Monometallism as the Winner's Curse (My Latest Working Paper)

I will be presenting this paper at this year's Policy History Conference.

By the middle of the 19th century major western nations began to adopt the gold standard. Britain was first to do so with its resumption of the gold standard in 1821. It was followed a half-century later by Germany in 1871 and the Latin Monetary Union – made up of France, Belgium, Italy, and Switzerland – in 1873, both of which also demonetized silver. The United States followed suit with the Coinage Act of 1873 which put the U.S. on a de jure gold standard when it resumed redemption in 1879. Before this, the price of gold remained relatively stable as countries on a bimetallic standard ensured that the exchange rate between silver and gold did not vary greatly. Thus, if one metal became scarce, a nation might adopt the other, by law or by practice, so as to alleviate a shortage of base money. By adopting the gold standard, governments disallowed the employment of substitutes for gold – i.e., silver – as base money and therefore made the demand for gold more inelastic. This made the monetary system more fragile. As a result of the demonetization of silver, shifts in demand for gold exercised increased influence over the price level. 

This was an inevitable consequence of the adoption of gold backed legal tender. Any change in the monetary gold stock, in GDP, or in the velocity of gold exercised greater influence on prices after the switch. Changes in the Sauerbeck-Statist index, a measure of wholesale prices, after 1873 reflect the downward pressure on prices as the index reached a peak in 1873 and followed a strong downward trend until after 1896. The problem was amplified as gold reserves were centralized under central banks. Combined with an already decreased elasticity of demand, suspension and later readoption of the gold standard promoted instability in gold denominated prices during WWI and the interwar era. As central banks increased or decreased the volume of gold held on reserve, prices moved in the opposite direction. 

This paper investigates the above problem by identifying the direction of changes in the elasticity of the price level in terms of gold with respect to changes in the monetary gold stock, GDP, and the velocity of gold, the latter of which is also known as the inverse of portfolio demand for gold. Of greatest concern is the last of these. The velocity of gold during the period cannot be measured directly. The model employed here estimates it indirectly and show that it exhibited tremendous downward pressure on prices once the gold standard was adopted and that the consolidation of gold at central banks greatly increased the sensitivity of prices to changes in GDP, the monetary gold stock, and the velocity of gold.

*Thanks to Carlos Ramirez for our many discussions about modeling.

HT Phil Magness

What Exit Strategy?: Currency Crises Under a De Facto International Dollar Standard

The Fed is considering ending tapering as unemployment rates have fallen, but the situation in emerging markets is weak as Argentina has recently devalued.

Emerging markets are vulnerable to spillover effects as developed countries start to rein in monetary stimulus, Lagarde said last week in Davos.

The next day, emerging-market stocks dropped, extending the worst start to a year since 2009, as currencies tumbled on concern that a slowdown in China and Federal Reserve stimulus tapering will trigger more outflows. Argentina scrapped some of its currency controls a day after devaluing the peso as policy makers there sought to stem a financial crisis and restore investor confidence.  

I also bring your attention to trouble in Turkey and South Africa.

While the routs in the Turkish lira and the South African rand have garnered most attention recently, there have been ructions across most EM currencies. The looming end of quantitative easing started making investors rethink the relative attractiveness of higher yielding emerging markets assets last spring. 

Central bank expansion might have stabilized the situation at home, but unwinding their balance sheet is no easy task. 

Since the sell-off of 2013, doom-mongers may argue, two things have got worse. First it has become even clearer that the rich world’s central bankers do not have much of a clue how to tame the beast they have created in the form of ultra-loose monetary policy. Ben Bernanke, the outgoing Fed chief, chairs his last policy meeting on January 28th and 29th. The Fed is expected to trim its bond purchases by a further $10 billion, to $65 billion a month. No doubt this will be accompanied by a torrent of elegant verbiage to show that the Fed is in command. But sceptics should look at Britain, where the newish central bank boss, Mark Carney, has abandoned the framework he put in place only half a year ago. It was supposed to govern the pace at which monetary policy would return to an even keel. The process of normalising central banks’ balance-sheets is going to be mighty unpredictable and disruptive.

And as a result of the expansion, there has been a boom abroad alongside mediocre growth in developed countries.

