Chronicle of a Deflation Unforetold

Questions & answers

Q1. What was the actual mechanism of French monetary policy in this period that makes it usable as a natural experiment?

Unlike coins since the nineteenth century, the gold and silver coins circulating in 1720s France bore no indication of their value in the unit of account (the livre tournois); that value was set by government decree and could be, and was, changed overnight – for example, on the morning of September 22, 1724, “every man in France woke up with 20% fewer units of account in his pocket.” This single decree was one of a sequence of reductions that cumulated to roughly a 45-50% cut in the nominal value of the money stock over a few months in 1724 (Introduction; Conclusion), giving Velde an unusually clean, exact, and instantaneous change in the nominal money supply to study, even though the underlying currency was commodity money rather than fiat.

Q2. Why does the paper treat the foreign exchange market as the key identification device, and what does it show?

The foreign exchange market is the one market the paper shows adjusted immediately and completely to the diminutions, because no-arbitrage “mint points” (derived from the mint price and mint equivalent of silver and gold) place tight, mechanically-implied bounds on the livres-tournois price of foreign currency, and market exchange-rate quotes on London and Hamburg are shown tracking those bounds closely through each change in coin value (Quantitative evidence, Figs. 2-3). Because this adjustment is governed by arbitrage rather than by any price-setting or contracting friction, it establishes that the nominal shock itself was real and fully transmitted to at least one market, which makes the slow, partial adjustment documented elsewhere in the paper a genuine nominal rigidity rather than a measurement artifact.

Q3. How did prices of manufactured goods and industrial wages respond, in contrast to the exchange rate?

Prices of manufactured goods and industrial wages fell only slowly, over many months, and not by the full amount of the nominal reduction, drawing on archival factory prices, cloth-hall prices, fair prices, and wage reports gathered by government cloth inspectors and intendants across multiple French regions (Quantitative evidence, e.g. Table 6). The paper’s own cloth-price tables show, for instance, factory prices for a basket of cloths rising about 70% from 1716-17 to January 1724 (as the money stock had been progressively increased) and then falling only 13-14% from January to April 1724 and a further 13-14% from April to October 1724 – far short of the contemporaneous cuts to the unit of account – while price declines at different fairs and cloth-halls over 1724-25 likewise lagged well behind the nominal reduction.

Q4. What happened to real wages, interest rates, and grain prices, and why is that significant?

Real wages rose, at least initially, and interest rates on commercial paper rose and peaked around mid-1726 – evidence the paper reads as a “credit crunch,” consistent with contemporary reports of scarce money – while even grain markets, among the most competitive markets imaginable, failed to adjust immediately (Conclusion; Quantitative evidence on fairs and interest rates). The paper notes that the fairs’ own interest-rate reports corroborate contemporaries’ talk of a “scarcity of money,” and that an ill-timed reduction in the legal usury ceiling around the same time may have compounded the credit tightening.

Q5. What happened to industrial output, and how is it measured?

The industrial sector – proxied by manufacturing of woolen cloths, using activity indices built from the regular reports of government cloth inspectors – went into a contraction of about 30%, and the paper notes the onset of the downturn may have predated the start of the deflationary policy itself, though contemporaries widely linked the two (Conclusion; Quantitative evidence). When the government later reversed course and raised the nominal money supply overnight by about 20%, prices responded more readily than they had to the earlier cuts, and the woolen industry rebounded – a second natural experiment, in the opposite direction, that the paper treats as corroborating evidence for the first.

Q6. What role did expectations of future policy changes play in explaining the slow price adjustment?

The paper documents extensive contemporary evidence that market participants’ expectations of further diminutions (or of a reversal/augmentation) shaped behavior well before – and independently of – the actual decrees: inspectors’ reports describe farmers and grain merchants holding inventories rather than selling in anticipation of diminutions, traders rushing to buy goods for cash ahead of expected cuts, and merchants holding off on price cuts in expectation of an augmentation of coinage that would let them raise prices again. The French government itself explicitly worried about this channel, going so far as to make the spreading of rumors of future diminutions a punishable offense (October 1724) and to interrogate intendants about the sources of such rumors – direct evidence, in the paper’s reading, that policymakers at the time understood expectations were interfering with the intended price adjustment.

Q7. How did the French government try to force prices down once the deflation did not occur as expected, and how effective were these efforts?

Having ruled out direct price controls on necessities as too dangerous, the government relied mainly on “moral suasion” – instructing intendants to pressure producers, merchants, and traders sequentially along the supply chain to lower prices to a pre-1720 benchmark – escalating over time to threats, secret “sting” bargaining operations to identify noncompliant merchants, and aggressive tax collection timed to force farmers to sell inventories; the one significant exception was a brief, narrowly targeted episode of explicit price-setting for a handful of named high-end woolen manufacturers (Vanrobais, Julienne, Pagnon, Rousseau) in Paris in 1724 and again in 1725. The intendant of Bourges’s own bewildered complaint – that despite coin values having nearly doubled in nominal terms, “everyone is so accustomed to sell dearly that no one can bring themselves to lower their prices” – is cited as representative of the government’s frustration that moral suasion alone proved unable to produce the intended, fuller price adjustment.

Q8. What does the paper conclude about the relationship between the commodity-money regime and the slow price adjustment observed?

The paper’s own conclusion is that, because one effect of the policy – the overnight reduction in the nominal money supply – was exact and instantaneous regardless of the commodity-money regime, and because the only market (foreign exchange) that adjusted fully and immediately did so precisely because of mechanical no-arbitrage bounds rather than any feature specific to commodity money, the slow and partial adjustment of goods prices and wages elsewhere in the economy reflects genuine nominal price and wage rigidities rather than a peculiarity of operating under a gold/silver standard. The paper notes this bears on a broader claim in the literature (citing Alogoskoufis and Smith 1991; Bordo 1995) that inflation behaves very differently, in particular much less persistently, under commodity standards than under fiat money – a claim this episode’s evidence does not support for the adjustment of goods and labor markets, even though it fully supports instantaneous adjustment in the frictionless foreign-exchange market.