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IV. Economics and Ideas

44. On the International Monetary Problem

What is nowadays called governmental monetary management encompasses two kinds of policy. It is, on the one hand, deficit spending, i.e., undisguised inflation to enable the government to spend over and beyond the amount of funds collected by taxation or borrowed from the public. It is, on the other hand, a policy of easy money, i.e., of attempts to lower the market rate of interest by credit expansion.

The governments as well as their henchmen are fully convinced that this expansionist policy is highly beneficial to the immense majority of all decent people. They emphatically deny that increasing the quantity of money in circulation is what economists, politicians, and all sane people used to call and still call "inflation." As they see it, inflation has nothing to do with the quantity of money in circulation; rather it is a reprehensible procedure of greedy businessmen that ought to be prevented by government control of prices. In the eyes of the official doctrine, interest is essentially a factor hindering the development of "really productive" business. Such a doctrine views interest as a tribute that the industrious members of society are compelled to pay to a race of lazy moneylenders.

Only a few outsiders have the courage to deviate from the government-decreed methods of dealing with the expansionist policy. Very seldom does one meet in public discussion of the problem of rising prices and wage rates any reference to the government-made inflation. It is not that the authors of books, articles, and speeches about the problems involved knowingly avoid dealing with the genuine cause of the phenomena investigated. They are honest in their argumentation. Their "new economics" has told them that nothing but evil can emerge from the "anarchy" of the market. Their panacea is the "plan," i.e., the government's unlimited dictatorship in all economic and political affairs.

In monetary matters mankind has already for many years enjoyed the benefits of a world-embracing planning office, but it seems that the results do not satisfy anybody. There is irritating talk about an international or world problem of the nations' mutual monetary relations. There are national and international committees and conferences for the study of the matter. Many books and innumerable pamphlets and articles deal with the subject. There is general agreement that the present state is unsatisfactory and that a change is unavoidable. With this in mind, let us examine the international monetary problem.

Balance of Payments Doctrine

When the servants of a government search for the cause of some unsatisfactory condition, they always discover that the authorities have done all that could be done for a perfectly satisfactory solution of the matter in question. But the beneficial effects of their action failed to appear because the people frustrated the wise plan of their rulers. The best-known doctrine of this type was once the balance of trade theory and later its modern offshoot, the balance of payments theory.1

After all, it made some sense in the 19th century when some people still referred to this long-since entirely refuted doctrine as justification for some restrictions on the importation of foreign merchandise and on other payments to foreigners. It gave the government an excuse?of course, a vicious one?for maintaining that by indulging in foreign luxuries people were sabotaging their ruler's wise monetary policy. When domestic money is shipped to foreign countries as payment for imported "superfluous luxuries," proclaimed the officials, it becomes superabundant abroad and therefore its price, in terms of foreign money, falls, causing the price of the foreign money to rise in terms of the domestic money. This unwelcome rise in the price of foreign exchange in terms of the domestic money is caused, it is said, by an "unfavorable balance of payments," due to sending money abroad to pay for foreign imports. This doctrine explained the depreciation of the domestic money by the "unpatriotic" consumption habits of consumers. It is, therefore, the sacred duty of good government to prevent such bad citizens from damaging the interests of the nation.

But in recent decades the declarations of U.S. government authorities with reference to the "balance of payments" bogey could not even seemingly exonerate the government and make the people responsible. The government of the United States in this period not only spent scores of billions of dollars for the conduct of foreign wars and for garrisoning armed forces in far distant parts of the world. It distributed alms of many dozens of billions under the newfangled title of "foreign aid." It was ridiculous demagogy to mention the "balance of payments" issue in connection with the expenses of American tourists visiting the Acropolis, of American students attending the University of Paris, and to pass over in silence the subsidies that enabled various "F?hrers" of semibarbarous countries to establish and to preserve their despotic regimes. Only ignorance on the part of the representatives of the "new economics" can explain their attempts to revive the long since entirely discredited "balance of payments" interpretation of mutual exchange ratios between various currencies.

