The Casselian-Mundelian view: An overvalued dollar caused the Great Recession

This is CNBC’s legendary Larry Kudlow in a comment to my previous post:

My friend Bob Mundell believes a massively over-valued dollar (ie, overly tight monetary policy) was proximate cause of financial freeze/meltdown.

Larry’s comment reminded me of my long held view that we have to see the Great Recession in an international perspective. Hence, even though I generally agree on the Hetzel-Sumner view of the cause – monetary tightening – of the Great Recession I think Bob Hetzel and Scott Sumner’s take on the causes of the Great Recession is too US centric. Said in another way I always wanted to stress the importance of the international monetary transmission mechanism. In that sense I am probably rather Mundellian – or what used to be called the monetary theory of the balance of payments or international monetarism.

Overall, it is my view that we should think of the global economy as operating on a dollar standard in the same way as we in the 1920s going into the Great Depression had a gold standard. Therefore, in the same way as Gustav Cassel and Ralph Hawtrey saw the Great Depression as result of gold hoarding we should think of the causes of the Great Recession as being a result of dollar hoarding.

In that sense I agree with Bob Mundell – the meltdown was caused by the sharp appreciation of the dollar in 2008 and the crisis only started to ease once the Federal Reserve started to provide dollar liquidity to the global markets going into 2009.

I have earlier written about how I believe international monetary disorder and policy mistakes turned the crisis into a global crisis. This is what I wrote on the topic back in May 2012:

In 2008 when the crisis hit we saw a massive tightening of monetary conditions in the US. The monetary contraction was a result of a sharp rise in money (dollar!) demand and as the Federal Reserve failed to increase the money supply we saw a sharp drop in money-velocity and hence in nominal (and real) GDP. Hence, in the US the drop in NGDP was not primarily driven by a contraction in the money supply, but rather by a drop in velocity.

The European story is quite different. In Europe the money demand also increased sharply, but it was not primarily the demand for euros, which increased, but rather the demand for US dollars. In fact I would argue that the monetary contraction in the US to a large extent was a result of European demand for dollars. As a result the euro zone did not see the same kind of contraction in money (euro) velocity as the US. On the other hand the money supply contracted somewhat more in the euro zone than in the US. Hence, the NGDP contraction in the US was caused by a contraction in velocity, but in the euro zone the NGDP contraction was caused by both a contraction in velocity and in the money supply, reflecting a much less aggressive response by the ECB than by the Federal Reserve.

To some extent one can say that the US economy was extraordinarily hard hit because the US dollar is the global reserve currency. As a result global demand for dollar spiked in 2008, which caused the drop in velocity (and a sharp appreciation of the dollar in late 2008).

In fact I believe that two factors are at the centre of the international transmission of the crisis in 2008-9.

First, it is key to what extent a country’s currency is considered as a safe haven or not. The dollar as the ultimate reserve currency of the world was the ultimate safe haven currency (and still is) – as gold was during the Great Depression. Few other currencies have a similar status, but the Swiss franc and the Japanese yen have a status that to some extent resembles that of the dollar. These currencies also appreciated at the onset of the crisis.

Second, it is completely key how monetary policy responded to the change in money demand. The Fed failed to increase the money supply enough to meet the increase in the dollar demand (among other things because of the failure of the primary dealer system). On the other hand the Swiss central bank (SNB) was much more successful in responding to the sharp increase in demand for Swiss francs – lately by introducing a very effective floor for EUR/CHF at 1.20. This means that any increase in demand for Swiss francs will be met by an equally large increase in the Swiss money supply. Had the Fed implemented a similar policy and for example announced in September 2008 that it would not allow the dollar to strengthen until US NGDP had stopped contracting then the crisis would have been much smaller and would long have been over…

…I hope to have demonstrated above that the increase in dollar demand in 2008 not only hit the US economy but also led to a monetary contraction in especially Europe. Not because of an increased demand for euros, lats or rubles, but because central banks tightened monetary policy either directly or indirectly to “manage” the weakening of their currencies. Or because they could not ease monetary policy as members of the euro zone. In the case of the ECB the strict inflation targeting regime let the ECB to fail to differentiate between supply and demand shocks which undoubtedly have made things a lot worse.

