All Commentary
Thursday, December 1, 1960

Monetary Cross Roads

Dr. Sennholz is Professor of Economics at Grove City College, Pennsylvania.

No matter what the politicians may have promised the American people, the new administration faces some hard facts of economic life. Most electioneering promises, if implemented, involve increased government spending for such fa­vored pressure groups as farmers, workers, small businessmen, and the aged. But more government spending necessitates higher rev­enues which must be obtained from the people.

If the new administration tries to keep its campaign promises, it will have to raise the taxes or in­cur budget deficits. Judging from past experience, it will do both: close tax “loopholes,” which in plain English means higher taxes on some groups of taxpayers; and rely on deficit financing, which means inflation.

The most popular approach dur­ing the last 30 years has been deficit financing, which largely ac­counts for the ominous deprecia­tion of our dollar. During the Roosevelt, Truman, and Eisen­hower administrations, unusual conditions hid the most spectacu­lar effects of inflation from the eyes of the public. The new ad­ministration may be less fortu­nate for, in addition to the pres­ently visible effects of inflation, it is likely to face a gold crisis.

In September 1960, the Ameri­can gold stock slipped below $19 billion for the first time in 20 years. Since 1958, it has decreased some $4 billion and continues to decline month after month. In ad­dition, foreign banks and capital­ists have built up large liquid as­sets in this country which may be redeemed in gold upon demand by foreign central banks. Foreigners now own in the United States ap­proximately $21 billion of liquid assets. Though we still hold nearly $19 billion of gold, some $12 bil­lion of that is required as mone­tary reserves under our Federal Reserve Bank laws. This leaves a free gold reserve of some $7 bil­lion against $21 billion of liquid foreign assets.

An Unfavorable Balance of Payments

In popular language, this out­flow of gold and build-up of for­eign balances is called an “unfa­vorable balance of payments.” It gives rise to alarm because for­eigners may some day decide to ask for gold en masse, which would leave the U. S. Treasury bankrupt in international pay­ments. But some government offi­cials are still disposed to view the gold loss as a passing phenomenon of limited scope because most of the foreign dollar gains are de­posited in American banks or in­vested in American securities.

The popular explanations of this unfavorable balance are often quite superficial. The general pub­lic believes that an unfavorable balance is the result of unfortu­nate circumstances over which the citizens have no control, and that correction of the situation re­quires government action on an international scale.

The truth is that the flow of gold and international exchange is the inevitable outcome of the monetary policies conducted by the government. A policy of infla­tion or credit expansion causes an outflow of gold because inflation makes commodity prices rise and short-term interest rates decline. Foreigners purchase less from us and our imports increase. At the same time, short-term capital is sent abroad in order to earn higher interest. Consequently, gold leaves a country until its in­flationary policy is abandoned or until it is surpassed by inflation in foreign countries.

The socialists and nationalists are quick to lay the blame for the gold losses on sinister foreign forces that are said to attack the stability of the dollar. The Fed­eral Reserve System is applauded for its valiant defense of the cur­rency against foreign intrigue and speculation.

In reality, the Federal Reserve System is the government engine of inflation that causes the gold losses. The Federal Reserve ex­pands its credit more than the European central banks expand theirs. American prices thus tend to rise more quickly than prices in Europe, and the American in­terest rates tend to be lower than European rates. Foreigners have nothing to do with the causation of these phenomena. European and American businessmen react alike to American credit expan­sion. They buy less in the United States and more abroad, and both tend to shift some capital over­seas.

On August 1 when the Federal Reserve discount rate stood at 31/2 per cent, the comparative rates stood at 6 per cent in England, 5 per cent in West Germany, 4 per cent in France, and 7.3 per cent in Japan. It is no coincidence that each of these countries was in­creasing its gold reserves and dol­lar holdings. From January 1, 1959 to March 31, 1960 (the latest date for which statistics are available at this writing) the United Kingdom gained $159 mil­lion in gold and dollar holdings, Germany $291 million, France $783 million, and Japan $522 mil­lion.’ So large are the gold and dollar holdings of the German and Swiss banks that both central banks have taken steps to halt the heavy inflow of funds from the United States.

Foreign Inflation Facilitated Dollar Depreciation

Such a turn of events comes as a shock to many American ob­servers. The United States gov­ernment has expanded credit nu­merous times and has incurred huge budgetary deficits for some 30 years without the dilemma of embarrassing gold losses. Why could the previous administrations conduct inflationary policies with such impunity?

