Woods on “Sound Money” and Deflation: A Critique

After looking at the video, if you do not want to read the whole discussion, I suggest merely reading point (3) below. It makes the point that the actual “gold standard” era was mostly a myth owing to the overwhelming amount of non-commodity credit money in that era.




Points to consider:

(1) I’m not concerned with the first comments on the alleged idea that elites are “pushing” the gold standard and Austrian economics. That is obviously false!

(2) The idea that entirely privatised money will control inflation or even money supply growth is nonsense, and the whole notion that “creating money out of thin air” is fraudulent or immoral is not true. Anyone can create money: witness how private sector agents can create negotiable bills of exchange, promissory notes, negotiable cheques and private banknotes, all of which add to the money supply.

(3) Woods is also mistaken that the gold standard saw “the greatest burst of economic progress in the history of the world.” He refers here to the industrial revolution.

First, people forget that the actual real output growth during the industrial revolution was only revolutionary compared to what preceded it. Real output growth in the periods that followed the gold standard has been superior.

We can easily verify this by looking at real per capita GDP growth across the whole OECD in historical terms:

1700–1820 – 0.2%
1820–1913 – 1.2%
1919–1940 – 1.9%
1950–1973 – 4.9%
1973–1990 – 2.5%
(Davidson 1999: 22).

First, it is obvious that the 1820–1913 period (roughly the industrial revolution) was superior to the 1700–1820 period and previous periods. But those periods also had a commodity standard: silver and gold were the base money in many ancient, medieval and pre-modern economies. Yet none of those economies experienced an industrial revolution. It is naive in the extreme to think that there was any necessary connection between the gold standard and the industrial revolution. The invention of new technologies such as steam power and the mechanisation of textile production did not necessarily require commodity money, but human ingenuity. (In the UK, the emergence of the mechanised textile production – the basis of the British industrial revolution – required a large degree of protectionism.)

Moreover, the 1946–1973 era won out as the best period in terms of per capita GDP growth: in fact, it was better than all other eras by a very considerable degree.

If any era deserves the mantle of “the greatest burst of economic progress in the history of the world,” it is the Keynesian golden age of capitalism.

Secondly, capitalism before 1914 during the industrial revolution was certainly a dynamic era. But investment and economic growth requires credit and credit money, and since the latter is essentially a part of the broad money supply, that requires an elastic or partly endogenous money stock.

In the face of rising demand for credit money during the 19th century, Western nations created credit money in ever greater amounts in addition to gold:

“[the] reconciliation of high rates of economic growth with exchange-rate and gold-price stability [in the 19th century] was made possible … by the rapid growth and proper management of bank money, and could hardly have been achieved under the purely, or predominantly, metallic systems of money creation characteristic of the previous centuries. Finally, the term ‘gold standard’ could hardly be applied to the period as a whole, in view of the overwhelming dominance of silver during its first decades, and of bank money during the latter ones. All in all, the nineteenth century could be far more accurately described as the century of an emerging and growing credit-money standard, and of the euthanasia of gold and silver moneys, rather than as the century of the gold standard.” (Triffin 1985: 153).

Triffin (1985: 152) estimates that in 1800 bank money or credit money probably constituted less than 33% of the money supply. But by 1913 paper currency and bank deposits accounted for 90% of overall currency circulation in the world, and actual gold itself for not much more than 10%.

So much for the classic gold standard era! It was mostly a myth.

(4) The notion that Canada did not suffer from financial “panics” during the 19th century because it had no formal central bank ignores the fact that the financial system in Canada was stabilised by the large and powerful “Bank of Montreal” that in some ways acted like a de facto central bank (Bordo 2002: 121), by taking over insolvent banks and being committed to the stability of the Canadian financial system.

Woods suggests that if only the US had no restrictions on branch banking (from 18.00) then its financial system might have been more stable. But Australia had the closest thing to a free banking system in the 19th century with free branch banking, and yet the system ended in a disastrous asset bubble, financial crisis and debt deflationary depression.

