The mark of all the varieties of the gold standard and the gold-exchange standard as they existed on the eve of World War I was the gold parity of the country’s monetary unit, precisely determined by a duly promulgated law. It was understood that this parity would never be changed. In virtue of the parity law the unit of the national currency system was practically a definite quantity of the metal gold. It was of no consequence whether or not banknotes had been endowed with legal-tender power. They were redeemable in gold, and the central banks really did redeem them fully on demand.

The difference between the standard that was later called the orthodox or the classical gold standard and the gold-exchange standard was a difference of degree. Under the former there were gold coins in the cash holdings of the individual citizens and firms and they were—together with banknotes, checks, and fractional coins—employed in business transactions. Under the gold-exchange standard no gold was used in transacting domestic business. But the central bank sold gold bullion and foreign exchange against domestic currency at rates that did not exceed the legal parity by more than the gold margin would be under the classical gold standard. Thus the countries under the gold-exchange standard were no less integrated into the system of the international gold standard than those under the classical gold standard.

The flexible standard, a development of the period between World War I and World War II, originated from the gold-exchange standard. Its characteristic features are:

1. The domestic standard’s parity as against gold and foreign exchange is not fixed by a law but simply by the government agency entrusted with the conduct of monetary affairs.

2. This parity is subject to sudden changes without previous notice to the public. It is flexible. But this flexibility is practically always employed for lowering the domestic currency’s exchange value as against gold and those foreign currencies which did not drop against gold. If the downward jump of parity was rather conspicuous, it was called a devaluation. If it was slight only, it was usual to speak of a newly manifested weakness of the currency concerned.

3. The only method available for preventing a currency’s exchange value from dropping below the parity chosen is unconditional redemption of any amount offered. But the term redemption has in the ears of the self-styled unorthodox statesman an unpleasant connotation. It reminds him of the past when the holder of a banknote had a legally warranted right to redemption at par. The modern bureaucrat prefers the term pegging. In fact, in this connection pegging and redeeming mean exactly the same thing. They mean that the currency concerned is prevented from dropping below a certain point by the fact that any amount offered for sale is bought at this price by the redeeming or pegging agency.

Of course, this point—the parity—is not fixed by a law under the flexible standard, and the agency is free to decline to buy an amount offered at this rate. Then the price of foreign exchange begins to rise as against this parity. If the government does not intend to adopt the freely vacillating standard, the pegging is soon resumed at a lower level, that is, the price of foreign exchange is now higher in terms of the domestic currency. Such an event is sometimes referred to as raising the price of gold.

4. In some countries the conduct of pegging operations is entrusted to the central bank, in others to a special agency called foreign-exchange equalization account or a similar name.1

• 1For the reasons that led to the establishment of such foreign-exchange equalization accounts, see Human Action, pp. 458-59.

If the government practices restraint in the issuance of additional amounts of its credit or fiat money and if public opinion assumes that the inflationary policy will be stopped altogether in a not too distant future, an inflationary currency system can prevail for a series of years. The country experiences all the effects resulting from a currency the unit of which vacillates in exchange value as against the international gold standard. With regard to these effects the freely vacillating currency may be called a bad currency. But it can last and is not inevitably headed for a breakdown.

The characteristic mark of this freely vacillating currency is that the owner of any amount of it has no claim whatever against the Treasury, a bank, or any other agency. There is no redemption either de jure or de facto. The pieces are not money substitutes but money proper in themselves.

It sometimes happened, especially in the European inflations of the 1920s, that the government, frightened by a speedy decline in its currency’s price in terms of gold or foreign exchange, tried to counteract the decline by selling on the market a certain amount of gold and foreign exchange against domestic currency. It was a rather nonsensical operation. It would have been much simpler and much more effective if the government had never issued those amounts which it later bought back on the market. Such ventures did not affect the course of events. The only reason they must be mentioned is that governments and their agents sometimes falsely referred to them as pegging.

The outstanding instance of a freely vacillating currency today is the United States dollar, the New Deal dollar. It is not redeemable in gold or any foreign exchange. The administration is committed to an inflationary policy, increasing more and more the amount of notes in circulation and of bank deposits subject to check. If the Treasury had been permitted to act according to the designs of its advisers, the dollar would have long since gone the way of the German mark of 1923. But lively protests on the part of a few economists alarmed the nation and enjoined restraint on the Treasury. The speed of the inflation was slowed down. Yet the future of the dollar is precarious, dependent on the vicissitudes of the continuing struggle between a small minority of economists on the one hand and hosts of ignorant demagogues and their “unorthodox” allies on the other hand.

