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1. Stabilization of the Monetary Unit — From the Viewpoint of Theory (1923)

V. Comments on the "Balance of Payments" Doctrine

1. Refined Quantity Theory of Money

The generally accepted doctrine maintains that the establishment of sound relationships among currencies is possible only with a “favorable balance of payments.” According to this view, a country with an “unfavorable balance of payments” cannot maintain the stability of its monetary value. In this case, the deterioration in the rate of exchange is considered structural and it is thought it may be effectively counteracted only by eliminating the structural defects.

The answer to this and to similar arguments is inherent in the Quantity Theory and in Gresham's Law.

The Quantity Theory demonstrated that in a country which uses only commodity money, the “purely metallic currency” standard of the Currency Theory, money can never flow abroad continuously for any length of time. The outflow of a part of the gold supply brings about a contraction in the quantity of money available in the domestic market. This reduces commodity prices, promotes exports and restricts imports, until the quantity of money in the domestic economy is replenished from abroad. The precious metals being used as money are dispersed among the various individual enterprises and thus among the several national economies, according to the extent and intensity of their respective demands for money. Governmental interventions, which seek to regulate international monetary movements in order to assure the economy a “needed” quantity of money, are superfluous.

The undesirable outflow of money must always be simply the result of a governmental intervention which has endowed differently valued moneys with the same legal purchasing power. All that the government need do to avoid disrupting the monetary situation, and all it can do, is to abandon such interventions. That is the essence of the monetary theory of Classical economics and of those who follow in its footsteps, the theoreticians of the Currency School.18

With the help of modern subjective theory, this theory can be more thoroughly developed and refined. Still it cannot be demolished. And no other theory can be put in its place. Those who can ignore this theory only demonstrate that they are not economists.

2. Purchasing Power Parity

One frequently hears, when commodity money is being replaced in one country by credit or token money—because the legally-decreed equality between the over-issued paper and the metallic money has prompted the sequence of events described by Gresham's Law—that it is the balance of payments that determines the rates of foreign exchange. That is completely wrong. Exchange rates are determined by the relative purchasing power per unit of each kind of money. As pointed out above, exchange rates must eventually be established at a height at which it makes no difference whether one uses a piece of money directly to buy a commodity, or whether one first exchanges this money for units of a foreign currency and then spends that foreign currency for the desired commodity. Should the rate deviate from that determined by the purchasing power parity, which is known as the “natural” or “static” rate, an opportunity would emerge for undertaking profit-making ventures.

It would then be profitable to buy commodities with the money which is legally undervalued on the exchange, as compared with its purchasing power parity, and to sell those commodities for that money which is legally overvalued on the exchange, as compared with its actual purchasing power. Whenever such opportunities for profit exist, buyers would appear on the foreign exchange market with a demand for the undervalued money. This demand drives the exchange up until it reaches its “final rate.”19 Foreign exchange rates rise because the quantity of the [domestic] money has increased and commodity prices have risen. As has already been explained, it is only because of market technicalities that this cause and effect relationship is not revealed in the early course of events as well. Under the influence of speculation, the configuration of foreign exchange rates on the Bourse forecasts anticipated future changes in commodity prices.

The balance of payments doctrine overlooks the fact that the extent of foreign trade depends entirely on prices. It disregards the fact that nothing can be imported or exported if price differences, which make the trade profitable, do not exist. The balance of payments doctrine derives from superficialities. Anyone who simply looks at what is taking place on the Bourse every day and every hour sees, to be sure, only that the momentary state of the balance of payments is decisive for supply and demand on the foreign exchange market. Yet this diagnosis is merely the start of the inquiry into the factors determining foreign exchange rates. The next question is: What determines the momentary state of the balance of payments? This must lead only to the conclusion that the balance of payments is determined by the structure of prices and by the sales and purchases inspired by differences in prices.

3. Foreign Exchange Rates

With rising foreign exchange quotations, foreign commodities can be imported only if they find buyers at their higher prices. One version of the balance of payments doctrine seeks to distinguish between the importation of necessities of life and articles which are considered less vital or necessary. It is thought that the necessities of life must be obtained at any price, because it is absolutely impossible to get along without them. As a result, it is held that a country's foreign exchange must deteriorate continuously if it must import vitally-needed commodities while it can export only less-necessary items. This reasoning ignores the fact that the greater or lesser need for certain goods, the size and intensity of the demand for them, or the ability to get along without them, is already fully expressed by the relative height of the prices assigned to the various goods on the market.

No matter how strong a desire the Austrians may have for foreign bread, meat, coal or sugar, they can satisfy this desire only if they can pay for them. If they want to import more, they must export more. If they cannot export more manufactured, or semimanufactured, goods, they must export shares of stock, bonds, and titles to property of various kinds.

