The latest crisis in the foreign exchanges illustrates once more the inherent unsoundness of the International Monetary Fund system. That should have been obvious when it was first set up at Bretton Woods, N. H., in 1944. The system not only permits and encourages but almost compels world inflation.
There follows a reprint of the article I wrote in Newsweek of
In an epilogue I discuss the measures needed to extricate ourselves from the present international monetary crisis and to prevent a repetition.
The World Monetary Earthquake
Copyright Newsweek, Inc., October 3, 1949. Reprinted by permission.
Within a single week 25 nations have deliberately slashed the values of their currencies. Nothing quite comparable with this has ever happened before in the history of the world.
This world monetary earthquake will carry many lessons. It ought to destroy forever the superstitious modern faith in the wisdom of governmental economic planners and monetary managers. This sudden and violent reversal proves that the monetary bureaucrats did not understand what they were doing in the preceding five years. Unfortunately, it gives no good ground for supposing that they understand what they are doing now.
This column has been insisting for years, with perhaps tiresome reiteration, on the evil consequences of overvalued currencies. On Dec. 18, 1946, the International Monetary Fund contended that the trade deficits of European countries "would not be appreciably narrowed by changes in their currency parities." I wrote in Newsweek of March 3, 1947: "It is precisely because their currencies are ridiculously overvalued that the imports of these countries are over encouraged and their export industries cannot get started." In the issue of Sept. 8, 1947, as well as in my book, Will Dollars Save the World? I wrote: "Nearly every currency in the world (with a few exceptions like the Swiss franc) is overvalued in terms of the dollar. It is precisely this overvaluation which brings about the so-called dollar scarcity."
Yet until Sept. 18 of this year the European bureaucrats continued I to insist that their currencies were not overvalued and that even if they were this had nothing to do, or negligibly little to do, with their trade deficits and the "dollar shortage" that they continued to blame on America. And the tragedy was that former Secretary of State Marshall, the President, and Congress, completely misunderstanding the real situation, accepted this European theory and poured billions of the American taxpayers’ dollars into the hands of European governments to finance the trade deficits that they themselves were bringing about by their socialism and exchange controls with overvalued currencies.
In time the managers of the Monetary Fund learned half the lesson. They recognized that most European currencies were overvalued. They recognized that this overvaluation was a real factor in causing the so-called "dollar shortage" and unbalancing and choking world trade. But they proposed the wrong cure.
They did not ask for the simple abolition of exchange controls. (Their own organization in its very origin was tied up with the maintenance of exchange controls.) They proposed instead that official currency valuations be made "realistic." But the only "realistic" currency valuation (as long as a currency is not made freely convertible into a definite weight of gold) is the valuation that a free market would place upon it. Free-market rates are the only rates that keep demand and supply constantly in balance. They are the only rates that permit full and free convertibility of paper currencies into each other at all times.
Sir Stafford Cripps fought to the last against the idea that the rate of the pound had anything to do with the deepening British crisis. Trying to look and talk as much like God as possible, he dismissed all such contentions with celestial disdain. But at the eleventh hour he underwent an intellectual conversion that was almost appallingly complete. We "must try and create conditions," he said, "in which the sterling area is not prevented from earning the dollars we need. This change in the rate of exchange is one of those conditions and the most important one" (my italics). And on the theory that what’s worth doing is worth overdoing, he slashed the par value of the pound overnight from $4.03 to $2.80.
There are strong reasons (which space does not permit me to spell out at this time) for concluding that the new pound parity he adopted was well below what the real free-market level of widely usable sterling was or would have been on the day he made the change. What he did, in other words, was not merely to adjust the pound to its market value as of Sept. 18 but to make a real devaluation.
The first consequence was to let loose a world scramble for competitive devaluation far beyond anything witnessed in the ’30s. Most nations fixed new rates lower than their existing real price and cost levels called for. These countries, therefore, will now undergo still another epidemic of suppressed inflation. Their internal prices and living costs will start to soar. Unions will strike for higher wages. And if the past (or Sir Stafford’s Sept. 18 talk) is any guide, the governments will try to combat this by more internal price-fixing and rationing, continued or increased food subsidies, unbalanced budgets, and wage fixing.
In this country, on the contrary, the tendency will be to drag down our price level somewhat by lowering the dollar price of imported commodities and forcing reductions in the dollar price of export commodities. This will increase our problems at a time when the unions are pressing for a wage increase in the camouflaged form of insurance-pension benefits.
