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Counterfeiting and American Monetary History

Published February 15, 2012 Hawtrey , monetary history 23 Comments

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

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

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

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

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

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

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

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

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

Ludwig von Mises and the Great Depression

Many thanks to gliberty who just flagged for me a piece by Mark Spitznagel in today’s (where else?) Wall Street Journal about how Ludwig von Mises, alone among the economists of his day, foresaw the coming of the Great Depression, refusing the offer of a high executive position at the Kredit-Anstalt, Austria’s most important bank, in the summer of 1929, because, as he put it to his fiancée (whom he did not marry till 1938 just before escaping the Nazis), “a great crash is coming, and I don’t want my name in any way connected with it.” Just how going to work for the Kredit Anstalt would have led to Mises’s name being associated with the crash (the result, in Mises’s view, of the inflationary policy of the US Federal Reserve) is left unclear. But it’s such a nice story.

Ludwig von Mises was an extremely well-read and diligent economist, who had some extraordinary insights into economics and business and politics. As a result he made some important contributions to economics, most important the discovery that idea of a fully centrally planned economy is not just an impossibility, it is incoherent. He made other contributions to economics as well, but that insight, perhaps also perceived by Max Weber, was first spelled out and explained by Mises in his book Socialism. That contribution alone is enough to ensure Mises an honorable place in the history of economic thought.

Mises also perceived how the monetary theory of Knut Wicksell, based on a distinction between a market and a natural rate of interest, could be combined with the Austrian theory of capital, developed by his teacher Eugen von Bohm-Bawerk into a theory of business cycles. Von Mises is therefore justly credited with being the father of Austrian business-cycle theory. His own development of the theory was somewhat sketchy, and it was his student F. A. Hayek, who made the great intellectual effort of trying to work out the detailed steps in the argument by which monetary expansion would alter the structure of capital and production, leading to a crisis when the monetary expansion was halted or reversed.

Relying on their newly developed theory of business cycles, Mises and Hayek warned in the late 1920s that the decision of the Federal Reserve to reduce interest rates in 1927, when it appeared that the US economy could be heading into a recession, would distort the structure of production and lead eventually to an even worse downturn than the one the Fed avoided in 1927. That was the basis for Mises’s “prediction” of a “crash” ahead of the Great Depression.

Of course, as I have pointed out previously, Mises and Hayek were not the only ones to have predicted that there could be a downturn. R.G. Hawtrey and Gustav Cassel had been warning about that danger since 1919, should an international return to the gold standard not be managed properly, failing to prevent a rapid deflationary increase in the international monetary demand for gold. When the insane Bank of France began accumulating gold at a breathtaking rate in 1928, and the US reversed its monetary stance in late 1928 and itself began accumulating gold, Hawtrey and Cassel recognized the potential for disaster and warned of the disastrous consequences of the change in Federal Reserve policy.

So Mises and Hayek were not alone in their prediction of a crash; Hawtrey and Cassel were also warning of a looming disaster, and were doing so on the basis of a theory that was both more obvious and more relevant to the situation than theory with which Mises and Hayek were working, a theory that, even giving it the benefit of every doubt, could not possibly have predicted a downturn even remotely approaching the severity of the 1929-31 downturn. Indeed, as I have also pointed out, the irrelevance of the Mises and Hayek “explanation” of the Great Depression is perfectly illustrated by Hayek’s 1932 defense of the insane Bank of France, showing a complete misunderstanding of the international adjustment mechanism and the disastrous consequences of the gold accumulation policy of the insane Bank of France.

Mr. Spitznagel laments that the economics profession somehow ignored Ludwig von Mises. Actually, they didn’t. Some of the greatest economists of the twentieth century were lapsed believers in the Austrian business-cycle theory. A partial list would include, Mises’s own students, Gottfried Haberler and Fritz Machlup; it would include Hayek’s dear friend and colleague, Lionel Robbins who wrote a book on the Great Depression eloquently explaining it in terms of the Austrian theory in a way that even Mises might have approved, a book that Robbins later repudiated and refused to allow to be reprinted in his lifetime (but you can order a new edition here); it would include Hayek’s students, Nobel Laureate J.R. Hicks, Nicholas Kaldor, Abba Lerner, G.L.S. Shackle, and Ludwig Lachmann (who sought a third way incorporating elements of Keynesian and Austrian theory). Hayek himself modified his early views in important ways and admitted that he had given bad policy advice in the 1930s. The only holdout was Mises himself, joined in later years after his arrival in America by a group of more doctrinaire (with at least one notable exception) disciples than Mises had found in Vienna in the 1920s and 1930s. The notion that Austrian theory was ignored by the economics profession and has only lately been rediscovered is just the sort of revisionist history that one tends to find on a lot of wacko Austro-libertarian websites like Lewrockwell.org. Apparently the Wall Street Journal editorial page is providing another, marginally more respectable, venue for such nonsense. Rupert, you’re doing a heckuva job.

Daniel Kuehn Explains the Dearly Beloved Depression of 1920-21

Published February 1, 2012 monetary history , monetary policy 27 Comments

In the folklore of modern Austrian Business Cycle Theory, the Depression of 1920-21 occupies a special place. It is this depression that supposedly proves that all depressions are caused by government excesses and that, if left unattended, with no government fiscal or monetary stimulus, would work themselves out, without great difficulty, just as happened in 1920-21. In other words, government is the problem, not the solution, and the free market is the solution, not the problem. If only (the crypto-socialist) Herbert Hoover and (the not-so-crypto) FDR had followed the wholesome example of the great Warren G. Harding, cut spending to the bone and cut taxes, the Great Depression would have been over in 18 months or less, just as the 1920-21 Depression was. And if Bush and Obama had followed the Harding example, our own Little Depression would have surely long since have been a distant memory.

In two recent papers (“A Critique of the Austrian School Interpretation of the 1920-21 Depression“, “A note on America’s 1920-21 depression as an argument for austerity“), fellow blogger Daniel Kuehn provides some historical background and context for the 1920-21 Depression, showing that the 1920-21 Depression was the product of a deliberately deflationary fiscal and monetary policy aimed at undoing (at least in part) the very rapid inflation that occurred in the final stages and the aftermath of World War I. In that sense, the 1920-21 Depression really is very much unlike the kind of overinvestment/malinvestment episodes envisioned by the Austrian theory.

