Posts Tagged 'Treasury View'

Hawtrey’s Good and Bad Trade, Part XI: Conclusion

For many readers, I am afraid that the reaction to the title of this post will be something like: “and not a moment too soon.” When I started this series two months ago, I didn’t expect it to drag out quite this long, but I have actually enjoyed the process of reading Hawtrey’s Good and Bad Trade carefully enough to be able to explain (or at least try to explain) it to an audience of attentive readers. In the course of the past ten posts, I have actually learned a fair amount about Hawtrey that I had not known before, and a number of questions have arisen that will require further investigation and research. More stuff to keep me busy.

My previous post about financial crises and asset crashes was mainly about chapter 16, which is the final substantive discussion of Hawtrey’s business-cycle theory in the volume. Four more chapters follow, the first three are given over to questions about how government policy affects the business cycle, and finally in the last chapter a discussion about whether changes in the existing monetary system (i.e., the gold standard) might eliminate, or at least reduce, the fluctuations of the business cycle.

Chapter 17 (“Banking and Currency Legislation in Relation to the State of Trade”) actually has little to do with banking and is mainly a discussion of how the international monetary system evolved over the course of the second half of the nineteenth century from a collection of mostly bimetallic standards before 1870 to a nearly universal gold standard, the catalyst for the evolution being the 1870 decision by newly formed German Empire to adopt a gold standard and then proceeded to convert its existing coinage to a gold basis, thereby driving up the world value of gold. As a result, all the countries with bimetallic standards (usually tied to a 15.5 to 1 ratio of silver to gold) to choose between adopting the gold standard and curtailing the unlimited free coinage of silver or tolerating the inflationary effects of Gresham’s Law as overvalued and depreciating silver drove gold out of circulation.

At the end of the chapter, Hawtrey speculates about the possibility that secular inflation might have some tendency to mitigate the effects of the business cycle, comparing the period from 1870 to 1896, characterized by deflation of about 1 to 2% a year, with the period from 1896 to 1913, when inflation was roughly about 1 to 2% a year.

Experience suggests that a scarcity of new gold prolongs the periods of depression and an abundance of new gold shortens them, so that the whole period of a fluctuation is somewhat shorter in the latter circumstances than is the former. (p. 227)

Hawtrey also noted the fact that, despite unlikelihood that long-term price level movements had been correctly foreseen, the period of falling prices from 1870 to 1896 was associated with low long-term interest rates while the period from 1896 to 1913 when prices were rising was associated with high interest rates, thereby anticipating by ten years the famous empirical observation made by the British economist A. W. Gibson of the positive correlation between long-term interest rates and the price level, an observation Keynes called the Gibson’s paradox, which he expounded upon at length in his Treatise on Money.

[T]he price was affected by the experience of investments during the long gold famine when profits had been low for almost a generation, and indeed it may be regarded as the outcome of the experience. In the same way the low prices of securities at the present time are the product of the contrary experience, the great output of gold in the last twenty years having been accompanied by inflated profits. (p. 229)

Chapter 18 (“Taxation in Relation to the State of Trade”) is almost exclusively concerned not with taxation as such but with protective tariffs. The question that Hawtrey considers is whether protective tariffs can reduce the severity of the business cycle. His answer is that unless tariffs are changed during the course of a cycle, there is no reason why they should have any cyclical effect. He then asks whether an increase in the tariff would have any effect on employment during a downturn. His answer is that imposing tariffs or raising existing tariffs, by inducing a gold inflow, and thus permitting a reduction in interest rates, would tend to reduce the adverse effect of a cyclical downturn, but he stops short of advocating such a policy, because of the other adverse effects of the protective tariff, both on the country imposing the tariff and on its neighbors.

Chapter 19 (“Public Finance in Relation to the State of Trade”) is mainly concerned with the effects of the requirements of the government for banking services in making payments to and accepting payments from the public.

Finally, Chapter 20 (“Can Fluctuations Be Prevented?”) addresses a number of proposals for mitigating the effects of the business cycle by means of policy or changes institutional reform. Hawtrey devotes an extended discussion to Irving Fisher’s proposal for a compensated dollar. Hawtrey is sympathetic, in principle, to the proposal, but expressed doubts about its practicality, a) because it did not seem in 1913 that replacing the gold standard was politically possible, b) because Hawtrey doubted that a satisfactory price index could be constructed, and c) because the plan would, at best, only mitigate, not eliminate, cyclical fluctuations.

