The Classic Liberal Blog

By Ludwig von Mises.

The use of the terminology of warfare is inappropriate in dealing with monetary matters, as it is in the treatment of all other catallactic problems. There is no such thing as a "war" between the central banks. No sinister forces are "attacking" a bank's position and threatening the stability of foreign-exchange rates. No "defender" is needed to "protect" a nation's currency system. It is, moreover, not true that what prevents a nation's central bank or its private banks from lowering the domestic market rate of interest is considerations of the preservation of the gold standard and of foreign-exchange stability and of frustrating the machinations of an international combine of capitalistic moneylenders. The market rate of interest cannot be lowered by a credit expansion except for a short time, and even then it brings about all those effects that the theory of the trade cycle describes.

When the Bank of England redeemed a banknote issued according to the terms of the contract, it did not render unselfishly a vital service to the British people. It simply did what every housewife does in paying the grocer's bill. The idea that there is some special merit in a central bank's fulfillment of its voluntarily assumed responsibilities could originate only because again and again governments granted to these banks the privilege of denying to their clients the payments to which they had a legal title. In fact, the central banks became more and more subordinate offices of the treasuries, mere tools for the performance of credit expansion and inflation. It does not make any difference practically whether they are or are not owned by the government and directly managed by government officials. In effect the banks granting circulation credit are in every country today only affiliates of the treasuries.

There is but one means of keeping a local and national currency permanently at par with gold and foreign exchange: unconditional redemption. The central bank has to buy at the parity rate any amount of gold and foreign exchange offered against domestic banknotes and deposit currency; on the other hand it has to sell, without discrimination, any amount of gold and foreign exchange asked for by people ready to pay the parity price in domestic banknotes, coins, or deposit currency. Such was the policy of central banks under the gold standard. Such was also the policy of those governments and central banks that had adopted the currency system commonly known under the name of the gold-exchange standard. The only difference between the "orthodox" or classical gold standard as it existed in Great Britain from the early '20s of the 19th century until the outbreak of the First World War and in other countries on the one hand, and the gold-exchange standard on the other, concerned the use of gold coins on the domestic market. Under the classical gold standard a part of the cash holdings of the citizens consisted in gold coins and the rest in money substitutes. Under the gold-exchange standard the cash holdings consisted entirely in money substitutes.

Pegging a certain rate of foreign exchange is tantamount to redemption at this rate.

A foreign-exchange equalization account, too, can succeed in its operations only as far as it clings to the same methods.

The reasons why European governments in the last few years have preferred foreign-exchange equalization accounts to the operation of central banks are obvious. Central-bank legislation was an achievement of liberal governments or of governments that did not dare to challenge openly, at least in the conduct of financial policies, public opinion of the liberal countries. The operations of central banks were therefore adjusted to economic freedom. For that reason they were considered unsatisfactory in this age of rising totalitarianism. The main characteristics of the operation of a foreign-exchange equalization account as distinguished from central-bank policy are

1. The authorities keep the transactions of the account secret. The laws have obliged the central banks to publicize their actual status at short intervals, as a rule every week. But the status of the foreign-exchange equalization accounts is known only to the initiated. Officialdom renders a report to the public only after a lapse of time when the figures are of interest to historians alone and of no use whatever to the businessman.
2. This secrecy makes it possible to discriminate against people not in great favor with the authorities. In many continental countries of Europe it resulted in scandalous corruption. Other governments used the power to discriminate to the detriment of businessmen belonging to linguistic or religious minorities or supporting opposition parties.
3. A parity is no longer fixed by a law duly promulgated by parliament and therefore known to every citizen. The determination depends upon the arbitrariness of bureaucrats. From time to time the newspapers reported, "The Ruritanian currency is weak." A more correct description would have been "The Ruritanian authorities have decided to raise the price of foreign exchange."

A foreign-exchange equalization account is not a magic wand for remedying the evils of inflation. It cannot apply any means other than those available to "orthodox" central banks. And it must, like the central banks, fail in the endeavors to keep foreign-exchange rates at par if there is domestic inflation and credit expansion.

It has been asserted that the "orthodox" methods of fighting an external drain by raising the rate of discount no longer work because nations are no longer prepared to comply with "the rules of the game." Now, the gold standard is not a game but a social institution. Its working does not depend on the preparedness of any people to observe some arbitrary rules. It is controlled by the operation of inexorable economic law.

The critics give point to their objection by citing the fact that in the interwar period a rise in the rate of discount failed to stop the external drain, i.e., the outflow of specie and the transfer of deposits into foreign countries. But this phenomenon was caused by the governments' antigold and proinflation policies. If a man expects that he will lose 40 percent of his balance by an impending devaluation, he will try to transfer his deposit into another country and will not change his mind if the bank rate in the country planning a devaluation rises 1 or 2 percent. Such a rise in the rate of discount is obviously not a compensation for a loss ten or twenty or even forty times greater. Of course, the gold standard cannot work if governments are eager to sabotage its operations.

Unconditional Redemption for Gold

Ludwig von Mises was the acknowledged leader of the Austrian School of economic thought, a prodigious originator in economic theory, and a prolific author. Mises's writings and lectures encompassed economic theory, history, epistemology, government, and political philosophy. His contributions to economic theory include important clarifications on the quantity theory of money, the theory of the trade cycle, the integration of monetary theory with economic theory in general, and a demonstration that socialism must fail because it cannot solve the problem of economic calculation. Mises was the first scholar to recognize that economics is part of a larger science in human action, a science that Mises called "praxeology." See Ludwig von Mises's article archives.

This article is excerpted from chapter 17 of Human Action and is read by Jeff Riggenbach.