Hawtrey’s Good and Bad Trade: A Centenary Retrospective

Abstract

Ralph Hawtrey, a leading economist of the interwar period, published his first work in economics, Good and Bad Trade, in 1913. The book presents the key elements of the theoretical model Hawtrey developed and refined over the next quarter century. Though he was remarkably consistent in maintaining the theoretical framework outlined in his first work, Hawtrey later rejected the Humean price-specie flow mechanism outlined in Good and Bad Trade, after concluding that, even without gold shipments, international arbitrage equalized national price levels under the gold standard.

1 Introduction

Over a career spanning almost 60 years, Ralph George Hawtrey produced a steady stream of publications, at least twenty books, over a hundred articles, mostly in professional journals, and perhaps an equal number of book reviews, becoming one of the best-known and most frequently cited economists of the interwar period. A Cambridge man, and an Apostle who recommended Keynes, four years his junior, for membership in the Apostles, Hawtrey, like Keynes, belonged to the Bloomsbury Group and remained close to Keynes, though not part of his inner circle. Despite his irritation at Hawtrey’s persistent criticisms of early drafts of the General Theory, Keynes more than once acknowledged Hawtrey’s influence on his thinking, famously describing Hawtrey as his “grandparent in the paths of errancy” (Keynes, 1937, 241n.).

Good and Bad Trade, Hawtrey’s first work in economics, was published in 1913 when Hawtrey was 34 years old, and had worked at the Treasury for almost a decade. It was only Hawtrey’s second publication, the first having been an article on naval strategy, written before his arrival at Cambridge. Perhaps on the strength of that youthful publication, Hawtrey began his civil-service career in the Admiralty, before transferring shortly thereafter to the Treasury, where he remained till 1947.

At Cambridge, Hawtrey studied mathematics and philosophy. He was deeply influenced by the Cambridge philosopher G. E. Moore, an influence apparent in The Economic Problem (1926), one of Hawtrey’s few publications not mainly concerned with monetary theory and policy. Hawtrey’s mathematical interests led him to a correspondence with another Cambridge man Bertrand Russell, a correspondence cited in the Principia Mathematica and acknowledged in the preface. Surprisingly, Hawtrey seems to have had no contact with Alfred Marshall or any other Cambridge economists while at Cambridge. Indeed, the only economist mentioned by Hawtrey in Good and Bad Trade is Irving Fisher, whose distinction between the real and nominal rates of interest is mentioned in Chapter 5, and whose proposal to stabilize the purchasing power of the dollar by altering its gold is discussed in Chapter 20.

An autodidact in economics, Hawtrey probably began his self-education while studying for the civil-service entrance examination. In his forward to the 1962 edition of Good and Bad Trade, Hawtrey (1913 [1962], vii) recounted being informed, in 1909, by an unidentified economist friend that the principle he was relying on to explain the business cycle—the fall of prices below those that producers had expected when borrowing to finance their productive activities—had been anticipated by Fisher in his Theory of Interest (1907). Hawtrey added that his cycle theory consisted in a new development and elaboration of Fisher’s insight.

Hawtrey’s self-education was evidently continuing even as he was writing Good and Bad Trade, acknowledging in the forward to the second edition (p. ix) inaccuracies in his account of the functions of bill-brokers. Despite some gaps in his self-education, Hawtrey’s exceptional analytical skill, his attention to detail, and his meticulously logical exposition were already manifest in his first work. Referring to Hawtrey’s 1937 exchange with Keynes about the theory of interest in the General Theory, G. L. S. Shackle (1967, 243) described the effect that Hawtrey’s expository style had on readers, already likely felt by readers of his first work:

Sir Ralph’s patient, exact and unimpassioned formulations steadily build up in his reader a solid trust in Sir Ralph’s logic, and a disposition to look a second and a third time at any proposition which seems at first sight to endanger his faith.

At the outset (p. 3), Hawtrey laid out the following description of his method and his goal:

My present purpose is to examine certain elements in the modern economic organization of the world, which appear to be intimately connected with the fluctuations. I shall not attempt to work back from a precise statistical analysis of the fluctuations which the world has experienced to the causes of all the phenomena disclosed by such analysis. But I shall endeavor to show what the effects of certain assumed economic causes would be, and it will, I think, be found that these calculated effects correspond very closely with the observed features of the fluctuations.

The general result up to which I hope to work is that the fluctuations are due to disturbances in the available stock of “money” – the term “money” being taken to cover every species of purchasing power available for immediate use, both legal tender money and credit money, whether in the form of coin, notes, or deposits at banks.

The chief problem with the business cycle, Hawtrey explained, is that unemployed workers cannot earn an income with which to sustain themselves during business-cycle contractions. Although, when analyzed in the context of an equilibrium, money might seem unimportant, inasmuch as any set of absolute prices is consistent with equilibrium, provided that relative prices are consistent with equilibrium, Hawtrey attributed the problem to a malfunction of the monetary system.

For perhaps 25 years after Hawtrey published Good and Bad Trade, the basic model described in his first work on the business cycle was considered the definitive articulation of a purely monetary theory of the business cycle. In his classic survey of business-cycle theories, Gottfried Haberler (1937) undertook an extensive summary Hawtrey’s work as the representative treatment of a purely monetary cycle theory. Even another decade later, Schumpeter (1954) still credited Hawtrey with having advanced the most comprehensive monetary theory of the cycle.

When Schumpeter wrote, monetary theories of the cycle, having failed to account for the Great Depression and then having been eclipsed by the Keynesian ascendancy, had already fallen out of fashion. But just as Schumpeter was writing about Hawtrey, Milton Friedman was beginning his long collaboration with Anna Schwartz, later to be joined by many dedicated students and colleagues, in attempting to show that monetary forces really did play the central role in the Great Depression. Unaware of, or uninterested in, Hawtrey’s contributions, Friedman, advancing his own version of a monetary theory of the Great Depression, acknowledged only a largely invented Chicago oral tradition as a forerunner of his own monetary theory, thereby contributing to, and hastening, Hawtrey’s passage into obscurity.

A milestone in both the history of monetary theory and the history of business-cycle theory, Good and Bad Trade undoubtedly deserves renewed attention and reconsideration. Aside from its general importance as a path-breaking work of monetary theory, Good and Bad Trade is also noteworthy for at least seven specific contributions: (1) the concept of effective demand, (2) the concept of purchasing-power parity, (3) the concept of a multiplier, (4) the pathological implications of an expected deflation greater than the real rate of interest, (5) the “Treasury view” he subsequently articulated in Hawtrey (1925), (6) the positive historical correlation between price levels and interest rates (Gibson Paradox), and (7) a theoretical account of the dynamics of financial crises and their relationship to cyclical fluctuations.

Finally, notwithstanding the remarkable continuity in Hawtrey’s theoretical approach and basic model throughout his long career, Hawtrey did, in subsequent works, change one important feature of the model presented in Good and Bad Trade: his reliance on the price-specie-flow mechanism (PSFM) to explain the process of international adjustment in prices, interest rates, and gold reserves under the gold standard.

