Posts Tagged 'David Laidler'

Samuelson Rules the Seas

I think Nick Rowe is a great economist; I really do. And on top of that, he recently has shown himself to be a very brave economist, fearlessly claiming to have shown that Paul Samuelson’s classic 1980 takedown (“A Corrected Version of Hume’s Equilibrating Mechanisms for International Trade“) of David Hume’s classic 1752 articulation of the price-specie-flow mechanism (PSFM) (“Of the Balance of Trade“) was all wrong. Although I am a great admirer of Paul Samuelson, I am far from believing that he was error-free. But I would be very cautious about attributing an error in pure economic theory to Samuelson. So if you were placing bets, Nick would certainly be the longshot in this match-up.

Of course, I should admit that I am not an entirely disinterested observer of this engagement, because in the early 1970s, long before I discovered the Samuelson article that Nick is challenging, Earl Thompson had convinced me that Hume’s account of PSFM was all wrong, the international arbitrage of tradable-goods prices implying that gold movements between countries couldn’t cause the relative price levels of those countries in terms of gold to deviate from a common level, beyond the limits imposed by the operation of international commodity arbitrage. And Thompson’s reasoning was largely restated in the ensuing decade by Jacob Frenkel and Harry Johnson (“The Monetary Approach to the Balance of Payments: Essential Concepts and Historical Origins”) and by Donald McCloskey and Richard Zecher (“How the Gold Standard Really Worked”) both in the 1976 volume on The Monetary Approach to the Balance of Payments edited by Johnson and Frenkel, and by David Laidler in his essay “Adam Smith as a Monetary Economist,” explaining why in The Wealth of Nations Smith ignored his best friend Hume’s classic essay on PSFM. So the main point of Samuelson’s takedown of Hume and the PSFM was not even original. What was original about Samuelson’s classic article was his dismissal of the rationalization that PSFM applies when there are both non-tradable and tradable goods, so that national price levels can deviate from the common international price level in terms of tradables, showing that the inclusion of tradables into the analysis serves only to slow down the adjustment process after a gold-supply shock.

So let’s follow Nick in his daring quest to disprove Samuelson, and see where that leads us.

Assume that durable sailing ships are costly to build, but have low (or zero for simplicity) operating costs. Assume apples are the only tradeable good, and one ship can transport one apple per year across the English Channel between Britain and France (the only countries in the world). Let P be the price of apples in Britain, P* be the price of apples in France, and R be the annual rental of a ship, (all prices measured in gold), then R=ABS(P*-P).

I am sorry to report that Nick has not gotten off to a good start here. There cannot be only tradable good. It takes two tango and two to trade. If apples are being traded, they must be traded for something, and that something is something other than apples. And, just to avoid misunderstanding, let me say that that something is also something other than gold. Otherwise, there couldn’t possibly be a difference between the Thompson-Frenkel-Johnson-McCloskey-Zecher-Laidler-Samuelson critique of PSFM and the PSFM. We need at least three goods – two real goods plus gold – providing a relative price between the two real goods and two absolute prices quoted in terms of gold (the numeraire). So if there are at least two absolute prices, then Nick’s equation for the annual rental of a ship R must be rewritten as follows R=ABS[P(A)*-P(A)+P(SE)*-P(SE)], where P(A) is the price of apples in Britain, P(A)* is the price of apples in France, P(SE) is the price of something else in Britain, and P(SE)* is the price of that same something else in France.

OK, now back to Nick:

In this model, the Law of One Price (P=P*) will only hold if the volume of exports of apples (in either direction) is unconstrained by the existing stock of ships, so rentals on ships are driven to zero. But then no ships would be built to export apples if ship rentals were expected to be always zero, which is a contradiction of the Law of One Price because arbitrage is impossible without ships. But an existing stock of ships represents a sunk cost (sorry) and they keep on sailing even as rentals approach zero. They sail around Samuelson’s Iceberg model (sorry) of transport costs.

This is a peculiar result in two respects. First, it suggests, perhaps inadvertently, that the law of price requires equality between the prices of goods in every location when in fact it only requires that prices in different locations not differ by more than the cost of transportation. The second, more serious, peculiarity is that with only one good being traded the price difference in that single good between the two locations has to be sufficient to cover the cost of building the ship. That suggests that there has to be a very large price difference in that single good to justify building the ship, but in fact there are at least two goods being shipped, so it is the sum of the price differences of the two goods that must be sufficient to cover the cost of building the ship. The more tradable goods there are, the smaller the price differences in any single good necessary to cover the cost of building the ship.

