Milton Friedman on Gold Demand and the Price Level

In 1990, Milton Friedman published “Crime of 1873”, an article that comprised a chapter in his Money Mischief – a book that is generally underappreciated, though not by some of my favorite monetary theorists. Friedman’s thesis is that the Crime of 1873 was actually a crime, though perhaps not in the legal sense:

Whether or not a verdict of "guilty" would have been appropriate in a court of law for "the crime of '73," it is appropriate in the court of history. The omission of the fateful line [allowing for silver coinage] had momentous consequences for the subsequent monetary history of the United States and, indeed, to some extent, of the world… The act of 1873 cast the die for a gold standard, which explains its significance. Moreover, while the conventional view is Laughlin's, that "the act of 1873 was a piece of good fortune" ([1886] 1896, p. 93), my own view is that it was the opposite: a mistake that had highly adverse consequences.

The U.S. demonetized silver just as European nations joined the gold standard, and thus demonetized silver: Germany in 1871, France, Belgium, Italy, and Switzerland in 1873, “The Scandanavian Union (Denmark, Norway, and Sweden), the Netherlands, and Russia followed suit in 1875-76 and Austria in 1879.” This switch by all major Western nations led to a significant price deflation in gold terms between 1873 and 1896. This also coincided with other deflationary forces:

The increased world demand for gold for monetary purposes coincided with a slowing in the rate of increase of the world's stock of gold and a rising output of goods and services. These forces put downward pressure on the price level. Stated differently, with gold scarcer relative to output in general, the price of gold in terms of goods went up, which means that the nominal price level (under a gold standard, the price level in terms of gold) went down.

This painful deflation – painful at least for debtors – could have been avoided.

Gresham’s law states that under a legal tender monopoly, money whose actual value is higher than the face value offered by the mint is hoarded and the “cheaper money” is used for exchange (as the unit of account) while the hoarded money serves as a store of value. Had the U.S. maintained a bimetal standard, gold would have been hoarded as its value had risen due to slowing production and increased demand in Europe. Silver would have been used for exchange as the face value of silver coins and bullion would likely have been higher than the value of its silver content. This also would have served to stabilize the gold price of silver by guaranteeing a market for it. Despite its shortcomings, price stability was one significant advantage of bimetallism.

Friedman findings support this:

If my estimates are anywhere near correct, a bimetallic-or really silver-standard would have produced a considerably steadier price level than the gold standard that was adopted.

He supports this with a graph that is hard to argue with:

Friedman shows that the price ratio of gold and silver remained relatively stable throughout the 19^th century. It was not until all major nations demonetized silver in favor of gold that the ratio lost became unhinged. Friedman provides a counter-historical regression line to support his argument. It is estimated by multiplying the gold price of silver by 16 and dividing it by a hypothetical price of gold had the U.S. not joined the gold standard (see the article for more details). The outcome would have been different:

Friedman's predictor line suggests that the price ratio of gold and silver would still have risen, but that rise would have been short lived as the existence of a legal price of silver in the U.S. would have encouraged discouraged deviations that were far from the official ratio.

Friedman's argument is compelling. My only addition to it is that falling prices under a gold standard, and the later price volatility during and after World War I was the result of the elimination of precious metal substitutes for gold as outside money by gold standard countries. More on that in the future.

Hayek and Selgin's "Productivity Norm": Theory vs. Practice

A couple weeks ago I came across George Selgin’s work on Great Depression era monetary theory. In “Hayek vs. Keynes on How the Price Level Ought to Behave” Selgin notes many of the same issues that I have been recently reviewing. Of particular interest is Hayek’s changing views on deflation and price level stability. Hayek started in the 1920s with “a general indifference to deflation, whatever its cause” and did not began to change his views until after the onset of the Great Depression.

Throughout the second half of this piece, Selgin points out that Hayek grew to embrace the "productivity norm." This is true, but the claim requires qualification that, unless I have overlooked it, is lacking here. Selgin writes:

He [Hayek] therefore felt obliged to reformulate his major policy recommendation by stressing up-front what in the earlier edition appeared only as an afterthought, namely, that ‘any changes 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.’

