Archive for the 'R. G. Hawtrey' Category

The Demise of Bretton Woods Fifty Years On

Today, Sunday, August 15, 2021, marks the 50th anniversary of the closing of the gold window at the US Treasury, at which a small set of privileged entities were at least legally entitled to demand redemption of dollar claims issued by the US government at the official gold price of $35 an ounce. (In 1971, as in 2021, August 15 fell on a Sunday.) When I started blogging in July 2011, I wrote one of my early posts about the 40th anniversary of that inauspicious event. My attention in that post was directed more at the horrific consequences of Nixon’s decision to combine a freeze on wages and price with the closing of the gold window, which was clearly far more damaging than the largely symbolic effect of closing the gold window. I am also re-upping my original post with some further comments, but in this post, my attention is directed solely on the closing of the gold window.

The advent of cryptocurrencies and the continuing agitprop aiming to restore the gold standard apparently suggest to some people that the intrinsically trivial decision to do away with the final vestige of the last remnant of the short-lived international gold standard is somehow laden with cosmic significance. See for example the new book by Jeffrey Garten (Three Days at Camp David) marking the 50th anniversary.

About 10 years before the gold window was closed, Milton Friedman gave a lecture at the Mont Pelerin Society which he called “Real and Pseudo-Gold Standards“, which I previously wrote about here. Many if not most of the older members of the Mont Pelerin Society, notably (L. v. Mises and Jacques Rueff) were die-hard supporters of the gold standard who regarded the Bretton Woods system as a deplorable counterfeit imitation of the real gold standard and longed for restoration of that old-time standard. In his lecture, Friedman bowed in their direction by faintly praising what he called a real gold standard, which he described as a state of affairs in which the quantity of money could be increased only by minting gold or by exchanging gold for banknotes representing an equivalent value of gold. Friedman argued that although a real gold standard was an admirable monetary system, the Bretton Woods system was nothing of the sort, calling it a pseudo-gold standard. Given that the then existing Bretton Woods system was not a real gold standard, but merely a system of artificially controlling the price of a particular commodity, Friedman argued that the next-best alternative would be to impose a quantitative limit on the increase in the quantity of fiat money, by enacting a law that would prohibit the quantity of money from growing by more than some prescribed amount or by some percentage (k-percent per year) of the existing stock percent in any given time period.

While failing to win over the die-hard supporters of the gold standard, Friedman’s gambit was remarkably successful, and for many years, it actually was the rule of choice among most like-minded libertarians and self-styled classical liberals and small-government conservatives. Eventually, the underlying theoretical and practical defects in Friedman’s k-percent rule became sufficiently obvious to cause even Friedman, however reluctantly, to abandon his single-minded quest for a supposedly automatic non-discretionary quantitative monetary rule.

Nevertheless, Friedman ultimately did succeed in undermining support among most right-wing conservative, libertarian and many centrist or left-leaning economists and decision makers for the Bretton Woods system of fixed, but adjustable, exchange rates anchored by a fixed dollar price of gold. And a major reason for his success was his argument that it was only by shifting to flexible exchange rates and abandoning a fixed gold price that the exchange controls and restrictions on capital movements that were in place for a quarter of a century after World Was II could be lifted, a rationale congenial and persuasive to many who might have otherwise been unwilling to experiment with a system of flexible exchange rates among fiat currencies that had never previously been implemented.

Indeed, the neoliberal economic and financial globalization that followed the closing of the gold window and freeing of exchange rates after the demise of the Bretton Woods system, whether one applauds or reviles it, can largely be attributed to Friedman’s influence both as an economic theorist and as a propagandist. As much as Friedman deplored the imposition of wage and price controls on August 15, 1971, he had reason to feel vindicated by the closing of the gold window, the freeing of exchange rates, and, eventually, the lifting of all capital controls and the legalization of gold ownership by private individuals, all of which followed from the Camp David meeting.

But, the objective economic situation confronted by those at Camp David was such that the Bretton Woods System could not be salvaged. As I wrote in my 2011 post, the Bretton Woods system built on the foundation of a fixed gold price of $35 an ounce was not a true gold standard because a free market in gold did not exist and could not be maintained at the official price. Trade in gold was sharply restricted, and only privileged central banks and governments were legally entitled to buy or sell gold at the official price. Even the formal right of the privileged foreign governments and central banks was subject to the informal, but unwelcome and potentially dangerous, disapproval of the United States.

The gold standard is predicated on the idea that gold has an ascertainable value, so that if money is made exchangeable for gold at a fixed rate, money and gold will have an identical value owing to arbitrage transactions. Such arbitrage transactions can occur only if, and so long as, no barriers prevent effective arbitrage. The unquestioned convertibility of a unit of currency into gold ensured that arbitrage would constrain the value of money to equal the value of gold. But under Bretton Woods the opportunities for arbitrage were so drastically limited that the value of the dollar was never clearly equal to the value of gold, which was governed by, pardon the expression, fiat rather than by free-market transactions.

The lack of a tight link between the value of gold and the value of the dollar was not a serious problem as long as the value of the dollar was kept essentially stable and there was a functioning (albeit not freely) gold market. After its closure during World War II, the gold market did not function at all until 1954, so the wartime and postwar inflation and the brief Korean War inflation did not undermine the official gold price of $35 an ounce that had been set in 1934 and was maintained under Bretton Woods. Even after a functioning, but not entirely free, gold market was reopened in 1954, the official price was easily sustained until the late 1960s thanks to central-bank cooperation, whose formalization through the International Monetary Fund (IMF) was one of the positive achievements of Bretton Woods. The London gold price was hardly a free-market price, because of central bank intervention and restrictions imposed on access to the market, but the gold holdings of the central banks were so large that it had always been in their power to control the market price if they were sufficiently determined to do so. But over the course of the 1960s, their cohesion gradually came undone. Why was that?

The first point to note is that the gold standard evolved over the course of the eighteenth and nineteenth centuries first as a British institution, and much later as an international institution, largely by accident from a system of simultaneous gold and silver coinages that were closely but imperfectly linked by a relative price of between 15 to 16 ounces of silver per ounce of gold. Depending on the precise legal price ratio of silver coins to gold coins in any particular country, the legally overvalued undervalued metal would flow out of that country and the undervalued overvalued metal would flow into that country.

When Britain undervalued gold at the turn of the 18th century, gold flowed into Britain, leading to the birth of the British of gold standard. In most other countries, silver and gold coins were circulating simultaneously at a ratio of 15.5 ounces of silver per ounce of gold. It was only when the US, after the Civil War, formally adopted a gold standard and the newly formed German Reich also shifted from a bimetallic to a gold standard that the increased demand for gold caused gold to appreciate relative to silver. To avoid the resulting inflation, countries with bimetallic systems based on a 15.5 to 1 silver/gold suspended the free coinage of silver and shifted to the gold standard further raising the silver/gold price ratio. Thus, the gold standard became an international not just a British system only in the 1870s, and it happened not by design or international consensus but by a series of piecemeal decisions by individual countries.

The important takeaway from this short digression into monetary history is that the relative currency values of the gold standard currencies were largely inherited from the historical definitions of the currency units of each country, not by deliberate policy decisions about what currency value to adopt in establishing the gold standard in any particular country. But when the gold standard collapsed in August 1914 at the start of World War I, the gold standard had to be recreated more or less from scratch after the War. The US, holding 40% of the world’s monetary gold reserves was in a position to determine the value of gold, so it could easily restore convertibility at the prewar gold price of $20.67 an ounce. For other countries, the choice of the value at which to restore gold convertibility was really a decision about the dollar exchange rate at which to peg their currencies.

Before the war, the dollar-pound exchange rate was $4.86 per pound. The postwar dollar-pound exchange rate was just barely close enough to the prewar rate to make restoring the convertibility of the pound at the prewar rate with the dollar seem doable. Many including Keynes argued that Britain would be better with an exchange rate in the neighborhood of $4.40 or less, but Winston Churchill, then Chancellor of the Exchequer, was persuaded to restore convertibility at the prewar parity. That decision may or may not have been a good one, but I believe that its significance for the world economy at the time and subsequently has been overstated. After convertibility was restored at the prewar parity, chronically high postwar British unemployment increased only slightly in 1925-26 before declining modestly until with the onset of the Great Deflation and Great Depression in late 1929. The British economy would have gotten a boost if the prewar dollar-pound parity had not been restored (or if the Fed had accommodated the prewar parity by domestic monetary expansion), but the drag on the British economy after 1925 was a negligible factor compared to the other factors, primarily gold accumulation by the US and France, that triggered the Great Deflation in late 1929.

The cause of that deflation was largely centered in France (with a major assist from the Federal Reserve). Before the war the French franc was worth about 20 cents, but disastrous French postwar economic policies caused the franc to fall to just 2 cents in 1926 when Raymond Poincaré was called upon to lead a national-unity government to stabilize the situation. His success was remarkable, the franc rising to over 4 cents within a few months. However, despite earlier solemn pledges to restore the franc to its prewar value of 20 cents, he was persuaded to stabilize the franc at just 3.92 cents when convertibility into gold was reestablished in June 1928, undervaluing the franc against both the dollar and the pound.

Not only was the franc undervalued, but the Bank of France, which, under previous governments had been persuaded or compelled to supply francs to finance deficit spending, was prohibited by the new Monetary Law that restored convertibility at the fixed rate of 3.92 cents from increasing the quantity of francs except in exchange for gold or foreign-exchange convertible into gold. While protecting the independence of the Bank of France from government fiscal demands, the law also prevented the French money stock from increasing to accommodate increases in the French demand for money except by way of a current account surplus, or a capital inflow.

Meanwhile, the Bank of France began converting foreign-exchange reserves into gold. The resulting increase in French gold holdings led to gold appreciation. Under the gold standard, gold appreciation is manifested in price deflation affecting all gold-standard countries. That deflation was the direct and primary cause of the Great Depression, which led, over a period of five brutal years, to the failure and demise of the newly restored international gold standard.

These painful lessons were not widely or properly understood at the time, or for a long time afterward, but the clear takeaway from that experience was that trying to restore the gold standard again would be a dangerous undertaking. Another lesson that was intuited, if not fully understood, is that if a country pegs its exchange rate to gold or to another currency, it is safer to err on the side of undervaluation than overvaluation. So, when the task of recreating an international monetary system was undertaken at Bretton Woods in July 1944, the architects of the system tried to adapt it to the formal trappings of the gold standard while eliminating the deflationary biases and incentives that had doomed the interwar gold standard. To prevent increasing demand for gold from causing deflation, the obligation to convert cash into gold was limited to the United States and access to the US gold window was restricted to other central banks via the newly formed international monetary fund. Each country could, in consultation with the IMF, determine its exchange rate with the dollar.

