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?"

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)

Hawtrey's Narrative and My Critique of the Classical Gold Standard/Monometallism

I’ve been making my way through one of Ralph Hawtrey’s classic works, The Gold Standard in Theory and Practice. The book is both highly readable and insightful. Of interest today is Hawtrey’s narrative of the classical gold standard.

Gold and silver were both used for exchange in commerce throughout much of recorded history. It was not until the 1870s that the western world moved to a uniform gold standard. The foundations for this move were laid as a result of large gold discoveries in Australia and California during the middle of the 19th century. Gold had been the more highly valued money, which under bimetallism meant that it was hoarded and silver was used for exchange as official par overvalued it. After the gold discoveries, the reverse was true. The increase in the monetary gold stock brought down its value so that now silver traded at a premium under bimetal standards. Hawtrey notes that this was not without consequence:

The French franc from a silver unit became a gold unit. The two great financial centres of the world, London and Paris, were both gold centres.

At the time Germany employed a silver standard, and conditions were not favorable for such a position:

Germany no longer derived any advantage from the silver standard in her trade with Eastern Europe, because silver had there made way for inconvertible paper. The bimetallic currencies of Western Europe had passed from a state of fixity in terms of silver [i.e., a de facto silver standard under a bimetal regime], with a slight fluctuating premium on gold, to fixity in terms of gold, with a slight fluctuating premium on silver… Even if the ratio of gold to silver continued to be stabilized by the bimetallism of the Latin Union, the silver standard might be expected to be a disadvantage to the German financial centres.

After its war in 1871 Germany adopted the gold standard and suspended the free coinage of silver. With new demand for gold, this shifted the price ratio in favor of a de facto silver standard for bimetal regimes. [See my brief discussion of Gresham’s law from last post.] That is, had bimetal regimes operated as they had beforehand, silver would have been employed under those regimes. But at this time, “Russia Austria-Hungary, Italy and the United States were using depreciated paper” and France made her money inconvertible. With the suspension of redemption in traditionally bimetal regimes:

There was nothing to relieve the sudden scarcity of gold, and the price of silver in gold began to fall. But that meant that the currencies of silver-using countries began to depreciate… The only remedy was the suspension of coinage of silver.

Given the above described political situation, the general adoption of the gold standard appears to be an accident of history. What were the precise impacts of this "accident"?

An interesting, yet not broadly acknowledged, aspect of the adoption of the gold standard concerns its promotion of a relatively unstable price level. After the gold standard was adopted, the impact on the price level from a change in the monetary gold stock or in production appears to increase. Notice the change that occurs in 1873:

Notice that prices had stabilized from about 1856 to 1873. The gold standard era can be divided into an era of price deflation, 1873-1896, and of price inflation, 1896-1914. During 1914 most nations on the gold standard suspended redemption, but since gold was implicitly the only metallic standard - the return of redemption was anticipated after the war - price rose steeply as demand for gold fell. Precisely what one would expect given a lack of metallic money substitutes. 

I ran a series of regressions to investigate:

Years	VARIABLES	British GDP	Monetary Gold Stock	Constant
1839	Sauerbeck-Statist Index	-0.608*	0.469**	9.583***
to		(0.32)	(0.19)	(2.78)
1873	SIGMA2			0.00701***
1839	Sauerbeck-Statist Index	-1.433***	0.878***	17.04***
to		(0.17)	(0.12)	(1.40)
1896	SIGMA2			0.00800***
1839	Sauerbeck-Statist Index	-1.404***	0.868***	16.76***
to		(0.14)	(0.10)	(1.16)
1913	SIGMA2			0.00718***
Standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1

I used an ARCH model to account for the clustering of price level volatility as changes in direction tend to occur for more than one year at a time. The coefficients (those numbers with *s next to them) estimate the percent impact of a one percent increase in the independent variables – GDP and Monetary Gold – on the Sauerbeck-Statist Index, a measure of the British wholesale prices. The effect of both about doubles across the entire time period after the gold standard is established. The effects decrease slightly when the time period is extended to 1913, likely due to the increase in production of gold that began to occur in the 1890s after the discovery of the cyanide process for extraction. This alleviated the impacts of an increase in demand for gold.

