When Keynes wrote his General Theory, he emphasized solutions to the problem of depression and did not worry himself with the reason for the Great Depression. This is understandable as a change in policies contemporary to Keynes might have helped fend off further deepening of the Depression. As the gold standard was intimately tied to problems, Keynes perception of its operation might provide insight into why he disagreed with Ralph Hawtrey’s review of monetary policy in the late 1920s.
Keynes understood that conflicting policies from independent central banks hampered the functioning of the gold standard.
Thus, to overcome the obstacles to an international agreement – the conservatism of France and the independence of the United States – might cause serious and perhaps intolerable delays… (A Treatise on Money, ii., 336-7; 1965)
To-day the reasons seem stronger – in spite of the disastrous inefficiency which the international gold standard has worked since its restoration five years ago (fulfilling the worst fears and the gloomiest prognostications of its opponents), and the economic losses… to reverse the order of procedure… and to hope for progress from that starting-point towards a scientific management of the central controls… of our economic life. (338)
While his recognition of the problem is appropriate, his analysis of the monetary problem is less adequate. He relied primarily on the interest rate in conducting his analysis. He argued that in the case where there is a discrepancies between interest rates in gold standard countries,
…the restoration of equilibrium may require not only a change in interest-rate, but also a lasting change in income-levels (and probably price-levels). That is to say, a country’s price-level and income level are affected not only by changes in the price-level abroad, but also by changes in interest-rate, due to a change in the demand for investment abroad relatively to the demand at home. (i., 326-27)
While not incorrect, Keynes omitted a more fundamental element: the international price of gold (or in other words the international price level).
Gold might move between countries as a result of discrepancies between domestic interest rates and foreign interest rates. Likewise with discrepancies between domestic prices and international prices. But what about when the international price level plummets? Ralph Hawtrey, in his review of the Treatise critiqued Keynes for giving “insufficient prominence to the international aspects of the credit cycle (The Art of Central Banking, 400; 1934).” He elaborates,
He defines the cycle in terms of the price level, for by ‘the alterations of excess and defect in the rate of investment over that of saving’ he means alternations of excess and defect of the price level over costs. But with a gold standard the price level is determined internationally. The internal price level of any particular country varies relatively to its external price level in response to the credit measures taken to correct any variation in its balance of payments. But the external price levels of all countries with a common monetary standard move together. I regard the credit cycle as essentially a periodical fluctuations in the world value of gold. (400-1)
The cause of the Great Depression, Hawtrey believed, was that central banks increased demand for gold and forced upward the price of gold. He though that this could have been prevented had the Bank of England and the Federal Reserve led the world in lowering reserve ratios.
Keynes and Hawtrey and conflicted on this issue previously at the Macmillan Commission. Keynes questioned Hawtrey about the relationship between employment and the gold standard. (I should note that Alan Gaukroger has done a tremendous favor to those interested in the history of thought by including this conversation in his doctoral thesis)
KEYNES. . . . you regard the history of events from 1924 to 1930, and their effect on unemployment, as the tragedy of a series of avoidable errors in monetary policy?
HAWTREY. Well, yes.
KEYNES. And that is based on two assumptions. . . . the Bank of England could . . . have followed an easy money policy without losing too much gold . . . and . . . if it had . . . that would have cured unemployment?
KEYNES. As regards the first, of course, you can only get a conclusive answer by trying?
KEYNES. . . . as regards the other, do you consider that the level of money wages in this country was such that, in order to obtain full employment, the rise of prices in the outside world would have had to be quite substantial?
HAWTREY. No . . . Wages in America are 120 per cent above the pre-war level and prices are about 40 per cent above . . . no doubt [due] to technical improvements in production. . . . The Americans do not have a monopoly on technical improvements. I think it reasonable to assume that the enormous disparity . . . between prices and wages would have had its counterpart here. Wages here are [only] 70 per cent . . . above the pre-war level. (293-94)
Here, Alan Gaukroger notes that Hawtrey was responding to “the implication in Keynes’s question that British wages were unduly high in relation to world rates." The conversation continued on,
KEYNES. It is an expression of opinion on your part. The argument to me is rather this. One wants a man to weight 12 stone to be healthy. He, in fact, weighs 10 stone’ you say if he ate another biscuit every day he would weigh 12 stone. But all you have proved is that the tendency of the biscuit would be to increase his weight?
HAWTREY. I think you have statistical data which take you further than that. The American price level in 1925 was 161 . . . now it is 140. That disparity is . . . fully equivalent to the percentage of unemployment here.
KEYNES. . . . to assert that if the Bank of England had been brave it could have had sufficiently cheap money to prevent a fall of prices is, it seems to me, unwarranted?
HAWTREY. I have given you ground for supposing the . . . price change involved was sufficient . . . that ought to wipe out all exceptional unemployment we are suffering from. (294-95)
Hawtrey suggested that England could encourage prices to rise internationally if only the Bank of England eased its monetary stance. Other countries would likely adjust their policies to maintain their exchange rate with the pound, which would mitigate to some extent gold outflows from England. It is difficult to know for sure if Hawtrey was correct. Had this been the policy of the Bank of England from the beginning of the gold exchange standard, it might have accomplished this maintenance of higher prices abroad. If not, that is if England’s lowering of the reserve ratio did not sufficiently lower demand for gold internationally, it would have been forced to leave the gold standard much earlier than it did in 1931, rather than extend its period of high unemployment rates.
According to Hawtrey, increased demand for gold was the impetus for the fall in prices and was the primary factor preventing recovery. Keynes downplayed this factor. He believed that markets lacked a timely mechanism for adjustment of monetary disequilibrium. This was true whether or not the gold standard operated efficiently. J. Stuart Wood, in his superb summary of business cycle theories notes that “Keynes argued that there was no market mechanism which could bring the supply of savings into equality with the demand for borrowed funds for investment, and Keynes assumed that capital goods are homogeneous, neglecting the heterogeneity of capital goods which Mises and Hayek saw as the essential cause of the recession (An Encyclopedia of Keynesian Economics, 79; 1997).” Although Keynes understood the problems associated with the gold standard, he saw the Depression as an endogenous phenomenon that did not necessarily need the gold standard to occur. He appears have believed that Hawtrey’s theory of gold demand and depression was insufficient because it assumed that, otherwise, savings and investment would be matched automatically.
Of course, Keynes won the battle for the minds of his contemporaries. It is less clear that his diagnosis was more apt than that of Hawtrey.