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III. INFLATION AND CREDIT EXPANSION

1. Inflation

INFLATIONISM IS THAT POLICY which by increasing the quantity of money or credit seeks to raise money prices and money wages or seeks to counteract a decline of money prices and money wages which threatens as the result of an increase in the supply of consumers’ goods.

    In order to understand the economic significance of inflationism we have to refer to a fundamental law of monetary theory. This law says: The service which money renders to the economic community is independent of the amount of money. Whether the absolute amount of money in a closed economic system is large or small does not matter. In the long run the purchasing power of the monetary unit will establish itself at the point at which the demand for money will equal the quantity of money. The fact that each individual would like to have more money should not deceive us. Everybody wants to be richer, to have more goods, and he expresses it by saying he wants more money But were he to receive additional money, he would spend it by increasing his consumption, or by increasing his investments; he would in the long run neither increase his ready cash at all, nor increase it significantly compared with the increase in his supply of goods and services. Furthermore, the satisfaction which he derives from the receipt of additional money will depend on his receiving a larger share of the additional money than others and on receiving it earlier than others. An inhabitant of Berlin, who in 1914 would have been jubilant upon receiving an unexpected legacy of 1,000 marks, did not think an amount of 1,000,000,000 marks worth his attention in the fall of 1923.

    If we disregard the function of money as a standard of deferred payments, that is, the fact that there are obligations and claims expressed in fixed amounts of money maturing in the future, we easily recognize that it does not matter for a closed economy whether its total quantity of money is x million money units or 100 x million money units. In the latter case prices and wages will simply be expressed in larger quantities of the monetary unit.

    What the advocates of inflation desire and the proponents of sound money oppose is not the ultimate result of inflation, namely, the increase of the money quantity itself, but rather the effects of the process by which the additional money enters the economic system and gradually changes prices and wages. The social consequences of inflation are twofold: (1) the meaning of all deferred payments is altered to the advantage of the debtors and to the disadvantage of the creditors, or (2) the price changes do not occur simultaneously nor to the same extent for all individual commodities and services. Therefore, as long as the inflation has not exerted its full effects on prices and wages there are groups in the community which gain, and groups which lose. Those gain who are in a position to sell the goods and services they are offering at higher prices, while they are still paying the old low prices for the goods and services they are buying. On the other hand, those lose who have to pay higher prices, while still receiving lower prices for their own products and services. If, for instance, the government increases the quantity of money in order to pay for armaments, the entrepreneurs and workers of the munitions industries will be the first to realize inflationary gains. Other groups will suffer from the rising prices until the prices for their products and services go up as well. It is on this time-lag between the changes in the prices of various commodities and services that the import-discouraging and export-promoting effect of the lowering of the purchasing power of the domestic money is based.

    Because the effects which the inflationists seek by inflation are of a temporary nature only, there can never be enough inflation from the inflationist point of view. Once the quantity of money ceases to increase, the groups who were reaping gains during the inflation lose their privileged position. They may keep the gains they realized during the inflation but they cannot make any further gains. The gradual rise of the prices of goods which they previously were buying at comparatively low prices now impairs their position because as sellers they cannot expect prices to rise further. The clamor for inflation will therefore persist.

    But on the other hand inflation cannot continue indefinitely. As soon as the public realizes that the government does not intend to stop inflation, that the quantity of money will continue to increase with no end in sight, and that consequently the money prices of all goods and services will continue to soar with no possibility of stopping them, everybody will tend to buy as much as possible and to keep his ready cash at a minimum. The keeping of cash under such conditions involves not only the costs usually called interest, but also considerable losses due to the decrease in the money’s purchasing power. The advantages of holding cash must be bought at sacrifices which appear so high that everybody restricts more and more his ready cash. During the great inflations of World War I, this development was termed “a flight to commodities” and the “crack-up boom.” The monetary system is then bound to collapse; a panic ensues; it ends in a complete devaluation of money Barter is substituted or a new kind of money is resorted to. Examples are the Continental Currency in 1781, the French Assignats in 1796, and the German Mark in 1923.