The other really big difference between the 1920-21 Depression and the Great Depression is that there was effectively no gold standard operating in 1920-21. True the US had restored convertibility between the dollar and gold by 1920, but almost no other currencies in the world were then tied to gold. The US held 40 percent of the world’s reserves of gold, so the US was determining the value of gold rather than gold determining the value of the dollar. The Federal Reserve had as much control over the US price level as any issuer of fiat currency could ever desire. By 1929, there was a world market for gold in which many other central banks were exerting — and none more than the insane Bank of France — a powerful influence, almost exclusively on the side of deflation. Thus, immediately following a wartime inflation — historically almost always a time for deflation — it was relatively easy to unwind the inflationary increases in wages and prices of the preceding few years. When the Fed signaled in 1921, by reducing its discount rate, that it was no longer aiming for deflation, the deflation quickly came to an end. But in the Great Depression, notwithstanding the characteristically exaggerated, if not delusional, Austrian rhetoric about the inflationary excesses 1920s, there was in fact no previous inflation to unwind. As long as a country remained on the gold standard, there was no escape from deflation caused by an increasing real value of gold.

On at least one occasion, no less an authority on Austrian Business Cycle theory than Murray Rothbard, himself, actually admitted that the 1920-21 Depression was indeed a purely monetary episode, in contrast to the Great Depression in which real factors played a major role. In the late 1960s, when I was an undergrad in economics at UCLA, Rothbard gave a talk at UCLA about the Great Depression. All I really remember is that he spent most of the talk berating Herbert Hoover for being just as bad as FDR. Most people were surprised to find out that Hoover was such an interventionist, though anyone who had read Ronald Coase’s classic article on the FCC would have already known that Hoover was very far from being a free market ideologue. I had just started getting interested in Austrian economics – while my contemporaries were experimenting with drugs, I was experimenting with Austrian economics; go figure! I sure hope no permanent damage was done – and was curious to hear what Rothbard had to say. But it was all about Herbert Hoover. Later, I asked Axel Leijonhufvud, who had also attended the talk, what he thought. Axel said that Rothbard was a scholar, but didn’t elaborate except to say that he had chatted with Rothbard after the talk asking Rothbard if there had ever been a purely monetary depression and that Rothbard had said that the 1920-21 Depression had been purely monetary. So there you have it, Rothbard, on at least one occasion, admitted that the 1920-21 Depression was a purely monetary phenomenon.

Just How Scary Is the Gold Standard?

Published January 8, 2012 gold standard , monetary history , monetary policy 44 Comments

With at least one upper-tier Republican candidate for President openly advocating the gold standard and pledging to re-establish it if he is elected President, more and more people are trying to figure out what going back on a gold standard would mean.

Tyler Cowen wrote about the gold standard on his blog the week before last, explaining why restoring the gold standard is a dangerous idea.

The most fundamental argument against a gold standard is that when the relative price of gold is go up, that creates deflationary pressures on the general price level, thereby harming output and employment. There is also the potential for radically high inflation through gold, though today that seems like less a problem than it was in the seventeenth century.

Why put your economy at the mercy of these essentially random forces? I believe the 19th century was a relatively good time to have had a gold standard, but the last twenty years, with their rising commodity prices, would have been an especially bad time. When it comes to the next twenty years, who knows?

Whether or not there is “enough gold,” and there always will be at some price, the transition to a gold standard still involves the likelihood of major price level shocks, if only because the transition itself involves a repricing of gold. A gold standard, by the way, is still compatible with plenty of state intervention.

Tyler’s short comment seems basically right to me, but some commenters were very critical.

Lars Christensen, commenting favorably on Tyler’s criticism of the gold standard, opened up his blog to a debate about the merits of the gold standard, and Blake Johnson, who registered sharp disagreement with Tyler’s take on the gold standard in a comment on Tyler’s post, submitted a more detailed criticism which Lars posted on his blog. Johnson makes some interesting arguments against Tyler, showing considerably more sophistication than your average gold bug, so I thought that it would be worthwhile to analyze Blake’s defense of the gold standard.

Blake begins by quibbling with Tyler’s statement that if the relative price of gold rises under a gold standard, the appreciation of gold is expressed in falling prices, reducing output and employment. Johnson points out that when prices are falling in proportion to increases in productivity deflation is not necessarily bad. That’s valid (but not necessarily conclusive) point, but I suspect that that is not the scenario that Tyler had in mind when he made his comment, as Johnson himself recognizes:

Cowen’s claim likely refers to the deflation that turned what may have been a very mild recession in the late 1920’s into the Great Depression. The question then is whether or not this deflation was a necessary result of the gold standard. Douglas Irwin’s recent paper “Did France cause the Great Depression” suggests that the deflation from 1928-1932 was largely the result of the actions of the US and French central banks, namely that they sterilized gold inflows and allowed their cover ratios to balloon to ludicrous levels. Thus, central bankers were not “playing by the rules” of the gold standard.

The plot thickens. The problem with Johnson’s comment is that he is presuming that there ever were any clearly articulated rules of the gold standard. The most ardent supporters of the gold standard at the time, people like von Mises and Hayek, Lionel Robbins, Jacques Rueff and Charles Rist in France, Benjamin Anderson in America, were all defending the Bank of France against criticism for its actions. (See this post about Hayek’s defense of the Bank of France.) I don’t think that they were correct in their interpretation of what the rules of the gold standard required, but it is clearly not possible to look up the relevant rules of how to play the gold-standard game, as one could look up, say, the rules of playing baseball. Central bankers were not playing by the rules of the gold standard, because the existence of such rules was a convenient myth, covering up the fact that central banks, especially the Bank of England, ran the gold standard in the late 19^th and early 20^th centuries and exercised considerable discretion in doing so. The gold standard was never a fully automatic self-regulating system.

Johnson continues:

Personally, I see this more as an indictment of central bank policy than of the gold standard. Peter Temin has claimed that the asymmetry in the ability of central banks to interfere with the price specie flow mechanism was the fundamental flaw in the inter-war gold standard. Central banks that wanted to inflate were eventually constrained by the process of adverse clearings when they attempted to cause the supply of their particular currency [to] exceed the demand for that currency. However, because they were funded via taxpayer money, they were insulated from the profit motive that generally caused private banks to economize on gold reserves, and refrain from the kind of deflation that would result from allowing your cover ratio to increase as drastically as the US and French central banks did.

