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.

Integrating Gold Flows into Austrian Business Cycle Theory

Standard policy proposal concerning gold flows took a number of forms for Austrians economists, with two being most common. Lionel Robbins expressed what appears to be the standard Austrian view that if gold inflows were the result of monetary expansion by another central banks, the central bank receiving them were under no responsibility to expand:

Broadly speaking they [the “rules of the Gold Standard game”] are simply these: that centres receiving gold should expand credit, and centres losing gold should contract credit. In detail, they require that the expansions and contractions should more or less counterbalance each other. . . (1934, 28).

Robbins’s view, those receiving gold had no responsibility to expand the base money stock due to inflows were the result of over expansion by another central bank. On this point, he agrees with Austrian economist Murray Rothbard (2000, 148).[1] Hayek conveyed several opinions at the time, one which is also closely in line with what Murray Rothbard considered a second best central banking policy (Rothbard 2000, 95). Hayek suggested that the central bank should stabilize the ratio of gold reserves to the broader money stock:

The only real cure would be if the reserves kept were large enough to allow them to vary by the full amount by which the total circulation of the country might possibly change. (1937, 33)

Hayek appears to have though that such a policy would help neutralize the real effects of changes in the broader money stock.[2] This policy prescription was both impractical to administer and at odds with the “rules of the game.” Hayek expressed other opinions throughout the 1930s, including that monetary expansion was merited during times of “acute crisis”, that an MV stabilization norm is theoretically most attractive, and that passive increases in the monetary base due to gold inflows were appropriate even in the context of loose monetary policies from other countries (1935, 123-125; 1999, 153). The latter of these was also expressed by Lionel Robbins (1934, 24-29), although this is at odds with the above quotation from the same chapter! Elsewhere, Hayek also considered the need for central banks with relatively large stock of gold to reduce their demand in order to allow other central banks to readopt the gold standard:

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. (1937, 86)

Here, Hayek formulates precisely the same argument that Hawtrey and Cassel had made for at least two decades (Cassel 1920a, 1920b, 1923; Hawtrey 1919). It is apparent that there was not a consistent Austrian position concerning central bank reaction to gold flows. This confusion occurred because gold flows were not included as an element in the ABCT. 

I have mentioned in a previous post that the merit of the international gold standard was, as Hayek phrased it, that it approximated an “international currency system” where all countries essentially used the same money (1937, 2). This merit depended on the stability of exchange rates. If distortions in exchange rates persisted, the benefits of an international money was lost. It is for this reason that stabilization of exchange rates under the gold standard was the most appropriate policy (Cassel 1922, 256). Participation in the international gold standard inherently necessitated this. If stability of exchange rates was not possible, then the benefits of the gold standard were lost.

Depreciation of a nation’s currency by the lowering of a central bank’s reserve ratio promoted gold outflows which, if not curtailed, would threaten the gold basis of the currency. Increases in the reserve ratio accomplished the opposite feat: the currency gained value relative to other currencies and initiated gold inflows. In either case, relative prices between countries are distorted, and both production and exchange are hampered. A central bank regime whose rule of thumb is to curtail domestic price inflation, no matter the cause of that inflation, ignores the mechanisms that enable the international gold standard to promote international trade. Whether or not economists at the time agreed, the “rules of the game” demanded that central banks respond passively to gold flows, expanding the broader monetary base as gold came in and contracting it as gold flowed out.

This presents a problem not previously confronted by the Austrian Business Cycle Theory. The central bank receiving resultant gold inflows (outflows) must choose between two bads. The central bank can import foreign inflation (deflation) and inherit all arbitrary changes in nominal factors. This will distort the structure of production. Or, it can try to offset the change in prices domestically by practicing either passively sterilization, allowing reserve levels to rise (fall) as gold flows in (out) or by engaging in active sterilization. Either option in the second case may minimize relative price changes domestically, but strengthens (weakens) the domestic currency relative to all other currencies. Imports are made cheaper (more expensive) and domestic producers face diminished (increased) demand for their products. Relative prices of goods and services residing in different countries are distorted by not allowing exchange rates to move back toward their old parity. Trade is harmed as changes in the relative prices of foreign goods and services alter profit margins for domestic producers who buy inputs from foreign suppliers and also for domestic producers who sell their goods to foreign markets. Whether a central bank keeps reserve ratios constant or sterilizes gold flows, the structure of production changes. In the second case, the burden of relative price changes are exported to countries where central banks hold reserve ratios constant. This has the added effect of endangering the international gold standard, clearly an inferior result compared to a simple adjustment in the structure of production. In sum, the appropriate policy suggestion, in light of Austrian capital theory and given an international gold standard where central banks practice fraction reserves, is for central banks to maintain stable exchange rates, not to offset changes in the domestic price level that occur due to gold inflows and outflows.