The chapter is organized as follows. In the next section, I sketch the logical structure of the book, highlighting the main elements of Hawtrey’s theoretical schema. In Sect. 10.3, I discuss the above-mentioned innovations or advances made by Hawtrey in Good and Bad Trade. In Sect. 10.4, I consider his explanations for financial crises. And in Sect. 10.5, I discuss his revision in later works of the price-specie-flow mechanism described in Good and Bad Trade. I conclude in Sect. 10.6.

2 The Structure and Argument of Good and Bad Trade

• A. An Overview of Good and Bad Trade

Hawtrey’s explanatory strategy was to start from what he regarded as the simplest possible assumptions, derive a useful result, and then to gradually modify the assumptions to make the analysis correspond increasingly closely to conditions in the real world. Hawtrey’s objective in Good and Bad Trade was to derive from his theoretical model a pattern of cyclical fluctuations resembling those actually observed. After a brief introductory chapter, Hawtrey, in Chapter 2, introduced the idea of a demand to hold money such that people aim to hold, on average, a certain percentage of their total money income in the form of money as a working balance with which to carry out transactions. Given such a demand to hold money, and a fixed amount of inconvertible paper money, the absolute level of total income in nominal terms and the absolute level of prices would be determined, money income being a multiple (corresponding to the inverse of the percentage of total income that people wish to hold as money) of the fixed quantity of money. In Chapter 3, Hawtrey extended his analysis to encompass credit money created by banks.

In Chapter 4, Hawtrey discussed the organization of production, the accumulation of capital, and the employment of labor, explaining the matching circular flows: expenditure on goods and services, the output of goods and services, and the incomes accruing from that output and expenditure.

Having introduced the basic elements of a simple isolated economy, Hawtrey, in Chapter 5, described how an isolated economy using just fiat money would adjust to a change in the quantity of fiat money, and, in Chapter 6, how such an economy would adjust to a monetary disturbance affected a banking system supplying credit money convertible into fiat money. In Chapter 7, Hawtrey discussed how monetary disturbances affecting the banking system might arise in an isolated community.

In Chapter 8, Hawtrey extended the discussion of the previous three chapters to an open economy connected to an international system in which each country uses its own fiat money. Hawtrey explained the exchange rates of the various national currencies in such an interconnected international system by formulating the principle of purchasing-power parity. In Chapter 9, Hawtrey dropped the assumption of inconvertible paper moneys and introduced an international metallic system (corresponding to the international gold standard then in operation).

Having described his working model of multiple economies using credit (i.e., bank-created) moneys convertible into gold, Hawtrey, in Chapter 10, discussed other sources of change, e.g., population growth and technological progress, and changes in the supply of gold. In Chapter 11, Hawtrey dropped the assumption of the previous chapters that there are no forces leading to changes in relative prices among commodities, showing that such changes, unlike changes in monetary conditions, give rise to no cumulative changes in income and expenditure, and therefore have only transitory effects.

In Chapter 12, Hawtrey began a deep analysis of money, credit, and banking, largely focusing on the differences between deposits and banknotes, and, in Chapter 13, he described international differences in money and banking institutions. In Chapters 14 and 15, Hawtrey undertook an explanation of how monetary instability can produce a recurring cycle, not just a cumulative expansion or contraction that leads directly to a new equilibrium state. In Chapter 16, Hawtrey explained that financial crises are the result of a severe monetary contraction when banks respond to the drain on their reserves characteristic of the late stages of a business-cycle expansion, the crisis being triggered if the monetary contraction is unusually sharp.

The final four chapters discuss the effect of government policies on the business cycle. Chapter 17 considers how the business cycle had been affected by changes in monetary arrangements during the second half of the nineteenth century, primarily the shift from bimetallic standards to the gold standard in the 1870s. Chapter 18 considers the effects of tariff policy on the cycle, and Chapter 19 discusses whether the requirements of the government for banking services in receiving payments from, and in disbursing payments to, the public have repercussions on the cycle. Finally, in Chapter 20, Hawtrey considered proposals for moderating the severity of the cycle, the two proposals of interest being Irving Fisher’s proposal for stabilizing the price level by altering the gold content of the currency to reflect changes in a general index of prices and the proposal of the Minority Report of the Poor Law Commission to increase government spending during recessions to mitigate unemployment.

• B. The Basic Model of Good and Bad Trade

Hawtrey aimed to explain recurrent cyclical fluctuations, believing that only monetary disturbances could account for (a) cumulative expansions and contractions and (b) for the transformation of a contraction into an expansion and vice versa, rather than a direct reversion to an equilibrium state. To explain cumulative expansions and contractions, Hawtrey focused on the sensitivity of middlemen, wholesalers, and merchants who finance their inventories mainly with short-term bank loans. Hawtrey held that the desired levels of such inventories would vary directly with the costs of financing the inventories. Changes in desired inventories would in turn cause middlemen to make similar changes in the size of their orders to manufacturers, thereby causing similar variations in manufacturing output. Changes in output would lead to changes in workers’ incomes as manufacturers changed payrolls more or less in proportion with output changes, while workers changed their purchases of finished goods in rough proportion with income changes. The process of adjusting inventories, orders, and output would continue, because changes in consumer demand would cause additional, though progressively smaller, changes in desired inventories, and, consequently, in output and income as the adjustment process continued.

Hawtrey’s recognition of the connection between income and expenditure was the germ of the multiplier analysis, which Hawtrey actually worked out for Keynes a decade and a half later in his comments on the draft of the Treatise on Money that Keynes sent to Hawtrey before publication. The key difference between the Hawtreyan multiplier and the Keynesian multiplier was that Hawtrey believed that the multiplier effect was triggered by changes in bank lending rates, while Keynes believed that they were triggered by changes in spending plans of households, business, or government.

The tendency for changes in bank lending rates to generate cumulative expansions or contractions was not sufficient to account for the observed cyclical pattern of those fluctuations. Hawtrey therefore had to explain how the expansion or contraction itself could give rise to a change in monetary conditions that would reverse the initial cumulative expansion or contraction once it had gotten underway.

Hawtrey identified the banking system as the transforming agent required for a theory of recurring cycles. The key behavioral relationship for Hawtrey was that banks demand reserves—either gold or currency or reserves held with the central bank—into which their own liabilities (banknotes or deposits) are convertible. Given their demand for reserves, banks set interest rates with a view to maintaining their reserves at the level desired, given their outstanding liabilities (deposits and banknotes). Accordingly, they raise interest rates when they consider reserves to be inadequate, and reduce rates when reserves seem excessive. Whether total spending increases or decreases depends on whether the lending rate set by banks is less than or greater than the profit rate of businesses. If the bank rate is less than the profit rate, borrowing from the banks increases; if the profit rate is greater than bank rate, borrowing decreases. The profit rate corresponds to the real or natural rate plus expected inflation.

