The Economics of Illusion

The views most commonly held in the present discussion on the problem of stabilization may be summarized as follows: Advocates of stabilization argue that the disturbances and divergences to which the world economy is subject today are attributable primarily to the fact that the exchanges are not stable; those who oppose the idea of stabilization consider the causal sequence to be in the very opposite direction, urging that the first step to take is to bring about a rough equalization of the divergent elements, notably the difference in the purchasing power parity between different countries. They assert that a stabilization, if at all desirable, should be the final phase of a kind of experimental period during which one must needs have restored rational purchasing-power parity conditions, whereas the advocates of stabilization desire forthwith the binding of the exchange ratios as a prerequisite if the purchasing power parity is to be restored, which, however, they do not consider to be in itself absolutely essential. “When the Council of the B.I.S. contemplate (as in their last report) a return to a regime of fixed gold parities, they are living in an unreal world, a fool’s world!” In this recent utterance of Keynes2 the views of the opposition reach their highest pitch of intensity.

Even if, like the author of these lines, one accepts the arguments of the antistabilizationists, one must nevertheless admit that the English economists in particular have on one point thoroughly misjudged the situation. Assuming that what they consider to be common sense will obviously appear to be so too in the eyes of others, they have for some time past been forecasting an early devaluation of the gold currencies. This has not yet taken place, however, and, at any rate as far as Switzerland and Holland are concerned, it is extremely doubtful whether such a step is imminent. Those who entertain a different view on this point underestimate the strength of the antidevaluationist ideas and of tradition in these gold-bloc countries. They forget that in this no less than in other spheres it is not always the logically tenable ideologies that determine the issue.

Whether, however, one believes that the present exchange conditions in the world will be of long or of short duration, these conditions, which have in any case lasted for years, merit theoretical analysis with a view to ascertaining how far those exchanges which are today firmly linked to gold are really to be regarded as gold exchanges in the classical sense of the term.

Among the gold currencies, those which are subject to exchange control and only thereby maintain their old or a more or less reduced parity have no doubt shown the greatest changes. It is a moot question whether these exchanges are still to be regarded, even in the less strict sense of the term, as gold exchanges. On this point the views of the country concerned and those of foreign countries mostly differ. Perhaps these currencies might conveniently be termed formal gold currencies, seeing that the exchange rate, which is fixed officially in relation to other exchanges, is essentially of only formal significance. For the foreign exchange cannot freely be obtained at the official rate for the purpose of adjusting items either in the trade balance or in the balance of payments in general. Debt and interest payments as well as capital transfers to abroad are prohibited or regulated in some way or other. Foreign exchange to finance imports is not sold at the official rate on a scale sufficient to meet every demand but is rationed, while for the exports-exchange it is in reality not the official rate but, thanks to subsidies and premiums, a lower rate that applies. Thus, the official rate is not the price at which an adjustment is effected between supply and demand, the “parity” rate becoming in actual fact a purely formal one. It is difficult therefore to understand why any such rate is maintained at all. However, we shall not discuss that aspect of the matter here.

To the monetary theorist the real gold exchanges that still exist are of far greater interest. For, however paradoxical it may sound, it may well be asked, even in regard to them, whether they are still gold exchanges in the traditional sense.

Opinions on the essential nature of the gold exchanges are as widely divergent as most economic doctrines. Few perhaps will contradict the statement that Ricardo’s views, as propounded in those passages of his works in which he deals as an exponent of the quantity theory with monetary and banking problems,3 are to be regarded as the best thought out and still the most widely held in the world today. We shall only mention en passant here the fact that in other passages 4 he bases the value of gold and money on the amount of labor they contain, a theory which is untenable and in conflict with the theory just mentioned.

