PART IV MONETARY RECONSTRUCTION CHAPTER 21 THE PRINCIPLE OF SOUND MONEY Chapter Outline 1. The Classical Idea of Sound Money

The principle of sound money must be placed in the context of the broader, classical liberal program of containing government tyranny. Just as a constitution or a bill of rights would be adopted, in light of historical abuses of civil liberties, in the same way the classical liberals of the nineteenth century wanted to prevent governments from wrecking currencies as had occurred throughout history.

Sound money involves a metallic standard, with all tokens and paper notes being redeemable in the metallic money upon demand. In practice, this has meant gold since the late nineteenth century.

Although their ideas were correct, the classical liberals did not adequately defend the gold standard from its critics, and the public fell sway to erroneous inflationary doctrines.

2. The Virtues and Alleged Shortcomings of the Gold Standard

It is true that the public generally welcomes inflationism as opposed to the orthodoxy of the gold standard, but only because they misunderstand the true situation. Producers welcome “high prices” when it is their own prices in question, but they don’t welcome increasing prices in the items they themselves must purchase. Inflation can only give even the appearance of prosperity, in situations where the majority don’t recognize what is happening. For this reason, inflationism cannot be a lasting economic policy.

Contrary to its critics, the gold standard did not “collapse.” Rather, it was systematically and intentionally destroyed by governments bent on inflation. Those writers who blame the “rules of the gold standard game” for keeping interest rates high, do not understand the function of interest rates and how credit expansion causes economic booms and busts.

3. The Full-Employment Doctrine

An employer will only hire a man if he is productive enough to justify the wage he expects to be paid. If the employer would lose money by hiring the man, he will remain unemployed. When government policies and unions use coercion to hold wage rates above the market-clearing level, institutional unemployment results.

In this setting, it is true that monetary inflation may cause commodity prices to rise faster than wage rates. This will decrease the unemployment rate, but only because it effectively lowers the workers’ real wages. Once the labor unions realize what is happening, they will begin demanding automatic wage increases tied to the “cost of living.” Then the apparent benefits of inflation (in reducing unemployment) will disappear.

4. The Emergency Argument in Favor of Inflation

Some writers concede the negative effects of inflation, but argue that in certain emergency situations, it is the only method by which governments can carry out vital tasks. Yet inflation per se does not increase the physical and human resources at a country’s disposal. If an apologist for inflation claims that it is the only way to finance a war, he is admitting that the public would not agree with the government’s war expenditures if it fully understood the sacrifice they would entail.

Important Contributions

• On pages 420–21 Mises responds to a critique of the gold standard that its opponents continue to use. Modern-day critics still say (as they did in Mises’s time) that the gold standard “collapsed” and that governments are no longer willing to play the “rules of the gold standard game.” What they mean is that governments were no longer willing to renounce the (short-term) benefits to themselves of inflation, and so they refused to redeem their currencies in specie. Yet Mises points out that the governments did much more than this. In order to wean the public off gold, they employed “policemen, customs guards, penal courts, prisons, in some countries even executioners.” In Mises’s view, governments actively combat the public’s preference for a sound commodity money. Contrary to the claims of the inflationists, maintenance of a commodity money doesn’t require a special commitment from the government, but rather requires only that the government obey its contractual obligations like everybody else in a market economy.

• On pages 423–26, Mises places Keynesian analysis in a tradition of faulty theories going back to the “spurious grocer philosophy ... exploded by Adam Smith and Jean-Baptist Say.” These classical economists argued that a general business depression was not caused by a “dearness of money,” and consequently could not be solved by monetary inflation. Say’s discussion (which later came to be summarized as “Say’s Law”) explained that ultimately, the grocer’s customers earned the purchasing power to demand his products by first supplying their own goods and services. As an economy grew over time, the various sectors increased their output across the board. Say argued that relative prices would adjust to maintain the proper balance among the sectors, but there was not a danger that the economy as a whole could produce a “general glut” that could only be remedied by an expansion of the stock of money.

New Terminology

Institutional unemployment: The situation where workers are qualified and willing to accept jobs at prevailing wage rates, yet cannot find employers to hire them.

Real wages: Wage rates relative to the prices of goods and services.

