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

Appendix: Balance of Payments and Foreign Exchange Rates

The printing press played an important role in creating the means for carrying on the war.29 Every belligerent nation and many neutral ones used it. With the cessation of hostilities, however, no halt was called to the money-creating activities of the banks of issue. Previously, notes were printed to finance the war. Today, notes are still being printed, at least in some countries, to satisfy domestic demands of various kinds. The entire world is under the sway of inflation. The prices of all goods and services rise from day to day and no one can say when these increases will come to an end.

Inflation today is a general phenomenon, but its magnitude is not the same in every country. The increase in the quantity of money in the different currency areas is neither equal statistically—an equality which, given the different demands for money in the different areas, would be apparent only—nor has the increase proceeded in all areas in the same ratio to the demand for money. Thus, price increases, insofar as they are due to changes from the money side, have not been the same everywhere. ...

Price increases, which are called into existence by an increase in the quantity of money, do not appear overnight. A certain amount of time passes before they appear. The additional quantity of money enters the economy at a certain point. It is only from there, step by step, that it is dispersed. It goes first to certain individuals in the economy only and to certain branches of production. As a result, in the beginning it raises the demand for certain goods and services only, not for all of them. Only later do the prices of other goods and services also rise. Foreign exchange quotations, however, are speculative rates of exchange—that is, they arise out of the transactions of business people, who, in their operations, consider not only the present but also potential future developments. Thus, the depreciation of the money becomes apparent relatively soon in the foreign exchange quotations on the Bourse—long before the prices of other goods and services are affected. ...

Now, there is one theory which seeks to explain the formation of foreign exchange rates by the balance of payments, rather than by a currency's purchasing power. This theory makes a distinction in the depreciation of the money between the decline in the currency's value on international markets and the reduction in its purchasing power domestically. It maintains that there is only a very slight connection between the two or, as many say, no connection at all. The exchange rate of foreign currencies is a result of the momentary balance of payments. If the payments going abroad rise without a corresponding increase in the payments coming into the country, or if the payments coming from abroad should decline without a corresponding reduction of the payments going out of the country, then foreign exchange rates must rise.

We shall not speculate on the reasons why such a theory can be advanced. Between the change in the exchange rates for foreign currencies and the change in the monetary unit's domestic purchasing power, there is usually a time lag—shorter or longer. Therefore, superficial observation could very easily lead to the conclusion that the two data were independent of one another. We have also heard that the balance of payments is the immediate cause of the daily fluctuations in exchange rates. A theory which explained surface appearances only and did not analyze the situation thoroughly could easily overlook the facts that (a) the day-to-day ratio between the supply of and demand for foreign exchange determined by the balance of payments can evoke only transitory variations from the “static” rate formed by the purchasing power of various kinds of money, (b) these deviations must disappear promptly, and (c) these variations will vanish more quickly and more completely the less restraints are imposed on trade and the freer speculation is.

Certainly there shouldn't be any reason to examine this theory further. It has been settled scientifically. The fact that it plays a significant role in economic policy may be a reason for investigating the political basis for its undoubted popularity among government officials and writers. Still that may be left to others.

However, we must concern ourselves with a new variety of this balance of payments doctrine which originated with the war. People say it may be generally true that the purchasing power of the money, rather than the balance of payments, determines the exchange rate of foreign currencies. But now, in view of the reduction of trade brought about by the war, this is not the case. Since trade is hampered, the process which would restore the disrupted “static” exchange ratios among foreign currencies is held in check. As a result, therefore, the balance of payments becomes decisive for the exchange rates of foreign currencies.30 If it is desired to raise the foreign exchange rate, or to keep it from declining further, one must try to establish a favorable balance of payments. ...

The basic fallacy in this theory is that it completely ignores the fact that the height of imports and exports depends primarily on prices. Neither imports nor exports are undertaken out of caprice or just for fun. They are undertaken to carry on a profitable trade, that is to earn money from the differences in prices on either side. Thus imports or exports are carried on until price differences disappear. ...

The balance of payments doctrine of foreign exchange rates completely overlooks the meaning of prices for the international movement of goods. It proceeds erroneously from the act of payment, instead of from the business transaction itself. That is a result of the pseudo-legal monetary theory—a theory which has brought the most cruel consequences to German science—the theory which looks on money as a means of payment only, and not as a general medium of exchange.

When deciding to undertake a business transaction, a merchant does not ignore the costs of obtaining the necessary foreign currency until the time when the payment actually comes due. A merchant who proceeded in this way would not long remain a merchant. The merchant takes the ratio of foreign currency very much into account in his calculations, as he always has an eye to the selling price. Also, whether he hedges against future changes in the exchange rate, or whether he bears the risk himself of shifts in foreign currency values, he considers the anticipated fluctuations in foreign exchange. The same situation prevails mutatis mutandis with reference to tourist traffic and international freight. ...

It is easy to recognize that we find here only a new form of the old favorable and unfavorable balance of trade theory championed by the Mercantilist School of the sixteenth to eighteenth centuries. That was before the widespread use of banknotes and other bank currency. The fear was then expressed that a country with an unfavorable balance of trade could lose its entire supply of the precious metals to other lands. Therefore, it was held that by encouraging exports and limiting imports so far as possible, a country could take precautions to prevent this from happening. Later, the idea developed that the trade balance alone was not decisive, that it was only one factor in creating the balance of payments and that the entire balance of payments must be considered. As a result, the theory underwent a partial reorganization. However, its basic tenet—namely that when a government did not control its foreign trade relations, all its precious metals might flow abroad—persisted until it lost out finally to the hard-hitting criticism of Classical economics.

