The Search for an Ideal Money
NOVEMBER 01, 1975 by HENRY HAZLITT
Mr. Hazlitt, noted economist, journalist and author, here examines perhaps the most important question facing us today.
For more than a century economists have toyed with the idea of designing or inventing an ideal money. So far no two of them seem to have precisely agreed on the detailed nature of such a money. But they do seem at the moment to agree on at least one negative point. I doubt that there is any economist today who would defend the international or American monetary system just as it is. No one openly defends the violent daily and hourly fluctuations in exchange rates, the steadily increasing unpredictability of future import, export, or domestic prices. Every newspaper reader fears that commodity prices will be higher next year and still higher the year after that. Even the man in the street, in brief, senses that the world is drifting toward monetary chaos.
But concerning the remedy, we find little agreement. Inflation is bad, some agree. Yes; but it isn’t as bad as depression and unemployment; and at least it puts off those greater evils, so we must have just a little more inflation as long as these evils threaten us. Inflation is bad, others agree; but it has nothing to do with the monetary system. Rising prices are brought about by the greed and rapacity of sellers; they could promptly be stopped by price controls. Or, inflation is bad, still others concede; and yes, it is brought about by the increase in the quantity of money and credit.
But this is not the fault of the monetary system itself, but of the blunders and misdeeds of the politicians or the bureaucrats in charge of it.
Even those who admit that there is something wrong with the monetary system itself cannot agree on the reforms needed in that system. Scores of such reforms have been proposed.
The reformers, however, tend to fall into two main groups. One of these would have nothing to do with a gold, a silver, or any other commodity standard, but would leave the issuance and control of the currency entirely in the hands of the State. The other group would return to some form of the gold standard.
Each of these two groups may again be divided into two schools. In what I shall call the statist or paper-money group, one school would leave everything to the day-to-day discretion of government monetary authorities, and the other would subject these authorities to strict quantitative controls. And in the gold group, likewise, one school would allow discretion, within vague but wide limits, to private bankers and government authorities, while the second would impose severe and definite limits on that discretion.
So we have, then, four main schools of monetary theorists.
Nearly every currency proposal can be classified under one of them.
Paper Money — No Controls
Let us begin with School One, the paper-money statists, who would leave the power of controlling the nature, quantity and value of our money solely in the hands of the politicians in office or the bureaucrats they appoint. This is the worst imaginable monetary system, but it is the one that prevails nearly everywhere in the world today. It has brought about practically universal inflation, unprecedented uncertainty, and economic disruption.
None of this is accidental. It was built into the system deliberately adopted at a conference of 44 nations at Bretton Woods in 1944, under the guidance of Harry Dexter White of the U.S. and Lord Keynes of England. The ostensible purpose of that conference was to increase "international cooperation" and — believe it or not — to "stabilize" currencies and exchange rates.
The chief architects sincerely believed (though they did not as openly avow) that this end could best be achieved by phasing gold out of the monetary system. So they put the world, in effect, not on a gold but on a dollar standard. The value of every other currency was to be maintained by making it convertible into the American dollar at a fixed official exchange rate.
The system still had one tie to gold. The dollar itself was to be kept convertible into that metal at $35 an ounce. But this tie was weakened in two ways. Other countries could keep their currencies stabilized in terms of the dollar, not through the operations of a free foreign exchange market (as under the pre-World War I gold standard) but by government sales or purchases of dollars — in other words by government pegging operations. And dollars were no longer convertible into gold on demand by anybody who held them; they were convertible only by foreign central banks. The U.S. could even (off-the-record) use its great political and economic power — which in time it did — to indicate to any central bank with the effrontery to ask for gold that this was not considered a friendly act.
So the artificial stability that the Bretton Woods system was able to maintain for a few years was not the result of any real attempt by each country to keep its own currency sound — by refraining from excessive issuance of money and credit — but of government pegging operations and gentlemen’s agreements not to upset the apple cart.
This arrangement proved, in the end, unwise, unsound, and unstable. The system was able to maintain the appearance of stability only by the stronger currencies constantly rushing to the rescue of the weaker. The U.S., say, would rush in and lend Britain millions of dollars, or buy millions of pounds. It would do the like for other currencies in crisis. But using the stronger currencies to support the weaker only weakened the stronger currencies. When the U.S. Treasury bought millions of pounds with dollars, it in effect got these dollars by printing them.
