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Today we will look at Robert Mundell's interpretation of the Interwar
Period, 1914-1944.
October
30, 2016: Nonmonetary Perspectives on the Great Depression 3:
Nonmonetary Causes
October
23, 2016: Nonmonetary Perspectives on the Great Depression 2: Steindl,
Schwartz, and Eichengreen
October
16, 2016: Nonmonetary Perspectives on the Great Depression
October
2, 2016: The Interwar Period, 1914-1944
When I entered the "supply side inner circle" around 2001, I was
surprised to find that a lot of the "supply side" legends said a lot of
things that didn't sound right to me, or to the others I knew. When
Robert Mundell gave his version of
twentieth-century economic history as part of his 1999 Nobel Prize
acceptance speech, there was a fair amount of grumbling in the "inner
circle" that Mundell seemed a little floppy. I shared this view. I
would even say that it became a little bit of a litmus test: "What did
you think of Mundell's 1999 speech?" You had to know what was being
referred to, and have a well-founded opinion about it.
While I shared others' misgivings, I withheld any concrete judgement
until I could get a better idea of what Mundell's arguments were. (This
took fifteen years.) The version in the speech is really an abbreviated
version. Was there some kind of detailed argument behind it, perhaps
supported by evidence and data? Mundell is a smart guy, and he probably
had some sort of reasoning behind his conclusions. Maybe I would learn
something new. I looked at Mundell's entire bibliography, at his
personal website, and did not find any titles that suggested such an
in-depth treatment. I did eventually find a more detailed treatment of
these ideas, which we will look into later.
http://robertmundell.net/bibliography/
I put this is a separate category, as this version of things hasn't
really spread much beyond Mundell himself I would say, and is not a
widely-held "interpretation."
For today, let's just look at the version in the 1999 speech.
http://robertmundell.net/nobel-prize/
By comparison with past centuries, the
twentieth has produced extremes. Its earliest part was a benign
continuation of the pax of the 19th century. But this calm before the
storm was followed by World War I, communism, hyperinflation, fascism,
depression, genocide, World War II, the atom bomb, and the Soviet
occupation of Eastern Europe. There followed a period of comparative
stability, punctuated by the balance of terror of the Cold War, the
Nato Alliance, and decolonialism. Toward the end of the century the
Cold War ended, the Soviet Empire was dismantled, democracy emerged in
Eastern Europe, the Pax Americana flourished and the euro came into
being. The clue to the 20th century lies in the links between its first
and last decades, the “bookends” of the century.
In 1906, Whitelaw Reid, the US Ambassador to Britain, gave a lecture at
Cambridge University with the title, The Greatest Fact in Modern
History, in which the author, a diplomat, journalist and politician,
was given as his subject, the rise and development of the United
States!1 It cannot have been obvious then that the rise of the United
States was the “greatest fact in modern history” but it was true that
in a matter of only two centuries a small colony had become the biggest
economy in the world. The first decade of the century hinted at what
the last decade confirmed, viz., American preponderance. Forget the
seventy-five years between 1914 and 1989!
An underlying theme of my lecture today is the role of the United
States in what has been aptly called the “American century.” I want to
bring out the role of the monetary factor as a determinant of political
events. Specifically, I will argue that many of the political changes
in the century have been caused by little-understood perturbations in
the international monetary system, while these in turn have been a
consequence of the rise of the United States and mistakes of its
financial arm, the Federal Reserve System.
The twentieth century began with a highly efficient international
monetary system that was destroyed in World War I, and its bungled
recreation in the inter-war period brought on the great depression,
Hitler and World War II. The new arrangements that succeeded it
depended more on the dollar policies of the Federal Reserve System than
on the discipline of gold itself. When the link to gold was finally
severed, the Federal Reserve System was implicated in the greatest
inflation the United States has yet known, at least since the days of
the Revolutionary War. Even so, as the century ends, a relearning
process has created an entirely new framework for capturing some of the
advantages of the system with which the century began.
The century can be divided into three distinct, almost equal parts. The
first part, 1900-33, is the story of the international gold standard,
its breakdown during the war, mismanaged restoration in the 1920’s and
its demise in the early 1930’s. The second part, 1934-71, starts with
the devaluation of the dollar and the establishment of the $35 gold
price and ends when the United States took the dollar off gold. The
third part of the century, 1972-1999, starts with the collapse into
flexible exchange rates and continues with the subsequent outbreak of
massive inflation and stagnation in the 1970’s, the blossoming of
supply-side economics in the 1980’s, and the return to monetary
stability and the birth of the euro in the 1990’s. The century ends,
however, with our monetary system in deficit compared to the first
decade of the century and that suggests unfinished business for the
decades ahead.
