In my last post I explained the crucial role the gold standard played in the classical economists’ theory of free trade. This is of vital importance because the classical approach deals a damaging blow against the globalists so-called ‘free trade’ arguments. The classical theory argued that for the flow of international goods to be determined by the purchasing power of each trading nation a stable exchange rate was essential which in turn required a self-regulating specie standard. Therefore, only a specie standard could ensure an international division of land, capital and labour would result in these factors being allocated to their most valued ends thereby raising the standard of living above what it would otherwise be.
But the classical economists were adamant that purchasing power parity1 was based on the prices of internationally tradeable goods: domestic goods were excluded. This meant that price levels play no role in their thinking. Frank Taussig emphasised Ricardo’s important position on this issue when he pointed out that the
price of foreign exchange thus may change without any movement in the general range of prices in either country2.
According to the current economic orthodoxy purchasing power parity is a theory of exchange rate determination in which the law of one price prevails. meaning that the same goods in each country will have the same prices once their currencies equilibrium. For example, let us assume that an Australian hamburger costs $4 and an American hamburger also costs $4, then the implied purchasing power (or exchange rate) of the US dollar to the Australian dollar would be US$1 to aud$13. Let us say that because of disequilibrium the exchange becomes US$1 to aud$0.80c then the Australian dollar would be overvalued by 25 percent. Prices of American goods will fall by 20 per cent while the prices of Australian goods will rise by 25 per cent4. This means that American exports to Australia would increase while Australian exports to America would fall. In other words, it amounts to Australia putting a tax on her exports and a bounty on American imports while also bringing about a change in relative prices6.
All of this would be meaningless to a classical economist because, as Ricardo stressed, genuine equilibrium for exchange rates can only be achieved under a specie standard. Therefore, even though domestic prices in different countries would vary considerably from each other the exchange rates would still remain at par5. Under current monetary conditions we have become accustomed to significant and rapid changes in exchange rates6. Under a gold the standard fluctuations in the exchanges would only
vary within a few per cents; a variation of ten per cent,… is considered something extraordinary, and only occurs under rare combinations7.
It is self-evident that it is the difference in prices that makes for international trade. But the classical economists reasoned that without an exchange rate that was fixed to a given quantity of specie, preferably gold, then international prices could be badly distorted which in effect means that the law of comparative advantage would be largely overridden. This leads to the conclusion that a country could lose an industry because its comparative advantage had been destroyed by an overvalued currency8. It should not be forgotten that when 1797 England suspended gold payments there was considerable anguish over the depreciation of the currency, driving Ricardo to declare:
It is also forgotten that, from 1797 to 1819, we had no standard whatever by which to regulate the quantity or value of our money. Its quantity and its value depended entirely on the Bank of England, the Directors… exposed the country to the greatest embarrassment….9
Most of us have heard of the Dutch disease, the phenomenon where a country suddenly finds a huge quantity of a natural resource which results in an overvalued currency thereby reducing the export of manufactured goods while expanding the demand for imports at the expense of domestic production and industrial investment. This phenomenon is impossible on a gold standard. Let say that it is England in the 1870s and that huge oil deposits have been discovered in East Anglia from which kerosene can be cheaply extracted and then exported to the Continent along with other oil-based products. These kerosene producers will have bills drawn on foreign traders. Rather than wait for payment they would cash their bills at their local banks10 who would exchange their own notes for the exporters’ bills. (After the 1844 Act the banks would create demand deposits and not issue additional notes.)
This means that if sufficient bills were cashed then England’s money income would rise by the value of the exports, minus the discount on the bills, which then raises the demand for imports without any upward movement in prices and without any gold being imported. In short, a shift in demand to the right occurs without a general rise in prices, though some relative prices would change, leaving the exchanges within the gold points.
However, if those importers on the Continent were to find that when it was time to make their payments that the demand for bills drawn on Britain exceeded the supply then gold would be shipped to England. Whether this would raise British prices depends on the size of the shipment and the speed of its effect on incomes and hence the demand for imports.
What remains is the fact that it doesn’t matter whether changes in the balance of trade were brought about by the classical specie flow mechanism or whether they achieved by a change in demand due to payments for bills.
Hence, the gold standard made it impossible for the phenomenon of the Dutch disease to exist as well as significant swings in exchange rates11. It is also why classical economists never thought to ask whether a government had to choose between stabilising the so-called price level or stabilising the exchange rate12.
