Monetary Cross Roads
DECEMBER 01, 1960 by HANS SENNHOLZ
Dr. Sennholz is Professor of Economics at
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
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
On August 1 when the Federal Reserve discount rate stood at 31/2 per cent, the comparative rates stood at 6 per cent in
Foreign Inflation Facilitated Dollar Depreciation
Such a turn of events comes as a shock to many American observers. The
During the 1930′s, the fetish of cheap money dominated
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
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
While more and more European governments endeavored to balance their budgets and took steps toward currency convertibility, the
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
May We Ignore 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?
It seems unlikely, however, that the
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,
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
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
This is poor advice. German handouts to
An intensification of our payments problem will bring the
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
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
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
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.