Archive for the Category Monetary History


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.

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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:


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.

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.

Monetary policy counterfactuals are tricky

Rajat asked one of his characteristically probing questions, in the previous post:

As you’ve often said with monetary policy, it all depends on the yardstick or counterfactual. With your examples, because you’ve put the focus on interest rates, the reader naturally assumes that the counterfactual is no change in official interest rates. For example, in (1), surely the cut in the Fed Funds rate from 5.25% to 2% was less contractionary than if the Fed did not lower the rate? The money supply may not have risen in 2007-08, but wouldn’t it have fallen if rates were kept at 5.25%, as the market devoured the short-term securities the Fed offered at that yield? I understand that the reduction in official rates was not expansionary in any meaningful sense (ie against a benchmark of ideal monetary policy under inflation or NGDP targeting).

This is probably correct, but I’d argue that it could also be misleading, resulting in too much reassurance that interest rates aren’t that bad an indicator after all.  Rajat’s point is that if the Fed never even began cutting rates, then they would have had to reduce the money supply rather dramatically.  So much so that NGDP would have done even worse than with cut from 5.25% to 2.0%.  So does that mean the interest rate cut was expansionary after all?  Not quite.

Consider the two following hypotheticals:

A.  No change in the base from August 2007 to May 2008, rates fall from 5.25% to 2.0% (actual policy)

B.  The base rises by 5%, while rates move from 5.25% in August 2007 to 5.25% in May 2008.

I would claim that policy B is almost certainly more expansionary.  Rajat might reply that policy B was not an option.  If the monetary base had risen by 5%, then interest rates would have declined even more rapidly than they actually did.

I don’t quite agree, although for any given day I’d agree with that claim.  Thus on any given day, a lower fed funds target requires a larger base than otherwise (at least before IOR was instituted in October 2008).  But that true fact leads many Keynesians to jump to a seemingly similar, but unjustified conclusion.  Many people assume that over a 9-month period a more expansionary monetary policy implies a faster decline in interest rates.

In fact, option B probably was available to the Fed, but only if they moved much more aggressively in the early part of this period and/or if they changed their policy target.  Thus there are two possible ways the Fed might have achieved policy option B:

B1.  Cut rates sharply enough in August 2007 to dramatically boost NGDP growth expectations, and then gradually raise rates enough over the next few months to get them back to 5.25% by May 2008.  In that case, NGDP growth would have held up well, and yet the path of interest rates over that period would have ended up higher than otherwise.

B2.  Adopt a policy of 5% NGDPLT, which would have radically changed expectations, and hence boosted the Wicksellian equilibrium rate.

Rajat might view option B2 as cheating, so let me make a case for option B1.  I’d argue that the Fed did almost exactly what I describe in option B1 during 1967.  Just to set the scene, the economy was slowing sharply during early 1967, and some people worried that we might enter a recession.  The Fed moved quite aggressively, and their move was so successful that over a period of 10 months there was no rate cut at all.

3 month T-bill yields:

January 1967:  4.72%

June 1967:  3.54%

November 1967:  4.73%

So interest rates were basically unchanged over this period, and yet I’d argue that policy was far more expansionary than during August 2007 to May 2008, when rates fell sharply.  The monetary base grew by over 5% in just 10 months, and this allowed the US to avoid recession.

(BTW, in retrospect, a mild recession would have been preferable in 1967, as a way of avoiding the Great Inflation.  Instead, the US left the gold standard in April 1968, Bretton Woods blew up 3 years later, and the rest is history.  But since policymakers didn’t know all of this would occur, the mistake of the 1960s was sort of inevitable—just a question of when.)


In 1967, the expansionary policy early in the year boosted NGDP growth expectations enough so that they could raise rates back up later in the year, and still see robust NGDP growth.  In 1968, interest rates rose still higher, but this was expansionary because the base was also rising briskly.  So you have both rising base velocity (from higher rates) and a rising monetary base.

There’s a grain of truth in Rajat’s comment, but it’s best thought of as applying to a given day, where a lower interest rate implies a faster growth in the money supply, and easier money.  Over a more extended period of time things become much dicier.  Those who focus on interest rates are more likely to be led astray, the longer the period being examined.