Given the earlier experience, countries had an incentive to set exchange rates that undervalued their currencies relative to the dollar. Thus, for most of the 1950s and early 1960s, the US had to contend with a currency that was overvalued relative to the currencies of its principal trading partners, Germany and Italy (the two fastest growing economies in Europe) and Japan (later joined by South Korea and Taiwan) in Asia. In one sense, the overvaluation was beneficial to the US, because access to low-cost and increasingly high-quality imports was a form of repayment to the US of its foreign-aid assistance, and its ongoing defense protection against the threat of Communist expansionism , but the benefit came with the competitive disadvantage to US tradable-goods industries.

When West Germany took control of its economic policy from the US military in 1948, most price-and-wage controls were lifted and the new deutschmark was devalued by a third relative to the official value of the old reichsmark. A further devaluation of almost 25% followed a year later. Great Britain in 1949, perhaps influenced by the success of the German devaluation, devalued the pound by 30% from old parity of $4.03 to $2.80 in 1949. But unlike Germany, Britain, under the postwar Labour government, attempting to avoid postwar inflation, maintained wartime exchange controls and price controls. The underlying assumption at the time was that the Britain’s balance-of-payments deficit reflected an overvalued currency, so that devaluation would avoid repeating the mistake made two decades earlier when the dollar-pound parity had overvalued the pound.

That assumption, as Ralph Hawtrey had argued in lonely opposition to the devaluation, was misguided; the idea that the current account depends only, or even primarily, on the exchange rate abstracts from the monetary forces that affect the balance of payments and the current account. Worse, because British monetary policy was committed to the goal of maximizing short-term employment, the resulting excess supply of cash inevitably increased domestic spending, thereby attracting imports and diverting domestically produced products from export markets and preventing the devaluation from achieving the goal of improving the trade balance and promoting expansion of the tradable-goods sector.

Other countries, like Germany and Italy, combined currency undervaluation with monetary restraint, allowing only monetary expansion that was occasioned by current-account surpluses. This became the classic strategy, later called exchange-rate protection by Max Corden, of combining currency undervaluation with tight monetary policy. British attempts to use monetary policy to promote both (over)full employment subject to the balance-of-payments constraint imposed by an exchange rate pegged to the dollar proved unsustainable, while Germany, Italy, France (after De Gaulle came to power in 1958 and devalued the franc) found the combination of monetary restraint and currency undervaluation a successful economic strategy until the United States increased monetary expansion to counter chronic overvaluation of the dollar.

Because the dollar was the key currency of the world monetary system, and had committed itself to maintain the $35 an ounce price of gold, the US, unlike other countries whose currencies were pegged to the dollar, could not adjust the dollar exchange rate to reduce or alleviate the overvaluation of the dollar relative to the currencies of its trading partners. Mindful of its duties as supplier of the world’s reserve currency, US monetary authorities kept US inflation close to zero after the 1953 Korean War armistice.

However, that restrained monetary policy led to three recessions under the Eisenhower administration (1953-54, 1957-58, and 1960-61). The latter recessions led to disastrous Republican losses in the 1958 midterm elections and to Richard Nixon’s razor-thin loss in 1960 to John Kennedy, who had campaigned on a pledge to get the US economy moving again. The loss to Kennedy was a lesson that Nixon never forgot, and he was determined never to allow himself to lose another election merely because of scruples about US obligations as supplier of the world’s reserve currency.

Upon taking office, the Kennedy administration pressed for an easing of Fed policy to end the recession and to promote accelerated economic expansion. The result was a rapid recovery from the 1960-61 recession and the start of a nearly nine-year period of unbroken economic growth at perhaps the highest average growth rate in US history. While credit for the economic expansion is often given to the across-the-board tax cuts proposed by Kennedy in 1963 and enacted in 1964 under Lyndon Johnson, the expansion was already well under way by mid-1961, three years before the tax cuts became effective.

The international aim of monetary policy was to increase nominal domestic spending and to force US trading partners with undervalued currencies either to accept increased holdings of US liabilities or to revalue their exchange rates relative to the dollar to diminish their undervaluation relative to the dollar. Easier US monetary policy led to increasing complaints from Europeans, especially the Germans, that the US was exporting inflation and to charges that the US was taking advantage of the exorbitant privilege of its position as supplier of the world’s reserve currency.

The aggressive response of the Kennedy administration to undervaluation of most other currencies led to predictable pushback from France under de Gaulle who, like many other conservative and right-wing French politicians, was fixated on the gold standard and deeply resented Anglo-American monetary pre-eminence after World War I and American dominance after World War II. Like France under Poincaré, France under de Gaulle sought to increase its gold holdings as it accumulated dollar-denominated foreign exchange. But under Bretton Woods, French gold accumulation had little immediate economic effect other than to enhance the French and Gaullist pretensions to grandiosity.

Already in 1961 Robert Triffin predicted that the Bretton Woods system could not endure permanently because the growing world demand for liquidity could not be satisfied by the United States in a world with a relatively fixed gold stock and a stable or rising price level. The problem identified by Triffin was not unlike that raised by Gustav Cassel in the 1920s when he predicted that the world gold stock would likely not increase enough to prevent a worldwide deflation. This was a different problem from the one that actually caused the Great Depression, which was a substantial increase in gold demand associated with the restoration of the gold standard that triggered the deflationary collapse of late 1929. The long-term gold shortage feared by Cassel was a long-term problem distinct from the increase in gold demand caused by the restoration of the gold standard in the 1920s.

The problem Triffin identified was also a long-term consequence of the failure of the international gold stock to increase to provide the increased gold reserves that would be needed for the US to be able to credibly commit to maintaining the convertibility of the dollar into gold without relying on deflation to cause the needed increase in the real value of gold reserves.

Had it not been for the Vietnam War, Bretton Woods might have survived for several more years, but the rise of US inflation to over 4% in 1968-69, coupled with the 1969-70 recession in an unsuccessful attempt to reduce inflation, followed by a weak recovery in 1971, made it clear that the US would not undertake a deflationary policy to make the official $35 gold price credible. Although de Gaulle’s unexpected retirement in 1969 removed the fiercest opponent of US monetary domination, confidence that the US could maintain the official gold peg, when the London gold price was already 10% higher than the official price, caused other central banks to fear that they would be stuck with devalued dollar claims once the US raised the official gold price. Not only the French, but other central banks were already demanding redemption in gold of the dollar claims that they were holding.

An eleventh-hour policy reversal by the administration to save the official gold price was not in the cards, and everyone knew it. So all the handwringing about the abandonment of Bretton Woods on August 15, 1971 is either simple foolishness or gaslighting. The system was already broken, and it couldn’t be fixed at any price worth pondering for even half an instant. Nixon and his accomplices tried to sugarcoat their scrapping of the Bretton Woods System by pretending that they were announcing a plan that was the first step toward its reform and rejuvenation. But that pretense led to a so-called agreement with a new gold-price peg of $38 an ounce, which lasted hardly a year before it died not with a bang but a whimper.

What can we learn from this story? For me the real lesson is that the original international gold standard was, to borrow (via Hayek) a phrase from Adam Ferguson: “the [accidental] result of human action, not human design.” The gold standard, as it existed for those 40 years, was not an intuitively obvious or well understood mechanism working according to a clear blueprint; it was an improvised set of practices, partly legislated and partly customary, and partially nothing more than conventional, but not very profound, wisdom.

The original gold standard collapsed with the outbreak of World War I and the attempt to recreate it after World War I, based on imperfect understanding of how it had actually functioned, ended catastrophically with the Great Depression, a second collapse, and another, even more catastrophic, World War. The attempt to recreate a new monetary system –the Bretton Woods system — using a modified feature of the earlier gold standard as a kind of window dressing, was certainly not a real gold standard, and, perhaps, not even a pseudo-gold standard; those who profess to mourn its demise are either fooling themselves or trying to fool the rest of us.

We are now stuck with a fiat system that has evolved and been tinkered with over centuries. We have learned how to manage it, at least so far, to avoid catastrophe. With hard work and good luck, perhaps we will continue to learn how to manage it better than we have so far. But to seek to recreate a system that functioned fairly successfully for at most 40 years under conditions not even remotely likely ever again to be approximated, is hardly likely to lead to an outcome that will enhance human well-being. Even worse, if that system were recreated, the resulting outcome might be far worse than anything we have experienced in the last half century.

Krugman on Mr. Keynes and the Moderns

UPDATE: Re-upping this slightly revised post from July 11, 2011

Paul Krugman recently gave a lecture “Mr. Keynes and the Moderns” (a play on the title of the most influential article ever written about The General Theory, “Mr. Keynes and the Classics,” by another Nobel laureate J. R. Hicks) at a conference in Cambridge, England commemorating the publication of Keynes’s General Theory 75 years ago. Scott Sumner and Nick Rowe, among others, have already commented on his lecture. Coincidentally, in my previous posting, I discussed the views of Sumner and Krugman on the zero-interest lower bound, a topic that figures heavily in Krugman’s discussion of Keynes and his relevance for our current difficulties. (I note in passing that Krugman credits Brad Delong for applying the term “Little Depression” to those difficulties, a term that I thought I had invented, but, oh well, I am happy to share the credit with Brad).

In my earlier posting, I mentioned that Keynes’s, slightly older, colleague A. C. Pigou responded to the zero-interest lower bound in his review of The General Theory. In a way, the response enhanced Pigou’s reputation, attaching his name to one of the most famous “effects” in the history of economics, but it made no dent in the Keynesian Revolution. I also referred to “the layers upon layers of interesting personal and historical dynamics lying beneath the surface of Pigou’s review of Keynes.” One large element of those dynamics was that Keynes chose to make, not Hayek or Robbins, not French devotees of the gold standard, not American laissez-faire ideologues, but Pigou, a left-of-center social reformer, who in the early 1930s had co-authored with Keynes a famous letter advocating increased public-works spending to combat unemployment, the main target of his immense rhetorical powers and polemical invective.  The first paragraph of Pigou’s review reveals just how deeply Keynes’s onslaught had wounded Pigou.

When in 1919, he wrote The Economic Consequences of the Peace, Mr. Keynes did a good day’s work for the world, in helping it back towards sanity. But he did a bad day’s work for himself as an economist. For he discovered then, and his sub-conscious mind has not been able to forget since, that the best way to win attention for one’s own ideas is to present them in a matrix of sarcastic comment upon other people. This method has long been a routine one among political pamphleteers. It is less appropriate, and fortunately less common, in scientific discussion.  Einstein actually did for Physics what Mr. Keynes believes himself to have done for Economics. He developed a far-reaching generalization, under which Newton’s results can be subsumed as a special case. But he did not, in announcing his discovery, insinuate, through carefully barbed sentences, that Newton and those who had hitherto followed his lead were a gang of incompetent bunglers. The example is illustrious: but Mr. Keynes has not followed it. The general tone de haut en bas and the patronage extended to his old master Marshall are particularly to be regretted. It is not by this manner of writing that his desire to convince his fellow economists is best promoted.

