First a few interesting links:
1. Adam Smith did favor laissez-faire.
Mark Thoma recently linked to a Gavin Kennedy post that argued Adam Smith did not favor laissez-faire. I don’t agree. The evidence cited was a one page list of government interventions that Smith favored. The US, by contrast, has enough government interventions to fill a New York City phone book, if not a small library. And the US is regarded by the Europeans as “unbridled capitalism.” Even Hong Kong intervenes in far more ways than Adam Smith contemplated. Of course Smith was not an anarchist, he did favor some government intervention in the economy. But relative to any real world economy, his policies views were extremely laissez-faire.
I see this as a common cognitive bias. The Gavin Kennedy list posted by Thoma certainly looks impressive, but when you think more deeply about the issue it is a trivial set of policies. I’m reminded of what happens when I discuss Singapore, which usually ranks number two in the world in lists of economic freedom. People will often respond by telling me about all the ways the Singapore government intervenes. My response is “so what?” They could intervene in a 1000 different ways and still be vastly more laissez-faire than the US government. Laissez-faire is a relative concept, and always has been. I’ve read The Wealth of Nations, and Adam Smith is clearly a pragmatic libertarian.
2. Tim Duy nails the Fed:
I also discovered this link in Thoma’s blog. Worth reading.
3. The FT says fiscal policy won’t work, try raising NGDP instead.
But they don’t tell us how to raise NGDP. If fiscal policy is off the table, are there any other suggestions?
4. Better 13 months too late, than never.
President Obama may finally be getting around to filling the three vacancies at the Board of Governors. This would give him a majority in setting interest rates. (Note, the FOMC may be less important in the future. The interest rate paid on bank reserves will be the new policy tool, and it will be set by the Board, not the FOMC.)
Thanks to JimP for both the 3rd and 4th links. Here’s a new view of what went wrong in October 1931. (Not that new, I published it in the 1990s.)
5.f The First Dollar Panic
It is not particularly surprising that the Dow declined by less than one percent on September 21st, the averages had already declined 8.2 percent over the previous two days in apparent anticipation of the British devaluation. What was surprising, however, was the 25.4 percent plunge in the Dow between September 23 and October 5, 1931. Although theory suggests that asset prices should respond immediately to news, the extraordinary rapidity of this decline, and its close proximity to the British devaluation, makes it unlikely that the two events were completely unrelated.
 This decline was presumably due to the perception that the British devaluation would force countries remaining on the gold standard to adopt more contractionary monetary policies.
The 7.1 percent drop in the Dow on September 24, 1931 was the tenth largest decline in history, and on the following day the NYTheadline announced “Sales Of Gold Upset Money Market Here; Stock Prices Break”. Is there a plausible link between the gold outflow and the decline in the Dow? We have already seen that gold flows, by themselves, provide no information regarding the stance of world monetary policy under an international gold standard. A gold flow from the U.S. to France could be caused either by a reduction in the U.S. gold ratio (i.e. an expansionary policy in the U.S.), or an increase in France’s gold ratio, (a contractionary policy in France.)
We now know that the late-1931 gold flows were associated with sharp increases in the gold ratios of the gold bloc countries, as world monetary policy tightened sharply after the British devaluation. The subsequent increases in the U.S. discount rate were merely the symptom of this tightening. If one views the behavior of (the gold bloc) central banks in terms of a profit-maximizing model where low nominal interest rates and fears of subsequent devaluations lead central banks to sell foreign assets for gold, then the dollar crisis should have been fully discounted by September 21st. Alternatively, if the markets viewed the interwar central banks as having some ability to cooperate in the pursuance of other goals such as macroeconomic stability, then it is not surprising that Wall Street apparently failed to immediately anticipate all of the repercussions associated with of the British decision to devalue the pound.
The increasing maldistribution of gold (i.e. rising gold reserve ratio) was not the only fallout from the German and British crises. A number of other countries followed Britain’s lead in leaving the gold standard, and during the fall of 1931 there were fears that the U.S. might do the same. This climate of uncertainty led to an increase in the private hoarding of gold, and the world monetary gold stock declined in July, September, and October 1931. Private gold hoarding provides a second mechanism by which the German and British currency crises depressed aggregate demand throughout the world.
