Archive for the 'Milton Friedman' Category

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Milton Friedman and the Chicago School of Debating

I had planned to follow up my previous post, about Milton Friedman and the price of money, with a clarification and further explanation of my assertion that Friedman’s failure to understand that there is both a purchase price of money – roughly corresponding to the inverse of the price level – and a rental price of money – roughly corresponding, but not necessarily equal, to the rate of interest. The basic clarification and extension were prompted by a comment/question from Bob Murphy to which I responded with a comment of my own. I thought that it would be worth a separate post to elaborate on that point (and perhaps I’ll get around to writing it), but in the meantime I have been captivated by several intertwined Twitter threads – triggered by the recent scandal over the deplorable, abusive and sexist putdowns that infest so many of the interactions on the now infamous Economics Job Market Rumors website – about the historical role of the economics workshops in fostering a culture of rudeness in academic economic interactions and whether such rudeness has discouraged young women entering the economics profession.

Rather than run through the Twitter threads here I will just focus on an excellent post by Carolyn Sissoko who recognizes the value of the aggressive debating fostered by the Chicago workshops in honing the critical skills that young economists need to be make real contributions to the advancement of knowledge. The truth is that being overly kind and solicitous toward the feelings of a scientific researcher doesn’t do the researcher a favor nor does it promote the advancement of science, or, for that matter, of any intellectual discipline. The only way that knowledge really advances is by rooting out error, not an easy task, and critical skills — the skills to tease out the implications of an argument and to check its consistency with other propositions that we believe or that seem reasonable, or with the empirical facts that we already know or that might be able to discover – are essential to performing the task well.

I think Carolyn was aiming at a similar point in her blogpost. Here’s how she puts it:

Claudia Sahm writes about ” the toll that our profession’s aggressive, status-obsessed culture can take” and references specific dismissive criticism that is particularly content-free and therefore non-constructive. Matthew Kahn follows up with some ideas about improving mutual respect noting that “researchers are very tough on each other in public seminars (the “Chicago seminar” style).” This is followed up by prominent economists’ tweets about economics’ hyper-aggressiveness and rudeness.

I think it’s important to distinguish between the consequences of “status-obsession,” dismissiveness of women’s work and an “aggressive” seminar-style.

First, a properly run “Chicago-style” seminar requires senior economists who set the right tone. The most harshly criticized economists are senior colleagues and the point is that the resultant debate about the nature of economic knowledge is instructive and constructive for all. Yes, everyone is criticized, but students have been shown many techniques for responding to criticism by the time they are presenting. Crucial is the focus on advancing economic knowledge and an emphasis on argument rather than “status-obsession”.

The simple fact is that “Chicago-style” seminars when they are conducted by “status-obsessed” economists are likely to go catastrophically wrong. One cannot mix a kiss up-kick down culture with a “Chicago-style” seminar. They are like oil and water.

Carolyn is totally right to stress the importance of debate and criticism, and she is equally right to point out the need for the right kind of balance in the workshop environment so that criticism and debate are focused on ideas and concepts and evidence, and not on social advancement for oneself by trying to look good at someone else’s expense and even more so not to use an unavoidably adversarial social situation as an opportunity to make someone look bad or foolish. And the responsibility for setting the right tone is necessarily the responsibility of the leader(s) of the workshop.

In a tweet responding to Carolyn’s post, Beatrice Cherrier quoted an excerpt from a 2007 paper by Ross Emmett about the origins of the Chicago workshops which grew out of the somewhat contentious environment at Chicago where the Cowles Commission was housed in the 1940s and early 1950s before moving to Yale. The first formal workshop at Chicago – the money workshop – was introduced by Milton Friedman in the early 1950s when he took over responsibility for teaching the graduate course in monetary theory. However, Emmett, who draws on extensive interviews with former Chicago graduate students, singles out the Industrial Organization workshop presided over by George Stigler, a pricklier character than Friedman, and the Law and Economics workshop in the Law School as “the most notorious, and [having given] Chicago workshops a reputation for chewing up visitors.” But Emmett notes that “most workshop debate was intense without being insulting.”

That characterization brought to mind the encounter at the money workshop at Chicago in the early 1970s between Milton Friedman and a young assistant professor recently arrived at Chicago by the name of Fischer Black. The incident is recounted in chapter six (“The Money Wars) of Perry Mehrling’s wonderful biography of Black (Fischer Black and the Revolutionary Idea of Finance). Here is how Mehrling describes the encounter.

Friedman’s Workshop in Money and Banking was the most famous workshop at Chicago, and special rules applied. You had to have Friedman’s permission to attend, and one of the requirements for attendance was to offer work of your own for discussion by the other members of the workshop. Furthermore, in Friedman’s workshop presentation was limited to just a few minutes at the beginning. Everyone was expected to have read the paper already, and to have come prepared to discuss it. Friedman himself always led off the discussion, framing the issues that he thought most needed attention.

Into the lion’s den went Fischer, with the very paper that Friedman had dismissed as fallacious (Fisher arguing that inflationary overissue of money by banks is impossible because of the law of reflux). Jim Lorie recalls, “It was like an infidel going to St. Peter’s and announcing that all this stuff about Jesus was wrong.” Friedman led off the discussion: “Fisher Black will be presenting his paper today on money in a two-sector model. We all know that the paper is wrong. We have two hours to work out why it is wrong.” And so it began. But after two hours of defending the indefensible, Fischer emerged bloodied but unbowed. As one participant remembers, the final score was Fisher Black 10, Monetary Workshop 0.

And the next week, Fischer was back again, now forcing others to defend themselves against his own criticisms. If it was a theoretical paper, he would point out the profit opportunity implied for anyone who understood the model. If it was an empirical paper, he would point out how the correlations were consistent with his own theory as well as the quantity theory. “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 issue. (pp. 159-60)

So here was a case in which Friedman, the senior economist responsible for the seminar engaged in some blatant intimidation tactics against a junior colleague with whom he happened to disagree on a fundamental theoretical point. Against most junior colleagues, and almost all graduate students, such tactics would likely have succeeded in cowing the insubordinate upstart. But Fischer Black, who relished the maverick role, was not one to be intimidated. The question is what lesson did graduate students take away from the Friedman/Black encounter. That you could survive a battle with Friedman, or that, if you dissented from orthodoxy, Friedman would try to crush you?

Milton Friedman Says that the Rate of Interest Is NOT the Price of Money: Don’t Listen to Him!

In the comments to Scott Sumner’s post asking for a definition of currency manipulation, one of Scott’s regular commenters, Patrick Sullivan, wrote the following in reply to an earlier comment by Bob Murphy:

‘For example, if Fed officials take some actions during the day and we see interest rates go up, surely that’s all we need to know if we’re going to classify it as “tight” or “loose” money, right?’

As I was saying just a day or so ago, until the economics profession grasps that interest rates are NOT the price[s] of money, there’s no hope that journalists or the general public will.

Bob Murphy, you might want to reread ‘Monetary Policy v. Fiscal Policy.’ The transcript of the famous NYU debate in 1968 between Walter Heller and Milton Friedman. You’ve just made the same freshman error Heller made back then. Look for Friedman’s correction of that error in his rebuttal.

Friedman’s repeated claims that the rate of interest is not the price of money have been echoed by his many acolytes so often that it is evidently now taken as clear evidence of economic illiteracy (or “a freshman error,” as Patrick Sullivan describes it) to suggest that the rate of interest is the price of money. It was good of Sullivan to provide an exact reference to this statement of Friedman, not that similar references are hard to find, Friedman never having been one who was loathe to repeat himself. He did so often, and not without eloquence. Even though I usually quote Friedman to criticize him, I would never dream of questioning his brilliance or his skill as an economic analyst, but he was a much better price theorist than a monetary theorist, and he was a tad too self-confident, which made him disinclined to be self-critical or to admit error, or even entertain such a remote possibility.

So I took Sullivan’s advice and found the debate transcript and looked up passage in which Friedman chided Heller for saying that the rate of interest is the price of money. Here is what Friedman said in responding to Heller:

Let me turn to some of the specific issues that Walter raised in his first discussion and see if I can clarify a few points that came up.

First of all, the question is, Why do we look only at the money stock? Why don’t we also look at interest rates? Don’t you have to look at both quantity and price? The answer is yes, but the interest rate is not the price of money in the sense of the money stock. The interest rate is the price of credit. The price of money is how much goods and services you have to give up to get a dollar. You can have big changes in the quantity of money without any changes in credit. Consider for a moment the 1848-58 period in the United States. We had a big increase in the quantity of money because of the discovery of gold. This increase didn’t, in the first instance, impinge on the credit markets at all. You must sharply distinguish between money in the sense of the money or credit market, and money in the sense of the quantity of money. And the price of money in that second sense is the inverse of the price level—not the interest rate. The interest rate is the price of credit. As I mentioned earlier, the tax increase we had would tend to reduce the price of credit because it reduces the demand for credit, even though it didn’t affect the money supply at all.

So I do think you have to look at both price and quantity. But the price you have to look at from this point of view is the price level, not the interest rate.

What is wrong with Friedman’s argument? Simply this: any asset has two prices, a purchase price and a rental price. The purchase price is the price one pays (or receives) to buy (or to sell) the asset; the rental price is the price one pays to derive services from the asset for a fixed period of time. The purchase price of a unit of currency is what one has to give up in order to gain ownership of that unit. The purchasing price of money, as Friedman observed, can be expressed as the inverse of the price level, but because money is the medium of exchange, there will actually be a vector of distinct purchase prices of a unit of currency depending on what good or service is being exchanged for money.

But there is also a rental price for money, and that rental price represents what you have to give up in order to hold a unit of currency in your pocket or in your bank account. What you sacrifice is the interest you pay to the one who lends you the unit of currency, or if you already own the unit of currency, it is the interest you forego by not lending that unit of currency to someone else who would be willing to pay to have that additional unit of currency in his pocket or in his bank account instead of in yours. So although the interest rate is in some sense the price of credit, it is, indeed, also the price that one has to pay (or of which to bear the opportunity cost) in order to derive the liquidity services provided by that unit of currency.

It therefore makes perfect sense to speak about the rate of interest as the price of money. It is this price – the rate of interest – that is the cost of holding money and governs how much money people are willing to keep in their pockets and in their bank accounts. The rate of interest is also the revenue per unit of currency per unit of time derived by suppliers of money for as long as the unit of money is held by the public. Money issued by the government generates a return to the government equal to the interest that the government would have had to pay had it borrowed the additional money instead of printing the money itself. That flow of revenue is called seignorage or, alternatively, the inflation tax (which is actually a misnomer, because if nominal interest rates are positive, the government derives revenue from printing money even if inflation is zero or negative).

Similarly banks, by supplying deposits, collect revenue per unit of time equal to the interest collected per unit of time from borrowers. But all depositors, not just borrowers, bear that interest cost, because anyone holding deposits is either by paying interest — in this theoretical exposition I ignore the reprehensible fees and charges that banks routinely exact from their customers — to the bank or is foregoing interest that could have been earned by exchanging the money for an interest-bearing instrument.

Now if banking is a competitive industry banks compete to gain market share by paying depositors interest on deposits held in their institutions, thereby driving down the cost of holding money in the form of deposits rather than in the form of currency. In an ideal competitive banking system, banks would pay depositors interest nearly equal to the interest charged to borrowers, making it almost costless to hold money so that liquidity premium (the difference between the lending rate and the deposit rate) would be driven close to zero.

