The foregoing description of credit creation and of the problems generated by this process has shown us how important it is that the economic system be assured of monetary stability. We also learned how difficult it is to prevent those monetary diseases (inflation and deflation) which destroy this stability. Let us begin by setting forth the nature of the problem as realistically as we can. Let us suppose that, in the year 1913, a dentist made a wager with his patient that the price of the gold filling he was about to insert would follow the general rise in prices which was then getting under way. The dentist, of course, would have lost his wager; a quick glance at his files on his previous gold purchases could have told him as much. For the simple and ingenious coupling mechanism of the gold standard, by defining the monetary unit as a fixed weight of gold, tied gold to money in such wise that the price of gold remained stable though all other prices fluctuated.
A contrasting and yet equally illuminating experience is one which was recounted to the author by a lady of his acquaintance. She showed him a magnificent belt of wrought silver which she acquired in India on a visit there with her husband towards the end of the last century. She explained proudly that she had got a wonderful bargain inasmuch as the native jeweler had demanded for his silver belt neither more or less than its weight in silver rupees. Had she not thereby gotten the exquisite handiwork for nothing? In truth, the lady’s satisfaction in her bargaining ability was premature for at the time of her visit the pure silver standard in India had been replaced by a blocked silver standard. When the Indian government discontinued the free coinage of silver, silver became scarcer in minted form than in unminted form; the bonds linking money to a precious metal, corresponding to those of the gold standard, had been broken, causing the mint value of the silver rupee to exceed considerably the value of silver itself. The rupee became a kind of metal bank note whose scarcity was determined not by the production of silver but by the decision of the issuing government. To underscore the moral of this story, we have only to visualize a transaction wherein a purchaser of visiting cards is required to pay a quantity of paper money equal to the weight of the cards.
And now a third illustration which takes us from the gold standard and the blocked silver standard to paper money. More than a quarter of a century ago, an astonishing and ingenious crime was committed which resulted in the institution of a most interesting civil suit. A band of international swindlers succeeded in convincing the well-known London firm of Waterlow & Sons, engravers of postage stamps and bank notes, that they were the representatives of the Central Bank of Portugal come to place an order for the printing of a large quantity of Portuguese bank notes. The order was duly filled and the bank notes delivered to the swindlers. When the fraud was finally discovered, the Bank of Portugal caused all of its extant notes (of whose genuineness there was, naturally, no question) to be withdrawn from circulation and replaced with a new issue. Since it proved impossible to catch the criminals, the Bank of Portugal sued Waterlow & Sons, demanding that the engraving firm make good the losses resulting from the issue of the fraudulent notes. The English courts presently discovered that the case involved issues of unusual subtelty and complexity, adjudication of which necessitated the admission of testimony by leading monetary theorists. The question before the courts was: how great were the actual losses incurred by the Bank of Portugal? If it had been postage stamps instead of bank notes in which the swindlers had trafficked, it is perfectly clear that the loss of the Portuguese government would have equaled the total value of the stamps. With respect to the bank notes, however, no such simple calculation could be made. Among the many questions which troubled the experts the following stand out as particularly relevant to our study: would the Bank of Portugal have issued the same amount of notes even if the swindlers had not done so? If not, was the increase in the supply of money resulting from the introduction of the fraudulent notes good or bad for Portugal? The answer to this question would depend on whether the circulation of the fraudulent notes disrupted the orderly processes of the Portuguese economy looking to the regulation of the volume of money; it would depend, in other words, on whether the additional notes served to avert an otherwise imminent deflation, or whether they resulted in an inflation. If the first supposition were true, then the swindlers would have unintentionally done a favor to Portugal. These and other considerations did, in fact, influence the highest English court to award the Bank of Portugal only a fraction of the damages it had claimed.*
What lessons are contained in these three illustrations? They point to the truth of at least these three principles: (1) the value of money is determined by its relative scarcity; (2) monetary policy has no more important task than to regulate this scarcity in such wise that the value of money remains as stable as possible; (3) this task can be accomplished in different ways. Under a gold standard (or a silver standard with free coinage of fully-valued coins), the scarcity of money is automatically fixed by the scarcity of the standard metal. This, in turn, is affected primarily by the quantity of the metal which is produced in a given period. Such relationships are characteristic of so-called tied monetary standards under which money is linked securely to a precious metal with the regulation of the quantity of money being a function and a reflection of variations in the quantity of the precious metal. Under the “blocked” silver standard and, a fortiori, under the paper standard, the quantity of money is independent of the quantity of the precious metal and is regulated by the arbitrary decree of the government (free or manipulated standard). The determination of whether the control of the quantity of money should be submitted to the automatic forces of gold and silver production or to the conscious decree of the government is one of the cardinal problems confronting those entrusted with the making of monetary policy and upon the answer to which depends the choice of the particular monetary system in each case. A liberal—one [in Europe] who puts his trust in economic laws rather than in the whims of government—will generally opt for the tied or automatic standard. A collectivist—one who is willing to trust the caprice of the government over natural economic forces—will prefer the untied or manipulated standard. Since, however, the linking of money to a precious metal implies a much stricter control over the quantity of money than can be expected from arbitrary government regulation, we find that, paradoxically, it is the [European] liberal who, in money matters at least, demands a discipline far stricter than the collectivist.
