David Glasner

Classical Monetary Theory and the Quantity Theory

Commission, S-5018, Washington, D.C. 20580; e-mail: dglasner@ftc.gov. I am indebted to Mark Blaug, Meyer Burstein, Robert Clower, David Laidler, Denis O’Brien, and Neil Skaggs for their helpful comments on previous drafts of this paper. I also greatly benefited from the opportunity to present an early draft of this article at the 1997 meeting of the History of Economics Society. I alone bear responsibility for any remaining errors. Classical Monetary Theory and the Quantity Theory

Pre-Keynesian Monetary Theories of the Great Depression: What Ever Happened to Hawtrey and Cassel?

A strictly monetary theory of the Great Depression is generally thought to have originated with Milton Friedman. Designed to counter the Keynesian notion that the Depression resulted from instabilities inherent in modern capitalist economies, Friedman’s explanation identified the culprit as an ill-conceived monetary policy pursued by an inept Federal Reserve Board. More recent work on the Depression suggests that the causes of the Depression, rooted in the attempt to restore an international gold standard that had been suspended after World War I started, were more international in scope than Friedman believed. We document that current views about the causes of the Depression were anticipated in the 1920s by Ralph Hawtrey and Gustav Cassel who independently warned that restoring the gold standard could cause a disastrous deflation unless the resulting increase in the international monetary demand for gold could be limited. Although their early warnings of potential disaster were validated, and their policy advice after the Depression started was consistently correct, their contributions were later ignored and forgotten. This paper explores the possible reasons for the remarkable disregard by later economists of the Hawtrey-Cassel monetary explanation of the Great Depression.

The Sraffa-Hayek Debate on the Natural Rate of Interest

Hayeks Prices and Production, based on his hugely successful lectures at LSE in 1931, was the first English presentation of Austrian business-cycle theory, and established Hayek as a leading business-cycle theorist. Sraffas 1932 review of Prices and Production seems to have been instrumental in turning opinion against Hayek and the Austrian theory. A key element of Sraffas attack was that Hayek’s idea of a natural rate of interest, reflecting underlying real relationships, undisturbed by monetary factors, was, even from Hayeks own perspective, incoherent, because, without money, there is a multiplicity of own rates, none of which can be uniquely identified as the natural rate of interest. Although Hayeks response failed to counter Sraffa’s argument, Ludwig Lachmann later observed that Keyness treatment of own rates in Chapter 17 of the General Theory (itself a generalization of Fisher’s (1896) distinction between the real and nominal rates of interest) undercut Sraffas criticism. Own rates, Keynes showed, cannot deviate from each other by more than expected price appreciation plus the cost of storage and the commodity service flow, so that anticipated asset yields are equalized in intertemporal equilibrium. Thus, on Keyness analysis in the General Theory, the natural rate of interest is indeed well-defined. However, Keynes’s revision of Sraffa’s own-rate analysis provides only a partial rehabilitation of Hayeks natural rate. There being no unique price level or rate of inflation in a barter system, no unique money natural rate of interest can be specified. Hayek implicitly was reasoning in terms of a constant nominal value of GDP, but barter relationships cannot identify any path for nominal GDP, let alone a constant one, as uniquely compatible with intertemporal equilibrium.

Hawtrey's Good and Bad Trade: A Centenary Retrospective

Ralph Hawtrey, one of the leading economists of the interwar period, published his first work in economics, Good and Bad Trade, in 1913. The book contains the key elements of the theoretical model developed and refined by Hawtrey over the next quarter century. Notwithstanding Pigou’s judgment that the book showed little originality, a number of new contributions can be identified. 1) Hawtrey introduced the term “effective demand” in the same sense in which Keynes used it in the General Theory. 2) Hawtrey derived the principle of purchasing power parity to explain the determination of exchange rates between fiat currencies. 3) Hawtrey offered a new explanation of how interest rates affect total spending: the sensitivity to the rate of interest of the desired holdings of inventories by middlemen and traders. 4) Hawtrey derived from this sensitivity a relationship between income and expenditure that would later be deployed by Keynes in the General Theory, which helps explain Hawtrey’s early discovery of the multiplier analysis, despite having famously argued (the Treasury view) that government spending could not increase total output or employment, an argument first made in Good and Bad Trade. 5) Hawtrey also provided a sophisticated analysis of financial crises, not as an isolated events caused solely by financial factors, but as the result of unforeseen reductions in aggregate demand when banks suddenly raise interest rates to protect their reserves. 6) Hawtrey also attended to the generally overlooked case in which expected deflation exceeds the real rate of interest, and 7) identified the correlation between price levels and interest rates that Keynes later called Gibson’s paradox in recognition of a paper published by A. H. Gibson ten years after Good and Bad Trade was published. Finally, it is noteworthy that although the international price adjustment mechanism presented in Good and Bad Trade is the Humean price-specie flow mechanism, Hawtrey later criticized the Humean analysis, because international arbitrage, operating without any gold shipments, would maintain a uniform international price level.

