Origin and Effects
According to the NCS theory, currency crises occur within the institutional framework of a fractional-reserve banking system in which the cash reserves of the private commercial banks have been nationalized and concentrated in the central bank. This system was generally referred to as the “one-reserve system”,15 however Hayek
14 Ludwig von Mises, “The ‘Austrian’ Theory of the Trade Cycle,” in Richard M. Ebel- ing, The Austrian Theory of the Trade Cycle and Other Essays, 2nd ed. (Auburn, Ala.: Ludwig von Mises Institute, [1978] 1996), pp. 25–27.
15 Mises, Human Action, p. 462; Hayek, Monetary Nationalism, p. 12.
suggested a more descriptive name for it, “the system of national reserves.” This system was not the outcome of market forces, but rather was superimposed on the commercial banks by governments
“in order to make it easier for the central banks to embark upon credit expansion.”16 The United States, for example, effectively nationalized bank reserves in 1917. The Amendment to the Federal Reserve Act of June 21, 1917 mandated that only reserve deposits held at the Federal Reserve Banks would be counted as legal reserves of member banks, resulting in a centralization of gold reserves at the Fed.17
In European countries, where central banks began to emerge as early as the late seventeenth century, the nationalization of reserves began even earlier, under the classical gold standard.18 Other coun- tries arrived at the national reserve system by adopting the gold exchange standard after World War I in order to economize on their gold holdings which yielded no return. This attenuated version of the gold standard naturally centralized reserves in the form of interest- bearing foreign securities in the central bank and thus placed “in the hands of governments the power to manipulate their nations’ cur- rency easily.”19 Another postwar device for “economizing gold,” the gold bullion standard, under which currencies were only convert- ible into large and expensive bars of gold, also served to concentrate
16 Mises, Human Action, p. 262.
17 C.A. Phillips, T.F. McManus, and R.W. Nelson, Banking and the Business Cycle:
A Study of the Great Depression in the United States (New York: Arno Press & The New York Times, [1937] 1972), pp. 24–25; W.P.G. Harding, The Formative Period of the Federal System (During the World Crisis) (New York: Houghton Mifflin Com- pany, 1925), pp. 72–74. As Benjamin Anderson (Economics and the Public Wel- fare: A Financial and Economic History of the United States, 1914–1946, 2nd ed.
[Indianapolis, Ind.: Liberty Press, 1979], p. 56) pointed out, the theory underlying this Amendment was “not very clear” but “in 1916 and in early 1917 there was a very definite practical consideration that we might be involved in war, and that it was important that the gold of the country be concentrated in a central reservoir as a basis for war finance.” So the centralization of gold reserves in the Fed was under- taken with the definite intention of facilitating an inflationary monetary policy.
18 According to Mises, “In order to make it easier for the central banks to embark upon credit expansion, the European governments aimed long ago at a concentra- tion of their countries’ gold reserves with the central banks (Mises, Human Action, p. 462).
19 Ibid., p. 780.
gold reserves in the hands of the central bank and “made possible an increase in circulating media out of all proportion to the current pro- duction of gold.”20
The national reserve system brought about two momentous changes in the institutional framework of financial markets. The first was a radical alteration of the way in which the commercial banks conducted business. When a central bank was granted the legal or de facto monopoly of warehousing the gold deposits of the public, its notes and deposits were no longer treated as instantaneously redeem- able property titles to the actual money commodity housed within its vaults. The gold now became subsumed under the general cate- gory of central bank “assets” serving as “reserves” against its issue of instantly maturing “liabilities,” i.e., notes and deposits. These notes and deposits in time came to be generally accepted by the public as money itself rather than what they actually were: titles to money or
“money certificates” that conveniently substituted in trade for the money commodity.
