My review of Hayek’s work, which with today’s post now thoroughly, though not completely, spans from late 1920s to 1930s, has revealed to me a consistent weakness throughout his writing. Aside from short inklings into his future work on spontaneous social orders, his work from this period is backward looking and his attempts to bridge theory and policy produce awkward, and probably unworkable, suggestions. It is this tension between Hayek the theorist and Hayek the policy wonk that I hope relay in reviewing his analysis of the international gold standard. I must first present the monetary difficulties that the world faced due to a managed gold standard and the distaste for gold that his bred.
A great strength of Hayek’s analysis of the gold standard is that he differentiates the gold standard in practice from the gold standard in the abstract. The Great Depression was a consequence of the former, a managed gold standard. He writes at the end of Price and Production:
I am not even convinced that a good deal of the harm which is just now generally ascribed to the gold standard will not by a future and better informed generation of economists be recognized as a result of the different attempts of recent years to make the mechanism of the gold standard inoperative.
To some extent, he was correct in this prediction, though it seems that few economists have actually spelled this out specifically so as to place the failure of the gold standard entirely on the shoulders of bad management. (I am unsure if the phrase good management is not a paradox within this context.) Richard Timberlake states this most clearly:
They [presumably Barry Eichengreen and Peter Temin] seem unaware that if central bankers are managing a ‘gold standard’ in order to control monetary policy, whatever it is they are managing is not really a gold standard.
The problem is not due to gold. If central banks managed any other commodity standard with fixed exchange rates, the same problem would likely occur. The problem was management. Historical observation and counter-historical modeling from Christina Romer and Chang-Tai Hsieh support a similar conclusion:
Our evidence from the one time that the Federal Reserve undertook monetary expansion in the early 1930s is that the Federal Reserve actually had substantial room to maneuver. For this reason, we are inclined to agree with Friedman and Schwartz that the Federal Reserve’s failure to act was a policy mistake of monumental proportions, not the inevitable result of the U.S. adherence to the gold standard.
Despite evidence that ought to rectify an excessively harsh view toward the gold standard qua gold standard (see also here and here), the general sentiment toward it remains closer to the “golden fetters” perspective than to any other. In short, the dominant sentiment has not changed considerably since the Great Depression, this is likely due to the difficulty of separating policy from theory, especially among intellectuals (in the Hayekian sense).
Hayek sums the monetary problem clearly at the start of Monetary Nationalism and International Stability.
It [monetary nationalism] will certainly continue to gain influence for some time to come, and it will probably indefinitely postpone the restoration of a truly international currency system. Even if it does not prevent the restoration of an international gold standard, it will almost inevitably bring about its renewed breakdown soon after it has been re-established.
The gold standard, as it historically operated under a system of independent central banks, is, in the long run, not a functional solution. The policies of central banks will likely not promote the health of the system as they are not constrained by market incentives. This system was especially fragile. As I argue in my recent paper, “the resumption of gold redemption by European central banks [after WWI] would lead to financial disaster even if only several attempted to maintain prewar exchange rates or attract gold by other means.” In particular, the Federal Reserve had to arbitrarily inhibit demand for gold as Great Britain returned to the gold standard at an overvalued parity. They and other central banks unsuccessfully engaged the prisoner’s dilemma. Hayek certainly takes this into account in Monetary Nationalism and International Stability:
It seems to me impossible to doubt that there is indeed a very considerable difference between the case where a country, whose inhabitants are induced to decrease their share in the world’s stock of money by ten percent, does so by actually giving up this ten percent in gold, and the case where, in order to preserve the accustomed reserve proportions, it pays out only one percent in gold and contracts the credit superstructure in proportion to the reduction of reserves. It is as if all balances of international payments had to be squeezed through a narrow bottleneck as special pressure to be brought on people who would otherwise not have been affected by the change to give up money which they would have invested productively.
Hayek must have in mind the deflation that followed tight central bank policies in 1928 and 1929.
It is not unsurprising that some readers might be confused by such a view from Hayek. Throughout the 1920s, Hayek was concerned about inflationary central bank policy. Even in Prices and Production, a lecture that were given in the midst of a deflationary crisis, Hayek busied himself by explaining the policies that might lead to depression and only touches on policies necessary to avert the deepening of a depression:
Hence the only practical maxim for monetary policy to be derived from our considerations is probably the negative one that the simple fact of an increase of production and trade forms no justification for an expansion of credit, and that – save in an acute crisis – bankers need not be afraid to harm production by overcaution.
It is only natural that the attention of academics is swayed by present circumstances. If one is interested in providing policy suggestions to officials, he or she must pay attention to the crisis at hand, not the problems of yesterday. Given the circumstances of the Great Depression, Hayek made himself irrelevant.
Hayek continued this trend throughout the decade. As noted by David Glasner, Hayek defended France’s policy of an undervalued Franc. In 1932 he wrote:
The accusation that France systematically hoarded gold seems at first sight to be more likely to be correct [than the charge that the US Federal Reserve had been hoarding gold, an accusation dismissed in the previous paragraph]. France did pursue an extremely cautious foreign policy after the franc stabilized at a level which considerably undervalued it with respect to its domestic purchasing power, and prevented an expansion of credit proportional to the amount of gold coming in. Nevertheless, France did not prevent her monetary circulation from increasing by the very same amount as that of the gold inflow – and this alone is necessary for the gold standard to function.
So Hayek’s observation that France did not prevent her monetary circulation from increasing by the very same amount as that of the gold inflow means only that the Bank of France refused to increase the French money supply at all (or even attempted to decrease it), forcing the French to increase their holdings of cash by acquiring gold through an export surplus.
It is bad enough that Hayek suggests backward looking solutions in arguing against the price level stabilizers. He surely discredited himself among contemporaries in 1932 as he sanctioned the policy that was steering the world economy off course and destroying the gold standard. To his opponents
were it was very clear that the
interwar gold standard and its effect on the price of gold was the source of
the trouble. In 1928, Cassel noted the problem and suggested a solution:
But if the gold-economizing policy does not succeed, or if it at a future time is found no longer possible to carry through, the unavoidable consequence must be that the gold standard will have to be abolished, and that the world's economy will have to be based on paper standards regulated with the single purpose of keeping the general level of prices constant.
In retrospect it is not difficult to see why Hayek lost this battle. For about a decade he fought against price stabilization without fully acknowledging the danger of gold price volatility and without offering a realistic alternative. The earliest concession from Hayek concerning the gold standard and central bank driven price distortion
from Hayek that I can find is in Monetary Nationalism and International Stability, and which I have
mentioned in a previous post:
Now the present abundance of gold offers an exceptional opportunity for such a reform. But to achieve the desired result not only the absolute supply of gold but also its distribution is of importance. In this respect it must appear unfortunate that those countries which command already abundant gold reserves and would therefore be in a position to work the gold standard on these lines, should use that position to keep the price artificially high. 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 appears to be the moment that Hayek’s analysis in some ways catches up with the profession. But it would be about another about another decade before his research into spontaneous order merged with his monetary interest (see last post) and still more time before this would allow him to create work that was far ahead of his field.
There is still much more to appreciate from Monetary Nationalism and International Instability. Next time I plan to compare Hayek’s analysis with Friedman’s article “Real and Pseudo Gold Standards.”