All Commentary
Friday, August 1, 1969

Floating Exchange Rates

My theme is human folly. It is a theme so prolific and inexhausti­ble that one wonders at the sur­vival of a species incessantly pre­occupied with the assertion of absurdities, that is, with the de­nial of salient facts about the en­vironment in which it exists.

All nations have their own local and national nonsense; but on none of these would I presume to address you. I am in a foreign country. Decency, therefore, for­bids me to expatiate upon the foi­bles of Britain; and good manners debar me from referring to those of my hosts. There is, however, no lack of material on that ac­count, because you and we and many other nations participate together in one and the same grand nonsense, which is respect­fully referred to as “the international monetary system.” This huge pyramid or Tower of Babel is constructed upon a simple but perfectly adequate foundation. This is the assertion that the val­ues of the different national cur­rency units in terms of one an­other and of ounces of pure gold ought not to vary from month to month or from year to year or even from decade to decade—at least, unless they are altered by a committee decision among the nations. It is similar to, and as absurd as, asserting that all the prices of stocks and shares are to remain unaltered unless and until this one or that is revised by the Stock Exchange Commission.

I will not detain you by argu­ing, what is obvious, that neither in the one case nor the other will the prices ever be right—except, by some remote chance, for an in­stant of time. Apart from this extreme exception, they are all bound to be more or less wrong, in one direction or the other, all the time. Of course, if the various national currencies were gold, chopped into bits of different sizes, or gold represented by pieces of paper which could in­stantly and unconditionally be ex­changed for a specified bit of gold, then indeed their respective values in terms of one another would be, if so desired, immutable, because they would all be one and the same stuff.

This used, until just after I was born, to be the case; and the memory like the memory of so much else prewar (which to me means “pre-World War I) still haunts mankind and is part of the etiology of the collective aberra­tion I am discussing. This was specially plain when we in Britain plunged into it in 1925 by what was miscalled “going back onto gold.” After a decade of war and confusion, at last the blessed, the magic, the prewar equation of £3:17:101/2 sterling with an ounce of fine gold occurred in the mar­ket. It was a nostalgic moment, and small wonder if we tried to grapple it to ourselves forever, saying, like Faust to the passing hour: “Oh, tarry yet; thou art so fair.”

Within six or seven years the decision was found to be unsus­tainable and presently it became widely accepted that it had also been inherently wrong and one of the causes of the depression into which we and other countries descended around 1930 and from which some recovery was percep­tible after 1931. It is one of the ironies of our age that those who wholeheartedly accepted this view hastened to re-establish the sys­tem of 1925 again after 1944 and have maintained it pertinaciously ever since, explaining that all that was wrong in 1925 was the par­ticular figure chosen to be fixed.

$35 an Ounce

You in the United States still live under the influence of a sim­ilar popular emotion. Having once asserted, thirty-five years ago, that the price of fine gold was $35 an ounce, you have persisted in that assertion as though the mere repetition could make and keep it true. There is an enormously deep human yearning—which finds mul­tifarious religious expression —for something changeless and eternal to which to cling: “0 Thou that changest not, abide with me.”

Here was an equation, closely allied with the concept of the na­tion itself, something around which in any case the human in­stinct for survival and diuturnity strongly centers—the equation between a piece of gold and a dollar bill, the very symbol of America. Surely its permanence could be as­serted and, being asserted, be se­cured? Once again, if and so long as that dollar bill was instantly and unconditionally exchangeable with gold, the statement would be a truism and therefore true; but when it ceased to be so exchange­able, there was no reason why, ex­cept for a brief chance moment, the price of gold in terms of dol­lars or of dollars in terms of gold, should remain at any particular figure: the conditions of supply and demand, of production and de­sirability, of the two things hav­ing no specific and necessary rela­tionship. Yet, to maintain the assertion, you have more than half emptied Fort Knox and spun a web of controls and compulsions around American citizens.