Bottom line, a monometallic standard is bad for price stability. Was this bad for production? It is hard to tell because the industrial revolution was in full bloom at the time of the change. Clearly the world economy was able to handle a less flexible monetary standard as the growth associated with the period was before unthinkable. And perhaps the move to a common standard decreased transactions costs enough to compensate for the inflexibility. The interesting question is: on net, did the gold standard hurt or help economic growth?

Late note: The use of ARCH does not seem to matter as I receive the same output with a simple regression with Newey-West HAC errors.

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.

Matt Yglesias Should Spend More Time Learning Economics and Less Writing About Gold

Matt Yglesias has taken up critiquing arguments pertaining to the gold standard. To the general reader, his arguments might seem convincing, but the devil is in the details. There are a few points worth considering and elaborating on. I’ll go through 1 point at a time. Worth highlighting is Matt does a poor job of distinguishing between the use of gold as money with and without a legal tender regime, and shows his ignorance of the differences between a change in supply and a change in quantity supplied and of the significance of the existence of multiple markets for a particular good.

1) A gold standard wouldn’t stabilize inflation

Matt provides a nice graph of oil prices measured in troy ounces of gold over the last several decades. He’s right on this one. Prices fluctuate, sometimes wildly. I would prefer if he also presented a chart of oil prices alongside the gold graph. Compared to its price in terms of dollars, the gold price of oil has exhibited more stability. Notice that the price of oil in terms of gold stays pretty tightly between 10 ounces and 30 ounces. Compare that to the dollar price that has fluctuated between 140 and 10 dollars. We need to compare the price stability of gold to the status quo. I in no way support the return of an international gold standard with legal tender regimes, but clearly gold beats the dollar in this case.

2) A gold standard wouldn’t stabilize exchange rates

This is true. We live in a world where individuals and firms can hedge against exchange rate fluctuations by diversifying their portfolio of currencies and asset holding. Not much to say here except that exchange rates fluctuated under the gold standard whenever central banks changed their reserve ratios. Any time the demand or the stock of a given currency changes, exchange rates change. This is a mundane point!

3) There’s no inflation problem to cure

The problem to cure is policy induced price instability. Federal Reserve policy has done a good job of minimizing this problem in the last few decades. After Greenspan, we inherited new problems where, instead of engaging in injections of liquidity, Bernanke targeted particular institutions so as to prevent systemic collapse of the banking sector. We have a new problem now: what to do with the part of the monetary base which is parked at the Fed. This activism from the Federal Reserve nurtures unclear expectations.

4) There’s nothing stopping you from writing gold contracts

This is simply false. 1) I expect that courts might not uphold these contracts. (I’m willing to hear examples of this that prove me wrong here). 2) The same result might be arrived at by immediately converting all deposits in one’s account into holdings of gold ETFs, mining companies, etc… The problem is that these are not treated as money by law, so the use of gold is expensive. They are subject to capital gains taxes, making use of gold as a store of value less efficient than otherwise. The same holds true for any asset that one might want to employ as a store of value, and gives reason for us to question this form of taxation.

5) Gold recessions could last for years

This critique is legitimate for a gold standard where gold operates as legal tender. When there are no substitutes available to use for base money in the economy, liquidity crises are endemic. This was true under the gold standard, though the market innovated around this intervention to some extent as clearinghouse associations often provided emergency liquidity during crises.

6) The gold standard wouldn’t eliminate political money

True. Any money that is regulated by the government is subject to political interests. This is reason to, in the least, restrain money creation according to a rule and remove regulations that inhibit the creation of moneys in the market, if not attempt to find a way to remove government from this industry altogether.

