Archive for the 'sterilization' Category

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Advertisements

Sterilizing Gold Inflows: The Anatomy of a Misconception

In my previous post about Milton Friedman’s problematic distinction between real and pseudo-gold standards, I mentioned that one of the signs that Friedman pointed to in asserting that the Federal Reserve Board in the 1920s was managing a pseudo gold standard was the “sterilization” of gold inflows to the Fed. What Friedman meant by sterilization is that the incremental gold reserves flowing into the Fed did not lead to a commensurate increase in the stock of money held by the public, the failure of the stock of money to increase commensurately with an inflow of gold being the standard understanding of sterilization in the context of the gold standard.

Of course “commensurateness” is in the eye of the beholder. Because Friedman felt that, given the size of the gold inflow, the US money stock did not increase “enough,” he argued that the gold standard in the 1920s did not function as a “real” gold standard would have functioned. Now Friedman’s denial that a gold standard in which gold inflows are sterilized is a “real” gold standard may have been uniquely his own, but his understanding of sterilization was hardly unique; it was widely shared. In fact it was so widely shared that I myself have had to engage in a bit of an intellectual struggle to free myself from its implicit reversal of the causation between money creation and the holding of reserves. For direct evidence of my struggles, see some of my earlier posts on currency manipulation (here, here and here), in which I began by using the concept of sterilization as if it actually made sense in the context of international adjustment, and did not fully grasp that the concept leads only to confusion. In an earlier post about Hayek’s 1932 defense of the insane Bank of France, I did not explicitly refer to sterilization, and got the essential analysis right. Of course Hayek, in his 1932 defense of the Bank of France, was using — whether implicitly or explicitly I don’t recall — the idea of sterilization to defend the Bank of France against critics by showing that the Bank of France was not guilty of sterilization, but Hayek’s criterion for what qualifies as sterilization was stricter than Friedman’s. In any event, it would be fair to say that Friedman’s conception of how the gold standard works was broadly consistent with the general understanding at the time of how the gold standard operates, though, even under the orthodox understanding, he had no basis for asserting that the 1920s gold standard was fraudulent and bogus.

To sort out the multiple layers of confusion operating here, it helps to go back to the classic discussion of international monetary adjustment under a pure gold currency, which was the basis for later discussions of international monetary adjustment under a gold standard (i.e, a paper currency convertible into gold at a fixed exchange rate). I refer to David Hume’s essay “Of the Balance of Trade” in which he argued that there is an equilibrium distribution of gold across different countries, working through a famous thought experiment in which four-fifths of the gold held in Great Britain was annihilated to show that an automatic adjustment process would redistribute the international stock of gold to restore Britain’s equilibrium share of the total world stock of gold.

The adjustment process, which came to be known as the price-specie flow mechanism (PSFM), is widely considered one of Hume’s greatest contributions to economics and to monetary theory. Applying the simple quantity theory of money, Hume argued that the loss of 80% of Britain’s gold stock would mean that prices and wages in Britain would fall by 80%. But with British prices 80% lower than prices elsewhere, Britain would stop importing goods that could now be obtained more cheaply at home than they could be obtained abroad, while foreigners would begin exporting all they could from Britain to take advantage of low British prices. British exports would rise and imports fall, causing an inflow of gold into Britain. But, as gold flowed into Britain, British prices would rise, thereby reducing the British competitive advantage, causing imports to increase and exports to decrease, and consequently reducing the inflow of gold. The adjustment process would continue until British prices and wages had risen to a level equal to that in other countries, thus eliminating the British balance-of-trade surplus and terminating the inflow of gold.

This was a very nice argument, and Hume, a consummate literary stylist, expressed it beautifully. There is only one problem: Hume ignored that the prices of tradable goods (those that can be imported or exported or those that compete with imports and exports) are determined not in isolated domestic markets, but in international markets, so the premise that all British prices, like the British stock of gold, would fall by 80% was clearly wrong. Nevertheless, the disconnect between the simple quantity theory and the idea that the prices of tradable goods are determined in international markets was widely ignored by subsequent writers. Although Adam Smith, David Ricardo, and J. S. Mill avoided the fallacy, but without explicit criticism of Hume, while Henry Thornton, in his great work The Paper Credit of Great Britain, alternately embraced it and rejected it, the Humean analysis, by the end of the nineteenth century, if not earlier, had become the established orthodoxy.

Towards the middle of the nineteenth century, there was a famous series of controversies over the Bank Charter Act of 1844, in which two groups of economists the Currency School in support and the Banking School in opposition argued about the key provisions of the Act: to centralize the issue of Banknotes in Great Britain within the Bank of England and to prohibit the Bank of England from issuing additional banknotes, beyond the fixed quantity of “unbacked” notes (i.e. without gold cover) already in circulation, unless the additional banknotes were issued in exchange for a corresponding amount of gold coin or bullion. In other words, the Bank Charter Act imposed a 100% marginal reserve requirement on the issue of additional banknotes by the Bank of England, thereby codifying what was then known as the Currency Principle, the idea being that the fluctuation in the total quantity of Banknotes ought to track exactly the Humean mechanism in which the quantity of money in circulation changes pound for pound with the import or export of gold.

