Published January 28, 2000
The LBMC Report
My original plan, several months ago, was to do homage before the 20th century ended to the French economist Jacques Rueff, by nominating him as the “rightest” political economist of the century. I had to rethink that plan after the Royal Swedish Academy of Sciences awarded the Nobel Prize for Economics to Robert A. Mundell in October. It would have seemed strange to honor the dead before the living, so I devoted December’s LBMC Report to Mundell (“Nobel Prize-Winner Robert A. Mundell: An Appreciation,” 29 December 1999). I also realized that there was no need to shoehorn Rueff into the last days of the 20th century. Jacques Rueff wasn’t the most famous or the most influential economist of his time; John Maynard Keynes walks away with both those awards. But Rueff’s ideas about economic policy will easily make the transition to the 21st century, whereas Keynes’s will not.
I should explain that Rueff has had a profound influence on our financial markets forecasting firm, Lehrman Bell Mueller Cannon, Inc. Our senior partner, Lewis Lehrman, knew Rueff well, and the Lehrman Institute published Rueff’s complete works in his native France. Our use of the “World Dollar Base” is one of many LBMC analytical tools that were inspired by Rueff’s work. But my nomination of Rueff has a more objective basis. Rueff was both a theorist and a successful practitioner of economic policy, who gave the earliest accurate diagnosis of the two biggest economic policy problems of the 20th Century: unemployment and inflation. He used that diagnosis to engineer several successful reforms of national economic policy, and his analysis is just as valid today as when developed in the 1920s. Rueff also contributed to the philosophy of the “social market economy” and of the European Union. He succeeded in explaining the critical link between economics as a science and economic policy as a branch of moral or political philosophy, the importance of which is increasingly evident in economic policy debates.
Theorist of Theory
Born in 1896, the son of a physician, Jacques Rueff was trained in science and mathematics at the Ecole Polytechnique. His attention was turned from the study of medicine when he studied classical economics under Clement Colson, and was especially influenced by the mathematical general-equilibrium theory of Leon Walras.
We are now accustomed to thinking of economics as a mathematical science. But early in the 20th century this was the exception, not the rule. In fact, it was widely believed that economics could never be an exact science. Rueff accordingly devoted his first theoretical work, From the Physical to the Moral Sciences (1922), to methodology, showing that exactly the same scientific method can be applied to “moral” or “social” sciences like economics, as to the physical sciences.
The objection was typically raised that methods applied, say, to the theory of thermodynamics cannot be applied to the study of human beings endowed with free will. Rueff replied that just as there is no thermodynamics for a single molecule, there is no economics for an individual. The acts of individuals — individual particles in physics or free human beings in social sciences — are essentially “indeterminate”; yet in both cases, the pattern of behavior of a large number of individuals can be explained and predicted as a matter of statistical probability. The greater precision commonly observed in natural sciences is simply a function of sample size: while human beings in a national economy are typically counted in the millions (multiples of 10^6) or at most billions (multiples of 10^9), molecules are measured in moles (multiples of 6 x 10^23).
Also, Rueff said, in both cases theories or “models” are not so much the discovery as the logical “creation” of causes to fit empirical facts. A theory should be logically consistent, and thus true given its premises. But if an existing theory fails to explain the facts, a different theory must be created. In economics no less than physics, as Rueff later wrote, “A scientific theory is considered correct only if it makes forecasting possible.” Rueff taught the statistics of political economy at the newly established Statistical Institute of the University of Paris, and later joined a handful of like-minded economists like Ragnar Frisk in founding the International Econometric Society with its journal Econometrica.
Rueff was selected in 1923 as an “inspector of finance” — a competitive position unique to France, which gives a few relatively young men supervisory power over the many government agencies associated with the Ministry of Finance. While in this post, he embarked upon a series of path breaking studies combining economic theory with statistical evidence along the lines he had outlined. The subjects of these studies were not only hot topics at the time, but also highlighted what would become the main economic policy problems of the 20th century.
The ‘Transfer Problem’
His first study, “Exchange: a Natural Phenomenon” (1922), concerned fluctuations in exchange rates — a striking postwar event for populations used to the stability of the gold standard. Rueff described the principle of “purchasing power parity” and showed the conditions under which any divergences in purchasing power of different currencies must lead to restoration of equilibrium in the balance of payments. The study brought Rueff to the notice of French officials, since it had immediate implications for the question of German reparations, which preoccupied international relations throughout the 1920s and early 1930s. It also led Rueff later to debate John Maynard Keynes — who had not yet published the General Theory, or even the Treatise on Money — on what became known as the “transfer problem.”
