Journal of Monetary Economics 17 (1986) 305-313. North-Holland

MONEY IN CRISIS

A Review Essay *

David LAIDLER Uniuersip of Western Ontario, Lotldon, Ont., Canudu N6A SC2

Money in Crisis is a readable and provocative collection of essays though rather one-sided. A quick inspection of the ‘Selected Bibliography’ - which is not, and ought to have been, a consolidated list of works referred to in the text - reveals five entries for Ludwig von Mises, none for Joseph Schumpeter; thirteen for Friedrich von Hayek, none for John Maynard Keynes; seven for Murray Rothbart, none for James Tobin; and so on.’ Even so, Austrian views by no means monopolise the volume, and they deserve more attention than they have been given by mainstream economists in recent years. Money in Crisis, then, is well worth reading.

Axe1 Leijonhufvud’s is the outstanding essay of ‘Money and the Economy’, as the first of the book’s three sections is called, not least because it contains a written account of his ‘blueback’ scheme for curing inflation, hitherto only available to those with access to the UCLA ‘oral tradition’. If ‘greenback inflation is fully anticipated, and running at, say 15% per annum, why go through a recession to eliminate it? Why not instead begin to issue ‘bluebacks’ which, by law, appreciate at the rate of 15% per annum against greenbacks? Greenbacks may now continue to depreciate, no one’s expectations need be disturbed, but price level stability - in terms of ‘bluebacks’ - is instantly and costlessly created. Of course the proposal is satirical; but conventional models of the welfare costs of inflation do tell us that its cure is that simple, just as they also tell us that its costs verge upon the trivial.

*A review of Money in Crisis: The Federal Reserve, The Economv, und Monetuty Reform edited by Barry N. Siegel wjth a Foreword by Leland B. Yeager, Cambridge, MA, Balhnger Publishing Co. for the Pacific Institute for Public Policy Research, 1984, pp. xxv + 361. I am grateful to Alvin Marty and George Stadler for helpful discussions of certain issues raised in this essay, but they are not implicated in any errors and omissions.

‘The complaint about references is serious. One contributor, Charles Wainhouse, refers to other publications by author’s name and date of publication only, and the editor should not have left readers to fill in the other details.

0304-3923/86/$3.5001986. Elsevier Science Publishers B.V. (North-Holland)

306 D. Luidler. Monqv in crisis

Leijonhufvud argues that the inflation of the last twenty years has involved a change of monetary regime, in a deeper sense than that agents have had to substitute one coherent set of rules for forming rational inflation expectations for another. He suggests that any kind of coherence of expectations over time or across agents has become impossible, either concerning the price level or the structure of relative prices (and I wish Leijonhufvud would distinguish more clearly between the two). Under what. he terms our ‘random walk monetary standard’ the monetary system fails to perform properly its vital functions of conveying information and providing incentives to the productive coordination of economic activity, and the economy becomes chronically dislocated and inefficient. Leijonhufvud is not just arguing that, when mone- tary shocks are unanticipated, the economy produces outcomes which, though the product of coordinated and ex ante voluntary choices, are regretted ex post. Rather he is arguing that the economy ceases to function ‘as if’ activity was coordinated by a centralised, continuously clearing Walrasian market. This radical theme is hardly a new one in his work, but the clarity - and brevity - of this essay wil.l, I hope, persuade more people to take notice of it than have done so in the past.2

The other two essays in this section are more narrowly focussed. J. Stuart Wood’s useful contribution shows how. inflation interacts with unindexed accounting and taxation systems to erode the economy’s capital stock, while Charles Wainhouse, in one of the explicitly Austrian contributions, presents ‘Empirical Evidence for Hayek’s Theory of Economic Fluctuations’. This essay, dealing as it does with a much neglected piece of theory, is welcome, but, in my view, it is also ultimately unsatisfactory. Wainhouse gives a clear account of Hayek’s analysis, but badly overstates its distinctiveness. His empirical work, therefore, fails to concentrate on the crucial questions which distinguish Hayek’s diagnosis of the cycle from others. As Wainhouse says. non-neutrality of money is central to Hayek’s theory, but so it is to all theories of the business cycle which descend from Wicksell, including, for example, those of Hawtrey, Robertson, Keynes (of the Treafise) and Schumpeter.) It is also central to Robert E. Lucas’ work, of which more in a moment.