7) Gold-backed money reduces the supply of gold

This is a misunderstanding of economic theory and of the gold standard more generally. What Matt means is that the adoption of a gold standard will raise demand for gold, and therefore, raise its price. This increased demand pulls gold out of the non-monetary market – for arts, jewelry, manufacturing, etc… – and into the monetary market. This means that the available stock of gold for non-monetary uses will decrease as non-monetary gold flows into the market for monetary gold. However, increased demand for gold will lead to an increase in the quantity supplied in a given time period because the increase in price will provide incentive for miners to mine more.

He should also consider functioning of a gold standard. Modern finance allows for most transactions to take place digitally. From a small amount of base money – i.e., gold – a much larger money stock will form. Again, imagine that ETFs serve as a store a value from which you can draw directly and cheaply convert into dollars. For all intents and purposes, the resource costs of a gold standard are miniscule whether we include typical banking deposits or ETFs in our analysis. (Larry White makes this point about deposits in his wonderful book).


My Conclusion

I’m not sure why Matt chose the number 7, but his write-up would have been greatly improved if he considered the significance of legal tender regimes and limited his analysis to those points. The problems that he finds with the gold standard are existent with any standard, fiat or otherwise. He would also benefit from reading my analysis of the classical and interwar gold standards.

P.S. Steve Horwitz isn't happy about this either.

Under Appreciated Article on the Classical Gold Standard

Bordo and Redish published "Is Deflation Depressing? Evidence from the Classical Gold Standard" in 2003. I have not seen it cited in my research. Their findings are under appreciated. They conclude that only changes in aggregate demand, particularly changes in demand for gold, had a long run impact on the price level during the classical gold standard, although increase in output had short run effects on the price level. They also find that demand shocks did not significantly impact output.

We distinguish between good and bad deflations. In the former case, falling prices may be caused by aggregate supply (possibly driven by technology advances) increasing more rapidly than aggregate demand. In the latter case, declines in aggregate demand outpace any expansion in aggregate supply. This was the experience in the Great Depression (1929-33), the recession of 1919-21, and may be the case in Japan today. In this paper we focus on the price level and growth experience of the United States and Canada, 1870-1913. Both countries adhered to the international gold standard. This meant that the domestic price level was largely determined by international (exogenous) forces. In addition, neither country had a central bank which could intervene in the gold market to shield the domestic economy from external conditions. We proceed by identifying separate supply' shocks, money supply shocks and demand shocks using a Blanchard-Quah methodology. We model the economy as a small open economy on the gold standard and identify the shocks by imposing long run restrictions on the impact of the shocks and on output prices. We then do a historical decomposition to examine the impact of each shock on output. The results for the U.S. are clear: the different rates of change in the price levels before and after 1890 are attributed to different monetary shocks, but these shocks explain very little of output growth or volatility, which is almost entirely a response to supply' shocks. For Canada the results are murkier. As in the U.S., the money supply shocks before 1896 are predominantly negative and after that are largely positive. However, they are non-neutral, and relative to the U.S., money supply shocks play a larger role in determining output behavior in Canada. The key conclusion of our analysis is that the simple demarcation of good vs. bad deflation, where either prices fall because of a positive supply shock, or prices fall because of a negative demand (money) shock does not capture the complexity of the historical experience of the pre-1896 period. Indeed, we find that prices fell as a result of a combination of negative money supply shocks and positive supply shocks.

My One Paragraph Summary of the Gold Standard

Here is the conclusion of an essay I am working on for a macroeconomics anthology/textbook. The essay is essentially a less technical summary of my "Good as Gold?" paper, currently under review at the Financial History Review.

Both during and after the classical gold standard, policies of governments and central banks were responsible for unusual changes in prices. First, with the demonetization of silver during the 1870s, prices fell as demand for gold outpaced the growth of the gold stock. The increase in demand, however, was not so severe as to cause an international depression. By the end of the classical era, changes in policies had a much greater impact on prices. Instead of exerting a persistent, but shallow, downward effect on prices, prices in terms of gold became unhinged. Rising rapidly during and shortly after the war, then falling dramatically in two stages. Each of these swings was accompanied by substantial changes in gold holdings by central banks.  When central banks had finally consolidated nearly all of the world’s monetary gold stock at the end of the 1920s, increased demand for gold pushed down prices persistently enough to initiate the Great Depression. By this logic, it appears that the Great Depression was not a glitch, but was the logical end of a monometallic standard. The elimination of metallic base money substitutes by governments and sweeping consolidation of gold made the international monetary system increasingly fragile until, in 1929, it broke.

