Advent of the Gold-Exchange Standard

It did not take quite as long to find a solution to Austria's postwar financial calamities. The first real breakthrough came at a conference that took place in the fall of 1922 in Genoa and led to the signing of a convention in Geneva on October 4, 1922. The so-called Geneva Protocol was the last in a series of negotiations that had begun at the end of 1921, when Austria was promised loans from the British, French, Czechs, and Italians. The condition was that the Austrian government had to grant institutionalized supervision inside of Austria, and to pledge some of its income and assets to the foreign creditors.

These conditions were at first unacceptable to the Austrian Chancellor, Johann Schober, but time was running out. The only alternative to foreign loans was increased taxation and inflation, and these options were even less acceptable. The social democrats virulently opposed any more taxation of the general population. They were still advocating a special tax on wealth—always a popular proposal, but incapable of balancing the budget. And more inflation would certainly bring monetary breakdown and ensuing civil chaos.

A turning point was reached when, at the end of May 1922, Monsignor Ignatz Seipel assumed the chancellorship with the firm resolution to lead Austria out of the financial nightmare. He already had some experience in handling catastrophic situations in Austrian politics, having been a member of the last imperial government under Heinrich Lammasch in 1918. A Catholic priest, Seipel was not a man to despair over the unpopularity of the decisions that needed to be made. Living in a Vienna monastery, he was not as exposed as were his other party comrades to the many temptations of personal friendship and the spotlight of fame.⁶² He knew that reliance on international loans under the conditions spelled out by western creditors was a dangerous strategy because it would lead his country into dependence on foreign powers.⁶³ But there was no alternative if the goal was to rid the country of the poison of inflation. Mises and his friend Wilhelm Rosenberg convinced Seipel of the necessity of this reform.⁶⁴ With candid foresight, they stressed that the reform was bound to produce a crisis; there would be massive unemployment and other interests would be hurt as well. This crisis would merely bring to light the damage already done by the previous inflation, but public opinion would blame the reformer. Seipel appreciated the frankness of his advisors; Mises later recalled: “he adopted fully my ideas about sound money and I cooperated with him.”⁶⁵ In the same month, Mises was appointed the president of the Bureau for Claims Settlements.⁶⁶

In one of his first actions after his initial orientation, Seipel dealt a heavy blow to Austria's inflation party, which had its stronghold in the Austro-Hungarian Bank. Following the stipulations of Article 206 of the Treaty of Saint-Germain, he abolished the old central bank and established a new one—under the leadership of Richard Reisch, a former student of Carl Menger's and a civil servant under Böhm-Bawerk in the Ministry of Finance. At the time of his appointment to the presidency of the new central bank, he had just been appointed a vice president under Mises at the Bureau for Claims Settlements.

Seipel's reforms hurt those groups whose incomes had been paid out of the inflation, in particular the nationalized industries and socialist municipal governments that had started creating expensive welfare programs immediately after the war—programs that could only be paid for through the printing press of the Austro-Hungarian Bank. Hurting these interests entailed only moderate political costs for the government, and might have even been a welcome side effect of Seipel's reform in that it promised to hurt groups that were part of the socialist opposition. It turned out, however, that the very success of the reform extended the survival of these groups. The stable monetary framework attracted a great volume of foreign credit to Austria, which was then used to finance local welfare schemes.

The reform did visibly curtail Austrian sovereignty in financial and economic matters. Seipel's government accepted the establishment of the office of a Commissar General, who henceforth controlled Austria's public finance. This action effectively surrendered control over Seipel's budget to the Entente-controlled League of Nations. Dr. Alfred Zimmermann, a former mayor of Rotterdam, was appointed Commissar General and stayed for three years in Vienna.⁶⁷ With Austria colonized, its government a subject to foreign powers—the socialists did not hesitate to accuse Seipel of giving up the country's sovereignty. The German nationalists in Seipel's coalition saw things the same way.

