Archive for the 'Great Depression' Category

Monetarism v. Hawtrey and Cassel

The following is an updated and revised version of the penultimate section of my paper with Ron Batchelder “Pre-Keynesian Theories of the Great Depressison: What Ever Happened to Hawtrey and Cassel?” which I am now preparing for publication. The previous version is available on SSRN.

In the 1950s and early 1960s, empirical studies of the effects of money and monetary policy by Milton Friedman, his students and followers, rehabilitated the idea that monetary policy had significant macroeconomic effects. Most importantly, in research with Anna Schwartz Friedman advanced the seemingly remarkable claim that the chief cause of the Great Depression had been a series of policy mistakes by the Federal Reserve. Although Hawtrey and Cassel, had also implicated the Federal Reserve in their explanation of the Great Depression, they were unmentioned by Friedman and Schwartz or by other Monetarists.[1]

The chief difference between the Monetarist and the Hawtrey-Cassel explanations of the Great Depression is that Monetarists posited a monetary shock (bank failures) specific to the U.S. as the primary, if not sole, cause of the Depression, while Hawtrey and Cassel considered the Depression a global phenomenon reflecting a rapidly increasing international demand for gold, bank failures being merely an incidental and aggravating symptom, specific to the U.S., of a more general monetary disorder.

Arguing that the Great Depression originated in the United States following a typical business-cycle downturn, Friedman and Schwartz (1963) attributed the depth of the downturn not to the unexplained initial shock, but to the contraction of the U.S. money stock caused by the bank failures. Dismissing any causal role for the gold standard in the Depression, Friedman and Schwartz (359-60) acknowledged only its role in propagating, via PSFM, an exogenous, policy-driven, contraction of the U.S. money stock to other gold-standard countries. According to Friedman and Schwartz, the monetary contraction was the cause, and deflation the effect.

But the causation posited by Friedman and Schwartz is the exact opposite of the true causation. Under the gold standard, deflation (i.e., gold appreciation) was the cause and the decline in the quantity of money the effect. Deflation in an international gold standard is not a local phenomenon originating in any single country; it occurs simultaneously in all gold standard countries.

To be sure the banking collapse in the U.S. exacerbated the catastrophe. But the collapse was the localized effect of a more general cause: deflation. Without deflation, neither the unexplained 1929 downturn nor the subsequent banking collapse would have occurred. Nor was an investment boom in the most advanced and most productive economy in the world unsustainable as posited, with no evidence of unsustainability other than the subsequent economic collapse, by the Austrian malinvestment hypothesis.

Friedman and Schwartz based their assertion that the monetary disturbance that caused the Great Depression occurred in the U.S. on the observation that, from 1929 to 1931, gold flowed into, not out of, the U.S. Had the disturbance occurred elsewhere, they argued, gold would have flowed out of, not into, the U. S.

Table 1 shows the half-year changes in U.S., French, and world gold reserves starting in June 1928, when the French monetary law re-establishing the gold standard was enacted.

TABLE 1: Gold Reserves in US, France, and the World June 1928-December 1931 (measured in dollars)
Date World ReservesUS ReservesUS Share (percent)French ReservesFrench Share (percent)
June 19289,7493,73238.31,13611.7
Dec. 192810,0573,74637.21,25412.4
2nd half 1928 change31214-1.11180.7
June 192910,1263,95639.11,43614.2
1st half 1929 change692101.91821.8
Dec. 192910,3363,90037.71,63315.8
2nd half 1929 change210-56-1.41971.6
June 193010,6714,17839.21,72716.2
1st half 1930 change3352781.5940.4
Dec. 193010,9444,22538.72,10019.2
2nd half 1930 change 27347-0.53733.0
June 193111,264459340.82,21219.6
1st half 1931 change3203682.11120.4
Dec. 193111,3234,05135.82,69923.8
2nd half 1931 change59-542-5.04874.2
June 1928-Dec. 1931 change1,574319-2.51,56312.1
Source: H. C. Johnson, Gold, France and the Great Depression

In the three-and-a-half years from June 1928 (when gold convertibility of the franc was restored) to December 1931, gold inflows into France exceeded gold inflows into the United States. The total gold inflow into France during the June 1928 to December 1931 period was $1.563 billion compared to only $319 billion into the United States.

However, much of the difference in the totals stems from the gold outflow from the U.S. into France in the second half of 1931, reflecting fears of a possible U.S. devaluation or suspension of convertibility after Great Britain and other countries suspended the gold standard in September 1931 (Hamilton 2012). From June 1928 through June 1931, the total gold inflow into the U.S. was $861 billion and the total gold inflow into France was $1.076 billion, the U.S. share of total reserves increasing from 38.3 percent to 40.6 percent, while the total French share increased from 11.7 percent to 19.6 percent.[2]

In the first half of 1931, when the first two waves of U.S. bank failures occurred, the increase in U.S. gold reserves exceeded the increase in world gold reserves. The shift by the public from holding bank deposits to holding currency increased reserve requirements, an increase reflected in the gold reserves held by the U.S. The increased U.S. demand for gold likely exacerbated the deflationary pressures affecting all gold-standard countries, perhaps contributing to the failure of the Credit-Anstalt in May 1931 that intensified the European crisis that forced Britain off the gold standard in September.

The combined increase in U.S. and French gold reserves was $1.937 billion compared to an increase of only $1.515 billion in total world reserves, indicating that the U.S. and France were drawing reserves either from other central banks or from privately held gold stocks. Clearly, both the U.S. and France were exerting powerful deflationary pressure on the world economy, before and during the downward spiral of the Great Depression.[3]

Deflationary forces were operating directly on prices before the quantity of money adjusted to the decline in prices. In some countries the adjustment of the quantity of money was relatively smooth; in the U.S. it was exceptionally difficult, but, not even in the U.S., was it the source of the disturbance. Hawtrey and Cassel understood that; Friedman did not.

In explaining the sources of his interest in monetary theory and the role of monetary policy, Friedman (1970) pointedly distinguished between the monetary tradition from which his work emerged and the dominant tradition in London circa 1930, citing Robbins’s (1934) Austrian-deflationist book on the Great Depression, while ignoring Hawtrey and Cassel. Friedman linked his work to the Chicago oral tradition, citing a lecture by Jacob Viner (1933) as foreshadowing his own explanation of the Great Depression, attributing the loss of interest in monetary theory and policy by the wider profession to the deflationism of LSE monetary economists. Friedman went on to suggest that the anti-deflationism of the Chicago monetary tradition immunized it against the broader reaction against monetary theory and policy, that the Austro-London pro-deflation bias provoked against monetary theory and policy.

Though perhaps superficially plausible, Friedman’s argument ignores, as he did throughout a half-century of scholarship and research, the contributions of Hawtrey and Cassel and especially their explanation of the Great Depression. Unfortunately, Friedman’s outsized influence on economists trained after the Keynesian Revolution distracted their attention from contributions outside the crude Keynesian-Monetarist dichotomy that shaped his approach to monetary economics.

Eclectics like Hawtrey and Cassel were neither natural sources of authority, nor obvious ideological foils for Friedman to focus upon. Already forgotten, providing neither convenient targets, nor ideological support, Hawtrey and Cassel, could be easily and conveniently ignored.

[1] Meltzer (2001) did mention Hawtrey, but the reference was perfunctory and did not address the substance of his and Cassel’s explanation of the Great Depression.

[2] By far the largest six-month increase in U.S. gold reserves was in the June-December 1931 period coinciding with the two waves of bank failures at the end of 1930 and in March 1931 causing a substantial shift from deposits to currency which required an increase in gold reserves owing to the higher ratio of required gold reserves against currency than against bank deposits.

[3] Fremling (1985) noted that, even during the 1929-31 period, the U.S. share of world gold reserves actually declined. However, her calculation includes the extraordinary outflow of gold from the U.S. in the second half of 1931. The U.S. share of global gold reserves rose from June 1928 to June 1931.

The Hawley-Smoot Tariff and the Great Depression

The role of the Hawley-Smoot Tariff (aka Smoot-Hawley Tariff) in causing the Great Depression has been an ongoing subject of controversy for close to a century. Ron Batchelder and I wrote a paper (“Debt, Deflation and the Great Depression”) published in this volume (Money and Banking: The American Experience) that offered an explanation of the mechanism by which the tariff contributed to the Great Depression. That paper was written before and inspired another paper “Pre-Keynesian Theories of the Great Depression: What Ever Happened to Hawtrey and Cassell“) I am now revising the paper for republication, and here is the new version of the relevant section discussing the Hawley-Smoot Tariff.

Monetary disorder was not the only legacy of World War I. The war also left a huge burden of financial obligations in its wake. The European allies had borrowed vast sums from the United States to finance their war efforts, and the Treaty of Versailles imposed on Germany the obligation to pay heavy reparations to the allies, particularly to France.

We need not discuss the controversial question whether the burden imposed on Germany was too great to have been discharged. The relevant question for our purposes is by what means the reparations and war debts could be paid, or, at least, carried forward without causing a default on the obligations. To simplify the discussion, we concentrate on the relationship between the U.S. and Germany, because many of the other obligations of the allies to the U.S. were offset by those of Germany to the allies.[1]

The debt to the U.S. could be extinguished either by a net payment in goods reflected in a German balance-of-trade surplus and a U.S. balance-of-trade deficit, or by a transfer of gold from Germany to the U.S. Stretching out the debt would have required the U.S., in effect to lend Germany the funds required to service its obligations.

For most of the 1920s, the U.S. did in fact lend heavily to Germany, thereby lending Germany the funds to meet its financial obligations to the U.S. (and its European creditors). U.S. lending was not explicitly for that purpose, but on the consolidated national balance sheets, U.S. lending offset German financial obligations, obviating any real transfer.

Thus, to avoid a transfer, in goods or specie, from Germany to the U.S., continued U.S. lending to Germany was necessary. But the sharp tightening of monetary policy by the Federal Reserve in 1928 raised domestic interest rates to near record levels and curtailed lending abroad, as foreign borrowers were discouraged from seeking funds in U.S. capital markets. Avoiding an immediate transfer from Germany to the U.S. was no longer possible except by default. To effect the necessary transfer in goods, Germany would have been required to shift resources from its non-tradable-goods sector to its tradable-goods sector, which would require reducing spending on, and the relative prices of, non-tradable goods. Thus, Germany began to slide into a recession in 1928.

In 1929 the United States began making the transfer even more difficult when the newly installed Hoover administration reaffirmed the Republican campaign commitment to raising U.S. tariffs, thereby imposing a tax on the goods transfer through which Germany could discharge its obligations. Although the bill to increase tariffs that became the infamous Hawley-Smoot Act was not passed until 1930, the commitment to raise tariffs made it increasingly unlikely that the U.S. would allow the debts owed it to be discharged by a transfer of goods. The only other means by which Germany could discharge its obligations was a transfer of gold. Anticipating that its obligations to the U.S. could be discharged only by transferring gold, Germany took steps to increase its gold holdings to be able to meet its debt obligations. The increased German demand for gold was reflected in a defensive tightening of monetary policy to raise domestic interest rates to reduce spending and to induce an inflow of gold to Germany.