Microfoundations?: Pascal Salin Needs Macroeconomic Tools to Conduct Macroeconomic Analysis

Pascal Salin’s “Money and Micro-Economics” is now online. I was hoping to find some insights into market process oriented macro, but instead found a blasé overview with a weak critique of market monetarism. Perhaps nothing stands out more than Salin’s distaste for monetary expansion. This attitude is reflected clearly in Salin’s suggestion that market monetarism should be called “market Kenesianism” as “it is simply a branch of new-Keynesianism." I’m not sure what book in intellectual history that Salin is reading from, but I do know that he lacks foundation for his interpretation of market monetarism. As I have noted before, market monetarists of the heirs of Ralph Hawtrey, not John Maynard Keynes. Macroeconomic outcomes are dependent upon microeconomic outcomes, but certain macroeconomic variables tell us a lot about economic conditions. This information can be employed in a manner that considers market process in analysis and policy implementation, rather than inhibits market robustness.

Salin's prime error appears to be the assumption that the macroeconomy can be defined solely in terms of microeconomic agents. A macroeconomics that does not give special attention to certain macrovariables is of little service. While it is understandable that economists interested in market process emphasize that information is lost in aggregation, a loss of information does not necessitate that useful information does not exist in these macrovariables. This really requires a detour into the pillars of macroeconomic analysis:

1.  Say’s Principle
2. The Equation of Exchange
3. Expectations

These concepts permeate any discussion of macroeconomics, although their employment is not always recognized explicitly. Consider Say’s principle. Say’s law expresses the principle in its most basic form. Goods must pay for goods. In other words, if you want to demand a good, you must have the means to facilitate exchange with payment. This means is tied at some point to either one’s labor, a good in one’s possession, or a promise, of a good or service outstanding. Say’s principle, as formulated by Leijonhufvud and Clower (1973), identify money as an nth commodity included in Say’s identity. It conveys that if there is an excess demand for money, there must be an excess supply of goods in some other market or markets. The only way for all markets of available goods and services to clear is for either more money to enter the hands of those agents demanding more money or for prices to fall. Prices, especially wages, tend to be sticky downward, so the extent to which prices are unable to adjust there is a shortfall in demand and a falloff in economic activity.

Cue the equation of exchange and the role of expectations. The equation of exchange, MV = Py, tells us that changes in velocity can affect prices and output levels. An increase in demand for money materializes as an increase cash balances. An agent will increase portfolio demand for money as a result of deflationary expectations (money is expected to be worth more in the future), in response to increased uncertainty, or as a result of planned future expenditures not induced by expected deflation. The reader can see that demand for money is dependent on what one expects to use it for in the future and on expectation of future conditions more generally. Modern finance blurs the line between an increase in portfolio demand and an increase in investment, the latter of which tends also to increase the broader money stock. The difficulty comes when secure investments are exhausted and cease to respond to the amount of savings in the economy. When this occurs, short term rates fall toward zero and the yield curve steepens (Moreira and Savov 2013; Sunderam 2012). In the short run, low rates might result from an expansion of the monetary base, but it is unlikely that the market could be fooled for nearly a decade. The cause of our recent low rates lies elsewhere. If nominal rates on short term securities are depressed for an extended period of time, the likely cause is increased uncertainty, deflationary expectations, or both. In any case, the reader can see that expectations are intimately tied to demand for money and quasi-moneys.

A nominal income target can help eliminate both uncertainty about the availability of credit to creditworthy borrowers during a downturn and self-feeding deflationary expectations. And as I will later explain, the mechanisms by which a nominal income rule can be implemented need not lead to insurmountable systemic distortions. The key to understanding this lies in tying together the core principles of classical macroeconomics which I have outlined.