Unfortunately, I cannot make any sense out of this. “Central banks that wanted to inflate” presumably refers to central banks keeping their lending rate at a level below the rates in other countries, thereby issuing an excess supply of banknotes that financed a balance of payments deficit and causing an outflow of gold (adverse clearings). Somehow Johnson transitions from the assumption of inflationary bias to the opposite one of deflationary bias in which, “funded via taxpayer money,” central banks were insulated from the profit motive that generally caused private banks to economize on gold reserves, thus refraining from the kind of deflation that would result from allowing your cover ratio to increase as drastically as the US and French central banks did. Sorry, but I don’t see how we get from point A to point B.

At any rate, Johnson seems to be suggesting — though this is just a guess – that central banks are more likely than private banks to hoard gold reserves. That may perhaps be true, but it might not be true if there are significant economies of scale in holding reserves. Under a gold standard with no central banks and no lender of last resort, the precautionary demand for gold reserves by individual banks might be so great that the aggregate monetary demand for gold by the banking system could be greater than the monetary demand of central banks for gold. We just don’t know. And the only way to find out is to make ourselves guinea pigs and see how a gold standard would work itself out with or without central banks. I personally am curious to see how it would turn out, but not curious enough to actually want to live through the experiment.

Johnson goes on:

I would further point out that if you believe Scott Sumner’s claim that the Fed has failed to supply enough currency, and that there is a monetary disequilibrium at the root of the Great Recession, it seems even more clear that central bankers don’t need the gold standard to help them fail to reach a state of monetary equilibrium. While we obviously haven’t seen anything like the kind of deflation that occurred in the Great Depression, this is partially due to the drastically different inflation expectations between the 1920’s and the 2000’s. The Fed still allowed NGDP to fall well below trend, which I firmly believe has exacerbated the current crisis.

What Johnson fails to consider is that inflation expectations are not totally arbitrary; inflation expectations in the 1930s plunged, because people understood that gold was appreciating toward its pre-World War I level. The only way to avoid that result for an individual country on the gold standard was to get off the gold standard, because the price level of any country on the gold standard is determined by the value of gold. That’s why FDR was able to initiate a recovery in March 1933 with the stroke of a pen by suspending the convertibility of the dollar into gold, allowing the dollar to depreciate against gold and gold-standard currencies, causing prices in dollar terms to start rising, thereby stimulating increased output and employment practically over night. The critical difference that Johnson is ignoring is that no country under a gold standard could stop deflating until it got off the gold standard. The FOMC is doing a terrible job, but all they have to do is figure out what needs to be done. They don’t have to get permission to do what is right from anyone else.

So how scary is the gold standard? Scarier than you think.

Christina Romer Really Gets It

Published December 18, 2011 monetary history , monetary policy 24 Comments

Marcus Nunes beat me to it, highlighting Christina Romer’s column in today’s New York Times, but her column today deserves all the attention and praise that it can get, and a lot more besides. Romer debunks then notion that real downturns that follow financial crises are necessarily deeper and longer-lasting than ordinary downturns, showing that the policy pessimism engendered by the notion that recoveries from recessions precipitated by financial crises are necessarily weak and drawn out, given currency by the recent book by Rogoff and Reinhart This Time Is Different, is not at all justified by the historical record.

I will just elaborate on a couple of points made by Romer. Citing the account of the Great Depression in the United States given by Milton Friedman and Anna Schwartz in their Monetary History of the United States, Romer observes:

The Friedman-Schwartz study found four distinct waves of banking panics in the early 1930s. After the first three, output plummeted. But after the last one, in early 1933, output skyrocketed, with industrial production rising nearly 60 percent from March to July. That time was very different.

What accounts for the difference? Romer explains:

[T]he policy response largely explains why output fell after the American banking panics in 1930 and 1931, but rose after the final wave in early 1933. After the first waves, the Fed did little, and President Herbert Hoover signed a big tax increase to replenish revenue. After the final wave, President Franklin D. Roosevelt abandoned the gold standard, increased the money supply and began a program of New Deal spending.

I don’t disagree with that, but I understand the process differently. It was the gold standard itself that had caused the downturn, because gold was appreciating (meaning that prices and wages were falling), causing profits to drop and business and households to stop spending. Bank failures were caused by a deflation that made it impossible for debts fixed in nominal terms to be repaid, so that the assets held by banks were becoming worthless. Bank failures were not the cause of the problem, they were a symptom of a problem — falling prices — inherent in and inseparable from the perverse dynamics of the gold standard. Once FDR abandoned the gold standard, the dollar depreciated relative to gold allowing dollar prices to start rising, the money supply increasing more or less automatically as a result.

Romer also disscusses a paper comparing the severity of the Great Depression in Spain and in the US.

Why was the Great Depression so much worse here than in Spain? According to an influential paper by Ehsan Choudhri and Levis Kochin, Spain benefited from not being on the gold standard. Its central bank was able to lend freely and increase the money supply after the panic. By contrast, in 1931, the Federal Reserve in the United States raised interest rates to defend its gold reserves and stay on the gold standard, setting off further declines in output and exacerbating the banking crisis.

It’s true that freedom from the gold standard allowed Spain to take monetary measures it could not have taken while on the gold standard, but the more important point is that by not being on the gold standard, prices in Spain did not have to fall to reflect the increasing value of gold. So the deflationary forces that suffused all the countries on the gold standard simply bypassed Spain and other countries not on the gold standard. It was not the increase in interest rates by the US that was caused the deflation in the US it was the gold standard. Raising interest rates were necessary only insofar as a country did not want to allow an export of its gold reserves.

In closing, I will just mention that the paper by Choudri and Kochin contains a diagram on p. 569 showing that Belgium experienced a rapid deflation and a big drop in industrial production in the early 1930s. In my post last week about the analysis of the Deutsche Bank comparing the euro crisis to the 1930s gold standard crisis, the diagram copied from the DB analysis seemed to indicate that Belgium did not suffer a substantial drop in real GDP. The Choudri and Kochin paper provides further reason to be skeptical about the graph in the DB analysis.