It is, indeed, not surprising that the liberal should attach such importance to the maintenance of effective and positive control over the quantity of money and that he should desire in this case at least, that nothing should be left to chance. It was an English liberal of the early nineteenth century and one of the leading adherents of the Currency School, Lord Overstone, who drew the clear and emphatic distinction between money and goods. There is no sense, he observed, in applying to the manufacture of money the principle of cheap and abundant production which, with regard to the manufacture of goods, the liberal expects to find operating in a competitive economy. What is essential in the case of money, on the contrary, is strict control of its quantity. While the liberal holds private initiative and free competition to be desirable in the realm of goods production, he knows that judicious regulation of the quantity of money cannot be expected to emanate from those sources. What is needed instead is a carefully thought-out system of monetary control instituted and supervised by government. If in the production of goods the most important pedal is the accelerator, in the production of money it is the brake. To insure that this brake works automatically and independently of the whims of government and the pressure of parties and groups seeking “easy money” has been one of the main functions of the gold standard. That the liberal should prefer the automatic brake of gold to the whims of government in its role of trustee of a managed currency is understandable.
This distrust of the manipulated monetary standard is not alone a consequence of the liberal philosophy. Almost the whole course of monetary history vindicates this distrust. For as money has become increasingly etherealized—attaining the pinnacle of incorporeality and insubstantiality in the form of credit money—the danger of arbitrariness and caprice in the regulation of the quantity of money has become correspondingly greater. It is, of course, true that even the standard metals have been at times subject to considerable fluctuations in value. But these have been negligible compared with the monetary fluctuations which have occurred since manipulated standards have been adopted, and the laws of nature and of economics exchanged for the unpredictable caprices of politicians and governments. It was the paper standard which first taught us the meaning of the word “inflation.” Indeed, it would be difficult to cite a single paper standard which has not sooner or later succumbed to depreciation because the government concerned was unable or perhaps even unwilling to keep the quantity of money within limits.
It should by now be clear that the quantity of money in circulation decisively affects the purchasing power of money, an increase in the supply of money lowering its purchasing power (inflation), a decrease raising it (deflation). In the long run, the first mentioned danger of an inflationary increase in the money supply has always been decidedly greater than that of a deflationary reduction in the supply of money. The temptation to engage in inflation is omnipresent for its immediate consequences are usually very popular. Recent history knows no case of the murder of a statesman responsible for inflation. On the other hand, there have been at least several instances in which statesmen thought to be responsible for deflation have been done in (e.g., in Czechoslovakia and Japan). This one example may suffice to show that arbitrariness in the matter of issuing money tends more in the direction of the “too much” than in the direction of the “too little.” And indeed every money of which we have record has at some time in its history been prey to the disease of inflation which, if it has not proved fatal, has left the permanent scar of depreciation. If we lay side by side a modern bank note and the gold coin which is its equivalent, we could lay heavy odds on the certainty that in a hundred years’ time the bank note—even the “hardest” and most respectable—will have suffered the ignominy of depreciation while the piece of gold will still enjoy the same valuation and the same esteem as the gold pieces of King Croesus of Lydia enjoyed 2,500 years ago. The most finely-spun theories on the stupidity of the gold standard, all the clever satires on mankind’s frenetic digging for the yellow metal, and all the ingenious schemes for creating a gold-less money will never change the truly remarkable fact that for thousands of years men have continued to regard gold as the commodity of highest and surest worth and as the most secure anchor of wealth. One may protest this as often as one likes—the fact remains. It is this stubborn fact that continues to make the gold standard the best and most eminently useful of all monetary systems.
