Archive for the 'monetary theory' Category

Can There Really Be an Excess Supply of Commercial Bank Money?

Nick Rowe has answered the question in the affirmative. Nick mistakenly believes that I have argued that there cannot be an excess supply of commercial bank money. In fact, I agree with him that there can be an excess supply of commercial bank money, and, for that matter, that there can be an excess demand for commercial bank money. Our disagreement concerns a slightly different, but nonetheless important, question: is there a market mechanism whereby an excess supply of commercial bank money can be withdrawn from circulation, or is the money destined to remain forever in circulation, because, commercial bank money, once created, must ultimately be held, however unwillingly, by someone? That’s the issue. I claim that there is a market mechanism that tends to equilibrate the quantity of bank money created with the amount demanded, so that if too much bank money is created, the excess will tend to be withdrawn from circulation without generating an increase in total expenditure. Nick denies that there is any such mechanism.

Nick and I have been discussing this point for about two and a half years, and every time I think we inch a bit closer to agreement, it seems that the divide separating us seems unbridgeable. But I’m not ready to give up yet. On the other hand, James Tobin explained it all over 50 years ago (when the idea seemed so radical it was called the New View) in his wonderful, classic (I don’t have enough adjectives superlatives to do it justice) paper “Commercial Banks and Creators of Money.” And how can I hope to improve on Tobin’s performance? (Actually there was a flaw in Tobin’s argument, which was not to recognize a key distinction between the inside (beta) money created by banks and the outside (alpha) money created by the monetary authority, but that has nothing to do with the logic of Tobin’s argument about commercial banks.)

Message to Nick: You need to write an article (a simple blog post won’t do, but it would be a start) explaining what you think is wrong with Tobin’s argument. I think that’s a hopeless task, but I’m sorry that’s the challenge you’ve chosen for yourself. Good luck, you’ll need it.

With that introduction out of the way, let me comment directly on Nick’s post. Nick has a subsequent post defending both the Keynesian multiplier and the money multiplier. I reserve the right (but don’t promise) to respond to that post at a later date; I have my hands full with this post. Here’s Nick:

Commercial banks are typically beta banks, and central banks are typically alpha banks. Beta banks promise to convert their money into the money of alpha banks at a fixed exchange rate. Alpha banks make no such promise the other way. It’s asymmetric redeemability. This means there cannot be an excess supply of beta money in terms of alpha money. (Nor can there be an excess demand for alpha money in terms of beta money.) Because people would convert their beta money into alpha money if there were. But there can be an excess supply of beta money in terms of goods, just as there can be an excess supply of alpha money in terms of goods. If beta money is in excess supply in terms of goods, so is alpha money, and vice versa. If commercial and central bank monies are perfect or imperfect substitutes, an increased supply of commercial bank money will create an excess supply of both monies against goods. The Law of Reflux will not prevent this.

The primary duty of a central bank is not to make a profit. It is possible to analyze and understand its motivations and its actions in terms of policy objectives that do not reflect the economic interests of its immediate owners. On the other hand, commercial banks are primarily in business to make a profit, and it should be possible to explain their actions in terms of their profit-enhancing effects. As I follow Nick’s argument, I will try to point where I think Nick fails to keep this distinction in mind. Back to Nick:

Money, the medium of exchange, is not like other goods, because if there are n goods plus one money, there are n markets in which money is traded, and n different excess supplies of money. Money might be in excess supply in the apple market, and in excess demand in the banana market.

If there are two monies, and n other goods, there are n markets in which money is traded against goods, plus one market in which the two monies are traded for each other. If beta money is convertible into alpha money, there can never be an excess supply of beta money in the one market where beta money is traded for alpha money. But there can be an excess supply of both beta and alpha money in each or all of the other n markets.

Sorry, I don’t understand this at all. First of all, to be sure, there can be n different excess demands for money; some will be positive, some negative. But it is entirely possible that the sum of those n different excess demands is zero. Second, even if we assume that the n money excess demands don’t sum to zero, there is still another market, the (n+1)st market in which the public exchanges assets that provide money-backing services with the banking system. If there is an excess demand for money, the public can provide the banks with additional assets (IOUs) in exchange for money, and if there is an excess supply of money the public can exchange their excess holding of money with the banks in return for assets providing money-backing services. The process is equilibrated by adjustments in the spreads between interests on loans and deposits governing the profitability of the banks loans and deposits. This is what I meant in the first paragraph when I said that I agree that it is possible for there to an excess demand for or supply of beta money. But the existence of that excess demand or excess supply can be equilibrated via the equilibration of market for beta money and the market for assets (IOUs) providing money-backing services. If there is a market process equilibrating the quantity of beta money, the adjustment can take place independently of the n markets for real goods and services that Nick is concerned with. On the other hand, if there is an excess demand for or supply of alpha money, it is not so clear that there are any market forces that cause that excess demand or supply to be equilibrated without impinging on the n real markets for goods and services.

