Archive for the 'R. G. Hawtrey' Category

Cleaning Up After Burns’s Mess

In my two recent posts (here and here) about Arthur Burns’s lamentable tenure as Chairman of the Federal Reserve System from 1970 to 1978, my main criticism of Burns has been that, apart from his willingness to subordinate monetary policy to the political interests of he who appointed him, Burns failed to understand that an incomes policy to restrain wages, thereby minimizing the tendency of disinflation to reduce employment, could not, in principle, reduce inflation if monetary restraint did not correspondingly reduce the growth of total spending and income. Inflationary (or employment-reducing) wage increases can’t be prevented by an incomes policy if the rate of increase in total spending, and hence total income,  isn’t controlled. King Canute couldn’t prevent the tide from coming in, and neither Arthur Burns nor the Wage and Price Council could slow the increase in wages when total spending was increasing at rate faster than was consistent with the 3% inflation rate that Burns was aiming for.

In this post, I’m going to discuss how the mess Burns left behind him upon leaving the Fed in 1978 had to be cleaned up. The mess got even worse under Burns’s successor, G. William Miller. The clean up did not begin until Carter appointed Paul Volcker in 1979 when it became obvious that the monetary policy of the Fed had failed to cope with problems left behind by Burns. After unleashing powerful inflationary forces under the cover of the wage-and-price controls he had persuaded Nixon to impose in 1971 as a precondition for delivering the monetary stimulus so desperately desired by Nixon to ensure his reelection, Burns continued providing that stimulus even after Nixon’s reelection, when it might still have been possible to taper off the stimulus before inflation flared up, and without aborting the expansion then under way. In his arrogance or ignorance, Burns chose not to adjust the policy that had so splendidly accomplished its intended result.

Not until the end of 1973, after crude oil prices quadrupled owing to a cutback in OPEC oil output, driving inflation above 10% in 1974, did Burns withdraw the monetary stimulus that had been administered in increasing doses since early 1971. Shocked out of his complacency by the outcry against 10% inflation, Burns shifted monetary policy toward restraint, bringing down the growth in nominal spending and income from over 11% in Q4 1973 to only 8% in Q1 1974.

After prolonging monetary stimulus unnecessarily for a year, Burn erred grievously by applying monetary restraint in response to the rise in oil prices. The largely exogenous rise in oil prices would most likely have caused a recession even with no change in monetary policy. By subjecting the economy to the added shock of reducing aggregate demand, Burns turned a mild recession into the worst recession since 1937-38 recession at the end of the Great Depression, with unemployment peaking at 8.8% in Q2 1975.. Nor did the reduction in aggregate demand have much anti-inflationary effect, because the incremental reduction in total spending occasioned by the monetary tightening was reflected mainly in reduced output and employment rather than in reduced inflation.

But even with unemployment reaching the highest level in almost 40 years, inflation did not fall below 5% – and then only briefly – until a year after the bottom of the recession. When President Carter took office in 1977, Burns, hoping to be reappointed to another term, provided Carter with a monetary expansion to hasten the reduction in unemployment that Carter has promised in his Presidential campaign. However, Burns’s accommodative policy did not sufficiently endear him to Carter to secure the coveted reappointment.

The short and unhappy tenure of Carter’s first appointee, G. William Miller, during which inflation rose from 6.5% to 10%, ended abruptly when Carter, with his Administration in crisis, sacked his Treasury Secretary, replacing him with Miller. Under pressure from the financial community to address the seemingly intractable inflation that seemed to be accelerating in the wake of a second oil shock following the Iranian Revolution and hostage taking, Carter felt constrained to appoint Volcker, formerly a high official in the Treasury in both the Kennedy and Nixon administrations, then serving as President of the New York Federal Reserve Bank, who was known to be the favored choice of the financial community.

A year after leaving the Fed, Burns gave the annual Per Jacobson Lecture to the International Monetary Fund. Calling his lecture “The Anguish of Central Banking,” Burns offered a defense of his tenure, by arguing, in effect, that he should not be blamed for his poor performance, because the job of central banking is so very hard. Central bankers could control inflation, but only by inflicting unacceptably high unemployment. The political authorities and the public to whom central bankers are ultimately accountable would simply not tolerate the high unemployment that would be necessary for inflation to be controlled.

Viewed in the abstract, the Federal Reserve System had the power to abort the inflation at its incipient stage fifteen years ago or at any later point, and it has the power to end it today. At any time within that period, it could have restricted money supply and created sufficient strains in the financial and industrial markets to terminate inflation with little delay. It did not do so because the Federal Reserve was itself caught up in the philosophic and political currents that were transforming American life and culture.

Burns’s framing of the choices facing a central bank was tendentious; no policy maker had suggested that, after years of inflation had convinced the public to expect inflation to continue indefinitely, the Fed should “terminate inflation with little delay.” And Burns was hardly a disinterested actor as Fed chairman, having orchestrated a monetary expansion to promote the re-election chances of his benefactor Richard Nixon after securing, in return for that service, Nixon’s agreement to implement an incomes policy to limit the growth of wages, a policy that Burns believed would contain the inflationary consequences of the monetary expansion.

However, as I explained in my post on Hawtrey and Burns, the conceptual rationale for an incomes policy was not to allow monetary expansion to increase total spending, output and employment without causing increased inflation, but to allow the monetary restraint to be administered without increasing unemployment. But under the circumstances in the summer of 1971, when a recovery from the 1970 recession was just starting, and unemployment was still high, monetary expansion might have hastened a recovery in output and employment the resulting increase in total spending and income might still increase output and employment rather than being absorbed in higher wages and prices.

But using controls over wages and prices to speed the return to full employment could succeed only while substantial unemployment and unused capacity allowed output and employment to increase; the faster the recovery, the sooner increased spending would show up in rising prices and wages, or in supply shortages, rather than in increased output. So an incomes policy to enable monetary expansion to speed the recovery from recession and restore full employment might theoretically be successful, but, only if the monetary stimulus were promptly tapered off before driving up inflation.

Thus, if Burns wanted an incomes policy to be able to hasten the recovery through monetary expansion and maximize the political benefit to Nixon in time for the 1972 election, he ought to have recognized the need to withdraw the stimulus after the election. But for a year after Nixon’s reelection, Burns continued the monetary expansion without let up. Burns’s expression of anguish at the dilemma foisted upon him by circumstances beyond his control hardly evokes sympathy, sounding more like an attempt to deflect responsibility for his own mistakes or malfeasance in serving as an instrument of the criminal Campaign to Re-elect the President without bothering to alter that politically motivated policy after accomplishing his dishonorable mission.

But it was not until Burns’s successor, G. William Miller, was succeeded by Paul Volcker in August 1979 that the Fed was willing to adopt — and maintain — an anti-inflationary policy. In his recently published memoir Volcker recounts how, responding to President Carter’s request in July 1979 that he accept appointment as Fed chairman, he told Mr. Carter that, to bring down inflation, he would adopt a tighter monetary policy than had been followed by his predecessor. He also writes that, although he did not regard himself as a Friedmanite Monetarist, he had become convinced that to control inflation it was necessary to control the quantity of money, though he did not agree with Friedman that a rigid rule was required to keep the quantity of money growing at a constant rate. To what extent the Fed would set its policy in terms of a fixed target rate of growth in the quantity of money became the dominant issue in Fed policy during Volcker’s first term as Fed chairman.

In a review of Volcker’s memoir widely cited in the econ blogosphere, Tim Barker decried Volcker’s tenure, especially his determination to control inflation even at the cost of spilling blood — other people’s blood – if that was necessary to eradicate the inflationary psychology of the 1970s, which become a seemingly permanent feature of the economic environment at the time of Volcker’s appointment.

If someone were to make a movie about neoliberalism, there would need to be a starring role for the character of Paul Volcker. As chair of the Federal Reserve from 1979 to 1987, Volcker was the most powerful central banker in the world. These were the years when the industrial workers movement was defeated in the United States and United Kingdom, and third world debt crises exploded. Both of these owe something to Volcker. On October 6, 1979, after an unscheduled meeting of the Fed’s Open Market Committee, Volcker announced that he would start limiting the growth of the nation’s money supply. This would be accomplished by limiting the growth of bank reserves, which the Fed influenced by buying and selling government securities to member banks. As money became more scarce, banks would raise interest rates, limiting the amount of liquidity available in the overall economy. Though the interest rates were a result of Fed policy, the money supply target let Volcker avoid the politically explosive appearance of directly raising rates himself. The experiment—known as the Volcker Shock—lasted until 1982, inducing what remains the worst unemployment since the Great Depression and finally ending the inflation that had troubled the world economy since the late 1960s. To catalog all the results of the Volcker Shock—shuttered factories, broken unions, dizzying financialization—is to describe the whirlwind we are still reaping in 2019. . . .