Krugman acknowledges Keynes’s shady scholarship (“I know that there’s dispute about whether Keynes was fair in characterizing the classical economists in this way”), only to absolve him of blame. He then uses Keynes’s example to attack “modern economists” who deny that a failure of aggregate demand can cause of mass unemployment, offering up John Cochrane and Niall Ferguson as examples, even though Ferguson is a historian not an economist.

Krugman also addresses Robert Barro’s assertion that Keynes’s explanation for high unemployment was that wages and prices were stuck at levels too high to allow full employment, a problem easily solvable, in Barro’s view, by monetary expansion. Although plainly annoyed by Barro’s attempt to trivialize Keynes’s contribution, Krugman never addresses the point squarely, preferring instead to justify Keynes’s frustration with those (conveniently nameless) “classical economists.”

Keynes’s critique of the classical economists was that they had failed to grasp how everything changes when you allow for the fact that output may be demand-constrained.

Not so, as I pointed out in my first post. Frederick Lavington, an even more orthodox disciple than Pigou of Marshall, had no trouble understanding that “the inactivity of all is the cause of the inactivity of each.” It was Keynes who failed to see that the failure of demand was equally a failure of supply.

They mistook accounting identities for causal relationships, believing in particular that because spending must equal income, supply creates its own demand and desired savings are automatically invested.

Supply does create its own demand when economic agents succeed in executing their plans to supply; it is when, owing to their incorrect and inconsistent expectations about future prices, economic agents fail to execute their plans to supply, that both supply and demand start to contract. Lavington understood that; Pigou understood that. Keynes understood it, too, but believing that his new way of understanding how contractions are caused was superior to that of his predecessors, he felt justified in misrepresenting their views, and attributing to them a caricature of Say’s Law that they would never have taken seriously.

And to praise Keynes for understanding the difference between accounting identities and causal relationships that befuddled his predecessors is almost perverse, as Keynes’s notorious confusion about whether the equality of savings and investment is an equilibrium condition or an accounting identity was pointed out by Dennis Robertson, Ralph Hawtrey and Gottfried Haberler within a year after The General Theory was published. To quote Robertson:

(Mr. Keynes’s critics) have merely maintained that he has so framed his definition that Amount Saved and Amount Invested are identical; that it therefore makes no sense even to inquire what the force is which “ensures equality” between them; and that since the identity holds whether money income is constant or changing, and, if it is changing, whether real income is changing proportionately, or not at all, this way of putting things does not seem to be a very suitable instrument for the analysis of economic change.

It just so happens that in 1925, Keynes, in one of his greatest pieces of sustained, and almost crushing sarcasm, The Economic Consequences of Mr. Churchill, offered an explanation of high unemployment exactly the same as that attributed to Keynes by Barro. Churchill’s decision to restore the convertibility of sterling to gold at the prewar parity meant that a further deflation of at least 10 percent in wages and prices would be necessary to restore equilibrium.  Keynes felt that the human cost of that deflation would be intolerable, and held Churchill responsible for it.

Of course Keynes in 1925 was not yet the Keynes of The General Theory. But what historical facts of the 10 years following Britain’s restoration of the gold standard in 1925 at the prewar parity cannot be explained with the theoretical resources available in 1925? The deflation that began in England in 1925 had been predicted by Keynes. The even worse deflation that began in 1929 had been predicted by Ralph Hawtrey and Gustav Cassel soon after World War I ended, if a way could not be found to limit the demand for gold by countries, rejoining the gold standard in aftermath of the war. The United States, holding 40 percent of the world’s monetary gold reserves, might have accommodated that demand by allowing some of its reserves to be exported. But obsession with breaking a supposed stock-market bubble in 1928-29 led the Fed to tighten its policy even as the international demand for gold was increasing rapidly, as Germany, France and many other countries went back on the gold standard, producing the international credit crisis and deflation of 1929-31. Recovery came not from Keynesian policies, but from abandoning the gold standard, thereby eliminating the deflationary pressure implicit in a rapidly rising demand for gold with a more or less fixed total supply.

Keynesian stories about liquidity traps and Monetarist stories about bank failures are epiphenomena obscuring rather than illuminating the true picture of what was happening.  The story of the Little Depression is similar in many ways, except the source of monetary tightness was not the gold standard, but a monetary regime that focused attention on rising price inflation in 2008 when the appropriate indicator, wage inflation, had already started to decline.

Welcome to Uneasy Money, aka the Hawtreyblog

UPDATE: I’m re-upping my introductory blog post, which I posted ten years ago toady. It’s been a great run for me, and I hope for many of you, whose interest and responses have motivated to keep it going. So thanks to all of you who have read and responded to my posts. I’m adding a few retrospective comments and making some slight revisions along the way. In addition to new posts, I will be re-upping some of my old posts that still seem to have relevance to the current state of our world.

What the world needs now, with apologies to the great Burt Bachrach and Hal David, is, well, another blog.  But inspired by the great Ralph Hawtrey and the near great Scott Sumner, I decided — just in time for Scott’s return to active blogging — to raise another voice on behalf of a monetary policy actively seeking to promote recovery from what I call the Little Depression, instead of the monetary policy we have now:  waiting for recovery to arrive on its own.  Just like the Great Depression, our Little Depression was caused mainly by overly tight money in an environment of over-indebtedness and financial fragility, and was then allowed to deepen and become entrenched by monetary authorities unwilling to commit themselves to a monetary expansion aimed at raising prices enough to make business expansion profitable.

That was the lesson of the Great Depression.  Unfortunately that lesson, for reasons too complicated to go into now, was never properly understood, because neither Keynesians nor Monetarists had a fully coherent understanding of what happened in the Great Depression.  Although Ralph Hawtrey — called by none other than Keynes “his grandparent in the paths of errancy,” and an early, but unacknowledged, progenitor of Chicago School Monetarism — had such an understanding,  Hawtrey’s contributions were overshadowed and largely ignored, because of often irrelevant and misguided polemics between Keynesians and Monetarists and Austrians.  One of my goals for this blog is to bring to light the many insights of this perhaps most underrated — though competition for that title is pretty stiff — economist of the twentieth century.  I have discussed Hawtrey’s contributions in my book on free banking and in a paper published years ago in Encounter and available here.  Patrick Deutscher has written a biography of Hawtrey.

What deters businesses from expanding output and employment in a depression is lack of demand; they fear that if they do expand, they won’t be able to sell the added output at prices high enough to cover their costs, winding up with redundant workers and having to engage in costly layoffs.  Thus, an expectation of low demand tends to be self-fulfilling.  But so is an expectation of rising prices, because the additional output and employment induced by expectations of rising prices will generate the demand that will validate the initial increase in output and employment, creating a virtuous cycle of rising income, expenditure, output, and employment.

The insight that “the inactivity of all is the cause of the inactivity of each” is hardly new.  It was not the discovery of Keynes or Keynesian economics; it is the 1922 formulation of Frederick Lavington, another great, but underrated, pre-Keynesian economist in the Cambridge tradition, who, in his modesty and self-effacement, would have been shocked and embarrassed to be credited with the slightest originality for that statement.  Indeed, Lavington’s dictum might even be understood as a restatement of Say’s Law, the bugbear of Keynes and object of his most withering scorn.  Keynesian economics skillfully repackaged the well-known and long-accepted idea that when an economy is operating with idle capacity and high unemployment, any increase in output tends to be self-reinforcing and cumulative, just as, on the way down, each reduction in output is self-reinforcing and cumulative.

But at least Keynesians get the point that, in a depression or deep recession, individual incentives may not be enough to induce a healthy expansion of output and employment. Aggregate demand can be too low for an expansion to get started on its own. Even though aggregate demand is nothing but the flip side of aggregate supply (as Say’s Law teaches), if resources are idle for whatever reason, perceived effective demand is deficient, diluting incentives to increase production so much that the potential output expansion does not materialize, because expected prices are too low for businesses to want to expand. But if businesses can be induced to expand output, more than likely, they will sell it, because (as Say’s Law teaches) supply usually does create its own demand.

[Comment after 10 years: In a comment, Rowe asked why I wrote that Say’s Law teaches that supply “usually” creates its own demand. At that time, I responded that I was just using “usually” as a weasel word. But I subsequently realized (and showed in a post last year) that the standard proofs of both Walras’s Law and Say’s Law are defective for economies with incomplete forward and state-contingent markets. We actually know less than we once thought we did!] 

Keynesians mistakenly denied that, by creating price-level expectations consistent with full employment, monetary policy could induce an expansion of output even in a depression. But at least they understood that the private economy can reach an impasse with price-level expectations too low to sustain full employment. Fiscal policy may play a role in remedying a mismatch between expectations and full employment, but fiscal policy can only be as effective as monetary policy allows it to be. Unfortunately, since the downturn of December 2007, monetary policy, except possibly during QE1 and QE2, has consistently erred on the side of uneasiness.

With some unfortunate exceptions, however, few Keynesians have actually argued against monetary easing. Rather, with some honorable exceptions, it has been conservatives who, by condemning a monetary policy designed to provide incentives conducive to business expansion, have helped to hobble a recovery led by the private sector rather than the government which  they profess to want. It is not my habit to attribute ill motives or bad faith to people whom I disagree with. One of the finest compliments ever paid to F. A. Hayek was by Joseph Schumpeter in his review of The Road to Serfdom who chided Hayek for “politeness to a fault in hardly ever attributing to his opponents anything but intellectual error.” But it is a challenge to come up with a plausible explanation for right-wing opposition to monetary easing.

[Comment after 10 years: By 2011 when this post was written, right-wing bad faith had already become too obvious to ignore, but who could then have imagined where the willingness to resort to bad faith arguments without the slightest trace of compunction would lead them and lead us.] 

In condemning monetary easing, right-wing opponents claim to be following the good old conservative tradition of supporting sound money and resisting the inflationary proclivities of Democrats and liberals. But how can claims of principled opposition to inflation be taken seriously when inflation, by every measure, is at its lowest ebb since the 1950s and early 1960s? With prices today barely higher than they were three years ago before the crash, scare talk about currency debasement and future hyperinflation reminds me of Ralph Hawtrey’s famous remark that warnings that leaving the gold standard during the Great Depression would cause runaway inflation were like crying “fire, fire” in Noah’s flood.

The groundlessness of right-wing opposition to monetary easing becomes even plainer when one recalls the attacks on Paul Volcker during the first Reagan administration. In that episode President Reagan and Volcker, previously appointed by Jimmy Carter to replace the feckless G. William Miller as Fed Chairman, agreed to make bringing double-digit inflation under control their top priority, whatever the short-term economic and political costs. Reagan, indeed, courageously endured a sharp decline in popularity before the first signs of a recovery became visible late in the summer of 1982, too late to save Reagan and the Republicans from a drubbing in the mid-term elections, despite the drop in inflation to 3-4 percent. By early 1983, with recovery was in full swing, the Fed, having abandoned its earlier attempt to impose strict Monetarist controls on monetary expansion, allowed the monetary aggregates to grow at unusually rapid rates.

