The link between free trade, the nineteenth century business cycle and the gold standard

Gerard Jackson
28 November 2022

Peter Smith1, Steve Kates2, John Quiggin3 are economists. Smith and Kates are on the right while Quiggin is on the left. Despite their political differences all three have serious doubts about the benefits of free trade. I’ll begin with Steve Kates who made this important observation on free trade:

But you know what was also current then [in the nineteenth century]? The gold standard. There are many ways this process of comparative advantage breaks down, but with the abandonment of the gold standard and fixed exchange rates, there are all kinds of ways to cheat in foreign trade relations that are not discussed as part of the basic theory4.

Unfortunately, this was too much for Professors Sinclair Davidson and Judith Sloan with Davidson making the absurd accusation that Kates believes the theory of comparative advantage is wrong because the world is not on gold. Sloan wasn’t much better, calling Kates’ point about gold a “dud”. The only duds here are Davidson and Sloan. At a later stage we shall see why classical economists considered gold crucial to maintaining free trade and why Kates’ view that comparative advantage broke down is misguided. Peter Smith, like nearly all economists, does not link the gold standard to the principle of free trade, even going so far as to emphatically state that there is no such thing as “free trade”5.

Professor Quiggin, who confesses to being something a “heretic on free trade”, takes a macroeconomic approach to nineteenth free trade, arguing  that it created the  “impossible trinity”, according to which governments

 cannot simultaneously pursue an independent macroeconomic policy, maintain a fixed currency exchange rate, and allow free international capital movements. Over the last two centuries, governments have responded to this dilemma in very different ways. The economy of the 19th century, like that of the late 20th century, was one of unrestricted capital movements and tight constraints on macroeconomic policies. By contrast, during the long postwar boom — the so-called ‘Keynesian’ era — governments restricted capital movements in order to give themselves the macroeconomic policy independence that was required to maintain full employment6.

It important to bear in mind that if a country is on a gold standard then its currency (paper money) must represent a given amount of gold.  For example, the pound sterling was slightly less than 1/4 of a gold ounce while the American dollar was defined as 1/20 of a gold ounce. Where so many economists slip up today is to assume that large trade surpluses or deficits were always adjusted by gold flows. But as Frank Tausig7 pointed out, after the 1873 crisis imports rapidly increased, greatly exceeding exports. At a later stage the situation was reversed and then balance was restored, all without any gold shipments. It was this apparent anomaly that puzzled Taussig. What else struck him was just how smooth and swift was the trade  adjustment, despite the absence of the mechanism by which prices are changed by gold flows.  Professor Lloyd A. Metzler8 concluded that

the balancing of international payments and receipts might be at attributable to economic forces not considered in the classical theory…the missing link in the classical theory became almost self-evident: …[it] was found to be largely the result of induced movements of income and employment.

It therefore appeared that at the very least the classical specie flow theory was incomplete. Not so, there is no “missing link”. The classical theory explained why the fear that a country with a bad trade deficit could lose all of its specie was baseless and that trade deficits were self-correcting through gold flows — where the trade deficit was caused by a domestic monetary expansion. In the case of America the rise in the trade deficit was caused by heavy borrowing  up to 1873, followed by a trade surplus.

With respect to the American case that Taussig described let us assume, for the sake of simplicity, that her large deficit was with England. Now prices have not risen in England, they were actually falling, and American gold isn’t being shipped to London. However, British businessmen have acquired a large number of bills drawn on American businesses. As was the then custom these bills would have been taken to banks to be discounted and then credited to their clients’ accounts. The result is a rise in domestic incomes and hence imports all without a single shipment of gold9  or a rise in prices.

The point is that no “trinity” was necessary under the gold standard because it was self-regulating process. And it was the only means by which the exchange rate could be stabilised, ensuring that trade would correspond to the principle  of comparative advantage. This is why Ricardo stated that under certain circumstances a tariff was necessary. In doing so he was making it clear that according to classical thinking there is a direct link between comparative advantage and the gold standard. The Keynesian approach is that maintaining full employment, which in any case it has failed to do, is more important than a stable exchange rate. According to Quiggin the

standard classical theory suggested that depressions should not occur and, if they did, would rapidly fix themselves10.