Barker is correct that Volcker had been persuaded that to tighten monetary policy the quantity of reserves that the Fed was providing to the banking system had to be controlled. But making the quantity of bank reserves the policy instrument was a technical change. Monetary policy had been — and could still have been — conducted using an interest-rate instrument, and it would have been entirely possible for Volcker to tighten monetary policy using the traditional interest-rate instrument. It is possible that, as Barker asserts, it was politically easier to tighten policy using a quantity instrument than an interest-rate instrument.

But even if so, the real difficulty was not the instrument used, but the economic and political consequences of a tight monetary policy. The choice of the instrument to carry out the policy could hardly have made more than a marginal difference on the balance of political forces favoring or opposing that policy. The real issue was whether a tight monetary policy aimed at reducing inflation was more effectively conducted using the traditional interest-rate instrument or the quantity-instrument that Volcker adopted. More on this point below.

Those who praise Volcker like to say he “broke the back” of inflation. Nancy Teeters, the lone dissenter on the Fed Board of Governors, had a different metaphor: “I told them, ‘You are pulling the financial fabric of this country so tight that it’s going to rip. You should understand that once you tear a piece of fabric, it’s very difficult, almost impossible, to put it back together again.” (Teeters, also the first woman on the Fed board, told journalist William Greider that “None of these guys has ever sewn anything in his life.”) Fabric or backbone: both images convey violence. In any case, a price index doesn’t have a spine or a seam; the broken bodies and rent garments of the early 1980s belonged to people. Reagan economic adviser Michael Mussa was nearer the truth when he said that “to establish its credibility, the Federal Reserve had to demonstrate its willingness to spill blood, lots of blood, other people’s blood.”

Did Volcker consciously see unemployment as the instrument of price stability? A Rhode Island representative asked him “Is it a necessary result to have a large increase in unemployment?” Volcker responded, “I don’t know what policies you would have to follow to avoid that result in the short run . . . We can’t undertake a policy now that will cure that problem [unemployment] in 1981.” Call this the necessary byproduct view: defeating inflation is the number one priority, and any action to put people back to work would raise inflationary expectations. Growth and full employment could be pursued once inflation was licked. But there was more to it than that. Even after prices stabilized, full employment would not mean what it once had. As late as 1986, unemployment was still 6.6 percent, the Reagan boom notwithstanding. This was the practical embodiment of Milton Friedman’s idea that there was a natural rate of unemployment, and attempts to go below it would always cause inflation (for this reason, the concept is known as NAIRU or non-accelerating inflation rate of unemployment). The logic here is plain: there need to be millions of unemployed workers for the economy to work as it should.

I want to make two points about Volcker’s policy. The first, which I made in my book Free Banking and Monetary Reform over 30 years ago, and which I have reiterated in several posts on this blog and which I discussed in my recent paper “Rules versus Discretion in Monetary Policy Historically Contemplated” (for an ungated version click here) is that using a quantity instrument to tighten monetary policy, as advocated by Milton Friedman, and acquiesced in by Volcker, induces expectations about the future actions of the monetary authority that undermine the policy and render it untenable. Volcker eventually realized the perverse expectational consequences of trying to implement a monetary policy using a fixed rule for the quantity instrument, but his learning experience in following Friedman’s advice needlessly exacerbated and prolonged the agony of the 1982 downturn for months after inflationary expectations had been broken.

The problem was well-known in the nineteenth century thanks to British experience under the Bank Charter Act that imposed a fixed quantity limit on the total quantity of banknotes issued by the Bank of England. When the total of banknotes approached the legal maximum, a precautionary demand for banknotes was immediately induced by those who feared that they might not later be able to obtain credit if it were needed because the Bank of England would be barred from making additional credit available.

Here is how I described Volcker’s Monetarist experiment in my book.

The danger lurking in any Monetarist rule has been perhaps best summarized by F. A. Hayek, who wrote:

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 under such a provision it ever became known that the amount of cash in circulation was approaching the upper limit and therefore a need for increased liquidity could not be met.

Hayek’s warnings were subsequently borne out after the Federal Reserve Board shifted its policy from targeting interest rates to targeting the monetary aggregates. The apparent shift toward a less inflationary monetary policy, reinforced by the election of a conservative, antiinflationary president in 1980, induced an international shift from other currencies into the dollar. That shift caused the dollar to appreciate by almost 30 percent against other major currencies.

At the same time the domestic demand for deposits was increasing as deregulation of the banking system reduced the cost of holding deposits. But instead of accommodating the increase in the foreign and domestic demands for dollars, the Fed tightened monetary policy. . . . The deflationary impact of that tightening overwhelmed the fiscal stimulus of tax cuts and defense buildup, which, many had predicted, would cause inflation to speed up. Instead the economy fell into the deepest recession since the 1930s, while inflation, by 1982, was brought down to the lowest levels since the early 1960s. The contraction, which began in July 1981, accelerated in the fourth quarter of 1981 and the first quarter of 1982.

The rapid disinflation was bringing interest rates down from the record high levels of mid-1981 and the economy seemed to bottom out in the second quarter, showing a slight rise in real GNP over the first quarter. Sticking to its Monetarist strategy, the Fed reduced its targets for monetary growth in 1982 to between 2.5 and 5.5 percent. But in January and February, the money supply increased at a rapid rate, perhaps in anticipation of an incipient expansion. Whatever its cause, the early burst of the money supply pushed M-1 way over its target range.

For the next several months, as M-1 remained above its target, financial and commodity markets were preoccupied with what the Fed was going to do next. The fear that the Fed would tighten further to bring M-1 back within its target range reversed the slide in interest rates that began in the fall of 1981. A striking feature of the behavior of interest rates at that time was that credit markets seemed to be heavily influenced by the announcements every week of the change in M-1 during the previous week. Unexpectedly large increases in the money supply put upward pressure on interest rates.

The Monetarist explanation was that the announcements caused people to raise their expectations of inflation. But if the increase in interest rates had been associated with a rising inflation premium, the announcements should have been associated with weakness in the dollar on foreign exchange markets and rising commodities prices. In fact, the dollar was rising and commodities prices were falling consistently throughout this period – even immediately after an unexpectedly large jump in M-1 was announced. . . . (pp. 218-19)

I pause in my own earlier narrative to add the further comment that the increase in interest rates in early 1982 clearly reflected an increasing liquidity premium, caused by the reduced availability of bank reserves, making cash desirable to hold than real assets thereby inducing further declines in asset values.

However, increases in M-1 during July turned out to be far smaller than anticipated, relieving some of the pressure on credit and commodities markets and allowing interest rates to begin to fall again. The decline in interest rates may have been eased slightly by . . . Volcker’s statement to Congress on July 20 that monetary growth at the upper range of the Fed’s targets would be acceptable. More important, he added that he Fed was willing to let M-1 remain above its target range for a while if the reason seemed to be a precautionary demand for liquidity. By August, M-1 had actually fallen back within its target range. As fears of further tightening by the Fed subsided, the stage was set for the decline in interest rates to accelerate, [and] the great stock market rally began on August 17, when the Dow . . . rose over 38 points [almost 5%].

But anticipation of an incipient recovery again fed monetary growth. From the middle of August through the end of September, M-1 grew at an annual rate of over 15 percent. Fears that rapid monetary growth would induce the Fed to tighten monetary policy slowed down the decline in interest rates and led to renewed declines in commodities price and the stock market, while pushing up the dollar to new highs. On October 5 . . . the Wall Street Journal reported that bond prices had fallen amid fears that the Fed might tighten credit conditions to slow the recent strong growth in the money supply. But on the very next day it was reported that the Fed expected inflation to stay low and would therefore allow M-1 to exceed its targets. The report sparked a major decline in interest rates and the Dow . . . soared another 37 points. (pp. 219-20)

The subsequent recovery, which began at the end of 1982, quickly became very powerful, but persistent fears that the Fed would backslide, at the urging of Milton Friedman and his Monetarist followers, into its bad old Monetarist habits periodically caused interest-rate spikes reflecting rising liquidity premiums as the public built up precautionary cash balances. Luckily, Volcker was astute enough to shrug off the overwrought warnings of Friedman and other Monetarists that rapid increases in the monetary aggregates foreshadowed the imminent return of double-digit inflation.

