Price Specie Flow Mechanism Assumptions And Critical Thinking

[Excerpted from An Austrian Perspective on the History of Economic Thought, vol. 1, Economic Thought Before Adam Smith (1995). An MP3 audio file of this article, read by Jeff Riggenbach, is available for download.]

David Hume (1711–1776), the famous Scottish philosopher, was a close friend of Adam Smith's who was named Smith's executor, an acquaintance of Turgot's and of the French adherents of laissez-faire, and a member of the moderate élite of the Scottish Enlightenment.

Born in Edinburgh the son of a Scottish lord, Hume studied on the Continent, where he published his epochal philosophical work, A Treatise of Human Nature (1739–1740), at the age of 28. Hume's Treatise was pivotal in its corrosive and destructive skepticism, managing unfairly to discredit the philosophy of natural law, to create an artificial split between fact and value, and therefore to cripple the concept of natural rights on behalf of utilitarianism and indeed to undermine the entire classical-realist analysis of cause and effect.

There is no figure more important in the unfortunate discrediting of the classical philosophical tradition of natural-law realism, a tradition that had lasted from Plato and Aristotle at least through Aquinas and the late Scholastics. In a sense, Hume completed the corrosive effect of the 17th-century French philosopher René Descartes's influential view that only the precisely mathematical and analytic could provide certain knowledge. Hume's skeptical and shaky empiricism was the other side of the Cartesian coin.

While highly influential in later decades, Hume's Treatise was ignored in his own day, and after writing it he turned to brief essays on political and economic topics, and eventually to his then-famous multivolume History of England, which he presented from a Tory point of view.

Barred from academia for his skepticism and alleged irreligion, Hume joined the diplomatic corps and served as secretary to Lord Hertford, the British ambassador to France. In 1765, Hume became the British chargé d'affaires in Paris, and two years later rose to the post of undersecretary of state. Finally, in 1769, Hume retired to Edinburgh.

Hume's contribution to economics is fragmentary, and consists of approximately 100 pages of essays in his Political Discourses (1752). The essays are distinguished for their lucid and even sparkling style, a style that shone in comparison to his learned but plodding contemporaries.

Hume's most important contribution is his elucidation of monetary theory, in particular his clear exposition of the price-specie-flow mechanism that equilibrates national balances of payments and international price levels. In monetary theory proper, Hume vivifies the Lockean quantity theory of money with a marvelous illustration, highlighting the fact that it doesn't matter what the quantity of money may be in any given country: any quantity, smaller or larger, will suffice to do money's work of facilitating exchange. Hume pointed up this important truth by postulating what would happen if every individual, overnight, should find the stock of money in his possession to have doubled miraculously:

For suppose that, by miracle, every man in Great Britain should have five pounds slipped into his pocket in one night; this would much more than double the whole money that is at present in the kingdom; yet there would not next day, nor for some time, be any more lenders, nor any variation in the interest.

Prices then, following Locke's quantity theory of money, will increase proportionately.

The price-specie-flow mechanism is the quantity theory extrapolated into the case of many countries. The rise in the supply of money in country A will cause its prices to rise; but then the goods of country A are no longer as competitive compared to other countries. Exports will therefore decline, and imports from other countries with cheaper goods will rise.

The balance of trade in country A will therefore become unfavorable, and specie will flow out of A in order to pay for the deficit. But this outflow of specie will eventually cause a sharp contraction of the supply of money in country A, a proportional fall in prices, and an end to, indeed a reversal of, the unfavorable balance.

As prices in A fall back to previous levels, specie will flow back in until the balance of trade is in balance, and until the price levels in terms of specie are equal in each country. Thus, on the free market, there is a rapidly self-correcting force at work that equilibrates balances of payments and price levels and prevents an inflation from going very far in any given country.

While Hume's discussion is lucid and engaging, it is a considerable deterioration from that of Richard Cantillon. First, Cantillon did not believe in aggregate proportionality of money and price-level changes, instead engaging in a sophisticated microprocess analysis of money going from one person to the next. As a result, money and prices will not rise proportionately even in the eventual new equilibrium state.

Second, Cantillon included the "income effect" of more money in a country, whereas Hume confined himself to the aggregate-price effect. In short, if the money supply in country A increases, it will equilibrate not only by prices rising in A, but also by the fact that monetary assets and incomes are higher in A, and therefore more money will be spent on imports. This income, or more precisely the cash balance, effect will generally work faster than the price effect.