Our researches thus far have perhaps yielded sufficient proof of the theory that the value or the purchasing power of money is determined primarily by the proportion of the quantity of money to the volume of goods (quantity or scarcity theory of money). Hence, those abrupt changes in the purchasing power of money which are the characteristic symptoms of the monetary diseases of inflation and deflation will be found to have originated in a marked increase or decrease in the quantity of money (including credit money). The most important prerequisite of an orderly monetary system is therefore the regulation of the quantity of money in such wise that the monetary system is immunized against the ever-present contagion of inflation.
These considerations need to be emphasized at a time like the present marked as it is by a rash of risky monetary schemes aimed at banishing the dominant bogey of our time—deflation.9 In the long run, we repeat, it is inflation, and nowadays especially the insidious inflation of credit money, which constitutes the greatest and most imminent danger. Indeed, the effectiveness (or lack of it) in keeping money scarce may well serve as a criterion by which we may judge and understand, in its minutest operations, the performance of any monetary system whatsoever. The linking of money to a precious metal, the establishment of reserve requirements by central banks, the strenuous efforts to control the operations of the note-issuing banks—all these measures serve the same ultimate aim of keeping money scarce. And now for decades the world has been wrestling with the ever more acute problem of finding the most efficacious methods of braking the credit-creating powers of the modern banking system. In the long run, moreover, it is the greater or smaller degree of scarcity of money in an economy which determines the exchange relationships between domestic and foreign money (the exchange rate).10
Our generation, which recalls the despair caused by the inflations in the post World War I era and which was required to undergo the self-same catastrophes following World War II, needs no instruction concerning the fact that the worst disease with which a monetary system can be afflicted is that kind of inflation which is caused by a deficit of the government budget. The German inflation of the years 1920-23 will always remain as a horrible example of what happens when a government attempts to cover its budget deficits by resorting to the deceitful and irresponsible expedient of the printing press. What in Germany began as “deficit financing’’ ended in a series of catastrophic price rises which caused the shameless enrichment of some at the cost of the hopeless impoverishment of others, and in a serious undermining of the whole economic and social structure. But the inflationary creation of money caused by the budget deficits of government need not necessarily lead to the economic and social disorders attendant on an open inflation of the kind that followed World War I. Beginning in 1933, National Socialist Germany demonstrated that a determined government can change an open into a repressed inflation by placing the country in the economic strait jacket of a command economy. Rationing, the imposition of stringent controls on wages, consumption, capital investment, rates of interest, and similar measures aimed at restricting the free use of the increasing amount of purchasing power may succeed in containing for an indefinite period the mounting inflationary pressure on prices, wages, exchange rates, stock prices, etc.
Since Hitler has shown how far and how long a government can neutralize an inflation by means of the command economy, we may well ask ourselves whether from now on there will be any government which will not follow the same road when it disposes of a functioning coercive apparatus. The greater the inflationary pressure the stronger will be the counterpressure of the command economy needed to repress it. By the same token, the command economy must resort to ever more comprehensive and ruthless controls if it is to effectively contain the mounting forces of inflation. This leads logically to the question of whether such a command economy is possible without totalitarian slavery (of which the Third Reich was such a repellent example).
The experience of Germany demands that we consider a little more closely this peculiar phenomenon of repressed inflation. As we have seen, it consists, fundamentally, in the fact that a government first promotes inflation but then seeks to interdict its influence on prices and rates of exchange by imposing the now familiar wartime devices of rationing and fixed prices, together with the requisite enforcement measures. As inflationary pressures force up prices, costs, and exchange rates, the ever more comprehensive and elaborate apparatus of the command economy seeks to repress this upward movement with the countermeasures of the police state. The repressed inflation can be conceived of, then, as the deliberate maintenance of a system of coercive and fictitious values in which, economically speaking, there is neither rhyme nor reason. Such a system is an inevitable feature of a collectivist economic regime and is to be encountered wherever socialism has gained control of influence (Soviet Union, National Socialist Germany, Austria, Great Britain, Sweden, and some other European countries). Where this repressed inflation leads was shown with tragic incisiveness in the complete disintegration of the German economy, a process which was arrested only by the comprehensive economic and monetary reform which restored a free price system in which actual rather than fictitious supply-demand relationships were reflected (Summer, 1948). The prolongation of a policy of repressed inflation means that all economic values become increasingly fictitious, and this in a twofold sense: (1) stated values correspond less and less to actual scarcity relationships and (2) fewer and fewer transactions are completed on the basis of such values. The distortion of all value relationships which accompany the division of the economy into “official” and “black” markets, and the struggle between the directives of the market and those of the administrative authorities finally lead to chaos, to a situation in which any kind of order, whether of the collectivist or the market economy type, is lacking.
