The Theory of Money and Credit - Ludwig von Mises [111]
During thousands of years, in all parts of the inhabited earth, innumerable sacrifices have been made to the chimera of just and reasonable prices. Those who have offended against the laws regulating prices have been heavily punished; their property has been confiscated, they themselves have been incarcerated, tortured, put to death. The agents of etatism have certainly not been lacking in zeal and energy. But, for all this, economic affairs cannot be kept going by magistrates and policemen.
4 The Balance-of-Payments Theory as a Basis of Currency Policy
According to the current view, the maintenance of sound monetary conditions is only possible with a "credit balance of payments." A country with a "debit balance of payments" is supposed to be unable permanently to stabilize the value of its money; the depreciation of the currency is supposed to have an organic basis and to be irremediable except by the removal of the organic defects.
The confutation of this and related objections is implicit in the quantity theory and in Gresham's law. The quantity theory shows that money can never permanently flow abroad from a country in which only metallic money is used (the "purely metallic currency" of the currency principle). The tightness in the domestic market called forth by the efflux of part of the stock of money reduces the prices of commodities, and so restricts importation and encourages exportation, until there is once more enough money at home. The precious metals which perform the function of money are distributed among individuals, and consequently among separate countries, according to the extent and intensity of the demand of each for money. State intervention to assure to the community the necessary quantity of money by regulating its international movements is supererogatory. An undesired efflux of money can never be anything but a result of state intervention endowing money of different values with the same legal tender All that the state need do, and can do, in order to preserve the monetary system undisturbed, is to refrain from such intervention. That is the essence of the monetary theory of the Classical economists and their immediate successors, the Currency School. It is possible to refine and amplify this doctrine with the aid of the modern subjective theory; but it is impossible to overthrow it, and impossible to put anything else in its place. Those who are able to forget it only show that they are unable to think as economists.
When a country has substituted credit money or fiat money for metallic money because the legal equating of the overissued paper and the metallic money sets in motion the mechanism described by Gresham's law, it is often asserted that the balance of payments determines the rate of exchange. But this also is a quite inadequate explanation. The rate of exchange is determined by the purchasing power possessed by a unit of each kind of money; it must be determined at such a level that it makes no difference whether commodities are purchased directly with the one kind of money or indirectly, through money of the other kind. If the rate of exchange moves away from the position that is determined by the purchasing-power parity, which we call the natural or equilibrium rate, then certain sorts of transaction would become profitable. It would become lucrative to purchase commodities with the money that was undervalued by the rate of exchange as compared with the ratio given by its purchasing power, and to sell them for the money that was overvalued in the rate of exchange in comparison with its purchasing power And because there were such opportunities of profit, there would be a demand on the foreign-exchange market for the money that was undervalued by the exchanges and this would raise the rate of exchange until it attained its equilibrium position. Rates of exchange vary because the quantity