The theory maintained by economists, the so-called purchasing-power-parity theory, says: the exchange ratio between different currencies tends toward a point at which it does not make any difference which currency is employed in selling or buying. The parity is characterized by the fact that no gains can be made by buying against units of A currency and selling against units of B currency or vice versa. Any deviation from this parity will be corrected?"automatically," as a frequently misinterpreted term says?by the actions of people who want to profit by such buying and selling. This insight was already implied in the reasoning of Gresham's law. When domestic inflation makes prices in the country of A currency rise while there is no inflation and therefore no general upward movement of prices in the country of B currency, the previous exchange ratio between the two currencies A and B must change.2

International Exchange Ratios

If all over the world there prevailed the strict and pure gold standard, no other monetary problems would exist other than technological ones, e.g., that of properly minting the coins. No government interference with the technical production of coins would be necessary. The same would be the case if there could be established a world monetary center, not a bank operated by angels removed from all earthly concerns and interests.

In our actual world every government claims national sovereignty in all monetary matters. Even this state of affairs could result, at least for a majority of civilized nations, in rather satisfactory conditions, i.e., a state of affairs characterized by the absence of any monetary problems and crises. In order to achieve and to preserve such a state of affairs every nation belonging to this group of civilized nations would have to abstain from any kind of "monetary welfarism." It would have to strictly avoid any policy that would interfere with the?once and for all time?established exchange ratio between its domestic currency and the currencies of all the other nations that proceeded in the same way and thereby belonged to this group of civilized nations.

The actual state of affairs is entirely different. Most of the civilized nations are officially committed to a policy of a stable exchange ratio either between their national currency and gold or, what ought to be the same, between their national currency and the currencies of countries, that also aim officially at a stable exchange ratio between their own currency and those of other nations that are committed to the same principle. But the government economists maintain there are conditions that make it extremely difficult or even quite impossible for the monetary authorities of a nation to preserve this officially-decreed exchange ratio. There are unpatriotic citizens whose business transactions impair the nation's balance of payments. And, still worse, there are speculators who aim directly at making the price of foreign exchange rise above the parity fixed by the authorities. To frustrate these "attacks" upon the stability of the foreign exchange rates is believed to be one of the foremost duties of good government.

In the terminology of economics, what the military jargon employed by monetary authorities qualifies as "attacks" is a rising demand for foreign exchange. Notwithstanding its policy of increasing the quantity of money and lowering interest rates, the government wants to maintain a definite exchange ratio between the domestic (national) currency on the one side and gold and foreign exchange of other countries committed to the same policy on the other side. As the demand for gold or foreign exchange rises, the government sees the amount of its "reserves" dwindle. This is the situation in which the governments and public opinion declare that "something must be done." There is no need to expatiate about this fact and its consequences. The question to be raised and answered is: What is it that increases the demand for foreign exchange and moves people to offer higher prices in domestic currency for it?

Inflation and Inflationism

Practically all governments consider the two foremost goals of monetary policy to be: first, to inflate their nation's currency system in order to be able to spend more than the amounts collected by taxation or borrowed from the public; and secondly, to bring about credit expansion in order to lower the rates of interest below the height they would attain on a free money market. It is these policies that necessarily and inevitably produce all those phenomena which the monetary authorities ascribe to the alleged unfavorable state of the balance of payments and to the machinations of speculators.

Let us begin with inflation and inflationism. Inflation is an increase in the quantity of money in circulation that surpasses the increase in the demand for money for cash holding. Inflationism is a government policy of increasing the quantity of money in order to enable the government to spend more than the funds provided by taxation and borrowing. Such "deficit spending" is nowadays, as everybody knows, the characteristic signature of the U.S. government's financial policies. It is highly praised under the label of "the new economics."

