Domestic Inflation Versus International Solvency
FEBRUARY 01, 1967 by GARY NORTH
Gary North teaches at the University of California at Riverside while working on a doctorate in economic history.
In recent months there has been an increasing amount of discussion concerning "international liquidity," "balance of payments," "dollar glut," gold outflow, and monetary stability. Economists, even when they agree on the nature of the problems involved, seldom are unanimous on the solutions. The debates that are going on among economists, bankers, and politicians are frequently phrased in highly technical and abstruse language, but the basic issue is simply this: how can nations continue to inflate their domestic currency and credit systems, and at the same time preserve mutual trust in each other’s solvency?
The "ideal" economic world, in the view of many of our leading economists, is one in which we would have "freedom for each country to pursue its own independent economic policy unhampered by balance-of-payments considerations; and stability of [monetary] exchange rates to encourage international relations."’ Unfortunately, as the author hastens to add, "the two are incompatible…." The goal of today’s international finance experts, therefore, is to discover the best compromise possible, the most workable balance between the two alternatives.
In the context of contemporary economic theory and practice, the phrase, "freedom to pursue domestic economic policy," invariably means the freedom of the monetary authorities to inflate a nation’s circulating media (currency, coins, and credit). The motivations behind domestic inflation are varied; an important one is that the state can raise its level of expenditure without imposing a corresponding increase in the visible tax rate. Inflation, in short, is a form of invisible taxation, and those on relatively fixed incomes are the ones who pay the tax; they must decrease their purchases of consumer products and services when the level of prices rises.
Inflation for Full Employment
But the primary economic argument which is used today to defend an expansion of the domestic money supply is that inflation keeps "effective demand" at high levels, that people with the newly created money will buy more goods, and that businesses as a direct result will be stimulated to increase production. Consequently, more people will be employed by these firms.
Fundamental to this argument is the idea that the operation of the free market is insufficient to insure employment for all those who desire to work. Somehow, the market fails to dispose of all goods offered for sale (through the unhampered action of the pricing mechanism), and therefore the demand registered by purchases is unable to encourage greater production. This perspective has been common to most socialist parties, but it became a basic presupposition of modern nonsocialist thought through the teachings of John Maynard Keynes in his General Theory of Employment, Interest and Money (1936). Keynes realized that a downward revision of the level of wages would be opposed vigorously by labor unions, and the governments of most western democracies would find such a downward revision politically inexpedient. Money wages must not be permitted to fall. However, if inflation were allowed to raise costs and prices, real wages would fall without the organized opposition of labor.2 It was clear that if real wages did not fall, the result would be unemployment; the least productive workers would have to be dismissed.
Keynes wrote during the depression, but an analogous situation exists today. The structure of minimum wage laws creates a similar problem: the low production worker would lose his job were it not for the fact that governments are permitting real wages to fall (at least in comparison to what the wages would be in the absence of inflation). Minimum wage laws have, in effect, made inflation a political necessity. Eventually, the misallocation of scarce resources promoted by the inflation will harm both the laborers and the manufacturers, as prices soar beyond the means of all but the most influential companies (politically) and the members of the strongest labor unions.
In order to keep businesses going at full production, according to the "new economics," thus keeping labor fully employed, ever-increasing doses of inflation are required. As Wilhelm Roepke has pointed out, it was precisely this philosophy of inflationary full employment which motivated the peacetime economic planning of Nazi Germany, with the resulting system of "repressed inflation" — rationing, shortages, and misallocation of resources.3
The nation which indulges itself with an inflationary "boom" inevitably faces the economic consequences: either runaway inflation or a serious recession-depression. If the inflation should cease, unemployment will increase, and the earlier forecasts of the nation’s entrepreneurs (which were based on the assumption of continuing inflation) will be destroyed.4 Since no political party is anxious to face the consequences at the polls of a depression, there is a tendency for inflations, once begun, to become permanent phenomena. Tax increases are postponed as long as possible, "tight" money (i.e., higher interest rates) is unpopular, and cuts in governmental expenditures are not welcomed by those special interest groups which have been profiting by the state’s purchases. The inflation continues. As Jacques Rueff has put it: "I know that these [monetary] authorities are not able, they have not the power — the human possibility, at least in our regime — to follow the policy which they ought to."5
This should serve as an introduction to the domestic problem which faces the various western democracies. From an international standpoint, the situation is reversed. The primary need for international trade is a common means of payment which is not subject to violent upward surges, a money free from most inflationary tendencies. Foreign governments and central banks want to be able to trust their neighbors’ currencies.
