domestic market.
The quotations on the Bourse for foreign exchange always reflect speculative rates in the light of the currently evolving, but not yet consummated, change in the purchasing power of the monetary unit. However, the monetary depreciation, at an early stage of its gradual evolution, has already had its full impact on foreign exchange rates before it is fully expressed in the prices of all domestic goods and services. This lag in commodity prices, behind the rise of the foreign exchange rates, is of limited duration. In the last analysis, the foreign exchange rates are determined by nothing more than the anticipated future purchasing power attributed to a unit of each currency. The foreign exchange rates must be established at such heights that the purchasing power of the monetary unit remains the same, whether it is used to buy commodities directly, or whether it is first used to acquire another currency with which to buy the commodities. In the long run the rate cannot deviate from the ratio determined by its purchasing power. This ratio is known as the “natural” or “static” rate.
In order to stabilize the value of a monetary unit at its present value, the decline in monetary value must first be brought to a stop. The value of the monetary unit in terms of gold must first attain some stability. Only then can the relationship of the monetary unit to gold be given any lasting status. First of all, as pointed out above, the progress of inflation must be blocked by halting any further increase in the issue of notes. Then one must wait awhile until after foreign exchange quotations and commodity prices, which will fluctuate for a time, have become adjusted. As has already been explained, this adjustment would come about not only through an increase in commodity prices but also, to some extent, with a drop in the foreign exchange rate.
Comments on the “Balance of Payments” Doctrine
1. Refined Quantity Theory of Money
The generally accepted doctrine maintains that the establishment of sound relationships among currencies is possible only with a “favorable balance of payments.” According to this view, a country with an “unfavorable balance of payments” cannot maintain the stability of its monetary value. In this case, the deterioration in the rate of exchange is considered structural and it is thought it may be effectively counteracted only by eliminating the structural defects.
The answer to this and to similar arguments is inherent in the Quantity Theory and in Gresham’s Law.1
The Quantity Theory demonstrated that in a country which uses only commodity money, the “purely metallic currency” standard of the Currency Theory, money can never flow abroad continuously for any length of time. The outflow of a part of the gold supply brings about a contraction in the quantity of money available in the domestic market. This reduces commodity prices, promotes exports and restricts imports, until the quantity of money in the domestic economy is replenished from abroad. The precious metals being used as money are dispersed among the various individual enterprises and thus among the several national economies, according to the extent and intensity of their respective demands for money. Governmental interventions, which seek to regulate international monetary movements in order to assure the economy a “needed” quantity of money, are superfluous.
The undesirable outflow of money must always be simply the result of a governmental intervention which has endowed differently valued moneys with the same legal purchasing power. All that the government need do to avoid disrupting the monetary situation, and all it can do, is to abandon such interventions. That is the essence of the monetary theory of Classical economics and of those who followed in its footsteps, the theoreticians of the Currency School.2
With the help of modern subjective theory, this theory can be more thoroughly developed and refined. Still it cannot be demolished. And no other theory can be put in its place. Those who can ignore this theory only demonstrate that they are not economists.
One frequently hears, when commodity money is being replaced in one country by credit or token money—because the legally-decreed equality between the over-issued paper and the metallic money has prompted the sequence of events described by Gresham’s Law—that it is the balance of payments that determines the rates of foreign exchange. That is completely wrong. Exchange rates are determined by the relative purchasing power per unit of each kind of money. As pointed out above, exchange rates must eventually be established at a height at which it makes no difference whether one uses a piece of money directly to buy a commodity, or whether one first exchanges this money for units of a foreign currency and then spends that foreign currency for the desired commodity. Should the rate deviate from that determined by the purchasing power parity, which is known as the “natural” or “static” rate, an opportunity would emerge for undertaking profit-making ventures.
It would then be profitable to buy commodities with the money which is legally undervalued on the exchange, as compared with its purchasing power parity, and to sell those commodities for that money which is legally overvalued on the exchange, as compared with its actual purchasing power. Whenever such opportunities for profit exist, buyers would appear on the foreign exchange market with a demand for the undervalued money. This demand drives the exchange up until it reaches its “final rate.”3 Foreign exchange rates rise because the quantity of the [domestic] money has increased and commodity prices have risen. As has already been explained, it is only because of market technicalities that this cause and effect relationship is not revealed in the early course of events as well. Under the influence of speculation, the configuration of foreign exchange rates on the Bourse forecasts anticipated future changes in commodity prices.
The balance of payments doctrine overlooks the fact that the extent of foreign trade depends entirely on prices. It disregards the fact that nothing can be imported or exported if price differences, which make the trade profitable, do not exist. The balance of payments doctrine derives from superficialities. Anyone who simply looks at what is taking place on the Bourse every day and every hour sees, to be sure, only that the momentary state of the balance of payments is decisive for supply and demand on the foreign exchange market. Yet this diagnosis is merely the start of the inquiry into the factors determining foreign exchange rates. The next question is: What determines the momentary state of the balance of payments? This must lead only to the conclusion that the balance of payments is determined by the structure of prices and by the sales and purchases inspired by differences in prices.
With rising foreign exchange quotations, foreign commodities can be imported only if they find buyers at their higher prices. One version of the balance of payments doctrine seeks to distinguish between the importation of necessities of life and articles which are considered less vital or necessary. It is thought that the necessities of life must be obtained at any price, because it is absolutely impossible to get along without them. As a result, it is held that a country’s foreign exchange must deteriorate continuously if it must import vitally-needed commodities while it can export only less-necessary items. This reasoning ignores the fact that the greater or lesser need for certain goods, the size and intensity of the demand for them, or the ability to get along without them is already fully expressed by the relative height of the prices assigned to the various goods on the market.
No matter how strong a desire the Austrians may have
