Posts Tagged 'Genoa Conference'

Ralph Hawtrey, Part 1: An Overview of his Career

Published October 28, 2023 Alfred Marshall , Clara Elizabeth Mattei , David Ricardo , gold standard , gold-exchange standard , Great Depression , Keynes , Milton Friedman , R. G. Hawtrey , Robert Hetzel , Winston Churchill 18 Comments
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One of my goals when launching this blog in 2011 was to revive interest in the important, but unfortunately neglected and largely forgotten, contributions to monetary and macroeconomic theory of Ralph Hawtrey. Two important books published within the last year have focused attention on Ralph Hawtrey: The Federal Reserve: A New History by Robert Hetzel, and The Capital Order by Clara Elizabeth Mattei.

While Hetzel’s discussion of Hawtrey’s monetary theory of the Great Depression is generally positive, it criticizes him for discounting, unlike Milton Friedman, the efficacy of open-market operations in reviving aggregate demand. But Hetzel’s criticism relies on an incomplete reading of Hawtrey’s discussions of open-market operations. Mattei’s criticism of Hawtrey is very different from Hetzel’s narrow technical criticism. Mattei is clearly deeply hostile to Hawtrey, portraying him as the grey eminence behind the austerity policies of the British Treasury and the Bank of England in the 1920s both before and after Britain restored the prewar gold standard. Mattei holds Hawtrey uniquely responsible for providing the intellectual rationale for the fiscal and monetary policies that ruthlessly tolerated high unemployment to suppress inflation and hold down wages.

I’ll address the inaccuracies in Hetzel’s discussion of Hawtrey and especially in Mattei’s deeply flawed misrepresentations of Hawtrey in future posts. In this post, I provide an overview of Hawtrey’s career drawn from papers I’ve written (two of which were co-authored by my friend Ron Batchelder) about Hawtrey included in my recent book, Studies in the History of Monetary Theory: Controversies and Clarifications (Chapters 10-14)

Ralph George Hawtrey, born in 1879, two years before his friend, fellow Cambridge man and Apostle, John Maynard Keynes, with whom he often disagreed, was in the 1920s and early 1930s almost as well-known as, and perhaps even more influential, at least among economists and policy-makers, than Keynes. Despite their Cambridge educations and careers in economics, as undergraduates, they both concentrated on mathematics[1] and philosophy and were deeply influenced by the Cambridge philosopher, G. E. Moore. Neither formally studied economics under Alfred Marshall.[2]

Perhaps the last autodidact to make significant contributions to economic theory, Hawtrey began his study of economics only when preparing for the civil-service exam at the Treasury. Hawtrey’s Cambridge background, his friendship with Keynes, and the similarities between his own monetary theories and those of Marshall, Keynes and other Cambridge economists contributed to the widespread impression that Hawtrey had ties to the Cambridge school of economics, a connection Hawtrey denied. Hawtrey’s powerful analytical mind, his command of monetary history and deep and wide knowledge of monetary and business institutions, acquired by dint of intense independent study, led to a rapid rise in the Treasury bureaucracy, eventually becoming Director of Economic Studies in 1919, a position he held until he retired from the Treasury in 1945.

Coincidentally, both Hawtrey and Keynes published their first books in 1913, Keynes writing about the reform of the Indian Currency system (Indian Currency and Finance) and Hawtrey propounding his monetary theory of the business cycle (Good and Bad Trade). A more substantive coincidence in their first books is that they both described a gold-exchange standard (resurrecting an idea described almost a century earlier by Ricardo in his Proposals for an Economical and Secure Currency) in which gold coins do not circulate and the central bank holds reserves, not in gold, but in foreign exchange denominated in currencies legally convertible into gold.

The trajectory of Hawtrey’s carrier (like Keynes’s) was sharply upward after publication of his first book. Hawtrey’s reputation was further enhanced by important academic articles about the history of monetary institutions and the gold standard. Those studies were incorporated in Hawtrey’s most important work on monetary economics, Currency and Credit published in 1919, a profound treatise on monetary economics in which his deep theoretical insights were deployed to shed light on important events and developments in the history of monetary institutions. A resounding success, the volume becoming a standard work routinely assigned to students of money and banking for over a decade, establishing Hawtrey as one of the most widely read and frequently cited economists in the 1920s and even the 1930s.

Although Keynes, by virtue of his celebrated book The Economic Consequences of the Peace became one of the most prominent public figures in Britain in the immediate postwar period, Hawtrey’s reputation among economists and policy makers likely overshadowed Keynes’s in the early 1920s. That distinction is exemplified by their roles at the 1922 Genoa Conference on postwar international cooperation and reconstruction.

In his writings about postwar monetary reconstruction, Hawtrey emphasized the necessity for international cooperation to restore international gold standard lest an uncoordinated restoration by individual countries with countries seeking to accumulate gold, thereby causing gold to appreciate and prices in terms of gold to fall. It was Hawtrey’s warnings, echoed independently by the Swedish economist Gustav Cassel, that caused the Treasury to recommend that planning for a coordinated restoration of the gold standard be included in agenda of the Genoa Conference.