Einzig (1937) reports weekly forward exchange rate data for six currencies. The dollar/pound exchange rate shows the dollar slipping from a premium to a discount against the pound during October 1931. Unfortunately, Einzig does not report forward data for the U.S. dollar price of gold. However there was no realistic prospect of a revaluation in the gold bloc currencies, and thus we can use the forward premium on the French franc (and three-way arbitrage) to estimate a lower bound for the discount of the forward dollar against gold. Using this procedure, the U.S. dollar sold at a forward discount against the franc throughout October 1931, with the three month forward discount peaking at close to 2 percent on October 17.
 There had been no monthly declines during 1930, or during the first half of 1931.
One problem with forward exchange rate data is that it provides no information regarding fears of a devaluation occurring more than three months into the future. Long-term bond prices can provide some indication of investor perceptions about the long run soundness of the dollar. Friedman and Schwartz (p. 319) note that the prices of long-term U.S. Treasury bonds declined sharply during the final quarter of 1931. They indicate that some observers attributed this decline to fears of huge budget deficits produced by radical Congressional spending bills, but then argue that a more likely explanation is that banking difficulties led banks to sell bonds in order to accumulate excess reserves. One problem with Friedman and Schwartz’s hypothesis is that the price of French government bonds (also payable in gold) did not decline substantially during this period. Thus, their hypothesis requires the existence of some degree of market segmentation.
An alternative hypothesis is that devaluation fears led to an increase in either the inflation premium or the default risk on U.S. Treasury bonds. We don’t know if investors did draw this distinction between U.S. and French government bonds, but subsequent events show that it would have been sensible for them to have done so. Less than two years later the U.S. dollar was devalued, the gold clause was abrogated, and U.S. inflation did accelerate vis-a-vis French inflation. It is also significant that the price of U.S. Treasury bonds (3% coupon, due 1951-55, henceforth ‘T-bonds’) remained remarkably stable throughout the turbulent period from September 15 through September 23, never varying by more than 2/32 of a point on any given day. Then on September 24, the very day the heavy gold outflows began, the price of these bonds dropped from 99 15/32 to 99 3/32, the beginning of a decline that would take price below 90 by October 19, 1931.
One of the most interesting aspects of the October bear market in Treasury bonds was the contrasting reactions of the U.S. and (continental) European press. The U.S. financial press was perplexed by the sharp decline in T-bond prices. During earlier stages of the Depression, T-bonds had often rallied when stock, corporate bond, and commodity prices were declining. Thus, the October 17 issue of the NYT (p. 23) noted that “the fluctuations [in T-bond prices] were as confusing as they were incomprehensible to the rational mind”. The decline in T-bond prices could conceivably have been due to the unusual circumstance of a discount rate increase during a period of economic weakness. But the press knew that that explanation was inadequate. The fact that French bond prices were stable during this period indicated that there was a decline in investor perceptions of the soundness of U.S. Treasury obligations. Rather than confront this issue head-on, an October 11 NYT headline argued that a French “Campaign of Insinuation Leads Public to Believe We Plan Wholesale Inflation”.
 This would be viewed as an increase in default risk if one viewed U.S. Treasury bonds as being payable in gold, and an increase in inflation risk if one viewed the bonds as being payable in dollars. Hamilton (1988) looks at short term T-bill yields, and comes to a similar conclusion. Also see Wigmore (1985, pp. 215-16.)
These rumors were attributed to a lack of understanding on the part of Europeans of the American banking system in general, and in particular, to a lack of understanding of a recent policy initiative of the Hoover administration. On October 6, 1931, President Hoover had proposed the creation of a “National Credit Corporation” to provide up to $500,000,000 in loans to ailing banks and the Dow soared 14.9 percent on the news, which was second only in size to the 15.3 percent rise after the 1933 bank holiday. On October 8 the Dow jumped another 8.3 percent and on the following day the NYT headline reported “Further Moves Considered by Hoover, Including Federal Reserve Revision”. Commodity prices also increased sharply during this period.
Hoover’s initiative was prompted by the unprecedented amount of U.S. currency hoarding associated with the British devaluation and the subsequent banking panic. In just the five weeks from September 16 to October 21, the U.S. currency stock rose by nearly 10 percent. During a period of declining prices and output, an increase of this magnitude meant a significant slowdown in currency velocity, and the money multiplier. The situation was so tense that weekly changes in the currency stock became front page news in the NYT! European rumors regarding the dollar appear to have been motivated by both the Hoover banking initiative, and also by massive gold outflows coinciding with a huge increase in the currency stock.