Hawtrey combined this behavioral relationship with two key empirical relationships: (1) that workers and other lower-income groups generally make little use of banknotes (limited in Britain to denominations above £5, roughly the equivalent of $200 at today’s prices) and almost none of bank deposits; (2) that the labor share of total income is countercyclical. Hawtrey began his story at the upper turning point, when a combination of rising inflation and diminishing reserves causes banks to raise their interest rates to stem outflows of reserves.¹

At the peak of the cycle when employment is close to—perhaps beyond—being full, with expenditure increasing and inflation rising, the bank rate is presumably below the profit rate. When banks increase their lending rates to stem a reserve outflow, the initial effect is to reduce spending. Despite a slowdown in spending, the loss of reserves may not stop, because workers increase their desired holdings of cash as their wages rise, causing a further drain on bank reserves. The rate banks charge borrowers may therefore continue to increase for a time even after it already exceeds the profit rate. Meanwhile, the increased bank rate causes middlemen and traders to reduce desired stock levels; their orders to manufacturers begin to diminish, causing manufacturers to curtail output and employment. This reaction starts a downturn, triggering a vicious downward cycle of declining orders, output, employment, and spending. Falling wages and employment cause workers to reduce their demand for cash. All these effects of the downturn improve the reserve position of the banks, while also tending to reduce the quantity of reserves that banks want to hold, their liabilities having fallen owing to the reduced business demand for bank credit. As their reserve positions improve, banks begin reducing their lending rates, but that adjustment tends to lag behind the reduction in the profit rate. Eventually, the excess reserves held by banks increases sufficiently that they reduce their lending rates below the profit rate. When lending rates fall below the profit rate, businesses again find it profitable to increase their borrowing, and for middlemen and traders to add to, rather than decrease, their inventories, creating the conditions for a turnaround and a new expansion of stocks, output, and employment.

Although both employment and wages fall in the downturn, Hawtrey maintained that profits fall more sharply than wages, so that the share of labor in total income actually increases in the downturn. The full passage is worth quoting, because it also constitutes an implicit criticism of the Austrian theory of the downturn, although it is doubtful that Hawtrey was yet acquainted with the Austrian theory of the business cycles, its primary text, Mises’s Theory of Money and Credit, having been published in German in 1913 at about the same time as Good and Bad Trade. The key difference between Hawtrey’s monetary theory of the cycle and the Austrian theory is that the Austrian theory presumes that business investment in fixed capital is highly sensitive to short-term bank lending rates while Hawtrey believed short-term lending rates primarily affect the holding of working capital and inventories. Hawtrey considered the Austrian focus on long-term capital investment a factually incorrect premise and their focus on the capital structure of the economy as an important causal factor in the cycle to be misplaced, inasmuch as long-term capital investment is financed mainly by retained earnings, or by the issue of new stock and bonds, not by short-term borrowing from banks.²

[R]ather than let their plant lie idle, manufacturers will sacrifice part or even the whole of their profits, and that in this way the restriction of output is mitigated. If all producers insisted on stopping work unless they could obtain a normal rate of profit, there would be a greater restriction of output and more workmen would be discharged, and in that case the proceeds of the diminished output would be divided (approximately) in the same proportion between the capitalists and the workmen as before. But in consequence of the sacrifice of profits to output which actually occurs, the number of workmen in employment and therefore also the aggregate of working-class earnings will not be so severely diminished as they would otherwise be. Thus the capitalists will get a smaller proportion and the workmen a greater proportion of the gross proceeds than before. But anything which tends to increase or maintain working-class earnings tends to increase or maintain the amount of cash in the hands of the working classes. If the banks have succeeded in reducing the outstanding amount of credit money by 10 percent, they will probably have reduced the incomes of the people with bank accounts by 10 percent, but the earnings of the working classes will have been reduced in a much smaller proportion – say, 5 percent. (pp. 189–190)

The reduced quantity of the liabilities of the banking system in the hands of the public will relieve the pressure felt by banks to increase their reserves, diminishing their need to raise interest rates.

Here is the process at work which is likely enough to produce fluctuations. For the bankers will thereupon be ready to increase the stock of credit money again, and once they have embarked on this course they may find it very difficult to stop short of a dangerous inflation…

Instead of ending up, therefore, with the establishment of a golden mean of prosperity, unbroken by any deviation towards less or more, the depression will be marked in its later stages by a new complication. At the time when the reduction of wages is beginning to be accompanied not merely by an increase of employment, but also by an increase of profits, the banks will find that cash is beginning to accumulate in their vaults. They will ease off the rate of interest to something a little below the profit rate, and dealers will take advantage of the low rate to add to their stocks. The manufacturers will become aware of an increase in orders, and they will find that they can occupy their plant more fully. And now that stocks and output are both increased, borrowing will be increased and the bankers will have gained their end. But then the new accession to the amount of credit money means a corresponding increase of purchasing power. At existing prices the dealers find that their stocks are being depleted by the growing demand from the consumer. The prospect of rising prices is an inducement to add to their stocks as much as they can at existing prices, and so their orders to the manufacturers grow, wholesale prices go up; and as the consumers’ demands on the dealers’ stocks grow, retail prices go up; and as prices go up, the money needed to finance a given quantity of goods grows greater and greater, and both dealers and manufacturers borrow more and more from their bankers. In fact here are all the characteristics of a period of trade expansion in full swing. (pp. 190–192)

How far such a cumulative process of credit expansion can proceed before it reaches its upper turning point depends on the willingness of the banks to continue supplying credit as the margin of their reserves relative to liabilities steadily diminishes. But as the expansion proceeds, and businesses begin to expect to profit from selling their products at rising prices, businesses, short of workers with which to increase output, will start bidding up wages. As costs rise relative to prices, the incentive for further expansion will dissipate.

Production having been stimulated to great activity there is a scarcity of labour, or at any rate of properly trained and competent labour, and employers are so anxious to get the benefit of the high profits that they are more ready than usual to make concessions in preference to facing strikes which would leave their workers idle. There follows a period of full employment and rising wages. But this means growing cash requirements, and sooner or later the banks must take action to prevent their reserves being depleted. If they act in time they may manage to relieve the inflation of credit money gradually and an actual financial crisis may be avoided. But in either case there must ensue a period of slack trade. Here, therefore, we have proved that there is an inherent tendency toward fluctuations in the banking institutions which prevail in the world as it is. (p. 199)

3 Innovations in Good and Bad Trade

I indicated above that at least seven different conceptual or theoretical innovations could be identified in Good and Bad Trade. I consider each of them in turn.

• A. The term “Effective Demand”.³

At very outset (p. 4) of Good and Bad Trade, the reader encounters the following passage.

The producers of commodities depend, for their profits and for the means of paying wages and other expenses, upon the money which they receive for the finished commodities. They supply in response to a demand, but only to an effective demand. A want becomes an effective demand when the person who experiences the want possesses (and can spare) the purchasing power necessary to meet the price of the thing which will satisfy it. A man may want a hat, but if he has no money [i.e., income or wealth] he cannot buy it, and his want does not contribute to the effective demand for hats. (p. 4, emphasis added)

Almost immediately thereafter, at the beginning of Chapter 2 (p. 6, emphasis added), Hawtrey continues:

The total effective demand for all finished commodities in any community is simply the aggregate of all money incomes. The same aggregate represents also the total cost of production of all finished commodities.

Again, in Chapter 4 (pp. 32–33, emphasis added), Hawtrey the concept of effective demand:

It was laid down that the total effective demand for all commodities is simply the aggregate of all incomes, and that the same aggregate represents the total cost of production of all commodities.

Hawtrey attributed fluctuations in employment to fluctuations in effective demand, because wages and prices would not adjust immediately to a change in total spending. Here is how Keynes defined effective demand (1936, 55).

