Under Appreciated Article on the Classical Gold Standard

Bordo and Redish published "Is Deflation Depressing? Evidence from the Classical Gold Standard" in 2003. I have not seen it cited in my research. Their findings are under appreciated. They conclude that only changes in aggregate demand, particularly changes in demand for gold, had a long run impact on the price level during the classical gold standard, although increase in output had short run effects on the price level. They also find that demand shocks did not significantly impact output.

We distinguish between good and bad deflations. In the former case, falling prices may be caused by aggregate supply (possibly driven by technology advances) increasing more rapidly than aggregate demand. In the latter case, declines in aggregate demand outpace any expansion in aggregate supply. This was the experience in the Great Depression (1929-33), the recession of 1919-21, and may be the case in Japan today. In this paper we focus on the price level and growth experience of the United States and Canada, 1870-1913. Both countries adhered to the international gold standard. This meant that the domestic price level was largely determined by international (exogenous) forces. In addition, neither country had a central bank which could intervene in the gold market to shield the domestic economy from external conditions. We proceed by identifying separate supply' shocks, money supply shocks and demand shocks using a Blanchard-Quah methodology. We model the economy as a small open economy on the gold standard and identify the shocks by imposing long run restrictions on the impact of the shocks and on output prices. We then do a historical decomposition to examine the impact of each shock on output. The results for the U.S. are clear: the different rates of change in the price levels before and after 1890 are attributed to different monetary shocks, but these shocks explain very little of output growth or volatility, which is almost entirely a response to supply' shocks. For Canada the results are murkier. As in the U.S., the money supply shocks before 1896 are predominantly negative and after that are largely positive. However, they are non-neutral, and relative to the U.S., money supply shocks play a larger role in determining output behavior in Canada. The key conclusion of our analysis is that the simple demarcation of good vs. bad deflation, where either prices fall because of a positive supply shock, or prices fall because of a negative demand (money) shock does not capture the complexity of the historical experience of the pre-1896 period. Indeed, we find that prices fell as a result of a combination of negative money supply shocks and positive supply shocks.

A Note on Institutions as Aids to Intertemporal Division of Labor and Guarantors of Liberty

Long lived institutions promote an intertemporal division of labor. Our forbearers solved particular problems. Institutions allows us in the present to rely on the wisdom of the past concerning these problems and work on more pressing issues. Hayek notes in The Constitution of Liberty that we do not, “as Thomas Jefferson believed… ‘ascribe to the men of the preceding age a wisdom more than human, and… suppose what they did to be beyond amendment.” There is here a confusion between the wisdom of a particular person and the collective wisdom of persons across many generations:

Far from assuming that those who created the institutions were wiser than we are, the evolutionary view is based on the insight that the result of experimentation of many generations may embody more experience than any one man possesses.

The formation of institutions across time represent the creation and application of information to relevant social problems. These solutions, as embodied in common law, have tended to increase freedom of the individual. The weakening of these institutions by increased reliance on legislation diminishes the freedom procured by this knowledge. It is this danger that Hayek refers to in his critique of rationalism. If the state is empowered to make too swift of changes too often and to deviate from the principles that underlie a liberal society, those principles, which secure the freedom to engage in any action not restricted, may be lost:

Not only is liberty a system under which all government action is guided by principles, but it is an ideal that will not be preserved unless it is itself accepted as an overriding principle governing all particular acts of legislation. Where no such fundamental rule is stubbornly adhered to as an ultimate ideal about which there must be no compromise for the sake of material advantages – as an ideal which, even though it may have to be temporarily infringed during a passing emergency, must for the basis of all permanent arrangements – freedom is almost certain to be destroyed by piecemeal encroachments.

It is on this intellectual foundation that one might argue for an encumbering of legislative action and increased reliance on common law as a means for promoting the general welfare.

Hayek and Foucault: Two Views On Institutions and Coercion

Perhaps the prime problem that society faces is that of violence. Every individual is capable of violence. And even if 99 percent of individuals do not engage themselves initiate violence, the actions of the few that do employ violence, if left unchecked, can be terminally destabilizing for society.

The hallmark of modern society is the existence of robust institutions that constrain violence, promoting its predictability. For example, I know that if I attempt to steal a vehicle or illegally enter a residence that I can expect a violent response from either the owner, local security, or the police. If I don’t pay my taxes, I can expect to end up in court and maybe have an unpleasant interaction with armed agents from the IRS. We are constantly confronted by implicit threats of violence that, at least in part, guide our actions. Violence is the norm, not the exception, for society. Even when we have overcome violence, it is overcome by threat of violence embodied in particular institutions – i.e., property rights, civil liberties. These rights represent protection from force, protection that is organized according to particular rules. With violence as a given, how do we move toward a state of freedom?

This is an issue that both F.A. Hayek and Michel Foucault confront. The former is optimistic about the range of institutional arrangements that might secure liberty. The latter views legal tradition as an extension of warfare, and therefore as a system of oppression. For Foucault, institutional evolution is an extension of oppression that might be one day overthrown. Though in ways opposed, the views of these authors concerning institutions also inform one another.

In The Constitution of Liberty, Hayek’s first task is to define liberty in light of the problem of violence:

It is often objected that our concept of liberty is negative. This is true in the sense that peace is also a negative concept or that security or quiet or the absence of any particular impediment or evil is negative. It is to this class of concepts that liberty belongs: it describes the absence of a particular obstacle – coercion by men. It does not assure us of any particular opportunities, but leave it to us to decide what use we shall make of the circumstance in which we find ourselves.

Liberty as described by Hayek above represents its pure form. We may never escape coercion, but we can constrain it so as to maximize individual freedom and creativity:

Coercion is evil precisely because it thus eliminates an individuals as a thinking and valuing person and makes him a bare tool in the achievement of the ends of another… Coercion, however, cannot be altogether avoided because the only way to prevent it is by the threat of coercion. Free society has met this problem by conferring the monopoly of coercion on the state and by attempting to limit this power of the state to instances where it is required to prevent coercion by private persons. This is possibly only by the state’s  protecting known private spheres of the individuals against interference by others and delimiting these private spheres, not by specific assignation, but by creating conditions under which the individual can determine his own sphere by relying on rules which tell him what the government will do in different types of situations.

Coercion by some prevents individuals from enacting their will on reality. The advantage of rules that make predictable the employment of violence is that, although they cannot provide an individual with absolute freedom – what can? – rules greatly expand one’s option set.