Trapped by Error

So here are our two nations, along with others, making asser­tions about the respective values of our domestic currencies which are manifestly untrue, and asser­tions about the stability or per­manence of those respective values which are manifestly absurd. Yet to these assertions we are com­mitted by dint of habit and repe­tition and the most solemn and repeated asseveration.

This is no new phenomenon. Indeed, as I have suggested, one form or another of it is perfectly normal. Consequently, we have ample experience from which to predict with assurance how peo­ple will react in order to defend and shore up the untruth and ab­surdity, because, of course, being untrue and absurd, it is always threatening to collapse. One reac­tion—I will not dilate on it at any length—is to shout at anyone who points out the untruth or ab­surdity, to drive him away with stones and curses, and, in primi­tive times, if possible to kill him. Those who in recent years have been so bold as to talk in public about a floating pound or a mar­ket price for gold will be person­ally familiar with this kind of treatment.

The next reaction is to invent a range of imaginary terrors de­picting what would happen if the untruth or absurdity were aban­doned. This may, psychologically, be an attempt to frighten oneself out of thinking, and is perhaps close kin to those medieval elabo­rations of the horrific torments which awaited those who ques­tioned the dogmas of ecclesiastical authority. These superstitious fears are, I believe, worth exten­sive and patient examination, be­cause they illustrate one of the great dangers to freedom, whether it be freedom of thought and speech, or of trade and economic decision. This is that, once free­dom has been lost, it can so easily be made to appear impracticable, and indeed chimerical.

Unfounded Fears

As soon as the price of an arti­cle is controlled, men are soon per­suaded that unless it were con­trolled, the article would be unobtainable: if food prices were decontrolled, they imagine they would starve; if house rents were freed, they imagine they would perish of exposure. Thus the loss of a freedom becomes self-perpet­uating through fear of the un­known, and habit soon teaches men to believe there is no alter­native to the state in which they find themselves. This is cognate with the awkward fact that while the effect of control is easy to ar­gue—”if the government fixes the price, then that is the price which will apply”— the practicability and superiority of freedom are in the last resort demonstrable only ex­perimentally, by experience.

We know that men can walk erect on two legs, because in fact they do; but if we had been kept for long enough on all fours, we should treat with skepticism and ridicule any bold spirit who sug­gested that it would be much easier and simpler to walk about. We should have become convinced that any such dangerous and un­proven experiment would speedily result in broken noses or cracked skulls.

The terrors with which imagi­nation has invested the simple no­tion that gold and the various na­tional currencies should be allowed to price themselves, like anything else, in the market and that all the contortions and controls de­signed to fix their respective prices are futile and harmful, find close parallels wherever the mar­ket has been distorted or des­troyed. Hence, in examining the superstitious fears attendant on the preservation of “the interna­tional monetary system,” we are confronting the same imaginary monsters as bar the road to every freedom.

I take the first. “We should be plunged into uncertainty, and never know the exchange rates from one day to the next.” This is the cry of the prisoner of the Bastille, who pitifully longed for the security of his confinement. He, however, did at least get reg­ular meals and live in the same old cell. The irony today is that the very people who express this fear never know at present a mo­ment’s freedom from anxiety. Day by day the headlines scream at them about impending devalua­tion, or revaluation, or some other abrupt and disagreeable contingency. The pains they dread are those with which they are already suffering—but in a specially acute form, for one more uncertainty and unknown is added to all those which exist anyhow: namely, the uncertainty as to whether, when, and how the arbitrary fixed price will be altered.

An Added Uncertainty

There is no uncertainty in this world quite so great as the uncer­tainty about what a government is going to do next. These uncer­tainties already have to be taken into account in every transaction in which the future exchange value of currencies is a factor. In the jargon, only “spot” is fixed while “forward” varies from day to day, reflecting as best it can the opinions which those con­cerned hold about the future.