[T]he effective demand is simply the aggregate income or (proceeds) which the entrepreneurs expect to receive, inclusive of the income which they will hand on to the other factors of production, from the amount of current employment which they decide to give. The aggregate demand function relates various hypothetical quantities of employment to the proceeds which their outputs are expected to yield; and the effective demand is the point on the aggregate demand function which becomes effective because, taken in conjunction with the conditions of supply, it corresponds to the level of employment which maximizes the entrepreneur’s expectation of profit. (emphasis added)

So the conception of effective demand presented by Keynes in the General Theory is essentially the same as that which Hawtrey had presented two decades earlier. Keynes’s conception is, to be sure, more sophisticated than Hawtrey’s, being expressed in terms of entrepreneurial expectations of income and expenditure and specifying a general functional relationship (aggregate demand) between employment and expected income. But the basic idea still bears a close resemblance to Hawtrey’s usage of the same term. Interestingly, Hawtrey never asserted a claim of priority on the concept, whether because of an innate diffidence,⁴ or because of some disagreement with how Keynes used the idea, I cannot venture to say. Perhaps others may be able to suggest reasons for Hawtrey’s silence on this point.

• B. Purchasing-Power Parity

In Chapter 7, Hawtrey analyzed an international system of fiat currencies, each issued and used within a single country in which that currency alone (or credit money convertible into that currency) is routinely accepted as payment. Hawtrey set out to explain the exchange rates between pairs of such currencies and the corresponding price levels in those countries. In summing up his discussion (pp. 90–93) of what determines the rate of exchange between any two currencies, Hawtrey made the following observation:

Practically, it may be said that the rate of exchange equates the general level of prices of commodities in one country with that in the other. This is of course only approximately true, since the rate of exchange is affected only by those commodities which are or might be transported between the two countries. If one of the two countries is at a disadvantage in the production of commodities which cannot be imported, or indeed in those which can only be imported at a specially heavy cost, the general level of prices, calculated fairly over all commodities, will be higher in that country than in the other. But, subject to this important qualification, the rate of exchange under stable conditions does represent that ratio between the units of currency which makes the price-levels and therefore the purchasing powers of the two units equal. (pp. 92–93, emphasis added)

That is a terse, and precise, statement of the purchasing-power-parity doctrine. What makes it interesting, and possibly noteworthy, is that Hawtrey made it 100 years ago, in 1913, three years before Hawtrey’s older contemporary Gustav Cassel (1916, 1918), often credited with having originated the doctrine, gave his formulation of the doctrine. Here is how Cassel put it:

According to the theory of international exchanges which I have tried to develop during the course of the war, the rate of exchange between two countries is primarily determined by the quotient between the internal purchasing power against goods of the money of each country. The general inflation which has taken place during the war has lowered this purchasing power in all countries, though in a very different degree, and the rates of exchanges should accordingly be expected to deviate from their old parity in proportion to the inflation in each country.

At every moment the real parity between two countries is represented by this quotient between the purchasing power of the money in the one country and the other. I propose to call this parity “the purchasing power parity.” As long as anything like free movement of merchandise and a somewhat comprehensive trade between two countries takes place, the actual rate of exchange cannot deviate very much from this purchasing power parity. (1918, 413)

Of course, as documented by Humphrey (1979), the purchasing-power-parity doctrine has a long pedigree extending back to Henry Thornton (1802 [1939]) and was understood by many classical economists before it was articulated by Cassel and Hawtrey.⁵

Hawtrey went on to explain how international relationships would be affected by a contraction in the currency of one country. The immediate effects would be the same as those described in the case of a single closed economy. However, in an international system, the effects of a contraction in one country would create opportunities for international transactions, both real and financial, that would involve both countries in the adjustment to the initial monetary disturbance originating in one country. Hawtrey sums up his discussion about the adjustment to a contraction of the currency of one country as follows:

From the above description, which is necessarily rather complicated, it will be seen that the mutual influence of two areas with independent currency systems is on the whole not very great. Indeed, the only important consequence to either of a contraction of currency in the other, is the tendency for the first to lend money to the second in order to get the benefit of the high rate of interest. This hastens the movement towards ultimate equilibrium in the area of stringency. At the same time it would raise the rate of interest slightly in the other country. But as this rise in the rate of interest is due to an enhanced demand for loans, it will not have the effect of diminishing the total stock of bankers’ money. (p. 99)

He concludes the chapter with a refinement of the purchasing-power-parity doctrine.

It is important to notice that as soon as the assumption of stable conditions is abandoned the rate of exchange ceases to represent the ratio of the purchasing powers of the two units of currency which it relates. A difference between the rates of interest in the two countries concerned displaces the rate of exchange from its normal position of equality with this ratio, in the same direction as if the purchasing power of the currency with the higher rate of interest had been increased. Such a divergence between the rates of interest would only occur in case of some financial disturbance, and though such disturbances, great or small, are bound to be frequent, the ratio of purchasing powers may still be taken (subject to the qualification previously explained) to be the normal significance of the rate of exchange. (p. 101)

Thus, according to Hawtrey, interest-rate differentials between countries could prevent equalization of the purchasing powers of the two currencies, the higher interest rate in one country depressing the purchasing power of the currency of that country relative to the other. Hawtrey’s reasoning was not fully spelled out, but it might be rationalized as having intuitively grasped a tendency explained 70 years later by Max Corden (1985) in his theory of exchange-rate protection in which a country depreciates its exchange rate to favor its tradable-goods sector. Exchange-rate depreciation enhances the profitability of the country’s tradable-good sector only if exchange-rate depreciation does not lead to equiproportionate increases in wages and prices. To prevent equiproportionate increases in wages and prices, the monetary authority must create an excess demand for money, so that households and firms reduce their spending in order to build up their cash holdings. Given the depreciated exchange rate and reduced domestic spending, imports will decrease and exports will increase, causing resources to be shifted from the non-tradable-goods sector to the tradable-good sector.

In Hawtrey’s example, the monetary disturbance in one country causes an excess demand for cash in that country, raising interest rates and reducing prices, thereby causing currency appreciation. As interest rates in that country rise, borrowers will seek to borrow from lenders in the other country, thereby redistributing cash balances between the two countries and reducing the interest-rate differential between them. But the indebtedness of one country to the other will require a reduction of spending in that country, causing a shift of resources from its non-tradable- to its tradable-goods sector. That shift implies that the prices of non-tradable goods in the debtor country will fall, while, in the other creditor country, the prices of non-tradables will rise. Thus, purchasing power of the currency in terms of both tradables and non-tradables will increase in the debtor country and will fall in the creditor country.

• C. Income and Expenditure

In explaining the cumulative processes of expansion and contraction, Hawtrey recognized that an increase (decrease) in orders from traders to manufacturers causes the total output of manufacturers, along with total employment and income, to increase (decrease). The increase (decrease) in income induces a further increase (decrease) in spending by workers, leading to a further increase (decrease) in orders. Increased (decreased) spending by consumers causes a drawdown (buildup) of inventories and further increases (decreases) in the orders of traders and middlemen trying to restock (reduce) their inventories to desired levels, triggering further increases (decrease) in output, income and employment, and so on. Although Hawtrey did not explicitly assume that the ratio of the change in consumption to the change in income was less than one, that assumption was clearly made implicitly.

