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The Price-Specie Flow Mechanism

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Published : January 30th, 2022
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Now we move on to the third paper in The Gold Standard, Retrospect and Prospect, which is called: “Price-Specie-Flow Mechanism and the Monetary Approach to the Balance of Payments As Theories of International Adjustment.” It is by Kwabena Boateng and Joshua Hendrickson.

January 23, 2022: The Gold Standard: Retrospect and Prospect

There is hardly anything dumber in all of economics than the claimed “price-specie flow mechanism,” so any paper that kicks sand in the face of this stupidity gets a thumbs up from me.

March 19, 2016: The “Price-Specie Flow Mechanism”
July 18, 2016: The “Price-Specie Flow Mechanism” #2: Let’s Kill It For Good
January 16, 2016: David Hume, “On the Balance of Trade,” 1752

In the first paper of the book, George Selgin gives a nice short explanation of how things really worked:

In truth, the world’s most successful international monetary arrangement appears to have worked automatically, with deliberate planning playing an even more minor part in its operation than it had played in its emergence. The institutional setup consisted, first of all, of nothing other than the sum of national gold standard arrangements: there was nothing in it akin to the International Monetary Fund or Special Drawing Rights or other such centralized and bureaucratic facilities. Indeed, as T. E. Gregory (1935: 7-8) observes, “The only intelligible meaning to be assigned to the phrase ‘the international gold standard’ is the simultaneous presence, in a group of countries, of arrangements by which, in each of them, gold is convertible at a fixed rate into the local currency and the local currency into gold, and by which gold movements from any one of these areas to any of the others are freely permitted by all of them.” The most notable achievements of the classical gold standard — including its tendency to keep international exchange rates from fluctuating beyond very narrow bounds and, thereby, encourage the growth of international trade and investment — appear to have required nothing more, in other words, than a resolve on the part of the involved countries to keep their own gold standards in working order.

In other words, a bank operating a gold standard currency merely needs to keep the value of its banknotes in line with the gold parity. This is basically accomplished, in the simplest case, with the gold conversion mechanism. When the value of banknotes is below the gold parity (at $35 for example), so that it takes $36 to buy an ounce of gold, then the bank (or central bank) selling gold at $35 is the cheapest seller of gold. People buy gold from the bank, giving banknotes (or other base money) in return. The money supply shrinks by a corresponding amount. When the demand for “money” is high, and thus the value of the currency rises beyond its parity such that it takes only $34 to buy an ounce of gold, then the bank offering to buy gold at $35 becomes the highest bidder. Everyone sells their gold to the bank, and takes newly-created money in return. The money supply expands. This is true of a monopoly central bank, such as the Federal Reserve or the Bank of England, and it is also true of the hundreds of smaller banknote-issuing banks common in the United States before 1913. Since Selgin has a good grasp of free-banking principles, he would naturally understand this.

You can see from this short explanation why Selgin calls this system “automatic.” There is no council of Wise Men deciding what to do every six weeks. Also, you can see that it doesn’t have anything to do with trade, and not much to do with international gold flows. General prices (such as the CPI) don’t go up and down.

Note from this explanation that central banks generally do not transact directly with each other. They might do this, but even when they do, the end effect is much the same as if they made all transactions with the private market. Let’s take, as an example, a currency-board system based on the British pound, Central Bank A, that decides that it will take 50% of its reserves (all British government bonds) and convert it to gold. (France basically did this in 1928-1932.) What happens next? Central Bank A sells the bonds on the open market, and receives a payment in return. This payment consists of a bank account balance typically at a London-based bank, Commercial Bank B, just as would be the case for any bond investor. Note that Central Bank A does not transact with the Bank of England directly. British government bonds are not a liability of the Bank of England, they are a liability of the British government. The Bank of England is under no obligation whatsoever to accept British government bonds for any reason. So far, nothing has happened that is any different from any investor selling government bonds on the open market. Now, Central Bank A takes its bank account at Commercial Bank B, and buys gold from the Bank of England, which has an open offer to sell gold at 3L 17s 10d per ounce. Commercial Bank B must then pay the Bank of England for this gold, using its bank reserves at the Bank of England. Base money contracts, and Currency Board A gets its gold. This is really no different from anyone buying gold, for example a British jewelry maker that also had an account at Commercial Bank B.

Now what happens? Commercial Bank B now has low reserves, because it used a lot of reserves to pay the Bank of England. Maybe the whole banking system is low on reserves, because base money has contracted. The British pound rises a bit. Now, the Bank of England becomes the highest bidder for gold, and automatically buys gold on the open market. In this process, it replenishes its gold bullion reserves. Or, there are many other potential outcomes, but the basic result is more or less the same. Note that in this scenario, Central Bank A decided to transact with the Bank of England. But, it could transact with anyone selling gold. Probably, they would just take the offer with the lowest price. So, the only reason to transact with the Bank of England would be if the Bank was the lowest seller; in other words, because the pound was a little weak compared to its parity. But even if Central Bank A was being ornery, and bought gold from the Bank of England even though it could get a better deal elsewhere, things would work out fine according to the automatic processes described above.

This is how USD-based currency boards work today. It is also how stablecoins like Tether work. It is actually how a wide variety of financial instruments work, including money market funds, mutual funds and ETFs.

June 30, 2019: A Rosetta Stone of “Stablethings”

It is how gold-linked stablecoins like Tether Gold work today.

I wrote a whole book about the details of this process, which was Gold: The Monetary Polaris.

A gold bullion ETF, like GLD, is not much different than a gold standard currency.