    Many false arguments are used to defend inflationism. Least harmful is the claim that a moderate inflation does not do much harm. This has to be admitted. A small dose of poison is less pernicious than a large one. But this is no justification for administering the poison in the first place.

    It is claimed that in times of a grave emergency the use of means may be justified which in normal times would not be considered. But who is to decide whether the emergency is grave enough to warrant the application of dangerous measures? Every government and every political party in power is inclined to regard the difficulties it has to cope with as quite extraordinary and to conclude that any means for combatting them is justified. The drug addict, who says he will abstain from tomorrow on, will never conquer the drug habit. We have to adopt a sound policy today, not tomorrow.

    It is frequently asserted that an inflation is impossible as long as there are unemployed workers and idle machines. This, too, is a dangerous error. If, in the course of an inflation, money wages first remain unchanged and consequently real wages fall, more workers can be employed as long as this condition prevails. But this does not alter the other effects of inflation. Whether idle plants will resume operations depends on whether the prices of the goods they are able to produce will be among those first affected by the price rise due to inflation. If this is not the case the inflation will fail to put them back to work.

    Even worse is the error underlying the assertion that we cannot speak of inflation when the increased quantity of money corresponds to a rising output of the means of production and productive facilities. It is irrelevant as far as changes in prices and wages due to the inflation are concerned for what purposes the additional money is being spent. No matter how the means for spending are procured, the interests of a community and its citizens are better served under all conditions by building streets, houses, and plants than by destroying streets, houses, and plants. But this has nothing to do with the problem of inflation. Its effects on prices and production make themselves felt even if it is used to finance useful projects.

    Inflation, the issue of additional paper money, and credit expansion are always intentional; they are never acts of God which strike people, like an earthquake. No matter how great and how urgent a need may be, it can only be satisfied from available goods, by goods which are produced by restricting other consumption. The inflation does not produce additional goods, it determines only how much each individual citizen is to sacrifice. Like taxes or government borrowing, it is a means of financing, not a means of satisfying demand.

    It is maintained that inflation is unavoidable in times of war. This, too, is an error. An increase in the quantity of money does not create war materials—either directly or indirectly Rather we should say, if a government does not dare to disclose to the people the bill for the war expenditures and does not dare impose the restrictions on consumption which cannot be avoided, it will prefer inflation to the other two means of financing, namely taxation and borrowing. In any case, increased armaments and war must be paid for by people through restriction of other consumption. But it is politically expedient—even though fundamentally undemocratic—to tell the people that increased armaments and war create boom conditions and increase wealth. In any event, inflation is a shortsighted policy.

    Many groups welcome inflation because it harms the creditor and benefits the debtor. It is thought to be a measure for the poor and against the rich. It is surprising to what extent traditional concepts persist even under completely changed conditions. At one time, the rich were creditors, the poor for the most part were debtors. But in the time of bonds, debentures, savings banks, insurance, and social security, things are different. The rich have invested their wealth in plants, warehouses, houses, estates, and common stock and consequently are debtors more often than creditors. On the other hand, the poor-except for farmers—are more often creditors than debtors. By pursuing a policy against the creditor one injures the savings of the masses. One injures particularly the middle classes, the professional man, the endowed foundations, and the universities. Every beneficiary of social security also falls victim to an anti-creditor policy.

    It is not necessary specifically to discuss the counterpart of inflationism, namely deflationism. Deflation is unpopular for the very reason that it furthers the interests of the creditors at the expense of the debtors. No political party and no government has ever tried to make a conscious deflationary effort. The unpopularity of deflation is evidenced by the fact that inflationists constantly talk of the evils of deflation in order to give their demands for inflation and credit expansion the appearances of justification.

2. Credit Expansion

    It is a fundamental fact of human behavior that people value present goods higher than future goods. An apple available for immediate consumption is valued higher than an apple which will be available next year. And an apple which will be available in a year is in turn valued higher than an apple which will become available in five years. This difference in valuation appears in the market economy in the form of the discount, to which future goods are subject as compared to present goods. In money transactions this discount is called interest.