In his next book on business cycles, Currency and Credit (1919), Hawtrey was more explicit in spelling out the relationship between income and expenditure, introducing the concepts of “consumers income” and “consumers outlay” to represent the ideas of income and expenditure.⁶ So it was no accident that Hawtrey was an early discoverer of the multiplier (Cain, 1982; Davis, 1980; Deutscher, 1990; Dimand, 1997), for which he presented an algebraic exposition in a memorandum originally written to supplement his critical comments on Keynes’s Treatise on Money, later included in (Hawtrey, 1932, Chapter 6).⁷

Despite being articulated more explicitly in later works, the key elements of his analysis were already identified in Good and Bad Trade. The multiplier analysis provided the basis of Hawtrey’s theory cyclical theory, making Hawtrey’s role in developing the multiplier a natural development of his earlier work rather than, as Clarke (1988) suggested, an accidental aberration unrelated to the body of Hawtrey’s work.⁸

In particular, Clarke considered Hawtrey’s derivation of the multiplier to be at odds with his subsequent well-known (if not notorious) articulation (Hawtrey, 1925) of the “Treasury view” that government spending cannot increase output and employment. But that supposed inconsistency arises from a misunderstanding of Hawtrey’s reasoning in support of the Treasury view. Hawtrey argued that additional government spending, whether financed by taxation or by borrowing, must diminish private spending by an equivalent amount, without changing total spending (effective demand). The multiplier analysis becomes applicable when there is a net increment to total spending. If an increase in government spending were offset by an equal reduction in private spending, as Hawtrey argued, there would be no basis upon which the multiplier could take effect. The issue is not the multiplier but the “crowding out.” The issues are related but not the same.

Hawtrey’s premise may have been incorrect, because taxation and borrowing may reduce not just private spending, but also private saving. Depending on the circumstances, reduced private saving entails either reduced private investment or reduced cash holdings. If increased government spending is partly financed by reduced cash holding, then increased government spending would indeed lead to an increase in total spending. Hawtrey (1939) eventually conceded the point in his review of the General Theory. Hawtrey’s argument for the Treasury view was not premised on the non-existence of a multiplier effect, but on its inapplicability.

• D. Deflationary Expectations

In Chapter 14, explaining a business-cycle downturn, when, a rising rate of interest reduces total spending triggering an inflow of gold to the banks, Hawtrey digressed to consider what he called “a special case.”

What if the rate of depreciation of prices is actually greater than the natural rate of interest? If that is so, nothing that the bankers can do will make borrowing sufficiently attractive. Business will be revolving in a vicious circle; the dealers unwilling to buy in a falling market, the manufacturers unable to maintain their output in face of ever-diminishing orders, dealers and manufacturers alike cutting down their borrowings in proportion to the decline of business, demand falling in proportion to the shrinkage in credit money, and with the falling demand, the dealers more unwilling to buy than ever. This, which may be called “stagnation” of trade, is of course exceptional, but it deserves our attention in passing

From the apparent impasse there is one way out – a drastic reduction of money wages. If at any time this step is taken the spell will be broken. Wholesale prices will fall abruptly, the expectation of a further fall will cease, dealers will begin to replenish their stocks, manufacturers to increase their output, dealers and manufacturers alike will borrow again, and the stock of credit money will grow. In fact the profit rate will recover, and will again equal or indeed exceed the natural rate. The market rate, however, will be kept below the profit rate, since in the preceding period of stagnation the bankers’ reserves will have been swollen beyond the necessary proportions, and the bankers will desire to develop their loan and discount business. (pp. 186–187)

Although Hawtrey, in Chapter 4, referred to the Fisher equation relating the real and the nominal rates of interest by way of the expected rate of inflation, in this context, despite its obvious relevance, he overlooked the Fisher equation. The problematic nature of the Fisher equation when the expected rate of deflation exceeds the real rate of interest so that it cannot be satisfied at a non-negative nominal rate of interest is an anomaly rarely mentioned in the literature,⁹ Hawtrey’s discussion being the earliest discussion that I am aware of. Though he correctly understood the pathology associated with the situation, he did not fully describe the pathology or provide a complete account of how a new equilibrium might be established or of the nature of a new equilibrium if it were to be reached.

Instead, Hawtrey simply assumed that a sufficiently large reduction in nominal wages would cause price expectations to turn positive rather than remaining negative, or, worse become even more negative. Nor did Hawtrey reckon with the possibility that a downward spiral of output and prices might not, even with steep nominal wage reductions, lead to a new equilibrium but continue indefinitely unless countered by a deliberately expansionary countercyclical policy.¹⁰

• E. The Treasury View

Perhaps Hawtrey’s most famous paper is his 1925 paper “Public Expenditure and the Demand for Labour” in which he argued that government spending in a depression would not reduce unemployment, because any spending by the government would displace an equal amount of spending by the private sector. His argument was invoked several years later in 1929 by Winston Churchill, then Chancellor of the Exchequer, in responding to the proposals, supported by Keynes and other economists, of the Liberal opposition, an argument he described as the “orthodox Treasury view.”

Especially after the General Theory was published, the Treasury view has been considered a fallacy, and Hawtrey’s role in articulating it has been considered a blemish on his reputation.¹¹ Although Hawtrey’s reasoning was not beyond reproach, as he himself later acknowledged, it was not entirely wrong either.¹² But the relevant point in this context is that, in the final chapter of Good and Bad Trade, Hawtrey had already provided a fairly complete statement of the Treasury view he presented 12 years later. Hawtrey did so in considering the proposal of the minority report of the Poor Law Commission of 1909 advocating that government spending on public works be limited to periods of depression to moderate the hardships on the working classes resulting from the business cycle. The essence of his argument appears in a long footnote from which I quote the last two sentences (p. 262):

The effective demand for all other commodities [aside from Government services] is made up of the incomes of all members of the community (including those in the service of the Government) less the amount paid in taxation, and the cost of production of all these commodities is made up of the incomes of all people not directly or indirectly in the service of the Government. An increase of Government expenditure diminishes the effective demand for commodities, and diminishes correspondingly the number of people employed in producing commodities.

• F. Gibson’s Paradox

Anticipating A. W. Gibson’s investigation of the relationship between price-level changes and long-term interest rates, Hawtrey noted the puzzling tendency of interest rates to be higher at the price level peak in 1913 than at the price level trough of 1896, dismissing the possibility that differing expectations of long-term movements in the price level could account for observed interest-rate differentials.

In Chapter 17, in discussing the effects of various legislative measures on the business cycle, Hawtrey observed that the shift of many countries in the early 1870s from bimetallic, but de facto, silver standards to the gold standard led to a significant and ongoing increase in the monetary demand for gold, which led to a prolonged period of declining prices until new gold discoveries in the mid-1890s led to nearly two decades of stable or mildly rising prices before the outbreak of World War I in August 1914 caused the gold standard to collapse. Hawtrey believed it unlikely that long-term price-level movements are correctly foreseen. And if the price trend had been foreseen, the decline in interest rates would have occurred early, not late, in the period, just as the declining price trend was replaced by a rising trend in prices.