Michel Foucault takes a different approach. As with Hayek, Foucault understands that institutions transform and delimit violence. But for Foucault, this transformation is merely in extension of state of war. Institutions embody oppression:

The role of political power, on this hypothesis, is perpetually to re-inscribe this relation through a form of unspoken warfare; to re-inscribe it in social institutions, in economic inequalities, in language, in the bodies themselves of each and everyone [sic] of us.
So this would be the first meaning to assign the inversion of Clausewitz’s aphorism that war is politics continued by other means. (Power/Knowledge: Selected Interview and Other Writings, 1972-1977, Two Lectures)

Foucault’s perspective is not unfounded. Recent research on violence and institutions reinforces his view. In their theory of development, North, Weingast, and Wallace state explicitly that the earliest institutions are those that extract rents for elites that are greater than can be extracted under a state of warfare:

To be credible, the commitment [to peace] requires that the violence specialists be able to mobilize and gather their rents, which are produced by the remainder of the population. Mobilizing rents, in turn, requires specialists in other activities. It is here that we move away from the simple ideas about violence and back toward a more reasonable depiction of the logic of the natural state. In the earliest societies of recorded human history, priests and politicians provided the redistributive network capable of mobilizing output and redistributing it between elites and non-elites. (Violence and Social Orders)

If this was the whole story, Foucault would be correct to claim that:

The system of right, the domain of the law, are permanent agents of these relations of domination, these polymorphous techniques of subjugation. Right should be viewed, I believe, not in terms of a legitimacy to be viewed, but in terms of the methods of subjugation that it instigates. (Power/Knowledge: Selected Interview and Other Writings, 1972-1977, Two Lectures)

The extremeness of Foucault’s claim here betrays him. “The system of right, the domain of the law” are not “permanent agents” but constantly evolving compromises whose benefits flow outward from  the elites who initiate them to broader sections of the population. Violence, in particular violence from elite groups, is the starting point. Systematization of violence may represent a more benign form of warfare removed one degree from violence, but as the agreements evolve over time, extractive rents are diminished and individual freedom can, though it is not necessary that it does, increase.

Foucault leaves the reader with a solution that is inefficient, if not altogether unworkable. For Foucault, the power of violence continues in the disciplining of society, and therefore “it is not toward the ancient right of sovereignty that one should turn, but towards the possibility of a new form of right, on which must indeed by anti-disciplinarian, but at the same time liberated from the principle of sovereignty.” Foucault asks for a quantum leap in social organization, an elimination of violence. His singular concentration on institutions as an extension of oppression disallows his recognition of gains made by broader portions of the population that have resulted under existing regimes. As institutions evolve, violence is constrained by rules and society may move closer to a state, as phrased by Hayek, “in which coercion of some by others is reduced as much as is possible in society.” That is a state of freedom. On the other hand, one ought to remain conscious of Foucault’s critique as it carries with it a public choice angle. Rules and laws often benefit particular parties to the disadvantage of others.

Thoughts on Matt Zwolinski's Argument for Basic Income Guarantee

The blogosphere is abuzz with critique of Matt Zwolinski’s welfare proposal. Matt suggests that the government guarantee a minimum income in place of the welfare state. He gives 3 reasons to support this proposal: 

1) A Basic Income Guarantee [BIG] would be much better than the current welfare state.  

2) A Basic Income Guarantee might be required on libertarian grounds as reparation for past injustice.  

3) A Basic Income Guarantee Might be required to meet the basic needs of the poor.

On the first one, the answer is “no duh.” Economists agree that straightforward cash transfers are more efficient than in-kind transfers. He captures the spirit of his argument in his final remark on the issue:

Shouldn’t we trust poor people to know what they need better than the federal government?

His second argument, that “a Basic Income Guarantee might be required” is not so obvious to me nor is this obvious to David Henderson:

I think we can all agree that many people have what they have at least in part due to previous rights violations. It doesn't seem clear to me that they are on top in what I take to be Matt's narrower sense rather than my wider sense. I think, for example, of people who paid into Medicare and Social Security only a fraction, even in present value terms, of what they get back from taxes on the current young and middle-aged people. Sure, many of them are on top, but many are not. I don't see how a basic income guarantee redresses that rights violation.

Finally, the third argument seems too strong of a statement. That “a Basic Income Guarantee might be required to meet the basic needs of the poor” is at best ambiguous. I am skeptical that a BIG is required for any purpose in regard to basic needs. If implemented, it will reflect that individuals prefer to live in a society with a basic safety net. It can be promoted without being wrapped in a moral argument.

We need to ask some of the most important question in political economy. Under what rules shall we live? How shall we decide these rules? The BIG, along with its funding, is a potential rule. If some threshold of society, say 2/3s, votes directly or indirectly for a BIG, than a BIG has been legitimized in some respect. (i.e., via constitutional amendment) Philosophical foundation is helpful, but I am not sure there is any better reason than that enough of the U.S. electorate has agreed upon this arrangement.

Why would we want a BIG? Consider the impact on two accounts. Matt Zwolinski hits on the first. If we are to have a safety net, direct transfers are preferable. As suggested by Hayek, any payment must be distributed equitably, although this obviously does not require equitable taxation – in such a case there would be no possibility of a BIG. If we have to choose, BIG is better. Second, there is reason to prefer a society that encourages individuals to take risks and innovate. To encourage individuals not to fear failure! A large minimum income might incentivize this too much, but a small guaranteed income, say $5000, would probably not represent an economically destabilizing moral hazard. It would represent relative subsistence, which is probably optimal for a welfare program.

Matt Zwolinski also notes problems with a BIG.

1) Disincentives [to work]  

2) Effects on Migration  

3) Effects on Economic Growth

A $5000 BIG would probably not entail problems with 1) and 3). Problem 2), that a BIG incentivizes migration, can be fixed by a simple rule. If you are an immigrant, you must wait 5 years before receiving the BIG.

Those who want to see a complete disassembly of government will have problems with all of the above. While I sympathize, I do not expect the government to go away any time soon. I do not expect welfare programs to disappear any time soon. So we have a choice. Libertarians can present realistic reform programs or simply allow politics to continue as usual as our ideas are ignored. 

A program like BIG forgoes political paternalism and the narrative of equality that has dominated the politics of the last century. It instead, promotes a political program that embraces individual autonomy.

***Late Thought: We could also define BIG as some percent of average per capita GDP. 5000 would be about 10% by today's estimates.