As many of my readers know, the mechanisms governing the gold standard closely parallel those governing a nominal income level target. It should be no surprise that it also illustrates the principle that I am attempting to convey.  Under the gold standard, the monetary gold stock consistently grew at a rate of 2 to 3% per year. The years during which the growth rate of the gold stock deviated from this range tend to correlate tightly with changes in the price level (see figure from a recent post). When gold denominated prices fell sharply (the price of gold rose), the rate of growth might be as high as 7 to 10%. Barring a sudden reduction of the world’s gold stock – perhaps the plot of a devious Goldfinger or simply the result of insane banking policies – a rise in the price of gold was concomitant with an increase in demand for gold. As Say’s principle tells us, an increase in demand leading to an excess demand for gold implies a relative increase in present surplus stocks of goods. Luckily, an increase in the price of gold tends to increase the quantity supplied in a given period. Thus, gold flowed from mines and the market for non-monetary gold into the hands of those who valued it more as money. In other words, a shortage of gold identifies itself by a rise in the price of gold and, thus, simultaneously promotes its own remedy. Unfortunately, modern monetary systems lack this sort of mechanism for the monetary base.

A nominal income target is an nth best policy option which economists in favor of free markets ought to seriously consider. I don’t expect that anyone in the developed world will find himself or herself living in Mises’s evenly rotating economy any time soon. Absent from reality is a robust free-banking system that would develop absent financial regulation and central bank accommodation. Since I do not expect the state to give up its monopoly on  money any time soon. A rule that endogenizes the base money stock so as to 1) compensate for changes in portfolio demand for money and 2) stabilize expectations about the growth rate of the money stock, and therefore about inflation/deflation and monetary policy more generally, can help promote the coallescence of the plans of economic agents and avoid distortions that arise from expectation of targeted bail outs. This is especially important in a world where banks have come to expect central bank accommodation during periods of constrained liquidity and crisis. The recent crisis has shown that those managing private banks have come to integrate fiscal and monetary intervention into their expectations (Calomiris 2009). When accommodation becomes expected, the result is increased leverage and irresponsible lending.

            

By essentially turning the central bank into a computer program, a monetary rule will stabilize expectations about monetary policy. A monetary rule will essentially vanquish deflationary expectations and any expectations of a future bailout. This allows credit to play a coordinating rule whereby lending can, at a price, alleviate a shortage in money. If monetary expansion is 1) expected and 2) distributed broadly across financial markets, distortions from expansion will be minimized and money will tend to enter the hands of those who value it most (Selgin 2012). A policy of nominal income targeting alongside the reforms suggested by George Selgin would go a long way to minimizing distortions that result from interventions in financial markets. Thus, I am not convinced that Salin is considering a novel or uncorrectable problem in his description of Cantillon effects:

Those who are the first ones to borrow obtain a gain in purchasing power in comparison with others, since they can spend the money thus obtained before the increase in prices occurs when there is more money creation. Insofar as money creation implies a decrease in interest rates, some people also receive a benefit from money creation for this reason. Money creation therefore has distributional effects which cannot be justified since they are completely arbitrary. (11)

There is a cost to inaction just as there is a cost to monetary activism. At least a rule promotes stable expectations.

Unfortunately, Salin does not consider the three principles that lie at the heart of macroeconomics. By concentrating on microeconomic relationships and ignoring the macroeconomic principles that I have outlined, Salin has not really presented much that is new or useful to the debate regarding monetary policy. Strangely, he also finds that predictable expansion leads to uncertainty, but does not fully explain why:

In addition, an expansionary monetary policy creates uncertainty since no one can forecast accurately and precisely the rate of inflation and, above all, the distortions in price structures (which depend on the structure of credit and the structure of expenditures made by those who benefit from credits of monetary origin). (12)

To the extent that Salin is correct, this problem holds true for any expansion of the monetary base or of credit. This includes, to a lesser extent, expansion under a decentralized commodity standard, which is Salin’s (and my) standard par excellence.