As with the debt moratorium, the National Credit Corporation proved to be ineffective, probably due to the mistaken assumption that the banking crises resulted merely from a lack of liquidity. Nevertheless, the Wall Street reaction suggests that investors understood the deflationary impact of currency hoarding, and that a proposal that offered even a hope of reflation could have a major impact on real stock values.
The two discount rates increases of October 1931 are widely viewed as a major policy error by the Federal Reserve. Hamilton (1988. p. 83) called their impact on the economy “devastating”, and Temin (p. 29) also thought that they depressed the economy. Friedman and Schwartz (p. 317) argued that the increase “contributed to a spectacular increase in bank failures.” Yet in contrast to the other major monetary shocks of 1931, the reaction of the stock market to the two discount rate increases was, if anything, slightly positive.
 In the absence of any “supply-side” news, these commodity price increases were also attributed to Hoover’s announcement. French stock prices fell sharply. This presumably reflects the fact that a major devaluation has an adverse affect on those nations remaining on the gold standard.
 The October 30 NYT headline read “Currency Is Abated; Gold Drain Wanes”.
 The first discount rate increase (from 1.5 to 2.5 percent) was announced at 3:30 P.M. on October 8th, and the Dow decreased just over one percent on the following day. A week later, the Dow actually increased 3.8 percent after an additional one percentage point increase in the discount rate.
One explanation for this non-reaction is that investors did not view the discount rate as an important policy indicator. Yet the two previous increases in the discount rate (on July 11, 1928 and August 8, 1929) were associated with major stock market declines. Another possible explanation is that the increases in the discount rate were anticipated, particularly in light of the ongoing gold outflow. The October 16th NYT (p. 1) did indicate that investors were anticipating a discount rate increase, but also indicated that although the stock exchange was closed, in the over-the-counter market “bank stocks went soaring after the news was flashed at 3:30”, a clear indication that the increase was at least partially unexpected and/or larger that anticipated. And the yields on short-term T-bills and T-notes jumped sharply on the day after each of the discount rate increases, another indication that the increases were partially unexpected.
When viewed from the perspective of Bernanke’s “multiple monetary equilibria” hypothesis, the market reaction to the discount rate increases is not surprising. Investors may have realized that during this tense period the expansionary impact (on the gold ratio) of a low discount rate would be more than offset by the contractionary effects stemming from a loss of confidence in the dollar, which could have led to more gold hoarding. In any event, the discount rate increases were successful in restoring confidence in the dollar, and after October 1931 there was a modest reduction in currency and gold hoarding. Stock prices rose significantly during early November.
The various market responses to different types of monetary policy news suggest that investors focused on areas where policy discretion could make a meaningful difference. Although Hoover’s banking initiative was not successful, the subsequent impact of the Federal Deposit Insurance Corporation shows that the potential existed for banking reforms to influence the level of currency hoarding. And the sharp increase in the gold reserve ratio within the gold bloc represented a discretionary policy choice for these gold-rich nations. Conversely, proposals that the Fed engage in modest open market purchases; were viewed as being even less feasible than had been the case prior to the British devaluation.
 French officials pressured the U.S. take steps to restore confidence in the dollar. In return, the French agreed to repatriate their gold holdings at a measured pace.
 The yield on T-notes with a maturity of 3 to 9 months rose from a range of .76 to 1.15 percent on October 8th, to between 1.66 and 2.08 percent on October 9th. The yields then increased from a range of 1.86 to 2.23 percent on October 15th to between 2.26 and 2.81 percent on October 16th.
Wigmore (1985, p. 217) is one of the few to dissent from the standard view, arguing that monetary policy was loose during this period. Despite the large gain in stock prices, I wouldn’t go that far. The Fed had two options (tight money or a run on the dollar); neither option was very appealing and neither would have meant policy was expansionary.
 The November 7, 1931 issue of the CFC (p. 3029) discusses a proposal by Irving Fisher for more open market purchases to boost the economy.