Thus, the Monetarist obsession with controlling the monetary aggregates senselessly prolonged an already deep recession that, by Q1 1982, had already slain the inflationary dragon, inflation having fallen to less than half its 1981 peak while GDP actually contracted in nominal terms. But because the money supply was expanding at a faster rate than was acceptable to Monetarist ideology, the Fed continued in its futile but destructive campaign to keep the monetary aggregates from overshooting their arbitrary Monetarist target range. It was not until Volcker in summer of 1982 finally and belatedly decided that enough was enough and announced that the Fed would declare victory over inflation and call off its Monetarist campaign even if doing so meant incurring Friedman’s wrath and condemnation for abandoning the true Monetarist doctrine.

Which brings me to my second point about Volcker’s policy. While it’s clear that Volcker’s decision to adopt control over the monetary aggregates as the focus of monetary policy was disastrously misguided, monetary policy can’t be conducted without some target. Although the Fed’s interest rate can serve as a policy instrument, it is not a plausible policy target. The preferred policy target is generally thought to be the rate of inflation. The Fed after all is mandated to achieve price stability, which is usually understood to mean targeting a rate of inflation of about 2%. A more sophisticated alternative would be to aim at a suitable price level, thereby allowing some upward movement, say, at a 2% annual rate, the difference between an inflation target and a moving price level target being that an inflation target is unaffected by past deviations of actual from targeted inflation while a moving price level target would require some catch up inflation to make up for past below-target inflation and reduced inflation to compensate for past above-target inflation.

However, the 1981-82 recession shows exactly why an inflation target and even a moving price level target is a bad idea. By almost any comprehensive measure, inflation was still positive throughout the 1981-82 recession, though the producer price index was nearly flat. Thus, inflation targeting during the 1981-82 recession would have been almost as bad a target for monetary policy as the monetary aggregates, with most measures of inflation showing that inflation was then between 3 and 5 percent even at the depth of the recession. Inflation targeting is thus, on its face, an unreliable basis for conducting monetary policy.

But the deeper problem with targeting inflation is that seeking to achieve an inflation target during a recession, when the very existence of a recession is presumptive evidence of the need for monetary stimulus, is actually a recipe for disaster, or, at the very least, for needlessly prolonging a recession. In a recession, the goal of monetary policy should be to stabilize the rate of increase in nominal spending along a time path consistent with the desired rate of inflation. Thus, as long as output is contracting or increasing very slowly, the desired rate of inflation should be higher than the desired rate over the long-term. The appropriate strategy for achieving an inflation target ought to be to let inflation be reduced by the accelerating expansion of output and employment characteristic of most recoveries relative to a stable expansion of nominal spending.

The true goal of monetary policy should always be to maintain a time path of total spending consistent with a desired price-level path over time. But it should not be the objective of the monetary policy to always be as close as possible to the desired path, because trying to stay on that path would likely destabilize the real economy. Market monetarists argue that the goal of monetary policy ought to be to keep nominal GDP expanding at that whatever rate is consistent with maintaining the desired long-run price-level path. That is certainly a reasonable practical rule for monetary policy, but the policy criterion I have discussed here would, at least in principle, be consistent with a more activist approach in which the monetary authority would seek to hasten the restoration of full employment during recessions by temporarily increasing the rate of monetary expansion and in nominal GDP as long as real output and employment remained below the maximum levels consistent with desired price level path over time. But such a strategy would require the monetary authority to be able to fine tune its monetary expansion so that it was tapered off just as the economy was reaching its maximum sustainable output and employment path. Whether such fine-tuning would be possible in practice is a question to which I don’t think we now know the answer.

 

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Judy Shelton Speaks Up for the Gold Standard

I have been working on a third installment in my series on how, with a huge assist from Arthur Burns, things fell apart in the 1970s. In my third installment, I will discuss the sad denouement of Burns’s misunderstandings and mistakes when Paul Volcker administered a brutal dose of tight money that caused the worst downturn and highest unemployment since the Great Depression in the Great Recession of 1981-82. But having seen another one of Judy Shelton’s less than enlightening op-eds arguing for a gold standard in the formerly respectable editorial section of the Wall Street Journal, I am going to pause from my account of Volcker’s monetary policy in the early 1980s to give Dr. Shelton my undivided attention.

The opening paragraph of Dr. Shelton’s op-ed is a less than auspicious start.

Since President Trump announced his intention to nominate Herman Cain and Stephen Moore to serve on the Federal Reserve’s board of governors, mainstream commentators have made a point of dismissing anyone sympathetic to a gold standard as crankish or unqualified.

That is a totally false charge. Since Herman Cain and Stephen Moore were nominated, they have been exposed as incompetent and unqualified to serve on the Board of Governors of the world’s most important central bank. It is not support for reestablishing the gold standard that demonstrates their incompetence and lack of qualifications. It is true that most economists, myself included, oppose restoring the gold standard. It is also true that most supporters of the gold standard, like, say — to choose a name more or less at random — Ron Paul, are indeed cranks and unqualified to hold high office, but there is indeed a minority of economists, including some outstanding ones like Larry White, George Selgin, Richard Timberlake and Nobel Laureate Robert Mundell, who do favor restoring the gold standard, at least under certain conditions.

But Cain and Moore are so unqualified and so incompetent, that they are incapable of doing more than mouthing platitudes about how wonderful it would be to have a dollar as good as gold by restoring some unspecified link between the dollar and gold. Because of their manifest ignorance about how a gold standard would work now or how it did work when it was in operation, they were unprepared to defend their support of a gold standard when called upon to do so by inquisitive reporters. So they just lied and denied that they had ever supported returning to the gold standard. Thus, in addition to being ignorant, incompetent and unqualified to serve on the Board of Governors of the Federal Reserve, Cain and Moore exposed their own foolishness and stupidity, because it was easy for reporters to dig up multiple statements by both aspiring central bankers explicitly calling for a gold standard to be restored and muddled utterances bearing at least vague resemblance to support for the gold standard.

So Dr. Shelton, in accusing mainstream commentators of dismissing anyone sympathetic to a gold standard as crankish or unqualified is accusing mainstream commentators of a level of intolerance and closed-mindedness for which she supplies not a shred of evidence.

After making a defamatory accusation with no basis in fact, Dr. Shelton turns her attention to a strawman whom she slays mercilessly.

But it is wholly legitimate, and entirely prudent, to question the infallibility of the Federal Reserve in calibrating the money supply to the needs of the economy. No other government institution had more influence over the creation of money and credit in the lead-up to the devastating 2008 global meltdown.

Where to begin? The Federal Reserve has not been targeting the quantity of money in the economy as a policy instrument since the early 1980s when the Fed misguidedly used the quantity of money as its policy target in its anti-inflation strategy. After acknowledging that mistake the Fed has, ever since, eschewed attempts to conduct monetary policy by targeting any monetary aggregate. It is through the independent choices and decisions of individual agents and of many competing private banking institutions, not the dictate of the Federal Reserve, that the quantity of money in the economy at any given time is determined. Indeed, it is true that the Federal Reserve played a great role in the run-up to the 2008 financial crisis, but its mistake had nothing to do with the amount of money being created. Rather the problem was that the Fed was setting its policy interest rate at too high a level throughout 2008 because of misplaced inflation fears fueled by a temporary increases in commodity prices that deterred the Fed from providing the monetary stimulus needed to counter a rapidly deepening recession.

But guess who was urging the Fed to raise its interest rate in 2008 exactly when a cut in interest rates was what the economy needed? None other than the Wall Street Journal editorial page. And guess who was the lead editorial writer on the Wall Street Journal in 2008 for economic policy? None other than Stephen Moore himself. Isn’t that special?

I will forbear from discussing Dr. Shelton’s comments on the Fed’s policy of paying interest on reserves, because I actually agree with her criticism of the policy. But I do want to say a word about her discussion of currency manipulation and the supposed role of the gold standard in minimizing such currency manipulation.