This development in turn led the commercial banks to hold the minimum amount of reserves—now in the form of central bank notes and deposits—necessary to meet the day-to-day net redemp- tions of their own instantaneous liabilities. These included not only their demand deposits but also their interest-bearing savings deposits, upon which notice of withdrawal was increasingly waived, despite the fact that the funds for both of these categories of deposits had been invested by business borrowers for shorter or longer periods in the economy’s structure of production.21 This mismatching of the matu- rity structure of the commercial banks’ assets and liabilities, which had always existed to a limited extent when fractional reserves banks were responsible for holding their own gold reserves, was thus greatly
20 Phillips et al., Banking and the Business Cycle, p. 49.
21 For discussion of the changes in the legal and institutional conditions that led to the transformation of time deposits into instantaneous liabilities and their role in generating bank credit inflation and financial instability in the 1920s and 1930s, see Heilperin, Aspects of the Pathology of Money, pp. 267–68 and idem, International Monetary Economics, pp. 92–93; Mises, “Senior’s Lectures on Monetary Problems,”
pp. 107–08; Phillips et al., Banking and the Business Cycle, pp. 29, 95–101.
promoted by the practically unlimited access granted to banks under the national reserve system to loans from the central bank when they found themselves short of reserves.
Mises22 concisely summed up the revolution in banking practice that resulted from the national reserve system:
[The banks] no longer keep a reserve against their daily maturing liabilities. They do not consider it necessary to bal- ance the maturity dates of their liabilities and assets in such a way as to be any day ready to comply unaided with their obli- gations to their creditors. They rely upon the central bank.
When the creditors want to withdraw more than the ‘normal’
amount, the private banks borrow the funds needed from the central bank. A private bank considers itself liquid if it owns a sufflcient amount either of collateral against which the cen- tral bank will lend or of bills of exchange which the central bank will rediscount.
The national reserve system effected a second revolutionary alteration in the financial system of the interwar period. This was the layering of different moneys—more properly, money substitutes—of a progressively narrower range of acceptability atop one another so that the monetary structure of a nation came to resemble an inverted pyramid resting upon a narrow base of gold, the universally accepted money. As Hayek,23 who was the first to fully elaborate the implica- tions of this institutional structure, explained:
The ordinary individual will hold only a sort of money which can be used directly for payments of clients of the same bank;
he relies upon the assumption that his bank will hold for all its clients a reserve which can be used for other payments.
The commercial banks in turn will only hold reserves of such more liquid or more widely acceptable sort of money as can be used for inter-bank payments within the country. But for the holding of the reserves of the kind which can be used for pay- ments abroad, or even those which are required if the public would want to convert a considerable part of its deposits into cash, the banks rely largely on the central bank. … It was only
22 Mises, Human Action, p. 462.
23 Hayek, Monetary Nationalism, pp. 10, 12.
with the growth of centralized national banking systems that all inhabitants of a country came … to be dependent on the same amount of more liquid assets held for them collectively as a national reserve.24
Hayek’s analysis of the national reserve system sheds important light on the effects of international monetary flows under alternative institutional arrangements. Within the national currency area, inter- local transfers of money, no matter how large or abrupt, put no strain on the overall financial system because they do not entail any dis- turbance of the gold base of the national monetary pyramid. In par- ticular, they do not necessitate that the central bank raise its discount rate to “protect” its “gold reserves,” because the monetary transfers were accomplished wholly though changes in the assets and liabilities of banks within the same national reserve system. This is especially important because, as Hayek25 pointed out, “not every movement of money … is a transfer of capital.”26 That is, not every net flow of money between regions is a response to a shift of supply and demand on the investible funds market. Some movements of money result either from a temporary and reversible discrepancy between the imports and exports of a given region or from a more permanent reconfiguration of the interregional pattern of the demand for money. In both cases,
24 Two minor mistakes marred Hayek’s analysis. It ignored Mises’s crucial distinc- tion between “money” and “money substitutes” and it confounded the Mengerian concept of “acceptability” or “marketability” and the Keynesian notion of “liquid- ity.” Different kinds of money substitutes can be more or less widely acceptable, but as soon as any kind comes to be considered as less than perfectly “liquid,” it will be deprived of its monetary function. For an enlightening discussion of the difference between the two concepts from a slightly different perspective, see Heilperin, Inter- national Monetary Economics, pp. 93–94. For an explanation of Mises’s taxonomy of money and a defense of his distinction between money and money substitutes, see Joseph T. Salerno, “Ludwig von Mises’s Monetary Theory in Light of Modern Mon- etary Thought,” The Review of Austrian Economics 8, no. 1: pp. 75–77 [reprinted here as Chapter 2].