And so when the dollar itself, as the result of our own recklessness, began to turn bad, and when we went off the gold standard openly in August, 1971, other nations were affected. Germany, for instance, under the terms of the Bretton Woods agreements, had to buy billions of dollars to keep the D-mark from going above its official parity. And where did Germany get the billions of marks necessary to buy the billions of dollars? Why, by printing them.
So the faster-inflating nations almost systematically exported their inflations to the slower-inflating nations. And this almost systematically brought the world toward its present inflationary chaos.
True, the nations with stronger currencies, even when they felt obliged by their Bretton Woods agreement to buy weaker currencies, did not have to increase their own money supply to buy them. Neither Germany nor any other nation that acquired dollars had to use the dollars as added central bank "reserves" against which they could issue still more of their own currency. They could have "sterilized" their reserves of dollars. Or they could have reduced their other government expenditures correspondingly when they felt obliged to buy dollars, or raised the amount by added taxation, instead of simply printing more D-marks or whatever. But these would have been very difficult decisions. They might have endangered the tenure of the governments that made them. What they chose seemed under the circumstances the path of least resistance.
What has to be made crystal clear, if we are to lay the foundations for any permanent sound monetary reform, is that the present worldwide inflationary chaos is not a mere accident. It is not something that has happened in spite of the wonderfully modern and enlightened International Monetary Fund system. It is something that has happened precisely because of that system. It is, in fact, its almost inevitable result.
It was precisely the kind of "international cooperation" it set up that led to its final breakdown. The countries whose policies were chronically leading them into currency crises should have been obliged to pay the penalty. The faltering currencies should not have been rescued by the central banks of other countries. It was exactly because the soft-currency countries knew that an American or international safety net would be almost automatically spread out to save them that they chronically got themselves into more trouble. As it was, the system kept breaking down anyway, but there was a sort of open conspiracy to ignore its fundamental unsoundness. In September, 1949, the British pound was devalued by 30 per cent, from $4.03 to $2.80. When this happened some 25 other countries devalued within a single week. In November, 1967 the British pound was devalued once more, this time from $2.80 to $2.40. There have been in fact hundreds of devaluations of currencies in the International Monetary Fund since it opened for business in 1946. In its Monthly Bulletin the Fund has printed literally millions of statistics a year, but it has steadfastly refused, up to now, to publish one figure — the total number of these devaluations.
Enough of this. It should no longer be necessary to prove how bad the Bretton Woods system turned out to be. Few people, aside from the bureaucrats whose jobs are at stake, would seriously try to glue it together again. The system is dead. Unfortunately the corpse has not been buried.
Let us turn to the next candidate — the proposals of the so-called monetarists. Two things may by said in favor of the monetarists. First, they do recognize the close connection between the quantity of money and the purchasing power of the monetary unit. And second, they do acknowledge the importance of imposing strict and explicit limits on the issuance of money. But there are serious weaknesses both in their factual assumptions and in their policy proposals.
It is true that there is a close relation between the outstanding supply of money and the buying power of the individual monetary unit. But it is not true that this relation is inversely proportional or in any other way fixed and dependable. Nor is it true that there is any fixed "lag" between an increase of a given percentage in the "growth" of the money supply and an increase of the same percentage in prices. The statistics on which this conclusion is based are at best inadequate. They do not cover enough currencies over long enough periods.
What happens during a typical inflation, for example, is that in its early stages commodity prices do not rise as fast as the supply of money is increased and in its later stages prices rise much faster than the supply of money is increased.
Monetarists will dismiss this whole comparison as unfair and irrelevant. They do not regard themselves as proposing inflation at all. To them inflation is defined not as an increase in the money supply, but only as a rise in prices. And their proposal, as they see it, is to increase the stock of money 3 to 5 per cent a year just to keep the price "level" from falling. They propose an annual increase in the money stock merely to compensate for an expected annual increase of 3 per cent or more in the "productivity" of the economy.
The monetarists’ proposal rests on a false factual assumption. There is no automatic and dependable annual increase in "productivity" of 3 per cent or any other fixed rate. The increase in productivity that has occurred in the U.S. in recent years is the result of saving, investment, and technical progress. None of these is automatic. In fact, in the last two years or so, the usual "productivity" measures have actually been declining.
Wholly apart from the formidable mathematical and statistical problems involved, which space does not permit me to go into, the maintenance of the price "level" is a dubious goal. It is based on the assumption that falling prices are somehow "deflationary," and that in any case they tend to bring about recession. This assumption is questionable. When the stock of money is not increased, falling prices are a normal result of increased production and economic progress. They need not bring recession, because the falling prices are themselves the result of falling production costs. Real profit margins are not reduced. Money wage-rates may not increase, but real wages will increase because the same money will buy more. Falling prices with continued or rising prosperity have occurred again and again in our history.
