This brings us to the objection to the international gold standard on the grounds of its alleged incompatibility with domestic macro- economic stability. Granted that the “normal’ operation of the gold standard secures tolerable long-run price stability in the world econ- omy, is it not still the case that it facilitates the domestic importation of random shocks or monetary policy errors originating abroad? For example, a rise in prices generated by an abnormally expansionary monetary policy in a large nation will result in a balance-of-payments surplus and influx of gold for a nation pursuing a relatively non-infla- tionary monetary policy. If it strictly adheres to the gold standard, the latter nation will be denied recourse to an “autonomous” or “indepen- dent” monetary policy designed to dampen the inflationary impact on domestic prices. Conversely, a contraction of economic activity abroad will generate a balance-of-payments deficit and loss of gold reserves for the nation in question, due to a falling off of demand for its products on depressed world markets. The resulting contraction of its money stock will create excess supply in the domestic goods’ mar- ket, thus depressing domestic prices, employment, and real income.
All this, it is generally held, can be avoided at very little cost by the simple instrumentality of a freely floating national fiat currency.
Under this monetary regime, when expansionary pressure is exerted on a nation from abroad, the exchange rate will simply float upward, obviating the need for balance-of-payments adjustment via inflation of domestic money and prices. Contrariwise, foreign depressions will be stopped dead at the nation’s borders by a painless depreciation of the exchange rate, which substitutes for the grinding shrinkage of money, prices, and economic activity imposed by the gold standard.20
Chicago Press, 1953), pp. 206–08; and Joseph T. Salerno, “Gold Standards: True and False,” The Cato Journal 3, (Spring 1983): pp. 251–55 [reprinted here as Chapter 13].
An empirical illustration can be found in Michael David Bardo, “The Classical Gold Standard: Some Lessons for Today,” Federal Reserve Bank of St. Louis, Review 63 (May 1981): pp. 2–17.
20 See the classic article, Milton Friedman, “The Case for Flexible Exchange Rates,”
in Friedman, Positive Economics, pp. 157–203.
While this argument is very plausible, it is open to challenge on the grounds that it ignores the effects of inflation and deflation on rel- ative prices. It is true that some advocates of floating exchange rates have recognized this issue and attempted to deal with it.
For instance, Gottfried Haberler has admitted that “… float- ing does not provide complete protection from recession abroad, because it shields a country only from purely monetary disturbances from abroad, which can be defined as foreign-induced changes in the money supply. But floating does not protect a country from real dis- turbances. And the effects of recessions are not purely monetary in nature. Nonmonetary (real) aspects of recessions are their differential impact on different commodities and industries (for example, on raw materials versus manufactured goods and, often overlapping, export versus import goods). …”21
The foregoing is a significant qualification, which opens the door for the development of a much more fundamental criticism of the case for fluctuating exchange rates.
This development was begun by Heilperin in the 1930s. He argued that complete insulation from the destabilizing effects of for- eign monetary policies can never be successfully achieved as long as the nation’s residents are free to carry on any international eco- nomic relations at all. Fluctuating exchange rates cannot insure internal stability—although they may indeed stabilize some arbi- trarily selected price index—because a country’s internal “price structure” or actual pattern of relative prices is primarily deter- mined by world market forces.
According to Heilperin:
The very fact of international trade ought to convey a warn- ing to advocates of a choice (between internal and external stability)! Fluctuating exchanges must affect the formation of prices within any one country, and do so to an increas- ing degree as foreign trade plays a more important part in
21 Gottfried Haberler, “The International Monetary System after Jamaica and Manila,” in William Fellner, Contemporary Economic Problems 1977 (Washington, D.C.: American Enterprise Institute for Public Policy Research, 1977), p. 273.
the economy of a country. Countries which are working with imported raw materials could hardly maintain stable inter- nal prices when exchanges of the countries from which they import raw materials fall or rise. If advocates of internal sta- bility, as opposed to international stability, would state their case in terms of the structure of prices and not in terms of average price levels, they would see at once that their case is very weak, unless, of course, they go on to condemn the whole of foreign trade as a disturbing factor and proceed to advocate a policy of autarchy.22
On this basis, Heilperin objects to the view that economic distur- bances and fluctuations are an imported evil, against which a country can insulate itself through fluctuating exchange. The main body of the theory of business cycles is worked out on the assumption of a closed economy. International relations spread and synchronize economic fluctuations. …”23
As a proponent of the “Austrian” or “monetary overinvestment”
theory of the business cycle developed by Ludwig von Mises and Hayek, Heilperin emphasizes the key role of relative changes between the prices of capital goods and the prices of consumers’ goods, which are wrought by monetary inflation, in precipitating business fluctu- ations.24 But a system of fluctuating exchange rates does not inter- fere with the international transmission of changes in relative prices;
it merely neutralizes the external forces acting upon a given nation’s absolute level of prices. Indeed, the free-market proponents of freely- floating exchange rates tirelessly proclaim that one of the greatest virtues of their scheme is that it does not preclude the international changes in relative prices which are needed to induce a rearrange- ment of productive activities according to the ever-changing dictates of comparative advantage.