25 Hayek, Monetary Nationalism, p. 31.
26 Heilperin (International Monetary Economics, pp. 92–93) made a similar dis- tinction: “ ‘[C]apital’ is the fund of purchasing power made available for investment.
It is to be distinguished from monetary funds whose destination has not yet been decided upon by the owners. One has to note that the organization of credit does not make possible a sharp distinction between the two types of funds—which is one of the great factors in economic instability.”
therefore, no change of the discount rate or of interest rates in general is warranted, since no transfer of real capital is involved.
When we consider purely monetary transfers between two regions that are parts of different national reserve systems, matters are not much different as long as these transfers are the result of nor- mal fluctuations in the balance of trade or occasional changes in the relative demands for money. In these cases, the accompanying movements of gold from one country to another would be relatively minor and would be rapidly ended or reversed by relative changes in the price structures of the two countries as described by the clas- sical price-specie-flow mechanism. In order for this mechanism to function central banks need do no more than honor their contrac- tual obligations to redeem at par and on demand the titles to gold they issued and to strictly limit the new receipts issued to the actual amount of new gold that is brought to them for storage, i.e., to operate as honest and simple bailees in warehousing the money commodity.
If central banks operated in this manner, the expansion of the money supply in the surplus country and the contraction of money supply in the deficit country would be precisely equal to each other and to the net transfer of gold through the balance of payments. This out- come is precisely the same economically as it would be if the transfer of money occurred between two regions that were constituents of the same system of national reserves.
The (Mis)Behavior of the Central Bank
According to the NCS analysis, then, when central banks behaved according to the “currency principle”—ensuring that the national money supply varies on a one-to-one basis with gold flows to and from abroad—the nation’s currency was unlikely to encounter crisis condi- tions. Things were radically different, however, when a central bank attempted to lower domestic interest rates by unilaterally expanding bank credit. This caused the pyramided layers of money substitutes to expand relative to the national reserve of gold, resulting in a pro- gressive rise of domestic prices. The rise in domestic prices and the decline of domestic interest rates relative to levels prevailing abroad
would precipitate a deficit on both current and capital accounts.27 This overall deficit in the balance of payments would persist until the cheap money policy was brought to an end. In the meantime, the deficit was financed by the steadily dwindling “gold reserves” of the expansionist central bank. This “external drain” of gold would eventually inspire a loss of confidence in the domestic currency, precipitating an “internal drain” of gold as domestic and foreign investors and the public at large rushed to convert into gold the ever-growing mass of money substi- tutes issued by the central bank and the commercial banks. As this crisis point approached, the central bank, if it wished to maintain the gold standard, would be compelled to sharply raise its discount rate in order to contract bank credit and replenish its depleted stock of gold.28
The outflow of gold reserves and the rise of the discount rate marked the turning point in the business cycle, when it was revealed that domestic interest rates could not be permanently reduced by cen- tral bank credit expansion below their natural level as determined on international capital markets by the quantity of voluntary savings. The rise of the discount rate was therefore not an exogenous cause of the ensuing recession, but rather a necessary step in the corrective process which revealed to entrepreneurs that there were not sufficient savings and real capital goods available to sustain the investment projects they had initiated under the stimulus of cheap money.
The NCS theorists emphasized that the inapt rhetoric of war used to describe the sequence of events leading up to the loss of reserves led to serious misconceptions among economists and the public about the causal process involved as well as the role of central banks in this process. Mises29 cut through this rhetoric and identified the true cause as the violation of contract:
27 Of course, if the country in question is experiencing relatively rapid growth in real output, the credit expansion may not manifest itself in rising prices of consumer goods, but solely in declining interest rates and swelling bubbles in financial and real estate markets. This occurred in the U.S. in the 1920s and 1990s.