Nick goes on to pose the following question:

Start in equilibrium, where the existing stocks of both alpha and beta money are willingly held. Hold constant the stock of alpha money. Now suppose the issuers of beta money create more beta money. Could this cause an excess supply of money and an increase in the price level?

That’s a great question. Just the question that I would ask. Here’s how Nick looks at it:

If alpha and beta money were perfect substitutes for each other, people would be indifferent about the proportions of alpha to beta monies they held. The desired share or ratio of alpha/beta money would be indeterminate, but the desired total of alpha+beta money would still be well-defined. If beta banks issued more beta money, holding constant the stock of alpha money, the total stock of money would be higher than desired, and there would be an excess supply of both monies against all other goods. But no individual would choose to go to the beta bank to convert his beta money into alpha money, because, by assumption, he doesn’t care about the share of alpha/beta money he holds. The Law of Reflux will not work to eliminate the excess supply of alpha+beta money against all other goods.

The assumption of perfect substitutability doesn’t seem right, as Nick himself indicates, inasmuch as people don’t seem to be indifferent between holding currency (alpha money) and holding deposits (beta money). And Nick focuses mainly on the imperfect-substitutes case. But, aside from that point, I have another problem with Nick’s discussion of perfect substitutes, which is that he seems to be conflate the assumption that alpha and beta moneys are perfect substitutes with the assumption that they are indistinguishable. I may be indifferent between holding currency and deposits, but if I have more deposits than I would like to hold, and I can tell the difference between a unit of currency and a deposit and there is a direct mechanism whereby I can reduce my holdings of deposits – by exchanging the deposit at the bank for another asset – it would seem that there is a mechanism whereby the excess supply of deposits can be eliminated without any change in overall spending. Now let’s look at Nick’s discussion of the more relevant case in which currency and deposits are imperfect substitutes.

Now suppose that alpha and beta money are close but imperfect substitutes. If beta banks want to prevent the Law of Reflux from reducing the stock of beta money, they would need to make beta money slightly more attractive to hold relative to alpha money. Suppose they do that, by paying slightly higher interest on beta money. This ensures that the desired share of alpha/beta money equals the actual share. No individual wants to reduce his share of beta/alpha money. But there will be an excess supply of both alpha and beta monies against all other goods. If apples and pears are substitutes, an increased supply of pears reduces the demand for apples.

What does it mean for “beta banks to want to prevent the Law of Reflux from reducing the stock of beta money?” Why would beta banks want to do such a foolish thing? Banks want to make profits for their owners. Does Nick think that by “prevent[ing] the Law of Reflux from reducing the stock of beta money” beta banks are increasing their profitability? The method by which he suggests that they could do this is to increase the interest they pay on deposits? That does not seem to me an obvious way of increasing the profits of beta banks. So starting from what he called an equilibrium, which sounds like a position in which beta banks were maximizing their profits, Nick is apparently positing that they increased the amount of deposits beyond the profit-maximizing level and, then, to keep that amount of deposits outstanding, he assumes that the banks increase the interest that they are paying on deposits.

What does this mean? Is Nick saying something other than that if banks collectively decide on a course of action that is not profit-maximizing either individually or collectively that the outcome will be different from the outcome that would have resulted had they acted with a view to maximize profits? Why should anyone be interested in that observation? At any rate, Nick concludes that because the public would switch from holding currency to deposits, the result would be an increase in total spending, as people tried to reduce their holdings of currency. It is not clear to me that people would be trying to increase their spending by reducing their holdings of deposits, but I can see that there is a certain ambiguity in trying to determine whether there is an excess supply of deposits or not in this case. But the case seems very contrived to say the least.

