The Indian “Gold-Exchange Standard” Received Great Praise from Keynes for Its Inflationary Potential

The gold-exchange standard was not created de novo by Great Britain in the interwar period. It is true that a number of European central banks before 1914 had held foreign exchange reserves in addition to gold, but these were strictly limited, and they were held as earning assets—these after all were privately owned central banks in need of earnings—not as instruments of monetary manipulation. But in a few cases, particularly where the pyramiding countries were from the Third World, they did function as a gold-exchange standard: that is, the Third World currency pyramided its currency on top of a key country’s reserves (pounds or dollars) instead of on gold. This system began in India, after the late 1870s, as a historical accident. The plan of the British imperial center was to shift India which, like many Third World countries, had been on a silver standard, onto a seemingly sounder gold, following the imperial nations. India’s reserves in pound sterling balances in London were supposed to be only a temporary transition to gold. But, as in so many cases of seeming transition, the Indian gold-exchange standard lingered on, and received great praise for its modern inflationary potential from John Maynard Keynes, then in his first economic post at the India Office. It was Keynes, after leaving the India Office and going to Cambridge, who trumpeted the new form of monetary system as a “limping” or imperfect gold standard but as a “more scientific and economic system,” which he dubbed the gold-exchange standard. As Keynes wrote in February 1910, “it is cheaper to maintain a credit at one of the great financial centres of the world, which can be converted with great readiness to gold when it is required.“ In a paper delivered the following year to the Royal Economic Society, Keynes proclaimed that out of this new system would evolve “the ideal currency of the future.”

Elaborating his views into his first book, Indian Currency and Finance (London, 1913), Keynes emphasized that the gold-exchange standard was a notable advance because it “economized” on gold internally and internationally, thus allowing greater “elasticity” of money (a longtime code word for ability to inflate credit) in response to business needs. Looking beyond India, Keynes prophetically foresaw the traditional gold standard as giving way to a more “scientific” system based on one or two key reserve centers. “A preference for a tangible reserve currency,” Keynes declared blithely, “is . . . a relic of a time when governments were less trustworthy in these matters than they are now.” He also believed that Britain was the natural center of the new reformed monetary order. While his book was still in proofs, Keynes was appointed a member of the Royal Commission on Indian Finance and Currency, to study and make recommendations for the basic institutions of the Indian monetary system. Keynes dominated the commission proceedings, and while he got his way on maintaining the gold-exchange standard, he was not able to convince the commission to adopt a central bank. However, he managed to bully it into including his annex favoring the state bank in its report, completed in early 1914. In addition, in his work on the commission, Keynes managed to enchant his doting mentor, Alfred Marshall, the unquestioned ruler of academic economists in Britain.

—Murray N. Rothbard, A History of Money and Banking in the United States: The Colonial Era to World War II, ed. Joseph T. Salerno (Auburn, AL: Ludwig von Mises Institute, 2002), 387-389.

Under the 1920s Gold-Exchange Standard, Britain “Exported” Her Inflation to Other Nations Without Paying a Price

The major twist, the major deformation of a genuine gold standard perpetrated by the British in the 1920s, was not the gold bullion standard, unfortunate though that was. The major inflationary camouflage was to return, not to a gold standard at all, but to a “gold-exchange” standard. In a gold-exchange standard, only one country, in this case Great Britain, is on a gold standard in the sense that its currency is actually redeemable in gold, albeit only gold bullion for foreigners. All other European countries, even though nominally on a gold standard, were actually on a pound-sterling standard. In short, a typical European country, say, “Ruritania,” would hold as reserves for its currency, not gold but British pounds sterling, in practice, bills or deposits payable in sterling at London. Anyone who demanded redemption for Ruritanian “rurs,” then, would receive British pounds rather than gold.