In noting that the period of falling prices from 1870 to 1896 was associated with falling long-term interest rates while the period from 1896 to 1913, when prices were rising, was associated with rising interest rates, Hawtrey anticipated by ten years the famous empirical observation made by the British economist A. W. Gibson (1923) of the positive correlation between long-term interest rates and the price level, an observation that Keynes (1930, v. 2, p. 198), in attempting to explain the correlation, called the Gibson paradox.

Aside from noting the anomalous correlation between price levels and interest rates, Hawtrey offered a theoretical explanation for the correlation between price levels and interest rates. Rising prices, Hawtrey suggested, subsidize businesses that borrow, enabling them to repay nominal debts previously incurred with money of reduced real value. By increasing the return on capital financed by borrowing, inflation increases the demand for borrowed funds, raising nominal interest rates.

[T]he price was affected by the experience of investments during the long gold famine when profits had been low for almost a generation, and indeed it may be regarded as the outcome of the experience. In the same way the low prices of securities at the present time are the product of the contrary experience, the great output of gold in the last twenty years having been accompanied by inflated profits. (p. 229)

The continuous windfall profits from mild unexpected inflation accruing to businesses that borrowed would tend to encourage further investment by businesses with available funds, but it is not clear why the increased profits would cause increased by borrowing by businesses that were experiencing increasing net cash flows as a result of inflation unless their expectations of future inflation were gradually increasing. That was Irving Fisher’s (1930) explanation of Gibson’s Paradox. Of course, agreement between Fisher and Hawtrey would not be surprising.

4 Financial Crises

Good and Bad Trade is also noteworthy for its account of financial and banking crises, explaining them as the consequence of a cyclical downturn resulting from rising interest rates that cause demand to fall short of expectations, making debts uncollectable, thereby impairing the solvency of both borrowers and lenders. The most vulnerable borrowers are dealers in stocks whose loans from banks are callable.

Among Hawtrey’s best-known epigrams is “the inherent instability of credit.” Hawtrey begins Chapter 7 (“Origination of Monetary Disturbances in an Isolated Community”) with the following deceptively modest introductory paragraph.

In the last two chapters we have postulated a perfectly arbitrary change in the quantity of legal tender currency in circulation. However closely the consequences traced from such an arbitrary change may correspond with the phenomena we have set out to explain, we have accomplished nothing till we have shown that causes which will lead to those consequences actually occur…. At the present stage, however it is already possible to make a preliminary survey of the causes of fluctuations with the advantage of an artificial simplification of the problem. And at the outset it must be recognized that arbitrary changes in the quantity of legal tender currency in circulation cannot be of much practical importance. Such changes rarely occur. (p. 73)

In other words, Hawtrey is suggesting that the contractionary effects of a reduction, or the expansionary effects of an increase, in “legal tender” or base money are more likely to arise in the real world from changes in the demand for base money than in the supply of base money. Such spontaneous fluctuations in the demand for base money, even if quantitatively small, may have large real effects.

[W]henever the prevailing rate of profit deviates from the rate of interest charged on loans the discrepancy between them at once tends to be enlarged. If trade is for the moment stable and the market rate of interest is equal to the profit rate, and if we suppose that by any cause the profit rate is slightly increased, there will be an increased demand for loans at the existing market rate. But this increased demand for loans leads to an increase in the aggregate amount of purchasing power, which in turn still further increases the profit rate. This process will continue with ever accelerated force until the bankers intervene to save their reserves by raising the rate of interest up to and above the now enhanced profit rate. A parallel phenomenon occurs when the profit rate, through some chance cause, drops below the market rate; the consequent curtailment of loans and so of purchasing power leads at once to a greater and growing fall in profits, until the bankers intervene by reducing the rate of interest. It appears, therefore, that the equilibrium which the bankers have to maintain in fixing the rate of interest is essentially “unstable,” in the sense that if the rate of interest deviates from its proper value by any amount, however small, the deviation will tend to grow greater and greater until steps are taken to correct it. This of itself shows that the money market must be subject to fluctuations. A flag in a steady breeze could theoretically remain in equilibrium if it were spread out perfectly flat in the exact direction of the breeze. But it can be shown mathematically that that position is “unstable,” that if the flag deviates from it to any extent, however small, it will tend to deviate further. Consequently the flag flaps. (pp. 76–77)

In addition to fluctuations in the demand for money, Hawtrey considered another class of monetary disturbances: the inability of debtors to repay their obligations to creditors because they have incorrectly forecast the future.

Credit money is composed of the obligations of bankers, and if a banker cannot meet his obligations the credit money dependent upon him is wholly or partly destroyed. Again, against his obligations the banker holds equivalent assets, together with a margin. These assets are composed chiefly of two items, legal tender currency and loans to traders. The solvency of the banker will depend largely on the reality of these assets, and the value of the loans will depend in turn on the solvency of the borrowers. (p. 77)

Thus, the solvency of borrowers hinges on whether their expectations of the future will be realized. But those expectations may ultimately be disappointed, in which case the solvency of those holding the liabilities of the borrowers may be threatened or impaired.

The whole value of the manufacturer’s efforts in producing the goods depends upon there being an effective demand for them when they are completed. It is only because the dealer anticipates that this effective demand for them will be forthcoming that he gives the manufacturer the order. The dealer, in fact, is taking the responsibility of saying how £10,000 worth of the productive capacity of the country shall be employed. The manufacturer, in accepting the order, and the banker in discounting the bill, are both endorsing the opinion of the dealer. The whole transaction is based ultimately on an expectation of a future demand, which must be more or less speculative….

Now if a contraction of credit money occurs, the consequent slackening of demand, and fall in the prices of commodities, will lead to a widespread disappointment of dealers’ expectations. At such a time the weakest dealers are likely to be impaired. An individual or company in starting a manufacturing business would usually add to the capital they can provide themselves, further sums borrowed in the form of debentures secured on the business and yielding a fixed rate of interest…. But when the general level of prices is falling, the value of the entire business will be falling also, while the debenture and other liabilities, being expressed in money, will remain unchanged…. [D]uring this period of falling prices, the expenses of production resist the downward tendency, and the profits are temporarily diminished and may be entirely obliterated or turned into an actual loss. A weak business cannot bear the strain, and being unable to pay its debenture interest and having no further assets on which to borrow, it will fail. If it is not reconstructed but ceases operations altogether, that will of course contribute to the general diminution of output. Its inability to meet its engagements will at the same time inflict loss on the banks. But at present we are considering credit, and credit depends on the expectation of future solvency. A business which is believed to be weak will have difficulty in borrowing, because bankers fear that it may fail. At a time of contracting trade the probability of any given business failing will be increased. At the same time the probability of any particular venture for which it may desire to borrow resulting in a loss instead of a profit will likewise be increased. Consequently at such a time credit will be impaired, but this will be the consequence, not the cause of the contracting trade. (pp. 78–80)

The solvency of the banker, in turn, depends on the solvency of those businesses to which it has extended credit. An overly optimistic anticipation of future demand must therefore inevitably impair the solvency of the banks.

