion.” Implementing this idea, via “operation twist” implies taking short-term Treasuries out of the market and replacing them with longer-term Treasuries, but doing so denies “banks the core asset on which they build their balance sheets,” thus impairing the provision of credit by the banking system instead of promoting it.

I agree.

Finally Fisher rejects 4), “the idea more central bank liabilities will eventually translate into ‘too much money chasing too few goods and services’ at least so as to avoid a fall in the general price level.” Fisher asks:

What assets would the Fed buy? More Treasuries? Would the Fed embark on such a radical course in a presidential election year?

Perhaps the Fed could buy foreign currencies, engineer a much weaker dollar and, thereby, stimulate inflation and growth. Would the rest of the world permit this? I doubt it. They would probably respond in kind and we would all have a real currency war. Nor is it clear the US external sector is large enough to import enough inflation to make a difference. If energy and commodity prices soared, would American consumers “chase” consumption opportunities or would they suppress consumption and trigger a recession? Recent experience suggests the latter. How much “chasing behaviour” would we get in a recession? Engineering a dollar collapse would be to play with fire and gasoline. It might create inflation or it might create a depression.

These are concerns that have been expressed before, especially in astute and challenging comments by David Pearson to many of my posts on this blog. They are not entirely misplaced, but I don’t think that they are weighty enough to undermine the case for monetary easing, especially monetary easing tied to an explicit price level or NGDP target. As I pointed out in a previous post, Ralph Hawtrey addressed the currency-war argument 80 years ago in the middle of the Great Depression, and demolished it. FDR’s 40-percent devaluation of the dollar in 1933, triggering the fastest four-month expansion in US history, prematurely aborted by the self-inflicted wound of the National Recovery Administration, provides definitive empirical evidence against the currency-war objection. As for the fear that monetary easing and currency depreciation would lead to an upward spiral of energy and commodity prices that would cause a retrenchment of consumer spending, thereby triggering a relapse into recession, that is certainly a risk. But if you believe that we are in a recession with output and employment below the potential output and employment that the economy could support, you would have to be awfully confident that that scenario is the most likely result of monetary easing in order not to try it.

The point of tying monetary expansion to an explicit price level or spending target is precisely to provide a nominal anchor for expectations. That nominal anchor would provide a barrier against the kind of runaway increase in energy and commodity prices that would supposedly follow from a commitment to use monetary policy to achieve a price-level or spending target. Hawtrey’s immortal line about crying “fire, fire” in Noah’s flood is still all too apt.

Krugman v. Friedman

Published May 2, 2012 Cassel , Friedman , gold standard , Great Depression , Hawtrey , monetary history , monetary policy 53 Comments

Regular readers of this blog will not be surprised to learn that I am not one of Milton Friedman’s greatest fans. He was really, really smart, and a brilliant debater; he had a great intuitive grasp of price theory (aka microeconomics), which helped him derive interesting, and often testable, implications from his analysis, a skill he put to effective use in his empirical work in many areas especially in monetary economics. But he was intolerant of views he didn’t agree with and, when it suited him, he could, despite his libertarianism, be a bit of a bully. Of course, there are lots of academics like that, including Karl Popper, the quintessential anti-totalitarian, whose most famous book The Open Society and Its Enemies was retitled “The Open Society and its Enemy Karl Popper” by one of Popper’s abused and exasperated students. Friedman was also sloppy in his scholarship, completely mischaracterizing the state of pre-Keynesian monetary economics, more or less inventing a non-existent Chicago oral tradition as carrier of the torch of non-Keynesian monetary economics during the dark days of the Keynesian Revolution, while re-packaging a diluted version of the Keynesian IS-LM model as a restatement of that oral tradition. Invoking a largely invented monetary tradition to provide a respectable non-Keynesian pedigree for the ideas that he was promoting, Friedman simply ignored, largely I think out of ignorance, the important work of non-Keynesian monetary theorists like R. G. Hawtrey and Gustav Cassel, making no mention of their monetary explanation of the Great Depression in any of works, especially in the epochal Monetary History of the United States.

