A Critique of Phillips, McManus, and Nelson on Central Bank Demand for Gold and the Initiation of the Great Depression

A popular source among Austrian economists and gold bugs interested in the Great Depression, Banking and the Business Cycle by Phillips, McManus, and Nelson presents a detailed analysis of the Great Depression that is thoroughly steeped in Austrian insights. Its popularity among the groups I mention makes it worthy of investigation. In this post I consider the role of gold in their narrative of the Great Depression. They appear, along with many with many other Austrian and Austrian-leaning economists at the time, to have been blinded by their gold standard fetish.

In a chapter title, “The Role of Gold”, the authors summarize arguments of their contemporaries concerning gold.

It has frequently been asserted in certain quarters that the recent disaster was brought about by an insufficiency of gold to support the price level, or that it was the result of an inadequate rate of increase of the world’s monetary stock of gold. Otherwise stated, it is insisted that prices have necessarily fallen either because the gold supplies of the world at large are insufficient in the absolute sense, or because the per annum rate of increase in the world’s monetary gold stock has failed to keep pace with the rate of increase in the physical volume of production. Or, it is argued that maldistribution of the available supply of gold is responsible for the trouble. It is also asserted that the inherent nature of the gold standard itself is a necessary and sufficient explanation. (38-39)

In the two decades preceding the Great Depression, central bank holdings of gold as a percent of the world monetary gold stock increased from 63 percent in 1913 to 90 percent in 1929. Although they had increased their share of the world’s monetary gold, especially after World War I, this did not result in an equivalent expansion.

The appetite of central banks for gold far exceeded the actual increase in the money stock. The authors recognize this problem.

The annual average increase in monetary gold stocks in central banks and governmental treasuries for the period 1900-1929 was 5.8 per cent; for the period 1913-1929, 4.8 per cent. 

The gold stock tended to increase at a rate of 2 to 3 percent per year. Central bank demand increased at a rate faster than the supply of gold grew. They go on to downplay the problem because “because of the superior credit expansion possibilities of gold in central banks as contrasted with gold in circulation as a medium of payment (47)." In short, central banks increase liquidity by using a gold reserve ratio of less than 100%. Central bank consolidation of the gold stock, then, is said to have had no connection to the initiation of the Great Depression. This is strange indeed and, as I will go on to show, simply incorrect.

The end of the chapter considers the most poignant formulation of the gold-standard theory of the Great Depression.

The idea that maldistribution of the world’s gold supplies with excessive concentration in the two countries, France and the United States, is the reason for the decline in prices, carries a greater degree of plausibility. (51)

The authors cite Cassel

Indeed, the sudden breakdown of commodity prices can only be explained by two events on the monetary side that have come into the foreground since the middle of 1929 * * * The second factor which since the middle of 1929 has tended to reduce the world’s supply of means of payment is the very unequal distribution of gold caused by tremendous gold imports into France and the United States.

They respond by arguing, since Cassel is referring to events from 1929, his argument that gold hoarding led to the Great Depression is surely incorrect. Prices began dropping in the fall of 1929, which is for some reason cited as evidence that Cassel’s assertion is mistaken. Even if we were to cede this ground, the authors appear to be unfamiliar with the situation in France. In a bit of sloppy scholarship, they take their own citation at face value rather than digging through the data. If they did, they would have seen that France increased its gold reserves by about 33% between June 1928 and September 1929. By the end of 1930, France had nearly doubled its monetary gold stock since June 1928.

(Board of Governors 1943)

There is no excuse for this. The authors appear to be aware of French monetary policy, but only consider the impact of increased demand from France after September 1929.

It is quite true that the gold holding of the Bank of France reached the enormous total of $3,218 millions in June, 1932. But this, it is to be emphasized, was long after the depression and the fall of prices had set in. The fact that the gold reserve of the Bank of France more than doubled from September, 1929, to June, 1932, might well be regarded as evidencing maldistribution as of the latter date, but it does not explain the start of the fall of prices in late 1929. The nationalistic hoarding of gold was a contributing factor in the precipitancy and persistency of that fall, once started, but it by no means follows, as Cassel and others contend, that the initiation of price decline should be attributed largely to the pre-depression maldistribution of gold. For the fact remains that the most striking maldistribution of gold occurred after the decline in prices set in. And it appears more probably that the price situation brought about the alleged maldistribution, than does the converse argument. (53)

If the authors had considered French monetary policy before September 1929, they could not have arrived at this conclusion. Their presentation is therefore distorted, inadequate, and wrong.

