Archive for the Category Gold standard


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


Josh Hendrickson on the Labor Standard of Value

If you asked me to name the five greatest works of macroeconomics during the 20th century, I might produce something like the following list (in chronological order):

1.  Fisher’s Purchasing Power of Money

2.  Friedman and Schwartz’s Monetary History

3.  Friedman’s 1968 AEA Presidential address

4.  The “Lucas Critique” paper

5.  Earl Thompson’s 1982 labor standard of value paper

(BTW, Krugman’s 1998 expectations trap paper might well make the top 10.)

Most economists would replace Thompson’s paper with something like the General Theory by Keynes.  In this post I explained why this 2 page never published paper that looks like something out of the Middle Ages is so important. (Please look at the link; the paper’s formatting is hilarious.)  Thompson’s student David Glasner did some excellent work on this idea in the late 1980s.

Josh Hendrickson has a new Mercatus paper which explains the logic behind the Thompson proposal.  Although Josh’s paper is very clear and well written, I can’t resist adding a few comments, as I fear that the extremely unconventional nature of Thompson’s idea might make it hard for some people to grasp the significance.

Josh starts off with an analogy to a gold standard regime, and then discusses the well-known drawbacks of that approach.  With a gold standard regime, any necessary changes in the real or relative price of gold can only occur through changes in the overall price level (or more importantly NGDP), which can be disruptive to the economy.

Here I’d like to emphasize the importance of the issue of sticky prices.  Adjustments in the overall price level can be costly because many nominal wages and prices tend to be sticky, or slow to change over time.  In contrast, gold prices are very flexible, changing second by second to assure that the gold market stays in equilibrium.  Under a gold standard, the nominal price of gold is fixed, and thus the ability of gold prices to quickly adjust is in a sense “wasted”.  Instead, we ask stickier prices to adjust when the real price of gold needs to change.

When reading Josh’s paper, try to keep sticky wages in the back of your mind.  Whenever the aggregate nominal wage level needs to adjust unexpectedly, some wages will be slow to change, and will be out of equilibrium for a certain period of time.  If there is downward wage inflexibility, especially a reluctance to cut nominal wages, then labor market disequilibrium can persist for years.

Normally, when we think of a government program aimed at fixing a price (gasoline, rents, etc.) we think of a market that is pushed out of equilibrium.  Nominal wage targeting is different.  Under Thompson’s proposed regime, individual nominal wages are still free to change, but monetary policy is adjusted until labor market participants do not want to change the aggregate average nominal wage rate.  In that case, the aggregate average nominal wage should stay at the equilibrium level (although of course individual wages might still occasionally move a bit above or below equilibrium.)

Under our current system, a sudden fall in nominal wage growth actually leaves the aggregate nominal wage too high, as some wages have not yet adjusted downwards.  We’d like to prevent that, by providing enough money so that the aggregate average nominal wage does not need to adjust.

My second comment has to do with the mechanism that Josh discusses:

Suppose that the central bank promised to buy and sell gold on demand at its current market price, but guaranteed that an ounce of gold would buy a fixed quantity of labor, on average. This is a promise to keep an index of nominal wages constant.

This approach is called indirect convertibility, a subject that Bill Woolsey discussed in a series of papers published in the 1990s.  I have a couple brief comments.  First, this sort of scheme need not involve gold at all.  Second it’s essentially a form of “futures targeting”, which is something I’ve done a lot of work on myself.  Indeed, this idea was independently discovered by numerous economists during the 1980s, but Thompson was the first.

If you are having trouble understanding the logic behind the indirect convertibility mechanism for a labor standard, think about the fact that aggregate wage data comes out with a lag, and hence you need to target a future announcement of the wage index.  To assure that monetary policy is set at a position where expected future wages are stable, you need a futures market mechanism where investors could profit any time aggregate wages are expected to move.  Their attempts to profit from wage changes nudge monetary policy back to the stance likely to keep average wages stable.

In addition, the specific proposal discussed by Josh involves a stable wage level, but given political realities it’s more likely the actual target would creep upward at 2% to 3%/year.

Also note that Josh argues that a labor standard is a vastly superior approach for achieving the goals of recent “job guarantee” proposals, put forth by progressives.  I agree.

PS.  I have a new Mercatus Bridge post discussing a WSJ article that called for monetary reform aimed at stable money.

PPS.  My recent post at Econlog on the usefulness of the yield spread got zero comments, which surprised me given all the recent focus on that variable.

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.