Exchange Rates and Gold

Back in the 1960’s, an academic debate began over currency exchange rates. Milton Friedman championed the idea of floating exchange rates, i.e., the abolition of government-imposed price controls on currencies.

This was an intellectual assault on the Bretton Woods (a New Hampshire hotel) agreement of 1944, which established the International Monetary Fund. Member nations of the IMF were supposed to maintain fixed exchange rates with other member nations. Nations would hold dollars as well as gold as their monetary reserves. Dollar-denominated U.S. Treasury securities paid interest. Gold didn’t. The Americans who negotiated the IMF expected the agreement to increase demand for U.S. Treasury securities. It did.

The IMF also promised to lend dollars to any member nation that was experiencing a run on its dollar reserves, but only if that nation met certain IMF requirements. The IMF’s loan was to give the besieged nation’s central bankers some breathing room until they could reduce the rate of monetary expansion and thereby create a recession. This recession would ideally lead to lower domestic prices – waves of bankruptcies produce that effect, after all – which would make the nation’s goods attractive to foreign buyers, who would cease bringing in the nation’s currency and demanding dollars. Thus, the nation’s central bank would not have to float its currency, i.e., cease providing dollars on demand at the older fixed rate.

No member nation was supposed to float its currency in the international currency markets. Fixed exchange rates were sacrosanct. This really meant that the various currencies’ fixed exchange rates with the dollar were sacrosanct.

But why are fixed rates ever sacrosanct? The prices of most goods are left free to rise or fall in terms of supply and demand. Why should currencies be different? This was Friedman’s rhetorical question. It was a reasonable question.

Defenders of fixed exchange rates had no intellectually viable answers. They sometimes tried, but they always wound up sounding like apologists for the wisdom of a government bureaucracy in fixing prices. Of course, this is exactly what they were, but to be exposed publicly for what they were was embarrassing for many of them.

Fixed exchange rates with the dollar meant that the Federal Reserve System could crank up the printing press and force every other IMF member nation to crank up its printing presses. The dollar was the world’s reserve currency. Thus, despite domestic monetary expansion, the dollar would maintain its value internationally, while the newly created money could keep the American economic boom going strong.

When all the world wanted dollars after World War II, nobody complained. In the late 1950’s, however, a few free market economists, most notably Jacques Rueff and Wilhelm Roepke, put a name on the process: exported inflation.

NIXON’S THE ONE!

On Sunday, August 15, 1971, President Nixon unilaterally announced the "closing of the gold window," i.e., the repudiation of America’s promise in the Bretton Woods agreement to allow foreign governments and central banks to redeem dollars for gold at $35/oz. This promise was the heart of the original agreement. It made the dollar a substitute for gold. It made the dollar "as good as gold." It encouraged foreign central banks to buy dollar-denominated Treasury debt certificates instead of holding gold.

The IMF was an extension of the Genoa Conference of 1922, where European nations formally abandoned the pre-World War I gold standard, substituting British pounds or dollars for gold. This was a major step in freeing central banks from runs on their gold by other central banks. Each of the national central banks had stolen the gold from its nation’s commercial banks after World War I broke out. The commercial banks had been granted the right to break contract and not redeem gold on demand by depositors. The central banks did to the commercial banks what the commercial banks had done to their depositors.

Nixon then did to the central banks what they had done to their commercial banks. The Federal Reserve System wound up with the largest hoard of gold on earth, which it holds on deposit for the U.S. government, or so the official explanation goes.

Nixon that same day also floated the dollar. Simultaneously, he froze most wages and prices. That is, he abandoned price controls over money and imposed them on everything else. This was economic schizophrenia. The National Association of Manufacturers and the U.S. Chamber of Commerce immediately applauded Nixon’s decision. A Democrat-run Congress did not oppose him, either.

Nixon in 1971 was presiding over a recession. For each of the two years, fiscal 1970 and 1971 (which ended on September 30), his administration ran a deficit of $25 billion, which was considered huge in those quaint days. The Federal Reserve System was pumping in money to get the economy rolling, as usual. Prices were rising rapidly. A gold run had developed.

