Wisdom of the elders

[Harrison Quinn] “Listen, boy, you bank at the Golden Gate Trust in San Francisco, don’t you?”

[Nick Charles] “Got a little money there.”

“Get it out, boy. I heard tonight they’re plenty shaky.”

“All right. I haven’t got much there, though.”

“No? What do you do with all your money?”

“Me and the French hoard gold.”

He shook his head solemnly. “It’s fellows like you that put the country on the bum.”

“And it’s fellows like me that don’t go on the bum with it,” I said.

— The Thin Man, Chapter 20, Dashiell Hammett

A book from my father

As regular readers know, I lost my father last year. He loved mystery novels and had perhaps a thousand of them accumulated in his den when he died. I inherited many of them and during my time off in August I finally took Dad’s advice to read what he considered the greatest mystery writer: Dashiell Hammett. I started with one of Dad’s favorites, The Thin Man, written in 1933 and set in 1932, amid the depths of the Great Depression. The passage above struck me because it plainly illustrates that a popular novelist of the day clearly understood the exact mechanism that economists took another 60 years to concluded caused the Great Depression.

Two lessons

There are two lessons to be learned from this. The importance of “small-c” (Burkean) conservatism and the supremacy of fiat monetary systems, for all their faults and potential for manipulation, to fixed monetary arrangements like the gold standard, Bitcoin or currency boards. To understand each lesson, one needs to know how the gold standard worked, how it helped cause the Great Depression, and the evolution of economic thought that followed the Depression. Let’s begin with the gold standard.

The gold standard

Under the gold standard, a central bank backed each unit of currency issued by a fixed proportion of gold. In the US, the Federal Reserve was required to back each dollar note with 40¢ of gold and each dollar deposit with 35¢. The system was supposed to be self-balancing since international payments were made in gold rather than foreign exchange. If US exports were more competitive than the UK, the US trade surplus with the UK, paid for in gold, would rise. The increase in US gold reserves would expand the US money supply, increasing inflation and making the US less competitive. The opposite would occur in the UK. The gold outflow would restrict the money supply, lowering inflation and making the UK more competitive, closing the trade gap. The effects on the financial (or capital) account reinforced the self-equilibration: Rising gold and money balances in the US depressed interest rates, causing gold to flow out of the country; falling gold and money balances in the UK raised interest rates, attracting gold back into the country.

Asymmetric risks

But there was a problem: what if someone decided to hoard gold? Central banks had a minimum required backing for gold, but no maximum: they could always choose to hold more. In econ-speak, a central bank could “sterilize” gold inflows by selling domestic bonds to remove newly created money from the economy. This allowed a central bank to accumulate gold without increasing the money supply or stimulating inflation. But this feature was asymmetric. While a hoarding central bank could buy virtually unlimited gold without inflationary consequence, a central bank suffering gold outflows had a required minimum holding to defend. Once the minimum was reached, a central bank had only a few choices: it could raise interest rates to lure gold back into the country; it could suspend convertibility; or it would have to devalue its currency.

Blame France

This is exactly what happened a century ago and is generally believed to have caused the Great Depression. Between 1927 and 1932, France went on a gold-buying binge, increasing its share of global gold reserves from 7% to 27%, sterilizing most of the inflows.¹[1] Central banks — like the Federal Reserve — that attempted to defend their gold reserves and maintain convertibility were forced to hike interest rates, even after a recession began in 1929. Rising interest rates choked off new lending and investment, pushed debtors into bankruptcy and accelerated the economic free fall. Banks began to teeter as liquidity tightened and bad loans mounted. But central banks like the Fed faced an internal conflict between acting as lender of last resort to commercial banks and defending their gold reserves. The Fed prioritised the latter, contributing to a cascade of bank failures that ran into the thousands.

And self-interest

The gold standard also incentivized individual behavior that accelerated the debt-deflation spiral, as illustrated in the quoted passage above. Harrison Quinn, the stockbroker of Hammett’s hero detective, Nick Charles, warns him about another prospective bank failure and asks him where he keeps his money. Charles says that “Me and the French hoard gold.” Quinn chides him for worsening the national banking crisis. Charles’ reply makes the private incentive brutally clear: whatever the systemic consequences, hoarding protects him from going “on the bum” with the country.

Dashiell Hammett, economist extraordinaire?

Hammett’s clear understanding of the Depression’s cause — written in its depths by a popular novelist who was no economist — stood out to me because it took nearly 60 years for academic economists to come to the same conclusion. In the late 1980s, economic historians like Barry Eichengreen began to reconstruct the effects of French gold hoarding and other central banks’ refusal to abandon the gold standard in generating the Great Depression. Over the next several years, other economists, including former Federal Reserve Chairman Ben Bernanke, conclusively prosecuted the case with cross-country studies.²[2] Mr. Bernanke’s research also demonstrated the way out: the Depression’s nadir in each country was the day before it abandoning the gold standard and reflated through devaluation.³[3]

Forgotten knowledge

But here’s the crazy part: Messrs. Bernanke and Eichengreen were only rediscovering what contemporary economists already knew. Dashiell Hammett’s expression of “common knowledge” in The Thin Man was due to contemporary economists’ research. Two years before Nick Charles told Harrison Quinn that he was hoarding gold, the Federal Reserve discussed the risk from French gold accumulation under the gold standard,⁴[4] the UK Parliament held hearings on the topic,⁵[5] and the League of Nations even produced an in-depth study on it.⁶[6] These followed nearly a decade of warning from academic economists about the flaws of the new post-World War I gold standard that differed from the “classical” Victorian gold standard in ways that are beyond my scope here.⁷[7] Yet, the Federal Reserve stubbornly clung to the gold standard, driving the US deeper and deeper into depression until FDR’s inauguration. Roosevelt immediately closed the banks, devalued the dollar by 41%, suspended convertibility, and made private gold holdings illegal. As due penance for its sins, FDR also substantially restructured the Fed in 1935 and later subordinated its independence to the Treasury to finance World War II. Fed independence was only restored by the Truman Administration in the Fed-Treasury Accord of 1951.

