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The Economics of Illusion

July 3, 2009

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[This is the title essay of Hahn's The Economics of Illusion, his frontal attack on the Keynesian system. It is based on a lecture delivered at the Studiengesellschaft fur Wirtschaftspolitik, Zurich, Switzerland, September 12, 1947.]

 

 

M.C. Escher, "Waterfall" (1961)

Quite briefly the essence of the late Lord Keynes's work The General Theory of Employment, Interest, and Money is: employment fluctuates with the intensity of effective demand, which depends, given a certain propensity to consume, upon the amount of investment — the spending of purchasing power for the purpose of adding to capital equipment. Investment in turn fluctuates — productivity of capital remaining the same — with the interest rate at which loanable funds are offered. Therefore, employment can be created by reducing the interest rate, provided entrepreneurs are willing to pay any interest at all; if they are not, the state must take over their investment activity, directing into circulation the purchasing power that private entrepreneurs would otherwise spend. An easy-money policy and — if that does not suffice — government deficit spending — monetary measures in a wider sense — can guarantee full employment.

Obviously an adherent of the pre-Keynesian approach would call this whole line of thinking an illusion. But it is perhaps less obvious that it represents not only illusionary economics but an "economics of illusion" in a very specific sense. For it presupposes an economy whose members do not see through the changes brought about by monetary or fiscal manipulation — or, as some might say, the swindle. Above all, it presupposes that people are blinded by the idea that the value of money is stable — by the "money illusion," as Irving Fisher called it. In all this we are not saying anything new; fundamentally, we are merely stating the approach of the classical economists.

The Classical Economists and the Money Illusion

It is usual nowadays to characterize classical economists as antiquated halfwits whose "teaching is misleading and disastrous if we apply it to the facts of experience."[1] This characterization could perhaps be applied more justly to Keynes's own theory. It is certainly not just when applied to the classical economists, who were familiar with the effects of manipulations that increase the supply of money. They were well aware that booms can be provoked and prolonged by inflation. Their vehement protests were founded on very extensive experience and acquaintance with the monetary depreciation, debasement of coins, and bank-note experiments of the Mercantilist and post-Mercantilist periods. No classical economist denies that, in the first stage of an inflation, prosperity spreads as if by magic. Yet this prosperity is unreal; nowhere is it depicted more brilliantly than in the second part of Goethe's Faust. Prices rise faster than costs and profit margins are widened, rendering new enterprises profitable. For the following reasons, however, the stimulus soon loses its force: On the one hand, prices break after a certain time unless new doses of the inflation poison are injected (and if they are, the experiment ends with the destruction of the currency). A rise in prices leads entrepreneurs to expect further rises. Consequently, they make new investments and build inventories, which in turn operate to boost prices further. The moment the stimulus of rising prices is exhausted, the cumulative boom spiral reverses its direction. Since there is no new stratum of buyers on whom the bulls can unload, the downward movement gains momentum. The English economist, A.C. Pigou, gives a penetrating description of the process in his Industrial Fluctuations (London, 1927). In an economy dependent largely upon exports, prices collapse even earlier: under the impact of the rising domestic price level, the balance of payments deteriorates, and the outflowing gold causes a deflationary process within the country, as David Ricardo described clearly in his 1810 pamphlet, The High Price of Bullion.

On the other hand, costs adjust themselves to the higher prices. The new enterprises become undermined from the cost side and the boom collapses for this reason:[2]

Interest rates cannot be held down in the long run, for interest rates rise because higher prices demand greater amounts of credit.[3]

If larger amounts of credit are created through the progressive increase of money, i.e., by the printing press, the process ends in a hopeless depreciation of the currency, in terms of both domestic goods and foreign exchange.

Wages, which have lagged behind prices, ultimately catch up, for workers care more about their real than their nominal wages. As Adam Smith remarked long ago: "Though the wages of the workmen are commonly paid to him in money, his real revenue, like that of all other men, consists, not in money, but in the money's worth, not in the metal pieces, but in what can be got for them."[4]

Unemployment, therefore, cannot be alleviated by monetary measures. It is caused by what today goes under the name of basic maladjustments in the cost structure. These must be corrected by voluntary adjustments of production factors. Production factors cannot be forced into curtailing their demands by a reduction in the real value of the money unit, i.e., by deceit or trickery.