I. Mismanagement of the Gold Standard
The international gold standard at the beginning of the 20th century
operated smoothly to facilitate trade, payments and capital movements.
Balance of payments were kept in equilibrium at fixed exchange rates by
an adjustment mechanism that had a high degree of automaticity. The
world price level may have been subject to long-terms trends but annual
inflation or deflation rates were low, tended to cancel out, and
preserve the value of money in the long run. The system gave the world
a high degree of monetary integration and stability.
International monetary systems, however, are not static. They have to
be consistent and evolve with the power configuration of the world
economy. Gold, silver and bimetallic monetary standards had prospered
best in a decentralized world where adjustment policies were automatic.
But in the decades leading up to World War I, the central banks of the
great powers had emerged as oligopolists in the system. The efficiency
and stability of the gold standard came to be increasingly dependent on
the discretionary policies of a few significant central banks. This
tendency was magnified by an order of magnitude with the creation of
the Federal Reserve System in the United States in 1913. The Federal
Reserve Board, which ran the system, centralized the money power of an
economy that had become three times larger than either of its nearest
rivals, Britain and Germany. The story of the gold standard therefore
became increasingly the story of the Federal Reserve System.
World War I made gold unstable. The instability began when deficit
spending pushed the European belligerents off the gold standard, and
gold came to the United States, where the newly-created Federal Reserve
System monetized it, doubling the dollar price level and halving the
real value of gold. The instability continued when, after the war, the
Federal Reserve engineered a dramatic deflation in the recession of
1920-21, bringing the dollar (and gold) price level 60 percent of the
way back toward the prewar equilibrium, a level at which the Federal
Reserve kept it until 1929.
It was in this milieu that the rest of the world, led by Germany,
Britain and France, returned to the gold standard. The problem was
that, with world (dollar) prices still 40 percent above their prewar
equilibrium, the real value of gold reserves and supplies was
proportionately smaller. At the same time monetary gold was badly
distributed, with half of it in the United States. In addition,
uncertainty over exchange rates and reparations (which were fixed in
gold) increased the demand for reserves. In the face of this situation
would not the increased demand for gold brought about by a return to
the gold standard bring on a deflation? A few economists, like Charles
Rist of France, Ludwig von Mises of Austria and Gustav Cassel of
Sweden, thought it would.
Cassel(1925) had been very explicit even before Britain returned to
gold:
“The gold standard, of course, cannot secure a greater stability in the
general level of prices of a country than the value of gold itself
possesses. Inasmuch as the stability of the general level of prices in
desirable, our work for a restoration of the gold standard must be
supplemented by endeavours to keep the value of gold as constant as
possible…With the actual state of gold production it can be taken for
certain that after a comparatively short time, perhaps within a decade,
the present superabundance of gold will be followed, as a consequence
of increasing demand, by a marked scarcity of this precious metal
tending to cause a fall of prices…”
After gold had been restored, Cassel pursued his line of reasoning
further, warning of the need to economize on the monetary use of gold
in order to ward off a depression. In 1928 he wrote:
“The great problem before us is how to meet the growing scarcity of
gold which threatens the world both from increased demand and from
diminished supply. We must solve this problem by a systematic
restriction of the monetary demand for gold. Only if we succeed in
doing this can we hope to prevent a permanent fall of the general price
level and a prolonged and world-wide depression which would inevitably
be connected with such a fall in prices.”
Rist, Mises and Cassel proved to be right. Deflation was already in the
air in the late 1920’s with the fall in prices of agricultural products
and raw materials. The Wall Street crash in 1929 was another symptom,
and generalized deflation began in 1930. That the deflation was
generalized if uneven can be seen from the percentage loss of wholesale
prices in various countries from the high in 1929 to September 1931
(the month that Britain left the gold standard): Japan, 40.5;
Netherlands, 38.1; Belgium, 31.3; Italy 31.0; United States, 29.5;
United Kingdom, 29.2; Canada, 28.9; France, 28.3; Germany, 22.0.