Abuses of Union Power
In our present world of powerful and aggressive labor unions, with legally built-in coercive powers, the monetarists do have a legitimate fear that such unions will not be satisfied with increased purchasing power for the same money wages. In that case, when such unions ask and get excessive wage-rates, they may bring on unemployment and recession. But this danger will exist under any monetary system whatever, as long as we retain our present one-sided labor laws and union ideology.
The central and fatal flaw of the monetarist proposal is its extreme political naïveté. It puts the power of controlling the quantity, the quality, and the purchasing power of our money entirely in the hands of the State — that is, of the politicians and bureaucrats in office.
I am tempted to add that it leaves this power entirely to the discretion, the arbitrary caprice, of the temporary holders of office in the State. The monetarists would deny this. They would limit the discretion of the monetary managers, they contend, by a strict rule. The managers would be ordered to increase the stock of money by only 2, or 3, or 4, or 5 per cent per year; and this figure would be written into the law, or into the Constitution.
It is a sign of the monetarists’ own vacillation that they have never quite decided whether this figure should be a month-to-month bureaucratic goal, or embodied in a law, or nailed into the Constitution. Nor have they ever definitely decided whether the figure itself should be 2 or 3 or 4 or 5. They can apparently hold their ranks together only by remaining vague.
Continuous Political Pressure
It is obvious that once the premises of this system were adopted there would be continuous political pressure for inflation. Those who contended that an annual increase of 2 per cent in the money stock would be enough would constantly have to combat the fears of their colleagues that this might be too low, and threaten to bring on recession. The 3 percenters, again, would have to fight a ceaseless rearguard action against the advocates of 4 per cent, or these in turn against the champions of 5 per cent. And so ad infinitum. Every time a recession seemed imminent, it would be blamed on the lowness of the existing rate of money increase. Agitation would be resumed to boost it.
None of this is a figment of my imagination. It is occurring today. On February 20, 1975, Henry Ford II, in presenting the disappointing annual report of his motor company, emphasized the need of measures to "assure strong recovery." Among these, he stipulated: "The Federal Reserve must raise the monetary growth rate to the range of 6 to 8 per cent for a short period."
I cite this as only one among scores of examples. It was especially instructive because it came from a businessman and not from a politician.
A month later there was a far more striking illustration. On March 18 the Senate of the U.S. adopted unanimously, 86 to 0, a resolution urging the Federal Reserve Board to expand the money supply in a way "appropriate to facilitating prompt economic recovery." It also asked the board to consult with the House and Senate Banking Committee every six months on "objectives and plans" concerning the money supply. This was in effect an order to the Fed to continue inflating, and presumably to increase the rate of inflation. It also put the Fed on notice that whatever it may have previously supposed, it is not independent, but is subject to the directions of the politicians in office. The substance of this resolution was later adopted by the full Congress.
The monetarists’ program would inevitably make the monetary system a political football. What else could we expect? Isn’t it the height of naïveté deliberately to put the power of determining the money supply in the hands of the State, and then expect existing officeholders not to use that power in the way they think is most likely to assure their own tenure of office?
The first requisite of a sound monetary system is that it put the least possible power over the quantity or quality of money in the hands of the politicians.
This brings us to gold. It is the outstanding merit of gold as the money standard that it makes the supply and the purchasing power of the monetary unit independent of government, of office holders, of political parties, and of pressure groups. The great merit of gold is precisely that it is scarce; that its quantity is limited by nature; that it is costly to discover, to mine, and to process; and that it cannot be created by political fiat or caprice. It is precisely the merit of the gold standard, finally, that it puts a limit on credit expansion.
Fractional or Full Reserve?
But there are two major kinds of gold standard. One is the fractional-reserve system, and the other the pure gold or 100 per cent reserve system.
The fractional-reserve system is the one that developed and prevailed in the Western world in the century from 1815 to 1914. It is what we now call the classical gold standard. It had the so-called advantage of elasticity. And it made possible — we might justly say it was responsible for — the business cycle, the recurrent round of prosperity and recession, of boom and bust.