One common characteristic of all emerging countries today is that they have all shared in the colossal credit boom. Loans have been growing by double-digit rates for many years. Vietnam has already blown up—it has set up a “bad bank” to try and clean up its lenders. Perhaps more countries are yet to own up to big, bad debt problems of their own. If you want to give yourself a fright on this front consider the share price of Standard Chartered, a Western bank largely exposed to the emerging world. It has collapsed.

These problems will likely put more downward pressure on the value of currencies in developed countries as investors seek safe haven. The problem might be made worse if central banks in developing countries respond with a tightening of domestic money supplies, as this will increase demand for foreign exchange. All of this is in addition to any deflation that might occur as a result of contraction in previously booming emerging markets. Of course devaluation is also a danger, but probably the lesser of the two evils as long as it occurs as a one time devaluation.

In a world of dollarization and dollar dependence, the Federal Reserve must consider the international effects of its policy. (See this post by Lars Christiansen) The dollar serves a role similar to that of gold under the gold standard. Not surprising, the current crisis is similar to a problem that occurred under the gold standard. According to Barry Eichengreen,

When countries like Britain suffered a decline in exports, the Bank of England could restore external balance by raising interest rates [tightening] so as to discourage foreign investment. But the countries of Latin America, many of which lacked even a central bank, had no control over the direction of international capital flows. Moreover, disruptions to their export markets rendered them less desirable places to invest. Hence they simultaneously suffered declines in export revenues and in capital inflows.

Banks faced two poor options. They could devalue as gold flowed out, which tended to lead to inflation more than it increased production, or they could tighten, which would lead to deflation and a credit crunch. Central banks in emerging countries face a similar problem when central banks in developed countries cease their stimulus programs. Deflation in developed countries will attract currency abroad home, putting pressure on central banks in emerging markets to either devalue allow their currencies to devalue or contract their money stocks. Either situation is not conducive to growth and stability.

The problem is conducive to increased demand for dollars and contraction of the broader money stocks. If policy tightens as demand for dollars increase, we can expect deflation and contraction of credit. If policy makers are not careful,  tightening might lead to systemic issues as in the housing crisis.

Late Add: Lars recently wrote an enlightening post on the difference between fixed exchange rate and floating exchange rate regimes.

On the Overwrought Distinction Between the Classical and Interwar Gold Standards (A Preview of My Current Project)

In his critique of the standard interpretation of the interwar gold standard, Richard Timberlake claims that “the Fed and other central banks’ deliberate management of the gold-exchange standard prevented monetary adjustment in the period 1929-33 from resembling the pattern of equilibrium of the classical gold standard (2007, 326).” He goes on to equate a “true” gold standard with the classical gold standard. In similar fashion, Milton Friedman argues that the gold-exchange standard was a “pseudo gold standard” because France and the United States engaged in sterilized gold inflows (1961). Though they were avoided, the same policies were possible under the classical gold standard, making the distinction dubious. The difference between the classical gold standard and the interwar gold standard was a difference in degree, not kind.

The gold standard grew continually more cumbersome after it was officially adopted during the 1870s. That gold, and gold alone, was employed under all legal tender regimes in the West altered the standard’s operation. If a major central bank changed its gold reserve ratio or interest rate, this would certainly impact the price of gold elsewhere. This was true during the classical standard just as it was during the interwar gold standard. Before World War I, this was obscured by informal coordination of central bank policies, led by the Bank of England. As phrased by Barry Eichengreen, “when the Bank of England raised her rate, the Bank of France and the Reichsbank were quick to follow (1989, 13).” The stability offered by such an arrangement masked its underlying weakness.

When national governments suspended the gold standard, both in law and in practice, and England gave up her leadership, the managed gold standard lost its coordinating mechanism. The problem was augmented by another feature of the gold standard: the tendency toward centralization of gold reserves in the previous half century. In 1914, most of the world’s monetary gold was stored at a small number of central banks. By 1922, “the world market in gold was practically coterminous with the monetary demand of one great country” as nearly half of the world’s monetary gold resided at the Federal Reserve (Hawtrey 1947, 97). Consolidation made prices even more sensitive to changes in the demand and supply of gold. When coordination of independent central banks from the Bank of England ceased, the price of gold became unhinged, swinging wildly between 1914 and 1920 and again between 1929 and 1932.