Keynes argued that German reparations were in themselves destabilizing, on the grounds that a country has a certain “natural” balance of trade, which limits the amount of financial transfers it is able to make. Rueff argued (as did the Swedish economist Bertil Ohiin) that the amount of an international transfer is limited only by the ability of a country’s government to finance the necessary taxes or loans through its budget — in short, the price mechanism will cause the trade balance to adjust to accommodate the capital transfer, not the reverse. Rueff showed that, when France had been forced to pay sizeable reparations to Prussia after the Franco-Prussian war of 1870, the financial transfer induced the necessary large surplus in the French trade balance, enabling the reparations to be paid without difficulty.
Economists today recognize that Rueff and Ohlin were essentially correct, and Keynes incorrect on this issue. Yet English-speaking economists did not recognize the implications of this truth until the 1960s, when economists like Robert Mundell (1999 winner of the Nobel Prize) and Harry Johnson pioneered the “monetary approach to the balance of payments.”
In Towards a Theory of Inflation” (January 1925), Rueff examined the hyperinflations in France, Italy, Germany, Poland and Austria during World War I and the early Twenties. Rueff showed that in each case the main cause was the issue of money by the central bank to finance government budget deficits —and that if the “real” or inflation-adjusted amount of money is to remain relatively constant, prices will tend to rise exponentially. This preceded Phillip Cagan’s “classic” studies of hyperinflation by 30 years, but like many of Rueff’s works is little known because it was not published in English.
Rueff’s Law of Unemployment
In ‘Variations in Unemployment in England” (December 1925) Rueff was the first to show empirically that the reason for the unprecedented appearance of chronic high unemployment in England in the 1920s was a rise in the relative price of labor, as measured by the ratio of wage rates to the wholesale price index. He traced its cause to the institution after World War I of an open-ended “dole,” which was fixed in nominal terms (that is, so many shillings a week), in the face of postwar decline in the price level — a deflation that was required by Britain’s return to the pound’s prewar gold value. Rueff’s study first appeared in a French academic journal, and was described in the Financial Times in 1926, but caused a sensation when an updated version appeared in the London Times in 1931 as British unemployment rose again sharply. Later researchers, following Rueff’s lead, found a similar strong relationship between the relative price of labor and unemployment — which became known as “Rueff’s Law” — in the other industrial countries in Europe through the 1920s and 1930s. Keynes’s General Theory implicitly depends on Rueff’s Law, plus the assumption that wage rates are fixed in nominal but not real terms.
Interestingly, Rueff’s original study was published six months before Irving Fisher published what would later be called a “Phillips Curve” explanation of unemployment. Whereas Rueff explained joblessness as a function of the relative price of labor. Fisher explained unemployment as a function of the rate of price inflation. (A.W. Phillips was a British economist who rediscovered an apparent inflation/unemployment trade-off in the late 1950s.) The Phillips Curve relationship broke down when the Bretton Woods system exploded in 1971. But I have shown that Rueff’s Law, suitably updated, has held up empirically. (The necessary updating takes advantage of the greater detail of national income data now available, and takes into account taxes and transfer payments — which are no longer small enough to be ignored — when measuring the relative price of labor. For a recent illustration, see ‘Welfare Reform Lowered Unemployment,” LBMC Report, July 23, 1999.)
These striking studies brought Rueff to the attention of French policymakers. When foreign minister Raymond Poincare became French premier in 1926, he commissioned Rueff to determine the level at which the French franc should be stabilized. Like many conservative politicians, Poincare was intent upon a return to the prewar gold parity of the currency, as Britain had done, though this was against the advice of Charles Rist and Pierre Quesnay, the deputy governors of the Bank of France. But Poincare was ultimately persuaded, for fear of causing unemployment, to refix the gold value of the franc at only one-fifth the prewar parity. This was the level Rueff had chosen, the highest which would not require a deflation of prices, thereby causing unemployment. The Poincare reform was a rousing success: the currency was stabilized and the economy boomed, without inflation or unemployment, as capital flowed back to France. Moreover, many features of Poincare’s stabilization package were drawn from another Rueff paper, The Conditions of Sound Finance” (April 1925).