The connection between Germany’s debt obligations and its demand for gold sheds light on the deflationary macroeconomic consequences of the Hawley-Smoot tariff. Given the huge debts owed to the United States, the tariff imposed a deflationary monetary policy on all U.S. debtors as they attempted to accumulate sufficient gold to be able to service their debt obligations to the U.S. But, under the gold standard, the United States could not shield itself from the deflationary effects that its trade policy was imposing on its debtors.[2]

The U.S. could have counteracted these macroeconomic pressures by a sufficiently expansive monetary policy, thereby satisfying the demand of other countries for gold. Monetary expansion would have continued, by different means, the former policy of lending to debtors, enabling them to extend their obligations. But preoccupied with, or distracted by the stock-market boom, U.S. monetary authorities were oblivious to the impossible alternatives that were being forced on U.S. debtors by a combination of tight U.S. monetary policy and a protectionist trade policy.

As the prospects that protectionist legislation would pass steadily improved even as tight U.S. monetary policy was being maintained, deflationary signs became increasingly clear and alarming. The panic of October 1929, in our view, was not, as much Great Depression historiography describes it, the breaking of a speculative bubble, but a correct realization that a toxic confluence of monetary and trade policies was leading the world over a deflationary precipice.

Once the deflation took hold, the nature of the gold standard with a fixed price of gold was such that gold would likely appreciate against weak currencies that were likely to be formally devalued, or allowed to float, relative to gold. A vicious cycle of increasing speculative demand for gold in anticipation of currency devaluation further intensified the deflationary pressures (Hamilton, 1988). Moreover, successive devaluations by one country at a time increased the deflationary pressure in the remaining gold-standard countries. A uniform all-around devaluation might have had some chance of quickly controlling the deflationary process, but piecemeal deflation could only prolong the deflationary pressure on nations that remained on the gold standard.


[1] The United States, as a matter of law, always resisted such a comparison, contending that the war debts were commercial obligations in no way comparable to the politically imposed reparations. However, as a final matter, there was obviously a strict correspondence between the two sets of obligations. The total size of German obligations was never precisely determined. However, those obligations were certainly several times the size of the war debts owed the United States. Focusing simply on the U.S.-German relationship is therefore simply a heuristic device.

[2] Viewed from a different perspective, the tariff aimed at transferring wealth from the foreign debtors to the U.S. government by taxing debt payments on debt already fixed in nominal terms. Moreover, deflation from whatever source increased the real value of the fixed nominal debts owed the U.S.






A         Real-Bills Doctrine





B         Lender of Last Resort


















HAWTREY: I do not know what orthodox Central Banking is.




            C         Scope of Banking







On the Price Specie Flow Mechanism

I have been working on a paper tentatively titled “The Smithian and Humean Traditions in Monetary Theory.” One section of the paper is on the price-specie-flow mechanism, about which I wrote last month in my previous post. This section develops the arguments of the previous post at greater length and draws on a number of earlier posts that I’ve written about PSFM as well (e.g., here and here )provides more detailed criticisms of both PSFM and sterilization and provides some further historical evidence to support some of the theoretical arguments. I will be grateful for any comments and feedback.

The tortured intellectual history of the price-specie-flow mechanism (PSFM) received its still classic exposition in a Hume (1752) essay, which has remained a staple of the theory of international adjustment under the gold standard, or any international system of fixed exchange rates. Regrettably, the two-and-a-half-century life span of PSFM provides no ground for optimism about the prospects for progress in what some are pleased to call without irony economic science.

PSFM describes how, under a gold standard, national price levels tend to be equalized, with deviations between the national price levels in any two countries inducing gold to be shipped from the country with higher prices to the one with lower prices until prices are equalized. Premised on a version of the quantity theory of money in which (1) the price level in each country on the gold standard is determined by the quantity of money in that country, and (2) money consists entirely in gold coin or bullion, Hume elegantly articulated a model of disturbance and equilibration after an exogenous change in the gold stock in one country.

Viewing banks as inflationary engines of financial disorder, Hume disregarded banks and the convertible monetary liabilities of banks in his account of PSFM, leaving to others the task of describing the international adjustment process under a gold standard with fractional-reserve banking. The task of devising an institutional framework, within which PSFM could operate, for a system of fractional-reserve banking proved to be problematic and ultimately unsuccessful.

For three-quarters of a century, PSFM served a purely theoretical function. During the Bullionist debates of the first two decades of the nineteenth century, triggered by the suspension of the convertibility of the pound sterling into gold in 1797, PSFM served as a theoretical benchmark not a guide for policy, it being generally assumed that, when convertibility was resumed, international monetary equilibrium would be restored automatically.

However, the 1821 resumption was followed by severe and recurring monetary disorders, leading some economists, who formed what became known as the Currency School, to view PSFM as a normative criterion for ensuring smooth adjustment to international gold flows. That criterion, the Currency Principle, stated that the total currency in circulation in Britain should increase or decrease by exactly as much as the amount of gold flowing into or out of Britain.[1]

The Currency Principle was codified by the Bank Charter Act of 1844. To mimic the Humean mechanism, it restricted, but did not suppress, the right of note-issuing banks in England and Wales, which were allowed to continue issuing notes, at current, but no higher, levels, without holding equivalent gold reserves. Scottish and Irish note-issuing banks were allowed to continue issuing notes, but could increase their note issue only if matched by increased holdings of gold or government debt. In England and Wales, the note issue could increase only if gold was exchanged for Bank of England notes, so that a 100-percent marginal gold reserve requirement was imposed on additional banknotes.

Opposition to the Bank Charter Act was led by the Banking School, notably John Fullarton and Thomas Tooke. Rejecting the Humean quantity-theoretic underpinnings of the Currency School and the Bank Charter Act, the Banking School rejected the quantitative limits of the Bank Charter Act as both unnecessary and counterproductive, because banks, obligated to redeem their liabilities directly or indirectly in gold, issue liabilities only insofar as they expect those liabilities to be willingly held by the public, or, if not, are capable of redeeming any liabilities no longer willingly held. Rather than the Humean view that banks issue banknotes or create deposits without constraint, the Banking School held Smith’s view that banks issue money in a form more convenient to hold and to transact with than metallic money, so that bank money allows an equivalent amount of gold to be shifted from monetary to real (non-monetary) uses, providing a net social savings. For a small open economy, the diversion (and likely export) of gold bullion from monetary to non-monetary uses has negligible effect on prices (which are internationally, not locally, determined).

The quarter century following enactment of the Bank Charter Act showed that the Act had not eliminated monetary disturbances, the government having been compelled to suspend the Act in 1847, 1857 and 1866 to prevent incipient crises from causing financial collapse. Indeed, it was precisely the fear that liquidity might not be forthcoming that precipitated increased demands for liquidity that the Act made it impossible to accommodate. Suspending the Act was sufficient to end the crises with limited intervention by the Bank. [check articles on the crises of 1847, 1857 and 1866.]

It may seem surprising, but the disappointing results of the Bank Charter Act provided little vindication to the Banking School. It led only to a partial, uneasy, and not entirely coherent, accommodation between PSFM doctrine and the reality of a monetary system in which the money stock consists mostly of banknotes and bank deposits issued by fractional-reserve banks. But despite the failure of the Bank Charter Act, PSFM achieved almost canonical status, continuing, albeit with some notable exceptions, to serve as the textbook model of the gold standard.

The requirement that gold flows induce equal changes in the quantity of money within a country into (or from) which gold is flowing was replaced by an admonition that gold flows lead to “appropriate” changes in the central-bank discount rate or an alternative monetary instrument to cause the quantity of money to change in the same direction as the gold flow. While such vague maxims, sometimes described as “the rules of the game,” gave only directional guidance about how to respond to change in gold reserves, their hortatory character, and avoidance of quantitative guidance, allowed monetary authorities latitude to avoid the self-inflicted crises that had resulted from the quantitative limits of the Bank Charter Act.

Nevertheless, the myth of vague “rules” relating the quantity of money in a country to changes in gold reserves, whose observance ensured the smooth functioning of the international gold standard before its collapse at the start of World War I, enshrined PSFM as the theoretical paradigm for international monetary adjustment under the gold standard.

That paradigm was misconceived in four ways that can be briefly summarized.

  • Contrary to PSFM, changes in the quantity of money in a gold-standard country cannot change local prices proportionately, because prices of tradable goods in that country are constrained by arbitrage to equal the prices of those goods in other countries.
  • Contrary to PSFM, changes in local gold reserves are not necessarily caused either by non-monetary disturbances such as shifts in the terms of trade between countries or by local monetary disturbances (e.g. overissue by local banks) that must be reversed or counteracted by central-bank policy.
  • Contrary to PSFM, changes in the national price levels of gold-standard countries were uncorrelated with gold flows, and changes in national price levels were positively, not negatively, correlated.
  • Local banks and monetary authorities exhibit their own demands for gold reserves, demands exhibited by choice (i.e., independent of legally required gold holdings) or by law (i.e., by legally requirement to hold gold reserves equal to some fraction of banknotes issued by banks or monetary authorities). Such changes in gold reserves may be caused by changes in the local demands for gold by local banks and the monetary authorities in one or more countries.

Many of the misconceptions underlying PSFM were identified by Fullarton’s refutation of the Currency School. In articulating the classical Law of Reflux, he established the logical independence of the quantity convertible money in a country from by the quantity of gold reserves held by the monetary authority. The gold reserves held by individual banks, or their deposits with the Bank of England, are not the raw material from which banks create money, either banknotes or deposits. Rather, it is their creation of banknotes or deposits when extending credit to customers that generates a derived demand to hold liquid assets (i.e., gold) to allow them to accommodate the demands of customers and other banks to redeem banknotes and deposits. Causality runs from creating banknotes and deposits to holding reserves, not vice versa.

The misconceptions inherent in PSFM and the resulting misunderstanding of gold flows under the gold standard led to a further misconception known as sterilization: the idea that central banks, violating the obligations imposed by “the rules of the game,” do not allow, or deliberately prevent, local money stocks from changing as their gold holdings change. The misconception is the presumption that gold inflows ought necessarily cause increases in local money stocks. The mechanisms causing local money stocks to change are entirely different from those causing gold flows. And insofar as those mechanisms are related, causality flows from the local money stock to gold reserves, not vice versa.

Gold flows also result when monetary authorities transform their own asset holdings into gold. Notable examples of such transformations occurred in the 1870s when a number of countries abandoned their de jure bimetallic (and de facto silver) standards to the gold standard. Monetary authorities in those countries transformed silver holdings into gold, driving the value of gold up and silver down. Similarly, but with more catastrophic consequences, the Bank of France, in 1928 after France restored the gold standard, began redeeming holdings of foreign-exchange reserves (financial claims on the United States or Britain, payable in gold) into gold. Following the French example, other countries rejoining the gold standard redeemed foreign exchange for gold, causing gold appreciation and deflation that led to the Great Depression.