The dollar price level hit bottom in 1932 and 1933. The highlights of
the price level from 1914 to 1934 are given in Table 1:
![](http://www.24hgold.com/24hpmdata/articles/img/Nathan Lewis-Robert Mundells Interpretation of the Interwar Period-2016-11-06-001.png)
For decades economists have wrestled with the problem of what caused
the deflation and depression of the 1930’s. The massive literature on
the subject has brought on more heat than light. One source of
controversy has been whether the depression was caused by a shift of
aggregate demand or a fall in the money supply. Surely the answer is
both! But none of the theories—monetarist or Keynesian—would have been
able to predict the fall in the money supply or aggregate demand in
advance. They were rooted in short-run closed-economy models which
could not pick up the gold standard effects during and after World War
I. By contrast, the theory that the deflation was caused by the return
to the gold standard was not only predictable, but was actually, as we
have noted above, predicted.
The gold exchange standard was already on the ropes with the onset of
deflation. It moved into its crisis phase with the failure, in the
spring of 1931, of the Viennese Creditanstalt, the biggest bank in
Central Europe, bringing into play a chain reaction that spread to
Germany, where it was met by deflationary monetary policies and a
reimposition of controls, and to Britain, where, on September 21, 1931,
the pound was taken off gold. Several countries, however, had preceded
Britain in going off gold: Australia, Brazil, Chile, New Zealand,
Paraguay, Peru, Uruguay and Venezuela, while Austria, Canada, Germany
and Hungary had imposed controls. A large number of other countries
followed Britain off gold.
Meanwhile, the United States hung onto to the gold standard for dear
life. After making much of its sensible shift to a monetary policy that
sets as its goal price stability rather than maintenance of the gold
standard, it reverted back to the latter at the very time it mattered
most, in the early 1930’s.
Instead of pumping liquidity into the system, it chose to defend the
gold standard. Hard on the heels of the British departure from gold, in
October 1931, the Federal Reserve raised the rediscount rate in two
steps from 1_ to 3_ percent dragging the economy deeper into the mire
of deflation and depression and aggravating the banking crisis. As we
have seen, wholesale prices fell 35 percent between 1929 and 1933.
Monetary deflation was transformed into depression by fiscal shocks.
The Smoot-Hawley tariff, which led to retaliation abroad, was the
first: between 1929 and 1933 imports fell by 30 percent and,
significantly, exports fell even more, by almost 40 percent. On June 6,
1932, the Democratic Congress passed, and President Herbert Hoover
signed, in a fit of balanced-budget mania, one of its most ill-advised
acts, the Revenue Act of 1932, a bill which provided the largest
percentage tax increase ever enacted in American peacetime history.
Unemployment rose to a high of 24.9 percent of the labor force in 1933,
and GDP fell by 57 percent at current prices and 22 percent in real
terms.
The banking crisis was now in full swing. Failures had soared from an
average of about 500 per year in the 1920’s, to 1,350 in 1930, 2,293 in
1931, and 1,453 in 1932. Franklin D. Roosevelt, in one of his first
actions on assuming the presidency in March 1933, put an embargo on
gold exports. After April 20, the dollar was allowed to float downward.
The deflation of the 1930’s was the mirror image of the wartime rise in
the price level that had not been reversed in the 1920-21 recession.
When countries go off the gold standard, gold falls in real value and
the price level in gold countries rise. When countries go onto the gold
standard, gold rises in real value and the price level falls. The
appreciation of gold in the 1930’s was the mirror image of the
depreciation of gold in World War I. The dollar price level in 1934 was
the same as the dollar price level in 1914. The deflation of the 1930’s
has to be seen, not as a unique “crisis of capitalism,”as the Marxists
were prone to say, but as a continuation of a pattern that had appeared
with considerable predictability before—whenever countries shift onto
or return to a monetary standard. The deflation in the 1930’s has its
precedents in the 1780’s, the 1820’s and the 1870’s.
What verdict can be passed on this third of the century? One is that
the Federal Reserve System was fatally guilt of inconsistency at
critical times. It held onto the gold standard between 1914 and 1921
when gold had become unstable. It shifted over to a policy of price
stability in the 1920’s that was successful. But it shifted back to the
gold standard at the worst time imaginable, when gold had again become
unstable. The unfortunate fact was that the least experienced of the
important central banks—the new boy on the block—had the awesome power
to make or break the system by itself.
The European economies were by no means blameless in this episode. They
were the countries that changed the status quo and moved onto the gold
standard without weighing the consequences. They failed to heed the
lessons of history—that a concerted movement off, or onto, any metallic
standard brings in its wake, respectively, inflation or deflation.