This is only half true. Hayek admitted this problem on theoretical grounds, but in practice saw a policy of this sort as an unworkable, utopian ideal since it would require money to be injected at a precise place and time in order for it to remain neutral (see my earlier post). Thus, Hayek’s reformulation was hardly a policy recommendation, but rather, a theoretical admission followed by hand waving that implied something like “oh well, we can’t do anything about that anyway!” The same follows for another claim by Selgin that, in his article "Saving", Hayek "emphasized the desirability of expanding the stock of money to offset 'hoarding.'" Again, Hayek's analysis is positive and does not include a policy prescription. Even in his later works where he does recommend specific policies, he emphasizes that any monetary policy ought to be subject automatic, not subject to the whims of policy makers. 

With this in mind, I find it strange that Selgin lumps Hayek in with “Evan Durbin, Allen G. B. Fisher, Gottfried Haberler, Ralph Hawtrey, Eric Lindahl, Arthur Pigou, Dennis Robertson, [and] Gunner Myrdal” as supporting a “productivity norm.” As valuable as such a norm might be as a policy recommendation, Hayek did not support it as such.The confusion, I believe, is rooted in Hayek’s view toward price stabilization. Selgin admits that:

Hayek remained as opposed as ever to "the widespread illusion that we have simply to stabilize the value of money in order to eliminate all monetary influences on production" (ibid., 126). He also remained committed to the gold standard, which must have appeared to him even more acceptable than before (when he judged it insufficiently deflationary).

However, Hayek did not support a “productivity norm” prescription over one of price level stabilization. His comments must be viewed as only theoretical in nature as his policy suggestions did not change at least until 1937 as reflected in “Monetary Nationalism and International Stability” and waited until “A Commodity Reserve Currency” in 1943 for further elaboration. Even so, in 1937 Hayek was still advocating the gold standard as the appropriate monetary policy. Other policies, including a “productivity norm” would result in distortion of relative prices, presumably he believed worse than under a gold standard, because money is injected typically in financial markets rather than the point where a change in velocity is distorting prices.

*Note: I am not as familiar with Selgin’s work as I would like to be, so if he later corrected this I’d be happy if you let me know in the comments.

Shifts in Relative Prices vs Changes in the Price Level - A Preliminary Analysis Employing the Sauerbeck-Statist Index

I’ve recently grown interested in testing the predictive value of changes in relative prices as opposed to changes in the price level. So when I found myself with a few extra hours the other day, I ran some preliminary tests using the Saurbeck-Statist Index.

The Sauerbeck-Statist Index was published yearly from 1846 to 1948. It employs several baskets of commodities that are merged to form the final index. These are divided into two groups. The first group, “food”, includes baskets “vegetable”, “animal”, “sugar, tea, and coffee.” The second group, “raw materials”, includes “minerals”, “textile fibres”, and “sundrie”. In a set of regressions with changes in Great Britain’s GDP between 1878 and 1938, 1) I test the explanatory power of the sum of the absolute values of year-to-year percent changes in the price of these baskets, 2) of the sum of the absolute values of year-to-year percent changes less the percent change in the overall index, and 3) the absolute value of the percent change in the overall index. I anticipated that either 1) or 2) would provide more insight into changes in GDP, but this was incorrect. Regression 1) predicted about as well as 3), and 2) was far less accurate than both. (I also ran regression with squared variables, none of which proved more accurate and none of which are shown here.) The results are pictured below:

dlngbgdp = Percent Change in Great Britain GDP
APV = Absolute Price Volatility

RPV = Relative Price Volatility

absdSSI = Absolute Value of Year-to-Year Percent Changes in the Sauerbeck-Statist Index

wwi = Dummy Vairable 1915-1917

The signs on each measure of changes in price are negative as expected, so nothing appears unreasonable above. Also, the coefficient for changes in the Sauerbeck-Statist Index is about six times as large as the coefficient for the measure of Absolute Price Volatility. This is not surprising as there are 6 sectors considered in the Sauerbeck-Statist Index. The results appear consistent.

This is in no way a final say on the matter. There are certainly problems with this method of testing the impact of relative price changes.Summing changes in separate indices is not the same as summing changes in all prices as weighted according to their value relative to GDP. This also does not attempt in any way to separate output according to their location in the structure of production. Still this is worth considering because it does show the sum of changes in the value of certain baskets in different sectors - a proxy for price volatility - changes that surely would encourage economic discoordination.