A more plausible way to look at the case Nick has in mind might be the following. Suppose banks perceive that their (marginal) costs of intermediation have fallen. Intermediation costs are very hard to measure, and banks aren’t necessarily very good at estimating those costs either. That may be one reason for the inherent instability of credit, but that’s a whole other discussion. At any rate, under the assumption that marginal intermediation costs have fallen, one could posit that the profit-maximizing response of beta banks would be to increase their interest payments on deposits to support an increase in their, suddenly more profitable than heretofore, lending. With bank deposits now yielding higher interest than before, the public would switch some of their holdings of currency to deposits. The shift form holding currency to holding deposits would initially involve an excess demand for deposits and an excess supply of currency. If the alpha bank was determined not to allow the quantity of currency to fall, then the excess supply of currency could be eliminated only through an increase in spending that would raise prices sufficiently to increase the demand to hold currency. But Nick would apparently want to say that even in this case there was also an excess supply of deposits, even though we saw that initially there was an excess demand for deposits when banks increased the interest paid on deposits, and it was only because the alpha bank insisted on not allowing the quantity of currency to fall that there was any increase in total spending.

So, my conclusion remains what it was before. The Law of Reflux works to eliminate excess supplies of bank money, without impinging on spending for real goods and services. To prove otherwise, you have to find a flaw in the logic of Tobin’s 1963 paper. I think that that is very unlikely. On the other hand, if you do find such a flaw, you just might win the Nobel Prize.

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Milton Friedman’s Dumb Rule

Josh Hendrickson discusses Milton Friedman’s famous k-percent rule on his blog, using Friedman’s rule as a vehicle for an enlightening discussion of the time-inconsistency problem so brilliantly described by Fynn Kydland and Edward Prescott in a classic paper published 36 years ago. Josh recognizes that Friedman’s rule is imperfect. At any given time, the k-percent rule is likely to involve either an excess demand for cash or an excess supply of cash, so that the economy would constantly be adjusting to a policy induced macroeconomic disturbance. Obviously a less restrictive rule would allow the monetary authorities to achieve a better outcome. But Josh has an answer to that objection.

The k-percent rule has often been derided as a sub-optimal policy. Suppose, for example, that there was an increase in money demand. Without a corresponding increase in the money supply, there would be excess money demand that even Friedman believed would cause a reduction in both nominal income and real economic activity. So why would Friedman advocate such a policy?

The reason Friedman advocated the k-percent rule was not because he believed that it was the optimal policy in the modern sense of phrase, but rather that it limited the damage done by activist monetary policy. In Friedman’s view, shaped by his empirical work on monetary history, central banks tended to be a greater source of business cycle fluctuations than they were a source of stability. Thus, the k-percent rule would eliminate recessions caused by bad monetary policy.

That’s a fair statement of why Friedman advocated the k-percent rule. One of Friedman’s favorite epigrams was that one shouldn’t allow the best to be the enemy of the good, meaning that the pursuit of perfection is usually not worth it. Perfection is costly, and usually merely good is good enough. That’s generally good advice. Friedman thought that allowing the money supply to expand at a moderate rate (say 3%) would avoid severe deflationary pressure and avoid significant inflation, allowing the economy to muddle through without serious problems.

But behind that common-sense argument, there were deeper, more ideological, reasons for the k-percent rule. The k-percent rule was also part of Friedman’s attempt to provide a libertarian/conservative alternative to the gold standard, which Friedman believed was both politically impractical and economically undesirable. However, the gold standard for over a century had been viewed by supporters of free-market liberalism as a necessary check on government power and as a bulwark of liberty. Friedman, desiring to offer a modern version of the case for classical liberalism (which has somehow been renamed neo-liberalism), felt that the k-percent rule, importantly combined with a regime of flexible exchange rates, could serve as an ideological substitute for the gold standard.

To provide a rationale for why the k-percent rule was preferable to simply trying to stabilize the price level, Friedman had to draw on a distinction between the aims of monetary policy and the instruments of monetary policy. Friedman argued that a rule specifying that the monetary authority should stabilize the price level was too flexible, granting the monetary authority too much discretion in its decision making.

The price level is not a variable over which the monetary authority has any direct control. It is a target not an instrument. Specifying a price-level target allows the monetary authority discretion in its choice of instruments to achieve the target. Friedman actually made a similar argument about the gold standard in a paper called “Real and Pseudo Gold Standards.” The price of gold is a target, not an instrument. The monetary authority can achieve its target price of gold with more than one policy. Unless you define the rule in terms of the instruments of the central bank, you have not taken away the discretionary power of the monetary authority. In his anti-discretionary zeal, Friedman believed that he had discovered an argument that trumped advocates of the gold standard .