The gold-exchange standard, then, cunningly broke the classical gold standard’s stringent limits on monetary and credit expansion, not only for the other European countries, but also for the base or key currency country, Great Britain itself. Under the genuine gold standard, inflating the number of pounds in circulation would cause pounds to flow into the hands of other countries, which would demand gold in redemption. Thereby gold would move out of British bank and currency reserves, and pressure would be put on Britain to end its inflation and to contract credit. But, under the gold-exchange standard, the process was very different. If Britain inflated the number of pounds in circulation, the result, again, was a deficit in the balance of trade and sterling balances piling up in the accounts of other nations. But now that these nations have been induced to use pounds as their reserves rather than gold, these nations, instead of redeeming the pounds in gold, would inflate, and pyramid a multiple of their currency on top of their increased stock of pounds. Thus, instead of checking inflation, a gold-exchange standard encourages all countries to inflate on top of their increased supply of pounds. Britain, too, is now able to “export” her inflation to other nations without paying a price. Thus, in the name of sound money and a check against inflation, a pseudo gold standard was instituted, designed to induce a double-inverted pyramid of inflation, all on top of British pounds, the whole process supported by a gold stock that does not dwindle.

Since all other countries were sucked into the inflationary gold-exchange trap, it seemed that the only nation Britain had to worry about was the United States, the only country to continue on a genuine gold standard. That was the reason it became so vitally important for Britain to get the United States, through the Morgan connection, to go along with this system and to inflate, so that Britain would not lose gold to the United States.

—Murray N. Rothbard, A History of Money and Banking in the United States: The Colonial Era to World War II, ed. Joseph T. Salerno (Auburn, AL: Ludwig von Mises Institute, 2002), 384-386.

Michael Heilperin’s Error Was His Proposal for a Managed Gold Bullion Standard with Government as Money Manager

Like the more famous advocate of the gold standard, Jacques Rueff, Heilperin was long an opponent of the gold exchange standard and presented insightful and prophetic critiques of the system, especially as it operated during the Bretton Woods era (1946-1971). His prophecies of its eventual and inevitable collapse, though derided when they were initially advanced, were right on the money in light of later developments. This serves as an invaluable illustration of the usefulness of sound deductive economic theory in the forecasting of the evolution and devolution of broad patterns of economic activities. Moreover, Heilperin’s objections to the gold exchange standard have contemporary relevance in view of the support for a return to a system of the Bretton Woods type that has been voiced by a number of prominent supply siders and other advocates of a monetary “price rule.”

Contemporary proponents of a genuine gold standard can hopefully learn from the damaging mistakes committed by Heilperin in his characterization and defense of the international gold standard. His errors in this respect stem from a fundamental misconception, shared with most modern economic theorists and policymakers, of the nature and evolution of money and monetary institutions. It was this underlying “constructivist” approach to money that led Heilperin to propose a “semiautomatic” or “managed” gold bullion standard in which the government is accorded the role of money manager. The unfortunate fact is that proposals like Heilperin’s have lent credibility to the distorted portrayal of the gold standard as nothing more than a government price-fixing scheme carried out on a grand scale.

—Joseph T. Salerno, “Gold and the International Monetary System: The Contribution of Michael A. Heilperin,” in The Gold Standard: Perspectives in the Austrian School, ed. Llewellyn H. Rockwell Jr. (Auburn, AL: Ludwig von Mises Institute, 1992), 82.

The International Gold Standard Provided an Automatic Mechanism for Keeping the Balance of Payments in Equilibrium

The international gold standard provided an automatic market mechanism for checking the inflationary potential of government. It also provided an automatic mechanism for keeping the balance of payments of each country in equilibrium. As the philosopher and economist David Hume pointed out in the mid-eighteenth century, if one nation, say France, inflates its supply of paper francs, its prices rise; the increasing incomes in paper francs stimulate imports from abroad, which are also spurred by the fact that prices of imports are now relatively cheaper than prices at home. At the same time, the higher prices at home discourage exports abroad; the result is a deficit in the balance of payments, which must be paid for by foreign countries cashing in francs for gold. The gold outflow means that France must eventually contract its inflated paper francs in order to prevent a loss of all of its gold. If the inflation has taken the form of bank deposits, then the French banks have to contract their loans and deposits in order to avoid bankruptcy as foreigners call upon the French banks to redeem their deposits in gold. The contraction lowers prices at home, and generates an export surplus, thereby reversing the gold outflow, until the price levels are equalized in France and in other countries as well.

--Murray N. Rothbard, What Has Government Done to Our Money? (Auburn, AL: Ludwig von Mises Institute, 2010), 90-91.

