Book Highlights: The Midas Paradox (Parts 1 & 2)

I was greatly influenced by monetarist ideas, particularly A Monetary History of the United States,

Ultimately, I decided that the gold reserve ratio was the most sensible way of thinking about the stance of monetary policy under a gold standard.

Obviously, “effect” cannot precede “cause”; what was actually happening was that markets were anticipating that gold market disturbances would impact future monetary policy, and this caused asset prices to respond immediately to the expected change in policy.

I was shocked to see so many misconceptions from the Great Depression repeated in the current crisis: 1. Assuming causality runs from financial panic to falling aggregate demand (rather than vice versa). 2. Assuming that sharply falling short-term interest rates and a sharply rising monetary base meant “easy money.” 3. Assuming that monetary policy became ineffective once rates hit zero.

(A modern example of this conundrum occurred when many pundits blamed the Fed for missing a housing bubble that was also missed by the financial markets.)

One purpose of this study is to show that monetary policy lags are much shorter than many researchers have assumed, and that both stock prices and industrial output often responded quickly to monetary shocks.

A recent study of the U.S. Treasury bond market showed that if one divides the trading day into five-minute intervals, virtually all of the largest price changes occur during those five-minute intervals that immediately follow government data announcements.6 There is simply no plausible explanation for this empirical regularity other than that these events are related, and that the causation runs from the data announcement to the market response.

Previous economic historians have missed the way that gold market instability triggered the boom and bust of 1936–1938 and have mistakenly blamed the recession on tighter fiscal policy or higher reserve requirements.

Keynes’s stagnation hypothesis falsely attributes problems caused by government labor market regulations to inherent defects in free-market capitalism.

But under a gold standard, the nominal price of gold cannot change, and thus a fall in the value of gold can only occur through a rise in the price of all other goods.

During the 1920s, prices were well above pre–World War I levels, and there was concern about a looming “shortage” of gold; that is, future increases in the world gold supply would not be sufficient to prevent deflation. (The term “shortage” is misleading; “scarcity” better describes the problem.)

If the coin be locked up in chests, it is the same thing with regard to prices, as if it were annihilated.

Some would argue that there is nothing the Federal Reserve could have done, but that’s not what Fed officials claim. Ben Bernanke has repeatedly emphasized that the Fed is never “out of ammunition.”

By mid-1928, the United States had exported almost $500 million in gold and there was a growing perception of excessive speculation in the stock market. At this time, the Fed switched to a contractionary policy aimed at restraining Wall Street’s “irrational exuberance.”

By March 1929 pundits were complaining that the Fed’s antispeculation policy was hurting the European economies, particularly Britain.

Wall Street had rallied on the reassuring news that the Bank of England had refrained from an increase in its discount rate.24 Despite what we now know about its ultimate effects, it is hard to be too critical of the Fed’s action, given that the markets seem to have made the same miscalculation.

While an unanticipated increase in the central bank’s target interest rate can be viewed as being contractionary on the day it is announced, over longer periods of time the nominal interest rate is an especially unreliable indicator of the stance of monetary policy.

The U.S. stock market crash so reduced the demand for credit that existing discount rates throughout the world, and even somewhat lower rates, now represented highly contractionary policies capable of dramatically increasing the world gold reserve ratio.

Although stocks did not fall on October 26, Bittlingmayer (p. 399) suggested that the speech’s “contents or fundamental message could have reached Wall Street a day or two earlier,

As the seriousness of the Depression became more apparent during 1930, opposition to the tariff spread among the public, the press, and even many business groups.

“tariff war does not furnish good soil for the growth of world peace.”

suggests that the impact of German political difficulties on the U.S. markets owed more to their perceived effect on the prospects for international cooperation, than any impact they might have had on U.S. fiscal policy.

Interestingly, the financial press seemed to interpret the relationship between stocks and commodities differently in 1929 than in 1930. Because stock prices fell far more sharply than commodity prices in October 1929, many analysts viewed the concurrent commodity price decline as merely a symptom of the stock market crash. By mid-1930 the order of causality was usually reversed, with the commodity markets (i.e., “deflation”) seen as exerting a “depressing” influence on stocks.

More sophisticated observers held that declines in both markets could be attributed to monetary factors:

How one partitions “blame,” depends on how seriously one takes the concept of the “rules of the game” (i.e., a stable gold reserve ratio). In my view, the system was fundamentally flawed, which makes it difficult to assign blame.

Either the Great Depression was not forecastable in September 1929, or financial markets are not efficient.

Indeed, Bordo and Eichengreen (1998) showed that with more enlightened monetary policies the world monetary gold stocks were sufficient to underpin the international gold standard for several more decades.

The key U.S. policy error was the failure to accommodate Britain’s need to rebuild gold reserves in 1930,

If the Federal Reserve (Fed) had pursued an expansionary policy (a lower gold ratio), then a vigorous recovery might have occurred.

Contrary to popular belief, 1931 did not mark the end of the international gold standard; if it had, the Depression might have ended much more quickly. Instead, it marked the end of a stable international gold standard. For the remainder of the 1930s, a hobbled gold standard did far more damage than would have been possible from either a pure gold standard or a pure fiat money regime.

The price of the German war reparations bonds, dubbed “Young Plan bonds” (YPBs), were a good indicator of political turmoil in Germany during late 1930 and proved to be an even better indicator during 1931 and 1932.

A gold flow from the United States to France could be caused either by a reduction in the U.S. gold ratio (i.e., an expansionary policy in the United States), or an increase in France’s gold ratio (a contractionary policy in France).

