Recently, we’ve been taking a look at the “price-specie flow mechanism”, a rather stupid notion that has been around forever. It is one of the main intellectual impediments today keeping people from realizing how simple and easy a gold standard system, or any fixed-value system, really is.
We already looked at David Hume directly, and found that he didn’t really say what people think he said. Mostly — although Hume was a little fuzzy — he argued against anything resembling a “price-specie flow mechanism.” Hume was basically a “law of one price” guy.
I think that the notions attributed to Hume were basically the Mercantilist ideas that were floating around prior to Hume, and which Hume was, to some degree, dismissing. Mercantilism was always a reflection of monarchist big government, while the Classical system, prior to 1914, reflected smaller government (although they were often still monarchies). This “balance of payments” nonsense made a big recovery especially after WWI, and especially after WWII, corresponding with increasing statism, including money manipulation along Keynesian lines by monopoly central banks. By the latter 19th century, it was even more irrelevant, since actual movements of gold between countries didn’t have any particular direct connection with base money, which was by then almost entirely banknotes and central bank deposits. It still continues today, amazingly, in various notions that central bank foreign exchange reserves have something to do with the “balance of payments.”
But, for now let’s just go back to the “classical gold standard” era of 1870-1914, and also prior to that, when gold and silver coinage itself made up most of the money in most places, and banknotes were rare.
Today, I’m adding a paper by Fillippo Cesarano, who was a researcher at the Bank of Italy. Like us, he actually read what Hume actually said, and found that it doesn’t say what people think it does.
In a later book, Cesarano called the “price-specie flow mechanism” a “myth that in no way reflects how the gold standard actually worked.” “The intricate debate that has run on for two-and-a-half centuries is the product of an erroneous interpretation,” Cesarano continued. “In Hume’s essay, the law of one price is not violated and in fact is the foundation of his analysis.” (Monetary Theory and Bretton Woods: the Construction of an International Monetary Order, 2006, p. 23)
Of course, whether Hume said this or that is not really so important today. The important thing is that people keep citing Hume, basically because they agree with him — or think they do. They “agree” with the “price-specie flow” notion that they attribute to Hume, although I would say that Hume was actually trying to dismiss such notions in his essay.
As Hume might have argued, gold is, “like water,” the same value everywhere — a.k.a., the “law of one price.” An area — Europe, for example — that uses gold and silver coinage as money, and where trade in bullion or coinage is relatively free and easy, is not really any different from two regions in the same country with the same conditions. It has nothing to do with trade. Prices don’t go up and down, the value of coinage doesn’t go up and down, and there is never a surplus here and a shortage there. As we leave Hume’s time and advance to the Classical gold standard period where banknotes become dominant over coinage, we can see that trade and gold flows remain irrelevant. A gold standard system merely keeps the value of the banknotes at the gold parity, and gold is the same value everywhere. The basic mechanism by which this accomplished has nothing to do with trade, but, via one means or another, is one which the supply of base money expands when the currency’s value is marginally above its gold parity, and contracts when it is marginally below.
This process is inherent in any currency board system today. I talk about it in great detail in Gold: the Monetary Polaris.
In his 1995 book The Anatomy of an International Monetary Regime: The Classical Gold Standard, 1880-1914 — probably the best book on the topic at least since 1950 — Giulio Gallarotti said:
“The practice of gold monometallism is partly what has been known in monetary economics as a rule for regulating domestic money supplies. … Under a gold standard, authorities maintain a stable value of the currency … by defending the value of gold vis-à-vis the currency itself. When gold goes to a premium vis-à-vis notes (rises above the par value), it means the money supply is too large … and therefore must be held in check. When the value of gold drops below par, it means that the money supply needs to be increased.” (p. 22)
You see how easy this is?
Note that it has nothing to do with the “balance of payments,” price levels, interest rates, activities of other central banks, or any other such thing. The volume of gold that is here or there or somewhere else is irrelevant. The value is the important thing — and the value is the same everywhere. With a currency board, the “standard of value” is different — a foreign currency, instead of gold. But, except for that, the process is basically the same.