Hawtrey's Narrative and My Critique of the Classical Gold Standard/Monometallism

I’ve been making my way through one of Ralph Hawtrey’s classic works, The Gold Standard in Theory and Practice. The book is both highly readable and insightful. Of interest today is Hawtrey’s narrative of the classical gold standard.

Gold and silver were both used for exchange in commerce throughout much of recorded history. It was not until the 1870s that the western world moved to a uniform gold standard. The foundations for this move were laid as a result of large gold discoveries in Australia and California during the middle of the 19th century. Gold had been the more highly valued money, which under bimetallism meant that it was hoarded and silver was used for exchange as official par overvalued it. After the gold discoveries, the reverse was true. The increase in the monetary gold stock brought down its value so that now silver traded at a premium under bimetal standards. Hawtrey notes that this was not without consequence:

The French franc from a silver unit became a gold unit. The two great financial centres of the world, London and Paris, were both gold centres.

At the time Germany employed a silver standard, and conditions were not favorable for such a position:

Germany no longer derived any advantage from the silver standard in her trade with Eastern Europe, because silver had there made way for inconvertible paper. The bimetallic currencies of Western Europe had passed from a state of fixity in terms of silver [i.e., a de facto silver standard under a bimetal regime], with a slight fluctuating premium on gold, to fixity in terms of gold, with a slight fluctuating premium on silver… Even if the ratio of gold to silver continued to be stabilized by the bimetallism of the Latin Union, the silver standard might be expected to be a disadvantage to the German financial centres.

After its war in 1871 Germany adopted the gold standard and suspended the free coinage of silver. With new demand for gold, this shifted the price ratio in favor of a de facto silver standard for bimetal regimes. [See my brief discussion of Gresham’s law from last post.] That is, had bimetal regimes operated as they had beforehand, silver would have been employed under those regimes. But at this time, “Russia Austria-Hungary, Italy and the United States were using depreciated paper” and France made her money inconvertible. With the suspension of redemption in traditionally bimetal regimes:

There was nothing to relieve the sudden scarcity of gold, and the price of silver in gold began to fall. But that meant that the currencies of silver-using countries began to depreciate… The only remedy was the suspension of coinage of silver.

Given the above described political situation, the general adoption of the gold standard appears to be an accident of history. What were the precise impacts of this "accident"?

An interesting, yet not broadly acknowledged, aspect of the adoption of the gold standard concerns its promotion of a relatively unstable price level. After the gold standard was adopted, the impact on the price level from a change in the monetary gold stock or in production appears to increase. Notice the change that occurs in 1873:

Notice that prices had stabilized from about 1856 to 1873. The gold standard era can be divided into an era of price deflation, 1873-1896, and of price inflation, 1896-1914. During 1914 most nations on the gold standard suspended redemption, but since gold was implicitly the only metallic standard - the return of redemption was anticipated after the war - price rose steeply as demand for gold fell. Precisely what one would expect given a lack of metallic money substitutes. 

I ran a series of regressions to investigate:

Years	VARIABLES	British GDP	Monetary Gold Stock	Constant
1839	Sauerbeck-Statist Index	-0.608*	0.469**	9.583***
to		(0.32)	(0.19)	(2.78)
1873	SIGMA2			0.00701***
1839	Sauerbeck-Statist Index	-1.433***	0.878***	17.04***
to		(0.17)	(0.12)	(1.40)
1896	SIGMA2			0.00800***
1839	Sauerbeck-Statist Index	-1.404***	0.868***	16.76***
to		(0.14)	(0.10)	(1.16)
1913	SIGMA2			0.00718***
Standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1

I used an ARCH model to account for the clustering of price level volatility as changes in direction tend to occur for more than one year at a time. The coefficients (those numbers with *s next to them) estimate the percent impact of a one percent increase in the independent variables – GDP and Monetary Gold – on the Sauerbeck-Statist Index, a measure of the British wholesale prices. The effect of both about doubles across the entire time period after the gold standard is established. The effects decrease slightly when the time period is extended to 1913, likely due to the increase in production of gold that began to occur in the 1890s after the discovery of the cyanide process for extraction. This alleviated the impacts of an increase in demand for gold.

Bottom line, a monometallic standard is bad for price stability. Was this bad for production? It is hard to tell because the industrial revolution was in full bloom at the time of the change. Clearly the world economy was able to handle a less flexible monetary standard as the growth associated with the period was before unthinkable. And perhaps the move to a common standard decreased transactions costs enough to compensate for the inflexibility. The interesting question is: on net, did the gold standard hurt or help economic growth?

Late note: The use of ARCH does not seem to matter as I receive the same output with a simple regression with Newey-West HAC errors.

Milton Friedman on Gold Demand and the Price Level

In 1990, Milton Friedman published “Crime of 1873”, an article that comprised a chapter in his Money Mischief – a book that is generally underappreciated, though not by some of my favorite monetary theorists. Friedman’s thesis is that the Crime of 1873 was actually a crime, though perhaps not in the legal sense:

Whether or not a verdict of "guilty" would have been appropriate in a court of law for "the crime of '73," it is appropriate in the court of history. The omission of the fateful line [allowing for silver coinage] had momentous consequences for the subsequent monetary history of the United States and, indeed, to some extent, of the world… The act of 1873 cast the die for a gold standard, which explains its significance. Moreover, while the conventional view is Laughlin's, that "the act of 1873 was a piece of good fortune" ([1886] 1896, p. 93), my own view is that it was the opposite: a mistake that had highly adverse consequences.

The U.S. demonetized silver just as European nations joined the gold standard, and thus demonetized silver: Germany in 1871, France, Belgium, Italy, and Switzerland in 1873, “The Scandanavian Union (Denmark, Norway, and Sweden), the Netherlands, and Russia followed suit in 1875-76 and Austria in 1879.” This switch by all major Western nations led to a significant price deflation in gold terms between 1873 and 1896. This also coincided with other deflationary forces:

The increased world demand for gold for monetary purposes coincided with a slowing in the rate of increase of the world's stock of gold and a rising output of goods and services. These forces put downward pressure on the price level. Stated differently, with gold scarcer relative to output in general, the price of gold in terms of goods went up, which means that the nominal price level (under a gold standard, the price level in terms of gold) went down.

This painful deflation – painful at least for debtors – could have been avoided.