22 Heilperin, International Monetary Economics, p. 12
23 Heilperin, Pathology of Money, p. 71.
24 For a sympathetic discussion of the Austrian theory of the business cycle, see Heil perin, Pathology of Money, 153–62. A detailed explication and critique of the theory can be found in Gottfried Haberler, Prosperity and Depression: A Theoretical Analysis of Cyclical Movements (New York: Atheneum, 1963), pp. 33–72.
This is precisely the reason why fluctuating exchange rates can- not successfully insulate a nation from macroeconomic fluctuations generated abroad. Although Heilperin himself never extended his analysis this far, this point can be illustrated by using the Austrian business-cycle theory to develop a model sequence of the effects that follow from the initiation of a purely national inflation in a world of fluctuating exchange rates.
When the monetary authorities of a foreign nation of significant size inflate their national fiat money stock, typically via the expansion of bank loans to business borrowers in their own nation, the prices of capital, or “higher-order,” goods are bid up—not just in the inflating nation but throughout the world economy, since commodity markets are internationally integrated. The increase of capital goods’ prices relative to consumer goods’ prices signals business firms in the rel- evant industries in all nations to expand the output of capital goods and contract the output of consumer goods. The stimulus to capital goods’ production will continue until the inflation is brought to a halt.
At that time, a reverse movement of inflation-distorted relative prices occurs and businessmen finally realize that many of the long-term investments made in the capital goods industries during the inflation- ary boom are unprofitable and must be liquidated. The revelation of these malinvestments and misallocations of productive factors coin- cides with the onset of a worldwide recession or depression.
Internationally integrated capital markets provide a further mech- anism for transmitting the business cycle from country to country. Thus the impulse to (artificially) lowered interest rates on the money and capital markets of the country experiencing bank credit expansion will swiftly spread throughout the world economy, as domestic and foreign investors are induced by the developing interest-rate differential to shift their funds to higher-yielding investments abroad. In addition, foreign business firms will find it profitable to expand their sales of their securi- ties in that market where security prices have begun to rise above world levels due to declining interest rates, while restricting their borrowings and security offerings on their respective domestic credit markets. Such equilibrating shifts in the supply of and demand for savings between national capital markets (actually submarkets) insure that a strictly
national bank credit inflation will tend to uniformly drive down inter- est rates throughout the world economy. This fall in interest rates will give further impetus to the worldwide boom in capital goods’ prices and production described above, since lower interest rates promote an increase in the capital values of long-lived plant and equipment. On the other hand, when the inflating nation calls a halt to further bank credit creation, an impulse to rising interest rates travels throughout interna- tional capital markets, precipitating a world-embracing collapse of the capital values of investment goods and the onset of recession.
As long as it engages in international trade, therefore, a country may undergo a boom-and-bust cycle with a perfectly ‘stable’ national price level, protected by floating exchange rates, when there occur reversible relative-price and interest-rate changes in world commod- ity and capital markets that are the result of an inflationary boom engineered by foreign monetary authorities.
The alleged benefits of a system of fluctuating exchange rates, purchased at the substantial cost of the demolition of an interna- tional money, thus turn out to be only a mirage of macroeconomic theorizing.
Bibliography
Bardo, Michael David. 1981. “The Classical Gold Standard: Some Lessons for Today.”
Federal Reserve Bank of St. Louis, Review 63 (May): pp. 2–17.
Friedman, Milton. 1953. “Commodity-Reserve Currency.” In idem, Essays in Posi- tive Economics. Chicago: The University of Chicago Press.
_____. 1953. “The Case for Flexible Exchange Rates.” In Friedman, Essays in Positive Economics. Chicago: University of Chicago Press.
Haberler, Gottfried. 1963. Prosperity and Depression: A Theoretical Analysis of Cyclical Movements. New York: Atheneum.