The Interwar Revolution in Monetary Thinking: Internal Stability, Full Employment, and NO Regard to the Balance of Payments

Stripped of technicalities and of short-run considerations the controversy over exchange rates: fixed or flexible, is essentially an aspect of the broader controversy over international economic integration (on the basis of the price mechanism and a common standard of value) as opposed to economic nationalism. The latter takes the form, in the area of monetary relations, of concern over a country’s ‘monetary independence’. Flexible or floating exchange rates have, in the opinion of their advocates, the great virtue of allowing a country (i.e. a government) to adopt an internal monetary, financial and, indeed, economic policy without concern for balance-of-payments equilibrium. As Professor Friedrich A. Lutz wrote in the December 1954 issue of the Banca Nazionale del Lavoro Quarterly Review: ‘The main advantage that can be claimed for a policy of flexible exchange rates is that it allows a country both to avoid quantitative import controls and to follow . . . an “independent” monetary policy, i.e. a policy that is unaffected by deficits or surpluses in its balance of payments.’

Several years ago, writing in the same vein, Professor Alvin H. Hansen of Harvard University spoke of a revolution in monetary thinking: ‘In the interwar decades a new standard of monetary policy increasingly won its way—emancipation from the adjustment process dictated by the gold standard; freedom to pursue a programme of internal stability and full employment without regard to the balance of payments.’ I have italicized the last words of the quotation; they express, as does the earlier quotation from Professor Lutz, one of the widespread and yet very fallacious aspirations of certain governments (their number has happily shown a substantial decline of late) and of altogether too many learned economists, aspiration to ‘do as one pleases’ without suffering any adverse consequences. A very human aspiration indeed—but also one that has been proved time and again to be unattainable—and one in which it is rather unwise to persevere.

—Michael A. Heilperin, “Fixed Parities and International Order (1955),” in Aspects of the Pathology of Money: Monetary Essays from Four Decades (Auburn, AL: Ludwig von Mises Institute, 2007), Ludwig von Mises Institute e-book.

What Does “Keeping the General Price Level Stable in Some Sense” Mean for Policy Makers Today?

What does “keeping the general price level stable in some sense” mean for policy makers today? It certainly does not mean complete price-level stability. The shift from inelastic commodity money to elastic paper money was consummated precisely in order to allow the constant expansion of the money supply, and, as we have seen and as is not contested by the mainstream, this will lead to an ongoing decline in money’s purchasing power. Today’s macroeconomic consensus maintains that this is helpful for growth. In the preceding chapters we saw that this is not the case. Be that as it may, a too-rapid decline in money’s purchasing power is deemed undesirable, and good money is thus defined as money whose purchasing power diminishes constantly but at a moderate pace. Most major central banks now define price level stability as constant inflation of around 2 percent per annum.

In some way, the fixation with the price level is understandable if we consider that accelerating inflation and ultimately hyperinflation is an inherent risk in any paper currency but logically impossible in commodity money systems such as proper gold standards. As we will see in the next part of our investigation, every paper money system in history has, after some time, experienced rising inflation, and no paper money system in history has survived. Either a voluntary return to commodity money was accomplished before a complete currency meltdown occurred, or the system collapsed in hyperinflation and economic and social chaos. We are frequently told that this time is different. Policy makers assure us that they have learned the lessons of history and will now pay close attention to the inflation rate. Thus, we may appreciate why the price level has achieved such extraordinary importance in policy debates. This focus, however, has been the source of new and dangerous fallacies.

—Detlev S. Schlichter, Paper Money Collapse: The Folly of Elastic Money, 2nd ed. (Hoboken, NJ: John Wiley and Sons, 2014), 160-161.

Under the Gold standard, the Formation of the Value of the Monetary Unit Is Not Directly Subject to the Action of the Government

Under the gold standard, the formation of the value of the monetary unit is not directly subject to the action of the government. The production of gold is free and responds only to the opportunity for profit. All gold not introduced into trade for consumption or for some other purpose flows into the economy as money, either as coins in circulation or as bars or coins in bank reserves. Should the increase in the quantity of money exceed the increase in the demand for money, then the purchasing power of the monetary unit must fall. Likewise, if the increase in the quantity of money lags behind the increase in the demand for money, the purchasing power of the monetary unit will rise.