The moral is this. We do not banish change and uncertainty by pretending, or asserting, that they do not exist. We thereby only make them even harder to antici­pate and to guard against. A premium has always to be paid to insure against the unknown. That premium will be higher if the unknown includes the actions and decisions of politicians and if trends and changes in the real world are not constantly being re­flected, genuinely and freely, by changing market prices. What a terrifying position it would be if the spot prices on the Stock Ex­change were pegged—and inci­dentally, therefore, rigged and subsidized by the controlling au­thorities—while only the futures were allowed to move.

I have disposed, just now, inci­dentally of the argument that in­ternational trade would be inhib­ited by a higher cost of insurance against currency risks, by point­ing out that the opposite would in fact be expected. I pause only to note that this argument is a special form of the general claim that control is economical and minimizes costs by substituting certainty for uncertainty—a prop­osition which any person or trade with practical experience of state control finds highly satirical. The actual effect is to replace continu­ous adjustment by large, jerky, and belated concessions to a real­ity it is no longer possible to deny or defy—in this context, the sud­den, long-anticipated but long-delayed jolts of devaluation and revaluation.

Planned Chaos vs. Freedom

Sometimes, however, it is sim­ply stated as self-evident that the growth of world trade would suf­fer if the respective currencies and gold were continuously priced against one another in the market. This is a recognizable variant of the well-known “chaos” supersti­tion, whereby the operation of the market in any area is described as “chaotic,” immediately creating by this metaphor the impression that the movement of individuals and their relations with one an­other are impeded. We are so fa­miliar with such terms as “traffic chaos,” “administrative chaos,” “chaos and dark night,” that the mere mention of the word is suf­ficient not merely to suspend judgment but to neutralize experi­ence.

People who are perfectly and daily familiar with the market where it exists—in the shopping center, for example, or on the stock exchanges—will instantly persuade themselves wherever they are not accustomed to it that it would produce “chaos.” This im­pression is reinforced by the ap­plication of the solemn and im­pressive term “system” to the op­posite. It is wonderful what can be achieved by giving to the, truly chaotic, behavior of national gov­ernments in the last twenty years the title of “the international mon­etary system,” and describing as “a threatened collapse of the sys­tem into monetary chaos” the prospect of those governments be­ing forced to recognize the true respective values of their curren­cies.

The “system”—to call it for once by its nickname— incidentally necessitates, and has in fact al­ways necessitated, the repeated and abrupt interference of gov­ernments in the trade and invest­ment of their subjects, internal and external: changes of taxation, import controls, import deposits, import surcharges, alterations of interest rates, prohibitions on loans. To be able seriously to argue that such a system is actu­ally favorable to international trade is striking evidence of the depth to which superstition has penetrated. The fear of the un­known like all fear renders its vic­tims irrational and blind to their surroundings.

The Course of Trade

Another superstitious fear—we may be more familiar with this in Britain than you are here—is that if the exchange rate of a country’s currency were to fall, it would be unable to buy the raw materials for its industries or even the food which it needs. This is a particular version of the general cry in defense of control: “If it were not there, we should starve.”

There is, of course, absolutely no rational basis for this fear. If a given number of British prod­ucts of a certain kind exchange for a given amount of raw materi­al or finished goods in Brussels or Buenos Aires or New York on one day, so they do the next day, ir­respective of any alteration over­night in the exchange value of sterling. The supply and demand equation in Brussels or Buenos Aires or New York is unaffected by the number of pounds the ex­porter gets for his francs or pesos or dollars when he changes them to come home, or by the number of pounds the importer has to find to buy the goods in francs or pesos or dollars. The realities are unaltered: the same volume of British goods and ser­vices exchanges in the outside world for the same volume of for­eign goods and services. In other words, our ability to buy what we want from abroad is unaffected: our standard of living remains absolutely unchanged.

What would happen is that if the exchange rate fell, and con­sequently importers had to find more pounds while exporters earned more pounds, there would be a shift—ever so slight, but enough and just enough to pro­duce a balance without borrowing—away from imports and toward exports. The shift would be so slight as to be imperceptible —less, at the moment, than one per cent of the national product or much less than the gain which we make year by year in production—and the shift in jobs would, of course, be even smaller still.

