Compare and contrast the explanations of the functioning of the pre World War I International Gold Standard from Hume to Kindleberger.

Introduction:

Arguably one of Britain’s greatest contributions to the monetary world system, the international gold standard arrangement (1870 – 1919) noted a pivotal moment in economic history and liberalism. Historically marked by record flows of foreign capital, economic growth and balance of trade equilibrium; the international gold standard set precedence for a number of structural features and characteristics which predominate in the international system today.  Its fundamental advantages regarding inflationary limits, fixed-exchange rates and economic stability were palpable, and are one of the many reasons a phalanxes of contemporary economists call for its restoration.  Originally gaining provenance in Britain in 1717, the adoption of the normative gold standard was legally imposed in Britain in 1821 after legal-tender for small transactions of silver was abolished.  Later becoming the dominant system in the international economy, Germany adopted the gold standard in 1871, the United States in 1979, and by the early 1900s, “most of the non-European world had gone onto gold.”

Two of the greatest contributors to gold standard theory and discussion, Ian Hume and Charles P Kindleberger both provided seminal theories for the explanation of features in the pre World War I gold standard system. In this essay, I will juxtapose these two theories, and highlight comparisons and differences between them in explaining predominant features of the pre World War I gold standard system from 1880 - 1919.  The most notable area of concern where these two theories overlap is their alternate explanations of the how the stability in the gold standard system was achieved.  As we shall see in this essay, Kindleberger addressed the stability of the gold standard by opining it was Britain’s hegemonic status and monetary prowess which provided the flexibility and modulation the system required.  Hume’s formulas and theoretical mechanisms, on the other hand, explained the system’s stability and functioning in a much purer economic sense, with virtually zero reference to political engagements or discussion.

Main

Ian Hume’s 1758 paper “On the Balance of Trade” provided one of the greatest literal advocations for a gold standard arrangement, and developed its most notable feature -“the price-specie-flow mechanism.” This argued that gold capital flows would eliminate any trade imbalances for all economies in the system, and that the trade surpluses - which mercantilists at the time argued would be beneficial to the UK - could never be sustained. In order for his model to work, Hume’s included key assumptions about the political paradigm it was operating in.  As Eichengreen puts it:

“Hume considered a world where only gold coins circulated and the role of the banks was negligible.  Each time merchandise was exported, the exporter received payment in gold, which he took to the mint to have coined.  Each time an importer purchase merchandise abroad, he made payment by exporting gold.”

What Hume went on to argue, was that when a country in the gold standard arrangement had a trade deficit - where the country imported more than it exported – it experienced a gold outflow which reduced the quantity of gold (and money) in the domestic country.  The resulting effect  was that with a larger amount of money (gold) circulating abroad, prices abroad would rise, leading to inflation in the surplus country.  The “price-specie-mechanism” thereby produced a change in relative prices. The reverberations for this in the international system led to a self-equalizing equilibrium in balances of trade and payments; explained through the quantitative theory of money (QTM).  Incorporating this theory, Hume led to the conclusion that a country with a trade surplus would have high amounts of gold flowing into the country, which would raise domestic prices (inflation) and reduce exports/increase imports.  In contrast, a country operating a trade deficit will have suffered gold outflows from the country, leading to a reduction in relative domestic prices, which would encourage exports – thus the balance of trade is equalized automatically over time.  Thus, what Hume essentially created was an asymmetrical system with rules for counterbalancing.

We can see therefore, that Hume’s explanation for stability in the gold standard is purely from an economic standpoint, which relied on implicit assumptions about how free trade and economies in the gold standard operated.  In concatenation, his motivation for proving current mercantilist economic theory wrong led to an inherently optimistic account for gold standard arrangements.

In contrast to Hume however, Kindleberger offered a much more political explanation for monetary stability of the gold standard, which relied heavily on British hegemonic power and political solidarity to explain the stability and features of the gold standard.  His salient “Hegemonic Stability Theory”, explains that the international stability of the gold standard resulted chiefly from Britain’s leading role in the international monetary system.  Along with Eichengreen, Kindleberger suggests that it was Britain’s effective “management” of the system, through co-coordinating macroeconomic policy and providing counter-cyclical long-term lending which stabilized the system.  Eichengreen provides further support for Kindleberger’s explanation, stating, “The stability of the system hinged on the participation of the British”.

Kindberger also argued Britain’s dominance in the system enabled her to make monetary decisions on behalf of the world. He noted that when the Bank of England discount rate changed, others countries followed suit, precisely because it was in their interest to maintain close links to British sterling and trade (since she was the financial centre of the world and offered significant flexibility and opportunities).To quote Keynes on the dominance of Britain in the system: “During the latter half of the nineteenth century the influence of London on credit conditions thoughout the world was so predominant that the Bank of England could almost have claimed to be the conductor of the international orchestra.”