What distinguished Hayek from most of his contemporaries was the belief that the activities of the banking system initiate, as opposed to permit, real investment to run ahead of voluntary saving during the upswing, and the view that the upper turning point resulted from the underlying saving rate reimpos- ing itself as a constraint upon the process of capital deepening. Wainhouse’s analysis of patterns of Granger causality that arise between various economic

‘Nor does this theme of Leijonhufvud’s leave us at a dead end in theoretical research, As Peter Howitt (1985) has noted, the analysis of labour market coordination failures arising from fundamental externalities in search processes, such as he and Peter Diamond, e.g.. (1984). are now beginning to create, is closely related to Leijonhufvud’s concerns.

‘Haberler (1958) is still, of course, the classic survey of intetwar business cycle theory.

D. Luidler, Money in crisis 307

variables (what would Hayek think about the application of this methodology to his model?) certainly suggests, for example, that credit expansion varies independently of fluctuations in saving and that there are systematic changes in the relative prices of producers’ and consumers’ goods over the cycle. But these facts and the others he highlights are consistent with many theories other than Hayek’s.

More seriously, Wainhouse does not address except in passing (see pp. 51-52) what seemed in the 193Os, and still seems, to be a critical flaw in Hayek’s mode1 - namely its inability to explain the fluctuations in employ- ment that accompany the cycle as a logical consequence of the mechanisms which it highlights. Like Lucas - see, e.g. (1977) - Hayek set his cycle in motion with what we would nowadays term an unanticipated monetary shock. During Hayek’s upswing, which like Lucas’ begins at full employment, labour shifts from consumer to producer goods industries in response to relative price changes. He did not explain, to the satisfaction of his contemporaries, why this movement of labour could not simply reverse itself during the downswing; for if it could, then the cycle would be characterised by systematic shifts in the structure of production, redundant capital at and after the peak, but continu- ous full employment of labour. This gap in Hayek’s model is one reason why Keynes’s (1936) General Theory, with its emphasis upon explaining the overall level of income and employment, to the neglect of much else certainly, proved so overwhelmingly attractive an alternative to those same contemporaries.4

Lucas’ fundamental contribution to cycle theory is to have shown that employment fluctuations can after all be explained within the competitive framework used by Hayek. In his analysis, monetary shocks drive a wedge between real wages as perceived by suppliers and demanders of labour, and necessarily produce variations in the level, as well as the structure, of employ- ment. Because Wainhouse insisted on classifying Lucas among those for whom ‘the neutrality of money has become largely unexamined assumption’ (p. 38) he fails to do justice to the connections between Hayek’s contribution and modern work on the role of money in the cycle and to the theoretical advances contained in that modem work.

The second section of this book, ‘The Record of Federal Reserve Policy’, is concerned with diagnosing the causes of monetary instability in the United States since 1913. In Murray Rothbart’s very Austrian view, the problem lies with the existence of the Federal Reserve System, which from the outset has been no more than a cartelisation device enabling commercial banks to carry on highly profitable (to them) but highly damaging (to the rest of the economy) inflationary policies. International collaboration among central banks during and after the First World War, far from stabilising the system, ensured that

‘For a discussion of this issue, see Hicks (1967).

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damage was worldwide. The Great Depression was the inevitable consequence of all this, and the fault of the Fed from 1929 to 1933 was not that it acted too timidly in expanding the monetary base, but that its ‘inflationary’ policy over those years made the Depression even worse. To readers brought up on Friedman and Schwartz (1963) all this will seem absurd, but we should resist the temptation to dismiss Rothbart as a crank. He is doing no more than, first, suggesting that the Fed, like many other regulatory agencies set up at about the same time (the ICC, the FTC, the Department of Agriculture), should be viewed as the creature of the regulated; and second, applying Austrian monetary theory, such as described earlier by Wainhouse, to deriving the consequences of this.

It would take someone with a deeper knowledge of U.S. history than this reviewer to pass a firm judgement on the importance of the first of these suggestions, but it does appear to be well documented here. Moreover, in the light of two decades of public choice literature insisting that self-interest is as powerful a force in political matters as it is in the marketplace, Friedman and Schwartz’s story of a largely disinterested central bank, lacking, after a promising start, the skill and courage to act like one when under extreme pressure, might well need some modification along these lines. However, Rothbart’s actual diagnosis of the Depression, and of Britain’s problems in the 192Os, as the consequences of a chronic overinflation of bank credit, seems to me to be the product of assuming that Austrian theory is correct, and thereafter forcing the facts to fit it.5

Jonathan Hughes’ penetrating and sceptical essay surveying alternative explanations of the Great Depression argues that historical explanation based on tightly specified economic theory always runs the danger of slipping into such oversimplified mono-causality, particularly when it deals with a specific episode such as the Depression. One experiment, whose outcome is known before people start constructing their explanations of that outcome, is unlikely to enable us to discriminate among those explanations. If Rothbart is guilty here, he has plenty of company among students of the Depression as Hughes tellingly demonstrates.

