Forty Centuries of Wage and Price Controls

14

The Price of World Currency

When someone buys a share in a large corporation for $100, he is merely exchanging one commodity (money) for another (stock). Similarly, one international currency (say, dollars) can be exchanged for another (say, yen or sterling). The exchange rate between dollars and stock which buyer and seller agree on is the price of the share; the exchange rate between currencies is usually referred to only as the exchange rate, although in every way it is just like a price.

One of the key ways in which exchange rates are like prices is that governments strive to regulate them.

GOLD AND SILVER

Suppose that we have only two international currencies, gold and silver. Then there will be an exchange rate between them, since people are willing to exchange most things provided that they can agree on the rate of exchange.

In the Middle Ages, gold and silver circulated as media of exchange in exactly this way. Sometimes gold was the most common medium, sometimes silver. In the sixteenth century the new finds of silver in the New World gave silver the upper hand. But such inflows strained the accepted doctrine that silver had a “proper” gold price. In other words, price-fixing of silver against gold was subject to just the same pressures as any other attempt to fix prices.

Because of the so-called Gresham’s Law,* named after the English Treasury Minister of the time:

There was a tendency for one type of coin to become dominant when governments were willing to exchange silver for gold. . . [only] according to a specific standard. Under these conditions either the gold or silver coin could be expected to circulate less. If, for example, the free bullion market gave more silver for gold than the government standard for coinage at the government mint, the natural tendency would be to melt down gold coins and sell them for silver on the free market. On the other hand, if the free bullion market gave more gold for silver than the government mint, the tendency would be for gold to be coined while silver coins would be melted clown for bullion to sell in the free market. . . . The “bad” money, that contained the metal less favored in the free market compared with the government standard, drove out the “good” money, that contained the metal more favored in the free market. Gresham’s law was for centuries a bete noire to governments issuing bimetallic currencies, because as the market ratio between them would change, one currency would tend to move out of circulation.1

Price-fixing of one currency in terms of another just did not work.

In order to get around the problems of bimetallism, England started to quote prices in gold and also in silver, allowing the value of gold in terms of silver to vary, but the so-called “parallel standard” was an obvious inconvenience to trade and in 1717 it was abolished. And once more the official exchange rate of 15:20 did not correspond with the market rate. The official exchange of silver for gold was higher than the market rate and so silver tended to move out of circulation.

Again, market conditions changed, and the price trends eventually reversed, such that gold climbed in the 1781–1800 period to reach an exchange rate of 15.09, and seemed likely to move above the official rate. Had this been so, Gresham’s law would have meant that silver would have been brought back into circulation and gold would have been pushed out. To prevent this, the British government had to stop the coinage of silver altogether, except for coins which were so “bad” (that is, had a silver content less than their face value) that they stayed in circulation.

Most of Europe remained on bimetallism, but this happy price-fixing was blotted by two developments in the mid-nineteenth century. The first was the rapid increase in gold production from California; the second was the absorption of all world silver production as currency in India. Hence, the market price of silver in Europe was pushed up and bimetallism was put under irresistible strains.

Strangely, the conventional wisdom in international currency markets was that a fixed rate of exchange between gold, silver and other (paper) currencies was the very foundation of stable world trade and prosperity. It is an understandable belief, but it was eventually shattered by the upheaval of the First World War. Exchange rates began to fluctuate, to be set at new levels, and then to fluctuate again. Britain fixed its currency in terms of the price of gold in 1925. But the pressure upon sterling (and upon most of the currencies of the belligerents) proved too much to withstand, and on September 21, 1931, Britain allowed the pound to float. Its value against the dollar declined 30 percent by the end of the year. Rolfe and Burtle write:2

In most of the world, England’s abandonment of the gold standard was viewed as an unprecedented disaster. But, freed of the burden of an unrealistic exchange rate, the economic results in England were favorable. Between 1931 and 1936, United Kingdom manufacturing production climbed 44.5 percent. Much less progress was made in countries that went back to the gold standard. England’s floating rate was followed in 1934 by a dollar devaluation in terms of gold (of 40.9 percent) and the gold bloc in an effort to retain their fixed parities was put under more and more strain.

BRETTON WOODS

The world powers meeting at Bretton Woods, New Hampshire, in 1944, developed a new system of international currency exchange, which fixed parities up to a point, but which never really worked. The gold exchange system was revived and gold became the foundation of the new economic system. Each nation would hold its reserves in gold, which could be freely converted into dollars. The parities of other currencies were fixed, but devaluation was possible within a narrow range of ten percent, more if there was agreement from the International Monetary Fund.

So, prices were fixed once again. But before Bretton Woods could work, huge depreciations against the dollar were necessary, and took place before 1950. This widespread suspension of the rules made the effectiveness of the whole agreement open to doubt and by 1958 it had become more evident that the system of fixed rates created massive disequilibria, huge and alarming flows of gold from the United States, and so on. Currencies reeled in 1965 as countries like Britain found they had to devalue against the dollar and Germany became the new financial power in Europe. The agreement was formally dissolved in 1971 when President Nixon ended the convertibility of the dollar into gold. Despite the fact that these devaluations and revaluations were regarded as a major defeat for the countries concerned and a major defeat for a system which they all wanted to succeed, they found that “the process designed to maintain international payments equilibrium or to restore it if it has been disturbed. . . [functioned] less and less effectively.”3 The professed objective of the agreement, “to promote exchange stability and exchange arrangements and to avoid competitive exchange depreciation,”4 did not work. The theory of the value of fixed currency prices turned out to be an obsolete misconception.

FOOTNOTES

1. Sidney E. Rolfe and James Burtle, The Great Wheel: The World Monetary System (New York: Quadrangle/The New York Times Book Co., 1973) p. 4.

2. Ibid., p. 31.

3. Tom De Vries, “Jamaica, or the Non-reform of the International Monetary System,” Foreign Affairs, April 1976, Vol. 54, p. 578.

4. Van Merrhaege, International Economic Institutions (New York: St. Martin’s Press 1971) p. 23.

* Bad money drives out good.