While Hawtrey was the intellectual inspiration for including restoration of gold standard on the agenda of the Genoa Conference, Keynes’s role at Genoa was journalistic, serving as a correspondent for the Manchester Guardian. Keynes criticized the plan to reestablish an international gold standard even in the form of a gold-exchange standard that he and Hawtrey had described a decade earlier. Keynes observed that there was then only one nation with an effective gold standard, the United States. Conjecturing that the US, holding 40% of the world’s gold reserves, would likely choose to divest itself of at least part of its gold hoard, causing gold depreciation, Keynes argued that rejoining the gold standard would mean importing inflation from the United States. Keynes therefore recommended that Britain to adopt an independent monetary policy detached from gold to achieve a stable domestic price level. 

But after it became clear that the US had no intention of unburdening itself of its huge gold holdings, Keynes reversed his rationale for opposing restoration of the gold standard. Given the depreciation of sterling against the dollar during and after World War I, the goal of restoring the prewar dollar-sterling parity of $4.86/pound would require Britain to endure even more deflation than it had already suffered following the sharp US deflation of 1920-21.

When Winston Churchill, appointed Chancelor of the Exchequer in the new Conservative Government, announced in November 1924 that he would restore the gold standard at the prewar parity by April 1925, the pound appreciated against the dollar. But the market exchange rate with the dollar remained 10% below the prewar parity. Keynes began arguing against restoring the prewar parity because a further 10% deflation would impose an unacceptable hardship on an economy that had not recovered from the effects of the recession and high unemployment caused by earlier deflation.

After personally consulting Keynes in person about his argument against restoring the prewar parity, Churchill also invited Hawtrey to hear his argument in favor of restoring the prewar parity. Hawtrey believed that doing so would bolster London’s position as the preeminent international financial center. But he also urged that, to avoid the dire consequences that Keynes warned would follow restoration of the prewar parity, the Bank of England reduce Bank Rate to promote economic expansion and employment. Given the unique position of London as the center of international finance, Hawtrey was confident that the Bank of England could ease its monetary policy and that the Federal Reserve and other central banks would ease their policies as well, thereby allowing the gold standard to be restored without significant deflation.

Supported by his Treasury advisers including Hawtrey, Churchill restored the gold standard at the prewar dollar parity in April 1925, causing Keynes to publish his brutal critique of that decision in his pamphlet The Economic Consequences of Mr. Churchill. While the consequences were perhaps not as dire as Keynes had predicted, they were less favorable than Hawtrey had hoped, the Bank of England refusing to reduce Bank Rate below 5% as Hawtrey had urged. At any rate, after a brief downturn in the latter part of 1925, the British economy did expand moderately from 1926 through early 1929 with unemployment declining slightly before Britain, along with the rest of the world, plunged into the Great Depression in the second half of 1929.

Keynes and Hawtrey again came into indirect opposition in the 1929 general election campaign, when Lloyd George, leader of the Liberal Party, proposed a program of public works to increase employment. In rejecting Lloyd George’s proposal, Churchill cited the “traditional Treasury view” that public spending simply displaced an equal amount of private spending, merely shifting spending from the private to the public sector without increasing total output and employment.

The source of “the traditional Treasury” view” was Hawtrey, himself, who had made the argument at length in a 1925 article in the Economic Journal which he had previously made in less detail in Good and Bad Trade. Replying to Churchill, Keynes and Hubert Henderson co-authored a pamphlet Can Lloyd George Do It supporting Lloyd George’s proposal and criticizing the Treasury View.

Keynes and Hawtrey confronted each other in person when Hawtrey testified before the Macmillan Committee investigating the causes of high unemployment. As a member of the Committee, Keynes questioned Hawtrey about his argument that the Bank of England could have countered rising unemployment by reducing Bank Rate, seemingly exposing an inconsistency in Hawtrey’s responses to his questions. But, when considered in light of Hawtrey’s assumption that a reduction in Bank Rate by the Bank of England would have led to Federal Reserve and other central banks to reduce their interest rates rather than absorb further inflows of gold, the inconsistency is resolved (see this post for further explanation).

Although Hawtrey had warned of the dreadful consequences of restoring the gold standard without coordination among central bank to avoid rapid accumulation of gold reserves, his warnings were disregarded when France returned to the gold standard in 1927 and began rapidly increasing its gold reserves in 1928. Hawtrey’s association with the Treasury view fostered the misimpression that, despite his unheeded advocacy of reducing Bank Rate to reduce unemployment, Hawtrey was oblivious to, or unconcerned by, the problem of unemployment. While Keynes often tried out new ideas, as he did with his neo-Wicksellian theory of the business cycle in his Treatise on Money only to abandon it in response to criticism and the changing economic environment of the Great Depression before writing his General Theory of Interest, Income and Money, Hawtrey stuck to the same basic theory developed in his first two books.

While his output of new publications in the 1930s did not flag, Hawtrey’s reputation among economists and his influence in the Treasury gradually declined, especially after publication of Keynes’s General Theory as the attention of economists was increasingly occupied by an effort to comprehend and assimilate it into the received body of economic theory. By the time he retired from the Treasury in 1945 to become Professor of International Economics at the Royal Institute for International Affairs, Hawtrey was no longer at the cutting edge of the economics profession, and his work gradually fell from the view of younger economists.

Nevertheless, for the next two decades as he advanced to old age, Hawtrey continued to publish important works, mostly, but not exclusively concerning the conduct of British monetary policy, especially his lonely criticism of Britain’s 1947 devaluation of the pound. Elaborating on arguments advanced in his early writings, Hawtrey anticipated much of what would become known as the monetary approach to the balance of payments.