The Fisher Effect and the Financial Crisis of 2008

This paper uses the Fisher equation relating the nominal interest rate to the real interest rate and expected inflation to provide a deeper explanation of the financial crisis of 2008 and the subsequent recovery than attributing it to the bursting of the housing-price bubble. The paper interprets the Fisher equation as an equilibrium condition in which expected returns from holding real assets and cash are equalized. When inflation expectations decline, the return to holding cash rises relative to holding real assets. If nominal interest rates are above the zero lower bound, equilibrium is easily restored by adjustments in nominal interest rates and asset prices. But at the zero lower bound, nominal interest rates cannot fall, forcing the entire adjustment onto falling asset prices, thereby raising the expected real return from holding assets. Such an adjustment seems to have triggered the financial crisis of 2008, when the Federal Reserve delayed reducing nominal interest rates out of a misplaced fear of inflation in the summer of 2008 when the economy was already contracting rapidly. Using stock market price data and inflation-adjusted US Treasury securities data, the paper finds that, unlike the 2003–2007 period, when stock prices were uncorrelated with expected inflation, from 2008 through at least 2016, stock prices have been consistently and positively correlated with expected inflation.

Hayek, Hicks, Radner and Three Equilibrium Concepts: Sequential, Temporary and Rational Expectations

Hayek was among the first to realize that for intertemporal equilibrium to obtain all agents must have correct expectations of future prices. Before comparing four categories of intertemporal, the paper explains Hayek’s distinction between correct expectations and perfect foresight. The four equilibrium concepts considered are: (1) Perfect foresight equilibrium of which the Arrow-Debreu-McKenzie (ADM) model of equilibrium with complete markets is an alternative version, (2) Radner’s sequential equilibrium with incomplete markets, (3) Hicks’s temporary equilibrium, and an extension by Bliss; (4) the Muth rational-expectations equilibrium as extended by Lucas into macroeconomics. While Hayek’s understanding closely resembles Radner’s sequential equilibrium, described by Radner as an equilibrium of plans, prices, and price expectations, Hicks’s temporary equilibrium seems to have been the natural extension of Hayek’s approach. The now dominant Lucas rational-expectations equilibrium misconceives intertemporal equilibrium, suppressing Hayek’s insights and retreating to a perfect-foresight equilibrium.

The Logic of Market Definition

Despite all the commentary that the topic has attracted in recent years, confusion still surrounds the proper definition of relevant markets in antitrust. This paper addresses that confusion and attempts to explain the underlying logic of market definition. It does so largely by way of exclusion. The paper identifies and explains three common errors in the way that courts and advocates approach market definition. The first error is what we call the natural market fallacy. This is the mistake of assuming that relevant markets are identifiable constructs and features of competition in the world, rather than the purely conceptual analytic devices that they actually are. The second error is what we call the independent market fallacy. This is the failure to appreciate that relevant markets do not exist independent of any theory of harm but must always be customized to reflect the specific details of a given theory of harm. The third error is what we call the single market fallacy. This is the tendency to seek some single, best relevant market, when in reality there will typically be many relevant markets that could be helpfully and appropriately drawn to aid in the analysis of a given case or investigation. In the course of identifying and debunking these fallacies, the paper clarifies the appropriate framework for understanding and conducting market definition.

Review of the Empire of Credit: The Financial Revolution in Britain, Ireland, and America, 1688-1715

This paper reviews a collection of essays relating to various aspects of the financial revolution in Britain starting with the creation of the Bank of England in the late seventeenth century and ending with the defeat of Napoleon in 1815, a period in which Britain unexpectedly became the dominant power in Europe and acquired an international empire. The volume under review explores some of the historical and intellectual connections between the financial revolution and Britain’s military ascendancy.

Monetary Disequilibrium and the Demand for Money in Ricardo and Thornton

This paper provides an account of the reasons for the differences between the theories of David Ricardo and Henry Thornton for the depreciation of sterling during the Napoleonic Wars. Ricardo held that only overissue by the Bank of England could cause depreciatiaon of sterling during the Restriction while Thornton believed that other causes, like a bad harvest, could also be responsible for declining value of sterling in terms of bullion. Ricardo thought that a strict application of the conditions of international commodity arbitrage under the gold standard showed that a bad harvest could not cause a depreciation of sterling, but, applying a barter model, he failed to consider the effect of a bad harvest on the demand for money. In contrast, Thornton’s anticipation of Wicksell’s natural-rate theory did not strictly adhere to the conditions of international commodity arbitrage assumed by Ricardo, allowing for the operation of a Humean price-specie-flow mechanism, but, like Ricardo, Thornton implicitly made the untenable assumption of an unchanging demand for money.

Where Keynes Went Wrong: An Unnecessary Revolution?

This paper discusses the development of Keyness ideas about monetary theory in the context of the consequences of Britains return to the gold standard (opposed by Keynes) in 1925 and his initial unsuccessful attempt to develop a comprehensive theory of macroeconomic fluctuations in his Treatise on Money. The paper suggests that Keynes, who had predicted that rejoining the gold standard at the prewar parity would lead to economic stagnation and high unemployment was shaken in his belief in a monetary explanation for the Great Depression by the failure of Britains departure from the gold standard to cause a rapid recovery and reduce unemployment. This disappointment led him to undertake a more radical revision of his views in the Treatise than he at first contemplated. In this shift of approach he departed from the views of Ralph Hawtrey with whose monetary theory of the Great Depression he had previously been largely sympathetic.