Stephen DeCanio, who concentrates on explaining why the Depression persisted for so long, is not entirely innocent here. He develops a theoretical framework that allows him to allocate the causes of unemployment between a failure of business confidence and rising real wages, and advances the provoca- tive (and refreshingly non-monetary) hypothesis that the advent of the New Deal both raised confidence among firms after 1933, but, because so many of

‘And if people WC going to cite Lionel Robbins’ Great Depressio~r (1934). as Rothbart, Hughes and Siegel (in the ‘Select Bibliography’) all do, could they please do that great economist’s memory the elementary courtesy of noting first that he explicitly repudiated this book later in his career. and second that he referred to his espousal of deflationary policies in 1929-30, itsell the result of a commitment to Austrian cycle theory, as ‘the greatest mistake of my professional career’. See Robbins (1971, pp. 154-55).

D. Luidler, Monev ill crisis 309

its measures actively raised real wages, simultaneously prevented this increase in confidence being translated into higher employment. DeCanio may be right about this, but because his model assumes that firms are always on their notional demand curves for labour, his empirical work effectively precludes his ‘supply side’ explanation of unemployment from being. compared with a Keynesian alternative based on a deficiency of effective demand.6

Even so, the moral of Hughes’ essay is that, in dealing with so singular an event as the Great Depression, the historian would be wise to consider the possibility that it resulted from the interaction of a variety of factors. He certainly does not argue against according monetary instability an important role. Moreover, Richard Timberlake’s argument, advanced in his commentary on post World War II experience, that monetary expansion was a sine qua non of the inflation which has plagued us since the mid-1960s is hard to dispute. I am, though, baffled that Timberlake fails to mention the fiscal pressures generated by the Vietnam War as one of the underlying causes here. Surely the association of war finance with monetary expansion and inflation is one of the few historical phenomena that repeat themselves often enough to permit economics at least a tenuous claim to be an experimental science.

For all the reservations I have noted, the overwhelming impression left by the first two parts of this volume is that monetary instability does affect the economy’s behaviour for the worse, and that the discretionary activities of the Federal Reserve System have often contributed to such instability. How to limit that discretionary behaviour, to ‘constitutionalise’ the conduct of mone- tary policy, is then a serious issue. It is addressed in the six essays which make up the final part of this book.

The most remarkable characteristic of these essays on ‘Monetary Reform’ is a negative one. None of them advocates a straightforward Friedman money growth rule. Only yesterday it seems, this was by far the most popular device among supporters of constitutional constraints on monetary policy, but the fact of institutional change within the banking system to which the experience of the last decade has forced us to pay attention effectively undermines it. To make a specific definition of ‘money’ part of any binding rule is to risk that rule’s becoming irrelevant: and to fail to define it simply legitimatises discre- tionary policy by permitting the authorities to do so on an ad hoc basis. There is no way out of this impasse. Though traces of Friedman’s rule are to be found here - in Timberlake’s suggestion that it be applied to the monetary base, as opposed to the money supply, and in the late Robert Weintraub’s proposal that a form of gold convertibility for Ml be reintroduced and then used to ensure that the latter aggregate’s growth rate never exceeds 3% per

“It is worth pointing out that the study by Benjamin and Kochin (1979) of British interwar unemployment. cited here by Bordo and by Reynolds, suffers from the same basic methodological limitation.

310 D. Loidler, Money in crisis

annum - most contributors focus on other means of stabilising the purchasing power of money.

Proposals to restore the gold standard do not fare well here, however. Alan Reynolds’s paean of praise ‘Gold and .Economic Boom.. . ’ attributes every- thing good that happened under gold to its benevolent influence and every- thing bad to other causes, and is effectively undermined by Michael Bordo’s much more careful analysis of the historical record. As Bordo shows, the system’s considerable success in achieving secular price stability came at the cost of a good deal of short-run instability.7 Moreover, the fact that the past cannot be changed does not render it irrelevant. Friedrich von Hayek, unlike so many modem economists, understands this and comments: ‘To restore the gold standard would.. . require a return to beliefs that have been destroyed, and to do so would probably cause such fluctuations in the value of gold that the standard would break down before long’ (p. 327, n. 7).