Friedman’s failure to understand why the rate of interest is indeed a price of money was an unfortunate blind spot in his thinking which led him into a variety of theoretical and policy errors over the course of his long, remarkable, but far from faultless career.

What’s Wrong with the Price-Specie-Flow Mechanism, Part III: Friedman and Schwartz on the Great US Inflation of 1933

I have been writing recently about two great papers by McCloskey and Zecher (“How the Gold Standard Really Worked” and “The Success of Purchasing Power Parity”) on the gold standard and the price-specie-flow mechanism (PSFM). This post, for the time being at any rate, will be the last in the series. My main topic in this post is the four-month burst of inflation in the US from April through July of 1933, an episode that largely escaped the notice of Friedman and Schwartz in their Monetary History  of the US, an omission criticized by McCloskey and Zecher in their purchasing-power-parity paper. (I will mention parenthetically that the 1933 inflation was noticed and its importance understood by R. G. Hawtrey in the second (1933) edition of his book Trade Depression and the Way Out and by Scott Sumner in his 2015 book The Midas Paradox. Both Hawtrey and Sumner emphasize the importance of the aborted 1933 recovery as have Jalil and Rua in an important recent paper.) In his published comment on the purchasing-power-parity paper, Friedman (pp. 157-62) responded to the critique by McCloskey and Zecher, and I will look carefully at that response below. But before discussing Friedman’s take on the 1933 inflation, I want to make four general comments about the two McCloskey and Zecher papers.

My first comment concerns an assertion made in a couple of places in which they interpret balance-of-payments surpluses or deficits under a fixed-exchange-rate regime as the mechanism by which excess demands for (supplies of) money in one country are accommodated by way of a balance-of-payments surpluses (deficits). Thus, given a fixed exchange rate between country A and country B, if the quantity of money in country A is less than the amount that the public in country A want to hold, the amount of money held in country A will be increased as the public, seeking to add to their cash holdings, collectively spend less than their income, thereby generating an export surplus relative to country B, and inducing a net inflow of country B’s currency into country A to be converted into country A’s currency at the fixed exchange rate. The argument is correct, but it glosses over a subtle point: excess supplies of, and excess demands for, money in this context are not absolute, but comparative. Money flows into whichever country has the relatively larger excess demand for money. Both countries may have an absolute excess supply of money, but the country with the comparatively smaller excess supply of money will nevertheless experience a balance-of-payments surplus and an inflow of cash.

My second comment is that although McCloskey and Zecher are correct to emphasize that the quantity of money in a country operating with a fixed exchange is endogenous, they fail to mention explicitly that, apart from the balance-of-payments mechanism under fixed exchange rates, the quantity of domestically produced inside money is endogenous, because there is a domestic market mechanism that adjusts the amount of inside money supplied by banks to the amount of inside money demanded by the public. Thus, under a fixed-exchange-rate regime, the quantity of inside money and the quantity of outside money are both endogenously determined, the quantity of inside money being determined by domestic forces, and the quantity of outside money determined by international forces operating through the balance-of-payments mechanism.

Which brings me to my third comment. McCloskey and Zecher have a two-stage argument. The first stage is that commodity arbitrage effectively constrains the prices of tradable goods in all countries linked by international trade. Not all commodities are tradable, and even tradable goods may be subject to varying limits — based on varying ratios of transportation costs to value — on the amount of price dispersion consistent with the arbitrage constraint. The second stage of their argument is that insofar as the prices of tradable goods are constrained by arbitrage, the rest of the price system is also effectively constrained, because economic forces constrain all relative prices to move toward their equilibrium values. So if the nominal prices of tradable goods are fixed by arbitrage, the tendency of relative prices between non-tradables and tradables to revert to their equilibrium values must constrain the nominal prices of non-tradable goods to move in the same direction as tradable-goods prices are moving. I don’t disagree with this argument in principle, but it’s subject to at least two qualifications.

First, monetary policy can alter spending patterns; if the monetary authority wishes, it can accumulate the inflow of foreign exchange that results when there is a domestic excess demand for money rather than allow the foreign-exchange inflow to increase the domestic money stock. If domestic money mostly consists of inside money supplied by private banks, preventing an increase in the quantity of inside money may require increasing the legal reserve requirements to which banks are subject. By not allowing the domestic money stock to increase in response to a foreign-exchange inflow, the central bank effectively limits domestic spending, thereby reducing the equilibrium ratio between the prices of non-tradables and tradables. A monetary policy that raises the relative price of tradables to non-tradables was called exchange-rate protection by the eminent Australian economist Max Corden. Although term “currency manipulation” is chronically misused to refer to any exchange-rate depreciation, the term is applicable to the special case in which exchange-rate depreciation is combined with a tight monetary policy thereby sustaining a reduced exchange rate.

Second, Although McCloskey and Zecher are correct that equilibrating forces normally cause the prices of non-tradables to move in the direction toward which arbitrage is forcing the prices of tradables to move, such equilibrating processes need not always operate powerfully. Suppose, to go back to David Hume’s classic thought experiment, the world is on a gold standard and the amount of gold in Britain is doubled while the amount of gold everywhere else is halved, so that the total world stock of gold is unchanged, just redistributed from the rest of the world to Britain. Under the PSFM view of the world, prices instantaneously double in Britain and fall by half in the rest of the world, and it only by seeking bargains in the rest of the world that Britain gradually exports gold to import goods from the rest of the world. Prices gradually fall in Britain and rise in the rest of the world; eventually (and as a first approximation) prices and the distribution of gold revert back to where they were originally. Alternatively, in the arbitrage view of the world, the prices of tradables don’t change, because in the world market for tradables, neither the amount of output nor the amount of gold has changed, so why should the price of tradables change? But if prices of tradables don’t change, does that mean that the prices of non-tradables won’t change? McCloskey and Zecher argue that if arbitrage prevents the prices of tradables from changing, the equilibrium relationship between the prices of tradables and non-tradables will also prevent the prices of non-tradables from changing.

I agree that the equilibrium relationship between the prices of tradables and non-tradables imposes some constraint on the movement of the prices of non-tradables, but the equilibrium relationship between the prices of tradables and non-tradables is not necessarily a constant. If people in Britain suddenly have more gold in their pockets, and they can buy all the tradable goods they want at unchanged prices, they may well increase their demand for non-tradables, causing the prices of British non-tradables to rise relative to the prices of tradables. The terms of trade will shift in Britain’s favor. Nevertheless, it would be very surprising if the price of non-tradables were to double, even momentarily, as the Humean PSFM argument suggests. Just because arbitrage does not strictly constrain the price of non-tradables does not mean that the appropriate default assumption is that the prices of non-tradables would rise by as much as suggested by a naïve quantity-theoretic PSFM extrapolation. Thus, the way to think of the common international price level under a fixed-exchange-rate regime is that the national price levels are linked by arbitrage, so that movements in national price levels are highly — but not necessarily perfectly — correlated.

My fourth comment is terminological. As Robert Lipsey (pp. 151-56) observes in his published comment about the McCloskey-Zecher paper on purchasing power parity (PPP), when the authors talk about PPP, they usually have in mind the narrower concept of the law of one price which says that commodity arbitrage keeps the prices of the same goods at different locations from deviating by more than the cost of transportation. Thus, a localized increase in the quantity of money at any location cannot force up the price of that commodity at that location by an amount exceeding the cost of transporting that commodity from the lowest cost alternative source of supply of that commodity. The quantity theory of money cannot operate outside the limits imposed by commodity arbitrage. That is the fundamental mistake underlying the PSFM.

PPP is a weaker proposition than the law of one price, refering to the relationship between exchange rates and price indices. If domestic price indices in two locations with different currencies rise by different amounts, PPP says that the expected change in the exchange rate between the two currencies is proportional to relative change in the price indices. But PPP is only an approximate relationship, while the law of one price is, within the constraints of transportation costs, an exact relationship. If all goods are tradable and transportation costs are zero, prices of all commodities sold in both locations will be equal. However, the price indices for the two location will not have the same composition, goods not being produced or consumed in the same proportions in the two locations. Thus, even if all goods sold in both locations sell at the same prices the price indices for the two locations need not change by the same proportions. If the price of a commodity exported by country A goes up relative to the price of the good exported by country B, the exchange rate between the two countries will change even if the law of one price is always satisfied. As I argued in part II of this series on PSFM, it was this terms-of-trade effect that accounted for the divergence between American and British price indices in the aftermath of the US resumption of gold convertibility in 1879. The law of one price can hold even if PPP doesn’t.

With those introductory comments out of the way, let’s now examine the treatment of the 1933 inflation in the Monetary History. The remarkable thing about the account of the 1933 inflation given by Friedman and Schwartz is that they treat it as if it were a non-event. Although industrial production increased by over 45% in a four-month period, accompanied by a 14% rise in wholesale prices, Friedman and Schwartz say almost nothing about the episode. Any mention of the episode is incidental to their description of the longer cyclical movements described in Chapter 9 of the Monetary History entitled “Cyclical Changes, 1933-41.” On p. 493, they observe: “the most notable feature of the revival after 1933 was not its rapidity but its incompleteness,” failing to mention that the increase of over 45% in industrial production from April to July was the largest increase industrial production over any four-month period (or even any 12-month period) in American history. In the next paragraph, Friedman and Schwartz continue:

The revival was initially erratic and uneven. Reopening of the banks was followed by rapid spurt in personal income and industrial production. 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. (pp. 493-95)

Friedman and Schwartz don’t say anything about the suspension of convertibility by FDR and the devaluation of the dollar, all of which caused wholesale prices to rise immediately and substantially (14% in four months). It is implausible to think that the huge increase in industrial production and in wholesale prices was caused by the anticipation of increased wages and production quotas that would take place only after the NIRA was implemented, i.e., not before August. The reopening of the banks may have had some effect, but it is hard to believe that the effect would have accounted for more than a small fraction of the total increase or that it would have had a continuing effect over a four-month period. In discussing the behavior of prices, Friedman and Schwartz, write matter-of-factly:

Like production, wholesale prices first spurted in early 1933, partly for the same reason – in anticipation of the NIRA codes – partly under the stimulus of depreciation in the foreign exchange value of the dollar. (p. 496)

This statement is troubling for two reasons: 1) it seems to suggest that anticipation of the NIRA codes was at least as important as dollar depreciation in accounting for the rise in wholesale prices; 2) it implies that depreciation of the dollar was no more important than anticipation of the NIRA codes in accounting for the increase in industrial production. Finally, Friedman and Schwartz assess the behavior of prices and output over the entire 1933-37 expansion.

What accounts for the greater rise in wholesale prices in 1933-37, despite a probably higher fraction of the labor force unemployed and of physical capacity unutilized than in the two earlier expansions [i.e., 1879-82, 1897-1900]? One factor, already mentioned, was devaluation with its differential effect on wholesale prices. Another was almost surely the explicit measures to raise prices and wages undertaken with government encouragement and assistance, notably, NIRA, the Guffey Coal Act, the agricultural price-support program, and National Labor Relations Act. The first two were declared unconstitutional and lapsed, but they had some effect while in operation; the third was partly negated by Court decisions and then revised, but was effective throughout the expansion; the fourth, along with the general climate of opinion it reflected, became most important toward the end of the expansion.