    Interest therefore cannot be abolished. In order to do away with interest we would have to prevent people from valuing a house, which today is habitable, more highly than a house which will not be ready for use for ten years. Interest is not peculiar to the capitalistic system only. In a socialist community too the fact will have to be considered that a loaf of bread which will not be ready for consumption for another year does not satisfy present hunger.

    Interest does not have its origin in the meeting of supply and demand of money loans in the capital market. It is rather the function of the loan market, which in business terms is called the money market (for short-term credit) and the capital market (for long-term credit), to adjust the interest rates for loans transacted in money to the difference in the valuation of present and future goods. This difference in valuation is the real source of interest. An increase in the quantity of money, no matter how large, cannot in the long run influence the rate of interest.

    No other economic law is less popular than this, that interest rates are, in the long run, independent of the quantity of money. Public opinion is reluctant to recognize interest as a market phenomenon. Interest is thought to be an evil, an obstacle to human welfare, and, therefore, it is demanded that it be eliminated or at least considerably reduced. And credit expansion is considered the proper means to bring about “easy money.”

    There is no doubt that credit expansion leads to a reduction of the interest rate in the short run. At the beginning, the additional supply of credit forces the interest rate for money loans below the point which it would have in an unmanipulated market. But it is equally clear that even the greatest expansion of credit cannot change the difference in the valuation of future and present goods. The interest rate must ultimately return to the point at which it corresponds to this difference in the valuation of goods. The description of this process of adjustment is the task of that part of economics which is called the theory of the business cycle.

    At every constellation of prices, wages, and interest rates, there are projects which will not be carried out because a calculation of their profitability shows that there is no chance for the success of such undertakings. The businessman does not have the courage to start the enterprise because his calculations convince him that he will not gain, but will lose by it.

    This unattractiveness of the project is not a consequence of money or credit conditions; it is due to the scarcity of economic goods and labor and to the fact that they have to be devoted to more urgent and therefore more attractive uses.

    When the interest rate is artificially lowered by credit expansion the false impression is created that enterprises which previously had been regarded as unprofitable now become profitable. Easy money induces the entrepreneurs to embark upon businesses which they would not have undertaken at a higher interest rate. With the money borrowed from the banks they enter the market with additional demand and cause a rise in wages and in the prices of the means of production. This boom of course would have to collapse immediately in the absence of further credit expansion, because these price increases would make the new enterprises appear unprofitable again. But if the banks continue with the credit expansion this brake fails to work. The boom continues.

    But the boom cannot continue indefinitely. There are two alternatives. Either the banks continue the credit expansion without restriction and thus cause constantly mounting price increases and an ever-growing orgy of speculation, which, as in all other cases of unlimited inflation, ends in a “crack-up boom” and in a collapse of the money and credit system.[1] Or the banks stop before this point is reached, voluntarily renounce further credit expansion and thus bring about the crisis. The depression follows in both instances.

    It is obvious that a mere banking process like credit expansion cannot create more goods and wealth. What the credit expansion actually accomplishes is to introduce a source of error in the calculations of the entrepreneurs and thus causes them to misjudge business and investment projects. The entrepreneurs act as if more producers’ goods were available than are actually at hand. They plan expansion of production on a scale for which the available quantities of producers’ goods are not sufficient. These plans are bound to fail because of the deficiency in the available amount of producers’ goods. The result is that there are plants which cannot be used because the complementary facilities are lacking; there are plants which cannot be completed; there are other plants again whose products cannot be sold because consumers desire other products more urgently which cannot be produced in sufficient quantities because the necessary productive facilities are not ready. The boom is not over-investment, it is misdirected investment.

    It is frequently argued against this conclusion that it would hold true only if at the beginning of the credit expansion there were neither unused capacity nor unemployment. If there were unemployment and idle capacity, things would be different, they claim. But these assumptions do not affect the argument.