Gresham’s law states that under a legal tender monopoly, money whose actual value is higher than the face value offered by the mint is hoarded and the “cheaper money” is used for exchange (as the unit of account) while the hoarded money serves as a store of value. Had the U.S. maintained a bimetal standard, gold would have been hoarded as its value had risen due to slowing production and increased demand in Europe. Silver would have been used for exchange as the face value of silver coins and bullion would likely have been higher than the value of its silver content. This also would have served to stabilize the gold price of silver by guaranteeing a market for it. Despite its shortcomings, price stability was one significant advantage of bimetallism.

Friedman findings support this:

If my estimates are anywhere near correct, a bimetallic-or really silver-standard would have produced a considerably steadier price level than the gold standard that was adopted.

He supports this with a graph that is hard to argue with:

Friedman shows that the price ratio of gold and silver remained relatively stable throughout the 19^th century. It was not until all major nations demonetized silver in favor of gold that the ratio lost became unhinged. Friedman provides a counter-historical regression line to support his argument. It is estimated by multiplying the gold price of silver by 16 and dividing it by a hypothetical price of gold had the U.S. not joined the gold standard (see the article for more details). The outcome would have been different:

Friedman's predictor line suggests that the price ratio of gold and silver would still have risen, but that rise would have been short lived as the existence of a legal price of silver in the U.S. would have encouraged discouraged deviations that were far from the official ratio.

Friedman's argument is compelling. My only addition to it is that falling prices under a gold standard, and the later price volatility during and after World War I was the result of the elimination of precious metal substitutes for gold as outside money by gold standard countries. More on that in the future.

Hayek and Selgin's "Productivity Norm": Theory vs. Practice

A couple weeks ago I came across George Selgin’s work on Great Depression era monetary theory. In “Hayek vs. Keynes on How the Price Level Ought to Behave” Selgin notes many of the same issues that I have been recently reviewing. Of particular interest is Hayek’s changing views on deflation and price level stability. Hayek started in the 1920s with “a general indifference to deflation, whatever its cause” and did not began to change his views until after the onset of the Great Depression.

Throughout the second half of this piece, Selgin points out that Hayek grew to embrace the "productivity norm." This is true, but the claim requires qualification that, unless I have overlooked it, is lacking here. Selgin writes:

He [Hayek] therefore felt obliged to reformulate his major policy recommendation by stressing up-front what in the earlier edition appeared only as an afterthought, namely, that ‘any changes in the velocity of circulation would have to be compensated by a reciprocal change in the amount of money in circulation if money is to remain neutral toward prices.’

This is only half true. Hayek admitted this problem on theoretical grounds, but in practice saw a policy of this sort as an unworkable, utopian ideal since it would require money to be injected at a precise place and time in order for it to remain neutral (see my earlier post). Thus, Hayek’s reformulation was hardly a policy recommendation, but rather, a theoretical admission followed by hand waving that implied something like “oh well, we can’t do anything about that anyway!” The same follows for another claim by Selgin that, in his article "Saving", Hayek "emphasized the desirability of expanding the stock of money to offset 'hoarding.'" Again, Hayek's analysis is positive and does not include a policy prescription. Even in his later works where he does recommend specific policies, he emphasizes that any monetary policy ought to be subject automatic, not subject to the whims of policy makers. 

With this in mind, I find it strange that Selgin lumps Hayek in with “Evan Durbin, Allen G. B. Fisher, Gottfried Haberler, Ralph Hawtrey, Eric Lindahl, Arthur Pigou, Dennis Robertson, [and] Gunner Myrdal” as supporting a “productivity norm.” As valuable as such a norm might be as a policy recommendation, Hayek did not support it as such.The confusion, I believe, is rooted in Hayek’s view toward price stabilization. Selgin admits that:

Hayek remained as opposed as ever to "the widespread illusion that we have simply to stabilize the value of money in order to eliminate all monetary influences on production" (ibid., 126). He also remained committed to the gold standard, which must have appeared to him even more acceptable than before (when he judged it insufficiently deflationary).

However, Hayek did not support a “productivity norm” prescription over one of price level stabilization. His comments must be viewed as only theoretical in nature as his policy suggestions did not change at least until 1937 as reflected in “Monetary Nationalism and International Stability” and waited until “A Commodity Reserve Currency” in 1943 for further elaboration. Even so, in 1937 Hayek was still advocating the gold standard as the appropriate monetary policy. Other policies, including a “productivity norm” would result in distortion of relative prices, presumably he believed worse than under a gold standard, because money is injected typically in financial markets rather than the point where a change in velocity is distorting prices.

*Note: I am not as familiar with Selgin’s work as I would like to be, so if he later corrected this I’d be happy if you let me know in the comments.

Shifts in Relative Prices vs Changes in the Price Level - A Preliminary Analysis Employing the Sauerbeck-Statist Index

I’ve recently grown interested in testing the predictive value of changes in relative prices as opposed to changes in the price level. So when I found myself with a few extra hours the other day, I ran some preliminary tests using the Saurbeck-Statist Index.

The Sauerbeck-Statist Index was published yearly from 1846 to 1948. It employs several baskets of commodities that are merged to form the final index. These are divided into two groups. The first group, “food”, includes baskets “vegetable”, “animal”, “sugar, tea, and coffee.” The second group, “raw materials”, includes “minerals”, “textile fibres”, and “sundrie”. In a set of regressions with changes in Great Britain’s GDP between 1878 and 1938, 1) I test the explanatory power of the sum of the absolute values of year-to-year percent changes in the price of these baskets, 2) of the sum of the absolute values of year-to-year percent changes less the percent change in the overall index, and 3) the absolute value of the percent change in the overall index. I anticipated that either 1) or 2) would provide more insight into changes in GDP, but this was incorrect. Regression 1) predicted about as well as 3), and 2) was far less accurate than both. (I also ran regression with squared variables, none of which proved more accurate and none of which are shown here.) The results are pictured below:

dlngbgdp = Percent Change in Great Britain GDP
APV = Absolute Price Volatility

RPV = Relative Price Volatility

absdSSI = Absolute Value of Year-to-Year Percent Changes in the Sauerbeck-Statist Index

wwi = Dummy Vairable 1915-1917

The signs on each measure of changes in price are negative as expected, so nothing appears unreasonable above. Also, the coefficient for changes in the Sauerbeck-Statist Index is about six times as large as the coefficient for the measure of Absolute Price Volatility. This is not surprising as there are 6 sectors considered in the Sauerbeck-Statist Index. The results appear consistent.

