In Search of a New Monetary Order; H. Sennholz

ij~ ~I\~©~ @~ ~ ~m ~@~~~~W @~[ID~~ HANS F. SENNHOLZ EVER SINCE President Nixon sus pended gold payments, on August 15, 1971, the question of realistic par values of the world's currencies has become a vexing international pclitical issue. Governments and CEntral banks are searching for new rules that permit "more flex ible" currency fluctuations. Some thing beyond dollars and gold is needed, they believe, to provide a solid base for a new monetary or der. Return to the old system spawned at Bretton Woods, N. H., in 1944, is out of the question. It was a gold and dollar standard, with the U.S. dollar payable in gold ,at $35 an ounce while other countries pegged their moneys to the dollar, holding them within a range of 1 per cent up or down Dr. Sennholz heads the Department of Eco nomics at Grove City College and is a noted writer and lecturer on monetary and economic principles and practices.

from the parity registered with the lIB-country International Monetary Fund. Now, since the suspension of gold payments, the world has been waiting for monetary authorities to find a new monetary system. .The process must necessarily be slow, as a political solution is sought to economic problems that were generated by various polit ical considerations. After all, the depreciation of the U.S. dollar, which finally led to the gold pay ment suspension, was a political act by the monetary authorities of several Federal administrations. The decision to "float" the dollar rather than face the humiliation of a formal devaluation was also a political act. Similarly, the other governments are motivated polit ically in their attempts at mone tary management. 3 4 THE FREEMAN January While most "experts" make the government, its powers and objec tives, their point of departure for monetary deliberation, a few schol ars continue to base their inqui ries on the fundamental principles that flow from individual choice and action. In their judgment, the factors that affect the exchange relations between various national currencies rest on the economic principles that determine the pur chasing power of each and every type of medi um of exchange, whether it is a precious metal or government fiat money.

As they see it, the purchasing power of any monetary unit de pends on the relation between the demand for and the quantity of money in individual cash holdings. The demand for money is purely individual, although a great many extraneous factors may influence this demand. There is, for' in stance, the expectation of future changes in the exchange value of money. An expected fall tends to reduce the demand for money and thus its purchasing power; an ex pected rise brings about the oppo site. Also, the availability of goods affects the demand for money. In an expanding economy when more and better goods are offered on the market, the demand for money tends to rise; in a declining econ omy, where capital is consumed and the division of labor breaks down, the demand for money tends to decline.! The Stock of Money The supply of money is the stock of money available for ex change. During the ,age of the gold standard it consisted of gold bullion, gold coins and their vari ous substitutes, such as bank notes, tokens, and demand de posits. In this age of government currency, it consists of fiat money and its substitutes, such as tokens and demand deposits. The substi tutes may either be fully backed by money proper or else they are fiduciary, Le., uncovered. Thus, an expansion or contraction of fidu ciary media directly a,ffects the total quantity of money available for exchange.

A change in the money relation through changes in either the de mand for money or the stock of money affects changes in the pur chasing power of money. As one factor of demand or supply can not perfectly offset changes in the other factors, money can never be neutral. Now, if there a.re two or more media of exchange, such as gold or silver, or va.rious fiat cur rencies, what determines the ex change ratio between the various' 1 Ludwig von Mises, The Theory of Money and Credit (Irvington-on-Hudson, N. Y.: The Foundation for Economic Ed ucation, Inc., 1971), p. 97 et seq.

1972 IN SEARCH OF A NEW MONETARY ORDER 5 media? Their purchasing powers! That is to say, exchange ratios correspond to the ratio of each one's purchasing power in terms of all other goods. Market forces tend to establish the parity be tween the purchasing powers and thus their exchange ratios. The equilibrium exchange rate is called the purchasing power parity. Gold and Silver as Money For more than 2,500 years the civilized world used gold and silver as money. These metals became valuable media of exchange be cause they were not only desirable for nonmonetary uses, but also suited so well for economic ex changes as they were durable, portable, and divisible. Silver was generally used for small transac tions and gold in aU larger ex changes. And throughout the ages their exchange ratios were deter mined by their purchasing power parities.. If one ounce of gold bought a horse that also could be bought for 10 ounces of silver, the parity between gold and silver was 1: 10. If for any reason the ex change rate differed from this parity, arbitrage would soon re store the exchange ratio to its purchasing power parity. If, in our example, the exchange ratio should be 11: 1 and the purchas ing power 10:1 it would be very profitable to exchange gold for silver and then buy commodities.