Of course there was a huge problem with this argument, though Friedman was rarely called on it. The money supply, under any definition that Friedman ever entertained, is no more an instrument of the monetary authority than the price level. Most of the money instruments included in any of the various definitions of money Friedman entertained for purposes of his k-percent rule are privately issued. So Friedman’s claim that his rule would eliminate the discretion of the monetary authority in its use of instrument was clearly false. Now, one might claim that when Friedman originally advanced the rule in his Program for Monetary Stability, the rule was formulated the context of a proposal for 100-percent reserves. However, the proposal for 100-percent reserves would inevitably have to identify those deposits subject to the 100-percent requirement and those exempt from the requirement. Once it is possible to convert the covered deposits into higher yielding uncovered deposits, monetary policy would not be effective if it controlled only the growth of deposits subject to a 100-percent reserve requirement.

In his chapter on monetary policy in The Constitution of Liberty, F. A. Hayek effectively punctured Friedman’s argument that a monetary authority could operate effectively without some discretion in its use of instruments to execute a policy aimed at some agreed upon policy goal. It is a category error to equate the discretion of the monetary authority in the choice of its policy instruments with the discretion of the government in applying coercive sanctions against the persons and property of private individuals. It is true that Hayek later modified his views about central banks, but that change in his views was at least in part attributable to a misunderstanding. Hayek erroneoulsy believed that his discovery that competition in the supply of money is possible without driving the value of money down to zero meant that competitive banks would compete to create an alternative monetary standard that would be superior to the existing standard legally established by the monetary authority. His conclusion did not follow from his premise.

In a previous post, I discussed how Hayek also memorably demolished Friedman’s argument that, although the k-percent rule might not be the theoretically best rule, it would at least be a good rule that would avoid the worst consequences of misguided monetary policies producing either deflation or inflation. John Taylor, accepting the Hayek Prize from the Manhattan Institute, totally embarrassed himself by flagarantly misunderstanding what Hayek was talking about. Here are the two relevant passages from Hayek. The first from his pamphlet, Full Employment at any Price?

I wish I could share the confidence of my friend Milton Friedman who thinks that one could deprive the monetary authorities, in order to prevent the abuse of their powers for political purposes, of all discretionary powers by prescribing the amount of money they may and should add to circulation in any one year. It seems to me that he regards this as practicable because he has become used for statistical purposes to draw a sharp distinction between what is to be regarded as money and what is not. This distinction does not exist in the real world. I believe that, to ensure the convertibility of all kinds of near-money into real money, which is necessary if we are to avoid severe liquidity crises or panics, the monetary authorities must be given some discretion. But I agree with Friedman that we will have to try and get back to a more or less automatic system for regulating the quantity of money in ordinary times. The necessity of “suspending” Sir Robert Peel’s Bank Act of 1844 three times within 25 years after it was passed ought to have taught us this once and for all.

Hayek in the Denationalization of Money, Hayek was more direct:

As regards Professor Friedman’s proposal of a legal limit on the rate at which a monopolistic issuer of money was to be allowed to increase the quantity in circulation, I can only say that I would not like to see what would happen if it ever became known that the amount of cash in circulation was approaching the upper limit and that therefore a need for increased liquidity could not be met.

And in a footnote, Hayek added.

To such a situation the classic account of Walter Bagehot . . . would apply: “In a sensitive state of the English money market the near approach to the legal limit of reserve would be a sure incentive to panic; if one-third were fixed by law, the moment the banks were close to one-third, alarm would begin and would run like magic.

So Friedman’s k-percent rule was dumb, really dumb. It was dumb, because it induced expectations that made it unsustainable. As Hayek observed, not only was the theory clear, but it was confirmed by the historical evidence from the nineteenth century. Unfortunately, it had to be reconfirmed one more time in 1982 before the Fed abandoned its own misguided attempt to implement a modified version of the Friedman rule.

Does Macroeconomics Need Financial Foundations?

One of the little instances of collateral damage occasioned by the hue and cry following upon Stephen Williamson’s post arguing that quantitative easing has been deflationary was the dustup between Scott Sumner and financial journalist and blogger Izabella Kaminska. I am not going to comment on the specifics of their exchange except to say that the misunderstanding and hard feelings between them seem to have been resolved more or less amicably. However, in quickly skimming the exchange between them, I was rather struck by the condescending tone of Kaminska’s (perhaps understandable coming from the aggrieved party) comment about the lack of comprehension by Scott and Market Monetarists more generally of the basics of finance.