Again, back to Nick:

Start with zero exports, zero ships, and P=P*. Then suppose, like Hume, that some of the gold in Britain magically disappears. (And unlike Hume, just to keep it simple, suppose that gold magically reappears in France.)

Uh-oh. Just to keep it simple? I don’t think so. To me, keeping it simple would mean looking at one change in initial conditions at a time. The one relevant change – the one discussed by Hume – is a reduction in the stock of gold in Britain. But Nick is looking at two changes — a reduced stock of gold in Britain and an increased stock of gold in France — simultaneously. Why does it matter? Because the key point at issue is whether a national price level – i.e, Britain’s — can deviate from the international price level. In Nick’s two-country example, there should be one national price level and one international price level, which means that the only price level subject to change as a result of the change in initial conditions should be, as in Hume’s example, the British price level, while the French price level – representing the international price level – remained constant. In a two-country model, this can only be made plausible by assuming that France is large compared to Britain, so that a loss of gold could potentially affect the British price level without changing the French price level. Once again back to Nick.

The price of apples in Britain drops, the price of apples in France rises, and so the rent on a ship is now positive because you can use it to export apples from Britain to France. If that rent is big enough, and expected to stay big long enough, some ships will be built, and Britain will export apples to France in exchange for gold. Gold will flow from France to Britain, so the stock of gold will slowly rise in Britain and slowly fall in France, and the price of apples will likewise slowly rise in Britain and fall in France, so ship rentals will slowly fall, and the price of ships (the Present Value of those rents) will eventually fall below the cost of production, so no new ships will be built. But the ships already built will keep on sailing until rentals fall to zero or they rot (whichever comes first).

So notice what Nick has done. Instead of confronting the Thompson-Frenkel-Johnson-McCloseky-Zecher-Laidler-Samuelson critique of Hume, which asserts that a world price level determines the national price level, Nick has simply begged the question by not assuming that the world price of gold, which determines the world price level, is constant. Instead, he posits a decreased value of gold in France, owing to an increased French stock of gold, and an increased value of gold in Britain, owing to a decreased British stock of gold, and then conflating the resulting adjustment in the value gold with the operation of commodity arbitrage. Why Nick thinks his discussion is relevant to the Thompson-Frenkel-Johnson-McCloseky-Zecher-Laidler-Samuelson critique escapes me.

The flow of exports and hence the flow of specie is limited by the stock of ships. And only a finite number of ships will be built. So we observe David Hume’s price-specie flow mechanism playing out in real time.

This bugs me. Because it’s all sorta obvious really.

Yes, it bugs me, too. And, yes, it is obvious. But why is it relevant to the question under discussion, which is whether there is an international price level in terms of gold that constrains movements in national price levels in countries in which gold is the numeraire. In other words, if there is a shock to the gold stock of a small open economy, how much will the price level in that small open economy change? By the percentage change in the stock of gold in that country – as Hume maintained – or by the minisicule percentage change in the international stock of gold, gold prices in the country that has lost gold being constrained from changing by more than allowed by the cost of arbitrage operations? Nick’s little example is simply orthogonal to the question under discussion.

I skip Nick’s little exegetical discussion of Hume’s essay and proceed to what I think is the final substantive point that Nick makes.

Prices don’t just arbitrage themselves. Even if we take the limit of my model, as the cost of building ships approaches zero, we need to explain what process ensures the Law of One Price holds in equilibrium. Suppose it didn’t…then people would buy low and sell high…..you know the rest.

There are different equilibrium conditions being confused here. The equilibrium arbitrage conditions are not same as the equilibrium conditions for international monetary equilibrium. Arbitrage conditions for individual commodities can hold even if the international distribution of gold is not in equilibrium. So I really don’t know what conclusion Nick is alluding to here.

But let me end on what I hope is a conciliatory and constructive note. As always, Nick is making an insightful argument, even if it is misplaced in the context of Hume and PSFM. And the upshot of Nick’s argument is that transportation costs are a function of the dispersion of prices, because, as the incentive to ship products to capture arbitrage profits increases, the cost of shipping will increase as arbitragers bid up the value of resources specialized to the processes of transporting stuff. So the assumption that the cost of transportation can be treated as a parameter is not really valid, which means that the constraints imposed on national price level movements are not really parametric, they are endongenously determined within an appropriately specified general equilibrium model. If Nick is willing to settle for that proposition, I don’t think that our positions are that far apart.