Of course, these advocates of boundless inflation have adopted a terminology that attaches to the words a different meaning. They use the term "inflation" to refer to what is merely the unavoidable effect of inflation, namely the general tendency of prices and wages toward higher points, and they ascribe this tendency to the greed and avarice of businessmen. They pretend that the government is sincerely and honestly committed to a policy of price stability.

Let us see. The government plans an additional expenditure. Let us assume that the government wants to raise the salaries of a group of public servants. It collects the funds required by raising the taxes to be paid by certain people. Then the increase in purchases, in terms of the national money on the part of those benefited by higher salaries corresponds to the drop in purchases on the part of those who were forced to pay higher taxes. By and large, no change in the purchasing power of the monetary unit results.

But if the government simply provides the funds required for the higher salaries by issuing an additional quantity of legal-tender money, things are different. Those benefited by the new additional money compete on the market with all those whose demand had already been instrumental in the determination of the previous prices. An increased quantity of money is offered to buy a not-increased quantity of goods. The outcome is higher prices for vendible merchandise, or, what is the same, a drop in the "purchasing power" of the country's monetary unit.

Let us assume the exchange ratio between the Ruritanian rur and the Maritanian mar was 1 to 2. Now the Ruritanian government inflates and consequently prices expressed in rurs are rising while no changes occur in Maritania. It is obvious that such a state of affairs must necessarily bring about a corresponding alteration in the price of rurs expressed in mars or, what is the same, in the price of mars expressed in rurs. For now one rur buys only a smaller quantity of merchandise than 2 mars. One can gain by buying against mars, selling against rurs, and then exchanging these rurs at the rate of 1:2 against mars. Such transactions are inevitably bound to transform the previous exchange rate and finally to establish again a purchasing-power-parity rate adequate to the altered purchasing power of the rur.

The regular course of events under present conditions is this: Ruritania inflates and consequently Ruritanian prices are rising. But the Ruritanian government is anxious to preserve the previous exchange rate against foreign currencies. It tries to maintain this rate in its own exchange operations. As it is profitable to buy mars at the official rate, the demand for them increases and the monetary authorities of Ruritania see their "reserves" of foreign exchange drop. This is the emergency that is called "illiquidity" and makes the official circles clamor for more "reserves."

Then there is a second kind of government policy that results likewise in an increased demand for foreign exchange. The governments want to lower the market rate of interest. They resort to various measures for the attainment of this end. As far as these measures bring about credit expansion, they produce the same effects which the simple inflation of deficit spending brings about. But they disarrange besides the equilibrium of the market for short-term loans. Funds are withdrawn from the country's market for short-term loans, usually called money market, precisely because the authorities have temporarily succeeded in lowering domestic interest rates. This movement too results in a rising demand for foreign exchange.

We see now that this intensified demand for foreign exchange, these "attacks" upon the "reserves" in the hands of the monetary authorities, the central bank or its equivalent, are neither acts of God nor the outcome of machinations on the part of antipatriotic selfish citizens or of foreign enemies. They are the inevitable reaction of the market upon the monetary interventionism of the government, its misguided and misplaced monetary welfarism.

Inflationism is not a variety of economic policies. It is an instrument of destruction; if not stopped very soon, it destroys the market entirely. There is no need to refer to historical experiences, such as that of the German Weimar Republic of the years of 1920-1923. It is a shame that in the discussions concerning present-day monetary problems some of the nonsense is revived that was brought forward in earlier periods of inflation.

Inflation Cannot Last

Any variety of inflationism and any attempts of institutionally lowering the rate of interest are incompatible with plans for the establishment of something that could be called an international system or order of monetary affairs. As long as the governments of many or even of most of the commercially important nations are committed to such policies, it is idle to talk about an efficient international organization of monetary matters.