The balance of payments of a country is nothing but the sum of the balances of payments of all its individual enterprises. The essence of every balance is that the debit and credit sides are equal. If one compares the credit entries and the debit entries of an enterprise the two totals must be in balance. The situation can be no different in the case of the balance of payments of an entire country. Then too, the totals must always be in balance. This equilibrium, that must necessarily prevail because goods are exchanged—not given away—in economic trading, is not brought about by undertaking all exports and imports first, without considering the means of payment, and then only later adjusting the balance in money. Rather, money occupies precisely the same position in undertaking a transaction as do the other commodities being exchanged. Money may even be the usual reason for making exchanges.

In a society in which commodity transactions are monetary transactions, every individual enterprise must always take care to have on hand a certain quantity of money. It must not permit its cash holding to fall below the definite sum considered necessary for carrying out its transactions. On the other hand, an enterprise will not permit its cash holding to exceed the necessary amount, for allowing that quantity of money to lie idle will lead to loss of interest. If it has too little money, it must reduce purchases or sell some wares. If it has too much money, then it must buy goods.

For our purposes here, it is immaterial whether the enterprise buys producers’ or consumers’ goods. In this way, every individual sees to it that he is not without money. Because everyone pursues his own interest in doing this, it is impossible for the free play of market forces to cause a drain of all money out of a city, a province or an entire country. The government need not concern itself with this problem any more than does the city of Vienna with the loss of its monetary stock to the surrounding countryside. Nor—assuming a precious metals standard (the purely metallic currency of the English Currency School)—need government concern itself with the possibility that the entire country's stock of precious metals will flow out.

If we had a pure gold standard, therefore, the government need not be in the least concerned about the balance of payments. It could safely relinquish to the market the responsibility for maintaining a sufficient quantity of gold within the country. Under the influence of free trade forces, precious metals would leave the country only if a surplus was on hand and they would always flow in if too little was available, in the same way that all other commodities are imported if in short supply and exported if in surplus. Thus, we see that gold is constantly moving from large-scale gold producing countries to those in which the demand for gold exceeds the quantity mined—without the need for any government action to bring this about31. ...

It may be asked, however, doesn't history show many examples of countries whose metallic money (gold and silver) has flown abroad? Didn't gold coins disappear from the market in Germany just recently? Didn't the silver coins vanish here at home in Austria? Isn't this evidence a clear-cut contradiction of the assertion that trade spontaneously maintains the monetary stock? Isn't this proof that the state needs to interfere in the balance of payments?

However, these facts do not in the least contradict our statement. Money does not flow out because the balance of payments is unfavorable and because the state has not interfered. Rather, money flows out precisely because the state has intervened and the interventions have called forth the phenomenon described by the well-known Gresham's Law. The government itself has ruined the currency by the steps it has taken. And then the government tries in vain, by other measures, to restore the currency it has ruined.

The disappearance of gold money from trade follows from the fact that the state equates, in terms of legal purchasing power, a lesser-valued money with a higher-valued money. If the government introduces into trade quantities of inconvertible banknotes or government notes, then this must lead to a monetary depreciation. The value of the monetary unit declines. However, this depreciation in value can affect only the inconvertible notes. Gold money retains all, or almost all, of its value internationally. However, since the state—with its power to use the force of law—declares the lower-valued monetary notes equal in purchasing power to the higher-valued gold money and forbids the gold money from being traded at a higher value than the paper notes, the gold coins must vanish from the market. They may disappear abroad. They may be melted down for use in domestic industry. Or they may be hoarded. That is the phenomenon of good money being driven out by bad, observed so long ago by Aristophanes, which we call Gresham's Law.

No special government intervention is needed to retain the precious metals in circulation within a country. It is enough for the state to renounce all attempts to relieve financial distress by resorting to the printing press. To uphold the currency, it need do no more than that. And it need do only that to accomplish this goal. All orders and prohibitions, all measures to limit foreign exchange transactions, etc., are completely useless and purposeless.

If we had a pure gold standard, measures to prevent a gold outflow from the country due to an unfavorable balance of payments would be completely superfluous. He who has no money to buy abroad, because he has neither exported goods nor performed services abroad, will be able to buy abroad only if foreigners give him credit. However, his foreign purchases then will in no way disturb the stability of the domestic currency.

  • 29. Originally published as “Zahlungsbilanz und Devisenkurse” in Mitteilungen des Verbandes Oesterreichischer Banken und Bankiers 2, nos. 3–4 (1919). This translated excerpt represents about one-third of the original article.
  • 30. For the sake of completeness only, it should be mentioned that the adherents of this theory attribute domestic price increases, not to the inflation, but to the shortage of goods exclusively.
  • 31. See Hertzka, Das Wesen des Geldes (Leipzig, 1887), pp. 44ff.; Wieser, “Der Geldwert und seine Veränderungen,” Schriften des Vereins für Sozialpolitik 132 (Leipzig, 1910): 530ff.