This problem was inherent in the system. It was not a defect of the gold standard per se. It was a defect of management under a system of fixed exchange rates where deflation must almost inevitably follow an unbacked expansion of the money stock by the central bank. Under a system of floating exchange rates, on the other hand, the economy probably would have adjusted to a higher price level and “the subsequent collapse would almost surely not have occurred (Friedman 1961, 68).” Of course this also could have been avoided by a return to the gold standard at adjusted parities, but such an option was politically unpalatable.[1] In light of political constraints, the economic instability associated with the latter decades of the gold standard was not a glitch, but rather the logical end of a monometallic legal tender regime.

---

[1] “The implications drawn by Cassel from this situation were that countries should not go back to prewar parities, or if the objective was price stability, to the prewar system at all. A much talked of advantage of the prewar system was its ‘high degree of stability’, and which ‘we should now endeavor to restore’. Adopting mispriced currencies and squabbling over inadequate gold reserves were not the ways to do it. He was ignored by policymakers and rejected by most economists.” (Mazumder and Wood, 2013, 162)

Reminder: Hayek Did not Support Stabilizing MV During the Great Depression

Hayek’s theoretical preference was to stabilize MV. This was not a policy suggestion. He wrote in Prices and Production,

Such 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 enamoured 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. (1935, 123-124)

Don’t be fooled.  A reading of the lines that follow this quote shows that he was not actually suggesting this as policy. 

But quite apart from the particular difficulty which, from the point of view of pure theory, may not prove insuperable, it should be clear that only to satisfy the legitimate demand for money in this sense, and otherwise to leave the amount of the circulation unchanged, can never be a practical maxim of currency policy. (124)

In other words, Hayek did not approve of MV stabilization during the Great Depression. Nope. Instead, he waved his hands and said that policy probably will not accomplish what is theoretically possible. He then goes on to confuse the issue by considering changes in demand due to changes in production and trade. In this context he suggests that central banks should not expand the money stock "save an accute crisis", but apparently believed that even this sort of policy was to no good end no matter the reason. He explains, 

In any case, it [expansion] could be attempted only by a central monetary authority for the whole world: action on the part of a single country would be doomed to disaster... The most we may hope for is that the growing information of the public may make it easier for central banks to follow a cautious policy during the upward swing of the cycle, and so to mitigate the following depression, and to resist the well-meaning but dangerous proposals to fight depression by "a little inflation". (125)

Hayek is unclear whether he is considering changes in y or V, not that it changes his conclusion. He clearly believes that central banks cannot  should not "fight depression by 'a little inflation'."

Various Links

1. Noahpinion has a guest post about being honest with time series regressions.

2. Jonathan Finegold asks if Hayek's Austrian Business Cycle Theory work was really "inconsequential".

3. Lars Christiansen has compiled a list of established and aspiring monetary theorists. The ideas is to connect those with related interests. If you have not already, go sign up.

Theory of Money and Credit at 101: The Regression Theorem and Bitcoin (Liberty Fund)

Liberty Fund recently published a set of essays concerning Theory of Money and Credit by Ludwig von Mises. Larry White writes the lead essay, with responses and critiques from Jörg Guido Hülsmann, Jeffrey Rogers Hummel, and George Selgin. Each brings unique insights concerning Bitcoin and the regression theorem.

White presents two attempts to describe the emergence of Bitcoin in terms of the regression theorem,

Two responses to the challenge seem possible. One is to say that the historical component posited by the regression theorem is not strictly necessary to explain the purchasing-power expectations people initially formed for Bitcoin. The historical component is important to the initial medium-of-exchange value of a good that did have a market value the previous day as an ordinary commodity, or as a redeemable claim, but it cannot be important to a new medium of exchange that had neither. In such a case purchasing-power expectations must arise entirely from forward-looking speculation. Early adopters who paid positive numbers of dollars (or traded pizzas or devoted CPU time) to acquire Bitcoins did so because they believed that it might attain a higher dollar value in the future. In this account, the value of Bitcoin is basically a bubble, a self-feeding phenomenon unanchored by fundamentals. The trouble with a bubble story, of course, is that is consistent with any price path, and thus gives no explanation for a particular price path. Consistent with the bubble story, some Bitcoin-imitator crypto-currencies have crashed to zero after trying to launch into positive value. 