This is not true. In 1802 Henry Thornton11 provided a monetary theory of the trade cycle in which he explained that forcing down the rate of interest below its market clearing rate would produce excess lending leading to a boom followed by a depression. Ricardo adopted the theory and strongly expressed it in his High Price of Bullion pamphlet12. He later wrote that in

rich and powerful countries where large capitals are invested in machinery, more distress will be experienced from a revulsion in trade [the contraction], than in poorer countries where there is proportionally a much smaller amount of fixed, and a much larger amount of circulating capital, and where consequently more work is done by the labour of men. It is not so difficult  to withdraw a circulating as a fixed capital, from any employment in which it may be engaged. It is often impossible to divert the machinery which may have been erected for one manufacture, to the purposes of another13.

This is an important and insightful passage that refutes Quiggin’s opinion, an opinion shared by the great majority of economists, that classical economists thought depressions were impossible or at least unlikely because of “Say’s Law”.  (Letters between Say and Malthus dispel the myth that classical economists did not take the trade cycle seriously14.) Ricardo notes that the more industrialized a country the deeper the depression. He further noted that capital is heterogeneous, not homogeneous, and that because of the specific nature of some capital it would have be abandoned. This misdirected capital is what the Austrian School calls malinvestments.

What is also not understood is that there is a link between the nineteenth century business cycle and balance of trade problems and one that the classical economists fully understood. In his High Price of Bullion pamphlet Ricardo warns, in keeping with Henry Thornton’s business cycle theory, that allowing the banks to force interest rates down below their market clearing levels will result in an expanding demand for cheap loans which in turn produces malinvestments. However, before the “revulsion” appears the monetary expansion will have increased the demand for imports. The exchange will now exceed the gold export point15 thereby setting in motion an external gold drain.

Every classical economist understood that gold drains were caused by inflation and that this left no alternative than to raise interest rates. Quiggin’s argument that it was the flow of gold that caused booms and busts is complete nonsense16. During the period Britain was on the gold standard every boom and bust was caused by the banking system deviating from the gold standard by inflating the currency17.

It is crucial to understand the function of the exchange rate. Because of a 1714 Act of Parliament that priced the guinea at 21 shillings Isaac Newton, who was master of the mint, had to set the exchange rate at £3 17s 10½d per standard ounce of gold, meaning that the British pound represented a given weight of gold. From the classical point of view the gold standard had the advantage of being, unlike paper currencies,  a self-regulating mechanism18. Ricardo made this clear when he bitterly complained

that from 1797 to 1819 we had no standard whatever, by which to regulate the quantity or value of our money19.

A fixed exchange rate also made the gold standard an attractive proposition for classical economists because it ensured that the flow of international goods would be determined by the purchasing power parity20, otherwise labour and capital would be misdirected.  This very important point has been completely overlooked by today’s economists, particularly those who like to quote Ricardo in their defense of free trade.

Peter Smith’s problem is that he assumes there is no more to the classical theory of international trade than what he was taught at university. Steve Kates mistake is that he did not delve into the subject before speaking out. Quiggin is a piece of work on the subject because he deliberately gives his readers the impression that he has read the classical economists when it is clear to any person with a reasonable knowledge of the subject that he did no such thing. He made this fact clear with his smug comment that “the free market economy of the 19th century failed21”.

As an afterthought,  I should add that Quiggin also claims to have refuted the Austrian school theory of the trade cycle. All he did was to prove to any informed person that he did no such thing.


1Peter Smith is a former bank economist; former CEO of Australian Payments Clearing Association; and author of Bad Economics, Connor Court, June 2012. He is a regular contributor to Quadrant.

2Steve Kates was the Chief Economist for the Australian Chamber of Commerce for 24 years and a Commissioner on the Productivity Commission. He is now an honorary adjunct associate professor in the College of Business at RMIT University in Melbourne.

3John Quiggin is an Australian economist, a professor at the University of Queensland. He was formerly an Australian Research Council Laureate Fellow and Federation Fellow and a member of the board of the Climate Change Authority of the Australian Government. (Wikipedia.)

4 Catallaxy, March 5, 2018

5Enemies of the People

6Globalisation: Australian impacts, edited by Christopher Sheil, UNSW Press Sydney 2001, pp.19-20.

7F. W. Taussig, International Trade, The Macmillan Company, 1934. p. 394, 124-127.

