Professor Mitchell, a Modern Monetary Theory exponent, gets the gold standard badly wrong: Part 3

The striking thing about those who malign the gold standard (this also applies to most of its supporters) is their ignorance of how it really functioned, as revealed by the fact that Britain was not even on a genuine gold standard but on a quasi-gold standard. Before continuing with this line of thought we need to clarify further points regarding Professor Mitchell’s error that classical economists focused on trade deficits with respect to gold drains.

One cannot help but be struck by the professor failure to mention exchange rates or even provide an explanation for gold drains. As the classical economists had determined that the exchange rate, not the trade deficit, was the key indicator with respect to an unhealthy trade deficit and the depreciation of the currency it is necessary to understand how they arrived at this conclusion, a decision that contains important and lasting economic lessons.

In today’s world exchange rates are usually explained in terms of purchasing power parity —an idea that goes back to the Spanish scholastics1 — the essence of which is the idea that equilibrium rates are the quotients between the price levels of different countries. (The Big Mac index springs to mind, even though it started somewhat tongue-in-cheek). Now the classical economists fully grasped what was really meant by purchasing power parity and that’s why they never resorted to the concept of a price level to calculate the equilibrium exchange rate.

They knew that the prices of identical goods in different countries could differ significantly, even when the exchanges are in equilibrium, meaning when they are at par. This meant that the prices of individual goods were to be ignored in dealing with exchange rates. In exploring the economic laws that govern the global distribution of gold and silver Ricardo came to the conclusion that the distribution of precious metals is based on the relative purchasing power of exportable goods. He made it abundantly clear that he was fully aware of the fact that prices of similar goods in different countries varied considerably when he stressed that though the prices of many commodities “may differ 5, 10, or even 20 per cent” the exchange will still be at par. This why he warned that

[i]n speaking of the exchange and the comparative value of money in different countries, we must not in the least refer to the value of money estimated in commodities, in either country. The exchange is never ascertained by estimating the comparative value of money in corn, cloth, or any commodity whatever, but by estimating the value of the currency of one country, in the currency of another2.

As Malthus succinctly put it:

[T]he quantity of money in each country is determined by the quantity wanted to maintain its general exchanges at par3. [This means the money supply in terms of gold cannot be endogenous4.]

But Nassau Senior was the first to provide a detailed explanation of what the classical doctrine meant by comparative values of money in different countries and also why it kept the exchanges at par. He went on to note that

The reciprocal value of the moneys of different countries using different coins or, as it is usually termed, the foreign exchange, is governed by the same principles although their application is more complex5.

One should now see why nineteenth century economists considered the state of the foreign exchanges, not trade deficits, as indicating whether or not the currency was depreciating. This brings us back to bills of exchange because gold would only be shipped when the demand for foreign bills exceeded the supply to the extent that their prices made it cheaper to export gold. When this happened it was said that the country has an “adverse exchange”6.

It followed that for the classical economists the state of the exchanges, not trade deficits, became the only true test of an excess currency7. Professor Mitchell, however, completely overlooked the crucial role of the exchanges, directing his attention to trade deficits and gold flows thereby giving his readers the misleading impression that gold drains and deflations were a frequent and destructive feature of the gold standard.

Reading Professor Mitchell one is left with the stark impression that under the gold standard the balancing process in international trade was anything but smooth and rapid. However, Professor Taussig found that the balancing process moved with a surprising speed and smoothness that could not be explained by the classical gold flow mechanism, stating that the  “actual merchandise movements seem to have been adjusted to the shifting balance of payments with surprising exactness and speed”8, and without the gold flows and changes in relative prices predicted by the classical theory, leaving him to lament that it “must be confessed that here we have phenomena not fully understood.” In the absence of gold flows and changing prices how could the balance of payments rapidly adjust? It should be borne in mind that gold flows imply a domestic shift in demand for exports and imports. If there are no gold flows then such shifts could not take place, at least according to the orthodox theory.

Lloyd A. Metzler, a Keynesian, noted:

It is apparent that the operation of the classical mechanism is even more difficult to explain than Taussig had supposed. Not only did the trade balances move with surprising rapidity, but they moved in the expected direction despite the fact that the physical volume of imports is normally responsive only in a slight degree to changes in relative prices9.

Metzler concluded that the “missing link in the classical theory” was an “induced change in employment and incomes. He argued that if, for example, country A increases its imports from Country B without increasing its exports or exporting gold to pay for the imports “a more or less automatic mechanism will soon offset least part of the initial disturbance”, even if gold were exported by A and then centralised by B’s central bank.  According to Metzler B’s export industries would then increase output thereby expanding employment and incomes. The increased incomes would spread through the economy, raising the demand for A’s exports which in turn will eliminate in part if not the whole of A’s trade deficit with B. Suffice to say that Metzler implicitly assumed that B’s money supply would automatically expand to fund the country’s expansion of exports. How else could total money incomes rise?

As it turns out Taussig was wrong on his last point. His conundrum is no conundrum at all. In 1802 Thornton10 raised the question of what the effect on the economy would be if a large unilateral payment was made to another country. He used Hume’s classical specie mechanism to explain the process and result. Ricardo11 and John Wheatly12 disagreed, arguing that the transfer would have no effect on domestic prices and that the gold did not even have to leave the country. This sparked a very interesting debate that became known as the “transfer problem”. A 115 years later Wicksell13 was basically repeating Ricardo and Wheatly’s argument.

I stressed in part 1 that the vast structure of international trade that emerged under the gold standard was enabled not by gold shipments but by bills of exchange, without which international trade would have been drastically curtailed. This suggests that the focus should be on bills and not non-existent gold flows. The enormous advantage of bills is that they virtually eliminated the need for gold shipments. The only time rapid and heavy shipments of gold were likely to occur was in the event of a serious crop failure or perhaps a severe political crisis.