Endogenous Money Growth and Prices: Pilkington's Says Equation of Exchange Does not Support Monetarist Case for Inflation

Phil Pilkington is convinced that inflation is not always and everywhere a monetary phenomenon.

First, he thinks that he's found the trick to monetarism.

The monetarists proper converted this identity into a behavioral equation. This equation ran as follows and should be read running from left to right:Note two things. First, the fact that we have converted the “equal by identity” sign into a standard equals sign. This implies causality running from left to right. So, the left-hand side of the equation causes the right-hand side. Secondly, we have placed ‘hats’ on the velocity and quantity variables. This implies that they are to be thought of as fixed. Thus the equation reads: “The sum of prices is equal to the quantity of money”. We understand the sum of prices here to be the Consumer Price Index (CPI).

He misunderstands the claim. Prices are a function of the monetary base in the long run. This is proven empirically. In a world where there are zero transactions costs and perfect information, prices and output would always match the product of money and its velocity. Money exists because we do not live in a frictionless world with perfect knowledge, so this thought exercise is of little use unless it helps us to imagine the obstacles preventing market clearing and the means by which agents overcome those obstacles. One means is that prices lower. The other is that new moneys are created in response to increased demand for money in the broadest sense. More on that later.

Pilkington then goes on to disprove the quantity theory with some graphs.

Let us first lay these out in a standard graph form to see if we can intuitively spot any correlation. All graphs measure percentage changes year-on-year of both variables mapped. The reader can click on the image to enlarge it.

Conspicuously missing, the monetary base. Let me show you what that looks like compared to CPI to the monetary base.

***Note three things. 1) I left out the years since the crisis as the Federal Reserve has been sterilizing its own injections. 2) A first difference log transformation will show some correlation, but the correlation will be imperfect due to international demand for dollars and some endogeneity of Federal Reserve Policy. 3) The long run trend is important, which is why I show year to year changes in the second graph. Both measures appear to be following roughly the same long run trend.

I admit that in the microeconomic sense, Pilkington is right. Prices are not set with perfect knowledge, so sometimes they are set too high, and other times too low. If they are set too high, a surplus of goods is built up by the sellers. Likewise, if prices are too low, sellers liquidate their inventory before demand is satiated. In the first case, the problem can be alleviated by two means. Either prices fall or agents acquire sufficient funds to purchase the excess inventory.

Likely both happen. If firms are price searchers, then there are going to be times when they lead prices ahead of demand and others where demand leads prices. And there will be rare circumstances where the theoretical equilibrium price and the market price meet. Most of the time, there will be either too much or too little demand for money and, necessarily, gluts and shortages of goods. This promotes volatility in the broader monetary aggregates.

The broadest monetary aggregates expand endogenously. When prices are higher than the broader money stock merits, two things happen. 1) Prices eventually begin to fall and 2) agents still want to make purchases, so they attempt to acquire money by more costly means and employ assets less commonly used as money in exchanges (i.e., asset swaps). In fact, we can imagine a theoretical monetary aggregate that includes everything used as money that is built on top of the base. Let's call it, the total money stock - M_t. I expect that this aggregate and prices would tend to oscillate around one another. If this is the case, then we would have a circumstance where the price level - the theoretical construct, not some price level built ex post - affects the money stock  much like the money stock affects the price level. The time taken between events where the market reserve ratio is equal to the natural reserve ratio - the ratio of base money to broader money that would be reached if all pareto improvements could be made -  cannot be ascertained theoretically. It is an empirical question.

The long run level of prices is determined by three things. The size of the monetary base, the natural reserve ratio, and velocity per time period. For analysis, we can hold velocity constant. The ratio of base money to broader money will tend to oscillate around this natural ratio as deviations to far from it will lead to losses. That is, if ever reserve ratios become too far below or too far above the natural ratio, banks and other financial institutions must allow their reserve or capital ratios to rise or else risk insolvency. Those banks that don't adjust in a timely manner go out of business.