Those of us interested in market process and macroeconomic problems need to consider the full extent of the problems which we study.  If I or anyone else promotes a free market monetary system, we cannot simply rely on the systems theoretical superiority to win the day. We need to consider improvements to the current system that can be made. As long as the government continues to promote a legal tender monopoly, bright minds should consider how to make that standard as little damaging as possible. In addition to those made in this post, I have suggested a number of other reforms including the elimination of capital gains taxes and of regulations that inhibit liquidity. If we are stuck with a legal tender monopoly, a monetary base constrained by a predictable rule is probably the best policy possible. Hayek appears to have come to grips with this once he stopped defending the international gold standard (both the classical gold and gold exchange standards were managed standards; see Hayek 1943 and 1960 about rules and predictability). It is time that market process theorists consider how an nth best policy might do the least harm or even promote development. In doing so, we must also make clear that we are suggesting an nth best solution, not a road to Utopia.

I’ll close by briefly addressing one critique by Salin that appears to have teeth. He argues that “monetary instruments should be used to solve monetary problems and real instruments to solve real problems (19).” Salin critiques nominal income level targeting on the grounds that expansion under a target will lead to inflation even when there is no growth in real income. On these grounds, I might also criticize the gold standard. The gold stock tended to grow even in years of contraction. In essence, the gold standard was a de facto income target, but one that was not only guided by changes in demand for money, but also changes in the supply of gold. In some years, surprise discoveries led to gold production that was far above average. In other years, constrained supply led to a relatively unresponsive money stock. As Barsky and DeLong have shown, inflationary expectations do not appear to have been accurate under such a scenario. Although his phrase may roll smoothly off my tongue – “monetary instruments should be used to solve monetary problems” – it is unclear that the type of system that Salin suggests is actually an historical artifact. No natural money that I know of is governed by this principle. 

Markets use imperfect moneys. What is important for a monetary system is that market actors can collectively form accurate expectations about future monetary conditions. This need a nominal income target can fulfill. If this condition is fulfilled, a failure of expectations to converge will not be the fault of monetary policy but will lie elsewhere.

Glasner on Friedman's Real and Pseudo Gold Standard

David Glasner has posted a deep analysis of Friedman's 1961 Mont Pelerin Society presentation of "Real and Pseudo Gold Standards." This is a favorite paper of mine, and finds value in it as well. His presentation also points out some confusion between which gold standards were real and which were pseudo. The more I study the gold standard, the more I believe that both the classical and gold-exchange standards were pseudo standards. The international gold standard, as we know it, was an exchange rate standard. Needless to say, I found this post especially enjoyable. Here's a preview of his post.

So what were Friedman’s examples of a pseudo gold standard? He offered five. First, US monetary policy after World War I, in particular the rapid inflation of 1919 and the depression of 1920-21. Second, US monetary policy in the 1920s and the British return to gold. Third, US monetary policy in the 1931-33 period. Fourth the U.S. nationalization of gold in 1934. And fifth, the International Monetary Fund and post-World War II exchange-rate policy.
Just to digress for a moment, I will admit that when I first read this paper as an undergraduate I was deeply impressed by his introductory statement, but found much of the rest of the paper incomprehensible. Still awestruck by Friedman, who, I then believed, was the greatest economist alive, I attributed my inability to follow what he was saying to my own intellectual shortcomings. So I have to admit to taking a bit of satisfaction in now being able to demonstrate that Friedman literally did not know what he was talking about.

I highly encourage anyone who is at all interested to read the entire post.

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.