This tiny margin is the sole extent to which Britain’s standard of living is being, even tempo­rarily, maintained by the rest of the world: it is a margin so nar­row that the economic growth even of a single average year is sufficient to swamp it. Yet, it is the only basis for the accusation which the British positively enjoy leveling against themselves, that they “imagine the rest of the world owes them a living.”

“Balance of Payments”

Another common but equally irrational fear that prevails in countries which, under a system of fixed parities, inevitably have what is called “a deficit on the bal­ance of payments,” is that if the current parity were not artificially maintained but were to be replaced by a free and therefore fluctuating and at first presumably lower val­uation, foreigners would, as the phrase goes, “take their capital out.” The victims of this delusion imagine, as many of us do in Britain, that they would thereby be impoverished, like a village which has been pillaged by a horde of marauders.

In the first place, no productive capital, whoever it belongs to, can be shipped abroad: these assets are, as you might say, landlord’s fixtures, and the refineries, re­torts, and furnaces are there to stay. The most that a foreigner who holds shares in them can do is to try to find somebody to buy the shares from him for cash, and then exchange the cash for for­eign currency. The capacity of the country to produce goods and ser­vices remains the same.

Let us, however, follow through what would happen. To the extent that foreigners decide to exchange their shares, or other interest-bearing securities, for the cash of the country, the demand for cash is increased and for shares and securities is lowered. In other words, the prices of the shares and securities fall, and the interest obtainable on them—or the re­ward for surrendering one’s cash in exchange for them—corre­spondingly increases. When the foreigners, having realized their securities, proceed to convert them into other currencies, to that ex­tent they drive down the rate of exchange of the currency out of which they are getting in favor of those into which they are get­ting; and thus, in effect, they ob­tain a lower rate of return on their money—or suffer a loss of value, whichever way you like to look at it—in the new situation compared with the old. Thus, the more foreigners “take their money out,” the more the inducements not to do so mount up, in the form of higher rewards for stay­ing and severer penalties on go­ing. It is a sobering experience which, even with fixed parities, has befallen a number of investors in Britain in recent years.

So the fear of a “rush of money out of the country” is pure bogey­man. I have spelled it out in terms of the foreign holder; but obvi­ously the same logic applies to one’s own nationals. By all means, if they like to exchange their as­sets for cash and then convert and invest it abroad, good luck to them! They take the consequences, but none of the rest of us suffers. If internal interest rates rise somewhat in consequence, that is nothing to the rise in rates which we have actually suffered in the effort to “keep up with the Joneses.” In itself, a fall in the rate of exchange neither harms nor impoverishes a country. In­deed, there is no such thing as a “high” exchange rate or a “low” exchange rate, but only a “right” exchange rate and a “wrong” ex­change rate.

Projecting a Trend

Then comes another “but,” in­troducing another superstitious fear. “But if we let the exchange rate go free, it may fall and fall and never stop.” This is, in fact, a very common argument against the market in any area where it does not already prevail: if prices are free to rise, they will go on rising forever; or alternatively, if prices are free to fall, they will go on falling forever. It is, of course, nonsense, but none the less dan­gerous for that. This is why, when food prices were controlled, peo­ple feared they would skyrocket otherwise: so long as the price of an egg is controlled at 6 pence, you cannot prove that this does not prevent it from rising to one shilling, or two shillings or any figure you care to name. When the pound is pegged at $2.40, there are people who come to you, seri­ous, educated adults, and say that if it were free, it would fall to $1.00. It is their version of the two-shilling egg. One retort, as above, is: “Well; and if so, what of it?” But another, perhaps more suitable for the weaker brethren, is: “No, it wouldn’t; because if the discrepancy between the fixed price and the free price were any­thing like that, nothing on earth under our sort of conditions—not even a combination of central bankers—would be able to main­tain the present fixed price for any length of time.” But all this illustrates once again the force of the superstitious fear of the un­known.