However, in 1984 (a Presidential election year) after several consecutive quarters of GDP growth at annual rates above 7 percent, the Fed, fearing a resurgence of inflation, began limiting the rate of growth in the monetary aggregates. Reagan’s secretary of the Treasury, Donald Regan, as well as a variety of outside Administration supporters like Arthur Laffer, Larry Kudlow, and the editorial page of the Wall Street Journal, began to complain bitterly that the Fed, in its preoccupation with fighting inflation, was deliberately sabotaging the recovery. The argument against the Fed’s tightening of monetary policy in 1984 was not without merit. But regardless of the wisdom of the Fed tightening in 1984 (when inflation was significantly higher than it is now), holding up the 1983-84 Reagan recovery as the model for us to follow now, while excoriating Obama and Bernanke for driving inflation all the way up to 1 percent, supposedly leading to currency debauchment and hyperinflation, is just a bit rich. What, I wonder, would Hawtrey have said about that?

In my next posting I will look a little more closely at some recent comparisons between the current non-recovery and recoveries from previous recessions, especially that of 1983-84.

Gabriel Mathy and I Discuss the Gold Standard and the Great Depression

Sometimes you get into a Twitter argument when you least expect to. It was after 11pm two Saturday nights ago when I saw this tweet by Gabriel Mathy (@gabriel_mathy)

Friedman says if there had been no Fed, there would have been no Depression. That’s certainly wrong, even if your position is that the Fed did little to nothing to mitigate the Depression (which is reasonable IMO)

Chiming in, I thought to reinforce Mathy’s criticism of Friedman, I tweeted the following:

Friedman totally misunderstood the dynamics of the Great Depression, which was driven by increasing demand for gold after 1928, in particular by the Bank of France and by the Fed. He had no way of knowing what the US demand for gold would have been if there had not been a Fed

I got a response from Mathy that I really wasn’t expecting who tweeted with seeming annoyance

There already isn’t enough gold to back the gold standard by the end of World War I, it’s just a matter of time until a negative shock large enough sent the world into a downward spiral (my emphasis). Just took a few years after resumption of the gold standard in most countries in the mid-20s. (my emphasis)

I didn’t know exactly what to make of Mathy’s assertion that there wasn’t enough gold by the end of World War I. The gold standard was effectively abandoned at the outset of WWI and the US price level was nearly double the prewar US price level after the postwar inflation of 1919. Even after the deflation of 1920-21, US prices were still much higher in 1922 than they were in 1914. Gold production fell during World War I, but gold coins had been withdrawn from circulation and replaced with paper or token coins. The idea that there is a fixed relationship between the amount of gold and the amount of money, especially after gold coinage had been eliminated, has no theoretical basis.

So I tweeted back:

The US holdings of gold after WWI were so great that Keynes in his Tract on Monetary Reform [argued] that the great danger of a postwar gold standard was inflation because the US would certainly convert its useless holding of gold for something more useful

To which Mathy responded

The USA is not the only country though. The UK had to implement tight monetary policies to back the gold standard, and eventually had to leave the gold standard. As did the USA in 1931. The Great Depression is a global crisis.

Mathy’s response, I’m afraid, is completely wrong. Of course, the Great Depression is a global crisis. It was a global crisis, because, under the (newly restored) gold standard, the price level in gold-standard countries was determined internationally. And, holding 40% of the world’s monetary reserves of gold at the end of World War I, the US, the largest and most dynamic economy in the world, was clearly able to control, as Keynes understood, the common international price level for gold-standard countries.

The tight monetary policy imposed on the UK resulted from its decision to rejoin the gold standard at the prewar dollar parity. Had the US followed a modestly inflationary monetary policy, allowing an outflow of gold during the 1920s rather than inducing an inflow, deflation would not have been imposed on the UK.

But instead of that response, I replied as follows:

The US didn’t leave till 1933 when FDR devalued. I agree that individual countries, worried about losing gold, protected their reserves by raising interest rates. Had they all reduced rates together, the conflict between individual incentives and common interest could have been avoided.

Mathy then kept the focus on the chronology of the Great Depression, clarifying that he meant that in 1931 the US, like the UK, tightened monetary policy to remain on the gold standard, not that the US, like the UK, also left the gold standard in 1931:

The USA tightens in 1931 to stay on the gold standard. And this sets off a wave of bank failures.

Fair enough, but once the situation deteriorated after the crash and the onset of deflation, the dynamics of the financial crisis made managing the gold standard increasingly difficult, given the increasingly pessimistic expectations conditioned by deepening economic contraction and deflation. While an easier US monetary policy in the late 1920s might have avoided the catastrophe and preserved the gold standard, an easier monetary policy may, at some point, have become inconsistent with staying on the gold standard.

So my response to Mathy was more categorical than was warranted.

Again, the US did not have to tighten in 1931 to stay on the gold standard. I agree that the authorities might have sincerely thought that they needed to tighten to stay on the gold standard, but they were wrong if that’s what they thought.

Mathy was having none of it, unleashing a serious snark attack

You know better I guess, despite collapsing free gold amidst a massive speculative attack

What I ought to have said is that the gold standard was not worth saving if doing so entailed continuing deflation. If I understand him, Mathy believes that deflation after World War I was inevitable and unavoidable, because there wasn’t enough gold to sustain the gold standard after World War I. I was arguing that if there was a shortage of gold, it was because of the policies followed, often in compliance with legal gold-cover requirements, that central banks, especially the Bank of France, which started accumulating gold rapidly in 1928, and the Fed, which raised interest rates to burst a supposed stock-market bubble, were following. But as I point out below, the gold accumulation by the Bank of France far exceeded what was mandated by legal gold-cover requirements.

My point is that the gold shortage that Mathy believes doomed the gold standard was not preordained; it could have been mitigated by policies to reduce, or reverse, gold accumulation. France could have rejoined the gold standard without accumulating enormous quantities of gold in 1928-29, and the Fed did not have to raise interest rates in 1928-29, attracting additional gold to its own already massive holdings just as France was rapidly accumulating gold.

When France formally rejoined the gold standard in July 1928, the gold reserves of the Bank of France were approximately equal to its foreign-exchange holdings and its gold-reserve ratio was 39.5% slightly above the newly established legal required ratio of 35%. In subsequent years, the gold reserves of the Bank of France steadily increased while foreign exchange reserves declined. At the close of 1929, the gold-reserve ratio of the Bank of France stood at 47.3%, while its holdings of foreign exchange hardly changed. French gold holdings increased in 1930 by slightly more than in 1929, with foreign-exchange holdings almost constant; the French gold-reserve ratio at the end of 1930 was 53.2%. The 1931 increase in French gold reserves, owing to a 20% drop in foreign-exchange holdings, was even larger than in 1930, raising the gold-reserve ratio to 60.5% at the end of 1931.

Once deflation and the Great Depression started late in 1929, deteriorating rapidly in 1930, salvaging the gold standard became increasingly unlikely, with speculators becoming increasingly alert to the possibility of currency devaluation or convertibility suspension. Speculation against a pegged exchange rate is not always a good bet, but it’s rarely a bad one, any change in the pegged rate being almost surely in the direction that speculators are betting on. 

But, it was still at least possible that, if gold-cover requirements for outstanding banknotes and bank reserves were relaxed or suspended, central banks could have caused a gold outflow sufficient to counter the deflationary expectations then feeding speculative demands for gold. Gold does not have many non-monetary uses, so a significant release of gold from idle central-bank reserves might have caused gold to depreciate relative to other real assets, thereby slowing, or even reversing, deflation.

Of course, deflation would not have stopped unless the deflationary expectations fueling speculative demands for gold were reversed. Different expectational responses would have led to different outcomes. More often than not, inflationary and deflationary expectations are self-fulfilling. Because expectations tend to be mutually interdependent – my inflationary expectations reinforce your inflationary expectations and vice versa — the notion of rational expectation in this context borders on the nonsensical, making outcomes inherently unpredictable. Reversing inflationary or deflationary expectations requires policy credibility and a willingness by policy makers to take policy actions – even or especially painful ones — that demonstrate their resolve.

In 1930 Ralph Hawtrey testified to the Macmillan Committee on Finance and Industry, he recommended that the Bank of England reduce interest rates to counter the unemployment and deflation. That testimony elicited the following exchange between Hugh Pattison Macmillan, the chairman of the Committee and Hawtrey:

MACMILLAN: Suppose . . . without restricting credit . . . that gold had gone out to a very considerable extent, would that not have had very serious consequences on the international position of London?

HAWTREY: I do not think the credit of London depends on any particular figure of gold holding. . . . The harm began to be done in March and April of 1925 [when] the fall in American prices started. There was no reason why the Bank of England should have taken any action at that time so far as the question of loss of gold is concerned. . . . I believed at the time and I still think that the right treatment would have been to restore the gold standard de facto before it was restored de jure. That is what all the other countries have done. . . . I would have suggested that we should have adopted the practice of always selling gold to a sufficient extent to prevent the exchange depreciating. There would have been no legal obligation to continue convertibility into gold . . . If that course had been adopted, the Bank of England would never have been anxious about the gold holding, they would have been able to see it ebb away to quite a considerable extent with perfect equanimity, . . and might have continued with a 4 percent Bank Rate.

MACMILLAN: . . . the course you suggest would not have been consistent with what one may call orthodox Central Banking, would it?

HAWTREY: I do not know what orthodox Central Banking is.

MACMILLAN: . . . when gold ebbs away you must restrict credit as a general principle?

HAWTREY: . . . that kind of orthodoxy is like conventions at bridge; you have to break them when the circumstances call for it. I think that a gold reserve exists to be used. . . . Perhaps once in a century the time comes when you can use your gold reserve for the governing purpose, provided you have the courage to use practically all of it.

Hawtrey’s argument lay behind this response of mine to Mathy:

What else is a gold reserve is for? That’s like saying you can’t fight a fire because you’ll drain the water tank. But I agree that by 1931 there was no point in defending the gold standard and the US should have made clear the goal was reflation to the 1926 price level as FDR did in 1933.

Mathy responded:

If the Fed cuts discount rates to 0%, capital outflow will eventually exhaust gold reserves. So do you recommend a massive OMO in 1929? What specifically is the plan?

In 1927, the Fed reduced its discount rate to 3.5%; in February 1928, it was raised the rate to 4%. The rate was raised again in August 1928 and to 6% in September 1929. The only reason the Fed raised interest rates in 1928 was a misguided concern with rising stock prices. A zero interest rate was hardly necessary in 1929, nor were massive open-market operations. Had the Fed kept its interest rate at 4%, and the Bank of France not accumulated gold rapidly in 1928-29, the history of the world might well have followed a course much different from the one actually followed.