Study Questions

1. What was the “serious blunder” of the nineteenth-century advocates of the gold standard? (p. 415)

2. What connection does Mises make between the gold standard and representative government? (p. 416)

3. How did governments manage to abandon the gold standard? (p. 420)

4. What is the only efficacious way to raise real wage rates? (p. 424)

5. What’s wrong with the emergency argument in favor of inflation? (pp. 426–28)

CHAPTER 22

CONTEMPORARY CURRENCY SYSTEMS

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)

CHAPTER 23

THE RETURN TO SOUND MONEY

Summary

The disintegration of the worldwide classical gold standard has gone hand-in-hand with the march toward all-round central planning. The return to sound money involves a renunciation of inflation. This is only possible if the public recognizes the futility of interventionist government.

The return to sound money still means a return to the gold standard. Only under this system will the determination of the monetary unit’s purchasing power remain outside the sphere of government control. The only way to truly safeguard a nation’s money is to remove all avenues for inflation. This includes not only the government’s resorting to the printing press to finance its deficits, but also commercial banks’ ability to issue deposits not fully backed up by money proper.

For a relatively small country (“Ruritania”) the government of which has been using inflation to finance its deficits, the government must first (temporarily) prohibit the further issuance of fiduciary media denominated in “rurs.” Once the rur’s exchange rate (as well as the price of gold quoted in rurs) has clearly peaked, the government of Ruritania locks in the current market price of either a U.S. dollar or gold (quoted in rurs). An agency will be dedicated with the sole task of maintaining the rur’s redemption rate to either the dollar or gold at this rate, forever. Ruritania will be back on the gold exchange standard.

The United States government must return to the classical gold standard. An agency will be established that will buy or sell gold against dollars upon demand, at this rate. In order to provide more resistance to future inflation, the government should suppress small-denomination paper notes, which would force Americans to once again carry full-weight gold coins in their cash balances.

Only an abandonment of the interventionist mindset, coupled with a return to the classical gold standard, can safeguard the currency.

Chapter Outline

1. Monetary Policy and the Present Trend Toward All-Round Planning

The disintegration of the worldwide classical gold standard has gone hand-in-hand with the march toward all-round central planning. The trends are related. Inflation allows government officials to seize control of more resources than the public would otherwise approve. Rising prices pushes people into higher tax brackets and allows the government to tax “excess profits” from businesses. The social unrest caused by inflation can be blamed upon capitalism, giving the government yet another pretext to expand its power.

The return to sound money involves a renunciation of inflation. This is only possible if the public recognizes the futility of interventionist government.

2. The Integral Gold Standard

The return to sound money still means a return to the gold standard. Only under this system will the determination of the monetary unit’s purchasing power remain outside the sphere of government control.

The only way to truly safeguard a nation’s money is to remove all avenues for inflation. This includes not only the government’s resorting to the printing press to finance its deficits, but also commercial banks’ ability to issue deposits not fully backed up by money proper. In other words, governments must spend only what they tax or borrow, and banks must be prohibited from issuing new fiduciary media.

3. Currency Reform in Ruritania

For a relatively small country the government of which has been using inflation to finance its deficits, the crucial thing is to quickly assure world investors that the currency is stabilized. There is a two-step process involved. First, the government of Ruritania must (temporarily) prohibit the further issuance of fiduciary media denominated in “rurs,” the currency of the country. This will cause the exchange rate of the rur to stop falling against other, major currencies as well as gold.

Once the rur’s exchange rate (as well as the price of gold quoted in rurs) has clearly peaked, and begun a definite downward trend, it is time for step two. In this stage, the government of Ruritania locks in the current market price of either a U.S. dollar or gold (quoted in rurs). An agency will be dedicated with the sole task of maintaining the rur’s redemption rate to either the dollar or gold at this rate, forever. If people turn in dollars or gold (depending on the choice of the link), the agency is allowed to issue new rurs, which are backed up 100 percent by the new deposit. At this point, the rur will be back on either a dollar- or gold-exchange standard, and no new fiduciary media can be issued.

4. The United States’ Return to a Sound Currency

The United States government must return to the classical gold standard, which offered a stronger check on inflation than the gold-exchange standard. It must first prohibit the issuance of new dollars, whether in the form of Treasury notes or bank balances not backed up 100 percent by cash deposits. After the dollar-price of gold stabilizes, the U.S. government will announce the current market price as the new, permanent exchange rate between the U.S. dollar and gold. (The new price might very well be higher than the official rate of $35 per ounce, established in the Bretton Woods agreement near the end of World War II, and lasting until Richard Nixon abolished the last remnants of the gold standard in 1971.)