What then to do? Robert Hall, who rejects a return to gold for much the same reasons as Hayek, suggests imposing a feedback rule linking the treasury bill rate to the price level. His proposal seems to me to need a little fleshing out before we pass judgement on it. Suppose it is quantities rather than prices that respond initially to shocks: might not that introduce uncomfortably long lags into his system? Didn’t Phillips (1954) long ago warn us that the stability of feedback systems was very sensitive to their lag structure? Hall doesn’t discuss these issues, and his case is thus left incomplete.8

Another possibility, aspects of which are explored here by Hayek and Lawrence White, is to give market forces a much bigger play than they now have in guiding the performance of the monetary system. Simply to rely on competition among banks is not enough, for such competition ensures only that real balances bear a competitive real rate of return. It leaves the inflation rate and money’s nominal rate of return indeterminate. As White correctly argues, though, this does not imply that money is a natural monopoly of the state. It is in the provision of a monetary standard, a unit of account, that natural monopoly questions arise; not in the provision of means of exchange and stores of value.

White’s fascinating essay shows that, given the ability of the general public to distinguish among the liabilities of individual banks, a competitive banking system can be relied upon to provide stable money - both currency and deposits - at least for an open economy whose monetary standard is either

‘It might be noted in passing that, in the view of another Austrian business cycle theorist, Joseph Schumpeter, such short-run instability, far from being undesirable, was an essential feature of the process of economic growth under capitalism. Schumpeter’s ideas are worth some fresh exploration in the light of recent time series work by Nelson and Plosser (1982). This seems to show that the business cycle, far from being a deviation of income from a stable underlying trend, is better represented as reflecting shifts in the trend itself.

‘His proposal should not be dismissed out of hand though. Jonung (1981, pp. 299-300) tells us that, for a short time during the Depression, the Swedish authorities experimented successfully with a procedure rather like that proposed by Hall. Hall does not refer to this experience.

D. Loidler. Money in crisis 311

gold, or some dominant world currency. As White argues, the Scottish banking system did just that for more than a century, but it was made up of rather few banks, served a rather close knit and extremely sophisticated business com- munity, and relied upon England to provide a stable monetary standard.g I am far from sure that Scottish experience of the 18th and early 19th centuries can be generalised even to the contemporary United States, let alone to the international economy. The information requirements which such a system would impose upon the public to render it completely viable are fierce, and competition among banks does not, in itself, provide that elusive stable standard of value upon which the system would have to be based. Free banking is all very well, but it doesn’t provide a total blueprint for a monetary constitution.

Hayek’s more limited proposal, to encourage private banks to emit liabilities convertible on demand into purchasing power guaranteed baskets of selected currencies also raises worries about the capacity of agents to digest and utilise information, but it does attempt to come to grips with the critical issue of how to provide a stable monetary standard through competitive means. It is not obvious how this would work out in practice as, with his characteristic modesty about the possibility of predicting the outcome of social experiments, Hayek himself admits. He points out that the banks issuing such liabilities may find it difficult to acquire enough of the indexed assets which they would need to match them and that the scheme might not flourish for that reason. He doesn’t, however, explicitly consider the alternative of what would happen if such indexed monies became successful enough to affect the viability of the curren- cies in terms of which they were redeemable. Would some kind of commodity convertibility not be needed after all to anchor the system at this stage, and how would the transition from one form of convertibility to the other be managed. Y” Hayek would presumably answer that that wonderful device for discovering viable means of coping with such problems, the market, should be deployed in search of a solution.

Just as Hughes’ thoughtful scepticism makes his the omstanding essay of the second part of this book, so does Hayek’s lack of pretence about what social engineering can be expected to produce in the way of improved monetary

‘White’s essay is in fact drawn from a Ph.D. thesis dealing with British, particularly Scottish, banking. A monograph. White (1984). based on the entire thesis has recently been published.

“‘European readers will recognize the issues involved here as having been earlier debated in the context of discussions of European Monetary Union. Some of the contributors here drew. quite explicitly, on Hayek’s ideas. The only author in this volume to acknowledge the existence of the extensive European literature is White who refers to but two contributions to it. Since one of these is by Benjamin Klein (1978) - the other is Roland Vaubel(l977) - one must conclude, sadly, that American economists have now become just as dangerously insular as they used to accuse Europeans of being. Fratianni and Peeters (1978), where Klein’s paper appears, and Sumner and Zis (1982) provide a useful starting point for those wishing to get the Ravour of European discussions.