The best means of insuring international responsibility in monetary affairs is the gold standard. This has always been true. Since gold cannot be mined rapidly enough to create mass inflation, it retains its value over long periods of time. For example, the stability of British wholesale prices between 1821 and 1914 was remarkable.6 Central banks can demand payment of debts in gold, or in currencies which are (supposedly) 100 per cent redeemable in gold. The banks can then use these foreign securities as a base on which to expand their own credit systems, on the assumption that the debtors’ promises are as good as gold. At present, central banks hold American dollars and British pounds sterling in lieu of gold — or more accurately, they hold interest-bearing bonds and securities that are supposedly convertible into gold at any time.
Here is the basis of the conflict between domestic and international economic policies. Gold is presently necessary to support international trade and to maintain international trust in the two key currencies, the dollar and the pound. On the other hand, both Britain and the United States have printed more paper and credit IOU’s to gold than they have to redeem all outstanding claims. The domestic inflations have kept their postwar booms going, but now the trust abroad in both currencies is weakened. It is becoming clear that either the domestic inflations must stop, or else the key currencies are going to experience an international "bank run" on their gold reserves. Domestic inflation, in short, is the sole cause of the gold outflow in both the United States and Britain. Since 1960, the U. S. Treasury’s stock of gold has been cut in half, and at the present time, there are foreign claims outstanding for over twice the amount of gold than the United States has in reserve (including that gold which is supposed to support our domestic credit and currency).
Jacques Rueff, a French economist, certainly cannot be criticized for these words: "How can you expect a creditor to remain passive when he sees every day an increase in monetary liabilities and a decrease of the gold available to repay them? That is where you get a `scissors phenomenon.’ The U. S. is caught between the blades of the scissors. "7 Yet Rueff is sneered at as France’s "palace economist," as if the truth of a principle were the monopoly of the French. De Gaulle is castigated as economically insane for his attempt to claim what is legally his, the gold to which his country holds legal claims. The United States has contracted debts; it now is faced with the prospect of not being able to meet its debts. The issue is really very simple.
If higher interest rates are not offered in the United States and in Britain, then foreign investors and central banks will cash in their investments and demand payment in gold. On the other hand, if interest rates are permitted to climb higher, the domestic rate of growth will be drastically affected. Money will be "too tight," too expensive for the prospective borrowers. Hence, the "scissors effect." There is no simple solution to the problem.
In 1964, the United States lost some $385 million in gold; in 1965, the loss tripled, amounting to over $1.1 billion. In the first six months of 1966, the outflow was almost $300 million.8 The costs of the war in Viet Nam are increasing the deficit in the budget. In Britain, Prime Minister Wilson has been forced to declare a price and wage freeze in order to halt the inflationary rise in prices; this, of course, is repressed inflation — the hampering of the market by government controls — and not a cure. But at least political leaders in the two nations have come to the realization that continued deficits and continued increases in the money supply ( apart from increases in gold and silver) cannot go on much longer without serious repercussions in the world money market, and hence, in the world’s trading community.