I pause to note for the record Friedman’s assertion that the United States and France did not follow “gold-standard rules.” Warming up to the idea, he then accused them of sterilization.



Friedman’s discussion of sterilization is at odds with basic theory. Working with a naïve version of PSFM, he imagines that gold flows passively respond to trade balances independent of monetary forces, and that the monetary authority under a gold standard is supposed to ensure that the domestic money stock varies roughly in proportion to its gold reserves. Ignoring the international deflationary dynamic, he asserts that the US money stock perversely declined from 1929 to 1931, while its gold stock increased. With a faltering banking system, the public shifted from holding demand deposits to currency. Gold reserves were legally required against currency, but not against demand deposits, so the shift from deposits to currency entailed an increase gold reserves. To be sure the increased US demand for gold added to upward pressure on value of gold, and to worldwide deflationary pressure. But US gold holdings rose by only $150 million from December 1929 to December 1931 compared with an increase of $1.06 billion in French gold holdings over the same period. Gold accumulation by the US and its direct contribution to world deflation during the first two years of the Depression was small relative to that of France.

Friedman also erred in stating “the common policies they followed were misguided and contributed to the severity and rapidity of transmission of the U.S. shock to the international community.” The shock to the international community clearly originated not in the US but in France. The Fed could have absorbed and mitigated the shock by allowing a substantial outflow of its huge gold reserves, but instead amplified the shock by raising interest rates to nearly unprecedented levels, causing gold to flow into the US.

After correctly noting the incompatibility between fixed exchange rates and internal price stability, Friedman contradicts himself by asserting that, in seeking to stabilize their internal price levels, Strong and Moreau violated the gold-standard “rules,” as if it were rules, not arbitrage, that constrain national price to converge toward a common level under a gold standard.

Friedman’s assertion that, after 1925, the dollar was undervalued and sterling overvalued was not wrong. But he misunderstood the consequences of currency undervaluation and overvaluation under the gold standard, a confusion stemming from the underlying misconception, derived from PSFM, that foreign exchange rates adjust to balance trade flows, so that, in equilibrium, no country runs a trade deficit or trade surplus.

Thus, in Friedman’s view, dollar undervaluation and sterling overvaluation implied a US trade surplus and British trade deficit, causing gold to flow from Britain to the US. Under gold-standard “rules,” the US money stock and US prices were supposed to rise and the British money stock and British prices were supposed to fall until undervaluation and overvaluation were eliminated. Friedman therefore blamed sterilization of gold inflows by the Fed for preventing the necessary increase in the US money stock and price level to restore equilibrium. But, in fact, from 1925 through 1928, prices in the US were roughly stable and prices in Britain fell slightly. Violating gold-standard “rules” did not prevent the US and British price levels from converging, a convergence driven by market forces, not “rules.”

The stance of monetary policy in a gold-standard country had minimal effect on either the quantity of money or the price level in that country, which were mainly determined by the internationally determined value of gold. What the stance of national monetary policy determines under the gold standard is whether the quantity of money in the country adjusts to the quantity demanded by a process of domestic monetary creation or withdrawal or by the inflow or outflow of gold. Sufficiently tight domestic monetary policy restricting the quantify of domestic money causes a compensatory gold inflow increasing the domestic money stock, while sufficiently easy money causes a compensatory outflow of gold reducing the domestic money stock. Tightness or ease of domestic monetary policy under the gold standard mainly affected gold and foreign-exchange reserves, and, only minimally, the quantity of domestic money and the domestic price level.

However, the combined effects of many countries simultaneously tightening monetary policy in a deliberate, or even inadvertent, attempt to accumulate — or at least prevent the loss — of gold reserves could indeed drive up the international value of gold through a deflationary process affecting prices in all gold-standard countries. Friedman, even while admitting that, in his Monetary History, he had understated the effect of the Bank of France on the Great Depression, referred only the overvaluation of sterling and undervaluation of the dollar and franc as causes of the Great Depression, remaining oblivious to the deflationary effects of gold accumulation and appreciation.

It was thus nonsensical for Friedman to argue that the mistake of the Bank of France during the Great Depression was not to increase the quantity of francs in proportion to the increase of its gold reserves. The problem was not that the quantity of francs was too low; it was that the Bank of France prevented the French public from collectively increasing the quantity of francs that they held except by importing gold.

Unlike Friedman, F. A. Hayek actually defended the policy of the Bank of France, and denied that the Bank of France had violated “the rules of the game” after nearly quadrupling its gold reserves between 1928 and 1932. Under his interpretation of those “rules,” because the Bank of France increased the quantity of banknotes after the 1928 restoration of convertibility by about as much as its gold reserves increased, it had fully complied with the “rules.” Hayek’s defense was incoherent; under its legal obligation to convert gold into francs at the official conversion rate, the Bank of France had no choice but to increase the quantity of francs by as much as its gold reserves increased.

That eminent economists like Hayek and Friedman could defend, or criticize, the conduct of the Bank of France during the Great Depression, because the Bank either did, or did not, follow “the rules of the game” under which the gold standard operated, shows the uselessness and irrelevance of the “rules of the game” as a guide to policy. For that reason alone, the failure of empirical studies to find evidence that “the rules of the game” were followed during the heyday of the gold standard is unsurprising. But the deeper reason for that lack of evidence is that PSFM, whose implementation “the rules of the game” were supposed to guarantee, was based on a misunderstanding of the international-adjustment mechanism under either the gold standard or any fixed-exchange-rates system.

Despite the grip of PSFM over most of the profession, a few economists did show a deeper understanding of the adjustment mechanism. The idea that the price level in terms of gold directly constrained the movements of national price levels across countries was indeed recognized by writers as diverse as Keynes, Mises, and Hawtrey who all pointed out that the prices of internationally traded commodities were constrained by arbitrage and that the free movement of capital across countries would limit discrepancies in interest rates across countries attached to the gold standard, observations that had already been made by Smith, Thornton, Ricardo, Fullarton and Mill in the classical period. But, until the Monetary Approach to the Balance of Payments became popular in the 1970s, only Hawtrey consistently and systematically deduced the implications of those insights in analyzing both the Great Depression and the Bretton Woods system of fixed, but adjustable, exchange rates following World War II.

The inconsistencies and internal contradictions of PSFM were sometimes recognized, but usually overlooked, by business-cycle theorists when focusing on the disturbing influence of central banks, perpetuating mistakes of the Humean Currency School doctrine that attributed cyclical disturbances to the misbehavior of local banking systems that were inherently disposed to overissue their liabilities.


Lawrence White and Thomas Hogan have just published a new paper in the Journal of Economic Behavior and Organization (“Hayek, Cassel, and the origins of the great depression”). Since White is a leading Hayek scholar, who has written extensively on Hayek’s economic writings (e.g., his important 2008 article “Did Hayek and Robbins Deepen the Great Depression?”) and edited the new edition of Hayek’s notoriously difficult volume, The Pure Theory of Capital, when it was published as volume 11 of the Collected Works of F. A. Hayek, the conclusion reached by the new paper that Hayek had a better understanding than Cassel of what caused the Great Depression is not, in and of itself, surprising.

However, I admit to being taken aback by the abstract of the paper:

We revisit the origins of the Great Depression by contrasting the accounts of two contemporary economists, Friedrich A. Hayek and Gustav Cassel. Their distinct theories highlight important, but often unacknowledged, differences between the international depression and the Great Depression in the United States. Hayek’s business cycle theory offered a monetary overexpansion account for the 1920s investment boom, the collapse of which initiated the Great Depression in the United States. Cassel’s warnings about a scarcity gold reserves related to the international character of the downturn, but the mechanisms he emphasized contributed little to the deflation or depression in the United States.

I wouldn’t deny that there are differences between the way the Great Depression played out in the United States and in the rest of the world, e.g., Britain and France, which to be sure, suffered less severely than did the US or, say, Germany. It is both possible, and important, to explore and understand the differential effects of the Great Depression in various countries. I am sorry to say that White and Hogan do neither. Instead, taking at face value the dubious authority of Friedman and Schwartz’s treatment of the Great Depression in the Monetary History of the United States, they assert that the cause of the Great Depression in the US was fundamentally different from the cause of the Great Depression in many or all other countries.

Taking that insupportable premise from Friedman and Schwartz, they simply invoke various numerical facts from the Monetary History as if those facts, in and of themselves, demonstrate what requires to be demonstrated: that the causes of the Great Depression in the US were different from those of the Great Depression in the rest of the world. That assumption vitiated the entire treatment of the Great Depression in the Monetary History, and it vitiates the results that White and Hogan reach about the merits of the conflicting explanations of the Great Depression offered by Cassel and Hayek.

I’ve discussed the failings of Friedman’s treatment of the Great Depression and of other episodes he analyzed in the Monetary History in previous posts (e.g., here, here, here, here, and here). The common failing of all the episodes treated by Friedman in the Monetary History and elsewhere is that he misunderstood how the gold standard operated, because his model of the gold standard was a primitive version of the price-specie-flow mechanism in which the monetary authority determines the quantity of money, which then determines the price level, which then determines the balance of payments, the balance of payments being a function of the relative price levels of the different countries on the gold standard. Countries with relatively high price levels experience trade deficits and outflows of gold, and countries with relatively low price levels experience trade surpluses and inflows of gold. Under the mythical “rules of the game” under the gold standard, countries with gold inflows were supposed to expand their money supplies, so that prices would rise and countries with outflows were supposed to reduce their money supplies, so that prices fall. If countries followed the rules, then an international monetary equilibrium would eventually be reached.

That is the model of the gold standard that Friedman used throughout his career. He was not alone; Hayek and Mises and many others also used that model, following Hume’s treatment in his essay on the balance of trade. But it’s the wrong model. The correct model is the one originating with Adam Smith, based on the law of one price, which says that prices of all commodities in terms of gold are equalized by arbitrage in all countries on the gold standard.

As a first approximation, under the Smithean model, there is only one price level adjusted for different currency parities for all countries on the gold standard. So if there is deflation in one country on the gold standard, there is deflation for all countries on the gold standard. If the rest of the world was suffering from deflation under the gold standard, the US was also suffering from a deflation of approximately the same magnitude as every other country on the gold standard was suffering.

The entire premise of the Friedman account of the Great Depression, adopted unquestioningly by White and Hogan, is that there was a different causal mechanism for the Great Depression in the United States from the mechanism operating in the rest of the world. That premise is flatly wrong. The causation assumed by Friedman in the Monetary History was the exact opposite of the actual causation. It wasn’t, as Friedman assumed, that the decline in the quantity of money in the US was causing deflation; it was the common deflation in all gold-standard countries that was causing the quantity of money in the US to decline.

To be sure there was a banking collapse in the US that was exacerbating the catastrophe, but that was an effect of the underlying cause: deflation, not an independent cause. Absent the deflationary collapse, there is no reason to assume that the investment boom in the most advanced and most productive economy in the world after World War I was unsustainable as the Hayekian overinvestment/malinvestment hypothesis posits with no evidence of unsustainability other than the subsequent economic collapse.