The Great Depression and the Great Reflation

The classical economists gathered their experience during and after inflationary periods, and their teachings reflect their reaction to inflation. The present generation of economists gathered its experience during the Great Depression of 1929–1930, and its opinion reflects its reaction to the Depression and a swinging over of the pendulum to the preclassical, Mercantilist approach that greatly overestimated the beneficial effects of inflation. This is not to say that the reaction was not in part justified. The hyper-classicism of those who in the early 'thirties sabotaged every attempt at reflation, of whom many today are the most zealous and extreme proponents of monetary and budgetary manipulation, was undoubtedly theoretically untenable and practically disastrous. In most countries the hoarding of foreign exchange and of gold from fear of devaluation, and in the United States the hoarding of money from fear of further price reductions, deepened the Depression more and more. Wider and wider circles of the economy were ruined by deflation, until finally only the strongest enterprises survived, or those that were protected by moratoriums or subsidies. Unemployment increased. But hardly was the pressure from the money side — in most countries after the devaluation of the currency or the introduction of currency restrictions — mitigated (not because of the intelligence of the responsible persons but under the impact of the loss of foreign exchange) when suddenly the proverbial life on the ruins bloomed. The effects of the Depression vanished over night and strong recovery set in: in England after the devaluation; in the United States after numerous injections of credit; in the gold standard countries of that time — France, Holland, and Switzerland — after their devaluations, which occurred much too late; in Germany after the nonsensical Brüning-Luther deflation policy was given up and the Nazis had started their work-creation and spending measures. No wonder that faith in monetary manipulation through what one may call the Great Reflation (in contrast to the Great Depression) was strongly reinforced. The public and the experts deduced, post hoc ergo propter hoc and undoubtedly with some justification, the force of monetary reflation in overcoming crises.

Limitations on and Possibilities of Creating Employment by Increasing Investment

Does the experience of the Great Reflation refute the theory of the classical economists? Does it contradict what we said about the collapse of the price level and inflation on the one hand and the adjustment of costs upward on the other? We think not. Indeed we believe that it substantiates classical theory. The Great Depression showed that the limitations — and within the limitations the possibilities — of creating employment through investment and/or alleviation from the money side are in fact exactly those the classical economists described.

The rise in prices and employment after 1932 was, especially in the United States, succeeded by a severe though short depression in 1937. Once more the classical economists were vindicated — Boom was followed by Bust.

The easy-money policy initiated in 1932 was a factor in raising the price level generally, or at least was not an impediment. The extent of the price rise is striking when one looks on the depression of 1937–1938 as merely an interruption and views the entire period since 1932 as a unit. Prices are everywhere higher than they were in 1932, and in some countries, many times higher — a clear expression of the old quantity theory that the effect of a greater amount of money practically exhausts itself by inflating prices.

The year 1936 was a real boom year as far as prices and many other indices are concerned, but, in contrast to earlier boom years, it did not lead to full employment. Several million were unemployed, even at the peak of the cycle — a phenomenon for which many explanations were given, among which the "classical" is the most plausible. The rapid upward adjustment of costs, especially wages, shortened the lag that in former cycles had made possible the employment of less productive labor.

Yet for five full years after 1932 the economy undoubtedly showed distinct signs of recovery. During this period, therefore, not all the circumstances that according to the classical economists nullify the effects of monetary changes can have been present. An analysis of the Great Reflation shows why and reveals the prerequisites of what the classicists called the "transition" period.

The price level obviously cannot break unless prices have risen. In the first stage of an inflation, prices either do not rise at all or rise only slightly because of their traditional stickiness. A sort of voluntary price ceiling and rationing system keeps them in line. During the first years of both world wars a similar system, enforced by law, offset the effects of lax methods of war financing.