Although Hegemonic Stability Theory was designed to be politically transcendent and not intended to solely be applicable for one historical episode, he strongly makes the case that it was not only relevant during the gold standard years, but that is the best explanation for the exchange-rate stability that predominated the system during the period  To me however, it seems one of Kindleberger’s largest gripes in solely relying on Hume’s theory of gold movements, is that it was too narrow and didn’t account for putative features of the gold standard which were prevalent in the late 19^th century.  In “A Financial History of Western Europe,” Kindleberger notes that Hume’s model “must be modified” since the original model didn’t take into account the increased rate of gold flows which were succored by central banks and discount rate mechanisms (sterilization).  One of the major ways in which the two theories contrast then, leads on from above.

While Kindleberger also argued Britain’s position in the gold standard system was asymmetric, he believed the main reason economic stability ensued from 1870 – 1919 was because Britain offered the monetary flexibility the system required. Through financial crediting terms and its grandiose financial base in London; Britain had control and access to massive capital flows which could move freely and rapidly to all corners of the world.  A key principle in Kindleberger’s theory which distantiated it from Hume’s explanation then, was that it was Britain, not the price-specie-flow mechanism, which controlled the mass movement of gold flows. As de Cecco puts it, such Britain’s dominance in the gold standard arrangement, “the system was really based on sterling rather than gold.”

Effectively, Britain’s banks in her various colonies and protectorate provided the scope and leverage to shift capital (to wherever it needed to go) through an eclectic range of monetary control methods including discounts rates, securities, bills of exchange and gold reserves. India, as de Cecco notes, provided a crucial role in Britain’s hegemonic control of the system.  India’s reserves provided a ‘masse de manouvre’ which British authorities could use to supplement their own needs and balance out the system.  “In effect, India’s trade surplus with the rest of the world and her trade deficit with Britain allowed the latter to square her international settlements on the current account.” Marcuzzo and Roselli also noted that if the demand and supply of bills of exchange were strongly connected to trading activities of the British Empire, than the determinants of the trade follows are obviously the determinants of the exchange rate.”  To sum up Kindleberger’s argument then, I feel a useful quote from Vernando is relevant:“Capital flows could be destabilizing, but the capacity of the Bank of England to tame them was crucial for the maintenance of the system.”

From historical analysis and the readings of other scholars, we can see a significant number of systems and processes operating in the gold standard which Hume’s model could not, or rather did not, make account for.  In concatenation, Eichengreen also notes how Hume’s model fails to extend and explain international capital flows, as well as its inaccuracy in portraying real world features, notably the “absence of international gold shipments on the scale predicted by the model”.  However I also believe that one of the main advantages for Kindleberger and his “Hegemonic Stability Theory” is that unlike Hume, he was blessed with the virtue of hindsight.  As such, Kindleberger could use historical data and cognizance to draw out theories through inductive reasoning.  Hume’s model on the other hand, was based on principles which, while arguably content and accurate at the time of writing (1758), are not necessarily accurate or pensive enough to explain features of a system one hundred years later.  It wasn’t until the Cuncliffe Committee at the end of World War I before Hume’s model was officially extended to include capital flows.  Thus, a key difference between Hume’s and Kindleberger’s explanations of the gold standard is that the former is prospective where as the latter is retrospective.

In defense of Hume however, the majority of his theory seems widely accepted as the norm of gold standard.  While Kindleberger notes the model must be “modified”, a modification is by no means the refutation of the theory’s key components; only that the original model was lacking in depth.  We can therefore see then, that while both models differ with regards to the content and reasoning ultimatum, they are actually remarkably similar in their explanations of the gold standard and exchange-rate stability.  Kindleberger still acknowledges the role of gold, QTM theory and that a balance of payments was a pertinent feature of gold standard.  Hegemonic Stability Theory still largely defends the bulk of Hume’s work, and his price-specie-flow mechanism is implicit.  Ultimately, if the title of this essay was to compare both theories explanations for stability in the system, there would be disparities. But with respect to explaining features of the gold standard, they are very similar in content and logic.

An area, in which I feel the models go off on tangents, is in the concepts of homogonous economies and equality of economic prospects.  Hume, in his theory, essentially regards all economies as equal, and that the balance of trade and price-specie-flow mechanism will operate universally.  What Kindleberger seems to draw attention to throughout his work however, is that countries are definitely not all equal in the gold standard international system.  As Kindleberger underlines, Britain (or England) as a leading country in the international economy could increase her discount rate to avoid an outflow of gold, and precipitate an inflow of gold from other countries.

