Gold and the International Monetary System

0:00In my talk on gold and the international monetary system, I have chosen to focus on the works of an undeservedly obscure economist by the name of Michael A. Heilprin. There are, I feel, a number of compelling reasons for doing so. First and foremost, Heilprin was one of a tiny handful of professional economists after World War I to urge going back to a relatively hard-money classical gold standard. Second, while his contributions understandably were never greeted with great warmth by mainstream economists, he has also been inexplicably neglected even by Wall Street and other pro-gold economists. In some small way today, I wish to correct this oversight. Third, Halpern dealt with the whole broad range of issues involved with an international monetary system based on gold, and he did so from a basically Austrian perspective.

0:53Some of the Austrian themes in his writings include the insight that there is an automatic mechanism that ensures that national balances of payments are quickly and precisely adjusted by the market and also that a correct understanding of this mechanism can only be achieved by focusing on individual prices and individual incomes rather than on such misleading aggregates which we hear so much about like the national price level or the gross national product. That's an extremely Austrian insight. Halprin's writings also serve as an invaluable illustration that abstract, sound economic theory does provide an indispensable tool for accurately forecasting the broad effects on economic activities of government policies and institutions.

1:38But perhaps Halprin's most important contribution, and this I will focus on in my talk today, This is brilliant demolition of a long-standing legend to the effect that an international gold standard regularly imposes on a nation internal economic instability. That is, inflationary booms alternating with recessionary busts. So in what follows, I will more or less treat Milprin's masterful demonstration that the international gold standard is both internally and externally stable and that it is the inflationary As early as 1923, John Maynard Keynes declared that the choice of an international monetary regime involved a painful, unpleasant dilemma.

2:32Keynes argued that the operation of the mechanism by which international balances of payments are equilibrated or adjusted under the gold standard regularly and necessarily subjects a nation to bouts of inflation or deflation. This characterization of the gold standard appeared to be confirmed by events when in 1925 Britain reestablished convertibility of the pound and promptly experienced deflationary pressure on its economy. that Britain was only able to offset this pressure by a so-called autonomous monetary policy, or going off gold, in 1931, served as further evidence or proof of the correctness of Keynes' argument. For Halbron, however, the belief that the normal operation of the gold standard is inconsistent with domestic price stability is based on a number of serious errors of economic theory and historical interpretation.

3:27Thus Heilprin considers the dilemma more apparent than real, and I won't be quoting him liberally here, I won't stop to say that I'm quoting him, because it has its source in a rather oversimplified theory of the functioning of the gold standard. One of the most important aspects of this oversimplification involves the use of the concept of a national price level when discussing the functioning of the mechanism. And let me just quote a few sentences from Heilprin here because I think this is important. Such statistical constructions seem to provide a comfortable way out of the perplexing multiplicity and heterogeneity presented by the economic world and the processes that are taking place therein. But the multiplicity does exist, and by ignoring it, one falls into erroneous or meaningless statements about the world and about economic processes, averages more often conceal reality than reveal it, and have to be used cautiously, even in homogeneous collections.

4:27But they are simply without meaning in collections that are not homogeneous. More straightforwardly, Halpern goes on to say, There is no such thing in the real economic world as the general price level. But what exists are prices, and it is the movements of prices and the changes in the structure of money values, including incomes, prices and debts, that are of real interest and of intense importance and the Importance for the Understanding of Economic Phenomena. Thus, by conducting analysis in terms of national price levels, one is naturally led to conclude that what is required, for example in the case of a deficit, is a general deflation of the nation's price level. But this hides the fact that what is really needed to restore balance of payments equilibrium in a deficit situation, that is in a situation where gold is falling out of the country, is a decline of some particular prices, which hardly qualifies as deflation, but deflation in the usual sense of the term.