Hawtrey next turns to the question whether government spending could be timed to coincide with business cycle downturns so that it would offset the reduction in private spending, thereby preventing the overall demand for labor from falling as much as it otherwise would during the downturn. Hawtrey emphatically rejects this idea because any spending by the government on projects would simply displace an equal amount of private spending, leaving total expenditure unchanged.

The underlying principle of this proposal is that the Government should add to the effective demand for labour at the time when the effective private demand of private traders falls off. But [the proposal] appears to have overlooked the fact that the Government by the very fact of borrowing for this expenditure is withdrawing from the investment market savings which would otherwise be applied to the creation of capital. (p. 260)

Thus, already in 1913, Hawtrey formulated the argument later advanced in his famous 1925 paper on “Public Expenditure and the Demand for Labour,” an argument which eventually came to be known as the Treasury view. The Treasury view has been widely condemned, and, indeed, it did overlook the possibility that government expenditure might induce private funds that were being hoarded as cash to be released for spending on investment. This tendency, implied by the interest-elasticity of the demand for money, would prevent government spending completely displacing private spending, as the Treasury view asserted. But as I have observed previously, despite the logical gap in Hawtrey’s argument, the mistake was not as bad as it is reputed to be, because, according to Hawtrey, the decline in private spending was attributable to a high rate of interest, so that the remedy for unemployment is to be found in a reduction in the rate of interest rather than an increase in government spending.

And with that, I think I will give Good and Bad Trade and myself a rest.

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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.

Hawtrey and the “Treasury View”

Mention the name Ralph Hawtrey to most economists, even, I daresay to most monetary economists, and you are unlikely to get much more than a blank stare. Some might recognize the name because of it is associated with Keynes, but few are likely to be able to cite any particular achievement or contribution for which he is remembered or worth remembering. Actually, your best chance of eliciting a response about Hawtrey might be to pose your query to an acolyte of Austrian Business Cycle theory, for whom Hawtrey frequently serves as a foil, because of his belief that central banks ought to implement a policy of price-level (actually wage-level) stabilization to dampen the business cycle, Murray Rothbard having described him as “one of the evil genius of the 1920s” (right up there, no doubt, with the likes of Lenin, Trotsky, Stalin and Mussolini). But if, despite the odds, you found someone who knew something about Hawtrey, there’s a good chance that it would be for his articulation of what has come to be known as the “Treasury View.”

The Treasury View was a position articulated in 1929 by Winston Churchill, then Chancellor of the Exchequer in the Conservative government headed by Stanley Baldwin, in a speech to the House of Commons opposing proposals by Lloyd George and the Liberals, supported notably by Keynes, to increase government spending on public-works projects as a way of re-employing the unemployed. Churchill invoked the “orthodox Treasury View” that spending on public works would simply divert an equal amount of private spending on other investment projects or consumption. Spending on public-works projects was justified if and only if the rate of return over cost from those projects was judged to be greater than the rate of return over cost from alternative private spending; public works spending could not be justified as a means by which to put the unemployed back to work. The theoretical basis for this position was an article published by Hawtrey in 1925 “Public Expenditure and the Demand for Labour.”

Exactly how Hawtrey’s position first articulated in a professional economics journal four years earlier became the orthodox Treasury View in March 1929 is far from clear. Alan Gaukroger in his doctoral dissertation on Hawtrey’s career at the Treasury provides much helpful background information. Apparently, Hawtrey’s position was elevated into the “orthodox Treasury View” because Churchill required some authority on which to rely in opposing Liberal agitation for public-works spending which the Conservative government and Churchill’s top Treasury advisers and the Bank of England did not want to adopt for a variety of reason. The “orthodox Treasury View” provided a convenient and respectable doctrinal cover with which to clothe their largely political opposition to public-works spending. This is not to say that Churchill and his advisers were insincere in taking the position that they did, merely that Churchill’s position emerged from on-the-spot political improvisation in the course of which Hawtrey’s paper was dredged up from obscurity rather than from applying any long-standing, well-established, Treasury doctrine. For an illuminating discussion of all this, see chapter 5 (pp. 234-75) of Gaukroger’s dissertation.