Inflation Jitters

My last group of superstitions centers around inflation. We have been having a bad dose of these superstitions in Britain lately, be­cause it has paid the politicians to support (whether knowingly or not) the myth that a fall in a country’s exchange rate automati­cally causes a general rise in prices. This served both as a bogey to protect the absurdity of the fixed rate system, and also as a blind to cover the causes of the higher prices which actually oc­curred in the fiscal year 1968 when the pound sterling was de­valued.

When a market exchange rate is substituted for a fixed exchange rate, two things happen; the def­icit (or surplus)—that is, the loan to or from foreigners of a certain quantity of goods and ser­vices—disappears; and secondly, relative prices alter internally so as to accommodate that change. Other things being equal, the re­sult would be a general rise (or fall) in prices, the total of goods and services available being that much less (or more). However, as I have pointed out, the proportion was in our case minute and, in any event, more than compensated for by the rise in domestic output. There would, therefore, have been no general rise in prices if other factors had been neutral.

After the change-over from a fixed to a market rate has taken place, further changes in the rate will cause an alteration in some internal prices relative to others if, but only if, there is a change in the terms of trade; that is, if a given quantity of a nation’s goods and services exchanges for more or fewer than before in the outside world. When this happens, there may also, but will not neces­sarily, be a rise or fall in the gross national product in consequence and thus, in the absence of other factors, a general fall or rise in prices.

However, the principal context in which inflation appears in this whole debate is the belief that fixed rates of exchange are a safe­guard against domestic inflation, and—according to taste—either prevent the politicians from in­dulging in it or force them to keep control upon it. There are three answers to this, at different levels. One is that fixed rates of exchange demonstrably do not pre­vent domestic inflation, and that there is no correlation between the stability or otherwise of do­mestic prices in various countries and their showing in deficit or surplus under the system of fixed exchange rates.

The second answer is one I am entitled to give with confidence as a working politician: it is that if there were no such thing as the balance of payments, if the country concerned were the only inhabited land on the globe, the politicians would still be punished by the electorate for indulging in more than a certain mild degree of inflation. The true sanction on inflation, and the true penalty for practicing it, is the effect on peo­ple of the defeat of expectations and the shift of power from per­son to person, class to class, gov­erned to government, which it causes. That is what the politician has to answer for when he meets his constituents.

But the third, and last, answer is a defiance. “If we here want to inflate our currency, what busi­ness is it of any other country, provided we do not try to insist on everybody else financing us? That is, provided we accept the consequences in terms of truth­ful exchange rates, it is part of our sovereign independence to do as we will with our own domestic currency and to be as much, or as little, pseudo-Keynesian as we please.”

Finally, Common Sense and Reason Become Suspect

I conclude by confronting the last and most dangerous of the demons which keep people im­prisoned in the cage of control and falsification, once the spring door has closed behind them. This is, that common sense and reason themselves become suspect. “If you were right,” the prisoners protest, “we would have walked out of prison long ago; if the bars were illusory, we should not then have all lain in fetters so many years. What you say is too simple and obvious to be true. Away with you; you are a false prophet.” So the prisoners are made to act as their own wardens, and the world has witnessed these last twenty-five years, if it would but look, the ironical spectacle of whole nations wrestling with conundrums, com­monly miscalled “economic prob­lems,” which are the creation of their own persistence in absurd, and manifestly absurd, practices.

How, then, if rational argument thus becomes counterproductive, are the superstitions to be de­stroyed and the imaginary pris­oners liberated? Don Quixote turned sane on his death bed, but that cure will not do. My own guess is that sooner or later, quite accidentally and unpredictably, an inrush of reality occurs, against which even the most entrenched superstitions and self-punishing delusions are not proof, and the edifice of control and falsification collapses, leaving the former vic­tims out in the open, bewildered but intact. That will be the mo­ment, with encouraging and re­assuring words, to approach and say: “That’s all right. There was nothing to be afraid of all along. I told you so!” This uttered, it will only remain to turn smartly away, and open the attack upon some ensuing folly.

From an address of May 19, 1969, before Trustees and guests of The Foundation for Economic Education.