Mises had been one of the driving forces behind the reform. He thought Austria could have done without the 650 million kronen of credit, but not without the commissar. Austrian politicians needed a fall guy to take responsibility for unpopular policies. He did not exactly have a high opinion of Zimmermann himself, but had great respect for chief executive Hans Patzauer, a civil servant from the Ministry of Finance. Mises was widely perceived as enjoying very good ties to Patzauer. This working relation turned him into a power broker. For example, the leadership of the University of Vienna sought his “advice” (lobbying with Patzauer) whenever it planned an increase of its budget.⁶⁸

The Genoa conference had not only provided a solution for Austrian financial calamities, but it also paved the way for the so-called gold exchange standard.⁶⁹

In the 1870s, an international monetary system had emerged that covered the entire western world and its colonies: the classical gold standard. The money of this system was gold, but in most cases the currency—that is, the means of payment that actually circulated in the countries taking part in this system—were the fractional-reserve notes of the various national central banks. In a many countries, most notably in Russia, Austria-Hungary, and India, the national currency was backed up not only by physical gold in the vaults of the central bank, but also by other gold-denominated currencies. This practice of holding both gold and gold-denominated foreign banknotes became known as the “gold-exchange standard” when it became standard procedure in the interwar period.⁷⁰

During the war, most countries had abandoned the classical gold standard to finance war expenditure through inflation. After the war, many statesmen promoted the reestablishment of an international gold standard. But the accumulated war debts were so huge that redemption at prewar parities would have ruined most governments. On the other hand, these same governments did not wish to create the (correct) impression that they had cheated their creditors and could not fulfill their promises. The natural solution in this context was the adoption of the gold-exchange standard. The advantage of this system was that a central bank could minimize its (non-interest-bearing) gold holdings by trusting other central banks, which held the physical gold needed for redemption. The disadvantages were not as apparent before World War I. It made redemption more uncertain than it had been under the “classical” fractional-reserve gold standard. And because it made redemption dependent on a prior redemption in some other country, it gave political leverage to these foreign central banks. The Banque de France acquired a reputation for its ruthlessness in using this leverage.

The first steps toward the creation of the international gold-exchange standard were made at the Genoa conference in the fall of 1922. Here the representatives of the major central banks agreed to cooperate more closely. The idea was to help out central banks that were unable to redeem their notes, as well as, more generally, to “coordinate” central-bank policies. A few years later, Mises stated in plain language what coordination meant: the coordinated central banks would increase their note issues in concert, thus avoiding the embarrassment of the falling exchange rates that inevitably result from unilateral inflation.⁷¹

Coordination of national inflation policies in order to suppress one of the main symptoms of monetary decay has remained the state of the art to this day. For debtors in a very inflationary currency area, cooperation between the central banks is a boon. Without foreign assistance, the exchange rate of their currency would constantly fall and thus it would be next to impossible to obtain foreign credit. Central bank cooperation solves this problem, at the expense of creditors or would-be debtors in the more stable countries. In the 1920s, this mechanism worked to the advantage of the most ruthless debtors: the socialist municipal and provincial governments in Austria and Germany.

Mises took part in expert meetings at the Finance Ministry, discussing the implications of the Geneva Protocol for Austria.⁷² The western loans had given Seipel's government some flexibility in the short run, and the inflation was under control (starting in September 1922, the exchange rate stabilized around 70,000 kronen per dollar) but in the longer run, economic stability and Austrian political independence could only be gained if the budget was balanced without inflation. Large increases of government income were not to be expected because the economy was still in a slump, and a quick recovery was out of the question given the prohibitive trade barriers erected by neighboring countries. The only way out was to cut government spending.

The largest expenses were the heavy food-price subsidies and the payments for the huge deficits of the railroads and the post office.⁷³ But these were sacred cows of the socialists, and Seipel did not dare touch them for fear of a violent reaction from the opposition, especially because unemployment would rise quickly.⁷⁴ He therefore put all his hopes into reducing government expenditure by dismissing 50,000 civil servants.