5:21More importantly, it is highly inappropriate to use the terms inflation or deflation in describing the adjustment process under an international gold standard. On this point, Heilperin approvingly refers to the path-breaking analysis of Friedrich Hayek, of whom we've heard a lot in the past two days. The key to Hayek's analysis is the insight that the adjustment of balance of payments disturbances, that is, surpluses and deficits, occurs via processes of changes in individual prices, incomes and expenditures, which extend throughout the world economy without regard to what nation the seller is located in. The magnitude and even the direction of the change of a particular good's price does not depend, therefore, upon the nation in which the good is offered for sale.

6:09Without really getting abstract, Hayek basically concludes that this microeconomic approach to the balance of payments analysis reveals how superficial and misleading the kind of argument is which runs in terms of the prices and the incomes of the country, There is a second aspect to Hayek's case against the use of terms like inflation and deflation to describe the effects of the international money flows that occur regularly under a gold standard. Now this derives from the fact that under the international gold standard, gold serves in effect as a world money or a world currency.

6:57And therefore, changes in the quantity of money in a particular nation have no more and no less significance than changes in the quantity of money in a particular state, city, or even household. The reason is that each of these units, including the nation, does not form an independent currency area, but is a constituent of the world currency area that employs gold as the general medium of exchange. So, barring a change in the world supply of gold, a net transfer of money from one nation to another will only occur in response to a relative change in the demand for money between the two nations. But the same is true today of a net transfer of dollar balances from one region within, let's say, the U.S. dollar area to another. In the latter case, we would hardly refer, let us say, to the loss of dollars in New Jersey and the acquisition of these currency units by the New York residents as constituting a monetary deflation or inflation.

7:52Thus, to assert that fluctuations in national stocks of money under the international gold standard constitute inflation and deflation is to confuse redistributions of money within one currency area that are components of a larger unified currency area In light of the foregoing considerations, Heilprin concludes that serious balance of payments disturbances requiring large and broad-based adjustments in a nation's price structure do not arise from the day-to-day operation of the gold standard, but from the attempts of government monetary authorities to frustrate such operations. In Halpern's words, in a free economy, the principal cause of a cumulative deficit in a country's international payments is to be found in inflation.

8:43Deficits due to rising domestic prices caused by monetary inflation are in turn exacerbated by outflows of short-term funds and the discouragement of long-term foreign investment as a result of widespread loss of confidence in the ability of the government to maintain convertibility of the domestic currency in the face of persistent deficits and gold outflows. Continued inflation under these circumstances leads to a breakdown of the gold standard and of exchange rate stability. So we get both internal and external instability, not from the gold standard, but from abuses of the gold standard. Thus it is not adherence to the international gold standard that imposes a sacrifice of domestic price stability on a nation. To the contrary, it is the pursuit of inflationary monetary policies leading ultimately to the abolition of the gold standard, which precipitates both internal and external instability in the form of an upward spiraling of domestic prices and the corresponding freefall of the national currency on the foreign exchange markets.

9:42The operation of the gold standard, when correctly understood, therefore poses no dilemma between internal and external stability. But what of the abnormal case in which a large domestic inflation has driven a government to repudiate its pledge to redeem the national currency in gold? Under these circumstances, doesn't the stabilization of the currency via the restoration of the gold standard require internal deflation of money and prices? And the U.S. is in this situation today. And Governor Part T addressed this question and I think gave the wrong answer to it. Under these circumstances, doesn't the stabilization of the currency, the answer is no to all this. All the monetary authorities need to do in this situation is to cease further inflation of the stock of money, and to then tie back onto gold at a devalued parity, or in other words, at a higher price of gold.

10:30In our case, estimates range from $500 to $1400 per ounce, which approximately does reflect the rate of inflation. And this, of course, is the policy that was advocated by Halperin. In fact, this was the course pursued by France under the Poincaré reforms of 1926 through 1928, which put France back on a gold standard. And in fact, France did not suffer any depression of economic activity or deflation of prices during this period. Prices were stable. On the other hand, England did, because they attempted to return to the gold standard at a price that tended to overvalue the pound by 10% and make England's goods uncompetitive on foreign markets.

