A Tract on Monetary Reform: Chapter IV - Alternative Aims in Monetary Policy

A Tract on Monetary Reform, by John Maynard Keynes is part of HackerNoon’s Book Blog Post series. You can jump to any chapter in this book here. Chapter IV: Alternative Aims in Monetary Policy

CHAPTER IV. ALTERNATIVE AIMS IN MONETARY POLICY

Our first two chapters, on the evils proceeding from instability in the purchasing power of money and on the part played by the exigencies of Public Finance, have indicated the practical importance of our subject to the welfare of society. In the third chapter an attempt has been made to lay a foundation of theory upon which to raise constructions. We can now turn, in this and the following chapter, to Remedies.

The instability of money has been compounded, in most countries except the United States, of two elements: the failure of the national currencies to remain stable in terms of what was supposed to be the standard of value, namely gold; and the failure of gold itself to remain stable in terms of purchasing power. Attention has been mainly concentrated (e.g. by the Cunliffe Committee) on the first of these two factors. It is often assumed that the restoration of the gold standard, that is to say, of the convertibility of each national currency at a fixed rate in terms of gold, must be, in any case, our objective; and that the main question of controversy is whether national currencies should be restored to their pre-war gold value or to some lower value nearer to the present facts; in other words, the choice between Deflation and Devaluation.

This assumption is hasty. If we glance at the course of prices during the last five years, it is obvious that the United States, which has enjoyed a gold standard throughout, has suffered as severely as many other countries, that in the United Kingdom the instability of gold has been a larger factor than the instability of the exchange, that the same is true even of France, and that in Italy it has been nearly as large. On the other hand, in India, which has suffered violent exchange fluctuations, the standard of value, as we shall see below, has been more stable than in any other country.

We should not, therefore, by fixing the exchanges get rid of our currency troubles. It is even possible that this step might weaken our control. The problem of stabilisation has several sides, which we must consider one by one:

1. Devaluation versus Deflation. Do we wish to fix the standard of value, whether or not it be gold, near the existing value? Or do we wish to restore it to the pre-war value?

2. Stability of Prices versus Stability of Exchange. Is it more important that the value of a national currency should be stable in terms of purchasing power, or stable in terms of the currency of certain foreign countries?

3. The Restoration of a Gold Standard. In the light of our answers to the first two questions, is a gold standard, however imperfect in theory, the best available method for attaining our ends in practice?

Having decided between these alternative aims, we can proceed, in the next chapter, to some constructive suggestions.

I. Devaluation versus Deflation.

The policy of reducing the ratio between the volume of a country’s currency and its requirements of purchasing power in the form of money, so as to increase the exchange value of the currency in terms of gold or of commodities, is conveniently called Deflation.

The alternative policy of stabilising the value of the currency somewhere near its present value, without regard to its pre-war value, is called Devaluation.

Up to the date of the Genoa Conference of April 1922, these two policies were not clearly distinguished by the public, and the sharp opposition between them has been only gradually appreciated. Even now (October 1923) there is scarcely any European country in which the authorities have made it clear whether their policy is to stabilise the value of their currency or to raise it. Stabilisation at the existing level has been recommended by International Conferences;40 and the actual value of many currencies tends to fall rather than to rise. But, to judge from other indications, the heart’s desire of the State Banks of Europe, whether they pursue it successfully, as in Czecho-Slovakia, or unsuccessfully, as in France, is to raise the value of their currencies. In only one country so far have practical steps been taken to fix the exchange, namely in Austria.

40 Whilst the Conference of Genoa (April 1922) affirmed the doctrine in general, representatives of the countries chiefly affected were united in declaring that it must not be applied to them in particular. Signor Peano, M. Picard, and M. Theunis, speaking on behalf of Italy, France, and Belgium, announced, each for his own country, that they would have nothing to do with devaluating, and were determined to restore their respective currencies to their pre-war values. Reform is not likely to come by joint, simultaneous action. The experts of Genoa recognised this when they “ventured to suggest” that “a considerable service will be rendered by that country which first decides boldly to set the example of securing immediate stability in terms of gold” by devaluation.

The simple arguments against Deflation fall under two heads.