An interesting overlap and similarity between Kindleberger and Hume’s theories is that they both discount the hallmark gold standard “rules of the game” (the actions required to make gold convertibility consistent and the gold standard successful).  In Hume’s model, the features of the gold standard are explained solely through a simple set of equations.  He makes no reference to discount rates or capital flows, and it wasn’t until later that the “rules of the game” rhetoric emerged.  For Kindleberger, he believed neither credibility nor cooperation was at the center of the working of the gold standard.  Instead, it was Britain’s hegemonic leadership and ability to manage world capital-flows, acting as “underwriter” of the system and offering flexibility to the system (such as diffusing localized inflation).  It was this which allowed the system to run exchange-rate stability as it did, not the political commitment to “rules of the game.”  Unlike Kindleberger’s account of the gold standard however, Hume makes no account of political decision making or the availability of monetary fiscal policy.  Thus, government intervention and the independence of countries in shaping their economic objectives provides a clear distinction between the two models.  Kindleberger accepts central banks such as the Bank of France will regularly make adjustments to the discount rate, Hume doesn’t account for it.

The long-term outcome and gains of the gold standard through Kindleberger’s and Hume’s explanation of the systems are also significant.  Kindleberger notes that the majority of countries that operate in the gold standard looked to maximize their own short-run gains.  He argues further, suggesting that through self-interest (involving currency depreciation, foreign-exchange control, tariffs and terms of trade), a country may “worsen the welfare of its partners by more than its own gain”. He continues, “Beggar-thy-neighbor tactics may lead to retaliation, so that each country ends up in a worse position from having pursued its own gain”. Through his refutation of co-operation (for example how the Bank of France ignored the “rules of the game”) and his alternate views on the composition, it seems Kindleberger’s explanation of how the gold standard operates leads to a non-zero-sum game, where all exponents are worse off from it.  Clearly this contrasts heavily with Hume’s price-specie-flow theory, which suggests a more optimistic, pro-Smithian attitude, with free trade promoting growth and opportunities for all countries in the system.

Conclusion:

It’s interesting to see that while Kindleberger and Hume offer many similarities between their explanations for the gold standard system, their explanations themselves lead to such long-term disparities.

We have seen that the two systems share views on explaining how the system operates fundamentally.  Both scholars accept the normative principles of the gold standard were present i.e. their explanations for the gold standard system include shared thoughts on gold-convertibility, parity and gold flows.  Indeed, Hume’s price-specie-mechanism is a virtual pre-requisite for Kindelberger’s explanation of the system.

In addition, I have shown that one of the most interesting similarities between both theories’ explanations of the gold standard is that they both ignore what many would consider the hallmark features of the gold standard – the “rules of the system.”  For Hume, his failure to extend his model to incorporate the role of governments and banks in cash/capital flows led to the ommitance of the rules.  And for Kindleberger, his explanation of the system suggests that co-operation and the composition of the gold standard was a complete fallacy.

Where the two explanations diverge most however, is that Hume believed the price-specie-flow mechanism in itself would create a stable monetary system of fixed exchange rates.  Kindleberger, on the other hand, believed it was the central role of the City of London, and Britain’s stance as a hegemonic power which provided stability and functionality of the gold standard.  Without such a strong power holding such mighty financial leverage, Kindleberger’s explanation of how the gold standard works would not make it functional.  The most significant, and thought-provoking difference between the two explanations of the theories I believe however, is the outcome of results the explanations precipitate. For Kindleberger, the gold standard leads to a non-zero-sum game where all the countries end up worse off.  For Hume however, all countries benefit from the system (extending strong themes from Adam Smith’s work).

Ultimately, the key differences between the two explanations about the gold standard arrangement lie in their assumptions.  Hume’s assumes all countries are homogonous in the system and that countries won’t interfere in monetary policy.  Kindleberger’s on the other hand acknowledges countries are different, that they do temper in fiscal policy, and that their self-interests can destroy the system’s worth.

Bibliography:

Alberto Giovannini, “Rules of the Game During the International Gold Standard: England & Germany” (1986)

De Cecco, “Money & Empire: The International Gold Standard 1890 – 1914”

Eichengreen, “Globalising Capital” (1996)

Eichengreen and Flandreau, “Gold Standard in Theory & History” (1997)

Eichengreen, “Hegemonic Stability Theory and Economic Analysis: Reflections on Financial Instability and the Need for an International Lender of Last Resort” (1996)

Kindleberger, “The World in Depression: 1929 – 1939” (1986)

Kindleberger, “A Financial History of Western Europe” (2006)

Matias Vernengo, “The Gold Standard & Centre-Periphery Interactions” (2003)

Michael D. Bordo, “Gold Standard” (1984)

Sergio Rossi et al “Modern Theories of Money: The Nature and Role of Money in Capitalist Economies” (2003)

Theo et al “International Economics” (2009)

Be Sociable, Share!

• 

No related posts.