So what did cause deflation under the gold standard? It was the rapid increase in the monetary demand for gold resulting from the insane policy of the Bank of France (disgracefully endorsed by Hayek as late as 1932) which Cassel, along with Ralph Hawtrey (whose writings, closely parallel to Cassel’s on the danger of postwar deflation, avoid all of the ancillary mistakes White and Hogan attribute to Cassel), was warning would lead to catastrophe.

It is true that Cassel also believed that over the long run not enough gold was being produced to avoid deflation. White and Hogan spend inordinate space and attention on that issue, because that secular tendency toward deflation is entirely different from the catastrophic effects of the increase in gold demand in the late 1920s triggered by the insane policy of the Bank of France.

The US could have mitigated the effects if it had been willing to accommodate the Bank of France’s demand to increase its gold holdings. Of course, mitigating the effects of the insane policy of the Bank of France would have rewarded the French for their catastrophic policy, but, under the circumstances, some other means of addressing French misconduct would have spared the world incalculable suffering. But misled by an inordinate fear of stock market speculation, the Fed tightened policy in 1928-29 and began accumulating gold rather than accommodate the French demand.

And the Depression came.

An Austrian Tragedy

It was hardly predictable that the New York Review of Books would take notice of Marginal Revolutionaries by Janek Wasserman, marking the susquicentenial of the publication of Carl Menger’s Grundsätze (Principles of Economics) which, along with Jevons’s Principles of Political Economy and Walras’s Elements of Pure Economics ushered in the marginal revolution upon which all of modern economics, for better or for worse, is based. The differences among the three founding fathers of modern economic theory were not insubstantial, and the Jevonian version was largely superseded by the work of his younger contemporary Alfred Marshall, so that modern neoclassical economics is built on the work of only one of the original founders, Leon Walras, Jevons’s work having left little impression on the future course of economics.

Menger’s work, however, though largely, but not totally, eclipsed by that of Marshall and Walras, did leave a more enduring imprint and a more complicated legacy than Jevons’s — not only for economics, but for political theory and philosophy, more generally. Judging from Edward Chancellor’s largely favorable review of Wasserman’s volume, one might even hope that a start might be made in reassessing that legacy, a process that could provide an opportunity for mutually beneficial interaction between long-estranged schools of thought — one dominant and one marginal — that are struggling to overcome various conceptual, analytical and philosophical problems for which no obvious solutions seem available.

In view of the failure of modern economists to anticipate the Great Recession of 2008, the worst financial shock since the 1930s, it was perhaps inevitable that the Austrian School, a once favored branch of economics that had made a specialty of booms and busts, would enjoy a revival of public interest.

The theme of Austrians as outsiders runs through Janek Wasserman’s The Marginal Revolutionaries: How Austrian Economists Fought the War of Ideas, a general history of the Austrian School from its beginnings to the present day. The title refers both to the later marginalization of the Austrian economists and to the original insight of its founding father, Carl Menger, who introduced the notion of marginal utility—namely, that economic value does not derive from the cost of inputs such as raw material or labor, as David Ricardo and later Karl Marx suggested, but from the utility an individual derives from consuming an additional amount of any good or service. Water, for instance, may be indispensable to humans, but when it is abundant, the marginal value of an extra glass of the stuff is close to zero. Diamonds are less useful than water, but a great deal rarer, and hence command a high market price. If diamonds were as common as dewdrops, however, they would be worthless.

Menger was not the first economist to ponder . . . the “paradox of value” (why useless things are worth more than essentials)—the Italian Ferdinando Galiani had gotten there more than a century earlier. His central idea of marginal utility was simultaneously developed in England by W. S. Jevons and on the Continent by Léon Walras. Menger’s originality lay in applying his theory to the entire production process, showing how the value of capital goods like factory equipment derived from the marginal value of the goods they produced. As a result, Austrian economics developed a keen interest in the allocation of capital. Furthermore, Menger and his disciples emphasized that value was inherently subjective, since it depends on what consumers are willing to pay for something; this imbued the Austrian school from the outset with a fiercely individualistic and anti-statist aspect.

Menger’s unique contribution is indeed worthy of special emphasis. He was more explicit than Jevons or Walras, and certainly more than Marshall, in explaining that the value of factors of production is derived entirely from the value of the incremental output that could be attributed (or imputed) to their services. This insight implies that cost is not an independent determinant of value, as Marshall, despite accepting the principle of marginal utility, continued to insist – famously referring to demand and supply as the two blades of the analytical scissors that determine value. The cost of production therefore turns out to be nothing but the value the output foregone when factors are used to produce one output instead of the next most highly valued alternative. Cost therefore does not determine, but is determined by, equilibrium price, which means that, in practice, costs are always subjective and conjectural. (I have made this point in an earlier post in a different context.) I will have more to say below about the importance of Menger’s specific contribution and its lasting imprint on the Austrian school.

Menger’s Principles of Economics, published in 1871, established the study of economics in Vienna—before then, no economic journals were published in Austria, and courses in economics were taught in law schools. . . .

The Austrian School was also bound together through family and social ties: [his two leading disciples, [Eugen von] Böhm-Bawerk and Friedrich von Wieser [were brothers-in-law]. [Wieser was] a close friend of the statistician Franz von Juraschek, Friedrich Hayek’s maternal grandfather. Young Austrian economists bonded on Alpine excursions and met in Böhm-Bawerk’s famous seminars (also attended by the Bolshevik Nikolai Bukharin and the German Marxist Rudolf Hilferding). Ludwig von Mises continued this tradition, holding private seminars in Vienna in the 1920s and later in New York. As Wasserman notes, the Austrian School was “a social network first and last.”

After World War I, the Habsburg Empire was dismantled by the victorious Allies. The Austrian bureaucracy shrank, and university placements became scarce. Menger, the last surviving member of the first generation of Austrian economists, died in 1921. The economic school he founded, with its emphasis on individualism and free markets, might have disappeared under the socialism of “Red Vienna.” Instead, a new generation of brilliant young economists emerged: Schumpeter, Hayek, and Mises—all of whom published best-selling works in English and remain familiar names today—along with a number of less well known but influential economists, including Oskar Morgenstern, Fritz Machlup, Alexander Gerschenkron, and Gottfried Haberler.

Two factual corrections are in order. Menger outlived Böhm-Bawerk, but not his other chief disciple von Wieser, who died in 1926, not long after supervising Hayek’s doctoral dissertation, later published in 1927, and, in 1933, translated into English and published as Monetary Theory and the Trade Cycle. Moreover, a 16-year gap separated Mises and Schumpeter, who were exact contemporaries, from Hayek (born in 1899) who was a few years older than Gerschenkron, Haberler, Machlup and Morgenstern.

All the surviving members or associates of the Austrian school wound up either in the US or Britain after World War II, and Hayek, who had taken a position in London in 1931, moved to the US in 1950, taking a position in the Committee on Social Thought at the University of Chicago after having been refused a position in the economics department. Through the intervention of wealthy sponsors, Mises obtained an academic appointment of sorts at the NYU economics department, where he succeeded in training two noteworthy disciples who wrote dissertations under his tutelage, Murray Rothbard and Israel Kirzner. (Kirzner wrote his dissertation under Mises at NYU, but Rothbard did his graduate work at Colulmbia.) Schumpeter, Haberler and Gerschenkron eventually took positions at Harvard, while Machlup (with some stops along the way) and Morgenstern made their way to Princeton. However, Hayek’s interests shifted from pure economic theory to deep philosophical questions. While Machlup and Haberler continued to work on economic theory, the Austrian influence on their work after World War II was barely recognizable. Morgenstern and Schumpeter made major contributions to economics, but did not hide their alienation from the doctrines of the Austrian School.

So there was little reason to expect that the Austrian School would survive its dispersal when the Nazis marched unopposed into Vienna in 1938. That it did survive is in no small measure due to its ideological usefulness to anti-socialist supporters who provided financial support to Hayek, enabling his appointment to the Committee on Social Thought at the University of Chicago, and Mises’s appointment at NYU, and other forms of research support to Hayek, Mises and other like-minded scholars, as well as funding the Mont Pelerin Society, an early venture in globalist networking, started by Hayek in 1947. Such support does not discredit the research to which it gave rise. That the survival of the Austrian School would probably not have been possible without the support of wealthy benefactors who anticipated that the Austrians would advance their political and economic interests does not invalidate the research thereby enabled. (In the interest of transparency, I acknowledge that I received support from such sources for two books that I wrote.)

Because Austrian School survivors other than Mises and Hayek either adapted themselves to mainstream thinking without renouncing their earlier beliefs (Haberler and Machlup) or took an entirely different direction (Morgenstern), and because the economic mainstream shifted in two directions that were most uncongenial to the Austrians: Walrasian general-equilibrium theory and Keynesian macroeconomics, the Austrian remnant, initially centered on Mises at NYU, adopted a sharply adversarial attitude toward mainstream economic doctrines.

Despite its minute numbers, the lonely remnant became a house divided against itself, Mises’s two outstanding NYU disciples, Murray Rothbard and Israel Kirzner, holding radically different conceptions of how to carry on the Austrian tradition. An extroverted radical activist, Rothbard was not content just to lead a school of economic thought, he aspired to become the leader of a fantastical anarchistic revolutionary movement to replace all established governments under a reign of private-enterprise anarcho-capitalism. Rothbard’s political radicalism, which, despite his Jewish ancestry, even included dabbling in Holocaust denialism, so alienated his mentor, that Mises terminated all contact with Rothbard for many years before his death. Kirzner, self-effacing, personally conservative, with no political or personal agenda other than the advancement of his own and his students’ scholarship, published hundreds of articles and several books filling 10 thick volumes of his collected works published by the Liberty Fund, while establishing a robust Austrian program at NYU, training many excellent scholars who found positions in respected academic and research institutions. Similar Austrian programs, established under the guidance of Kirzner’s students, were started at other institutions, most notably at George Mason University.

One of the founders of the Cato Institute, which for nearly half a century has been the leading avowedly libertarian think tank in the US, Rothbard was eventually ousted by Cato, and proceeded to set up a rival think tank, the Ludwig von Mises Institute, at Auburn University, which has turned into a focal point for extreme libertarians and white nationalists to congregate, get acquainted, and strategize together.

Isolation and marginalization tend to cause a subspecies either to degenerate toward extinction, to somehow blend in with the members of the larger species, thereby losing its distinctive characteristics, or to accentuate its unique traits, enabling it to find some niche within which to survive as a distinct sub-species. Insofar as they have engaged in economic analysis rather than in various forms of political agitation and propaganda, the Rothbardian Austrians have focused on anarcho-capitalist theory and the uniquely perverse evils of fractional-reserve banking.

