“Chinese Silver Standard Economy and the 1929 Great Depression”

Only two major countries – China and Spain – were not on the Gold Standard at the onset of the Great Depression in 1929. As a consequence both countries avoided the most negative consequences of the Great Depression. That is a forcefully demonstration of how the “wrong” exchange rate regimes can mean disaster, but also a reminder of Milton Friedman’s dictum never to underestimate the importance of luck.

I have recently found this interesting paper by

Cheng-chung Lai and Joshua Jr-shiang Gau on the “Chinese Silver Standard Economy  and the 1929 Great Depression”. Here is the abstract for you:

“It is often said that the silver standard had insulated the Chinese economy from the Great Depression that prevailed in the gold standard countries during the 1929-35 period. Using econometric testing and counterfactual simulations, we show that if China had been on the gold standard (or on the gold-exchange standard), the balance of trade of this semi-closed economy would have been ameliorated, but the general price level would have declined significantly. Due to limited statistics, two important factors (the GDP and industrial production level) are not included in the analysis, but the general argument that the silver standard was a lifeboat to the Chinese economy remains defensible.”

If anybody has knowledge of research on Spanish monetary policy during the Great Depression I would be very interested hearing from you (lacsen@gmail.com).

PS Today I have received Douglas Irwin’s latest book “Trade Policy Disaster: Lessons From the 1930s” in the mail. I look forward to reading it and sharing the conclusions with my readers. But I already know a bit about the conclusion: Countries that stayed longer on the Gold Standard were more protectionist than countries with more flexible exchange rate regimes. This fits with Milton Friedman’s views – see here and here.


Milton Friedman on Exchange rate policy #2

“The Case for Flexible Exchange Rates”

I 1950 Milton Friedman was attached to the US Economic Cooperation Administration (ECA), which was charged with overseeing the implementation of the Marshall plan.

The ECA wanted to see a common European market and therefore a liberalisation of intra-European trade and a breaking down of customs barriers between the European countries. Most European nations were, however, sceptical of the idea, as they feared it would lead to problematic balance of payments deficits – and thus pressure on the fixed exchange rate policy.

Once again the political dynamics of the fixed exchange rate system were stoking protectionist tendencies. This was an important theme in the memorandum that Milton Friedman wrote to the ECA on the structure of exchange rate policy in Europe. This memorandum, “Flexible Exchange Rates as a Solution to the German Exchange Crisis”, formed the foundation for his now classic article from 1953, “The Case for Flexible Exchange Rates”, in which he presented his arguments for floating exchange rates. The main arguments are presented below.

Friedman’s basic argument against fixed exchange rate policies is fundamentally political. He pointed out that the combination of inflexible wages and prices and a fixed exchange rate policy would lead to imbalances in the economy – such as balance of payments deficits. Friedman feared – and as in the Canadian example above also observed – that politicians would attempt to “solve” these problems through widespread regulation of the economy in the form of trade restrictions and price and wage controls – precisely what Friedman wanted at all costs to avoid.

When prices and wages are very flexible, imbalances can be corrected relatively painlessly via wage and price adjustments. Thus there would be no great need for changes in exchange rates. In the real world, however, wages and prices are not fully flexible, says Friedman, and so imbalances can arise when pursuing a fixed exchange rate policy. Sooner or later these imbalances will put pressure on the fixed exchange rate system.

According to Friedman there are two ways to solve this problem: either regulating the movement of capital and goods across international borders or allowing currencies to float freely. There is of course a third option – make prices and wages more flexible. However, this would require significant reforms, and Friedman is doubtful that politicians would choose this route – even though he might constantly argue for such reforms.

Thus for Friedman there are in reality just two options, and he is in no doubt that flexible exchange rates are by far preferable to further regulation and protectionism.

Friedman acknowledges that adjustment to a “shock” to the economy (for example a jump in oil prices) can happen via pricing. However, he states that prices are typically not fully flexible – in part due to various forms of government regulation – and that an adjustment of the exchange rate will therefore be much less painful.

Friedman illustrates this with the so-called Daylight-Saving-Time argument. According to Friedman, the argument in favour of flexible exchange rates is in many ways the same as that for summer time. Instead of changing the clocks to summer time, everyone could instead “just” change their behaviour: meet an hour later at work, change programme times on the TV, let buses and trains run an hour later, etc. The reason we do not do this is precisely because it is easier and more practical to put clocks an hour forward than to change everyone’s behaviour at the same time. It is the same with exchange rates, one can either change countless prices or change just one – the exchange rate.

According to Friedman, a further advantage of flexible exchange rates is that adjustments to economic shocks can be continual and gradual. This is in stark contrast to fixed exchange rates. Here, all adjustments have to take place via changes in prices and wages, and as prices and wages are sluggish movers, the adjustment process will be slow. This implies that the country will still at some point be forced to adjust its exchange rate (devalue or revalue), and these adjustments will typically be much greater than the continual adjustments that occur in a flexible exchange rate system, as imbalances will grow larger in a fixed exchange rate system than in a flexible exchange rate system.