I have seen references to the Treasury View for a very long time, probably no later than my first year in graduate school, but until a week or two ago, I had never actually read Hawtrey’s 1925 paper. Brad Delong, who has waged a bit of a campaign against the Treasury View on his blog as part of his larger war against opponents of President Obama’s stimulus program, once left a comment on a post of mine about Hawtrey’s explanation of the Great Depression, asking whether I would defend Hawtrey’s position that public-works spending would not increase employment. I think I responded by pleading ignorance of what Hawtrey had actually said in his 1925 article, but that Hawtrey’s explanation of the Great Depression was theoretically independent of his position about whether public-works spending could increase employment. So in a sense, this post is partly belated reply to Delong’s query.

The first thing to say about Hawtrey’s paper is that it’s hard to understand. Hawtrey is usually a very clear expositor of his ideas, but sometimes I just can’t figure out what he means. His introductory discussion of A. C. Pigou’s position on the wisdom of concentrating spending on public works in years of trade depression was largely incomprehensible to me, but it is worth reading, nevertheless, for the following commentary on a passage from Pigou’s Wealth and Welfare in which Pigou proposed to “pass behind the distorting veil of money.”

Perhaps if Professsor Pigou had carried the argument so far, he would have become convinced that the distorting veil of money cannot be put aside. As well might he play lawn tennis without the distorting veil of the net. All the skill and all the energy emanate from the players and are transmitted through the racket to the balls. The net does nothing; it is a mere limiting condition. So is money.

Employment is given by producers. They produce in response to an effective demand for products. Effective demand means ultimately money, offered by consumers in the market.

A wonderful insight, marvelously phrased, but I can’t really tell, beyond Pigou’s desire to ignore the “distorting veil of money,” how it relates to anything Pigou wrote. At any rate, from here Hawtrey proceeds to his substantive argument, positing “a community in which there is unemployment.” In other words, “at the existing level of prices and wages, the consumers’ outlay [Hawtrey’s term for total spending] is sufficient only to employ a part of the productive resources of the country.” Beyond the bare statement that spending is insufficient to employ all resources at current prices, no deeper cause of unemployment is provided. The problem Hawtrey is going to address is what happens if the government borrows money to spend on new public works?

Hawtrey starts by assuming that the government borrows from private individuals (rather than from the central bank), allowing Hawtrey to take the quantity of money to be constant through the entire exercise, a crucial assumption. The funds that the government borrows therefore come either from that portion of consumer income that would have been saved, in which case they are not available to be spent on whatever private investment projects they would otherwise have financed, or they are taken from idle balances held by the public (the “unspent margin” in Hawtrey’s terminology). If the borrowed funds are obtained from cash held by the public, Hawtrey argues that the public will gradually reduce spending in order to restore their cash holdings to their normal level. Thus, either way, increased government spending financed by borrowing must be offset by a corresponding reduction in private spending. Nor does Hawtrey concede that there will necessarily be a temporary increase in spending, because the public may curtail expenditures to build up their cash balances in anticipation of lending to the government. Moreover, there is always an immediate effect on income from any form of spending (Hawtrey understood the idea of a multiplier effect, having relied on it in his explanation of how an increase in the stock of inventories held by traders in response to a cut in interest rates would produce a cumulative increase in total income and spending), so if government spending on public works reduces spending elsewhere, there is no necessary net increase in total spending even in the short run. Here is how Hawtrey sums up the crux of his argument.