When an economy is emerging from a deep depression, wide sectors still function under the law of decreasing costs. Greater profits are reaped through faster turnover until the point of optimum utilization of equipment is reached. Up to that point, turnover alone, not prices, tends to rise substantially and the danger of price breaks remains at a minimum.

The danger of a reaction is caused not by a rise in prices but by the expectation of further rises engendered by a rise in prices. At the beginning of a cyclical upswing, however, the psychological environment is still deflationary. When the price rise eventually comes, it therefore has at first merely an antideflationary effect, not an inflationary one. Instead of inducing the illusion of further rises in prices, it only dispels the illusion of further declines in prices.

Despite rising prices, costs do not adjust themselves upward so long as the "money illusion" is effective, i.e., so long as the public, and especially labor, thinks that what is happening is a chance and temporary rise of prices coming from the side of goods, not of money, and that it is not due to depreciation of the currency. In our inflation-conscious times, however, when everyone — certainly every union leader — seems to carry a living-standard index curve in his pocket, the money illusion can hardly fool anyone for long. The chief assumption of Keynes's employment theory — namely, that the workers demand in "the general case" maintenance of their nominal wages, not of their real wages — is therefore entirely unrealistic today.

Even if workers realize that their hourly real wages are declining, they nevertheless may not demand higher wage rates at the beginning of recovery. First, because the rise in weekly wages, through increased employment, offsets the decline in hourly real wage. Second, because after the rise in real wages during the depression, the moral justification for wage increases appears slight. Third, unions cannot expect that their demands will be heeded when there is unemployment. However, this period of acquiescence, too, tends to become shorter. The idea inherent in the so-called purchasing power theory — that high wages stimulate recovery — has in many important quarters replaced the more correct idea that high wages curtail employment.

Long-term wage agreements, as well as long-term rent and loan contracts, can, for purely technical or juridical reasons, prevent the adjustment of costs to the changing value of the currency, though for a certain time only.

The Alleged Permanency of the Money Illusion — The Beginning of the Great Illusion

The effects of monetary manipulations thus last until the impact of the manipulation on prices, then the repercussion of prices on costs, are felt; in other words, as long as the economy is in what I have called the "reaction-free period." All this is in accordance with the approach of the neoclassicists, who derived their monetary business-cycle theories from the knowledge of the mechanism of the transition period — without, however, making the mistake of deriving from it a general theory of employment.

What the neoclassicists reproach Keynes and his followers with is that they have succumbed to this error. By assuming that the special conditions of the transition period are always present, they have formulated a theory of employment that is unrealistic and confusing, if not illogical, and that has thrown economic science back, if not into, then surely to the brink of, a purely Mercantilistic preclassical approach. Keynes himself, it is true, was cautious in his formulations. His responsibility lies solely in claiming that the assumptions of his theory were present in "the general case." But most of his followers, and above all the vulgar-Keynesian writers, forget that the replacement of the wage-theory of employment by an inflation- or reflation-theory of employment is justified only as a theory of the recovery phase, never as a general theory. Within the framework of a business-cycle theory it makes sense to regard certain factors, especially costs, as lagging behind others. If large groups of the population did not retain faith in the traditional value of money longer than other groups, there would be neither stability of economic life nor cyclical changes in employment. Prices would, so to speak, get out of hand from one moment to the next; and not being able to rely on even moderately stable costs, no entrepreneur would venture to expand production. However, to assume that when the value of money is consciously and willfully manipulated, the members of the economy will be bluffed for any length of time and will allow dupes to be made of themselves is an illusion.

To what economic-political illusions has this economics of illusion led?