January 3, 2010: The GLD Standard

In Gold: The Final Standard, I took a little time to trash “price-specie flow mechanism” notions, in particular quoting Bank of Italy researcher Filippo Cesarano:

The intricate debate that has run on for two-and-a-half centuries is the product of an erroneous interpretation … In Hume’s essay, the law of one price is not violated and in fact is the foundation of his analysis.

Cesarano wrote a whole paper debunking this nonsense, which was “Hume’s specie-flow mechanism and classical monetary theory: An alternative interpretation,” which you can read here.

He also had some good comments about it in Monetary Theory and Bretton Woods: The Construction of an International Monetary Order (2006). In that book, he called the “price-specie flow mechanism” a “myth that in no way reflects how the gold standard actually worked.”

Another writer who set aside a long time to destroy this stupid notion was Giulio Gallarotti, in The Anatomy of an International Monetary Regime: The Classical Gold Standard, 1880-1914 (1995).

Unfortunately, the authors of this paper have not, in my opinion, quite embraced or understood what I have laid out above. They go with the “Monetary Approach to the Balance of Payments,” which was a 1970s-era step outside the insane focus on the “balance of payments” common in the 1960s. It was a kind of halfway-house, with some good ideas, but still clouded with error.

The authors state that some aspects of the MABP basically coincide with what I just described above:

The natural distribution of money refers to the idea that central bank (or the banking systems under competitive note issuance) portfolio choices determine the distribution of money across countries. This implies that, when the demand for money increases faster than the domestic money supply, international reserves [gold and foreign exchange] will increase. Gold will flow into the country. When the domestic money supply increases faster than money demand, international reserves will decumulate and gold will flow out.

p. 79

This is a crude description of the process I just described above, with gold conversion at (for example) $35/oz. Actually, gold doesn’t “flow into the country,” it “flows” into central bank vaults. This doesn’t happen by magic fairies in the middle of the night, or because of “trade,” but because someone at the central bank bought the gold, in accordance with the central bank’s gold conversion policy. Or, someone at the central bank might want to change the reserve holdings, for example, selling $1B of government bonds and buying $1B of gold. These are “portfolio choices.”

There is a lot of silly math and complicated explanation that goes along with the MABP, but you can see the basic problems just in the title. This is the “balance of payments.” As you can see from my short explanation above, the operation of any fixed-value currency, such as a gold standard currency, a euro currency board, or Tether, is a simple automatic process related to the supply and demand of the currency, and its resulting market value compared to its parity target. It doesn’t have anything to do with trade, or the “balance of payments.” This is most obvious in the case of the US’s decentralized system, with 1000+ banknote issuing banks. How are you going to argue that the operations of the Bank of Dry Gulch, Montana has something to do with the overall trade statistics for the whole United States? Today, how would you argue that competing gold stablecoin cryptocurrencies, such as Tether Gold and Coro Global, which are used all over the world by the way, have something to do with US trade statistics? Or, you could say the same about competing USD stablecoins including Tether USD, USD Coin and Binance USD. The people actually running these companies today would think you are bonkers talking about trade statistics.

So, although we should definitely discard the “price-specie flow mechanism,” we should also discard the “monetary approach to the balance of payments,” keeping of course the sections that are correct.

One of the better economists of the twentieth century, who understood these things pretty well, was Edwin Walter Kemmerer.

April 15, 2017: Gold and the Gold Standard: The Story of Gold Money, Past, Present and Future, by Edwin Walter Kemmerer

Kemmerer actually set up several functioning gold standard systems, between about 1900 and 1930, mostly in Latin America which was transitioning away from silver coinage. If you read his book, he explains that the process is not really much different than, for example, Tether Gold today. (Actually, he mostly worked with “gold exchange standards,” or currencies linked to major international gold-linked currencies such as the US dollar or British pound. So, it was more like USDT Tether.)

We today are going to have to understand these things at least as well as Edwin Walter Kemmerer in the 1940s, which is not hard because you can just read his book.

Along the way, toss out the “Monetary Approach to the Balance of Payments,” which is just a historical artifact of a time when very confused people became a little less confused. It serves no useful purpose today.

The authors in the paper make some odd connections between the MABP approach and the “Thompson, Glasner, and Sumner” “interpretation” of the Great Depression. I looked into those theories, and found that they didn’t amount to anything.

October 2, 2016: The Interwar Period
August 25, 2016: The Interwar Period #2: It’s Not That Complicated

July 23, 2017: The Midas Paradox (2015), by Scott Sumner
July 31, 2017: The Midas Paradox #2: Blame Gold
August 3, 2017: The Midas Paradox #3: It’s So Because I Say It Is
August 11, 2017: The Midas Paradox #4: Much Ado About Nothing
August 18, 2017: The Midas Paradox #5: It’s Getting Uncomfortable In The Prices, Interest, Money Box

February 25, 2018: David Glasner Cheers for Hawtrey And Cassel
March 11, 2018: Larry White and David Glasner on: “Should We Restore the Gold Standard?”

November 6, 2016: Robert Mundell’s Interpretation of the Interwar Period
November 13, 2016: Robert Mundell’s Interpretation of the Interwar Period 2: the “Mundell-Johnson Hypothesis”


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Nathan Lewis was formerly the chief international economist of a firm that provided investment research for institutions. He now works for an asset management company based in New York. Lewis has written for the Financial Times, Asian Wall Street Journal, Japan Times, Pravda, and other publications. He has appeared on financial television in the United States, Japan, and the Middle East.
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