The classical gold standard established an international benchmark for currency values, consistent with free-trade principles. Today’s arrangements permit governments to manipulate their currencies to gain an export advantage.

Having previously explained to Dr. Shelton that currency manipulation to gain an export advantage depends not just on the exchange rate, but the monetary policy that is associated with that exchange rate, I have to admit some disappointment that my previous efforts to instruct her don’t seem to have improved her understanding of the ABCs of currency manipulation. But I will try again. Let me just quote from my last attempt to educate her.

The key point to keep in mind is that for a country to gain a competitive advantage by lowering its exchange rate, it has to prevent the automatic tendency of international price arbitrage and corresponding flows of money to eliminate competitive advantages arising from movements in exchange rates. If a depreciated exchange rate gives rise to an export surplus, a corresponding inflow of foreign funds to finance the export surplus will eventually either drive the exchange rate back toward its old level, thereby reducing or eliminating the initial depreciation, or, if the lower rate is maintained, the cash inflow will accumulate in reserve holdings of the central bank. Unless the central bank is willing to accept a continuing accumulation of foreign-exchange reserves, the increased domestic demand and monetary expansion associated with the export surplus will lead to a corresponding rise in domestic prices, wages and incomes, thereby reducing or eliminating the competitive advantage created by the depressed exchange rate. Thus, unless the central bank is willing to accumulate foreign-exchange reserves without limit, or can create an increased demand by private banks and the public to hold additional cash, thereby creating a chronic excess demand for money that can be satisfied only by a continuing export surplus, a permanently reduced foreign-exchange rate creates only a transitory competitive advantage.

I don’t say that currency manipulation is not possible. It is not only possible, but we know that currency manipulation has been practiced. But currency manipulation can occur under a fixed-exchange rate regime as well as under flexible exchange-rate regimes, as demonstrated by the conduct of the Bank of France from 1926 to 1935 while it was operating under a gold standard.

Dr. Shelton believes that restoring a gold standard would usher in a period of economic growth like the one that followed World War II under the Bretton Woods System. Well, Dr. Shelton might want to reconsider how well the Bretton Woods system worked to the advantage of the United States.

The fact is that, as Ralph Hawtrey pointed out in his Incomes and Money, the US dollar was overvalued relative to the currencies of most its European trading parties, which is why unemployment in the US was chronically above 5% after 1954 to 1965. With undervalued currencies, West Germany, Italy, Belgium, Britain, France and Japan all had much lower unemployment than the US. It was only in 1961, after John Kennedy became President, when the Federal Reserve systematically loosened monetary policy, forcing Germany and other countries to revalue their countries upward to avoid importing US inflation that the US was able redress the overvaluation of the dollar. But in doing so, the US also gradually rendered the $35/ounce price of gold, at which it maintained a kind of semi-convertibility of the dollar, unsustainable, leading a decade later to the final abandonment of the gold-dollar peg.

Dr. Shelton is obviously dedicated to restoring the gold standard, but she really ought to study up on how the gold standard actually worked in its previous incarnations and semi-incarnations, before she opines any further about how it might work in the future. At present, she doesn’t seem to be knowledgeable about how the gold standard worked in the past, and her confidence that it would work well in the future is entirely misplaced.

Ralph Hawtrey Wrote the Book that Arthur Burns Should Have Read — but Didn’t

In my previous post I wrote about the mistakes made by Arthur Burns after Nixon appointed him Chairman of the Federal Reserve Board. Here are the critical missteps of Burns’s unfortunate tenure.

1 Upon becoming chairman in January 1970, with inflation running at over 5% despite a modest tightening by his predecessor in 1969, Burns further tightened monetary policy, causing a downturn and a recession lasting the whole of 1970. The recession was politically damaging to Nixon, leading to sizable Republican losses in the November midterm elections, and causing Nixon to panic about losing his re-election bid in 1972. In his agitation, Nixon then began badgering Burns to loosen monetary policy.

2 Yielding to Nixon’s demands for an easing of monetary policy, Burns eased monetary policy sufficiently to allow a modest recovery to get under way in 1971. But the recovery was too tepid to suit Nixon. Fearing the inflationary implications of a further monetary loosening, Burns began publicly lobbying for the adoption of an incomes policy to limit the increase of wages set by collective bargaining between labor unions and major businesses.

3 Burns’s unwillingness to provide the powerful stimulus desired by Nixon until an incomes policy was in place to hold down inflation led Nixon to abandon his earlier opposition to wage-and-price controls. On August 15, 1971 Nixon imposed a 90-day freeze on all wages and prices to be followed by comprehensive wage-and-price controls. With controls in place, Burns felt secure in accelerating the rate of monetary expansion, leaving it to those controlling wages and prices to keep inflation within acceptable bounds.

4 With controls in place, monetary expansion at first fueled rapid growth of output, but as time passed, the increase in spending was increasingly reflected in inflation rather than output growth. By Q4 1973, inflation rose to 7%, a rate only marginally affected by the Arab oil embargo on oil shipments to the United States and a general reduction in oil output, which led to a quadrupling of oil prices by early 1974.

5 The sharp oil-price increase simultaneously caused inflation to rise sharply above the 7% rate it had reached at the end of 1973 even as it caused a deep downturn and recession in the first quarter of 1974. Rather than accommodate the increase in oil prices by tolerating a temporary increase in inflation, Burns sharply tightened monetary policy reducing the rate of monetary expansion so that the rate of growth of total spending dropped precipitously. Given the increase in oil prices, the drop in total spending caused a major contraction in output and employment, resulting in the deepest recession since 1937-38.

These mistakes all stemmed from a failure by Burns to understand the rationale of an incomes policy. Burns was not alone in that failure, which was actually widespread at the time. But the rationale for such a policy and the key to its implementation had already been spelled out cogently by Ralph Hawtrey in his 1967 diagnosis of the persistent failures of British monetary policy and macroeconomic performance in the post World War II period, failures that had also been deeply tied up in the misunderstanding of the rationale for – and the implementation of — an incomes policy. Unlike Burns, Hawtrey did not view an incomes policy as a substitute for, or an alternative to, monetary policy to reduce inflation. Rather, an incomes policy was precisely the use of monetary policy to achieve a rate of growth in total spending and income that could be compatible with full employment, provided the rate of growth of wages was consistent with full employment.

In Burns’s understanding, the role of an incomes policy was to prevent wage increases from driving up production costs so high that businesses could not operate profitably at maximum capacity without a further increase in inflation by the Federal Reserve. If the wage increases negotiated by the unions exceeded the level compatible with full employment at the targeted rate of inflation, businesses would reduce output and lay off workers. Faced with that choice, the Fed or any monetary authority would be caught in the dreaded straits of Scylla and Charybdis (aka between a rock and a hard place).

What Burns evidently didn’t understand, or chose to ignore, was that adopting an incomes policy to restrain wage increases did not allow the monetary authority to implement a monetary policy that would cause nominal GDP to rise at a rate faster than was consistent with full employment at the target rate of inflation. If, for example, the growth of the labor force and the expected increase in productivity was consistent with a 4% rate of real GDP growth over time and the monetary authority was aiming for an inflation rate no greater than 3%, the monetary authority could not allow nominal GDP to grow at a rate above 7%.

This conclusion is subject to the following qualification. During a transition from high unemployment to full employment, a faster rate of nominal GDP growth than the posited 7% rate could hasten the restoration of full employment. But temporarily speeding nominal GDP growth would also require that, as a state of full employment was approached, the growth of nominal GDP be tapered off and brought down to a sustainable rate.

But what if an incomes policy does keep the rate of increase in wages below the rate consistent with 3% inflation? Could the monetary authority then safely conduct a monetary policy that increased the rate of nominal GDP growth in order to accelerate real economic growth without breaching the 3% inflation target? Once again, the answer is that real GDP growth can be accelerated only as long as sufficient slack remains in an economy with less than full employment so that accelerating spending growth does not result in shortages of labor or intermediate products. Once shortages emerge, wages or prices of products in short supply must be raised to allocate resources efficiently and to prevent shortages from causing production breakdowns.

