Here I will bring together several parts of Lawrence White’s book that deal with monetary policy: the debate over the gold standard, the ascendancy of monetarism during the inflationary 1970s, and the recent sovereign debt crisis in several countries.
Tying a nation’s currency to gold places a limit on the money supply. Mercantilists used to worry that if a country allowed too many imports, paying for them would deplete its stock of gold. In 1752 David Hume made a classical case for free trade, describing an automatic balancing process now known as the “price-specie-flow mechanism.” The gold that flows out of a country that has a trade deficit causes deflation in that country and inflation in the surplus country. That tends to correct the trade imbalance by making the deficit country’s goods cheaper and the surplus country’s goods more expensive. Prosperity does not depend on restricting the import of goods or the outflow of gold.
A more realistic criticism of a gold standard is that it limits the government’s options for financing its spending. Government spending is balanced by tax revenue, a change in debt, or a change in the stock of government-issued money held by the private sector (G = T + ΔD + ΔM). If money is backed by gold, the government can’t just print more of it without causing a run on gold. Many critics of government spending welcome that restraint, but advocates of Keynesian deficit spending do not. Printing more money is not, of course, a way of getting something for nothing, since the country may pay for it through inflated prices. But if the government spending so financed creates employment and increased production, a Keynesian can argue that the benefits outweigh the risks.
World War I set off a chain of events that led to the decline of the gold standard:
During the First World War, the governments of Britain, France, Germany, and other combatant nations of Europe each suspended the gold standard so that it could print money to finance war expenditures. With currency irredeemable in gold, no gold outflows constrained the government’s monetary expansion. Considerable
monetary expansion had the inevitable effect of considerably raising the domestic price level.
After the war, England tried to return to the gold standard by restoring the pound to its prewar price in gold, but with so many pounds now in circulation, the result was a run on gold. Other European countries had similar problems.
Large amounts of British and continental European gold flowed into the United States during and after the First World War. The leaders of the new Federal Reserve System, which first opened its doors in 1914, often chose to “sterilize” the inflows, that is, to prevent them from expanding the domestic money stock and bank credit and thereby raising the price level, although such adjustments were part of Hume’s process for stemming the flows and restoring international payments equilibrium.
Supporters of the gold standard say that it could have continued to work if central bankers hadn’t interfered with it, either by printing money not backed by gold or by trying to control prices instead of letting them respond to gold flows. In any case, European countries found it increasingly burdensome to back their currencies with gold. England went off the gold standard for good in 1931. The Bretton Woods conference of 1944 “committed the major European currencies to redeemability not for gold but only for U.S. dollars, with the U.S. dollar as the key international reserve currency that other central banks could redeem for gold….Exchange rates against the dollar were to be pegged, that is, fixed for the time being but adjustable when necessary.”
This system lasted until 1971, when the U.S. itself left the gold standard because it was experiencing its own balance-of-trade deficit and run on gold. Inflation in the United States was reducing the purchasing power of the dollar at home, but fixed exchange rates between the dollar and other currencies made imported goods a relative bargain. The foreign businesses that sold us goods exchanged the dollars for local currency through their central bank, which then had the option of redeeming the dollars for gold. When very little gold was left in the U.S., the Bretton Woods system broke down.
During the “Great Inflation” of the 1970s, the “monetarist” economists led by Milton Friedman gained influence at the expense of the Keynesians. Friedman was one of the economists who had joined the Mont Pelerin society organized by Friedrich von Hayek in 1947, with the purpose of keeping classically liberal free-market economics alive. Now he argued that the principal cause of inflation was a too-rapid increase in the money supply. (Similarly, he argued that the main reason for the severity of the Great Depression was the failure of the Federal Reserve to maintain an adequate money supply.) He recommended a consistent policy of only modest and steady monetary expansion, and he warned against the kind of activist Keynesian policy that tried to stimulate the economy with deficit spending and/or rapid monetary expansion.
I was surprised that a book about the clash of economic ideas wouldn’t have a chapter on economists’ interpretations of the housing bubble and the Great Recession of 2007-09. White does mention that the recession sparked a new interest in Keynesian economics, but he doesn’t elaborate. He does have a chapter on sovereign debt crisis in countries such as Greece, with a strong monetarist emphasis. An increasing burden of debt gives a government a strong incentive to expand the money supply, since “reducing the value of the monetary unit reduces the real burden of any existing debt denominated in that unit.” In fact, some economists argue that the growth of government debt eventually forces it to resort to inflationary finance. As a government borrows more and more, lenders can demand higher interest, until the cost of servicing the entire debt increases faster than the additional amount borrowed. Additional borrowing is then counterproductive, and expanding the money supply is the only way left to finance a increasing deficit. Eventually, that leads to a collapse of confidence in the currency.
Maybe the reason White focuses on sovereign debt crisis instead of other aspects of the recent economic crisis is that he is most comfortable telling a monetarist story that blames economic problems on government. As with the first chapter about the earlier “turn away from laissez-faire,” he seems more reluctant to acknowledge market failures, which seem rather conspicuous during the housing bubble. Also, having just read Michael Pettis’s The Great Rebalancing, I know that economists differ sharply in their interpretations of sovereign debt crisis as well. Pettis attributes it as much to over-saving in creditor countries like Germany and China as to over-borrowing in deficit countries like Greece and the United States. He specifically warns against blaming the debtors alone for the global capital flows that finance both asset bubbles and sovereign debt.
Overall, I found the book a better exposition of classical and monetarist views than of less free-market-oriented alternatives, especially in its discussions of recent economic developments.