First I’d just like to say I feel much of the misunderstanding comes from the fact that market monetarists tend to ignore the influence of shadow banking and market plumbing in the monetary world. I also think (especially from my conversation with Lars Christensen) that they ignore technological disruption, and the influence this has on wealth distribution and purchasing decisions amongst the wealthy, banks and corporates. Also, as I outlined in the post, my view is slightly different to Williamson’s, it’s based mostly on the scarcity of safe assets and how this can magnify hoarding instincts and fragment store-of-value markets, in a Gresham’s law kind of way. Expectations obviously factor into it, and I think Williamson is absolutely right on that front. But personally I don’t think it’s anything to do with temporary or permanent money expansion expectations. IMO It’s much more about risk expectations, which can — if momentum builds — shift very very quickly, making something deflationary, inflationary very quickly. Though, that doesn’t mean I am worried about inflation (largely because I suspect we may have reached an important productivity inflection point).

This remark was followed up with several comments blasting Market Monetarists for their ignorance of the basics of finance and commending Kaminska for the depth of her understanding to which Kaminska warmly responded adding a few additional jibes at Sumner and Market Monetarists. Here is one.

Market monetarists are getting testy because now that everybody started scrutinizing QE they will be exposed as ignorant. The mechanisms they originally advocated QE would work through will be seen as hopelessly naive. For them the money is like glass beads squirting out of the Federal Reserve, you start talking about stuff like collateral, liquid assets, balance sheets and shadow banking and they are out of their depth.

For laughs: Sumner once tried to defend the childish textbook model of banks lending out reserves and it ended in a colossal embarrassment in the comments section http://www.themoneyillusion.com/?p=5893

For you to defend your credentials in front of such “experts” is absurd. There is a lot more depth to your understanding than to their sandbox vision of the monetary system. And yes, it *is* crazy that journalists and bloggers can talk about these things with more sense than academics. But this [is] the world we live in.

To which Kaminska graciously replied:

Thanks as well! And I tend to agree with your assessment of the market monetarist view of the world.

So what is the Market Monetarist view of the world of which Kaminska tends to have such a low opinion? Well, from reading Kaminska’s comments and those of her commenters, it seems to be that Market Monetarists have an insufficiently detailed and inaccurate view of financial intermediaries, especially of banks and shadow banks, and that Market Monetarists don’t properly understand the role of safe assets and collateral in the economy. But the question is why, and how, does any of this matter to a useful description of how the economy works?

Well, this whole episode started when Stephen Williamson had a blog post arguing that QE was deflationary, and the reason it’s deflationary is that creating more high powered money provides the economy with more safe assets and thereby reduces the liquidity premium associated with safe assets like short-term Treasuries and cash. By reducing the liquidity premium, QE causes the real interest rate to fall, which implies a lower rate of inflation.

Kaminska thinks that this argument, which Market Monetarists find hard to digest, makes sense, though she can’t quite bring herself to endorse it either. But she finds the emphasis on collateral and safety and market plumbing very much to her taste. In my previous post, I raised what I thought were some problems with Williamson’s argument.

First, what is the actual evidence that there is a substantial liquidity premium on short-term Treasuries? If I compare the rates on short-term Treasuries with the rates on commercial paper issued by non-Financial institutions, I don’t find much difference. If there is a substantial unmet demand for good collateral, and there is only a small difference in yield between commercial paper and short-term Treasuries, one would think that non-financial firms could make a killing by issuing a lot more commercial paper. When I wrote the post, I was wondering whether I, a financial novice, might be misreading the data or mismeasuring the liquidity premium on short-term Treasuries. So far, no one has said anything about that, but If I am wrong, I am happy to be enlightened.

Here’s something else I don’t get. What’s so special about so-called safe assets? Suppose, as Williamson claims, that there’s a shortage of safe assets. Why does that imply a liquidity premium? One could still compensate for the lack of safety by over-collateralizing the loan using an inferior asset. If that is a possibility, why is the size of the liquidity premium not constrained?