This is in no way a final say on the matter. There are certainly problems with this method of testing the impact of relative price changes.Summing changes in separate indices is not the same as summing changes in all prices as weighted according to their value relative to GDP. This also does not attempt in any way to separate output according to their location in the structure of production. Still this is worth considering because it does show the sum of changes in the value of certain baskets in different sectors - a proxy for price volatility - changes that surely would encourage economic discoordination.

In the near future, I would like to attempt a much more thorough, and probably more modern for the sake of convenience, analysis of changes in relative prices. For now, these preliminary results do not suggest that the sum of such changes may not be are a better predictor than changes in the overall price level. This is no surprise as rational producers will substitute away from inputs that become more expensive and consumers will substitute away from goods that do the same.

Glasner on Krugman's Comparison of Interwar France with Modern Germany

David Glasner posted today in response to Krugman's comparison of the Bank of France during the Great Depression and Germany in the modern era. Worth a look if you have been interested in my posts about the price level in terms of gold. He sums:

Indeed, there are similarities, but there is a crucial difference in the mechanism by which damage is being inflicted: the world price level in 1930, under the gold standard, was determined by the value of gold. An increase in the demand for gold by central banks necessarily raised the value of gold, causing deflation for all countries either on the gold standard or maintaining a fixed exchange rate against a gold-standard currency. By accumulating gold, nearly quadrupling its gold reserves between 1926 and 1932, the Bank of France was a mighty deflationary force, inflicting immense damage on the international economy. Today, the Eurozone price level does not depend on the independent policy actions of any national central bank, including that of Germany. The Eurozone price level is rather determined by the policy choices of a nominally independent European Central Bank. But the ECB is clearly unable to any adopt policy not approved by the German government and its leader Mrs. Merkel, and Mrs. Merkel has rejected any policy that would raise prices in the Eurozone to a level consistent with full employment. Though the mechanism by which Mrs. Merkel and her government are now inflicting damage on the Eurozone is different from the mechanism by which the insane Bank of France inflicted damage during the Great Depression, the damage is just as pointless and just as inexcusable. But as the damage caused by Mrs. Merkel, in relative terms at any rate, seems somewhat smaller in magnitude than that caused by the insane Bank of France, I would not judge her more harshly than I would the Bank of France — insanity being, in matters of monetary policy, no defense.

If Shifts in Velocity Can Alter Relative Prices, What About Changes in Gold Holdings by Central Banks?

I am currently busy working on a new project which has kept me away from blogging over the last week. In researching I have stumbled upon a fact that is revealing of late Hayek. It seems that he never came to terms with absolute inability of government adhere whatsoever to any fixed standard. In Denationalization of Money, he writes:

One might hope to prevent the violent fluctuations in the value of money in recent years by returning to the gold standard or some regime of fixed exchanges. I still believe that, so long as the management of money is in the hands of government, the gold standard with all its imperfections is the only tolerably safe system.

To be fair, I must acknowledge that Hayek does admit “the undeniable truth that the gold standard has serious defects.” He also places constraints on his support for the gold standard, saying:

It [gold] certainly could not bear the strain if the majority of countries tried to run their own gold standard. There just is not enough gold about. An international gold standard could today mean only that a few countries maintained a gold standard while the other hung on to them through a gold exchange standard.

Confusing, no? The gold exchange standard was the system that bred mistrust and monetary catastrophe. It was certainly no second best option. As has been revealed through my study of Hayek as a common theme, any time he mentions a policy that is in some respect compromised, specifically if it is backward looking, it comes across as awkward. To clarify, for Hayek gold is not preferable as a currency, but it is the only appropriate choice of government chooses control currency. If that happens, countries will have to adopt a gold exchange standard with only a few holding the actual gold reserves.

Take a deep breath, as I am done confusing you for now, and prepare for Hayek’s scarcely adulterated wisdom. Oddly, his analysis of gold under a free banking standard reveals precisely the problem that it carried under a managed standard. He writes:

It may be that, with free competition between different kinds of money, gold coins might at first prove to be the most popular. But this very fact, the increasing demand for gold, would probably lead to such a rise (and perhaps also violent fluctuations) of the price of gold that, though it might still be widely used for hoarding, it would soon cease to be convenient as the unit for business transactions and accounting.

Increased demand for gold under the gold standard increased its value just the same as might occur in a world of private currencies. That was the very reason why it failed. Changes in the price of gold, in other words the gold price level, created two sorts of price distortion. First it altered relative prices of goods so that the plans of entrepreneurs were upset by a technically unnecessary adjustment. Second, the inflation and deflation associated with the interwar gold standard altered the terms of credit so that creditors were benefitted under deflation and debtors were benefitted under inflation. Of course when price movements are extreme, the benefits for either party are likely outweighed by the cost of a shrinking volume of economic activity. Also, the further divergence of relative prices only compounds the problem. Hayek clearly understood this in regard to changes in velocity of domestic currency:

It can be maintained that the analyses in terms of the demand for cash balances and the use of the concept of velocity of circulation by the quantity theory are formally equivalent. The difference is important. The cash balance approach directs attention to the crucial causal factor, the individual’s desire for holdings of stocks of money. The velocity of circulation refers to a resultant statistical magnitude which experience may show to be fairly constant over the fairly long periods for which we have useful data – thus providing some justification for claiming a simple connection between ‘the’ quantity of money and ‘the’ price level – but which is often misleading because it becomes so easily associated with the erroneous belief that monetary changes affect only the general level of prices. [Monetary changes] are then often regarded as harmful chiefly for this reason, as if they raised or lowered all prices simultaneously and by the same percentage. Yet the real harm they do is due to the differential effect on different prices, which change successively in a very irregular order and to a very different degree, so that as a result the whole structure of relative prices becomes distorted and misguides production into the wrong directions.

The very same difficulty occurs when central banks hoard gold. Hayek somehow never specifically outlines that problem. He was not the only one to let this pass. This problem is pervasive in the literature. Those who more fully understood the dangers of price level volatility due to shifting demand for gold by central banks did not consider the problem of distortions in relative price. Their lack of concern for "noise" from relative price changes may be one reason why some were content with simple price level stabilization which ignores changes in real output. 

The merits of both views must be considered. The fusion between an Austrian perspective on prices and a monetarist perspective on gold can reveal much. More to be said on that next time as I consider other arguments and spell out the problem with more technical language.

