Archive for the Category Monetary History

 
 

Hu McCulloch on the interwar gold standard

The interwar gold standard is one of the most complex and interesting case studies in all of macroeconomics.  I’ve devoted much of my life to studying this issue.  It is difficult to wade through all the complexities without eventually getting off course, focusing on the wrong issues and misinterpreting key facts.  I’m pleased to say that Hu McCulloch’s brilliant new essay at Alt-M is one of the very best descriptions of this period that I have ever read.  I agree with well over 90% of his judgments, including all of the key points.  Here I’ll focus on a few small points where I disagree.

McCulloch argues that the fundamental problem was that European gold demand plunged during WWI, as countries sold off gold and printed money to finance the war.  This sharply reduced the value of gold, which meant a higher price level in countries (such as the US) still on the gold standard.  Furthermore, it was almost inevitable that once the international gold standard got back on its feet, the value of gold would gradually return to its prewar level.  This would mean substantial deflation in countries such as the US and the UK.  McCulloch illustrates this idea with a graph:

Screen Shot 2018-08-23 at 12.01.47 PMMcCulloch cites Clark Johnson and Doug Irwin, who showed that the adjustment process was made more unstable by the big surge in French gold demand in the late 1920s and early 1930s.  He suggests that, (assuming that we stayed with gold) the best feasible outcome was a more gradual deflation over many years, until the global price level got back on track.

That’s a perfectly valid way of looking at the picture, and indeed is one of the plausible counterfactuals that I discuss in my own book on the Depression.  But I do slightly quibble with this statement:

However, given that the U.S. had a fixed exchange rate relative to gold and no control over Europe’s misguided policies, it was stuck with importing the global gold deflation — regardless of its own domestic monetary policies. The debt/deflation problem undoubtedly aggravated the Depression and led to bank failures, which in turn increased the currency/deposit ratio and compounded the situation. However, a substantial portion of the fall in the U.S. nominal money stock was to be expected as a result of the inevitable deflation — and therefore was the product, rather than the primary cause, of the deflation. The anti-competitive policies of the Hoover years and FDR’s New Deal (Rothbard 1963, Ohanian 2009) surely aggravated and prolonged the Depression, but were not the ultimate cause.

He’s right about the banking problems, and also about the New Deal, but I believe he lets the Fed (and Federal government more broadly) off the hook a bit too easily.  Here are a few points to keep in mind:

1.   The Fed was created partly because the US no longer wanted a “classical gold standard” where the government played no role in preventing crises.  The Fed did in fact exercise countercyclical policies during the 1920s. (Whether effectively is a complicated question.)

2.  The US had enormous gold reserves in 1929, nearly 40% of the global total.

3.  Legal gold reserve ratios could and should be adjusted during a crisis, and indeed Hoover did get Congress to ease the Fed’s gold requirements during early 1932.

4.  When the US left the gold standard during 1933, it still had by far the world’s largest gold reserves.  I seem to recall that Richard Timberlake once said something to the effect that there’s no shame in losing the gold standard after a valiant effort, what’s shameful is not even trying to stabilize the economy by using “emergency” gold reserves, before completely abandoning the system. When the US left gold in 1933, we still had by far the world’s largest gold reserves.

As an analogy, if in 1912 there was a regulation that all cruise ships should have 20 lifeboats on deck, that does not mean that the lifeboats should remain on deck after hitting an iceberg.  Later on, McCulloch indicates that he does understand this problem:

Unfortunately, however, there was often a misguided assumption that central banks (and private banks) should suspend redemptions whenever the legal reserve requirement was not met. This gave them an incentive to hold a substantial amount of excess, or “free,” reserves over and above the legal requirement. Instead, it should have been understood that a bank is obligated to meet its demand liabilities, so long as it has any reserves at all, and that a “reserve requirement” means that it may extend or renew credit to the government and/or the private sector only if it has reserves in excess of the “required” level.

At a minimum, the Fed should have been far more aggressive in doing whatever it took to engineer a gradual deflation after 1926, say 2%/year, rather than allow double-digit deflation after 1929.  I believe the Fed had enough resources to do this, even singlehandedly.  If you are skeptical of this claim, keep in mind the following facts:

1. Fed policy during the first year of the Depression (October 1929-October 1930) was extremely tight.  The gold reserve ratio rose sharply at the same time that France and the UK were also increasing their gold ratios.  This was the proximate cause of the first year of the Depression.  An expansionary Fed policy would have made the 1930 slump much milder.