The Illusion of Devaluation

The attempt to alleviate depressions by devaluating the domestic currency in relation to gold or foreign currency has been made again and again throughout history. Devaluation of the currency is a trick by which, in countries dependent upon foreign trade, the domestic price level can be pushed upward by raising the supply price of imports and the demand price of exports. The immediate consequence is that a rigid and overpriced cost level is rendered cheap and bearable in terms of domestic as well as world market prices. The devaluation doubtless has the advantage, before deflation, that it favors debtors, who are already sorely tried, and prevents the revolution-creating effect of too drastic an "adjustment downwards" — a fact overlooked by certain hyper-classicists during the Great Depression. Devaluation obviously can have the desired effect only if made in the reaction-free period. An emergency measure, it can be applied only once and under special circumstances. In "the general case" it cannot work, as the classicists have demonstrated time and again, for as costs adjust themselves upward, the facilitation of production is canceled. Furthermore, there is of course always the danger that foreign countries too will devaluate in competition for the temporary advantages in foreign trade. Then prices on world markets decline in terms of gold but do not rise in terms of the domestic cost level — the only thing that counts. Incidentally, it seems as if the illusion of devaluation had been replaced by something that might be called the "illusion of nondevaluation" — the illusion that in the long run devaluation can be avoided though no attempt is made to halt domestic inflation. Our times labor under the illusion that unwarranted foreign exchange rates can be maintained permanently. Devaluations are therefore improbable even if they are warranted by internal inflation. Even more improbable is a "preceding" devaluation, one not forced by the cost structure but undertaken for the sake of foreign trade advantages. It was just this sort of devaluation that seemed to the proponents of Bretton Woods so especially menacing — without reason, since the devaluations of the 'thirties were nowhere, except in the United States, "preceding" devaluations.

The Illusion of an Easy-Money Policy and Deficit Spending

We must distinguish whether these measures are taken in order to combat unemployment, or for other — especially fiscal — reasons.

The Fight Against Unemployment

When a depression is so far advanced that most of the exaggerations of the preceding boom have been liquidated, an easy-money policy can help to shorten the depression and to ward off the so-called secondary deflation, which is mainly psychological. But further benefits are often attributed to an easy-money policy. It is thought that even after the economy has reached the recovery stage, employment can be stepped up by lowering interest rates. However, employment is either not increased at all or increased only for a time. In the last analysis, employment depends upon the relation between wages and prices. Outside the "reaction-free period," wages rise as money declines in value. To assume, as some Keynesians do, that prevailing unemployment hinders the upward adjustment of wages is erroneous. It should do so, but does not because of the power of trade unions. Lower interest rates, to be sure, facilitate production. But only for a time. Lower interest rates mean higher profits, which awaken the envy of labor. Many a wage increase has been won with the slogan that an increase in corporation profits should be used to raise wages. As far as labor absorbs the profit margin resulting from lower interest rates, employment does not grow but declines. Because labor — not only in the large enterprises but also in the small and marginal — has become more expensive and capital cheaper, the economy adopts more capitalistic and laborsaving methods. Moreover, lowering interest rates is a one-time stimulus: it cannot be repeated, for negligible rates cannot be reduced further.

Lowering interest rates during a boom can at best prolong the boom for a certain time — but the price is a still worse collapse when it comes. For the reduction does not take place in a "reaction-free" period but in a period overripe for reaction. In this period the public's illusion that the boom will go on forever breaks down. No monetary manipulation — at least, not one made within the framework of a free capitalist economy — can save the illusion. Investments decline irresistibly. Keynes's idea that low interest rates are a remedy for booms[5] is therefore strange, to say the least.

About the complex question of deficit spending, on which the literature has continuously been growing, we confine ourselves to the following brief remarks:

Budgetary deficits as such need not lead to catastrophe, but they harbor certain dangers — whether the deficits are involuntary, as in France today, or voluntary, as in the United States in the 'thirties.

Underlying the deficit spending idea is the recognition that the pessimism prevalent during depressions and its cumulative effects can be mitigated or even dissipated if the state proceeds to invest in place of private entrepreneurs who are reluctant to invest. The idea is old. It has always found expression in most financial textbooks in the recommendation that the government should concentrate its investments in depressions and exercise restraint during prosperity.

As far as the much-advertised "functional finance" is identical with this recommendation, it is appropriate but not new, despite the claims of its advocates. However, something more far-reaching is usually understood by functional finance — a fiscal policy according to which the government must support demand by compensatory spending whenever unemployment develops. In other places I have taken a stand against the crude, naive approach that is the basis for recommending such a policy. Here I mention only the objections that follow directly upon what I have said above about an easy-money policy in inflationary times.