Hayek’s 1932 Defense of the Insane Bank of France

Published December 17, 2011 Hawtrey , Hayek , monetary history , monetary policy , monetary theory 27 Comments

In my post last Monday, I suggseted that Hayek’s attachment to the gold standard led him to recommend a policy of deflation during the Great Depression even though his own neutral-money policy criterion of stabilizing aggregate monetary expenditure would have implied aggressive monetary expansion during the Great Depression. Forced to choose between two conflicting principles, Hayek made the wrong choice, opting for defense of the gold standard rather than for stabilizing nominal GDP. He later changed his views, disavowing support for the gold standard as early as 1943 in a paper (“A Commodity Reserve Currency”) in the Economic Journal (reprinted as chapter 10 of Individualism and Economic Order) and reaffirming his opposition to the gold standard in The Constitution of Liberty (p. 335). I cited his 1932 paper “the Fate of the Gold Standard” translated from the original German and republished in his collected works and quoted his opening paragraph lamenting that Britain had abandoned the gold standard because (in September 1931 as the Great Depression was rapidly spiraling downward) Britain found the discipline of the gold standard “irksome.”

I also referred to Hayek’s defense of what I called “the insane French policy of gold accumulation.” I did not want to burden readers of an already long post with further quotations from Hayek’s article, so I just left it there without giving another quotation. But I think it may be worth analyzing what Hayek wrote, not because I want to make Hayek look bad, but because his defense of the Bank of France betrays a basic misunderstanding of the theory of international monetary adjustment and how the gold standard worked that is characteristic of many discussions of the gold standard.

Here is what Hayek wrote (F. A. Hayek, The Collected Works of F. A. Hayek, Good Money, Part 1, p. 160).

The accusation that France systematically hoarded gold seems at first sight to be more likely to be correct [than the charge that the US Federal Reserve had been hoarding gold, an accusation dismissed in the previous paragraph]. France did pursue an extremely cautious foreign policy after the franc stabilized at a level which considerably undervalued it with respect to its domestic purchasing power, and prevented an expansion of credit proportional to the amount of gold coming in. Nevertheless, France did not prevent her monetary circulation from increasing by the very same amount as that of the gold inflow – and this alone is necessary for the gold standard to function.

Hayek made a fundamental error here, assuming that a small open economy (which France could be considered to have been in the late 1920s) had control over its money supply and its price level under the gold standard. The French price level, once France pegged the franc to the dollar in 1926 at $0.0392/franc, was no longer under the control of French monetary authorities, commodity arbitrage requiring commodity prices quoted in francs to equal commodity prices quoted in dollars adjusted for the fixed dollar/franc parity. The equalization was not perfect, because not all commodities enter into international trade and because there are differences between similar products sold in different countries that preclude full price equalization. But there are strict limits on how much national price levels could diverge under a gold standard. Similarly, the money supply in a country on the gold standard could not be controlled by the monetary authority of that country, because if people in that country wanted to hold more money than the monetary authority made available, they could increase their holdings of money by increasing exports or decreasing imports, thereby generating an inflow of gold, which could be converted into banknotes or deposits.

So Hayek’s observation that France did not prevent her monetary circulation from increasing by the very same amount as that of the gold inflow means only that the Bank of France refused to increase the French money supply at all (or even attempted to decrease it), forcing the French to increase their holdings of cash by acquiring gold through an export surplus. Hayek’s statement thus betrays a total misunderstanding of what “is necessary for the gold standard to function.” All that was necessary was that France maintain a fixed parity between the dollar and the franc, not that the Bank of France achieve a particular change in the money supply governed by the amount that its holdings of gold had changed. Hayek wrongly assumed that the French monetary authorities had control over the French money supply and that the inflow of gold was somehow determined by real forces independent of French monetary conditions. But it was just the opposite. The French money supply increased because the French wanted to increase the amount of cash balances they were holding. The only question was whether the French banking system would be allowed by the Bank of France to accommodate the French demand for money by increasing the French money supply, or whether the desired increase in the money supply would be permitted only through gold imports generated by an export surplus. Refusing to allow the French money supply to increase except through the importation of gold meant that the increase in the French demand for money was transformed into an equivalent increase in French (and, hence, the world) demand for gold, thereby driving up the value of gold, the proximate source of the deflation that produced the Great Depression.

As I said, this misconception of money supply adjustment under the gold standard was not unique to Hayek. In some ways it is characteristic of many orthodox treatments of the gold standard and it can be traced back at least to the British Currency School of the 1830 and 1840s, if not even further back to David Hume in the 18th century. Milton Friedman was similarly misguided in many of his discussions of the gold standard and international adjustment, especially in his discussion of the Great Depression in his Monetary History of the United States. Ralph Hawtrey, as usual, got it right. But the analysis was much later articulated in more conventional model by Harry Johnson and his associates in their development of the monetary approach to the balance of payments.

Deutsche Bank Gets It, Why Can’t Mrs. Merkel?

Published December 14, 2011 monetary history , monetary policy 24 Comments

A report by the Deutsche Bank comparing the current euro crisis with the gold standard crisis of the 1930s has been quoted by a few bloggers. I can’t seem to find a link to the report itself, but here is what seems to be an extract from the Deutsche Bank report itself.

The 1930s in Europe was a slow moving game of falling dominoes with countries one by one leaving the narrow confines of the Gold Standard after chronic growth problems that a fixed currency system intensified. There was a definite trend in the 1930s that saw those countries that left the Gold Standard seeing a much quicker recovery from the Depression than those that stayed on for a number of years into the latter half of the decade. Figure 12 shows a case study of six countries currencies relative to Gold in the 1930s. We’ve rebased them to 100 at the start of the series. In order of leaving the Gold Standard, we had the UK (left September 1931), Sweden (also left September 1931), US (April 1933), Belgium (March 1935), France (September 1936) and Italy (October 1936).

Interestingly, by the middle of 1937 all had devalued by at least 40% to Gold except Belgium who had devalued by around 30% in 1935. France, which held on until September 1936, then saw its currency collapse by nearly 70% in the three years up to WWII. Figure 13 then shows the same six countries nominal (left) and real (right) GDP performance over the same period.