In 1927, Rueff published his Theory of Monetary Phenomena, which sketched an alternate macroeconomic approach to the monetarism of Irving Fisher or what would later become Keynesian theory. Rueff examined Fisher’s “equation of exchange,” MV = PT, which says that the nominal volume of transactions (PT) is equal to the quantity of money times its “velocity of circulation” (MV). Rueff pointed out that, while formally true, the equation doesn’t say anything about causality: it merely means that the amount of payments made in an economy is equal to the amount of payments received. The United States had to re-learn this fact by bitter experience when the Federal Reserve treated it as a causal relation and used it to conduct monetary policy from 1979 to 1982.
In the same work, Rueff employed and explained the concepts of “total demand” and “total supply” a decade before Keynes’s General Theory; but his ideas never suffered the drawbacks of Keynesian theory. For better or worse, Keynes revolutionized the way economists think about the economy. One of the worse parts was that Keynes assumed a closed national economy, and implicitly assumed rigidity of wages and prices. And , in shifting the emphasis from the behavior of individuals to the behavior of aggregates — aggregate demand, aggregate supply, monetary aggregates, and the like — Keynes’s macroeconomic theory also lost any consistent microeconomic foundations.
Rueff’s theory was also comprehensive, but his economic aggregates were built up consistently from individual households and firms, and he was always explicit about the fact that economic relations among nations do not differ in kind from economic relations among national regions or among individual firms or households. In fact, the essence of his disagreement with Keynes, with whom he often debated, was precisely over the ability of markets to adjust when not hindered from doing so bylaw or regulation.
(An earlier LBMC Report, “The Rueffian Synthesis,” June/July 1991, considered Rueff’s economic ideas and their relation to Keynesian, monetarist and “supply-side” theory in more detail. The report is available on request.)
This output would be enough for most economists. But one reason Rueff’s theories are extraordinarily applicable in the real world is that he grappled for most of his life with the day-to-day problems of economic policy. (In fact, the increasing demands of these duties soon did away with the leisure necessary for empirical studies. He continued to develop his theories, but had to be content with expressing the hope that other researchers would prove them empirically.)
From 1927 to 1930, Rueff was assigned to the new League of Nations, where he worked as a “currency doctor” to devise economic programs, based on the principles he had worked out, for countries like Greece, Bulgaria and Portugal. Where they were applied, all were successful.
“Reserve Currency” Disaster
In 1929 Rueff was attached to the League’s Gold Committee, which studied the problems facing the international monetary system. In his report, “Abnormal Fluctuations in the Purchasing Power of Gold,” Rueff called attention for the first time to the threat posed by the “gold-exchange standard.” Rueff warned that, whereas the consequences of typical economic policy mistakes were confined to the country that made them, the nature of the “reserve-currency” system was to transmit inflation or deflation on a worldwide scale.
From 1930 to 1933, Rueff served as French financial attache in London, where he was in charge of the Bank of France’s sterling reserves, and was able to analyze and correctly warn about the deflationary collapse of the gold-exchange standard.
The “hardening” of European currencies in the course of the 1920s soon revealed the flaw in the international monetary system as it had evolved since the First World War. The gold values of the dollar and the pound sterling had been re-established at the prewar parities; but the general price levels in terms of those currencies had increased substantially because of wartime monetary expansion. Ultimately one of two things had to happen: either the gold parities would have to be changed to match the price level, or else prices in terms of those currencies would be subject to an eventual deflation back to the prewar level.
Instead of facing the choice squarely, policymakers at the 1922 Genoa conference recommended making up for the resulting “scarcity” of gold by supplementing the undervalued gold reserves with foreign exchange reserves — securities denominated in pounds or dollars, which were convertible into gold. The effect was greatly to increase the leverage of the world financial system.
The collapse against which Rueff had warned began when, after Nazi political gains caused a capital flight from Germany, an international panel of experts led by the United States effectively imposed exchange controls on capital invested in Germany. The immobilization of investments in Germany triggered the liquidation of assets elsewhere by creditors who needed to service their own debts. In the process, numerous banks failed, and almost all the world’s dollar and sterling exchange reserves were liquidated. The problem was intensified when industrial countries sought to protect themselves with trade and capital controls. The pound floated in 1931 and the dollar in 1933 — but by that time, prices in dollar terms had deflated back to pre-World War I levels. The resulting social disruptions hastened the rise of totalitarian governments of the right and left.
From 1934 to 1939, Rueff supervised France’s international payments (since international payments were now generally blocked, they were subject to negotiation), and served as director of the Finance Ministry’s exchange stabilization fund, which controlled France’s official monetary reserves.