Along with the various international monetary crises, the political situation during October 1931 was disturbed by the onset of the Sino-Japanese war and by Nazi agitation in Germany. In addition, currency realignments were leading many nations to impose retaliatory tariffs, further reducing the prospects of international monetary cooperation. Even proponents of cooperation such as Gustav Cassel felt that it was now too late for an institution such as the BIS to coordinate an expansionary monetary policy. Paul Einzig argued that following the international monetary crisis of 1931 central bankers had not acted as autonomous economic policymakers, but rather had substituted gold for foreign exchange reserves much as “ignorant and illiterate depositors do in times of panic.”
5.g More Problems in Germany
Equations 7 and 8 from Table 5 show that movements in the price of YPBs continued to be strongly correlated with the Dow during the final three months of 1931. The October 17th CFCnoted that problems in Germany were depressing U.S. stock prices on October 13, 14, and 15. Less clear, however, is the mechanism which was continuing to link these two markets. The financial press suggested that Wall Street was concerned about the large quantity of short-term credits that U.S. banks had extended to German firms and municipalities. Many of these credits were frozen by a “standstill agreement” in the wake of the German exchange crisis of July 1931. Because these credits were dollar denominated, a major German devaluation would have greatly increased the debts in mark terms, and almost certainly would have led to widespread defaults. This may explain why the price of YPBs declined so sharply during the British exchange crisis of September 18-19. Many European nations immediately followed Britain off the gold standard, and investors were naturally concerned that German would be the next “domino” to fall.
By November 7, 1931, the YPBs had regained all of the ground lost between September 23 and October 6, and two days later, the Dow also regained its September 23 peak. Then, between November 9 and December 17 the Dow fell by nearly 37 percent, and from November 7 to December 17 the price of YPBs plunged by more than 48 percent, both reaching their yearly low on the same day.
 Those who would argue that the higher tariffs, rather than monetary shocks, can explain the 1931 stock market decline must contend with the fact the British stock prices rose sharply following the devaluation, despite the fact that Britain now faced higher tariff barriers on the continent.
 Cassel (1936) blamed the depression on the hoarding of gold by the U.S. and France.
 Einzig (1933, p. 14.) Hawtrey expressed similar views.
During mid-November a number of NYTreports indicated that Wall Street was continuing to be affected by the reparations dilemma and/or the deteriorating situation in Germany. The new British tariffs were hurting German exports, and Germany was again requesting a reduction in its war debts. On November 27, the price of YPBs fell 3.9 percent in reaction to an uncompromising speech by French Premier Laval. The Dow fell 2.8 percent.
During December 1931, five months after the German exchange crisis began, German news was still dominating the front page of the NYT. On December 4, the price of YPBs declined 8.5 percent and the Dow dropped 3.3 percent. The following day the NYT (p. eight) reported that “Bank Stocks Break on German Rumor” (that the gold standard would be abandoned.) On December 5, the price of YPBs jumped 17.6 percent, the Dow rose 3.9 percent, and the next day’s NYT (p. 14N) noted that “Traders took heart on the news that the slogan of the Hitler party will be: ‘private debts – yes; reparations – no!'”.
Several December 11th headlines in the NYT reported another major initiative by President Hoover: “Hoover Wants War Debt Board Revived”, and “Hoover Debt Stand Hailed in Europe”. Unfortunately, there was a great deal of hostility to the plan in Congress, and in contrast to previous Hoover initiatives, this plan failed to boost stock prices. The next day the NYT (p. 11N) noted that “It was pointed out yesterday that several news developments which formed the bases for substantial upturns during the last year were regarded as of paramount importance when they first made their appearance, although subsequent events showed that their significance had been greatly exaggerated.” That is quite an understatement.
During mid-December, stocks and YPBs continued to fall as the hostility of Congress to further debt relief dominated the headlines. Finally, on December 18, the Dow rebounded 8.9 percent and the price of YPBs jumped 14.2 percent. The financial press attributed the dramatic (midday) rally to concurrent Congressional testimony by banking expert Thomas W. Lamont. Lamont suggested that the German debt situation was not as serious as had been rumored, and bank stocks experienced especially impressive increases. Of more importance, however, was the dramatic rise in the prices of industrial and railroad stocks, and commodities. These increases suggest that the debt problems were perceived as affecting not just bank earnings, but more broadly, the entire monetary sector and thus total aggregate demand.
 He indicated that France would not allow private German debts to take precedence over war reparations.