_____. 1977. “The International Monetary System after Jamaica and Manila.” In Wil- liam Fellner, Contemporary Economic Problems, 1977. Washington, D.C.:
American Enterprise Institute for Public Policy Research.
Hawtrey, R.G. 1919. Currency and Credit. New York: Longmans, Green and Co.
_____. 1926. “The Gold Standard and the Balance of Payments.” The Economic Jour- nal 36 (March): pp. 50–68.
Hayek, F.A. 1971. Monetary Nationalism and International Stability. New York:
Augustus M. Kelley.
Heilperin, Michael A. 1939. International Monetary Economics. London: Long- mans, Green and Co.
_____. 1968. Aspects of the Pathology of Money: Monetary Essays from Four Decades. London: Michael Joseph Limited.
Keynes, John Maynard. 1923. A Tract on Monetary Reform. London: Macmillen.
Marget, Arthur W. 1966. The Theory of Prices: A Re-Examination of the Central Problems of Monetary Theory, 2 vols. New York: Augustus M. Kelley.
Paish, F.W. 1936. “Banking Policy and the Balance of Payments.” Economica 3 (November): pp. 404–22, rep. in Howard S. Ellis and Lloyd A. Metzler, 1950.
Readings in the Theory of International Trade, pp. 35–55. Homewood, Ill.:
Richard D. Irwin.
Robbins, Lionel. 1937. Economic Planning and International Order. New York:
Macmillan.
_____. 1971. Money, Trade and International Relations. New York: St. Martin’s Press.
_____. 1972. “Inflation: an International Problem.” In Inflation as Global Problem, Randall Hinshaw, ed. Baltimore: Johns Hopkins University Press.
Salerno, Joseph T. 1982. “The 100 Percent Gold Standard: A Proposal for Monetary Reform.” In Supply-Side Economics: A Critical Appraisal. Richard H. Fink, ed., Frederick, Md.: University Publications of America, Inc.
_____. 1983. “Gold Standards: True and False.” The Cato Journal 3 (Spring): pp.
251–55.
White, Lawrence H. 1984. Free Banking in Britain: Theory, Experience, and Debate, 1800–1845. New York: Cambridge University Press.
CHAPTER 16
Money and Gold in the 1920s and 1930s:
An Austrian View
In consecutive issues of The Freeman, Richard Timberlake has con- tributed an interesting trilogy of articles advancing a monetarist cri- tique of the conduct of U.S. monetary policy during the 1920s and 1930s.1 In the first of these articles, Timberlake disputes the late Mur- ray Rothbard’s “Austrian” account of the boom-bust cycle of the 1920s and 1930s. Timberlake contends that Rothbard proceeds on the basis of a “new and unacceptable meaning” for the term “inflation” and a con- trived definition of the money supply to “invent” a Fed-orchestrated inflation of the 1920s that, in fact, never occurred. Moreover, Timber- lake alleges, Rothbard’s account was marred by a “mismeasurement of the central bank’s monetary data” as well as by a misunderstanding of the nature and operation of the Fed-controlled pseudo-gold standard by which U.S. dollars were created during this period.
In the two subsequent articles, Timberlake takes issue, respec- tively, with the U.S. Treasury’s policy of neutralizing gold inflows and
1 Richard H. Timberlake, “Money in the 1920s and 1930s,” The Freeman (April 1999): pp. 37–42; “Gold Policy in the 1930s,” The Freeman (May 1999): pp. 36–41;
and “The Reserve Requirement Debacle of 1935–1938,” The Freeman (June 1999):
pp. 23–29.
421
From: “Money and Gold in the 1920s and 1930s: An Austrian View,” The Freeman:
Ideas on Liberty 49 (October 1999). Available at thefreemanonline.org [reprinted here as Chapter 16].
the Fed’s policy of sharply raising reserve requirements in the mid- 1930s, arguing that these complementary policies aborted an incipient economic recovery and brought on the recession of 1937–38. In what follows I will address the weighty charges brought against Rothbard and, in the process, offer an evaluation of the Federal Reserve System’s culpability for the economic events of these tragic years that diverges radically from Timberlake’s.
The Meaning of “Inflation”
Let me begin with Timberlake’s contention that Rothbard imputes a meaning to the word “inflation” that is both new and unac- ceptable. In fact Rothbard’s definition of inflation as “the increase in money supply2 not consisting in, i.e., not covered by, an increase in gold,” is an old and venerable one. It was the definition that was forged in the theoretical debate between the hard-money British Currency School and the inflationist British Banking School in the mid-nine- teenth century. According to the proto-Austrian Currency School, which triumphed in the debate, the gold standard was not sufficient to prevent the booms and busts of the business cycle, which had con- tinued to plague Great Britain despite its restoration of the gold stan- dard in 1821.3
In brief, according to the Currency School if commercial banks were permitted to issue bank notes via lending or investment opera- tions in excess of the gold deposited with them this would increase the money supply and precipitate an inflationary boom. The result- ing increase in domestic money prices and incomes would eventually cause a balance-of-payments deficit financed by an outflow of gold.