There has been much discussion in recent years of a wage-price spiral or price-wage spiral as an explanation of post-World War II price movements. We have grave doubts that autonomous changes in wages and prices played an important role in that period. There seems to us a much stronger case for a wage-price or price-wage spiral interpretation of 1933-37 – indeed this is the only period in the near-century we cover for which such an explanation seems clearly justified. During those years there were autonomous forces raising wages and prices. (p. 498)

McCloskey and Zecher explain the implausibility of the idea that the 1933 burst of inflation (mostly concentrated in the April-July period) that largely occurred before NIRA was passed and almost completely occurred before the NIRA was implemented could be attributed to the NIRA.

The chief factual difficulties with the notion that the official cartels sanctioned by the NRA codes caused a rise in the general price level is that most of the NRA codes were not enacted until after the price rise. Ante hoc ergo non propter hoc. Look at the plot of wholesale prices of 1933 in figure 2.3 (retail prices, including such nontradables as housing, show a similar pattern). Most of the rise occurs in May, June, and July of 1933, but the NIRA was not even passed until June. A law passed, furthermore, is not a law enforced. However eager most businessmen must have been to cooperate with a government intent on forming monopolies, the formation took time. . . .

By September 1933, apparently before the approval of most NRA codes — and, judging from the late coming of compulsion, before the effective approval of agricultural codes-three-quarters of the total rise in wholesale prices and more of the total rise in retail food prices from March 1933 to the average of 1934 was complete. On the face of it, at least, the NRA is a poor candidate for a cause of the price rise. It came too late.

What came in time was the depreciation of the dollar, a conscious policy of the Roosevelt administration from the beginning. . . . There was certainly no contemporaneous price rise abroad to explain the 28-percent rise in American wholesale prices (and in retail food prices) between April 1933 and the high point in September 1934. In fact, in twenty-five countries the average rise was only 2.2 percent, with the American rise far and away the largest.

It would appear, in short, that the economic history of 1933 cannot be understood with a model closed to direct arbitrage. The inflation was no gradual working out of price-specie flow; less was it an inflation of aggregate demand. It happened quickly, well before most other New Deal policies (and in particular the NRA) could take effect, and it happened about when and to the extent that the dollar was devalued. By the standard of success in explaining major events, parity here works. (pp. 141-43)

In commenting on the McCloskey-Zecher paper, Friedman responds to their criticism of account of the 1933 inflation presented in the Monetary History. He quibbles about the figure in which McCloskey and Zecher showed that US wholesale prices were highly correlated with the dollar/sterling exchange rate after FDR suspended the dollar’s convertibility into gold in April, complaining that chart leaves the impression that the percentage increase in wholesale prices was as large as the 50% decrease in the dollar/sterling exchange rate, when in fact it was less than a third as large. A fair point, but merely tangential to the main issue: explaining the increase in wholesale prices. The depreciation in the dollar can explain the increase in wholesale prices even if the increase in wholesale prices is not as great as the depreciation of the dollar. Friedman continues:

In any event, as McCloskey and Zecher note, we pointed out in A Monetary History that there was a direct effect of devaluation on prices. However, the existence of a direct effect on wholesale prices is not incompatible with the existence of many other prices, as Moe Abramovitz has remarked, such as non-tradable-goods prices, that did not respond immediately or responded to different forces. An index of rents paid plotted against the exchange rate would not give the same result. An index of wages would not give the same result. (p. 161)

In saying that the Monetary History acknowledged that there was a direct effect of devaluation on prices, Friedman is being disingenuous; by implication at least, the Monetary History suggests that the importance of the NIRA for rising prices and output even in the April to July 1933 period was not inferior to the effect of devaluation on prices and output. Though (belatedly) acknowledging the primary importance of devaluation on wholesale prices, Friedman continues to suggest that factors other than devaluation could have accounted for the rise in wholesale prices — but (tellingly) without referring to the NIRA. Friedman then changes the subject to absence of devaluation effects on the prices of non-tradable goods and on wages. Thus, he is left with no substantial cause to explain the sudden rise in US wholesale prices between April and July 1933 other than the depreciation of the dollar, not the operation of PSFM. Friedman and Schwartz could easily have consulted Hawtrey’s definitive contemporaneous account of the 1933 inflation, but did not do so, referring only once to Hawtrey in the Monetary History (p. 99) in connection with changes by the Bank of England in Bank rate in 1881-82.

Having been almost uniformly critical of Friedman, I would conclude with a word on his behalf. In the context of Great Depression, I think there are good reasons to think that devaluation would not necessarily have had a significant effect on wages and the prices of non-tradables. At the bottom of a downturn, it’s likely that relative prices are far from their equilibrium values. So if we think of devaluation as a mechanism for recovery and restoring an economy to the neighborhood of equilibrium, we would not expect to see prices and wages rising uniformly. So if, for the sake of argument, we posit that real wages were in some sense too high at the bottom of the recession, we would not necessarily expect that a devaluation would cause wages (or the prices of non-tradables) to rise proportionately with wholesale prices largely determined in international markets. Friedman actually notes that the divergence between the increase of wholesale prices and the increase in the implicit price deflator in 1933-37 recovery was larger than in the 1879-82 or the 1897-99 recoveries. The magnitude of the necessary relative price adjustment in the 1933-37 episode may have been substantially greater than it was in either of the two earlier episodes.

What’s Wrong with the Price-Specie-Flow Mechanism, Part II: Friedman and Schwartz on the 1879 Resumption

Having explained in my previous post why the price-specie-flow mechanism (PSFM) is a deeply flawed mischaracterization of how the gold standard operated, I am now going to discuss two important papers by McCloskey and Zecher that go explain in detail the conceptual and especially the historical shortcomings of PSFM. The first paper (“How the Gold Standard Really Worked”) was published in the 1976 volume edited by Johnson and Frenkel, The Monetary Approach to the Balance of Payments; the second paper, (“The Success of Purchasing Power Parity: Historical Evidence and its Relevance for Macroeconomics”) was published in a 1984 NBER conference volume edited by Schwartz and Bordo, A Retrospective on the Classical Gold Standard 1821-1931. I won’t go through either paper in detail, but I do want to mention their criticisms of The Monetary History of the United States, 1867-1960, by Friedman and Schwartz and Friedman’s published response to those criticisms in the Schwartz-Bordo volume. I also want to register a mild criticism of an error of omission by McCloskey and Zecher in failing to note that, aside from the role of the balance of payments under the gold standard in equilibrating the domestic demand for money with the domestic supply of money, there is also a domestic mechanism for equilibrating the domestic demand for money with the domestic supply; it is only when the domestic mechanism does not operate that the burden for adjustment falls upon the balance of payments. I suspect that McCloskey and Zecher would not disagree that there is a domestic mechanism for equilibrating the demand for money with the supply of money, but the failure to spell out the domestic mechanism is still a shortcoming in these two otherwise splendid papers.

McCloskey and Zecher devote a section of their paper to the empirical anomalies that beset the PSFM.

If the orthodox theories of the gold standard are incorrect, it should be possible to observe signs of strain in the literature when they are applied to the experiences of the late nineteenth century. This is the case. Indeed, in the midst of their difficulties in applying the theories earlier observers have anticipated most of the elements of the alternative theory proposed here.

On the broadest level it has always been puzzling that the gold standard in its prime worked so smoothly. After all, the mechanism described by Hume, in which an initial divergence in price levels was to be corrected by flows of gold inducing a return to parity, might be expected to work fairly slowly, requiring alterations in the money supply and, more important, in expectations concerning the level and rate of change of prices which would have been difficult to achieve. The actual flows of gold in the late nineteenth century, furthermore, appear too small to play the large role assigned to them. . . . (pp. 361-62)

Later in the same section, they criticize the account given by Friedman and Schwartz of how the US formally adopted the gold standard in 1879 and its immediate aftermath, suggesting that the attempt by Friedman and Schwartz to use PSFM to interpret the events of 1879-81 was unsuccessful.

The behavior of prices in the late nineteenth century has suggested to some observers that the view that it was gold flows that were transmitting price changes from one country to another is indeed flawed. Over a short period, perhaps a year or so, the simple price-specie-flow mechanism predicts an inverse correlation in the price levels of two countries interacting with each other on the gold standard. . . . Yet, as Triffin [The Evolution of the International Monetary System, p. 4] has noted. . . even over a period as brief as a single year, what is impressive is “the overeall parallelism – rather than divergence – of price movements, expressed in the same unit of measurement, between the various trading countries maintaining a minimum degree of freedom of trade and exchange in their international transactions.

Over a longer period of time, of course, the parallelism is consistent with the theory of the price-specie-flow. In fact, one is free to assume that the lags in its mechanism are shorter than a year, attributing the close correlations among national price levels within the same year to a speedy flow of gold and a speedy price change resulting from the flow rather than to direct and rapid arbitrage. One is not free, however, to assume that there were no lags at all; in the price-specie-flow theory inflows of gold must precede increase in prices by at least the number of months necessary for the money supply to adjust to the new gold and for the increased amount of money to have an inflationary effect. The American inflation following the resumption of specie payments in January 1879 is a good example. After examining the annual statistics on gold flows and price levels for the period, Friedman and Schwartz [Monetary History of the United States, 1867-1960, p. 99] concluded that “It would be hard to find a much neater example in history of the classical gold-standard mechanism in operation.” Gold flowed in during 1879, 1880, and 1881 and American prices rose each year. Yet the monthly statistics on American gold flows and price changes tell a very different story. Changes in the Warren and Pearson wholesale price index during 1879-81 run closely parallel month by month with gold flows, rising prices corresponding to net inflows of gold. There is no tendency for prices to lag behind a gold flow and some tendency for them to lead it, suggesting not only the episode is an especially poor example of the price-specie flow theory in operation, but also that it might well be a reasonably good one of the monetary theory. (pp. 365-66)

Now let’s go back and see exactly what Friedman and Schwartz said about the episode in the Monetary History. Here is how they describe the rapid expansion starting with the resumption of convertibility on January 1, 1879:

The initial cyclical expansion from 1879 to 1882 . . . was characterized by an unusually rapid rise in the stock of money and in net national product in both current and constant prices. The stock of money rose by over 50 per cent, net national product in current prices over 35 per cent, and net national product in constant prices nearly 25 per cent. . . . (p. 96)

The initial rapid expansion reflected a combination of favorable physical and financial factors. On the physical side, the preceding contraction had been unusually protracted; once it was over, there tended to be a vigorous rebound; this is a rather typical pattern of reaction. On the financial side, the successful achievement of resumption, by itself, eased pressure on the foreign exchanges and permitted an internal price rise without external difficulties, for two reasons: first, because it eliminated the temporary demand for foreign exchange on the part of the Treasury to build up its gold reserve . . . second because it promoted a growth in U.S. balances held by foreigners and a decline in foreign balances held by U.S. residents, as confidence spread that the specie standard would be maintained and that the dollar would not depreciate again. (p. 97)

The point about financial conditions that Friedman and Schwartz are making is that, in advance of resumption, the US Treasury had been buying gold to increase reserves with which to satisfy potential demands for redemption once convertibility at the official parity was restored. The gold purchases supposedly forced the US price level to drop further (at the official price of gold, corresponding to a $4.86 dollar/sterling exchange rate) than it would have fallen if the Treasury had not been buying gold. (See quotation below from p. 99 of the Monetary History). Their reasoning is that the additional imports of gold ultimately had to be financed by a corresponding export surplus, which required depressing the US price level below the price level in the rest of the world sufficiently to cause a sufficient increase in US exports and decrease of US imports. But the premise that US exports could be increased and US imports could be decreased only by reducing the US price level relative to the rest of the world is unfounded. The incremental export surplus required only that total domestic expenditure be reduced, thereby allowing an incremental increase US exports or reduction in US imports. Reduced US spending would have been possible without any change in US prices. Friedman and Schwartz continue:

These forces were powerfully reinforced by accidents of weather that produced two successive years of bumper crops in the United States and unusually short crops elsewhere. The result was an unprecedentedly high level of exports. Exports of crude foodstuffs, in the years ending June 30, 1889 and 1881, reached levels roughly twice the average of either the preceding or the following year five years. In each year they were higher than in any preceding year, and neither figure was again exceeded until 1892. (pp. 97-98)

This is a critical point, but neither Friedman and Schwartz nor McCloskey and Zecher in their criticism seem to recognize its significance. Crop shortages in the rest of the world must have caused a substantial increase in grain and cotton prices, but Friedman and Schwartz provide no indication of the magnitudes of the price increases. At any rate, the US was then still a largely agricultural economy, so a substantial rise in agricultural prices determined in international markets would imply an increase in an index of US output prices relative to an index of British output prices reflecting both a shifting terms of trade in favor of the US and a higher share of total output accounted for by agricultural products in the US than in Britain. That shift, and the consequent increase in US versus British price levels, required no divergence between prices in the US and in Britain, and could have occurred without operation of the PSFM. Ignoring the terms-of-trade effect after drawing attention to the bumper crops in the US and crop failures elsewhere was an obvious error in the narrative provided by Friedman and Schwartz. With that in mind, let us return to their narrative.

