The True Gold Standard (Second Edition)
The Rueffian Synthesis
Previous article: Rueff Restates the Quantity Theory of Money
We said that to demand money, people must supply goods or claims; this tends to lower the price of goods and claims. Under a gold standard, however, the money price of gold is constant because some monetary institution keeps the money it issues convertible into gold at a fixed parity. The fall in price of other goods lowers the cost, and increases the profitability, of mining gold. Shifting some labor and capital from producing other goods to the gold industry (or, in a country without gold mines, to producing goods for export to acquire gold) provides employment for labor and, through coinage or monetization, results in the quantity of money demanded.
Moreover, Rueff points out, the same thing can occur under any monetary standard, as long as people can discount commercial paper at the central bank (in effect, borrow money from the bank by exchanging it for an IOU issued against their assets). Again, when people sell claims or goods to acquire cast, it lowers the price of both goods and claims. (Rueff showed that if one happens, it will lead to the other.) But a fall in the price of claims means at least a temporary increase in the interest rate.
As long as the central bank’s discount rate (or today, the Federal Funds rate) remains above the market interest rate, then the excess demand for money will be satisfied by a fall in the price of goods and a rise in the rate of interest. But when the market interest rate rises to the central bank’s discount rate – or the central bank lowers its interest rate to the market rate – people can receive the whole quantity of money they demand, without any further fall in the price of goods or any further rise in the interest rate, by discounting their claims at the bank.
Because in the real world there are delays in adjustment, stability of the general price level is not literally possible; because in many markets the price differences must become fairly large before the process of arbitrage is profitable. For example, you and I don’t pack up and move because, say, salaries in our line of work have risen a few pfennigs this week in Germany. The differential would have to become rather large for us to even consider it. This is one reason why the general price level tends to rise and fall over time even in the best-regulated monetary system. But the adjustments do occur. The advantage of the gold standard, according to Rueff, is that its mechanism guaranteed that the general price index would always return to approximately the same level.
Next Installment: Rupturing the Link
For several decades, the theories of John Maynard Keynes replaced the classical theory which had dominated policy-making for more than a century until the Great Depression. This brought things full circle, because the classical economists had succeeded the Mercantilists. And the Mercantilists were proto-Keynesian in their contention that, left to itself, the economy has a tendency toward “under-consumption,” which, they argued, must be combated by public spending, combined with measures to increase the money supply.
The classical economists replied that consumption can look after itself. No one, they said, would go to the trouble and expense of producing goods, unless they planned either to consume them or exchange them for good which they would ultimately consume.
Jean-Baptiste Say’s “Law of Markets” says, in effect, that goods exchange for goods: the goods produced, taken together, provide the value with which to purchase themselves. “The creation of a new product is the opening of a new market for other products, [while] the consumption of destruction of a product is the stoppage of a vent for them,” Say wrote (A Treatise on Political Economy, Chapter XV).
To emphasize this point, the classical economists elaborated a barter theory of exchange. They also had a theory of money, which went back to David Hume, but the two theories were not formally integrated. The classical economists emphasized that, although money is only half of every exchange, it has only a temporary role in facilitating the exchange of goods. “Money performs but a momentary function in this double exchange; and when the transaction is finally closed, it will always be found, that one kind of commodity has been exchanged for another,” Say argued (idem).
Say himself recognized that total demand for goods would not exactly equal total supply if people sold more goods than they bought, in order to increase their holdings of money. But he emphasized that, sooner or later, supply and demand for goods would balance. First, because more money would be forthcoming: “There is always money enough to conduct the circulation and mutual exchange of other values, when those values really exist,” he said. “[M]erchants know well enough how to find substitutes for the product serving as the medium of exchange or money: and money itself soon pours in, for this reason, that all produce naturally gravitates to that place where it is most in demand.” (This was Hume’s theory.) Second, because hoarded money would be spent sooner or later: “Even when money is obtained with a view to hoard or bury it, the ultimate object is always to employ it in a purchase of some kind. The heir of the lucky finder uses it that way, if the miser do not; for money, as money, has no other use than to buy with” (idem). To anticipate things a bit, we not that Say’s answer depends on some empirical arguments about the supply and demand for money.