The other possible response is to preserve the universal applicability of the regression theorem by saying that Bitcoin must have been a useful commodity to some people before it became a medium of exchange. As Murphy (2013b) puts a version of this case, it could be argued that “the very first people to trade for it did so because it provided them withdirect utility because they knew there was at least a chance that it would serve to chafe the governments of the world with their printing presses.… [T]he early adopters of Bitcoin were doing it for ideological reasons, not for pecuniary reasons.” Then, once it had an observable positive price, “it was off to the races in terms of standard Misesian theory.” This scenario, however, does not deliver what the argument requires, namely, an account of how Bitcoins initially had a positive value apart from their actual or prospective use as medium of exchange. The value at every point in this scenario derives entirely from use or prospective use as a medium of exchange (only such use as a dollar competitor is what might “chafe the governments,” not the existence of untraded digital character strings).

Hülsmann agrees with at least part of the second story,

What is the rock bottom of Bitcoin? Presently it is antistatist ideology. If ever the ideology vanishes, something else will have to take its place. At present, it is not clear what that could be.

Selgin nuances the story,

In short, a clever marketing strategy, including a little strategic sleight-of-hand, can substitute for history in putting a positive sign on the expected value of an otherwise useless potential exchange medium.

And Hummel tackles the fiscal theory of the price level in regard to the regression theorem,

If correct, the FTPL implies that neither fiat nor credit money are true outside money in the sense of being assets only, with no offsetting liability. Instead they are really what current monetary theorists refer to as inside money, with future taxes representing the offsetting liability-side, making them much like shares of stock, whose value depends on an anticipated future income stream. Not only does this conclusion eliminate any real-balance effect that can result from fiat or credit money constituting net wealth (unlike commodity money), but it impinges on the long-standing debate over whether a pure inside-money economy would be feasible. 

Hawtrey on the Weakness of the Gold Standard: Gold, per se, was not the Problem

As I continue my study of the Ralph Hawtrey's analysis of the classical gold standard in The Gold Standard in Theory and Practice, I notice that he sets forward in his narrative an argument that implies the problem that I am currently extrapolating upon in an upcoming paper. (I hope to get it up on SSRN in the next week or two.) He writes:

The immediate effect of the suspension of the free coinage of silver in Europe was to concentrate the whole demand for additional metallic currency upon the gold supply of the world.

As I have argued before, the establishment of the gold standard eliminated metallic substitutes for gold as base money. By definition, this made demand for gold more inelastic, thus creating an environment that encouraged price volatility.

As the price of any good becomes more expensive, individuals tend to substitute away from it. By preventing the employment of substitutes for gold, gold standard countries – meaning, in practice, all western nations after 1879 – made more fragile the international monetary system. This is a fact too little appreciated in the literature concerning the gold standard - with the exception research from Bordo and Reddish that I posted recently, and probably David Glasner, Scott Sumner, and other interested market monetarists. The restraint provided by the classical gold standard appears to garner support for it among libertarian leaning economists. As a result, the effects of intervention in the classical gold standard have gone on generally ignored as arguments concerning it have become polarized. i.e., in debate gold becomes either a barbarous relic or a beacon of growth and economic stability. 

Researchers should be asking: “How did the gold standard change when silver was demonetized?” and “Why did it fail?” Hawtrey baldly explains the problem:

Since there is nothing in the circumstances of either metal [gold or silver] to make it more stable in value than the other, are we to be driven to the conclusion that the precious metals are inherently defective for that purpose? That would be a mistake. The true moral of the nineteenth-century monetary experience is rather that the defects in gold and silver as standards of value have been attributed to causes within human control. Governments have been too prone to modify their currency systems without regard to the reactions they might cause in the world markets for the precious metals, and therefore in the currency systems of their neighbors.

Conflicting policies from independent central banks destroyed the stability provided by the gold standard. Hawtrey preferred that central banks might cooperate to avoid the problems associated with the monometallic standard, but such hopes were dashed by political reality.