Nick Rowe Teaches Us a Lot about Apples and Bananas

Last week I wrote a post responding to a post by Nick Rowe about money and coordination failures. Over the weekend, Nick posted a response to my post (and to one by Brad Delong). Nick’s latest post was all about apples and bananas. It was an interesting post, though for some reason – no doubt unrelated to its form or substance – I found the post difficult to read and think about. But having now read, and I think, understood (more or less), what Nick wrote, I confess to being somewhat underwhelmed. Let me try to explain why I don’t think that Nick has adequately addressed the point that I was raising.

That point being that while coordination failures can indeed be, and frequently are, the result of a monetary disturbance, one that creates an excess demand for money, thereby leading to a contraction of spending, and thus to a reduction of output and employment, it is also possible that a coordination failure can occur independently of a monetary disturbance, at least a disturbance that could be characterized as an excess demand for money that triggers a reduction in spending, income, output, and employment.

Without evaluating his reasoning, I will just restate key elements of Nick’s model – actually two parallel models. There are apple trees and banana trees, and people like to consume both apples and bananas. Some people own apple trees, and some people own banana trees. Owners of apple trees and owners of banana trees trade apples for bananas, so that they can consume a well-balanced diet of both apples and bananas. Oh, and there’s also some gold around. People like gold, but it’s not clear why. In one version of the model, people use it as a medium of exchange, selling bananas for gold and using gold to buy apples or selling apples for gold and using gold to buy bananas. In the other version of the model, people just barter apples for bananas. Nick then proceeds to show that if trade is conducted by barter, an increase in the demand for gold, does not affect the allocation of resources, because agents continue to trade apples for bananas to achieve the desired allocation, even if the value of gold is held fixed. However, if trade is mediated by gold, the increased demand for gold, with prices held fixed, implies corresponding excess supplies of both apples and bananas, preventing the optimal reallocation of apples and bananas through trade, which Nick characterizes as a recession. However, if there is a shift in demand from bananas to apples or vice versa, with prices fixed in either model, there will be an excess demand for bananas and an excess supply of apples (or vice versa). The outcome is suboptimal because Pareto-improving trade is prevented, but there is no recession in Nick’s view because the excess supply of one real good is exactly offset by an excess demand for the other real good. Finally, Nick considers a case in which there is trade in apple trees and banana trees. An increase in the demand for fruit trees, owing to a reduced rate of time preference, causes no problems in the barter model, because there is no impediment to trading apples for bananas. However, in the money model, the reduced rate of time preference causes an increase in the amount of gold people want to hold, the foregone interest from holding more having been reduced, which prevents optimal trade with prices held fixed.

Here are the conclusions that Nick draws from his two models.

Bottom line. My conclusions.

For the second shock (a change in preferences away from apples towards bananas), we get the same reduction in the volume of trade whether we are in a barter or a monetary economy. Monetary coordination failures play no role in this sort of “recession”. But would we call that a “recession”? Well, it doesn’t look like a normal recession, because there is an excess demand for bananas.

For both the first and third shocks, we get a reduction in the volume of trade in a monetary economy, and none in the barter economy. Monetary coordination failures play a decisive role in these sorts of recessions, even though the third shock that caused the recession was not a monetary shock. It was simply an increased demand for fruit trees, because agents became more patient. And these sorts of recessions do look like recessions, because there is an excess supply of both apples and bananas.

Or, to say the same thing another way: if we want to understand a decrease in output and employment caused by structural unemployment, monetary coordination failures don’t matter, and we can ignore money. Everything else is a monetary coordination failure. Even if the original shock was not a monetary shock, that non-monetary shock can cause a recession because it causes a monetary coordination failure.

Why am I underwhelmed by Nick’s conclusions? Well, it just seems that, WADR, he is making a really trivial point. I mean in a two-good world with essentially two representative agents, there is not really that much that can go wrong. To put this model through its limited endowment of possible disturbances, and to show that only an excess demand for money implies a “recession,” doesn’t seem to me to prove a great deal. And I was tempted to say that the main thing that it proves is how minimal is the contribution to macroeconomic understanding that can be derived from a two-good, two-agent model.