The resulting increased demand for dollars meant that a relatively higher price level in the United States was consistent with equilibrium in the balance of payments.

Friedman and Schwartz are assuming that a demand for dollars under a fixed-exchange-rate regime can be satisfied only by through an incremental adjustment in exports and imports to induce an offsetting flow of dollars. Such a demand for dollars could also be satisfied by way of appropriate banking and credit operations requiring no change in imports and exports, but even if the demand for money is satisfied through an incremental adjustment in the trade balance, the implicit assumption that an adjustment in the trade balance requires an adjustment in relative price levels is totally unfounded; the adjustment in the trade balance can occur with no divergence in prices, such a divergence being inconsistent with the operation of international arbitrage.

Pending the rise in prices, it led to a large inflow of gold. The estimated stock of gold in the United States rose from $210 million on June 30, 1879, to $439 million on June 30, 1881.

The first sentence is difficult to understand. Having just asserted that there was a rise in US prices, why do Friedman and Schwartz now suggest that the rise in prices has not yet occurred? Presumably, the antecedent of the pronoun “it” is the demand for dollars, but why is the demand for dollars conditioned on a rise in prices? There are any number of reasons why there could have been an inflow of gold into the United States. (Presumably, higher than usual import demand could have led to a temporary drawdown of accumulated liquid assets, e.g., gold, in other countries to finance their unusually high grain imports. Moreover, the significant wealth transfer associated with a sharply improving terms of trade in favor of the US would have led to an increased demand for gold, either for real or monetary uses. More importantly, as banks increased the amount of deposits and banknotes they were supplying to the public, the demand of banks to hold gold reserves would have also increased.)

In classical gold-standard fashion, the inflow of gold helped produce an expansion in the stock of money and in prices. The implicit price index for the U.S. rose 10 per cent from 1879 to 1882 while a general index of British prices was roughly constant, so that the price level in the United States relative to that in Britain rose from 89.1 to 96.1. In classical gold-standard fashion, also, the outflow of gold from other countries produced downward pressure on their stock of money and their prices.

To say that the inflow of gold helped produce an expansion in the stock of money and in prices is simply to invoke the analytically empty story that gold reserves are lent out to the public, because the gold is sitting idle in bank vaults just waiting to be put to active use. But gold doesn’t just wind up sitting in a bank vault for no reason. Banks demand it for a purpose; either they are legally required to hold the gold or they find it more useful or rewarding to hold gold than to hold alternative assets. Banks don’t create liabilities payable in gold because they are holding gold; they hold gold because they create liabilities payable in gold; creating liabilities legally payable in gold may entail a legal obligation to hold gold reserves, or create a prudential incentive to keep some gold on hand. The throw-away references made by Friedman and Schwartz to “classical gold-standard fashion” is just meaningless chatter, and the divergence between the US and the British price indexes between 1879 and 1882 is attributable to a shift in the terms of trade of which the flow of gold from Britain to the US was the effect not the cause.

The Bank of England reserve in the Banking Department declined by nearly 40 percent from mid-1879 to mid-1881. In response, Bank rate was raised by steps from 2.5 per cent in April 1881 to 6 per cent in January 1882. The resulting effects on both prices and capital movements contributed to the cessation of the gold outflow to the U.S., and indeed, to its replacement by a subsequent inflow from the U.S. . . . (p. 98)

The only evidence about the U.S. gold stock provided by Friedman and Schwartz is an increase from $210 million to $439 million between June 30, 1879 to June 30, 1881. They juxtapose that with a decrease in the gold stock held by the Bank of England between mid-1879 and mid-1881, and an increase in Bank rate from 2.5% to 6%. Friedman and Schwartz cite Hawtrey’s Century of Bank Rate as the source for this fact (the only citation of Hawtrey in the Monetary History). But the increase in Bank rate from 2.5% did not begin till April 28, 1881, Bank rate having fluctuated between 2 and 3% from January 1878 to April 1881, two years and three months after the resumption. Discussing the fluctuations in the gold reserve of the Bank England in 1881, Hawtrey states:

The exports of gold had abated in the earlier part of the year, but set in again in August, and Bank rate was raised to 4 per cent. On the 6th of October it was put up to 5 per cent and on the 30th January, 1882, to 6.

The exports of gold had been accentuated in consequence of the crisis in Paris in January, 1882, resulting from the failure of the Union Generale. The loss of gold by export stopped almost immediately after the rise to 6 per cent. In fact the importation into the United States was ceasing, in consequence partly of the silver legislation which went far to satisfy the need for currency with silver certificates. (p. 102)

So it’s not at all clear from the narrative provided by Friedman and Schwartz to what extent the Bank of England, in raising Bank rate in 1881, was responding to the flow of gold to the United States, and they certainly do not establish that price-level changes between 1879 to 1881 reflected monetary, rather than real, forces. Here is how Friedman and Schwartz conclude their discussion of the effects of the resumption of US gold convertibility.

These gold movements and those before resumption have contrasting economic significance. As mentioned in the preceding chapter, the inflow into the U.S. before resumption was deliberately sought by the Treasury and represented an increased demand for foreign exchange. It required a surplus in the balance of payments sufficient to finance the gold inflow. The surplus could be generated only by a reduction in U.S. prices relative to foreign prices or in the price of the U.S. dollar relative to foreign currencies and was, in fact, generated by a relative reduction in U.S. prices. The gold inflow was, as it were, the active element to which the rest of the balance of payments adjusted.

This characterization of the pre-resumption deflationary process is certainly correct insofar as refers to the necessity of a deflation in US dollar prices for the dollar to appreciate to allow convertibility into gold at the 1861 dollar price of gold and dollar/sterling exchange rate. It is not correct insofar as it suggests that beyond the deflation necessary to restore purchasing power parity, a further incremental deflation was required to finance the Treasury’s demand for foreign exchange

After resumption, on the other hand, the active element was the increased demand for dollars resulting largely from the crop situation. The gold inflow was a passive reaction which temporarily filled the gap in payments. In its absence, there would have had to be an appreciation of the dollar relative to other currencies – a solution ruled out by the fixed exchange rate under the specie standard – or a more rapid [sic! They meant “less rapid”] rise in internal U.S. prices. At the same time, the gold inflow provided the basis and stimulus for an expansion in the stock of money and thereby a rise in internal prices at home and downward pressure on the stock of money and price abroad sufficient to bring an end to the necessity for large gold inflows. (p. 99)

This explanation of the causes of gold movements is not correct. The crop situation was a real, not a monetary, disturbance. We would now say that there was a positive supply shock in the US and a negative supply shock in the rest of the world, causing the terms of trade to shift in favor of the US. The resulting gold inflow reflected an increased US demand for gold induced by rapid economic growth and the improved terms of trade and a reduced demand to hold gold elsewhere to finance a temporary excess demand for grain. The monetary demand for gold would have also increased as a result of an increasing domestic demand for money. An increased demand for money could induce an inflow of gold to be minted into coin or to be held as legally required reserves for banknotes or to be held as bank reserves for deposits. The rapid increase in output and income, fueled in part by the positive supply shock and the improving terms of trade, would normally be expected to increase the demand to hold money. If the gold inflow was the basis, or the stimulus, for an expansion of the money stock, then increases in the gold stock should have preceded increases in the money stock. But as I am going to show, Friedman himself later provided evidence showing that in this episode the money stock at first increased more rapidly than the gold stock. And just as price increases and money expansion in the US were endogenous responses to real shocks in output and the terms of trade, adjustments in the stock of money and prices abroad were not the effects of monetary disturbances but endogenous monetary adjustments to real disturbances.

Let’s now turn to the second McCloskey-Zecher paper in which they returned to the 1879 resumption of gold convertibility by the US.

In an earlier paper (1976, p. 367) we reviewed the empirical anomalies in the price-specie-flow mechanism. For instance, we argued that Milton Friedman and Anna Schwartz misapplied the mechanism to an episode in American history. The United States went back on the gold standard in January 1879 at the pre-Civil War parity. The American price level was too low for the parity, allegedly setting the mechanism in motion. Over the next three years, Friedman and Schwartz argued from annual figures, gold flowed in and the price level rose just as Hume would have had it. They conclude (1963, p. 99) that “it would be hard to find a much neater example in history of the classical gold-standard mechanism in operation.” On the contrary, however, we believe it seems much more like an example of purchasing-power parity and the monetary approach than of the Humean mechanism. In the monthly statistics (Friedman and Schwartz confined themselves to annual data), there is no tendency for price rises to follow inflows of gold, as they should in the price-specie-flow mechanism; if anything, there is a slight tendency for price rises to precede inflows of gold, as they would if arbitrage were shortcutting the mechanism and leaving Americans with higher prices directly and a higher demand for gold. Whether or not the episode is a good example of the monetary theory, it is a poor example of the price-specie-flow mechanism. (p. 126)

Milton Friedman, a discussant at the conference at which McCloskey and Zecher presented their paper, submitted his amended remarks about the paper which were published in the volume along with comments of the other discussant, Robert E. Lipsey, and a transcript of the discussion of the paper by those in attendance. Here is Friedman’s response.

[McCloskey and Zecher] quote our statement that “it would be hard to find a much neater example in history of the classical gold-standard mechanism in operation” (p. 99). Their look at that episode on the basis of monthly data is interesting and most welcome, but on closer examination it does not, contrary to their claims, contradict our interpretation of the episode. McCloskey and Zecher compare price rises to inflows of gold, concluding, “In the monthly statistics … there is no tendency for price rises to follow inflows of gold . . . ; if anything, there is a slight tendency for price rises to precede inflows of gold, as they would if arbitrage were shortcutting the mechanism.”