11:15In short, the price of gold must be altered after an extended bout of fiat money inflation to ensure a smooth transition back to the gold standard. Once the gold standard is again normally operating, there is no further need to tamper with the gold parities to guarantee monetary stability throughout the world currency area. This brings us to the final objection to the international gold standard on the grounds of its alleged incompatibility with domestic macroeconomic stability. Granted that the normal operation of the gold standard secures tolerable long-run price stability in the world economy, Is it not still the case that it facilitates the international transmission of random shocks, such as increases in oil prices, or monetary errors originating in one particular nation, such as large inflations in South American countries?

12:02For example, a rise in prices generated by an abnormally expansionary monetary policy in a large nation will result in a balance of payment surplus and inflow of gold for a nation pursuing a relatively non-inflationary monetary policy. If it strictly adheres to the gold standard, the latter non-inflationary nation will be denied recourse to an autonomous or independent monetary policy to offset the inflationary impact on domestic crisis. Conversely, a contraction of economic activity abroad will generate a balance of payments deficit and loss of gold reserves for the nation in question due to falling off of demand for its products on depressed world markets. The resulting contraction of its money stock will create excess supply in the domestic goods market, thus depressing domestic prices, employment and real income.

12:51All this, we are told, by the monitors in particular, can be avoided at very little cost by the simple expedient of a freely floating national fiat currency, which the world is filled with today. Today. Under this monetary regime, when expansionary pressure is exerted on a nation from abroad, the exchange rate will simply float upward, obviating the need for balance of payments adjustments via inflation of domestic money and prices. Contrary-wise, foreign depressions will be stopped dead at the nation's borders, or so we are told, by a painless depreciation of the exchange rate, which substitutes for the grinding shrinkage of money, prices and and economic activity imposed by the gold standard. Now, Halperin raises two weighty objections to the seemingly impregnable case for fluctuating exchange rates.

13:39First, he contends that the national monetary and economic independence that is promised is far from costless. It is, in fact, purchased at the price of the breakup of the world currency area secured by the international gold standard, and also at the price of the loosening of the only effective anti-inflation restraint and Binding the Hands of National Monetary Authorities. And that is the gold standard. In Halpern's words, the real meaning of the gold standard is that it allows the various currencies to be freely converted to one another, and thus gives the best practical approximation to a world currency. Thus, the international gold standard minimizes the disturbing effects, which a plurality of national currencies can have upon international commercial and financial relations.

14:25In addition, the position of gold as the base of money and credit is the only way of ensuring against wide fluctuations in the value of currencies. And the sensitive response of the money supply to the flow of gold in and out of a country would be the most effective discipline on national economic policies. Now Halpern admits that there exists an abstract possibility of stable exchange rates and non-distorted trade and financial flows under a system of fluctuating exchange rates. However, the abstract model is not borne out by actual experience. This is certainly the lesson to be drawn from the 1930s. Admittedly, the world of the 1930s represents an extraordinary case, as governments struggled to export their unemployment problems and to reflate their economies out of the Depression.

15:12Nonetheless, with theoretical insight leavened by this historical experience, Heilbritt in 1952 was able to accurately foresee And finally, the broad outline of a world of fluctuating national fiat currencies, which we got 20 years later in 1973. Again, let me just read a few sentences from Heilbrunn here. He says, The freedom of action which individual countries, large or small, have in the absence of an international monetary system makes it possible to have a large number of national inflations going on simultaneously, differing in intensity and sheltered by exchange controls and import restrictions adopted by the respective governments. These simultaneous and concurrent national inflations are a characteristic feature of a world of independent currency systems, insulated from one another and protected by national full employment and development programs.

