The Theory of Money and Credit

When compared with conditions in the United States or in Switzerland, Ruritania appears a poor country. The average income of a Ruritanian is below the average income of an American or a Swiss.

Once, in the past, Ruritania was on the gold standard. But the government issued little sheets of printed paper to which it assigned legal-tender power in the ratio of one paper rur to one gold rur. All residents of Ruritania were made to accept any amount of paper rurs as the equivalent of the same nominal amount of gold rurs. The government alone did not comply with the rule it had decreed. It did not convert paper rurs into gold rurs in accordance with the ratio 1 : 1. As it went on increasing the quantity of paper rurs, the effects resulted which Gresham’s law describes. The gold rurs disappeared from the market. They were either hoarded by Ruritanians or sold abroad.

Almost all the nations of the earth have behaved in the way the Ruritanian government did. But the rates of the inflationary increase of the quantities of their national fiat money have been different. Some nations were more moderate in issuing additional quantities, some less. The result is that the exchange ratios between the various nations’ local fiat-money currencies are no longer the same ratios that prevailed between their currencies in the period before they went off the gold standard. In those old days five gold rurs were equal to one gold dollar. Although today’s dollar is no longer the equivalent of the weight of gold it represented under the gold standard, that is, before 1933, 100 paper rurs are needed to buy one of these depreciated dollars. A short time ago eighty paper rurs could buy one dollar. If the present rates of inflation both in the United States and in Ruritania do not change, the paper rur will drop more and more in terms of dollars.

The Ruritanian government knows very well that all it has to do in order to prevent a further depreciation of the paper rur as against the dollar is to slow down the deficit spending it finances by continued inflation. In fact, in order to maintain a stable exchange rate against the dollar, it would not be forced to abandon inflation altogether. It would only have to reduce it to a rate in due proportion to the extent of American inflation. But, government officials say, it is impossible for Ruritania, being a poor country, to balance its budget with a smaller amount of inflation than the present one. For such a reduction would enjoin upon it the necessity of undoing some of the results of social progress and of relapsing into the conditions of “social backwardness” of the United States. The government has nationalized railroads, telegraphs, and telephones and operates various plants, mines, and branches of industry as national enterprises. Every year the conduct of affairs of almost all the public undertakings produces a deficit that must be covered by taxes collected from the shrinking group of nonnationalized and nonmunicipalized businesses. Private business is a source of the treasury’s revenue. Nationalized industry is a drain upon the government’s funds. But these funds would be insufficient in Ruritania if not swelled by more and more inflation.

From the point of view of monetary technique the stabilization of a national currency’s exchange ratio as against foreign, less-inflated currencies or against gold is a simple matter. The preliminary step is to abstain from any further increase in the quantity of domestic currency. This will at the outset stop the further rise in foreign-exchange rates and the price of gold. After some oscillations a somewhat stable exchange rate will appear, the height of which depends on the purchasing-power parity. At this rate it no longer makes any difference whether one buys or sells against currency A or currency B.

But this stability cannot last indefinitely. While an increase in the production of gold or an increase in the issuance of dollars continues abroad, Ruritania now has a currency the quantity of which is rigidly limited. Under these conditions there can no longer prevail full correspondence between the movements of commodity prices on the Ruritanian markets and those on foreign markets. If prices in terms of gold or dollars are rising, those in terms of rurs will lag behind them or even drop. This means that the purchasing-power parity is changing. A tendency will emerge toward an enhancement of the price of the rur as expressed in gold or dollars. When this trend becomes manifest, the propitious moment for the completion of the monetary reform has arrived. The exchange rate that prevails on the market at this juncture is to be promulgated as the new legal parity between the rur and either gold or the dollar. Unconditional convertibility at this legal rate of every paper rur against gold or dollars and vice versa is henceforward to be the fundamental principle.

The reform thus consists of two measures. The first is to end inflation by setting an insurmountable barrier to any further increase in the supply of domestic money. The second is to prevent the relative deflation that the first measure will, after a certain time, bring about in terms of other currencies the supply of which is not rigidly limited in the same way. As soon as the second step has been taken, any amount of rurs can be converted into gold or dollars without any delay and any amount of gold or dollars into rurs. The agency, whatever its appellation may be, that the reform law entrusts with the performance of these exchange operations needs for technical reasons a certain small reserve of gold or dollars. But its main concern is, at least in the initial stage of its functioning, how to provide the rurs necessary for the exchange of gold or foreign currency against rurs. To enable the agency to perform this task, it has to be entitled to issue additional rurs against a full—100 percent—coverage by gold or foreign exchange bought from the public.

It is politically expedient not to charge this agency with any responsibilities and duties other than those of buying and selling gold or foreign exchange according to the legal parity. Its task is to make this legal parity an effective real market rate, preventing, by unconditional redemption of rurs, a drop of their market price against legal parity, and, by unconditional buying of gold or foreign exchange, an enhancement of the price of rurs as against legal parity.

