20. Problems of Credit Policy

CHAPTER 20 PROBLEMS OF CREDIT POLICY

Summary

The governments of Europe and America have been guided by the idea that the natural desire of the banks to issue fiduciary media must be checked, in order to avoid economic crises. However, this goal conflicts with the other desires for low interest rates and high selling prices.

The degradation of the classical gold standard was already well underway before the outbreak of World War I. First, citizens ceased using gold in everyday transactions, and the actual gold was stockpiled in the vaults of each country’s central bank, which issued paper notes instead. Then the gold was even further concentrated into the central banks of just a few major countries, so that not even the central banks (of most countries) had gold in their vaults. Although it would have undesirable deflationary consequences, a transition back to an actual gold currency—in which people used genuine gold coins in daily purchases—is the only realistic check on government-sponsored inflation.

The original étatist arguments for regulating the issue of competing notes by private banks do not look nearly as compelling after the experience of German hyperinflation. The alleged evils of a free market in banking are nothing compared to the actual evils under a government monopoly of the currency.

People must choose between a fiat system regulated by index numbers of prices, or a return to an actual gold currency. In order to prevent recurring economic crises, the absolute prohibition of the further issuance of fiduciary media is necessary. If banks continue with the ability to issue fiduciary media, it leaves open the destruction of the entire monetary system, as a coordinated policy of expansion—perhaps under a World Bank—would have no checks on its inflationary potential.

Chapter Outline

I. PREFATORY REMARK

1. The Conflict of Credit Policies

Since the time of the Currency School, the governments of Europe and America have been guided by the idea that the natural desire of the banks to issue fiduciary media must be checked, in order to avoid economic crises. However, this goal conflicts with the other desires to foster “cheap money” and “reasonable prices,” i.e., low interest rates and high prices for certain producers.

II. PROBLEMS OF CREDIT POLICY BEFORE THE WAR

2. Peel’s Act

Peel’s Bank Act [Bank Charter Act 1844] took the power of issuing new notes away from private banks and vested it completely with the Bank of England, which itself was required to maintain 100 percent metallic backing for any new notes that it issued. However, the Act crucially did not impose such a restriction on the extension of deposits. In other words, private banks could create more fiduciary media by granting loans (not backed by gold) to their customers, thus lowering the rate of interest and expanding the stock of money in the broader sense. In this way, Peel’s Act contained a “safety valve” that prevented a sharp rise in the objective exchange value of money (i.e., falling prices of goods and services), but at the same time it failed to eliminate economic crises because it erroneously thought they were due exclusively to unbacked notes.

3. The Nature of Discount Policy

Many writers, as well as the general public, do not understand the “real” economic forces behind movements in interest rates; instead they view increases in interest rates as arbitrary and unnecessary constraints on the community’s prosperity. For example, it is in the nature of banking that an individual bank must raise the interest rate it charges on new loans, if its reserves of money in the narrower sense are being drained because it has issued more fiduciary media than its competitors. This behavior would occur whether or not government or central bank rules required it.

When it comes to international movements of capital, people also fail to understand that domestic interest rates must reflect conditions in the world market. There is nothing more mysterious in foreign events altering domestic interest rates, than (say) a foreign crop failure raising domestic fruit prices.

4. The Gold-Premium Policy

The Bank of France implemented a well-known gold-premium policy, in which it charged a premium (somewhere in the range of 0.4 to 0.8 percent) on requests to exchange francs for gold, if the gold were going to be invested abroad seeking a higher return. The purpose of the policy was to widen the gap by which the Bank of France could maintain a lower discount rate than prevailed in other countries. The policy hindered capital outflows and inflows, and hindered the full incorporation of France into the world market. The only way to truly insulate Bank policy from the rest of the world market would be to leave the gold standard entirely, adopting credit money or fiat money and thereby suffering inflation.

5. Systems Similar to the Gold-Premium Policy

Central banks have adopted other techniques to hinder the export of gold. For example, they might not surrender gold to exporters in the most convenient form, or they might give worn-out coins that had slightly less metal content than the coins intended for domestic use.

6. The Non-Satisfaction of the So-called “Illegitimate” Demand for Money

Attempts to only provide gold for export when the purpose is “legitimate” would fail to achieve their objective in the long-term, as speculators would find other means to achieve the same end. Moreover, there is a whole spectrum of intermediate cases between “legitimate” demands for commodity importation and “illegitimate” speculation on foreign investments. For example, what if a foreign company wanted to withdraw deposits that it had previously invested in a country? Would the authorities permit a “loss” of gold in this circumstance?

7. Other Measures for Strengthening the Stock of Metal Held by the Central Banks-of-Issue

While central banks-of-issue adopted policies to raise the upper gold point and thus discourage the export of gold, at the same time many adopted policies to reduce the lower gold point and thus encourage imports of gold. The two sets of policies largely offset each other, so that the actual gap between the gold points did not change as much as might have been supposed.

8. The Promotion of Cheque and Clearing Transactions as a Means of Reducing the Rate of Discount

In Germany before the first World War, there was an effort to reduce the German people’s everyday use of gold, and replace it with the use of check and clearing transactions. This would allegedly allow the Reichsbank to hold a larger reserve of metal, and keep a lower discount rate. However, there is no necessary connection between the long-run rate of interest and the quantity of fiduciary media.