“Keynesians” first strike

How did economists “lose” that knowledge? In 1936, John Maynard Keynes published his magnum opus, The General Theory of Employment, Interest, and Money, and “Keynesian” economics rose to dominate the field.⁸[8] Despite the fact that Mr. Keynes was far more nuanced in his own analysis and had also diagnosed the monetary sources of the Depression, post-War economists focused on his theories of insufficient aggregate demand and fiscal authorities’ role in correcting it, giving us what we today call “Keynesian economics.” The strong recovery that followed World War II fiscal outlays seemed to prove the theory (albeit later research showed that a recovery was well underway by late 1941 and that monetary policy had played the dominant role in both the 1937-38 contraction — amid the New Deal policy sweep — and the pre-war recovery⁹[9]). Yet it’s hard for me to ignore that the (fiscal-dominant) Keynesian view provided a powerful political argument for the New Deal’s government intervention and control — while conveniently eliding over the 1933 dollar devaluation and foreign creditor default — incentivizing leading economists of the day to adopt it.

Keynesians’ death and rebirth

In 1963, Milton Friedman and Anna Schwartz reminded economists of the monetary causes of the Depression.¹⁰[10] Yet, the debate raged on for decades as their monetary-policy thesis challenged the then dominant paradigm within the field. It wasn’t until the definitive cross-country research of the late 1980s and early 1990s that the debate finally (mostly) died. Ironically, just as the “old Keynesian” theories that undergirded fiscal omniscience were being put to bed, the “New Keynesian Synthesis” that would allow academic economists to dominate central banks for the next three decades was being birthed.

Lesson 1: Tried and proven over newfangled

This brings me to lesson number one: the value of small-c conservatism (i.e. this is not a political endorsement of the large-C Conservative Party). Contrary to progressives’ mischaracterizations of it, conservatism does not reject progress or new ideas. But it values tried and proven methods over novel, theoretical approaches. Only when faced with truly novel problems — which are rare — does Burkean conservatism turn to unproven theories.

A century of folly

The last century of economic thought and its application to policy are a series of lessons in Burkean conservatism: the classical gold standard of the Victorian era — which wasn’t perfect, but worked — was replaced with a newly designed gold standard that, despite warnings of its dangers, led to the Great Depression, which was prolonged by new theories of fiscal omnipotence, and whose associated theories of monetary control yielded the inflation of the 1960s and ‘70s, which in turn were tamed through Burkean trial and error, only to be abandoned in favor of the New Keynesian Synthesis that yielded the fiscal dominance of Quantitative Easing and the ongoing inflation from which major economies continue to suffer. I’m vastly oversimplifying both the last century of economic thought and the resultant policies and consequences, but the rough point remains: governments get into trouble when they chase new, unproven ideas that seem politically attractive and, unfortunately, economists have been an unending source of such ideas for at least a century.

A warning on Warsh and Trump

By the way, this is one of my biggest concerns about both new Fed Chairman Kevin Warsh’s apparent purge of the New Keynesians and the implied “geoeconomics” of the Trump Administration: recognizing the old problem is only part of the solution. You need to replace it with something and Burkean conservatism suggests that replacing it with another untested theory or framework will only lead to different problems.

Lesson 2: Learn from your mistakes

The second, related economic lesson is that our elders — Dashiell Hammett and his era’s economists — warned us about the potential follies of a many of the solutions being proposed as modern fixes. Goldbugs and Bitcoiners would be wise to reflect that it wasn’t excessive US debt that caused the Great Depression nor was it an overvalued stock market. The market crash of 1929 yielded a garden variety recession in 1930, much like the 2001 recession that followed the 2000 market crash. The Depression followed the Fed’s ill-thought attempt to defend its gold reserves by raising interest rates steeply in the 1930 recession. The role of a fixed money supply, i.e. the gold standard, in causing the Depression is crystal crystal clear in both the economic data and contemporary literature.

I’ve read this book before

That lesson is important to keep in mind in the current economic environment. The next time you read another Cassandra hyping the (non-existent) “dollar debasement” trade, consider the disaster that would befall the US (and world) economy if we were still tied to the gold standard today with China hoovering up gold at a pace that would make the Banc de France of a century ago blush. Similarly, while Bitcoinomists like Lyn Alden proselytize crucification upon a cross of bits based on a false, rose-tinted narrative of the gold standard that ignores not only its tremendous volatility in economic output, employment and inflation (yes, inflation), but more importantly its catastrophic failure in extreme scenarios, it is those extremities that matter when choosing a monetary system. The length and breadth of economic history are testament that extreme outcomes plague every economic system with regular and unpredictable occurrence. In a Bitcoin economy, celebrated for its fixed money supply, there is no lender of last resort in case of trouble. “HODLers” like Nick Charles would only amplify the problem and abandonment would be the only exit from a deflationary spiral.