EVER SINCE President Nixon suspended gold payments, on
August 15, 1971, the question of realistic par values of the world's
currencies has become a vexing international political issue,
Governments and contral banks are searching for new rules that permit
"more flexible" currency fluctuations. Something beyond dollars and gold
is needed, they believe, to provide a solid base for a new monetary
order. Return to the old system spawned at Bretton Woods, N. H., in
1944, is out of the question. It was a gold and dollar standard, with
the U.S. dollar payable in gold at $35 an ounce while other countries
pegged their moneys to the dollar, holding them within a range of 1 per
cent up or down from the parity registered with the 118-country
International Monetary Fund.
Now, since the suspension of gold payments, the world
has been waiting for monetary authorities to find a new monetary system.
The process must necessarily be slow, as a political solution is sought
to economic problems that were generated by various political
considerations. After all, the depreciation of the U.S. dollar, which
finally led to the gold payment suspension, was a political act by the
monetary authorities of several Federal administrations. The decision to
"float" the dollar rather than face the humiliation of a formal
devaluation was also a political act. Similarly, the other governments
are motivated politically in their attempts at monetary management.
While most "experts" make the government, its powers
and objectives, their Point of departure for monetary deliberation, a
few scholars continue to base their inquiries on the fundamental
principles that flow from individual choice and action. In their
judgment, the factors that affect the exchange relations between various
national currencies rest on the economic principles that determine the
purchasing power of each and every type of medium of exchange, whether
it is a precious metal or government flat money.
As they see it, the purchasing Power of any monetary
unit depends on the relation between the demand for and the quantity of
money in individual cash holdings. The demand for money is purely
individual, although a great many extraneous factors may influence this
demand. There is, for instance, the expectation of future changes in the
exchange value of money. An expected fall tends to reduce the demand for
money and thus its purchasing power; an expected rise brings about the
opposite. Also, the availability of goods affects the demand for money.
In an expanding economy when more and better goods are offered on the
market, the demand for money tends to rise; in a declining economy,
where capital is consumed and the division of labor breaks down, the
demand for money tends to decline.1
The Stock of Money
The supply of money is the stock of money available for
exchange. During the age of the gold standard it consisted of gold
bullion, gold coins and their various substitutes, such as bank notes,
tokens, and demand deposits. In this age of government currency, it
consists of flat money and its substitutes, such as tokens and demand
deposits. The substitutes may either be fully backed by money proper or
else they are fiduciary, i.e., uncovered. Thus, an expansion or
contraction of fiduciary media directly affects the total quantity of
money available for exchange.
A change in the money relation through changes in
either the demand for money or the stock of money affects changes in the
purchasing power of money. As one factor of demand or supply cannot
perfectly offset changes in the other factors, money can never be
neutral. Now, if there are two or more media of exchange, such as gold
or silver, or various fiat currencies, what determines the exchange
ratio between the various media? Their purchasing powers! That is to
say, exchange ratios correspond to the ratio of each one's purchasing
power in terms of all other goods. Market forces tend to establish the
parity between the purchasing powers and thus their exchange ratios. The
equilibrium exchange rate is called the purchasing power parity.
Gold and Silver as Money
For more than 2,500 years the civilized world used gold
and silver as money. These metals became valuable media of exchange
because they were not only desirable for nonmonetary uses, but also
suited so well for economic exchanges as they were durable, portable,
and divisible. Silver was generally used for small transactions and gold
in all larger exchanges. And throughout the ages their exchange ratios
were determined by their purchasing power parities. If one ounce of gold
bought a horse that also could be bought for 10 ounces of silver, the
parity between gold and silver was 1:10. If for any reason the exchange
rate differed from this parity, arbitrage would soon restore the
exchange ratio to its purchasing power parity. If, in our example, the
exchange ratio should be 11:1 and the purchasing power 10:1 it would be
very profitable to exchange gold for silver and then buy commodities.
But such money exchanges would soon drive the ratio back to its parity.