There is no doubt about the fact that, in the last generation, the purchasing power of gold has declined. Yet earlier, during the two decades following the German monetary reform and the great economic crisis of 1873, there was widespread complaint over the decline of commodity prices. Governments consulted experts for advice on how to eliminate this generally prevailing “evil.” Powerful political parties recommended measures for pushing prices up by increasing the quantity of money. In place of the gold standard, they advocated the silver standard, the double standard [bimetallism] or even a paper standard, for they considered the annual production of gold too small to meet the growing demand for money without increasing the purchasing power of the monetary unit. However, these complaints died out in the last five years of the nineteenth century, and soon men everywhere began to grumble about the opposite situation, i.e., the increasing cost of living. Just as they had proposed monetary reforms in the 1880s and 1890s to counteract the drop in prices, they now suggested measures to stop prices from rising.

—Ludwig von Mises, “Monetary Stabilization and Cyclical Policy (1928),” in The Causes of the Economic Crisis: And Other Essays Before and After the Great Depression, ed. Percy L. Greaves Jr., trans. Bettina Bien Greaves and Percy L. Greaves Jr. (Auburn, AL: Ludwig von Mises Institute, 2006), 60-61.

Both Fisher and Keynes Wanted a Government “Manipulated” Standard to Hold the Purchasing Power of the Monetary Unit Stable

One of the proposals, for a multiple commodity standard, was intended simply to supplement the precious metals standard. Putting it into practice would have left metallic money as a universally acceptable medium of exchange for all transactions not involving deferred monetary payments. (For the sake of simplicity in the discussion that follows, when referring to metallic money we shall speak only of gold.) Side by side with gold as the universally acceptable medium of exchange, the index or multiple commodity standard would appear as a standard of deferred payments.

Proposals have been made in recent years, however, which go still farther. These would introduce a “tabular,” or “multiple commodity,” standard for all exchanges when one commodity is not exchanged directly for another. This is essentially Keynes’ proposal. Keynes wants to oust gold from its position as money. He wants gold to be replaced by a paper standard, at least for trade within a country’s borders. The government, or the authority entrusted by the government with the management of monetary policy, should regulate the quantity in circulation so that the purchasing power of the monetary unit would remain unchanged.

The American, Irving Fisher, wants to create a standard under which the paper dollar in circulation would be redeemable, not in a previously specified weight of gold, but in a weight of gold which has the same purchasing power the dollar had at the moment of the transition to the new currency system. The dollar would then cease to represent a fixed amount of gold with changing purchasing power and would become a changing amount of gold supposedly with unchanging purchasing power. It was Fisher’s idea that the amount of gold which would correspond to a dollar should be determined anew from month to month, according to variations detected by the index number. Thus, in the view of both these reformers, in place of monetary gold, the value of which is independent of the influence of government, a standard should be adopted which the government “manipulates” in an attempt to hold the purchasing power of the monetary unit stable.

—Ludwig von Mises, “Monetary Stabilization and Cyclical Policy (1928),” in On the Manipulation of Money and Credit: Three Treatises on Trade-Cycle Theory, trans. Bettina Bien Greaves, ed. Percy L. Greaves Jr. (Indianapolis: Liberty Fund, 2011), 60-61.

Irving Fisher Made One of the First Attempts to Dismiss the Business Cycle as an Independent Economic Concept

In 1891, Fisher wrote the first dissertation in economics at Yale University, Mathematical Investigations in the Theory of Value and Prices (1892). It was directed in part by members of the Yale mathematics faculty and became a true landmark in the development of mathematical economics. The use of mathematics in economics spread in the first half of the twentieth century and came to dominate the economics profession in the second half of the century. It now enjoys near complete supremacy in graduate programs and in the leading academic journals devoted to economics. Likewise, the general equilibrium theorizing from his dissertation has also become the stock in trade of mainstream economics.

Fisher (1913) also changed how the economics profession viewed the quantity theory of money. He converted the classical view of the quantity theory from a theory into a mechanism that could (and should) be manipulated in order to stabilize the value of money. He presented his views in The Purchasing Power of Money, where he introduced the concept of a “compensated dollar.” He wanted to change our notion of the dollar from one of a coin with a constant weight of gold to one of a currency that had constant purchasing power. Fisher is therefore credited with forming the foundations of monetarism and the monetary policy rules used today by central bankers.