During the 1930′s, the fetish of cheap money dominated Europe and other parts of the world. No matter what President Roosevelt did to the U.S. dollar, the Euro­pean governments outdid him. The prestige of the pound sterling went in eclipse when, in 1931, the Bank of England quit paying gold and went off the gold standard. Capital and gold holdings no longer seemed safe in England. Also, France and Switzerland suf­fered severe gold losses by reason of their currency devaluations in 1936 and the explosive political situation in Europe. The rise of Hitler caused gold to leave Ger­many until rigid government con­trols halted all movements. With the outbreak of war and the threat of German occupation, the flight of European gold to the United States naturally accelerated. Euro­pean chaos and monetary disorder afforded U.S. monetary authori­ties tremendous leeway for their own inflationary ventures.

For the same reason, the nu­merous bursts of Federal Reserve credit expansion in the first post­war decade failed to create a dan­gerous payments problem. The Federal Reserve System in the Tru­man Administration could expand credit and depreciate the dollar be­cause foreign currency deprecia­tions were even worse. In Eng­land, France, Germany, Italy, and Japan, the central banks created credit even faster than did the Federal Reserve, and their gov­ernmental trade restrictions were even worse than those of the Fair Deal.

When foreign governments re­turned to balanced budgets, the situation was bound to change. Foreign currency stabilization and continuous American credit ex­pansion meant that capital and gold would turn away from the United States. In 1957, this turn­ing point was finally reached.

United States Continues Inflation

While more and more European governments endeavored to bal­ance their budgets and took steps toward currency convertibility, the United States government continued its policy of deficit spending and credit expansion. In 1958 and 1959 respectively, the federal government incurred defi­cits of $7.3 billion and $8.0 billion. The Federal Reserve lowered its discount rate from 3 per cent in January to 13/4 per cent in April of 1958, but felt obliged to raise the rate again later in the year.

Beginning in June 1960, Fed­eral Reserve authorities took sev­eral additional steps to ease credit. The discount rate at which the System stands ready to lend its funds to member banks was low­ered in two stages from 4 per cent to 3 per cent. Effective Sep­tember 1, the reserve require­ments for banks in New York and Chicago were reduced to 171/2 per cent from 18 per cent. Rules were relaxed as to the amount of cash in bank vaults that may be counted as part of a bank’s legal reserves. These two steps provide commer­cial banks with more than $600 million of new reserves. The Sys­tem also embarked upon large-scale open-market purchases of government securities which in­jected more than $600 million in­to the economy. A further indica­tion of the resumption of easy money policies is the reduction of margin requirements on stock market credit from 90 per cent to 70 per cent.

The United States government and its Federal Reserve System are firmly committed to deficit fi­nancing. Whenever the American economy shows symptoms of eco­nomic decline, the government feels called upon to create another boom through deficit spending and credit expansion. This atti­tude is the ideological cause that is creating and perpetuating the problem of gold losses.

May We Ignore the Problem?

The United States cannot con­tinue a payments deficit of present proportions and lose gold indefi­nitely. What can and should be done to solve the problem?

Some persons suggest that we merely ignore the problem be­cause gold is an ancient relic for which there is no place in the modern economy. Who wants to sacrifice the government’s auton­omy in economic planning for the sake of gold and a given exchange rate?

For the U.S. government to ig­nore the gold problem is to invite dollar disaster. It is true that our government may temporarily suc­ceed in persuading foreign cen­tral banks to ignore the dollar weakness. Through persuasion or gentle coercion it may induce for­eign depositors to maintain their dollar balances and refrain from further gold withdrawals. But the foreign banker who heeds the American advice runs the risk of staggering losses in case the U.S. government should suddenly cease gold payments, which would cause the dollar to fall in relation to gold and foreign exchange. And he invites disaster regarding his own career. To protect his own solvency, he must continue his gold withdrawals although he may start a run and precipitate a dol­lar crisis.