Turning Point: Hayek as Monetary Visionary

In 1949, Hayek reflected on the success of socialist ideology and the waning of classical liberalism:

In particular, socialist thought owes its appeal to the young largely to its visionary character; the very courage to indulge in Utopian thought is in this respect a source of strength to the socialists which traditional liberalism sadly lacks. He closes the article by arguing:

We must make the building of a free society once more an intellectual adventure, a deed of courage. What we lack is a liberal Utopia, a program which seems neither a mere defense of things as they are nor a diluted kind of socialism, but a truly liberal radicalism which does not spare the susceptibilities of the mighty (including the trade unions), which is not too severely practical, and which does not confine itself to what appears today as politically possible.

During the Great Depression Hayek had struggled to convince his colleagues of the merits of certain classical liberal tenants that he valued. He failed to sway their opinion concerning the gold standard. This was also true concerning the Austrian Business Cycle Theory. He only partly succeeded in disillusioning them of their socialist utopian dreams with his participation in the Socialist Calculation Debate. Where had Hayek gone wrong? Hayek’s remarks in “Intellectuals and Socialism” about utopianism appear to be confession. He had not been idealistic enough.

Written before “Intellectuals and Socialism” in 1943, Hayek’s “A Commodity Reserve Currency” represents a shift in his research program where he begins to stress future avenues to prosperity and political organization, rather than a propose solutions that might be interpreted as “a mere defense of things as they are.” It is a truly symbolic of this change in that he moves from criticizing price level stabilization to proposing not only how it might successfully operate, but how the rules of its operations my mitigate the extreme fluctuations of the business cycle. His proposal is not the same as his peers. He suggests that, rather than having the price level be stabilized by changes in the money stock that offset changes in velocity, the use of a commodity reserves can stabilize the general price of commodities directly by setting a fixed exchange rate for commodities which will increase demand for them when prices fall below the fixed rate and alleviate demand when prices rise above the fixed rate:

With this [commodity] system in operation an increase in the demand for liquid assets would lead to the accumulation of stocks of raw commodities of the most general usefulness. As the hoarded money was again returned to circulation, and demand for commodities increased these stock would be released to satisfy the new demand.

He explains how this will dampen the business cycle:

The revival of activity will not lead to an extra stimulus to the production of raw commodities which would continue on an even keel. There is reason to regard the temporary stimulus of excessive expansion of production to raw commodities, which used to be given by the sharp rise of their prices in boom periods, as one of the most serious causes of general instability. This would be entirely avoided under the proposed scheme – at least so long as the monetary authority had any stocks from which to sell.

 Instead of pointing to the problem associated with past policies and suggesting a return to the golden days – which is easily interpreted as a return to the status quo – Hayek projects a vision of a future that improves upon the past.

This represents an about face from the direction of much of his previous work. His critique of price level stabilization and promotion of the gold standard during the 1930s had apparently gained Hayek few followers. The western world had suffered tragedy twice within two decades – first with the Great War, then the Great Depression – and the zeitgeist of the era did not look to the past for future success. Intellectuals craved idealism, not recitation of former creeds. They wanted swift change and saw the state as the vehicle for that change. Hayek learned that if the liberal values that he promoted were to survive, he needed to propose policies that were a radical departure for the past. The new vision must present previously unrealized solutions that constrain, rather than empower, the state. This new program is well exemplified in a couple passages of his 1943 article where he stresses the importance of rules:

There would, in particular, be no need for the monetary authorities or the government in any way directly to handle the many commodities of which the commodity unit is composed. Both the bringing-together of the required assortment of warrants and the actual storing of the commodities could be safely left to private initiative. Specialist brokers would soon take care of the collecting and tendering of warrants as soon as their aggregate market price fell ever so little below the standard figure and of withdrawing and redistributing the warrants to their various markets if their aggregate prices rose above that figure. In this respect the business of the monetary authority would be as mechanical as the buying and selling of gold under the gold standard.

And:

Even apart from monetary consideration, the great need is for a system under which these controls are taken from the separate bodies which can but act in what is essentially an arbitrary and unpredictable manner and to make the controls instead subject to a mechanical and predictable rule.

We can certainly see the roots of Hayek’s later work on spontaneous order as Hayek suggested rules that might procure stability that allows economic agents to make plans and coordinate them with others.

"Joiners" and Strong Social Bonds

Robin Hanson at Overcoming Bias reflects on the relationship between extreme opinions and social bonds:

High commitment groups produce stronger community bonds, and people vary in their taste for such strong bonds. Some folks are “joiners,” with a taste for more strongly bonded groups. Joiners have an induced taste for groups with extreme opinions, and thus an induced taste to have their own more extreme opinions, in order to better fit with stronger groups. Thus joiners tend to let themselves have more opinions and more extreme opinions on many topics.

Well worth reading in its entirety.

Scott Sumner On Kahan Tea Party Intelligence Distribution

Insightful. Check it out.

I apologize for picking on Dan Kahan, because he seems like a good guy.  And he’s no worse than the typical Yale academic.  But he really should be embarrassed. How could an academic expect people who identify with the Tea Party to be below average in any sort of intelligence/education metric? It boggles the mind. 

Average people pay little attention to public affairs.  Following public policy is not normal behavior; it’s what smart people do.  People like to talk about how popular Fox News is, but compare its ratings to professional wrestling, or some other non-intellectual show.  You will be surprised by how few people watch Fox.  The only reason the Tea Party didn’t do better is that the group included those who merely sympathize–if you took actual members the score would have been far higher.

Blindsided: Hayek, Austrian Business Cycle Theory, and the Narrative Fallacy

The other day I had a conversation with Garett Jones about the sources of dysfunction in the medical sector. After I rattled off an explanation in which I cited barriers to entry, the revolving regulatory door, and systematic control of journals by departments whose interests are aligned with big-pharma, etc… he asked, “What do you think the R-squared is for that?” In other words, on a scale of 0 to 100 percent, how much does your story explain? I felt pretty confident about the causation presented by my narrative, but this brought to my attention the problem of the narrative fallacy within the field of economics.

Of special concern to me, of course, is appearance of the narrative fallacy within Austrian economics, especially as expressed by Hayek in his early work. His analysis of central bank policy usually centered on the possibility of discoordination as a result of relative price changes that occur with the expansion of the money stock. Hayek believed that this was the primary source of the economic disturbances for greater than a decade after the war. His concern with relative price movements in Prices and Production is well encapsulated in his critique of Ralph Hawtrey:

But the main concern of this type of theory [price level targeting] is avowed, with certain suppositions ‘tendencies, which affect all prices equally, or at any rate, impartially, at the same time in the same direction.’ And it is only after the alleged causal relation between changes in the quantity of money and average prices has thus been established that effects on relative prices are considered… 

He though that Hawtrey was incorrect to claim:

...that money acts upon prices and production only if the general price level changes, and, therefore, that prices and production are always unaffected by money – that they are at their ‘natural’ level – if the price level remains stable.