We see, then, that a repressed inflation is worse than an open one because, in the end, money loses not only its function as a medium of exchange and as a measure of value (as happens in the last stages of an open inflation), but also its even more important function as a stimulus to the production and distribution of maximum quantities of goods. Repressed inflation is a road which ends inevitably in chaos and paralysis. The more values are raised by inflation, the more will the authorities feel compelled to use their machinery of compulsion. But the more fictitious the system of compulsory values, the greater will be the economic chaos and the public discontent and the more threadbare either the authority of the government or its claim to be democratic. If the repressed inflation is not stopped in time it will, drawing strength from its own momentum, lead to the dissolution of economic activity and perhaps even of the state itself. This modern economic disease is one of the most serious of all; it is doubly pernicious since it tends to be recognized only when it is in an advanced stage.11
Today in 1962, inflation, in the particularly pernicious form of repressed inflation it took in the immediate postwar period, has been overcome in a majority of the developed industrial countries of the free world, if not in a large number of underdeveloped countries and in the Communist states of whose economic systems it constitutes an integral part. This does not mean, of course, that inflation may be considered as banished. Instead of the clearly distinguishable forms it has hitherto assumed, inflation has taken on a creeping character, the analysis of which is not an easy task. Two particularly noticeable types of this “creeping inflation” are the so-called “wage inflation” and the so-called “imported inflation.”12
By wage inflation is meant the inflationary impulses originating in the labor market, and which take the form of wage increases which—in those labor markets dominated by powerful labor unions—are so rapid and of such large amount that the ratio between goods and money is upset. The result is on the one hand an inflationary overpressure of demand and, on the other, an increase in costs which may bring an increase in prices in its train, though in both cases inflation is possible only to the extent that the monetary and fiscal authorities permit the creation of a corresponding addition to the supply of money. Were such additions to the supply of money not permitted, the wage and/or price increases would have the effect of making some portion of domestic output unsaleable and thus cause unemployment. But when the government and the central bank of a country believe themselves obliged to maintain full employment despite wage increases, the choice they then face of accepting some unemployment or some inflation will often be decided in favor of inflation. The decision may also be, as has been the case for some time in the United States, to effect a compromise between these two alternatives. In such case, unemployment and economic stagnation are joined to continuous, if mild price increases. In the United States, labor union power of a degree unknown in Europe has caused a wage inflation of such a severe and chronic type that the government and the central bank (the Federal Reserve System) have been obliged—in the interest of avoiding unfavorable effects on the balance of payments—to go further in the direction of tight money than they would otherwise dare to go, given the risks implicit in such policies of unemployment and economic stagnation.
We may speak of imported inflation where a country such as West Germany achieves a continuous surplus in its balance of payments (i.e., an excess of payments from abroad over payments to abroad, irrespective of the transactions giving rise to such payments). Since the surplus takes the form of a net receipt of foreign monies or gold which the central bank (the Deutsche Bundesbank) is obliged to convert into domestic currency, its end effect is to expand the domestic money supply. Because the increase in the quantity of money is not offset by an increase in the quantity of goods—the surplus itself being due to the exportation of a portion of domestic output without any corresponding importation of goods—such “monetization of the balance of payments surplus” becomes the agent in an inflationary increase of prices, wages, investments, consumer demand, and in the emergence of an acute shortage of labor (over-employment) . The inflation in such case is not the “fault” of the domestic monetary authorities, but is brought in from outside, is “imported.” The origin of the balance of payments surpluses which cause such imported inflation lies, paradoxically, in the fact that in the affected country (Germany in our example) efforts to control creeping inflation by means of stricter monetary and fiscal discipline are more successful than elsewhere. In the specific case of West Germany, moreover, part of the reason for the surplus was the fact that the competitiveness of the German economy was continually increased as the result of advances in production and distribution techniques and the reestablishment of contact with foreign markets in the years following war and occupation. The result was that Germany was a country which, until the revaluation of the Deutschemark in March 1961, remained “cheap” in relation to other countries. The only effective remedy for this particularly virulent form of inflation was the surgical operation of changing the rate of exchange: the international purchasing power of the Deutschemark was increased in order that its internal purchasing power be prevented from falling.