(5) Financial panics existed in many nations without central banks, and the Rothbardian notion that fractional reserve banking is inherently immoral or fraudulent is wrong. Capitalism is stuck with fractional reserve banking, and whatever destabilising effects unregulated fractional reserve banking might have – and it certainly does have such effects – are an inherent flaw of capitalism.

(6) Woods repeats the idea of Murray Rothbard that the 1873–1879 era was “one of the most prosperous periods in American history.” But that idea is now totally discredited, as I have shown here:

“Rothbard on the US Economy in the 1870s: A Critique,” September 24, 2012.

“US Unemployment Graph, 1869–1899,” February 27, 2013.

It appears that the US had a recession from 1873 to 1875 lasting less than 3 years, and unemployment was rising in these years and continued rising until 1878.

(7) The second part of this video (from about 19.00) is taken up with an Austrian defence of price deflation. The gaping whole in the analysis is the absence of any reference to debt deflation.

(8) While it is true that an economy can have real output growth with price deflation, nevertheless economic problems can develop, both in theory and in practice in real world economies where deflationary periods have been observed.

(9) Woods states that “we had falling prices all through US history up through the early 20th century” (my emphasis; 19.15–19.22). That is false, if he means that there was continuous price deflation throughout all that period.

Perhaps Woods means that there was a long-term falling trend in prices throughout US history, but even if you want to take him in that sense there were plenty of inflationary episodes in US history, as can be seen here:

Year | Inflation Rate
1775 | -5.24%
1776 | 14.17%
1777 | 21.87%
1778 | 29.78%
1779 | -11.51%
1780 | 12.25%
1781 | -19.34%
1782 | 9.70%
1783 | -12.33%
1784 | -3.88%
1785 | -4.84%
1786 | -2.55%
1787 | -1.85%
1788 | -4.43%
1789 | -0.93%
1790 | 3.75%
1791 | 2.71%
1792 | 1.87%
1793 | 3.45%
1794 | 10.95%
1795 | 14.38%
1796 | 5.26%
1797 | -3.75%
1798 | -3.33%
1799 | 0.00%
1800 | 2.10%
1801 | 1.31%
1802 | -15.73%
1803 | 5.49%
1804 | 4.38%
1805 | -0.70%
1806 | 4.23%
1807 | -5.41%
1808 | 8.66%
1809 | -2.05%
1810 | 0.00%
1811 | 6.80%
1812 | 1.26%
1813 | 20.02%
1814 | 9.89%
1815 | -12.29%
1816 | -8.65%
1817 | -5.36%
1818 | -4.34%
1819 | 0.00%
1820 | -7.87%
1821 | -3.52%
1822 | 3.65%
1823 | -10.65%
1824 | -7.88%
1825 | 2.57%
1826 | 0.00%
1827 | 0.83%
1828 | -4.96%
1829 | -1.85%
1830 | -0.89%
1831 | -6.26%
1832 | -0.95%
1833 | -1.93%
1834 | 1.97%
1835 | 2.89%
1836 | 5.62%
1837 | 2.77%
1838 | -2.70%
1839 | 0.00%
1840 | -7.10%
1841 | 0.95%
1842 | -6.62%
1843 | -9.24%
1844 | 1.12%
1845 | 1.10%
1846 | 1.09%
1847 | 7.69%
1848 | -4.14%
1849 | -3.14%
1850 | 2.16%
1851 | -2.11%
1852 | 1.08%
1853 | 0.00%
1854 | 8.68%
1855 | 2.95%
1856 | -1.91%
1857 | 2.92%
1858 | -5.67%
1859 | 1.00%
1860 | 0.00%
1861 | 5.96%
1862 | 14.17%
1863 | 24.82%
1864 | 25.14%
1865 | 3.68%
1866 | -2.53%
1867 | -6.82%
1868 | -3.91%
1869 | -4.14%
1870 | -4.24%
1871 | -6.40%
1872 | 0.00%
1873 | -2.03%
1874 | -4.83%
1875 | -3.62%
1876 | -2.35%
1877 | -2.31%
1878 | -4.73%
1879 | 0.00%
1880 | 2.48%
1881 | 0.00%
1882 | 0.00%
1883 | -2.02%
1884 | -2.06%
1885 | -2.00%
1886 | -2.15%
1887 | 1.10%
1888 | 0.00%
1889 | -3.25%
1890 | -1.12%
1891 | 0.00%
1892 | 0.00%
1893 | -1.13%
1894 | -4.36%
1895 | -2.40%
1896 | 0.00%
1897 | -1.23%
1898 | 0.00%
1899 | 0.00%
1900 | 1.24%
1901 | 1.23%
1902 | 1.21%
1903 | 2.28%
1904 | 1.17%
1905 | -1.16%
1906 | 2.23%
1907 | 4.47%
1908 | -2.09%
1909 | -1.12%
1910 | 4.42%
1911 | 0.00%
1912 | 2.06%
1913 | 2.13%
1914 | 0.94%