It would be one thing if Friedman had provided a better explanation for the Great Depression than Hawtrey and Cassel did, but in every important respect his explanation was inferior to that of Hawtrey and Cassel (see my paper with Ron Batchelder on Hawtrey and Cassel). Friedman’s explanation was partial, providing little if any insight into the causes of the 1929 downturn, treating it as a severe, but otherwise typical, business-cycle downturn. It was also misleading, because Friedman almost entirely ignored the international dimensions and causes of the downturn, causes that directly followed from the manner in which the international community attempted to recreate the international gold standard after its collapse during World War I. Instead, Friedman, argued that the source, whatever it was, of the Great Depression lay in the US, the trigger for its degeneration into a worldwide catastrophe being the failure of the Federal Reserve Board to prevent the collapse of the unfortunately named Bank of United States in early 1931, thereby setting off a contagion of bank failures and a contraction of the US money supply. In doing so, Friedman mistook a symptom for the cause. As Hawtrey and Cassel understood, the contraction of the US money supply was the result of a deflation associated with a rising value of gold, an appreciation resulting mainly from the policy of the insane Bank of France in 1928-29 and an incompetent Fed stupidly trying to curb stock-market speculation by raising interest rates. Bank failures exacerbated this deflationary dynamic, but were not its cause. Once it started, the increase in the monetary demand for gold became self-reinforcing, fueling a downward deflationary spiral; bank failures were merely one of the ways in which increase in the monetary demand for gold fed on itself.

So if Paul Krugman had asked me (an obviously fanciful hypothesis) whether to criticize Friedman’s work on the Great Depression, I certainly would not have discouraged him from doing so. But his criticism of Friedman on his blog yesterday was misguided, largely accepting the historical validity of Friedman’s account of the Great Depression, and criticizing Friedman for tendentiously drawing political conclusions that did not follow from his analysis.

When wearing his professional economist hat, what Friedman really argued was that the Fed could easily have prevented the Great Depression with policy activism; if only it had acted to prevent a big fall in broad monetary aggregates all would have been well. Since the big decline in M2 took place despite rising monetary base, however, this would have required that the Fed “print” lots of money.

This claim now looks wrong. Even big expansions in the monetary base, whether in Japan after 2000 or here after 2008, do little if the economy is up against the zero lower bound. The Fed could and should do more — but it’s a much harder job than Friedman and Schwartz suggested.

Krugman is mischaracterizing Friedman’s argument. Friedman said that the money supply contracted because the Fed didn’t act as a lender of last resort to save the Bank of United States from insolvency setting off a contagion of bank runs. So Friedman would have said that the Fed could have prevented M2 from falling in the first place if it had acted aggressively as a lender of last resort, precisely what the Fed was created to do in the wake of the panic of 1907. The problem with Friedman’s argument is that he ignored the worldwide deflationary spiral that, independently of the bank failures, was already under way. The bank failures added to the increase in demand for gold, but were not its source. To have stopped the Depression the Fed would have had to flood the rest of the world with gold out of the massive hoards that had been accumulated in World War I and which, perversely, were still growing in 1928-31. Moreover, leaving the gold standard or devaluation was clearly effective in stopping deflation and promoting recovery, so monetary policy even at the zero lower bound was certainly not ineffective when the right instrument was chosen.

Krugman then makes a further charge against Friedman:

Beyond that, however, Friedman in his role as political advocate committed a serious sin; he consistently misrepresented his own economic work. What he had really shown, or thought he had shown, was that the Fed could have prevented the Depression; but he transmuted this into a claim that the Fed caused the Depression.

Not so fast. Friedman claimed that the Fed converted a serious recession in 1929-30 into the Great Depression by not faithfully discharging its lender of last resort responsibility. I don’t say that Friedman never applied any spin to the results of his positive analysis when engaging in political advocacy. But in Friedman’s discussions of the Great Depression, the real problem was not the political spin that he put on his historical analysis; it was that his historical analysis was faulty on some basic issues. The correct historical analysis of the Great Depression – the one provided by Hawtrey and Cassel – would have been at least as supportive of Friedman’s political views as the partial and inadequate account presented in the Monetary History.

