Mr DeLong writes: “For Keynes, the underlying problem was a failure of the economy’s credit channels.” And he offers this explanation:



"A few years later, Keynes proposed a fix to the problem. In The General Theory of Employment, Interest, and Money, Keynes explained how booms are created when “investments which will in fact yield, say, 2% in conditions of full employment are made in the expectation of a yield of, say, 6% and are valued accordingly.” In a recession, the problem is flipped. Investments that would yield 2% are “expected to yield less than nothing.”



Mr. Delong, apparently believes that the alternative hypothesis about the causes of business cycles was some sort *deus ex machina of inevitability*, and writes:



“For many economists, recessions are an inevitable part of the business cycle – the bust that necessarily follows, like a hangover, from any boom. John Maynard Keynes, however, had little time for this view.”



First a bit of history, an (or perhaps the) alternative hypothesis of a monetary cause of business cycles appears to have been part of the discussions since the economic depression of 1893. That depression also caused thousands of banks and businesses to fail, many thousands of workers lost their jobs, and foreign investors withdrew their capital from America. Conservatives, pejoratively referred to as ‘gold bugs’ argued that staying on a disciplinary financial course, which was ensured by adhering to the “rules of the game” under gold standard would ensure a speedy recovery. ‘Silverites’, in contrast, maintained that the value of the dollar was too high because of shortage of base money and adding a ‘silver standard’ would increase the money supply and stimulates growth. President McKinley, the nominee from the Republican Party, a supporter of financial discipline won the election of 1896, and just few months after his election there were business reports suggesting that aggregate demand had improved greatly, stimulating investment, and leading to the hiring of the unemployed workers. A kind of global financial balance led to the increased prosperity of Europeans which used the new wealth to rearm themselves.



To be able to finance their war efforts during the WWI, the United States and Europeans suspended the gold standard discipline. After the war, the United States that had emerged as the strongest industrial nation at the end of the nineteenth century was not directly affected by the Versailles conference disastrous economic decisions. So in 1920, she returned to the pure gold standard and the Federal Reserve imposed a severe monetary contraction. Britain as well as all European countries also wanted to restore the gold standard regime. France returned to the gold standard because of the very favourable terms she obtained in the Versailles conference. Germans could not join the gold club because they had no gold left to back their Marks.



As for British, the Cunliffe Committee which was established to make recommendation for the development of the economy reported in 1918 that

"it is imperative that after the war, the conditions necessary for the maintenance of an effective gold standard should be restored without delay." (Cunliffe, 1918).

Keynes was a member of that Committee but his dissension led to Cunliffe calling for his resignation, arguing that:

“Mr. Keynes, in commercial circles,” ...is... “not considered to have any knowledge or experience in practical exchange or business problems”



Thus British, that were determined to restore the prewar gold parity, had to wait for price deflation and sterling appreciation, and while they waited, the formal embargo of exports on gold protected the Bank of England's gold reserve. On December 11, 1923, Keynes thus responded in his A Tract on Monetary Reform



"In truth, the gold standard is already a barbarous relic. All of us, from the Governor of the Bank of England downwards, are now primarily interested in preserving the stability of business, prices, and employment, and are not likely, when the choice is forced on us, deliberately to sacrifice these to the outworn dogma, which had its value once, of £3 17s ½d per ounce. Advocates of the ancient standard do not observe how remote it now is from the spirit and the requirements of the age. A regulated non-metallic standard has slipped in unnoticed. It exists. Whilst the economists dozed, the academic dream of a hundred years, doffing its cap and gown, clad in paper rags, has crept into the real world by means of bad fairies – always so much more potent than the good – the wicked ministers of finance. (CW IV, pp 137–8)"



In April 1925, the Chancellor of Exchequer, Winston Churchill, restored the sterling to the gold standard at its pre-war exchange rate of $4.86. According to Churchill:



"A return to an effective gold standard has long been the settled and declared policy of this country. Every Expert Conference since the War—Brussels, Genoa—every expert Committee in this country, airs urged the principle of a return to the gold standard. No responsible authority has advocated any other policy. No British Government—and every party has held office—no political party, no previous holder of the Office of Chancellor of the Exchequer has challenged, or so far as I am aware is now challenging, the principle of a reversion to the gold standard in international affairs at the earliest possible moment. It has always been taken as a matter of course that we should return to it, and the only questions open have been the difficult and the very delicate questions of how and when."



Keynes was flabbergasted about Churchill’s decision, writing:



"Why did he do such a silly thing? Partly, perhaps, because he has no instinctive judgment to prevent him from making mistakes; partly because, lacking this instinctive judgment, he was deafened by the clamorous voices of conventional finance; and, most of all, because he was gravely misled by his experts. (Keynes, 1925)"



Of course. I am not advocating a return to gold standard. But, given today’s global financial imbalances the world desperately needs a new and powerful global financial order. The main cause of the successive, exhibiting explosive dynamics, of recent years is a glaring lack of financial discipline. As David Hume argued some centuries ago, the role of gold was to ‘annihilate’ the money disequilibrium in response to global shifts in supply and demand. Take the case of country like Germany where she is running a trade surplus – buying less goods and services than it is selling to the rest of the world. Under the gold standard, this will lead to increased German gold reserves and an expansion of her money supply, leading to a rise in her unit labour cost level compared to the rest of the world, which will improve the competitiveness of the rest of the world and eradicate German trade surplus, (in fact markets would ensure an efficient execution of all the three remedies that Ben Bernanke has recently suggested for restoring German financial balance).