  1. The support of demand in depressions after the exaggerations of the boom have been somewhat corrected is not only allowable but advisable.

  2. Outside of this situation deficit spending cannot lessen unemployment owing to structural conditions, especially high wages, or to laws inimical to enterprise. It would have to be continued indefinitely. The higher price level that would render production feasible under a given cost situation would have to be supported by ever new governmental spending, because part of the purchasing power would always be seeping away through savings. Permanent governmental deficits, however, mean of course cumulative governmental indebtedness, which in turn leads eventually to bankruptcy or inflation, or both. It is wrong to assume, as some do, that the public will absorb any amount of government bonds. They fail to recognize that, from a certain moment on, new bonds can be placed only on very disadvantageous terms, and ultimately not at all — with the result of genuine inflation.

The idea behind functional finance has quite logically led to the claim that the state can and must guarantee full employment. The claim is incomprehensible for an economy that is still so far free that the state controls neither prices nor wages. Shall full employment be guaranteed at every (even the most senseless) wage level that trade unions, believing in the purchasing power theory, contrive to attain? Unless a state controls the amount and price of labor in a totalitarian way, it cannot guarantee full employment, any more than a physician who is not in a position to keep his patient from drinking to excess can guarantee him health.

If deficit spending is used to prolong a boom that is ripe for collapse, as has also been proposed, the consequences for the finances of the government will be still more disastrous. Unless the real maladjustments are corrected, not only will the financial position of the state be ruined but in a relatively short time the entire structure of the economy will be altered. The economy will become overwhelmingly socialist or state-capitalist — just what the proponents of functional finance allegedly want to prevent. For the state would have to replace "compensatorily" all the many enterprises that can operate only during a boom because they do not adjust their costs, especially wages, to the changed conditions.

But the idea of deficit spending is illusionary in a specific sense also: the desired effects can happen only if and as long as the members of the economy are unaware of the nature and effect of the budgetary manipulation.

The ability of the state to invest, and to this end to lend and spend, when private enterprise does not dare, is not due to any supernatural force or quality. It comes about merely because, unlike the private entrepreneur, the state can distribute the deficits among the members of the community. Even if the deficits are at first lent by the members and not taken from them by taxation, the members remain liable and must some day pay at least the interest on them, unless the government debt is allowed to mount indefinitely. A community that takes into account governmental investment but not the resulting debt would be just as short-sighted as is a community that regards an increase of war loans in the hands of individuals as an increase of wealth for the community, or a private enterprise that enters its assets but not its liabilities on its books. The businessman, especially the investor, is well aware of these matters, as is evident from his attitude toward an increasing public debt — his fear of declining profit margins because of the threat of higher taxes.

In the long run the entrepreneur responds to deficit spending by compensating reactions; with the result that private investment in general declines as government investment increases. As soon as prospective taxes are calculated as present costs, private enterprise becomes unprofitable and is given up.

Nevertheless, deficit spending can for a time and under certain conditions create employment. There must be the illusion that the community is not liable; or that the other fellow will pay the bill-as is usual in war booms; or that by the time the taxes have to be paid boom conditions will prevail and profits will be so high that the tax burden can be disregarded in current cost calculations. This third approach would be sensible. However, it is clear that all these conditions can be present only under special circumstances and only for a limited time.

Fiscal Reasons for an Easy-Money Policy and Deficit Spending

Antideflationary measures to combat unemployment will hardly be of practical importance in the near future. With the exception perhaps of the United States, where from time to time the imminence of deflation is discussed, it is generally admitted that the world is in the midst of an inflationary boom. Where there is unemployment, it is not attributed, even by the most extreme Keynesians, to lack of demand.