So there you go – you have to see the crisis in an international monetary perspective and the Fed could have avoided the crisis if it had acted to ensure that the dollar did not become significantly “overvalued” in 2008. So yes, I am as much a Mundellian (hence a Casselian) as a Sumnerian-Hetzelian when it comes to explaining the Great Recession. A lot of my blog posts on monetary policy in small-open economies and currency competition (and why it is good) reflect these views as does my advocacy for what I have termed an Export Price Norm in commodity exporting countries. Irving Fisher’s idea of a Compensated Dollar Plan has also inspired me in this direction.

That said, the dollar should be seen as an indicator or monetary policy tightness in both the US and globally. The dollar could be a policy instrument (or rather an intermediate target), but it is not presently a policy instrument and in my view it would be catastrophic for the Fed to peg the dollar (for example to the gold price).

Unlike Bob Mundell I am very skeptical about fixed exchange rate regimes (in all its forms – including currency unions and the gold standard). However, I do think it can be useful for particularly small-open economies to use the exchange rate as a policy instrument rather than interest rates. Here I think the policies of particularly the Czech, the Swiss and the Singaporean central banks should serve as inspiration.

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Vince Cable gives me hope

It is very easy to get frustrated about the discussion of monetary policy in today’s world. However, this morning we got something to cheer about as Vince Cable British Minister for Business, Innovation and Skills gave a speech on the UK recovery in the 1930s and the parallels to today’s crisis at the think tank Centre Forum. The entire speech is very uplifting.

Here is Cable:

“you learn far more about our recovery in the 1930s from looking at monetary conditions that you can from examining fiscal policy.”

Yes, yes, yes! We should stop wrangling about fiscal policy. What brought Britain out of the Great Depression was the decision to give up the gold standard in 1931 and what will bring the UK economy out of this crisis is monetary easing. Fiscal policy in that regard is basically irrelevant. Luckily Vince Cable seems to comprehend that – as do Chancellor of the Exchequer George Osborn. Bank of England Governor Mervyn King might also (finally) get it.  

Back to Cable’s speech:

“… It is worth recalling just how brutal were the first dozen years after the First World War.  Britain attempted to return to its pre War gold level, which meant chronic deflation to bring us back with world prices (what Southern Europe is attempting today).  As a result, the price index which had risen from 100 in 1914 to 250 in 1920, fell to 180 in a couple of years and continued falling all the way below 150 in 1930.”

Yes again! The British economy was struggling to get out of the crisis because of a misguided commitment to the gold standard. Once the gold standard was given up it was recovery time. And luckily Vince Cable fully well knows that monetary easing also would do the trick today.

And he knows that fiscal easing is not the important thing – monetary policy will do the job:

“without a noticeable relaxation in fiscal policy, the economy surged into strong growth which was becoming apparent mid 1933. As I said earlier the obvious explanation was a sharp loosening of monetary policy”

Can it get much more Market Monetarist than that? Yes in fact it can:

“What tools does the Government have? The first is continued use of monetary policy, and stronger communication of the policy aim it is meant to achieve – robust recovery in money spending and GDP. “

Cable calls for an NGDP targeting regime!

And even better Cable seems to want a Market Monetarist as the next Bank of England Governor – or at least somebody in favour of NGDP targeting:

“I am sure that all the candidates to take over from Mervyn King are thinking very hard about how best to do this [a robust recovery in money spending and GDP].”

In 1931 the British government showed the way. I hope that today’s British government will show the same kind of resolve. Vince Cable gives me a lot of hope to be optimistic about that.

Thank you Vince, you’ve made my day!

Danish and Norwegian monetary policy failure in 1920s – lessons for today

History is fully of examples of massive monetary policy failure and today’s policy makers can learn a lot from studying these events and no one is better to learn from than Swedish monetary guru Gustav Cassel. In the 1920s Cassel tried – unfortunately without luck – to advise Danish and Norwegian policy makers from making a massive monetary policy mistake.

After the First World War policy makers across Europe wanted to return to the gold standard and in many countries it became official policy to return to the pre-war gold parity despite massive inflation during the war. This was also the case in Denmark and Norway where policy makers decided to return the Norwegian and the Danish krone to the pre-war parity.