Nixon dealt with all of this by breaking America’s contract with foreign central banks and by outlawing all new private contracts at prices higher than those that prevailed on August 15. In short, he put his World War II background as a bureaucrat with the Office of Price Administration to contract-undermining use.

According to the Inflation Calculator on the home page of the Web site of the U.S. government’s Bureau of Labor Statistics, it takes $4,558 today to purchase what $1,000 purchased in 1971.

THE OLD ASSUMPTIONS

The Genoa agreement was designed to square the circle. Its goal was to re-establish the pre-War stability of currency exchange rates, but without the use of gold. Currencies were to remain stable against each other, but without the public’s legal right of convertibility of currency into gold at a fixed rate of exchange.

Governments wanted the fruits of the traditional gold standard, but without the roots. They wanted stable exchange rates based on fiat currencies. The gold coin standard had provided fixed exchange rates based on a legal contract: full redeemability on demand at a fixed rate. The pre-War exchange rates among currencies were the result of fixed exchange rates between gold and each national currency. The fixed rate of exchange, gold vs. any national currency, was not officially a price control. It was a contractual agreement between the central bank and anyone holding the nation’s currency.

If you hand over your dog for me to keep for you when you go on a trip, and I hand you an IOU for your dog, there is no price control. There is a legal relationship. My IOU isn’t the same as your dog, but it establishes the fact that your dog is in my possession. Legally, you can get your dog back on demand when you present the IOU to me.

If the government then declares that collies are the same as basset hounds, and you have given me your collie for safekeeping, I can now legally return a basset hound to you.

A price control is not the same as a warehouse receipt. A warehouse receipt for an ounce of 24-karat gold in exchange for ten shekels will circulate at a one-to-one fixed rate with a receipt for an ounce of 24-karat gold for ten denarii. There is no price control. The free market establishes a fixed rate of exchange between shekels and denarii. The fixed exchange rate is the product of fixed rates of exchange between denarii and gold and shekels and gold. As we learned in high school geometry, and occasionally actually remember, "things equal to the same thing are equal to each other."

The Genoa agreement converted what had been a desirable outcome (stable prices among currencies) of a system of voluntary contracts (free convertibility of gold) into a system of price controls. It officially abolished internationally what had been abolished nationally in 1914 by every country involved in World War I: the redemption of currencies for gold. It substituted currencies for actual gold held in central bank vaults. Nations (central banks) henceforth would hold British pounds or the U.S. dollar instead of gold. This was agreed to even before Britain returned to gold, at the pre-War exchange rate, in 1925. Nations were expected to honor fixed exchange rates.

In fact, most nations continued to accumulate gold.

The central bankers did not trust each other.

Fast forward. The Bretton Woods agreement worked from 1946, when the 1944 agreement was implemented, to 1971 because the United States had possession of most of the West’s gold. The United States had come out of World War II as the leading economy on earth. Its currency was trusted by central bankers because (1) the U.S. government promised full redeemability, and (2) the U.S. economy had so many goods for sale. Foreigners wanted dollars to buy things made in America. Only in the late 1950’s did the sporadic run on U.S. gold reserves begin.

The old assumption – the desirability of stable currency exchange rates – still reigned, but the faith that sustained it had been abandoned: the right of anyone holding a nation’s currency to exchange it at a fixed rate for gold. Because the world’s currencies were not individually governed by fixed exchange rates with gold, the system of fixed exchange rates among currencies was not a free market phenomenon. It was a price control system. It was basset hounds = collies.

Stable exchange rates among currencies in a world without legally enforceable exchange rates between each currency and gold are like stable marriages without legally enforceable marriage covenants. Politicians want the benefits of stable currencies, while escaping runs on central bank gold reserves due to domestic monetary expansion, which they don’t want to abandon. They also want their wives to show up at their campaign rallies, while they are having affairs with their 22-year-old aides, which they also don’t want to abandon – this week, anyway.

FRIEDMAN WAS RIGHT, SORT OF

Friedman was correct in identifying the inherent futility of fixed exchange rates in a world of fiat currencies. He saw that fixed exchange rates are merely a species of price control: price control on non-specie currencies.