Given his monetary explanation of the Great Depression, it might have been expected that Monetarists, especially Milton Friedman, who, in the early 1950s, began his effort to develop a monetary theory of the Great Depression as an alternative to the Keynesian theory of a sudden decline in animal spirits that caused a stock-market crash and a drop in investment spending from which the private economy could not recover on its own, would have found Hawtrey’s explanation of the causes of the Great Depression to be worth their attention. However, one would search for Hawtrey’s name almost in vain in Friedman’s writings in general, and in his writings on the Great Depression, in particular. Certainly there was no recognition in the Monetarist literature on the Great Depression that a monetary theory of the Great Depression had actually been advanced by Hawtrey as the Great Depression was unfolding or that Hawtrey had warned in advance of the danger of the catastrophic deflation that would result from an uncoordinated restoration of the gold standard.

Years after Friedman’s magnum opus The Monetary History of the US was published, various researchers, including Peter Temin, Barry Eichengreen, Ben Bernanke, Kenneth Mouré, Clark Johnson, Scott Sumner, and Ronald Batchelder and I, recognized the critical importance of the newly restored gold standard in causing the Great Depression. While most of the later authors cited Hawtrey’s writings, the full extent of Hawtrey’s contributions that fully anticipated all the major conclusions of the later research remains generally unrecognized in most of the recent literature on the Great Depression, while Friedman’s very flawed account of the Great Depression continues to be regarded by most economists and financial historians as authoritative if not definitive.

In a future post, I’ll discuss Hetzel’s account of Hawtrey’s explanation of the Great Depression. Unlike earlier Monetarists who ignored Hawtrey’s explanation entirely, Hetzel does credit Hawtrey with having provided a coherent explanation of the causes of the Great Depression, without acknowledging the many respects in which Hawtrey’s explanation is more complete and more persuasive than Friedman’s. He also argues that Friedman provided a better account of the recovery than Hawtrey, because Friedman, unlike Hawtrey, recognized the effectiveness of open-market operations which Hawtrey maintained would be ineffective in initiating a recovery in situations of what Hawtrey called credit deadlock.

In another post, I’ll discuss the highly critical, and I believe tendentious, treatment by Clara Elizabeth Mattei, of Hawtrey’s supposed role in devising and rationalizing the austerity policies of the British Treasury in the 1920s up to and including the Great Depression.

[1] While Keynes was an accomplished mathematician who wrote an important philosophical and mathematical work A Treatise on Probability praised extravagantly by Bertrand Russell, Hawtrey’s mathematical skills were sufficiently formidable to have drawn the attention of Russell who included a footnote in his Principia Mathematica replying to a letter from Hawtrey.

[2] Keynes, however, the son of John Neville Keynes, a Cambridge philosopher and economist, had a personal connection to Marshall apart from his formal studies at Cambridge. Rather than pursue graduate studies, Hawtrey chose a career in the civil service, first at the Admiralty and soon thereafter at the Treasury.

Gold Standard or Gold-Exchange Standard: What’s the Difference?

Published July 1, 2015 David Ricardo , gold standard , gold-exchange standard , Keynes 27 Comments
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In recent posts (here and here) I have mentioned both the gold standard and the gold-exchange standard, a dichotomy that suggests that the two are somehow distinct, and I noted that the Genoa Conference of 1922 produced a set of resolutions designed to ensure that the gold standard, whose restoration was the goal of the conference, would be a gold-exchange standard rather than the traditional pre-World War I gold standard. I also mentioned that the great American central banker Benjamin Strong had stated that he was not particularly fond of the gold-exchange standard favored by the Genoa Resolutions. So there seems to be some substantive difference between a gold standard (of the traditional type) and a gold-exchange standard. Wherein lies the difference? And what, if anything, can we infer from that difference about how the two standards operate?

Let’s begin with some basics. Suppose there’s a pure metallic (gold) currency. All coins that circulate are gold and their value reflects the weight and fineness of the gold, except that the coins are stamped so that they don’t have to be weighed or assayed; they trade at their face value. Inevitably under such systems, there’s a problem with the concurrent circulation of old and worn coins at par with newly minted coins. Because they have the same face value, it is old coins that remain in circulation, while the new coins are hoarded, leading to increasingly overvalued (underweight) coins in circulation. This observation gives rise to Gresham’s Law: bad (i.e., old and worn) money drives out the good (i.e., new full-weight) money. The full-weight coin is the standard, but it tends not to circulate.

When the currency consists entirely of full-weight gold coins, it is redundant to speak of a gold standard. The term “gold standard” has significance only if the coin represents a value greater than the value of its actual metallic content. When underweight coins can circulate at par, because they are easily exchangeable for coins of full weight, the coinage is up to standard. If coins don’t circulate at par, the coinage is debased; it is substandard.

Despite the circulation of gold coins for millenia, the formal idea of a gold standard did not come into being until the eighteenth century, when, because the English mint was consistently overvaluing gold at a ratio relative to silver of approximately 15.5 to 1, while on the Continent, the gold-silver ratio was about 15 to 1, inducing an influx of gold into England. The pound sterling had always been a silver coin, like the shilling (20 shillings in a pound), but by the end of the 17th century, debasement of the silver coinage led to the hoarding and export of full weight silver coins. In the 17th century, the British mint had begun coining a golden guinea, originally worth a pound, but, subsequently, reflecting the premium on gold, guineas traded in the market at a premium.