In another exchange, Mathy pointed to the 1920s adoption of the gold-exchange standard rather than a (supposedly) orthodox version of the gold standard as evidence that there wasn’t enough gold to support the gold standard after World War I. (See my post on the difference between the gold standard and the gold-exchange standard.)

Mathy: You seem to be implying there was plentiful free gold [i.e., gold held by central banks in excess of the amount required by legal gold-cover requirements] in the world after WW1 so that gold was not a constraint. How much free gold to you reckon there was?

Glasner: All of it was free. Legal reserve requirements soaked up much but nearly all the free gold

Mathy: All of it was not free, and countries suffered speculative attacks before their real or perceived minimum backings of gold were reached

Glasner: All of it would have been free but for the legal reserve requirements. Of course countries were subject to speculative attacks, when the only way for a country to avoid deflation was to leave the gold standard.

Mathy: You keep asserting an abundance of free gold, so let’s see some numbers. The lack of free gold led to the gold exchange standard where countries would back currencies with other currencies (themselves only partially backed by gold) because there wasn’t enough gold.

Glasner: The gold exchange standard was a rational response to the WWI inflation and post WWI deflation and it could have worked well if it had not been undermined by the Bank of France and gold accumulation by the US after 1928.

Mathy: Both you and [Douglas] Irwin assume that the gold inflows into France are the result of French policy. But moving your gold to France, a country committed to the gold standard, is exactly what a speculative attack on another currency at risk of leaving the gold standard looks like.

Mathy: What specific policies did the Bank if France implement in 1928 that caused gold inflows? We can just reason from accounting identities, assuming that international flows to France are about pull factors from France rather than push factors from abroad.

Mathy: So lay out your counterfactual- how much gold should the US and France have let go abroad, and how does this prevent the Depression?

Glasner: The increase in gold monetary holdings corresponds to a higher real value of gold. Under the gold standard that translates into [de]flation. Alternatively, to prevent gold outflows central banks raised rates which slowed economic activity and led to deflation.

Mathy: So give me some numbers. What does the Fed do specifically in 1928 and what does France do specifically in 1928 that avoid the debacle of 1929. You can take your time, pick this up Monday.

Mathy: The UK was suffering from high unemployment before 1928 because there wasn’t enough gold in the system. The Bank of England had been able to draw gold “from the moon” with a higher bank rate. After WW1, this was no longer possible.

Glasner: Unemployment in the UK steadily fell after 1922 and continued falling till ’29. With a fixed exchange rate against the $, and productivity in the US rising faster than in the UK, the UK needed more US inflation than it got to reach full employment. That has nothing to do with what happened after 1929.

Mathy: UK unemployment rises 1925-1926 actually, that’s incorrect and it’s near double digits throughout the 1920s. That’s not good at all and the problems start long before 1928.

There’s a lot to unpack here, and I will try to at least touch on the main points. Mathy questions whether there was enough free gold available in the 1920s, while also acknowledging that the gold-exchange standard was instituted in the 1920s precisely to avoid the demands on monetary gold reserves that would result from restoring gold coinage and imposing legal gold-cover requirements on central-bank liabilities. So, if free-gold reserves were insufficient before the Great Depression, it was because of the countries that restored the gold standard and also imposed legal gold-cover requirements, notably the French Monetary Law enacted in June 1928 that imposed a minimum 35% gold-cover requirement when convertibility of the franc was restored.

It’s true that there were speculative movements of gold into France when there were fears that countries might devalue their currencies or suspend gold convertibility, but those speculative movements did not begin until late 1930 or 1931.

Two aspects of the French restoration of gold convertibility should be mentioned. First, France pegged the dollar/franc exchange rate at $0.0392, with the intention of inducing a current-account surplus and a gold inflow. Normally that inflow would have been transitory as French prices and wages rose to the world level. But the French Monetary Law allowed the creation of new central-bank liabilities only in exchange for gold or foreign exchange convertible into gold. So French demand for additional cash balances could be satisfied only insofar as total spending in France was restricted sufficiently to ensure an inflow of gold or convertible foreign exchange. Hawtrey explained this brilliantly in Chapter two of The Art of Central Banking.

Mathy suggests that the gold-standard was adopted by countries without enough gold to operate a true gold standard, which he thinks proves that there wasn’t enough free gold available. What resort to the gold-exchange standard shows is that countries without enough gold were able to join the gold standard without first incurring the substantial cost of accumulating (either by direct gold purchases or by inducing large amounts of gold inflows by raising domestic interest rates); it does not prove that the gold-exchange standard system was inherently unstable.

Why did some countries restoring the gold standard not have enough gold? First, much of the world’s stock of gold reserves had been shipped to the US during World War I when countries were importing food, supplies and war material from the US paid with gold, or, promising to repay after the war, on credit. Second, wartime and immediate postwar inflation required increased quantities of cash to conduct transactions and satisfy liquidity demands. Third, legislated gold-cover requirements in the US, and later in France and other countries rejoining the gold standard, obligated monetary authorities to accumulate gold.

Those gold-cover requirements, forcing countries to accumulate additional gold to satisfy any increased demand by the public for cash, were an ongoing, and unnecessary, cause of rising demand for gold reserves as countries rejoined the gold standard in the 1920s, imparting an inherent deflationary bias to the gold standard. The 1922 Genoa Accords attempted to cushion this deflationary bias by allowing countries to rejoin the gold standard without making their own currencies directly convertible into gold, but by committing themselves to a fixed exchange rate against those currencies – at first the dollar and subsequently pound sterling – that were directly convertible into gold. But the accords were purely advisory and provided no effective mechanism to prevent the feared increase in the monetary demand for gold. And the French never intended to rejoin the gold standard except by making the franc convertible directly into gold.

Mathy asks how much gold I think that the French and the US should have let go to avoid the Great Depression. This is an impossible question to answer, because French gold accumulation in 1928-29, combined with increased US interest rates in 1928-29, which caused a nearly equivalent gold inflow into the US, triggered deflation in the second half of 1929 that amplified deflationary expectations, causing a stock market crash, a financial crisis and ultimately the Great Depression. Once deflation got underway, the measures needed to calm the crisis and reverse the downturn became much more extreme than those that would have prevented the downturn in the first place.

Had the Fed kept its discount rate at 3.5 to 4 percent, had France not undervalued the franc in setting its gold peg, and had France created a mechanism for domestic credit expansion instead of making an increase in the quantity of francs impossible except through a current account surplus, and had the Bank of France been willing to accumulate foreign exchange instead of requiring its foreign-exchange holdings to be redeemed for gold, the crisis would not have occurred.

Here are some quick and dirty estimates of the effect of French policy on the availability of free gold. In July 1928 when France rejoined the gold standard and enacted the Monetary Law drafted by the Bank of France, the notes and demand deposits against which the Bank was required to gold reserves totaled almost ff76 billion (=$2.98 billion). French gold holdings in July 1928 were then just under ff30 billion (=$1.17 billion), implying a reserve ratio of 39.5%. (See the discussion above.)

By the end of 1931, the total of French banknotes and deposits against which the Bank of France was required to hold gold reserves was almost ff114 billion (=$4.46 billion). French gold holdings at the end of 1931 totaled ff68.9 billion (=$2.7 billion), implying a gold-reserve ratio of 60.5%. If the French had merely maintained the 40% gold-reserve ratio of 1928, their gold holdings in 1931 would have been approximately ff45 billion (=$1.7 billion).

Thus, from July 1929 to December 1931, France absorbed $1 billion of gold reserves that would have otherwise been available to other central banks or made available for use in non-monetary applications. The idea that free gold was a constraint on central bank policy is primarily associated with the period immediately before and after the British suspension of the gold standard in September 1931, which occasioned speculative movements of gold from the US to France to avoid a US suspension of the gold standard or a devaluation. From January 1931 through August 1931, the gold holdings of the Bank of France increased by just over ff3 billion (=$78 million). From August to December of 1931 French gold holdings increased by ff10.3 billion (=$404 million).

So, insofar as a lack of free gold was a constraint on US monetary expansion via open market purchases in 1931, which is the only time period when there is a colorable argument that free gold was a constraint on the Fed, it seems highly unlikely that that constraint would have been binding had the Bank of France not accumulated an additional $1 billion of gold reserves (over and above the increased reserves necessary to maintain the 40% gold-reserve ratio of July 1928) after rejoining the gold standard. Of course, the claim that free gold was a binding constraint on Fed policy in the second half of 1931 is far from universally accepted, and I consider the claim to be pretextual.

Finally, I concede that my assertion that unemployment fell steadily in Britain after the end of the 1920-22 depression was not entirely correct. Unemployment did indeed fall substantially after 1922, but remained around 10 percent in 1924 — there are conflicting estimates based on different assumptions about how to determine whom to count as unemployed — when the pound began appreciating before the restoration of the prewar parity. Unemployment continued rising rise until 1926, but remained below the 1922 level. Unemployment then fell substantially in 1926-27, but rose again in 1928 (as gold accumulation by France and the US led to a rise in Bank rate), without reaching the 1926 level. Unemployment fell slightly in 1929 and was less than the 1924 level before the crash. See Eichengreen “Unemployment in Interwar Britain.”

I agree that unemployment had been a serious problem in Britain before 1928. But that wasn’t because sufficient gold was lacking in the system. Unemployment was a British problem caused by an overvalued exchange rate; it was not a systemic gold-standard problem.

Before World War I, when the gold standard was largely a sterling standard (just as the postwar gold standard became a dollar standard), the Bank of England had been able to “draw gold from the moon” by raising Bank rate. But the gold that had once been in the moon moved to the US during World War I. What Britain required was a US discount rate low enough to raise the world price level, thereby reducing deflationary pressure on Britain caused by overvaluation of sterling. Instead of keeping the discount rate at 3.5 – 4%, and allowing an outflow of gold, the Fed increased its discount rate, inducing a gold inflow and triggering a worldwide deflationary catastrophe. Between 1929 to 1931, British unemployment nearly doubled because of that catastrophe, not because Britain didn’t have enough gold. The US had plenty of gold and suffered equally from the catastrophe.

My Conversation about Hawtrey with the Hawtrey Study Group

About six weeks ago, I was contacted by Jay Pocklington, who leads the Hawtrey Study Group, one of many study groups conducted under the auspices of the Young Scholars Initiative, of The Institute for New Economic Thinking. Jay asked if I would be willing to participate in a zoom conversation with the group about Hawtrey and my interest in, and my engagement with, his work. I was of course happy to accept the invitation, and the conversation took place about two weeks ago on May 26.

The timing was very convenient, because I had just finished working through all of the sixteen essays (both previously published and never published) to be included in a forthcoming volume to be published by Palgrave Macmillan. My limited blogging activity in recent months has been partly due to my need to work on the essays before submitting them for publication. Earlier versions of several of the essays in the volume originally appeared as, or were developed from, posts on this blog, whose tenth anniversary is about to occur four weeks hence. The working title of the volume is Studies in the History of Monetary Theory: Controversies and Clarifications.