2.  More importantly, the really big increases in gold demand during the early 1930s came from four sources, three of which were endogenous—caused by the Depression itself.  The one exogenous factor was France’s decision to raise its gold ratio.  One endogenous cause was the extra gold needed to back base money created during the banking crises that began in October 1930.  Without a deep depression, the banking crises might never have occurred, and certainly would have been far milder.  Second, many gold bloc central banks accumulated large gold reserves partly in consequence of the Depression itself.  Indeed even part of France’s increase in gold hoarding was motivated by the Depression.  Thus it rapidly replaced dollar and pound reserves with gold after the UK left the gold standard in September 1931, and people began to fear the US would also eventually devalue.  Third, private gold hoarding increased strongly after 1930, once people correctly began to see that various countries were likely to eventually devalue.  All three of these causes of sharply higher gold demand were entirely endogenous, and largely explain why things got worse so dramatically after 1929.

Think in terms of the butterfly effect in chaos theory.  A modestly more expansionary Fed policy in 1930 could have prevented much of the gold hoarding related to panicky investors fearing devaluation, panicky bank depositors fearing bank failures and panicky governments fearing their paper forex reserves would be devalued.  I believe the Fed could have engineered a soft landing, where prices fell at a gradual pace, as European nations gradually rebuilt the international gold standard.

Having said all of that, there’s a good argument against the views I just expressed.  This policy regime would have required a high level of wisdom by the central bank.  But if central banks were that wise, there would be no point in having the gold standard in the first place.  You’d just have fiat money, and then have them target the price level.  Furthermore, if the wise policy I sketched began well into the Depression then it would have been increasingly difficult to implement, increasingly likely to lead to a run on the dollar where the US ran out of gold.  Thus it would have been easier to implement in 1930 than 1931, and easier to do in 1931 than 1932.  So there a lot of truth in McCulloch’s claim that given the institutional set-up of this period, the disruption to the gold standard caused by WWI was the root cause of the big interwar deflation.  Certainly Friedman and Schwartz gave too little attention to this problem.

I would also slightly quibble with this:

H. Clark Johnson views the non-monetary demand for gold as a destabilizing factor during the 1920s and points a particularly accusatory finger at India (pp. 46-8). However, the non-monetary demand for gold actually stabilizes prices under a gold standard, since it will reduce the inflation that occurs when monetary demand is reduced (as during the early 1920s), and its reversal will mitigate the deflation that occurs when monetary demand has increased (as at the end of the 1920s and early 1930s).

That’s generally true, and was true in 1930, when the Depression raised the value of gold and reduced private gold demand.  Less private gold demand is stabilizing during a depression.  But private gold demand began rising sharply after mid-1931, and in several other gold hoarding episodes right through 1933.  These bouts of private gold hoarding were caused by fear of devaluation, and this prevented the normal stabilizing properties of the gold standard from having their usual effect.  Although I have not studied the mid-1890s, I believe something similar occurred when silver agitation created fears that the US might abandon gold.

My third quibble has to do with the conclusion, where McCulloch makes a few brief comments about the Great Recession.  He does not place enough emphasis on the role of tight money at the Fed, which drove NGDP sharply lower during 2008-09.

But these are small points.  If you want a quick explanation of what went wrong during the interwar period, read McCulloch’s essay.  If this whets your appetite and you want a more complete explanation . . . well you know where to look:

Screen Shot 2018-08-23 at 12.53.47 PMHT: John Hall

 

Inflation before the oil shock

Tyler Cowen recently linked to an interesting William Fischel paper from 2016:

In the 1970s, unprecedented peacetime inflation, touched off by the oil cartel OPEC, combined with longstanding federal tax privileges to transform owner-occupied homes into growth stocks. The inability to insure their homes’ newfound value converted homeowners into “homevoters,” whose local political behavior focused on preventing development that might devalue their homes. Homevoters seized on the nascent national environmental movement, epitomized by Earth Day, and modified its agenda to serve local demands, thereby eroding the power of the prodevelopment coalition called the “growth machine.” The post-1970 shift in the American economy from industrial employment to knowledge-based services rewarded college graduates and regions that specialized in software and finance. Residents of suburbs in the larger urban areas of the Northeast and West Coast used existing zoning and new environmental leverage to protect the growth rate of their home values. The regional spread of these regulations has slowed the growth of the economy and perpetuated regional income inequalities. I argue that the most promising way to modify this trend is to reduce federal tax subsidies to homeownership.

