Book club: Scott Sumner’s ‘Alternative Approaches to Monetary Policy’
Chapter 2: The Strange World of Interwar Monetary Policy
In Chapter 2 of AAMP, Sumner uses monetary policy in the interwar period, particularly the period from 1929 to 1934, to illustrate some of the propositions laid out in Chapter 1. The interwar period is instructive for a number of reasons. Most notably, it includes what Sumner calls the most ‘clearly identified monetary shock in all of US history,’ namely the devaluation of the US dollar with respect to gold between April 1933 and February 1934. The devaluation illustrates the price of money approach outlined in Chapter 1, both as a monetary policy operating instrument, but also a framework for evaluating the effects of policy.
The interwar gold exchange standard was an interim regime between the pre-World War One classical gold standard and the post-World War Two Bretton Woods system of fixed exchange rates anchored to the US dollar, which in turn was pegged to the price of gold. The gold exchange standard that prevailed in the 1920s and 1930s entailed dual media of account in terms of gold and the dollar, anchored by the nominal price of gold, fixed at $20.67 an ounce. The price level was a function of the global supply and demand for gold. Interest rates, the money supply and the price level were all endogenous in this system, with the long-run price level reflecting the cost of gold mining.
The physical stock of gold did not decline during the Great Depression, so the deflationary shock associated with that episode must reflect an increase in real gold demand. The source of that demand was central bank gold hoarding, with the global gold reserve ratio increasing by nearly 10% on Sumner’s estimates, mainly on the part of Fed, BoE and BdF. Central bank gold hoarding had a variety of motivations, but drove the world economy into depression. The subsequent problems in the US banking system, which led to further gold and currency hoarding by the public, were symptomatic of the gold reserve ratio shock.
In contrast to the gold reserve ratio, neither interest rates nor the money supply (the focus of Friedman and Schwartz’s account of the Great Depression), gave an unambiguous indication that the stance of monetary policy had been tightened.
The devaluation of the US dollar to $35/ounce between April 1933 and February 1934 employed the price of money approach discussed in Chapter 1 and was dramatically effective in raising nominal GDP, as well measures of real output. High frequency movements in the price of stocks and commodities through this episode were correlated with the gold price, which helps to further identify the effects of devaluation. Raising the dollar price of gold was a credible signal about the future path of monetary policy. The dollar price of gold would not change again until March 1968.
Central bank gold stocks were not in danger of being depleted, so gold reserves were not a constraint on monetary policy. The price of money approach demonstrates that the gold standard and the zero lower bound on nominal interest rates were not a constraint on the effectiveness of monetary policy. The Great Depression was a monetary phenomenon, but not quite in the way described by Friedman and Schwartz, who focused on the decline in M2 rather than the gold reserve ratio shock, which was arguably upstream of the decline in the broader money supply. By mid-1934, the US economy had all but fully recovered. But as Sumner shows in much more detail in The Midas Paradox (TMP), the recovery was then derailed by a series of rolling real wage shocks under the NIRA, inducing a renewed downturn.
Chapter 2 is only an outline of the much more detailed narrative contained in TMP, in which Sumner uses primary sources and high frequency data to identify the role of the gold price through this episode. The goal of Chapter 2 is not to convince you of this narrative, but to illustrate the price of money approach to monetary policy. But the price of money approach helps explain why economists have struggled to land on a compelling and coherent narrative of the Great Depression. Reliable identification of monetary policy shocks and their effects is not possible focusing solely on interest rates (in the Keynesian tradition) or monetary aggregates (in the monetarist tradition).
According to Sumner, TMP was rejected by Cambridge and then Princeton University Press, on the advice of reviewers (you can read about the history of that book here). My guess is that the reviewers could not get their head around the price of money approach embedded within it, for which AAMP is a useful corrective. As an amateur economic historian, I find TMP the most economically compelling account of the Great Depression, but it probably works better as a follow up to AAMP. Sumner’s books are perhaps best read in reverse publication order!
ICYMI
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