The UK and Sweden, which left the Gold Standard earliest (September 1931) in this sample, saw a ‘relatively’ mild negative growth shock compared to the other four. In contrast, France which stuck to Gold until late 1936 saw growth notably under-perform until they left the standard. Interestingly as discussed above, France later saw a dramatic 3 year 70% devaluation to Gold which helped restore nominal GDP close to that of the UK and Sweden by the end of the 1930s. However, in real terms they were still the laggard at this point. The worst slump of all was that seen in the US between 1929 and 1932 where they lost nearly half the value of their economy in nominal terms and nearly 30% in real terms. However, the bottom pretty much corresponded to the end of the Dollar’s gold convertibility and subsequent devaluation. From this point on, the recovery was fairly dramatic until the 1937 recession we’ll discuss below. Overall, Figure 13 does indicate some fairly strong evidence that growth did seem to respond to currency debasement and that countries which left this later ended up with weaker economies for longer and also, in France’s case, a more dramatic end devaluation.

Here is DBs comparison of the current crisis and the one eighty years ago.

In real terms, we are not too different in many countries to the outcome seen in the Depression. However, the overall price level in the economy has held up much better than it did in the 1930s leaving nominal GDP above its 2007/2008 peak in Austria (106.5 relative to a rebased 100 peak), Belgium (106.4), US (105.3), UK (104.7), Germany (103.7), France (103.3), Finland (102.9) and the Netherlands (101.3). Much of this has been because of QE and other dramatic interventions preventing the collapse of much systemically crucial debt (particularly banks) that would otherwise have defaulted and led to deflation.

However, all the peripheral five are below their nominal peak still with Portugal, Italy and Spain just below their peak but with Greece (92.8) and Ireland (82.4) well below. When using Ireland as a positive case study for what others can achieve, it is worth being aware that they have seen a near 20% fall in their economy on a nominal basis. This has allowed them to dramatically improve their competitiveness. Unless others are prepared to make the same hard decisions and can be funded in the meantime, we think they are unlikely to be able to repeat Ireland’s competitive gains.

The problem is that a country could just leave the gold standard or devalue its currency, as did Great Britain and Sweden in 1931, followed eventually by everyone else, if it wanted to. No one has yet figured out an escape from the euro trap. If Mrs. Merkel could only give her OK to the ECB to conduct a policy of aggressive monetary expansion, the euro might still be saved. But, in her consummate narrow-mindedness, Mrs. Merkel seems determined to drive Europe into the abyss. OMG!

Keynes v. Hayek: Enough Already

Published December 12, 2011 Cassel , Hawtrey , Hayek , Keynes , monetary history , monetary policy , monetary theory 78 Comments

First, it was the Keynes v. Hayek rap video, and then came the even more vulgar and tasteless Keynes v. Hayek sequel video reducing the two hyperintellectuals to prize fighters. (The accuracy of the representations signaled in its portrayal of Hayek as bald and Keynes with a full head of hair when in real life it was the other way around.) Then came a debate broadcast by the BBC at the London School of Economics, and then another sponsored by Reuters with a Nobel Prize winning economist on the program arguing for the Hayek side. Now comes a new book by Nicholas Wapshott Keynes Hayek, offering an extended account of the fraught relationship between two giants of twentieth century economics who eventually came to a sort of intellectual détente toward the end of Keynes’s life, a decade or more after a few years of really intense, even brutal, but very high level, polemical exchanges between them (and some of their surrogates) in the pages of England’s leading economics journals. Tyler Cowen has just reviewed Wapshott’s book in the National Review (see Marcus Nunes’s blog).

As I observed in September after watching the first Keynes-Hayek debate, we can still learn a lot by going back to Keynes’s and Hayek’s own writings, but all this Keynes versus Hayek hype creates the terribly misleading impression that the truth must lie with only one side or the other, that one side represents truth and enlightenment and the other represents falsehood and darkness, one side represents pure disinterested motives and the other is shilling for sinister forces lurking in the wings seeking to advance their own illegitimate interests, in short that one side can be trusted and the other cannot. All this attention on Keynes and Hayek, two charismatic personalities who have become figureheads or totems for ideological movements that they might not have endorsed at all — and certainly not endorsed unconditionally — encourages an increasingly polarized discussion in which people choose sides based on pre-existing ideological commitments rather than on a reasoned assessment of the arguments and the evidence.

In part, this framing of arguments in ideological terms simply reflects existing trends that have been encouraging an increasingly ideological approach to politics, law, and public policy. For an example of this approach, see Naomi Klein’s recent musings about global warming and the necessity for acknowledging that combating global warming requires the very social transformation that makes right-wingers oppose, on ideological principle, any measure to counter global warming. Those are just the terms of debate that Naomi Klein wants. Thus, both sides have come to see global warming not as a problem to be addressed or mitigated, but as a weapon to be used in the context of a comprehensive ideological struggle. Those who want to address the problem in a pragmatic, non-ideological, way are losing control of the conversation.

The amazing thing about the original Keynes-Hayek debate is not only that both misunderstood the sources of the Great Depression for which they were confidently offering policy advice, but that Ralph Hawtrey and Gustav Cassel had explained what was happening ten years before the downturn started in the summer of 1929. Both Hawtrey and Cassel understood that restoring the gold standard after the demonetization of gold that took place during World War I would have hugely deflationary implications if, when the gold standard was reinstated, the world’s monetary demand for gold would increase back to the pre-World War I level (as a result of restoring gold coinage and the replenishment of the gold reserves held in central bank coffers). That is why both Hawtrey and Cassel called for measures to limit the world’s monetary demand for gold (measures agreed upon in the international monetary conference in Genoa in 1922 of which Hawtrey was the guiding spirit). The measures agreed upon at the Genoa Conference prevented the monetary demand for gold from increasing faster than the stock of gold was increasing so that the world price level in terms of gold was roughly stable from about 1922 through 1928. But in 1928, French demand for gold started to increase rapidly just as the Federal Reserve began tightening monetary policy in a tragically misguided effort to squelch a supposed stock-price bubble on Wall Street, causing an inflow of gold into the US while the French embarked on a frenzied drive to add to their gold holdings, and other countries rejoining the gold standard were increasing their gold holdings as well, though with a less fanatical determination than the French. The Great Depression was therefore entirely the product of monetary causes, a world-wide increase in gold demand causing its value to increase, an increase manifesting itself, under the gold standard, in deflation.