PS Judging from some of the reactions that I have seen to this post, I suspect that my comments about Friedman came across somewhat more harshly than I intended. My feelings about Friedman are indeed ambivalent, so I now want to emphasize that there is a great deal to admire in his work. And even though he may have been intolerant of opposing views when he encountered them from those he regarded as his inferiors, he was often willing to rethink his ideas in the face of criticism. My main criticism of his work on monetary theory in general and the Great Depression in particular is that he was not well enough versed in the history of thought on the subject, and, as a result, did not properly characterize earlier work that he referred to or simply ignored earlier work that was relevant. I am very critical of Friedman for having completely ignored the work of Hawtrey and Cassel on the Great Depression, work that I regard as superior to Friedman’s on the Great Depression, but that doesn’t mean that what Friedman had to say on the subject is invalid.

Edmund Phelps Should Read Hawtrey and Cassel

Published April 18, 2012 Cassel , gold standard , Great Depression , Hawtrey , Keynes , monetary history , monetary policy 17 Comments

Marcus Nunes follows Karl Smith and Russ Roberts in wondering what Edmund Phelps was talking about in his remarks in the second Hayek v. Keynes debate. I have already explained why I find all the Hayek versus Keynes brouhaha pretty annoying, so, relax, I am not going there again. But Marcus did point out that in the first paragraph of Phelps’s remarks, he actually came close to offering the correct diagnosis of the causes of the Great Depression, an increase in the value of gold. Unfortunately, he didn’t quite get the point, the diagnosis independently provided 10 years before the Great Depression by both Ralph Hawtrey and Gustave Cassel. Here’s Phelps:

Keynes was a close observer of the British and American economies in an era in which their depressions were wholly or largely monetary in origin – Britain’s slump in the late 1920s after the price of the British currency was raised in terms of gold, and America’s Great Depression of the 1930s, when the world was not getting growth in the stock of gold to keep pace with productivity growth. In both cases, there was a huge fall of the price level. Major deflation is a telltale symptom of a monetary problem.

What Phelps unfortunately missed was that from 1925 to mid-1929, Great Britain was not in a slump, at least not in his terminology. Unemployment was high, a carryover from the deep recession of 1920-21, and there were some serious structural problems, especially in the labor market. But the overvaluation of the pound that Phelps blames for a non-existent (under his terminology) slump caused only mild deflation. Deflation was mild, because the Federal Reserve, under the direction of the great Benjamin Strong, was aiming at a roughly stable US (and therefore, world) price level. Although there was still deflationary pressure on Britain, the pound being overvalued compared to the dollar, the accommodative Fed policy (condemned by von Mises and Hayek as intolerably inflationary) allowed a gradual diminution of the relative overvaluation of sterling with only mild British deflation. So from 1925 to 1929, the British economy actually grew steadily, while unemployment fell from over 11% in 1925 to just under 10% in 1929.

The problem that caused the Great Depression in America and the rest of the world (or at least that portion of the world that had gone back on the gold standard) was not that the world stock of gold was not growing as fast as productivity was growing – that was a separate long-run problem that Cassel had warned about that had almost nothing to do with the sudden onset of the Great Depression in 1929. The problem was that in 1928 the insane Bank of France started converting its holdings of foreign exchange into gold. As a result, a tsunami of gold, drawn mostly from other central banks, inundated the vaults of the Bank of France, forcing other central banks throughout the world to raise interest rates and to cash in their foreign exchange holdings for gold in a futile effort to stem the tide of gold headed for the vaults of the IBOF.

One central bank, the Federal Reserve, might have prevented the catastrophe, but, the illustrious Benjamin Strong tragically having been incapacitated by illness in early 1928, the incompetent crew replacing Strong kept raising the discount rate in a frenzied attempt to curb stock-market speculation on Wall Street. Instead of accommodating the world demand for gold by allowing an outflow of gold from its swollen reserves — over 40% of total gold reserves held by central banks, the Fed actually was inducing an inflow of gold into the US in 1929.

That Phelps agrees that the 1925-29 period in Britain was characterized by a deficiency of effective demand because the price level was falling slightly, while denying that there is now any deficiency of aggregate demand in the US because prices are rising slightly, though at the slowest rate in 50 years, misses an important distinction, which is that when real interest rates are negative as they are now, an equilibrium with negative inflation is impossible. Forcing down inflation lower than it is now would trigger another financial panic. With positive real interest rates in the late 1920s, the British economy was able to tolerate deflation without imploding. It was only when deflation fell substantially below 1% a year that the British economy, like most of the rest of the world, started to implode.