1.  Consider it done.  The 2017 tax bill will lead to 60% fewer people using the mortgage interest deduction.  That didn’t take long!  Seriously, I do think this reform will help, but we should not expect miracles.  So far it doesn’t seem to have dramatically slowed the rate of appreciation in home prices, although it’s plausible that the increase would have been a bit faster without the tax change.

2.  The environmental movement did have some major successes, such as cutting air and water pollution.  But the requirement for “environmental impact statements” now seems like a major mistake, and indeed might actually hurt the environment by making it harder to build in major cities.

3.  Not to get too picky, but the idea that OPEC touched off the Great Inflation is a myth.  Here’s inflation before the oil shock of October 1973:

Screen Shot 2018-08-08 at 12.52.30 PM

During the early 1960s, inflation averaged a bit over 1%/year.  Monetary stimulus beginning in the mid-1960s pushed the rate up to 6% by the end of the decade.  A slightly tighter monetary policy led to a very small recession, and pushed inflation down to 4.3%.  Price controls then pushed (measured) inflation down to 3% in 1972.  But those controls were used by Nixon as cover to pump up NGDP growth to 9% right before the 1972 election.  By the third quarter of 1973, year over year NGDP growth was running at over 11%, and 12-month CPI inflation was up to 7.4%.  And this is all before the first OPEC oil shock.  It was a demand-side problem.

BTW, budget deficits also played no role in the Great Inflation, as they were quite modest during this period.  If budget deficits caused inflation, by 2019 we’d be well on our way to hyperinflation.  Overall, the Great Inflation was almost 100% monetary policy, even as year-to-year volatility was impacted by oil prices (after October 1973).

Despite these nitpicks, the Fischel abstract sounds basically correct to me—it’s a good way to frame the housing problem.

 

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.

Post-modern recessions

Classical recessions were often caused by shocks that reduced the natural rate of interest.  As market interest rates fell (there was no Fed), the demand for gold increased.  Because gold was the medium of account, this was a negative demand shock.

Modern recessions occurred because the Fed struggled to control inflation, as we gradually moved to a fiat money system after the Depression.  Inflation would rise too high, and this would cause the Fed to tighten.

I recall that Paul Krugman once did a post suggesting that the most recent recessions were not caused by the Fed, but rather were caused by factors such as bubbles and investment/financial instability.  The recessions of 1991, and especially 2001 and 2008, were not preceded by particularly high inflation expectations, which were well anchored by Taylor Rule-type policies. Thus these recent recessions (in his view) were not triggered by tight money policies aimed at reducing inflation, as had been the case in 1982, 1980, 1974, 1970, etc.

I suspect that the post-modern recessions are indeed a bit different, but not quite in the way that Krugman suggests.  Although I don’t think interest rates are a useful way of thinking about monetary policy, I’ll use them in this post.  (If I just talked about slowdowns in NGDP growth it would not convince any Keynesians.)

In the New Keynesian model, a tight money policy occurs when the Fed’s target rate is set above the natural rate of interest. In 1981, that meant the Fed had to raise its interest rate target sharply, to make sure that nominal interest rates rose well above the already high inflation expectations, high enough to sharply reduce aggregate demand.  In contrast, interest rates were cut in 2007, despite a strong economy and low unemployment.  The natural interest rate started falling in 2007 as the real estate sector contracted.

In a deeper sense, however, the post modern recessions are no different than pre-1990 recessions.  They still involve the Fed setting its fed funds target above the natural rate.  The difference is that in recent recessions this has occurred via a fall in the natural rate of interest, whereas in 1981 it occurred through a sharp rise in the market rate of interest.

You might say that we used to have errors of commission, whereas now we have errors of omission.  But that only makes sense if you accept the notion that interest rates represent monetary policy.  But they don’t. Every major macro school of thought suggests that something other than interest rates represent the stance of monetary policy.  Monetarists cite M2, Mundell might cite exchange rates, New Keynesians cite the spread between market rates and the natural rate.  No competent economist believes that market interest rates represent the stance of monetary policy.

Thus in the end, Krugman’s distinction doesn’t really make any sense.  It’s always the same—recessions are triggered by the Fed setting market interest rates above the natural interest rate.  Since 1982, the natural rate of interest (real and nominal) has been trending downwards.  This was an unexpected event that very few people forecast.  (I certainly did not.) The Fed would occasionally end up behind the curve in terms of noticing the decline in the natural rate.  The FOMC would only realize its error when NGDP growth fell well below their desired rate.  Then they’d try to ease policy, but initially they’d underestimate how much they needed to cut rates in order to get the proper amount of stimulus.  The natural rate was lower than they assumed.  Hence slow recoveries.