Nothing characterizes the state of present-day "official" economic doctrine better than the fact that in the great flood of books and articles published about the international monetary problems there is hardly any reference to the issues of inflation and anti-interest measures. In the light of this literature and the pronouncements of the "monetary authorities" there prevails some mysterious evil, mostly called lack of liquidity, that thwarts the allegedly well-designed endeavors of governments and central banks to render international monetary conditions perfectly satisfactory. There is not enough "liquidity"; the "reserves" of the central banks, or of the institutions to which the functions of a central bank have been entrusted, are not large enough. The remedy is obvious: one needs more reserves. How can this be achieved? Of course, by "creating" more legal tender of those nations for whose notes and deposits the demand is most urgent.

Ruritania has succeeded in lowering its domestic loan market's interest rates. The result is a withdrawal of short-term funds from Ruritania, and a rising demand for mars. The Ruritanian central bank sees its reserve in mars and in other foreign currencies dwindle. There is, say the experts, a solution for this problem: let the Maritanian central bank or other central banks lend to their Ruritanian sister the mars or other foreign money required. That means: let the foreign banks inflate up to a point at which their own currencies are no longer better than that of Ruritania.

The insufficiency of this suggestion moved some authors to elaborate plans for a "reserve currency." This currency should serve merely as an increase in the "reserve" of central banks. But the withdrawals of funds from Ruritania are made not only by other nations' central banks; they are made first of all by people who want to invest or to spend the funds withdrawn. For these people a "reserve currency" is useless. They want to get "real" money, not a "reserve" money.

Whatever people may say about a policy of increasing the quantity of fiat money, there is one aspect of it that even the most obstinate of its advocates cannot deny: Inflationism cannot last; if not radically stopped in time, it must lead inexorably to a complete breakdown. It is an expedient of people who do not care a whit for the future of their nation and its civilization. It is the policy of Madame de Pompadour, the mistress of the French King Louis XV—Après nous le Déluge.

Today we are still able to stop the progress of inflation and to return to sound principles of financing government expenditure. But will we have the same opportunity tomorrow?


To prevent a misinterpretation of the preceding statements concerning the height of the rate of interest and the height of profits some additional remarks are appropriate.

In dealing with the problems of an inflationary upward movement of prices, when one refers to the gross rate or market rate of interest, one must realize that the expectation of such a change in the height of prices will affect the size of the gross interest rate. People who expect a rise in definite prices are prepared to borrow at higher gross rates of interest than they would be ready to pay if they were to expect a less momentous rise in prices, or no rise at all. On the other hand the lender under such conditions grants loans only if the gross rate agreed upon is higher than it would be in the absence of such expectations. Thus, the expectation of rising prices has the tendency to make the market rate, the gross rate of interest, rise. There appears in this gross market rate a component?called the "price premium" by economists?that owes its existence to the cognition and anticipation of the inflationary movement of prices.

There is need to stress this point to show the futility of the usual methods of distinguishing between what people call low and high rates of interest. When the market rate rises above the height they consider "normal," people believe that everything possible has been done to keep "speculation" under control. From this point of view they gauge the raising of the rate of discount by one or a few percentage points by the monetary authorities as a "check" upon "inflationary speculation."

Another fact to be noted concerns the height of profits. All customary methods of accounting are necessarily based upon the unit of the nation's currency system. They do not pay heed to changes in this unit's purchasing power. One result of this neglect is that with the progress of inflation the habitual depreciation quotas shrink substantially, and that profits calculated without taking this fact into consideration are illusory. A second source of overvaluation of an enterprise's profits is due to the drop in the money's purchasing power occurring in the period between the acquisition and sale of merchandise. And then come the tax authorities and the labor unions and claim their share of these "excessive" profits that in fact i.e., when calculated in gold or a not-inflated foreign currency, may be not profits at all, but losses.

Reprinted from American Opinion, March 1967.

  • 1. For a brilliant critique of the balance of payments theory of foreign exchange see Rothbard, Man, Economy and State, Princeton 1962, pp. 719-722.
  • 2. For a detailed exposition see the writings of Gustav Cassel, Edwin Cannan, and Benjamin McAlester Anderson and my own contributions.