But such money exchanges would soon drive the ratio back to its parity. In all countries where gold was the standard money, the exchange ratios betweein gold coins of dif ferent weight and fineness were determined simply by this differ ence. If one coin weighed one ounce and another coin of equal fineness 'only one-third of an ounce, the exchange ratio obviously was 1 :3. Under the gold-coin standard, commonly called the orthodox or classical gold· standard, gold coins were the standard money. Nation al currencies represented a certain quantity of gold of a certain fine ness. The U.S. dollar, for example, consisted of 25.8 grains of gold, nine-tenths fine, before the 1934 devaluation, and 15 5/21 grains thereafter, or' in troy ounces 1/20.67 and 1/35 respectively. The U.S. $20 gold coin (Double Eagle) contained 30.09312 grams of fine gold, the $10 coin (Eagle) 15.04656 grams, and the $5 coin (Half Eagle) 7.52328 grams. The British Sovereign contained 7.322 grams, the Mexican 50 Peso coin 37.5 grams, the French 20 Francs coin, also called Napoleon, 5.8 grams, and the Swiss 20 Francs coin 5.8 grams. 2 Exchange ratios 2 Cf. Franz Pick, Currency Yearbook (New York: Pick Publishing Corp., 1970) , pp. 13-15.

6 THE FREEMAN January between the various currency units consisting of gold thus were determined by their relative meas ures of gold. International Acceptability The world had an international currency while on the classical gold standard. It evolved without international treaties, conventions or institutions. Noone had to make the gold standard work as an international system. When the leading countries had adopted gold as their standard money the world had an international cur rency without problems of con vertibility or even parity. The fact that the coins bore different names and had different weights hardly mattered. As long as they consisted of gold, the national stamp or brand did not negate their function as an international medium of exchange. The purchasing power of gold, tended to be the same the world over. Once it was mined, it ren dered exchange services through out the world market, moving back and forth and thereby equalizing its purchasing power except for the costs of transport. It is true, the composition of this purchas ing power differed from place to place. A gram of gold would buy more labor in Mexico than in the U.S. But as long as some goods were traded, gold, like any other economic good, would move to seek its highest purchasing power and thereby equalize its value through out thenworld market. As an coins and bullion were traded in terms of weight of gold, there were no "exchange rates" such as those between gold and silver, or vari ous fiat monies.

The Exchange-Rate Dilemma The departure from the gold coin standard, set the stage for the present exchange-rate dilem ma. At first, governments began to restrict the actual circulation of gold. They gradually estab lished the gold-bullion standard in which government or its central bank was managing the country's bullion supply. Gold coins ,vere withdrawn from individual cash holdings and national currency was no longer redeemable in gold coins, but only in large, expensive gold bars. This standard then gave way to the gold-exchange stand ard in which the gold reserves were replaced by trusted foreign currency that was redeemable in gold bullion at a given rate. The world's monetary gold was held by a few central banks, such as the Bank of England and the Federal Reserve System, that served as the reserve banks of the world. 3 But 3 Cf. Leland B. Yeager, International Monetary Relations (New York: Harper & Row, Publishers, 1966), p. 251 et seq.

1972 IN SEARCH OF A NEW MONETARY ORDER 7 after World War II, the Bank of England which was holding the gold reserves for more than 60 countries, commonly called the pound sterling area, gradually lost its eminent position. It began to hold most of its reserves in U.S. dol lar claims to gold, which made the Federal Reserve System the ulti mate reserve bank of the world; thus the gold-exchange standard became a de facto gold and dollar standard. Finally, during the ac celerating inflation and credit ex pansion of the 1960's in the U.S., the dollar gradually fell from its respected position. Several mone tary crises which triggered world wide demands for dollar redemp tion greatly depleted the Ameri can stock of gold, and created precarious payment situations. Altogether, in less than four years, we experienced seven cur rency crises that foretold the end of the international monetary sys tem. In November, 1967, Great Britain devalued the pound and a number of other countries im mediately followed suit. In March of 1968, under the pressure of massive pound sterling liquida tion, the nine-nation gold pool was abandoned and the two-tier sys tem adopted. The third crisis oc curred in France in May, 1969, when political riots, followed by rapid currency expansion, greatly weakened the franc which was later devalued. The fourth crisis erupted in September, 1969, when massive dollar conversions to West German marks forced the German central bank to "float" the mark and then revalue it upward by 9.3 per cent. The·.fifth crisis occurred in March and early April, 1971, when a new flight from the dollar threatened to inundate several European central hanks. In a con certed effort, the U.S. Treasury and the Export-Import Bank en deavored to "sop up" the dollar flood. The sixth crisis began in May, 1971, when a new flow of dollars into German marks, Swiss francs, and several other curren cies caused the mark to float anew, the Swiss franc to be revalued up ward by 7.07 per cent, and several other currencies to be allowed to float or be revalued. The seventh and last crisis was of such mas sive proportions that President Nixon was forced to announce the collapse of the· old monetary order.