The decision to bring back the currencies to the pre-war gold-parity brought massive economic and social hardship to Denmark and Norway in the 1920s and probably also killed of the traditionally strong support for laissez faire capitalism in the two countries. Paradoxically one can say that government failure opened the door for a massive expansion of the role of government in both countries’ economies. No one understood the political dangers of monetary policy failure better than Gustav Cassel.

Here you see the impact of the Price Level (Index 1924=100) of the deflation policies in Denmark and Norway. Sweden did not go back to pre-war gold-parity.

While most of the world was enjoying relatively high growth in the second half of the 1920s the Danish and the Norwegian authorities brought hardship to their nations through a deliberate policy of deflation. As a result both nations saw a sharp rise in unemployment and a steep decline in economic activity. So when anybody tells you about how a country can go through “internal devaluation” please remind them of the Denmark and Norway in the 1920s. The polices were hardly successful, but despite the clear negative consequences policy makers and many economists in the Denmark and Norway insisted that it was the right policy to return to the pre-war gold-parity.

Here is what happened to unemployment (%).

Nobody listened to Cassel. As a result both the Danish and the Norwegian economies went into depression in the second half of the 1920s and unemployment skyrocketed. At the same time Finland and Sweden – which did not return to the pre-war gold-partiy – enjoyed strong post-war growth and low unemployment.

Gustav Cassel strongly warned against this policy as he today would have warned against the calls for “internal devaluation” in the euro zone. In 1924 Cassel at a speech in the Student Union in Copenhagen strongly advocated a devaluation of the Danish krone. The Danish central bank was not exactly pleased with Cassel’s message. However, the Danish central bank really had little to fear. Cassel’s message was overshadowed by the popular demand for what was called “Our old, honest krone”.

To force the policy of revaluation and return to the old gold-parity the Danish central bank tightened monetary policy dramatically and the bank’s discount rate was hiked to 7% (this is more or less today’s level for Spanish bond yields). From 1924 to 1924 to 1927 both the Norwegian and the Danish krone were basically doubled in value against gold by deliberate actions of the two Scandinavian nation’s central bank.

The gold-insanity was as widespread in Norway as in Denmark and also here Cassel was a lone voice of sanity. In a speech in Christiania (today’s Oslo) Cassel in November 1923 warned against the foolish idea of returning the Norwegian krone to the pre-war parity. The speech deeply upset Norwegian central bank governor Nicolai Rygg who was present at Cassel’s speech.

After Cassel’s speech Rygg rose and told the audience that the Norwegian krone had been brought back to parity a 100 years before and that it could and should be done again. He said: “We must and we will go back and we will not give up”. Next day the Norwegian Prime Minister Abraham Berge in an public interview gave his full support to Rygg’s statement. It was clear the Norwegian central bank and the Norwegian government were determined to return to the pre-war gold-parity.

This is the impact on the real GDP level of the gold-insanity in Denmark and Norway. Sweden did not suffer from gold-insanity and grew nicely in the 1920s.

The lack of reason among Danish and Norwegian central bankers in the 1920s is a reminder what happens once the “project” – whether the euro or the gold standard – becomes more important than economic reason and it shows that countries will suffer dire economic, social and political consequences when they are forced through “internal devaluation”. In both Denmark and Norway the deflation of the 1920s strengthened the Socialists parties and both the Norwegian and the Danish economies as a consequence moved away from the otherwise successful  laissez faire model. That should be a reminder to any free market oriented commentators, policy makers and economists that a deliberate attempt of forcing countries through internal devaluation is likely to bring more socialism and less free markets. Gustav Cassel knew that – as do the Market Monetarists today.

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My account of these events is based on Richard Lester’s paper “Gold-Parity Depression in Denmark and Norway, 1925-1928″ (Journal of Political Economy, August 1937)

Update: Here is an example that not all German policy makers have studied economic and monetary history.

