It is therefore not permissible to look upon debt abatement as a device of a system of economic policies which could be considered as an alternative to any other system of society’s permanent economic organization. It is by no means a tool of constructive action. It is a bomb that destroys and can do nothing but destroy. If it is applied only once, a reconstruction of the shattered credit system is still possible. But if the blows are repeated, total destruction results.
It is not correct to look upon inflation and deflation exclusively from the point of view of their effects upon deferred payments. It has been shown that cashinduced changes in purchasing power do not affect the prices of the various commodities and services at the same time and to the same extent, and what role this unevenness plays in the market.1 But if one regards inflation and deflation as means of rearranging the relations between creditors and debtors, one cannot fail to realize that the ends sought by the government resorting to them are attained only in a very imperfect degree and that, besides, consequences appear which, from the government’s point of view, are highly unsatisfactory. As is the case with every other variety of government interference with the price structure, the results obtained not only are contrary to the intentions of the government but produce a state of affairs which, in the opinion of the government, is more undesirable than conditions on the unhampered market.
As far as a government resorts to inflation in order to favor the debtors at the expense of the creditors, it succeeds only with regard to those deferred payments which were stipulated before. Inflation does not make it cheaper to contract new loans; it makes it, on the contrary, more expensive by the appearance of a positive price premium. If inflation is pushed to its ultimate consequences, it makes any stipulation of deferred payments in terms of the inflated currency cease altogether.
3. The Evolution of Modern Methods of Currency Manipulation
A metallic currency is not subject to government manipulation. Of course, the government has the power to enact legal tender laws. But then the operation of Gresham’s Law brings about results which may frustrate the aims sought by the government. Seen from this point of view, a metallic standard appears as an obstacle to all attempts to interfere with the market phenomena by monetary policies.
In examining the evolution which gave governments the power to manipulate their national currency systems, we must begin by mentioning one of the most serious shortcomings of the classical economists. Both Adam Smith and David Ricardo looked upon the costs involved in the preservation of a metallic currency as a waste. As they saw it, the substitution of paper money for metallic money would make it possible to employ capital and labor, required for the production of the quantity of gold and silver needed for monetary purposes, for the production of goods which could directly satisfy human wants. Starting from this assumption, Ricardo elaborated his famous Proposals for an Economical ana Secure Currency, first published in 1816. Ricardo’s plan fell into oblivion. It was not until many decades after his death that several countries adopted its basic principles under the label gold exchange standard in order to reduce the alleged waste involved in the operation of the gold standard nowadays decried as “classical” or “orthodox.”
Under the classical gold standard a part of the cash holdings of individuals consists in gold coins. Under the gold exchange standard the cash holdings of individuals consist entirely in moneysubstitutes. These moneysubstitutes are redeemable at the legal par in gold or foreign exchange of countries under the gold standard or the gold exchange standard. But the arrangement of monetary and banking institutions aims at preventing the public from withdrawing gold from the Central Bank for domestic cash holdings. The first objective of redemption is to secure the stability of foreign exchange rates.
In dealing with the problems of the gold exchange standard all economists—including the author of this book—failed to realize the fact that it places in the hands of governments the power to manipulate their nations’ currency easily. Economists blithely assumed that no government of a civilized nation would use the gold exchange standard intentionally as an instrument of inflationary policy. Of course, one must not exaggerate the role that the gold exchange standard played in the inflationary ventures of the last decades. The main factor was the proinflationary ideology. The gold exchange standard was merely a convenient vehicle for the realization of the inflationary plans. Its absence did not hinder the adoption of inflationary measures. The United States was in 1933 by and large still under the classical gold standard. This fact did not stop the New Deal’s inflationism. The United States at one stroke—by confiscating its citizens’ gold holdings—abolished the classical gold standard and devalued the dollar against gold.
The new variety of the gold exchange standard as it developed in the years between the first and the second World Wars may be called the flexible gold exchange standard or, for the sake of simplicity, the flexible standard. Under this system the Central Bank or the Foreign Exchange Equalization Account (or whatever the name of the equivalent governmental institution may be) freely exchanges the moneysubstitutes which are the country’s national legal tender either against gold or against foreign exchange, and vice versa. The ratio at which these exchange deals are transacted is not invariably fixed, but subject to changes. The parity is flexible, as people say. This flexibility, however, is practically always a downward flexibility. The authorities used their power to lower the equivalence of the national currency in terms of gold and of those foreign currencies whose equivalence against gold did not drop; they never ventured to raise it. If the parity against another nation’s currency was raised, the change was only the consummation of a drop that had occurred in that other currency’s equivalence (in terms of gold or of other nations’ currencies which had remained unchanged). Its aim was to bring the appraisal of this definite foreign currency into agreement with the appraisal of gold and the currencies of other foreign nations.
