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Advancing Austrian Economics, Liberty, and Peace

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Making Economic Sense
by Murray Rothbard
(Contents by Publication Date)

Chapter 74
Back to Fixed Exchange Rates

Hold on to your hats: the world has now embarked on yet another "new economic order"--which means another disaster in the making. Ever since the abandonment of the "classical" gold-coin standard in World War I (by the United States in 1933), world authorities have been searching for a way to replace the peaceful world rule of gold by the coordinated, coercive rule of the world's governments.

They have searched for a way to replace the sound money of gold by an internationally coordinated inflation which would provide cheap money, abundant increases in the money supply, increasing government expenditures, and prices that do not rise too wildly or too far out of control, and with no embarrassing monetary crises or excessive declines in any one country's currency. In short, governments have tried to square the circle, or, to have their pleasant inflationary cake without "eating" it by suffering decidedly unpleasant consequences.

The first new economic order of the 20th century was the New Era dominated by Great Britain, in which the world's countries were induced to ground their currencies on a phony gold standard, actually based on the British pound sterling, which was in turn loosely based on the dollar and gold. When this recipe for internationally coordinated inflation collapsed and helped create the Great Depression of the 1930s, a new and very similar international order was constructed at Bretton Woods in 1944. In this case, another phony gold standard was created, this time with all currencies based on the U.S. dollar, in turn supposedly redeemable, not in gold coin to the public, but in gold bullion to foreign central banks and governments at $35 an ounce.

In the late 1920s, governments of the various nations could inflate their currencies by pyramiding on top of an inflating pound; similarly in the Bretton Woods system, the U.S. exported its own inflation by encouraging other countries to inflate on top of their expanding accumulation of dollar reserves. As world currencies, and especially the dollar, kept inflating, it became evident that gold was undervalued and dollars overvalued at the old $35 par, so that Western European countries, reluctant to continue inflationary policies, began to demand gold for their accumulated dollars (in short, Gresham's Law, that money overvalued by the government will drive undervalued money out of circulation, came into effect). Since the U.S. was not able to redeem its gold obligations, President Nixon went off the Bretton Woods standard, which had come to its inevitable demise, in 1971. 

Since that date, or rather since 1933, the world has had a fluctuating fiat standard, that is, exchange rates of currencies have fluctuated in accordance with supply and demand on the market. There are grave problems with fluctuating exchange rates, largely because of the abandonment of one world money (i.e. gold) and the shift to international barter. Because there is no world money, every nation is free to inflate its own currency at will--and hence to suffer a decline in its exchange rates. And because there is no longer a world money, unpredictably fluctuating uncertain exchange rates create a double uncertainty on top of the usual price system--creating, in effect, multi-price systems in the world.

The inflation and volatility under the fluctuating exchange rate regime has caused politicians and economists to try to resurrect a system of fixed exchange rates--but this time, without even the element of the gold standard that marked the Bretton Woods era. But without a world gold money, this means that nations are fixing exchange rates arbitrarily, without reference to supply and demand, and on the alleged superior wisdom of economists and politicians as to what exchange rates should be.

Politicians are pressured by conflicting import and export interests, and economists have made the grave error of mistaking a long-run tendency (of exchange rates on a fluctuating market to rest at the proportion of purchasing- powers of the various currencies) for a criterion by which economists can correct the market. This attempt to place economists above the market overlooks the fact that the market properly sets exchange rates on the basis, not only of purchasing power proportions, but also expectations of the future, differences in interest rates, differences in tax policy, fears of future inflation or confiscation, etc. Once again, the market proves wiser than economists.

This new coordinated attempt to fix exchange rates is a hysterical reaction against the high dollar. The Group of Seven nations (the U.S., Britain, France, Italy, West Germany, Japan, and Canada) helped drive down the value of the dollar, and then, in their wisdom, in February 1987, decided that the dollar was now somehow at a perfect rate, and coordinated their efforts to keep the dollar from falling further.

In reality, the dollar was high until early 1986 because foreigners had been unusually willing to invest in dollars--purchasing  government bonds as well as other assets. While this happy situation continued, they were willing to finance Americans in buying cheap imports. After early 1987, this unusual willingness disappeared, and the dollar began to fall in order to equilibrate the U.S. balance of payments. Artificially propping up the dollar in 1987 has led the other countries of the Group of Seven to purchase billions of dollars with their own currencies--a shortsighted effort which cannot last forever, especially because West Germany and Japan have fortunately not been willing to inflate their own currencies and lower their interest rates further, to divert capital from themselves toward the U.S.

Instead of realizing that this coordination game is headed toward inevitable crisis and collapse, Secretary of Treasury James Baker, the creator of the new system, proposes to press ahead to a more formal New Order. In his September speech to the IMF and World Bank, Secretary Baker proposed a formal, coordinated regime of fixed exchange rates, in which--as a sop to public sentiment for gold--gold is to have an extremely shadowy, almost absurd, role. In the course of fine tuning the world economy, the central banks and treasuries of the world, in addition to looking at various "indicators" on their control panels--price levels, interest rates, GNP, unemployment rates, etc.--will also be consulting a new commodity price index of their own making which, by secret formula, would also include gold.

Such a ludicrous substitute for genuine gold money will certainly fool no one, and is an almost laughable example of the love of central bankers and treasury officials for secrecy and mystification for its own sake, so as to bewilder and bamboozle the public. I do not often agree with J.K. Galbraith, but he is certainly on the mark when he calls this new secret index a "marvelous exercise in fantasy and obfuscation."

Politically, the secret index embodies a ruling alliance within the Reagan Administration between such conservative Keynesians as Secretary Baker and such supply-siders as Professor Robert Mundell and Congressman Jack Kemp (who have both hailed the scheme as a glorious step in the right direction). The supply-siders have long desired the restoration of a Bretton Woods-type system that would allow coordinated cheap money and inflation worldwide, coupled with a phony gold standard as camouflage, so as to build unjustified confidence in the new scheme among the pro-gold public.

The conservative Keynesians have long desired a new Bretton Woods, based eventually on a new world paper unit issued by a World Central Bank. Hence the new alliance. The alliance was made politically possible by the disappearance from the Reagan Administration of the Friedmanite monetarists, such as former Undersecretary of Treasury for Monetary Policy Beryl W. Sprinkel and Jerry Jordan, spokesmen for fluctuating exchange rates. With monetarism discredited by the repeated failures of their monetary predictions over the last several years, the route was cleared for a new international, fixed-rates system.

Unfortunately, the only thing worse than fluctuating exchange rates is fixed exchange rates based on fiat money and international coordination. Before rates were allowed to fluctuate, and after the end of Bretton Woods, the U.S. government tried such an order, in the international Smithsonian Agreement of December 1971. President Nixon hailed this agreement as "the greatest monetary agreement in the history of the world." This exercise in international coordination lasted no more than a year and a half, foundering on monetary crises brought about by Gresham's Law from overvaluation of the dollar.

How long will it take this new, New Order, along with its puerile secret index, to collapse as well?

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