But, in fact, even within a two-good, two-agent model, it turns out there is room for a coordination problem, not considered by Nick, to occur. In his very astute comment on Nick’s post, Kevin Donoghue correctly pointed out that even trade between an apple grower and a banana grower depends on the expectations of each that the other will actually have what to sell in the next period. How much each one plants depends on his expectations of how much the other will plant. If neither expects the other to plant, the output of both will fall.

Commenting on an excellent paper by Backhouse and Laidler about the promising developments in macroeconomics that were cut short because of the IS-LM revolution, I made reference to a passage quoted by Backhouse and Laidler from Bjorn Hansson about the Stockholm School. It was the Stockholm School along with Hayek who really began to think deeply about the relationship between expectations and coordination failures. Keynes also thought about that, but didn’t grasp the point as deeply as did the Swedes and the Austrians. Sorry to quote myself, but it’s already late and I’m getting tired. I think the quote explains what I think is so lacking in a lot of modern macroeconomics, and, I am sorry to say, in Nick’s discussion of apples and bananas.

Backhouse and Laidler go on to cite the Stockholm School (of which Ohlin was a leading figure) as an example of explicitly dynamic analysis.

As Bjorn Hansson (1982) has shown, this group developed an explicit method, using the idea of a succession of “unit periods,” in which each period began with agents having plans based on newly formed expectations about the outcome of executing them, and ended with the economy in some new situation that was the outcome of executing them, and ended with the economy in some new situation that was the outcome of market processes set in motion by the incompatibility of those plans, and in which expectations had been reformulated, too, in the light of experience. They applied this method to the construction of a wide variety of what they called “model sequences,” many of which involved downward spirals in economic activity at whose very heart lay rising unemployment. This is not the place to discuss the vexed question of the extent to which some of this work anticipated the Keynesian multiplier process, but it should be noted that, in IS-LM, it is the limit to which such processes move, rather than the time path they follow to get there, that is emphasized.

The Stockholm method seems to me exactly the right way to explain business-cycle downturns. In normal times, there is a rough – certainly not perfect, but good enough — correspondence of expectations among agents. That correspondence of expectations implies that the individual plans contingent on those expectations will be more or less compatible with one another. Surprises happen; here and there people are disappointed and regret past decisions, but, on the whole, they are able to adjust as needed to muddle through. There is usually enough flexibility in a system to allow most people to adjust their plans in response to unforeseen circumstances, so that the disappointment of some expectations doesn’t become contagious, causing a systemic crisis.

But when there is some sort of major shock – and it can only be a shock if it is unforeseen – the system may not be able to adjust. Instead, the disappointment of expectations becomes contagious. If my customers aren’t able to sell their products, I may not be able to sell mine. Expectations are like networks. If there is a breakdown at some point in the network, the whole network may collapse or malfunction. Because expectations and plans fit together in interlocking networks, it is possible that even a disturbance at one point in the network can cascade over an increasingly wide group of agents, leading to something like a system-wide breakdown, a financial crisis or a depression.

But the “problem” with the Stockholm method was that it was open-ended. It could offer only “a wide variety” of “model sequences,” without specifying a determinate solution. It was just this gap in the Stockholm approach that Keynes was able to fill. He provided a determinate equilibrium, “the limit to which the Stockholm model sequences would move, rather than the time path they follow to get there.” A messy, but insightful, approach to explaining the phenomenon of downward spirals in economic activity coupled with rising unemployment was cast aside in favor of the neater, simpler approach of Keynes. No wonder Ohlin sounds annoyed in his comment, quoted by Backhouse and Laidler, about Keynes. Tractability trumped insight.

Unfortunately, that is still the case today. Open-ended models of the sort that the Stockholm School tried to develop still cannot compete with the RBC and DSGE models that have displaced IS-LM and now dominate modern macroeconomics. The basic idea that modern economies form networks, and that networks have properties that are not reducible to just the nodes forming them has yet to penetrate the trained intuition of modern macroeconomists. Otherwise, how would it have been possible to imagine that a macroeconomic model could consist of a single representative agent? And just because modern macroeconomists have expanded their models to include more than a single representative agent doesn’t mean that the intellectual gap evidenced by the introduction of representative-agent models into macroeconomic discourse has been closed.

Why Are Wages Sticky?