In the first place, Deflation is not desirable, because it effects, what is always harmful, a change in the existing Standard of Value, and redistributes wealth in a manner injurious, at the same time, to business and to social stability. Deflation, as we have already seen, involves a transference of wealth from the rest of the community to the rentier class and to all holders of titles to money; just as inflation involves the opposite. In particular it involves a transference from all borrowers, that is to say from traders, manufacturers, and farmers, to lenders, from the active to the inactive.

But whilst the oppression of the taxpayer for the enrichment of the rentier is the chief lasting result, there is another, more violent, disturbance during the period of transition. The policy of gradually raising the value of a country’s money to (say) 100 per cent above its present value in terms of goods—I repeat here the arguments of Chapter I.—amounts to giving notice to every merchant and every manufacturer, that for some time to come his stock and his raw materials will steadily depreciate on his hands, and to every one who finances his business with borrowed money that he will, sooner or later, lose 100 per cent on his liabilities (since he will have to pay back in terms of commodities twice as much as he has borrowed). Modern business, being carried on largely with borrowed money, must necessarily be brought to a standstill by such a process. It will be to the interest of every one in business to go out of business for the time being; and of every one who is contemplating expenditure to postpone his orders so long as he can. The wise man will be he who turns his assets into cash, withdraws from the risks and the exertions of activity, and awaits in country retirement the steady appreciation promised him in the value of his cash. A probable expectation of Deflation is bad enough; a certain expectation is disastrous. For the mechanism of the modern business world is even less adapted to fluctuations in the value of money upwards than it is to fluctuations downwards.

In the second place, in many countries, Deflation, even were it desirable, is not possible; that is to say, Deflation in sufficient degree to restore the currency to its pre-war parity. For the burden which it would throw on the taxpayer would be insupportable. I need add nothing on this to what I have already written in the second chapter above. This practical impossibility might have rendered the policy innocuous, if it were not that, by standing in the way of the alternative policy, it prolongs the period of uncertainty and severe seasonal fluctuation, and even, in some cases, can be carried into effect sufficiently to cause much interference with business. The fact, that the restoration of their currencies to the pre-war parity is still the declared official policy of the French and Italian Governments, is preventing, in those countries, any rational discussion of currency reform. All those—and in the financial world they are many—who have reasons for wishing to appear “correct,” are compelled to talk foolishly. In Italy, where sound economic views have much influence and which may be nearly ripe for currency reform, Signor Mussolini has threatened to raise the lira to its former value. Fortunately for the Italian taxpayer and Italian business, the lira does not listen even to a dictator and cannot be given castor oil. But such talk can postpone positive reform; though it may be doubted if so good a politician would have propounded such a policy, even in bravado and exuberance, if he had understood that, expressed in other but equivalent words, it was as follows: “My policy is to halve wages, double the burden of the National Debt, and to reduce by 50 per cent the prices which Sicily can get for her exports of oranges and lemons.”

One single country—Czechoslovakia—has made the experiment on a modest but sufficient scale. Comparatively free from the burden of internal debt, and free also from serious budgetary deficits, Czechoslovakia was able in the course of 1922, in pursuance of the policy of her Finance Minister, Dr. Alois Rasin, to employ the proceeds of certain foreign loans to improve the exchange value of the Czech crown to nearly three times the rate which had been touched in the previous year. The policy has cost her an industrial crisis and serious unemployment. To what purpose? I do not know. Even now the Czech crown is not worth a sixth of its pre-war parity; and it remains unstabilised, fluttering before the breath of the seasons and the wind of politics. Is, therefore, the process of appreciation to continue indefinitely? If not, when and at what point is stabilisation to be effected? Czechoslovakia was better placed than any country in Europe to establish her economic life on the basis of a sound and fixed currency. Her finances were in equilibrium, her credit good, her foreign resources adequate, and no one could have blamed her for devaluating the crown, ruined by no fault of hers and inherited from the Habsburg Empire. Pursuing a misguided policy in a spirit of stern virtue, she preferred the stagnation of her industries and a still fluctuating standard.41

41 I cannot criticise the work, in his second term of office (1922), of Dr. Rasin, now fallen by the hand of an assassin, without reference to his great achievement during his first term (1919) in rescuing his country’s currency from the surrounding chaos. The stamping of the Austrian notes and the levy on holders of titles to money which accompanied it was the only drastic, courageous, and successful measure of finance carried through anywhere in Europe at that epoch; the story of it from Dr. Rasin’s own pen can be read in his The Financial Policy of Czecho-Slovakia. Before he had finished other influences became dominant. But, when in 1922 this austere and disinterested Minister returned to office, he missed, in my judgment, his opportunity. He could have completed his task by establishing the currency on a fixed and stable basis, instead of which he used his great authority to disorder trade by a futile process of Deflation.

