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.



14 Responses to “Josh Hendrickson reviews The Midas Paradox”

  1. Gravatar of BJH BJH
    19. June 2017 at 18:25

    Is there an ungated version of the review?

  2. Gravatar of Colin W Colin W
    19. June 2017 at 21:17


    I currently research the effects of devaluation expectations in the 1890s (My name links to my website). Based on what I’ve found, I think your explanation is fairly accurate. Two additional points. First, interestingly enough, for whatever reason, people in the U.S. also held more currency in response to devaluation fears (perhaps because it could be more quickly converted to gold relative to bank deposits and securities); the Commercial and Financial Chronicle even questioned this practice in an article at some point. The overall currency-deposit ratio jumped around a lot as devaluation expectations changed in the U.S. Second, a big factor in driving the initial gold flows/change in gold demand was the presence of currency mismatch on corporate balance sheets due to gold clauses.

  3. Gravatar of Alec Fahrin Alec Fahrin
    20. June 2017 at 04:13

    I’m sure there are some mathematicians or economists who can model this relationship. Doesn’t necessarily mean it will be simple or make logical sense though. Essentially, there are two types of depreciation, or every depreciation is the same (a fall in relative value) but outside factors change its effects?

    Although this question is only vaguely related, I read one of your posts from 2013 about bubbles. I believe the overall theory behind the post was the EMH. Your main point was that many asset bubbles are less “bubbles” in the sense of compounding price increases, and more the formation of valleys leading to the perception of mountains rising. It is not the price increases that create “bubbles”‘, but the sharp crashes in asset prices. That’s displayed by the fact the value of almost every asset class in the world is today above the peaks of their bubbles. Were 1929, 2000, and 2008 bubbles? I am not actually sure the crashes were destined or “necessary” in the first place.

    It seems to me that this theory (or explanation) is connected to the gold price movements during the Great Depression, and it might help explain the two opposing results of depreciation. When investors look at the short-term picture in an economic slowdown, the results are self-fulfilling deflation. When investors begin to look at the long-term picture again, the results are inflationary.

  4. Gravatar of LK Beland LK Beland
    20. June 2017 at 09:23

    A bit off-topic, sorry:

    A major critique of NGDP targeting is that it may lead to inflation instabilities.

    In some sense, inflation targeting mirrors this problem: it leads to NGDP growth instability.

    A possible solution could be to make Fed policy a function of both inflation and ngdp growth.

    The Fed would favor tight monetary policy when inflation and inflation expectations are larger than, say, 2.5%. And it would favor loose policy policy when NGDP growth and growth expectations are under, say, 3.0%.

    The inflation target would work as a soft cap and the NGDP target would work as a soft floor.

    We can imagine a few scenarios:
    1- High NGDP growth (say 4%) and low inflation (say 1%). Then monetary policy should be neutral.
    2- High NGDP growth (say 4%) and high inflation (say 3%). Then monetary policy should be tightened.
    3- Low NGDP growth (say 2.5%) and low inflation (say 1.5%). Then monetary policy should be loosened.
    4- Low NGDP growth (say 2.5%) and high inflation (say 3%). Then policy should be neutral.

    The further inflation and inflation expectations are above it’s soft cap, the further the Fed’s reaction function should be tight. The further NGDP and NGDP expectation are under it’s soft floor, the further the Fed’s reaction function should be loose.

    I guess that this is a similar idea to the Taylor rule, but where the output gap is replaced by ngdp growth and the reaction function on inflation and ngdp are not symmetric (there would be no penalties to low inflation or high NGDP).

  5. Gravatar of LK Beland LK Beland
    20. June 2017 at 09:35

    In such a system (soft ceiling for inflation and soft floor for ngdp growth), the economy would react to negative supply shocks by letting ngdp growth fall a bit (i.e. leading to a modest rise in unemployment and delinquent debt) and by letting inflation rise a bit. But the soft ceiling and floor would protect against spiraling unemployment and/or inflation.

    A positive supply shock would lead to a mix of low inflation and high ngdp growth.

    It seems pretty reasonable to me.

  6. Gravatar of ssumner ssumner
    20. June 2017 at 13:03

    BJH, I’m not sure.

    Colin, I noticed that too. I attributed it to the fact that devaluation expectations were highly correlated with banking panics. Is that your view?

    Alec, That view was based on the fact that people who invested at times like 1929 tended to do well, if they held stocks for a very long period.

    LK, NGDP instability is a problem, inflation instability is not (as long as NGDP is stable.)

  7. Gravatar of Colin W Colin W
    20. June 2017 at 13:45

    Scott, I think deflation and banking instability can explain at least some of the currency as well as gold hoarding. The deflation obviously makes currency more attractive relative to other assets, but also helped create the banking instability by leading to more loan defaults, leading to bank solvency issues that pushed currency demand even higher.

    I tend to think the importance of the banking holiday in early 1933 and Roosevelt’s anti-hoarding policies, which restored faith in the banking system, in helping the Roosevelt devaluation be expansionary (at least initially) can’t be overlooked.

    Overall though, I think the most important factor in explaining the difference between devaluations and devaluation expectations is that the actual devaluation was inflationary but devaluation expectations without a devaluation create deflation.

  8. Gravatar of Benjamin Cole Benjamin Cole
    20. June 2017 at 20:31

    Side note:

    There is a “buying frenzy” in housing in Seoul, right on the border with the North.

    The Korean stock market is up 20.9% YOY and 16.3% YTD.

    The N. Korean leadership looks perfectly loathsome.

    The S. Koreans are very deeply unconcerned.

  9. Gravatar of Scott Sumner Scott Sumner
    21. June 2017 at 05:29

    Colin, Good points.

  10. Gravatar of TravisV TravisV
    21. June 2017 at 14:09

    Must-read by Bryan Caplan:

    “Build, Baby, Build”

  11. Gravatar of Vladimir Vladimir
    22. June 2017 at 13:29

    I was just checking if your book was on Scribd and sure enough it’s there, right next to another book….

  12. Gravatar of Bob Murphy Bob Murphy
    23. June 2017 at 16:18


    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?

  13. Gravatar of Scott Sumner Scott Sumner
    23. June 2017 at 17:23

    Bob, Maybe, that does make sense. But the number of dollars was not falling. Perhaps it was fear of banking instability that led to hoarding of cash, and this prevented the fall in the stock of currency. So your argument might be right on a ceteris paribus basis, but in this case ceteris was not paribus.

    Good comment.

  14. Gravatar of Bob Murphy Bob Murphy
    24. June 2017 at 18:17


    Well, hold on a second. In my exposition I didn’t say currency specifically, but I just said “dollars.” So certainly the total quantity of dollars held by the public fell during the period in question, if we mean M1.

    For example, suppose a guy originally has $100 in actual currency, and $900 in his checking account, when he is sure that the US government will forever redeem dollars for gold at $20.67.

    Then, he is shocked to realize that maybe next year, they will devalue. So he decides to rebalance, and wants to reduce his holdings of dollars from by $206.70, in order to hold 10 more ounces of gold. Absent anything that would change his desire for currency vs. demand deposits, presumably he would hold his new amount of $793.30 with something like $80 in currency and the rest in his checking account. Right?

    And so back to your response: Right, if the actual amount of currency held by the public went up, then I would argue it was because of the banking fears laid on top of the mechanism I described.

    Out of curiosity, did the amount of gold held by the US government go up or down during this period when the private sector “hoarded gold”? If it went up (which it seems you are saying, if the total quantity of outstanding currency went up?) then how did the public bulk up on gold holdings also? Did gold flow in from abroad?

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