Read on: Milton Friedman on exchange rate policy #3

See also my post: “Milton Friedman on Exchange rate policy #1”

The Tintin of NGDP targeting

Have a look at Tintin explaining NGDP targeting here.

HT Marcus Nunes.

Milton Friedman on exchange rate policy #1

There is no doubt that Milton Friedman is my favourite economist (sorry Scott, you are only number two on the list). In the coming days I will share my interpretation of Friedman’s view of exchange rate policy.

Friedman’s contributions to both economic theory and the public debate have had considerable influence on the organisation of the global financial system and the choice of currency regimes around the world. This can best be illustrated by looking at the history of global financial and currency developments.

Prior to the First World War the international currency system was based on the gold standard. Individual national currencies had a particular gold value and could therefore be exchanged at a specified and fixed exchange rate. Thus the gold standard was a fixed exchange rate system. The First World War, however, led to this system breaking down – mainly as a result of the warring nations cancelling the gold convertibility of their bank notes: They financed their military expenses by printing money. This subsequently created a level of inflation that was incompatible with the gold standard.

Attempts were made to reintroduce the gold standard after the First World War, but the Great Depression of the 1930s, among other things, made this difficult. Nevertheless, the idea of fixed exchange rates still enjoyed significant political support, and there was broad agreement among economists that some form or other of fixed exchange rate policy was desirable. Hence a further attempt was made after the Second World War, and in 1944 the so-called Bretton Woods system was established, named after the US town where the agreement was made to set up a fixed exchange rate system.

The Bretton Woods agreement meant that the US dollar was pegged at a fixed rate to the price of gold, while the other participating currencies (the majority of global currencies) could be traded at a fixed rate to the dollar, thus once again establishing a global fixed exchange rate system. The system, which finally broke down in 1971 when the USA decided to abandon the dollar’s fixed peg to gold, was in many ways the main reason for Friedman’s huge involvement in the currency issue – both from an economic theory and from a political perspective. Friedman was an outspoken critic of the Bretton Woods system right from its creation to its final demise in 1971, and he supplied much of the theoretical ammunition that President Nixon used to justify his decision to “close the gold window”.

Friedman made his first major mark on the international currency system in 1948, when on 18 April he took part in a radio debate with the deputy governor of the Canadian central bank, Donald Gordon, discussing among other things Canada’s fixed exchange rate policy.

In 1948 Canada was pursuing a fixed exchange rate policy within the framework of the Bretton Woods system. However, the policy had given rise to a number of problems – including increasing inflation – and the government and central bank were considering major intervention in the Canadian economy in an attempt to maintain the fixed exchange rate. Among the proposals was one to significantly curb imports to Canada. So it would seem that the desire to maintain a fixed exchange rate policy was leading directly to protectionism. Since the 1940s this political connection has formed one of Friedman’s key arguments against a fixed exchange rate policy.

While the Canadian government attempted to defend its fixed exchange rate policy with protectionism and wage and price controls, Friedman’s approach was completely different: abandon the fixed exchange rate policy and let the currency float freely. Gordon rejected Friedman’s prescription for Canada’s ills, but 18 months later, in September 1950, the country’s finance minister, Douglas Abbott, decided to take Friedman’s medicine, announcing:

“Today the Government … cancelled the official rates of exchange. . . . Instead, rates of exchange will be determined by conditions of supply and demand for foreign currencies in Canada.”
(Quoted from Schembri, Lawrence, “Revisiting the Case for Flexible Exchange Rates”, Bank of Canada, November 2000).

Friedman could chalk up his first major victory in the currency debate – while the next was to come in 1971 when Bretton Woods was abandoned. In the intervening years Friedman made a huge contribution to changing how currencies and exchange rates are viewed in economic theory.

First Wikipedia, now Facebook

Recently Market Monetarism has shown up on Wikipedia – and so has “Nominal Income Target”. Now it seems the time has come to Facebook. Somebody has started a group on Facebook named “Nominal GDP level targeting”. Take a look at it.

Thank you Kelly Evans

Those who have followed the debate about NGDP in the US will know about the views of the Wall Street Journal. I steal this from Scott Sumner:

“I had not heard of Kelly Evans until a few days ago, when I ran across an anti-NGDP targeting piece that she wrote for the WSJ. I did a post that was very critical of the article. Lots of people might have taken that personally, but Evans came over here and engaged in a discussion with me and the other commenters. That showed class.

Now she has a new piece on NGDP targeting, which clearly shows that she’s done her homework. It’s very fair, presenting both sides of the debate.

I applaud her willingness to overlook the sometimes harsh tone of blogosphere debate, and engage with those of us who are working hard to change Fed policy.”

…I don’t have much to add other than I also want to thank Kelly Evans for taking the debate about NGDP targeting serious – and Kelly I will be happy to assist you on and off the record if you want to investigate this issue further.