The doctrinal history of the controversies about the Bank Charter Act are very confused, and I have written about them at length in several papers (this, this, and this) and in my book on free banking, so I don’t want to go over that ground again here. But until the advent of the monetary approach to the balance of payments in the late 1960s and early 1970s, the thinking of the economics profession about monetary adjustment under the gold standard was largely in a state of confusion, the underlying fallacy of PSFM having remained largely unrecognized. One of the few who avoided the confusion was R. G. Hawtrey, who had anticipated all the important elements of the monetary approach to the balance of payments, but whose work had been largely forgotten in the wake of the General Theory.

Two important papers changed the landscape. The first was a 1976 paper by Donald McCloskey and Richard Zecher “How the Gold Standard Really Worked” which explained that a whole slew of supposed anomalies in the empirical literature on the gold standard were easily explained if the Humean PSFM was disregarded. The second was Paul Samuelson’s 1980 paper “A Corrected Version of Hume’s Equilibrating Mechanisms for International Trade,” showing that the change in relative price levels — the mechanism whereby international monetary equilibrium is supposedly restored according to PSFM — is irrelevant to the adjustment process when arbitrage constraints on tradable goods are effective. The burden of the adjustment is carried by changes in spending patterns that restore desired asset holdings to their equilibrium levels, independently of relative-price-level effects. Samuelson further showed that even when, owing to the existence of non-tradable goods, there are relative-price-level effects, those effects are irrelevant to the adjustment process that restores equilibrium.

What was missing from Hume’s analysis was the concept of a demand to hold money (or gold). The difference between desired and actual holdings of cash imply corresponding changes in expenditure, and those changes in expenditure restore equilibrium in money (gold) holdings independent of any price effects. Lacking any theory of the demand to hold money (or gold), Hume had to rely on a price-level adjustment to explain how equilibrium is restored after a change in the quantity of gold in one country. Hume’s misstep set monetary economics off on a two-century detour, avoided by only a relative handful of economists, in explaining the process of international adjustment.

So historically there have been two paradigms of international adjustment under the gold standard: 1) the better-known, but incorrect, Humean PSFM based on relative-price-level differences which induce self-correcting gold flows that, in turn, are supposed to eliminate the price-level differences, and 2) the not-so-well-known, but correct, arbitrage-monetary-adjustment theory. Under the PSFM, the adjustment can occur only if gold flows give rise to relative-price-level adjustments. But, under PSFM, for those relative-price-level adjustments to occur, gold flows have to change the domestic money stock, because it is the quantity of domestic money that governs the domestic price level.

That is why if you believe, as Milton Friedman did, in PSFM, sterilization is such a big deal. Relative domestic price levels are correlated with relative domestic money stocks, so if a gold inflow into a country does not change its domestic money stock, the necessary increase in the relative price level of the country receiving the gold inflow cannot occur. The “automatic” adjustment mechanism under the gold standard has been blocked, implying that if there is sterilization, the gold standard is rendered fraudulent.

But we now know that that is not how the gold standard works. The point of gold flows was not to change relative price levels. International adjustment required changes in domestic money supplies to be sure, but, under the gold standard, changes in domestic money supplies are essentially unavoidable. Thus, in his 1932 defense of the insane Bank of France, Hayek pointed out that the domestic quantity of money had in fact increased in France along with French gold holdings. To Hayek, this meant that the Bank of France was not sterilizing the gold inflow. Friedman would have said that, given the gold inflow, the French money stock ought to have increased by a far larger amount than it actually did.

Neither Hayek nor Friedman understood what was happening. The French public wanted to increase their holdings of money. Because the French government imposed high gold reserve requirements (but less than 100%) on the creation of French banknotes and deposits, increasing holdings of money required the French to restrict their spending sufficiently to create a balance-of-trade surplus large enough to induce the inflow of gold needed to satisfy the reserve requirements on the desired increase in cash holdings. The direction of causation was exactly the opposite of what Friedman thought. It was the desired increase in the amount of francs that the French wanted to hold that (given the level of gold reserve requirements) induced the increase in French gold holdings.

But this doesn’t mean, as Hayek argued, that the insane Bank of France was not wreaking havoc on the international monetary system. By advocating a banking law that imposed very high gold reserve requirements and by insisting on redeeming almost all of its non-gold foreign exchange reserves into gold bullion, the insane Bank of France, along with the clueless Federal Reserve, generated a huge increase in the international monetary demand for gold, which was the proximate cause of the worldwide deflation that began in 1929 and continued till 1933. The problem was not a misalignment between relative price levels, which is sterilization supposedly causes; the problem was a worldwide deflation that afflicted all countries on the gold standard, and was avoidable only by escaping from the gold standard.

At any rate, the concept of sterilization does nothing to enhance our understanding of that deflationary process. And whatever defects there were in the way that central banks were operating under the gold standard in the 1920s, the concept of sterilization averts attention from the critical problem which was the increasing demand of the world’s central banks, especially the Bank of France and the Federal Reserve, for gold reserves.


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.

Enter your email address to follow this blog and receive notifications of new posts by email.

Join 1,538 other followers

Follow Uneasy Money on WordPress.com