    The fact that a part of the productive capacity which cannot be diverted to other uses is unused is the consequence of errors of the past. Investments were made in the past under assumptions which proved to be incorrect; the market now demands something else than what can be produced by these facilities.[2] The accumulation of inventories is speculation. The owner does not want to sell the goods at the current market price because he hopes to realize a higher price at a future date. Unemployment of workers is also an aspect of speculation. The worker does not want to change his location or occupation, nor does he want to lower his wage demands because he hopes to find the work he prefers at the place he prefers and at higher wages. Both the owners of merchandise and the unemployed refuse to adjust themselves to market conditions because they hope for new data which would change market conditions to their advantage. Because they do not make the necessary adjustments the economic system cannot reach “equilibrium.”

    In the opinion of the advocates of credit expansion, what is necessary fully to utilize the unused capacity, to sell the supply at prices acceptable to the owners, and to enable the unemployed to find work at wages satisfactory to them is merely additional credit which such expansion could provide. This is the view which underlies all plans for “pump priming.” It would be correct for the stocks of goods and for the unemployed under two conditions: (1) if the price rises caused by the additional quantity of money and credit would uniformly and simultaneously affect all other prices and wages, and (2) if the owners of the excessive supplies and the unemployed would not increase their prices and wage demands. This would cause the exchange ratios between these goods and services and other goods and services to change in the same way as they would have to be changed in the absence of credit expansion, by reducing the price and wage demands in order to find buyers and employers.

    The course of the boom is not any different because, at its inception, there are unused productive capacity, unsold stocks of goods, and unemployed workers. We might assume, for instance, that we are dealing with copper mines, copper inventories, and copper miners. The price of copper is at a point at which a number of mines cannot profitably continue their production; their workers must remain idle if they do not want to change jobs; and the owners of the copper stocks can only sell part of it if they are unwilling to accept a lower price. What is needed to put the idle mines and miners back to work and to dispose of the copper supply without a price drop is an increase (p) in producers’ goods in general, which would permit an expansion of overall production, so that an increase in the price, sales, and production of copper would follow. If this increase (p) does not occur, but the entrepreneurs are induced by credit expansion to act as if it had occurred, the effects on the copper market will first be the same as if p actually had appeared. But everything that has been said before of the effects of credit expansion develops in this case as well. The sole difference is that misdirected capital investment, as far as copper is concerned, does not necessitate the withdrawal of capital and labor from other branches of production, which under existing conditions are considered more important by the consumers. But this is only due to the fact that, as far as copper is concerned, the credit expansion boom impinges upon previously misdirected capital and labor which have not yet been adjusted by the normal corrective processes of the price mechanism.

    The true meaning of the argument of unused capacity, unsold—or, as it is said inaccurately, unsalable—inventories, and idle labor, now becomes apparent. The beginning of every credit expansion encounters such remnants of older, misdirected capital investments and apparently “corrects” them. In actuality, it does nothing but disturb the workings of the adjustment process. The existence of unused means of production does not invalidate the conclusions of the monetary theory of the business cycle. The advocates of credit expansion are mistaken when they believe that, in view of unused means of production, the suppression of all possibilities of credit expansion would perpetuate the depression. The measures they propose would not perpetuate real prosperity, but would constantly interfere with the process of readjustment and the return of normal conditions.

    It is impossible to explain the cyclical changes of business on any basis other than the theory which commonly is referred to as the monetary theory of the business cycle. Even those economists who refuse to recognize in the monetary theory the proper explanation of the business cycle have never attempted to deny the validity of its conclusions about the effects of credit expansion. In order to defend their theories about the business cycle, which differ from the monetary theory, they still have to admit that the upswing cannot occur without simultaneous credit expansion, and that the end of the credit expansion also marks the turning point of the cycle. The opponents of the monetary theory actually confine themselves to the assertion that the upswing of the cycle is not caused by credit expansion, but by other factors, and that the credit expansion, without which the upswing would be impossible, is not the result of a policy intended to lower the interest rate and to invite the execution of additional business plans, but that it is released somehow by conditions leading to the upswing without intervention by the banks or by the authorities.

