The end of the Gold Standard

NYTimes September 21, 1931

84 years ago Britain left the Gold Standard. Some thought it was the end of Western civilization. Keynes thought it was the beginning of the end of the Depression, at least in Great Britain. He was certainly happy. He said: "There are few Englishmen who do not rejoice at the breaking of our gold fetters. We feel that we have at last a free hand to do what is sensible. The romantic phase is over, and we can begin to discuss realistically what policy is for the best." On the functioning of the Gold Standard and why the conventional view, which according to Eichengreen can still be roughly understood with Hume's specie-flow mechanism, is incorrect go here.

The Gold Standard and the Depression

I have been teaching on this topic this week. One of the accepted views on the Depression is that countries that depreciated earlier recovered faster from the crisis. The classic paper by Eichengreen and Sachs sort of established the result.* The notion is the traditional one. Depreciation leads to lower prices in foreign currency, increased competitiveness and higher exports. Graph below shows the correlation between depreciation (since the exchange rate is measured as the foreign price of domestic currency, lower rate means depreciation).

The indexes show the difference between the exchange rate and export volumes in 1929 (100) and 1935. So in 1935 France had not left the Gold Standard and the exchange rate remained at 100, while the exports were close to 50% of their 1929 level. There seems to be a clear negative relation between the exchange rate depreciation and export performance. However, note that in the United Kingdom a depreciation of about 40% implied exports at around 75% or so of the 1929 level. Only Norway and Finland seem to have higher exports in 1935 than in 1929. This was not an external demand led recovery.

This suggests that if depreciation had a role it was more likely related to the space that breaking with the Gold Standard rules provided for domestic authorities to pursue expansionary policies at home. Note that in this context, the depreciation, as much as higher tariffs and other trade related policies, are less relevant for their role in stimulating external demand, than by their role in protecting domestic production.

In the US the group of economists that were in favor of the depreciation of the dollar (see the letter by Harvard economists J. Raymond Walsh, Lauchlin Currie, John B. Crane, John M. Cassels, Robert Keen Lamb and Alan R. Sweezy in support of FDR's depreciation policy in 1934; and yes that includes Currie, later advisor to Eccles, and Paul's brother Alan, a Keynesian, not a Marxist), were also in favor of domestic fiscal expansion, which was at the end of the day Keynes point too. You can see Keynes arguing why the abandonment of the Gold Standard would be a good thing here, at the beginning of John Kenneth Galbraith's documentary.

This is still an important point, since there are significant lessons, at least it seems to me, for the European periphery story, in particular Greece. Depreciation alone cannot do the job. But a combination of import substituting policies, to reduce external constraint problems, with expansionary demand policies might work.

* There are also issues related to the role of the Gold Standard in causing the Depression, since the crisis was international, and many authors think that this suggests that it must have international causes. Hence, the Monetarist contraction story, or the Keynesian consumption collapse story (including the more radical version in which income distribution plays a role) would be incomplete. In this view, the relatively high rate of interest, related to the not credible inter-war Gold Standard, would be the cause of the depression. This view, as I noted before, seems closer to Keynes' Treatise on Money than his GT.

NBER: Mutual Assistance between Federal Reserve Banks, 1913-1960

By Barry Eichengreen, Arnaud J. Mehl, Livia Chițu, & Gary Richardson

This paper reconstructs the forgotten history of mutual assistance among Reserve Banks in the early years of the Federal Reserve System. We use data on accommodation operations by the 12 Reserve Banks between 1913 and 1960 which enabled them to mutualise their gold reserves in emergency situations. Gold reserve sharing was especially important in response to liquidity crises and bank runs. Cooperation among reserve banks was essential for the cohesion and stability of the US monetary union. But fortunes could change quickly, with emergency recipients of gold turning into providers. Because regional imbalances did not grow endlessly, instead narrowing when region-specific liquidity shocks subsided, mutual assistance created only limited tensions. These findings speak to the current debate over TARGET2 balances in Europe.

Read rest here (subscription required).

Tom O'Brien From Alpha to Omega Podcast on the Role of the Dollar

I was interviewed by Tom O'Brien of the "From Alpha to Omega" podcast. Episode also available here.



For more of Tom's interviews go here. The paper discussed in the interview is this one.

Balance of Payments Adjustment and the Euro Crisis

It is worth remembering that according to Eichengreen (1996, p. 25) “the most influential formalization of the gold-standard is the price-specie flow model of David Hume. Perhaps the most remarkable feature of this model is its durability: developed in the eighteenth century, it remains the dominant approach to thinking about the gold standard” (for a critique go here).