Others, however, recognized that the Mercantilists had not been fully answered. The earliest correction of Say’s Law seems to belong to John Stuart Mill. But it is contained in a little-noticed article which was published, I believe, only after his death (“Of the Influence of Production on Consumption,” in Some Unsettled Questions of Political Economy).
Restating Say’s Law, Mill observes: “Nothing is more than that it is produce which constitutes the market for produce, and that every increase in production, if distributed without miscalculation among all kinds of produce in the proportion which private interest would dictate, creates, or rather constitutes, its own demand.”
However, Mill observes, it would seem that Say’s Law “contradicts those obvious facts which are universally known and admitted to be not only possible, but of actual and even frequent occurrence” – namely, the existence of rises and falls in the price level, and of economic upswings and recessions. These conditions necessarily reflect an inequality between total supply and total demand.
Say’s Law, Mill notes, “is evidently founded on the supposition of a state of barter; and, on that supposition, it is perfectly incontestable. When two persons perform an act of barter, each of them is at once a seller and a buyer. He cannot sell without buying.”
“If, however, we suppose that money is used, these propositions cease to be exactly true…. [T]he effect of the employment of money, and even the utility of it, is that it enables this one act of interchange to be divided into two separate acts or operations… Although he who sells, really sells only to buy, he needs not buy at the same moment when he sells; and he does not therefore necessarily add to the immediate demand for one commodity when he adds to the supply of another.”
For Say’s Law to be strictly true, Mill concluded, “money must itself be considered as a commodity. It must, undoubtedly, be admitted that there cannot be an excess of all other commodities, and an excess of money at the same time.” To make such an argument, Mill says, “involves the absurdity that commodities may fall in value relatively to themselves.”
In this way, Mill anticipates what is known as Walras’ Law, but does not work it out. The proof that “money must itself be considered as a commodity,” since “there cannot be an excess of all other commodities, and an excess of money at the same time,” is generally credited to Leon Walras. Wealth can be divided into three categories – money, claims, and goods. Walras proved that any excess demand for money must equal the sum of the excess supply in the other two markets. It remains true that you can’t sell without buying, if you include money among the articles bought and sold.
Next: The Problem with Keynes
Previous: Who Was Jacques Rueff?
Rueff’s first work in monetary theory, Theorie des Phenomenes Monetaires (1927), was devoted partly to examining the theories put forward by Irving Fisher in The Purchasing Power of Money (1911). Rueff himself owed a large debt to Fisher, as does all of economics, for ideas like the modern understanding of income and capital. But Fisher is best remembered for his famous Equation of Exchange:
MV + M’V’ = PT
where M is the supply of money, M’ the supply of bank credit, and V and V’ referred to the “velocity of circulation” of money and bank credit, respectively.
For Fisher, unlike modern monetarists, P and T referred to the average price and transactions volume of all wealth exchanged for money – including financial claims and capital goods, not just the final products of labor and capital.
Nowadays, monetarists lump the M’s and V’s together so that they refer to composite money-plus-credit aggregates, and use the formula.
MV = PY
where P and Y refer only to the price and volume of final output of goods and services, measured for example by GNP.
Rueff pointed out that Irving Fisher’s Equation of Exchange is always true, “because it simply states that the amount of payments made over a certain period of time is identically equal to the value of the goods paid for during this period.
“However, the equation of exchange, like the quantity theory, calls for a basic reservation as regards the meaning to be ascribed to it. As a matter of fact, in the form in which we have stated it, and contrary to what is too commonly believed, the equation of exchange does not allow for any causal interpretation. In particular, nothing in this theory would justify an assertion that changes in the circulation of money should always be the cause of variations in the general price level…” (op cit., unpublished Lehrman Institute translation, I/19-20).
As an empirical matter, Rueff found that V and V’ tended to vary with the business cycle – rising and falling with wholesale prices.
Before discussing Rueff’s own monetary theory, let’s turn first to the problems raised by Say’s Law and Keynes theory, because Rueff’s answer to all three is related.
Next: The Problem of Say's Law
Previous:The Problem of Say's Law
Keynes begins his General Theory with a refutation of Say’s Law precisely on the grounds that had bothered Mill. Keynes treats Say’s Law, not as a tendency toward equilibrium, but as claiming an identity between the total supply and total demand for goods. Keynes put it this way: “Say’s Law, that the aggregate demand price of output as a whole is equal to the aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment.” Keynes pointed to the Great Depression, with its deflationary excess of supply over demand, and rested his case.