It seems unlikely, however, that the U.S. government can long per­suade foreign central banks to ig­nore the problem. Governments do not trust the integrity and hon­esty of one another in monetary matters. They learned the lesson in 1931 when the British govern­ment abandoned the gold standard and again in 1949 when it de­valued the pound. France and Hol­land, particularly, suffered huge losses on their sterling holdings in 1931 when they trusted assur­ances of the Bank of England’s Governor Montagu Norman that England would remain on the gold standard. But two days later he suspended gold payment. In 1949, Sir Stafford Cripps, Chancellor of the Exchequer, reassured the frightened public thirteen times of his sincere intention to main­tain the official exchange rate, whereupon he suddenly announced a devaluation. These examples il­lustrate the reasons why govern­ments and central bankers cannot trust each other in monetary mat­ters.

Foreign dollar-holders may re­member this lesson and withdraw their capital before it is deci­mated by an American devaluation or payment suspension. True, their withdrawal might precipi­tate a sudden run and crisis. But, in the long run, that might be less harmful than a continuation of currency expansion that is hidden and prolonged by dishonest tricks and subterfuge.

A Proposal by the President

It is imperative, some writers concede, that we maintain world confidence in the U.S. dollar and solve our payments problem; we must expand our exports of goods and services to offset our spend­ing.

President Eisenhower had this in mind when he outlined an ex­port development program to as­sist American exporters in ex­panding their sales in foreign markets. The government would promote exports through free ad­vice, guarantees, U.S. participa­tion in foreign trade fairs, expan­sion of export credit insurance by the Export-Import Bank, and other hidden subsidies.

Will such a policy solve the pay­ments problem? Obviously not! The government help may tempo­rarily promote American sales abroad because the public treas­ury carries some sales costs or re­duces the risk to exporters. These subsidies for the benefit of for­eign buyers and American export­ers may temporarily halt the gold losses. But government payments do not correct the basic maladjust­ment. If our credit expansion con­tinues and the purchasing power of the dollar further declines, ever larger export subsidies will be re­quired to counteract the basic maladjustment. It is obvious that this must end sooner or later. The subsidy approach is self-defeat­ing, as it necessitates more gov­ernment spending and deficit fi­nancing which is the very cause of the gold losses. In short, an evil cannot be remedied by an intensi­fication of its cause.

The government’s eagerness to help exporters with taxpayers’ money is usually accompanied by an official denunciation of foreign trade policies. Foreign trade bar­riers and restrictions are blamed for our inability to sell enough abroad to solve our payments di­lemma.

This attempt to shift the blame to foreign governments for what is clearly our own government’s making must be rejected. During recent years the industrial nations of the free world have reduced their trade barriers, which par­tially accounts for their upsurge in production and prosperity. While they were lowering their barriers, we were losing gold, which strongly suggests that we not attribute our losses to the re­maining, but reduced, foreign trade barriers.

The government reasoning im­plies that foreign governments are responsible for our dilemma and that the problem can be solved by foreign freedom of trade on the one hand and by American trade restrictions on the other hand. Although this is a conven­ient line of official reasoning, it is radically opposed to the truth. It is especially dangerous because it encourages protectionism in the United States. The payments ar­gument together with the argu­ment of higher labor costs in the United States, which allegedly hampers American competition at home and abroad, could lead to a great number of new American trade restrictions. Such a “solu­tion,” however, can only disrupt foreign trade, cause unemploy­ment at home and abroad, and further jeopardize our economic and political position in the free world.

Another imperative for the solu­tion of our payments problem, ac­cording to official reports, is that our prosperous allies take more of a share of the West’s responsi­bility for aid to underdeveloped countries. Our government offi­cials are urging Germany, in par­ticular, to embark upon more for­eign aid spending in Asia and Africa to give relief to the U.S. Treasury.

This is poor advice. German handouts to Ghana, Congo, or In­dia can affect the American gold problem only inasmuch as they in­duce the U.S. government to re­duce its spending, balance the budget, and refrain from credit expansion. It is doubtful, how­ever, that any foreign handout could bring about such a change in American attitude. On the con­trary, substantial German foreign aid spending would appear to vin­dicate American spending and en­courage our Washington planners to spend even more. Furthermore, foreign aid by their governments would tend to dissipate the econ­omic strength of our prosperous allies and create payments prob­lems for them. Foreign aid spend­ing encourages the recipient gov­ernments to embark upon central planning and development pro­grams and, thus, further promotes socialism in the underdeveloped areas of the world.