The Hoover (Merkel/Sarkozy) Moratorium

The global stock markets are strongly up today on the latest news from the EU on the deal on Greek debt (and little bit less…). There is no reason to spend a lot of time describing the deal here, but I nonetheless feel it might be a good day to tell a bit about something else – the so-called Hoover Moratorium of 1931.

80 years ago it was not Greece, which was at the centre of attention, but rather Germany. Germany was struggling to pay back war debt and reparations for World War I and Germany was effectively on the brink of default and the Germany economy was in serious trouble – not much unlike today’s Greek situation.

On June 20 1931 US President Hoover issued a statement in which he suggested a moratorium on payments of World War I debts, postponing the initial payments, as well as interest. Hoover’s hope was the moratorium would ease the strains on especially the German economy and thereby in general help the global economy, which of course at that time was deep in depression.

Hoover’s idea was certainly not popular with many US citizens (like today’s German taxpayers who are not to happy to see their taxes being spending in “saving” Greece). However, the plan got most opposition from the French government, which insisted that the German government had to pay it’s debts on time as scheduled.

Despite the negative reception of Hoover’s proposal it went on to gain support from fifteen nations including France by July 6 1931.

An interesting side story on the Hoover Moratorium is why Hoover came up with the idea in the first place. Barry Eichengreen askes this question in his great book on the gold standard and the Great Depression, “Golden Fetters”: “It is unclear whether Hoover was motivated by the need for action to stabilize the international economy or by a desire to protect U.S. banks that had invested heavily in Germany”. Try replace “Hoover” with “Merkel/Sarkozy”, “U.S. banks” with “German/French banks” and “Germany” with “Greece”.

So how did the Hoover Moratorium play out? The initial market reaction July 1931 was very favourable. German stock jumped 25% on the Monday announce the initial announcement of the Hoover Moratorium. Here is how the New York Times described the global market reaction “the swiftest advance during any corresponding period in a generation” (quoted from Clark Johnson’s “Gold, France and the Great Depression”).

However, the party did not last and soon the international market turned down and the Depression continued. Many countries didn’t emerge from the Depression before the end of World War II. Lets hope we are more lucky this time around.

Hawtrey, Cassel and Glasner

Recently I have been giving quite a bit attention to the writings Gustav Cassel (and I plan more…), but I have failed to give any attention to the great British monetary economist Raplh G. Hawtrey. That is not really fair – Hawtrey and Cassel lived more or less at the same time and both played important roles in the debate and formulation of monetary policy and monetary thinking around the world in 1920s and 1930s.

Long ago David Glasner – one of my big heros and the blogger on uneasymoney.com – and Ronald W. Batchelder long ago wrote a paper on the monetary economics of both Cassel and Hawtrey – “Pre-Keynesian monetary theories of the Great Depression”. You should all read it.

Google Trends: From Greek crisis to euro crisis

I have always found it fascinating how much information the internet is providing “real time” and  I believe that a lot of economic data can and should be “extracted” from data on internet activity. A good example is the development in google searches on the European debt crisis. Here Google Trends is an excellent tool.

We we input “Greek crisis” into Google Trends we get this timeline.

The graph is pretty clear – searches on the “Greek crisis” spikes in early 2010 and then start to ease off in May 2010. But then again from the early part of the Summer this year the “Greek crisis” start to take off again.

Then lets add one more search: “euro crisis”.

Here we compare the number of searches for “euro crisis” and “Greek crisis” respectively.

The picture is clear – there is a very high correlation between “Greek crisis” and “euro crisis”. However, there is more to tell. While “Greek crisis” searches is much higher the “euro crisis” searches in 2010 the picture has now changed.

Greek crisis becoming a euro crisis

Hence, since July the number of searches for “euro crisis” has outpaced the number of searches for “Greek crisis”. Zoom in on 2011 searches here.

Said in another way what Google Trends is telling us is that the Greek crisis has turned into a euro crisis. Is that a surprise? Maybe not, but it is an indication of the systemic risks involved in this terrible crisis.

Calomiris on “Contagious Events”

As we minute by minute are inching closer to the announcement of some form of restructuring/write-down of Greek Sovereign debt nervous investors focus on the risk of contagion from the Greek crisis to other European economies and contagion in the European banking sector.

In a paper from 2007 Charles Calomiris has a good and interesting discussion of what he calls “Contagious events”.

Here is the abstract:

“Bank failures during banking crises, in theory, can result either from unwarranted depositor withdrawals during events characterized by contagion or panic, or as the result of fundamental bank insolvency. Various views of contagion are described and compared to historical evidence from banking crises, with special emphasis on the U.S. experience during and prior to the Great Depression. Panics or “contagion” played a small role in bank failure, during or before the Great Depression-era distress. Ironically, the government safety net, which was designed to forestall the (overestimated) risks of contagion, seems to have become the primary source of systemic instability in banking in the current era.”

WARNING: If you are looking for a justification for bailouts you will probably not find it in this paper, but you will find some interesting “advise” on banking regulation.

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