Gallarotti debunks a lot of silly notions from the 1980s and 1990s, regarding gold standard systems, in his book. I mostly agree with his conclusions, although the writing is the sort of thing that only an academic could tolerate. I think it is significant that he was a professor of political science, not economics.
However, I think that, perhaps even in the 1880s or 1890s, people did not quite perceive this process. Perhaps bankers did; but they didn’t write books. Also, I think bankers had a somewhat limited and practical view of their tasks, and did not necessarily have a definitive view of the broader theoretical processes involved. They did not see it as their role to contradict the mistaken notions of academics, and perhaps didn’t even perceive those mistakes.
If you are really geeky, you might enjoy finding out how common this “price-specie flow mechanism” stuff was even in the 1980s (and, by extension, today). Here is a collection of academic papers from 1984:
Let me caution you that 95% of the material in that book should not be taken at face value. It is basically incorrect. But, it gives you an idea of the ways that academic economists were incorrect in the 1980s, and by extension, today.
This paper looks at the history of the “price-specie flow mechanism” idea.
I find it a little horrifying. Were people really so confused? I don’t think so — the paper represents, to some degree, a projection of the erroneous ideas of the 1980s upon earlier generations. However, I also think that the correct ideas were not really presented in a clear and definitive manner by earlier economists. They didn’t have to: in those days, the Bank of England knew what to do, and had reliably done so for nearly two centuries, so there wasn’t a need to go into details. It was a little like describing, in scientific detail, the rising of the sun. Today we have a need, because economists and central bankers have no clue.
Economists were so convinced that maintaining their currency values at gold parities had something to do with the “balance of payments” that, after 1950, the actual meaning of the term “balance of payments” underwent a kind of fissure. It meant two things: one, the actual meaning of the term, in reference to trade; and second, certain activities of central banks. That is why economists could complain about the U.S. “chronic balance of payments deficit” in the 1960s, a decade in which the current account balance was positive in every single year.
For example, one economist in 1993 actually said term “balance of payments” was:
“defined as official U.S. gold sales plus foreign accumulations of liquid dollar claims on the United States.”
(Garber, Peter. 1993. “The Collapse of the Bretton Woods Fixed Exchange Rates System.” In Michael Bordo and Barry Eichengreen, eds. 1993. A Retrospective on the Bretton Woods System: Lessons for International Monetary Reform. The University of Chicago Press, Chicago.)
“The monetary approach to the balance of payments (MABP) presupposes fixed exchange rates. A version associated with Harry G. Johnson and his followers became fashionable in the early and middle 1970s.We will call it the “strong” version. It identifies a country’s balance-of-payments surplus under fixed exchange rates with a process of satisfying a demand for domestic money to hold in excess of actual holdings, and it identifies a payments deficit with a process of working off a supply of domestic money in excess of desired holdings.”[italics in original]
Rabin, Alan and Leland B. Yeager. 1982. “Monetary Approaches to the Balance of Payments and Exchange Rates,” Essays in International Finance No. 148. Department of Economics, Princeton University, Princeton, NJ.
At least these economists were perceptive enough to understand that people were using the term “balance of payments” to mean completely different things. Most economists, I would say, did not have even this insight. Using the same term to mean completely different things is very confusing; and it is generally done by people who are very confused. I personally would not use the term “apple” to mean both the fruit of a tree of the genus Malus, and also the liver of a cow. Now try to imagine that I really thought they were one and the same. That is roughly what is going on here, in the field of economics.
So you see, we are not really arguing about Hume here, but rather the whole course of mistaken theory up to the present day.
This is a somewhat haphazard attempt to begin to describe the corrosive effect of this “balance of payments” and “price-specie flow” stuff over at least a century of economic thought, and perhaps — as Cesarano argues — over two and a half centuries. As you can see, I’ve been doing a little book research in these matters, and I can say that I have not yet come across a correct and detailed description of how a gold standard system works — from the 19th, 20th or 21st centuries. It is really very simple, as I show in Gold: the Monetary Polaris.