    It has been asserted that the credit expansion is released by the rise in the rate of interest through the failure of the banks to raise their interest rates in accordance with the rise in the “natural” rate.[3] This argument too misses the main point of the monetary theory of the cycle. Whether the credit expansion gets under way because the banks ease credit terms, or because they fail to stiffen the terms in accordance with changed market conditions, is of minor importance. Decisive only is the fact that there is credit expansion because there exist institutions which consider it their task to influence interest rates by the granting of additional credit.[4] Whoever believes that credit expansion is a necessary factor in the movement which forces the economy into the upswing, which must be followed by a crisis and depression, would have to admit that the surest means to achieve a cycle-proof economic system lies in preventing credit expansion. But despite the general agreement that measures should be taken to smooth the wave-like movements of the cycle, measures to prevent credit expansion do not receive consideration. Business cycle policy is given the task to perpetuate the upswing created by the credit expansion and yet to prevent the breakdown. Proposals to prevent credit expansion are refuted because supposedly they would perpetuate the depression. Nothing could be a more convincing proof of the theory which explains the business cycle as originating from interventions in favor of easy money than the obstinate refusal to abandon credit expansion.

    One would have to ignore all facts of recent economic history were one to deny that measures to lower rates are considered desirable and that credit expansion is regarded as the most reliable means to achieve this aim. The fact that the smooth functioning and the development and steady progress of the economy is over and over again disturbed by artificial booms and ensuing depressions is not a necessary characteristic of the market economy. It is rather the inevitable consequence of repeated interventions which intend to create easy money by credit expansion.

3. Foreign Exchange Control

    An attempt by government forcibly to give the national credit money or paper money a value higher than its market price causes effects which Gresham’s Law describes. A condition results which generally is called a shortage of foreign exchange. This expression is misleading. Anyone who offers less than the market price for any good is unable to buy it; this holds true for foreign exchange just as much as for all other goods.

    It is an essential characteristic of an economic good that it is not so abundant that it can satisfy all desired uses. A good of which in this sense there would not be a shortage would be a free good. As money is necessarily an economic good, not a free good, money of which there would not be a shortage is inconceivable. The governments, which adopt an inflationary policy but at the same time pretend that they have not lowered the purchasing power of the domestic money, have something else in mind when they complain about a shortage of foreign exchange. Were the government to refrain from any further action once it had increased the quantity of the domestic money by inflation, the value of the domestic money would fall relatively to metallic money and foreign exchange and its purchasing power would decline. However, there would not be a “shortage” of metallic money and foreign exchange. Those who were ready to pay the market price would obtain for their domestic money any desired amount of metallic money or foreign exchange. Those who buy goods have to pay the market price given by the exchange rate of the market; they either have to pay in metallic money (or foreign exchange) or pay that amount of domestic money which is determined by the market rate for foreign exchange.

    But the government is unwilling to accept these consequences. Being sovereign it believes itself omnipotent. It can issue penal laws; it has courts and police, gallows and jails at its disposal and can destroy anyone who rebels. Consequently, it orders that prices are not to rise. On the one hand, the government prints additional money, enters the market with it and thus creates an additional demand for goods. On the other hand it orders that prices should not rise, because government thinks it can do anything at will.

    We have already dealt with the attempts to fix the prices of goods and services. Now we have to consider the attempts to fix the rates of foreign exchange.