My exposition leads me to a second principle as well. The growth rate of M_t is a function of the expecation of P*y. If actual nominal GDP is lower than expected nominal GDP, there is an output deficiency. This follows from Say's law. If their is excess demand for money, then there is necessarily a surplus of goods due to their prices being above the market clearing price. This excess demand for money will be offset by the creation of purchasing power in the form of fiduciary currency or anything else used as money. The process can be described below.

1) Prices of goods are higher than money balances merit
2) Demand for money rises
3) New moneys and quasimoneys are created // prices begin to fall
4) Economy returns to long run growth path.

 (Both events in 3 occur simultaneously.)

Finally, we do not have a measure for the broadest money stock. The broadest money stock is difficult to measure because its definition must always expand to include brand new types of moneys. I'm happy to hear suggestions about which already constructed aggregates are most representative.

Austrian Business Cycle Theory Transmitted via Public and Private Ordering

When Ludwig von Mises first expounded his theory of the business cycle in 1913, itself a wedding of Wicksell’s natural rate hypothesis and Bohm Bawerk’s capital theory, central bank coordination was not a problem. The Bank of England played a leading role in determining policy and by doing so promoted international monetary stability (Eichengreen 1987; Bordo and Macdonald 2005). This allowed Mises to formulate a theory of the business cycle within a closed national economy.

Mises begins his formulation by arguing business cycles were the result of the fluctuations in credit monies issued by private banks practicing a fractional reserve policy. By concentrating on private banks, Mises is able to connect his business theory upon Wicksellian foundations and lead naturally into Bohm-Bawerk’s capital theory:

If it is possible for the credit issuing banks to reduce the rate of interest on loans below the rate determined by the whole economic situations (Wicksell’s natürlicher Kapitalizins or natural rate of interest), then the question arises of the particular consequences of a situation of this kind. . . A reduction of the rate of interest on loans must necessarily lead to a lengthening of the average period of production. . . . But there cannot be the slightest doubt as to where this will lead. A time must necessarily come when the means of subsistence available for consumption are all used up although the capital goods employed in production have not yet been transformed into consumption goods. . . . Since production and consumption are continuous, so that every day new processes of production are started upon and others completed, this situation does not imperil human existence by suddenly manifesting itself as a complete lack of consumption goods; it is merely expressed in a reduction of the quantity of goods available. . . The market prices of consumption goods rise and those of production fall. (1953, 359-362)

Nominal changes in money and money prices affect the structure of production, and thereby the real economy because relative prices, including the interest rate – the price of money across time– have been distorted.

But can competing firms generate a business cycle on their own and what is the range of systematic distortion that the process of private credit expansion is able to promote? Here Mises’s argument fits well, though not perfectly with the general old monetarist tradition (Hawtrey 1913,76)[1]. The interest rate is a lagging indicator of the real economy, so overinvestment in apparently profitable sectors is unavoidable. Overinvestment that results from private ordering occurs within bounds as “every bank is obliged to regulate its interest policy in accordance with that of the others (Mises 1953, 373).” Cycles occur, but they are limited in amplitude. Much in the same way that a flag is in stasis as it flaps in the wind, “the money market must be subject to fluctuations (Hawtrey 1913, 76-77).” Economic fluctuations are an inherent, yet constrained, aspect of markets.

The scenario is complicated by the introduction of a central bank. A private bank can lower interest rates for as long as it remains solvent. Losses, or the threat thereof, limit the extent to which banks can allow the market rate of interest to differ from the natural rate. Central banks can lower reserve ratios and the rate of interest charged on loans for a longer period of time than private banks because they face different kinds of liquidity restraints. Only when authorities find that expansion has generated gold losses that threaten target gold reserve ratios or worry that it has fueled too much speculation, is contraction necessitated (Mises 1953, 390).

With a central bank, booms grow stronger and busts grow deeper as a result of manipulation of the base money stock, but mechanisms for transmitting the boom are essentially the same. An increase in the money stock distorts relative prices and arbitrarily increases the length of the structure of production. With a central bank, however, the distortion is not an emergent, uncoordinated phenomena. It is a systematic distortion resulting from the central banks privilege to create base money creation.