I also pointed out in my previous post that a declining liquidity premium would be associated with a shift out of money and into real assets, which would cause an increase in asset prices. An increase in asset prices would tend to be associated with an increase in the value of the underlying service flows embodied in the assets, in other words in an increase in current prices, so that, if Williamson is right, QE should have caused measured inflation to rise even as it caused inflation expectations to fall. Of course Williamson believes that the decrease in liquidity premium is associated with a decline in real interest rates, but it is not clear that a decline in real interest rates has any implications for the current price level. So Williamson’s claim that his model explains the decline in observed inflation since QE was instituted does not seem all that compelling.

Now, as one who has written a bit about banking and shadow banking, and as one who shares the low opinion of the above-mentioned commenter on Kaminska’s blog about the textbook model (which Sumner does not defend, by the way) of the money supply via a “money multiplier,” I am in favor of changing how the money supply is incorporated into macromodels. Nevertheless, it is far from clear that changing the way that the money supply is modeled would significantly change any important policy implications of Market Monetarism. Perhaps it would, but if so, that is a proposition to be proved (or at least argued), not a self-evident truth to be asserted.

I don’t say that finance and banking are not important. Current spreads between borrowing and lending rates, may not provide a sufficient margin for banks to provide the intermediation services that they once provided to a wide range of customers. Businesses have a wider range of options in obtaining financing than they used to, so instead of holding bank accounts with banks and foregoing interest on deposits to be able to have a credit line with their banker, they park their money with a money market fund and obtain financing by issuing commercial paper. This works well for firms large enough to have direct access to lenders, but smaller businesses can’t borrow directly from the market and can only borrow from banks at much higher rates or by absorbing higher costs on their bank accounts than they would bear on a money market fund.

At any rate, when market interest rates are low, and when perceived credit risks are high, there is very little margin for banks to earn a profit from intermediation. If so, the money multiplier — a crude measure of how much intermediation banks are engaging in goes down — it is up to the monetary authority to provide the public with the liquidity they demand by increasing the amount of bank reserves available to the banking system. Otherwise, total spending would contract sharply as the public tried to build up their cash balances by reducing their own spending – not a pretty picture.

So finance is certainly important, and I really ought to know more about market plumbing and counterparty risk  and all that than I do, but the most important thing to know about finance is that the financial system tends to break down when the jointly held expectations of borrowers and lenders that the loans that they agreed to would be repaid on schedule by the borrowers are disappointed. There are all kinds of reasons why, in a given case, those jointly held expectations might be disappointed. But financial crises are associated with a very large cluster of disappointed expectations, and try as they might, the finance guys have not provided a better explanation for that clustering of disappointed expectations than a sharp decline in aggregate demand. That’s what happened in the Great Depression, as Ralph Hawtrey and Gustav Cassel and Irving Fisher and Maynard Keynes understood, and that’s what happened in the Little Depression, as Market Monetarists, especially Scott Sumner, understand. Everything else is just commentary.

Hawtrey’s Good and Bad Trade, Part IX: An Endogenous Cycle

We are now at the point at which Hawtrey’s model of the business cycle can be assembled from the parts laid out in the previous thirteen chapters. Hawtrey had already shown that monetary disturbances can lead to significant cumulative fluctuations, while mere demand shifts cause only minor temporary fluctuations, but his aim was to account not just for a single cumulative expansion or contraction in response to a single disturbance, but for recurring cyclical fluctuations. His theoretical model therefore required a mechanism whereby a positive or expansionary impulse would be reversed and transformed into a negative or contractionary impulse. A complete cyclical theory must provide some explanation of how an expansion becomes a contraction, and how a contraction becomes an expansion.

In chapters 14 and 15, Hawtrey identifies the banking system as the transforming agent required for a theory of recurring cycles. The key behavioral relationship for Hawtrey was that banks demand reserves — either gold or currency or reserves held with the central bank — into which their own liabilities (banknotes or deposits) are convertible. Given their demand for reserves, banks set interest rates at a level that will maintain their reserves at the desired level, raising interest rates when their reserves are less than desired, and reducing interest rates when reserves are greater than desired. Hawtrey combined this behavioral relationship with two key empirical relationships: 1) that workers and other lower-income groups generally make little use of banknotes (limited in Britain to denominations above £5, roughly the equivalent of $200 at today’s prices) and almost none of bank deposits; 2) that the share of labor in total income is countercyclical.