As if their narrative was not already problematic, they go on to describe the gold standard as needing management, but decry the mismanagement that led to its breakdown.

The gold standard admittedly requires experienced and skilled control in order to insure its relatively smooth working. Certain other conditions also are necessary, including a plasticity of and a reasonable agreement between costs and prices, readiness to accept payment of international debts in goods and services, and international goodwill as opposed to competitive nationalism, for it is only when these conditions are met that an international gold standard can function at all. . . . When, therefore, it is alleged that the gold standard has broken down, it is well to remember that scarcely any conditions necessary for its proper functioning have been realized. . . (54)

The culprit, they claim, was inflationary central bank policy that was bound to end in collapse. This is an odd proposition, as there seemed to be nothing inevitable about the collapse. If they were correct, certainly gold hoarding by France augmented the problem leading up to the initiation of the Great Depression in September and October of 1929. Their inclusion of commentary from Mises in a foot note helps elucidate their position as well as the errors that are included with it. Mises writes,

The dislocation of the monetary and credit system that is nowadays going on everywhere is not due – the fact cannot be repeated too often – to any inadequacy of the gold standard. The thing for which the monetary system of our time is chiefly blamed, the fall in prices during the last five years, is not the fault of the gold standard, but the inevitably and ineluctable consequence of the expansion of credit, which was bound to lead eventually to a collapse. (55)

Within a single country, Mises is right. Monetary expansion, all else held equal, will cause gold outflows that can only be offset by a subsequent contraction. Gold flows are the result of a discrepancy between exchange and interest rates in different nations. However, if these rates move together, there is no reason to expect that a subsequent deflation is inevitable. Simultaneous expansion (contraction) can lead to a general increase (decrease) in prices worldwide. If reserve ratios of central banks move in concert with one another, expansion is not a problem. However, the political situation did not allow for this, as French officials no longer wanted to participate in the gold exchange standard after 1927. Gold hoarding by France, however, is not the equivalent of an inevitable contraction that follows expansion. It was an example of independent central banking policy upsetting the existing balance of exchange rates.

This argument deserve more elucidation. The gold standard required management because of the difficulties that arose when exchange rates oscillated. As Barry Eichengreen has shown, European central banks typically followed the Bank of England’s lead in setting interest rates before World War I. The rules of the game, then, were simply for European central banks to coordinate with the Bank of England. Apparent harmony before World War I suggests that the program worked. But the coordination broke after World War I. The Bank of England lost her place as leader in Europe. When she tried to reclaim the position with the establishment of the gold exchange standard, she was in no position to exercise the dominance that she once held. Stability of the gold standard before World War I was a function of banks expanding and contracting in concert with the Bank of England. If a central bank expanded independently, than gold outflows would encourage tighter policy, forcing it to contract the money stock in order to stem the outflows. It was therefore impossible to state definitively whether banks had expanded the money stock by too much or too little except by referencing other central banks. France ceased to coordinate policy with the Bank of England after 1927. This was enough cause to bring down prices and discourage investment and production abroad. Falling prices and policy uncertainty were enough to bring on the Great Depression.

Phillips, McManus, and Nelson believe that the gold exchange standard represented “the world’s greatest experiment with a ‘managed currency’ within the gold standard”, but the nature of it was not much different than the classical gold standard (56). Smaller central banks had previously used foreign exchange to supplement their incomes as result the interest earned by lending their gold to larger central banks. This practice was expanded by the gold exchange standard. Consolidation of Europe’s gold at the Bank of England appears to have been the greater problem as it bred mistrust that led the insane Bank of France to hoard gold. (See Glasner for another example of an Austrian, this time Hayek, misdiagnosing the problem with the gold standard.)

As I seem to be noting a lot lately, those of you who disagree should read my paper where I describe in detail the distortions created by the mass adoption of gold-backed legal tender regimes after 1870. You’ll find that the international gold standard never existed except by intervention. Before that, it was practiced predominantly in England where merchants found it accommodative of large transactions.This is not to say that gold didn't serve as money before, but its use in no way represented an international gold standard.

