Archive for the Category Gold standard


Irving Fisher and George Warren

I am currently a bit over half way through an excellent book entitled “American Default“, by Sebastian Edwards. The primary focus of the book is the abrogation of the gold clause in debt contracts, which (I believe) is the only time the US federal government actually defaulted on its debt. But the book also provides a fascinating narrative of FDR’s decision to devalue the dollar in 1933-34.  I highly recommend this book, which I also discuss in a new Econlog post. Later I’ll do a post on the famous 1935 Court case on the gold clause.

Edwards has an interesting discussion of the difference between Irving Fisher and George Warren.  While both favored a monetary regime where gold prices would be adjusted to stabilize the price level, they envisioned somewhat different mechanisms.  Warren focused on the gold market, similar to my approach in my Great Depression book.  Changes in the supply and demand for gold would influence its value.  Raising the dollar price of gold was equivalent to raising the nominal value of the gold stock.  Money played little or no role in Warren’s thinking.

Fisher took a more conventional “quantity theoretic” approach, where changes in the gold price would influence the money supply, and ultimately the price level.  Edwards seems more sympathetic to Fisher’s approach, which he calls a “general equilibrium perspective”.  Fisher emphasized that devaluation would only be effective if the Federal Reserve cooperated by boosting the money supply.

I agree that Warren’s views were a bit too simplistic, and that Fisher was the far more sophisticated economist.  Nonetheless, I do think that Warren is underrated by most economists.

To some extent, the dispute reflects the differences between the closed economy perspective championed by Friedman and Schwartz (1963), and the open economy perspective advocated by people like Deirdre McCloskey and Richard Zecher in the 1980s.  Is the domestic price level determined by the domestic money supply?  Or by the way the global supply and demand for gold shape the global price level, which then influences domestic prices via PPP?  In my view, Fisher is somewhere in between these two figures, whereas Warren is close to McCloskey/Zecher.  I’m somewhere between Fisher and Warren, but a bit closer to Warren (and McCloskey/Zecher).

There’s a fundamental tension in Fisher’s monetary theory, which combines the quantity of money approach with the price of money approach.  Why does Fisher favor adjusting the price of gold to stabilize the price level (a highly controversial move), as opposed to simply adjusting the money supply (a less controversial move)?  Presumably because he understands that under a gold standard it might not be possible to stabilize the price level merely through changes in the domestic quantity of money.  If prices are determined globally (via PPP), then an expansionary monetary policy will lead to an outflow of gold, and might fail to boost the price level.  Thus Fisher’s preference for a “Compensated Dollar Plan” rather than money supply targeting is a tacit admission that Warren’s approach is in some sense more fundamental than Friedman and Schwartz’s approach.

Warren’s approach also links up with certain trends in modern monetary theory, particularly the role of expectations.  During the 1933-34 period of currency depreciation, both wholesale prices and industrial production soared much higher, despite almost no change in the monetary base.  Even the increase in M1 and M2 was quite modest; nothing that would be expected to lead to the dramatic surge in nominal spending.  That’s consistent with Warren’s gold mechanism being more important that Fisher’s quantity of money mechanism.  In fairness, the money supply did rise with a lag, but that’s also consistent with the Warren approach, which sees gold policy as the key policy lever and the money supply as being largely endogenous.  You might argue that the policy of dollar devaluation eventually forced the Fed to expand the money supply, via the mechanism of PPP.

A modern defender of Warren (like me) would point to models by people like Krugman and Woodford, where it’s the expected future path of policy that determines the current level of aggregate demand.  Dollar devaluation was a powerful way of impacting the expected future path of the money supply, even if the current money supply was held constant.

This isn’t to say that Warren’s approach cannot be criticized. The US was such a big country that changes in the money supply had global implications.  When viewed from a gold market perspective, you could think of monetary injections (OMPs) as reducing the demand for gold (lowering the gold/currency ratio), which would reduce the value of gold, i.e. raise the price level.  A big country doing this can raise the global price level.  So Warren was too dismissive of the role of money.  Nonetheless, Warren’s approach may well have been more fruitful than a domestically focused quantity theory of money approach.

Screen Shot 2018-06-07 at 12.15.35 PM

PS.  Because currency and gold were dual “media of account”, it’s not clear to me that the gold approach is less of a general equilibrium approach, at least under a gold standard.  When the price of gold is not fixed, then you could argue that currency is the only true medium of account, and hence is more fundamental.  During 1933-34, policy was all about shaping expectations of where gold would again be pegged in 1934 (it ended up being devalued from $20.67/oz. to $35/oz.)

PPS.  There is a related post (with bonus coverage of Trump!) over at Econlog.