It is hazardous to simplify the argument over the General Theory. This is partly because Keynes, as somebody put it, had a habit of following a long and murky argument with a clear and triumphant conclusion. But basically, Keynes argued that the price mechanism cannot be trusted to bring about equilibrium at full employment, except perhaps in the very long run. And in the long run, went the famous phrase of that childless theorist, we are all dead. The use of money spent, to Keynes, that supply and demand did not have to tally. If people hoarded part of their income as cash (or, in Keynes’s view, short-term securities), instead of spending the money on goods or lending it to entrepreneurs to invest, total demand would fall short of total supply. The argument is a lot more complicated, but that’s the basic idea.
Mill had said: “Although he who sells, really sells only to buy, he needs not buy at the same moment when he sells; and he does not therefore necessarily add to the immediate demand for one commodity when he adds to the supply of another.” Keynes puts it this way: “An individual decision to save does not, in actual fact, involve the placing of any specific forward order for consumption, but merely the cancellation of a present order.”
We note here that Keynes, like the Mercantilists, often confused demand with consumption. (As somebody put the distinction: If I have an apple, I can offer it for an orange – that’s demand; if I eat the apple, I’ve lost the ability to demand anything with it – that’s consumption.)
In any event, this is why Keynes asserted that the economy would settle into “unemployment equilibrium” before reaching full employment. Keynes proposed, like the Mercantilists, that the government fill this supposed gap in demand through deficit spending.
Rueff was among the first, though not the only critic of Keynes, to point out that this supposedly “general” theory rested on some very restricted assumptions. Above all, Keynes’s “unemployment equilibrium” depended, not upon some inherent characteristic of a market economy, but on a hidden assumption that prices and wages are immobile.
When people want to hold more money than they possess, they must sell more (or buy less of) other kinds of wealth to acquire it. If the money supply is fixed, as Keynes assumed, the prices of other wealth – goods and financial claims – will fall. This continues until the increased demand for money is released by a fall in the amount of money necessary to exchange any given volume of wealth. Rueff and others pointed out that if prices are free to adjust, total supply and total demand can be matched, with full employment, but at a lower price level.
Thus, Rueff noted, “the theory of employment which Keynes calls ‘general’ is valid only for very special cases, for economies which are entirely insensitive to movements of prices and interest rates.” (“The Fallacies of Lord Keynes’ General Theory,”The Quarterly Journal of Economics, May 1947, 343-367.)
Rueff also points out that Keynes is wrong in thinking that the money supply is fixed, or that to demand money is to demand nothing. But I would like to leave this to the discussion of Rueff’s monetary ideas.
A young fellow named James Tobin undertook to answer Rueff’s critique of Keynes in 1947 and tried to defend Keynes’s notion of “unemployment equilibrium.” But others, such Don Patinkin, quickly recognized that “this is an indefensible position.” Patinkin observed that price “flexibility means that the money wage falls with excess supply, and rises with excess demand; and equilibrium means that the system can continue through time without change. Hence, by definition, a system with price flexibility cannot be in equilibrium if there is any unemployment.” (“Price Flexibility and Full Employment,” American Economic Review, Sept. 1948, pp. 543-63).
Since the later 1940s, Keynes’s followers have been reduced to finding alternate theories to support his policy proposals, most of which emphasize the “stickiness” of wages and prices. But Rueff had demonstrated in 1947 that Keynes was wrong on the key point of his General Theory several decades before Keynes’s followers had their heyday in the United States.
Next Installment: Rueff's Macroeconomics: Minding Your P's and Q's
In which LBMC’s approach receives a name, Wanniski is refuted, and the setbacks of the supply-side movement are explained.
In his Life of D. Johnson, James Boswell describes Samuel Johnson’s reaction to the theory of George Berkeley, Bishop of Coyne. Berkeley’s theory claimed to disprove the existence of the physical universe, on the grounds that it exists only as an idea in the mind.
“I observed,” Boswell recalls telling Johnson, “that though we are satisfied his doctrine is not true, it is impossible to refute it. I never shall forget the alacrity with which John answered, striking his foot with mighty force against a large stone, till he rebounded from it, – ‘I refute it thus.’”