In an inflationary world, deficit spending and an easy-money policy have other reasons. Deficit spending is resorted to simply because of inability to balance the budget. It is purely involuntary. An easy-money policy is advocated because it seems to make possible a speedy reduction of the interest and debt burden of the government and the balancing of the budget without imposing higher taxes. Sometimes it is urged also as a command of social justice. The latter argument is of course based upon pure illusion. Small savers pay the bill directly or indirectly via savings banks and insurance companies, whereas large capitalists, who are interested chiefly in equities, harvest the profits from refunding operations.

Undesirable Concomitants

An easy-money policy is, however, illusionary in inflationary times mainly because of its undesirable concomitants. When demand for credit is strong, interest rates will not long remain low unless the quantity of money is increased. The inevitability of this increase is exactly why the classicists warned so persistently against keeping interest rates artificially low. In inflationary periods an increase in the quantity of money immediately affects prices. The inflation in most European countries today is due to a lax credit policy — as far as it is not due merely to a lax fiscal policy in the past and present. The illusion persists that one can go into the water of such an inflationary policy without getting wet by inflation. The illusion — or rather its breakdown — that an increase in the quantity of money does not inevitably lead to inflation sows a bumper crop of new illusions, as is only too evident now in England. The first illusion it creates is that, contrary to the experience of centuries, the groups of the population that most need protection can be protected from the consequences of inflation by price ceilings rather than by correction of the basic monetary mistakes. The result is black markets.

The second illusion is that price ceilings will not affect the quantity and kind of production. As ought to be self-evident, and as was confirmed by our experience under the O.P.A., an economy squeezed between rising costs and fixed prices cannot function. When maximum prices are set, especially on mass consumption goods, unessential and luxury goods are made instead. Production also declines absolutely with the rise in costs and wages.

Another illusion is that money can in the long run fulfill its function of stimulating production if a rationing system has deprived it of its unlimited purchasing power. When goods are rationed, more money means not more goods, but at best more savings. And savings are hardly desirable when people are starving, are therefore more concerned about the present than the future, and in addition fear that their savings will become worthless. If more money does not mean that people can buy more goods, they will work as little as possible, thereby reducing production still further. These interrelations are even more obvious in Germany than in England. The entire German economy seems to be collapsing chiefly because the currency has been degraded to a sort of supplement to ration coupons.

Astonished, a bit horrified at what they have perpetrated, yet happy over the prospect of new fields for their activity, the planners demand more and more regulation of production, as well as of investment, until finally everything, including job allocation, is regulated by the government. The "Road to Serfdom" is thereby followed to its end, not least for industrial workers, in whose name and for whose protection an easy-money policy was advocated.

The planners do not see that everything that has happened is due to a fundamental illusion: that scarcity of capital in a poor country can be glossed over by low discount rates. Poverty of nations, as of individuals, should manifest itself by a scarcity of money. There must not be as much — and as cheap — money available as is desired, and poverty only begins on the markets for goods. Under a reasonable monetary policy, there must be goods for every quantity of money. Scarcity must show itself in money. We do not wish to imply here that a sound monetary policy would solve all problems in needy Europe. Though certainly not a sufficient condition of recovery, it is however an essential one. Nor do we wish to say that it would be easy to raise discount rates substantially in a country accustomed to the poison of cheap money. Many difficulties, especially those connected with the nonconsolidation of the debt, with the banking situation, and with the budget, must first be overcome. Furthermore, a rise in discount rates alone would hardly be effective, though it would be much more effective than many contemporary theoreticians assume. Therefore, an energetic interest policy would probably have to be supplemented by measures aimed at absorbing and removing the pent-up inflationary forces — perhaps on the lines of the Belgian model. In other words, there would have to be a thorough monetary reform if the traditional means, the interest rate policy, did not suffice to render purchasing power, which was provisorily dormant during the war, permanently dormant. In any case, without rendering money scarce, the sole alternative to a progressive depreciation of the currency is a totalitarian economy regulated to the utmost.