After a great war, in which inflation has occurred in the monetary
leader and gold has become correspondingly undervalued, a return to the
gold standard is only consistent with price stability if the price of
gold is increased. Failing that possibility, countries would have fared
better had they heeded Keynes’ advice to sacrifice the benefits of
fixed exchange rates under the gold standard and instead stabilize
commodity prices rather than the price of gold.
Had the price of gold been raised in the late 1920’s, or,
alternatively, had the major central banks pursued policies of price
stability instead of adhering to the gold standard, there would have
been no Great Depression, no Nazi revolution and no World War II.
II. Policy Mix Under the Dollar
Standard
In April 1934, after a year of flexible exchange rates, the United
States went back to gold after a devaluation of the dollar. This
decreased the gold value of the dollar by 40.94 percent, raising the
official price of gold 69.33 percent to $35 an ounce. How history would
have been changed had President Herbert Hoover devalued the dollar,
three years earlier!
France held onto its gold parity until 1936, when it devalued the
franc. Two other far-reaching events occurred in that year. One was the
publication of Keynes’ General Theory; the other signing of the
Tripartite Accord among the United States, Britain and France. One
ushered in a new theory of policy management for a closed economy; the
other, a precursor of the Bretton Woods agreement, established some
rules for exchange rate management in the new international monetary
system.
The contradiction between the two could hardly be more ironic. At a
time when Keynesian policies of national economic management were
becoming increasingly accepted by economists, the world economy had
adopted a new fixed exchange rate system that was incompatible with
those policies.
In the new arrangements, which were
ratified at Bretton Woods in 1944, countries were required to establish
parities fixed in gold and maintain fixed exchange rates to one another.
...
IV. Conclusions
It is time to wrap up the century in some conclusions. A first
conclusion is that the international monetary system depends on the
power configuration of the countries that make it up. Bismarck once
said that the most important fact of the nineteenth century was that
England and America spoke the same language. Along the same lines, the
most important fact of the twentieth century has been the rise of the
United States as a superpower. Despite the incredible rise in gold
production, Gresham’s Law came into play and the dollar elbowed out
gold as the principal international money.
The first third of twentieth century economics was dominated by the
confrontation of the Federal Reserve System with the gold standard. The
gold standard broke down in World War I and its restoration in the
1920’s created the deflation of the 1930’s. Economists blamed the gold
standard instead of their mishandling of it and turned away from
international automaticity to national management. The Great Depression
itself let to totalitarianism and World War II.
The second third of the twentieth century was dominated by the
contradiction between national macroeconomic management and the new
international monetary system. In the new system, the United States
fixed the price of gold and the other major countries fixed their
currencies to the convertible dollar. But national macroeconomic
management precluded the operation of the international adjustment
mechanism and the system broke down in the early 1970’s when the United
States stopped fixing the price of gold and the other countries stopped
fixing the dollar.
The last third of the twentieth century started off with the
destruction of the international monetary system and the vacuum sent
officials and academics into a search for “structure.” In the 1970’s
the clarion call was for a “new international monetary order” and in
the 1990’s a “new international monetary architecture.” The old system
was one way of handling the inflation problem multilaterally.
Flexibility left each country on its own. Inflation was the initial
result but a learning mechanism educated a generation of monetary
officials on the advantages of stability and by the end of the century
fiscal prudence and inflation control had again become the watchword in
all the rich and many of the poor countries.
Today, the dollar, the euro and yen have established three islands of
monetary stability,which is a great improvement over the 1970’s and
1980’s. There are, however, two pieces of unfinished business. The most
important is the dysfunctional volatility of exchange rates that could
sour international relations in time of crisis. The other is the
absence of an international currency.
The century closes with an international monetary system inferior to
that with which it began, but much improved from the situation that
existed only two-and-a-half decades ago. It remains to be seen where
leadership will come from and whether a restoration of the
international monetary system will be compatible with the power
configuration of the world economy. It would certainly make a
contribution to world harmony.
Hmmmm.
First of all, this is, by all appearances, a predominantly monetary
"interpretation" of the Interwar Period including the Great Depression.
The main argument seems to be that gold itself changed value -- a
variant on the #5 theory that I ascribed to Gustav Cassell, who Mundell
mentioned. Mundell makes a little mention of "fiscal shocks" in the
form of tariffs and domestic tax hikes, but somewhat in passing (two
sentences!) while his monetary ideas get most of the attention.