Fisher’s development of index numbers as a method of measuring the purchasing power of the dollar is also a landmark in the history of modem economic orthodoxy. His policy of price-level stabilization requires the central bank’s monetary policy to target and stabilize a price index. Fisher (1927) was one of the first to define and calculate index numbers and he even began to publish a weekly wholesale price index in the early 1920s. His foundational work The Making of Index Numbers showed the basis of how central bankers could conduct and review monetary policy. Modern mainstream economists today would view any other approach to monetary policy as unscientific and they are in agreement with Fisher that price-level inflation and deflation are inherently bad things, and that the value of the dollar (as measured by price indexes) should be stabilized like physical measurements such as the meter or kilogram. Fisher (1925) can also be credited with one of the first attempts to dismiss the business cycle as an independent economic concept.⁷ He even discovered what was to become the famous Phillips curve (which depicts an inverse relationship between inflation and unemployment) decades prior to A. W. Phillips. In this light, modem macroeconomics can be seen as nothing but a thick layer of dust on the foundations laid by Fisher.

⁷ See Fisher (1925) where he attempts to empirically show that it is the instability of the purchasing power of the dollar that is the problem, not the business cycle per se. Mainstream economists also dismiss the idea of the business cycle and that it is really just “shocks” and “real factors” that cause changes in the economy. See for example Milton Friedman's (1993) plucking model.

—Mark Thornton, “The Great Depression: Mises vs. Fisher,” Quarterly Journal of Austrian Economics 11, no. 3 (Fall 2008): 233, 233n7.

In 1928, Mises Published a Book Predicting that Fisher’s Approach Would Lead to an Economic Crisis and Collapse

Ludwig von Mises established the foundations of modern Austrian economics while Irving Fisher established the foundations of modern mainstream macroeconomics and central bank policy. Fisher helped create and was a proponent of mathematical economics, statistics and index numbers, and a monetary policy that “stabilized” the value of the dollar. Fisher claimed that his scientific approach established a new era of prosperity during the 1920s. Mises published a book in 1928 that critiqued Fisher’s approach and predicted that it would lead to an economic crisis and collapse. Before the stock market crash in 1929 Fisher proclaimed a perpetual prosperity for the economy and continued to recommend investing in stocks long after the market had collapsed. In this important case study, Mises passed the “market test” while Fisher lost his personal fortune during an economic crisis that his economics help create.

—Mark Thornton, “The Great Depression: Mises vs. Fisher,” abstract, Quarterly Journal of Austrian Economics 11, no. 3 (Fall 2008): 230.

During the 1930s, Fisher and the Chicago School Were “pre-Keynes Keynesians” Wanting to “Reflate” the Price Level

And now, in his highly touted Monetary History of the United States, Friedman has demonstrated his Fisherine bias in interpreting American economic history. Benjamin Strong, undoubtedly the single most disastrous influence upon the economy of the 1920s, is lionized by Friedman for his inflation and price-level stabilization during that decade. In fact, Friedman attributes the 1929 depression not to the preceding inflation boom but to the failure of the post-Strong Federal Reserve to inflate the money supply enough before and during the depression.

In short, while Milton Friedman has performed a service in bringing back to the notice of the economics profession the overriding influence of money and the money supply on business cycles, we must recognize that this “purely monetarist” approach is almost the exact reverse of the sound—as well as truly free-market—Austrian view. For while the Austrians hold that Strong’s monetary expansion made a later 1929 crash inevitable, Fisher-Friedman believe that all the Fed needed to do was to pump more money in to offset any recession. Believing that there is no causal influence running from boom to bust, believing in the simplistic “Dance of the Dollar” theory, the Chicagoites simply want government to manipulate that dance, specifically to increase the money supply to offset recession.

During the 1930s, therefore, the Fisher-Chicago position was that, in order to cure the depression, the price level needed to be “reflated” back to the levels of the 1920s, and that reflation should be accomplished by:

1. the Fed expanding the money supply, and
2. the Federal government engaging in deficit spending and large-scale public works programs.

In short, during the 1930s, Fisher and the Chicago School were “pre-Keynes Keynesians,” and were, for that reason, considered quite radical and socialistic—and with good reason. Like the later Keynesians, the Chicagoans favored a “compensatory” monetary and fiscal policy, though always with greater stress on the monetary arm.

—Murray N. Rothbard, “Milton Friedman Unraveled,” in Economic Controversies (Auburn, AL: Ludwig von Mises Institute, 2011), 906-907.