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[1] Hawtrey argues that it is the discrepancy between the rate of profit and the rate of interest that drive the cycle:

               

If trade is for the moment stable and the market rate of interest is equal to the profit rate, and if we suppose that by any cause the profit rate is slightly increased, there will be an increased demand for loans at the existing market rate. But this increased demand for loans leads to an increase in the aggregate amount of purchasing power, which in turn still further increases the profit rate. This process will continue with ever accelerated force until the bankers intervene to save their reserves by raising the rate of interest up to and above the now enhanced profit rate. (76)

Tradeoff: Exchange Rates and Inflation Under the Gold Standard

The effects of central bank policy operated through multiple channels under the international gold standard. The most obvious is the domestic inflation rate. As the central bank expands the monetary base, prices tend to rise. As it contracts the base, prices tend to fall. A full account of the consequences of independent central bank policy must be broader than a measure of monetary expansion and movements of domestic prices – whether one is referring to movements of relative prices or price the price level. Central bank policy also influences exchange rates, and therefore, international trade.

Without fixed exchange rates, a unilateral inflation that lowered a central bank’s reserve ratio tends to also reduce the value of the respective national currency relative to other currencies. Under the gold standard, prices of currency were not allowed to fluctuate, so the prices of goods denominated in a particular currency reflected the adjustments. In other words, an ounce of gold became less valuable in a country that expanded its money stock faster than other gold standard nations. Gold thus flowed to nations whose rate of monetary expansion had not exceeded the general rate of monetary expansion of gold standard countries. In these nations, prices for both bonds [at least in the short run] and goods were lower than in the state that engaged in the out-of-sync expansion.                

Monetary policy under the old gold regime necessitated a tradeoff between domestic inflation and the balancing of exchange rates. Of concern here is a central bank’s response to gold inflows and outflows. If a central bank receives gold and allows its reserve ratio to rise, it engages in a passive sterilization. This perpetuates a discrepancy between prices in the countries receiving gold and losing gold. Likewise, if a central bank expands as gold flows into the country, it will tend to stabilize exchange rates by allowing prices to rise. The two options are mutually exclusive.

               

The merit of the international gold standard was, as Hayek phrased it, that it approximated an “international currency system (2)” where all countries essentially used the same money. This merit depended on the stability of exchange rates. If distortions in exchange rates persisted, the benefits of an international money was lost. It is for this reason that stabilization of exchange rates under the gold standard was the most appropriate policy.

Food for Thought: Although Hayek defended the merit of an international standard, he suggests that the best policy would be for a central bank to keep reserves “large enough to allow them to vary by the full amount by which the total circulation [of money] of the country might possibly change.” In other words, the central bank should offset changes in M1 by shifting reserve ratios. By doing this, however, the central banks would be distorting exchange rates. Hayek wanted to have his cake and eat it too. Either the standard is international, which under a “gold nucleus standard” [not 100% backed by gold] meant that central bank policy was to keep the reserve ratio constant, or domestic money expansion could be neutralized by changes in the reserve ratio. You can’t have both. 

Summary of Business Cycle Theories

Monetarist Business Cycle 

Inflationary booms are not necessarily followed by deflationary recession. They can have soft landings. Depression is caused by fall in the money stock or, likewise, a rise in demand for money unreciprocated by a fall in prices. (Yeager, Cash Balance Interpretation of Depression) Monetarist analysis relies on the equation of exchange: MV = Py. In the long run, a change in M leads to a change in P, but if prices are not fully flexible, y will be effected. Thus a fall in the money stock or a rise in demand for money (drop in velocity) effect real production when prices do not adjust instantaneously. Changes in MV shift the AD curve along the SRAS curve.

Implicit in this analysis is the assumption of an upward sloping SRAS curve. There is an SRAS because prices and wages are not fully flexible.  Changes in MV not met by changes in prices effect the real economy.

A depression might also be caused by too much inflation. Costs of adjustment – shoe leather cost – lead to a lower level of output (a level shift).

*Monetarists formalism relies on aggregates and ignores the Austrian argument about shifts in relative prices caused by monetary policy.