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.

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.

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[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)

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!

Keynes vs. Hawtrey (Final Round): Gold Demand and Gold Prices

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?

HAWTREY. Yes

KEYNES. As regards the first, of course, you can only get a conclusive answer by trying?

HAWTREY. Yes

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.

Keynes's Not-So-General Theory and the Supposed Impotence of Monetary Policy

In 1935, John Maynard Keynes wrote to George Bernard Shaw:

“I believe myself to be writing a book on economic theory which will largely revolutionize—not, I suppose, at once but in the course of the next ten years—the way the world thinks about economic problems.”

After he published The General Theory, Keynes’s formulation of economics was received as though it was revolutionary, especially by his younger followers. Many older economists were not quick to embrace Keynes’s doctrine. As David Laidler points out, “Pigou and Knight in particular, were scornful of his claims to novelty (Fabricating the Keynesian Revolution, 21).” In The General Theory Keynes draws upon arguments from both his contemporaries and past economists, but especially in the case of his contemporaries, he typically fails to cite them. So what did Keynes actually contribute to economic theory? His main contribution was to call attention the need for economic analysis where the macro-economy fails to reach an equilibrium, but this contribution is obscured by a framing of the argument that ignored the economic significance of institutional collapse and his denial of the ability of monetary policy on its own to aid the process of recovery.

In the opening chapter of The General Theory, Keynes immediately clarifies his stance and his goals. “The postulates of the classical theory,” Keynes writes, “are applicable to a special case only and not to the general case (3).” The particular case, according to Keynes, is the case of full employment and the general case includes all states where the economy operates below full employment. He builds his theory with the belief that the economy does not typically operate at full employment, but rather “without any marked tendency either towards recovery or toward complete collapse (249).” If both of these claims are true, then in most circumstances the classical model is inadequate to employ in analysis. For the sake of remaining concise, I shall only briefly state that this proposition is untrue. Empirical investigation shows that the economy tends to move toward the long-run outcome predicted by the classical model (Kehoe and Prescott 2007). Only in the case of a general fall in prices and sticky wages is there a shortfall in demand where the economy operates below its potential (Galloway and Vedder, 89-97; Leijonhufvud, 49-50).

                

It appears that Keynes’s theory is the “special case”. Not only is it special, it is so particular as to call into question its applicability altogether. That is, Keynes questions the efficacy of monetary policy and its ability to return aggregate demand to its potential. In order for his theory to be useful, it needs to be better than just a second best option, which, if monetary policy is effective, is the ranking to which the theory must be relegated. As Hawtrey explained in a paper critiquing the support of Keynes and others for increased capital outlays as a remedy for depression,

Currency depreciation is far the most satisfactory measure of revival. Not only is it better balanced, but it is quicker and easier to bring about. I have already pointed out that a capital programme regarded as a measure for breaking the vicious circle of depression is likely to be too slow and too gradual to be successful, and I have suggested that, when cheap money fails to bring about a prompt revival, there is more to be hoped from an open market policy, the purchase of securities by the central bank. I should be inclined to leave the question at that, confident that a sufficient purchase of securities would overcome any depression however severe. For whereas cheap money reaches a limit when the rate of interest approaches zero, the purchases of securities can be increased indefinitely.

. . . The capital programme has the grave disadvantage of coming into operation tardily and gradually. Nor is it possible to say how great a programme will is needed to resolve the deadlock or whether any practicable programme will be great enough. If a capital programme were the only means of resolving the deadlock, we should have to make the best of it, but I believe that there are good reasons for supposing that a sufficiently liberal measure of open market purchases by the central bank would be bound to achieve this object.

. . . Since a programme of capital outlay offers so limited and doubtful a contribution towards revival, I think it is regrettable that excessive prominence is given to it by economists. (456-58)

The need for capital outlays is contingent on Keynes’s claim that the price level will not respond to an increase in the money supply when the economy is at less-than-full employment because he proposes that the price level is primarily a function of wages. If interest rates are too low to encourage investment, entrepreneurs will not invest, and therefore, output will remain stagnant.

The acuteness and the peculiarity of our contemporary problem arises, therefore, out of the possibility that the average rate of interest which will allow a reasonable average level of employment is one so unacceptable to wealth-owners that it cannot be readily established merely by manipulating the quantity of money.