III. PROBLEMS OF CREDIT POLICY IN THE PERIOD IMMEDIATELY AFTER THE WAR

9. The Gold-Exchange Standard

During the World War I, the major powers (except the United States) explicitly suspended the gold standard. However, the degradation of the classical gold standard was already well underway before the outbreak of war. First, citizens ceased using gold in everyday transactions, and the actual gold was stockpiled in the vaults of each country’s central bank, which issued paper notes instead. Then the gold was even further concentrated into the central banks of just a few major countries, so that not even the central banks (of most countries) had gold in their vaults. Instead, they too had paper claims entitling them to the gold that was stored elsewhere.

In this way, virtually the entire world became accustomed to using paper as their money, which had a more and more tenuous link to gold. As of 1924, the world price of gold was dominated by the actions of the United States government. Yet such an outcome is the antithesis of the whole rationale for the gold standard: to keep political interference out of money.

10. A Return to a Gold Currency

Although it would have undesirable deflationary consequences, a transition back to an actual gold currency—in which people used genuine gold coins in daily purchases—is the only realistic check on government-sponsored inflation. Had the citizens of the great powers been using gold on the eve of World War I, it would have been much more difficult for their governments to run the printing presses to pay for armaments.

11. The Problem of the Freedom of the Banks

12. Fisher’s Proposal for a Commodity Standard

The famous American economist Irving Fisher proposed that index numbers would track an average of commodity prices, so that the dollar itself could be defined as a variable weight of gold that possessed constant purchasing power in terms of the commodities in the index.

There are several problems with Fisher’s proposal. First, the various index numbers are arbitrary; there is no scientific way to measure the “true” change in the purchasing power of gold from month to month. Another problem is that the market already has techniques for handling changes in the purchasing power of money; Fisher’s proposal would simply lead to an adjustment of the techniques. Finally, even ignoring the other problems, Fisher’s proposal would not counteract the differential impact that inflation has as it unevenly spreads through the economy. If the price index increases by 1 percent in a certain month, this is because some prices increased by more than 1 percent, while others increased by less.

13. The Basic Questions of Future Currency Policy

People must choose between a fiat system regulated by index numbers of prices, or a return to an actual gold currency. In order to prevent recurring economic crises, the absolute prohibition of the further issuance of fiduciary media is necessary. (Such a prohibition must go beyond Peel’s Act, and include bank deposits as well as notes, for economically the two are equivalent.) If banks continue with the ability to issue fiduciary media, it leaves open the destruction of the entire monetary system, as a coordinated policy of expansion—perhaps under a World Bank—would have no checks on its inflationary potential.

Only by freeing money and banking from political influence can people avoid economic crises while maintaining the highest possible stability of the purchasing power of money.

Technical Notes

• On pages 377–82, Mises describes the “gold-premium policy” implemented by the Bank of France. In the absence of such a premium, investors wouldn’t distinguish between domestic and foreign investments (except perhaps for a slight psychological preference for the former), and would put their capital where it would earn the highest return. If the Bank of England’s discount rate were higher than the Bank of France’s, then French investors would turn their francs in for gold, use the gold to buy bonds in England, then convert the gold back into francs after earning their interest. The result would be a higher rate of return (measured in francs) than if the investors had lent the money in France. However, if turning francs into gold involves payment of a (small) premium to the Bank of France, then investors would only adopt the above strategy if the difference in interest rates were sufficiently large. Therefore, the gold-premium policy gave the Bank of France a wider margin to keep interest rates relatively low, before suffering from an outflow of gold.

• On page 398, Mises points out that most arguments criticizing the operation of a private, competitive banking system were “thoroughly unsound.” The one legitimate argument came from the Currency School, which (correctly) pointed out that if private banks issued notes in excess of their gold reserves (i.e., fiduciary media), this could cause economic crises. Ironically, this danger only exists when the banks all operate under a uniform discount policy—they must all inflate in unison, or else the bank that is the most aggressive will have its fiduciary media returned to it (through clearing operations), and it will quickly lose its gold reserve to its competitors. Yet somehow, these observations led to the call to abolish competitive banknote issue and replace it with a government monopoly. As Mises says, “Now the monopolization of the banks-of-issue in each separate country does not merely fail to oppose any hindrance of this uniformity of procedure; it materially facilitates it.”

New Terminology

Upper gold point: Under the gold standard, the maximum market price of gold (quoted in a country’s currency) above which it is profitable—including all costs of transport, re-coinage, etc.—for foreigners to exchange the domestic currency for gold (at the official redemption rate, which is below the current market price), and have the gold shipped out of the original country.

Lower gold point: Under the gold standard, the minimum market price of gold (quoted in a country’s currency) beneath which it is profitable—including all costs of transport, re-coinage, etc.—for citizens to import gold and exchange it with the authorities at the official redemption rate for the domestic currency.

Study Questions

1. What was the theoretical error of the Currency School, and why was this mistake an “advantage” with respect to the implementation of Peel’s Act? (pp. 369–70)

*2. When Mises claims that a sole bank, engaging in a more inflationary policy than its competitors, would endanger its “solvency” (p. 374), is that consistent with his definition of the term (versus “liquidity”) on page 331?

3. Explain: “The banks would still have to have a discount policy even if there were no legislative regulation of the note cover.” (p. 374)

4. How did France’s gold-premium policy hinder both the outflow and inflow of capital? (p. 382)

5. Explain: “There is only one danger that is peculiar to the issue of notes; that of its being released from the common law obligation under which everybody who enters into a commitment is strictly required to fulfill it at all times and in all places. This danger is infinitely greater and more threatening under a system of monopoly.” (p. 399)

Study Guide to the Theory of Money and Credit