Hayek, along with his mentor Ludwig von Mises, could also claim to have predicted the 1929 downturn, having criticized the Fed in 1927, when the US was in danger of falling into a recession, for reducing interest rates to 3.5%, by historical standards far from a dangerously expansionary rate, as Hawtrey demonstrated in his exhaustive book on the subject A Century of Bank Rate. But it has never been even remotely plausible that a 3.5% discount rate at the Fed for a little over a year was the trigger for the worst economic catastrophe since the Black Death of the 14^th century. Nor could Keynes offer a persuasive explanation for why the world suddenly went into a catastrophic downward spiral in late 1929. References to animal spirits and the inherent instability of entrepreneurial expectations are all well and good, but they provide not so much an explanation of the downturn as a way of talking about it or describing it. Beyond that, the Hawtrey-Cassel account of the Great Depression also accounts for the relative severity of the Depression and for the sequence of recovery in different counties, there being an almost exact correlation between the severity of the Depression in a country and the existence and duration of the gold standard in the country. In no country did recovery start until after the gold standard was abandoned, and in no country was there a substantial lag between leaving the gold standard and the start of the recovery.

So not only did Hawtrey and Cassel predict the Great Depression, specifying in advance the conditions that would, and did, bring it about, they identified the unerring prescription – something provided by no other explanation — for a country to start recovering from the Great Depression. Hayek, on the other hand, along with von Mises, not only advocated precisely the wrong policy, namely, tightening money, in effect increasing the monetary demand for gold, he accepted, if not welcomed, deflation as the necessary price for maintaining the gold standard. (This by the way is what explains the puzzle (raised by Larry White in his paper “Did Hayek and Robbins Deepen the Great Depression?”) of Hayek’s failure to follow his own criterion for a neutral monetary policy, stated explicitly in chapter 4 of Prices and Production: stabilization of nominal expenditure (NGDP). However, a policy of stabilizing nominal expenditure was inconsistent with staying on the gold standard when the value of gold was rising by 5 to 10% a year. Faced with a conflict between maintaining the gold standard and following his own criterion for neutral money, Hayek, along with his friend and colleague Lionel Robbins in his patently Austrian book The Great Depression, both opted for maintaining the gold standard.)

Not only did Hayek make the wrong call about the gold standard, he actually defended the insane French policy of gold accumulation in his lament for the gold standard after Britain wisely disregarded his advice and left the gold standard in 1931. In his paper “The Fate of the Gold Standard” (originally Das Schicksal der Goldwahrung) reprinted in The Collected Works of F. A. Hayek: Good Money, Part 1, Hayek mourned the impending demise of the gold standard after Britain tardily did the right thing. The tone of Hayek’s lament is struck in his opening paragraph (p. 153).

There has been much talk about the breakdown of the gold standard, particularly in Britain where, to the astonishment of every foreign observer, the abandonment of the gold standard was very widely welcomed as a release from an irksome constraint. However, it can scarcely be doubted that the renewed monetary problems of almost the whole world have nothing to do with the tendencies inherent in the gold standard, but on the contrary stem from the persistent and continuous attempts from many sides over a number of years to prevent the gold standard from functioning whenever it began to reveal tendencies which were not desired by the country in question. Hence it was by no means the economically strong countries such as America and France whose measures rendered the gold standard inoperative, as is frequently assumed, but the countries in a relatively weak position, at the head of which was Britain, who eventually paid for their transgression of the “rules of the game” by the breakdown of their gold standard.

So what do we learn from this depressing tale? Hawtrey and Cassel did everything right. They identified the danger to the world economy a decade in advance. They specified exactly the correct policy for avoiding the danger. Their policy was a huge success for about nine years until the Americans and the French between them drove the world economy into the Great Depression, just as Hawtrey and Cassel warned would happen if the monetary demand for gold was not held in check. Within a year and a half, both Hawtrey and Cassel concluded that recovery was no longer possible under the gold standard. And as countries, one by one, abandoned the gold standard, they began to recover just as Hawtrey and Cassel predicted. So one would have thought that Hawtrey and Cassel would have been acclaimed and celebrated far and wide as the most insightful, the most farsighted, the wisest, economists in the world. Yep, that’s what one would have thought. Did it happen? Not a chance. Instead, it was Keynes who was credited with figuring out how to end the Great Depression, even though there was almost nothing in the General Theory about the gold standard and a 30% deflation as the cause of the Great Depression, despite his having vilified Churchill in 1925 for rejoining the gold standard at the prewar parity when that decision was expected to cause a mere 10% deflation.

But amazingly enough, even when economists began looking for alternative ways to Keynesianism of thinking about macroeconomics, Austrian economics still being considered too toxic to handle, almost no one bothered to go back to revisit what Hawtrey and Cassel had said about the Great Depression. So Milton Friedman was considered to have been daring and original for suggesting a monetary explanation for the Great Depression and finding historical and statistical support for that explanation. Yet, on the key elements of the historical explanation, Hawtrey and Cassel either anticipated Friedman, or on the numerous issues on which Friedman did not follow Hawtrey and Cassel — in particular the international gold market as the transmitter of deflation and depression across all countries on the gold standard, the key role of the Bank of France (which Friedman denied in the Monetary History and for years afterwards only to concede the point in the mid to late 1990s), the absence of an explanation for the 1929 downturn, the misplaced emphasis on the contraction of the US money stock and the role of U.S. bank failures as a critical factor in explaining the severity of the Great Depression — Hawtrey and Cassel got it right and Friedman got it wrong.

So what matters in the success in the marketplace of ideas seems to be not just the quality or the truth of a theory, but also (or instead) the publicity machine that can be deployed in support of a theory to generate interest in it and to attract followers who can expect to advance their own careers in the process of developing, testing, or otherwise propagating, the theory. Keynes, Friedman, and eventually Hayek, all had powerful ideologically driven publicity machines working on their behalf. And guess what? It’s the theories that attract the support of a hard core of ideologically motivated followers that tend to outperform those without a cadre of ideological followers.

That’s why it was very interesting, important, and encouraging that Tyler Cowen, in his discussion of the Keynes-Hayek story, felt the need to mention how Scott Sumner has shifted the debate over the past two years away from the tired old Keynes vs. Hayek routine. Of course Tyler, about as well read an economist as there is, slipped up when he said that Scott is reviving the Friedman Monetarist tradition. No, Scott is reviving the Hawtrey-Cassel pre-Monetarist tradition, of which Friedman’s is a decidedly inferior, and obsolete, version. It just goes to show that one person sometimes really can make a difference, even without an ideologically driven publicity machine working on his behalf. Just imagine what Hawtrey and Cassel could have accomplished if they had been bloggers.