At the very start of its operations the agency needs, as has been mentioned, a certain reserve of gold or foreign exchange. This reserve has to be lent to it either by the government or by the central bank, free of interest and never to be recalled. No business other than this preliminary loan must be negotiated between the govern ment and any bank or institution dependent on the government on the one hand and the agency on the other hand.2  The total amount of rurs issued before the start of the new monetary regime must not be increased by any operations on the part of the government; only the agency is free to issue additional new rurs, rigidly complying in such issuance with the rule that each of these new rurs must be fully covered by gold or foreign exchange paid in by the public in exchange for them.

The government’s mint may go on to coin and to issue as many fractional or subsidiary coins as seem to be needed by the public. In order to prevent the government from misusing its monopoly of mintage for inflationary ventures and flooding the market, under the pretext of catering to peoples’ demand for “change,” with huge quantities of such tokens, two provisions are imperative. To these fractional coins only a strictly limited legal-tender power should be given for payments to any payee but the government. Against the government alone they should have unlimited legal-tender power, and the government, moreover, must be obliged to redeem in rurs, without any delay and without any cost to the bearer, any amount presented, either by any private individual, firm, or corporation or by the agency. Unlimited legal-tender power must be reserved to the various denominations of banknotes of one rur and upward, issued either before the reform or, if after the reform, against full coverage in gold or foreign exchange.

Apart from this exchange of fractional coins against legal-tender rurs the agency deals exclusively with the public and not with the government or any of the institutions dependent on it, especially not with the central bank. The agency serves the public and deals exclusively with that part of the public that wants to avail itself, of its own free accord, of the agency’s services. But no privileges are accorded to the agency. It does not get a monopoly for dealing in gold or foreign exchange. The market is perfectly free from any restriction. Everybody is free to buy or sell gold or foreign exchange. There is no centralization of such transactions. Nobody is forced to sell gold or foreign exchange to the agency or to buy gold or foreign exchange from it.

When these measures are once achieved, Ruritania is either on the gold-exchange standard or on the dollar-exchange standard. It has stabilized its currency as against gold or the dollar. This is enough for the beginning. There is no need for the moment to go further. No longer threatened by a breakdown of its currency, the nation can calmly wait to see how monetary affairs in other countries will develop.

The reform suggested would deprive the government of Ruritania of the power to spend any rur above the sums collected by taxing the citizens or by borrowing from the public, whether domestic or foreign. Once this is achieved, the specter of an unfavorable balance of payment fades away. If Ruritanians want to buy foreign products, they must export domestic products. If they do not export, they cannot import.

But, says the inflationist, what about the flight of capital? Will not unpatriotic citizens of Ruritania and foreigners who have invested capital within the country try to transfer their capital to other countries offering better prospects for business?

John Badman, a Ruritanian, and Paul Yank, an American, have invested in Ruritania in the past. Badman owns a mine, Yank a factory. Now they realize that their investments are unsafe. The Ruritanian government is committed to a policy that confiscates not only all the yields of their investments but step by step the substance too. Badman and Yank want to salvage what still can be salvaged; they want to sell against rurs and to transfer the proceeds by buying dollars and exporting them. But their problem is to find a buyer. If all those who have the funds needed for such a purchase think like them, it will be absolutely impossible to sell even at the lowest price. Badman and Yank have missed the right moment. Now it is too late.

But perhaps there are buyers. Bill Sucker, an American, and Peter Simple, a Ruritanian, believe that the prospects of the investments concerned are more propitious than Badman and Yank assume. Sucker has dollars ready; he buys rurs and against these rurs Yank’s factory. Yank buys the dollars Sucker has sold to the agency. Simple has saved rurs and invests his savings in purchasing Badman’s mine. It would have been possible for him to employ his savings in a different way, to buy producers’ or consumers’ goods in Ruritania. The fact that he does not buy these goods brings about a drop in their prices or prevents a rise which would have occurred if he had bought them. It disarranges the price structure on the domestic market in such a way as to make exports possible that could not be effected before or to prevent imports which were effected before. Thus it produces the amount of dollars which Badman buys and sends abroad.

A specter that worries many advocates of foreign-exchange control is the assumption that the Ruritanians engaged in export trade could leave the foreign-exchange proceeds of their business abroad and thus deprive their country of a part of its foreign exchange.

Miller is such an exporter He buys commodity A in Ruritania and sells it abroad. Now he chooses to go out of business and to transfer all his assets to a foreign country. But this does not stop Ruritania’s exporting A. As according to our assumption there can be profits earned by buying A in Ruritania and selling it abroad, the trade will go on. If no Ruritanian has the funds needed for engaging in it, foreigners will fill the gap. For there are always people in markets not entirely destroyed by government sabotage who are eager to take advantage of any opportunity to earn profits.

Let us emphasize this point again: If people want to consume what other people have produced, they must pay for it by giving the sellers something they themselves have produced or by rendering them some services. This is true in the relation between the people of the state of New York and those of Iowa no less than in the relation between the people of Ruritania and those of Laputania. The balance of payments always balances. For if the Ruritanians (or New Yorkers) do not pay, the Laputanians (or Iowans) will not sell.

• 2For the only exception to this rule, see next paragraph below.