In 1939 he was named deputy governor of the Bank of France, and promptly charged with preparing for wartime exchange control. “But I’ve always been hostile to that institution, knowing the danger that it entails,” Rueff objected. That’s exactly why I’m asking you to direct the creation of an office of exchange controls,” Bank of France governor Pierre Fournier replied, “because I know they will rapidly become necessary, and I expect that you will apply the indispensable moderation.”
Rueff resigned the central bank post in 1941, after the German invasion (and after trying to keep France’s gold reserves out of German hands). He spent the war as an inspector of finance, and writing his greatest work, l’Ordre Social. As regions of France were liberated, he undertook to re-establish the functioning of a rudimentary system of payments. From France’s liberation in 1944, Rueff served as economic adviser to the Allied military mission for German and Austrian affairs until 1952.
Rueff co-operated with and promoted the ideas of like-minded German economists, such as Ludwig Erhard and Wilhelm Roepke, who developed Germany’s “social market economy,” the basis for the postwar Germam Wirtschaftswunder, or “economic miracle.”
“Neo-liberalism,” or the “Institutional Market”
Rueff, Erhard, Roepke and others sometimes called themselves “neo-liberals” or “social liberals” to distinguish their political philosophy from 19th-century classical liberalism. Unlike many American libertarians of today, they understood that economic freedom doesn’t happen spontaneously: it requires lots of hard work. Rueff also used the term “institutional market” to describe the approach. (He considered the United States the pre-eminent example of the “institutional market.”)
“If the institutional market distinguishes itself from the ‘Manchesterian’ market — not in its goals, but rather in its techniques — it’s because it rests on a totally different view of the evolution of human societies,” Rueff once explained. “For classical liberals liberty is, for man, the state of nature. ‘Man is born free, yet is everywhere in chains,’ Rousseau complained two centuries ago. If one wished to restore this lost liberty, it was not necessary to do anything, only to remove the shackles.
“For the neo-liberal, on the contrary, liberty is the fruit, painstakingly obtained and always threatened, of an evolution of institutions, founded on milennia of sad experience and on religious, moral, political and social interventions. Against Rousseau, he thinks that the great majority of men are born in chains, from which only the development of institutions can free them, and then only partially.
“Liberals [that is, libertarians] and neo-liberals share a common faith in the benefits of liberty. But the former expect a spontaneous generation, with which it is merely necessary not to interfere; whereas the latter want to help it be born, to grow and develop, by rendering it acceptable and avoiding those encroachments which constantly tend to annihilate it.”
This was not, for Rueff, merely an attitude. The main point of L’Ordre Social is to trace explicitly the juridical framework and economic theory of the price mechanism and the economic policy techniques upon which economic freedom and a liberal social order depend. Rueff had originally envisioned a second volume of monetary theory. But when finally published in 1945, it had broadened into a general outline of economic society, with a theory of economic policy and an analysis of different monetary, fiscal and regulatory policy regimes. The themes had become so sweeping, I think, because in the 1930s and 1940s European civilization had come to the brink, and the most immediate task was to rebuild it.
European Economic Union
Rueff was an early champion of European economic union. In April 1929, recognizing Europe’s 20,000 km of toll barriers as an obstacle to economic development, Rueff had recommended to France’s foreign minister, Aristide Briand, an “economic pact” among the nations of Europe to achieve “a common market in the whole of their territories, a market in which people, merchandise and capital would flow freely.” Briand, a Socialist politician and Nobel Peace Prize winner who had championed the League of Nations, expanded Rueff’s idea into a proposal, in December 1929, for a “United States of Europe.” But after the monetary collapse started, Europe was to go in a very different direction.
After the war, the European Common Market began more modestly and gradually, as the. European Coal and Steel Community, later the European Economic Community, and now the European Union. Rueff was appointed in 1952 a justice of the newly formed European Economic Community’s Court of Justice, and in that role he contributed to establishing its body of legal precedents until 1962. This was an unusual position for a non-jurist, but one at which he excelled. From 1962 to 1974, Rueff served on the European Community Economic and Social Affairs Council.
De Gaulle’s “Rueff Plan”
From the late 1940s, Rueff outlined plans to put the basket-case French republic, which was crippled by the combination of inflation and the continuation of wartime rationing and price controls, onto a sound financial footing. But he was given the chance to implement them only when Charles de Gaulle came to power in 1958. Despite the unanimous opposition of his cabinet, de Gaulle adopted the entire Rueff plan, which required sweeping measures to balance the budget and make the franc convertible after 17.5% devaluation — though not without qualms. “All your recommendations are excellent,” de Gaulle told Rueff. ‘But if I apply them all and nothing happens, have you considered how much real pain it will cause across this country?” Rueff replied, “I give you my word, mon General, that the plan, if completely adopted, will re-establish equilibrium in our balance of payments within a few weeks. Of this I am absolutely sure; I accept that your opinion of me will depend entirely on the result.” (It did: ten years later, de Gaulle awarded Rueff the medal of the Legion of Honor.) There was about the project something coherent and ardent, at once bold and ambitious, which strongly appealed to my judgement,” de Gaulle recounted in his memoirs.