There are more problems with Hume's analysis, problems other than the omission of previously discovered truths. For while Hume conceded that it does not matter for production or prosperity what the level of the money supply may be, he did lay great importance on changes in that supply. Now it is true that changes do have important consequences, some of which Cantillon had already analyzed. But the crucial point is that all such changes are disruptive and distort market activity and the allocation of resources.

But David Hume, on the contrary, in a pre-Keynesian fashion, hailed the allegedly vivifying effects of increases in the quantity of money upon prosperity, and called upon the government to make sure that the supply of money is always at least moderately increasing. The two contradictory prescriptions of Hume for the supply of money are actually presented in two successive sentences:

From the whole of this reasoning we may conclude, that it is of no manner of consequence, with regard to the domestic happiness of a state, whether money be in a greater or less quantity. The good policy of the magistrate consists only in keeping it, if possible, still increasing; because, by that means he keeps alive a spirit of industry in the nation.

Hume goes on, in proto-Keynesian fashion, to claim that the invigorating effect of increasing the supply of money occurs because employment of labor and other resources increases long before prices begin to rise. But Hume stops (as Keynes did) just as the problem becomes interesting: for then, it must be asked, why were resources underemployed before, and what is there about an increase in the money supply that might add to their employment?

As W.H. Hutt was to point out in the 1930s, deeper reflection would show that the only possible reason for unwanted unemployment of resources is if the resource owner demands too high a price (or wage) for its use. And more money could only reduce such unemployment when selling prices rise before wages or the price of resources, so that workers or other resource owners are fooled into working for a lower real, though not lower, money wage.

Furthermore, why should idle resources, as Hume implicitly postulates, reappear after the effects of new money have been fully digested in the economy in the form of higher prices? The answer can only be that after the price increases are accomplished and a new equilibrium attained, wages and other resource prices have caught up and the "money illusion" has evaporated. Real resource prices return to being excessively high for the full employment of resources.1

Hume's inner contradictions on the quantity of money and inflation permeate his meager writings on economics. On the one hand, continuing inflation over the centuries is depicted as bringing about economic growth; on the other, Hume sternly favored ultrahard money in relation to the banking system. Thus Hume delivered a hard-hitting attack on the unproductive and inflationary nature of the very existence of fractional-reserve banking. He wrote of

those institutions of banks, funds, and paper credit, with which we are in the kingdom so much infatuated. These render paper equivalent to money, circulate it throughout the whole state, make it supply the place of gold and silver, raise proportionately the price of labour and commodities, and by that means either banish a great part of those precious metals, or prevent their further increase. What can be more short-sighted than our reasoning on this head? We fancy, because an individual would be much richer, were his stock of money doubled, that the same good effect would follow were the money of every one increased; not considering, that this would raise as much the price of every commodity, and reduce every man, in time, to the same condition as before.

Elsewhere Hume noted that inconveniences result from the increase of genuine money (specie), but at least they are "compensated by the advantages which we reap from the possession of these precious metals," including bargaining power in negotiations with other nations. But, he added, "there appears no reason for increasing that inconvenience by a counterfeit money, which foreigners will not accept of in any payment, and which any great disorder in the state will reduce to nothing." To "endeavour to increase" paper credit "artificially," then, merely increases money "beyond its natural proportion to labour and commodities," thereby increasing their prices.

Hume concluded his penetrating analysis with an ultra-hard-money policy proposal — 100 percent specie-reserve banking: "it must be allowed, that no bank could be more advantageous, than such alone as locked up all the money it received, and never augmented the circulating coin." Hume added that this was the practice of the famous 100 percent specie-reserve Bank of Amsterdam.

Another important flaw in Hume's analysis of money was his propensity, picked up and magnified by Smith, Ricardo, and the classical school, for leaping from one long-run equilibrium state to another, without bothering about the dynamic process through time by which the real world actually moves from one state to another. It is this brusque neglect (or "comparative statics") that leads Hume to omit the Cantillonian analysis of micro-changes in cash balances and income, and that causes him to neglect income effects in the price-specie-flow mechanism of international monetary adjustment.2 Ironically, by doing so, and thereby neglecting the "distribution effects" of changing assets and incomes during the process, Hume — as well as countless other economists following him — distorts what happens in equilibrium itself. For they then cannot see that the new equilibrium will be very different from the old. Thus, when the money supply changes, there will not be an equiproportionate increase in all prices across the board.