Rejecting the political extremism of the Rothbardians, Kirznerian Austrians differentiate themselves by analyzing what they call market processes and emphasizing the limitations on the knowledge and information possessed by actual decision-makers. They attribute this misplaced focus on equilibrium to the extravagantly unrealistic and patently false assumptions of mainstream models on the knowledge possessed by economic agents, which effectively make equilibrium the inevitable — and trivial — conclusion entailed by those extreme assumptions. In their view, the focus of mainstream models on equilibrium states with unrealistic assumptions results from a preoccupation with mathematical formalism in which mathematical tractability rather than sound economics dictates the choice of modeling assumptions.

Skepticism of the extreme assumptions about the informational endowments of agents covers a range of now routine assumptions in mainstream models, e.g., the ability of agents to form precise mathematical estimates of the probability distributions of future states of the world, implying that agents never confront decisions about which they are genuinely uncertain. Austrians also object to the routine assumption that all the information needed to determine the solution of a model is the common knowledge of the agents in the model, so that an existing equilibrium cannot be disrupted unless new information randomly and unpredictably arrives. Each agent in the model having been endowed with the capacity of a semi-omniscient central planner, solving the model for its equilibrium state becomes a trivial exercise in which the optimal choices of a single agent are taken as representative of the choices made by all of the model’s other, semi-omnicient, agents.

Although shreds of subjectivism — i.e., agents make choices based own preference orderings — are shared by all neoclassical economists, Austrian criticisms of mainstream neoclassical models are aimed at what Austrians consider to be their insufficient subjectivism. It is this fierce commitment to a robust conception of subjectivism, in which an equilibrium state of shared expectations by economic agents must be explained, not just assumed, that Chancellor properly identifies as a distinguishing feature of the Austrian School.

Menger’s original idea of marginal utility was posited on the subjective preferences of consumers. This subjectivist position was retained by subsequent generations of the school. It inspired a tradition of radical individualism, which in time made the Austrians the favorite economists of American libertarians. Subjectivism was at the heart of the Austrians’ polemical rejection of Marxism. Not only did they dismiss Marx’s labor theory of value, they argued that socialism couldn’t possibly work since it would lack the means to allocate resources efficiently.

The problem with central planning, according to Hayek, is that so much of the knowledge that people act upon is specific knowledge that individuals acquire in the course of their daily activities and life experience, knowledge that is often difficult to articulate – mere intuition and guesswork, yet more reliable than not when acted upon by people whose livelihoods depend on being able to do the right thing at the right time – much less communicate to a central planner.

Chancellor attributes Austrian mistrust of statistical aggregates or indices, like GDP and price levels, to Austrian subjectivism, which regards such magnitudes as abstractions irrelevant to the decisions of private decision-makers, except perhaps in forming expectations about the actions of government policy makers. (Of course, this exception potentially provides full subjectivist license and legitimacy for macroeconomic theorizing despite Austrian misgivings.) Observed statistical correlations between aggregate variables identified by macroeconomists are dismissed as irrelevant unless grounded in, and implied by, the purposeful choices of economic agents.

But such scruples about the use of macroeconomic aggregates and inferring causal relationships from observed correlations are hardly unique to the Austrian school. One of the most important contributions of the 20th century to the methodology of economics was an article by T. C. Koopmans, “Measurement Without Theory,” which argued that measured correlations between macroeconomic variables provide a reliable basis for business-cycle research and policy advice only if the correlations can be explained in terms of deeper theoretical or structural relationships. The Nobel Prize Committee, in awarding the 1975 Prize to Koopmans, specifically mentioned this paper in describing Koopmans’s contributions. Austrians may be more fastidious than their mainstream counterparts in rejecting macroeconomic relationships not based on microeconomic principles, but they aren’t the only ones mistrustful of mere correlations.

Chancellor cites mistrust about the use of statistical aggregates and price indices as a factor in Hayek’s disastrous policy advice warning against anti-deflationary or reflationary measures during the Great Depression.

Their distrust of price indexes brought Austrian economists into conflict with mainstream economic opinion during the 1920s. At the time, there was a general consensus among leading economists, ranging from Irving Fisher at Yale to Keynes at Cambridge, that monetary policy should aim at delivering a stable price level, and in particular seek to prevent any decline in prices (deflation). Hayek, who earlier in the decade had spent time at New York University studying monetary policy and in 1927 became the first director of the Austrian Institute for Business Cycle Research, argued that the policy of price stabilization was misguided. It was only natural, Hayek wrote, that improvements in productivity should lead to lower prices and that any resistance to this movement (sometimes described as “good deflation”) would have damaging economic consequences.

The argument that deflation stemming from economic expansion and increasing productivity is normal and desirable isn’t what led Hayek and the Austrians astray in the Great Depression; it was their failure to realize the deflation that triggered the Great Depression was a monetary phenomenon caused by a malfunctioning international gold standard. Moreover, Hayek’s own business-cycle theory explicitly stated that a neutral (stable) monetary policy ought to aim at keeping the flow of total spending and income constant in nominal terms while his policy advice of welcoming deflation meant a rapidly falling rate of total spending. Hayek’s policy advice was an inexcusable error of judgment, which, to his credit, he did acknowledge after the fact, though many, perhaps most, Austrians have refused to follow him even that far.

Considered from the vantage point of almost a century, the collapse of the Austrian School seems to have been inevitable. Hayek’s long-shot bid to establish his business-cycle theory as the dominant explanation of the Great Depression was doomed from the start by the inadequacies of the very specific version of his basic model and his disregard of the obvious implication of that model: prevent total spending from contracting. The promising young students and colleagues who had briefly gathered round him upon his arrival in England, mostly attached themselves to other mentors, leaving Hayek with only one or two immediate disciples to carry on his research program. The collapse of his research program, which he himself abandoned after completing his final work in economic theory, marked a research hiatus of almost a quarter century, with the notable exception of publications by his student, Ludwig Lachmann who, having decamped in far-away South Africa, labored in relative obscurity for most of his career.

The early clash between Keynes and Hayek, so important in the eyes of Chancellor and others, is actually overrated. Chancellor, quoting Lachmann and Nicholas Wapshott, describes it as a clash of two irreconcilable views of the economic world, and the clash that defined modern economics. In later years, Lachmann actually sought to effect a kind of reconciliation between their views. It was not a conflict of visions that undid Hayek in 1931-32, it was his misapplication of a narrowly constructed model to a problem for which it was irrelevant.

Although the marginalization of the Austrian School, after its misguided policy advice in the Great Depression and its dispersal during and after World War II, is hardly surprising, the unwillingness of mainstream economists to sort out what was useful and relevant in the teachings of the Austrian School from what is not was unfortunate not only for the Austrians. Modern economics was itself impoverished by its disregard for the complexity and interconnectedness of economic phenomena. It’s precisely the Austrian attentiveness to the complexity of economic activity — the necessity for complementary goods and factors of production to be deployed over time to satisfy individual wants – that is missing from standard economic models.

That Austrian attentiveness, pioneered by Menger himself, to the complementarity of inputs applied over the course of time undoubtedly informed Hayek’s seminal contribution to economic thought: his articulation of the idea of intertemporal equilibrium that comprehends the interdependence of the plans of independent agents and the need for them to all fit together over the course of time for equilibrium to obtain. Hayek’s articulation represented a conceptual advance over earlier versions of equilibrium analysis stemming from Walras and Pareto, and even from Irving Fisher who did pay explicit attention to intertemporal equilibrium. But in Fisher’s articulation, intertemporal consistency was described in terms of aggregate production and income, leaving unexplained the mechanisms whereby the individual plans to produce and consume particular goods over time are reconciled. Hayek’s granular exposition enabled him to attend to, and articulate, necessary but previously unspecified relationships between the current prices and expected future prices.

Moreover, neither mainstream nor Austrian economists have ever explained how prices are adjust in non-equilibrium settings. The focus of mainstream analysis has always been the determination of equilibrium prices, with the implicit understanding that “market forces” move the price toward its equilibrium value. The explanatory gap has been filled by the mainstream New Classical School which simply posits the existence of an equilibrium price vector, and, to replace an empirically untenable tâtonnement process for determining prices, posits an equally untenable rational-expectations postulate to assert that market economies typically perform as if they are in, or near the neighborhood of, equilibrium, so that apparent fluctuations in real output are viewed as optimal adjustments to unexplained random productivity shocks.

Alternatively, in New Keynesian mainstream versions, constraints on price changes prevent immediate adjustments to rationally expected equilibrium prices, leading instead to persistent reductions in output and employment following demand or supply shocks. (I note parenthetically that the assumption of rational expectations is not, as often suggested, an assumption distinct from market-clearing, because the rational expectation of all agents of a market-clearing price vector necessarily implies that the markets clear unless one posits a constraint, e.g., a binding price floor or ceiling, that prevents all mutually beneficial trades from being executed.)

Similarly, the Austrian school offers no explanation of how unconstrained price adjustments by market participants is a sufficient basis for a systemic tendency toward equilibrium. Without such an explanation, their belief that market economies have strong self-correcting properties is unfounded, because, as Hayek demonstrated in his 1937 paper, “Economics and Knowledge,” price adjustments in current markets don’t, by themselves, ensure a systemic tendency toward equilibrium values that coordinate the plans of independent economic agents unless agents’ expectations of future prices are sufficiently coincident. To take only one passage of many discussing the difficulty of explaining or accounting for a process that leads individuals toward a state of equilibrium, I offer the following as an example:


In this theoretical muddle, Keynesian economics and the neoclassical synthesis were abandoned, because the key proposition of Keynesian economics was supposedly the tendency of a modern economy toward an equilibrium with involuntary unemployment while the neoclassical synthesis rejected that proposition, so that the supposed synthesis was no more than an agreement to disagree. That divided house could not stand. The inability of Keynesian economists such as Hicks, Modigliani, Samuelson and Patinkin to find a satisfactory (at least in terms of a preferred Walrasian general-equilibrium model) rationalization for Keynes’s conclusion that an economy would likely become stuck in an equilibrium with involuntary unemployment led to the breakdown of the neoclassical synthesis and the displacement of Keynesianism as the dominant macroeconomic paradigm.

But perhaps the way out of the muddle is to abandon the idea that a systemic tendency toward equilibrium is a property of an economic system, and, instead, to recognize that equilibrium is, as Hayek suggested, a contingent, not a necessary, property of a complex economy. Ludwig Lachmann, cited by Chancellor for his remark that the early theoretical clash between Hayek and Keynes was a conflict of visions, eventually realized that in an important sense both Hayek and Keynes shared a similar subjectivist conception of the crucial role of individual expectations of the future in explaining the stability or instability of market economies. And despite the efforts of New Classical economists to establish rational expectations as an axiomatic equilibrating property of market economies, that notion rests on nothing more than arbitrary methodological fiat.

Chancellor concludes by suggesting that Wasserman’s characterization of the Austrians as marginalized is not entirely accurate inasmuch as “the Austrians’ view of the economy as a complex, evolving system continues to inspire new research.” Indeed, if economics is ever to find a way out of its current state of confusion, following Lachmann in his quest for a synthesis of sorts between Keynes and Hayek might just be a good place to start from.