If Phelps wants to brush up on his Hawtrey and Cassel, a good place to start would be here.

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

Published March 29, 2012 Cassel , Friedman , gold standard , Hawtrey , Keynes , monetary history , monetary policy , monetary theory 7 Comments

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

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

Here’s the abstract.

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

Kuehn, Keynes and Hawtrey

Published March 7, 2012 Cassel , Hawtrey , Hayek , Keynes 5 Comments

Following up on Brad DeLong’s recent comment on his blog about my post from a while back in which I expounded on the superiority of Hawtrey and Cassel to Keynes and Hayek as explainers of the Great Depression, Daniel Kuehn had a comment on his blog cautioning against reading the General Theory either as an explanation of the Great Depression, which it certainly was not, or as a manual for how to recover from the Great Depression. Although Daniel is correct in characterizing the General Theory as primarily an exercise in monetary theory, I don’t think that it is wrong to say that the General Theory was meant to provide the theoretical basis from which one could provide an explanation of the Great Depression, or wrong to say that the General Theory was meant to provide a theoretical rationale for using fiscal policy as the instrument by which to achieve recovery. Certainly, it is hard to imagine that the General Theory would have been written if there had been no Great Depression. Why else would Keynes have been so intent on proving that an economy in which there was involuntary unemployment could nevertheless be in equilibrium, and on proving that money-wage cuts could not eliminate involuntary unemployment?

Daniel also maintains that Keynes actually was in agreement with Hawtrey on the disastrous effects of the monetary policy of the Bank of France, citing two letters that Keynes wrote on the subject of the Bank of France reprinted in his Essays in Persuasion. I don’t disagree with that, though I suspect that Keynes may have had a more complicated story in mind than Hawtrey did. But it seems clear that Hawtrey and Keynes, even though they were on opposite sides of the debate about restoring sterling to its prewar parity against the dollar, were actually very close in their views on monetary theory before 1931, Keynes, years later, calling Hawtrey his “grandparent in the paths of errancy.” They parted company, I think, mainly because Keynes in the General Theory argued, or at least was understood to argue, that monetary policy was ineffective in a liquidity trap, a position that Hawtrey, acknowledging the existence of what he called a credit deadlock, had some sympathy for, but did not accept categorically. Hawtrey is often associated with the “Treasury view” that holds that fiscal policy is always ineffective, because it crowds out private spending, but I think that his main point was that fiscal policy requires an accommodative monetary policy to be effective. But not having studied Hawtrey’s views on fiscal policy in depth, I must admit that that opinion is just conjecture on my part.

So my praise for Hawtrey and dismissal of Keynes-Hayek hype was not intended to suggest that Keynes had nothing worthwhile to say. My point is simply to that to understand what caused the Great Depression, the place to start from is the writings of Hawtrey and Cassel. That doesn’t mean that there is not a lot to learn about how economies work (or don’t work) from Keynes, or from Hayek for that matter. The broader lesson is that we should be open to contributions from a diverse and eclectic range of sources. So despite superficial appearances, there really is not that much that Daniel and I are disagreeing about.

PS (8:58 AM EST): I pressed a button by mistake and annihilated the original post. This is my best (quick) attempt to recover the gist of what I originally posted last night.

PPS (11:07 AM EST): Thanks to Daniel Kuehn for reminding me that Google Reader had protected my original post against annihilation. I have now restored fully whatever it was that I wanted to restore.

Brad Delong Likes Bagehot and Minsky Better than Hawtrey and Cassel

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

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

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

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

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

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

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

Hawtrey on Competitive Devaluation: Bring It On

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

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

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

To which I responded:

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

To which Greg replied:

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

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

And if so, why?

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

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

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

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

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

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

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

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

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

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

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

Hawtrey on the Short but Sweet 1933 Recovery

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Hawtrey on the Interwar Gold Standard

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

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

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

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

Back to Hawtrey:

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

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

Counterfeiting and American Monetary History

Published February 15, 2012 Hawtrey , monetary history 23 Comments

In the November 10, 2011 issue of the New York Review of Books, Gordon Wood, professor emeritus of history at Brown University, reviews a new book by Ben Tarnoff Moneymakers: The Wicked Lives and Surprising Adventures of Three Notorious Counterfeiters. I found the second paragraph of Wood’s essay, especially arresting.