In 1717, the master of the mint — a guy named Isaac Newton who, in his youth, had made something of a name for himself as a Cambridge mathematician — began to mint a golden pound at a mint price of £3 17 shillings and 10.5 pence (12 pence in a shilling) for an ounce of gold. The mint stopped minting guineas, which continued to circulate, and had an official value of 21 shillings (£1 1s.). In theory the pound remained a weight of silver, but in practice the pound had become a golden coin whose value was determined by the mint price chosen by that Newton guy.

Meanwhile the Bank of England based in London and what were known as country banks (because they operated outside the London metro area) as well as the Scottish banks operating under the Scottish legal regime that was retained after the union of England with Scotland, were all issuing banknotes denominated in sterling, meaning that they were convertible into an equivalent value of metallic (now golden) pounds. So legally the banks were operating under a pound standard not a gold standard. The connection to gold was indirect, reflecting the price at which Isaac Newton had decided that the mint would coin gold into pounds, not a legal definition of the pound.

The pound did not become truly golden until Parliament passed legislation in 1819 (The Resumption Act) after the Napoleonic Wars. The obligation of banks to convert their notes into coinage was suspended in 1797, and Bank of England notes were made legal tender. With the indirect link between gold and paper broken, the value of gold in terms of inconvertible pounds rose above the old mint price. Anticipating the resumption of gold payments, David Ricardo in 1816 penned what he called Proposals for an Economical and Secure Currency in which he proposed making all banknotes convertible into a fixed weight of gold, while reducing the metallic content of the coinage to well below their face value. By abolishing the convertibility of banknotes into gold coin, but restricting the convertibility of bank notes to gold bullion, Ricardo was proposing what is called a gold-bullion standard, as opposed to a gold-specie standard when banknotes are convertible into coin. Ricardo reasoned that by saving the resources tied up in a gold coinage, his proposal would make the currency economical, and, by making banknotes convertible into gold, his proposals would ensure that the currency was secure. Evidently too radical for the times, Ricardo’s proposals did not gain acceptance, and a gold coinage was brought back into circulation at the Newtonian mint price.

But as Keynes observed in his first book on economics Indian Currency and Finance published in 1913 just before the gold standard collapsed at the start of World War I, gold coinage was not an important feature of the gold standard as it operated in its heday.

A gold standard is the rule now in all parts of the world; but a gold currency is the exception. The “sound currency” maxims of twenty or thirty years ago are still often repeated, but they have not been successful, nor ought they to have been, in actually influencing affairs. I think that I am right in saying that Egypt is now the only country in the world in which actual gold coins are the principle medium of exchange.

The reasons for this change are easily seen. It has been found that the expense of a gold circulation is insupportable, and that large economics can be safely effected by the use of some cheaper substitute; and it has been found further that gold in the pockets of the people is not in the least available at a time of crisis or to meet a foreign drain. For these purposes the gold resources of a country must be centralized.

This view has long been maintained by economists. Ricardo’s proposals for a sound and economical currency were based on the principle of keeping gold out of actual circulation. Mill argued that “gold wanted for exportation is almost invariably drawn from the reserves of banks, and is never likely to be taken from the outside circulation while the banks remain solvent.” . . .

A preference for a tangible gold currency is no longer more than a relic of a time when Governments were less trustworthy in these matters than they are now, and when it was the fashion to imitate uncritically the system which had been established in England and had seemed to work so well during the second quarter of the nineteenth century. (pp. 71-73)

Besides arguing against the wastefulness of a gold coinage, Keynes made a further argument about the holding of gold reserves as a feature of the gold standard, namely that, as a matter of course, there are economic incentives (already recognized by Ricardo almost a century earlier) for banks to economize on their holdings of gold reserves with which to discharge their foreign obligations by holding foreign debt instruments which also serve to satisfy foreign claims upon themselves while also generating a pecuniary return. A decentralized informal clearinghouse evolved over the course of the nineteenth century, in which banks held increasing amounts of foreign instruments with which to settle mutual claims upon each other, thereby minimizing the need for actual gold shipments to settle claims. Thus, for purposes of discharging foreign indebtedness, the need for banks to hold gold reserves became less urgent. The holding of foreign-exchange reserves and the use of those reserves to discharge foreign obligations as they came due is the defining characteristic of what was known as the gold-exchange standard.

To say that the Gold-Exchange Standard merely carries somewhat further the currency arrangements which several European countries have evolved during the last quarter of a century is not, of course, to justify it. But if we see that the Gold-Exchange Standard is not, in the currency world of to-day, anomalous, and that it is in the main stream of currency evolution, we shall have a wider experience, on which to draw in criticising it, and may be in a better position to judge of its details wisely. Much nonsense is talked about a gold standard’s properly carrying a gold currency with it. If we mean by a gold currency a state of affairs in which gold is the principal or even, in the aggregate, a very important medium of exchange, no country in the world has such a thing. [fn. Unless it be Egypt.] Gold is an international, but not a local currency. The currency problem of each country is to ensure that they shall run no risk of being unable to put their hands on international currency when they need it, and to waste as small a proportion of their resources on holdings of actual gold as is compatible with this. The proper solution for each country must be governed by the nature of its position in the international money market and of its relations to the chief financial centres, and by those national customs in matters of currency which it may be unwise to disturb. It is as an attempt to solve this problem that the Gold Exchange Standard ought to be judged. . . .