Turning Point: Hayek as Monetary Visionary

In 1949, Hayek reflected on the success of socialist ideology and the waning of classical liberalism:

In particular, socialist thought owes its appeal to the young largely to its visionary character; the very courage to indulge in Utopian thought is in this respect a source of strength to the socialists which traditional liberalism sadly lacks. He closes the article by arguing:

We must make the building of a free society once more an intellectual adventure, a deed of courage. What we lack is a liberal Utopia, a program which seems neither a mere defense of things as they are nor a diluted kind of socialism, but a truly liberal radicalism which does not spare the susceptibilities of the mighty (including the trade unions), which is not too severely practical, and which does not confine itself to what appears today as politically possible.

During the Great Depression Hayek had struggled to convince his colleagues of the merits of certain classical liberal tenants that he valued. He failed to sway their opinion concerning the gold standard. This was also true concerning the Austrian Business Cycle Theory. He only partly succeeded in disillusioning them of their socialist utopian dreams with his participation in the Socialist Calculation Debate. Where had Hayek gone wrong? Hayek’s remarks in “Intellectuals and Socialism” about utopianism appear to be confession. He had not been idealistic enough.

Written before “Intellectuals and Socialism” in 1943, Hayek’s “A Commodity Reserve Currency” represents a shift in his research program where he begins to stress future avenues to prosperity and political organization, rather than a propose solutions that might be interpreted as “a mere defense of things as they are.” It is a truly symbolic of this change in that he moves from criticizing price level stabilization to proposing not only how it might successfully operate, but how the rules of its operations my mitigate the extreme fluctuations of the business cycle. His proposal is not the same as his peers. He suggests that, rather than having the price level be stabilized by changes in the money stock that offset changes in velocity, the use of a commodity reserves can stabilize the general price of commodities directly by setting a fixed exchange rate for commodities which will increase demand for them when prices fall below the fixed rate and alleviate demand when prices rise above the fixed rate:

With this [commodity] system in operation an increase in the demand for liquid assets would lead to the accumulation of stocks of raw commodities of the most general usefulness. As the hoarded money was again returned to circulation, and demand for commodities increased these stock would be released to satisfy the new demand.

He explains how this will dampen the business cycle:

The revival of activity will not lead to an extra stimulus to the production of raw commodities which would continue on an even keel. There is reason to regard the temporary stimulus of excessive expansion of production to raw commodities, which used to be given by the sharp rise of their prices in boom periods, as one of the most serious causes of general instability. This would be entirely avoided under the proposed scheme – at least so long as the monetary authority had any stocks from which to sell.

 Instead of pointing to the problem associated with past policies and suggesting a return to the golden days – which is easily interpreted as a return to the status quo – Hayek projects a vision of a future that improves upon the past.

This represents an about face from the direction of much of his previous work. His critique of price level stabilization and promotion of the gold standard during the 1930s had apparently gained Hayek few followers. The western world had suffered tragedy twice within two decades – first with the Great War, then the Great Depression – and the zeitgeist of the era did not look to the past for future success. Intellectuals craved idealism, not recitation of former creeds. They wanted swift change and saw the state as the vehicle for that change. Hayek learned that if the liberal values that he promoted were to survive, he needed to propose policies that were a radical departure for the past. The new vision must present previously unrealized solutions that constrain, rather than empower, the state. This new program is well exemplified in a couple passages of his 1943 article where he stresses the importance of rules:

There would, in particular, be no need for the monetary authorities or the government in any way directly to handle the many commodities of which the commodity unit is composed. Both the bringing-together of the required assortment of warrants and the actual storing of the commodities could be safely left to private initiative. Specialist brokers would soon take care of the collecting and tendering of warrants as soon as their aggregate market price fell ever so little below the standard figure and of withdrawing and redistributing the warrants to their various markets if their aggregate prices rose above that figure. In this respect the business of the monetary authority would be as mechanical as the buying and selling of gold under the gold standard.

And:

Even apart from monetary consideration, the great need is for a system under which these controls are taken from the separate bodies which can but act in what is essentially an arbitrary and unpredictable manner and to make the controls instead subject to a mechanical and predictable rule.

We can certainly see the roots of Hayek’s later work on spontaneous order as Hayek suggested rules that might procure stability that allows economic agents to make plans and coordinate them with others.