The Tender-Hearted Prof. Sumner Gives Mises and Hayek a Pass

Published November 29, 2011 Hayek , monetary history , monetary policy , monetary theory 50 Comments

Scott Sumner is such a kindly soul. You can count on him to give everyone the benefit of the doubt, bending over backwards to find a way to make sense out of the most ridiculous statement that you can imagine. Even when he disagrees, he expresses his disagreement in the mildest possible terms. And if you don’t believe me, just ask Paul Krugman, about whom Scott, despite their occasional disagreements, always finds a way to say something nice and complimentary. I have no doubt that if you were fortunate enough to take one of Scott’s courses at Bentley, you could certainly count on getting at least a B+ if you showed up for class and handed in your homework, because Scott is the kind of guy who just would not want to hurt anyone’s feelings, not even a not very interested student. In other words, Scott is the very model of a modern major general – er, I mean, of a modern sensitive male.

But I am afraid that Scott has finally let his niceness get totally out of hand. In his latest post “The myth at the heart of internet Austrianism,” Scott ever so gently points out a number of really serious (as in fatal) flaws in Austrian Business Cycle Theory, especially as an explanation of the Great Depression, which it totally misdiagnosed, wrongly attributing the downturn to a crisis caused by inflationary monetary policy, and for which it prescribed a disastrously mistaken remedy, namely, allowing deflation to run its course as a purgatory of the malinvestments undertaken in the preceding boom. Scott certainly deserves a pat on the back for trying to shed some light on a subject as fraught with fallacy and folly as Austrian Business Cycle Theory, but unfortunately Scott’s niceness got the better of him when he made the following introductory disclaimer:

This post is not about Austrian economics, a field I know relatively little about. [Scott is not just nice, he is also modest and self-effacing to a fault, DG] Rather it is a response to dozens of comments I have received by people who claim to represent the Austrian viewpoint.

And then after his partial listing of the problems with Austrian Business Cycle Theory, Scott just couldn’t help softening the blow with the following comment.

Austrian monetary economics has some great ideas – most notably NGDP targeting. I wish internet Austrians would pay more attention to Hayek, and less attention to whoever is telling them that the Depression was triggered by the collapse of an inflationary bubble during the 1920s. There was no inflationary bubble, by any reasonable definition of the world “inflation.”

Scott greatly admires Hayek (as do I), so he sincerely wants to believe that the mistakes of Austrian Business Cycle Theory are not Hayek’s fault, but are the invention of some nasty inauthentic Internet Austrians. In fact, because in a few places Hayek seemed to understand that an increased demand for money (aka a reduction in the velocity of circulation) would cause a reduction in total spending (aggregate demand or nominal income) unless matched by an increased quantity of money, acknowledging that, at least in principle, the neutral monetary policy he favored should not hold the stock of money constant, but should aim at a constant level of total spending (aggregate demand or nominal income), Scott wants to absolve Hayek from responsibility for the really bad (as in horrendous) policy advice he offered in the 1930s, opposing reflation and any efforts to increase spending by deliberately increasing the stock of money. During the Great Depression, Hayek’s recognition that in principle the objective of monetary policy ought to be to stabilize total spending was more in the way of a theoretical nuance than a bedrock principle of monetary policy. The recognition is buried in chapter four of Prices and Production. The tenor of his remarks and the uselessness of his recognition in principle that total spending should be stabilized are well illustrated by the following remark at the beginning of the final section of the chapter

Anybody who is sceptical of the value of theoretical analysis if it does not result in practical suggestions for economic policy will probably be deeply disappointed by the small return of so prolonged an argument.

Then in the 1932 preface to the English translation of his Monetary Theory and the Trade Cycle, Hayek wrote the following nugget:

Far from following a deflationary policy, Central Banks, particularly in the United States, have been making earlier and more far reaching efforts than have ever been undertaken before to combat the depression by a policy of credit expansion – with the result that the depression has lasted longer and has become more severe than any preceding one. What we need is a readjustment of those elements in the structure of production and of prices which existed before the deflation began and which then made it unprofitable for industry to borrow. But, instead of furthering the inevitable liquidation of the maladjustments brought about by the boom during the last three years, all conceivable means have been used to prevent that readjustment from taking place; and one of these means, which has been repeatedly tried though without success, from the earliest to the most recent stages of depression, has been this deliberate policy of credit expansion. (pp. 19-20)

And then Hayek came to this staggering conclusion (which is the constant refrain of all Internet Austrians):

To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection – a procedure which can only lead to a much more severe crisis as soon as the credit expansion comes to an end. It would not be the first experiment of this kind which has been made. We should merely be repeating, on a much larger scale, the course followed by the Federal Reserve system in 1927, an experiment which Mr. A. C. Miller, the only economist on the Federal Reserve Board [the Charles Plosser of his time, DG] and, at the same time, its oldest member, has rightly characterized as “the greatest and boldest operation ever undertaken by the Federal reserve system”, an operation which “resulted in one of the most costly errors committed by it or any other banking system in the last 75 years”. It is probably to this experiment, together with the attempts to prevent liquidation once the crisis had come, that we owe the exceptional severity and duration of the depression. We must not forget that, for the last six or eight years, monetary policy all over the world [like, say, France for instance? DG] has followed the advice of the stabilizers. It is high time that their influence, which has already done harm enough, should be overthrown. [OMG, DG] (pp. 21-22)

That the orthodox Austrian (espoused by Mises, Hayek, Haberler, and Machlup) view at the time was that the Great Depression was caused by an inflationary monetary policy administered by the Federal Reserve in concert with other central banks at the time is clearly shown by the following quotation from Lionel Robbins’s book The Great Depression. Robbins, one of the great English economists of the twentieth century, became a long-distance disciple of Mises and Hayek in the 1920s and was personally responsible for Hayek’s invitation to deliver his lectures (eventually published as Prices and Production) on Austrian Business Cycle Theory at the London School of Economics in 1931, and after their huge success, arranged for Hayek to be offered a chair in economic theory at LSE. Robbins published his book on the Great Depression in 1934 while still very much under the influence of Mises and Hayek. He subsequently changed his views, publicly disavowing the book, refusing to allow it to be reprinted in his lifetime.