In the view of Ricardo as an exponent of the quantity theory, the essence and aim of a gold exchange is to maintain the purchasing power of the domestic currency in relation to foreign gold currencies. To him a gold currency is an international currency—and this not so much for the reason that one can buy for it anywhere in the world as because its mechanism guarantees that one can buy as much for it at home as abroad. To him it is the currency that possesses an internationally anchored purchasing power. The mechanism that guarantees its safe anchorage works, as everyone knows, in the following manner: If, in consequence of the increasing abundance of money, or, as it would nowadays be expressed, in consequence of an expansion of credit, the prices in a country begin to rise, the exports will go down and the imports will increase. In order to cover the deficit in the trade balance, gold will flow out of the country. This will contract the gold-exporting country’s quantity of money, or credit, so that prices will fall, while the gold balances abroad will increase, with the effect of raising prices there. The process goes on in this manner until the purchasing power parity—as Ricardo would say were he to use our present-day form of expression—has been restored.

A gold standard in Ricardo’s view—and indeed in any common-sense view—is a standard subject to the following rules: both at home and abroad gold can freely be sold and bought at a fixed price. If the domestic price level rises, then gold as the cheapest export commodity is shipped abroad. This process lets loose forces which tend to deflation in the home country and to inflation abroad. This is the sole purpose that gold serves: by being transferred from one country to another it exercises internationally a stabilizing effect on the value of money.

The question whether the present gold-bloc currencies are still gold currencies in the classical sense may thus be reduced to the question whether the “rules of the game” are still being followed.

Hitherto the central banks of the gold-bloc countries have redeemed their notes with gold or gold exchanges on anyone’s demand. Consequently the gold-bloc exchanges have so far never fallen to any appreciable extent below the gold export point. Therefore there seems to be little reason to doubt that the rules just quoted are actually being followed. If, however, we look more closely into the circumstances under which the export of gold takes place, we find that, as soon as it assumes substantial proportions, this export principally meets the demand for gold which arises when people begin to lose confidence in their own currency. The function of gold exports has chiefly been to finance the flight of capital to gold or to other exchanges that are to be had for gold. This, however, is a purpose that Ricardo (for instance) never even thought of and which indeed can hardly be regarded as legitimate. On the other hand, as regards the export of gold for the purpose of adjusting differences in purchasing power, it is certainly true that gold is sometimes exported to finance deficits in the trade balance. But these deficits are never anything like proportionate to the difference in purchasing power. By means of a complicated and refined system of tariffs and quotas—compared with which the erstwhile high-tariff countries now seem like a free-trade paradise—such imports are excluded as would otherwise inundate the country owing to the difference in purchasing power, and deficits in the trade balance and in the balance of payment are prevented. The rules of the gold exchanges have not been suspended. But this is true only in a very formal sense; for the chief contestants in the game are never able to insist on the rules’ being respected. By taking measures in the sphere of trade policy, measures in that of gold policy can be avoided.

The domestic price level is maintained by keeping out a one-sided flow of imports—in protection of home enterprise, which would otherwise find it impossible to compete with the cheaper import goods. For if the prices at home were on a level with those abroad there would be no need for import restrictions. At the same time, however, the “gold automatism” that is the true purpose of every gold exchange is put out of function. As nevertheless the gold exchange is maintained, it is possible to observe as in many other spheres of social life the following very interesting phenomenon: What was originally a means becomes an end in itself and the original aim is no longer sought after—indeed in the present connection it is directly counteracted. But this involves the transition of the gold currency from an international exchange to a national one. Without transferring both his capital and himself abroad the citizen cannot use his gold for making purchases on the world market in conformity with its international purchasing power; he is prevented from doing so by import prohibitions and quota systems. He can disburse his gold only by converting it into the local currency—i.e., on the basis of the essentially lower domestic purchasing power. Out of this arises a paradoxical situation: The gold in the countries of the gold bloc possesses its full international purchasing power only in the hands of those who go to countries with a sterling or dollar exchange, not in the hands of those who remain at home. It may be said, therefore, that the gold exchange for the maintenance of which so many sacrifices are made in the countries of the gold bloc is there subject to a system of control which theoretically, in spite of all disparities as regards practical consequences, differs only quantitatively, not qualitatively, from the control exercised in countries with an exchange control system. These gold exchanges, then, may perhaps be termed denatured gold exchanges.