Burns might have pulled off a remarkable feat by ensuring Nixon’s re-election in 1972 with a massive monetary stimulus causing the fastest increase in nominal real GDP since the Korean War in Q4 of 1972, while wage-and-price controls ensured that the monetary stimulus would be channeled into increased output rather than accelerating inflation. But that strategy was viable only while sufficient slack remained to allow additional spending to call forth further increases in output rather than cause either price increases, or, if wages and prices are subject to binding controls, shortages of supply. Early in 1973, as inflation began to increase and real GDP growth began to diminish, the time to slow down monetary expansion had arrived. But Burns was insensible to the obvious change in conditions.

Here is where we need to focus the discussion directly on Hawtrey’s book Incomes and Money. By the time Hawtrey wrote this book – his last — at the age of 87, he had long been eclipsed not only in the public eye, but in the economics profession, by his slightly younger contemporary and fellow Cambridge graduate, J. M. Keynes. For a while in the 1920s, Hawtrey might have been the more influential of the two, but after The General Theory was published, Hawtrey was increasingly marginalized as new students no longer studied Hawtrey’s writing, while older economists, who still remembered Hawtrey and were familiar with his work, gradually left the scene. Moreover, as a civil servant for most of his career, Hawtrey never collected around himself a group disciples who, because they themselves had a personal stake in the ideas of their mentor, would carry on and propagate those ideas. By the end of World War II, Hawtrey was largely unknown to younger economists.

As a graduate student in the early 1970s, Hawtrey’s name came only occasionally to my attention, mostly in the context of his having been a notable pre-Keynesian monetary theorist whose ideas were of interest mainly to historians of thought. My most notable recollection relating to Hawtrey was that in a conversation with Hayek, whose specific context I no longer recall, Hayek mentioned Hawtrey to me as an economist whose work had been unduly neglected and whose importance was insufficiently recognized, even while acknowledging that he himself had written critically about what he regarded as Hawtrey’s overemphasis on changes in the value of money as the chief cause of business-cycle fluctuations.

It was probably because I remembered that recommendation that when I was in Manhattan years later and happened upon a brand new copy of Incomes and Money on sale in a Barnes and Noble bookstore, I picked it up and bought it. But buying it on the strength of Hayek’s recommendation didn’t lead me to actually read it. I actually can’t remember when I finally did read the book, but it was likely not until after I discovered that Hawtrey had anticipated the gold-appreciation theory of the Great Depression that I had first heard, as a graduate student, from Earl Thompson.

In Incomes and Money, Hawtrey focused not on the Great Depression, which he notably had discussed in earlier books like The Gold Standard and The Art of Central Banking, but on the experience of Great Britain after World War II. That experience was conditioned on the transition from the wartime controls under which Britain had operated in World War II to the partial peacetime decontrol under the Labour government that assumed power at the close of World War II. One feature of wartime controls was that, owing to the shortages and rationing caused by price controls, substantial unwanted holdings of cash were accumulating in the hands of individuals unable to use their cash to purchase desired goods and services.

The US dollar and the British pound were then the two primary currencies used in international trade, but as long as products were in short supply because of price controls, neither currency could serve as an effective medium of exchange for international transactions, which were largely conducted via managed exchange or barter between governments. After the war, the US moved quickly to decontrol prices, allowing prices to rise sufficiently to eliminate excess cash, thereby enabling the dollar to again function as an international medium of exchange and creating a ready demand to hold dollar balances outside the US. The Labour government being ideologically unwilling to scrap price controls, excess holdings of pounds within Britain could only be disposed of insofar as they could be exchanged for dollars with which products could be procured from abroad.

There was therefore intense British demand for dollars but little or no American demand for pounds, an imbalance reflected in a mounting balance-of-payments deficit. The balance-of-payments deficit was misunderstood and misinterpreted as an indication that British products were uncompetitive, British production costs (owing to excessive British wages) supposedly being too high to allow the British products to be competitive in international markets. If British production costs were excessive, then the appropriate remedy was either to cut British wages or to devalue the pound to reduce the real wages paid to British workers. But Hawtrey maintained that the balance-of-payments deficit was a purely monetary phenomenon — an excess supply of pounds and an excess demand for dollars — that could properly be remedied either by withdrawing excess pounds from the holdings of the British public or by decontrolling prices so that excess pounds could be used to buy desired goods and services at market-clearing prices.

Thus, almost two decades before the Monetary Approach to the Balance of Payments was developed by Harry Johnson, Robert Mundell and associates, Hawtrey had already in the 1940s anticipated its principal conclusion that a chronic balance-of-payments disequilibrium results from a monetary policy that creates either more or less cash than the public wishes to hold rather than a disequilibrium in its exchange rate. If so, the remedy for the disequilibrium is not a change in the exchange rate, but a change in monetary policy.

In his preface to Incomes and Money, Hawtrey set forth the main outlines of his argument.

This book is primarily a criticism of British monetary policy since 1945, along with an application of the criticism to questions of future policy.

The aims of policy were indicated to the Radcliffe Committee in 1957 in a paper on Monetary Policy and the Control of Economic Conditions: “The primary object of policy has been to combine a high and stable level of employment with a satisfactory state of the balance of payments”. When Sir Robert Hall was giving oral evidence on behalf of the Treasury, Lord Radcliffe asked, ”Where does sound money as an objective stand?” The reply was that “there may well be a conflict between the objective of high employment and the objective of sound money”, a dilemma which Treasury did not claim to have solved.

Sound money here meant price stability, and Sir Robert Hall admitted that “there has been a practically continuous rise in the price level. The rise in prices of manufactures since 1949 had in fact been 40 percent. The wage level had risen 70 percent.

Government pronouncements ever since 1944 had repeatedly insisted that wages ought not to rise more than in proportion to productivity. This formula meaning in effect price level of home production, embodies the incomes policy which is now professed by all parties. But it has never been enforced through monetary policy. It has only been enjoined by exhortation and persuasion. (p. ix)

The lack of commitment to a policy of stabilizing the price level was the key point for Hawtrey. If policy makers desired to control the rise in the price level by controlling the increase in incomes, they could, in Hawtrey’s view, only do so by way of a monetary policy whose goal was to keep total spending (and hence total income) at a level – or on a path – that was consistent with the price-level objective that policy-makers were aiming for. If there was also a goal of full employment, then the full-employment goal could be achieved only insofar as the wage rates arrived at in bargaining between labor and management were consistent with the targeted level of spending and income.

Incomes policy and monetary policy cannot be separated. Monetary policy includes all those measures by which the flow of money can be accelerated or retarded, and it is by them that the money value of a given structure of incomes is determined. If monetary policy is directed by some other criterion than the desired incomes policy, the income policy gives way to the other criterion. In particular, if monetary policy is directed to maintaining the money unit at a prescribed exchange rate parity, the level of incomes will adapt itself to this parity and not to the desired policy.

When the exchange parity of sterling was fixed in 1949 at $2.80, the pound had already been undervalued at the previous rate of $4.03. The British wage level was tied by the rate of exchange to the American. The level of incomes was predetermined, and there was no way for an incomes policy to depart from it. Economic forces came into operation to correct the undervaluation by an increase in the wage level. . . .

It was a paradox that the devaluation, which had been intended as a remedy for an adverse balance of payments, induced an inflation which was liable itself to cause an adverse balance. The undervaluation did indeed swell the demand for British exports, but when production passed the limit of capacity, and output could not be further increased, the monetary expansion continued by its own momentum. Demand expanded beyond output and attracted an excess of imports. There was no dilemma, because the employment situation and the balance of payments situation both required the same treatment, a monetary contraction. The contraction would not cause unemployment, provided it went no further than to eliminate over-employment.

The White Paper of 1956 on the Economic Implications of Full Employment, while confirming the Incomes Policy of price stabilization, placed definitely on the Government the responsibility for regulating the pressure of demand through “fiscal, monetary and social policies”. The Radcliffe Committee obtained from the Treasury the admission that this was not being done. No measures other than persuasion and exhortation were being taken to give effect to the incomes policy. Reluctant as the authorities were to resort to deflation, they nevertheless imposed a Bank rate of 7 per cent and other contractive measures to cope with a balance of payments crisis at the very moment when the Treasury representative were appearing before the Committee. But that did not mean that they were prepared to pursue a contractive policy in support of the incomes policy. The crises of 1957 and 1961 were no more than episodes, temporarily interfering with the policy of easy credit and expansion. The crisis of 1964-6 has been more than an episode, only because the deflationary measures were long delayed, and when taken, were half-hearted.