Hayek believed that Hawtrey’s concerns were misplaced, or to put it more accurately, poorly ordered. Price level changes only mattered so much as they affect relative prices. Hayek had the theory to prove it, and a nice story to tell about it. When confronting Cassel’s support of price stabilization, which was akin to that of Hawtrey, Hayek states clearly his narrative and the theory on which it relies:

But general price changes are no essential feature of a monetary theory of the trade cycle; they are not only unessential, but they would be completely irrelevant if only they were completely ‘general’ – that is, if they affected all prices at the same time and in the same proportion. The point of real interest to trade cycle theory is the existence of certain deviations in individual price relations occurring because changes in the volume of money appear at certain individual points; deviations, that is, away from the position that is necessary to maintain the whole system in equilibrium. Every disturbance of the equilibrium of prices leads necessarily to shifts in the structure of production, which must therefore be regarded as consequences of monetary change, never as additional separate assumptions. The nature of the changes in the composition of the existing stock of goods, which are effected through such monetary changes, depends of course on the point at which the money is injected into the economic system.

As usual, Hayek tells a story of how changes in relative prices affect the structure of production and breed economic discoordination. This claim is by no means  incorrect. But the question I must ask is, “What is the R-squared for that?” And I might add, “What variables are omitted?”

As I showed last post, both Cassel and Hawtrey were concerned about the short-run price level destabilization that might occur with the reestablishment of the gold standard. These men were not only concerned with shifts in velocity of the broader measures of the money stock, but of change in demand for gold itself, particularly by central banks. To the best of my knowledge, they did not emphasize the danger of shifts in relative prices, but of a sharp deflation or inflation associated with changes in demand for gold. It is curious that Hayek, who was concerned about destabilization of relative prices due to central bank policy, did not simply modify the concerns of Hawtrey and Cassel by attributing these dangers to relative prices. The reason, I believe, is that it threatened his narrative.

The prosperity that the western world experienced after 1870 came alongside mass adoption of the gold standard. Until World War I, the “rules of the game” of the game had procured relative monetary and price stability. If a central bank expanded the monetary base by too great a degree, investors would remove their gold from the central bank and place it elsewhere. This would discipline central banks that practiced easy money policies. Also, if excess gold in one nation led to a rise in prices, gold would flow to countries where prices were lower. Thus the gold standard was an international standard that allowed information about scarcity to be transmitted globally.

In light of this, Hayek stresses the significance of a return to the gold standard. In Monetary Nationalism and International Stability, he wrote:

Since people will always feel that against these emergencies they will have to hold some reserve of the one thing which by age-old custom civilized as well as uncivilized people are ready to accept – that is, since gold alone will serve one of the purposes for which stock of money are held – and since to some extent gold will always be held for this purpose, there can be little doubt that it is the only sort of international standard which in the present world has any chance of surviving. But, to repeat, while an international standard is desirable on purely economic grounds, the choice of gold with all its undeniable defects is made necessary entirely by political considerations.

But governments had found a way to not only subvert the discipline of gold, but make the standard entirely dysfunctional even for those who followed the “rules of the game.” By substantially increasing gold reserves at different times in the years following the war, countries like France and the United States depressed the price level, and in doing so, distorted relative prices. This is very similar to distortions that might occur due to changes in velocity of the broader money stock. Since gold holdings had been largely centralized by central banks, one can view this entirely as shifts in the price level that occurred due to central bank intervention. The emphasis of Austrian Business Cycle Theory on domestic inflation likely promoted this bias.

Hayek did not begin to integrate this element into his framework until late. After the war, the return to the gold standard required cooperation among central banks. Their policies were decided often on political grounds. This was the case in France when the franc was devalued and France’s share of the world increased from 7% in 1927 to 27% in 1932. In his 1932 article, “The Fate of the Gold Standard,” Hayek denied that this was a problem:

Hence it was by no means the economically strong countries such as America and France whose measures rendered the gold standard inoperative, as is frequently assumed, but the countries in a relatively weak position, at the head of which was Britain, who eventually paid for their transgression of the ‘rules of the game’ by the breakdown of their gold standard.

It was not until 1937 that he revised this view and admitted that central banks with large gold stocks need to relax their demand for gold:

The policy on the part of those countries which are already in a strong gold position, if it aims at the restoration of an international gold standard, should have been, while maintaining constant rates of exchange with all countries in a similar position, to reduce the price of gold in order to direct the stream of gold to those countries which are not yet in a position to resume gold payments. Only when the price of gold had fallen sufficiently to enable those countries to acquire sufficient reserves should a general simultaneous return to a free gold standard be attempted.

 This can be viewed appropriately as an extension of his theoretical admission in Prices and Production that:

A change in the ‘velocity of circulation’ has rightly always been considered as equivalent to a change in the amount of money in circulation, and though, for reasons which it would go too far to explain here, I am not particularly enamored of the concept of an average velocity of circulation, it will serve as sufficient justification of the general statement that any change in the velocity of circulation would have to be compensated by a reciprocal change in the amount of money in circulation if money is to remain neutral toward prices.

Not until his 1943 article, "A Commodity Reserve Currency," that Hayek apparently ceased supporting a gold standard that depended on central bank cooperation. By then he was ignored by the policy debate.

In review, Austrian Business Cycle Theory did not take into account the need for cooperation between central banks. Each bank must maintain stable exchange rates which do not under or overvalue the domestic currency. This made Hayek unable to adequately address the arguments of proponents of price level stabilization. He overestimated the explanatory power of the Austrian Business Cycle Theory in regard to economic instability during the interwar period and underestimated explanatory power of arguments from price level stabilization proponents. Hayek was slow to update his theory. For nearly two decades after the war, Hayek’s theory and his narrative were still in want of fuller consideration of the open economy and political economy!

Hayek on Gold Sterilization: Wither Gold Demand?

I finally got my hands on Good Money, Part I which is a collection of essays from Hayek on international monetary conditions during the interwar period. It is an ideal set of essays for anyone who is interested in understanding Hayek’s disposition toward the gold standard.