With the fractional-reserve system what typically happened is that in a given country — let us say Ruritania — borrowers would be given credit by the banks, in the form of demand deposits, and they would launch upon various enterprises. The new money so created, perhaps after taking up any slack in business and employment, would increase Ruritanian prices. Ruritania would become a better place to sell to, and a poorer place to buy from. The balance of trade or payments would begin to turn against it. This would be reflected in a fall in the exchange rate of the Ruritanian currency until the "gold export point" was reached. Gold would then flow out to other countries. In order to stop it, interest rates in Ruritania would have to be raised. With a higher interest rate or a smaller gold base, the volume of currency would be contracted. This would often mean a deflation or a crisis followed by a slump.
In brief, the gold standard with a fractional-reserve system tended almost systematically to bring about the cycle of boom and slump.
Under such a system, there is constant political pressure to reduce interest rates or the reserve requirements so that credit expansion — i.e., inflation — may be encouraged or continued. It is supposed to be the great advantage of a fractional-reserve system that it allows credit expansion. But what is overlooked is that, no matter how long the required legal reserve is set, there must eventually come a point when the permissible legal credit expansion has been reached. There is then inevitable political pressure to reduce the percentage of required reserves still further.
This has been the history of the system in the United States. The effect — and partly the intention — of the Federal Reserve Act was enormously to increase the potential volume of credit expansion. The required reserves for member banks were reduced under the new Federal Reserve Act from a range of 15 to 25 per cent for the previous national banks to 12 to 18 per cent for the new Federal Reserve member banks. In 1917 the required reserves for member banks were reduced still further to a range of 7 to 13 per cent.
But on top of the inverted pyramid of credit that the member banks were allowed to create, the newly established Federal Reserve Banks, which now held the reserves of the member banks, were permitted to erect a still further inverted credit pyramid of their own. The Reserve Banks were required to carry only a 35 per cent reserve against their deposits and a 40per cent gold reserve against their notes.
Later the Federal Reserve authorities became more strict in imposing reserve requirements on the member banks (they raised these sharply beginning in 1936, for example). But they continued to be very lenient in setting their own reserve requirements. Between June of 1945 and March of 1965 the reserve requirements were reduced from 35 and 40 per cent to a flat 25 per cent. And then they were dropped altogether.
So much for history. What of the future?
If the world, or at least this country, ever returns to its senses, and decides to re-establish a gold standard, the fractional-reserve system ought to be abandoned. If by some miracle the U.S. government were to make this decision tomorrow, it could not of course wipe out the already existing supply of fiduciary money and credit, or any substantial part of it, without bringing on a devastating and needless deflation. But the government would at least have to refrain from any further increase in the supply of such fiduciary currency. Assuming that the government were then able to fix upon a workable conversion rate of the dollar into gold — a rate that was sustainable and would not in itself lead to either inflation or deflation — the U.S. could then return to a sound currency and a sound gold basis.
But in the world as it has now become — sunk in hopeless confusion, inflationism, and demagogy — the likelihood of any such development in the foreseeable future is practically nil. The remedy I have suggested rests on the assumption that our government and other governments will become responsible, and suddenly begin doing what is in the long-run interest of the whole body of the citizens, instead of only in the short-run interest — or apparent interest —of special pressure groups. Today this is to expect a miracle.
But the outlook is not hopeless. I began by pointing out that for more than a century individual economists have tried to design an ideal money. Why have they not agreed? Why have their schemes come to nothing? They have failed, I think, because they have practically all begun with the same false assumption — the assumption that the creation and "management" of a monetary system is and ought to be the prerogative of the State.
This has become an almost universal superstition. It is tantamount to agreeing that a monetary system should be made the plaything of the politicians in power.
The proposals of the would-be monetary reformers have failed, in fact, for two main reasons. They have failed partly because they have misconceived the primary functions that a monetary system has to serve. Too many monetary reformers have assumed that the chief quality to be desired in a money is to be "neutral." And too many have assumed that this "neutrality" would be best achieved if they could create a money that would lead to a constant and unchanging "price level."
This was the goal of Irving Fisher in the 1920′s, with his "compensated dollar." It is the goal of his present-day disciples, the "monetarists," and their proposal for a government-managed increase in the money supply of 3 to 5 per cent a year to keep the "price-level" stable.
I believe that this goal itself is a c questionable one. But what is an even more serious and harmful error on their part is the method by which they propose to achieve this goal. They propose to achieve it by giving the power to the politicians in office to manipulate the currency according to the formula prescribed in advance by the monetarists.