Professor Salerno puts the point very well:

there is some truth to Keynes statement that … "Hume began the practice amongst economists of stressing the importance of the equilibrium position as compared with the ever-shifting transition towards it." For, in reading Hume, one gets an unmistakable whiff, if not the full flavor, of the notion that it is in the states of long-run equilibrium that the economy actually resides most of the time. The transition between these states, Hume conceives as proceeding rapidly and terminating before another change in the economic data can intervene and propel the economy toward a new equilibrium. This notion at times leads Hume to truncate a full step-by-step analysis of a given change in the data, thus slighting or skipping over altogether its short-run effects in order to focus upon a comparative-static analysis of its ultimate consequences.3

In reality, as the Austrians have emphasized, the situation is precisely the reverse of the Hume-British classical assumptions. Rather than the long-run equilibrium state being the fundamental reality, it never exists at all. Long-run equilibrium provides the tendency toward which the market is ever moving, but is never reached because the underlying data of supply and demand — and therefore the ultimate equilibrium point — are always changing.

Hence a full step-by-step analysis of a given change in the data is precisely what is needed to explain the process of successive short-run states which tend toward but never reach equilibrium. In the real world, the "long run" is not equilibrium at all, but a series of such short-run states, which will keep changing direction as underlying data are altered.

A final problem with Hume's monetary views is that, in contrast to the French laissez-faire school, he believed that money need not be a useful marketable commodity but was a mere convention. Writing to Abbé Andre Morellet (1727–1819), a disciple of Gournay's and lifelong friend of Turgot's, Hume opines that money functions as such because of the belief that others would accept it. Very true; but this does not mean that money originated as a mere convention. And Hume acknowledges that money should be made of materials "which have intrinsic value," for "otherwise it would be multiplied without end, and would sink to nothing."

Hume's thoughts on interest are illuminating, if only in contrast to the profundity and brilliance of Turgot's exposition 20 years later. Since money's impact is ultimately on prices only, Hume shows that interest can only be a phenomenon of real capital rather than of money. He discusses the relation between interest rates and profit rates (i.e., the fundamental rates of return on investment). Here he points out correctly that "no man will accept of low profits, where he can have high interest; and no man will accept of low interest where he can have high profits." In short, interest and profit rates tend to be equal on the market.

Very true, but which causes which, or what is the underlying cause of both? Hume characteristically abandons the search for cause, and says that "both arise from an extensive commerce, and mutually forward each other." Böhm-Bawerk is surely right when he says that this view is "somewhat superficial."4 But more than that, it is incorrect and reverses cause and effect by stating that "extensive commerce, by producing large stocks (capital), diminishes both interest and profits." For there is no reason why larger stocks of capital should lower interest or profit rates; what they do lower is the prices of capital goods and consumer goods.

The causal chain is the other way round: lower time-preference rates, which usually but not always attend higher standards of living and greater prosperity, will cause both capital to accumulate and profit and interest rates to fall. The two, as the Austrian School would later point out, are different sides of the same coin.5

Turning to the other areas of economics, it is possible that some of the deep flaws in Adam Smith's value theory were the result of David Hume's influence. For Hume had no systematic theory of value, and had no idea whatever of utility as a determinant of value. If anything, he kept stressing that labor was the source of all value.

On political economy, David Hume may be considered a free trader and opponent of mercantilism. A friend and mentor of Adam Smith from their first meeting in 1752, Hume came to know the French laissez-fairists during his years in that country, and Turgot himself translated Hume's Political Discourses into French.

This article is excerpted from An Austrian Perspective on the History of Economic Thought, vol. 1, Economic Thought Before Adam Smith (1995). An MP3 audio file of this article, read by Jeff Riggenbach, is available for download.

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The tortured intellectual history of the price-specie-flow mechanism (PSFM), which received its classic exposition in an essay (“Of the Balance of Trade”) by David Hume about 275 years ago is not a history that, properly understood, provides solid grounds for optimism about the chances for progress in what we, somewhat credulously, call economic science. In brief, the price-specie-flow mechanism asserts that, under a gold or commodity standard, deviations between the price levels of those countries on the gold standard induce gold to be shipped from countries where prices are relatively high to countries where prices are relatively low, the gold flows continuing until price levels are equalized. Hence, the compound adjective “price-specie-flow,” signifying that the mechanism is set in motion by price-level differences that induce gold (specie) flows.

The PSFM is thus premised on a version of the quantity theory of money in which price levels in each country on the gold standard are determined by the quantity of money circulating in that country. In his account, Hume assumed that money consists entirely of gold, so that he could present a scenario of disturbance and re-equilibration strictly in terms of changes in the amount of gold circulating in each country. Inasmuch as Hume held a deeply hostile attitude toward banks, believing them to be essentially inflationary engines of financial disorder, subsequent interpretations of the PSFM had to struggle to formulate a more general theoretical account of international monetary adjustment to accommodate the presence of the fractional-reserve banking so detested by Hume and to devise an institutional framework that would facilitate operation of the adjustment mechanism under a fractional-reserve-banking system.