It would be unfair to impute the entire responsibility for these faults of policy to Ministers. They are guided by their advisers, and they can plead in their defence that their misconceptions have been shared by the vast majority of economists. . . .

The fault of traditional monetary theory has been that it is static, and that is still true of Keynes’s theory. But a peculiarity of monetary policy is that, whenever practical measures have to be taken, the situation is always one of transition, when the conditions of static equilibrium have been departed from. The task of policy is to decide the best way to get back to equilibrium, and very likely to choose which of several alternative equilibrium positions to aim at. . . .

An incomes policy, or a wages policy, is the indispensable means of stabilizing the money unit when an independent metallic standard has failed us. Such a policy can only be given effect by a regulation of credit. The world has had long experience of the regulation of credit for the maintenance of a metallic standard. Maintenance of a wages standard requires the same instruments but will be more exacting because it will be guided by many symptoms instead of exclusively by movements of gold, and because it will require unremitting vigilance instead of occasional interference. (pp. ix-xii)

The confusion identified by Hawtrey between an incomes policy aiming at achieving a level of income consistent with full employment at a given level of wages by the appropriate conduct of monetary policy and an incomes policy aiming at the direct control of wages was precisely the confusion that led to the consistent failure of British monetary policy after World War II and to the failure of Arthur Burns. The essence of an incomes policy was to control total spending by way of monetary policy while gaining the cooperation of labor unions and business to prevent wage increases that would be inconsistent with full employment at the targeted level of income. Only monetary policy could determine the level of income, and the only role of exhortation and persuasion or direct controls was to prevent excessive wage increases that would prevent full employment from being achieved at the targeted income level.

After the 1949 devaluation, the Labour government appealed to the labour unions, its chief constituency, not to demand wage increases larger than productivity increases, so that British exporters could maintain the competitive advantage provided them by devaluation. Understanding the protectionist motive for devaluation was to undervalue the pound with a view to promoting exports and discouraging imports, Hawtrey also explained why the protectionist goal had been subverted by the low interest-rate, expansionary monetary policy of the Labour government to keep unemployment well below 2 percent.

British wages rose therefore not only because the pound was undervalued, but because monetary expansion increased aggregate demand faster than the British productive capacity was increasing, adding further upward pressure on British wages and labor costs. Excess aggregate demand in Britain also meant that domestic output that might have been exported was instead sold to domestic customers, while drawing imports to satisfy the unmet demands of domestic consumers, so that the British trade balance showed little improvement notwithstanding a 40% devaluation.

In this analysis, Hawtrey anticipated Max Corden’s theory of exchange-rate protection in identifying the essential mechanism by which to manipulate a nominal exchange rate so as to subsidize the tradable-goods sector (domestic export industries and domestic import-competing industries) as a tight-money policy that creates an excess demand for cash, thereby forcing the public to reduce spending as they try to accumulate the desired increases in cash holdings. The reduced demand for home production as spending is reduced results in a shift of productive resources from the non-tradable- to the tradable-goods sector.

To sum up, what Burns might have learned from Hawtrey was that even if some form of control of wages was essential for maintaining full employment in an economic environment in which strong labor unions could bargain effectively with employers, that control over wages did not — and could not — free the central bank from its responsibility to control aggregate demand and the growth of total spending and income.

Friedman and Schwartz, Eichengreen and Temin, Hawtrey and Cassel

Barry Eichengreen and Peter Temin are two of the great economic historians of our time, writing, in the splendid tradition of Charles Kindleberger, profound and economically acute studies of the economic and financial history of the nineteenth and early twentieth centuries. Most notably they have focused on periods of panic, crisis and depression, of which by far the best-known and most important episode is the Great Depression that started late in 1929, bottomed out early in 1933, but lingered on for most of the 1930s, and they are rightly acclaimed for having emphasized and highlighted the critical role of the gold standard in the Great Depression, a role largely overlooked in the early Keynesian accounts of the Great Depression. Those accounts identified a variety of specific shocks, amplified by the volatile entrepreneurial expectations and animal spirits that drive, or dampen, business investment, and further exacerbated by inherent instabilities in market economies that lack self-stabilizing mechanisms for maintaining or restoring full employment.

That Keynesian vision of an unstable market economy vulnerable to episodic, but prolonged, lapses from full-employment was vigorously, but at first unsuccessfully, disputed by advocates of free-market economics. It wasn’t until Milton Friedman provided an alternative narrative explaining the depth and duration of the Great Depression, that the post-war dominance of Keynesian theory among academic economists seriously challenged. Friedman’s alternative narrative of the Great Depression was first laid out in the longest chapter (“The Great Contraction”) of his magnum opus, co-authored with Anna Schwartz, A Monetary History of the United States. In Friedman’s telling, the decline in the US money stock was the critical independent causal factor that directly led to the decline in prices, output, and employment. The contraction in the quantity of money was not caused by the inherent instability of free-market capitalism, but, owing to a combination of incompetence and dereliction of duty, by the Federal Reserve.

In the Monetary History of the United States, all the heavy lifting necessary to account for both secular and cyclical movements in the price level, output and employment is done by, supposedly exogenous, changes in the nominal quantity of money, Friedman having considered it to be of the utmost significance that the largest movements in both the quantity of money, and in prices, output and employment occurred during the Great Depression. The narrative arc of the Monetary History was designed to impress on the mind of the reader the axiomatic premise that monetary authority has virtually absolute control over the quantity of money which served as the basis for inferring that changes in the quantity of money are what cause changes in prices, output and employment.

Friedman’s treatment of the gold standard (which I have discussed here, here and here) was both perfunctory and theoretically confused. Unable to reconcile the notion that the monetary authority has absolute control over the nominal quantity of money with the proposition that the price level in any country on the gold standard cannot deviate from the price levels of other gold standard countries without triggering arbitrage transactions that restore the equality between the price levels of all gold standard countries, Friedman dodged the inconsistency repeatedly invoking his favorite fudge factor: long and variable lags between changes in the quantity of money and changes in prices, output and employment. Despite its vacuity, the long-and-variable-lag dodge allowed Friedman to ignore the inconvenient fact that the US price level in the Great Depression did not and could not vary independently of the price levels of all other countries then on the gold standard.

I’ll note parenthetically that Keynes himself was also responsible for this unnecessary and distracting detour, because the General Theory was written almost entirely in the context of a closed economy model with an exogenously determined quantity of money, thereby unwittingly providing with a useful tool with which to propagate his Monetarist narrative. The difference of course is that Keynes, as demonstrated in his brilliant early works, Indian Currency and Finance and A Tract on Monetary Reform and the Economic Consequences of Mr. Churchill, had a correct understanding of the basic theory of the gold standard, an understanding that, owing to his obsessive fixation on the nominal quantity of money, eluded Friedman over his whole career. Why Keynes, who had a perfectly good theory of what was happening in the Great Depression available to him, as it was to others, was diverted to an unnecessary, but not uninteresting, new theory is a topic that I wrote about a very long time ago here, though I’m not so sure that I came up with a good or even adequate explanation.

So it does not speak well of the economics profession that it took nearly a quarter of a century before the basic internal inconsistency underlying Friedman’s account of the Great Depression was sufficiently recognized to call for an alternative theoretical account of the Great Depression that placed the gold standard at the heart of the narrative. It was Peter Temin and Barry Eichengreen, both in their own separate works (e.g., Lessons of the Great Depression by Temin and Golden Fetters by Eichengreen) and in an important paper they co-authored and published in 2000 to remind both economists and historians how important a role the gold standard must play in any historical account of the Great Depression.

All credit is due to Temin and Eichengreen for having brought to the critical role of the gold standard in the Great Depression to the attention of economists who had largely derived their understanding of what had caused the Great Depression from either some variant of the Keynesian narrative or of Friedman’s Monetarist indictment of the Federal Reserve System. But it’s unfortunate that neither Temin nor Eichnegreen gave sufficient credit to either R. G. Hawtrey or to Gustav Cassel for having anticipated almost all of their key findings about the causes of the Great Depression. And I think that what prevented Eichengreen and Temin from realizing that Hawtrey in particular had anticipated their explanation of the Great Depression by more than half a century was that they did not fully grasp the key theoretical insight underlying Hawtrey’s explanation of the Great Depression.