To show why this does not happen, we must go back to consider the hypothesis with which we started. We assumed that no additional bank credits are created. It follows that there is no increase in the supply of the means of payment. As soon as the people employed on the new public works begin to receive payment, they will begin to accumulate cash balances and bank balances. Their balances can only be provided at the expense of the people already receiving incomes. These latter will therefore become short of ready cash and will curtail their expenditures with a view to restoring their balances. An individual can increase his balance by curtailing his expenditure, but if the unspent margin (that is to say, the total of all cash balances and bank balances) remains unchanged, he can only increase his balance at the expense of those of his neighbours. If all simultaneously try to increase their balances, they try in vain. The effect can only be that sales of goods are diminished, and the consumers’ income is reduced as much as the consumers’ outlay. In the end the normal proportion between the consumers’ income and the unspent margin is restored, not by an increase in balances, but by a decrease in incomes. It is this limitation of the unspent margin that really prevents the new Government expenditure from creating employment. (pp. 41-42)

Stated in these terms, the argument suggests another possible mechanism by which government expenditure could increase total income and employment: an increase in velocity. And Hawtrey explicitly recognized it.

There is, however, one possibility which would in certain conditions make the Government operations the means of a real increase in the rapidity of circulation. In a period of depression the rapidity of circulation is low, because people cannot find profitable outlets for their surplus funds and they accumulate idle balances. If the Government comes forward with an attractive gild-edged loan, it may raise money, not merely by taking the place of other possible capital issues, but by securing money that would otherwise have remained idle in balances. (pp. 42-43)

In other words, Hawtrey did indeed recognize the problem of a zero lower bound (in later works he called it a “credit deadlock”) in which the return to holding money exceeds the expected return from holding real capital assets, and that, in such circumstances, government spending could cause aggregate spending and income to increase.

Having established that, absent any increase in cash balances, government spending would have stimulative effects only at the zero lower bound, Hawtrey proceeded to analyze the case in which government spending increased along with an increase in cash balances.

In the simple case where the Government finances its operations by the creation of bank credits, there is no diminution in the consumers’ outlay to set against the new expenditure. It is not necessary for the whole of the expenditure to be so financed. All that is required is a sufficient increase in bank credits to supply balances of cash and credit for those engaged in the new enterprise, without diminishing the balances held by the rest of the community. . . . If the new works are financed by the creation of bank credits, they will give additional employment. (p. 43)

After making this concession, however, Hawtrey added a qualification, which has provoked the outrage of many Keynesians.

What has been shown is that expenditure on public works, if accompanied by a creation of credit, will give employment. But then the same reasoning shows that a creation of credit unaccompanied by any expenditure on public works would be equally effective in giving employment.

The public works are merely a piece of ritual, convenient to people who want to be able to say that they are doing something, but otherwise irrelevant. To stimulate an expansion of credit is usually only too easy. To resort for the purpose to the construction of expensive public works is to burn down the house for the sake of the roast pig.

That applies to the case where the works are financed by credit creation. In the practical application of the policy, however, this part of the programme is omitted. The works are started by the Government at the very moment when the central bank is doing all it can to prevent credit from expanding. The Chinaman burns down his house in emulation of his neighbour’s meal of roast pork, but omits the pig.

Keynesians are no doubt offended by the dismissive reference to public-works spending as “a piece of ritual.” But it is worth recalling the context in which Hawtrey published his paper in 1925 (read to the Economics Club on February 10). Britain was then in the final stages of restoring the prewar dollar-sterling parity in anticipation of formally reestablishing gold convertibility and the gold standard. In order to accomplish this goal, the Bank of England raised its bank rate to 5%, even though unemployment was still over 10%. Indeed, Hawtrey did favor going back on the gold standard, but not at any cost. His view was that the central position of London in international trade meant that the Bank of England had leeway to set its bank rate, and other central banks would adjust their rates to the bank rate in London. Hawtrey may or may not have been correct in assessing the extent of the discretionary power of the Bank of England to set its bank rate. But given his expansive view of the power of the Bank of England, it made no sense to Hawtrey that the Bank of England was setting its bank rate at 5% (historically a rate characterizing periods of “dear money” as Hawtrey demonstrated subsequently in his Century of Bank Rate) in order to reduce total spending, thereby inducing an inflow of gold, while the Government simultaneously initiated public-works spending to reduce unemployment. The unemployment was attributable to the restriction of spending caused by the high bank rate, so the obvious, and most effective, remedy for unemployment was a reduced bank rate, thereby inducing an automatic increase in spending. Given his view of the powers of the Bank of England, Hawtrey felt that the gold standard would take care of itself. But even if he was wrong, he did not feel that restoring the gold standard was worth the required contraction of spending and employment.