The Gold-Exchange Standard arises out of the discovery that, so long as gold is available for payments of international indebtedness at an approximately constant rate in terms of the national currency, it is a matter of comparative indifference whether it actually forms the national currency.

The Gold-Exchange Standard may be said to exist when gold does not circulate in a country to an appreciable extent, when the local currency is not necessarily redeemable in gold, but when the Government or Central Bank makes arrangements for the provision of foreign remittances in gold at a fix, ed maximum rate in terms of the local currency, the reserves necessary to provide these remittances being kept to a considerable extent abroad. . . .

Its theoretical advantages were first set forth by Ricardo at the time of the Bullionist Controversy. He laid it down that a currency is in its most perfect state when it consists of a cheap material, but having an equal value with the gold it professes to represent; and he suggested that convertibility for the purposes of the foreign exchanges should be ensured by the tendering on demand of gold bars (not coin) in exchange for notes, — so that gold might be available for purposes of export only, and would be prevented from entering into the internal circulation of the country. (pp. 29-31)

The Gold-Exchange Standard in the form in which it has been adopted in India is justly known as the Lindsay scheme. It was proposed and advocated from the earliest discussions, when the Indian currency problem first became prominent, by Mr. A. M. Lindsay, Deputy-Secretary of the Bank of Bengal, who always maintained that “they must adopt my scheme despite themselves.” His first proposals were made in 1876 and 1878. They were repeated in 1885 and again in 1892, when he published a pamphlet entitled Ricardo’s Exchange Remedy. Finally he explained his views in detail to the Committee of 1898.

Lindsay’s scheme was severely criticized both by Government officials and leading financiers. Lord Farrer described it as “far too clever for the ordinary English mind with its ineradicable prejudice for an immediately tangible gold backing of all currencies.” Lord Rothschild, Sir John Lubbock (Lord Avebury), Sir Samuel Montagu (the late Lord Swythling) all gave evidence before the Committee that any system without a visible gold currency would be looked on with distrust. Mr. Alfred de Rothschild went so far as to say that “in fact a gold standard without a gold currency seemed to him an utter impossibility.” Financiers of this type will not admit the feasibility of anything until it has been demonstrated to them by practical experience. (pp. 34-35)

Finally, as to the question of what difference, aside from convenience, does it make whether a country operates on a full-fledged honest to goodness gold standard or a cheap imitation gold-exchange standard, I conclude with another splendid quotation from Keynes.

But before we pass to these several features of the Indian system, it will be worth while to emphasise two respects in which this system is not peculiar. In the first place a system, in which the rupee is maintained at 1s. 4d. by regulation, does not affect the level of prices differently from the way in which it would be affected by a system in which the rupee was a gold coin worth 1s 4d., except in a very indirect and unimportant way to be explained in a moment. So long as the rupee is worth 1s. 4d. in gold, no merchant or manufacturer considers of what material it is made when he fixes the price of his product. The indirect effect on prices, due to the rupee’s being silver, is similar to the effect of the use of any medium of exchange, such as cheques or notes, which economises the use of gold. If the use of gold is economised in any country, gold throughout the world is less valuable – gold prices, that is to say, are higher. But as this effect is shared by the whole world, the effect on prices in any country of economies in the use of gold made by that country is likely to be relatively slight. In short, a policy which led to a greater use of gold in India would tend, by increasing the demand for gold in the world’s markets, somewhat to lower the level of world prices as measured in gold; but it would not cause any alteration worth considering in the relative rates of exchange of Indian and non-Indian commodities.

In the second place, although it is true that the maintenance of the rupee at or near 1s. 4d. is due to regulation, it is not true, when once 1s. 4d. rather than some other gold value has been determined, that the volume of currency in circulation depends in the least upon the policy of the Government or the caprice of an official. This part of the system is as perfectly automatic as in any other country. (pp. 11-13)

Milton Friedman, Monetarism, and the Great and Little Depressions

Published March 31, 2015 1920-21 Depression , Brad Delong , Cassel , gold standard , Great Depression , Hawtrey , Keynes , Little Depression , Milton Friedman , Monetarism 25 Comments
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Brad Delong has a nice little piece bashing Milton Friedman, an activity that, within reasonable limits, I consider altogether commendable and like to engage in myself from time to time (see here, here, here, here, here , here, here, here, here and here). Citing Barry Eichengreen’s recent book Hall of Mirrors, Delong tries to lay the blame for our long-lasting Little Depression (aka Great Recession) on Milton Friedman and his disciples whose purely monetary explanation for the Great Depression caused the rest of us to neglect or ignore the work of Keynes and Minsky and their followers in explaining the Great Depression.

According to Eichengreen, the Great Depression and the Great Recession are related. The inadequate response to our current troubles can be traced to the triumph of the monetarist disciples of Milton Friedman over their Keynesian and Minskyite peers in describing the history of the Great Depression.

In A Monetary History of the United States, published in 1963, Friedman and Anna Jacobson Schwartz famously argued that the Great Depression was due solely and completely to the failure of the US Federal Reserve to expand the country’s monetary base and thereby keep the economy on a path of stable growth. Had there been no decline in the money stock, their argument goes, there would have been no Great Depression.