“The gold standard remains the best available monetary mechanism”

< UPDATE: See an updated version of this piece here >

This is from the Bank of International Settlements third annual report publish in May 1933:

“For the Bank for International Settlements, the year has been an eventful one, during which, while the volume of its ordinary banking business has necessarily been curtailed by the general falling off of international financial transactions and the continued departure from gold of more and more currencies, culminating in the defection of the American dollar, nevertheless the scope of its general activities has steadily broadened in sound directions. The widening of activities, aside from normal growth in developing new contacts, has been the consequence, primarily, of a year replete with international conferences, and, also, of the rapid extension of chaotic conditions in the international monetary system. In view of all the events which have occurred, the Bank’s Board of Directors determined to define the position of the Bank on the fundamental currency problems facing the world and it unanimously expressed the opinion, after due deliberation, that in the last analysis “the gold standard remains the best available monetary mechanism” and that it is consequently desirable to prepare all the necessary measures for its international reestablishment.”

Take a look at the report. The whole thing is outrageous – the world is falling apart and it is written very much as it is all business as usual. More and more countries are leaving the the gold standard and there had been massive bank runs across Europe and a number of countries in Europe had defaulted in 1932 (including Greece and Hungary!) Hitler had just become chancellor in Germany.

And then the report state: “the gold standard remains the best available monetary mechanism”! It makes you wonder how anybody can reach such a conclusion and in hindsight obviously today’s economic historians will say that it was a collective psychosis – central bankers were suffering from some kind of irrational “gold standard mentality” that led them to insanely damaging conclusions, which brought deflation, depression and war to Europe.

I wonder what economic historians will say in 7-8 decades about today’s central bankers.

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Reading recommendation of the day: Lords of Finance – The (Central!) Bankers who Broke the World

Completely unrelated take a look at this story about Bundesbank chief Jens Weidmann.

Meanwhile in Greece you have this and in Hungary you have this.

Draw your own conclusions…

Mises was clueless about the effects of devaluation

Over at the Ludwig von Mises Institute’s website they have reproduced a comment from good old Ludwig von Mises on The Objectives of Currency Devaluation” from Human Action. I love Human Action and there is no doubt Ludwig von Mises was a great economist, but to be frank when it comes to the issue of devaluation he was basically clueless. Sorry guys – his views on this issue are not too impressive.

He mentions five reasons why policy makers might favour “devaluation”:

  • To preserve the height of nominal wage rates or even to create the conditions required for their further increase, while real wage rates should rather sink
  • To make commodity prices, especially the prices of farm products, rise in terms of domestic money or, at least, to check their further drop
  • To favor the debtors at the expense of the creditors
  • To encourage exports and to reduce imports
  • To attract more foreign tourists and to make it more expensive (in terms of domestic money) for the country’s own citizens to visit foreign countries

It might be that this is what motivates policy makers to devalue the currency, but he forgets the real reason why it might make perfectly good sense to allow the currency to weaken. If monetary policy has caused nominal GDP to collapse as was the case during the Great Depression (or during the the Great Recession!) then a policy of devaluation is of course the policy to pursue. Hence, von Mises totally fails to understand the monetary implications of devaluation.

The core of von Mises’ lack to understand of the monetary impact of devaluation is that he – like Rothbard – has a very hard time differentiating between good and bad deflation. George Selgin has a great discussion of von Mises’ view of deflation in his 1990 paper “Ludwig von Mises and the Case for Gold”. George goes out of the way to explain that von Mises really did understand the difference between good and bad deflation and that given his views he should really have supported a monetary policy regime (rather than the gold standard) that ensures stabilisation of nominal spending (M*V). The paradox is of course that you can interpret von Mises in this way, but why would he then be so outspoken against devaluation? In my view von Mises did not fully appreciate that there is good and bad devaluation – so it is no surprise that his modern day internet supporters (of the populist kind…) is so in love with the gold standard. By the way the kind of arguments von Mises has against devaluation and in favour of the gold standard are very similar to the arguments of the most outspoken proponents of the euro today. Yes, the logic of a common currency and the gold standard is exactly the same.

I never understood people who support free markets could also be in favour of fixing the price of the currency – to me that makes absolutely no sense. Milton Friedman of course reached the same conclusion and more important Friedman realised that if you try to peg your currency at an unsustainable level then policy makers will try to pursue interventionist policies to maintain this peg. Capital restrictions and protectionism are the children of pegged exchange rates. Just ask Douglas Irwin.