* * * * *

If the restoration of many European currencies to their pre-war parity with gold is neither desirable nor possible, what are the forces or the arguments which have established this undesirable impossibility as the avowed policy of most of them? The following are the most important:

1. To leave the gold value of a country’s currency at the low level to which war has driven it is an injustice to the rentier class and to others whose income is fixed in terms of currency, and practically a breach of contract; whilst to restore its value would meet a debt of honour.

The injury done to pre-war holders of fixed interest-bearing stocks is beyond dispute. Real justice, indeed, might require the restoration of the purchasing power,148 and not merely the gold value, of their money incomes, a measure which no one in fact proposes; whilst nominal justice has not been infringed, since these investments were not in gold bullion but in the legal tender of the realm. Nevertheless, if this class of investors could be dealt with separately, considerations of equity and the expedience of satisfying reasonable expectation would furnish a strong case.

But this is not the actual situation. The vast issues of War Loans have swamped the pre-war holdings of fixed interest-bearing stocks, and society has largely adjusted itself to the new situation. To restore the value of pre-war holdings by Deflation means enhancing at the same time the value of war and post-war holdings, and thereby raising the total claims of the rentier class not only beyond what they are entitled to, but to an intolerable proportion of the total income of the community. Indeed justice, rightly weighed, comes down on the other side. Much the greater proportion of the money contracts still outstanding were entered into when money was worth more nearly what it is worth now than what it was worth in 1913. Thus, in order to do justice to a minority of creditors, a great injustice would be done to a great majority of debtors.

This aspect of the matter has been admirably argued by Professor Irving Fisher.42 We forget, he says, that not all contracts require the same adjustment in order to secure justice, and that while we are debating whether we ought to deflate to secure ideal justice for those who made contracts on old price levels, new contracts are constantly being made at the new price levels. An estimate of the volume of contracts now outstanding, classified according to their age, would show that some contracts are a day old, some are a month old, some are a year old, some are a decade old, and some are a century old, the great mass, however, being of very recent origin. Consequently the average, or centre of gravity, of the total existing indebtedness is probably always somewhat near the present. Before the war, Professor Fisher estimated, very roughly, that contracts in the United States were on the average about one year old.

42 In his article “Devaluation versus Deflation,” published in the eleventh Manchester Guardian Reconstruction Supplement (Dec. 7, 1922).

When, therefore, the depreciation of the currency has lasted long enough for society to adjust itself to the new values, Deflation is even worse than Inflation. Both are “unjust” and disappoint reasonable expectation. But whereas Inflation, by easing the burden of national debt and stimulating enterprise, has a little to throw into the other side of the balance, Deflation has nothing.

2. The restoration of a currency to its pre-war gold value enhances a country’s financial prestige and promotes future confidence.

Where a country can hope to restore its pre-war parity at an early date, this argument cannot be neglected. This might be said of Great Britain, Holland, Sweden, Switzerland, and (perhaps) Spain, but of no other European country. The argument cannot be extended to those countries which, even if they could raise somewhat the value of their legal-tender money, could not possibly restore it to its old value. It is of the essence of the argument that the exact pre-war parity should be recovered. It would not make much difference to the financial prestige of Italy whether she stabilised the lira at 100 to the £ sterling or at 60; and it would be much better for her prestige to stabilise it definitely at 100 than to let it fluctuate between 60 and 100.

This argument is limited, therefore, to those countries the gold value of whose currencies is within (say) 5 or 10 per cent of their former value. Its force in these cases depends, I think, upon what answer we give to the problem discussed below, namely, whether we intend to pin ourselves in the future, as in the past, to an unqualified gold standard. If we still prefer such a standard to any available alternative, and if future “confidence” in our currency is to depend not on the stability of its purchasing power but on the fixity of its gold-value, then it may be worth our while to stand the racket of Deflation to the extent of 5 or 10 per cent. This view is in accordance with that expressed by Ricardo in analogous circumstances a hundred years ago.43 If, on the other hand, we decide to aim for the future at stability of the price level rather than at a fixed parity with gold, in that case cadit quaestion.