Their comparison is the wrong one for determining whether prices were reacting to arbitrage rather than reflecting changes in the quantity of money. For that purpose the relevant comparison is with the quantity of money. Gold flows are relevant only as a proxy for the quantity of money. (p. 159)

I don’t understand this assertion at all. Gold flows are not simply a proxy for the quantity of money, because the whole premise of the PSFM is, as he and Schwartz assert in the Monetary History, that gold flows provide the “basis and stimulus for” an increase in the quantity of money.

If we compare price rises with changes in the quantity of money directly, a very different picture emerges than McCloskey and Zecher draw (see table C2.1). Our basic estimates of the quantity of money for this period are for semiannual dates, February and August. Resumption took effect on 1 January 1879. From August 1878 to February 1879, the money supply declined a trifle, continuing a decline that had begun in 1875 in final preparation for resumption. From February 1879 to August 1879, the money supply rose sharply, according to our estimates, by 15 percent. The Warren-Pearson monthly wholesale price index fell in the first half of 1879, reflecting the earlier decline in the money stock. It started its sharp rise in September 1879, or at least seven months later than the money supply.

Again, I don’t understand Friedman’s argument. The quantity of money began to rise after the resumption. In fact, Friedman’s own data show that in the six months from February to August of 1879, the quantity of money rose by 14.8% and the gold stock by 10.6%, without any effect on the price level. Friedman asserts that the price level only started to increase in September 8 or 9 months after the resumption in January. But it seems quite plausible that the fall harvest would have been the occasion for the effects of crop failures on grain prices to begin to make themselves felt on wholesale prices. So Friedman’s own evidence undercuts his argument that the increase in the quantity of money was what was driving the increase in US prices.

As to gold, the total stock of gold, as well as gold held by the Treasury, had been rising since 1877 as part of the preparation for resumption. But it had been rising at the expense of other components of high-powered money, which actually fell slightly. However, the decline in the money stock before 1879 had been due primarily to a decline in the deposit-currency ratio and the deposit-reserve ratio. After successful resumption, both ratios rose, which enabled the stock of money to rise despite no initial increase in gold flows. The large step-up in gold inflows in the fall of 1879, to which McCloskey and Zecher call attention, was mostly absorbed in raising the fraction of high-powered money in the form of gold rather than in speeding up monetary growth.

I agree with Friedman that the rapid increase in gold flows starting the fall of 1879 probably had little to do with the increase in the US price level, that increase reflecting primarily the terms-of-trade effect of rising agricultural prices, not a divergence between prices in the US and prices elsewhere in the world.  But that does not justify Friedman’s self-confident reiteration of the conclusion reached in the Monetary History that it would be hard to find a much neater example in history of the classical gold standard mechanism in operation. On the contrary, I see no evidence at all that “the classical gold standard mechanism” aka PSFM had anything to do with the behavior of prices after the resumption.

What’s Wrong with the Price-Specie-Flow Mechanism? Part I

The tortured intellectual history of the price-specie-flow mechanism (PSFM), which received its classic exposition in an essay (“Of the Balance of Trade”) by David Hume about 275 years ago is not a history that, properly understood, provides solid grounds for optimism about the chances for progress in what we, somewhat credulously, call economic science. In brief, the price-specie-flow mechanism asserts that, under a gold or commodity standard, deviations between the price levels of those countries on the gold standard induce gold to be shipped from countries where prices are relatively high to countries where prices are relatively low, the gold flows continuing until price levels are equalized. Hence, the compound adjective “price-specie-flow,” signifying that the mechanism is set in motion by price-level differences that induce gold (specie) flows.

The PSFM is thus premised on a version of the quantity theory of money in which price levels in each country on the gold standard are determined by the quantity of money circulating in that country. In his account, Hume assumed that money consists entirely of gold, so that he could present a scenario of disturbance and re-equilibration strictly in terms of changes in the amount of gold circulating in each country. Inasmuch as Hume held a deeply hostile attitude toward banks, believing them to be essentially inflationary engines of financial disorder, subsequent interpretations of the PSFM had to struggle to formulate a more general theoretical account of international monetary adjustment to accommodate the presence of the fractional-reserve banking so detested by Hume and to devise an institutional framework that would facilitate operation of the adjustment mechanism under a fractional-reserve-banking system.

In previous posts on this blog (e.g., here, here and here) a recent article on the history of the (misconceived) distinction between rules and discretion, I’ve discussed the role played by the PSFM in one not very successful attempt at monetary reform, the English Bank Charter Act of 1844. The Bank Charter Act was intended to ensure the maintenance of monetary equilibrium by reforming the English banking system so that it would operate the way Hume described it in his account of the PSFM. However, despite the failings of the Bank Charter Act, the general confusion about monetary theory and policy that has beset economic theory for over two centuries has allowed PSFM to retain an almost canonical status, so that it continues to be widely regarded as the basic positive and normative model of how the classical gold standard operated. Using the PSFM as their normative model, monetary “experts” came up with the idea that, in countries with gold inflows, monetary authorities should reduce interest rates (i.e., lending rates to the banking system) causing monetary expansion through the banking system, and, in countries losing gold, the monetary authorities should do the opposite. These vague maxims described as the “rules of the game,” gave only directional guidance about how to respond to an increase or decrease in gold reserves, thereby avoiding the strict numerical rules, and resulting financial malfunctions, prescribed by the Bank Charter Act.

In his 1932 defense of the insane gold-accumulation policy of the Bank of France, Hayek posited an interpretation of what the rules of the game required that oddly mirrored the strict numerical rules of the Bank Charter Act, insisting that, having increased the quantity of banknotes by about as much its gold reserves had increased after restoration of the gold convertibility of the franc, the Bank of France had done all that the “rules of the game” required it to do. In fairness to Hayek, I should note that decades after his misguided defense of the Bank of France, he was sharply critical of the Bank Charter Act. At any rate, the episode indicates how indefinite the “rules of the game” actually were as a guide to policy. And, for that reason alone, it is not surprising that evidence that the rules of the game were followed during the heyday of the gold standard (roughly 1880 to 1914) is so meager. But the main reason for the lack of evidence that the rules of the game were actually followed is that the PSFM, whose implementation the rules of the game were supposed to guarantee, was a theoretically flawed misrepresentation of the international-adjustment mechanism under the gold standard.

Until my second year of graduate school (1971-72), I had accepted the PSFM as a straightforward implication of the quantity theory of money, endorsed by such luminaries as Hayek, Friedman and Jacob Viner. I had taken Axel Leijonhufvud’s graduate macro class in my first year, so in my second year I audited Earl Thompson’s graduate macro class in which he expounded his own unique approach to macroeconomics. One of the first eye-opening arguments that Thompson made was to deny that the quantity theory of money is relevant to an economy on the gold standard, the kind of economy (allowing for silver and bimetallic standards as well) that classical economics, for the most part, dealt with. It was only after the Great Depression that fiat money was widely accepted as a viable system for the long-term rather than a mere temporary wartime expedient.

What determines the price level for a gold-standard economy? Thompson’s argument was simple. The value of gold is determined relative to every other good in the economy by exactly the same forces of supply and demand that determine relative prices for every other real good. If gold is the standard, or numeraire, in terms of which all prices are quoted, then the nominal price of gold is one (the relative price of gold in terms of itself). A unit of currency is specified as a certain quantity of gold, so the price level measure in terms of the currency unit varies inversely with the value of gold. The amount of money in such an economy will correspond to the amount of gold, or, more precisely, to the amount of gold that people want to devote to monetary, as opposed to real (non-monetary), uses. But financial intermediaries (banks) will offer to exchange IOUs convertible on demand into gold for IOUs of individual agents. The IOUs of banks have the property that they are accepted in exchange, unlike the IOUs of individual agents which are not accepted in exchange (not strictly true as bills of exchange have in the past been widely accepted in exchange). Thus, the amount of money (IOUs payable on demand) issued by the banking system depends on how much money, given the value of gold, the public wants to hold; whenever people want to hold more money than they have on hand, they obtain additional money by exchanging their own IOUs – not accepted in payment — with a bank for a corresponding amount of the bank’s IOUs – which are accepted in payment.

Thus, the simple monetary theory that corresponds to a gold standard starts with a value of gold determined by real factors. Given the public’s demand to hold money, the banking system supplies whatever quantity of money is demanded by the public at a price level corresponding to the real value of gold. This monetary theory is a theory of an ideal banking system producing a competitive supply of money. It is the basic monetary paradigm of Adam Smith and a significant group of subsequent monetary theorists who formed the Banking School (and also the Free Banking School) that opposed the Currency School doctrine that provided the rationale for the Bank Charter Act. The model is highly simplified and based on assumptions that aren’t necessarily fulfilled always or even at all in the real world. The same qualification applies to all economic models, but the realism of the monetary model is certainly open to question.

So under the ideal gold-standard model described by Thompson, what was the mechanism of international monetary adjustment? All countries on the gold standard shared a common price level, because, under competitive conditions, prices for any tradable good at any two points in space can deviate by no more than the cost of transporting that product from one point to the other. If geographic price differences are constrained by transportation costs, then the price effects of an increased quantity of gold at any location cannot be confined to prices at that location; arbitrage spreads the price effect at one location across the whole world. So the basic premise underlying the PSFM — that price differences across space resulting from any disturbance to the equilibrium distribution of gold would trigger equilibrating gold shipments to equalize prices — is untenable; price differences between any two points are always constrained by the cost of transportation between those points, whatever the geographic distribution of gold happens to be.

Aside from the theoretical point that there is a single world price level – actually it’s more correct to call it a price band reflecting the range of local price differences consistent with arbitrage — that exists under the gold standard, so that the idea that local prices vary in proportion to the local money stock is inconsistent with standard price theory, Thompson also provided an empirical refutation of the PSFM. According to the PSFM, when gold is flowing into one country and out of another, the price levels in the two countries should move in opposite directions. But the evidence shows that price-level changes in gold-standard countries were highly correlated even when gold flows were in the opposite direction. Similarly, if PSFM were correct, cyclical changes in output and employment should have been correlated with gold flows, but no such correlation between cyclical movements and gold flows is observed in the data. It was on this theoretical foundation that Thompson built a novel — except that Hawtrey and Cassel had anticipated him by about 50 years — interpretation of the Great Depression as a deflationary episode caused by a massive increase in the demand for gold between 1929 and 1933, in contrast to Milton Friedman’s narrative that explained the Great Depression in terms of massive contraction in the US money stock between 1929 and 1933.

Thompson’s ideas about the gold standard, which he had been working on for years before I encountered them, were in the air, and it wasn’t long before I encountered them in the work of Harry Johnson, Bob Mundell, Jacob Frenkel and others at the University of Chicago who were then developing what came to be known as the monetary approach to the balance of payments. Not long after leaving UCLA in 1976 for my first teaching job, I picked up a volume edited by Johnson and Frenkel with the catchy title The Monetary Approach to the Balance of Payments. I studied many of the papers in the volume, but only two made a lasting impression, the first by Johnson and Frenkel “The Monetary Approach to the Balance of Payments: Essential Concepts and Historical Origins,” and the last by McCloskey and Zecher, “How the Gold Standard Really Worked.” Reinforcing what I had learned from Thompson, the papers provided a deeper understanding of the relevant history of thought on the international-monetary-adjustment  mechanism, and the important empirical and historical evidence that contradicts the PSFM. I also owe my interest in Hawtrey to the Johnson and Frenkel paper which cites Hawtrey repeatedly for many of the basic concepts of the monetary approach, especially the existence of a single arbitrage-constrained international price level under the gold standard.