Thus in the last analysis, it was deliberate co-operation between Central bankers, deliberate “reflation” on the part of the Federal Reserve authorities, which produced the worst phase of this stupendous fluctuation. Far from showing the indifference to prevalent trends of opinion, of which they have so often been accused, it seems that they had learnt the lesson only too well. It was not old-fashioned practice but new-fashioned theory which was responsible for the excesses of the American disaster. (p. 54)

Like Robbins, Haberler and Machlup, who went on to stellar academic careers in the USA, also disavowed their early espousal of ABCT. Mises, unable to tolerate apostasy on the part of traitorous erstwhile disciples, stopped speaking to them. Hayek, though never disavowing his earlier views as Robbins, Haberler, and Machlup had, acknowledged that he had been mistaken in not forthrightly supporting a policy of stabilizing total spending. Mises was probably unhappy with Hayek for his partial u-turn, but continued speaking to him nevertheless. Of course, Internet Austrians like Thomas Woods, whose book Meltdown was a best-seller and helped fuel the revival of Austrianism after the 2008 crisis, feel no shame in citing the works of Hayek, Haberler, Machlup, and Robbins about the Great Depression that they later disavowed in whole or in part, without disclosing that the authors of the works being cited changed or even rejected the views for which they were being cited.

So I am sorry to have to tell Scott: “I know it’s hard for you, but stop trying to be nice to Mises and Hayek. They were great economists, but they got the Great Depression all wrong. Don’t try to sugarcoat it. It can’t be done.”

In Praise of Gustav Cassel

Published November 28, 2011 Cassel , Hawtrey , monetary history , monetary policy 11 Comments

When I started this blog almost 5 months ago, I decided to highlight my intellectual debt to Ralph Hawtrey by emblazoning his picture (to the annoyance of some – sorry, but deal with it) on the border of the blog and giving the blog an alias (hawtreyblog.com) to go along with its primary name. I came to realize Hawtrey’s importance when, sometime after being exposed as a graduate student to Earl Thompson’s monetary, but anti-Monetarist (in the Friedmanian sense), theory of the Great Depression, according to which the Depression was caused by a big increase in the world’s monetary demand for gold in the late 1920s when many countries, especially France, almost simultaneously rejoined the gold standard, driving down the international price level, causing ruinous deflation. Thompson developed his theory independently, and I assumed that his insight was unprecedented, so it was a surprise when (I can’t remember exactly how or when) I discovered that Ralph Hawtrey (by the 1970s a semi-forgotten fugure in the history of monetary thought) had developed Thompson’s theory years earlier. Not only that, but I found that Hawtrey had developed the theory before the fact, and had predicted almost immediately after World War I exactly what would happen if restoration of the gold standard (effectively suspended during World War I) was mismanaged, producing a large increase in the international monetary demand for gold. It dawned on me that there was a major intellectual puzzle, how was it that Hawtrey’s theory of the Great Depression had been so thoroughly forgotten (or ignored) by the entire economics profession.

A few years later, in a conversation with my old graduate school buddy, Ron Batchelder, also a student of Thompson, I mentioned to him that Earl’s theory of the Great Depression had actually been anticipated right after World War I by Ralph Hawtrey. Batchelder then told me that he had discovered that Earl’s theory had also been anticipated by the great Swedish economist, Gustav Cassel, who also had been warning during the 1920s that a depression could result from an increased monetary demand for gold. That was the genesis of the paper that Ron and I wrote many years ago, “Pre-Keynesian Monetary Theories of the Great Depression: Whatever Happened to Hawtrey and Cassel?” Ron and I wrote the paper in 1991, but always planning to do one more revision, we have submitted it for publication. I am hoping finally to do another revision in the next month or so and then submit it. An early draft is still available as a UCLA working paper, and I will post the revised version on the SSRN website. Scott Sumner wrote a blog post about the paper almost two years ago.

At any rate, when I started the blog, I had a bit of a guilty conscience for not giving Cassel his due as well as Hawtrey. I suppose that I prefer Hawtrey’s theoretical formulations, emphasizing the law of one price rather than the price-specie-flow mechanism, and the endogeneity of the money supply to Cassel’s formulations which are closer to the standard quantity theory than I feel comfortable with. But the substantive differences between Hawtrey and Cassel were almost nil, and both of these estimable scholars and gentlemen are deserving of all the posthumous glory that can be bestowed on them, and then some.

So, with that lengthy introduction, I am happy to give a shout-out to Doug Irwin who has just written a paper “Anticipating the Great Depression? Gustav Cassel’s Analysis of the Interwar Gold Standard.” Doug provides detailed documentation of Cassel’s many warnings before the fact about the potentially disastrous consequences of not effectively controlling the international demand for gold during the 1920s as countries returned to the gold standard, of his identification as they were taking place of the misguided policies adopted by the Bank of France and the Federal Reserve Board that guaranteed that the world would be plunged into a catastrophic depression, and his brave and lonely battle to persuade the international community to abandon the gold standard as the indispensable prerequisite for recovery.

Here is a quotation from Cassel on p. 19 Doug’s paper:

All sorts of disturbances and maladjustments have contributed to the present crisis. But it is difficult to see why they should have brought about a fall of the general level of commodity prices. . . . A restriction of the means of payment has caused a fall of the general level of commodity prices – a deflation has taken place. But people shut their eyes to what is going on in the monetary sphere and pay attention only to the other disturbances.

Another quote from Cassel appears in footnote 21 (pp. 31-32). Here is the entire footnote:

Before accepting the view that monetary policy was impotent, Cassel insisted that “we should make sure that the necessary measures have been applied with sufficient resoluteness. A central bank ought not to stop its purchases of Government securities just at the moment when such purchases could be expected to exercise a direct influence on the volume of active purchasing power. If it is stated in advance that [the?]central bank intends to go on supplying means of payment until a certain rise in the general level of prices has been brought about, the result will doubtless be much easier to attain.”

On top of all that, the paper is a pleasure to read, providing many interesting bits of personal and historical information as well as a number of valuable observations on Cassel’s relationships with Keynes and Hayek. In other words, it’s a must read.

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About Me

David Glasner
Washington, DC

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

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

Follow me on Twitter @david_glasner

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