Further reading:

My recent post on the monetary effects of devaluation: Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons

My posts on Milton Friedman’s view of exchange rate policy:

Milton Friedman on exchange rate policy #1
Milton Friedman on exchange rate policy #2
Milton Friedman on exchange rate policy #3
Milton Friedman on exchange rate policy #4
Milton Friedman on exchange rate policy #5
Milton Friedman on exchange rate policy #6

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UPDATE:  disagrees with me on this issue. Read his comment here. What I regret the most about the comments above is not that I have been a bit too hard on Mises, but rather that my representation of George Selgin’s views on the issue. While I do not think my representation of what George said in his 1999 paper is wrong I do admit that I could have expressed his position more clearly.

By the way I have noticed that when I verbally insult people – living or dead – then it clearly increases the traffic on my blog. So if I wanted to maximize “clicks” I would insult a lot more people. However, I do not like that kind of debate so I promise to try to stay civil and polite – also to people with whom I disagree. Using words like “clueless” in the headline might not live up to that criteria, but I will admit that I have been greatly frustrated by the arguments made by “internet Austrians” recently (And once again I am not talking about what we could call the GMU Austrians…).

Guest blog: Tyler Cowen is wrong about gold (By Blake Johnson)

In a recent post I commented on Tyler Cowen’s reservations about the gold standard on his excellent blog Marginal Revolution. In my comment I invited to dialogue between Market Monetarists and gold standard proponents and to a general discussion of commodity standards. I am happy that Blake Johnson has answered my call and written a today’s guest blog in which he discusses Tyler’s reservations about the gold standard.

Obviously I do not agree with everything that my guest bloggers write and that is also the case with Blake’s excellent guest blog. However, I think Blake is making some very valid points about the gold standard and commodity standards and I think that it is important that we continue to discuss the validity of different monetary institutions – including commodity based monetary systems – even though I would not “push the button” if I had the option to reintroduce the gold standard (I am indirectly quoting Tyler here).

Blake, thank you very much for contributing to my blog and I look forward to have you back another time.

Lars Christensen

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Guest blog: Tyler Cowen is wrong about gold

By Blake Johnson

I have been reading Marginal Revolution for several years now, and genuinely find it to be one of the more interesting and insightful blogs out there. Tyler Cowen’s prolific blogging covers a massive range of topics, and he is so well read that he has something interesting to say about almost anything.

That is why I was surprised when I saw Tyler’s most recent post on the gold standard. I think Tyler makes some claims based on some puzzling assumptions. I’d like to respond here to Cowen’s criticism of the gold standard, as well as one or two of Lars’ points in his own response to Cowen.

“The most fundamental argument against a gold standard is that when the relative price of gold is go up, that creates deflationary pressures on the general price level, thereby harming output and employment.  There is also the potential for radically high inflation through gold, though today that seems like less a problem than it was in the seventeenth century.”

I am surprised that Cowen would call this the most fundamental argument against the gold standard. First, regular readers of the Market Monetarist are likely very familiar with Selgin’s excellent piece “Less than Zero” which Lars is very fond of. There is plenty of evidence that suggests that there is nothing necessarily harmful about deflation. Cowen’s blanket statement of the harmful effects of deflation neglects the fact that it matters very much why the price level is falling/the real price of gold is going up. The real price of gold could increase for many reasons.

If the deflation is the result of a monetary disequilibrium, i.e. an excess demand for money, then it will indeed have the kind of negative consequences Cowen suggests. However, the purchasing power of gold (PPG) will also increase as the rest of the economy becomes more productive. An ounce of gold will purchase more goods if per unit costs of other goods are falling from technological improvements. This kind of deflation, far from being harmful, is actually the most efficient way for the price system to convey information about the relative scarcity of goods.

Cowen’s claim likely refers to the deflation that turned what may have been a very mild recession in the late 1920’s into the Great Depression. The question then is whether or not this deflation was a necessary result of the gold standard. Douglas Irwin’s recent paper “Did France cause the Great Depression” suggests that the deflation from 1928-1932 was largely the result of the actions of the US and French central banks, namely that they sterilized gold inflows and allowed their cover ratios to balloon to ludicrous levels. Thus, central bankers were not “playing by the rules” of the gold standard.