My Paper “Hayek, Deflation, Gold, and Nihilism” Is now Available on SSRN

I contributed a chapter entitled “Hayek, Deflation, Gold and Nihilism” to volume 13 of Hayek: A Collaborative Biography edited by Robert Leeson and published in 2018 by Palgrave Macmillan.

I have posted a preliminary draft of that chapter on SSRN. Here is the abstract.

In Hayek’s early writings on business cycle theory and the Great Depression he argued that business cycle downturns including the steep downturn of 1929-31 were caused by unsustainable elongations of capital structure of the economy resulting from bank-financed investment in excess of voluntary saving. Because monetary expansion was the cause of the crisis, Hayek argued that monetary expansion was an inappropriate remedy to cure the deflation and high unemployment caused by the crisis. He therefore recommended allowing the Depression to take its course until the distortions that led to the downturn could be corrected by market forces. However, this view of the Depression was at odds with Hayek’s own neutral money criterion which implied that prices should fall during expansions and rise during contractions so that nominal spending would remain more or less constant over the cycle. Although Hayek strongly favored allowing prices to fall in the expansion, he did not follow the logic of his own theory in favoring generally increasing prices during the contraction. This paper explores the reasons for Hayek’s reluctance to follow the logic of his own theory in his early policy recommendations. The key factors responsible for his early policy recommendations seem to be his attachment to the gold standard and the seeming necessity for countries to accept deflation to maintain convertibility and his hope or expectation that deflation would overwhelm the price rigidities that he believed were obstructing the price mechanism from speeding a recovery. By 1935 Hayek’s attachment to the gold standard was starting to weaken, and in later years he openly acknowledged that he had been mistaken not to favor policy measures, including monetary expansion, designed to stabilize total spending.

Dr. Shelton Remains Outspoken: She Should Have Known Better






























Friedman and Schwartz, Eichengreen and Temin, Hawtrey and Cassel

Barry Eichengreen and Peter Temin are two of the great economic historians of our time, writing, in the splendid tradition of Charles Kindleberger, profound and economically acute studies of the economic and financial history of the nineteenth and early twentieth centuries. Most notably they have focused on periods of panic, crisis and depression, of which by far the best-known and most important episode is the Great Depression that started late in 1929, bottomed out early in 1933, but lingered on for most of the 1930s, and they are rightly acclaimed for having emphasized and highlighted the critical role of the gold standard in the Great Depression, a role largely overlooked in the early Keynesian accounts of the Great Depression. Those accounts identified a variety of specific shocks, amplified by the volatile entrepreneurial expectations and animal spirits that drive, or dampen, business investment, and further exacerbated by inherent instabilities in market economies that lack self-stabilizing mechanisms for maintaining or restoring full employment.

That Keynesian vision of an unstable market economy vulnerable to episodic, but prolonged, lapses from full-employment was vigorously, but at first unsuccessfully, disputed by advocates of free-market economics. It wasn’t until Milton Friedman provided an alternative narrative explaining the depth and duration of the Great Depression, that the post-war dominance of Keynesian theory among academic economists seriously challenged. Friedman’s alternative narrative of the Great Depression was first laid out in the longest chapter (“The Great Contraction”) of his magnum opus, co-authored with Anna Schwartz, A Monetary History of the United States. In Friedman’s telling, the decline in the US money stock was the critical independent causal factor that directly led to the decline in prices, output, and employment. The contraction in the quantity of money was not caused by the inherent instability of free-market capitalism, but, owing to a combination of incompetence and dereliction of duty, by the Federal Reserve.

In the Monetary History of the United States, all the heavy lifting necessary to account for both secular and cyclical movements in the price level, output and employment is done by, supposedly exogenous, changes in the nominal quantity of money, Friedman having considered it to be of the utmost significance that the largest movements in both the quantity of money, and in prices, output and employment occurred during the Great Depression. The narrative arc of the Monetary History was designed to impress on the mind of the reader the axiomatic premise that monetary authority has virtually absolute control over the quantity of money which served as the basis for inferring that changes in the quantity of money are what cause changes in prices, output and employment.

Friedman’s treatment of the gold standard (which I have discussed here, here and here) was both perfunctory and theoretically confused. Unable to reconcile the notion that the monetary authority has absolute control over the nominal quantity of money with the proposition that the price level in any country on the gold standard cannot deviate from the price levels of other gold standard countries without triggering arbitrage transactions that restore the equality between the price levels of all gold standard countries, Friedman dodged the inconsistency repeatedly invoking his favorite fudge factor: long and variable lags between changes in the quantity of money and changes in prices, output and employment. Despite its vacuity, the long-and-variable-lag dodge allowed Friedman to ignore the inconvenient fact that the US price level in the Great Depression did not and could not vary independently of the price levels of all other countries then on the gold standard.

I’ll note parenthetically that Keynes himself was also responsible for this unnecessary and distracting detour, because the General Theory was written almost entirely in the context of a closed economy model with an exogenously determined quantity of money, thereby unwittingly providing with a useful tool with which to propagate his Monetarist narrative. The difference of course is that Keynes, as demonstrated in his brilliant early works, Indian Currency and Finance and A Tract on Monetary Reform and the Economic Consequences of Mr. Churchill, had a correct understanding of the basic theory of the gold standard, an understanding that, owing to his obsessive fixation on the nominal quantity of money, eluded Friedman over his whole career. Why Keynes, who had a perfectly good theory of what was happening in the Great Depression available to him, as it was to others, was diverted to an unnecessary, but not uninteresting, new theory is a topic that I wrote about a very long time ago here, though I’m not so sure that I came up with a good or even adequate explanation.

So it does not speak well of the economics profession that it took nearly a quarter of a century before the basic internal inconsistency underlying Friedman’s account of the Great Depression was sufficiently recognized to call for an alternative theoretical account of the Great Depression that placed the gold standard at the heart of the narrative. It was Peter Temin and Barry Eichengreen, both in their own separate works (e.g., Lessons of the Great Depression by Temin and Golden Fetters by Eichengreen) and in an important paper they co-authored and published in 2000 to remind both economists and historians how important a role the gold standard must play in any historical account of the Great Depression.

All credit is due to Temin and Eichengreen for having brought to the critical role of the gold standard in the Great Depression to the attention of economists who had largely derived their understanding of what had caused the Great Depression from either some variant of the Keynesian narrative or of Friedman’s Monetarist indictment of the Federal Reserve System. But it’s unfortunate that neither Temin nor Eichnegreen gave sufficient credit to either R. G. Hawtrey or to Gustav Cassel for having anticipated almost all of their key findings about the causes of the Great Depression. And I think that what prevented Eichengreen and Temin from realizing that Hawtrey in particular had anticipated their explanation of the Great Depression by more than half a century was that they did not fully grasp the key theoretical insight underlying Hawtrey’s explanation of the Great Depression.

That insight was that the key to understanding the common world price level in terms of gold under a gold standard is to think in terms of a given world stock of gold and to think of total world demand to hold gold consisting of real demands to hold gold for commercial, industrial and decorative uses, the private demand to hold gold as an asset, and the monetary demand for gold to be held either as a currency or as a reserve for currency. The combined demand to hold gold for all such purposes, given the existing stock of gold, determines a real relative price of gold in terms of all other commodities. This relative price when expressed in terms of a currency unit that is convertible into gold corresponds to an equivalent set of commodity prices in terms of those convertible currency units.

This way of thinking about the world price level under the gold standard was what underlay Hawtrey’s monetary analysis and his application of that analysis in explaining the Great Depression. Given that the world output of gold in any year is generally only about 2 or 3 percent of the existing stock of gold, it is fluctuations in the demand for gold, of which the monetary demand for gold in the period after the outbreak of World War I was clearly the least stable, that causes short-term fluctuations in the value of gold. Hawtrey’s efforts after the end of World War I were therefore focused on the necessity to stabilize the world’s monetary demands for gold in order to avoid fluctuations in the value of gold as the world moved toward the restoration of the gold standard that then seemed, to most monetary and financial experts and most monetary authorities and political leaders, to be both inevitable and desirable.

In the opening pages of Golden Fetters, Eichengreen beautifully describes backdrop against which the attempt to reconstitute the gold standard was about to made after World War I.

For more than a quarter of a century before World War I, the gold standard provided the framework for domestic and international monetary relations. . .  The gold standard had been a remarkably efficient mechanism for organizing financial affairs. No global crises comparable to the one that began in 1929 had disrupted the operation of financial markets. No economic slump had so depressed output and employment.

The central elements of this system were shattered by . . . World War I. More than a decade was required to complete their reconstruction. Quickly it became evident that the reconstructed gold standard was less resilient that its prewar predecessor. As early as 1929 the new international monetary system began to crumble. Rapid deflation forced countries to  producing primary commodities to suspend gold convertibility and depreciate their currencies. Payments problems spread next to the industrialized world. . . Britain, along with United State and France, one of the countries at the center of the international monetary system, was next to experience a crisis, abandoning the gold standard in the autumn of 1931. Some two dozen countries followed suit. The United States dropped the gold standard in 1933; France hung on till the bitter end, which came in 1936.

The collapse of the international monetary system is commonly indicted for triggering the financial crisis that transformed a modes economic downturn gold standard into an unprecedented slump. So long as the gold standard was maintained, it is argued, the post-1929 recession remained just another cyclical contraction. But the collapse of the gold standard destroyed confidence in financial stability, prompting capital flight which undermined the solvency of financial institutions. . . Removing the gold standard, the argument continues, further intensified the crisis. Having suspended gold convertibility, policymakers manipulated currencies, engaging in beggar thy neighbor depreciations that purportedly did nothing to stimulate economic recovery at home while only worsening the Depression abroad.

The gold standard, then, is conventionally portrayed as synonymous with financial stability. Its downfall starting in 1929 is implicated in the global financial crisis and the worldwide depression. A central message of this book is that precisely the opposite was true. (Golden Fetters, pp. 3-4).

That is about as clear and succinct and accurate a description of the basic facts leading up to and surrounding the Great Depression as one could ask for, save for the omission of one important causal factor: the world monetary demand for gold.

Eichengreen was certainly not unaware of the importance of the monetary demand for gold, and in the pages that immediately follow, he attempts to fill in that part of the story, adding to our understanding of how the gold standard worked by penetrating deeply into the nature and role of the expectations that supported the gold standard, during its heyday, and the difficulty of restoring those stabilizing expectations after the havoc of World War I and the unexpected post-war inflation and subsequent deep 1920-21 depression. Those stabilizing expectations, Eichengreen argued, were the result of the credibility of the commitment to the gold standard and the international cooperation between governments and monetary authorities to ensure that the international gold standard would be maintained notwithstanding the occasional stresses and strains to which a complex institution would inevitably be subjected.