Inflation, of course, also has repercussions outside the domestic prices. It leads to raising prices of the foreign exchange of countries whose monetary policy is more conservative — or which, because of their advantageous economic position, need not be conservative. If the foreign exchange rate is stabilized, inflation leads on the one hand to black markets for gold and foreign exchange, and on the other to a strongly passive balance of trade and payments with sound-currency countries. Gold and foreign exchange flow partly directly into these countries, partly indirectly via those third countries from which one has imported and to which one, in ignorance of the situation, has promised convertibility of one's own currency into "hard" currency. All allegedly superfluous payments to foreign countries are soon suspended and the currency is no longer convertible.

Illusions about International Effect of Inflation

From this situation arises a further illusion — the illusion of the "God-made passivity of the balance of trade," as I called it almost thirty years ago when I endeavored to fight the great German inflation. I tried to prove that the destruction of the mark was due simply to domestic inflation, not to disturbances in the balance of trade or payments. If President Havenstein and the others then in charge of the Reichsbank did not understand the argument and gave inflation a free rein, they can perhaps be pardoned because no tradition of monetary theory existed in Germany. But a similar excuse cannot be made for Great Britain today. Her most outstanding economist, David Ricardo, tried to make clear one hundred and thirty years ago — after the Napoleonic Wars — that it was not lack of goods or a compulsory passive balance of trade that induced the outflow of gold (as the directors of the Bank of England thought), but simply the fact that gold or foreign exchange was the sole cheap export. Ricardo compared the attempt to replenish the deficits in the balance of payments by buying or borrowing gold or foreign exchange from abroad with pouring water into the hole-riddled jar of the Danaids.[6]

"The Scarce Dollar"

A sort of subdivision of the illusion of the "God-made passivity of the balance of trade" is the illusion — and the slogan — of the "scarce dollar." It is understandable that debtor countries should use it, but not that creditor countries should take it seriously. In the last analysis, the dollar is scarce in England while many other currencies, especially of the pound area, are abundant because it is easy to export to soft-currency countries and difficult to import from them. And it is difficult to import not because their production apparatus was destroyed in the war. Neither Canada nor Australia was bombed or invaded. The differences in the possibilities of foreign trade with the hard- and soft-currency countries arise solely because the price of the hard currency is too low in terms of domestic currency, so that imports are unduly facilitated and exports impeded. This remains true although official prices of goods in soft-currency countries are sometimes no higher than in hard-currency countries, since at these prices goods are often unavailable.

To say that foreign exchange is scarce means to view economic phenomena in isolation rather than in the framework of causal conditions. Foreign currencies will always, and obviously, become scarce if the natural means of regulating demand for them — discount and credit policy — are not applied. Also, a scarcity of foreign currency should express itself in scarcity of domestic money.

Sacrifices Needed

A stringent monetary and fiscal policy entails sacrifices for the population. Taxes must be raised and wages and profits must be low enough to bear the greater interest burden. If for social and political reasons such sacrifices cannot be asked of the people, recourse must be had to foreign aid through taking loans or gifts. In the interests of truth, however, one should not speak of dollar scarcity until one has tried to increase the supply of and decrease the demand for domestic capital through higher interest rates in order to avoid the alleged crisis of the balance of payments, which is in reality merely an inflation crisis. Under a reasonable monetary policy, scarcity of capital or of goods need not lead to inflation or currency restrictions.

Illusion of Nondevaluation

From the illusion of the scarce dollar, and from the failure to recognize its real causes, follows the illusion that devaluation can be avoided. It is undoubtedly correct that, for the reasons mentioned above, devaluation alone would not be of any benefit. Unless supplemented by monetary reform, it would have to be resorted to over and over again. Moreover, theoretically, there is always the alternative of a very incisive deflationary policy which would go beyond forestalling future inflation. Such a policy is, however, practically out of the question for other reasons. It must be admitted that the "illusion of nondevaluation" is nourished by the Bretton Woods Organization, which reinforces still further the strong tendency of our time to conceal rather than remove inflations. The International Monetary Fund is based on the illusion that nineteenth-century currency stability can be achieved, even approximately or for a time, in this twentieth-century world, a world in which the will and the ability to adjust domestic factors, which have become rigid according to the exchange rate, are no longer present.

