Modern discussion of Hayek and the Great Depression tends to juxtapose Hayek with Keynes since Keynes was Hayek’s chief rival. But Hayek’s conversation with Keynes was not the only notable conversation about the Depression. Another conversation involved Ralph Hawtrey and Gustav Cassel, who were concerned that the return to the gold standard by central banks would cause tremendous deflation as these Big Players increased overall demand for gold. Hayek, on the other hand, saw nations that engaged in domestic inflation as being primarily responsible for the economic instability during the Great Depression. Below, I consider in greater depth the arguments of Hawtrey and Cassel concerning problems faced by the West’s attempt to resuscitate the gold standard during the 1920s, compare them to Hayek’s arguments, and show that Hayek eventually ceded ground in 1935 before proceeding to a more market-oriented view in 1943.
The developed and developing worlds moved to the gold standard during the 1870s. Before that time, England had adopted a gold standard, with other nations either on a bimetallic standard or on a silver standard. Note that the operation of a given monetary standard can manifest itself in substantially different ways. For example, a monetary standard in which individuals use gold and silver as money operates differently when private actors establish and maintain the system, as compared to one in which the state establishes fixed exchange values and manages the system through monetary policy. Actors in private systems find themselves primarily subject to the profit motive. Monetary systems managed by central banks are more likely to be driven by political motives, which do not operate systematically to improve the health of the monetary system.
Such was the nature of the problems that arose with the world’s monetary system at the start of World War I. Many nations suspended the gold standard to fund their war efforts. This led to price inflation not only in those nations that printed money to fund the war, but even in nations that remained on the gold standard and acted in accord with its rules, as Hawtrey observed. One nation’s suspension of the gold standard represented a decrease in demand for gold by that nation. As with any good, a fall in demand for gold tends to decrease its price. By definition, this means the prices of goods denominated in gold rise.
The effect of volatile demand for gold on prices was the focal problem for Ralph Hawtrey and Gustav Cassel. Hawtrey states this clearly:
If all the principal countries of the world settle in the near future what the value of their currency units in gold is to be, we want so to regulate the demand for gold that the value of these currency units in commodities do not vary substantially… By the gold exchange standard, which has become the favourite of currency theorists, it is possible to maintain the monetary unit of a country at par with the unit of a gold-using country, without the former absorbing any gold at all.… [A]ll that is required is that they [gold-standard nations] shall not endeavor to add to their stocks of gold at one another’s expense.
To be sure, a sudden return to the gold standard by nations that had abandoned it would result in a price deflation whose magnitude and duration would be difficult to predict. Again, even countries that had played by the rules of the game suffer in such a scenario because of the difficulty of predicting monetary policy of nations that return to the gold standard. Unfortunately, these problems continued with the establishment of the gold-exchange standard, in which nations were supposed to use as reserves currency backed by gold — British pounds — rather than physical gold.
During the early part of his career, Hayek recognized the same problems but believed that those nations that nominally sought to stabilize demand for gold were themselves the prime culprits in the gold standard’s demise:
It was by no means the economically strong countries such as America and France whose measures rendered the gold standard inoperative, as is frequently assumed, but the countries in a relatively weak position, at the head of which was Britain, who eventually paid for their transgression of the “rules of the game” by the breakdown of the gold standard.
Hayek valued the automaticity of the classical gold standard. If a nation expanded the non-gold portion of the base money stock, gold outflows would force it to reverse its inflationary policy. For Hayek, the establishment of the gold-exchange standard represented an attempt to short-circuit this mechanism. Assuming major holders of gold reserves did attempt to manipulate gold flows upon the establishment of the gold-exchange standard, this would not be a problem.
Both sides of the debate identified significant problems, but which problem was more imminent? Although one can imagine a world in which the gold-exchange standard actually functioned as proposed in 1922 in Genoa, the political and economic environment — which included high levels of unemployment in Great Britain, France’s lack of commitment to the standard due to the influence of nationalism, and a lack of political will to alleviate deflation at the Federal Reserve in the United States — likely made the gold-exchange standard dead from the start.
Whatever the case, Hayek’s opinion changed concerning the problem identified by Hawtrey and Cassel:
The problem of correcting the initial maldistribution of gold and adapting later the supply of the international medium to changes in demand will have to be solved if the gold standard is to become an anchor to which the individual nations can safely entrust the fate of their monetary systems.
Hayek eventually renounced the belief that a gold standard managed by central banks could avoid the problems that contributed to international economic depression. His recognition of the distortions a single central bank might cause in a managed monetary standard embodies key insights concerning changes in demand for money and market regulation of the money stock. The market was unable to keep pace with changes in demand for reserves by central banks. Complete command over the base money stock by central banks in the modern era has broken the automatic mechanism of the market whereby producers of commodity money offset excess demand for money by producing more of it at a profit. It’s precisely this logic that is reflected in Hayek’s 1943 article “A Commodity Reserve Currency“ and that free-banking scholars such as Lawrence White and George Selgin have built upon.
Perhaps if Hayek had sooner reconciled his views with Hawtrey and Cassel, a pure theory of money and banking — much like we see from modern free-banking theorists — would have become the accepted explanation for the Great Depression. Perhaps, in line with Ronald Batchelder and David Glasner’s argument, it was the inability of Hayek and other scholars to join forces against Keynes’s supposed innovations that contributed to Keynes’s victory among academics in the decades that followed.