The stability of the prewar gold standard was instead the result of two very different factors: credibility and cooperation. Credibility is the confidence invested by the public in the government’s commitment to a policy. The credibility of the gold standard derived from the priority attached by governments to the maintenance of to the maintenance of balance-of-payments equilibrium. In the core countries – Britain, France and Germany – there was little doubt that the authorities would take whatever steps were required to defend the central bank’s gold reserves and maintain the convertibility of the currency into gold. If one of these central banks lost gold reserves and its exchange rate weakened, fund would flow in from abroad in anticipation of the capital gains investors in domestic assets would reap once the authorities adopted measures to stem reserve losses and strengthen the exchange rate. . . The exchange rate consequently strengthened on its own, and stabilizing capital flows minimized the need for government intervention. The very credibility of the official commitment to gold meant that this commitment was rarely tested. (p. 5)

But credibility also required cooperation among the various countries on the gold standard, especially the major countries at its center, of which Britain was the most important.

Ultimately, however, the credibility of the prewar gold standard rested on international cooperation. When the stabilizing speculation and domestic intervention proved incapable of accommodating a disturbance, the system was stabilized through cooperation among governments and central banks. Minor problems could be solved by tacit cooperation, generally achieved without open communication among the parties involved. . .  Under such circumstances, the most prominent central bank, the Bank of England, signaled the need for coordinated action. When it lowered its discount rate, other central banks usually responded in kind. In effect, the Bank of England provided a focal point for the harmonization of national monetary policies. . .

Major crises in contrast typically required different responses from different countries. The country losing gold and threatened by a convertibility crisis had to raise interest rates to attract funds from abroad; other countries had to loosen domestic credit conditions to make funds available to the central bank experiencing difficulties. The follow-the-leader approach did not suffice. . . . Such crises were instead contained through overt, conscious cooperation among central banks and governments. . . Consequently, the resources any one country could draw on when its gold parity was under attack far exceeded its own reserves; they included the resources of the other gold standard countries. . . .

What rendered the commitment to the gold standard credible, then, was that the commitment was international, not merely national. That commitment was achieved through international cooperation. (pp. 7-8)

Eichengreen uses this excellent conceptual framework to explain the dysfunction of the newly restored gold standard in the 1920s. Because of the monetary dislocation and demonetization of gold during World War I, the value of gold had fallen to about half of its prewar level, thus to reestablish the gold standard required not only restoring gold as a currency standard but also readjusting – sometimes massively — the prewar relative values of the various national currency units. And to prevent the natural tendency of gold to revert to its prewar value as gold was remonetized would require an unprecedented level of international cooperation among the various countries as they restored the gold standard. Thus, the gold standard was being restored in the 1920s under conditions in which neither the credibility of the prewar commitment to the gold standard nor the level of international cooperation among countries necessary to sustain that commitment was restored.

An important further contribution that Eichengreen, following Temin, brings to the historical narrative of the Great Depression is to incorporate the political forces that affected and often determined the decisions of policy makers directly into the narrative rather than treat those decisions as being somehow exogenous to the purely economic forces that were controlling the unfolding catastrophe.

The connection between domestic politics and international economics is at the center of this book. The stability of the prewar gold standard was attributable to a particular constellation of political as well as economic forces. Similarly, the instability of the interwar gold standard is explicable in terms of political as well as economic changes. Politics enters at two levels. First, domestic political pressures influence governments’ choices of international economic policies. Second, domestic political pressures influence the credibility of governments’ commitments to policies and hence their economic effects. . . (p. 10)

The argument, in a nutshell, is that credibility and cooperation were central to the smooth operation of the classical gold standard. The scope for both declined abruptly with the intervention of World War I. The instability of the interwar gold standard was the inevitable result. (p. 11)

Having explained and focused attention on the necessity for credibility and cooperation for a gold standard to function smoothly, Eichengreen then begins his introductory account of how the lack of credibility and cooperation led to the breakdown of the gold standard that precipitated the Great Depression, starting with the structural shift after World War I that made the rest of the world highly dependent on the US as a source of goods and services and as a source of credit, rendering the rest of the world chronically disposed to run balance-of-payments deficits with the US, deficits that could be financed only by the extension of credit by the US.

[I]f U.S. lending were interrupted, the underlying weakness of other countries’ external positions . . . would be revealed. As they lost gold and foreign exchange reserves, the convertibility of their currencies into gold would be threatened. Their central banks would be forced to  restrict domestic credit, their fiscal authorities to compress public spending, even if doing so threatened to plunge their economies into recession.

This is what happened when U.S. lending was curtailed in the summer of 1928 as a result of increasingly stringent Federal Reserve monetary policy. Inauspiciously, the monetary contraction in the United States coincided with a massive flow of gold to France, where monetary policy was tight for independent reasons. Thus, gold and financial capital were drained by the United States and France from other parts of the world. Superimposed on already weak foreign balances of payments, these events provoked a greatly magnified monetary contraction abroad. In addition they caused a tightening of fiscal policies in parts of Europe and much of Latin America. This shift in policy worldwide, and not merely the relatively modest shift in the United States, provided the contractionary impulse that set the stage for the 1929 downturn. The minor shift in American policy had such dramatic effects because of the foreign reaction it provoked through its interactions with existing imbalances in the pattern of international settlements and with the gold standard constraints. (pp. 12-13)

Eichengreen then makes a rather bold statement, with which, despite my agreement with, and admiration for, everything he has written to this point, I would take exception.

This explanation for the onset of the Depression, which emphasizes concurrent shifts in economic policy in the Unites States and abroad, the gold standard as the connection between them, and the combined impact of U.S. and foreign economic policies on the level of activity, has not previously appeared in the literature. Its elements are familiar, but they have not been fit together into a coherent account of the causes of the 1929 downturn. (p. 13)

I don’t think that Eichengreen’s claim of priority for his explanation of the onset of the 1929 downturn can be defended, though I certainly wouldn’t suggest that he did not arrive at his understanding of what caused the Great Depression largely on his own. But it is abundantly clear from reading the writings of Hawtrey and Cassel starting as early as 1919, that the basic scenario outlined by Eichengreen was clearly spelled out by Hawtrey and Cassel well before the Great Depression started, as papers by Ron Batchelder and me and by Doug Irwin have thoroughly documented. Undoubtedly Eichengreen has added a great deal of additional insight and depth and done important quantitative and documentary empirical research to buttress his narrative account of the causes of the Great Depression, but the basic underlying theory has not changed.

Eichengreen is not unaware of Hawtrey’s contribution and in a footnote to the last quoted paragraph, Eichengreen writes as follows.

The closest precedents lie in the work of the British economists Lionel Robbins and Ralph Hawtrey, in the writings of German historians concerned with the causes of their economy’s precocious slump, and in Temin (1989). Robbins (1934) hinted at many of the mechanism emphasized here but failed to develop the argument fully. Hawtrey emphasized how the contractionary shift in U.S. monetary policy, superimposed on an already weak British balance of payments position, forced a draconian contraction on the Bank of England, plunging the world into recession. See Hawtrey (1933), especially chapter 2. But Hawtrey’s account focused almost entirely on the United States and the United Kingdom, neglecting the reaction of other central banks, notably the Bank of France, whose role was equally important. (p. 13, n. 17)

Unfortunately, this footnote neither clarifies nor supports Eichengreen’s claim of priority for his account of the role of the gold standard in the Great Depression. First, the bare citation of Robbins’s 1934 book The Great Depression is confusing at best, because Robbins’s explanation of the cause of the Great Depression, which he himself later disavowed, is largely a recapitulation of the Austrian business-cycle theory that attributed the downturn to a crisis caused by monetary expansion by the Fed and the Bank of England. Eichengreen correctly credits Hawtrey for attributing the Great Depression, in almost diametric opposition to Robbins, to contractionary monetary policy by the Fed and the Bank of England, but then seeks to distinguish Hawtrey’s explanation from his own by suggesting that Hawtrey neglected the role of the Bank of France.

Eichengreen mentions Hawtrey’s account of the Great Depression in his 1933 book, Trade Depression and the Way Out, 2nd edition. I no longer have a copy of that work accessible to me, but in the first edition of this work published in 1931, Hawtrey included a brief section under the heading “The Demand for Gold as Money since 1914.”

[S]ince 1914 arbitrary changes in monetary policy and in the demand for gold as money have been greater and more numerous than ever before. Frist came the general abandonment of the gold standard by the belligerent countries in favour of inconvertible paper, and the release of hundreds of millions of gold. By 1920 the wealth value of gold had fallen to two-fifths of what it had been in 1913. The United States, which was almost alone at that time in maintaining a gold standard, thereupon started contracting credit and absorbing gold on a vast scale. In June 1924 the wealth value of gold was seventy per cent higher than at its lowest point in 1920, and the amount of gold held for monetary purposes in the United States had grown from $2,840,000,000 in 1920 to $4,488,000,000.

Other countries were then beginning to return to the gold standard, Gemany in 1924, England in 1925, besides several of the smaller countries of Europe. In the years 1924-8 Germany absorbed over £100,000,000 of gold. France stabilized her currency in 1927 and re-established the gold standard in 1928, and absorbed over £60,000,000 in 1927-8. But meanwhile, the Unitd States had been parting with gold freely and her holding had fallen to $4,109,000,000 in June 1928. Large as these movements had been, they had not seriously disturbed the world value of gold. . . .

But from 1929 to the present time has been a period of immense and disastrous instability. France has added more than £200,000,000 to her gold holding, and the United Statesmore than $800,000,000. In the two and a half years the world’s gold output has been a little over £200,000,000, but a part of this been required for the normal demands of industry. The gold absorbed by France and America has exceeded the fresh supply of gold for monetary purposes by some £200,000,000.

This has had to be wrung from other countries, and much o of it has come from new countries such as Australia, Argentina and Brazil, which have been driven off the gold standard and have used their gold reserves to pay their external liabilities, such as interest on loans payable in foreign currencies. (pp. 20-21)

The idea that Hawtrey neglected the role of the Bank of France is clearly inconsistent with the work that Eichengreen himself cites as evidence for that neglect. Moreover in Hawtrey’s 1932 work, The Art of Central Banking, his first chapter is entitled “French Monetary Policy” which directly addresses the issues supposedly neglected by Hawtrey. Here is an example.

I am inclined therefore to say that while the French absorption of gold in the period from January 1929 to May 1931 was in fact one of the most powerful causes of the world depression, that is only because it was allowed to react an unnecessary degree upon the monetary policy of other countries. (p. 38)

In his foreward to the 1962 reprinting of his volume, Hawtrey mentions his chapter on French Monetary Policy in a section under the heading “Gold and the Great Depression.”