If the above reasoning is correct, it means that there are at present in the world two gold-exchange spheres, the French-Netherlands-Swiss and the British-American. (I here leave out of account the fact that the Bank of England, while it buys and sells gold, lets the buying and selling prices fluctuate within certain limits.) Between those spheres with a devalued and those with a nondevalued gold exchange there are differences in purchasing power, but these differences cannot be adjusted owing to difficulties being placed in the way of intercourse. The most striking peculiarity about this state of affairs is a tendency of the two spheres to adopt an increasingly strong autarchic attitude towards each other. For it is possible by means of a quota system to reduce imports but not to increase exports, since you can prevent the citizens of your own country from buying cheaply abroad but you cannot compel the foreigner to buy in a dear market. Likewise, for the same reason any attempt to bring exports up to a level with imports by means of reciprocal trade treaties is bound to fail. A policy aiming at an artificial restriction of a country’s imports, or else at making them by means of reciprocal agreements dependent upon the willingness of foreign countries to accept whatever that country wishes to export, may, on the whole (apart from certain exceptional cases), possibly succeed in preventing changes in the net result of the trade balance but is bound at the same time to force the trade turnover down to an ever lower and lower level. It is, however, of interest to note that the autarchic tendencies cannot go beyond certain limits. As soon as it is realized that the situation means ruin to all those branches of industry which are producing for visible or invisible export, it becomes necessary to subsidize that export. Indeed, in the non-devalued countries the export industries are now largely working with the aid of export premiums, while on behalf of those export industries which are not yet subsidized similar schemes have been drawn up which by force of circumstances will no doubt have to be put into practice. Ultimately, of course, these subsidies have to be paid for by the public in the form of increased taxes or enhanced prices. From the point of view of the consumers, therefore, the system acts as a devaluation, and it does in fact represent an indirect devaluation.

To the important question how long a system of this kind can be kept going it may be replied that theoretically there is no reason, from the purely technical point of view of the exchange problem, why such a system must break down. But from the practical and the political points of view the matter naturally becomes more complicated: The permanent depression which the system must for many reasons necessarily and unavoidably involve gives rise to factors of social tension whose scope is often underestimated. The perhaps not inevitable, but in any case possible, consequences of such tension have lately become apparent in France: Instead of the theoretically correct, but for reasons of practical politics Utopian, way out through price and budgetary deflation, which Laval wished to follow, the opposite extreme, price and budgetary inflation for the sake of “creating work,” is more and more insisted upon. This leads—the road via devaluation being blocked by obstacles of an internal politicopsychological nature—to what is from the point of view of monetary theory the most paradoxical of all demands, the demand for “an expansion of credit without devaluation.” But any such policy is bound to result, vis-à-vis abroad, in differences in purchasing power, the consequences of which cannot any longer be counteracted by the present system of trade restrictions. After some time it is bound, owing to the trade balance becoming more and more adverse, to lead to a heavy drainage of gold, even if, contrary to expectation, the authorities should succeed, by “creating an atmosphere of confidence,” in preventing the balance of payments from becoming increasingly unfavorable through the flight of capital. If they continue to pursue this policy, it will inevitably lead to exchange control—or devaluation. It is, however, the same with devaluation as with the Sibylline Books—the longer the delay the higher the price owing to the destruction of existing values. And yet, if devaluation is adopted at all, it will be adopted only at the very last moment. For the creditors make the currency laws, whereas the debtors do not always bring about a revolution, although they sometimes do. This no doubt explains why history can hardly produce a single instance in which the policy of the opposite extreme—the policy of adjustment and deflation, such as Laval tried to pursue—has ever been carried to a successful conclusion.

As regards Switzerland and Holland, there can be no doubt that a change in the policy of those two countries—if at all likely—is possible only under far more severe economic pressure than they are being subjected to at the present time.

The gold exchange which the United States has introduced at least temporarily by fixing the buying and selling price of gold at $35 per ounce is likewise more of a paradox than is generally imagined. If we are really to grasp its implications we must first of all distinguish between its effect in relation to the countries of the gold bloc on the one hand and countries possessing a paper currency on the other.