We have already seen that the banker’s estimate of the proper proportion of his reserve to his liabilities is almost entirely empirical, and that an arbitrary change in the proportion which he thinks fit to maintain between them will carry with it an increase or decrease, as the case may be, in the available amount of purchasing power in the community. If a banker really underestimates the proper amount of reserve, and does not correct his estimate, he may find himself at a moment of strain with his reserve rapidly melting away and no prospect of the process coming to an end before the reserve is exhausted. His natural remedy is to borrow from other banks; but this he can only do if they believe his position to be sound. If they will not lend, he must try to curtail his loans. But if has been lending imprudently, he will find that on his refusing to renew loans the borrowers will in some cases become bankrupt and his money will be lost. It is just when a banker has been lending imprudently that his fellow-bankers will refuse to lend to him, and thus the same mistake cuts him off simultaneously from the two possible remedies. (pp. 81–82)

But the failure of one bank may have wider repercussions, affecting the solvency of other banks as well.

When a bank fails, there is a cancellation of the whole amount of purchasing power represented by the loans outstanding at the moment of failure. The people who have borrowed from the defunct bank must either borrow from the surviving banks to pay the loans back as they fall due, or they must find the money by economizing their expenditures. The surviving banks cannot increase the aggregate of their loans without any increase in their reserves, and they must take steps to protect their reserves by raising the rate of interest…. In short, the aggregate of bankers’ loans having been excessive in comparison with the aggregate of legal tender currency, the former aggregate is diminished as soon as a catastrophe gives practical demonstration of the necessity of such a step. (p. 82)

In a later chapter, Hawtrey returns to the subject of financial crises, providing a detailed discussion of the dynamics of a financial crisis, focusing attention on the banks’ advances to dealers in stocks on the stock exchange. New investments in fixed capital, according to Hawtrey, are financed largely out of the pro-cyclical savings of the wealthy. The demand for new investment projects by businesses is also pro-cyclical, depending on the profits expected by businesses when considering the installation of new capital assets, the profit expectations, in turn, depending on current effective demand.

The financing for new long-term investment projects is largely channeled to existing businesses through what Hawtrey calls the investment market, the most important element of which is the stock exchange. The stock exchange functions efficiently only because of specialists whose business it is to hold inventories of various stocks, being prepared to buy those stocks from those wishing to sell them or sell the stocks to those wishing to buy them, at prices that seem at any moment to be market-clearing, i.e., at prices that keep buy and sell orders in rough balance. The specialists, like other traders and middlemen, finance their holdings of inventories by borrowing from banks, using the proceeds from purchases and sales—corresponding to the bid-ask spread—to repay their indebtedness to the banks. Unlike commercial traders and merchants, the turnover of whose inventories is relatively predictable with little chance of large price swings, and who can obtain short-term financing for a fixed term, stock dealers hold inventories that are not very predictable in their price and turnover and therefore can obtain financing only on a day-to-day basis, or “at call.” The securities held by the stock dealer serve as collateral for the loan, and banks require the dealer to hold securities with a value exceeding some minimum percentage (margin) of the dealer’s indebtedness to the bank.

New investment financed by the issue of stock must ultimately be purchased by savers seeking profitable investment opportunities into which they commit their savings. Existing firms may sometimes finance new projects by issuing new stock, but more often they issue debt or retained earnings to finance investment. Debt financing can be obtained by issuing bonds or preferred stock, or by borrowing from banks. New issues of stock must be underwritten and marketed through middlemen expecting to earn a return on their underwriting or marketing function who must have financing resources sufficient to bear the risk of holding a large stock of securities until they are sold to the public.

Now at a time of expanding trade and growing inflation, when there is a general expectation of high profits and at the same time there is a flood of savings seeking investment, an underwriter’s business yields a good profit at very little risk. But at the critical moment when the banks are compelled to intervene to reduce the inflation this is changed….. (pp. 210–211)

[O]f all the borrowers from the banks those who borrow for the purposes of the investment market are the most liable to failure when the period of good trade comes to an end. And as it happens, it is they who are most at the mercy of the banks in times of trouble. For it is their habit to borrow from day to day, and the banks, since they cannot call in loans to traders which will only mature after several weeks or months, are apt to try to reduce an excess of credit money by refusing to lend from day to day. If that happens, the investment market will suddenly have to find the money which the banks want. The total amount of ready money in the hands of the whole investment market will probably be quite small, and, except in so far as they can persuade the banks to wait (in consideration probably of a high rate of interest), they must raise money by selling securities. But there are limits to the amount that can be raised in this way. The demand for investments is very inelastic. The money offered at any time is ordinarily simply the amount of accumulated savings of the community till then uninvested. This total can only be added to by people investing sums which they would otherwise leave as part of their working balances of money, and they cannot be induced to increase their investments very much in this way, however low the price in proportion to the yield of the securities offered. Consequently when the banks curtail the accommodation which they give to the investment market and the investment market tries to raise money by selling securities, the prices of securities may fall heavily without attracting much additional money. Meanwhile the general fall in the prices of securities will undermine the position of the entire investment market, since the value of the assets held against their liabilities to the banks will be depreciated. If the banks insist on payment in such circumstances a multitude of failures on the Stock Exchange and in the investment market must follow. The knowledge of this will deter the banks from making the last turn of the screw if they can help it. But it may be that the banks themselves are acting under dire necessity. If they have let the creation of credit get beyond their control, if they are on the point of running short of the legal tender money necessary to meet the daily demands upon them, they must have no alternative but to insist on payment. When the collapse comes it is not unlikely that some of the banks themselves will be dragged down by it. A bank which has suffered heavy losses may be unable any longer to show an excess of assets over liabilities, and if subjected to heavy demands may be unable to borrow to meet them.

The calling in of loans from the investment market enables the banks to reduce the excess of credit money rapidly. The failure of one or more banks, by annihilating the credit money based upon their demand liabilities, hastens the process still more. A crisis therefore has the effect of bringing a trade depression into being with striking suddenness….

It should not escape attention that even in a financial crisis, which is ordinarily regarded as simply a “collapse of credit,” credit only plays a secondary part. The shortage of savings, which curtails the demand for investments, and the excess of credit money, which leads the banks to call in loans, are causes at least as prominent as the impairment of credit. And the impairment of credit itself is not a mere capricious loss of confidence, but is a revised estimate of the profits of commercial enterprises in general, which is based on the palpable facts of the market. The wholesale depreciation of securities at such a time is not due to a vague “distrust” but partly to the plain fact that the money values of the assets which they represent are falling and partly to forced sales necessitated by the sudden demand for money…. [T]he crisis dos not originate in distrust. Loss of credit in fact is only a symptom. (pp. 212–215)

A more astute and more incisive analysis of the forces creating the frightening downward spiral of the 2008 financial crisis than the generic description of what happens in a crisis provided by Hawtrey nearly a century earlier could not easily be found. The penetrating insightfulness of Hawtrey’s description is especially important to take note of inasmuch as Hawtrey, while recognizing that financial crises can play an important role in amplifying the severity of a business-cycle downturn, did not accept that any financial crisis can be understood apart from the context of a cyclical process of which it is but an acute manifestation.

5 The Price-Specie-Flow Mechanism

In Chapter 9 of Good and Bad Trade, Hawtrey reached what he regarded as the culmination of his theoretical account of the determination of prices, incomes, and exchange rates under a system of national fiat currencies, by then positing that those currencies were all to become convertible into a fixed weight of gold.