When I attended the History of Economics Society Meeting in Toronto a couple of weeks ago, I had the  pleasure of meeting Deirdre McCloskey for the first time. Anticipating that we would have a chance to chat, I reread the 1976 paper in the Johnson and Frenkel volume and a follow-up paper by McCloskey and Zecher (“The Success of Purchasing Power Parity: Historical Evidence and Its Implications for Macroeconomics“) that appeared in a volume edited by Michael Bordo and Anna Schwartz, A Retrospective on the Classical Gold Standard. We did have a chance to chat and she did attend the session at which I talked about Friedman and the gold standard, but regrettably the chat was not a long one, so I am going to try to keep the conversation going with this post, and the next one in which I will discuss the two McCloskey and Zecher papers and especially the printed comment to the later paper that Milton Friedman presented at the conference for which the paper was written. So stay tuned.

PS Here is are links to Thompson’s essential papers on monetary theory, “The Theory of Money and Income Consistent with Orthodox Value Theory” and “A Reformulation of Macroeconomic Theory” about which I have written several posts in the past. And here is a link to my paper “A Reinterpretation of Classical Monetary Theory” showing that Earl’s ideas actually captured much of what classical monetary theory was all about.

A Draft of my Paper on Rules versus Discretion Is Now Available on SSRN

My paper “Rules versus Discretion in Monetary Policy Historically Contemplated” which I spoke about last September at the Mercatus Center Conference on rules for a post-crisis world has been accepted by the Journal of Macroeconomics. I posted a draft of the concluding section of the paper on this blog several weeks ago. An abstract, and a complete draft, of the paper are available on the journal website, but only the abstract is ungated.

I have posted a draft of the paper on SSRN where it may now be downloaded. Here is the abstract of the paper.

Monetary-policy rules are attempts to cope with the implications of having a medium of exchange whose value exceeds its cost of production. Two classes of monetary rules can be identified: (1) price rules that target the value of money in terms of a real commodity, e.g., gold, or in terms of some index of prices, and (2) quantity rules that target the quantity of money in circulation. Historically, price rules, e.g. the gold standard, have predominated, but the Bank Charter Act of 1844 imposed a quantity rule as an adjunct to the gold standard, because the gold standard had performed unsatisfactorily after being restored in Britain at the close of the Napoleonic Wars. A quantity rule was not proposed independently of a price rule until Henry Simons proposed a constant money supply consisting of government-issued fiat currency and deposits issued by banks operating on a 100-percent reserve basis. Simons argued that such a plan would be ideal if it could be implemented because it would deprive the monetary authority of any discretionary decision-making power. Nevertheless, Simons concluded that such a plan was impractical and supported a price rule to stabilized the price level. Simons’s student Milton Friedman revived Simons’s argument against discretion and modified Simons plan for 100-percent reserve banking and a constant money supply into his k-percent rule for monetary growth. This paper examines the doctrinal and ideological origins and background that lay behind the rules versus discretion distinction.

Rules vs. Discretion Historically Contemplated

Here is a new concluding section which I have just written for my paper “Rules versus Discretion in Monetary Policy: Historically Contemplated” which I spoke about last September at the Mercatus Confernce on Monetary Rules in a Post-Crisis World. I have been working a lot on the paper over the past month or so and I hope to post a draft soon on SSRN and it is now under review for publication. I apologize for having written very little in past month and for having failed to respond to any comments on my previous posts. I simply have been too busy with work and life to have any energy left for blogging. I look forward to being more involved in the blog over the next few months and expect to be posting some sections of a couple of papers I am going to be writing. But I’m offering no guarantees. It is gratifying to know that people are still visiting the blog and reading some of my old posts.

Although recognition of a need for some rule to govern the conduct of the monetary authority originated in the perceived incentive of the authority to opportunistically abuse its privileged position, the expectations of the public (including that small, but modestly influential, segment consisting of amateur and professional economists) about what monetary rules might actually accomplish have evolved and expanded over the course of the past two centuries. As Laidler (“Economic Ideas, the Monetary Order, and the Uneasy Case for Monetary Rules”) shows, that evolution has been driven by both the evolution of economic and monetary institutions and the evolution of economic and monetary doctrines about how those institutions work.

I distinguish between two types of rules: price rules and quantity rules. The simplest price rule involved setting the price of a commodity – usually gold or silver – in terms of a monetary unit whose supply was controlled by the monetary authority or defining a monetary unit as a specific quantity of a particular commodity. Under the classical gold standard, for example, the monetary authority stood ready to buy or sell gold on demand at legally determined price of gold in terms of the monetary unit. Thus, the fixed price of gold under the gold standard was originally thought to serve as both the policy target of the rule and the operational instrument for implementing the rule.

However, as monetary institutions and theories evolved, it became apparent that there were policy objectives other than simply maintaining the convertibility of the monetary unit into the standard commodity that required the attention of the monetary authority. The first attempt to impose an additional policy goal on a monetary authority was the Bank Charter Act of 1844 which specified a quantity target – the aggregate of banknotes in circulation in Britain – which the monetary authority — the Bank of England – was required to reach by following a simple mechanical rule. By imposing a 100-percent marginal gold-reserve requirement on the notes issued by the Bank of England, the Bank Charter Act made the quantity of banknotes issued by the Bank of England both the target of the quantity rule and the instrument by which the rule was implemented.

Owing to deficiencies in the monetary theory on the basis of which the Act was designed and to the evolution of British monetary practices and institution, the conceptual elegance of the Bank Charter Act was not matched by its efficacy in practice. But despite, or, more likely, because of, the ultimate failure of Bank Charter Act, the gold standard, surviving recurring financial crises in Great Britain in the middle third of the nineteenth century, was eventually adopted by many other countries in the 1870s, becoming the de facto international monetary system from the late 1870s until the start of World War I. Operation of the gold standard was defined by, and depended on, the observance of a single price rule in which the value of a currency was defined by its legal gold content, so that corresponding to each gold-standard currency, there was an official gold price at which the monetary authority was obligated to buy or sell gold on demand.

The value – the purchasing power — of gold was relatively stable in the 35 or so years of the gold standard era, but that stability could not survive the upheavals associated with World War I, and so the problem of reconstructing the postwar monetary system was what kind of monetary rule to adopt to govern the post-war economy. Was it enough merely to restore the old currency parities – perhaps adjusted for differences in the extent of wartime and postwar currency depreciation — that governed the classical gold standard, or was it necessary to take into account other factors, e.g., the purchasing power of gold, in restoring the gold standard? This basic conundrum was never satisfactorily answered, and the failure to do so undoubtedly was a contributing, and perhaps dominant, factor in the economic collapse that began at the end of 1929, ultimately leading to the abandonment of the gold standard.

Searching for a new monetary regime to replace the failed gold standard, but to some extent inspired by the Bank Charter Act of the previous century, Henry Simons and ten fellow University of Chicago economists devised a totally new monetary system based on 100-percent reserve banking. The original Chicago proposal for 100-percent reserve banking proposed a monetary rule for stabilizing the purchasing power of fiat money. The 100-percent banking proposal would give the monetary authority complete control over the quantity of money, thereby enhancing the power of the monetary authority to achieve its price-level target. The Chicago proposal was thus inspired by a desire to increase the likelihood that the monetary authority could successfully implement the desired price rule. The price level was the target, and the quantity of money was the instrument. But as long as private fractional-reserve banks remained in operation, the monetary authority would lack effective control over the instrument. That was the rationale for replacing fractional reserve banks with 100-percent reserve banks.

But Simons eventually decided in his paper (“Rules versus Authorities in Monetary Policy”) that a price-level target was undesirable in principle, because allowing the monetary authority to choose which price level to stabilize, thereby favoring some groups at the expense of others, would grant too much discretion to the monetary authority. Rejecting price-level stabilization as monetary rule, Simons concluded that the exercise of discretion could be avoided only if the quantity of money was the target as well as the instrument of a monetary rule. Simons’s ideal monetary rule was therefore to keep the quantity of money in the economy constant — forever. But having found the ideal rule, Simons immediately rejected it, because he realized that the reforms in the financial and monetary systems necessary to make such a rule viable over the long run would never be adopted. And so he reluctantly and unhappily reverted back to the price-level stabilization rule that he and his Chicago colleagues had proposed in 1933.

Simons’s student Milton Friedman continued to espouse his teacher’s opposition to discretion, and as late as 1959 (A Program for Monetary Stability) he continued to advocate 100-percent reserve banking. But in the early 1960s, he adopted his k-percent rule and gave up his support for 100-percent banking. But despite giving up on 100-percent banking, Friedman continued to argue that the k-percent rule was less discretionary than the gold standard or a price-level rule, because neither the gold standard nor a price-level rule eliminated the exercise of discretion by the monetary authority in its implementation of policy, failing to acknowledge that, under any of the definitions that he used (usually M1 and sometimes M2), the quantity of money was a target, not an instrument. Of course, Friedman did eventually abandon his k-percent rule, but that acknowledgment came at least a decade after almost everyone else had recognized its unsuitability as a guide for conducting monetary policy, let alone as a legally binding rule, and long after Friedman’s repeated predictions that rapid growth of the monetary aggregates in the 1980s presaged the return of near-double-digit inflation.

However, the work of Kydland and Prescott (“Rules Rather than Discretion: The Inconsistency of Optimal Plans”) on time inconsistency has provided an alternative basis on which argue against discretion: that the lack of commitment to a long-run policy would lead to self-defeating short-term attempts to deviate from the optimal long-term policy.[1]

It is now I think generally understood that a monetary authority has available to it four primary instruments in conducting monetary policy, the quantity of base money, the lending rate it charges to banks, the deposit rate it pays banks on reserves, and an exchange rate against some other currency or some asset. A variety of goals remain available as well, nominal goals like inflation, the price level, or nominal income, or even an index of stock prices, as well as real goals like real GDP and employment.

Ever since Friedman and Phelps independently argued that the long-run Phillips Curve is vertical, a consensus has developed that countercyclical monetary policy is basically ineffectual, because the effects of countercyclical policy will be anticipated so that the only long-run effect of countercyclical policy is to raise the average rate of inflation without affecting output and employment in the long run. Because the reasoning that generates this result is essentially that money is neutral in the long run, the reasoning is not as compelling as the professional consensus in its favor would suggest. The monetary neutrality result only applies under the very special assumptions of a comparative static exercise comparing an initial equilibrium with a final equilibrium. But the whole point of countercyclical policy is to speed the adjustment from a disequilbrium with high unemployment back to a low-unemployment equilibrium. A comparative-statics exercise provides no theoretical, much less empirical, support for the proposition that anticipated monetary policy cannot have real effects.

So the range of possible targets and the range of possible instruments now provide considerable latitude to supporters of monetary rules to recommend alternative monetary rules incorporating many different combinations of alternative instruments and alternative targets. As of now, we have arrived at few solid theoretical conclusions about the relative effectiveness of alternative rules and even less empirical evidence about their effectiveness. But at least we know that, to be viable, a monetary rule will almost certainly have to be expressed in terms of one or more targets while allowing the monetary authority at least some discretion to adjust its control over its chosen instruments in order to effectively achieve its target (McCallum 1987, 1988). That does not seem like a great deal of progress to have made in the two centuries since economists began puzzling over how to construct an appropriate rule to govern the behavior of the monetary authority, but it is progress nonetheless. And, if we are so inclined, we can at least take some comfort in knowing that earlier generations have left us a lot of room for improvement.