Josh Hendrickson reviews The Midas Paradox

Josh Hendrickson has a very good review of my Great Depression book, published in the Journal of Economic History.  Here is one part of the review:

The role of monetary policy expectations is central to the modern New Keynesian model. Forward guidance has been a tool of monetary policy in the aftermath of the Great Recession. The role of expectations following the increase in the price of gold would seem to provide some empirical support for both the model and the practice. However, hidden in Sumner’s book is a cautionary tale about this type of policy. While it is true that the price level increased immediately following the increase in the price of gold, the gold standard has a built-in mechanism, namely international price arbitrage, which ensures that the price level would eventually rise. In a modern fiat regime there is no automatic mechanism capable of generating this outcome. The public’s expectations in a fiat regime depend on the commitment of the central bank to do something in the future. This word of caution is important because a key and recurring empirical observation in Sumner’s book is that fears of devaluation often led to private gold hoarding, which was deflationary (precisely the opposite effect of an actual devaluation). Sumner leaves the question of why expectations of devaluation and actual devaluation had precisely the opposite effect as a subject for future research. However, one possible hypothesis is that an actual devaluation had a built-in commitment mechanism. At the very least, this should give current policymakers some pause about forward guidance.

I think Josh is correct about the commitment mechanism, which is what made the 1933 dollar depreciation so effective.  Josh is right that I struggled with explaining why expectations of devaluation were often contractionary (not just in the Depression, BTW, but also in the 1890s.) It may have something to do with the dual media of account, gold and currency.  In a modern fiat money system, there is only one medium of account—base money.  If there is a 2% chance that the dollar will be devalued by 50% next year, then the expectation is that gold will earn a return 1% higher than currency.  If government bonds are also earning near zero interest rates, then gold becomes an relatively attractive investment.  This drives up the real value of gold all over the world, including the country where devaluation is thought to be a possibility.  That’s deflationary.  On the other hand, this reduces the demand for currency, which should be inflationary. And until the devaluation actually occurs, currency is pegged to gold at a fixed price.  There may be a way to model all this, but it’s not clear to me what it is.

An added complication is that fear of devaluation also seemed to trigger bank runs during 1931-33, and that’s also a deflationary factor.

Barsky and Summers explain why low rates are contractionary

Most people seemed to think my previous post was crazy, and looked for weaknesses.  A few perceptive observers, such as Nick Rowe and Jonathan, noticed that it had the same implication as the IS-LM model.  Some people wrongly assumed I was simply talking about correlation, whereas I was claiming that lower interest rates cause falling NGDP.  Some wondered why that is not reasoning from a price change.

I think the best way to address this confusion is to start with the classic 1988 paper by Barsky and Summers.  They claim that the “Gibson Paradox” is caused by the fact that low interest rates are deflationary under the gold standard, and that causation runs from falling interest rates to deflation.  Note that there was no NGDP data for this period, so they use the price level rather than NGDP as their nominal indicator.  But their basic argument is identical to mine.

The Gibson Paradox referred to the tendency of prices and interest rates to be highly correlated under the gold standard. Initially some people thought this was due to the Fisher effect, but it turns out that prices were roughly a random walk under the gold standard, and hence the expected rate of inflation was close to zero.  So the actual correlation was between prices and both real and nominal interest rates.  Nonetheless, the nominal interest rate is the key causal variable in their model, even though changes in that variable are mostly due to changes in the real interest rate.

Since gold is a durable good with a fixed price, the nominal interest rate is the opportunity cost of holding that good.  A lower nominal rate tends to increase the demand for gold, for both monetary and non-monetary purposes.  And an increased demand for gold is deflationary (and also reduces NGDP.)

Of course that’s just the demand for gold, what about the supply?  It so happens that the supply of gold was fairly stable under the gold standard, rising by about 2% per year, whereas the demand for gold was much more unstable.  Thus changes in the value of gold (which was the inverse of the price level under the gold standard) were mostly caused by shifts in the demand for gold, which were in turn caused by changes in nominal (and real) interest rates.

An interesting question is how these changes impacted the real economy.  I would argue that sticky wages caused the fall in NGDP to result in a fall in hours worked.  A real business cycle proponent might deny that, and claim that whatever caused real interest rates to decline, also caused workers to want to take long vacations.  But anyone who denies the RBC model, and believes wages are sticky, should agree with me; causation goes from interest rates to NGDP to hours worked, even if the initial change in real interest rates was caused by a real shock.  Falling NGDP has an independent effect on hours worked even if caused by a real shock, just as a gunshot wound hurts someone who already has pneumonia.

As far as the claim that this is just IS-LM, I suppose that’s true, but it didn’t stop Barksy and Summers from getting their paper published in the JPE, nor did it prevent Tyler Cowen from calling it an enjoyable paper that addressed an interesting “puzzle”.