From the standpoint of pure monetary analysis, notwithstanding all the bad press that the “Treasury View” has received, there is very little on which to fault the paper that gave birth to the “Treasury View.”

Keynes v. Hawtrey on British Monetary Policy after Rejoining the Gold Standard

The close, but not always cozy, relationship between Keynes and Hawtrey was summed up beautifully by Keynes in 1929 when, commenting on a paper by Hawtrey, “Money and Index Numbers,” presented to the Royal Statistical Society, Keynes began as follows.

There are very few writers on monetary subjects from whom one receives more stimulus and useful suggestion . . . and I think there are few writers on these subjects with whom I personally feel more fundamental sympathy and agreement. The paradox is that in spite of that, I nearly always disagree in detail with what he says! Yet truly and sincerely he is one of the writers who seems to me to be most nearly on the right track!

The tension between these two friendly rivals was dramatically displayed in April 1930, when Hawtrey gave testimony before the Macmillan Committee (The Committee on Finance and Industry) established after the stock-market crash in 1929 to investigate the causes of depressed economic conditions and chronically high unemployment in Britain. The Committee, chaired by Hugh Pattison Macmillan, included an impressive roster of prominent economists, financiers, civil servants, and politicians, but its dominant figure was undoubtedly Keynes, who was a relentless interrogator of witnesses and principal author of the Committee’s final report. Keynes’s position was that, having mistakenly rejoined the gold standard at the prewar parity in 1925, Britain had no alternative but to follow a policy of high interest rates to protect the dollar-sterling exchange rate that had been so imprudently adopted. Under those circumstances, reducing unemployment required a different kind of policy intervention from reducing the bank rate, which is what Hawtrey had been advocating continuously since 1925.

In chapter 5 of his outstanding doctoral dissertation on Hawtrey’s career at the Treasury, which for me has been a gold mine (no pun intended) of information, Alan Gaukroger discusses the work of the Macmillan Committee, focusing particularly on Hawtrey’s testimony in April 1930 and the reaction to that testimony by the Committee. Especially interesting are the excerpts from Hawtrey’s responses to questions asked by the Committee, mostly by Keynes. Hawtrey’s argument was that despite the overvaluation of sterling, the Bank of England could have reduced British unemployment had it dared to cut the bank rate rather than raise it to 5% in 1925 before rejoining the gold standard and keeping it there, with only very brief reductions to 4 or 4.5% subsequently. Although reducing bank rate would likely have caused an outflow of gold, Hawtrey believed that the gold standard was not worth the game if it could only be sustained at the cost of the chronically high unemployment that was the necessary consequence of dear money. But more than that, Hawtrey believed that, because of London’s importance as the principal center for financing international trade, cutting interest rates in London would have led to a fall in interest rates in the rest of the world, thereby moderating the loss of gold and reducing the risk of being forced off the gold standard. It was on that point that Hawtrey faced the toughest questioning.

After Hawtrey’s first day of his testimony, in which he argued to a skeptical committee that the Bank of England, if it were willing to take the lead in reducing interest rates, could induce a world-wide reduction in interest rates, Hawtrey was confronted by the chairman of the Committee, Hugh Macmillan. Summarizing Hawtrey’s position, Macmillan entered into the following exchange with Hawtrey

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

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

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

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

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

HAWTREY. . . . that kind of orthodoxy is like conventions at bridge; you have to break them when the circumstances call for it. I think that a gold reserve exists to be used. . . . Perhaps once in a century the time comes when you can use your gold reserve for the governing purpose, provided you have the courage to use practically all of it. I think it is possible that the situation arose in the interval between the return to the gold standard . . . and the early part of 1927 . . . That was the period at which the greater part of the fall in the [international] price level took place. [Gaukroger, p. 298]

Somewhat later, Keynes began his questioning.

KEYNES. When we returned to the gold standard we tried to restore equilibrium by trying to lower prices here, whereas we could have used our influence much more effectively by trying to raise prices elsewhere?

HAWTREY. Yes.

KEYNES . . . I should like to take the argument a little further . . . . the reason the method adopted has not been successful, as I understand you, is partly . . . the intrinsic difficulty of . . . [reducing] wages?