Footnote:

[1] Friedman in fact recognized the point in his writings, but he emphasized the dangers of allowing discretion in the choice of instruments rather than the time-inconsistency policy, because it was only former argument that provided a basis for preferring his quantity rule over price rules.

Larry White on the Gold Standard and Me

A little over three months ago on a brutally hot day in Washington DC, I gave a talk about a not yet completed paper at the Mercatus Center Conference on Monetary Rules for a Post-Crisis World. The title of my paper was (and still is) “Rules versus Discretion Historically Contemplated.” I hope to post a draft of the paper soon on SSRN.

One of the attendees at the conference was Larry White who started his graduate training at UCLA just after I had left. When I wrote a post about my talk, Larry responded with a post of his own in which he took issue with some of what I had to say about the gold standard, which I described as the first formal attempt at a legislated monetary rule. Actually, in my talk and my paper, my intention was not as much to criticize the gold standard as it was to criticize the idea, which originated after the gold standard had already been adopted in England, of imposing a fixed numerical rule in addition to the gold standard to control the quantity of banknotes or the total stock of money. The fixed mechanical rule was imposed by an act of Parliament, the Bank Charter Act of 1844. The rule, intended to avoid financial crises such as those experienced in 1825 and 1836, actually led to further crises in 1847, 1857 and 1866 and the latter crises were quelled only after the British government suspended those provisions of the Act preventing the Bank of England from increasing the quantity of banknotes in circulation. So my first point was that the fixed quantitative rule made the gold standard less stable than it would otherwise have been.

My second point was that, in the depths of the Great Depression, a fixed rule freezing the nominal quantity of money was proposed as an alternative rule to the gold standard. It was this rule that one of its originators, Henry Simons, had in mind when he introduced his famous distinction between rules and discretion. Simons had many other reasons for opposing the gold standard, but he introduced the famous rules-discretion dichotomy as a way of convincing those supporters of the gold standard who considered it a necessary bulwark against comprehensive government control over the economy to recognize that his fixed quantity rule would be a far more effective barrier than the gold standard against arbitrary government meddling and intervention in the private sector, because the gold standard, far from constraining the conduct of central banks, granted them broad discretionary authority. The gold standard was an ineffective rule, because it specified only the target pursued by the monetary authority, but not the means of achieving the target. In Simons view, giving the monetary authority to exercise discretion over the instruments used to achieve its target granted the monetary authority far too much discretion for independent unconstrained decision making.

My third point was that Henry Simons himself recognized that the strict quantity rule that he would have liked to introduce could only be made operational effectively if the entire financial system were radically restructured, an outcome that he reluctantly concluded was unattainable. However, his student Milton Friedman convinced himself that a variant of the Simons rule could actually be implemented quite easily, and he therefore argued over the course of almost his entire career that opponents of discretion ought to favor the quantity rule that he favored instead of continuing to support a restoration of the gold standard. However, Friedman was badly mistaken in assuming that his modified quantity rule eliminated discretion in the manner that Simons had wanted, because his quantity rule was defined in terms of a magnitude, the total money stock in the hands of the public, which was a target, not, as he insisted, an instrument, the quantity of money held by the public being dependent on choices made by the public, not just on choices made by the monetary authority.

So my criticism of quantity rules can be read as at least a partial defense of the gold standard against the attacks of those who criticized the gold standard for being insufficiently rigorous in controlling the conduct of central banks.

Let me now respond to some of Larry’s specific comments and criticisms of my post.

[Glasner] suggests that perhaps the earliest monetary rule, in the general sense of a binding pre-commitment for a money issuer, can be seen in the redemption obligations attached to banknotes. The obligation was contractual: A typical banknote pledged that the bank “will pay the bearer on demand” in specie. . . .  He rightly remarks that “convertibility was not originally undertaken as a policy rule; it was undertaken simply as a business expedient” without which the public would not have accepted demand deposits or banknotes.

I wouldn’t characterize the contract in quite the way Glasner does, however, as a “monetary rule to govern the operation of a monetary system.” In a system with many banks of issue, the redemption contract on any one bank’s notes was a commitment from that bank to the holders of those notes only, without anyone intending it as a device to govern the operation of the entire system. The commitment that governs a single bank ipso facto governs an entire monetary system only when that single bank is a central bank, the only bank allowed to issue currency and the repository of the gold reserves of ordinary commercial banks.

It’s hard to write a short description of a system that covers all possible permutations in the system. While I think Larry is correct in noting the difference between the commitment made by any single bank to convert – on demand — its obligations into gold and the legal commitment imposed on an entire system to maintain convertibility into gold, the historical process was rather complicated, because both silver and gold coins circulating in Britain. So the historical fact that British banks were making their obligations convertible into gold was the result of prior decisions that had been made about the legal exchange rate between gold and silver coins, decisions which overvalued gold and undervalued silver, causing full bodied silver coins to disappear from circulation. Given a monetary framework shaped by the legal gold/silver parity established by the British mint, it was inevitable that British banks operating within that framework would make their banknotes convertible into gold not silver.

Under a gold standard with competitive plural note-issuers (a free banking system) holding their own reserves, by contrast, the operation of the monetary system is governed by impersonal market forces rather than by any single agent. This is an important distinction between the properties of a gold standard with free banking and the properties of a gold standard managed by a central bank. The distinction is especially important when it comes to judging whether historical monetary crises and depressions can be accurately described as instances where “the gold standard failed” or instead where “central bank management of the monetary system failed.”

I agree that introducing a central bank into the picture creates the possibility that the actions of the central bank will have a destabilizing effect. But that does not necessarily mean that the actions of the central bank could not also have a stabilizing effect compared to how a pure free-banking system would operate under a gold standard.

As the author of Free Banking and Monetary Reform, Glasner of course knows the distinction well. So I am not here telling him anything he doesn’t know. I am only alerting readers to keep the distinction in mind when they hear or read “the gold standard” being blamed for financial instability. I wish that Glasner had made it more explicit that he is talking about a system run by the Bank of England, not the more automatic type of gold standard with free banking.

But in my book, I did acknowledge that there inherent instabilities associated with a gold standard. That’s why I proposed a system that would aim at stabilizing the average wage level. Almost thirty years on, I have to admit to having my doubts whether that would be the right target to aim for. And those doubts make me more skeptical than I once was about adopting any rigid monetary rule. When it comes to monetary rules, I fear that the best is the enemy of the good.

Glasner highlights the British Parliament’s legislative decision “to restore the convertibility of banknotes issued by the Bank of England into a fixed weight of gold” after a decades-long suspension that began during the Napoleonic wars. He comments:

However, the widely held expectations that the restoration of convertibility of banknotes issued by the Bank of England into gold would produce a stable monetary regime and a stable economy were quickly disappointed, financial crises and depressions occurring in 1825 and again in 1836.

Left unexplained is why the expectations were disappointed, why the monetary regime remained unstable. A reader who hasn’t read Glasner’s other blog entries on the gold standard might think that he is blaming the gold standard as such.

Actually I didn’t mean to blame anyone for the crises of 1825 and 1836. All I meant to do was a) blame the Currency School for agitating for a strict quantitative rule governing the total quantity of banknotes in circulation to be imposed on top of the gold standard, b) point out that the rule that was enacted when Parliament passed the Bank Charter Act of 1844 failed to prevent subsequent crises in 1847, 1857 and 1866, and c) that the crises ended only after the provisions of the Bank Charter Act limiting the issue of banknotes by the Bank of England had been suspended.

My own view is that, because the monopoly Bank of England’s monopoly was not broken up, even with convertibility acting as a long-run constraint, the Bank had the power to create cyclical monetary instability and occasionally did so by (unintentionally) over-issuing and then having to contract suddenly as gold flowed out of its vault — as happened in 1825 and again in 1836. Because the London note-issue was not decentralized, the Bank of England did not experience prompt loss of reserves to rival banks (adverse clearings) as soon as it over-issued. Regulation via the price-specie-flow mechanism (external drain) allowed over-issue to persist longer and grow larger. Correction came only with a delay, and came more harshly than continuous intra-London correction through adverse clearings would have. Bank of England mistakes boggled the entire financial system. It was central bank errors and not the gold standard that disrupted monetary stability after 1821.

Here, I think, we do arrive at a basic theoretical disagreement, because I don’t accept that the price-specie-flow mechanism played any significant role in the international adjustment process. National price levels under the gold standard were positively correlated to a high degree, not negatively correlated, as implied by the price-specie-flow mechanism. Moreover, the Bank Charter Act imposed a fixed quantitative limit on the note issue of all British banks and the Bank of England in particular, so the overissue of banknotes by the Bank of England could not have been the cause of the post-1844 financial crises. If there was excessive credit expansion, it was happening through deposit creation by a great number of competing deposit-creating banks, not the overissue of banknotes by the Bank of England.

This hypothesis about the source of England’s cyclical instability is far from original with me. It was offered during the 1821-1850 period by a number of writers. Some, like Robert Torrens, were members of the Currency School and offered the Currency Principle as a remedy. Others, like James William Gilbart, are better classified as members of the Free Banking School because they argued that competition and adverse clearings would effectively constrain the Bank of England once rival note issuers were allowed in London. Although they offered different remedies, these writers shared the judgment that the Bank of England had over-issued, stimulating an unsustainable boom, then was eventually forced by gold reserve losses to reverse course, instituting a credit crunch. Because Glasner elides the distinction between free banking and central banking in his talk and blog post, he naturally omits the third side in the Currency School-Banking School-Free Banking School debate.

And my view is that Free Bankers like Larry White overestimate the importance of note issue in a banking system in which deposits were rapidly overtaking banknotes as the primary means by which banks extended credit. As Henry Simons, himself, recognized this shift from banknotes to bank deposits was itself stimulated, at least in part, by the Bank Charter Act, which made the extension of credit via banknotes prohibitively costly relative to expansion by deposit creation.

Later in his blog post, Glasner fairly summarizes how a gold standard works when a central bank does not subvert or over-ride its automatic operation:

Given the convertibility commitment, the actual quantity of the monetary instrument that is issued is whatever quantity the public wishes to hold.

But he then immediately remarks:

That, at any rate, was the theory of the gold standard. There were — and are – at least two basic problems with that theory. First, making the value of money equal to the value of gold does not imply that the value of money will be stable unless the value of gold is stable, and there is no necessary reason why the value of gold should be stable. Second, the behavior of a banking system may be such that the banking system will itself destabilize the value of gold, e.g., in periods of distress when the public loses confidence in the solvency of banks and banks simultaneously increase their demands for gold. The resulting increase in the monetary demand for gold drives up the value of gold, triggering a vicious cycle in which the attempt by each to increase his own liquidity impairs the solvency of all.

These two purported “basic problems” prompt me to make two sets of comments:

1 While it is true that the purchasing power of gold was not perfectly stable under the classical gold standard, perfection is not the relevant benchmark. The purchasing power of money was more stable under the classical gold standard than it has been under fiat money standards since the Second World War. Average inflation rates were closer to zero, and the price level was more predictable at medium to long horizons. Whatever Glasner may have meant by “necessary reason,” there certainly is a theoretical reason for this performance: the economics of gold mining make the purchasing power of gold (ppg) mean-reverting in the face of monetary demand and supply shocks. An unusually high ppg encourages additional gold mining, until the ppg declines to the normal long-run value determined by the flow supply and demand for gold. An unusually low ppg discourages mining, until the normal long-run ppg is restored. It is true that permanent changes in the gold mining cost conditions can have a permanent impact on the long-run level of the ppg, but empirically such shocks were smaller than the money supply variations that central banks have produced.