September
25, 2016: The "Giant Rise in the Value of Gold" Theory of the 1930s 3:
Supply and Demand
September
18, 2016: The "Giant Rise in the Value of Gold" Theory of the 1930s 2:
Never Happened Before
September
11, 2016: The "Giant Rise in the Value of Gold" Theory of the 1930s
This is also a bit of a hodgepodge -- a little bit of this and a little
bit of that, somewhat in the manner of the Blame France arguments. The
overall impression is one of piling up a lot of justifications behind a
preordained conclusion.
August
7, 2016: Blame France 3: Dump A Pile Of Argle-Bargle On Their Heads
In the end -- like the Blame France-ers -- Mundell is a devaluationist.
His recommendation is no different than that of Keynes or Friedman or
Eichengreen or Temin, or what was actually done by Franklin Roosevelt.
"Had the price of gold been raised in the late 1920’s" -- this means a
devaluation, like the 1933 devaluation of the dollar from $20.67/oz. to
$35/oz. -- "or,
alternatively, had the major central banks pursued policies of price
stability instead of adhering to the gold standard" -- this means a
floating fiat currency whose value drops considerably, such that
nominal commodity prices would not have fallen -- "there would have
been no Great Depression, no Nazi revolution and no World War II." So,
now we know what the justifications are supposed to justify. It is an
interesting storyline to get there, but in the end, the conclusion is
100% by-the-consensus. The black sheep is still following the herd.
My overall impression is that Mundell was not willing to give up some
form of "monetary interpretation," which had become popular among all
right-leaning "small government free market" economists across the
board. He wasn't willing to say, as I have said, that Milton Friedman's
version of things is malarkey, a thinly-veiled justification for
devaluation and floating fiat currencies, no different than the
Keynesians.
June
19, 2014: Explaining "Freaky Friday" -- How the Gold Guys Became Their
Own Worst Enemies
I should also say that making up new "interpretations" of the Great
Depression, while coming to a 100%-by-the-consensus result, has long
been a proven career booster for ambitious academics. Keynes himself
set the example, making up a bunch of justifications in 1936 for what
politicians just wanted to do anyway in 1931. In effect, Keynes showed
the new generation of economists how to make a living in the new
environment. Friedman was another good example, ending up in exactly
the same spot as the Keynesians but by a wholly different route, sort
of like sailing west to Asia. Today, we get ever more creative
"interpretations" by the Blame-France-ers, plus things like Scott
Sumner's book The Midas Paradox.
I think any attempt at actually finding any truth has largely fallen by
the wayside. Today, this is mostly theater, and its purpose is to
entertain the department heads who determine tenure, and who have very
picky tastes.
It is not just the high priests of academic dogma who like to be
stroked. They too bend to the pressures exerted upon them -- pressures
that come, in large part, from central banks themselves. Since
"interpretations" of the Great Depression serve as the ultimate
justification for floating fiat currencies today, and it is floating
fiat currencies (instead of an automatic, nondiscretionary system like
a gold standard or currency board) which gives central bankers their
outsized status and influence, we should not be surprised to find that
various "blame gold interpretations" fit quite well within central
banks' present agenda.
The Federal Reserve, through its extensive network of consultants,
visiting scholars, alumni and staff economists, so thoroughly dominates
the field of economics that real criticism of the central bank has
become a career liability for members of the profession, an
investigation by the Huffington Post has found.
This dominance helps explain how, even after the Fed failed to foresee
the greatest economic collapse since the Great Depression, the central
bank has largely escaped criticism from academic economists. In the
Fed’s thrall, the economists missed it, too.
“The Fed has a lock on the economics world,” says Joshua Rosner, a Wall
Street analyst who correctly called the meltdown. “There is no room for
other views, which I guess is why economists got it so wrong.”
Priceless:
How the Federal Reserve Bought the Economics Profession
Probably it is a little incorrect to go into all this sort of thing,
which doesn't really address the assertions on the table directly at
all. But, having been involved in this sort of thing for a long time
now, what I am often most concerned about is what are the motivations of the
writer? From the motivations spring all the rest of the verbiage.
My motivation is to treat the gold standard as innocent until proven
guilty. The reason for this is that, if the gold standard really
"caused" the Great Depression, then it conceivably could do so again.
As I think we have seen in detail by now, neither the Keynesians nor
the Monetarists -- the two most popular "interpretations" over the past
eighty years -- make any real claims that the gold standard was the
"cause." There hasn't been much defense necessary, because there are no
claims to begin with. We are actually in agreement.
I intended this to be something of a coda to our look into "monetary
interpretations of the Great Depression", but I can tell already that
it is going to get pretty involved. We will continue with this
discussion soon.
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