. . . But the most stable, and the least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in future, the minimum rate of interest acceptable to the generality of wealth-owners. If a tolerable level of employment requires a rate of interest much below the average rates which ruled in the nineteenth century, it is most doubtful whether it can be achieved merely by manipulating the quantity of money. (308-9)

As Keynes links changes in the price level with changes in employment, this is his subtle way of saying that an increase in money will not lead to an increase in investment as holders of the new money will not lend it out. As mentioned in my last post on The General Theory, tremendous deflation occurred in England, Keynes home country, between 1929 and 1931. This continued in gold standard countries generally, including the U.S., until 1933. During this period of deflation, we can expect that the [hypothetical] equilibrium nominal rate of interest was negative for an extended period of time. Remember that,

i = π + r

Ex post real rates for this period are in the double digits during some years! (For example, see Thayer Watkins calculations for the U.S. here) The dramatic fall of in investment during this time period suggests that this was out of equilibrium play.

Deflation during these years was the result of a collapse of the banking system in the U.S. and of the international gold standard. Between 1929 and 1931, U.S. had experienced a tremendous increase in demand for money. This had made the Depression, to that point, one of the worst on record. Low levels of output in combination with a fragile unit-banking system that struggled to remain solvent prevented recovery. Between May 1931 and March 1933, a series of banking panics led to an increase in cash balances for a fearful public, and therefore, a continuation of the contraction of the money stock (Friedman and Schwartz, 308-315). Unit banking in the U.S. prevented the spread of liquidity which would have likely prevented or slowed the process – banking panics were prominent in the U.S. during this period, a problem not experienced by countries lacking this restriction.

Furthermore, some central banks had begun hoarding gold at the end of the 1920s and continued this practice into the 1930s. The prime offenders were the Bank of France and the Federal Reserve. The bank of France increased its holdings from 7 percent to 27 percent of the world’s total gold reserves (Board of Governors 1943, 544-55). In the U.S. gold holdings shrank only slightly as a proportion of the world’s gold reserves as board members at the Federal Reserve refused to adopt a policy of easy money until February 1932. Even then, they did so timidly until prodded by congress in the following months. By this time, the collapse of the banking system in the U.S. was already under way. 

If there were bottlenecks in production that resulted from interest rates failing to allocate resources across time, the demand deficiencies were the fault of bad monetary policy. Excessive deflation was the result of gold hoarding and tight monetary policy more generally. This being the case, fiscal policy is an unnecessary band-aid if the policy goal is to offset dramatic falls in aggregate demand. Aggressive monetary policy would have done just fine to offset the deflation, as is evidenced by the end of the first phase of the Great Depression in 1933 when FDR devalued the dollar.

Hayek's Confusing Perspectives on the Gold Standard

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.

Glasner comments:

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.”

Endogenous Credit Creation and Nominal Income Targeting: In Defense of Nominal Income Level Targeting

Many Austrian economists are skeptical of the efficacy of a nominal income level targeting policy for a central bank. For example, Alex Salter argues that nominal income (he discusses NGDP) should not be treated as an object of choice for central bankers. His perception that nominal income level targeting treats nominal income as an object of choice is representative of a widespread Austrian critique concerning prices and the role they play. The argument misses important nuance in comparing fiat regimes with hard money regimes. Given that the target is predicted by a futures market, it is not actually an object of choice. The central bank would not attempt to determine nominal income. Instead, it would respond to the best estimation of aggregate demand available. (That the target inflation rate is an object of choice is up for debate. For now I will assume that there is no inflation target embedded in the policy.) In this post, I will confront this objection by analyzing the mechanisms through which a regime that targets nominal income would function. I will also confront other objections as necessary.