In all countries where gold was the standard money, the
exchange ratios between gold coins of different weight and fineness were
determined simply by this difference. If one coin weighed one ounce and
another coin of equal fineness only one-third of an ounce, the exchange
ratio obviously was 1:3. Under the gold-coin standard, commonly called
the orthodox or classical gold standard, gold coins were the standard
money. National currencies represented a certain quantity of gold of a
certain fineness, The U.S. dollar, for example, consisted of 25.8 grains
of gold, nine-tenths fine, before the 1934 devaluation, and 15 5/21
grains thereafter, or in troy ounces 1/20.67 and 1/35 respectively. The
U.S. $20 gold coin (Double Eagle) contained 30.09312 grams of fine gold,
the $10 coin (Eagle) 15.04656 grams, and the $5 coin (Half Eagle)
7.52328 grams. The British Sovereign contained 7.322 grams, the Mexican
50 Peso coin 37.5 grams, the French 20 Francs coin, also called
Napoleon, 5.8 grams, and the Swiss 20 Francs coin 5.8 grams.2
Exchange ratios between the various currency units consisting of gold
thus were determined by their relative measures of gold.
International Acceptability
The world had an international currency while on the
classical gold standard. It evolved without international treaties,
conventions or institutions. No one had to make the gold standard work
as an international system. When the leading countries had adopted gold
as their standard money the world had an international currency without
problems of convertibility or even parity. The fact that the coins bore
different names and had different weights hardly mattered. As long as
they consisted of gold, the national stamp or brand did not negate their
function as an international medium of exchange.
The purchasing power of gold tended to be the same the
world over. Once it was mined, it rendered exchange services throughout
the world market, moving back and forth and thereby equalizing its
purchasing power except for the costs of transport. It is true, the
composition of this purchasing power differed from place to place. A
gram of gold would buy more labor in Mexico than in the U.S, But as long
as some goods were traded, gold, like any other economic good, would
move to seek its highest purchasing power and thereby equalize its value
throughout the world market. As all coins and bullion were traded in
terms of weight of gold, there were no "exchange rates" such as those
between gold and silver, or various fiat monies.
The Exchange-Rate Dilemma
The departure from the gold-coin standard, set the
stage for the present exchange-rate dilemma. At first, governments began
to restrict the actual circulation of gold. They gradually established
the gold-bullion standard in which government or its central bank was
managing the country's bullion supply. Gold coins were withdrawn from
individual cash holdings and national currency was no longer redeemable
in gold coins, but only in large, expensive gold bars. This standard
then gave way to the gold-exchange standard in which the gold reserves
were replaced by trusted foreign currency that was redeemable in gold
bullion at a given rate. The world's monetary gold was held by a few
central banks, such as the Bank of England and the Federal Reserve
System, that served as the reserve banks of the world.3 But
after World War II, the Bank of England which was holding the gold
reserves for more than 60 countries, commonly called the pound sterling
area, gradually lost its eminent position. It began to hold most of its
reserves in U.S. dollar claims to gold, which made the Federal Reserve
System the ultimate reserve bank of the world; thus the gold-exchange
standard became a de facto gold and dollar standard. Finally, during the
accelerating inflation and credit expansion of the 1960's in the U.S.,
the dollar gradually fell from its respected position. Several monetary
crises which triggered worldwide demands for dollar redemption greatly
depleted the American stock of gold, and created precarious payment
situations.
Altogether, in less than four years, we experienced
seven currency crises that foretold the end of the international
monetary system. In November, 1967, Great Britain devalued the pound and
a number of other countries immediately followed suit. In March of 1968,
under the pressure of massive pound sterling liquidation, the nine
nation gold pool was abandoned and the two-tier system adopted. The
third crisis occurred in France in May, 1969, when political riots,
followed by rapid currency expansion, greatly weakened the franc which
was later devalued. The fourth crisis erupted in September, 1969, when
massive dollar conversions to West German marks forced the German
central bank to "float" the mark and then revalue it upward by 9.3 per
cent. The fifth crisis occurred in March and early April, 1971, when a
new flight from the dollar threatened to inundate several European
central banks. In a concerted effort, the U.S. Treasury and the
Export-Import Bank endeavored to "sop up" the dollar flood. The sixth
crisis began in May, 1971, when a new flow of dollars into German marks,
Swiss francs, and several other currencies caused the mark to float
anew, the Swiss franc to be revalued upward by 7.07 per cent, and
several other currencies to be allowed to float or be revalued. The
seventh and last crisis was of such massive proportions that President
Nixon was forced to announce the collapse of the old monetary order.
Why the Breakdown of International Monetary Relations?
What had caused this gradual deterioration of
international monetary relations? An understanding of the causes may
provide an answer to the dilemma, prevent further deterioration, and
hopefully find a cure to all its somber consequences.