“traders took heart on the news that the slogan of the Hitler party will be: ‘private debts—yes; reparations—no!’”

Britain can hardly be blamed for being among the first to recognize that gold was merely a “barbarous relic,” a view that is now widely held.

The most controversial question from this period is whether the Fed’s bond purchases helped mitigate an otherwise disastrous set of exogenous shocks, had no impact on the economy, or actually worsened conditions by reducing confidence and increasing hoarding.

The spring of 1932 was a period of severe depression and deflation, corporate default risk was soaring, and a highly aggressive open market purchase operation was driving T-bill yields to below ½ percent. This is exactly the sort of period when one would expect T-bond prices to rally. Thus, the fact that they continued to trade at well below par could be viewed as a sign that other (hidden) factors were putting upward pressure on long-term yields. One of those hidden factors was presumably fear of devaluation.

Under a fiat money system, fears of future inflation will reduce the demand for money, thereby causing an immediate increase in prices. Under a gold standard, however, fears of future devaluation can be deflationary.

the New York Times noted ironically that: It resembles the reasoning which attained much popularity in this country a year or more ago; which began by declaring that the stock market decline was the result of unfavorable trade [i.e., business] conditions, and ended by insisting still more vigorously that the trade situation was the direct result of the decline in stocks. (5/22/32,

They argued that the business upswing in the late summer of 1932 was a delayed reaction to the spring OMPs, and that the Fed had prematurely abandoned the OMPs. It should be clear from the analysis in this chapter that I have some problems with this view. Monetary policy may impact macroeconomic aggregates with a lag, but it is difficult to reconcile the behavior of stock and commodity prices with the Friedman-Schwartz view.

It is not surprising that Keynes would have confused absolute liquidity preference with the constraints of the gold standard.

The United States still held massive gold reserves in 1932, and there is no reason why those reserves shouldn’t have been used more aggressively in an emergency such as the Great Depression.

“a proper central bank does not fail because it loses all its gold in a banking crisis. It only fails if it does not.”

Keynes viewed a liquidity trap as a situation in which further increases in the money supply would have no impact on aggregate demand, or prices. We have no real evidence that such a trap existed in 1932.32 Instead, the problem was that the gold standard limited the amount by which central banks could increase the monetary base.

The biggest problem with Hsieh and Romer’s analysis is their conclusion (p. 172) that during the OMPs “virtually no sign of expectations of devaluation” surfaced. I would argue exactly the opposite.

Yes, the forward discounts on the dollar were never very large in any of these crises, but that simply reflects that fact that traders never viewed dollar devaluation as a particularly likely outcome, especially within the next three months.

Bernanke and James (1991, p. 49) provide an even more persuasive reason to doubt that real interest rates were high during the early 1930s. They pointed out that those countries that left the gold standard early (such as Britain) were able to arrest the decline in prices but continued to offer the same sort of low nominal yields on safe assets as did countries remaining on the gold standard, such as the United States and France.

Given the unprecedented severity of the Depression, it seems implausible that any monocausal explanation is adequate.

Even if the Great Contraction of 1929–1932 was essentially a monetary phenomenon, the preceding account suggests that it was monetary in the broad sense of a breakdown in the international monetary system (as emphasized by Temin and Eichengreen), rather than simply a result of inept Fed policy (the focus of Friedman and Schwartz).

The large increases in the world gold reserve ratio during 1929–1930, and 1931–1932 did not reflect monetary policy being constrained by the gold standard.

Market responses to policy shocks merely show that the markets believed that the Fed was likely to act as if it felt constrained by potential gold outflows.

it doesn’t quite matter whether it was fiscal or monetary policy that caused this crisis. In either case the net effect of the crisis was to weaken the impact of countercyclical policy.

Are we accusing countries of violating well-agreed-upon ground rules (like a player cheating in a sports competition) or are we accusing countries of adopting ill-advised policies that hurt others and themselves?

In a sense, the interwar gold standard was both too flexible and not flexible enough. A rigid adherence to a fixed gold reserve ratio would have greatly reduced central bank hoarding during the early 1930s. Alternatively, a much more flexible regime which completely disregarded the gold reserve ratio would have allowed central banks to more easily cooperate to economize on the demand for monetary gold during a deflationary crisis.

But the policymakers of that era (particularly in America) were living in a world where devaluation seemed almost inconceivable. The entrenchment of the gold standard regime in America helps explain why the financial markets placed such high hopes on the possibility of international monetary cooperation, despite the ultimate ineffectiveness of those initiatives. They saw it as the only game in town.

Even our best-selling money textbooks emphasize the unreliability of interest rates as monetary policy indicators: It is dangerous always to associate the easing or the tightening of monetary policy with a fall or a rise in short-term nominal interest rates. (Mishkin, 2007, p. 606)

Not so long ago, economists liked to make fun of statements such as Joan Robinson’s claim that easy money couldn’t have caused the German hyperinflation as (she argued) nominal interest rates weren’t low.

Unfortunately, most economists seemed to miss the monetary nature of the second and more severe phase of the recent crisis, which began in mid-2008. Nominal GDP fell nearly 4 percent over the following twelve months, to a level more than 9 percent below trend.

To those closest to the problem, a severe fall in aggregate demand, or nominal GDP, almost never looks like it was caused by monetary policy. It is likely to be accompanied by very low nominal rates, and a bloated monetary base (as people and banks hoard currency). That looks like “easy money” to the untrained eye.

In the late 1990s, Milton Friedman also complained that modern economists had not really absorbed the lessons of the Great Depression: Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy… . After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die. (Friedman, 1998.)