The Theory of Money and Credit

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.