The popular explanation usually runs as follows: The
rapid worsening of the U.S. international balance-of-payment deficit was
the proverbial straw that broke the system's back. From a small surplus
of $2.7 billion in 1969, achieved mainly through various government
manipulations that amounted to window dressing, the 1970 payments
deficit soared to an all-time record deficit of some $10.7 billion, on
official settlement basis, i.e., official settlements between
governments only. Then, in May, 1971, the U.S. Commerce Department
announced that the first quarter 1971 deficit had grown to a record $5.4
billion.4 And finally, private sources estimated that in
1971, up through mid-August, some $22 billion more dollars flowed out of
the country than came in.
These new payment deficits were added to the
accumulated unpaid deficits of the U.S. for many years. U.S. dollars and
short-term claims to dollars in foreign hands amounted to $43 billion at
the end of 1970. After deducting U.S. short-term claims on foreigners
our net obligations exceeded $32 billion, plus the current deficits
mentioned above. And while the U.S. gold stock stood at $11 billion, the
lowest level since World War II it became obvious that the U.S. could
not meet its foreign obligations in gold.5
Dr. Arthur F. Burns, Chairman of the Federal Reserve
Board, probably reflected the official position of the U.S. government
when, on May 20, 1971, he blamed foreign governments for the precarious
situation. He urged them to release their restraints on imports and
American investments, and to help us with our foreign military operating
expenses. Raising our interest rates, he asserted, was not the right way
to improve the ailing dollar. He advocated more U.S. borrowing from the
Eurodollar market through Treasury certificates and, in order to become
more competitive in world markets, an "incomes policy" that would
restrain the cost-push momentum of American labor.6 Less than
three months later President Nixon announced a 90-day price and wage
freeze, to be followed by some government control thereafter, and a 10
per cent surtax on imports to stem the flood of cheap foreign goods.
"National Balance of Payment"
Academic theories basically concurred with Dr. Burns'
explanation although some offered different solutions, such as a
crawling peg, a wider bank, flexible exchange rates, or the creation of
new reserve assets, such as Special Drawing Rights by the International
Monetary Fund.7 But no matter what solution they proffer,
their point of departure is the collectivist concept of the "national"
balance of payment. Without any reference to individual actions and
balances' they build ambiguous structures that ignore the causes.
Balance of payments of a country is that very small segment of the
combined balances of millions of individuals, the segment that is based
on personal exchanges across national boundaries. As an individual may
choose to increase or decrease his cash holdings, so may the millions of
residents of a given country. But when they increase their holdings,
that is called "favorable" in balance of payments terminology. And when
they choose to reduce their cash holdings, that is called "unfavorable."
The fact is that drains of gold are not mysterious forces that must be
managed by wise governments, but are the result of deliberate choices by
people eager to reduce their cash holdings.
Wherever governments resort to inflation, people tend
to reduce their cash holdings through purchases of goods and services.
When domestic prices begin to rise while foreign prices continue to be
stable or rise at lower rates, individuals like to buy more foreign
goods at bargain prices. They ship some of their money abroad in
exchange for cheaper foreign products or property. Thus, an outflow of
foreign exchange and gold sets in. It is the inevitable result of a rate
of domestic inflation that exceeds that of the rest of the world and
sets into operation "Gresham's Law."
During the 1960's, the decade of the "Great Society,"
and again during 1970 and 1971, money and credit were created at
unprecedented rates prompted by recordbreaking government deficits.
Private demand deposits, bank credit at commercial banks, and Federal
Reserve credit, which is fueling the credit expansion, often rose at
rates of 10 per cent or more a year. Therefore, in spite of countless
promises and reassurances by the President and his advisers, the U.S.
dollar suffered inevitable depreciation at home and abroad. And the
August 15, 1971, default of payment was the result of this depreciation.
Blaming the Creditor
Refusal to make gold payments by the United States, the
richest and most powerful country on earth, casts serious doubt on
future monetary cooperation. The immediate prospect for worldwide
monetary reform is not too bright. The U.S., as the defaulting debtor,
is taking the position that it is up to the countries with huge
surpluses in their international payments to adjust their currencies
upward against the dollar. It is Washington's basic premise that the
U.S. was unfairly treated in international commerce and that it is time
for correction. Convinced of the indispensability of the U.S. dollar as
a world reserve currency, the U.S. is defiantly waiting for the others
to act.