More Subterfuges

An intensification of our pay­ments problem will bring the U.S. government to crucial monetary crossroads. One road leads to stabilization of the dollar through balanced budgets and credit sta­bility. This road requires the re­nunciation of a great deal of gov­ernment intervention. It is the road of individual enterprise and limited government. The other road leads to all-out socialism via a number of interventionist sub­terfuges designed to make infla­tion and credit expansion work.

One of these measures is the lowering of the legal reserve re­quirements. According to present legislation, the Federal Reserve System is required to maintain a reserve of 25 per cent in gold cer­tificates for its note and deposit obligations. As pointed out above, gold holdings are down to $19 bil­lion of which some $12 billion constitute required reserves, leav­ing a free gold reserve of some $7 billion. If foreign central banks continue to draw heavily against this amount, or if the Federal Re­serve should expand its obliga­tions through additional note is­sue or credit expansion, or if the two things go on simultaneously, the critical point may soon be reached. Under the present law, the Federal Reserve would then be required to contract its credit in order to reduce its obligations.

Rather than face up to a squeeze in that manner, however, the government will probably re­sort to a subterfuge it has prac­ticed before: reduce the legal re­serve requirements from 25 per cent to, let us say, 15 per cent. This would afford the System new leeway for further credit expan­sion by changing required gold reserves to free reserves.

Such a “solution,” however, would merely intensify the pay­ments problem through temporary continuation of present policies. Itwould shake the world’s confidence in our integrity and probably pre­cipitate the foreign run on the re­maining gold.

Another subterfuge in the ar­mory of statist planners is foreign exchange control. This is tanta­mount to nationalization of all for­eign exchange dealings. All ex­porters would be forced to cede their foreign earnings to the gov­ernment which would then sell them at arbitrary exchange rates to importers for purchases which the officials deem essential. For­eign money and gold would be ra­tioned according to central plan and official discretion. In a country that depends on imports from abroad, foreign exchange control is naked tyranny of the govern­ment over business. In the United States, where foreign trade is less important, foreign exchange con­trol would constitute another im­portant step toward total social­ism. Like the reduction of reserve requirements, nationalization of foreign exchange dealings can hardly be assumed to foster for­eign confidence; it probably would trigger the dreaded run.

Any government that invites such a run would most likely re­act to it by suspending gold pay­ments. Blaming foreigners and speculators, it would declare itself incapable of meeting the gold with­drawals. Immediately, the price of dollars in terms of gold and for­eign exchange would collapse. Foreign holders of dollars or claims on dollars would suffer se­vere losses. Though such bank­ruptcy might solve our payments difficulties, the price would be sui­cide as a free nation. The dollar would lose its position as a world currency. Foreign confidence in the United States as a free nation and a champion of freedom would be shattered. The resultant infla­tionary burst here would entail all-round price, wage, and rent controls. In other words, socialism would arise from the ashes of in­flation and payments bankruptcy.

Dollar Devaluation Is Inevitable

Another “remedy” of inflation­ists is currency devaluation. When the outflow of gold reaches men­acing proportions, an interven­tionist government is prone to de­value the currency officially. It sud­denly decrees that the price of gold and the value of foreign money have risen in terms of the depre­ciated dollar. Just as President Roosevelt devalued the dollar in 1933, the new administration will be tempted to devalue again, in­creasing the price of gold, for in­stance, from $35 per ounce to $50 or $60.

The effects of currency devalua­tion are disastrous. Like the pay­ments suspension, dollar devalua­tion would undermine the econ­omic position of the United States in the world. It would probably usher in price, wage, and rent controls. It would inflict severe losses on foreign depositors and on all creditors, thus penalizing thrift and self-reliance. It would destroy the people’s savings and capital en masse and cause capital consumption. Productivity and standards of living would decline.

Even so, currency devaluation is an inevitable step on the road of credit expansion and unbal­anced budgets. No matter how many controls the inflating gov­ernment may choose to impose on the people, currency depreciation sooner or later necessitates official devaluation, which re-establishes a more realistic exchange rate be­tween gold and depreciated cur­rency.

If our government continues its policies of monetary ease and de­preciation, dollar devaluation can­not be avoided. Devaluation con­stitutes official admission that the dollar has declined in value—proof that the laws of economics prevail over government planning.

  • Hans F. Sennholz (1922-2007) was Ludwig von Mises' first PhD student in the United States. He taught economics at Grove City College, 1956–1992, having been hired as department chair upon arrival. After he retired, he became president of the Foundation for Economic Education, 1992–1997.