In previous posts on this blog (e.g., here, here and here) a recent article on the history of the (misconceived) distinction between rules and discretion, I’ve discussed the role played by the PSFM in one not very successful attempt at monetary reform, the English Bank Charter Act of 1844. The Bank Charter Act was intended to ensure the maintenance of monetary equilibrium by reforming the English banking system so that it would operate the way Hume described it in his account of the PSFM. However, despite the failings of the Bank Charter Act, the general confusion about monetary theory and policy that has beset economic theory for over two centuries has allowed PSFM to retain an almost canonical status, so that it continues to be widely regarded as the basic positive and normative model of how the classical gold standard operated. Using the PSFM as their normative model, monetary “experts” came up with the idea that, in countries with gold inflows, monetary authorities should reduce interest rates (i.e., lending rates to the banking system) causing monetary expansion through the banking system, and, in countries losing gold, the monetary authorities should do the opposite. These vague maxims described as the “rules of the game,” gave only directional guidance about how to respond to an increase or decrease in gold reserves, thereby avoiding the strict numerical rules, and resulting financial malfunctions, prescribed by the Bank Charter Act.

In his 1932 defense of the insane gold-accumulation policy of the Bank of France, Hayek posited an interpretation of what the rules of the game required that oddly mirrored the strict numerical rules of the Bank Charter Act, insisting that, having increased the quantity of banknotes by about as much its gold reserves had increased after restoration of the gold convertibility of the franc, the Bank of France had done all that the “rules of the game” required it to do. In fairness to Hayek, I should note that decades after his misguided defense of the Bank of France, he was sharply critical of the Bank Charter Act. At any rate, the episode indicates how indefinite the “rules of the game” actually were as a guide to policy. And, for that reason alone, it is not surprising that evidence that the rules of the game were followed during the heyday of the gold standard (roughly 1880 to 1914) is so meager. But the main reason for the lack of evidence that the rules of the game were actually followed is that the PSFM, whose implementation the rules of the game were supposed to guarantee, was a theoretically flawed misrepresentation of the international-adjustment mechanism under the gold standard.

Until my second year of graduate school (1971-72), I had accepted the PSFM as a straightforward implication of the quantity theory of money, endorsed by such luminaries as Hayek, Friedman and Jacob Viner. I had taken Axel Leijonhufvud’s graduate macro class in my first year, so in my second year I audited Earl Thompson’s graduate macro class in which he expounded his own unique approach to macroeconomics. One of the first eye-opening arguments that Thompson made was to deny that the quantity theory of money is relevant to an economy on the gold standard, the kind of economy (allowing for silver and bimetallic standards as well) that classical economics, for the most part, dealt with. It was only after the Great Depression that fiat money was widely accepted as a viable system for the long-term rather than a mere temporary wartime expedient.

What determines the price level for a gold-standard economy? Thompson’s argument was simple. The value of gold is determined relative to every other good in the economy by exactly the same forces of supply and demand that determine relative prices for every other real good. If gold is the standard, or numeraire, in terms of which all prices are quoted, then the nominal price of gold is one (the relative price of gold in terms of itself). A unit of currency is specified as a certain quantity of gold, so the price level measure in terms of the currency unit varies inversely with the value of gold. The amount of money in such an economy will correspond to the amount of gold, or, more precisely, to the amount of gold that people want to devote to monetary, as opposed to real (non-monetary), uses. But financial intermediaries (banks) will offer to exchange IOUs convertible on demand into gold for IOUs of individual agents. The IOUs of banks have the property that they are accepted in exchange, unlike the IOUs of individual agents which are not accepted in exchange (not strictly true as bills of exchange have in the past been widely accepted in exchange). Thus, the amount of money (IOUs payable on demand) issued by the banking system depends on how much money, given the value of gold, the public wants to hold; whenever people want to hold more money than they have on hand, they obtain additional money by exchanging their own IOUs – not accepted in payment — with a bank for a corresponding amount of the bank’s IOUs – which are accepted in payment.