Today I shall concern myself with two points of Hayek’s analysis from 1924: 1) Hayek stresses that Federal Reserve operations should take into account Europe’s imminent return to the gold standard and 2) he ignores the impact of an increase in demand for gold from the United States on the price of gold.

In the opening paragraph of his 1924 article, “Monetary Policy in the United States after the Recovery from the Crisis of 1920,” Hayek writes that “the outcome of American monetary policy is of considerable importance, given that many European currencies are dependent on it at present and probably for some time to come.” At the time of writing, the United States was one of few nations still on the gold standard, and of those, had the largest stock of gold – around 45% of the world’s monetary gold reserves. He also notes that, since gold was most often not directly involved in transactions, “the value of gold… is determined almost exclusively by the purchasing power of the dollar” and that “foreign exchange policy is geared to maintaining the parity of their currency with the dollar.” Countries that pegged their currency values to the dollar and, thus, indirectly maintained an exchange rate in terms of gold. Given this observation the similarity of this scheme with the gold exchange standard, his disagreement with supporters of price stabilization seem out of place. But more on that next time.

Hayek does not fully take into account the significance of the large drop in the price level that would likely follow the reestablishment of the gold standard. He does at least intuit that the drop in the price level was due to a shift in demand for gold by central banks after they delinked from the gold standard:

With its confinement to a single large country, the gold currency lost the stabilizing effect that it had produced in the prewar period, as demonstrated by the sharp rise in the general price level between the outbreak of war and 1920, in which the value of the dollar was cut in half, and by the ensuing drop in prices. In the years that followed, it became clear that the United States could not maintain even the degree of price stability attained by countries with an unconvertible paper currency.

Year-to-Year Percent Change 

He never explicitly notes the impact of demand for gold on its price. As I have shown, the majority of the rise in the price level in terms of gold and its later fall can be explained by the percent change in the world's total gold reserves held less the percent change in the world’s total gold stock. The more positive the difference, the greater was the marginal impact on the price level.

The above graph certainly was not available in 1924, but Gustav Cassel and Ralph Hawtrey were making a similar argument throughout the decade. In 1918, Cassel wrote that “the decrease in the monetary demand for gold… has brought the value of gold down to about half its pre-war level” and worried that “bringing prices down again to their old level would probably be still more disastrous.” In observing the Genoa resolution (1922), Hawtrey expressed concerned that “if an undue demand for gold is to be avoided, we must have some method of economising the use of gold as currency.” For some reason – which I hope to fully uncover – Hayek does not consider these arguments.

Hayek also claims, and he was not alone in doing so, that the Federal Reserve was correct to not fully employ the gold arriving from Europe. This, as with the rest of his argument, is a consequence of ignoring the price distorting effects of an increase in demand for gold from the Federal Reserve. Hayek  stresses that:

The proper policy to pursue [i.e., not fully employing gold from Europe] became problematic only when the revival of business activity gave rise to increased demands for credit. It was clear from the very start that under existing international conditions and with the enormous gold reserves of the Federal Reserve Banks in mind, the raising of discount rates should not be postponed until reserves were nearly exhausted, lest a dangerous inflation be encouraged and a severe downturn subsequently precipitated in its wake.

His analysis is certainly peppered with insights from the Austrian Business Cycle Theory, although this is a strange extrapolation of it where he justifies one intervention – sterilization – as a means to reestablishing the gold standard. He writes:

Whatever its actual magnitude, there is no question that this fraction of the credit basis will be withdrawn whenever European currencies have been so reliably stabilized that the dollar will no longer need to be used in international trade. To that extent, the sterilization of the increased gold stocks is a justifiable policy of the Federal Reserve Board.

 Hayek writes this despite his admission that “the very measures that were taken to sterilize the increase in gold supplies and to prevent prices from rising contribute to continued gold imports.” Had Hayek taken into account the international deflationary effect of gold sterilization that resulted from an increase in the value of gold, perhaps he might have thought differently. Without any record of Hayek on the significance of demand for gold it is impossible to know, but the omission of this from his writing suggests that he was either ignorant of the issue or thought it unimportant.

In any case, Hayek continues with a distinctly Austrian analysis where he decries the inflation associated with eventual expansion of credit by the Federal Reserve, credit that relied on incoming gold. I’ll have more to say about that next time.

***If anyone is familiar with any writings from Hayek in which he references demand for gold, I would appreciate that information.

Low Blow after Low Blow: Tom Watson at Salon

Read it here.

At one point he uses the word authoritarian as a descriptor. Never does he approach the theoretical foundations. Instead he whines that libertarians oppose the notion that government solutions are superior. This quotation sums his position well:

The Libertarian Party itself – inaccurately described by Stop Watching Us as a “public advocacy organization” – is a right-wing political party that opposes all gun control laws and public healthcare, supported the government shutdown, dismisses public education, opposes organized labor, favors the end of Social Security as we know it, and argues in its formal political manifesto that “we should eliminate the entire social welfare system” while supporting “unrestricted competition among banks and depository institutions of all types.”

Yet my progressive friends would take the stage with the representatives of this political movement? Why? The loss is much greater than the gain. Organizers trade their own good names and reputations to stand alongside – and convey legitimacy to – a party that opposes communitarian participation in liberal society, and rejects the very role of government itself. And their own argument for privacy is weakened by the pollution of an ideology that uses its few positive civil liberties positions as a predator uses candy with a child.

The loudest cry of libertarians (big and small "L") is that markets and voluntary societies provide the surest means of securing an enduring freedom and prosperity. Why? Because markets and voluntary societies allow the provision of needs to be internalized within communities, both small and broad. They provide solutions where gains are positive sum, rather than zero or negative sum. Solutions provided by government, at least thus far, tend to be of the latter type. Why? Because actors in markets and voluntary societies face the consequences of failure more immediately than bureaucrats in public agencies. If a business runs substantial deficits for an extended period, it will face bankruptcy. Government agencies, for example the post office, can consistently run deficits but never see an end.

The problems don't end there. Government provision of goods and services tend to bifricate society by class. Those who are poorer tend to have government services available for options like medical care, education, etc... Why? Because provision of these goods and services by government crowd out cheaper options, regardless of their effectiveness. The result is that in poorer communities where the provision of these goods and services have been internalized, or at least could be, lose the option of voluntary provision and with it, social cohesion. The relative cost of joining a local community for support increases as the provision of subsidized benefits increase. 

It's simple economics.

@ 1231 P.S. Steve Horwitz just pointed out a couple other responses here and here.