Keynesian Business Cycle 

The macroeconomy tends not to reach full employment on its own. The loanable funds market does not serve as an optimal nexus for equilibrating savings and investment. An excess of savings of investment lead to a drop in demand. If AD = C + G + I, increased savings that results in a drop in C but no increase in I represents a drop in demand. A fall in AD is concomitant with a drop in demand for labor. Keynes posited that changes in the money stock that are not channeled through the labor market will not increase prices. Prices rise when money enters an industry that is in full employment. Only when the entire economy is at full employment will prices begin to rise in full proportion to increase in the money stock.

Given this framework, depression are an endogenous and persistent phenomena, only able to be vanquished by macroeconomic management. Keynes suggests that deficiencies in aggregate demand should be offset by increases in fiscal expenditures. These can be financed by either the central bank or underutilized private lending.

New Classical Business Cycle (Lucas Islands Model)

New Classical economics is tied intimately to rational expectations and the efficient market hypothesis. Agents in these models are rational optimizers. Lucas describes his model as being comprised of a rational economic agents in a world where “all prices are market clearing.” Price changes result from either “a relative demand shift or a nominal (monetary) one (Snowdon and Vane, 2005 236).”

It is difficult to imagine depression in a world with continuous market clearing and rational expectations. In Lucas’s model, agents are optimizing with imperfect information, which allows for systematically biased error. Producers perceive changes in P, general prices, but are unable to determine whether a change in P is joined by a rise in the relative price of the good they produce. This is Lucas’s case for an upward sloping SRAS. An unexpected increase in P leads producers to increase production even if relative prices are unchanged. This is what Lucas refers to as the “signal extraction problem”.

Lucas’s model beautifully shows the logical implications of rational expectations under imperfect information. Everyone is simultaneously fooled because of a nominal-real confusion. Business fluctuations are a function of upset expectations that result from unexpected changes in prices via changes in the money stock. Lucas’s model is of little use in a country where agents are accustomed to inflation. However, “an unanticipated monetary disturbance that takes place in a country where agents are expecting price stability will lead to a significant real output disturbance.” (Snowdon and Vane 2005, 241)

Real Business Cycle Theory

Real Business Cycle Theory is a continuation of the New Classical research program. It forgoes the impulse mechanism of Lucas – inaccurate expectations leading to nominal-real confusion – for a model that employs rational expectations with perfect information. In this model, actors are rational and perfectly informed. Macroeconomic changes occur due to technology shocks that affect the LRAS curve. “These supply-side shocks to the production function generate fluctuations in aggregate output and employment as rational individuals respond to the altered structure of relative prices by changing their labour supply and consumption decisions.” (Snowdon and Vane 2005, 297) Remember that, with no upward sloping SRAS curve, business cycles cannot be explained by nominal changes. Money-illusion ceases to impact y because expectations adjust prices immediately. Thus, real business cycle theory represents the logical end of rational expectations.

Implications of RBCT include: 1) Labor and leisure are highly substitutable. Changes in employment rates are the result of voluntary action. 2) Monetary policy is impotent because nominal changes are accounted for by rational expectations. 3) Output follows a random walk where all changes are due to real factors. Defined as Y_t = g_t + Y_t-1 + z_t where Y is output, g is the drift (growth) of output, and z represents a technology shock (Snowdon and Vane 2005, 301-303)

New Keynesian Business Cycle Theories

It is important to recognize that the New Keynesian research program is less focused than other programs. Models represent a search for explanation of short-run deviations from the long-run growth path. According to Mankiew and Romer, New Keynesian research confronts two questions:

1 Does the theory violate the classical dichotomy? That is, is money non-neutral?
2 Does the theory assume that real market imperfections in the economy are crucial for understanding economic fluctuations. (Snowdon and Vane 2005, 363)

New Keynesian theories do not rely exclusively on supply or demand shocks. Either can cause economic fluctuation. New Keynesians are concerned about market imperfections that slow the process of adjustment to the long-run growth path. The textbook New Keynesian model considers the impact of rigid nominal prices and real wages. Firms operate as price searchers that tend not to reduce prices due to menu costs. Firms hire labor at efficiency wages – wages slightly above the market wage – in order to hold onto labor during recessions and to ensure productivity. That is, the higher is one’s wage, the greater is the cost of unemployment. During a recession, firms are slow to reduce prices due to menu costs. In the labor market, real wages do not lower, so drop in demand for labor augments what would already be an increase in unemployment. In the Greenwald-Stiglitz model, firms are risk averse and reduce output in order to lower the risk of bankruptcy. Therefore, what begins as a recession caused by a negative AD shock can lead to a reduction in AS. Lastly, hysteresis is the phenomenon where prolonged periods of elevated unemployment sustain memory in the economic system. Because workers have remained out of the workforce for an extended period of time, their willingness and/or ability to return or diminished. High unemployment begets future high unemployment.