This interpretation makes a certain kind of sense, but it relies on a critical assumption. Friedman and Schwartz’s prescription would have worked only if interest rates and what economists call the “velocity of money” – the rate at which money changes hands – were largely independent of one another.

What is more likely, however, is that the drop in interest rates resulting from the interventions needed to expand the country’s supply of money would have put a brake on the velocity of money, undermining the proposed cure. In that case, ending the Great Depression would have also required the fiscal expansion called for by John Maynard Keynes and the supportive credit-market policies prescribed by Hyman Minsky.

I’m sorry, but I find this criticism of Friedman and his followers just a bit annoying. Why? Well, there are a number of reasons, but I will focus on one: it perpetuates the myth that a purely monetary explanation of the Great Depression originated with Friedman.

Why is it a myth? Because it wasn’t Friedman who first propounded a purely monetary theory of the Great Depression. Nor did the few precursors, like Clark Warburton, that Friedman ever acknowledged. Ralph Hawtrey and Gustav Cassel did — 10 years before the start of the Great Depression in 1919, when they independently warned that going back on the gold standard at the post-World War I price level (in terms of gold) — about twice the pre-War price level — would cause a disastrous deflation unless the world’s monetary authorities took concerted action to reduce the international monetary demand for gold as countries went back on the gold standard to a level consistent with the elevated post-War price level. The Genoa Monetary Conference of 1922, inspired by the work of Hawtrey and Cassel, resulted in an agreement (unfortunately voluntary and non-binding) that, as countries returned to the gold standard, they would neither reintroduce gold coinage nor keep their monetary reserves in the form of physical gold, but instead would hold reserves in dollar or (once the gold convertibility of sterling was restored) pound-denominated assets. (Ron Batchelder and I have a paper discussing the work of Hawtrey and Casssel on the Great Depression; Doug Irwin has a paper discussing Cassel.)

After the short, but fierce, deflation of 1920-21 (see here and here), when the US (about the only country in the world then on the gold standard) led the world in reducing the price level by about a third, but still about two-thirds higher than the pre-War price level, the Genoa system worked moderately well until 1928 when the Bank of France, totally defying the Genoa Agreement, launched its insane policy of converting its monetary reserves into physical gold. As long as the US was prepared to accommodate the insane French gold-lust by permitting a sufficient efflux of gold from its own immense holdings, the Genoa system continued to function. But in late 1928 and 1929, the Fed, responding to domestic fears about a possible stock-market bubble, kept raising interest rates to levels not seen since the deflationary disaster of 1920-21. And sure enough, a 6.5% discount rate (just shy of the calamitous 7% rate set in 1920) reversed the flow of gold out of the US, and soon the US was accumulating gold almost as rapidly as the insane Bank of France was.

This was exactly the scenario against which Hawtrey and Cassel had been warning since 1919. They saw it happening, and watched in horror while their warnings were disregarded as virtually the whole world plunged blindly into a deflationary abyss. Keynes had some inkling of what was going on – he was an old friend and admirer of Hawtrey and had considerable regard for Cassel – but, for reasons I don’t really understand, Keynes was intent on explaining the downturn in terms of his own evolving theoretical vision of how the economy works, even though just about everything that was happening had already been foreseen by Hawtrey and Cassel.

More than a quarter of a century after the fact, and after the Keynesian Revolution in macroeconomics was well established, along came Friedman, woefully ignorant of pre-Keynesian monetary theory, but determined to show that the Keynesian explanation for the Great Depression was wrong and unnecessary. So Friedman came up with his own explanation of the Great Depression that did not even begin until December 1930 when the Fed allowed the Bank of United States to fail, triggering, in Friedman’s telling, a wave of bank failures that caused the US money supply to decline by a third by 1933. Rather than see the Great Depression as a global phenomenon caused by a massive increase in the world’s monetary demand for gold, Friedman portrayed it as a largely domestic phenomenon, though somehow linked to contemporaneous downturns elsewhere, for which the primary explanation was the Fed’s passivity in the face of contagious bank failures. Friedman, mistaking the epiphenomenon for the phenomenon itself, ignorantly disregarded the monetary theory of the Great Depression that had already been worked out by Hawtrey and Cassel and substituted in its place a simplistic, dumbed-down version of the quantity theory. So Friedman reinvented the wheel, but did a really miserable job of it.

A. C. Pigou, Alfred Marshall’s student and successor at Cambridge, was a brilliant and prolific economic theorist in his own right. In his modesty and reverence for his teacher, Pigou was given to say “It’s all in Marshall.” When it comes to explaining the Great Depression, one might say as well “it’s all in Hawtrey.”

So I agree that Delong is totally justified in criticizing Friedman and his followers for giving such a silly explanation of the Great Depression, as if it were, for all intents and purposes, made in the US, and as if the Great Depression didn’t really start until 1931. But the problem with Friedman is not, as Delong suggests, that he distracted us from the superior insights of Keynes and Minsky into the causes of the Great Depression. The problem is that Friedman botched the monetary theory, even though the monetary theory had already been worked out for him if only he had bothered to read it. But Friedman’s interest in the history of monetary theory did not extend very far, if at all, beyond an overrated book by his teacher Lloyd Mints A History of Banking Theory.