Why the Breakdown of International Monetary Relations? What had caused this gradual deterioration of international mon etary relations? An understanding of the causes may provide an an swer to the dilemma, prevent further deterioration, and hope fully find a cure to all its somber consequences. The popular. explanation usually 8 THE FREEMAN January runs as follows: The rapid 'worsen ing of the U.S. international bal ance-of-payment deficit was the proverbial straw that broke the system's back. From a small sur plus of $2.7 billion in 1969, achieved mainly through various government manipulations that amounted to window dressing, the 1970 payments deficit soared to an all-time record deficit of some $10.7 billion, on official settlement basis, i.e., official settlements be tween governments only. Then, in May, 1971, the U.S. Commerce De partment announced that the first quarter 1971 deficit had grown to a record $5.4 billion. 4 And finally, private sources estimated that in 1971, up through mid-August, some $22 billion more dollars flowed out of the country than came in.

These new payment deficits were added to the accumulated un paid deficits of the U.S. for many years. U.S. dollars and short-term claims to dollars in foreign hands amounted to $43 billion at the end of 1970. After deducting U.S. short-term claims on foreigners our net obligations exceeded $32 billion, plus the current deficits mentioned above. And while the U.S. gold stock stood at $11 billion, the lowest level since World War II, it became obvious that the U.S. 4 Federal Reserve Bulletin, Sept., 1971, p. A75. could not meet its foreign obliga tions in gold.5 Dr. Arthur F. Burns, Chairman of the Federal Reserve Board, probably reflected the official posi tion of the U.S. government when, on May 20, 1971, he blamed for eign governments for the precari ous situation. He urged them to release their restraints on imports and American investments, and to help us with our foreign military operating expenses. Raising our interest rates, he asserted, was not the right way to improve the ail ing dollar. He advocated more U.S.

borrowing from the Eurodollar market through Treasury certifi cates and, in order to become more competitive in world markets, an "incomes policy" that would re strain the cost-push momentum of American labor. 6 Less than three months later President Nixon an nounced a 90-day price and wage freeze, to be followed by some gov ernment control thereafter, and a 10 per cent surtax on imports to stem the flood of cheap foreign goods. IINafional Balance of Payment ll Academic theories basically con curred with Dr. Burns' explana tion although some offered differ ent solutions, such as a crawling 5 Ibid., p. 94. 6 The Commercial and Financial Chronicle, June 9, 1971, p. 16.

1972 IN SEARCH OF A NEW MONETARY ORDER 9 peg, a wider bank, flexible ex change rates, or the creation of new reserve assets, such as Spe cial Drawing Rights by the Inter national Monetary Fund. 7 But no matter what solution they proffer, their point of departure is. the col lectivist concept of the "national" balance of payment. Without any reference to individual actions and balances, they build ambiguous structures that ignore the causes. Balance of payments of a country is that very small segment of the combined balances of millions of individuals, the segment that is 7 Cf. William Fellner "On Limited Ex change Rate Flexibility," Chapter 5 of Maintaining and Restoring Balance in International Payments, Princeton Uni versity Press, 1966; George N. Halm, "The Bank Proposal: The Limit of Per missible Exchange Rate Variations," Princeton Special Papers in International Economics, No.6; John H. Williamson: "The Crawling Peg," Princeton Essays in International Finance, l'fo.50; Francis Cassell, International Adjustment and the Dollar, 9th District Economic Infor mation Series, Federal Reserve Bank of Minneapolis, June, 1970; Walter S. Sa lant, "International Reserves and Pay ments Adjustment;" Banca Nazionale del Lavoro, Quarterly Review, Sept., 1969; Thomas D. Willet and Francesco Forte, "Interest Rate Policy and External Bal ance," Quarterly Journal of Economics, May, 1969; Friedrich A. Lutz, "Money Rates of Interest, Real Rates of Interest, and Capital Movements," Chapter 11 of Maintaining and Restoring Balance in International Payments, Princeton Uni versity Press, 1966; Milton Gilbert, "The Gold-Dollar System: Conditions of Equi librium and the Price of Gold," Princeton Essays in International Finance, No. 70.