Austrian Business Cycle 

Expansion of the money stock by a central bank leads to a lowering of the real interest rate and a distortion of relative prices. The change in the interest rate represents a change in the minimum rate of return required to sustain a project. With a drop in the rate, long term projects appear to be more profitable than before. Investment flows into these projects. The lower interest rate, since it does not reflect real preferences, distorts the structure of production. Eventually, the long term projects no longer appear profitable and the economy enters a period of depression, during which resources are reallocated.

Austrian Business Cycle Theory and the Significance of Different Monetary Regimes

The most popular version of the Austrian Business Cycle Theory [ABCT] attempts to explain economic booms and busts as a function of central bank intervention into the economy (For the sake of conciseness, I omit endogenous ABCT). The central bank is said to expand the money stock, creating an unsustainable boom that distorts the relative prices of goods and arbitrarily lengthens the structure of production (Hayek 1931; 1933; Rothbard 1963;Garrison 1999). The lengthening occurs without an increased willingness of agents to increase savings, and thereby lower the interest rate endogenously. As a result, consumption does not fall to make way for an increase in goods produced with capital and time and capital intensive techniques. As the new money makes its way from capital intensive processes into the hands of laborers, the consumer and producer goods industries bid up the price of inputs. Eventually, the new, more capital intensive forms of production prove to be unprofitable, at which point the boom turns to bust and resources are reallocated to reflect the actual time preferences of consumers.

Two factors of enormous significance weigh on the ABCT. First, analysis typically occurs within a closed economy (Hummel 1979, 50-51). Booms and busts within a single country are assumed to be a function of the largess of the domestic central bank. Second, analysis occurs within the international gold standard.  The nature of the gold standard fostered gold outflows from a nation when the central bank increased the base money stock without a concomitant increase in the nation’s gold stock. In order to stop the outflow, the central bank needed to either devalue the currency or contract the base money stock. Devaluation increased the domestic price of gold. Contraction restored the balance of exchange rates that previously existed. Underlying the entire analysis is the usual ceteris paribus condition, meaning that all other central banks are assumed to hold policy constant.

When the international nature of the gold standard is considered – and it is nothing short of a travesty that Austrians have for so long failed to account for the international nature of the international gold standard in the model – business cycles can be caused by more than just changes in the domestic money stock (Hummel 1979, 50-51; Barnett and Block 2008, 90). If a foreign central bank contracts its stock of base money, the contraction will attract gold to that country. This results in a rise in the interest rate that will attract investment, and a fall in prices that will attract commerce. The increase in gold for the foreign country is equivalent to a loss of gold for another. 

Now consider a situation where central bank “A” first expands its money stock, only to contract it in order to stem gold outflows. The home nation of central bank “A” might appropriately experience an ABCT-type boom and bust, but what about other countries on the gold standard? If other central banks only act passively – i.e., do not change their reserve ratios – then their nations’ money stocks will also expand. When central bank “A” finally contracts its money stock, the reverse occurs. As gold flows out from the other nations, those central banks contract their base money stocks in order to maintain their reserve ratios. Thus, the actions of a single central bank – if that bank is large enough – might result in an international boom and bust. Keep in mind that, even in a world where all but nation “A” are on 100% reserve standards, action by central bank “A” will lead to the same result.