    The government places the blame for the rise of foreign exchange rates on the unfavorable balance of payments and on speculation. Being unwilling to abandon the price fixing for foreign exchange, it takes measures to reduce the demand. Foreign exchange is to be bought only by those who require it for a purpose of which the government approves. Goods, the importation of which the government considers superfluous, should not be imported any longer; interest and amortization payments to foreign creditors are to be discontinued; citizens are not to travel abroad. The government fails to realize that its efforts to “improve” the balance of payments are futile. If less is imported, less can be exported. Citizens who spend less on trips abroad, imported goods, and interest and repayment of foreign loans will not use the unspent money to increase their ready cash; they will spend it within the country and thus raise prices in the domestic market. Because prices rise, because citizens buy more within the country, less will be exported. Prices rise not only because imports have become more expensive in terms of domestic money; they rise because the quantity of money was increased and because the citizens display a greater demand for domestic goods.

    The government believes that it can accomplish its purpose by nationalizing dealing in foreign exchange. Those who receive foreign exchange—from export transactions, for instance—must by law deliver it to the government and receive in exchange only the amount of domestic money which corresponds to the foreign exchange price which has been fixed by the government below the market price. Were this principle to be enforced consistently, exports would cease entirely. As the government does not want this effect it finally has to give in. It grants subsidies to the export trade intended to compensate for losses which the exporters suffer by the obligation to turn over to the government at the fixed price the foreign exchange they receive.

    On the other hand the government sells foreign exchange to those who want to use it for purposes which meet with the approval of the government. Were the government to adhere to its fiction and to demand only the official price for this foreign exchange this would amount to subsidizing the importers (not the import trade). As this is not intended by the government, compensation is sought, for instance, by a proportionate raising of import duties or by imposing special taxes on the profits and transactions of the importers.

    Control of foreign exchange means the nationalization of foreign trade and of all business with foreign countries. It does not alter foreign exchange rates. Whether or not the government suppresses the publication of actual foreign exchange rates which reflect market conditions is immaterial. In foreign trade transactions only those rates are significant which reflect the purchasing power of domestic money.

    The effects of such a nationalization of all economic relations with foreign countries on the life of the individual citizen are the more decisive the smaller the country and the more closely connected are its international economic relations. Foreign travel, attendance at foreign universities, and the reading of books and newspapers published abroad are only possible if the government places the necessary foreign exchange at the individual’s disposal. As a means of lowering the price of foreign exchange, the control is a complete failure. But it is an effective implement of dictatorship.

4. The Flight of Capital and the Problem of “Hot Money”

    It is claimed that foreign exchange control is necessary to prevent the flight of capital.

    If a capitalist fears complete or partial confiscation of his property by the government, he seeks to save whatever he can. It is, however, impossible to withdraw capital from enterprises and to transfer it to another country without heavy losses. If there is a general fear of confiscation by the government, the price paid for going businesses drops to the level which reflects the probability of such confiscation. In October 1917, enterprises in Russia which represented investments of millions of gold rubles were offered for the equivalent of a few pennies; later on they became completely unsalable.

    The term “capital flight” is misleading. The capital invested in enterprises, buildings, and estates cannot flee; it can only change hands. The state which intends to confiscate does not lose anything by it. The new owner becomes the victim of the confiscation instead of the previous owner.

    Only the entrepreneur who has recognized the danger of confiscation in time is able to avoid the threatening loss by means other than the sale of his entire business. He may refrain from renewing the parts of the equipment which become used up and worn out, and he may transfer the amounts he thus saves to other countries. He may leave abroad funds resulting from export transactions. If he uses the first means his plant will sooner or later cease to be productive or, at least, competitive. If he chooses the latter he will have to restrict or even close down his production because of the lack of working capital, unless he can borrow additional funds.

    With this exception a state which intends to confiscate, completely or partially, the enterprises located in its territory does not run the risk of losing part of its spoils by the flight of capital.

    The owners of money, promissory notes, deposits, and other claims find themselves in a better position than the owners of enterprises and real property. They, however, are threatened not only by confiscation; inflation too may deprive them of all or part of their property. But they are the ones who are able to buy foreign exchange and to transfer their capital abroad because their property consists of ready cash.

    The governments do not like to admit this. They believe it to be the duty of every citizen to suffer quietly the confiscatory measures; and this even in the case when—as in inflation—the measures do not benefit the state but only certain individual citizens. One of the tasks assigned to foreign exchange control is to prevent such a flight of capital.

