Wednesday, October 23, 2013

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.

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