It will be necessary to re-examine our whole foreign economic policy in the light of the new exchange rates. Marshall-plan aid with overvalued European currencies was largely futile; Marshall-plan aid with undervalued European currencies should be unnecessary. In fact, we may soon witness the reversal of the world flow of gold. For the first time since 1933 (if we omit the war years 1944 and 1945) gold may move away from, instead of toward, our shores.
But getting rid of overvalued currencies, even in the wrong way, is nonetheless a tremendous gain. The chief barrier that has held up a two-way flow of world trade in the last five years has at last been broken. The chief excuses for maintaining the strangling worldwide network of trade restrictions and controls have at last been destroyed. Were it not for the echoes of the atomic explosion in Russia, the outlook for world economic freedom would at last be brighter.
The best British comment I have read since the devaluation comes from The London Daily Express: "Let every foreign country pay what it thinks the pound is worth… But the socialists will never consent to free the pound. It would mean abandonment of their system of controls…. If you set money free you set the people free."
World Inflation Factory: Epilogue 1971
The prediction made in this 1949 piece, that the flow of gold would be reversed, proved correct. The deficit in our balance of payments, in fact, began in 1950. Our 1949 gold stock of nearly $25 billion proved to be its high point. Thereafter it declined. The decline accelerated after 1957 when our balance-of-payments deficits started to reach major proportions.
But all this should not have been too difficult to predict. For on top of the great world realignment of currency values in 1949, our monetary authorities began to inflate our own currency at a greatly increased rate. The dollar "shortage" disappeared, and was soon succeeded by a dollar flood. What would otherwise have been a slight tendency for our prices to fall was offset by an expansion of our money supply. In September, 1947, two years before the 1949 crisis, the U. S. money stock (currency in the hands of the public plus demand bank deposits) was $111.9 billion. In September, 1949, it was only $110 billion. But by December 1950 it had reached $115.2 billion, and by December, 1951, $122 billion. The figure at the end of May, 1971, was $225 billion.
It is important to remember that the present world monetary system is not a natural growth, like the old international gold standard, but an arbitrary scheme devised by a handful of monetary bureaucrats who did not even agree with each other. Some of them wanted inconvertible paper currencies free to fluctuate in the foreign exchange markets and "managed" by each country’s own bureaucrats solely in accordance with "the needs of the domestic economy." Others wanted "exchange stability," which meant fixed values for each currency in relation to the others. But none of them wanted constant convertibility of his country’s currency by any holder into a fixed weight of gold on demand. That had been the essence of the classic gold standard.
So a compromise was adopted. The American dollar alone was to be convertible into a fixed amount (one thirty-fifth of an ounce) of gold on demand. But only on the demand of official central banks, not of private holders of dollars. In fact, private citizens were forbidden to ask for or even to own gold. Then every other nation but the U. S. was to fix a "par value" of its currency unit in terms of the dollar; and it was to maintain this fixed value by agreeing either to buy or sell dollars to whatever extent necessary to maintain its currency in the market within 1 per cent of its parity.
The Burden of Responsibility
Thus there was devised a system which appeared to "stabilize" all currencies by tying them up at fixed rates to each other—and even indirectly, through the dollar, tying them at a fixed ratio to gold. This system seemed to have also the great virtue of "economizing" gold. If you could not call it a gold standard, you could at least call it a gold-exchange standard, or a dollar-exchange standard.
But the system, precisely because it "economized reserves," also permitted an enormous inflationary expansion in the supply of nearly all currencies. Even this expansion might have had a definite limit if the U. S. monetary managers had constantly recognized the awesome burdens and responsibilities that the system put upon the dollar. Other countries could go on inflationary sprees without hurting anybody but themselves; but the new system assumed that the American managers, at least, must always stay sober. They would refrain from anything but the most moderate expansion to keep the dollar constantly convertible into gold.
But the system was not such as to keep the managers responsible. Under the old gold standard, if a country over expanded its money and credit and pushed down interest rates, it immediately began to lose gold. This forced it to raise interest rates again and contract its currency and credit. A "deficit in the balance of payments" was quickly and almost automatically corrected. The debtor country lost what the creditor country gained.
Just Print Another Billion
But under the gold-exchange or dollar standard, the debtor country does not lose what the creditor country gains. If the U. S. owes $1 billion to West Germany, it simply ships over a billion paper dollars. The U. S. loses nothing, because in effect it either prints the billion dollars or replaces those shipped by printing another billion dollars. The German Bundesbank then uses these paper dollars, these American I. 0. U.’s, as "reserves" against which it can issue more D-marks.