  

Note that it is the gold standard itself that necessitates the boom and bust cycle. In a world of floating exchange rates, monetary expansion in one nation will, all else equal, diminish the value of that nation’s currency relative to other. Unlike under the gold standard, where an increase a nation’s domestic money stock encourages gold to leave that nation, under floating exchange rates the same action will lead to an increase in exports. The nation that expanded its money stock might experience a boom as foreigners buy cheaper goods. The boom is self-contained, only affecting other nations inasmuch as they can purchase cheaper goods from the nation that devalued and inasmuch as they alter patterns of productions as a result of the new stream of goods. There is no strong impulse that drives a boom in these countries, with the caveat that the purchase of goods from country “A” will increase demand for currency from country “A”, and symmetrically, decrease demand for other currencies. I doubt, however, that this effect would be large enough to stimulate a substantial boom in other countries. In this case, monetary expansion by central bank “A” will not lead to a similar increase in demand internationally as the responsiveness of floating exchange rates mitigate, though not perfectly, the central bank’s impact on the real economy in each country.

Given the above analysis, I feel justified in concluding that until ABCT has accounted for the significance of different types of monetary regimes, its applicability to the modern world will remain inhibited.

Is There a Role for Gold as Money?: Moving Emphasis Away from Deposit-Based Free Banking

Much of my research focuses on the shortcomings of the international gold standard. This is so much the case that I may come off to readers as opposing any attempts to use gold as money. There is, I believe, an opportunity for individuals to use gold, or really any asset, as money even in the modern environment. I think this would be beneficial for the financial system.

Money is itself a medium of exchange, a store of value, a unit of account, and a standard of deferred payment. As it stands, the unit of account is defined by one’s local legal tender regime. I doubt that this will change any time soon. As long as central banks don’t go off the rails and destabilize prices by their actions, this is not a problem. This might seem like a tall order, but for all their shortcomings, the world’s major central banks have not destabilized prices over the last few decades. (One might argue that they destabilized prices during the housing debacle, but government-provided incentives for investing in the housing market seem to me the appropriate villain in that story.) It follows that the unit of account is also the standard of deferred payment.

That leaves a medium of exchange and a store of value. While investors can write contracts that utilize gold, I don’t expect that to become the norm. More likely, gold, or any other asset, can be used as a store of value quite easily. In order for this to be useful, the asset must be quickly convertible into a common medium of exchange. It must be easily saleable, or in other words, have high liquidity.

Technological advances have greatly increased the degree of liquidity of many assets. If I so desire, the instant that I receive any money, I can invest as much of it as I wish in a gold ETF or mining company, at least while the market is open. Investment firms often provide debit and credit cards for accounts linked to money market mutual funds (MMMFs) if the holder so wishes. It is not a great jump to propose that one be allowed to link a credit or debit card directly to an investment account that includes investments in gold ETFs, or any stock or bond. As long as the account owner sets up a rule for sales and purchases – buy or sell such-and-such investment upon a deposit or purchase made using the account – and therefore cease to use local currency as a store of value if he so wishes, except to the extent that he chooses to hold cash on hand or deposit.

As David Glasner has pointed out with respect to MMMFs, investments that do not guarantee a fixed nominal value do not leave account holders in danger of a run. Investors face any losses immediately and equitably (See Chapter 9 of Free Banking and Monetary Reform). He refers specifically to MMMFs as an alternative to the traditional banking structure because the high level of liquidity of the MMMFs’ assets, typically a diverse portfolio of public bonds and commercial paper, promotes price stability. Following this line of thought, the expansion of the classes of assets that can be linked to an account, beyond MMMFs, would allow for something not too different than free banking.  Typically, free banking is described under a deposit system, but this is not necessary. My proposition might be even safer.

As it currently stands, I see two hurdles that must be overcome in order for this to occur. 1) Credit cards, debit cards, and checks must be allowed to be directly linked to investment accounts. 2) The capital gains tax must be eliminated. #2 is important because it will greatly increase the robustness of the monetary system by allowing investors to diversify wealth holdings as much as possible. Thus, an account will tend to maintain its real value over time, making inflation only a worry inasmuch as it distorts relative prices of dollar denominated assets. Beyond this, investment firms might need to restructure the way they charge their customers, maybe replacing per use fees with a flat fee or a fee based on a small percentage of one’s account. 

By these changes, gold, silver, titanium, shares of Apple stock, and basically any asset with high enough liquidity, can be used as money. One's choice of assets is simply a function of one's appetite for risk. Legal tender will function as a unit of account and as the final medium of exchange when a transaction occurs. I expect that portfolio demand for money - demand to hold cash balances - will diminish as the need to employ legal tender money as a store of value will be unnecessary.

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.