Nominal income level targeting is a policy suggestion that unfolds from Say’s law. In a market where there is an excess supply of goods, there is an excess demand for money (Clower and Leijonhufvud 1973; Yeager 1956). That is, nominal cash balances are not high enough to clear all markets at curent prices. Under a gold standard, increases in demand for money lead to an endogenous increase in the money stock. This increase is not instantaneous as the supply of gold is relatively inelastic. Nor are these changes in the gold stock neutral. The economic effects of the entry of this money depend on the injection point – i.e., where is the gold first spent or deposited? It is true that under a pure free banking system, the injection point is guided by real demand. It is also true that the endogenous mechanisms that guided the production of base money – gold – do not exist under the modern system of fiat currencies. The primary endogenous mechanism of money creation available under the present system is credit expansion. In markets where there are excess supplies of goods, the creation of credit helps clear these markets. Without a similar endogenous mechanism for the creation of base money, demand deficiencies are more likely to persist. Despite the objection from Salter that nominal income is an outcome and should not be targeted by the monetary authority, the lack of an endogenous mechanism to control the base money stock makes a nominal income level targeting regime necessary.

Whether or not the central bank practices nominal income level targeting, the fact remains that the central bank still operates.  We should not be given to the “Nirvana Fallacy.” Salter admits that nominal income level targeting might be preferable to the current regime. I think there is theoretical reason for fully embracing the norm. (I don’t have an answer for the public choice critiques at this time, so my defense concentrates on monetary theory.) The choice for policy makers is not between a free banking system and a system with a central bank. There is no policy choice that leaves the central bank on the sideline to do nothing in our present world of fiat currency regimes. We must ask, then, which policy will minimize nominal distortions? Which policy will promote healthy, flexible credit markets that can neutralize problems stemming from monetary disequilibrium?

Economic analysis allows us to imagine what an ideal regime would look like. As Hayek argued in Pricesand Production, MV stabilization is a theoretical ideal, but that ideal includes not just some aggregate stabilization. Monetary injections are provided at precisely the points where demand for money has increased. Such a norm is impossible for a central bank to implement directly. It is for this reason that Selgin and White promote a free banking standard under which the money stock responds to changes in demand for fiduciary currency (White 1999; Selginand White 1994). What is not typically appreciated in the argument about nominal income level targeting is that this policy norm would also be aided by financial intermediaries whose actions help stabilize nominal income much like in the Selgin and White free banking model.

Nominal income level targeting is not, on its own, an economic panacea. Expansion of the money stock always has non-neutral effects. Since injections occur through the financial sector, injections will affect interest rates. This is not as big of a shortcoming as the critics of nominal income level targeting claim it is. If the money stock is insufficient to meet the demands implied by expected nominal income, then we can expect interest rates to rise as an elevated demand for money does not allow markets to clear. As heightened demand for liquidity pushes up interest rates in this manner, all else equal, the market rate of interest is pushed above the natural rate which is the rate that reflects time preference. Credit markets are in disequilibrium.

In the case of disequilibrium, an expansion that offsets MV serves the same role that gold flows and gold production did under the gold standard. The difference is that the response of the base money stock to changes in demand for money occurs much more rapidly than it did under the gold standard. The employment of a nominal income futures market will allow the adjustment of the monetary base to offset changes in liquidity preference that affect credit markets in a way that emulates the response of the base money stock to changes in demand for money under a gold standard.

As mentioned above, monetary expansion by the Federal Reserve is channeled through the financial sectors. Some may voice objections relating to the channel of expansion (Selgin 2012). The Federal Reserve expands the money stock by buying from and selling to primary dealers of securities. Selgin correctly argues that confronting this problem will promote stability. Similarly, some worry that the policy will have asymmetric effects in different geographic regions and that efficient markets hypothesis will not hold with respect to the NGDP futures market (Murphy 2013). I agree with the first proposition, but even under the current circumstances, the alleviation of a general excess demand for money will be more stabilizing than the next best option, whether or not the allocation of the expansion of the base is improved.   If I am right that nominal income targeting will help offset distortions in the interest rate caused by liquidity preference, I do not believe the first objection is problematic. The implementation Selgin’s policy suggestions would certainly improve a nominal income targeting regime! Nor are the other objections fatal to the efficacy of nominal income targeting. My response to these require elaboration.