Professor Sinclair Davidson follows the orthodox line, stating that the
arguments for free trade remain as strong today as they did last year. The notion of comparative advantage is just as true today as it was in the 19th century13.
But, as we can see, the law of comparative advantage was only part of the classical argument for free trade with the gold standard being the other part. If the classical economists thought for a moment that the gold standard and the discipline it imposed on the exchange rate was irrelevant to free trade theory then they would never have stridently attacked paper currencies. It is true that the theory of comparative advantage is always valid. What is not true, according to classical thinking, is that the theory operates just as well in the absence of a gold standard. Professor Steve Kates was entirely right when he averred that the difference between free trade today and free trade in the nineteenth century is the gold standard14. Unfortunately, he failed to explain why that difference mattered.
1The classical economists abhorred the current approach of using reciprocal price level or reciprocal exchange rates to try and determine PPP, arguing that the only way to achieve PPP was through a fixed exchange rate based on a specie standard.
2He gave as an example a situation where New York traders find that there are insufficient bills drawn on London with the result that the bidding for these bills causes the pound to appreciate and the exchange rate to approach the gold import point. Once this process begins gold will flow from New York to London. This all occurs without any effect on domestic prices.
Frank William Taussig, International Trade, The Macmillan Company, 1929, p. 345.
3According to the orthodox definition of purchasing power parity the two currencies are in equilibrium, at par, when baskets of the same goods in each country are equally priced. In other words, the exchange rate is determined, at the point where the internal purchasing power of the currencies is equalised. This is also called absolute purchasing power parity and the one most commonly referred to. Relative purchasing power theory argues that the change in the exchange rate should be equal to a change in their price levels.
4In September 2012 an RBA memo estimated that the Australian dollar was overvalued at between 4 and 15 per cent. The bank explained that this was only “one standard deviation from the estimated long-run equilibrium real exchange rate”.
This is nonsense to anyone who adheres to the classical view. According to the current economic orthodoxy a real exchange rate between two countries is one that takes account of their relative price levels. But as we have already seen Ricardo pointed out, as did Malthus, that this method is wrong through and through. It’s not the prices of domestically traded goods that matter but the prices of internationally traded goods. The classical economists were emphatic on this subject.
Thomas Malthus, Principles of Political Economy, Augustus M. Kelley 1974, p. 130. (2nd edition 1836.)
5David Ricardo, Principles of Political Economy and Taxation, Penguin Books, 1971, pp. 164-65.
6Philip Pilkington, a Keynesian, considers PPP theory to be false. In the comments section he goes so far as to call it “rubbish”. Unfortunately for Mr Pilkington, what he is criticising is not the original PPP theory. Purchasing Power Parity (PPP) and the Exchange Rate
He should have read Taussig who noted that in
the absence of a common monetary standard, the rate of foreign exchange depends on the mere impact of the two quantities on hand at the moment.
Frank William Taussig, International Trade, The Macmillan Company, 1929, p. 345
This returns us to the gold standard and the classical economists theory of power theory
7George J. Goschen, The Theory of the Foreign Exchanges, Effingham Wilson, 1883, p. 64.
8This raises the question of how can we, in the absence of a specie standard, determine to what extent any currency overvalvalued?
9David Ricardo, On Protection to Agriculture, John Murray, 1822, p. 22. In the same pamphlet he also argued that under certain circumstances a tariff is justified if it compensates an industry for losing its comparative advantage.
10The bills could also be sold to bill brokers but this wouldn’t enlarge total demand unless the brokers’ banks funded the purchases out of their reserves.
11The inherent stability of the gold standard made it impossible for a Soros-like speculator to emerge.
12Classical economists welcomed a falling price level so long as it was productivity-induced.
13Sinclair Davidson, In This Peril, Remember Australia’s Success Secret, 2020
14Pointing out the fact that the gold standard makes for a fundamental difference between foreign trade today and foreign trade in the nineteenth century does not mean that one believes, as some economists think, that the theory of comparative advantage was based on gold or silver. When Steven Kates*, had the temerity to note that nineteenth century trade rested on the gold standard Professor Sinclair Davidson immediately accused him of suggesting that the “theory of comparative advantage is wrong because the world no longer holds to the gold standard.” This comment revealed a stunning ignorance of how the gold standard functioned. Professor Judith Sloan was no better, dismissing the gold standard as a “dud”.
*Senior Fellow, Centre for Labour Market Research, University of Canberra, Australia