If the quantity of notes were not increased, then the prices of the items for sale would be lower. If they then demand more imported goods, the prices of these imported items must rise. Or else the rise in the prices of vital necessities must be offset by a decline in the prices of less vital articles, the purchase of which is restricted to permit the purchase of more necessities. Thus a general rise in prices is out of the question [without an increase in the quantity of notes]. The international payments would come into balance either with an increase in the export of dispensable goods or with the export of securities and similar items. It is only because the quantity of notes has been increased that they can maintain their imports at the higher exchange rates without increasing their exports. This is the only reason that the increase in the rate of exchange does not completely choke off imports and encourage exports until the “balance of payments” is once again “favorable.”20

Certainly no proof is needed to demonstrate that speculation is not responsible for the deterioration of the foreign exchange situation. The foreign exchange speculator tries to anticipate prospective fluctuations in rates. He may perhaps blunder. In that case he must pay for his mistakes. However, speculators can never maintain for any length of time a quotation which is not in accord with market ratios. Governments and politicians, who blame the deterioration of the currency on speculation, know this very well. If they thought differently with respect to future foreign exchange rates, they could speculate for the government's account, against a rise and in anticipation of a decline. By this single act they could not only improve the foreign exchange rate, but also reap a handsome profit for the Treasury.

4. Foreign Exchange Regulations

The ancient Mercantilist fallacies paint a specter which we have no cause to fear. No people, not even the poorest, need abandon sound monetary policy. It is neither the poverty of the individual nor of the group, it is neither foreign indebtedness nor unfavorable conditions of production, that drives foreign exchange rates way up. Only inflation does this.

Consequently, every other means employed in the struggle against the rise in foreign exchange rates is useless. If the inflation continues, they will be ineffective. If there is no inflation, they are superfluous. The most significant of these other means is the prohibition or, at least, the restriction of the importation of certain goods which are considered dispensable, or at least not vitally necessary. The sums of money within the country which would have been spent for the purchase of these goods are now used for other purchases. Obviously, the only goods involved are those which would otherwise have been sold abroad. These goods are now bought by residents within the country at prices higher than those bid for them by foreigners. As a result, on the one side there is a decline in imports and thus in the demand for foreign exchange, while on the other side there is an equally large reduction in exports and thus also a decline in the supply of foreign exchange. Imports are paid for by exports, not with money as the superficial Neo-mercantilist doctrine still maintains.

If one really wants to check the demand for foreign exchange, then, to the extent that one wants to reduce imports, money must actually be taken away from the people—perhaps through taxes. This sum should be completely withdrawn from circulation, not even given out for government purposes, but rather destroyed. This means adopting a policy of deflation. Instead of restricting the importation of chocolate, wine and cigarettes, the sums people would have spent for these commodities must be taken away from them. The people would then either have to reduce their consumption of these or of some other commodities. In the former case [i.e., if the consumption of imported goods is reduced] less foreign exchange is sought. In the latter case [i.e., if the consumption of domestic articles declines] more goods are exported and thus more foreign exchange becomes available.

It is equally impossible to influence the foreign exchange market by prohibiting the hoarding of foreign moneys. If the people mistrust the reliability of the value of the notes, they will seek to invest a portion of their cash holdings in foreign money. If this is made impossible, then the people will either sell fewer commodities and stocks or they will buy more commodities, stocks, and the like. However, they will certainly not hold more domestic currency in place of foreign exchange. In any case, this behavior reduces total exports. The demand for foreign exchange for hoarding disappears and, at the same time, the supply of foreign exchange coming into the country in payment of exports declines. Incidentally, it may be mentioned that making it more difficult to amass foreign exchange hampers the accumulation of a reserve fund that could help the economy weather the critical time which immediately follows the collapse of a paper monetary standard. As a matter of fact, this policy could eventually lead to even more serious trouble.

It is entirely incomprehensible how the idea originates that making the export of one's own notes more difficult is an appropriate method for reducing the foreign exchange rate. If fewer notes leave the country, then more commodities must be exported or fewer imported. The quotation for notes on exchange markets abroad does not depend on the greater or lesser supplies of notes available there. Rather, it depends on commodity prices. The fact that foreign speculators buy up notes and hoard them, leading to a speculative boom, is only likely to raise their quoted price. If the sums held by foreign speculators had remained within the country, the domestic commodity prices and, as a result, the “final rate” of foreign exchange would have been driven up still higher.

If inflation continues, neither foreign exchange regulations nor control of foreign exchange clearings can stop the depreciation of the monetary unit abroad.

  • 18. [See Mises's The Theory of Money and Credit, pp. 180–86; 1980, pp. 207–13.—Ed.]
  • 19. See my paper “Zahlungsbilanz und Valutenkurse,” Mitteilungen des Verbandes österreichischer Banken und Bankiers II (1919): 39ff. [NOTE: Pertinent excerpts from this explanation of the “balance of payments” fallacy have been translated and appear here in the Appendix, pp. 44–51. See also Human Action, 1966, pp. 450–58; 1998, pp. 447–55.—Ed.]
  • 20. From the tremendous literature on the subject, I will mention here only T.E. Gregory's Foreign Exchange Before, During and After the War (London, 1921).