Johnson’s answer came to mind when I read a recent attack upon LBMC and all its works by Jude Wanniski of Polyconomics, Inc. Along with his new economist, David Goldman, Wanniski undertakes to challenge LBMC’s contention that the World Dollar Base can be used to help predict inflation more than two years in advance – and that this is how LBMC was able to predict the inflation of 1989-90 and the recent recession.
Polyconomics’ argument boils down to this: “LBMC believes that auction prices on futures markets react to changes in liquidity with a two-year lag. Nothing like this has ever been argued in the history of economics; all schools of economics believe that auction markets react almost instantaneously to changes in liquidity.”
In other words, LBMC can’t be right, because that would be against the economic theories of Polyconomics, Inc. (We pass over the rather uncharacteristic appeal to “all schools of economics.”)
Samuel Johnson was right: if any theory is so foolish as to deny a fact, its disproof is not another theory, but the fact itself. Polyconomics claims that inflation cannot be predicted as long as two years in advance. But they offer no evidence. So the answer to Polyconomics is simple. We refute them thus.
Graph 1 shows the year-to-year inflation of food and energy commodities over the past 50 years, as measured by the fixed-weight index for personal consumption expenditures. The graph compares it with the year-to-year increase in the World Dollar Base a bit more than two years earlier. (Our methodology is discussed later on.)
The graph shows that every major commodity inflation was preceded by a commensurate expansion of the World Dollar Base.
The relationship with food and energy commodities is essentially similar whether one uses producer prices, consumer prices, or the CRB commodity futures index.
Graph 2 shows the relation between the World Dollar Base and overall personal consumption expenditure inflation. This relationship is not quite as close, because the pricing of labor and capital services differs somewhat from the pricing of natural resources (see “The Myth of Core Inflation,” LBMC Report, April 1990). However, the relationship is still a strong one. The World Dollar Base has a strong ability to predict changes in inflation, more than two years in advance.
“’Tis strange – but true, for truth is always strange; Stranger than fiction.”
The main purpose of this report is to explain in some detail why this relationship is casual, not accidental. LBMC began with a theory and found the evidence to support it, and not vice versa. This enabled LBMC to predict both the inflation of 1989-90 and the recent recession and recovery – not merely explain them after the fact.
Polyconomics raises many minor points, and I’ve prepared a detailed response to them. But I’ve relegated much of it to an appendix. This is because, while LBMC is willing to enter an argument, for Wanniski the thing is merely a quarrel. Those interested in the quarrel may be interested in the appendix. Those interested only in the facts and theory may perform an appendectomy and learn what they wish to know by reading this paper. The appendix, it turns out, is almost as long as the body to which it is appended. This is because the economic argument concerns “only” the meaning of macroeconomics, while the quarrel concerns the meaning of Wanniski.
Part of the mystery, it would seem, is why Wanniski demands a comparison between LBMC’s inflation and recession predictions and those of Polyconomics. At the start of 1989, Polyconomics confidently predicted that “U.S. Inflation is not expected to be any higher than last year, and is probably headed lower” (“The Outlook for 1989,” p. 1, emphasis in original). Polyconomics dismissed the surge of inflation that almost instantly followed as a fluke, and at the end of 1989 flatly stated that “neither recession nor inflation are imminent risks” (“How Bad Are Profits?” Sept. 18, 1989, p. 1).
With undiminished assurance, Wanniski now explains the recession as the inexorable result of the Tax Reform Act of 1986. Alan Reynolds, who made the earlier predictions as Polyconomics’ chief economist, says, “I blame this recession mostly on the war” (Wall Street Journal, July 5, 1991, p. A2).
One can nitpick any two-year forecast, including LBMC’s; but it’s clear that Wanniski is not doing so because Polyconomics had either a correct or cogent prediction to tout.
Wanniski’s attack, it turns out, has nothing to do with business competition. LBMC and Polyconomics are not even competitors (as is suggested by the fact that we have mutual clients). One of Wanniski’s endearing qualities, in my view, is that his business has always been an offshoot of his role as a political gadfly – not vice versa. As I point out in the appendix, for Wanniski to offer LBMC-type econometric forecasts would be like a mullah running a distillery.
Next: The Debate Has a History
The Rueffian Synthesis