As for whether fiscal expansion called for by Keynes was necessary to end the Great Depression, we do know that the key factor explaining recovery from the Great Depression was leaving the gold standard. And the most important example of the importance of leaving the gold standard is the remarkable explosion of output in the US beginning in April 1933 (surely before expansionary fiscal policy could take effect) following the suspension of the gold standard by FDR and an effective 40% devaluation of the dollar in terms of gold. Between April and July 1933, industrial production in the US increased by 70%, stock prices nearly doubled, employment rose by 25%, while wholesale prices rose by 14%. All that is directly attributable to FDR’s decision to take the US off gold, and devalue the dollar (see here). Unfortunately, in July 1933, FDR snatched defeat from the jaws of victory (or depression from the jaws of recovery) by starting the National Recovery Administration, whose stated goal was (OMG!) to raise prices by cartelizing industries and restricting output, while imposing a 30% increase in nominal wages. That was enough to bring the recovery to a virtual standstill, prolonging the Great Depression for years.

I don’t say that the fiscal expansion under FDR had no stimulative effect in the Great Depression or that the fiscal expansion under Obama in the Little Depression had no stimulative effect, but you can’t prove that monetary policy is useless just by reminding us that Friedman liked to assume (as if it were a fact) that the demand for money is highly insensitive to changes in the rate of interest. The difference between the rapid recovery from the Great Depression when countries left the gold standard and the weak recovery from the Little Depression is that leaving the gold standard had an immediate effect on price-level expectations, while monetary expansion during the Little Depression was undertaken with explicit assurances by the monetary authorities that the 2% inflation target – in the upper direction, at any rate — was, and would forever more remain, sacred and inviolable.

Misunderstanding Reserve Currencies and the Gold Standard

Published November 22, 2014 Cassel , gold , gold standard , Great Depression , Hawtrey , John Mueller , Keynes , Lewis Lehrman 15 Comments
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In Friday’s Wall Street Journal, Lewis Lehrman and John Mueller argue for replacing the dollar as the world’s reserve currency with gold. I don’t know Lewis Lehrman, but almost 30 years ago, when I was writing my book Free Banking and Monetary Reform, which opposed restoring the gold standard, I received financial support from the Lehrman Institute where I gave a series of seminars discussing several chapters of my book. A couple of those seminars were attended by John Mueller, who was then a staffer for Congressman Jack Kemp. But despite my friendly feelings for Lehrman and Mueller, I am afraid that they badly misunderstand how the gold standard worked and what went wrong with the gold standard in the 1920s. Not surprisingly, that misunderstanding carries over into their comments on current monetary arrangements.

Lehrman and Mueller begin by discussing the 1922 Genoa Conference, a conference largely inspired by the analysis of Ralph Hawtrey and Gustav Cassel of post-World War I monetary conditions, and by their proposals for restoring an international gold standard without triggering a disastrous deflation in the process of doing so, the international price level in terms of gold having just about doubled relative to the pre-War price level.

The 1922 Genoa conference, which was intended to supervise Europe’s post-World War I financial reconstruction, recommended “some means of economizing the use of gold by maintaining reserves in the form of foreign balances”—initially pound-sterling and dollar IOUs. This established the interwar “gold exchange standard.”

Lehrman and Mueller then cite the view of the gold exchange standard expressed by the famous French economist Jacques Rueff, of whom Lehrman is a fervent admirer.

A decade later Jacques Rueff, an influential French economist, explained the result of this profound change from the classical gold standard. When a foreign monetary authority accepts claims denominated in dollars to settle its balance-of-payments deficits instead of gold, purchasing power “has simply been duplicated.” If the Banque de France counts among its reserves dollar claims (and not just gold and French francs)—for example a Banque de France deposit in a New York bank—this increases the money supply in France but without reducing the money supply of the U.S. So both countries can use these dollar assets to grant credit. “As a result,” Rueff said, “the gold-exchange standard was one of the major causes of the wave of speculation that culminated in the September 1929 crisis.” A vast expansion of dollar reserves had inflated the prices of stocks and commodities; their contraction deflated both.

This is astonishing. Lehrman and Mueller do not identify the publication of Rueff that they are citing, but I don’t doubt the accuracy of the quotation. What Rueff is calling for is a 100% marginal reserve requirement. Now it is true that under the Bank Charter Act of 1844, Great Britain had a 100% marginal reserve requirement on Bank of England notes, but throughout the nineteenth century, there was an shift from banknotes to bank deposits, so the English money supply was expanding far more rapidly than English gold reserves. The kind of monetary system that Rueff was talking about, in which the quantity of money in circulation, could not increase by more than the supply of gold, never existed. Money was being created under the gold standard without an equal amount of gold being held in reserve.

The point of the gold exchange standard, after World War I, was to economize on the amount of gold held by central banks as they rejoined the gold standard to prevent a deflation back to the pre-War price level. Gold had been demonetized over the course of World War I as countries used gold to pay for imports, much of it winding up in the US before the US entered the war. If all the demonetized gold was remonetized, the result would be a huge rise in the value of gold, in other words, a huge, catastrophic, deflation.