16:01In addition, and I think this is an extremely accurate forecast, coming as it did in 1952, habits of inflation become so widely accepted that inflation as a way of life comes to be regarded by many politicians and even economists, by economists, and I would say especially by economists, as entirely rational and acceptable. Now I submit that the foregoing is a much more accurate forecast of the outcome of the post-Bretton Woods system, or experiment with fluctuating exchange rates. Much more accurate than can be derived from the monetarist abstract model of exchange rates. According to the monetarist model, fluctuating exchange rates would lead to a decline in protectionism, is fewer tariffs, fewer quotas. As governments soon learned that they no longer need worry about their nation's external payments position, which is quickly and automatically adjusted by appropriate movements of the exchange rate. Moreover, we were advised that the world would attain a greater overall degree of macroeconomic stability since more sophisticated and prudent governments could now undertake independent monetary policies and would no longer be locked

17:06to automatically importing the consequences of errors and excesses in monetary policy committed by governments of lesser intelligence and self-restraint. I think the latter really characterizes all governments. While the monetary scenario is certainly one theoretically possible outcome of a fluctuating exchange rate system, it is certainly not the scenario that unfolds in the past decade since the breakdown of fixed exchange rates. In fact, the monetarist predictions come to grief precisely because they ignore, which Halpern does not, the sociological insight that governments are inherently inflationary institutions whose propensity to create money can only be curbed in practice by the gold standard. Furthermore, to camouflage highly visible and unpopular consequences of monetary inflation, such as higher import prices and continuously depreciating exchange rates, Governments can naturally be expected to resort to such expedience as pegging exchange rates at overvalued levels and placing restrictions on international trade investment, all of which was once again forecast by Halpern in 1952.

18:09Another feature of the current scene which the advocates of freely floating exchange rates failed to anticipate is the magnitude of the speculative flows of short-term funds generated by the uncertainty associated with the ever-present prospect of large and sudden changes in exchange rates, The absence of stable exchanges is a deterrent to long-term foreign lending, and as regards In short-term financial transactions, exchange fluctuations and their expectations are one of the most powerful incentives to speculation and to flights of capital.

19:05Besides facilitating inflation and subsequent recessions, and thereby promoting political barriers against international trade investment, fluctuating exchange rates reduce world income in two additional ways. First, speculative activities on the foreign exchange market absorb scarce resources that would otherwise be employed in productively serving consumers' demands. And second, the increased uncertainty associated with international commercial and financial transactions reduces their volume and creates distortions in their pattern from the point of view of comparative advantage. Now Halprin anticipated the well-known monetarist argument that the foreign exchange market provides facilities for hedging against exchange rate fluctuations. And he noted that in the long run, however, such hedging is of no avail.

19:52As regards current trade, this is a short-term transaction and therefore fairly immune to exchange fluctuations. However, the international division of labor and the regional and national specialization of production is a long-term proposition. Not only is the attempted inflation of the national economy through a policy of fluctuating exchange rates exceedingly costly, but it is a goal that can never be successfully achieved as long as the nation's residents are free to carry on any international economic relations whatever. Fluctuating exchange rates cannot ensure internal stability, although they may indeed stabilize some arbitrarily selected price index, because the country's internal price structure, or actual pattern of relative prices, is primarily determined by the world market.

20:42As a proponent of the Austrian theory of the business cycle developed by Mises and Hayek, Halpern emphasizes the key role of inflation-induced relative changes between the prices of capital goods and price of consumers' goods in precipitating business fluctuations. But a system of fluctuating exchange rates does not interfere with the international transmission of changes in relative prices. It merely neutralizes the external forces acting upon a given nation's absolute level of prices. Indeed, the free market proponents of freely floating exchange rates, that is, the monetarists, tirelessly proclaim that one of the greatest virtues of their scheme is that it does not preclude the international changes in relative prices, which are needed to induce a rearrangement of productive activities according to the ever-changing dictates of comparative advantage. So this can be used against them, in effect. This is precisely the reason, however, why the Austrians deny that fluctuating exchange rates can successfully insulate a nation from macroeconomic fluctuations generated abroad.

21:41For example, when the monetary authorities of a foreign nation of significant size inflate their national money supply, typically via the expansion of bank loans to businesses within their countries, the prices of capital or higher-order goods are bid up, not just in the inflating nation, but throughout the world economy, since commodity markets are internationally integrated. So the price of copper, for example, or of construction materials rises throughout the world in relation to other prices. The increase of capital goods prices and profit margins relative to consumers' goods prices and profit margins signals business firms in the relevant industries in all nations to expand the output of capital goods and contract the output of consumers' goods. The stimulus to capital goods production will continue until the inflation is brought to a halt.