That insight was that the key to understanding the common world price level in terms of gold under a gold standard is to think in terms of a given world stock of gold and to think of total world demand to hold gold consisting of real demands to hold gold for commercial, industrial and decorative uses, the private demand to hold gold as an asset, and the monetary demand for gold to be held either as a currency or as a reserve for currency. The combined demand to hold gold for all such purposes, given the existing stock of gold, determines a real relative price of gold in terms of all other commodities. This relative price when expressed in terms of a currency unit that is convertible into gold corresponds to an equivalent set of commodity prices in terms of those convertible currency units.

This way of thinking about the world price level under the gold standard was what underlay Hawtrey’s monetary analysis and his application of that analysis in explaining the Great Depression. Given that the world output of gold in any year is generally only about 2 or 3 percent of the existing stock of gold, it is fluctuations in the demand for gold, of which the monetary demand for gold in the period after the outbreak of World War I was clearly the least stable, that causes short-term fluctuations in the value of gold. Hawtrey’s efforts after the end of World War I were therefore focused on the necessity to stabilize the world’s monetary demands for gold in order to avoid fluctuations in the value of gold as the world moved toward the restoration of the gold standard that then seemed, to most monetary and financial experts and most monetary authorities and political leaders, to be both inevitable and desirable.

In the opening pages of Golden Fetters, Eichengreen beautifully describes backdrop against which the attempt to reconstitute the gold standard was about to made after World War I.

For more than a quarter of a century before World War I, the gold standard provided the framework for domestic and international monetary relations. . .  The gold standard had been a remarkably efficient mechanism for organizing financial affairs. No global crises comparable to the one that began in 1929 had disrupted the operation of financial markets. No economic slump had so depressed output and employment.

The central elements of this system were shattered by . . . World War I. More than a decade was required to complete their reconstruction. Quickly it became evident that the reconstructed gold standard was less resilient that its prewar predecessor. As early as 1929 the new international monetary system began to crumble. Rapid deflation forced countries to  producing primary commodities to suspend gold convertibility and depreciate their currencies. Payments problems spread next to the industrialized world. . . Britain, along with United State and France, one of the countries at the center of the international monetary system, was next to experience a crisis, abandoning the gold standard in the autumn of 1931. Some two dozen countries followed suit. The United States dropped the gold standard in 1933; France hung on till the bitter end, which came in 1936.

The collapse of the international monetary system is commonly indicted for triggering the financial crisis that transformed a modes economic downturn gold standard into an unprecedented slump. So long as the gold standard was maintained, it is argued, the post-1929 recession remained just another cyclical contraction. But the collapse of the gold standard destroyed confidence in financial stability, prompting capital flight which undermined the solvency of financial institutions. . . Removing the gold standard, the argument continues, further intensified the crisis. Having suspended gold convertibility, policymakers manipulated currencies, engaging in beggar thy neighbor depreciations that purportedly did nothing to stimulate economic recovery at home while only worsening the Depression abroad.

The gold standard, then, is conventionally portrayed as synonymous with financial stability. Its downfall starting in 1929 is implicated in the global financial crisis and the worldwide depression. A central message of this book is that precisely the opposite was true. (Golden Fetters, pp. 3-4).

That is about as clear and succinct and accurate a description of the basic facts leading up to and surrounding the Great Depression as one could ask for, save for the omission of one important causal factor: the world monetary demand for gold.

Eichengreen was certainly not unaware of the importance of the monetary demand for gold, and in the pages that immediately follow, he attempts to fill in that part of the story, adding to our understanding of how the gold standard worked by penetrating deeply into the nature and role of the expectations that supported the gold standard, during its heyday, and the difficulty of restoring those stabilizing expectations after the havoc of World War I and the unexpected post-war inflation and subsequent deep 1920-21 depression. Those stabilizing expectations, Eichengreen argued, were the result of the credibility of the commitment to the gold standard and the international cooperation between governments and monetary authorities to ensure that the international gold standard would be maintained notwithstanding the occasional stresses and strains to which a complex institution would inevitably be subjected.

The stability of the prewar gold standard was instead the result of two very different factors: credibility and cooperation. Credibility is the confidence invested by the public in the government’s commitment to a policy. The credibility of the gold standard derived from the priority attached by governments to the maintenance of to the maintenance of balance-of-payments equilibrium. In the core countries – Britain, France and Germany – there was little doubt that the authorities would take whatever steps were required to defend the central bank’s gold reserves and maintain the convertibility of the currency into gold. If one of these central banks lost gold reserves and its exchange rate weakened, fund would flow in from abroad in anticipation of the capital gains investors in domestic assets would reap once the authorities adopted measures to stem reserve losses and strengthen the exchange rate. . . The exchange rate consequently strengthened on its own, and stabilizing capital flows minimized the need for government intervention. The very credibility of the official commitment to gold meant that this commitment was rarely tested. (p. 5)

But credibility also required cooperation among the various countries on the gold standard, especially the major countries at its center, of which Britain was the most important.

Ultimately, however, the credibility of the prewar gold standard rested on international cooperation. When the stabilizing speculation and domestic intervention proved incapable of accommodating a disturbance, the system was stabilized through cooperation among governments and central banks. Minor problems could be solved by tacit cooperation, generally achieved without open communication among the parties involved. . .  Under such circumstances, the most prominent central bank, the Bank of England, signaled the need for coordinated action. When it lowered its discount rate, other central banks usually responded in kind. In effect, the Bank of England provided a focal point for the harmonization of national monetary policies. . .

Major crises in contrast typically required different responses from different countries. The country losing gold and threatened by a convertibility crisis had to raise interest rates to attract funds from abroad; other countries had to loosen domestic credit conditions to make funds available to the central bank experiencing difficulties. The follow-the-leader approach did not suffice. . . . Such crises were instead contained through overt, conscious cooperation among central banks and governments. . . Consequently, the resources any one country could draw on when its gold parity was under attack far exceeded its own reserves; they included the resources of the other gold standard countries. . . .

What rendered the commitment to the gold standard credible, then, was that the commitment was international, not merely national. That commitment was achieved through international cooperation. (pp. 7-8)

Eichengreen uses this excellent conceptual framework to explain the dysfunction of the newly restored gold standard in the 1920s. Because of the monetary dislocation and demonetization of gold during World War I, the value of gold had fallen to about half of its prewar level, thus to reestablish the gold standard required not only restoring gold as a currency standard but also readjusting – sometimes massively — the prewar relative values of the various national currency units. And to prevent the natural tendency of gold to revert to its prewar value as gold was remonetized would require an unprecedented level of international cooperation among the various countries as they restored the gold standard. Thus, the gold standard was being restored in the 1920s under conditions in which neither the credibility of the prewar commitment to the gold standard nor the level of international cooperation among countries necessary to sustain that commitment was restored.

An important further contribution that Eichengreen, following Temin, brings to the historical narrative of the Great Depression is to incorporate the political forces that affected and often determined the decisions of policy makers directly into the narrative rather than treat those decisions as being somehow exogenous to the purely economic forces that were controlling the unfolding catastrophe.

The connection between domestic politics and international economics is at the center of this book. The stability of the prewar gold standard was attributable to a particular constellation of political as well as economic forces. Similarly, the instability of the interwar gold standard is explicable in terms of political as well as economic changes. Politics enters at two levels. First, domestic political pressures influence governments’ choices of international economic policies. Second, domestic political pressures influence the credibility of governments’ commitments to policies and hence their economic effects. . . (p. 10)

The argument, in a nutshell, is that credibility and cooperation were central to the smooth operation of the classical gold standard. The scope for both declined abruptly with the intervention of World War I. The instability of the interwar gold standard was the inevitable result. (p. 11)

Having explained and focused attention on the necessity for credibility and cooperation for a gold standard to function smoothly, Eichengreen then begins his introductory account of how the lack of credibility and cooperation led to the breakdown of the gold standard that precipitated the Great Depression, starting with the structural shift after World War I that made the rest of the world highly dependent on the US as a source of goods and services and as a source of credit, rendering the rest of the world chronically disposed to run balance-of-payments deficits with the US, deficits that could be financed only by the extension of credit by the US.