Before the zoom conversation, I shared a draft of the introductory chapter, which lists eight key ideas that underlie, and are recurrent themes in, the subsequent chapters and explains how those ideas stem from my training as an aspiring young economist at the storied UCLA economics department. The first part of the zoom conversation was prompted by that introductory chapter.

The entire conversation is now posted on Youtube.

Here is the Table of Contents of the volume

Studies in the History of Monetary Theory: Controversies and Clarifications

1 Introduction

Part I: Classical Monetary Theory

2 A Reintepretation of Classical Monetary Theory

3 On Some Classical Monetary Controversies

4 The Real Bills Doctrine in the Light of the Law of Reflux

5 Classical Monetary Theory and the Quantity Theory

6 Monetary Disequilibrium in Ricardo and Thornton

7 The Humean and Smithian Traditions in Monetary Theory

8 Rules versus Discretion in Monetary Theory Historically Contemplated

9 Say’s Law and the Classical Theory of Depressions

Part II: Hawtrey, Keynes, and Hayek

10 Good and Bad Trade: A Centenary Retrospective

11 Hawtrey and Keynes

12 Where Keynes Went Wrong

13 Deflation, Debt and the Great Depression (With Ronald Batchelder)

14 Pre-Keynesian Theory of the Great Depression: Whatever Happened to Hawtrey and Cassel? (With Ronald Batchelder)

15 Sraffa versus Hayek on the Natural Rate of Interest (With Paul Zimmerman)

16 Hayek, Deflation, Gold and Nihilism

17 Hayek, Hicks, Radner and Four Equilibrium Concepts: Intertemporal, Sequential, Temporary and Rational Expectations

Monetarism v. Hawtrey and Cassel

The following is an updated and revised version of the penultimate section of my paper with Ron Batchelder “Pre-Keynesian Theories of the Great Depressison: What Ever Happened to Hawtrey and Cassel?” which I am now preparing for publication. The previous version is available on SSRN.

In the 1950s and early 1960s, empirical studies of the effects of money and monetary policy by Milton Friedman, his students and followers, rehabilitated the idea that monetary policy had significant macroeconomic effects. Most importantly, in research with Anna Schwartz Friedman advanced the seemingly remarkable claim that the chief cause of the Great Depression had been a series of policy mistakes by the Federal Reserve. Although Hawtrey and Cassel, had also implicated the Federal Reserve in their explanation of the Great Depression, they were unmentioned by Friedman and Schwartz or by other Monetarists.[1]

The chief difference between the Monetarist and the Hawtrey-Cassel explanations of the Great Depression is that Monetarists posited a monetary shock (bank failures) specific to the U.S. as the primary, if not sole, cause of the Depression, while Hawtrey and Cassel considered the Depression a global phenomenon reflecting a rapidly increasing international demand for gold, bank failures being merely an incidental and aggravating symptom, specific to the U.S., of a more general monetary disorder.

Arguing that the Great Depression originated in the United States following a typical business-cycle downturn, Friedman and Schwartz (1963) attributed the depth of the downturn not to the unexplained initial shock, but to the contraction of the U.S. money stock caused by the bank failures. Dismissing any causal role for the gold standard in the Depression, Friedman and Schwartz (359-60) acknowledged only its role in propagating, via PSFM, an exogenous, policy-driven, contraction of the U.S. money stock to other gold-standard countries. According to Friedman and Schwartz, the monetary contraction was the cause, and deflation the effect.

But the causation posited by Friedman and Schwartz is the exact opposite of the true causation. Under the gold standard, deflation (i.e., gold appreciation) was the cause and the decline in the quantity of money the effect. Deflation in an international gold standard is not a local phenomenon originating in any single country; it occurs simultaneously in all gold standard countries.

To be sure the banking collapse in the U.S. exacerbated the catastrophe. But the collapse was the localized effect of a more general cause: deflation. Without deflation, neither the unexplained 1929 downturn nor the subsequent banking collapse would have occurred. Nor was an investment boom in the most advanced and most productive economy in the world unsustainable as posited, with no evidence of unsustainability other than the subsequent economic collapse, by the Austrian malinvestment hypothesis.

Friedman and Schwartz based their assertion that the monetary disturbance that caused the Great Depression occurred in the U.S. on the observation that, from 1929 to 1931, gold flowed into, not out of, the U.S. Had the disturbance occurred elsewhere, they argued, gold would have flowed out of, not into, the U. S.

Table 1 shows the half-year changes in U.S., French, and world gold reserves starting in June 1928, when the French monetary law re-establishing the gold standard was enacted.

TABLE 1: Gold Reserves in US, France, and the World June 1928-December 1931 (measured in dollars)
Date World ReservesUS ReservesUS Share (percent)French ReservesFrench Share (percent)
June 19289,7493,73238.31,13611.7
Dec. 192810,0573,74637.21,25412.4
2nd half 1928 change31214-1.11180.7
June 192910,1263,95639.11,43614.2
1st half 1929 change692101.91821.8
Dec. 192910,3363,90037.71,63315.8
2nd half 1929 change210-56-1.41971.6
June 193010,6714,17839.21,72716.2
1st half 1930 change3352781.5940.4
Dec. 193010,9444,22538.72,10019.2
2nd half 1930 change 27347-0.53733.0
June 193111,264459340.82,21219.6
1st half 1931 change3203682.11120.4
Dec. 193111,3234,05135.82,69923.8
2nd half 1931 change59-542-5.04874.2
June 1928-Dec. 1931 change1,574319-2.51,56312.1
Source: H. C. Johnson, Gold, France and the Great Depression

In the three-and-a-half years from June 1928 (when gold convertibility of the franc was restored) to December 1931, gold inflows into France exceeded gold inflows into the United States. The total gold inflow into France during the June 1928 to December 1931 period was $1.563 billion compared to only $319 billion into the United States.

However, much of the difference in the totals stems from the gold outflow from the U.S. into France in the second half of 1931, reflecting fears of a possible U.S. devaluation or suspension of convertibility after Great Britain and other countries suspended the gold standard in September 1931 (Hamilton 2012). From June 1928 through June 1931, the total gold inflow into the U.S. was $861 billion and the total gold inflow into France was $1.076 billion, the U.S. share of total reserves increasing from 38.3 percent to 40.6 percent, while the total French share increased from 11.7 percent to 19.6 percent.[2]

In the first half of 1931, when the first two waves of U.S. bank failures occurred, the increase in U.S. gold reserves exceeded the increase in world gold reserves. The shift by the public from holding bank deposits to holding currency increased reserve requirements, an increase reflected in the gold reserves held by the U.S. The increased U.S. demand for gold likely exacerbated the deflationary pressures affecting all gold-standard countries, perhaps contributing to the failure of the Credit-Anstalt in May 1931 that intensified the European crisis that forced Britain off the gold standard in September.

The combined increase in U.S. and French gold reserves was $1.937 billion compared to an increase of only $1.515 billion in total world reserves, indicating that the U.S. and France were drawing reserves either from other central banks or from privately held gold stocks. Clearly, both the U.S. and France were exerting powerful deflationary pressure on the world economy, before and during the downward spiral of the Great Depression.[3]

Deflationary forces were operating directly on prices before the quantity of money adjusted to the decline in prices. In some countries the adjustment of the quantity of money was relatively smooth; in the U.S. it was exceptionally difficult, but, not even in the U.S., was it the source of the disturbance. Hawtrey and Cassel understood that; Friedman did not.

In explaining the sources of his interest in monetary theory and the role of monetary policy, Friedman (1970) pointedly distinguished between the monetary tradition from which his work emerged and the dominant tradition in London circa 1930, citing Robbins’s (1934) Austrian-deflationist book on the Great Depression, while ignoring Hawtrey and Cassel. Friedman linked his work to the Chicago oral tradition, citing a lecture by Jacob Viner (1933) as foreshadowing his own explanation of the Great Depression, attributing the loss of interest in monetary theory and policy by the wider profession to the deflationism of LSE monetary economists. Friedman went on to suggest that the anti-deflationism of the Chicago monetary tradition immunized it against the broader reaction against monetary theory and policy, that the Austro-London pro-deflation bias provoked against monetary theory and policy.

Though perhaps superficially plausible, Friedman’s argument ignores, as he did throughout a half-century of scholarship and research, the contributions of Hawtrey and Cassel and especially their explanation of the Great Depression. Unfortunately, Friedman’s outsized influence on economists trained after the Keynesian Revolution distracted their attention from contributions outside the crude Keynesian-Monetarist dichotomy that shaped his approach to monetary economics.

Eclectics like Hawtrey and Cassel were neither natural sources of authority, nor obvious ideological foils for Friedman to focus upon. Already forgotten, providing neither convenient targets, nor ideological support, Hawtrey and Cassel, could be easily and conveniently ignored.


[1] Meltzer (2001) did mention Hawtrey, but the reference was perfunctory and did not address the substance of his and Cassel’s explanation of the Great Depression.

[2] By far the largest six-month increase in U.S. gold reserves was in the June-December 1931 period coinciding with the two waves of bank failures at the end of 1930 and in March 1931 causing a substantial shift from deposits to currency which required an increase in gold reserves owing to the higher ratio of required gold reserves against currency than against bank deposits.

[3] Fremling (1985) noted that, even during the 1929-31 period, the U.S. share of world gold reserves actually declined. However, her calculation includes the extraordinary outflow of gold from the U.S. in the second half of 1931. The U.S. share of global gold reserves rose from June 1928 to June 1931.

The Real-Bills Doctrine, the Lender of Last Resort, and the Scope of Banking

Here is another section from my work in progress on the Smithian and Humean traditions in monetary economics. The discussion starts with a comparison of the negative view David Hume took toward banks and the positive view taken by Adam Smith which was also discussed in the previous post on the price-specie-flow mechanism. This section discusses how Smith, despite viewing banks positively, also understood that banks can be a source of disturbances as well as of efficiencies, and how he addressed that problem and how his followers who shared a positive view toward banks addressed the problem. Comments and feedback are welcome and greatly appreciated.

Hume and Smith had very different views about fractional-reserve banking and its capacity to provide the public with the desired quantity of money (banknotes and deposits) and promote international adjustment. The cash created by banks consists of liabilities on themselves that they exchange for liabilities on the public. Liabilities on the public accepted by banks become their assets, generating revenue streams with which banks cover their outlays including obligations to creditors and stockholders.

The previous post focused on the liability side of bank balance sheets, and whether there are economic forces that limit the size of those balance sheets, implying a point of equilibrium bank expansion. Believing that banks have an unlimited incentive to issue liabilities, whose face value exceeds their cost of production, Hume considered banks dangerous and inflationary. Smith disagreed, arguing that although bank money is a less costly alternative to the full-bodied money preferred by Hume, banks don’t create liabilities limitlessly, because, unless those liabilities generate corresponding revenue streams, they will be unable to redeem those liabilities, which their creditors may require of them, at will. To enhance the attractiveness of those liabilities and to increase the demand to hold them, competitive banks promise to convert those liabilities, at a stipulated rate, into an asset whose value they do not control. Under those conditions, banks have neither the incentive nor the capacity to cause inflation.