Conspicuous among countries accumulating reserves foreign exchange was France. Chapter 1 of this book records how, in the course of stabilizing the franc in the years 1926-8, the Bank of France accumulated a vast holding of foreign exchange [i.e., foreign bank liabilities payable in gold], and in the ensuing years proceeded to liquidate it [for gold]. Chapter IV . . . shows the bearing of the French absorption of gold upon the starting of the great depression of the 1930s. . . . The catastrophe foreseen in 1922 [!] had come to pass, and the moment had come to point to the moral. The disaster was due to the restoration of the gold standard without any provision for international cooperation to prevent undue fluctuations in the purchasing power of gold. (pp. xiv-xv)

Moreover, on p. 254 of Golden Fetters, Eichengreen himself cites Hawtrey as one of the “foreign critics” of Emile Moreau, Governor of the Bank of France during the 1920s and 1930s “for failing to build “a structure of credit” on their gold imports. By failing to expand domestic credit and to repel gold inflows, they argued, the French had violated the rules of the gold standard game.” In the same paragraph Eichengreen also cites Hawtrey’s recommendation that the Bank of France change its statutes to allow for the creation of domestically supplied money and credit that would have obviated the need for continuing imports of gold.

Finally, writers such as Clark Johnson and Kenneth Mouré, who have written widely respected works on French monetary policy during the 1920s and 1930s, cite Hawtrey extensively as one of the leading contemporary critics of French monetary policy.

PS I showed Barry Eichengreen a draft of this post a short while ago, and he agrees with my conclusion that Hawtrey, and presumably Cassel also, had anticipated the key elements of his explanation of how the breakdown of the gold standard, resulting largely from the breakdown of international cooperation, was the primary cause of the Great Depression. I am grateful to Barry for his quick and generous response to my query.

Hu McCulloch Figures out (More or Less) the Great Depression

Last week Houston McCulloch, one of the leading monetary economists of my generation, posted an  insightful and thoughtful discussion of the causes of the Great Depression with which I largely, though not entirely, agree. Although Scott Sumner has already commented on Hu’s discussion, I also wanted to weigh in with some of my comments. Here is how McCulloch sets up his discussion.

Understanding what caused the Great Depression of 1929-39 and why it persisted so long has been fairly characterized by Ben Bernanke as the “Holy Grail of Macroeconomics.” The fear that the financial crisis of 2008 would lead to a similar Depression induced the Fed to use its emergency powers to bail out failing firms and to more than quadruple the monetary base, while Congress authorized additional bailouts and doubled the national debt. Could the Great Recession have taken a similar turn had these extreme measures not been taken?




I agree with every word of this introductory passage, so let’s continue.



Here is where I start to quibble a bit with Hu, mainly about the importance of Britain’s 1925 resumption of convertibility at the prewar parity with the dollar. Largely owing to Keynes’s essay “The Economic Consequences of Mr. Churchill,” in which Keynes berated Churchill for agreeing to the demands of the City and to the advice of the British Treasury advisers (including Ralph Hawtrey), on whom he relied despite Keynes’s attempt to convince him otherwise, to quickly resume gold convertibility at the prewar dollar parity, warning of the devastating effects of the subsequent deflation on British industry and employment, much greater significance has been attributed to the resumption of convertibility than it actually had on the subsequent course of events. Keynes’s analysis of the deflationary effect of the resumption was largely correct, but the effect turned out to be milder than he anticipated. Britain had already undergone a severe deflation in the early 1920s largely as a result of the American deflation. Thus by 1925, Britain had already undergone nearly 5 years of continuous deflation that brought the foreign exchange value of sterling to within 10 percent of the prewar dollar parity. The remaining deflation required to enable sterling to appreciate another 10 percent was not trivial, but by 1925 most of the deflationary pain had already been absorbed. Britain was able to sustain further mild deflation for the next four years till mid-1929 even as the British economy grew and unemployment declined gradually. The myth that Britain was mired in a continuous depression after the resumption of convertibility in 1925 has no basis in the evidence. Certainly, a faster recovery would have been desirable, and Hawtrey consistently criticized the Bank of England for keeping Bank Rate at 5% even with deflation in the 1-2% range.

The US Federal Reserve was somewhat accommodative in the 1925-28 period, but could have easily been even more accommodative. As McCulloch correctly notes it was really France, which undervalued the franc when it restored convertibility in 1928, and began accumulating gold in record quantities that became the primary destabilizing force in the world economy. Britain was largely an innocent bystander.


Actually, the Fed, holding 40% of the world’s gold reserves in 1929, could have eased pressure on the world gold market by allowing an efflux of gold to accommodate the French demand for gold. However, instead of taking an accommodative stance, the Fed, seized by dread of stock-market speculation, kept increasing short-term interest rates, thereby attracting gold into the United States instead of allowing gold to flow out, increasing pressure on the world gold market and triggering the latent deflationary forces that until mid-1929 had been kept at bay. Anti-competitive policies under Hoover and under FDR were certainly not helpful, but those policies, as McCulloch recognizes, did not cause the collapse of output between 1929 and 1933.



As early as 1919 both Hawtrey and Cassel had warned that a global depression would follow an attempt to restore the gold standard as it existed before World War I. To avoid such a deflation it was necessary to limit the increase in the monetary demand for gold. Hawtrey and Cassel therefore proposed shifting to a gold exchange standard in which gold coinage would not be restored and central banks would hold non-gold foreign exchange reserves rather than gold bullion. The 1922 Genoa Resolutions were largely inspired by the analysis of Hawtrey and Cassel, and those resolutions were largely complied with until France began its insane gold accumulation policy in 1928 just as the Fed began tightening monetary policy to suppress stock-market speculation, thereby triggering, more or less inadvertently, an almost equally massive inflow of gold into the US. (On Hawtrey and Cassel, see my paper with Ron Batchelder.)

McCulloch has a very interesting discussion of the role of the gold standard as a tool of war finance, which reminds me of Earl Thompson’s take on the gold standard, (“Gold Standard: Causes and Consequences”) that Earl contributed to a volume I edited, Business Cycles and Depressions: An Encyclopedia. To keep this post from growing inordinately long, and because it’s somewhat tangential to McCulloch’s larger theme, I won’t comment on that part of McCulloch’s discussion.

The Gold Exchange Standard



This is basically right except that I don’t think it makes sense to refer to the US price level as being in equilibrium in 1922. Holding 40% of the world’s monetary gold reserves, the US was in a position to determine the value of gold at whatever level it wanted. To call the particular level at which the US decided to stabilize the value of gold in 1922 an equilibrium is not based on any clear definition of equilibrium that I can identify.

However, the European countries did not seriously try to get back on gold until the second half of the 1920s. The Genoa Conference of 1922 recognized that prices were too high for a full gold standard, but instead tried to put off the necessary deflation with an unrealistic “Gold Exchange Standard.” Under that system, only the “gold center” countries, the U.S. and UK, would hold actual gold reserves, while other central banks would be encouraged to hold dollar or sterling reserves, which in turn would only be fractionally backed by gold. The Gold Exchange Standard sounded good on paper, but unrealistically assumed that the rest of the world would permanently kowtow to the financial supremacy of New York and London.

There is an argument to be made that the Genoa Resolutions were unrealistic in the sense that they assumed that countries going back on the gold standard would be willing to forego the holding of gold reserves to a greater extent than they were willing to. But to a large extent, this was the result of systematically incorrect ideas about how the gold standard worked before World War I and how the system could work after World War I, not of any inherent or necessary properties of the gold standard itself. Nor was the assumption that the rest of the world would permanently kowtow to the financial supremacy of New York and London all that unrealistic when considered in the light of how readily, before World War I, the rest of the world kowtowed to the financial supremacy of London.


Here McCulloch is unintentionally displaying some of the systematically incorrect ideas about how the gold standard worked that I referred to above. McCulloch is correct that the franc was substantially undervalued when France restored convertibility in 1928. But under the gold standard, the French price level would automatically adjust to the world price level regardless of what happened to the French money supply. However, the Bank of France, partly because it was cashing in the rapidly accumulating foreign exchange reserves for gold as French exports were rising and its imports falling given the low internal French price level, and partly because it was legally barred from increasing the supply of banknotes by open-market operations, was accumulating gold both actively and passively. With no mechanism for increasing the quantity of banknotes in France, a balance of payment of surplus was the only mechanism by which an excess demand for money could be accommodated. It was not an inflow of gold that was being sterilized (sterilization being a misnomer reflecting a confusion about the direction of causality) it was the lack of any domestic mechanism for increasing the quantity of banknotes that caused an inflow of gold. Importing gold was the only means by which an excess domestic demand for banknotes could be satisfied.

The Second Post-War Deflation

By 1931, French gold withdrawals forced Germany to adopt exchange controls, and Britain to give up convertibility altogether. However, these countries did not then disgorge their remaining gold, but held onto it in the hopes of one day restoring free convertibility. Meanwhile, after having been burned by the Bank of England’s suspension, the “Gold Bloc” countries — Belgium, Netherlands and Switzerland — also began amassing gold reserves in earnest, raising their share of world gold reserves from 4.2% in June 1930 to 11.1% two years later (Johnson 1997, p. 194). Despite the dollar’s relatively strong position, the Fed also contributed to the problem by raising its gold coverage ratio to over 75% by 1930, well in excess of the 40% required by law (Irwin 2012, Fig. 5).



Once again McCulloch posits an equilibrium price level under a global gold standard. The mistake is in assuming that there is a fixed monetary demand for gold, which is an assumption completely without foundation. The monetary demand for gold is not fixed. The greater the monetary demand for gold the higher the equilibrium real value of gold and the lower the price level in terms of gold. The equilibrium price level is a function of the monetary demand for gold.


This is correct, and I fully agree.

How It Could Have been Different


Again, I reiterate that, although the UK resumption was more painful for Britain than it need have been, the resumption had little destabilizing effect on the international economy. The UK did not have a destabilizing effect on the world economy until the September 1931 crisis that caused Britain to leave the gold standard.


This is an important point. Devaluation was a way of avoiding an overvalued currency and the relative deflation that a single country needed to undergo. But the main problem facing the world in restoring the gold standard was not the relative deflation of countries with overvalued currencies but the absolute deflation associated with an increased world demand for gold across all countries. Indeed, it was France, the country that did devalue that was the greatest source of increased demand for gold owing to its internal monetary policies based on a perverse gold standard ideology.

In fact, the problem was not that gold was “undervalued” (as Johnson puts it) or that there was a “shortage” of gold (as per Cassel and others), but that the price level in terms of gold, and therefore dollars, was simply unsustainably high given Europe’s determination to return to gold. In any event, it was inconceivable that the U.S. would have devalued in 1922, since it had plenty of gold, had already corrected its price level to the world situation with the 1920-22 deflation, and did not have the excuse of a banking crisis as in 1933.

I think that this is totally right. It was not the undervaluation of individual currencies that was the problem, it was the increase in the demand for gold associated with the simultaneous return of many countries to the gold standard. It is also a mistake to confuse Cassel’s discussion of gold shortage, which he viewed as a long-term problem, with the increase in gold demand associated with returning to the gold standard which was the cause of sudden deflation starting in 1929 as a result of the huge increase in gold demand by the Bank of France, a phenomenon that McCulloch mentions early on in his discussion but does not refer to again.

About Me

David Glasner
Washington, DC




Join 2,769 other followers

Follow Uneasy Money on WordPress.com