A currency can be stabilized only when there is sovereignty in credit and fiscal matters, and above all, in the wage policy of a country. The International Monetary Fund has no sovereignty in individual countries and, as matters stand, can have none. Its potentialities are confined to certain "technicalities," especially in the realm of short-term equalization of the balance of payments, which in normal times are superfluous, and in times of insecurity, like today, are unimportant to the point of ridiculousness. Stabilization begins at home. On the other hand, the International Monetary Fund creates a psychological atmosphere that prevents exchange rates from reaching a level corresponding to their purchasing power and eternalizes currency restrictions — just the thing the Fund was set up to prevent. In this atmosphere, attention is distracted from the one really essential matter: sound credit and fiscal policies in the individual countries.

The Push to Bilateralism

In any case, the result of Bretton Woods has so far been that official (unfortunately, not unofficial) exchange rates are stabilized, but foreign trade is reduced through this very stabilization and, worse yet, pushed more strongly in the direction of bilateralism. If, nevertheless, the endeavor to stabilize currencies is not given up, but is supposed to be adopted by further organizations to be founded, the reason is probably that — as is so often the case — what was originally the means to the end, has become the end itself. Meanwhile what had to happen happened. If the foreign value of currencies is fixed at a level much above the level that would correspond to its domestic purchasing power and to the entire economic situation of the country, the only solution is an ever stricter regulation of all foreign trade. Through a complicated system of licenses, luxury articles — nonessential but much sought after in the inflationary environment, such as films and tobacco — must be kept out. There must also be a general transition to a strict reciprocity under which only as much is bought from each country as is sold to it. This system, which means of course the end of multilateral trade and of world free trade — so much desired especially by the United States — is familiar. It was the system of the so-called New Plan of Schacht. Introduced when Germany's balance of payments was deteriorating rapidly in the wake of the National Socialist spending policy, it was combined with a compulsory system of export subsidies and import excises designed to compensate for the fact that the external value of the mark had been fixed much too high. The system functioned well for years, but it must not be forgotten that it functioned within a totalitarian state in which free communication with foreign countries was forbidden and sending capital abroad was subject to the death penalty.

$25 $22

Mises thought very highly of Hahn's work, and none other than Henry Hazlitt has written the introduction to this classic anti-Keynesian work.

The most tragic — or tragicomic — illusion, the inevitable consequence of all other illusions, is that the world must now split, as far as foreign commerce is concerned, into two parts: the world of hard- and the world of soft-currency countries. It is as if the countries of these two worlds were in a kind of natural community determined by their economic conditions or by their lot in the war. But did Argentina and Sweden, which were typical war-profiteer countries, suffer from the war, or has something changed in their economic position? Or are they hurt by being caught between the pincers of agricultural and industrial prices? — of which the impact, incidentally, is very much overrated. Certainly not. The community of soft-currency countries is not a community of economic conditions but a community of lax monetary and fiscal policies, a community of ignorance about monetary theory, of inexperience with monetary policy, and of political doctrinaire stubbornness.

[bio] Comment on the blog.

Lecture delivered at the Studiengesellschaft fur Wirtschaftspolitik, Zurich, Switzerland, September 12, 1947. An abridged version was published in German in the Neue Zurcher Zeitung (Sept. 19–21, 1947). The last section was published in English in The Commercial and Financial Chronicle, Dec. 18, 1947, under the title "Easy-Money Policy — the End of an Illusion."

Notes

[1] Keynes, General Theory, p. 3.

[2] David Hume, Essay on Bank and Paper Money (1752), in A Select Collection of Scarce and Valuable Tracts and other Publications on Paper Currency and Banking, edited by McCulloch, 1862.

[3] David Ricardo, The High Price of Bullion, 4th ed., London, 1811, pp. 35–37.

[4] Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, 8th ed., London, 1796, I, 440.

[5] Keynes, op. cit., p. 322.

[6] On the tremendous effect of the domestic monetary policy on the balance of payments, see also Chapter 4, "Capital Is Made at Home," p. 34.

 


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