Price controls always lead to a shortage of the good whose price is set by the government below the free market price. Friedman was hardly the first economist to observe this. Sir Thomas Gresham got there first in the late sixteenth century: "Bad money drives out good money," as his famous law has come down to us.

It is not that Friedman was a genius in spotting the obvious, namely, that fixed exchange rates are price controls. What is astounding in retrospect is that his academic opponents were utterly blind regarding price controls placed on currencies, despite their Ph.D.’s in economics. They had accepted the economic logic of free markets, but then they halted at the door of the International Monetary Fund. "All ye who enter here, abandon price theory."

What is not widely perceived is this: Friedman abandoned price theory at the door of the Federal Reserve System. He has always opposed the gold coin standard. He regards resources spent in digging gold out of the earth as wasted whenever this gold is put in central bank vaults, which are also usually below ground.

Friedman has understood the theory behind the ideal of a state-free gold coin standard. He has even admitted that it is a good system in theory. Unfortunately, he says, it is just not feasible. It has never existed. (See his 1961 book, Capitalism and Freedom, p. 41.)

The economic pragmatism of the Chicago School is too often like gold plating on lead slugs. Nowhere is this pragmatism clearer than in Friedman’s theory of money. He wrote the following in 1961, and has never retracted it.

My conclusion is that an automatic commodity standard is neither a feasible nor a desirable solution to the problem of establishing monetary arrangements for a free society. It is not desirable because it would involve a large cost in the form of resources used to produce the monetary commodity. It is not feasible because of the mythology and beliefs required to make it effective do not exist. (Ibid., p. 42.)

Yet this same two-fold argument can be brought against every other pricing system in a free market society, and has been. He rejects the gold standard because it cannot be achieved at zero price (free resources), which is the classic argument of the Marxists and utopians against free market capitalism in general. He also rejects the gold standard because people don’t have faith in it, which is the classic argument of the anti-market socialists, i.e., the free market as the product of a corporate act of faith rather than the product of the right of individual ownership and contract.

The problem is not the public’s lack of faith in the gold standard. The problem is the public’s lack of faith in the binding nature of voluntary contracts. Voters repeatedly have allowed the state and its licensed agents to break their contracts and confiscate individuals’ gold.

The gold standard was the result of voluntary contracts: warehouse receipts for gold. Any gold standard that is not the product of voluntary contracts is just one more scheme by fractional reserve bankers or government officials to confiscate gold from naïve depositors.

If gold were stored in private vaults as legal reserves to back up warehouse receipts for gold, the system would place great restraints on the civil government. The state would not have a monopoly over the currency. The best situation would be where no state had any currency of its own, and could therefore not seek to manipulate its supply or its value. Under such conditions, the money spent on mining gold would be cheap insurance against expanding government control over the lives of its citizens.

A gold coin standard, coupled with 100% reserve banking and the abolition of government currencies, would place golden chains on the state. This is the reason why the state has always demanded sovereignty over money. The war against economic freedom always begins with the state’s assertion of sovereignty over money. That Friedman and all of the other academic guild-certified free market economists cannot see this is testimony to the effects of government propaganda. Repeat the mantra long enough – "state sovereignty over money" – and even intelligent people will not be able to accept the truth. What is the truth? That the state can no more be trusted in monetary affairs than it can be trusted in educational affairs.

When it comes to faith in the academic guild vs. faith in gold, place me in the latter camp.

CONCLUSION

The case for fixed exchange rates is the case for voluntary pricing. Ideally, it is the case for fixed exchange rates between coins with the same weight and fineness of metal.

The case for floating exchange rates is the case for voluntary pricing. Ideally, it is the case for floating exchange rates between silver coins and gold coins.

The case against fixed exchange rates is the case against state-imposed price controls. Ideally, it is the case against government interference in the economy except in the prosecution of violence or fraud (fractional reserve banking).

Simple, isn’t it? Yet economists just can’t get these matters straight in their thinking.

Why should we expect politicians to understand anything this simple? They are much too busy teaching their 22-year-old aides about loopholes in covenant law.