Study Guide to the Theory of Money and Credit

Chapter Outline

1.   The Inflexible Gold Standard

Under both the classical gold standard and the gold-exchange standard—as they had existed before World War I—each nation’s currency unit was legally tied to an inflexible (i.e., constant) exchange rate against gold. The difference between the two systems was one of degree. Under the classical gold standard, citizens within each country carried actual gold coins and used them in everyday transactions. Anybody could exchange gold for national notes and vice versa without delay. Later, under the gold-exchange standard, citizens only used the government’s paper notes and token coins in domestic commerce. However, the central banks of the world still exchanged their respective currencies against gold at the official (and inflexible) rates.

2.   The Flexible Standard

The flexible standard arose between the world wars out of the prewar gold exchange standard. Here there was no legal redemption requirement, locking in a fixed exchange rate of gold against the national currency. Instead, an agency (such as the central bank) would be given the authority to peg the currency to gold at a rate that could be subject to a sudden change. If the drop in the currency against gold was severe enough, the event would be called a devaluation.

3.   The Freely Vacillating Currency

A freely-vacillating currency is one with no official peg to gold at all. The currency is a credit or fiat money, held on account of its expected future purchasing power. If the government exercises restraint, such a money—even though it is a “bad currency”—can persist.

4.   The Illusive Standard

Sometimes a government will announce a (variable) peg to its currency, yet this isn’t a flexible standard. The government enforces the peg through penalties and confiscation, not through redemption at the official rate. The illusive standard is thus a form of price control, and leads to a shortage in the foreign exchange market.

Technical Notes

•   As Mises explained earlier in the book (pp. 180-86), exchange rates adjust on an unhampered market until there is no advantage to buying a commodity in one currency and immediately selling it in another currency. Yet under an illusive standard, the government of a country actively interferes with this process, often to keep the price of its own currency above the market-clearing price that would achieve purchasing power parity. In Mises’s example (p. 434), the market clears when one dollar trades for 100 Ruritanian rurs. If a barrel of oil (say) sells for $100 in the United States, and for 10,000 rurs in Ruritania, there is no arbitrage opportunity at the correct exchange rate. However, if the Ruritanian government announces that it will put people in prison who pay more than 50 rurs for one dollar, then the exchange rate will rise to the artificial price (at least within the borders of Ruritania). At the new exchange rate, oil purchased abroad will now only cost 5,000 rurs per barrel, compared to the domestic price of 10,000 rurs. Ruritanian refiners will thus try to sell their rurs against dollars, in order to buy oil and import it. However, foreigners will not want to sell many dollars for rurs at the ratio of 1-to-50, because the actual market ratio is 1-to-100. Consequently the Ruritanian refiners will complain that they “can’t find dollars” to finance their desired imports. There is an apparent “shortage of dollars.”

•   After explaining the mechanics of foreign-exchange controls, Mises on page 434 classifies them as “a device for the virtual expropriation of foreign investments.” He has in mind a scenario such as the following: Suppose a U.S. capitalist invests $1 million building a factory in Ruritania. At the original, market-determined exchange rate, the capitalist sells his $1 million for 100 million rurs, and uses the currency to buy materials, hire workers, etc. in Ruritania to set up the factory. Every year the factory earns a net income of 5 million rurs. The foreign owner would have his local agents sell the 5 million rurs in the foreign exchange market, converting them to $50,000, and wiring the money back to his bank account in the United States. Thus from either the viewpoint of the factory manager (reckoning in rurs) or from the foreign investor (reckoning in dollars), the rate of return on the invested capital is five percent per year. However, when the Ruritanian government imposes foreign-exchange controls and sets a new price of $1 for 50 rurs (instead of 100), the market for dollars dries up. Now when the factory earns its usual 5 million rurs, the American investor can’t get the money out of the country. It’s true that officially speaking, his 5 million rurs is now worth $100,000, double the previous amount. But this is little consolation, since no one with dollars will actually trade $100,000 for 5 million rurs. People around the world would be willing to trade half that ($50,000) for 5 million rurs, but the Ruritanian government will punish any of its citizens caught accepting such an offer. Thus the American’s $1 million factory in Ruritania has effectively been taken over by the Ruritanian government, since it controls the foreign-exchange market, and converting rurs into dollars is the only way the American owner can derive any benefit from his investment.

New Terminology

Classical gold standard: The system by which a country’s currency is redeemable on demand for a fixed weight of gold. In Mises’s usage, under a classical gold standard, a portion of the citizens’ cash balances consists of actual gold coins and bullion to be used for making purchases.

Gold-exchange standard: The system by which a country’s currency is redeemable on demand for a fixed weight of gold, though sometimes only by other governments and central banks. In Mises’s usage, under a gold-exchange standard the citizens used only paper notes in everyday transactions, while the actual gold was stored in bank or government vaults.

Flexible standard: The system by which a country’s currency is redeemable for a variable weight of gold, to be announced by the government at its discretion.

Currency peg: The variable and nonlegally-binding rate at which a government is currently maintaining its currency’s exchange rate against gold.

Devaluation: The situation in which a country on the flexible standard announces a large drop in the value of its currency against gold.

Freely-vacillating currency: A credit or fiat currency that has no official peg to gold at all. Its market price fluctuates just as any commodity.

Illusive standard: The system by which a country’s currency is pegged to gold at nonmarket rates. The exchange rate is maintained not through the manipulation of gold reserves but rather through the enforcement of foreign-exchange controls.

Foreign-exchange controls: Government restrictions on the market for foreign currencies.

Study Questions

1.  Under the classical and gold exchange standards, did it matter if banknotes were endowed with legal tender status? (p. 429)

2.  Why did the unorthodox statesman prefer the term “peg” to “redemption”? (p. 430)

*3.  Mises says (p. 431) that credit and fiat moneys “are not money substitutes but money proper in themselves.” Does this mean that commodity money is not money proper?

4.  What is the outstanding instance of a freely-vacillating currency? (p. 431)

5.  Why does Mises dislike the term “scarcity of foreign exchange”? (pp. 433–34)