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.



15 Responses to “Bob Murphy on the deflationary effects of devaluation fears”

  1. Gravatar of msgkings msgkings
    26. June 2017 at 07:31

    Off topic, but this was interesting. When even left leaning places like FiveThirtyEight start questioning raising the minimum wage (too much) we may be at an interesting moment.

    I’d be curious to hear your thoughts.

  2. Gravatar of Colin W Colin W
    26. June 2017 at 08:41

    I think one potential reason for the variation across devaluation news shocks that Josh mentions is the probability assigned to a devaluation. If the policy news reveals that devaulation is highly likely versus revealing only a small increase in the possibility of a devaluation (say from 1% to 5%), these should have very different effects on expectations about the future price level. Unfortunately, I don’t have any empirical examples to support this hypothesis as the 1890s were all the latter type of shock.

  3. Gravatar of Jerry Brown Jerry Brown
    26. June 2017 at 10:25

    What I take from Bob Murphy’s question is that it shows that the government should not promise to exchange its currency for anything limited such as gold. It is an explanation as to why a fiat currency is better.

    Right now the only promise the US gives on a one dollar bill is that you can use it to pay your taxes in the US. And that is enough to give it value to billions of people across the world.

  4. Gravatar of Jerry Brown Jerry Brown
    26. June 2017 at 10:33

    Well, my above comment was not exactly true. The US also promises to accept US dollars in payment of fees, fines, and as payment of private debts as determined through the judicial system for anything enforceable through US law.

  5. Gravatar of ssumner ssumner
    26. June 2017 at 11:00

    msgkings, I’ve predicted that a $15 minimum wage would cause a lot of problems if implemented nationally. I don’t have as strong an opinion about the Seattle area experiment, as their economy is stronger than the US as a whole. I’ll watch to see what happens as it plays out.

    I’m basically opposed to minimum wage laws, preferring the EITC.

    Colin, Yes, that may be important. Keep in mind that if the probability of devaluation is high it tends to cause an immediate crisis, and things break one way or another.

  6. Gravatar of bill bill
    26. June 2017 at 17:16

    Was the mechanism for confiscating gold in 1933 to pay $35 per ounce? That is, it was taken with zero compensation. But it was a forced conversion.

  7. Gravatar of Matthew Waters Matthew Waters
    26. June 2017 at 23:59

    I started trying to think of an “arbitrage-free” model where everyone knows, at some point, that there is a 50% chance in the future of devaluation. The Fed would still convert gold at $20.67 and still have the minimum gold reserve ratio.

    But it’s too tough to game out exactly. If everyone knew devaluation was likely in the future, and the Fed still converted the gold, then the Fed’s ability to convert at $20.67 would be exhausted quickly. A parallel situation could be Soros and others against the Bank of England.

    But in the end, somebody trying to do the Soros trade would make any money. The government confiscated all gold at $20.67. Somebody who made a big, Soros-type bet would have just lost significant transaction costs in the end. Traders probably thought something like that was possible. WWI saw many governments and central banks find ways around the de jure gold standard in order to pay for the war.

    I’m still trying to slog my way through the Midas Paradox. I’m stuck around the 1929 crash right now. So I could be talking a bunch of nonsense since I haven’t gotten to 1933, but that’s how I read it.

    In summary, just because gold will be valued at a higher dollar figure in the future does not mean gold-holders will realize the price difference.

  8. Gravatar of bill bill
    27. June 2017 at 12:14

    I found some sources about the gold confiscation. Wow. People were forced to convert at $20.67 and holding gold was made illegal. That’s pretty bad.

  9. Gravatar of Potpourri Potpourri
    27. June 2017 at 20:54

    […] If I said this post by Scott Sumner proves I am the Bobby Flay of economics blogging, would anybody get the […]

  10. Gravatar of Bob Murphy Bob Murphy
    27. June 2017 at 20:55

    My joy at Scott linking with me approval is counterbalanced only by Jerry Brown’s comment that my analysis confirms the superiority of fiat money.

  11. Gravatar of Bob Murphy Bob Murphy
    27. June 2017 at 20:56

    Gah, “with me” should be “me with.”

  12. Gravatar of Jerry Brown Jerry Brown
    27. June 2017 at 21:48

    Sorry about that Bob, I wasn’t trying to diminish your joy. But your very good comment also happens to point out a reason a government should not promise to exchange currency for something it may not have enough of.
    But don’t be too disappointed- a whole lot more people read and value Scott Sumner’s posts than my random comments.

  13. Gravatar of Mike Freimuth Mike Freimuth
    30. June 2017 at 13:55

    When you say “And suppose that the central bank responded to fears of devaluation by preventing the money stock from falling,” how can they do that if there is a hard peg with convertibility?

  14. Gravatar of ssumner ssumner
    30. June 2017 at 19:10

    Mike, Large central banks can do so by lowering their Gold/Currency ratio.

  15. Gravatar of Mike Freimuth Mike Freimuth
    30. June 2017 at 20:57

    But how, mechanically do they lower it when the public doesn’t want to hold more currency (perhaps because they fear a devaluation)? Wouldn’t any currency they didn’t want to hold just get redeemed for gold?

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