I turn now to a different topic: whether Smith’s rejection of the idea that banks are systematically biased toward overissuing liabilities implies that banks require no external control or intervention. I begin by briefly referring to Smith’s support of the real-bills doctrine and then extend that discussion to two other issues: the lender of last resort and the scope of banking.

A         Real-Bills Doctrine

I have argued elsewhere that, besides sketching the outlines of Fullarton’s argument for the Law of Reflux, Adam Smith recommended that banks observe a form of the real-bills doctrine, namely that banks issue sight liabilities only in exchange for real commercial bills of short (usually 90-days) duration. Increases in the demand for money cause bank balance sheets to expand; decreases cause them to contract. Unlike Mints (1945), who identified the Law of Reflux with the real-bills doctrine, I suggested that Smith viewed the real-bills doctrine as a pragmatic policy to facilitate contractions in the size of bank balance sheets as required by the reflux of their liabilities. With the discrepancy between the duration of liabilities and assets limited by issuing sight liabilities only in exchange for short-term bills, bank balance sheets would contract automatically thereby obviating, at least in part, the liquidation of longer-term assets at depressed prices.

On this reading, Smith recognized that banking policy ought to take account of the composition of bank balance sheets, in particular, the sort of assets that banks accept as backing for the sight liabilities that they issue. I would also emphasize that on this interpretation, Smith did not believe, as did many later advocates of the doctrine, that lending on the security of real bills is sufficient to prevent the price level from changing. Even if banks have no systematic incentive to overissue their liabilities, unless those liabilities are made convertible into an asset whose value is determined independently of the banks, the value of their liabilities is undetermined. Convertibility is how banks anchor the value of their liabilities, thereby increasing the attractiveness of those liabilities to the public and the willingness of the public to accept and hold them.

But Smith’s support for the real-bills doctrine indicates that, while understanding the equilibrating tendencies of competition on bank operations, he also recognized the inherent instability of banking caused by fluctuations in the value and liquidity of their assets. Smith’s support for the real-bills doctrine addressed one type of instability: the maturity mismatch between banks’ assets and liabilities. But there are other sources of instability, which may require further institutional or policy measures beyond the general laws of property and contract whose application and enforcement, in Smith’s view, generally sufficed for the self-interested conduct of private firms to lead to socially benign outcomes.

In the remainder of this section, I consider two other methods of addressing the vulnerability of bank assets to sudden losses of value: (1) the creation or empowerment of a lender of last resort capable of lending to illiquid, but solvent, banks possessing good security (valuable assets) as collateral against which to borrow, and (2) limits beyond the real-bills doctrine over the permissible activities undertaken by commercial banks.

B         Lender of Last Resort

Although the real-bills doctrine limits the exposure of bank balance sheets to adverse shocks on the value of long-term liabilities, even banks whose liabilities were issued in exchange for short-term real bills of exchange may be unable to meet all demands for redemption in periods of extreme financial distress, when debtors cannot sell their products at the prices they expected and cannot meet their own obligations to their creditors. If banks are called upon to redeem their liabilities, banks may be faced with a choice between depleting their own cash reserves, when they are most needed, or liquidating other assets at substantial, if not catastrophic, losses.

Smith’s version of the real-bills doctrine addressed one aspect of balance-sheet risk, but the underlying problem is deeper and more complicated than the liquidity issue that concerned Smith. The assets accepted by banks in exchange for their liabilities are typically not easily marketable, so if those assets must be shed quickly to satisfy demands for payment, banks’ solvency may be jeopardized by consequent capital losses. Limiting portfolios to short-term assets limits exposure to such losses, but only when the disturbances requiring asset liquidation affect only a relatively small number of banks. As the number of affected banks increases, their ability to counter the disturbance is impaired, as the interbank market for credit starts to freeze up or break down entirely, leaving them unable to offer short-term relief to, or receive it from, other momentarily illiquid banks. It is then that emergency lending by a lender of last resort to illiquid, but possibly still solvent, banks is necessary.

What causes a cluster of expectational errors by banks in exchanging their liabilities for assets supplied by their customers that become less valuable than they were upon acceptance? Are financial crises that result in, or are caused by, asset write downs by banks caused by random clusters of errors by banks, or are there systematic causes of such errors? Does the danger lie in the magnitude of the errors or in the transmission mechanism?

Here, too, the Humean and Smithian traditions seem to be at odds, offering different answers to problems, or, if not answers, at least different approaches to problems. Focusing on the liability side of bank balance sheets, the Humean tradition emphasizes the expansion of bank lending and the consequent creation of banknotes or deposits as the main impulse to macroeconomic fluctuations, a boom-bust or credit cycle triggered by banks’ lending to finance either business investment or consumer spending. Despite their theoretical differences, both Austrian business-cycle theory and Friedmanite Monetarism share a common intellectual ancestry, traceable by way of the Currency School to Hume, identifying the source of business-cycle fluctuations in excessive growth in the quantity of money.

The eclectic Smithian tradition accommodates both monetary and non-monetary business-cycle theories, but balance-sheet effects on banks are more naturally accommodated within the Smithian tradition than the Humean tradition with its focus on the liabilities not the assets of banks. At any rate, more research is necessary before we can decide whether serious financial disturbances result from big expectational errors or from contagion effects.

The Great Depression resulted from a big error. After the steep deflation and depression of 1920-22, followed by a gradual restoration of the gold standard, fears of further deflation were dispelled and steady economic expansion, especially in the United States, resulted. Suddenly in 1929, as France and other countries rejoined the gold standard, the fears voiced by Hawtrey and Cassel that restoring the gold standard could have serious deflationary consequences appeared increasingly more likely to be realized. Real signs of deflation began to appear in the summer of 1929, and in the fall the stock market collapsed. Rather than use monetary policy to counter incipient deflation, policy makers and many economists argued that deflation was part of the solution not the problem. And the Depression came.

It is generally agreed that the 2008 financial crisis that triggered the Little Depression (aka Great Recession) was largely the result of a housing bubble fueled by unsound mortgage lending by banks and questionable underwriting practices in packaging and marketing of mortgage-backed securities. However, although the housing bubble seems to have burst the spring of 2007, the crisis did not start until September 2008.

It is at least possible, as I have argued (Glasner 2018) that, despite the financial fragility caused by the housing bubble and unsound lending practices that fueled the bubble, the crisis could have been avoided but for a reflexive policy tightening by the Federal Reserve starting in 2007 that caused a recession starting in December 2007 and gradually worsening through the summer of 2008. Rather than ease monetary policy as the recession deepened, the Fed, distracted by rising headline inflation owing to rising oil prices that summer, would not reduce its interest-rate target further after March 2008. If my interpretation is correct, the financial crisis of 2008 and the subsequent Little Depression (aka Great Recession) were as much caused by bad monetary policy as by the unsound lending practices and mistaken expectations by lenders.

It is when all agents are cash constrained that a lender of last resort that is able to provide the liquidity that the usual suppliers of liquidity cannot provide, but are instead demanding, is necessary to avoid a systemic breakdown. In 2008, the Fed was unwilling to satisfy demands for liquidity until the crisis had deteriorated to the point of a worldwide collapse. In the nineteenth century, Thornton and Fullarton understood that the Bank of England was uniquely able to provide liquidity in such circumstances, recommending that it lend freely in periods of financial stress.

That policy was not viewed favorably either by Humean supporters of the Currency Principle, opposed to all forms of fractional-reserve banking, or by Smithian supporters of free banking who deplored the privileged central-banking position granted to the Bank of England. Although the Fed in 2008 acknowledged that it was both a national and international lender of last resort, it was tragically slow to take the necessary actions to end the crisis after allowing it to spiral nearly out of control.

While cogent arguments have been made that a free-banking alternative to the lender-of-last-resort services of the Bank of England might have been possible in the nineteenth century,[2] even a free-banking system would require a mechanism for handling periods of financial stress. Free-banking supporters argue that bank clearinghouses have emerged spontaneously in the absence of central banks, and could provide the lender-of-last resort services provided by central banks. But, insofar as bank clearinghouses would take on the lender-of-last-resort function, which involves some intervention and supervision of bank activities by either the clearinghouse or the central bank, the same anticompetitive or cartelistic objections to the provision of lender-of-last-resort services by central banks also would apply to the provision of those services by clearinghouses. So, the tension between libertarian, free-market principles and lender-of-last-resort services would not necessarily be eliminated bank clearinghouses instead of central banks provided those services.

This is an appropriate place to consider Walter Bagehot’s contribution to the lender-of-last-resort doctrine. Building on the work of Thornton and Fullarton, Bagehot formulated the classic principle that, during times of financial distress, the Bank of England should lend freely at a penalty rate to banks on good security. Bagehot, himself, admitted to a certain unease in offering this advice, opining that it was regrettable that the Bank of England achieved a pre-eminent position in the British banking system, so that a decentralized banking system, along the lines of the Scottish free-banking system, could have evolved. But given the historical development of British banking, including the 1844 Bank Charter Act, Bagehot, an eminently practical man, had no desire to recommend radical reform, only to help the existing system operate as smoothly as it could be made to operate.

But the soundness of Bagehot’s advice to lend freely at a penalty rate is dubious. In a financial crisis, the market rate of interest primarily reflects a liquidity premium not an expected real return on capital, the latter typically being depressed in a crisis. Charging a penalty rate to distressed borrowers in a crisis only raises the liquidity premium. Monetary policy ought to aim to reduce, not to increase, that premium. So Bagehot’s advice, derived from a misplaced sense of what is practical and prudent and financially sound, rather than from sound analysis, was far from sound.

Under the gold standard, or under any fixed-exchange-rate regime, a single country has an incentive to raise interest rates above the rates of other countries to prevent a gold outflow or attract an inflow. Under these circumstances, a failure of international cooperation can lead to competitive rate increases as monetary authorities scramble to maintain or increase their gold reserves. In testimony to the Macmillan Commission in 1930, Ralph Hawtrey masterfully described the obligation of a central bank in a crisis. Here is his exchange with the Chairman of the Commission Hugh Macmillan:

MACMILLAN: Suppose . . . without restricting credit . . . that gold had gone out to a very considerable extent, would that not have had very serious consequences on the international position of London?