After providing a detailed and painstaking account of the process of international adjustment in response to a loss of gold in one country, explaining how the loss of gold would cause interest rates to rise in the country losing gold, thus inducing other countries to lend to the country experiencing losing gold, Hawtrey traced out the repercussions of the disturbance on exchange rates within the limits set by gold import and export points, reflecting the cost of transporting gold and on domestic price levels of the countries experiencing gold flows. Here is how Hawtrey summarized his analysis:

Gold flows from foreign countries to the area of stringency in response to the high rate of interest, more quickly from the nearer and more slowly from the more distant countries. While this process is at work the rates of interests in foreign countries are raised, more in the nearer and less in the more distant countries. As soon as the bankers’ loans have been brought into the proper proportion to the stock of gold, the rate of interest reverts to the profit rate in the area of stringency, but the influx of gold continues from each foreign country until the average level of prices there has so far fallen that its divergence from the average level of prices in the area of stringency is no longer great enough to cover the cost of sending the gold.

So long as any country is actually exporting gold the rate of interest will there be maintained somewhat above the profit rate, so as to diminish the total amount of bankers’ loans pari passu with the stock of gold.

At the time when the export of gold ceases from any foreign country the rate of exchange in that country on the area of stringency is at the export specie point; and the exchange will remain at this point indefinitely unless some new influence arises to disturb the equilibrium. In fact, the whole economic system will, in the absence of such influence, revert to the stable conditions from which it started. (p. 113)

In subsequent writings, Hawtrey modified his account of the adjustment process in an important respect. I have not identified the first instance in which Hawtrey revised his account of the adjustment process, but, almost twenty years after Good and Bad Trade, Hawtrey (1932), Hawtrey explained with exceptional clarity what was wrong with the account of the international adjustment mechanism presented in the earlier work. In the course of an extended historical discussion of how the Bank of England had used its lending rate as an instrument of policy in the nineteenth and early twentieth centuries (a discussion later expanded upon in Hawtrey (1938), Hawtrey quoted the following passage from the First Interim Report of the Cunliffe First Interim Report Committee (1918, paragraphs 4–5) describing the operation of the prewar gold standard. The passage explains how, under the gold standard, the Bank of England, confronting an outflow of gold reserves, could restore an international equilibrium by raising Bank Rate. The explanation in the Cunliffe Report employs the same reasoning embodied in the above quotation from Good and Bad Trade.

The raising of the discount rate had the immediate effect of retaining money here which would otherwise have been remitted abroad, and of attracting remittances from abroad to take advantage of the higher rate, thus checking the outflow of gold and even reversing the stream.

If the adverse conditions of the exchanges was due not merely to seasonal fluctuations but to circumstances tending to create a permanently adverse trade balance, it is obvious that the procedure above described would not have been sufficient. It would have resulted in the creation of a volume of short-dated indebtedness to foreign countries, which would have been in the end disastrous to our credit and the position of London as the financial center of the world. But the raising of the Bank’s discount rate and the steps taken to make it effective in the market necessarily led to a general rise of interest rates and a restriction of credit. New enterprises were therefore postponed, and the demand for constructional materials and other capital goods was lessened. The consequent slackening of employment also diminished the demand for consumable goods, while holders of stocks of commodities carried largely with borrowed money, being confronted with an increase in interest charges, if not with actual difficulty in renewing loans, and with the prospect of falling prices, tended to press their goods on a weak market. The result was a decline in general prices in the home market which, by checking imports and stimulating exports, corrected the adverse trade balance which was the primary cause of the difficulty. (Interim Report of the Cunliffe Committee, sects. 10.4-10.5)

Acknowledging that the Cunliffe Report did in some sense reflect the orthodox view of how variations in Bank Rate achieved an international adjustment, Hawtrey took strong issue with the version of the adjustment process outlined in the Cunliffe Report.

This passage expresses very fairly the principle on which the Bank of England had been regulating credit from 1866 to 1914. They embody the art of central banking as it was understood in the half-century preceding the war. In view of the experience which has been obtained, the progress made in theory and the changes which have occurred since 1914, the principles of the art require reconsideration at the present day.

The Cunliffe Committee’s version of the effect of Bank rate upon the trade balance was based on exactly the same Ricardian theory of foreign trade as Horsely Palmer’s. It depended on adjustments of the price level. But the revolutionary changes in the means of communication during the past hundred years have unified markets to such a degree that for any of the commodities which enter regularly into international trade there is practically a single world market and a single world price. That does not mean absolutely identical prices for the same commodity at different places, but prices differing only by the cost of transport from exporting to the importing centers. Local divergences of prices form this standard are small and casual, and are speedily eliminated so long as markets work freely.

In Ricardo’s day, relatively considerable differences of price were possible between distant centers. The merchant could never have up-to-date information at one place of the price quotations at another. When he heard that the price of a commodity at a distant place had been relatively high weeks or months before, he was taking a risk in shipping a cargo thither, because the market might have changed for the worse before the cargo arrived. Under such conditions, it might well be that a substantial difference of price level was required to attract goods from one country to another.

Nevertheless it was fallacious to explain the adjustment wholly in terms of the price level. There was, even at that time, an approximation to a world price. When the difference of price level attracted goods from one country to another, the effect was to diminish the difference of price level, and probably after an interval to eliminate it altogether (apart from cost of transport). When that occurred, the importing country was suffering an adverse balance, not on account of an excess price level, but on account of an excess demand at the world price level. Whether there be a difference of price level or not, it is this difference of demand that is the fundamental factor.

In Horsely Palmer‘s day the accepted theory was that the rate of discount affected the price level because it affected the amount of note issue and therefore the quantity of currency. That did not mean that the whole doctrine depended on the quantity theory of money. All that had to be assumed was that an expansion or contraction of the currency so far tended to cause a rise or fall of the prices could be secured by an appropriate expansion or contraction of the currency. That is a very different thing from saying that the rise or fall of the price level would be exactly proportional to the expansion or contraction of the currency.

But it is not really necessary to introduce the quantity of currency into the analysis at all. What governs demand in any community is the consumers’ income (the total of all incomes expressed in terms of money) and consumers’ outlay (the total of all disbursements out of income, including investment).¹³ (pp. 144–145)

Hawtrey’s rejection of the PSFM, which he still accepted in Good and Bad Trade, is perhaps the only significant theoretical point on which he revised the views articulated in the first of his many publications.

6 Conclusion

Hawtrey was not the first economist to offer a monetary theory of the business cycle. In presenting his own version of a monetary theory of the trade cycle in an abstract, theoretical, and deductive exposition, with no citations to the earlier literature, other than two references to Irving Fisher, Hawtrey may have actually made his work appear less original than it was. In reviewing Good and Bad Trade, A. C. Pigou, loyal disciple of Marshall and staunch adherent of Marshallian doctrines, praised Hawtrey’s systematic and logical development of the material, while finding little novelty in the volume, and chided Hawtrey for not acknowledging earlier works, presumably those of Marshall and his students, in which, Pigou suggested, Hawtrey’s ideas had already been stated. Greater care in citing earlier contributions would have allowed Hawtrey to demonstrate the numerous points of originality in his work. But, over a century after its publication, it is not hard to recognize and admire the full extent of Hawtrey’s contribution in his first publication in economics.