This external drain of their gold reserves and the impending threat of internal drains due to domestic bank runs would then induce the banks to sharply restrict their loans and investments, resulting in a
2 For a review of this debate, see Murray N. Rothbard, Classical Economics: An Aus- trian Perspective on the History of Economic Thought (Brookfield, Vt.: Edward Elgar Publishing Company, 1995), vol. 2, pp. 225–74.
3 Charles Holt Carroll, Organization of Debt into Currency and Other Papers, ed.
Edward C. Simmons (Princeton, N.J.: D. Van Nostrand Company, Inc., 1964), p. 333.
severe contraction of their uncovered notes or “fiduciary media” and a decline in the domestic money supply accompanied by economy- wide depression.
To avoid the recurrence of this cycle, the Currency School rec- ommended that all further issues of fiduciary media be rigorously suppressed and that, henceforth, the money supply change strictly in accordance with the inflows and outflows of gold through the nation’s balance of payments. The latter provided a natural, non-cycle-gener- ating mechanism for distributing the world’s money supply strictly in accordance with the international pattern of monetary demands.
Following the triumph of the Currency School doctrine and the implementation of its policy prescription by the Bank of Eng- land, its definition of inflation became accepted in the English- speaking world, especially in the United States, where there existed a much more radical and analytically insightful American branch of the School. The term “inflation” was now used strictly to denote an increase in the supply of money that consisted in the creation of cur- rency and bank deposits unbacked by gold. Thus for example, the American financial writer Charles Holt Carroll wrote in 1868 that
“The source of inflation, and of the commercial crisis, is in the nature of the system which pretends to lend money, but creates currency by discounting such bills when there is no such money in existence.”
Even earlier, in 1858, Carroll had written, “Instead of using gold and silver for currency they are merely used as the basis of the greatest possible inflation by the banks,” and that “we should prevent any arti- ficial increase of currency to prevent a future … catastrophe.”4 So it was the “artificial increase of currency” only—through the creation of unbacked bank notes and deposits—that constituted inflation.
The leading monetary theorist in the United States in the last quarter of the nineteenth century was Francis A. Walker. According to Walker, writing in 1888, “A permanent excess of the circulating money of a country, over that country’s distributive share of the money of
4 Ibid., p. 91.
the commercial world is called inflation.”5 While this version of the definition is applicable to inconvertible paper fiat currency, Walker also believed that inflation was an inherent feature of the issuance of convertible bank notes and deposits that lacked gold backing. In Walk- er’s words, “there resides in bank money, even under the most strin- gent provisions for convertibility, the capability of local and temporary inflation.”6
Unfortunately, however, because the writers of the British Cur- rency School, unlike their American cousins, neglected to consider bank deposits as part of the money supply, their policies as adopted in Great Britain failed to prevent inflation and the business cycle. Con- sequently, and tragically, the School’s doctrines and policies fell into profound disrepute by the late nineteenth century, and its definition of inflation was replaced by that of the opposing Banking School, which saw inflation as a state in which the money supply exceeds the needs of trade.
Early American quantity theorists following the proto-monetar- ist Irving Fisher, in particular, seized upon and adapted this definition to their peculiar analytical perspective. Thus, Edwin Kemmerer wrote in 1920 that, “Although the term inflation in current discussion is used in a variety of meanings, there is one idea common to most uses of the word, namely, the idea of a supply of circulating media in excess of trade needs.”7 Kemmerer went on to define inflation as a state in which, “at a given price level, a country’s circulating media—money and deposit currency—increase relatively to trade needs.” From here it was a short step to the currently prevailing definition of inflation as an increase in the price level.8
So Rothbard’s theory is surely not new and to say that it is “unac- ceptable” is simply to express one’s agreement with the long-entrenched
5 Francis A. Walker, Political Economy (New York: Henry Holt and Company, 1888), p. 151.
6 Ibid., p. 171.
7 Edwin Walter Kemmerer, High Prices and Deflation (Princeton, N.J.: Princeton University Press, 1920), p. 3.
8 Ibid., p. 4.