The stickiness of wages seems to be one of the key stylized facts of economics. For some reason, the idea that sticky wages may be the key to explaining business-cycle downturns in which output and employment– not just prices and nominal incomes — fall is now widely supposed to have been a, if not the, major theoretical contribution of Keynes in the General Theory. The association between sticky wages and Keynes is a rather startling, and altogether unfounded, inversion of what Keynes actually wrote in the General Theory, heaping scorn on what he called the “classical” doctrine that cyclical (or in Keynesian terminology “involuntary”) unemployment could be attributed to the failure of nominal wages to fall in response to a reduction in aggregate demand. Keynes never stopped insisting that the key defining characteristic of “involuntary” unemployment is that a nominal-wage reduction would not reduce “involuntary” unemployment. The very definition of involuntary unemployment is that it can only be eliminated by an increase in the price level, but not by a reduction in nominal wages.

Keynes devoted three entire chapters (19-21) in the General Theory to making, and mathematically proving, that argument. Insofar as I understand it, his argument doesn’t seem to me to be entirely convincing, because, among other reasons, his reasoning seems to involve implicit comparative-statics exercises that start from a disequlibrium situation, but that is definitely a topic for another post. My point is simply that the sticky-wages explanation for unemployment was exactly the “classical” explanation that Keynes was railing against in the General Theory.

So it’s really quite astonishing — and amusing — to observe that, in the current upside-down world of modern macroeconomics, what differentiates New Classical from New Keynesian macroeconomists is that macroecoomists of the New Classical variety, dismissing wage stickiness as non-existent or empirically unimportant, assume that cyclical fluctuations in employment result from high rates of intertemporal substitution by labor in response to fluctuations in labor productivity, while macroeconomists of the New Keynesian variety argue that it is nominal-wage stickiness that prevents the steep cuts in nominal wages required to maintain employment in the face of exogenous shocks in aggregate demand or supply. New Classical and New Keynesian indeed! David Laidler and Axel Leijonhufvud have both remarked on this role reversal.

Many possible causes of nominal-wage stickiness (especially in the downward direction) have been advanced. For most of the twentieth century, wage stickiness was blamed on various forms of government intervention, e.g., pro-union legislation conferring monopoly privileges on unions, as well as other forms of wage-fixing like minimum-wage laws and even unemployment insurance. Whatever the merits of these criticisms, it is hard to credit claims that wage stickiness is mainly attributable to labor-market intervention on the side of labor unions. First, the phenomenon of wage stickiness was noted and remarked upon by economists as long ago as the early nineteenth century (e.g., Henry Thornton in his classic The Nature and Effects of the Paper Credit of Great Britain) long before the enactment of pro-union legislation. Second, the repeal or weakening of pro-union legislation since the 1980s does not seem to have been associated with any significant reduction in nominal-wage stickiness.

Since the 1970s, a number of more sophisticated explanations of wage stickiness have been advanced, for example search theories coupled with incorrect price-level expectations, long-term labor contracts, implicit contracts, and efficiency wages. Search theories locate the cause of wage nominal stickiness in workers’ decisions about what wage offers to accept. Thus, the apparent downward stickiness of wages in a recession seems to imply that workers are turning down offers of employment or quitting their jobs in the mistaken expectation that search will uncover better offers, but that doesn’t seem to be what happens in recessions, when quits decline and layoffs increase. Long-term contracts can and frequently are renegotiated when conditions change. Implicit contracts also can be adjusted when conditions change. So insofar as these theories posit that workers are somehow making decisions that lead to their unemployment, the story seems to be incomplete. If workers could be made better off by accepting reduced wages instead of being unemployed, why isn’t it happening?

Efficiency wages posit a different cause for wage stickiness: that employers have cleverly discovered that by overpaying workers, workers will work their backsides off to continue to be considered worthy of receiving the rents that their employers are conferring upon them. Thus, when a recession hits, employers use the opportunity to weed out their least deserving employees. This theory at least has the virtue of not assigning responsibility for sub-optimal decisions to the workers.

All of these theories were powerfully challenged about eleven or twelve years ago by Truman Bewley in a book Why Wages Don’t Fall During a Recession. (See also Peter Howitt’s excellent review of Bewely’s book in the Journal of Economic Literature.) Bewley, though an accomplished theorist, simply went out and interviewed lots of business people, asking them to explain why they didn’t cut wages to their employees in recessions rather than lay off workers. Overwhelmingly, the responses Bewley received did not correspond to any of the standard theories of wage-stickiness. Instead, business people explained wage stickiness as necessary to avoid a collapse of morale among their employees. Layoffs also hurt morale, but the workers that are retained get over it, and those let go are no longer around to hurt the morale of those that stay.