Bad debtors, when called upon to make payment, often
make such charges against their creditors. It is shocking, however, that
the U.S. government should prove to be such a poor debtor. Even its
basic assumption, the indispensability of the dollar, no longer goes
unchallenged. Sterling balances look more attractive today than dollar
holdings. In fact, the holdings of deutsche marks by central banks and
treasuries probably exceed $3 billion. Foreign airlines and shippers
have ceased to accept U.S. currency. And Eurodollar bonds are all but
unsaleable in European capital markets, while mark, guilder, and Swiss
franc securities remain in demand. The foreign position generally
rejects the Washington charge of unfair treatment. If the U.S. had
adopted appropriate domestic policies, foreign officials argue, it would
not have accrued its huge international payments deficits. Therefore,
they want the U.S. to share the burden of realignment. They are seeking
a devaluation of the dollar along with realignment of their currencies.
And above all, no one is suggesting that the U.S. dollar continue to
serve as an international reserve currency.
After all, managed currencies are the products of
political manipulations by parties and pressure groups, and all are
destined to be destroyed gradually by weak administrations yielding to
popular pressures for government largess and economic redistribution. No
such currency can serve for long as the international reserve currency
to which all others can repair. The U.S. dollar is no exception.
In the chaotic conditions of late 1971, the world may
still have the following options:
(1) It may continue on its present road of fiat money
and inflation, government manipulation of exchange rates, trade
restrictions, and exchange controls. The goal is "national autonomy" in
monetary and fiscal policies, an essential objective for all forms of
central economic planning. On this road we are bound to suffer not only
more inflation and depreciation, but also a gradual disintegration of
the world economy and its division of labor. Our ultimate destination is
a world-wide depression.
(2) Or the world may choose to turn off this road of
self-destruction and seek stability in sound money. The very monetary
authorities that have created the chaos and are now sitting in judgment
over the international monetary order must relinquish their rights and
powers over the people's money. This road leads to the various forms of
gold standard, from the gold-exchange to the gold-bullion, and finally
the gold-coin standard. For gold is the only international money the
quantity of which is limited by high costs of mining and the value of
which is independent of political aspirations and policies. Only the
gold standard can afford monetary stability and peaceful international
cooperation.
At the time of the original publication, Dr. Sennholz
headed the Department of Economics at Grove City College and was a
noted writer and lecturer on monetary and economic principles and
practices.
1 Ludwig von Mises, The Theory of Money and Credit
(Irvington -on -Hudson, N. Y.: The Foundation for Economic Education,
Inc., 1971), p. 97 ot seq.
2 Cf. Franz Pick, Currency Yearbook (New York: Pick
Publishing Corp., 1970), pp. 13-15.
3 Cf. Leland B. Yeager, International Monetary
Relations (New York: Harper & Row, Publishers, 1966), p. 261 et seq.
4 Federal Reserve Bulletin, Sept., 1971, p. A75.
5 Ibid., p. 94.
6 The Commercial and Financial Chronicle, June 9,1971,
p. 16.
7 Cf. William Fellner "On Limited Exchange Rate
Flexibility," Chapter 5 of Maintaining and Restoring Balance in
International Payments, Princeton University Press, 1966; George N.
Halm, "The Bank Proposal: The Limit of Permissible Exchange Rate
Variations," Princeton Special Papers in International Economics, No. 6;
John H. Williamson: "The Crawling Peg," Princeton Essays in
International Finance, No. 50; Francis Cassell, International Adjustment
and the Dollar, 9th District Economic Information Series, Federal
Reserve Bank of Minneapolis, June, 1970; Walter S. Salant, International
Reserves and Pay-ments Adjustment, "Banca Nazionale del Lavoro,
Quarterly Review, Sept., 1969; Thomas D. Willet and Francesco Forte,
"Interest Rate Policy and External Balance," Quarterly Journal of
Economics May, 1969, Friedrich A. Lutz, "Money Rates of Interest, Real
Rates of Interest, and Capital Movements," Chapter 11 of Maintaining and
Restoring Balance in International Payments, Princeton University Press,
1966; Milton Gilbert, "TheGold-Dollar System: Conditions of Equilibrium
and the Price of Gold," Princeton Essays in International Finance, No.
70.
Reprinted with permission from The
Freeman, a publication of The Foundation for Economic Education, Inc.,
January, 1972, Vol. 22, No. 1.
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