Arguments concerning the gold standard in history too often devolve into a fight about the merits of the gold standard per se. Consider George Selgin’s “The Rise and Fall of the Gold Standard in the United States” (which, despite my qualms, I still recommend for anyone attempting to gain familiarity with the gold standard. His discussion of silver demonetization quite informative!). Although he clarifies that a gold standard does not depend on “’legal tender’ status”, the complications associated with the adoption of a monometallic standard under a legal tender regime breeds complications that are ignored. In defending the gold standard against the claim that it is inherently deflationary and therefore suppresses economic growth, he writes:

…actual statistics for the [deflationary] interval in question reveal healthy average growth rates for both total and per capita real income … with declining prices reflecting, not flagging demand (as they did in the 1930s) but robust growth.”

The gold standard itself was not itself exceptionally deflationary, but a monometallic regime enforced by law was deflationary. This was not due to an increase in production. The growth of the gold stock could not keep pace with demand for gold after silver was demonetized. Deflation was more a result of the elimination of metallic substitutes than of increases in production. (See my earlier post.) It is for this reason that we see a strong downtrend in gold denominated prices between 1873, around the time that most major nations demonetized silver, and 1896.

Surely the debate can be improved. If the gold standard was destroyed by “causes within human control,” by governments that were “too prone to modify their currency systems without regard to the reactions they might cause,” then the interesting story to be told concerns political economy. In this story, the gold standard is more of a bystander than a system of instability or inherent promoter of deflation. 

While researchers like Barry Eichengreen and Peter Temin suggest that the gold standard was overly constrained monetary policy, I suggest that the classical gold standard overly constrained markets. The limitations of a monometallic legal tender monopoly impeded the formation of expectations in regard to future prices as substitution away from gold could no longer limit swings in prices. (For insight, see Barsky and De Long on inflation expectations under the classical gold standard.) If we are to discuss the gold standard, we must first ask "before or after silver was demonetized?"

Some Fodder from Hayek for the Conspiracy Folks

I was surprised to find that Hayek proposed some of Alex-Jones-sounding talking points before the man was born.

The problem assumes the greatest importance when we consider that we are probably only at the threshold of an age in which the technological possibilities of mind control are likely to grow rapidly and what may appear at first as innocuous or beneficial powers over the personality of the individual will be at the disposal of government. The greatest threats to human freedom probably still lie in the future. The day may not be far off when authority, by adding appropriate drugs to our water supply or by some other similar device, will be able to elate or depress, stimulate or paralyze, the minds of whole populations for its own purposes. If bills of rights are to remain in any way meaningful, it must be recognized early that their intention was certainly to protect the individual against all vital infringements of his liberty and that therefore they must be presumed to contain a general clause protecting against government’s interference those immunities which individuals in fact have enjoyed in the past. (The Constitution of Liberty, 2011 [1960], 325)

 He also includes a footnote concerning Aldous Huxley's Brave New World.

For a none too pessimistic account of the horrors that may be in store for us see Aldous Huxley, Brave New World: A Novel ... and Brave New World Revisited... and, even more alarming, because not intended as a warning but expounding a 'scientific' ideal, Burrhus Frederic Skinner, Walden Two.

My guess is that, in some manner, Hayek had in mind the eugenics movement that had peaked shortly before he published The Constitution of Liberty. I'd be delighted if any readers could share their insight.

Orwell on Hayek

Apparently George Orwell reviewed The Road to Serfdom (alongside The Mirror of the Past by K. Zilliacus) and liked a lot of it.

It cannot be said too often – at any rate, it is not being said nearly often enough – that collectivism is not inherently democratic, but, on the contrary, gives to a tyrannical minority such powers as the Spanish Inquisitors never dreamed of.

Professor Hayek is also probably right in saying that in this country the intellectuals are more totalitarian-minded than the common people.

But he did not like Hayek's alternative.

But he does not see, or will not admit, that a return to ‘free’ competition means for the great mass of people a tyranny probably worse, because more irresponsible, than that of the State. The trouble with competitions is that somebody wins them. Professor Hayek denies that free capitalism necessarily leads to monopoly, but in practice that is where it has led, and since the vast majority of people would far rather have State regimentation than slumps and unemployment, the drift towards collectivism is bound to continue if popular opinion has any say in the matter.