In the near future, I would like to attempt a much more thorough, and probably more modern for the sake of convenience, analysis of changes in relative prices. For now, these preliminary results do not suggest that the sum of such changes may not be are a better predictor than changes in the overall price level. This is no surprise as rational producers will substitute away from inputs that become more expensive and consumers will substitute away from goods that do the same.

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.

If Shifts in Velocity Can Alter Relative Prices, What About Changes in Gold Holdings by Central Banks?

I am currently busy working on a new project which has kept me away from blogging over the last week. In researching I have stumbled upon a fact that is revealing of late Hayek. It seems that he never came to terms with absolute inability of government adhere whatsoever to any fixed standard. In Denationalization of Money, he writes:

One might hope to prevent the violent fluctuations in the value of money in recent years by returning to the gold standard or some regime of fixed exchanges. I still believe that, so long as the management of money is in the hands of government, the gold standard with all its imperfections is the only tolerably safe system.

To be fair, I must acknowledge that Hayek does admit “the undeniable truth that the gold standard has serious defects.” He also places constraints on his support for the gold standard, saying:

It [gold] certainly could not bear the strain if the majority of countries tried to run their own gold standard. There just is not enough gold about. An international gold standard could today mean only that a few countries maintained a gold standard while the other hung on to them through a gold exchange standard.

Confusing, no? The gold exchange standard was the system that bred mistrust and monetary catastrophe. It was certainly no second best option. As has been revealed through my study of Hayek as a common theme, any time he mentions a policy that is in some respect compromised, specifically if it is backward looking, it comes across as awkward. To clarify, for Hayek gold is not preferable as a currency, but it is the only appropriate choice of government chooses control currency. If that happens, countries will have to adopt a gold exchange standard with only a few holding the actual gold reserves.

Take a deep breath, as I am done confusing you for now, and prepare for Hayek’s scarcely adulterated wisdom. Oddly, his analysis of gold under a free banking standard reveals precisely the problem that it carried under a managed standard. He writes:

It may be that, with free competition between different kinds of money, gold coins might at first prove to be the most popular. But this very fact, the increasing demand for gold, would probably lead to such a rise (and perhaps also violent fluctuations) of the price of gold that, though it might still be widely used for hoarding, it would soon cease to be convenient as the unit for business transactions and accounting.

Increased demand for gold under the gold standard increased its value just the same as might occur in a world of private currencies. That was the very reason why it failed. Changes in the price of gold, in other words the gold price level, created two sorts of price distortion. First it altered relative prices of goods so that the plans of entrepreneurs were upset by a technically unnecessary adjustment. Second, the inflation and deflation associated with the interwar gold standard altered the terms of credit so that creditors were benefitted under deflation and debtors were benefitted under inflation. Of course when price movements are extreme, the benefits for either party are likely outweighed by the cost of a shrinking volume of economic activity. Also, the further divergence of relative prices only compounds the problem. Hayek clearly understood this in regard to changes in velocity of domestic currency:

It can be maintained that the analyses in terms of the demand for cash balances and the use of the concept of velocity of circulation by the quantity theory are formally equivalent. The difference is important. The cash balance approach directs attention to the crucial causal factor, the individual’s desire for holdings of stocks of money. The velocity of circulation refers to a resultant statistical magnitude which experience may show to be fairly constant over the fairly long periods for which we have useful data – thus providing some justification for claiming a simple connection between ‘the’ quantity of money and ‘the’ price level – but which is often misleading because it becomes so easily associated with the erroneous belief that monetary changes affect only the general level of prices. [Monetary changes] are then often regarded as harmful chiefly for this reason, as if they raised or lowered all prices simultaneously and by the same percentage. Yet the real harm they do is due to the differential effect on different prices, which change successively in a very irregular order and to a very different degree, so that as a result the whole structure of relative prices becomes distorted and misguides production into the wrong directions.

The very same difficulty occurs when central banks hoard gold. Hayek somehow never specifically outlines that problem. He was not the only one to let this pass. This problem is pervasive in the literature. Those who more fully understood the dangers of price level volatility due to shifting demand for gold by central banks did not consider the problem of distortions in relative price. Their lack of concern for "noise" from relative price changes may be one reason why some were content with simple price level stabilization which ignores changes in real output. 

The merits of both views must be considered. The fusion between an Austrian perspective on prices and a monetarist perspective on gold can reveal much. More to be said on that next time as I consider other arguments and spell out the problem with more technical language.