Markets can handle small shocks quite well. It is in the face of large negative shocks that are self feeding – for example, a scenario of heavy deflation that makes credit markets dysfunctional, thus leading to further deflation – that markets have difficulty remaining anywhere close to the expected nominal income growth path. To be more specific, under a scenario of heavy deflation, both goods markets and intertemporal markets fail to clear as a rise in demand for money constrains liquidity. Bad central bank policy, like that of the Bank of France and the Federal Reserve leading into the Great Depression, can destabilize the economy and lead to such a situation. Under a nominal income targeting regime, problem caused by fluctuations in money demand are alleviated. Dramatic fluctuations in nominal income due to changes in money demand will be prevented. The shocks that are most damaging to the functioning of a healthy economy are neutralized. Even better, monetary policy that promotes this sort of disequilibrium - much like gold hoarding policies of the Great Depression - are not allowed under a nominal income targeting rule. 

So what of the significance of inaccuracies of expectations and asymmetric demand for money? The critics are correct that no measure is perfect. So long as the futures market actually reflects nominal income within a limited margin of error, credit markets can adjust the money stock for these small perturbations. The beauty of nominal income targeting is that it ensures that the credit market will be able to function, and thereby offset these problems. By increasing the base money stock and thereby aiding liquidity, a nominal income level target promotes more robust credit markets that can adjust the broader money stock to conform to particular circumstances not accounted for by the employment of the equation of exchange. In this sense, nominal income targeting and free banking should not be thought of as totally distinct. The endogenous response of the money stock that is at the core of free banking theory is very much present in modern credit markets. Without a well functioning credit sector, nominal income level targeting falls short of its goal. 

Final thought: A nominal income level target requires a credible commitment from the central bank to not bail insolvent institutions. This is where the public choice critique must be answered.

Two Roads?: Endogeneity of the Monetary Base during the Gold Standard (Part II)

In some ways, a nominal income target emulates the operation of a gold standard. Both a gold standard and a nominal income target allow the stock of base money to adjust to demand for money. The historical gold standard serves as an ideal case study as data exists for both the supply of and demand for monetary gold. The largest increases in demand for gold occurred as a result of the decisions of Big Players – central banks – so it will be useful to observe changes in gold production and prices relative to changes in central bank holdings of gold and changes in the official gold price in different countries (Koppl 2002). In order to understand how the central bank affected the gold market as a Big Player requires that we consider the mechanism of the market for money.

Under a gold standard, production of gold responds the price of gold as determined by gold’s demand and supply. Below is a graph comparing the yearly change in the world’s total gold stock with changes in the real price of gold (U.S. Gold Commission,1982). The time required for the quantity of gold supplied to adjust to changes in demand typically took one to two years (Rockoff 1984). Not surprising, changes in the gold stock trail movements in the real price of gold. The divergence between the price of gold and the rate of increase of the gold stock during the first decade of the twentieth century was likely due to the emergence of the cyanide process at the end of the 19^th century. This represented a positive shock to the supply of gold. On the demand side, changes in central bank gold reserves exercised tremendous influence over the price of gold. The data does not express this as clearly as the relationship between gold’s price and the quantity of gold supplied as the Federal Reserve did not consolidate much of the gold stock in the United States until the end of World War I. A similar problem holds after 1931 when England and other nations began to abandon the gold standard and 1933 when president Roosevelt devalued the dollar, thereby raising the world price of gold (Freidman and Schwartz 1963; McCloskey 1984). For the remainder of the decade changes in demand for gold are not fully captured by changes in gold reserve at central banks. During years where the data does not suffer from complications (1918-1931), there is a clear relationship between changes in gold reserves and changes in the real price of gold.

As noted above, the gold market was sometimes subject to distortions from price fixing. For example, France fixed the price of gold at an arbitrarily high price in 1927, after which point France began to accumulate a disproportionate share of the world’s gold (Irwin, 2012). In 1933, the United States made a similar move when the dollar was devalued so that the price for an ounce of gold rose from $20 per ounce to $35 (Friedman and Schwartz 1963). It is no surprise, then, that in the years that followed these price increases, the annual rate of increase in the world gold stock consistently rose for more than a decade. Ideally, a commodity standard would not be subject to price fixing.

In any case, there is a clear pattern. Changes in demand for gold correlate positively with a change in price. Changes in the production of gold are, subject to a 1-2 year lag, positively correlated with the price of gold. The quantity of gold supplied adjusts to meet the quantity demanded at a given price. That is to say that when gold serves as money, it is subject to Say’s principle. Say’s principle tells us that if there is a glut of goods subject to a single array of prices, then there is not enough money in the economy to clear all markets simultaneously at those prices. What is the cause of the excess supply of goods, but an excess demand for money? A higher real price of gold caused by an increase in demand for money promotes the production of more gold and the conversion of non-monetary gold into monetary gold. The market attempts to remedy the imbalance of trade, which in this case was caused by unpredictable central bank policies, by increasing the stock of base money. Prices convey that the remedy is needed.