The puzzle of why the economy does poorly when interest rates fall (such as during 2007-09) is in principle just as interesting as the one Barsky and Summers looked at.  Just as gold was the medium of account during the gold standard, base money is currently the medium of account.  And just as causation went from falling interest rates to higher demand for gold to deflation under the gold standard, causation went from falling interest rates to higher demand for base money to recession in 2007-08.

There’s no “trick” in my previous post, I meant what I said.  But I’m not surprised that people are confused; after all, didn’t most economists believe the Fed was pursuing an “expansionary” policy in 2008?  Funny how those “expansionary” policies are almost always associated with recessions.  People tend to wrongly equate interest rate movements and “monetary policy”.  Most changes in interest rates reflect changes in the macroeconomy (growth and inflation) not monetary policy. When rates fall, the Wicksellian rate is usually falling faster, which means money is getting tighter in the NK model.

And finally, a word on reasoning from a price change.  Suppose you claimed that low rates should lead to more housing construction, or more investment in general.  That would be reasoning from a price change.  You’d be talking about the impact of the change in a price, on the quantity in the very same (credit) market.  Obviously if low rates are caused by more supply of saving, then the quantity of investment will rise, and if caused by less demand for investment, then the quantity of investment will fall.  But here’s what I’d like to emphasize.  Lower rates will reduce velocity and NGDP regardless of whether they are caused by more supply of saving or less demand for investment.  And that’s because interest rates are not the price of money, they are the price of credit.  So interest rates become a shift variable in the money market.  Lower rates shift the demand for money to the right, which raises the value of money, which is deflationary.  So there’s no reasoning from a price change in that case.  Of course if I didn’t hold the supply of base money fixed, it would be reasoning from a price change.

Is it 1936 already?!?!?

Well that didn’t take long.  I have to admit that when I made this prediction eight days ago I didn’t really expect it to happen so fast:

The great irony of the Depression period is that by 1936 things had gotten so bad that even the French had to devalue.  The French had helped cause the Depression by their obsessive hoarding of gold, and their refusal to help out the weaker countries.  In other words, in monetary terms France was the Germany of the 1930s.  When you see doubts raised about countries like Finland and Austria, you really have to wonder if even the German debt is truly safe.

I still think the policy elite are slightly less pigheaded than in the 1930s, so I doubt things will go that far.  But it would be a lot simpler if they recognized reality right now, instead of dragging out the pain.

First a bit of background.  In the late 1920s and the early 1930s the Bank of France hoarded vast quantities of gold.  This raised the value of gold, which meant deflation (once the US and Britain stopped offsetting the French hoarding after October 1929.)  An international financial crisis ensued, with one country after another leaving the gold standard.  Britain in 1931, the US in 1933, etc.  At first France got off lightly, as their currency had been undervalued on the eve of the Depression.  But by 1936 the deflation in France was so bad that even they had to devalue.  In each case countries didn’t begin recovering until they had left the gold standard.

In the modern world things seem to move much faster than during the long agonizing 1931-36 collapse of the gold standard.  Today German bonds were hit hard:

The debt crisis that began more than two years ago now risks engulfing Germany. The Markit iTraxx SovX Western Europe Index of credit-default swaps on 15 governments rose to an all- time high as Germany failed to find buyers for 35 percent of the bonds offered at an auction.

Germany is of course the France of the 21st century.

It’s now quite possible that the Fed may have to move toward NGDP targeting before they would have liked.  The Fed cannot allow another collapse of NGDP like we saw in 2009.  The cost in terms of banking distress, worsening public finances, international discord and mass unemployment is simply too great to contemplate.  I have no doubt that Ben Bernanke of all people understands this.

Perhaps the Europeans will come together and do something dramatic in the next few days.  But if not, the Fed must be prepared to hold an emergency meeting and do whatever it takes.  To quote David Beckworth:

Also, if a nominal GDP level target is explicit and widely understood it would actually serve to mitigate the effects of financial shocks.  If the public understood the Fed would always close return nominal GDP to its trend path, public expectations would be better anchored and thus be less susceptible to wide swings.  That means velocity (i.e. real money demand) would be more stable.  For these reasons, it is reasonable to conclude that had the Fed been targeting nominal GDP during the 2008-2009 financial crisis, the outcome would have been far milder.  And for the same reasons, the Fed should be targeting nominal GDP now given the looming financial threat coming from the Eurozone crisis.

It’s Bernanke’s moment of truth.

PS.  Also check out Beckworth’s post showing the non-German NGDP in the eurozone.  And people wonder why the eurozone is having a sovereign debt crisis.