http://www.measuringworth.com/calculators/inflation/result.php

(10) Woods tells us that:

“Two of the periods of the most robust economic growth in US history were the periods from 1820–1850 and 1865–1900. And in those two cases – in each case prices fell about in half – ... [sc. there was] robust growth.” (from 19.36)

In regard to the 1820–1850 period, we can already see that there were plenty of inflationary periods here:

1820 | -7.87%
1821 | -3.52%
1822 | 3.65%
1823 | -10.65%
1824 | -7.88%
1825 | 2.57%
1826 | 0.00%
1827 | 0.83%
1828 | -4.96%
1829 | -1.85%
1830 | -0.89%
1831 | -6.26%
1832 | -0.95%
1833 | -1.93%
1834 | 1.97%
1835 | 2.89%
1836 | 5.62%
1837 | 2.77%
1838 | -2.70%
1839 | 0.00%
1840 | -7.10%
1841 | 0.95%
1842 | -6.62%
1843 | -9.24%
1844 | 1.12%
1845 | 1.10%
1846 | 1.09%
1847 | 7.69%
1848 | -4.14%
1849 | -3.14%
1850 | 2.16%

http://www.measuringworth.com/calculators/inflation/result.php

The inflationary periods roughly coincided with expansions in the business cycle (booms) and the deflation mostly associated with recessions, as far as I can see. There were probably recessions in this period in the following years:

US Recessions, 1820–1850
Years (Peak–Trough) | Recession Length (years)
1822–1823 |
1828–1829 |
1833–1834 |
1836–1837 | less than 1
1839–1840 | less than 3
(Davis 2006: 106).

These seem to coincide with deflationary periods (the correlation is not perfect, of course, but neither is the real GDP data).

In the end, whatever this GDP data is telling us, it is not showing the effects of continuous price deflation.

At any rate, from 1820 to 1850 real US GDP increased by 239.36% from $12,548 million to $42,583 million (in 1990 international Geary-Khamis dollars; Maddison 2003: 85–96).

But in a comparable 30 year period between 1934 (the beginning of the recovery from the Great Depression and 1964 (in the Keynesian “golden age of capitalism”) real US GDP increased by 277.46%, from $649,316 million to $2,450,915 million (in 1990 international Geary-Khamis dollars; Maddison 2003: 85–96).

So even real GDP growth from 1820 to 1850 was inferior to a later period after the gold standard had been abandoned.

With regard to the 1865–1900 period, it is certainly true that there was mostly deflation from 1873–1896. Although I do not have annual GDP estimates for 1865–1869, the average real GNP growth rate from 1870–1900 was 4.08%, which was historically high.

But matters are very different once we look at real per capita GDP: it was only 1.78% from 1871–1900, one of the lowest of all periods in modern US history:

Historical Real Per Capita GDP Growth Averages
Average Growth Rate 1879 to 1896: 1.36%
Average Growth Rate 1871–1914: 1.63%
Average Growth Rate 1871–1900: 1.78%
Average Growth Rate 1873–1879: 1.64%
Average Growth Rate 1991–2000: 1.94%
Roaring 20s, Average Growth Rate 1920–1929: 2.04%
Average Growth Rate 1971–1980: 2.16%
Average Growth Rate 1981–1990: 2.26%
Average Growth Rate 1948–1973: 2.30%.
Recovery from Depression 1934–1940: 5.75%.