22:30At that time, a reverse movement of inflation distorted relative prices occurs, and businessmen finally realize that many of the long-term investments made in the capital goods industry during the inflationary boom are unprofitable and must be liquidated. The revelation of these malinvestments and misallocations of productive resources coincides with the onset of a worldwide recession or depression. As long as it engages in international trade, therefore, a country will undergo a boom and bust cycle with a perfectly stable national price level, protected by floating exchange rates. Whenever there occur reversible relative price changes in world commodity markets that are the result of an inflationary boom engineered by one foreign monetary authority. So the alleged benefits of the system of fluctuating exchange rates purchased at the substantial cost of the demolition of the gold standard are thus turned out to be only a mirage of macroeconomic theorizing.

23:23You simply hold the price level constant, the national price level, and allegedly there are no effects from abroad. But again, as Austrians continuously emphasize, there are effects from abroad. Relative price effects, the price structure changes.

23:42While Halbron does not specifically identify the process by which business fluctuations are internationally transmitted, as I have done above. He is the only Austrian business cycle theorist to address the problem within the context of a world of open economies under a system of fluctuating exchange rates. And the broad conclusions of his investigation are clear-cut. Even in the absence, and I'm quoting him now, of an international monetary system, inflation, although primarily a domestic phenomenon of individual countries is far from being exclusively that. Even though various countries have independent monetary systems, inflation taking place in any one nation may have, and often does have, repercussions which go beyond that country's confines. This is especially true if the country experiencing inflation is an important economic unit. An economically important country, if it experiences inflation, can generate inflation elsewhere.

24:31The same is, of course, true of deflations, which follow upon the breakdown of the inflationary process. Process. Thus, even in the absence of an international monetary system, that is of an international gold standard, important economic units can transmit the virus of inflation to other countries. And by the way, only if we take Heilbrunn's view, can we explain the fact that the recessions, or more accurately, the depressions of 1973 through 1975 and 1980 through 1982 were not confined to any one country, but in fact, are world-wide phenomena, even though we did have quite quasi-floating exchange rates during that period. In effect, most currencies, important currencies, were floating against the dollar during those periods.

25:16Once again, we see that sound, Austrian economic theory yields more accurate economic forecasts than the allegedly more empirical and real-world theories of monetarist economics. In concluding, I would like to aim a mild criticism at Halperin, though we can be criticized very severely in other accounts, I won't get into it, in order to highlight an important point regarding the prospective transition to the gold standard. Halperin believed that the only way to restore the gold standard was to convene an international conference at which fixed gold parities for the various national currencies and the rules of the game to be followed by central banks were internationally agreed upon. Now this may have been possible in the 1960s when a tenuous link to gold still existed.

26:02Today I think that this would be a fatal error because the most likely result of such a new Bretton Woods would be precisely that, a new Bretton Woods, a fake or pseudo gold standard that must, as halberd and inexperience have taught us, collapse like a house of playing cards. All the old myths and wives tales regarding the instability of the gold standard would be upon us once again with a vengeance. The last best chance for a stable world monetary system would be lost for generations to come. So I think the call for a new Bretton Woods that has issued forth from the supply side camp must be decisively renounced by all troops advocates of a gold standard. And I was happy to see a Congressman Paul lead the way yesterday in this. The only safe and workable plan for restoring a gold money is for the U.S. government to unilaterally define the dollar as the weight of gold, regardless of what course other nations may take.

26:58Once said notes have been redeemed for gold and gold coin has gotten back into circulation in the U.S., other countries will be confronted with one of two choices, either to tie back onto an already functioning gold standard in an economically significant currency area, that is the U.S. economy, or to watch their respective fiat currencies continue to depreciate against the gold dollar and continue to suffer drains of capital from their Countries into the U.S. Economy. If they choose the former as they think they will, the international gold standard will begin to reemerge spontaneously without any political agreements. If they choose the latter, it's regrettable, but it will not make the U.S. gold standard any less viable.