43 See below, p. 153.

In any case this argument does not affect our main conclusion, that the right policy for countries of which the currency has suffered a prolonged and severe depreciation is to devaluate, and to fix the value of the currency at that figure in the neighbourhood of the existing value to which commerce and wages are adjusted.

3. If the gold value of a country’s currency can be increased, labour will profit by a reduced cost of living, foreign goods will be obtainable cheaper, and foreign debts fixed in terms of gold (e.g. to the United States) will be discharged with less effort.

This argument, which is pure delusion, exercises quite as much influence as the other two. If the franc is worth more, wages, it is argued, which are paid in francs, will surely buy more, and French imports, which are paid for in francs, will be so much cheaper. No! If francs are worth more they will buy more labour as well as more goods,—that is to say, wages will fall; and the French exports, which pay for the imports, will, measured in francs, fall in value just as much as the imports. Nor will it make in the long run any difference whatever in the amount of goods the value of which England will have to transfer to America to pay her dollar debts, whether in the end sterling settles down at four dollars to the pound, or at its pre-war parity. The burden of this debt depends on the value of gold, in terms of which it is fixed, not on the value of sterling. It is not easy, it seems, for men to apprehend that their money is a mere intermediary, without significance in itself, which flows from one hand to another, is received and is dispensed, and disappears when its work is done from the sum of a nation’s wealth.

* * * * *

In concluding this section, let me quote on the issue between Deflation and Devaluation two classic authorities, Gibbon and Ricardo, the one to represent the imposing but false wisdom of the would-be upright statesman, the other to speak in clear tones the voice of instructed reason.

In the eleventh chapter of The Decline and Fall, Gibbon deems incredible a story of how in a.d. 274 Aurelian’s deflationary zeal to restore the integrity of the coin excited an insurrection which caused the death of 7000 soldiers. “We might naturally expect,” he says, “that the reformation of the coin should have been an action equally popular with the destruction of those obsolete accounts, which by the emperor’s order were burnt in the forum of Trajan. In an age when the principles of commerce were so imperfectly understood, the most desirable end might perhaps be effected by harsh and injudicious means; but a temporary grievance of such a nature can scarcely excite and support a serious civil war. The repetition of intolerable taxes, imposed either on the land or on the necessaries of life, may at last provoke those who will not or who cannot relinquish their country. But the case is far otherwise in every operation which, by whatsoever expedients, restores the just value of money.”

Rome may have understood the principles of commerce imperfectly in the third century and not perfectly in the twentieth; but that does not save her citizens from experiencing their applications. Signor Mussolini might peruse with interest the annals of Aurelian, who, “ignorant or impatient of the restraints of civil institutions,” fell by the hand of an assassin within a year of his deflation of the currency, “regretted by the army, detested by the Senate, but universally acknowledged as a warlike and fortunate prince, the useful though severe reformer of a degenerate State.”

Ricardo, speaking in the House of Commons on the 12th of June 1822,44 gave his opinion that: “If in the year 1819 the value of the currency had stood at 14s. for the pound note, which was the case in the year 1813, he should have thought that, on a balance of all the advantages and disadvantages of the case, it would have been as well to fix the currency at the then value, according to which most of the existing contracts had been made; but when the currency was within 5 per cent of its par value, he thought they had made the best selection in recurring to the old standard.”

44 The great debate of June 11 and 12, 1822, on Mr. Western’s Motion concerning the Resumption of Cash Payments, well illustrates, more particularly in the speeches of the opener, Mr. Western, and of the opposer, Mr. Huskisson, the regularity of the evils which follow a deflationary raising of the standard, and the unchanging antithesis between the temperaments of deflationists and devaluers, though I doubt if any present-day deflationists could make a speech at the same time so able and so unfair as Mr. Huskisson’s.

The same is repeated in his Protection to Agriculture45 where he approves the restoration of the old standard when gold was £4 : 2s. per standard ounce, but adds that, if it had been £5 : 10s., “no measure could have been more inexpedient than to make so violent a change in all subsisting engagements.”

45 Works, p. 468.

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