What such reformers fail to recognize is that once the politicians and their appointees are granted such powers, they are less likely to use them to pursue the objectives of the reformers than they are to pursue their own objectives. The politicians’ own objectives will be those that seem best calculated to keep them in power. The particular policy they will assume is most likely to keep them in power is to keep increasing the issuance of money; because this will:
(1) increase "purchasing power" and so presumably increase the volume of trade and employment;
(2) keep prices going up as fast as union pressure pushes up wages, so that continued employment will be possible; and
(3) give subsidies and other handouts to special pressure groups without immediately raising taxes to pay for them. In other words, the best immediate policy for the politicians in power will always appear to them to be inflation.
In sum, the belief that the creation and management of a monetary system ought to be the prerogative of the State — i.e., of the politicians in power — is not only false but harmful. For the real solution is just the opposite. It is to get government, as far as possible, out of the monetary sphere. And the first step libertarians should insist on is to get our government and the courts not only to permit, but to enforce, voluntary private contracts providing for payment in gold or in terms of gold value.
A Movement Toward Gold
Let us see what would happen if this were done. As the rate of inflation increased, or became more uncertain, Americans would tend increasingly to make long-term contracts payable in gold. This is because sellers and lenders would become increasingly reluctant to make long-term contracts payable in paper dollars, or in irredeemable money-units of any other kind.
This would apply particularly to international contracts. The buyer or debtor would either have to keep a certain amount of gold in reserve, or make a forward contract to buy gold, or depend on buying gold in the open spot market with his paper money on the date that his contract fell due. In time, if inflation continued, even current transactions would increasingly be made in gold.
Thus there would grow up, side by side with fiat paper money, a private domestic and international gold standard. Each country that permitted this would then be on a dual monetary system, with a daily changing market relation between the two monies. And there would be a private gold system ready to take over completely on the very day that the government’s paper money became absolutely worthless — as it did in Germany in November 1923, and in scores of other countries at various times.
A Private Gold Standard?
Could there be such a private gold standard? To ask such a question is to forget that history and prehistory have already answered it. Private gold coins, and private gold currencies, existed centuries before governments decided to take them over — to nationalize them, so to speak. The argument that the kings and governments put forward for doing this — and it was a plausible one — was that the existing private coins were not of uniform and easily recognizable size, weight, and imprint; that the fineness of their gold content, or whether they were gold at all, could not be easily tested; that the private coins were crude and easily counterfeited; and finally that the legal recourse of the receiver, if he found a coin to be underweight or debased, was uncertain and difficult. But, the kings went on to argue, if the coins were uniform, and bore the instantly recognizable stamp of the realm, and if the government itself stood ever ready to prosecute all clippers or counterfeiters, the people could depend on their money. Business transactions would become more efficient and certain, and enormously less time-consuming.
Still another specious argument for a government coinage applied especially to subsidiary coins. It was impossible, it was contended, or ridiculously inconvenient, to make gold coins small enough for use in the millions of necessary small transactions, like buying a quart of milk or a loaf of bread.
What was needed was a subsidiary coinage, which represented halves, quarters, tenths, or hundredths of the standard unit. These coins, regardless of what they were made of, or what their intrinsic value might be, would be legally accept-table and convertible, at the rates stamped on them, into the standard gold coins.
It would be very difficult, I admit, to provide for this with a purely private currency, with everybody having the legal power to stamp out his own coins and guarantee their conversion by him into gold. A private coinage system might conceivably be able to solve this problem, but I confess I personally have been unable to think of any solution that would not be complicated, cumbersome, or undependable.
It is clear, in short, that a government-provided or a government-regulated coinage has some advantages. But these advantages are bought at a price. That price seemed comparatively low in the nineteenth century and until 1914; but today the price of government control of money has become excessive practically everywhere.
The basic problem that confronts us is not one that is confined to the monetary sphere. It is a problem of government. It is in fact the problem of government in every sphere. We need government to prevent or minimize internal and external violence and aggression and to keep the peace. But we are obliged to recognize that no group of men can be completely trusted with power. All power is liable to be abused, and the greater the power the greater the likelihood of abuse. For that reason, only minimum powers should be granted to government. But the tendency of government everywhere has been to use even minimum powers to increase its powers. And any government is certain to use great powers to usurp still greater powers. There is no doubt that the two great World Wars since 1914 brought on the present prevalence of the quasi-omnipotent State.
But the solution of the overall problem of government is beyond the province of this article. To decide what would be the best obtainable monetary system, if we could get it, would be a sufficiently formidable problem in itself. But a major part of the solution to this problem, to repeat once more, will be how to get the monetary system out of the hands of the politicians. Certainly as long as we retain our nearly omnipotent redistributive State, no sound currency will be possible.