[I]f U.S. lending were interrupted, the underlying weakness of other countries’ external positions . . . would be revealed. As they lost gold and foreign exchange reserves, the convertibility of their currencies into gold would be threatened. Their central banks would be forced to  restrict domestic credit, their fiscal authorities to compress public spending, even if doing so threatened to plunge their economies into recession.

This is what happened when U.S. lending was curtailed in the summer of 1928 as a result of increasingly stringent Federal Reserve monetary policy. Inauspiciously, the monetary contraction in the United States coincided with a massive flow of gold to France, where monetary policy was tight for independent reasons. Thus, gold and financial capital were drained by the United States and France from other parts of the world. Superimposed on already weak foreign balances of payments, these events provoked a greatly magnified monetary contraction abroad. In addition they caused a tightening of fiscal policies in parts of Europe and much of Latin America. This shift in policy worldwide, and not merely the relatively modest shift in the United States, provided the contractionary impulse that set the stage for the 1929 downturn. The minor shift in American policy had such dramatic effects because of the foreign reaction it provoked through its interactions with existing imbalances in the pattern of international settlements and with the gold standard constraints. (pp. 12-13)

Eichengreen then makes a rather bold statement, with which, despite my agreement with, and admiration for, everything he has written to this point, I would take exception.

This explanation for the onset of the Depression, which emphasizes concurrent shifts in economic policy in the Unites States and abroad, the gold standard as the connection between them, and the combined impact of U.S. and foreign economic policies on the level of activity, has not previously appeared in the literature. Its elements are familiar, but they have not been fit together into a coherent account of the causes of the 1929 downturn. (p. 13)

I don’t think that Eichengreen’s claim of priority for his explanation of the onset of the 1929 downturn can be defended, though I certainly wouldn’t suggest that he did not arrive at his understanding of what caused the Great Depression largely on his own. But it is abundantly clear from reading the writings of Hawtrey and Cassel starting as early as 1919, that the basic scenario outlined by Eichengreen was clearly spelled out by Hawtrey and Cassel well before the Great Depression started, as papers by Ron Batchelder and me and by Doug Irwin have thoroughly documented. Undoubtedly Eichengreen has added a great deal of additional insight and depth and done important quantitative and documentary empirical research to buttress his narrative account of the causes of the Great Depression, but the basic underlying theory has not changed.

Eichengreen is not unaware of Hawtrey’s contribution and in a footnote to the last quoted paragraph, Eichengreen writes as follows.

The closest precedents lie in the work of the British economists Lionel Robbins and Ralph Hawtrey, in the writings of German historians concerned with the causes of their economy’s precocious slump, and in Temin (1989). Robbins (1934) hinted at many of the mechanism emphasized here but failed to develop the argument fully. Hawtrey emphasized how the contractionary shift in U.S. monetary policy, superimposed on an already weak British balance of payments position, forced a draconian contraction on the Bank of England, plunging the world into recession. See Hawtrey (1933), especially chapter 2. But Hawtrey’s account focused almost entirely on the United States and the United Kingdom, neglecting the reaction of other central banks, notably the Bank of France, whose role was equally important. (p. 13, n. 17)

Unfortunately, this footnote neither clarifies nor supports Eichengreen’s claim of priority for his account of the role of the gold standard in the Great Depression. First, the bare citation of Robbins’s 1934 book The Great Depression is confusing at best, because Robbins’s explanation of the cause of the Great Depression, which he himself later disavowed, is largely a recapitulation of the Austrian business-cycle theory that attributed the downturn to a crisis caused by monetary expansion by the Fed and the Bank of England. Eichengreen correctly credits Hawtrey for attributing the Great Depression, in almost diametric opposition to Robbins, to contractionary monetary policy by the Fed and the Bank of England, but then seeks to distinguish Hawtrey’s explanation from his own by suggesting that Hawtrey neglected the role of the Bank of France.

Eichengreen mentions Hawtrey’s account of the Great Depression in his 1933 book, Trade Depression and the Way Out, 2nd edition. I no longer have a copy of that work accessible to me, but in the first edition of this work published in 1931, Hawtrey included a brief section under the heading “The Demand for Gold as Money since 1914.”

[S]ince 1914 arbitrary changes in monetary policy and in the demand for gold as money have been greater and more numerous than ever before. Frist came the general abandonment of the gold standard by the belligerent countries in favour of inconvertible paper, and the release of hundreds of millions of gold. By 1920 the wealth value of gold had fallen to two-fifths of what it had been in 1913. The United States, which was almost alone at that time in maintaining a gold standard, thereupon started contracting credit and absorbing gold on a vast scale. In June 1924 the wealth value of gold was seventy per cent higher than at its lowest point in 1920, and the amount of gold held for monetary purposes in the United States had grown from $2,840,000,000 in 1920 to $4,488,000,000.

Other countries were then beginning to return to the gold standard, Gemany in 1924, England in 1925, besides several of the smaller countries of Europe. In the years 1924-8 Germany absorbed over £100,000,000 of gold. France stabilized her currency in 1927 and re-established the gold standard in 1928, and absorbed over £60,000,000 in 1927-8. But meanwhile, the Unitd States had been parting with gold freely and her holding had fallen to $4,109,000,000 in June 1928. Large as these movements had been, they had not seriously disturbed the world value of gold. . . .

But from 1929 to the present time has been a period of immense and disastrous instability. France has added more than £200,000,000 to her gold holding, and the United Statesmore than $800,000,000. In the two and a half years the world’s gold output has been a little over £200,000,000, but a part of this been required for the normal demands of industry. The gold absorbed by France and America has exceeded the fresh supply of gold for monetary purposes by some £200,000,000.

This has had to be wrung from other countries, and much o of it has come from new countries such as Australia, Argentina and Brazil, which have been driven off the gold standard and have used their gold reserves to pay their external liabilities, such as interest on loans payable in foreign currencies. (pp. 20-21)

The idea that Hawtrey neglected the role of the Bank of France is clearly inconsistent with the work that Eichengreen himself cites as evidence for that neglect. Moreover in Hawtrey’s 1932 work, The Art of Central Banking, his first chapter is entitled “French Monetary Policy” which directly addresses the issues supposedly neglected by Hawtrey. Here is an example.

I am inclined therefore to say that while the French absorption of gold in the period from January 1929 to May 1931 was in fact one of the most powerful causes of the world depression, that is only because it was allowed to react an unnecessary degree upon the monetary policy of other countries. (p. 38)

In his foreward to the 1962 reprinting of his volume, Hawtrey mentions his chapter on French Monetary Policy in a section under the heading “Gold and the Great Depression.”

Conspicuous among countries accumulating reserves foreign exchange was France. Chapter 1 of this book records how, in the course of stabilizing the franc in the years 1926-8, the Bank of France accumulated a vast holding of foreign exchange [i.e., foreign bank liabilities payable in gold], and in the ensuing years proceeded to liquidate it [for gold]. Chapter IV . . . shows the bearing of the French absorption of gold upon the starting of the great depression of the 1930s. . . . The catastrophe foreseen in 1922 [!] had come to pass, and the moment had come to point to the moral. The disaster was due to the restoration of the gold standard without any provision for international cooperation to prevent undue fluctuations in the purchasing power of gold. (pp. xiv-xv)

Moreover, on p. 254 of Golden Fetters, Eichengreen himself cites Hawtrey as one of the “foreign critics” of Emile Moreau, Governor of the Bank of France during the 1920s and 1930s “for failing to build “a structure of credit” on their gold imports. By failing to expand domestic credit and to repel gold inflows, they argued, the French had violated the rules of the gold standard game.” In the same paragraph Eichengreen also cites Hawtrey’s recommendation that the Bank of France change its statutes to allow for the creation of domestically supplied money and credit that would have obviated the need for continuing imports of gold.

Finally, writers such as Clark Johnson and Kenneth Mouré, who have written widely respected works on French monetary policy during the 1920s and 1930s, cite Hawtrey extensively as one of the leading contemporary critics of French monetary policy.

PS I showed Barry Eichengreen a draft of this post a short while ago, and he agrees with my conclusion that Hawtrey, and presumably Cassel also, had anticipated the key elements of his explanation of how the breakdown of the gold standard, resulting largely from the breakdown of international cooperation, was the primary cause of the Great Depression. I am grateful to Barry for his quick and generous response to my query.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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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