2 The behavior of the banking system is indeed critically important for short-run stability. Instability wasn’t a problem in all countries, so we need to ask why some banking systems were unstable or panic-prone, while others were stable. The US banking system was panic prone in the late 19th century while the Canadian system was not. The English system was panic-prone while the Scottish system was not. The behavioral differences were not random or mere facts of nature, but grew directly from differences in the legal restrictions constraining the banks. The Canadian and Scottish systems, unlike the US and English systems, allowed their banks to adequately diversify, and to respond to peak currency demands, thus allowed banks to be more solvent and more liquid, and thus avoided loss of confidence in the banks. The problem in the US and England was not the gold standard, or a flaw in “the theory of the gold standard,” but ill-conceived legal restrictions that weakened the banking systems.

Larry makes two good points, but I doubt that they are very important in practice. The problem with the value of gold is that there is a very long time lag before the adjustment in the rate of output of new gold will cause the value of gold to revert back to its normal level. The annual output of gold is only about 3 percent of the total stock of gold. If the monetary demand for gold is large relative to the total stock and that demand is unstable, the swing in the overall demand for gold can easily dominate the small resulting change in the annual rate of output. So I do not have much confidence that the mean-reversion characteristic of the purchasing power of gold to be of much help in the short or even the medium term. I also agree with Larry that the Canadian and Scottish banking systems exhibited a lot more stability than the neighboring US and English banking systems. That is an important point, but I don’t think it is decisive. It’s true that there were no bank failures in Canada in the Great Depression. But the absence of bank failures, while certainly a great benefit, did not prevent Canada from suffering a downturn of about the same depth and duration as the US did between 1929 and 1933. The main cause of the Great Depression was the deflation caused by the appreciation of the value of gold. The deflation caused bank failures when banks were small and unstable and did not cause bank failures when banks were large and diversified. But the deflation  was still wreaking havoc on the rest of the economy even though banks weren’t failing.

Where Do Monetary Rules Come From and How Do They Work?

In my talk last week at the Mercatus Conference on Monetary Rules for a Post-Crisis World, I discussed how monetary rules and the thinking about monetary rules have developed over time. The point that I started with was that monetary rules become necessary only when the medium of exchange has a value that exceeds the cost of producing the medium of exchange. You don’t need a monetary rule if money is a commodity; people just trade stuff for stuff; it’s not barter, because everyone accepts one real commodity, making that commodity the medium of exchange. But there’s no special rule governing the monetary system beyond the rules that govern all forms of exchange. the first monetary rule came along only when something worth more than its cost of production was used as money. This might have happened when people accepted minted coins at face value, even though the coins were not full-bodied. But that situation was not a stable equilibrium, because eventually Gresham’s Law kicks in, and the bad money drives out the good, so that the value of coins drops to their metallic value rather than their face value. So no real monetary rule was operating to control the value of coinage in situations where the coinage was debased.

So the idea of an actual monetary rule to govern the operation of a monetary system only emerged when banks started to issue banknotes. Banknotes having a negligible cost of production, a value in excess of that negligible cost could be imparted to those essentially worthless banknotes only by banks undertaking a commitment — a legally binding obligation — to make those banknotes redeemable (convertible) for a fixed weight of gold or silver or some other valuable material whose supply was not under the control of the bank itself. This convertibility commitment can be thought of as a kind of rule, but convertibility was not originally undertaken as a policy rule; it was undertaken simply as a business expedient; it was the means by which banks could create a demand for the banknotes that they wanted to issue to borrowers so that they could engage in the profitable business of financial intermediation.

It was in 1797, during the early stages of the British-French wars after the French Revolution, when, the rumor of a French invasion having led to a run on Bank of England notes, the British government prohibited the Bank of England from redeeming its banknotes for gold, and made banknotes issued by the Bank of England legal tender. The subsequent premium on gold in Continental commodity markets in terms of sterling – what was called the high price of bullion – led to a series of debates which engaged some of the finest economic minds in Great Britain – notably David Ricardo and Henry Thornton – over the causes and consequences of the high price of bullion and, if a remedy was in fact required, the appropriate policy steps to be taken to administer that remedy.

There is a vast literature on the many-sided Bullionist debates as they are now called, but my only concern here is with the final outcome of the debates, which was the appointment of a Parliamentary Commission, which included none other than the great Henry Thornton, himself, and two less renowned colleagues, William Huskisson and Francis Horner, who collaborated to write a report published in 1811 recommending the speedy restoration of convertibility of Bank of England notes. The British government and Parliament were unwilling to follow the recommendation while war with France was ongoing, however, there was a broad consensus in favor of the restoration of convertibility once the war was over.

After Napoleon’s final defeat in 1815, the process of restoring convertibility was begun with the intention of restoring the pre-1797 conversion rate between banknotes and gold. Parliament in fact enacted a statute defining the pound sterling as a fixed weight of gold. By 1819, the value of sterling had risen to its prewar level, and in 1821 the legal obligation of the Bank of England to convert its notes into gold was reinstituted. So the first self-consciously adopted monetary rule was the Parliamentary decision to restore the convertibility of banknotes issued by the Bank of England into a fixed weight of gold.

However, the widely held expectations that the restoration of convertibility of banknotes issued by the Bank of England into gold would produce a stable monetary regime and a stable economy were quickly disappointed, financial crises and depressions occurring in 1825 and again in 1836. To explain the occurrence of these unexpected financial crises and periods of severe economic distress, a group of monetary theorists advanced a theory based on David Hume’s discussion of the price-specie-flow mechanism in his essay “Of the Balance of Trade,” in which he explained the automatic tendency toward equilibrium in the balance of trade and stocks of gold and precious metals among nations. Hume carried out his argument in terms of a fully metallic (gold) currency, and, in other works, Hume decried the tendency of banks to issue banknotes to excess, thereby causing inflation and economic disturbances.

So the conclusion drawn by these monetary theorists was that the Humean adjustment process would work smoothly only if gold shipments into Britain or out of Britain would result in a reduction or increase in the quantity of banknotes exactly equal to the amount of gold flowing into or out of Britain. It was the failure of the Bank of England and the other British banks to follow the Currency Principle – the idea that the total amount of currency in the country should change by exactly the same amount as the total quantity of gold reserves in the country – that had caused the economic crises and disturbances marking the two decades since the resumption of convertibility in 1821.

Those advancing this theory of economic fluctuations and financial crises were known as the Currency School and they succeeded in persuading Sir Robert Peel, the Prime Minister to support legislation to require the Bank of England and the other British Banks to abide by the Currency Principle. This was done by capping the note issue of all banks other than the Bank of England at existing levels and allowing the Bank of England to increase its issue of banknotes only upon deposit of a corresponding quantity of gold bullion. The result was in effect to impose a 100% marginal reserve requirement on the entire British banking system. Opposition to the Currency School largely emanated from what came to be known as the Banking School, whose most profound theorist was John Fullarton who formulated the law of reflux, which focused attention on the endogenous nature of the issue of banknotes by commercial banks. According to Fullarton and the Banking School, the issue of banknotes by the banking system was not a destabilizing and disequilibrating disturbance, but a response to the liquidity demands of traders and dealers. Once these liquidity demands were satisfied, the excess banknotes, returning to the banks in the ordinary course of business, would be retired from circulation unless there was a further demand for liquidity from some other source.

The Humean analysis, abstracting from any notion of a demand for liquidity, was therefore no guide to the appropriate behavior of the quantity of banknotes. Imposing a 100% marginal reserve requirement on the supply of banknotes would make it costly for traders and dealers to satisfy their demands for liquidity in times of financial stress; rather than eliminate monetary disturbances, the statutory enactment of the Currency Principle would be an added source of financial disturbance and disorder.

With the support of Robert Peel and his government, the arguments of the Currency School prevailed, and the Bank Charter Act was enacted in 1844. In 1847, despite the hopes of its supporters that an era of financial tranquility would follow, a new financial crisis occurred, and the crisis was not quelled until the government suspended the Bank Charter Act, thereby enabling the Bank of England to lend to dealers and traders to satisfy their demands for liquidity. Again in 1857 and in 1866, crises occurred which could not be brought under control before the government suspended the Bank Charter Act.

So British monetary history in the first half of the nineteenth century provides us with two paradigms of monetary rules. The first is a price rule in which the value of a monetary instrument is maintained at a level above its cost of production by way of a convertibility commitment. Given the convertibility commitment, the actual quantity of the monetary instrument that is issued is whatever quantity the public wishes to hold. That, at any rate, was the theory of the gold standard. There were – and are – at least two basic problems with that theory. First, making the value of money equal to the value of gold does not imply that the value of money will be stable unless the value of gold is stable, and there is no necessary reason why the value of gold should be stable. Second, the behavior of a banking system may be such that the banking system will itself destabilize the value of gold, e.g., in periods of distress when the public loses confidence in the solvency of banks and banks simultaneously increase their demands for gold. The resulting increase in the monetary demand for gold drives up the value of gold, triggering a vicious cycle in which the attempt by each to increase his own liquidity impairs the solvency of all.

The second rule is a quantity rule in which the gold standard is forced to operate in a way that prevents the money supply from adjusting freely to variations in the demand for money. Such a rule makes sense only if one ignores or denies the possibility that the demand for money can change suddenly and unpredictably. The quantity rule is neither necessary nor sufficient for the gold standard or any monetary standard to operate. In fact, it is an implicit assertion that the gold standard or any metallic standard cannot operate, the operation of profit-seeking private banks and their creation of banknotes and deposits being inconsistent with the maintenance of a gold standard. But this is really a demand for abolition of the gold standard in which banknotes and deposits draw their value from a convertibility commitment and its replacement by a pure gold currency in which there is no distinction between gold and banknotes or deposits, banknotes and deposits being nothing more than a receipt for an equivalent physical amount of gold held in reserve. That is the monetary system that the Currency School aimed at achieving. However, imposing the 100% reserve requirement only on banknotes, they left deposits unconstrained, thereby paving the way for a gradual revolution in the banking practices of Great Britain between 1844 and about 1870, so that by 1870 the bulk of cash held in Great Britain was held in the form of deposits not banknotes and the bulk of business transactions in Britain were carried out by check not banknotes.

So Milton Friedman was working entirely within the Currency School monetary tradition, formulating a monetary rule in terms of a fixed quantity rather than a fixed price. And, in ultimately rejecting the gold standard, Friedman was merely following the logic of the Currency School to its logical conclusion, because what ultimately matters is the quantity rule not the price rule. For the Currency School, the price rule was redundant, a fifth wheel; the real work was done by the 100% marginal reserve requirement. Friedman therefore saw the gold standard as an unnecessary and even dangerous distraction from the ultimate goal of keeping the quantity of money under strict legal control.

It is in the larger context of Friedman’s position on 100% reserve banking, of which he remained an advocate until he shifted to the k-percent rule in the early 1960s, that his anomalous description of the classical gold standard of late nineteenth century till World War I as a pseudo-gold standard can be understood. What Friedman described as a real gold standard was a system in which only physical gold and banknotes and deposits representing corresponding holdings of physical gold circulate as media of exchange. But this is not a gold standard that has ever existed, so what Friedman called a real gold standard was actually just the gold standard of his hyperactive imagination.


About Me

David Glasner
Washington, DC

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

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