Using these two relationships, Hawtrey provided a theoretical account of recurring cyclical fluctuations in output, income, and employment. He begins the story at the upper turning point, when a combination of rising inflation and diminishing reserves causes banks to raise their interest rates to stem a loss of reserves. The rise in interest rates causes a reduction in spending, thereby leading to falling prices, output, and employment. Hawtrey poses the following question:

We are now concerned not with the direct consequences of a given monetary disturbance, but with the influences at work to modify and, perhaps in the end, to counteract those consequence. In particular are we to regard the tendency towards renewed inflation which experience teaches us to expect after a period of depression as a fortuitous disturbance which may come sooner or later, or as a reaction the seeds of which are already sown? To put the same problem in another form, when the position of equilibrium which should follow a disturbance according to the theory of Chapter 6 is attained, is there any reason, apart from visible causes of renewed disturbance, why that equilibrium should not continue?  (pp. 182-83)

Hawtrey argues that the equilibrium will not continue, invoking the different money-holding habits of capitalists and workers along with the countercyclical share of labor in total income. Although both employment and wages fall in the downturn, Hawtrey maintains that profits fall more sharply than wages, so that the share of labor in total income actually increases in the downturn. The entire passage is worth quoting, because it also constitutes an implicit criticism of the Austrian theory of the downturn, notwithstanding the fact that Hawtrey very likely was not yet acquainted with the Austrian theory of the business cycles, its primary text, Mises’s Theory of Money and Credit, having been published in German in 1912 just a year before publication of Good and Bad Trade.

[R]ather than let their plant lie idle, manufacturers will sacrifice part or even the whole of their profits, and that in this way the restriction of output is mitigated. If all producers insisted on stopping work unless they could obtain a normal rate of profit, there would be a greater restriction of output and more workmen would be discharged, and in that case the proceeds of the diminished output would be divided (approximately) in the same proportion between the capitalists and the workmen as before. But in consequence of the sacrifice of profits to output which actually occurs, the number of workmen in employment and therefore also the aggregate of working-class earnings will not be so severely diminished as they would otherwise be. Thus the capitalists will get a smaller proportion and the workmen a greater proportion of the gross proceeds than before. But anything which tends to increase or maintain working-class earnings tends to increase or maintain the amount of cash in the hands of the working classes. If the banks have succeeded in reducing the outstanding amount of credit money by 10 percent, they will probably have reduced the incomes of the people with bank accounts by 10 percent, but the earnings of the working classes will have been reduced in a much smaller proportion – say, 5 percent. (pp. 189-90)

The reduction in the quantity of the liabilities of the banking system in the hands of the public will relieve the pressure that previously felt to increase their reserves, which pressure had caused them to raise interest rates.

Here is the process at work which is likely enough to produce fluctuations. For the bankers will thereupon be ready to increase the stock of credit money again, and once they have embarked on this course they may find it very difficult to stop short of a dangerous inflation. . . .

Instead of ending up, therefore, with the establishment of a golden mean of prosperity, unbroken by any deviation towards less or more, the depression will be marked in its later stages by a new complication. At the time when the reduction of wages is beginning to be accompanied not merely by an increase of employment, but also by an increase of profits, the banks will find that cash is beginning to accumulate in their vaults. They will ease off the rate of interest to something a little below the profit rate, and dealers will take advantage of the low rate to add to their stocks. The manufacturers will become aware of an increase in orders, and they will find that they can occupy their plant more fully. And now that stocks and output are both increased, borrowing will be increased and the bankers will have gained their end. But then the new accession to the amount of credit money means a corresponding increase of purchasing power. At existing prices the dealers find that their stocks are being depleted by the growing demand from the consumer. The prospect of rising prices is an inducement to add to their stocks as much as they can at existing prices, and so their order to the manufacturers grow, wholesale prices go up; and as the consumers’ demands on the dealers’ stocks grow, retail prices go up; ans as prices go up, the money needed to finance a given quantity of goods grows greater and greater, and both dealers and manufacturers borrow more and more from their bankers. In fact here are all the characteristics of a period of trade expansion in full swing. (pp. 190-92)

How far such a cumulative process of credit expansion can proceed before it reaches its upper turning point depends on the willingness of the banks to continue supplying credit with an ever smaller margin of reserves relative to liabilities.