1. As regards the former, it may be said that the fact of the United States’ having reverted to the system of fixed buying and selling prices for gold is of no real practical significance. For the importance of the gold automatism described above can only be a subordinate one. As a matter of fact, an efflux from the United States of such gold as is obtainable at a fixed price with the object of preventing a decline in the purchasing power of the dollar is quite out of the question, because at the new parity the dollar has a far higher purchasing power than the gold-bloc currencies have, and, unless a violent inflation in the United States is conceivable, this higher purchasing power will undoubtedly last for years. On the other hand gold automatism does not work in the contrary direction either. In the gold-bloc countries there can be no drainage of gold to the United States, with a resultant lowering of prices in those countries, because such a movement of gold is rendered impossible by their tariff and quota systems. Consequently, the true aim of the gold exchange—the adjustment of the international purchasing power differences—will not be achieved in the intercourse between the United States and the countries of the gold bloc. The fixed price of gold in the United States is of practical importance only in that a Frenchman, for instance, who desires to transfer his capital to the United States procures the dollar, via gold, at a price that is far too low in proportion to its purchasing power. He pays only 16 francs for the dollar instead of 26 francs as he did before the devaluation in the United States. This, however, is a factor that, from the American point of view, can hardly be of any decisive importance. The gold-bloc country may of course find these gold movements, caused by transfer of capital to that country in which the purchasing power is greatest, a problem, for such movements cannot be stopped by quotas and tariff regulations—as is the case with transfers of capital effected in the ordinary course of trade-but only by exchange control.

2. Seeing that the countries of the gold bloc are nowadays merely small islands in a sea of devaluation, it is in practice, of course, a far more important question how the new American gold currency functions vis-à-vis the paper currencies. If we regard without prejudice the function of the new dollar exchange, especially vis-à-vis the pound sterling, we shall find to our surprise that it depends primarily on the Bank of England whether the gold automatism is to come into play, whereas the American exchange authorities have no influence whatsoever in the matter. We might perhaps, therefore, call it a casual gold exchange, seeing that from the American point of view it is actually a matter of chance whether it functions as a gold exchange or not. It will be so only on condition that the Bank of England, or the British Exchange Equalization Fund, does not allow its own gold price to fluctuate parallel to the dollar’s movements in relation to the pound. In other words, if in consequence of a tendency to a rise in prices in the United States sterling rises in terms of the dollar, this will lead to an efflux of gold from the United States only when, in order to prevent this tendency from spreading to England, the Bank of England maintains its buying price for gold unchanged or at any rate refrains from lowering it by as much as the dollar falls in terms of the pound. In the event of the opposite tendency in the United States, the contrary will be the case. Only if the price of gold remains absolutely or relatively unchanged does gold fetch the highest price as an article imported into England and cost the lowest price as an article exported from England. Otherwise the pound rises and falls in relation to the dollar without giving rise to such a drainage of gold as would serve to adjust the purchasing power. The British tactics at the moment seem to be to keep the price of gold stabilized within certain limits. Whether there will be any change in this policy in future, when any tendencies to inflation in the United States appear to make it desirable that the sterling-dollar rate should go up, it is impossible to know, any more than we can know whether the contingency we have thus assumed will ever become a reality. In any case it should be clear how comparatively unimportant and incidental is the part played by the American gold as affecting the adjustment of the purchasing-power parity vis-à-vis the countries of the sterling bloc.

It might perhaps be said, then, that the huge stocks of gold in the United States are only of decorative importance. However, one of the primary functions of gold is also, of course, to represent the permanence of value in time and space. On this ancient and apparently eternal question we may venture to make a few brief remarks—merely with reference to the immediate future. The theoretical knowledge that the value of gold depends on the value of money in a far greater degree than vice versa is without doubt fairly common nowadays. For, after all, gold is worth only exactly as much as the price bid in the open market by the highest bidder among the note-issuing banks. Nonetheless, if we dispassionately examine all the relative facts we need not consider the value of gold to be threatened. So long as the overwhelming majority of the governors of the note-issuing banks believe that they are bound to link their currencies to the gold value which they themselves have previously fixed—so that the currencies may, so to speak, drag themselves by their hair out of the quicksand of worthlessness—for just so long will the “gold prejudice” be valid. It need not even be anticipated that the value of gold will go down to any appreciable extent in the near future. In the United States it will only be under very exceptional circumstances that any lowering of the value of gold will be undertaken. Nor is it likely in England that any appreciable reduction in the price of gold will be permitted, seeing that such a step would entail a rise in the sterling rate in terms of the dollar. On the other hand, neither in the United States nor in England is any new increase in the price of gold to be expected. For people have apparently come to realize the following facts, which are really self-evident: A one-sided increase in the value of gold can, as far as the world economy is concerned, lead only to increased tension in the matter of international purchasing-power differences—that is to say, to enhanced difficulties in the way of world trade. And, for the internal economy, an increase along such lines is neither necessary nor sufficient when one wishes to bring about a rise of the domestic price level.