The idea is that, at least in a fixed exchange rate regime, inflation and deflation do all the work of adjusting the balance of payments (BOPs). Modern versions add credibility and all that (which includes austerity) for the stabilizing flows of capital to work. Why do I bring this up? Because of Martin Wolf's column (subscription required) in the Financial Times today, which has the graph below.

Note that the countries in crisis, Greece, Ireland, Italy, Portugal and Spain have already adjusted their BOPs (in this case their trade balances). Yet the adjustment is more Keynesian than Humean, or to be more precise, it follows the analysis of A.G. Ford, who argued that peripheral countries, like Argentina, adjust their current account deficits with a good old recession not by lowering domestic prices. And yes, Wolf is right, the specie-flow would only work in a parallel universe.

Newton and the Gold Standard

My limited knowledge of Newton's involvement with the Gold Standard, as the Master of the Mint, came from Barry Eichengreen's discussion in Globalizing Capital [a book that is very influential in spite of his claim that a variation of Hume's specie-flow is still the best view of balance of payments adjustment; for a critique go here or here; mind you the book is the best description of the mainstream views of balance of payments adjustment in historical perspective]. In that book he suggests that Newton got the price of silver incorrectly against gold, a too low gold price for silver, with the consequence that Britain moved effectively into a Gold Standard by accident. In this view, the new supply of Gold from Brazil, and the undervalued price of silver explain the slow move into a Gold Standard.

The more recent book by Thomas Levenson, not an economist (that's often good), Newton and the Counterfeiter, which is more of a police story, suggests that Newton was well aware of the correct exchange rate between gold and silver, but was prevented from changing it by political reasons. He cites two reports by Newton an early one from the mid-1690s arguing that gold was cheaper in France leading to silver scarcity in England, and another one from 1717 or so suggesting that the problem was that gold was much cheaper in China and India, and that arbitrage opportunities moved silver eastward. Other than that Newton seems to have been favorable to paper currency an other financial innovations (getting famously entangled in the South Sea Bubble).

In the long run we are NOT all dead

Niall Ferguson has apologized for his offensive suggestion that Keynes' phrase on being dead in the long run was somehow related to his sexuality or the fact that he was childless (more here and here). Good for him. Note, however, that in that famous phrase from the Tract on Monetary Reform, from 1923, Keynes was still very much a conventional Marshallian author who thought that full employment would reassert itself, and that the Quantity Theory of Money (QTM) worked pretty well. In fact, it is often said that the Tract was Milton Friedman's favorite among all of Keynes' books.

The full quote says:

"But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again."

The point of the quote is that in the long run everything would be fine, since markets do get to full employment, and so, even without intervention, deflation and inflation do its magic, but the process is too long and painful, so it would be more reasonable to act in the short run. This was typical of the Cambridge version of Marginalism, which was very much in favor of government intervention to deal with market imperfections in the short run. This is true of Marshal and Pigou, as well as Robertson, and certainly Keynes, before the General Theory. Note that this does not mean, as most people think, that one should only be concerned with the short run. The point is that action in the short run facilitates the road towards the fully adjusted equilibrium in the long run.

This was still essentially Keynes' view by 1930, when he published the Treatise on Money, a book that is at heart Wicksellian [so at least he got rid of the QTM in this book], and that suggests that unemployment results from a monetary rate of interest that is too high with respect to the natural rate, in practice as a result from the Gold Standard rules, which Keynes wanted to abandon. [This precedes the modern views that the Gold Standard caused the Depression, by the way, as say defended by Barry Eichengreen]. This was a cyclical crisis that could be solved by reducing the monetary rate of interest, and in the short run employment programs, something Keynes defended in Can Lloyd George Do It?

The point of the General Theory (GT) is that there is no natural rate of interest, meaning that reducing the rate of interest would not bring investment to the full employment level of savings, and that the crisis was caused by lack of demand. The equilibrium between investment and savings was determined by variations in the level of output, and in the long run we are not self adjusted to full employment. Hence, the very logic of the phrase above is debunked by Keynes, when he became Keynesian, so to speak, and got rid of the old modes of thinking. Intervention is not needed because in the long run we are dead, but because the long run depends on the short run, and we tend to fluctuate around a sub-optimal position.

So in the long run we are NOT dead in the GT, in the absence of counter-cyclical policies we are all in deep trouble. Keynes was very much concerned about the possibility of capitalism to promote well being for all in the long run. In other words, not only is Ferguson wrong about the effects of Keynes' sexuality and lack of children on his economic reasoning, but he does not even get the point of the phrase.