HAWTREY. Yes.

KEYNES. . . . and partly the fact that the effort to reduce [prices] causes a sympathetic movement abroad . . .?

HAWTREY. Yes.

KEYNES. . . . you assume a low Bank Rate [here] would have raised prices elsewhere?

HAWTREY. Yes.

KEYNES. But it would also, presumably, have raised [prices] here?

HAWTREY. . . . what I have been saying . . . is aimed primarily at avoiding the fall in prices both here and abroad. . . .it is possible there might have been an actual rise in prices here . . .

KEYNES. One would have expected our Bank Rate to have more effect on our own price level than on the price level of the rest of the world?

HAWTREY. Yes.

KEYNES. So, in that case . . . wouldn’t dear money have been more efficacious . . . in restoring equilibrium between home and foreign price . . .?

HAWTREY. . . .the export of gold itself would have tended to produce equilibrium. It depends very much at what stage you suppose the process to be applied.

KEYNES. . . . so cheap money here affects the outside world more than it affects us, but dear money here affects us more than it affects the outside world.

HAWTREY. No. My suggestion is that through cheap money here, the export of gold encourages credit expansion elsewhere, but the loss of gold tends to have some restrictive effect on credit here.

KEYNES. But this can only happen if the loss of gold causes a reversal of the cheap money policy?

HAWTREY. No, I think that the export of gold has some effect consistent with cheap money.

In his questioning, Keynes focused on an apparent asymmetry in Hawtrey’s argument. Hawtrey had argued that allowing an efflux of gold would encourage credit expansion in the rest of the world, which would make it easier for British prices to adjust to a rising international price level rather than having to fall all the way to a stable or declining international price level. Keynes countered that, even if the rest of the world adjusted its policy to the easier British policy, it was not plausible to assume that the effect of British policy would be greater on the international price level than on the internal British price level. Thus, for British monetary policy to facilitate the adjustment of the internal British price level to the international price level, cheap money would tend to be self-defeating, inasmuch as cheap money would tend to raise British prices faster than it raised the international price level. Thus, according to Keynes, for monetary policy to close the gap between the elevated internal British price level and the international price level, a dear-money policy was necessary, because dear money would reduce British internal prices faster than it reduced international prices.

Hawtrey’s response was that the export of gold would induce a policy change by other central banks. What Keynes called a dear-money policy was the status quo policy in which the Bank of England was aiming to maintain its current gold reserve. Under Hawtrey’s implicit central-bank reaction function, dear money (i.e., holding Bank of England gold reserves constant) would induce no reaction by other central banks. However, an easy-money policy (i.e., exporting Bank of England gold reserves) would induce a “sympathetic” easing of policy by other central banks. Thus, the asymmetry in Hawtrey’s argument was not really an asymmetry, because, in the context of the exchange between Keynes and Hawtrey, dear money meant keeping Bank of England gold reserves constant, while easy money meant allowing the export of gold. Thus, only easy money would induce a sympathetic response from other central banks. Unfortunately, Hawtrey’s response did not explain that the asymmetry identified by Keynes was a property not of Hawtrey’s central-bank reaction function, but of Keynes’s implicit definitions of cheap and dear money. Instead, Hawtrey offered a cryptic response about “the loss of gold tend[ing] to have some restrictive effect on credit” in Britain.

The larger point is that, regardless of the validity of Hawtrey’s central-bank reaction function as a representation of the role of the Bank of England in the international monetary system under the interwar gold standard, Hawtrey’s model of how the gold standard operated was not called into question by this exchange. It is not clear from the exchange whether Keynes was actually trying to challenge Hawtrey on his model of the international monetary system or was just trying to cast doubt on Hawtrey’s position that monetary policy was, on its own, a powerful enough instrument to have eliminated unemployment in Britain without adopting any other remedial policies, especially Keynes’s preferred policy of public works. As the theoretical source of the Treasury View that public works were incapable of increasing employment without monetary expansion, it is entirely possible that that was Keynes’s ultimate objective. However, with the passage of time, Keynes drifted farther and farther away from the monetary model that, in large measure, he shared with Hawtrey in the 1920s and the early 1930s.


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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