The ECB Targets 1752 (Part 1)

(New Gold Supra-Theory Salon des Refusés - Post 1)

The year 1752, that is. In 1752 David Hume published his paper “On the balance of trade” presenting his theory about international trade known as the ‘price>specie>flow mechanism’. I have a theory to share with you about the ECB Eurosystem.

My theory is that Hume’s mechanism and the insights of the classical economists guided the Euro founding fathers’ in the design of two of the ECB’s most important currency management systems.
 

The two systems I’m referring to are the index called HICP and TARGET2. The ECB uses HICP to assess its performance in maintaining an average annual inflation rate of two (2) per cent. TARGET2 is the system that facilitates the flow of money around the Eurozone. Hume’s mechanism is usually discussed in terms of international trade but it is equally applicable to regional trade. This post is about trade and other flows within the Eurozone.

Confining the discussion to one currency zone while we explore this mechanism enables us to ignore some of the complications that need to be addressed in looking at international trade between currency zones. So when I rework part two of the series on gold and international trade settlement I’ll concentrate on trade settlement between currency zones and let this post try to explain the mechanism itself.

The main source I am drawing on for this post is a very dense, scholarly book published in 1937 called “Studies in the Theory of International Trade”. The writer was a Professor of Economics at the University of Chicago named Jacob Viner (Here’s a link to his bio.) In this book he discusses the work of the classical economists on international free trade theory as well as the many debates they were involved in.

Here is some background information for readers who are unfamiliar with this mechanism. I style this mechanism as prices+>money>flow. The expression ‘prices+’ is meant to convey that there are more factors involved than prices alone. Jacob Viner discusses factors such as real costs, relative demand, velocity, comparative advantage and so on. I replaced ‘specie’ with ‘money’ because this mechanism works with other types of money – not just gold “specie” coins.

For this mechanism to deliver its benefits you simply need to have the right conditions which are: (a) The countries trading with each other must share a common currency; and (b) Minimal friction in the flow of goods and money. In other words free trade and no capital controls or trade barriers to interfere with the flows. The common currency could be like the Euro – a currency union - but there are other ways to achieve the right conditions. If two trading partners both accept gold specie as money (as they did in Hume’s proof) then they are in one currency zone.

Now I need to emphasise a couple of important factoids about this mechanism. It comes from thinkers who viewed trade as a human welfare issue. To them trade was intrinsically a goods-for-goods and exports-for-imports exercise not a goods-for-money exercise. (Wherever I use the word ‘goods’ please read that as ‘goods and services’.) So we’ll leave the exploration of the goods-for-money perspective for the trade settlement series as well.

Hume’s mechanism didn’t increase overall trade between countries and regions. It enabled the mix of the most-demanded-goods available in each country to change. A flow of money was followed by a flow of exports from Country A into its trading partner Country B. This temporarily increased the money supply in Country B but the increased diversity of goods available to the citizens of Country B would endure.

In David Ricardo’s words (as quoted by Viner) this resulted in an increase in the “mass of commodities” and an increase in the “sum of enjoyments.” Ricardo also noted that people could increase their monetary savings instead if they didn’t want to avail themselves of, say, cheaper goods by increasing their consumption. Over time the prices+>money>flow mechanism rebalances the volume of money in each country until the next trade disruption.

A closely related theory of the classical economists about free trade was that it would tend to equalize the prices of the goods that were traded. Arbitrage and competition would reduce price differentials to weed out profit premiums and prices would more closely reflect actual cost differences for transport, relative demand and so on.

In the second, final part of this post (with Professor Viner’s help) we’ll try to connect the dots between TARGET2, HICP and the prices+>money>flow mechanism.