The Search for Substitutes
Thus, we can understand the frantic search for a nongold international medium of payment. The economic isolationism which always results from domestic inflations cannot be permitted to disrupt the fabric of international integration and trade. Devaluation (charging more dollars or pounds for a given quantity of gold) could easily destroy the confidence in both currencies, and thus result in international economic chaos. Mutual distrust would then be the order of the day in all international transactions. The problem is that no substitute for gold has yet been discovered (or created) by mankind; and gold, because of its resistance to "full employment" inflationary policies, is taboo. What is needed, we are told, is something "as good as gold," yet which permits domestic inflation. There are numerous suggestions for such an international money, probably under the control of the International Monetary Fund, but no single plan has reached even partial acceptance by the economists and officials of the nations involved.`’ A fundamental obstacle to be overcome is the basic division between the central banks and the governments: certain policies which are favorable for one group are harmful for the other. Paul H. Douglas, in his recent study of world trade, attempts to find a synthesis of these various schemes, but even his powers of exposition fail him.¹º The solution to the dilemma has not been found, and time (and gold) is running out.
A full gold coin standard would unquestionably solve the problem of international acceptance and solvency. Gold has always functioned as the means of international payment, and there is no reason to suppose that it will not in the future (assuming that prices and wages are permitted to adjust on an international free market). The opposition to gold in international trade is based upon ideological assumptions which are hostile to the idea of the free market economy. Gold would insure monetary stability, if that were what the economists and legislators really wanted. It would insure too much stability to suit them, and this is the point of contention. As the late Professor Charles Rist once wrote:
In reality, those theoreticians dislike monetary stability, because they dislike the fact that by means of money the individual may escape the arbitrariness of the government. Stable money is one of the last arms at the disposal of the individual to direct his own affairs, whether it be an enterprise or a household. It is certain that nothing so facilitates the seizure of all activities by the government as its liberty of action in monetary matters. If the partisans of [unbacked] paper money really desire monetary stability, they would not oppose so vehemently the reintroduction of the only system that has ever insured it, which is the system of the gold standard.11
1 Tibor Scitovsky, "Requirements of an International Reserve System," in Essays in International Finance, #49, November, 1965 (Princeton University’s International Finance Section), p. 3.
2 See the analysis of Keynes’s position by Murray N. Rothbard, Man, Economy and State (Princeton: Van Nostrand, 1962), II, pp. 683-87.
³ Roepke, "The Economics of Full Employment," in Henry Hazlitt (ed.), The Critics of Keynesian Economics (Princeton: Van Nostrand, 1960), p. 374. For a full discussion of "repressed inflation," see Roepke, A Humane Economy (Chicago: Regnery, 1960), pp. 151-221. My own pamphlet, Inflation: the Economics of Addiction (San Carlos, Cal.: The Pamphleteers, 1965), also deals with the issue of chronic inflation.
4 Cf. Ludwig von Mises, Human Action (New Haven, Conn.: Yale University Press, 1949, 1963), chapter 20. Also, see Rothbard, America’s Great Depression (Princeton: Van Nostrand, 1963).
5 Jacques Rueff and Fred Hirsch, "The Role and Rule of Gold: A Discussion," in Essays in International Finance, #47, June, 1965 (Princeton University’s International Finance Section), p. 6.
6 Arthur Kemp, "The Gold Standard: A Reappraisal," in Leland B. Yeager (ed.), In Search of a Monetary Constitution (Cambridge, Mass.: Harvard University Press, 1962), p. 148.
7 Interview with Rueff in U. S. News & World Report (Oct. 17, 1966), p. 61.
8 Computed from the tables in Mineral Industry Surveys (Washington, D. C.: Bureau of Mines, Aug., 1966), p. 3.
9 For a summary of these positions, or at least of the leading ones, see Arthur Kemp, The Role of Gold (Washington, D. C.: American Enterprise Institute, 1963).
10 Paul H. Douglas, America in the Market Place (New York: Holt, Rinehart and Winston, 1966).
11 Charles Rist, The Triumph of Gold (New York: Philosophical Library, 1960), p. 139.