My hunch is that we are coming to the end of this long downtrend in the natural rate of interest.  That means that future recessions will be caused by some other type of cognitive error.  That’s also why I expect this to be the longest economic expansion in US history.  But that’s not very impressive when you have such a weak recovery.  Much more impressive would be the longest consecutive streak of boom years.  Now that would Make America Great Again!

Bob Murphy on the deflationary effects of devaluation fears

In a recent post, I quoted from a Josh Hendrickson review of The Midas Paradox, particularly the discussion of the deflationary impact of devaluation fears during the 1930s.  I viewed this as a bit of a puzzle.  It’s no surprise that devaluation expectations would raise the demand for gold, and hence the value of gold.  And since gold was a medium of account, that would be deflationary.  But it would also reduce the demand for currency, which was also a medium of account. So why didn’t it reduce the value of currency?  After all, an actual devaluation would reduce the value of currency.

Bob Murphy has a very interesting explanation in the comment section:

Scott,

Forgive me if I’m just saying the same thing you did, in different vocabulary, but, wouldn’t the following make sense? I don’t see what the mystery here is.

(1) Right now the US government will trade gold for dollars at $20.67 / ounce.

(2) Investors are worried that next year, they will charge people $35 to give them an ounce of gold.

(3) So investors naturally shift out of dollars and into gold. (Just like if you suddenly thought Acme stock would go from $20.67 today to $35 next year, at a time of very low interest rates, you would rebalance your portfolio to buy more Acme stock than you were holding 5 minutes ago.)

(4) Yet since right now the US is still on the gold standard at $20.67, as people try to get rid of dollars and hold more gold, the only way to maintain that rate is for the US Treasury to absorb dollars and release gold from its vaults.

(5) As the total amount of dollars held by the public shrinks, prices in general (quoted in dollars) fall.

Am I missing something?

That may indeed be the solution.  If so, what did I overlook?

1. Perhaps I focused too much on the actual currency stock, which did not tend to fall during these episodes.  But that may be because devaluation fears were associated with banking crises.

2.  So let’s assume that Bob is correct that devaluation fears are deflationary because they reduce the currency stock, ceteris paribus.  In that case, the banking panics that increased currency demand could be viewed as a second deflationary shock, and perhaps the central bank increased the currency stock enough to partially offset this increase in currency demand, but not the initial shock of more demand for gold.

3.  Suppose there had been no banking panics.  And suppose that the central bank responded to fears of devaluation by preventing the money stock from falling. What then?  In that case, the shock might not have been deflationary.  But that’s not because devaluation fears are not deflationary, but rather because the central bank would have taken an expansionary monetary action to offset the private gold hoarding.  Under a gold standard, an outflow of gold into private hoards should normally result in a smaller currency stock, keeping the ratio of gold to currency stable.  So if the central bank refuses to let the currency stock fall, that’s an expansionary monetary policy.  It wouldn’t mean the devaluation fears were not deflationary, ceteris paribus, but rather that the deflationary impact of one shock was being offset by an expansionary policy elsewhere.

4.  Bob mentions that the M1 money supply did fall during the banking panics, which simplifies things, but I prefer to do all the analysis through the currency stock (or monetary base), which in this case made things more complicated for me.

5.  How about from a finance perspective?  At first glance it seems weird that people would hold both gold and currency, even though the expected return on gold was higher during a period of devaluation fears.  But gold and currency may not be perfect substitutes, and as the stock of currency declines the marginal liquidity services it provides increase relative to gold.  Or perhaps those who feared devaluation correctly anticipated that the government would confiscate domestic gold hoards.

I am still a bit confused by the evidence that markets respond differently when devaluation (or revaluation) seems imminent.  The markets were not adversely affected by the gold crisis in early March 1933, anticipating that FDR would soon do something dramatic.  And they were adversely affected by fears of revaluation during the “gold panic” of 1937.  So there are still some unresolved puzzles in my mind.  But Bob’s explanation for the basic pattern of the early 1930s seems better than anything else I’ve seen.

PS.  I am currently in San Diego, at the Western Economic Association conference. Blogging will be sporadic for most of the summer.