Almost from the beginning of American history Americans have relied on paper money. Indeed, the Massachusetts Bay Colony in 1690 was the first government in the Western world to print paper currency in order to pay its debts. Although this paper money was not redeemable in specie, the Massachusetts government did accept it in payment for taxes. Because Americans were always severely short of gold and silver, the commercial benefits of such paper soon became obvious. Not only the thirteen British colonies, but following the Revolution the new states and the Continental Congress all came to rely on the printing of paper money to pay most of their bills. By the early nineteenth century hundreds of banks throughout the country were issuing notes that passed as money. No place in the world had more paper money flying about than did America. By the time the federal government began regulating the money supply during the Civil War, there were more than ten thousand different kinds of notes circulating in the United States.

Note the explicit reference to the role of making paper money acceptable in payment for taxes as condition for the success of the paper money printed by the Massachusetts government even though the money was not redeemable in specie.

Wood goes on to recount the important role that counterfeiters played in American history focusing on the stories of the three “heroes” of Tarnoff’s book to illustrate the ways in which counterfeiters actually served the public interest by providing access to paper money that banks were not willing or able to provide, an observation that will resonate deeply with our own esteemed Benjamin Cole, who has loudly proclaimed the benefits of monetary expansion, even if accomplished by counterfeiting.

Another important point that I found extremely interesting comes toward the end of Wood’s piece.

The golden age of American counterfeiting came to an end during the Civil War. In 1862 the United States made paper money printed by the national government legal tender. This “bold expansion of federal sovereignty,” says Tarnoff, “represented nothing less than a revolution in American finance.” The National Currency Act of 1863 followed, and a tax on the notes of state banks put them out of business. The United States had become a new nation. “The war produced something unimaginable: a federal monopoly on paper currency. . . .Never before in American history,” says Tarnoff, “had the power to make paper money been held by a single authority.”

Counterfeiter felt the effects immediately. With a single national currency people no longer had to sift through thousands of different bills trying to distinguish the genuine from the fake. But an agency to detect and arrest counterfeiters was still needed, and in 1865 the Treasury Department created the US Secret Service, which soon severely cut down the number of counterfeiters and counterfeit notes. At the time of the Civil War one third or more of the paper money in circulation had been fraudulent; by the time the Federal Reserve System was established in 1913, counterfeit bills made up less than on thousandth of one percent of the paper money supply.

Obviously, centralizing the issue of bank notes greatly increases the incentive of the monopoly issuer to enforce its property rights and eliminate counterfeiting. With a decentralized supply of bank notes, individual banks have relatively little incentive to seek or undertake enforcement action against counterfeiters who are more likely to counterfeit someone else’s notes than their own. In his first great book on monetary theory, Good and Bad Trade, Ralph Hawtrey cited the reduced costs of identifying counterfeit notes as the principal advantage in suppressing free competition in the issue of banknotes.

Wood closes by noting that most of the $900 billion of Federal Reserve Notes in circulation in 2010 (now well over $1 trillion) are thought to be held outside the US. The amount of gold held in bullion or coins by private citizens is estimated to be 16% of the total of gold in existence in2008. The current stock of gold in all forms is about 170,000 metric tons. So about 25,000 metric tons of gold may now be privately held. At $1700 an ounce, private gold holdings are thus worth about $1.3 trillion. I don’t know how much of this is held outside the US, but I suspect it is much more than a half. Let’s assume it’s a round number like $1 trillion. Then the amount of privately held gold outside the US is about twice the amount of privately held Federal Reserve notes. However, holding Federal Reserve Notes is not the only way that people can hold dollars abroad. They can also hold euro dollar accounts, which are time deposits denominated in dollars held in offshore (outside the US) banks. No one knows what the volume of such accounts is, because it is basically an unregulated market outside the reach of US regulatory authority and pretty much left unregulated by foreign governments. But estimates of the size of euro dollar accounts (which may be denominated in other currencies, but are overwhelmingly denominate in dollars) are probably far more than $1 trillion. So based on the revealed preferences of legally unconstrained choices, the dollar seems to be way, way more popular than gold.

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About Me

David Glasner
Washington, DC

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

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

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