The Fallacy of Exchange Control

May 10, 1948

Nobody can for a moment doubt that it is far from the intention of the leading democratic countries to consider as a permanent arrangement the exchange control which, contrary to the fundamental character of their peacetime economy, they have introduced today. To do so in peacetime would in fact carry their political and economic life irresistibly down the slippery slope of collectivist authoritarian totalitarianism.

These words were written in wartime, in 1942, by the European economist Wilhelm Röpke, in his book International Economic Disintegration. His faith in the strength of the liberal tradition proved in this respect sadly misplaced. Surely the British, for example, must believe that they are getting something very substantial in return for the coercion of both producers and consumers, and the sacrifices of economic freedom, that exchange control involves. Are the supposed gains in fact delusive?

At the official rate of $4.03, the pound today is overvalued. This was shown by the quick collapse of sterling convertibility (at $4.03) last summer. Convertibility will continue to be a one-way street as long as British bureaucracy insists that sterling must be bought and sold above the value that the importers, exporters, bankers, and traders of the world in fact attach to it. Wherever in the world black or free markets appear they show rates for pound notes in the neighborhood of $2.60 and for the transferable sterling in the neighborhood of $3.25.

The British bureaucrats believe that they cannot afford to allow a free market rate for the pound. It would, they say, increase the cost of imports. It would certainly do so in terms of pounds but not of dollars. And what they complain of is not a pound shortage but a dollar shortage. If the pound on a free market sold as low as $3, then a million bushels of wheat would cost British consumers, say, £800,000 instead of only £600,000 as at present. But it would still cost Britain, as before, only $2,400,000 of its dollar reserves.

The British bureaucrats argue, on the export side, that if they let the pound fall to its market level Britain would get less for its exports. This is an outright fallacy. What the British exporter gets (or in a free system would get) for his exports to our market, for example, is determined by the price he can get for them in dollars in America. In the long run this has nothing to do with the rate for the pound. If a British exporter sells 2,400,000 yards of cloth in New York at $1 a yard, he gets $2,400,000 for it. If this exporter in a free exchange market got only $3 instead of $4 for each pound, he would quickly compensate for this by an exactly proportionate increase in the number of pounds he got for the same volume of exports. Where he now, at $4, gets only £600,000 for his 2,400,000 yards of cloth, he would at $3 get £800,000 for it.

So keeping the pound coercively at $4 helps Britain not at all in solving its dollar problem. On the contrary, it is the very thing that creates the problem. For the relative cheapness with which British citizens can buy American imports in terms of their own currency unduly encourages imports. This encouragement must then be offset by discriminatory bureaucratic prohibitions against the import of specific articles.

The overvalued pound, on the other hand, discourages and reduces exports. It wipes out the price premium that the British manufacturer might otherwise have had as an incentive to export instead of selling at home. It either puts a price premium on domestic sales or compels him to overprice his exports (in terms of foreign currencies) and hence to lose potential sales in foreign markets and end up with fewer dollars.

When such consequences are pointed out, the British bureaucrats reply that as a matter of fact British manufacturers are today selling abroad all that they are physically able to produce for export. But they complain in the very next breath that their foreign-trade position is desperate. On closer inspection they will find that this is largely because, and not in spite of, exchange control.