If the downward jump of the parity is very conspicuous, it is called a devaluation. If the alteration of the parity is not so great, editors of financial reports describe it as a weakening in the international appraisal of the currency concerned.2 In both cases it is usual to refer to the event by declaring that the country concerned has raised the price of gold.
The characterization of the flexible standard from the catallactic point of view must not be confused with its description from the legal point of view. The catallactic aspects of the issue are not affected by the constitutional problems involved. It is immaterial whether the power to alter the parity is vested in the legislative or in the administrative branch of the government. It is immaterial whether the authorization given to the administration is unlimited or, as was the case in the United States under New Deal legislation, limited by a terminal point beyond which the officers are not free to devalue further. What counts alone for the economic treatment of the matter is that the principle of flexible parities has been substituted for the principle of the rigid parity. Whatever the constitutional state of affairs may be, no government could embark upon “raising the price of gold” if public opinion were opposed to such a manipulation. If, on the other hand, public opinion favors such a step, no legal technicalities could check it altogether or even delay it for a short time. What happened in Great Britain in 1931, in the United States in 1933, and in France and Switzerland in 1936 clearly shows that the apparatus of representative government is able to work with the utmost speed if public opinion endorses the socalled experts’ opinion concerning the expediency and necessity of a currency’s devaluation.
One of the main objectives of currency devaluation—whether large-scale or small-scale—is, as will be shown in the next section, to rearrange foreign trade conditions. These effects upon foreign trade make it impossible for a small nation to take its own course in currency manipulation irrespective of what those countries are doing with whom its trade relations are closest. Such nations are forced to follow in the wake of a foreign country’s monetary
policies. As far as monetary policy is concerned they voluntarily become satellites of a foreign power. By keeping their own country’s currency rigidly at par against the currency of a monetary “suzerain-country,” they follow all the alterations which the “suzerain” brings about in its own currency’s parity against gold and the other nation’s currencies. They join a monetary bloc and integrate their country into a monetary area. The most talked about bloc or area is the sterling bloc or area.
The flexible standard must not be confused with conditions in those countries in which the government has merely proclaimed an official parity of its domestic currency against gold and foreign exchange without making this parity effective. The characteristic feature of the flexible standard is that any amount of domestic moneysubstitutes can in fact be freely exchanged at the parity chosen against gold or foreign exchange, and vice versa. At this parity the Central Bank (or whatever the name of the government agency entrusted with the task may be) freely buys and sells any amount of domestic currency and of foreign currency of at least one of those countries which themselves are either under the gold standard or under the flexible standard. The domestic banknotes are really redeemable.
In the absence of this essential feature of the flexible standard, decrees proclaiming a definite parity have a quite different meaning and bring about quite different effects.3
4. The Objectives of Currency Devaluation
The flexible standard is an instrument for the engineering of inflation. The only reason for its acceptance was to make reiterated inflationary moves technically as simple as possible for the authorities.
In the boom period that ended in 1929 labor unions had succeeded in almost all countries in enforcing wage rates higher than those which the market, if manipulated only by migration barriers, would have determined. These wage rates already produced in many countries institutional unemployment of a considerable amount while credit expansion was still going on at an accelerated pace. When finally the inescapable depression came and commodity prices began to drop, the labor unions, firmly supported by the governments, even by those disparaged as anti-labor, clung stubbornly to their high-wages policy. They either flatly denied permission for any cut in nominal wage rates or conceded only insufficient cuts. The result was a tremendous increase in institutional unemployment. (On the other hand, those workers who retained their jobs improved their standard of living as their hourly real wages went up.) The burden of unemployment doles became unbearable. The millions of unemployed were a serious menace to domestic peace. The industrial countries were haunted by the specter of revolution. But union leaders were intractable, and no statesman had the courage to challenge them openly.