28 After the discovery of open market operations in the 1920s, the central bank could also initiate monetary contraction and avoid a currency crisis by selling secu- rities to the commercial banks and the public.
29 Mises, Human Action, pp. 456–57.
The truth is that all that a central bank does lest its gold reserves evaporate is done for the sake of the preservation of its own solvency. It has jeopardized its financial position by embarking upon credit expansion and must now undo its previous action in order to avoid its disastrous conse- quences. … No “defender” is needed to “protect” a nation’s currency system. … When the Bank of England redeemed a bank note issued according to the terms of the contract … [i]t simply did what every housewife does in paying the gro- cer’s bill. The idea that there is some special merit in a central bank’s fulfillment of its voluntarily assumed responsibilities could originate only because again and again governments granted to these banks the privilege of denying to their clients the payments to which they had a legal title.
In particular, the central bank in the deficit (surplus) nation did not need to increase (decrease) the discount rate and bring about a contraction (expansion) of the national money supply that was a mul- tiple of the loss (gain) of gold through the balance of payments. The raising of the discount rate by the central bank of a deficit nation thus was not one of the “the rules of the game” of the gold standard.30 It was merely a byproduct of the cessation of credit expansion by a cen- tral bank that had been vainly attempting to maintain the domestic interest-rate structure below that prevailing on the global capital mar- ket. In other words, the fundamental rule of contract, not arbitrary and changeable rules of the game, dictated the central bank’s decision to preserve the redeemability of its demand liabilities at par.
Indeed, to the proponents of the NCS theory, the gold standard emerged in defiance of the arbitrary rules of the bimetallic standard adhered to by governments for centuries in a futile attempt to stabilize the exchange ratio between gold and silver.31 In the their view, then, the international gold standard was not a creation of policy rules but rather an organic product of the market economy, and its functioning, like
30 As Mises (Human Action, p. 459) explained: “it has been asserted that the ‘ortho- dox’ methods of fighting an external drain by raising the rate of discount no longer work because nations are no longer prepared to comply with ‘the rules of the game.’
Now the gold standard is not a game, but a social institution. Its working does not depend on the preparedness of any people to observe some arbitrary rules.”
31 Mises, Human Action, pp. 468–70.
that of all market institutions, was “controlled by the operation of inex- orable economic law.32
Anti-Deflation Policy and the Problem of “Hot Money”
Under the attenuated gold standard that arose in the 1920s, most central banks sought to evade the inevitable deflation of the domestic money pyramid entailed by external payments deficits. They began to treat money as a tool of policy rather than as simply the property of their depositors and note-holders who had been contractually assured complete and unimpeded disposal of their gold for domestic or for- eign transactions. The NCS theorists pointed out that the efforts of central banks in the postwar period to deliberately implement anti- deflation policy not only conflicted with their contractual obligations but disabled the balance of payments adjustment process that had operated under the gold standard to continually adapt the spatial dis- tribution of money to the ever changing conditions of international monetary equilibrium.
In a retrospective on his early contributions to international monetary theory, Machlup33 emphasized that equilibrating money flows were an inherent feature of the international gold standard and that the policy of creating domestic credit to replace gold and foreign exchange reserves lost through payments deficits only recreated mon- etary disequilibrium and caused further outflows of gold:
Under a gold standard … any excess stock of money leads to a deficit in the balance of payments which in turn leads to an outflow of gold reserves and to a concomitant contrac- tion of the money stock, restoring the balance … But all this presupposes that domestic credit creation does not recreate the excess money stock and rising prices. … I tried to make it clear that these policies of offsetting the contractionary effects of official sales of foreign exchange by expansions of domestic credit were sabotaging the adjustment mechanism.
32 Ibid., p. 459.
33 Machlup, “My Early work on International Money Problems,” pp. 118–19.