Personally, I see this more as an indictment of central bank policy than of the gold standard. Peter Temin has claimed that the asymmetry in the ability of central banks to interfere with the price specie flow mechanism was the fundamental flaw in the inter-war gold standard. Central banks that wanted to inflate were eventually constrained by the process of adverse clearings when they attempted to cause the supply of their particular currency exceed the demand for that currency. However, because they were funded via taxpayer money, they were insulated from the profit motive that generally caused private banks to economize on gold reserves, and refrain from the kind of deflation that would result from allowing your cover ratio to increase as drastically as the US and French central banks did. Indeed, one does not generally hear the claim that private banks will issue too little currency, the fear of those in opposition to private banks issuing currency is often that they will issue currency ad infinitum and destroy the purchasing power of that currency.

I would further point out that if you believe Scott Sumner’s claim that the Fed has failed to supply enough currency, and that there is a monetary disequilibrium at the root of the Great Recession, it seems even more clear that central bankers don’t need the gold standard to help them fail to reach a state of monetary equilibrium. While we obviously haven’t seen anything like the kind of deflation that occurred in the Great Depression, this is partially due to the drastically different inflation expectations between the 1920’s and the 2000’s. The Fed still allowed NGDP to fall well below trend, which I firmly believe has exacerbated the current crisis.

Finally, I would dispute the claim that the gold standard has the potential for “radically high inflation”. First, one has to ask the question, radically high compared to what? If one compares it to the era of fiat currency, the argument seems to fall flat on its face rather quickly. In a study by Rolnick and Weber, they found that the average inflation rate for countries during the gold standard to be somewhere between -0.5% and 1%, while the average inflation rate for fiat standards has been somewhere between 6.5% and 8%. That result is even more striking because Rolnick and Weber found this discrepancy even after throwing out all cases of hyperinflation under fiat standards. Perhaps the most fundamental benefit of a gold run is its property of keeping the long run price level relatively stable.

“Why put your economy at the mercy of these essentially random forces?  I believe the 19th century was a relatively good time to have had a gold standard, but the last twenty years, with their rising commodity prices, would have been an especially bad time.  When it comes to the next twenty years, who knows?”

I think Cowen makes two mistakes here. First, the forces behind a functioning gold standard are not random. They are the forces of supply and demand that seem to work pretty well in basically every other market. Lawrence H. White’s book “The Theory of Monetary Institutions” has an excellent discussion of the response in both the flow market for gold as well as the market for the stock of monetary gold to changes in the PPG. To go over it here in detail would take far too much space.

Second, commodity prices have not been increasing independent of monetary policy; the steady inflation over the last 30 years has had a significant effect on commodity prices. This is rather readily apparent if one looks at a graph of the real price of gold, which is extremely stable and even falling slightly until Nixon closes the Gold Window and ends the Bretton Woods system, at which point it begins fluctuating wildly. Market forces stabilize the purchasing power of the medium of redemption in a commodity standard; this would be true for any commodity standard, it is not something special about gold in particular.

As an aside, in response to Lars question, why gold and not some other commodity or basket of commodities, I would argue that without a low transaction cost medium of redemption the process of adverse clearings that ensures that money supply tends toward equilibrium becomes significantly less efficient. The reason the ANCAP standard, or a multi-commodity standard such as Yeager’s valun standard are not likely to have great success is mainly the problems of redemption (they also have not tracked inflation well since the 1980’s and 1990’s respectively.) I would gladly say that I believe there are many other commodities that a monetary standard could be based upon. C.O. Hardy argued that a clay brick standard would work fairly well if not for the problem of trying to get people to think of bricks as money (and Milton Friedman commented favorably on Hardy’s idea in a 1981 paper.)

“Whether or not there is “enough gold,” and there always will be at some price, the transition to a gold standard still involves the likelihood of major price level shocks, if only because the transition itself involves a repricing of gold.  A gold standard, by the way, is still compatible with plenty of state intervention.”