In this plight the frightened rulers bethought themselves of a makeshift long since recommended by inflationist doctrinaires. As unions objected to an adjustment of wages to the state of the money relation and commodity prices, they chose to adjust the money relation and commodity prices to the height of wage rates. As they saw it, it was not wage rates that were too high; their own nation’s monetary unit was overvalued in terms of gold and foreign exchange and had to be readjusted. Devaluation was the panacea.
The objectives of devaluation were:
1. To preserve the height of nominal wage rates or even to create the conditions required for their further increase, while real wage rates should rather sink.
2. To make commodity prices, especially the prices of farm products, rise in terms of domestic money or, at least, to check their further drop.
3. To favor the debtors at the expense of the creditors.
4. To encourage exports and to reduce imports.
5. To attract more foreign tourists and to make it more expensive (in terms of domestic money) for the country’s own citizens to visit foreign countries.
However, neither the governments nor the literary champions of their policy were frank enough to admit openly that one of the main purposes of devaluation was a reduction in the height of real wage rates. They preferred for the most part to describe the objective of devaluation as the removal of an alleged “fundamental disequilibrium” between the domestic and the international “level” of prices. They spoke of the necessity of lowering domestic costs of production. But they were anxious not to mention that one of the two cost items they expected to lower by devaluation was real wage rates, the other being interest stipulated on long-term business debts and the principal of such debts.
It is impossible to take seriously the arguments advanced in favor of devaluation. They were utterly confused and contradictory. For devaluation was not a policy that originated from a cool weighing of the pros and cons. It was a capitulation of governments to union leaders who did not want to lose face by admitting that their wage policy had failed and had produced institutional unemployment on an unprecedented scale. It was a desperate makeshift of weak and inept statesmen who were motivated by their wish to prolong their tenure of office. In justifying their policy, these demagogues did not bother about contradictions. They promised the processing industries and the farmers that devaluation would make prices rise. But at the same time they promised the consumers that rigid price control would prevent any increase in the cost of living.
After all, the governments could still excuse their conduct by referring to the fact that under the given state of public opinion, entirely under the sway of the doctrinal fallacies of labor unionism, no other policy could be resorted to. No such excuse can be advanced for those authors who hailed the flexibility of foreign exchange rates as the perfect and most desirable monetary system. While governments were still anxious to emphasize that devaluation was an emergency measure not to be repeated again, these authors proclaimed the flexible standard as the most appropriate monetary system and were eager to demonstrate the alleged evils inherent in stability of foreign exchange rates. In their blind zeal to please the governments and the powerful pressure groups of unionized labor and farming, they overstated tremendously the case of flexible parities. But the drawbacks of standard flexibility became manifest very soon. The enthusiasm for devaluation vanished quickly. In the years of the second World War, hardly more than a decade after the day when Great Britain had set the pattern for the flexible standard, even Lord Keynes and his adepts discovered that stability of foreign exchange rates has its merits. One of the avowed objectives of the International Monetary Fund is to stabilize foreign exchange rates.
If one looks at devaluation not with the eyes of an apologist of government and union policies, but with the eyes of an economist, one must first of all stress the point that all its alleged blessings are temporary only. Moreover, they depend on the condition that only one country devalues while the other countries abstain from devaluing their own currencies. If the other countries devalue in the same proportion, no changes in foreign trade appear. If they devalue to a greater extent, all these transitory blessings, whatever they may be, favor them exclusively. A general acceptance of the principles of the flexible standard must therefore result in a mutual overbidding between the nations. At the end of this race is the complete destruction of all nations’ monetary systems.
The much talked about advantages which devaluation secures in foreign trade and tourism, are entirely due, to the fact that the adjustment of domestic prices and wage rates to the state of affairs created by devaluation requires some time. As long as this adjustment process is not yet completed, exporting is encouraged and importing is discouraged. However, this merely means that in this interval the citizens of the devaluating country are getting less for what they are selling abroad and paying more for what they are buying abroad; concomitantly they must restrict their consumption. This effect may appear as a boon in the opinion of those for whom the balance of trade is the yardstick of a nation’s welfare. In plain language it is to be described in this way: The British citizen must export more British goods in order to buy that quantity of tea which he received before the devaluation for a smaller quantity of exported British goods.
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Human Action: A Treatise on Economics Page 111