5 Appeared first in Index, Review of Swennska Handelsbanken, 1936. It should not be forgotten that the article deals with the situation after the devaluation of the dollar and the pound in the thirties. At that time the problem was whether gold currencies without currency restrictions, not whether paper currencies with currency restrictions, should be devaluated. However, whether an artificial exchange rate can and should be maintained by trade restrictions, and whether internal inflation is compatible with external stabilization, is the problem of some European countries today as it was in 1936. The article was written in German and translated into English by the editors of Index.

6 John Maynard Keynes, in Lloyds Bank Monthly Review, No. 68.

7 David Ricardo, The High Price of Bullion, London, 1810.

8 David Ricardo, On the Principles of Political Economy and Taxation, London, 1817, Pt. 1, sect. 1.

• 1* Appeared first in The Commercial and Financial Chronicle, February 17, 1944.
• 2Tübingen, 1st ed., 1920; 2d ed., 1924; 3d ed., 1930.
• 3Berlin, 1930; Tübingen, 1931. These articles, as well as those mentioned above, are available in the New York Public Library.
• 4A summary of this volume will appear in German in “Ordo,” Zeitschrift für Ordnung von Gesellschaft und Wirtschaft, 1949, and in French in Economie appliquée, Archives de l’Institut de Science Economique Appliquée.
• 5  3. The Illusion of the War Boom*
• 6I have attempted to counter to the best of my ability the noxious extremes to which monetary policy and theory seem to swing, pendulum-like, as if subject to a historical law. My first publication, the Volkswirtschaftliche Theorie des Bankkredits, it is true, was an inflationary book in an inflationary time; it was understandable, however, as a reaction against the hyper-classicism of prevailing theory in which the effects on the economy of manipulation of money and credit were entirely ignored. It is, to my present way of thinking, a typical soft money book and I attribute its success mainly to the fact that any soft money book—any book that promises prosperity by the relatively easy means of monetary manipulations—is eagerly taken up by readers who have recently witnessed the beneficial effects of inflation in its first phases.
• 7When in 1929 practice and theory again became deflationary in most countries, and especially in Germany, my fight was directed against deflationism, particularly of the Bruening-Luther brand which, I was convinced, would undermine the economy to the breaking point. The Nazi revolution was, in my opinion, largely the inevitable result of the deflationary policy of the last pre-Hitler government. By lectures and articles in daily papers, notably the Frankfurter Zeitung, and in journals, I tried in vain to combat this policy. Of longer articles that were published separately, 1st Arbeitslosigkeit unvermeidlich? (Is Unemployment Unavoidable?) and Kredit und Krise (Credit and Crisis) may be mentioned. Like that of all similar endeavors, their effect was frustrated by the strongly anti-inflationary editorial attitude of the influential Frankfurter Zeitung and the Deutsche Volkswirt which, even after the pound sterling had been devaluated, saw in every monetary adjustment an attack on the value of the mark and persistently warned against what they called unzulässige Währungsexperimente (inadmissible currency experiments). As occurs all too frequently, the people, politicians, and economists had forgotten the past and were solely under the impression of the immediately preceding experience—the hyper-inflation of 1921-23.
• 8These articles are reprinted in this volume with only slight alterations—some omissions to prevent repetitions, and a few supplementary footnotes. I am conscious that today I would express many things differently and, above all, that somebody else, more familiar with the English language and the technique of expressing theoretical statements usual in this country could do better. However, in view of the almost entire lack of anti-Keynesian literature, I have felt obliged to surmount my inhibitions in order to relieve this situation to the best of my ability.