This is Cowen’s best point in my opinion. There would indeed be some sizable difficulties in returning from a fiat standard to a gold standard. In particular, it would not be fully effective if only one or two countries returned to a commodity standard, it would need to be part of a broader international movement to have the full positive effects of a commodity standard. Further, the parity at which countries return to the commodity standard would need to be better coordinated than the return to the gold standard in the 1920’s, when some countries returned with the currencies overvalued, and others returned with their currencies undervalued.

My main gripe is that Cowen’s claims seemed to be a broad indictment of the gold standard (or commodity standards) in general, rather than on the difficulties of returning to a gold standard today. They are two separate debates, and in my opinion, there is plenty of reason to believe that theoretically the gold standard is the better choice, particularly for lesser-developed countries. Even for countries such as the US with more advanced countries, the record does not seem so rosy. Central banks not only watched over, but we have reason to believe that their actions (or inaction) have been significant factors in the severity of both the Great Depression and the Great Recession.

© Copyright (2012) Blake Johnson

Tyler Cowen on the gold standard

Here is Tyler Cowen on the gold standard:

“The most fundamental argument against a gold standard is that when the relative price of gold is go up, that creates deflationary pressures on the general price level, thereby harming output and employment. There is also the potential for radically high inflation through gold, though today that seems like less a problem than it was in the seventeenth century.

Why put your economy at the mercy of these essentially random forces? I believe the 19th century was a relatively good time to have had a gold standard, but the last twenty years, with their rising commodity prices, would have been an especially bad time. When it comes to the next twenty years, who knows?

Whether or not there is “enough gold,” and there always will be at some price, the transition to a gold standard still involves the likelihood of major price level shocks, if only because the transition itself involves a repricing of gold. A gold standard, by the way, is still compatible with plenty of state intervention.”

I fully agree – I think it would be an extremely bad idea to introduce a gold standard today. That does not mean that the gold standard does not have some merits. It has – the gold standard will for example significantly reduce discretion in monetary policy and I surely prefer rules to discretion in monetary policy. Furthermore, I think that exchange rate based monetary policy also has some merits as it can “circumvent” the financial sector. Monetary policy is not conducted via a credit channel, but via a exchange rate channel – that makes a lot of sense in a situation will a financial crisis.

However, why gold? Why not silver? Or Uranium? Or rather a basket of commodities. Robert Hall has suggested a method that I fundamentally think has a lot of merit – the ANCAP standard, which is a basket of Ammonium Nitrate, Copper, Aluminum and Plywood. Why these commodities? Because as Robert Hall shows they have been relatively highly correlated with the general cost of living. I am not sure that these commodities are the best for a basket – I in fact think it would make more sense to use a even broader basket like the so-called CRB index, but that is not important – the important thing is that the best commodity standard is not one with one commodity (like gold), but rather a number of commodities so to reduce the volatility of the basket.

Furthermore, it makes very little sense to me to keep the exchange rate completely fixed against the the commodity basket. As I have advocated in a number of earlier posts I think a commodity-exchange rates based NGDP targeting regime could make sense for small open economies – and maybe even for large economies. Anyway, the important thing is that we can learn quite a bit from discussing exchange rate and commodity based monetary standards. Therefore, I think the Market Monetarists should engage gold standard proponents in in 2012. We might have more in common than we think.

Now I better stop blogging for this year – the guests will be here in a second and my wife don’t think it is polite to write about monetary theory while we have guests;-)

Happy new year everybody!

November 1932: Hitler, FDR and European central bankers

The headline of most stock markets reports yesterday said something like “Stocks: Worst Thanksgiving Drop Since ’32″. That made me think – what really happened in November 1932?

As is the case this time around European worries dominated the financial headlines back in November 1932. The first of two key events of November 1932 was the German federal elections on November 6 1932. We all know the outcome – Hitler’s National Socialist Germans Workers’ Party (NSDAP) won a landslide victory and got 33.1% of the vote. As the Communist Party won 16.9% the totalitarian parties commanded a firm majority – what at the time was called the “negative majority”. This eventually led to the formation of Hitler’s first cabinet in January 1933.