Thus, the simple monetary theory that corresponds to a gold standard starts with a value of gold determined by real factors. Given the public’s demand to hold money, the banking system supplies whatever quantity of money is demanded by the public at a price level corresponding to the real value of gold. This monetary theory is a theory of an ideal banking system producing a competitive supply of money. It is the basic monetary paradigm of Adam Smith and a significant group of subsequent monetary theorists who formed the Banking School (and also the Free Banking School) that opposed the Currency School doctrine that provided the rationale for the Bank Charter Act. The model is highly simplified and based on assumptions that aren’t necessarily fulfilled always or even at all in the real world. The same qualification applies to all economic models, but the realism of the monetary model is certainly open to question.

So under the ideal gold-standard model described by Thompson, what was the mechanism of international monetary adjustment? All countries on the gold standard shared a common price level, because, under competitive conditions, prices for any tradable good at any two points in space can deviate by no more than the cost of transporting that product from one point to the other. If geographic price differences are constrained by transportation costs, then the price effects of an increased quantity of gold at any location cannot be confined to prices at that location; arbitrage spreads the price effect at one location across the whole world. So the basic premise underlying the PSFM — that price differences across space resulting from any disturbance to the equilibrium distribution of gold would trigger equilibrating gold shipments to equalize prices — is untenable; price differences between any two points are always constrained by the cost of transportation between those points, whatever the geographic distribution of gold happens to be.

Aside from the theoretical point that there is a single world price level – actually it’s more correct to call it a price band reflecting the range of local price differences consistent with arbitrage — that exists under the gold standard, so that the idea that local prices vary in proportion to the local money stock is inconsistent with standard price theory, Thompson also provided an empirical refutation of the PSFM. According to the PSFM, when gold is flowing into one country and out of another, the price levels in the two countries should move in opposite directions. But the evidence shows that price-level changes in gold-standard countries were highly correlated even when gold flows were in the opposite direction. Similarly, if PSFM were correct, cyclical changes in output and employment should have been correlated with gold flows, but no such correlation between cyclical movements and gold flows is observed in the data. It was on this theoretical foundation that Thompson built a novel — except that Hawtrey and Cassel had anticipated him by about 50 years — interpretation of the Great Depression as a deflationary episode caused by a massive increase in the demand for gold between 1929 and 1933, in contrast to Milton Friedman’s narrative that explained the Great Depression in terms of massive contraction in the US money stock between 1929 and 1933.

Thompson’s ideas about the gold standard, which he had been working on for years before I encountered them, were in the air, and it wasn’t long before I encountered them in the work of Harry Johnson, Bob Mundell, Jacob Frenkel and others at the University of Chicago who were then developing what came to be known as the monetary approach to the balance of payments. Not long after leaving UCLA in 1976 for my first teaching job, I picked up a volume edited by Johnson and Frenkel with the catchy title The Monetary Approach to the Balance of Payments. I studied many of the papers in the volume, but only two made a lasting impression, the first by Johnson and Frenkel “The Monetary Approach to the Balance of Payments: Essential Concepts and Historical Origins,” and the last by McCloskey and Zecher, “How the Gold Standard Really Worked.” Reinforcing what I had learned from Thompson, the papers provided a deeper understanding of the relevant history of thought on the international-monetary-adjustment  mechanism, and the important empirical and historical evidence that contradicts the PSFM. I also owe my interest in Hawtrey to the Johnson and Frenkel paper which cites Hawtrey repeatedly for many of the basic concepts of the monetary approach, especially the existence of a single arbitrage-constrained international price level under the gold standard.

When I attended the History of Economics Society Meeting in Toronto a couple of weeks ago, I had the  pleasure of meeting Deirdre McCloskey for the first time. Anticipating that we would have a chance to chat, I reread the 1976 paper in the Johnson and Frenkel volume and a follow-up paper by McCloskey and Zecher (“The Success of Purchasing Power Parity: Historical Evidence and Its Implications for Macroeconomics“) that appeared in a volume edited by Michael Bordo and Anna Schwartz, A Retrospective on the Classical Gold Standard. We did have a chance to chat and she did attend the session at which I talked about Friedman and the gold standard, but regrettably the chat was not a long one, so I am going to try to keep the conversation going with this post, and the next one in which I will discuss the two McCloskey and Zecher papers and especially the printed comment to the later paper that Milton Friedman presented at the conference for which the paper was written. So stay tuned.

PS Here is are links to Thompson’s essential papers on monetary theory, “The Theory of Money and Income Consistent with Orthodox Value Theory” and “A Reformulation of Macroeconomic Theory” about which I have written several posts in the past. And here is a link to my paper “A Reinterpretation of Classical Monetary Theory” showing that Earl’s ideas actually captured much of what classical monetary theory was all about.

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