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arrangements make his the most attractive contribution to the third part. No matter how good blueprints for money growth or interest rate feedback rules, commodity convertibility, or free banking, may look on paper, put then into practice and they will surprise us with their consequences. Wholesale reform is not, then, the way to proceed. As Hayek, but also among the contributors to this volume, Timberlake and Weintraub, stress, in reforming the monetary system we must start from where history has placed us. We would be wise to keep our experiments modest, leaving room for manoeuvre when they encoun- ter, or indeed produce, unexpected events.

Viewed in this light, and without wishing to implicate anyone but myself in this suggestion, perhaps the current fashion among central banks for medium- term money growth targeting, unsatisfying though its intellectual basis un- doubtedly is, is not so bad. It has, after all, proved possible to implement it without wholesale institutional reform, and it is producing low and stable inflation. Though it would be pleasant to have more of a guarantee than we currently have that inflation will continue to fall, and ultimately be eliminated, those of us who have lived through the last two decades should be grateful for small mercies.

If these last two decades had not seen constant debate about the importance of monetary stability, it is hard to believe that a political consensus strong enough to support the more moderate monetary policies of the last few years could have been created; and if that debate does not continue, it is hard to believe that the consensus will persist, let alone that it can be strengthened enough. for some sort of monetary constitution to be put in place. The intellectual marketplace provides a relatively harmless venue in which to test not just new ideas but old ones too, and weed out at least some of the bad ones. The more competitive is that marketplace the more effective is it likely to be. Thus, if I am sceptical about many of the positions taken by contributors to Money in Crisis, that does not mean that it and books like it are irrelevant. Quite the contrary: the issues raised here need to be widely and continuously discussed among as broad a public as possible. It is only from such debate that an idea better than n&dium-term targeting, and surely there must be one, is likely to emerge. Even if it doesn’t, is not a well-informed and concerned public in any case a better guarantee of monetary stability than a constitu- tional arrangement put in place without such an underpinning?

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Benjamin, D.K. and L.A. Kochin, 1979, Searching Car an explanation of unemployment in intenvar Britain, Journal of Political Economy 87,441-478.

Diamond, P.A.. 1984, A search equilibrium approach to the micro foundations of macroeconom- ics: The Wicksell lectures - 1982 (MIT Press, Cambridge, MA).

Fratianni. M. and T. Peeters, 1978, One money for Europe (Macmillan, London). Friedman, M. and A.J. Schwartz, 1963, A monetary history of the United States 1867-1960

(Princeton University Press for the NBER, Princeton, NJ).

D. Luidler. Monqy in crisis 313

Haberler, G.. 1958, Prosperity and depression: A theoretical analysis of cyclical movements, 4th ed. (Harvard University Press, Cambridge, MA).

Hicks, J.R. (Sir), 1967, The Hayek story, in: Critical essays in monetary theory (The Clarendon Press, Oxford).

Hewitt. P.W., 1985, Transactions costs in the theory of unemployment, American Economic Review 75, 88-100.

Jonung. L., 1981, The depression in Sweden and the United States: A comparison of causes and policies, in: K. Brunner. ed.. The Great Depression revisited (Martinus NijholT Publishing, The Hague).

Keynes, J.M. (Lord), 1936, The general theory of employment. interest and money (Macmillan, London).

Klein. B., 1978. Competing monies, European monetary union, and the dollar, in: M. Fratianni and T. Peeters. eds.. One money for Europe (Macmillan, London).

Lucas, R.E., Jr., 1977, Understanding business cycles, in: K. Brunner and A.H. Meltzer. eds., Stabilization of the domestic and international economy, Carnegie-Rochester conference series, Vol. 5 (North-Holland, Amsterdam).

Nelson, C.R. and C.I. Plosser, 1982, Trends and random walks in macroeconomic time series, Journal of Monetary Economics 10,139-162.

Phillips, A.W.. 1954, Stabilization in a closed economy, Economic Journal 64. 290-323. Robbins, L.C. (Lord), 1934, The Great Depression (Macmillan, London). Robbins, L.C. (Lord). 1971, Autobiography of an economist (Macmillan, London). Sumner, M.T. and G. Zis, eds.. 1982, European monetary union progress and prospects

(Macmillan, London). Vaubel. R., 1977. Free currency competition, Weltwirtschaftliches Archiv 113, 435-461. White, L.A., 1984, Free banking in Britain (Cambridge University Press, Cambridge).