This returns us to Metzler’s hypothetical example. As pointed out in a previous article, when an exporter shipped his goods he would cash his bill of exchange rather than wait for payment. Now Metzler’s exporters would have bills drawn on B’s importers which would probably be payable in 90 days. In all likelihood these bills would be cashed at a bank. Assume the exporters are English and it is not yet 1844: The bank would then exchange its own notes for the exporters’ bills. (After the 1844 Act the banks would create demand deposits and not issue additional notes.)

If all the 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. The income effect on England would be as if the importing country had immediately paid the exporters in gold. In the meantime, a multitude of bills are being cashed and sold again while others are being drawn up. The result was that the exchanges were kept within the gold points rendering gold shipments unnecessary.

However, when payment is due and the importing country finds that its demand for English bills exceeded the supply then their prices would rise to the point where it would be cheaper to export gold. This situation was defined as an adverse exchange and is directly related to the boom-bust-cycle that deeply concerned the currency school of which Ricardo was a member.

When we consider the facts we see that there is nothing Keynesian about the adjustment process. Though Metzler was aware of the transfer debate he didn’t convey the impression that he had studied it in depth, as indicated by his dismissive attitude toward the economists in question, considering them to have failed because they had not seen the “light of the modern theory of employment”14, meaning they weren’t Keynesians. This was a conceited and utterly absurd thing to say.

Dutch disease

 In my last article I stated that the Dutch disease was not possible on a gold standard. Several people expressed doubts, wondering what would happen to the exchange rate if a country suddenly discovered massive deposits of a valuable resource.

I’ll try to make this as brief as possible while trying not to be repetitive. Imagine that it is England in the 1870s and that huge oil deposits have been discovered in East Anglia from which cheap kerosene can be extracted and then exported to the Continent. These kerosene producers will have bills drawn on foreign traders. Rather than wait for payment they sell their bills to the banks15. This raises the exporters incomes which they spend. The result is that during this transitional adjustment period demand shifts to the right which brings in more imports. (And exports are the price of imports). 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 undisturbed.

If those importers on the Continent find that when it is time to make a payment to the kerosene exporters that the demand for bills drawn on Britain exceeds the supply then gold will be shipped to England. Whether this will 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 the balance of trade is brought about by the classical specie flow mechanism or whether it is achieved by changes in relative demands the emergence of the Dutch disease is impossible on a gold standard16.

The classical economists understood that by maintaining a stable exchange rate the gold standard ensured that the pattern of international trade, as determined by comparative advantage, corresponded with a country’s purchasing power parity, a fact that Ricardo stressed17.  

 Professor Bill Mitchell, a Modern Monetary Theory exponent, gets the gold standard badly wrong: Part 1

Professor Bill Mitchell, a Modern Monetary Theory exponent, gets the gold standard badly wrong: Part 2


1In 1553 the Salamanca theologian Dominican Domingo de Soto applied a rigorous supply-and-demand analysis to foreign exchange rates. He observed that, in his own words

the more plentiful money is in Medina the more unfavourable are the terms of exchange and the higher the price must be paid by whoever wishes to send money from Spain to Flanders, since the demand for money in Spain is smaller than in Flanders. And the scarcer the money is in Medina [i.e., the greater its purchasing power] the less he need pay there, because more people want money there than are sending it to Flanders. (Grice-Hutchinson, Marjorie, Early Economic Thought in Spain,  George Allen and Unwin, 1978, p 103.)

In short, the purchasing power of money determines the exchange rate.

2Ricardo, David, Principles of Political Economy and Taxation, Penguin Books, 1971, p.165.

3Malthus, Thomas Robert, Principles of Political Economy, Augustus M. Kelley Publisher, 1971, p. 130.

4On a pure gold standard the fallacious “needs of business doctrine” could not take hold. According to this doctrine the money supply alters in response to the so-called “wants of trade”. There is no fundamental difference between this fallacy and the post-Keynesian and MMT argument that money is endogenous.

5Senior, Nassau W., Industrial Efficiency and Social Economy, Henry Holt and Company, 1928, pp. 58-9

6Goschen, George J., The Theory of the Foreign Exchanges, Effingham, Wilson, Royal Exchange, 1883, p. 88.

7Tooke, Thomas, Considerations on the State of the Currency, John Murray, 1826, p. 66.

8Taussig, Frank William, International Trade, The Macmillan Company, 1934, p. 239.

9Edited by Howard S. Ellis, A Survey of Contemporary Economics, The American Economic Association, 1948, chapter 6.

10Thornton, Henry, An Enquiry into the Nature and Effect of the Paper Credit of Great Britain, J. Hatchard, 1802, pp. 118-136. 

11Ricardo, David, The High Price of Bullion a Proof of the Depreciation of Bank Notes, John Murray, 1810, pp. 12-35. 

12Wheatley, John, An Essay on the Theory of Money and Principles of Commerce, W. Bulmer and Co. 1807, chapter 3.

13Viner, Jacob, Studies in the Theory of International Trade, Harper & Brothers, 1937, pp. 304-5.

14Edited by Howard S. Ellis, A Survey of Contemporary Economics, The American Economic Association, 1948,  p. 218.

15The 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.

16There are a number of articles on the net arguing that the Dutch disease is a product of market failure As we can see, it is the result of central banks failing to maintain their exchange rates at par in the sense that classical economists defined it, not that many economists are even aware of this fact. This means that the great majority of economists make the mistake of automatically treating the pattern of international trade as being determined solely by comparative advantage.

17Ricardo, David, On Protection for Agriculture, John Murray, 1822, pp. 12-16.

The boom-bust phenomenon and its so-called link with gold will be dealt with in later articles.

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