PS: The best book to understand the theoretical changes in Keynes' views is still Edward Amadeo's  Keynes' Principle of Effective Demand, his PhD dissertation, supervised by Murray Milgate, and co-supervised by Lance Taylor, published with an intro by Vicky Chick.

Heterodox Central Bankers: Robert Triffin

Robert Triffin (c. 1940)

Robert Triffin (of Triffin Dilemma fame) worked for the Federal Reserve in the 1940s, after his PhD at Harvard and before joining the IMF. He became the most prominent 'American' (he was Belgian born, in fact) money doctor of the 1940s, participating in missions to the Dominican Republic, Guatemala and Paraguay [other US money doctors in this period were Arthur Bloomfield, Bray Hammond, Henry Wallich, and John Williams; a list of missions available here at the end of the file]. Contrary to the Kemmerer missions of the 1920s and 1930s, or the British missions by Sir Otto Niemeyer of the same period, which advised on the creation of independent central banks strictly adhereing to the Gold Standard rules, the new Fed missions were quite heterodox.

In his National Central Banking and the International Economy, Triffin suggests that peripheral countries (agricultural in his terminology) were victims of the fluctuation of their terms of trade. He says:

"for most agricultural countries, large export receipts and favorable balances of payments usually coincide with high and not with low levels of domestic and export prices. The reason for this is that their ex- port volume and export prices fluctuate as much with demand as with supply conditions, if not more. That is, they are largely determined by international rather than domestic factors. Major fluctuations in export values result primarily from cyclical movements in economic activity and income in the buying countries, and not from changes in the relationship of domestic price or cost levels to prices and costs in other competing or buying countries. Thus, for many agricultural and raw material countries, the international cycle is mainly an imported product."

Crisis in the center dominated and caused crisis in the periphery. The global cycle, very similar to Raúl Prebisch's description of the nature of the crisis in the periphery at that time, implied that the automatic forces of the Gold Standard imposed deflationary adjustment that only made things worse. In Triffin's view, was to intervene in financial markets with exchange controls and promote expansionary policies in a recession. In his words:

"Capital tended to flow toward them in times of prosperity and away from them in times of depression, irrespective of their discount policy. The effect of such fluctuations in capital movements was to smooth down cyclical monetary and credit fluctuations in the creditor countries, but to accentuate them in the debtor countries. To that extent the finan- cial centers could shift part of the burden of readjustment upon the weaker countries in the world economy. Their only mechanism of defense was the policy consistently followed by the Central Bank of Argentina in the recent past with such remarkable success: to offset external drains from or accretions to its reserves through domestic policies of expansion or con- traction."

Note that the head of the Central Bank of Argentina at the time was Prebisch. By the time this study was published Triffin was at the International Monetary Fund.

The strange persistence of Monetarist history

The Monetarist view of history, as I noted in a recent post, is quite popular. The conventional wisdom on the Great Depression is that the Gold Standard forced contractionary monetary policies and the Great Contraction caused the recession. An open economy version of Milton Friedman’s story. The dominant view on the recovery from Great Depression, due to Christina Romer, is that the non-sterilized inflows of gold led to an increase of money supply. And the money supply brings the recovery. Forget the New Deal, that made things worse in the Monetarist alternative reality.

Krugman, that has otherwise done a great job of showing the anti-Keynesian bias in current discussions of the budget, also seems to have an inner Monetarist. He tells us in a recent post on taxes that: “the feds have the Fed, which can print money. But there are constraints on that, too — they’re not as sharp as the constraints on governments that can’t print money, but too much reliance on the printing press leads to unacceptable inflation. (Cue the MMT people — but after repeated discussions, I still don’t get how they sidestep the issue of limits on seignorage.)”

I guess we call endogenous money MMT (Modern Monetary Theory) now. If you print money and people spend, and there is capacity, there should be no inflation, but lower unemployment. Also, as people spend, firms tend to adjust capacity to demand. So the capacity limit is endogenous. The limit that most economies encounter is the balance of payments. As the economy grows and it imports more, eventually the current account deficit becomes too large, and depreciation fuels inflation.

But my concern is why even Krugman buys the notion that money causes prices. A graduate student told me that monetarism is a simple story that is ideologically convenient. That is true, but not ideologically convenient for progressives like Krugman. In his case and other progressives like him (there are even Marxists with Monetarist proclivities!), it seems, that the reasons have to do with the ability to convince people that certain events can only be explained by Monetarist ideas. That suggests to me that the power of institutions (universities, journals, press) that reproduce acceptable knowledge is incredible strong. Institution building should be at the top of the agenda for progressives.