    Let us look at an historic example. During the first years following the armistice of 1918, it was possible to sell abroad German, Austrian, and Hungarian bank notes, bonds, and debentures payable in the currencies of these countries. The governments impeded such sales either directly or indirectly by forcing their subjects to give up the foreign exchange received in such transactions. Did the German, Austrian, or Hungarian economies become richer or poorer by this intervention? Let us assume that in 1920 Austrians succeeded in selling Austrian mortgage bonds to foreigners at a price of $10 for each 1000 kronen par value. The Austrian creditor would thus have salvaged about 5% of the nominal value of his claim. The Austrian debtor would not have been affected at all. However, when the Austrian debtor had to repay the debt in the nominal value of 1000 kronen, which in 1914 was about $200, the 1,000 kronen he repaid in 1922 would have equaled only about 1.4 cents. The loss of approximately $9.98 would have been suffered by the foreign holder, not by an Austrian. Could one say, therefore, that a policy which prevented such transactions was justified from the standpoint of Austrian interests?

    The holders of ready cash try as far as possible to avoid the dangers of devaluation which today threaten in every country. They keep large bank balances in those countries in which there is the least probability of devaluation in the immediate future. If conditions change and they fear for these funds, they transfer such balances to other countries which for the moment seem to offer greater security. These balances which are always ready to flee-so-called “hot money”—have fundamentally influenced the data and the workings of the international money market. They present a serious problem in the operation of the modern banking system.

    During the last hundred years all countries have adopted the single-reserve system. In order to make it easier for the central bank to pursue a policy of domestic credit expansion the other banks were induced to deposit the greater part of their reserves with the central bank. The banks then reduced their vault cash to the amount necessary for the conduct of everyday normal business. They no longer considered it necessary to coordinate their payables and receivables as to maturity so that they should be able to fulfill their obligations at all times fully and promptly. To be able to meet the daily maturing claims of their depositors, they deemed it sufficient to own assets which the central bank considered a satisfactory basis for the granting of credit.

    When the influx of “hot money” began the banks did not see any danger in the increase of demand on short-term deposits. Relying on the central bank they accepted the deposits and used them as a basis for extending loans. They were unaware of the danger they were inviting. They did not give any thought to the means which they would someday need to repay those deposits which obviously were always ready to move.

    It is argued that the existence of such “hot money” necessitates foreign exchange control. Let us consider the situation in the United States. If, as of June 5, 1933, the United States had not forbidden the private holding of gold, the banks would have been able to carry on a gold deposit business as a particular branch of activity, separate from their other transactions. They would have bought gold for this branch of their activity and would have either held it themselves or deposited it earmarked for safekeeping with the Federal Reserve banks. Thus, this gold would have become sterilized from the standpoint of the American currency and banking system. It is only because the government has intervened by forbidding individuals to own gold that a “hot money” problem comes into being. The fact that the unwelcome effect of one intervention makes other interventions necessary does not justify interventionism.

    Of course, the entire problem is today no longer of importance. The fleeing funds have reached their last haven, America. There is no safe place left to which they could escape should this refuge prove vain.


[1]As explained in this section on “Credit Expansion.”

[2]1n the absence of credit expansion there also may be plants which are not fully utilized. But they do not disturb the market any more than does the unused submarginal land.

[3][Fritz] Machlup, (The Stock Market, Credit and Capital Formation, London, 1940, p. 248) speaks of “passive inflationism.”

[4]If a bank is unable to expand credit it cannot create an upswing even if it lowers its interest rate below the market rate. It would merely make a gift to its debtors. The conclusion to be drawn from the monetary theory of the cycle with regard to stabilizing measures is not the postulate that the banks should not lower the interest rate, but that they should not expand credit. This [Gottfried] Haberler (Prosperity and Depression, League of Nations, Geneva, 1939, p. 65ff.) misunderstood and therefore his criticisms are untenable.

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