HAWTREY: I do not think the credit of London depends on any particular figure of gold holding. . . . The harm began to be done in March and April of 1925 [when] the fall in American prices started. There was no reason why the Bank of England should have taken ny action at that time so far as the question of loss of gold is concerned. . . . I believed at the time and I still think that the right treatment would have been to restore the gold standard de facto before it was restored de jure. That is what all the other countries have done. . . . I would have suggested that we should have adopted the practice of always selling gold to a sufficient extent to prevent the exchange depreciating. There would have been no legal obligation to continue convertibility into gold . . . If that course had been adopted, the Bank of England would never have been anxious about the gold holding, they would have been able to see it ebb away to quite a considerable extent with perfect equanimity, . . and might have continued with a 4 percent Bank Rate.

MACMILLAN: . . . the course you suggest would not have been consistent with what one may call orthodox Central Banking, would it?

HAWTREY: I do not know what orthodox Central Banking is.

MACMILLAN: . . . when gold ebbs away you must restrict credit as a general principle?

HAWTREY: . . . that kind of orthodoxy is like conventions at bridge; you have to break them when the circumstances call for it. I think that a gold reserve exists to be used. . . . Perhaps once in a century the time comes when you can use your gold reserve for the governing purpose, provided you have the courage to use practically all of it.

Hawtrey here was echoing Fullarton’s insight that there is no rigid relationship between the gold reserves held by the Bank of England and the total quantity of sight liabilities created by the British banking system. Rather, he argued, the Bank should hold an ample reserve sufficient to satisfy the demand for gold in a crisis when a sudden and temporary demand for gold had to be accommodated. That was Hawtrey’s advice, but not Bagehot’s, whose concern was about banks’ moral hazard and imprudent lending in the expectation of being rescued in a crisis by the Bank of England. Indeed, moral hazard is a problem, but in a crisis it is a secondary problem, when, as Hawtrey explained, alleviating the crisis, not discouraging moral hazard, must be the primary concern of the lender of last resort.

            C         Scope of Banking

Inclined to find remedies for financial distress in structural reforms limiting the types of assets banks accept in exchange for their sight liabilities, Smith did not recommend a lender of last resort.[3] Another method of reducing risk, perhaps more in tune with the Smithian real-bills doctrine than a lender of last resort, is to restrict the activities of banks that issue banknotes and deposits.

In Anglophone countries, commercial banking generally evolved as separate and distinct from investment banking. It was only during the Great Depression and the resulting wave of bank failures that the combination of commercial and investment banking was legally prohibited by the Glass-Steagall Act, eventually repealed in 1999. On the Continent, where commercial banking penetrated less deeply into the fabric of economic and commercial life than in Anglophone countries, commercial banking developed more or less along with investment banking in what are called universal banks.

Whether the earlier, and more widespread, adoption of commercial banking in Anglophone countries than on the Continent advanced the idea that no banking institution should provide both commercial- and investment-banking services is not a question about which I offer a conjecture, but it seems a topic worthy of study. The Glass-Steagall Act, which enforced that separation after being breached early in the twentieth century, a breach thought by some to have contributed to US bank failures in the Great Depression, was based on a presumption against combining and investment-banking in a single institution. But even apart from the concerns that led to enactment of Glass-Steagall, limiting the exposure of commercial banks, which supply most of the cash held by the public, to the balance-sheet risk associated with investment-banking activities seems reasonable. Moreover, the adoption of government deposit insurance after the Great Depression as well as banks’ access to the discount window of the central bank may augment the moral hazard induced by deposit insurance and a lender of last resort, offsetting potential economies of scope associated with combining commercial and investment banking.

Although legal barriers to the combination of commercial and investment banking have long been eliminated, proposals for “narrow banking” that would restrict the activities undertaken by commercial banks continue to be made. Two different interpretations of narrow banking – one Smithian and one Humean – are possible.

The Humean concern about banking was that banks are inherently disposed to overissue their liabilities. The Humean response to the concern has been to propose 100-percent reserve banking, a comprehensive extension of the 100-percent marginal reserve requirement on the issue of banknotes imposed by the Bank Charter Act. Such measures could succeed, as some supporters (Simons 1936) came to realize, only if accompanied by a radical change the financial practices and arrangements on which all debt contracts are based. It is difficult to imagine that the necessary restructuring of economic activity would ever be implemented or tolerated.

The Humean concern was dismissed by the Smithian tradition, recognizing that banks, even if unconstrained by reserve requirements, have no incentive to issue liabilities without limit. The Smithian concern was whether banks could cope with balance-sheet risks after unexpected losses in the value of their assets. Although narrow banking proposals are a legitimate and possibly worthwhile response to that concern, the acceptance by central banks of responsibility to act as a lender of last resort and widespread government deposit insurance to dampen contagion effects have taken the question of narrowing or restricting the functions of money-creating banks off the table. Whether a different strategy for addressing the systemic risks associated with banks’ creation of money by relying solely on deposit insurance and a lender of last resort is a question that still deserves thoughtful attention.

White and Hogan on Hayek and Cassel on the Causes of the Great Depression

Lawrence White and Thomas Hogan have just published a new paper in the Journal of Economic Behavior and Organization (“Hayek, Cassel, and the origins of the great depression”). Since White is a leading Hayek scholar, who has written extensively on Hayek’s economic writings (e.g., his important 2008 article “Did Hayek and Robbins Deepen the Great Depression?”) and edited the new edition of Hayek’s notoriously difficult volume, The Pure Theory of Capital, when it was published as volume 11 of the Collected Works of F. A. Hayek, the conclusion reached by the new paper that Hayek had a better understanding than Cassel of what caused the Great Depression is not, in and of itself, surprising.

However, I admit to being taken aback by the abstract of the paper:

We revisit the origins of the Great Depression by contrasting the accounts of two contemporary economists, Friedrich A. Hayek and Gustav Cassel. Their distinct theories highlight important, but often unacknowledged, differences between the international depression and the Great Depression in the United States. Hayek’s business cycle theory offered a monetary overexpansion account for the 1920s investment boom, the collapse of which initiated the Great Depression in the United States. Cassel’s warnings about a scarcity gold reserves related to the international character of the downturn, but the mechanisms he emphasized contributed little to the deflation or depression in the United States.

I wouldn’t deny that there are differences between the way the Great Depression played out in the United States and in the rest of the world, e.g., Britain and France, which to be sure, suffered less severely than did the US or, say, Germany. It is both possible, and important, to explore and understand the differential effects of the Great Depression in various countries. I am sorry to say that White and Hogan do neither. Instead, taking at face value the dubious authority of Friedman and Schwartz’s treatment of the Great Depression in the Monetary History of the United States, they assert that the cause of the Great Depression in the US was fundamentally different from the cause of the Great Depression in many or all other countries.

Taking that insupportable premise from Friedman and Schwartz, they simply invoke various numerical facts from the Monetary History as if those facts, in and of themselves, demonstrate what requires to be demonstrated: that the causes of the Great Depression in the US were different from those of the Great Depression in the rest of the world. That assumption vitiated the entire treatment of the Great Depression in the Monetary History, and it vitiates the results that White and Hogan reach about the merits of the conflicting explanations of the Great Depression offered by Cassel and Hayek.

I’ve discussed the failings of Friedman’s treatment of the Great Depression and of other episodes he analyzed in the Monetary History in previous posts (e.g., here, here, here, here, and here). The common failing of all the episodes treated by Friedman in the Monetary History and elsewhere is that he misunderstood how the gold standard operated, because his model of the gold standard was a primitive version of the price-specie-flow mechanism in which the monetary authority determines the quantity of money, which then determines the price level, which then determines the balance of payments, the balance of payments being a function of the relative price levels of the different countries on the gold standard. Countries with relatively high price levels experience trade deficits and outflows of gold, and countries with relatively low price levels experience trade surpluses and inflows of gold. Under the mythical “rules of the game” under the gold standard, countries with gold inflows were supposed to expand their money supplies, so that prices would rise and countries with outflows were supposed to reduce their money supplies, so that prices fall. If countries followed the rules, then an international monetary equilibrium would eventually be reached.

That is the model of the gold standard that Friedman used throughout his career. He was not alone; Hayek and Mises and many others also used that model, following Hume’s treatment in his essay on the balance of trade. But it’s the wrong model. The correct model is the one originating with Adam Smith, based on the law of one price, which says that prices of all commodities in terms of gold are equalized by arbitrage in all countries on the gold standard.

As a first approximation, under the Smithean model, there is only one price level adjusted for different currency parities for all countries on the gold standard. So if there is deflation in one country on the gold standard, there is deflation for all countries on the gold standard. If the rest of the world was suffering from deflation under the gold standard, the US was also suffering from a deflation of approximately the same magnitude as every other country on the gold standard was suffering.

The entire premise of the Friedman account of the Great Depression, adopted unquestioningly by White and Hogan, is that there was a different causal mechanism for the Great Depression in the United States from the mechanism operating in the rest of the world. That premise is flatly wrong. The causation assumed by Friedman in the Monetary History was the exact opposite of the actual causation. It wasn’t, as Friedman assumed, that the decline in the quantity of money in the US was causing deflation; it was the common deflation in all gold-standard countries that was causing the quantity of money in the US to decline.

To be sure there was a banking collapse in the US that was exacerbating the catastrophe, but that was an effect of the underlying cause: deflation, not an independent cause. Absent the deflationary collapse, there is no reason to assume that the investment boom in the most advanced and most productive economy in the world after World War I was unsustainable as the Hayekian overinvestment/malinvestment hypothesis posits with no evidence of unsustainability other than the subsequent economic collapse.

So what did cause deflation under the gold standard? It was the rapid increase in the monetary demand for gold resulting from the insane policy of the Bank of France (disgracefully endorsed by Hayek as late as 1932) which Cassel, along with Ralph Hawtrey (whose writings, closely parallel to Cassel’s on the danger of postwar deflation, avoid all of the ancillary mistakes White and Hogan attribute to Cassel), was warning would lead to catastrophe.

It is true that Cassel also believed that over the long run not enough gold was being produced to avoid deflation. White and Hogan spend inordinate space and attention on that issue, because that secular tendency toward deflation is entirely different from the catastrophic effects of the increase in gold demand in the late 1920s triggered by the insane policy of the Bank of France.

The US could have mitigated the effects if it had been willing to accommodate the Bank of France’s demand to increase its gold holdings. Of course, mitigating the effects of the insane policy of the Bank of France would have rewarded the French for their catastrophic policy, but, under the circumstances, some other means of addressing French misconduct would have spared the world incalculable suffering. But misled by an inordinate fear of stock market speculation, the Fed tightened policy in 1928-29 and began accumulating gold rather than accommodate the French demand.

And the Depression came.

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 a 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 left behind by Burns, upon his departure from the Fed in 1978, had to be cleaned up. The mess got even worse under Burns’s successor, G. William Miller. The clean up didn’t 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 already 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 under both Kennedy and Nixon, 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. 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 its dishonorable mission had been accomplished.

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 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 needed 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, rendering 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 more 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, effort to keep the monetary aggregates from overshooting their arbitrary Monetarist target range. It was not until Volcker, in the 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 crusade 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 are bad ideas. 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.

 

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.


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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