The total credit money created by the banks will be so limited by them as not to outstrip the capacities of these working balances [deposits of the banks at the Bank of England], while the Bank of England will not allow the balances to grow out of proportion to its own cash holdings. It is indeed almost, though not quite, true to say that the entire stock of credit money in England is built up not on the cash holdings of the banks taken as a whole, but on the Reserve of the Bank of England. And as the legal tender money in circulation is something like four times the average amount of the reserves, it is obvious that a small proportional change in the quantity in circulation will produce a relatively large proportional change in the reserve, and therefor in the stock of credit money. The Bank of England does not maintain blindly a fixed proportion between reserve and deposits, so that a given change in the reserve isnot reflected immediately in the stock of credit money, but of course when there is a marked increase in the reserve there is a tendency toward a marked increase in the deposits and through the other banks towards a general increase in credit money. (pp. 195-96)

But as the expansion proceeds, and businesses begin to expect to profit from selling their output at rising prices, businesses short of workers with which to increase output will start bidding up wages.

Production having been stimulated to great activity there is a scarcity of labour, or at any rate of properly trained and competent labour, and employers are so anxious ot get the benefit of the high profits that ehy are more ready than usual to make concessions in preference to facing strikes which would leave their workers idle. There follows a period of full employment and rising wages. But this means growing cash requirements, and sooner or later the banks must take action to prevent their reserves being depleted. If they act in time they may manage to relieve the inflation of credit money gradually and an actual financial crisis may be avoided. But in either case there must ensue a period of slack trade. Here, therefore, we have proved that there is an inherent tendency toward fluctuations in the banking institutions which prevail in the world as it is. (p. 199)

This built-in cyclical pattern may also be amplified by other special factors.

Another cause which tends to aggravate trade fluctuations is that imprudent banking is profitable. In a period of buoyant trade such as marks the recovery from a state of depression the profit rate is high, and the rate of interest received by the banks on their loans and discounts is correspondingly high. It may be that during the depression the banks have had to be content with 1 or 1.5 percent. When the recovery begins they find in quite a short time that they can earn 4 or 5 percent. This is not 4 or 5 percent on their own capital, but on the money which they lend, which may be for ten times their capital. That portion of their deposits which is represented by cash in hand is idle and earns nothing, and they are eager to swell their profits by reducing their cash and reserves and increasing their loans and discounts. Working balances are more or less elastic and can at a pinch be reduced, but the lower its reserves fall the more likely is the bank to find it necessary to borrow from other institutions. Again, the reader a bank is to lend, the more likely it is to lend to speculative enterprises, the more likely it is to suffer losses through the total or perhaps temporary failure of such enterprises, and the more likely it is to show a balance on the wrong side of its accounts when it needs to borrow. When many banks have yielded to these temptations a crisis is almost inevitable, or if an acute crisis with its accompaniment of widespread bankruptcies is avoided, there is bound to be a very severe and probably prolonged depression during which the top-heavy structure of credit money is gently pulled down brick by brick. . . .

It will probably be only a minority of the banks that overreach themselves in speculation, and it may not occur in all countries. But the prudent banks have no means of guarding themselves against the consequences of their neighbours’ rashness. They could hardly be expected to increase their reserves beyond what they believe to be a prudent proportion. It is true that a central bank, in those countries where such an institution exists, can take this precaution. But it will only do so if aware of the over-speculation. Of this, however, it will have no accurate or complete knowledge, and it will experience great difficulty in determining what measures are to be taken. (pp. 200-02)

Hawtrey elaborates on his account of the cycle in chapter 16 with a discussion of financial crises, which he views as an exceptionally severe cyclical downturn. My next post in this series will focus on that discussion and possibly also on Hawtrey’s discussion in chapter 14 of another special case: the adjustment to an expected rate of deflation that exceeds the real rate of interest.

Eureka! Paul Krugman Discovers the Bank of France

Trying hard, but not entirely successfully, to contain his astonishment, Paul Krugman has a very good post (“France 1930, Germany 2013) inspired by Doug Irwin’s “very good” paper (see also this shorter version) “Did France Cause the Great Depression?” Here’s Krugman take away from Irwin’s paper.

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

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

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

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

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

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

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

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

Krugman concludes by comparing Germany today with France in 1930.

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

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

HT: ChargerCarl

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Hawtrey’s Good and Bad Trade: Part II

Here I am again back at you finally with another installment in my series on Hawtrey’s Good and Bad Trade. In my first installment I provided some background on Hawtrey and a quick overview of the book, including a mention of the interesting fact (brought to my attention by David Laidler) that Hawtrey used the term “effective demand” in pretty much the same way that Keynes, some 20 years later, would use it in the General Theory.

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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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