HT:  Joe2

A crisis Paul Krugman was born to cover

The ironies are piling up so fast, and becoming so surreal, that I’m almost at a loss for words.  Fortunately Paul Krugman isn’t, and makes some very good points. After quoting Mario Draghi on the importance of keeping inflation expectations well anchored, Krugman points out that they are failing:

Unbelievable. Right now, the ECB has too much credibility on the inflation front; the spread between German nominal and real interest rates, which is an implicit forecast of the inflation rate, is pointing to disastrously low medium-term inflation:

You’d think at a time like this if the ECB was going to err, they’d want to err on the side of a bit too much stimulus.  Instead they’ll miss their inflation target on the low side.

The events of the last few years have caused me to radically revise my views of the Great Depression.  Not in terms of the causal factors, those have been amply confirmed.  Falling NGDP does create domestic and international financial turmoil—no doubt about that.  But I used to think people were stupid back in the 1930s.  Remember Hawtrey’s famous “Crying fire, fire, in Noah’s flood”?  I used to wonder how people could have failed to see the real problem.  I thought that progress in macroeconomic analysis made similar policy errors unlikely today.  I couldn’t have been more wrong.  We’re just as stupid as they are.

Sometimes I get commenters saying that the Germans are inflation-phobic because of their experience with hyperinflation.  I doubt that’s the reason; when countries make mistakes they tend to repeat them again and again.  I don’t see much fear of inflation in Argentina.  And the Swiss are just as inflation-phobic as Germans, but they never had a hyperinflation.  The lesson that should be taught to German children is that the deflation of 1929-32 caused much more harm than the hyperinflation.  Here’s Krugman:

Dylan Grice of SocGen points out that it was the deflationary policies of 1930-32, not the inflation of 1923, that brought you-know-who to power.

Indeed. When we hear assertions that Germans are deeply hostile to loose money because of their historical memories, I always wonder why those memories are so selective. Why is 1923 seared into collective memory, while the Brüning disaster has apparently gone down the memory hole?

This is important “” and there’s not much time to get the record straight.

That’s right; it was deflation, not hyperinflation, which brought the Nazis to power.  As late as mid-1929 (six years after the hyperinflation) the Nazis had only a trivial share of seats in the Reichstag.  By early 1933 they were in power.

Here’s Krugman’s policy analysis:

There are strong self-fulfilling aspects to this crisis of confidence “” which is why Europe desperately needs the ECB to act as lender of last resort, and short-circuit the vicious circles.

But no, the ECB will defend its credibility. And it will end up as the highly credible defender of the value of a currency that no longer exists.

I’m not sure if the lender of last resort is needed.  It’s possible that a dramatic shift toward monetary stimulus could rescue the euro.  But we’ll never know for sure, as the ECH will definitely not undertake my moderate proposal.  Instead it’s all or nothing.  They will either do nothing, or they’ll start buying up lots of bad debt.  But there’ll be no conventional stimulus.

This reminds me of the US during the Great Depression.  Richard Timberlake pointed out that one of the most damning facts of the interwar period is that when the US left the gold standard in April 1933 it had the largest gold reserves in the world.  Just think about what that means.  Those reserves are there for a reason, and it’s not to prevent the NY Fed building from blowing away in a hurricane.  They are held in case of an emergency.  Why weren’t they used in 1929-33 to massively boost the money supply?  Because they were there for emergencies.  Are you stupid!  I’m sure Fed officials were quite proud of the fact that they maintained those reserves all through the financial hurricane of 1931-33.

Similarly, as Trichet left office he proudly stated that under his leadership the ECB had driven inflation to even lower levels than achieved by the Bundesbank.  The irony of 1933 is that the refusal to do more aggressive monetary stimulus prior to 1933, led to the eventually collapse of the international gold standard, a much more radical move.  And the irony of the ECB circa 2011 is that they’d prefer the collapse of the euro system, or the monetization of potentially worthless debt, to a more moderate program of targeting modestly higher NGDP growth.

Again, I’m not saying my proposal would definitely work, but surely there’s no excuse for undershooting your inflation target at a time like this.  The ECB seems determined to hold on to its credibility just as tightly as the Fed held on to its gold reserves.  And by doing so it may end up losing everything.

PS.  My unusual policy views puts me in the odd position of agreeing with both Krugman and Tyler Cowen.  Too much debt or too much disinflation?  Maybe both guys are right.

PPS.  I’m very grateful for the nice compliment from Tyler, but in all honesty I think both he and Krugman are much better at euro-analysis.  I’m like the hedgehog who knows one big thing—falling NGDP is very dangerous during a debt crisis.  Yes, it’s a rather important thing, but the euro crisis is very complex, and when I read others I am constantly reminded how much of it is beyond my comprehension.  That’s why I’m sticking to the “more NGDP” mantra, it’s the only advice I feel confident about offering.