An agency will be established that will buy or sell gold against dollars upon demand, at this rate. In order to provide more resistance to future inflation, the government should suppress small-denomination paper notes, which would force Americans to once again carry full-weight gold coins in their cash balances.

5. The Controversy Concerning the Choice of the New Gold Parity

Within the ranks of those advocating a return of the U.S. to the gold standard, there is controversy over the appropriate exchange rate. The restorers want to go back on gold at the rate of $35 per ounce, which was established in the 1934 Gold Reserve Act (and was the gold price used in the Bretton Woods system). The stabilizers want to free the market to hold and use gold, then set the dollar to the new price of gold that will be established in the market, even if it happens to be more than $35 per ounce.

The arguments of the restorers are inconsistent. There is nothing “honest” about going back to $35 per ounce. A much stronger case could be made that the pre-1933 price of $20.67 per ounce of gold was the true parity, which Roosevelt then dishonored as one of his first acts in office. Furthermore, the people who were harmed by the prior inflation would not necessarily be the same ones to benefit from a current bout of deflation. For example, it is true that a bond originally issued in (say) 1928, promising to pay $1,000 per year for fifty years, would have had its “real” market value sabotaged when FDR devalued the dollar. Yet if the original purchaser of the bond sold it in (say) 1950, then the new owner has already taken into account the new inflationary regime. The full capital loss has already been absorbed by the original owner. At this point, to raise the purchasing power of the dollar by restoring gold to its former parity, would be to present a gift to the new owner of the bond.

The other major flaw with the restorers’ viewpoint is that inflation is harmful not merely because it affects deferred payments. Money is not neutral, and an intentional deflation will have undesirable consequences that will occur in addition to—rather than undoing—the earlier consequences of the inflation.

Concluding Remarks

The public and most intellectuals lament the consequences of inflation, yet they support those policies (government deficit spending and low interest rates) that require inflation. Only an abandonment of the interventionist mindset, coupled with a return to the classical gold standard, can safeguard the currency.

Technical Notes

• On pages 439–40, Mises laments that even many supporters of sound money do not recognize the danger in bank credit expansion when undertaken to support business (as opposed to financing government deficits). Yet the circulation credit theory of the trade cycle (developed in part III, chapter v) shows the weakness in this thinking. That is why Mises here advocates a complete prohibition on the issuance of new fiduciary media, since he believes it is the only sure way to avoid future crises that will inevitably discredit capitalism. (Note that Mises’s suggested reforms would not transform the banking system into a 100-percent-reserve arrangement, because the previously issued fiduciary media would still exist.)

• Although they are similar, Mises’s proposals (in sections 3 and 4) for currency reform in the generic small country “Ruritania” versus the United States are different. Mises wants to quickly stop the rapidly depreciating currency of Ruritania, the government of which has been monetizing its deficits. Mises is content to stop the downward spiral by restoring Ruritania to either a dollar- or a gold-exchange standard. (Recall that the dollar itself was still tied to gold at the official rate of $35 per ounce when Mises wrote these proposals.) For the United States, Mises wants to stop the further issuance of fiduciary media—in order to arrest the boom-bust cycle—and to restore the classical gold standard. This latter objective explains Mises’s proposal for abolishing paper notes in denominations of $5, $10, and perhaps $20, so that the public would carry full-weight gold coins (stamped with $5, $10, etc.) for these transactions.

New Terminology

Restorers: Those who want a country to return to a gold standard at a historic parity, a move that would require deflation.

Stabilizers: Those who want a country to return to a gold standard by locking in the current market price of gold.

Monetizing government deficits: Covering the difference between government expenditures versus tax receipts and loans from private lenders, by resort to the printing press.

Study Questions

1. Explain: “While advocating high prices and wage rates as a panacea and praising the Administration for having raised ‘national income’ ... to an unprecedented height, they blamed private enterprise for charging outrageous prices and profiteering.” (p. 437)

*2. Mises writes (pp. 437–38) that allegedly progressive governments will not abandon their “most formidable weapon, inflation.” Yet isn’t this a version of the critique of the gold standard (pp. 420–21) that said modern governments were no longer willing to follow the rules of the gold-standard game?

3. In what consists the “eminence of the gold standard”? (p. 438)

4. Why does Mises (humorously) pick the name “John Badman” for the Ruritanian in one of his thought experiments? (p. 446)

5. What is the “incurable defect” of the gold-exchange standard (as opposed to the classical gold standard)? (p. 451)