This "gold-exchange" system began to grow up in 1920 and 1921. But the Bretton Woods agreements of 1944 made things much worse. Under these agreements each country pledged itself to accept other countries’ currencies at par. When holders of dollars shipped them into Germany, the Bundesbank had to buy them up to any amount at par with D-marks. Germany could do this, in effect, by printing more paper marks to buy more paper dollars. The transaction increased both Germany’s "reserves" and its domestic currency supply.
So while our monetary authorities were boasting that the American inflation was at least less than some inflations in Europe and elsewhere, they forgot that some of these foreign inflations were at least in part the result of our own inflation. Part of the dollars we were printing were not pushing up our own prices at home because they went abroad and pushed up prices abroad.
The IMF system, in brief, has been at least partly responsible for the world inflation of the last twenty-five years, with its increasingly ominous economic, political, and moral consequences.
What Should Be Done Now?
As long as the world’s currencies continue to consist of inconvertible paper there is no point in setting new fixed parities for them. What is a "realistic" rate for any currency today (in terms of others) will be an unrealistic one tomorrow, because each country will be inflating at a different rate.
The first step to be taken is the one that West Germany and a few others have already taken. No country should any longer be obliged to keep its currency at par by the device of buying and selling the dollar or any other paper currency at par. Paper currencies should be allowed to "float," with their prices determined by supply and demand on the market. This will tend to keep them always "in equilibrium," and the market will daily show which currencies are getting stronger and which are getting weaker. The daily changes in prices will serve as early warning signals both to the nationals of each country and to its monetary managers.
Floating rates will be to some extent disorderly and unsettling; but they will be much less so in the long run than pegged rates supported by secret government buying and selling operations. Floating rates, would, moreover, most likely prove a transitional system. It is unlikely that the businessmen of any major nation will long tolerate a paper money fluctuating in value daily.
The next monetary reform step should be for the central banks of all countries to agree at least not to add further to their holdings of paper dollars, pounds, or other "reserve" currencies.
Let Citizens Own Gold
The next step applies to the U. S. alone. There appears to be no alternative now to our government doing frankly and de jure what for the last three years it has been doing without acknowledgment but de facto: it should openly announce that it can no longer undertake to convert dollars into gold at $35 an ounce. It owns only about $1 in gold for every $45 paper dollars outstanding. Its dollar obligations to foreign central banks alone are now more than twice its holdings of gold. If it really allowed free conversion it would be bailed out of its remaining gold holdings within a week.
The government should also announce that until further notice it will neither buy nor sell gold.
Simultaneously, however, the United States should repeal all prohibitions against its citizens owning, buying, selling, or making contracts in gold. This would mean the restoration of a really free gold market here. Incidentally, because of distrust of floating paper currencies, it would mean that international trade and investment would soon be increasingly conducted in terms of gold, with a weight of gold as the unit of account. Gold, even if not "monetized" by any government, would become an international money, if not the international money. On the foreign-exchange markets national paper currencies would be quoted in terms of gold. Even if there were no formal international agreement, this would prepare the way for the return of national currencies, country by country, to a gold standard.
Stop the Reckless Government Spending that Brings Inflation
All this concerns technique. What chiefly matters is national economic and monetary policy. What is essential is that the inflation in the U. S. and elsewhere be brought to a halt. Government spending must be slashed; the budget must be consistently balanced; monetary managers as well as private banks must be deprived of the power of constantly and recklessly increasing the money supply.
Only abstention from inflating can make a gold standard workable; but a gold standard, in turn, provides the indispensable discipline to enforce abstention from inflating.
David Ricardo summed up this reciprocal relation more than 160 years ago:
"Though it [paper money] has no intrinsic value, yet, by limiting its quantity, its value in exchange is as great as an equal denomination of coin, or of bullion in that coin….
"Experience, however, shows that neither a state nor a bank ever has had the unrestricted power of issuing paper money without abusing that power; in all states, therefore, the issue of paper money ought to be under some check and control; and none seems so proper for that purpose as that of subjecting the issuers of paper money to the obligation of paying their notes either in gold coin or bullion."
A sentiment of trust in the legal money of the state is so deeply implanted in the citizens of all countries that they cannot but believe that some day this money must recover a part at least of its former value. To their minds it appears that value is inherent in money as such, and they do not apprehend that the real wealth, which this money might have stood for, has been dissipated once and for all. This sentiment is supported by the various legal regulations with which the Governments endeavor to control internal prices, and so to preserve some purchasing power for their legal tender. Thus the force of law preserves a measure of immediate purchasing power over some commodities and the force of sentiment and custom maintains, especially amongst peasants, a willingness to hoard paper which is really worthless.
JOHN MAYNARD KEYNES, The Economic Consequences of the Peace (1920)