I hope that I can write this quickly just so people won’t think that I’ve disappeared. I’ve been a bit under the weather this week, and the post that I’ve been working on needs more attention and it’s not going to be ready for a few more days. But the good news, from my perspective at any rate, is that Scott Sumner, as he has done so often in the past, has come through for me by giving me something to write about. In his most recent post at his second home on Econlog, Scott writes the following:
I recently did a post pointing out that higher interest rates don’t reduce AD. Indeed even higher interest rates caused by a decrease in the money supply don’t reduce AD. Rather the higher rates raise velocity, but that effect is more than offset by the decrease in the money supply.
Of course that’s not the way Keynesians typically look at things. They believe that higher interest rates actually cause AD to decrease. Except under the gold standard. Back in 1988 Robert Barsky and Larry Summers wrote a paper showing that higher interest rates were expansionary when the dollar was pegged to gold. Now in fairness, many Keynesians understand that higher interest rates are often associated with higher levels of AD. But Barsky and Summers showed that the higher rates actually caused AD to increase. Higher nominal rates increase the opportunity cost of holding gold. This reduces gold demand, and thus lowers its value. Because the nominal price of gold is fixed under the gold standard, the only way for the value of gold to decrease is for the price level to increase. Thus higher interest rates boost AD and the price level. This explains the “Gibson Paradox.”
Very clever on Scott’s part, and I am sure that he will have backfooted a lot of Keynesians. There’s just one problem with Scott’s point, which is that he forgets that an increase in interest rates by the central bank under the gold standard corresponds to an increase in the demand of the central bank for gold, which, as Scott certainly knows better than almost anyone else, is deflationary. What Barsky and Summers were talking about when they were relating interest rates to the value of gold was movements in the long-term interest rate (the yield on consols), not in central-bank lending rate (the rate central banks charge for overnight or very short-dated loans to other banks). As Hawtrey showed in A Century of Bank Rate, the yield on consols was not closely correlated with Bank Rate. So not only is Scott looking at the wrong interest rate (for purposes of his argument), he is – and I don’t know how to phrase this delicately – reasoning from a price change. Ouch!
