Domestic Inflation Versus International Solvency

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

International Complications

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.

The Dilemma

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.

Why Gold?

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.