8Theory of International Trade, in Howard S. Ellis [ed.) A Survey of Contemporary Economics, 1948).

9As trade is multilateral Britain could also indirectly increase the demand for American goods by using part of her export income from America by increasing imports from other countries who in turn could use part of this income to buy American goods. However, if the price of bills exceeded the cost of shipping gold then gold would be exported.

10John Quiggin, Zombie Economics, Princeton University Press, 2010, p. 20.

11Henry Thornton, An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, J. Hatchard, Bookseller to the Queen, 1802, p. 258.

12David Ricardo, The High Price of Bullion, John Murray, 1810.

13David Ricardo, Principles of Political and Taxation, Penguin Books, 1971, pp. 271-72.

14Jean-Baptiste Say, Letters to Mr. Malthus on Several Subjects of Political Economy and On The Cause of the Stagnation of Commerce 1821, August M. Kelley, 1967. These exchanges dispel any notion that the classical economists did not debate the nature of the business cycle.

15If exchange rates rise above or fall below the fixed mint rate by more than the cost of shipping gold from one country to another, large gold inflows or outflows occur until the rates return to the official level.

16John Quiggin, Globalisation, neoliberalism and inequality in Australia, Economic and Labour Relations Review, The, Vol. 10, No. 2, 1999.

17Both Mushet and Tooke vividly laid out the cause of the great financial crisis of 1825 and the depression that followed.

Robert Mushet, An Attempt to Explain from the Facts the Effects of the Issues of the Bank of England Upon its Own Interests, Public Credit and the Country Banks, Baldwick, Craddock, and Joy, Paternoster Row, 1826.

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

These two books battle it out over monetary theory and the trade cycle, with Wilson making some penetrating comments about capital goods and the nature of and the role of interest. One thing is clear: the authors’ analysis is that the boom begins when the banking system deviates from the gold standard. Every economist worth his salt should read these books.

Col. RobertTorrens,  The Principles and Practical Operation of Sir Robert Peel’s Bill of 1844 Explained and Defended against the Objections of Tooke, Fullarton and Wilson, Longman, Brown, Brown, Green, and Longmans, 1848.

James Wilson, Capital, Currency, and Banking, Published at the Office of The Economist, 1847.

18Lord Overstone, Tracts and Other Publications on Metallic and Paper Currency, London, 1857, p. 341.

George Warde Norman,   Letter to Charles Wood,  Letter on Money, and the Means of Economizing the Use of it, Pelham Richardson, 1841, p. 105.

Joseph Schumpeter, The History of Economic Analysis, Oxford University Press, 1994, p. 732.

19David Ricardo, On Protection to Agriculture, John Murray, 1822. p. 22

20The classical economists’ concept of purchasing power parity (a term they did not use) was very different from the one used today. It was only those goods that entered into international trade that mattered, not goods produced for domestic consumption regardless of their prices. Ricardo made the classical position clear when he wrote:

When each country has precisely the quantity of money which it ought to have, money will not indeed be of the same value in each, for with respect to many commodities it may differ 5, 10, or even 20 per cent., but the exchange will be at par.  (Principles of Political Economy and Taxation)

At par meant that the exchange was being kept between the gold points, ensuring stability and  that trade would take place according to the theory of comparative advantage. This could only  be done on a specie standard.  Without specie there is “no standard whatever, which to regulate the quantity or value of our money” was Ricardo’s plaintive response to the 1797 suspension of gold payments. (On Protection to Agriculture 1822)

21Christopher Sheil ed., Globalisation: Australian Impacts, UNSW Press Sydney 2001, p. 20.

2 thoughts on “The link between free trade, the nineteenth century business cycle and the gold standard”

  1. I think what you are saying is very important. I also think it will fall on deaf ears. Its pretty clear that our right isn’t interested in any real ideas, particularly from outsiders. The awful state of the Victorian Liberal Party proves that. Roskam was on Skynews rabbiting on about what is wrong with the Libs but he is just as close-minded as they are. What did he ever do to bring in new thinkers?

  2. Ive given your stuff a lot of and I decided there is some wrong with the right. Your either in or you’re out. Your article on the geat depression was great and revealing. You showed why the current view was wrong. Did anyone on the right refer to it?

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