The whole period of 1873–1879, which was the “great deflation of the late 19th century,” had a comparatively low real per capita GDP growth rate average of 1.64%, and a period within this from 1879–1896 had an average of 1.36%, the worst ever seen.

But more specifically, both the 1870s and 1890s were periods of clear economic malaise in US history, and the underlying cause may well have been debt deflation:

“Rothbard on the US Economy in the 1870s: A Critique,” September 24, 2012.

“Davis on US Recessions in the 19th Century,” August 25, 2012.

“US Unemployment in the 1890s,” January 24, 2012.

(11) Woods cites Atkeson and Kehoe (2004) on the alleged benign nature of deflation. He cites its finding that deflation is not necessarily related to recession. Any look through economic history shows that you can have real output growth with price deflation, so that Atkeson and Kehoe’s finding is not that surprising. Price deflation is a serious problem under certain circumstances: when it induces debt deflation in an economy with a high level of private debt.

But there are other reasons to be cautious about Atkeson and Kehoe’s findings. First, there is the question of the actual reliability of the real GDP data available for the 19th century. Most nations only have annualised (not quarterly) estimates for the 19th century which are provisional at best, so that any correlations or lack thereof between deflation and recession for the period before 1914 are hardly definitive. Secondly, after 1945, modern monetary and fiscal interventions have reduced deflationary periods, and even when they have occurred the same monetary and fiscal interventions have allowed modern economies to stave off the worst effects of debt deflation.

Thirdly, Woods ignores the important qualification at the end of Atkeson and Kehoe’s article:

“The data suggest that deflation is not closely related to depression. A broad historical look finds many more periods of deflation with reasonable growth than with depression, and many
more periods of depression with inflation than with deflation. Overall, the data show virtually
no link between deflation and depression.

This study simply characterizes the relation in the raw data between deflation and output growth, with no attempt to control for anything, like the type of monetary regime or the extent to which the deflation was anticipated. Perhaps a link between deflation and depression could be teased out of the data with a well-motivated set of controls. Our contribution here is to note that, without such controls, the data show no obvious relationship.” (Atkeson and Kehoe 2004: 102).

In other words, this is a crude study, with “no attempt to control for anything.”

Once you control for

(1) periods of unexpected deflation where
(2) the level of private debt was very high and
(3) asset bubbles were in existence, and
(4) modern stabilising monetary and fiscal interventions were not implemented,

then I have little doubt one could show a strong empirical relationship between deflation and economic crisis, via the mechanism of debt deflation.

BIBLIOGRAPHY

Atkeson, Andrew and Patrick J. Kehoe. 2004. “Deflation and Depression: Is There an Empirical Link?,” The American Economic Review 94.2, Papers and Proceedings of the One Hundred Sixteenth Annual Meeting of the American Economic Association San Diego, CA, January 3–5, 2004 (May, 2004): 99–103.

Bordo, M. D. 2002. “The Lender of Last Resort: Alternative Views and Historical Experience,” in Charles Goodhart and Gerhard Illing (eds.). Financial Crises, Contagion, and the Lender of Last Resort: A Reader. Oxford University Press, Oxford. 109–125.

Davidson, P. 1999. “Global Employment and Open Economy Macroeconomics,” in J. Deprez and J. T. Harvey (eds), Foundations of International Economics: Post-Keynesian Perspectives. Routledge, London and New York. 9–34.

Davis, J. H. 2006. “An Improved Annual Chronology of U.S. Business Cycles since the 1790s,” Journal of Economic History 66.1: 103–121.

Triffin, R. 1985. “Myth and Realities of the Gold Standard,” in B. Eichengreen and M. Flandreau (eds), The Gold Standard in Theory and History. Routledge, London and New York. 140–161.