The second key event of November 1932 of course was the US presidential elections. Two days after the German in elections Franklin D. Roosevelt won the US presidential elections defeating incumbent president Herbert Hoover on November 8 1932. FDR of course in 1933 took the US of the gold standard, but also introduced the catastrophic National Industrial Recovery Act (NIRA).

Going through the New York Times articles of November 1932 I found a short article on the gold standard in which it said the following:

“Governors of Europe’s central banks who met today (November 13 1932) at the Bank of International Settlements expressed the unanimous opinion that the gold standard was the only basis on which the world economic situation could be bettered”

Obviously we today’s know that the failed gold standard was the key reason for the Great Depression and especially European central bankers’ desperate attempt to save the failed monetary regime created the environment in which Hitler and his nazi party was able to win the German elections in November 1932. What would have happened for example if Germany had been given proper debt relief, the European central banks had given up the gold standard and the French central bank had stopped the hoarding of gold?

Had I been a Marxist I would had been extremely depressed today because then I would had believed in historical determinism. Fortunately I think we can learn from history and avoid repeating past mistakes. I hope today’s European central bankers share this view and will learn a bit from the events of November 1932.

If European central bankers this time around decide not to learn from events of 1932 then they might be interested in learning about the dissolution of the Austro-Hungarian currency union in 1919. Then they just have to read this excellent paper by Peter Garber and Michael Spencer.

Germany 1931, Argentina 2001 – Greece 2011?

The events that we are seeing in Greece these days are undoubtedly events that economic historians will study for many years to come. But the similarities to historical crises are striking. I have already in previous posts reminded my readers of the stark similarities with the European – especially the German – debt crisis in 1931. However, one can undoubtedly also learn a lot from studying the Argentine crisis of 2001-2002 and the eventual Argentine default in 2002.

What this crises have in common is the combination of rigid monetary regimes (the gold standard, a currency board and the euro), serious fiscal austerity measures that ultimately leads to the downfall of the government and an international society that is desperately trying to solve the problem, but ultimately see domestic political events makes a rescue impossible – whether it was the Hoover administration and BIS in 1931, the IMF in 2001 or the EU (Germany/France) in 2011. The historical similarities are truly scary.

I have no clue how things will play out in Greece, but Germany 1931 and Argentina 2001 does not give much hope for optimism, but we can at least prepare ourselves for how things might play out by studying history.

I can recommend having a look at this timeline for how the Argentine crisis played out. You can start on page 3 – the Autumn of 2001. This is more or less where we are in Greece today.

Milton Friedman on exchange rate policy #6

Gold standard?

The last remnants of the global gold standard system died when the Bretton Woods agreement collapsed in 1971, but the notion of a global currency system based on a gold standard occasionally pops up in both general and academic debates, especially in the USA.

Friedman was never any great proponent of the gold standard or other goods-based currency systems. He sees a gold standard system as neither possible nor desirable in a today’s world: undesirable because its reintroduction would imply enormous costs in connection with purchasing gold, and not possible because the “mythology” that surrounded the gold standard in the nineteenth century no longer exists. In the nineteenth century everyone expected changes in the money supply to be determined by developments in the price of gold, and that money and gold were close substitutes. Today, we expect the central bank – not gold – to ensure the value of our money. A reintroduction of the gold standard would require a shift in this perception.

In the nineteenth century the gold standard ensured low (or more correctly no) inflation for long periods of time. On the other hand, prices fluctuated considerably from year to year as gold production rose and fell. According to Friedman this was possible because the goods and labour markets were much more flexible at that time than now. Any attempt to reintroduce the gold standard now would result in exactly the same negative outcomes as a fixed exchange rate policy.

Despite the global gold standard having been abandoned many years ago, most central banks continue to own large amounts of gold. Friedman’s view is that one should fully acknowledge the end of the gold standard system and auction off the gold reserves of the central banks.

This concludes my little series on Milton Friedman’s view on FX policy. See the other posts here:

Milton Friedman on exchange rate policy #1
Milton Friedman on exchange rate policy #2
Milton Friedman on exchange rate policy #3
Milton Friedman on exchange rate policy #4
Milton Friedman on exchange rate policy #5

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