In his review, Orwell suggests no solution; instead he submits to pessimism.

Both of these writers are aware of this, more or less; but since they can show no practicable way of bringing it about the combined effect of their books is a depressing one.

Worth the two minutes it takes to read.

New Year's Resolutions

1. Stop procrastinating.

Already failing.

2. Publish an article in a top journal.

Waiting for a response from JEH. I plan to send off my next paper to Explorations in Economic History.

3. Break 5:00 in the mile/17:00 in the 3 mile.

I've reacquainted myself with the runner's high and want more.

4. Smile a little bit more.

If you know me, you know.

 5. Practice being intentional in my presentation.

Both formal and informal.

 365  364 days left!

The Road to Serfdom in Retrospect: Then and Now

In 1944, Hayek published The Road to Serfdom as a battle cry against collectivism and an affirmation of core liberal principles. It was such a smashing success that in 1945 Reader’s Digest published a condensed version. According to John Blundell, “Hayek thought it impossible to condense but always commented on what a great job the Reader’s Digest editors did.” It is in this spirit that I feel justified in reviewing some of Hayek’s claims from the condensed version.

There is a tension that runs throughout Hayek’s narrative between planning and equality its supposed welfare improving effects. The latter was the excuse for the former at the time of the original publication. Much of Hayek’s efforts are directed toward the act of planning. Thus, Hayek makes the extreme version of planning his focal point. This is well embodied in one of the jacket notes from the first edition of The Road to Serfdom:

In a planned system we cannot confine collective action to the tasks on which we agree but are forced to produce agreement on everything in order that any action can be taken at all.

Having lived through two world wars and observing the rise of collectivism in its most egregious forms in Italy, Germany, and the U.S.S.R and in its softer forms in the U.K. and U.S., Hayek was justified in his concern. He had observed collectivism at its climax. In those forms, the freedom of the individual had been practically extinguished.

The greater danger, one that remains today, that Hayek also identifies is the employment of a particular end to justify actions that subvert institutions which guarantee individual liberty:

There is literally nothing which the consistent collectivist must not be prepared to do if it serves ‘the good of the whole’, because that is to him the only criterion of what ought to be done.

There is no getting around that the common good will be used as justification for any action, no matter how materially or politically constructive or destructive. How much credence society lends these stated ends, as opposed to the likely results of particular action or legislation, is a function of general skepticism. It is especially important that intellectuals, those nodes that guide public sentiment, exercise skepticism in their evaluation of political programs and mature discretion in promotion of interventions that transform long lived institutions. A stable set of “rules of the game” regarding the use of force, i.e., the action of government, constrain that force and make it more predictable. It allows individuals to make plans and feel secure in those plans. This is the core of Hayek's argument. He writes:

Nothing distinguishes more clearly a free country from a country under arbitrary government than the observance in the former of the great principles known as the Rule of Law. Stripped of technicalities this means that government in all its actions is bound by rules fixed and announce beforehand – rules that make it possible to foresee with fair certainty how the authority will use its coercive powers in given circumstances and to plan one’s individual affairs on the basis of this knowledge. Thus, within the known rules of the game, the individual is free to pursue his personal ends, certain that the powers of government will not be used deliberately to frustrate his efforts. 

Throughout the remainder of his career, Hayek wrote in defense of "rules of the game" and it is this part of his legacy that is most applicable to the modern intellectual landscape.

No end is so important that it should justify swift and massive alteration of the "rules of the game". For example, if the zeitgeist of a generation, particularly my generation, carries with it a cry for equality as the highest end, as the most moral principle to be attained at any cost, then the stability generated by “rules of the game” may be placed at risk. It is for this reason that those interested in a prosperous future, especially those who generate ideas and those who reformulate and distribute them, must consider the impact of particular policies and ideas on these rules. If an end is to be accomplished, it must be according to rules agreed upon. If the rules are altered, they must be changed systematically. It is not the crazed dictator that we need to fear in 2014. It is the employment of high-minded ideals that supposedly justify the subversion of these rules. And for this role there is no shortage of candidates.