We can see by this exposition that endogeneity of the money stock is critical for the functioning of a healthy monetary economy. Prices signal the wants and needs of consumers and scarcity of resources to producers (Hayek, 1945). Embedded in the use of a commodity as money is the market’s auto-poetic response to a shortage in money. It should come as no surprise that the supply of money has come to include a mechanism that responds to disequilibrium pricing. The development of money itself was the market’s response to the high transaction costs of barter (Menger 1976). Its quantity adjusts in response to changes in demand. Under a gold standard, this adjustment translates to a reduction of gluts in the production of goods that are not gold.

Keynes vs. Hawtrey (Round 2): Fiscal vs Monetary Policy

In 1933, Ralph Hawtrey wrote “Public Expenditure and the Trade Depression” in which he presented a thorough analysis of the effects of fiscal policy. The reader should note that, in it, he refers to government expenditures as “capital outlays”. Hawtrey did not meet Keynes proposal of fiscal expansion with cheer. He notes that the complications inherent in fiscal policy make it a vehicle ill-suited to alleviate economic stress.

A capital programme of the kind advocated cannot be started till after a considerable preparatory interval. Secondly there is the question of magnitude. There is no certainty that, even when it is started, the programme will achieve its object. For it will have to meet precisely the same obstacles as any alternative method of credit expansion. A programme of 100,000,000 a year sounds impressive, but it is only about 3 per cent. of the national  income. A sudden increase of 3 per cent. might quite possibly effect the vital transition, and restore the normal flow of credit. A gradual increase of that amount spread over many months would be very unlikely to do so. The programme might be very much greater. But then there arises a very real difficulty in finding works ripe for execution which are really beneficial. There is a danger of vast sums of money being wasted. (452)

According to Hawtrey, the desired results might be accomplished in a simpler fashion.

In fact, if what is wanted is a momentary impulse to restart economic activity, it would be more hopeful to look for it in a reduction of taxation than in a programme of expenditure. (452)

In any case, the proposal of spending increases ignored the broader problem of concern.

Then secondly there is the effect of a capital programme on the balance of payments to be taken into account. A country on the gold standard, faced with the prospect of an appreciation of gold and unable to promote the international cooperation requisite to stop it, may be grateful for anything which will relieve the depression without causing an adverse balance of payments. But under those conditions the capital programme can be no more than a palliative; it does not promise to be a turning point in the depression to be followed by a progressive revival, for revival depends on international conditions. (457)

The policies of the United States, to a lesser extent, and France, to a far greater extent, depressed prices, thus leading to a fall in aggregate demand. Even if fiscal policy temporarily compensated for this problem, which it is unclear whether or not it would, this still did not serve as a solution to the international problem. Even if it did, the primary impetus appears to be monetary policy!

Hawtrey observed that the looming international problem complicated the effects of domestic monetary policy. In reflecting upon the effects of expansion from the Federal Reserve, he argues that, though it was somewhat effective, it was not substantial nor long enough.

I do not think the degree of success attained by the open market policy of the Federal Reserve Banks in the summer of 1932 has been sufficiently appreciated. The policy was applied under serious disadvantages. The Bank of France was liquidating its dollar holdings and withdrawing them in gold and the United States lost over $500 millions of gold between February and June. Hoarding also was a complication. … The improvement, it is true, was not sustained. But nor was the policy. The open market purchases ceased in August 1932, and in January 1933 there were even some sales. (451)

Of course an analysis of monetary expansion must also take into account the banking crises that occured at the time, but I must defer that task. Its positive effects on growth also were at least offset in part by France’s insane policy. To jump to the conclusion that monetary policy was ineffective was unwarranted in the eyes of Hawtrey, especially since there was correlation between the program and resumption of growth. Policy suggestions that ignored the problems created by the fouled operation of the international gold standard were a poor second best solution, if they were solutions at all.