While I have always preferred the search explanation for apparent wage stickiness, which was largely developed at UCLA in the 1960s (see Armen Alchian’s classic “Information costs, Pricing, and Resource Unemployment”), I recognize that it doesn’t seem to account for the basic facts of the cyclical pattern of layoffs and quits. So I think that it is clear that wage stickiness remains a problematic phenomenon. I don’t claim to have a good explanation to offer, but it does seem to me that an important element of an explanation may have been left out so far — at least I can’t recall having seen it mentioned.

Let’s think about it in the following way. Consider the incentive to cut price of a firm that can’t sell as much as it wants at the current price. The firm is off its supply curve. The firm is a price taker in the sense that, if it charges a higher price than its competitors, it won’t sell anything, losing all its sales to competitors. Would the firm have any incentive to cut its price? Presumably, yes. But let’s think about that incentive. Suppose the firm has a maximum output capacity of one unit, and can produce either zero or one units in any time period. Suppose that demand has gone down, so that the firm is not sure if it will be able to sell the unit of output that it produces (assume also that the firm only produces if it has an order in hand). Would such a firm have an incentive to cut price? Only if it felt that, by doing so, it would increase the probability of getting an order sufficiently to compensate for the reduced profit margin at the lower price. Of course, the firm does not want to set a price higher than its competitors, so it will set a price no higher than the price that it expects its competitors to set.

Now consider a different sort of firm, a firm that can easily expand its output. Faced with the prospect of losing its current sales, this type of firm, unlike the first type, could offer to sell an increased amount at a reduced price. How could it sell an increased amount when demand is falling? By undercutting its competitors. A firm willing to cut its price could, by taking share away from its competitors, actually expand its output despite overall falling demand. That is the essence of competitive rivalry. Obviously, not every firm could succeed in such a strategy, but some firms, presumably those with a cost advantage, or a willingness to accept a reduced profit margin, could expand, thereby forcing marginal firms out of the market.

Workers seem to me to have the characteristics of type-one firms, while most actual businesses seem to resemble type-two firms. So what I am suggesting is that the inability of workers to take over the jobs of co-workers (the analog of output expansion by a firm) when faced with the prospect of a layoff means that a powerful incentive operating in non-labor markets for price cutting in response to reduced demand is not present in labor markets. A firm faced with the prospect of being terminated by a customer whose demand for the firm’s product has fallen may offer significant concessions to retain the customer’s business, especially if it can, in the process, gain an increased share of the customer’s business. A worker facing the prospect of a layoff cannot offer his employer a similar deal. And requiring a workforce of many workers, the employer cannot generally avoid the morale-damaging effects of a wage cut on his workforce by replacing current workers with another set of workers at a lower wage than the old workers were getting. So the point that I am suggesting seems to dovetail with morale-preserving explanation for wage-stickiness offered by Bewley.

If I am correct, then the incentive for price cutting is greater in markets for most goods and services than in markets for labor employment. This was Henry Thornton’s observation over two centuries ago when he wrote that it was a well-known fact that wages are more resistant than other prices to downward pressure in periods of weak demand. And if that is true, then it suggests that real wages tend to fluctuate countercyclically, which seems to be a stylized fact of business cycles, though whether that is indeed a fact remains controversial.

David Laidler on Hawtrey and the Treasury View

My recent post on Hawtrey and the Treasury View occasioned an exchange of emails with David Laidler about Hawtrey, the Treasury View. and the gold standard. As usual, David made some important points that I thought would be worth sharing. I will try to come back to some of his points in future posts, but for now I will just refer to his comments about Hawtrey and the Treasury View.

David drew my attention to his own discussion of Hawtrey and the Treasury View in his excellent book Fabricating the Keynesian Revolution (especially pp. 112-28). Here are some excerpts.

It is well known that Hawtrey was a firm advocate of using the central bank’s discount rate – bank rate, as it is called in British terminology – as the principal instrument of monetary policy, and this might at first sight seem to place him in the tradition of Walter Bagehot. However, Hawtrey’s conception of the appropriate target for policy was very different from Bagehot’s, and he was well aware of the this difference. Bagehot had regarded the maintenance of gold convertibility as the sine qua non of monetary policy, and as Hawtrey told reader of his Art of Central Banking, “a central bank working the gold standard must rectify an outflow of gold by a restriction of credit and an inflow of gold by a relaxation of credit. Under Hawtrey’s preferred scheme, on the other hand,

substantially the plan embodied in the currency resolution adopted at the Genoa Conference of 1922, . . . the contral banks of the world [would[ regulated credit with a view to preventing undue fluctuations in the purchasing power of gold.