based on personal exchanges across national boundaries. As an individual may choose to increase or decrease his cash holdings, so may the millions of residents of a given country. But when they in crease their holdings, that is called "favorable" in balance of payments terminology. And when they choose to reduce their cash holdings, that is called "unfavor able." The fact is that drains of gold are not mysterious forces that must be managed by wise governments, but are the result of deliberate choices by people eager to reduce their cash holdings. Wherever governments resort to inflation, people tend to reduce their cash holdings through pur chases of goods and services. When domestic prices begin to rise while foreign prices continue to be stable or rise at lower rates, individuals like to buy more foreign goods at bargain prices. They ship some of their money ab!oad in exchange for cheaper foreign products or property. Thus, an outflow of for eign exchange and gold sets in. It is the inevitable result of a rate of domestic inflation that exceeds that of the rest of the world and sets into operation "Gresham's Law."

During the 1960's, the decade of the "Great Society," and again during 1970 and 1971, money and credit were created at unprece10 THE FREEMAN January dented rates prompted by record breaking government deficits. Pri vate demand deposits, bank credit at commercial banks, and Federal Reserve credit, which is fueling the credit expansion, often rose at rates of 10 per cent or more a year. Therefore, in spite of countless promises and reassurances by the President and his advisers, the U.S. dollar suffered inevitable de preciation at horne and abroad. And the August 15, 1971, default of payment was the result of this depreciation. Blaming the Creditor Refusal to make gold payments by the United States, the richest and most powerful country on earth, casts serious doubt on fu ture monetary cooperation. The immediate prospect for world wide monetary reform is not too bright. The U.S., as the default ing debtor, is taking· the position that it is up to the countries with huge surpluses in their interna tional payments to adj ust their currencies upward against the dol lar. It is Washington's basic prem ise that the U.S. was unfairly treated in international commerce and that it is time for correction.

Convinced of the indispensability of the U.S. dollar as a world re serve currency, the U.S. is defi antly waiting for the others to act. Bad debtors, when called upon to make payment, often make such charges against their creditors. It is shocking, however, that the U.S. government should prove to be such a poor debtor. Even its basic assumption, the indispensability of the dollar, no longer goes unchal lenged. Sterling balances ,look more attractive today than dollar holdings. In fact, the holdings of deutsche marks by central banks and treasuries probably exceed $3 billion. Foreign airlines and ship pers have ceased to accept U.S. currency. And Eurodollar bonds are all but unsaleable in European capital markets, while mark, guil der, and Swiss franc securities re main in demand. The foreign posi tion generally rejects the Wash ington charge of unfair treatment. If the U.S. had adopted appropri ate domestic policies, foreign of ficials argue, it would not have accrued its huge international pay ments deficits. Therefore, they want the U.S. to share the burden of realignment. They are seeking a devaluation of the dollar along with realignment of their curren cies. And above all, no one is sug gesting that the U.S. dollar con tinue to serve as an international reserve currency.

After all, managed currencies are the products of political manip ulations by parties and pressure groups, and all are destined to be destroyed gradually by. weak ad1972 IN SEARCH OF A NEW MONETARY ORDER 11 ministrations yielding to popular pressures for government largess and economic redistribution. No such currency can serve for long as the international reserve cur rency to which all others can re pair. The U.S. dollar is no excep tion. In the chaotic conditions of late 1971, the world may still have the following options: (1) It may continue on its pres ent road of fiat money and infla tion, government manipulation of exchange rates, trade restrictions, and exchange controls. The goal is "national autonomy" in monetary and fiscal policies, an essential ob jective for all forms of central eco nomic planning. On this road we are bound to suffer not only more inflation and depreciation, but also a gradual disintegration of the world economy and its division of Freedom is the Answer labor. Our ultimate destination is a worldwide depression.

(2) Or the world may choose to turn off this road of self -destruc tion and seek stability in sound money. The very monetary au thorities that have created the chaos and are now sitting in judg ment over the, international mone tary order must relinquish their rights and powers over the peo ple's money. This road leads to the various forms of gold standard, from the gold-exchange to the gold-bullion, and finally the gold coin standard. For gold is the only international money the quantity of which is limited by high costs of mining and the value of which is independent of political aspira tions and policies. Only the gold standard can afford monetary sta bility and peaceful international cooperation. ~ IDEAS ON LIBERTY THERE IS NOTHING wrong with money that freedom will not cure. This is another way of saying that the Good Society which many reformers have sought by way of monetary reform' cannot be achieved that way; if it is ever to be achieved, it will be done by freedom. So, then, the fight for sound money, to have meaning, must be related to the broader fight for freedom. It is only one of the several battles that must be fought.

F RAN K C HOD 0 R 0 v, from "Shackles of Gold"