The Chicagoite “Pure Monetary” Theory of the Business Cycle and the “Dance” of the “Price Level”

But the key problem with Friedman’s Fisherine approach is the same orthodox separation of the micro and macro spheres that played havoc with his views on taxation. For Fisher believed, again, that on the one hand there is a world of individual prices determined by supply and demand, but on the other hand there is an aggregate “price level” determined by the supply of money and its velocity of turnover, and never the twain do meet. The aggregate, macro, sphere is supposed to be the fit subject of government planning and manipulation, again supposedly without affecting or interfering with the micro area of individual prices.

In keeping with this outlook, Irving Fisher wrote a famous article in 1923, “The Business Cycle Largely a ‘Dance of the Dollar’”—recently cited favorably by Friedman—which set the model for the Chicagoite “purely monetary” theory of the business cycle. In this simplistic view, the business cycle is supposed to be merely a “dance,” in other words, an essentially random and causally unconnected series of ups and downs in the “price level.” The business cycle, in short, is random and needless variations in the aggregate level of prices. Therefore, since the free market gives rise to this random “dance,” the cure for the business cycle is for the government to take measures to stabilize the price level, to keep that level constant. This became the aim of the Chicago School of the 1930s, and remains Milton Friedman’s goal as well.

—Murray N. Rothbard, “Milton Friedman Unraveled,” in Economic Controversies (Auburn, AL: Ludwig von Mises Institute, 2011), 904.

The Keynesian and Fisherian/Chicagoan Bodies of Monetary Thought Theorize in an “Acatallactic” Fashion

There is, and always has been, wide disagreement among economists on the basic principles that determine the purchasing power of all this money. But in spite of all the disagreements among economists, there are only two basic schools of thought. One endeavors to explain the purchasing power of money on the basis of individual choice and action and to develop the theory of the value of money from a general theory of value. Its monetary doctrines remain an integrated part of general economics, and as such may be called the integrated or catallactic monetary doctrines. The other school embodies all doctrines and theories that are alien to any theory of exchange or system of the market society, and thus deny the principles of individual choice and exchange. Such monetary doctrines may be called segregated or acatallactic, for they do not view money as a market phenomenon.

Most contemporary theories of the value of money must be classified as acatallactic. Presented in mathematical, holistic equations, they either ignore individual choice and valuation, or merely pay lip service to individual action while theorizing about collective wholes. Some writers, especially in government, resemble the medieval schoolmen who ascribed the power to fix the values of coins to their princes. They hold that the value of money is a valor impositus, a value authenticated by the President and enforced through price and wage controls. To them, monetary phenomena, like all the phenomena of social life, are merely manifestations of the exercise of political power and government force. Their monetary explanations are not fallacious theories — they are not theories at all.

Some even deny the very existence of the science of economics. The radical inflationists, for instance, question the natural scarcity of economic goods and services, which is the very object of economic analysis. They blame selfish restraints on credit expansion imposed by bankers and other money lenders as the causes of scarcity and poverty, and therefore recommend unlimited public spending as the panacea. Their monetary pronouncements are built on a denial of economics.

But the two most popular bodies of monetary thought which shape contemporary monetary policies actually pay lip service to subjective economic theory while theorizing in acatallactic fashion. Both the income-expenditure theory of John Maynard Keynes and his numerous followers, and the quantity theory of Irving Fisher and his disciples, especially at the University of Chicago, completely ignore their catallactic premises when they arrive at the value of money. They deal with “price levels,” “national economies as a whole,” “levels of national output, employment, and income,” and other holistic concepts that have no place in subjective economic thought. Such theories are as sterile and futile as their primitive acatallactic predecessors, but they are very popular with governments eager to indulge in deficit spending.

An integrated or catallactic explanation of the value of money starts with the subjective valuations and actions of individuals. It never loses sight of the fact that a complete theory of money must rest on the subjective theory of value. In order to explain the determinants of the purchasing power of money and not only the causes of its changes, it endeavors to analyze the subjective significance or utility money has for individuals. For just as the price of an economic good is ultimately determined by the subjective valuation of buyers and sellers, so is the purchasing power of money.


—Hans F. Sennholz, “The Value of Money,” in Age of Inflation (Belmont, MA: Western Islands, 1979), 11-13.