More generally he saw the task of central banking as being to mitigate that inherent instability of credit which was the driving force of economic fluctuations, by ensuring, as far as possible, that cumulative expansions and contractions of bank deposits were eliminated, or, failing that, when faced by depression, to bring about whatever degree of monetary expansion might be required to restore economic activity to a satisfactory level. (pp. 122-23)

Laidler links Hawtrey’s position about the efficacy of central bank policy in moderating economic fluctuations to Hawtrey’s 1925 paper on public-works spending and employment, the classic statement of the Treasury View.

Unlike the majority of his English . . . contemporaries, Hawtrey thus had few doubts about the ultimate powers of conventional monetary policy to stimulate the economy, even in the most depressed circumstances. In parallel with that belief . . . he was skeptical about the powers of government-expenditure programs to have any aggregate effects on income and employment, except to the extent that they were financed by money creation. Hawtrey was, in fact, the originator of the particular version of “the Treasury view” of those matters that Hicks . . . characterized in terms of a vertical-LM-curve version of the IS-LM framework.

Hawtrey had presented at least the bare bones of that doctrine in Good and Bad Trade (1913), but his definitive exposition is to be found in his 1925 Economica paper. . . . [T]hat exposition was cast in terms of a system in which, given the levels of money wages and prices, the levels of output and employment were determined by the aggregate rate of low of expenditure on public works can be shown to imply an increase in the overall level of effective demand, the consequences must be an equal reduction in the expenditure of some other sector. . . .

That argument by Hawtrey deserves more respect than it is usually given. His conclusions do indeed follow from the money-growth-driven income-expenditure system with which he analysed the cycle. They follow from an IS-LM model when the economy is operating where the interest sensitivity of the demand for money in negligible, so that what Hicks would later call “the classical theory” is relevant. If, with the benefit of hindsight, Hawtrey might be convicted of over-generalizing from a special case, his analysis nevertheless made a significant contribution in demonstrating the dangers inherent in Pigou’s practice of going “behind the distorting veil of money” in order to deal with such matters. Hawtrey’s view, that the influence of public-works expenditures on the economy’s overall rate of flow of money expenditures was crucial to their effects on employment was surely valid. (pp.125-26)

Laidler then observes that no one else writing at the time had identified the interest-sensitivity of the demand for money as the relevant factor in judging whether public-works expenditure could increase employment.

It is true that the idea of a systematic interest sensitivity of the demand for money had been worked out by Lavington in the early 1920s, but it is also true that none of Hawtrey’s critics . . . saw its critical relevance to this matter during that decade and into the next. Indeed, Hawtrey himself came as close as any of them did before 1936 to developing a more general, not to say correct, argument about thte influence of the monetary system on the efficacy of public-works expenditure. . . . And he argued that once an expansion got under way, increased velocity would indeed accompany it. However, and crucially, he also insisted that “if no expansion of credit at all is allowed, the conditions which produce increased rapidity of circulation cannot begin to develop.”

Hindsight, illuminated by an IS-LM diagram with an upward-sloping LM curve, shows that the last step of his argument was erroneous, but Hawtrey was not alone in holding such a position. The fact is that in the 1920s and early 1930s, many advocates of public-works expenditures were careful to note that their success would be contingent upon their being accommodated by appropriate monetary measures. For example, when Richard Kahn addressed that issue in his classic article on the employment multiplier, he argued as follows:

It is, however, important to realize that the intelligent co-operation of the banking system is being taken for granted. . . . If the increased circulation of notes and the increased demand for working capital that may result from increased employment are made the occasion for a restriction of credit, then any attempt to increase employment . . . may be rendered nugatory. (pp. 126-27)

Thus, Laidler shows that Hawtrey’s position on the conditions in which public-works spending could increase employment was practically indistinguishable from Richard Kahn’s position on the same question in 1931. And I would emphasize once again that, inasmuch as Hawtrey’s 1925 position was taken when the Bank of England policy was setting its lending rate at the historically high level of 5% to encourage an inflow of gold and allow England to restore the gold standard at the prewar parity, Hawtrey was correct, notwithstanding any tendency of public-works spending to increase velocity, to dismiss public-works spending as a remedy for unemployment as long as bank rate was not reduced.


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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