Nor does the notion that the gold-exchange standard was the cause of speculation that culminated in the 1929 crisis have any theoretical or evidentiary basis. Interest rates in the 1920s were higher than they ever were during the heyday of the classical gold standard from about 1880 to 1914. Prices were not rising faster in the 1920s than they did for most of the gold standard era, so there is no basis for thinking that speculation was triggered by monetary causes. Indeed, there is no basis for thinking that there was any speculative bubble in the 1920s, or that even if there was such a bubble it was triggered by monetary expansion. What caused the 1929 crash was not the bursting of a speculative bubble, as taught by the popular mythology of the crash, it was caused by the sudden increase in the demand for gold in 1928 and 1929 resulting from the insane policy of the Bank of France and the clueless policy of the Federal Reserve after ill health forced Benjamin Strong to resign as President of the New York Fed.

Lehrman and Mueller go on to criticize the Bretton Woods system.

The gold-exchange standard’s demand-duplicating feature, based on the dollar’s reserve-currency role, was again enshrined in the 1944 Bretton Woods agreement. What ensued was an unprecedented expansion of official dollar reserves, and the consumer price level in the U.S. and elsewhere roughly doubled. Foreign governments holding dollars increasingly demanded gold before the U.S. finally suspended gold payments in 1971.

The gold-exchange standard of the 1920s was a real gold standard, but one designed to minimize the monetary demand for gold by central banks. In the 1920s, the US and Great Britain were under a binding obligation to convert dollars or pound sterling on demand into gold bullion, so there was a tight correspondence between the value of gold and the price level in any country maintaining a fixed exchange rate against the dollar or pound sterling. Under Bretton Woods, only the US was obligated to convert dollars into gold, but the obligation was largely a fiction, so the tight correspondence between the value of gold and the price level no longer obtained.

The economic crisis of 2008-09 was similar to the crisis that triggered the Great Depression. This time, foreign monetary authorities had purchased trillions of dollars in U.S. public debt, including nearly $1 trillion in mortgage-backed securities issued by two government-sponsored enterprises, Fannie Mae and Freddie Mac. The foreign holdings of dollars were promptly returned to the dollar market, an example of demand duplication. This helped fuel a boom-and-bust in foreign markets and U.S. housing prices. The global excess credit creation also spilled over to commodity markets, in particular causing the world price of crude oil (which is denominated in dollars) to spike to $150 a barrel.

There were indeed similarities between the 1929 crisis and the 2008 crisis. In both cases, the world financial system was made vulnerable because there was a lot of bad debt out there. In 2008, it was subprime mortgages, in 1929 it was reckless borrowing by German local governments and the debt sold to refinance German reparations obligations under the Treaty of Versailles. But in neither episode did the existence of bad debt have anything to do with monetary policy; in both cases tight monetary policy precipitated a crisis that made a default on the bad debt unavoidable.

Lehrman and Mueller go on to argue, as do some Keynesians like Jared Bernstein, that the US would be better off if the dollar were not a reserve currency. There may be disadvantages associated with having a reserve currency – disadvantages like those associated with having a large endowment of an exportable natural resource, AKA the Dutch disease – but the only way for the US to stop having a reserve currency would be to take a leaf out of the Zimbabwe hyperinflation playbook. Short of a Zimbabwean hyperinflation, the network externalities internalized by using the dollar as a reserve currency are so great, that the dollar is likely to remain the world’s reserve currency for at least a millennium. Of course, the flip side of the Dutch disease is at that there is a wealth transfer from the rest of the world to the US – AKA seignorage — in exchange for using the dollar.

Lehrman and Mueller are aware of the seignorage accruing to the supplier of a reserve currency, but confuse the collection of seignorage with the benefit to the world as a whole of minimizing the use of gold as the reserve currency. This leads them to misunderstand the purpose of the Genoa agreement, which they mistakenly attribute to Keynes, who actually criticized the agreement in his Tract on Monetary Reform.

This was exactly what Keynes and other British monetary experts promoted in the 1922 Genoa agreement: a means by which to finance systemic balance-of-payments deficits, forestall their settlement or repayment and put off demands for repayment in gold of Britain’s enormous debts resulting from financing World War I on central bank and foreign credit. Similarly, the dollar’s “exorbitant privilege” enabled the U.S. to finance government deficit spending more cheaply.

But we have since learned a great deal that Keynes did not take into consideration. As Robert Mundell noted in “Monetary Theory” (1971), “The Keynesian model is a short run model of a closed economy, dominated by pessimistic expectations and rigid wages,” a model not relevant to modern economies. In working out a “more general theory of interest, inflation, and growth of the world economy,” Mr. Mundell and others learned a great deal from Rueff, who was the master and professor of the monetary approach to the balance of payments.

The benefit from supplying the resource that functions as the world’s reserve currency will accrue to someone, that is the “exorbitant privilege” to which Lehrman and Mueller refer. But It is not clear why it would be better if the privilege accrued to owners of gold instead of to the US Treasury. On the contrary, the potential for havoc associated with reinstating gold as the world’s reserve currency dwarfs the “exorbitant privilege.” Nor is the reference to Keynes relevant to the discussion, the Keynesian model described by Mundell being the model of the General Theory, which was certainly not the model that Keynes was working with at the time of the Genoa agreement in which Keynes’s only involvement was as an outside critic.

As for Rueff, staunch defender of the insane policy of the Bank of France in 1932, he was an estimable scholar, but, luckily, his influence was much less than Lehrman and Mueller suggest.

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.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner

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