The illusive standard is based on a falsehood. The government decrees that there exists a parity between the domestic currency and gold or foreign exchange. It is fully aware of the fact that on the market there prevail exchange ratios lower than the illusory parity it is pleased to ordain. It knows that nothing is done to make the illusory parity an effective parity. It knows that there is no convertibility. But it clings to its pretense and forbids transactions at a ratio deviating from its fictitious exchange rate. He who sells or buys at any other ratio is guilty of a crime and severely punished.

Strict enforcement of such a decree would make all monetary transactions with foreign countries cease. Therefore the government goes a step further. It expropriates all foreign exchange owned by its subjects and indemnifies the expropriated by paying them the amount of domestic currency which according to the official decree is the equivalent of the confiscated foreign-exchange holdings. These confiscations convey to the government the national monopoly of dealing with foreign exchange. It is now the only seller of foreign exchange in the country. In compliance with its own decree it should sell foreign exchange at the official rate.

On the market not hampered by government interference there prevails a tendency to establish and to maintain such an exchange ratio between the domestic currency (A) and foreign exchange (B) that it does not make any difference whether one buys or sells merchandise against A or against B. As long as it is possible to make a profit buying a definite commodity against B and selling it against A, there will be a specific demand for amounts of B originating from merchants selling amounts of A. This specific demand will cease only when no further profits can be reaped on account of price discrepancies between prices expressed in terms of each of these two currencies. The market rate is maintained by the fact that there is no longer an advantage for anybody in paying a higher price for foreign exchange. Buying either of A against B or of B against A at a higher price (expressed in the first case in terms of B and in the second in terms of A) than the market price would not bring specific profits. Arbitrage operations tend to cease at this price. This is the process that the purchasing-power-parity theory of foreign exchange describes.

The policy pretentiously called foreign-exchange control tries to counteract the operation of the purchasing-power-parity principle and fails lamentably. Confiscating foreign exchange against an indemnity below its market price is tantamount to an export duty. It tends to lower exports and thus the amount of foreign exchange that the government can seize. On the other hand, selling foreign exchange below its market price is tantamount to subsidizing imports and thereby to increasing the demand for foreign exchange. The illusive standard and its main tool, foreign-exchange control, result in a state of affairs which is—rather inappropriately—called shortage of foreign exchange.

Scarcity is the essential feature of an economic good. Goods which are not scarce in relation to the demand for them are not economic goods but free goods. Human action is not concerned with them, and economics does not deal with them. No prices are paid for such free goods and nothing can be obtained in exchange for them. To establish the fact that gold or dollars are in short supply is to pronounce a truism.

The state of affairs which those talking of a scarcity of dollars want to describe is this: At the fictitious parity, arbitrarily fixed by the government and enforced by the whole governmental apparatus of oppression and compulsion, demand for dollars exceeds the supply of dollars offered for sale. This is the inescapable consequence of every attempt on the part of a government or other agency to enforce a maximum price below the height at which the unhampered market would have determined the market price.

The Ruritanians would like to consume more foreign goods than they can buy by exporting Ruritanian products. It is a rather clumsy way of describing this situation to declare that the Ruritanians suffer from a shortage of foreign exchange. Their plight is brought about by the fact that they are not producing more and better things either for domestic or for foreign consumption. If the dollar buys at the free market 100 Ruritanian rurs and the government fixes a fictitious parity of 50 rurs and tries to enforce it by foreign-exchange control, things become worse. Ruritanian exports drop and the demand for foreign goods increases.

Of course, the Ruritanian government will then resort to various measures allegedly devised to “improve” the balance of payments. But no matter what is tried, the “scarcity” of dollars does not disappear.

Foreign-exchange control is today primarily a device for the virtual expropriation of foreign investments. It has destroyed the international capital and money market. It is the main instrument of policies aiming at the elimination of imports and thereby at the economic isolation of the various countries. It is thus one of the most important factors in the decline of Western civilization. Future historians will have to deal with it circumstantially. In referring to the actual monetary problems of our day it is enough to stress the point that it is an abortive policy.