I am in the process of finding and interpreting Keynes's response, which I will hopefully get to later this week.

Two Roads?: Theoretical Case and Historical Precedent for a Nominal Anchor (Part IV)

We have left to consider the a defense of an endogenous fiat money base. Like the gold standard, but more responsive, a nominal income standard will alleviate excess demand for money. Sumner argues that nominal income targeting provides a nominal anchor, meaning that it prevents dramatic swings in prices that would otherwise result from an unstable demand for money (2012, 152). He notes that “the current price level and current NGDP are far more affected by the future expected money supply than they are by the current money supply (144).” If prices reflect expectations, then it is critical that growth rate of one of the major determinants of prices, the money stock, be predictable. Much in the way that “dynamic equilibrium requires consistency of plans which . . . depends on a flexible price system,” a rule that makes the expansion of the stock of base money stock both responsive to prices and predictable will help facilitate coordination of plans among economic actors (Lachmann 1978, 116). As convergent expectations are requisite for Say’s principle to hold, and therefore, for markets to clear, a clearly defined rule that predictably governs growth of the base money stock will reduce policy uncertainty and thereby increase the efficacy of the price system to convey tacit information (Hayek 1943).

The benefits of a nominal income level target are especially of significance for the loanable funds market as it should stabilize inflation expectations. By this effect, it will also better enable credit markets to clear as interest rates, the price of money in the future, will not suffer from distortions stemming from nominal factors such as volatile demand for base money. A nominal income target can also ensure that the rate of inflation remain positive. The significance of this becomes clear upon considering a scenario where the real rate, r, is less than the rate of deflation, -π. The Fisher equation denotes that in the long run the nominal – observed – interest rate as the sum of the real interest rate and the inflation rate. This is formally stated as:

i = r + π

We can imagine a scenario where the market clearing nominal rate of interest is negative. That is the abovementioned case where the real interest rate is less than the rate of deflation:

               r < -π

This special case was recognized in 1913 by Ralph Hawtrey:

What if the rate of depreciation of prices is actually greater than the natural rate of interest? If that is so nothing that the bankers can do will make borrowing sufficiently attractive. Business will be revolving in a vicious circle; the dealers unwilling to buy in a falling market, the manufacturers unable to maintain their output in face of ever-diminishing order, dealers and manufacturers alike cutting don their borrowings in proportion to the decline of business, demand falling in proportion to the shrinkage in credit money and with the falling demand, the dealers more unwilling to buy than ever. (186)

A reduction in the quantity of credit demanded leads to a surplus of savings. If, due to an abnormally high rate of deflation, the equilibrium nominal rate necessary to clear the loanable funds market is negative, then this surplus is inevitable. Since credit doubles as money, a fall in credit outstanding leads to an equivalent drop in total output. A nominal income target stops this problem in its tracks and will allow markets to more efficiently liquidate inventory. Instead of a fall in output, markets will respond by more quickly reallocating previously overvalued goods as a general expansion of the money stock is unlikely to save from bankruptcy those firms that made the most egregious mistakes during the boom. A base money stock that responds to changes in demand for money will help facilitate the reallocation of resource toward their highest valued use. Compare this to a general fall in prices whose end date is unknown.

The danger of tremendous deflation is not a new concern as bankers have long been concerned about financial destabilization due to deflation. Even before the establishment of the Federal Reserve, private banks innovated the means to mitigate the damaging effects of an elevated demand for money during recessions and depressions. Banks would issue temporary currency to stem a deflationary impulse (Timberlake 1984, 6). Money demand shocks were endogenously offset by temporary increases in the money stock. Those who issued the currency provided it to banks that appeared to be illiquid, but were unavailable to those banks that were clearly insolvent (7). Like endogenous gold and credit stocks, the increase in temporary currency arose due to the deflationary impulse set off by a sudden increase in demand for money. This temporary currency was elastic enough to prevent a crisis from turning systemic. Absent activist central bank policies, the gold standard, was able to serve as a nominal anchor. Only as a result of gold hoarding policies from the Bank of France and the Federal Reserve did the gold standard prevent a runaway deflation like occurred due to central bank intervention in 1929 (Eichengreen 1996; Irwin 2012). It does not take much imagination to see that a nominal income level target will serve a similar role to what temporary currency played in moderating crises.