Eventually the tension in the Austrian budget was reduced through this process. The stabilization of the krone and the virtual dependence of Austrian finance on foreign supervision had reinforced the creditworthiness of Austrian debtors, and especially of Austrian local governments. This tendency was reinforced by those agreements of the Genoa conference that paved the way for the gold exchange standard. And it was further reinforced by the onset of the great U.S. inflation of 1920, which came into full swing by early 1923 (the United States had overcome a minor postwar depression in 1920–1921). Austrian institutions now benefited from a near limitless inflow of new loans.⁷⁵

This gave a further boost to the ambitious spending plans of the Austrian socialists, particularly in “Red Vienna.” American funds financed one of the great experiments of communal socialism. Within a decade, Vienna was turned into a miniature nanny state designed to provide for the needs of the working class from cradle to grave. One mayor of Vienna boasted in Mises's presence: “The Viennese is born into Social Democracy, he lives in it and dies as he has lived.” To the great dismay of the socialist bystanders, Mises replied with a Vienna proverb: “Some say that even the owners of four-story houses are mortal.”⁷⁶

The new U.S. loans also supported the violent class struggle of the Vienna trade unions, which relied on the social infrastructure paid for out of the new public funds. A document from the time describes the situation from the perspective of Austrian firms:

As a consequence of the terror of the Free Trade Unions (that is, of the social-democratic trade unions), the situation in the factories had become unsupportable. The Free Trade Unions forced the non-social-democratic workers under threats to join their organizations and to contribute to their various funds. Threatening strikes, they forced the entrepreneurs to recognize their organizations as the only representatives of the interests of the worker classes. They prevented the employment of workers with other political orientations and even demanded that these persons be fired; thus thousands of workers were condemned to unemployment.⁷⁷

The Christian Socialists sought to introduce legislation outlawing the terror of the trade unions, but the social democratic parliamentarians vetoed all such measures.

The credit-fuelled increase of government power also had a profound impact on the traditional Austrian conflict between industrial and agrarian interests. Austria's conservative landed establishment came under pressure from two sides. While the imports of agrarian products from Hungary and other neighboring countries reduced the price of their products, the Austrian industries had an ever-higher demand for workers and attracted former peasants through higher wages. To counter these trends, the landed interests sought to have the government protect them through tariffs and monopolies, and they sought—unsuccessfully of course—to strike a backroom deal with big industrialists, pointing out that a stable agrarian sector was the backbone of the conservative order. The more peasants were drawn into industrial occupations, the more they would come under the spell of Marxist organizations and Marxist culture. It was therefore in the interest of Austria's industrialists, according to the landowners, not to compete for the agrarian workforce.⁷⁸

A very similar, though less dramatic development took place in other European countries. The general scheme was always the same: wartime inflation had been perpetuated after the end of the hostilities to finance the growth of the welfare state and to cover the deficits of nationalized industries. The governments of Germany and Russia had pursued this dangerous policy up to the bitter end of hyperinflation and the collapse of the monetary system. The other governments were less reckless, but still followed the same strategy, which they only abandoned once foreign loans, especially from the United States, became available on a large scale in the framework of the emerging gold-exchange standard. At that point they shifted from inflation to debt. With the help of the United States, Europe's initial problem—the lack of discipline to curtail government deficits—grew worse over the years, reproducing itself, as the Marxists say, on a higher scale.

Mises repeatedly denounced this practice in the midst of the Roaring Twenties. In a lecture on the “Therapy of European Public Finance,” which he delivered on February 27, 1925 to the Hungarian Cobden Association in Budapest, he pointed out that halting the inflation was not enough.⁷⁹ It was only the beginning, not the end, of monetary and financial reform. What was needed was a radical reduction on the expenditure side of the government's budget. “It was an error to start the reform of public finance by firing officers. One should have begun by reducing the superfluous government agendas, most of all by reducing government businesses.” And he stressed that it was “in particular the large issues of bonds which enabled the governments and local administrations to realize their plans for nationalization and communalization” of industry, culture, and infrastructure.

The seemingly unlimited availability of ever more foreign credit created the impression that the government had endless resources. The demands for government support and the confidence in government omnipotence waxed limitless. The Roaring Twenties set the stage for the roaring dictators of the thirties.