The Rueff plan worked: while unemployment remained at one percent, the economy accelerated sharply without a pickup of inflation. (However, bureaucratic inertia squelched a subsequent Rueff plan in 1959, consisting of dozens of “supply-side” measures to “remove obstacles to economic development,” such as World War I-vintage rent controls.)
More than French politics and policy was at stake. Success of the plan was necessary to fulfill the terms of the Treaty of Rome which had established the EEC, requiring the external convertibility of European currencies.
After the success of the Rueff Plan, Rueff was increasingly drawn to outline the problems of the postwar Bretton Woods monetary system. The reserve-currency problem became increasingly urgent starting at the end of the 1950s. Exactly as had happened in the 1920s, once the European currencies were stabilized and exchange controls ended, what had been viewed as an insoluble international “dollar shortage” suddenly turned into a perennial “dollar glut” that steadily drained U.S. gold reserves. Rueff shared with Robert Triffm, a Belgian economist, the distinction of diagnosing the Bretton Woods system as the cause of creeping international inflation and accurately predicting its breakdown. But they disagreed about the solution. Rueff sought a return to an international gold standard, getting rid of reserve currencies, and advocated a “Marshall Plan for the United States” funded by doubling the gold price: a reform that would have prevented the world-wide inflation of the 1970s and 1980s. Triffin championed Keynes’ 1943 plan for a paper currency loosely linked to gold, issued by a world central bank. In the end, the question was decided by the United States, where Keynesian and monetarist economists, who agreed on little else, favored the move to floating exchange rates.
During the 1960s, Rueff published a number of works applying his theories to problems of French and European economic policy and to the Bretton Woods monetary system. Those translated into English include The Age of Inflation, The Monetary Sin of the West, and Balance of Payments. One of his last works was The Gods and the Kings, a meditation on the relation between sciences and society, which returned to the themes of his first work. His very last. The Creation of the World, even put these themes in the form of a drama. Rueff was made a member of the Academic Francaise, succeeding Jean Cocteau. He died in 1978.
What would Rueff have to say if he were alive today? At the end of the 20th Century, all major industrial countries and most “emerging” economies seem largely to have licked the problem of chronic domestically-generated inflation. To do so, they have had to reject the Keynesian approach of inflationary finance of budget deficits and adopt a “Rueffian” policy. For example, in order to join the European Monetary Union, the countries of Europe have had to change the statutes governing their central banks to end inflationary finance of government deficits.
But the problem of chronic unemployment in Europe has not been solved. The cause is the influence of poorly designed transfer payment programs and other labor market rigidities that keep the cost of labor above the level consistent with full employment. Its solution requires reform of transfer payment programs that have elevated the cost of hiring — reforms like America’s welfare reform of the 1990s.
Nor have the problems caused by the use of international “reserve currencies” gone away. That was the essence of the “Asian crisis” of 1997-98. (See “A Layman’s Guide to the Asian Bubble Trouble,” LBMC Report, January 22, 1998; also “Asia’s Hot Money: Created with Dollar Reserves,” LBMC Report, May 27, 1999.) The international monetary system remains an accident always waiting to happen.
Finally, after the collapse of socialism, the politics of economic policy in most Western countries, including the United States, seems to offer no choice but a vapid libertarianism and a more vapid Third Way” mush. I think Rueff would be filling this void.
In a culture where people are famous for being famous, we are used to hearing celebrities pontificate about subjects outside their expertise. And so it is with economists and economic policy. To understand economic policy you have to grasp economic theory, but that’s not enough. Many a brilliant economist is sloppy — or even a raving loony — in his political philosophy. What Rueff grasped, as few other economists have done, is that in order to make good economic policy it is necessary to master both disciplines.
We badly need the penetrating philosophical and economic analysis, the optimistic belief in the persuasive power of reason, and the willingness to undertake large projects (and bring them to fruition), that Rueff provided. In that sense, Rueff’s career not only illuminated the economic struggles of the 20th century; his ideas remain, in my opinion, the most promising hope for the 21st.