C H A P T E R     S I X T E E N

Market and Productive Organization

Even capitalist business itself had to be sheltered from the unrestricted working of the market mechanism. This should dispose of the suspicion which the very term “man” and “nature” sometimes awaken in sophisticated minds, who tend to denounce all talk about protecting labor and land as the product of antiquated ideas if not as a mere camouflaging of vested interests.

Actually, in the case of productive enterprise as in that of man and nature the peril was real and objective. The need for protection arose on account of the manner in which the supply of money was organized under a market system. Modern central banking, in effect, was essentially a device developed for the purpose of offering protection without which the market would have destroyed its own children, the business enterprises of all kinds. Eventually, however, it was this form of protection which contributed most immediately to the downfall of the international system.

While the perils threatening land and labor from the maelstrom of the market are fairly obvious, the dangers to business inherent in the monetary system are not as readily apprehended. Yet if profits depend upon prices, then the monetary arrangements upon which prices depend must be vital to the functioning of any system motivated by profits. While, in the long run, changes in selling prices need not affect profits, since costs will move up and down correspondingly, this is not true in the short run, since there must be a time lag before contractually fixed prices change. Among them is the price of labor which, together with many other prices, would naturally be fixed by contract. Hence, if the price level was falling for monetary reasons over a considerable time, business would be in danger of liquidation accompanied by the dissolution of productive organization and massive destruction of capital. Not low prices, but falling prices were the trouble. Hume became the founder of the quantity theory of money with his discovery that business remains unaffected if the amount of money is halved since prices will simply adjust to half their former level. He forgot that business might be destroyed in the process.

This is the easily understandable reason why a system of commodity money, such as the market mechanism tends to produce without outside interference, is incompatible with industrial production. Commodity money is simply a commodity which happens to function as money, and its amount, therefore, cannot, in principle, be increased at all, except by diminishing the amount of the commodities not functioning as money. In practice commodity money is usually gold or silver, the amount of which can be increased, but not by much, within a short time. But the expansion of production and trade unaccompanied by an increase in the amount of money must cause a fall in the price level—precisely the type of ruinous deflation which we have in mind. Scarcity of money was a permanent, grave complaint with seventeenth-century merchant communities. Token money was developed at an early date to shelter trade from the enforced deflations that accompanied the use of specie when the volume of business swelled. No market economy was possible without the medium of artificial money.

The real difficulty arose with the need for stable foreign exchanges and the consequent introduction of the gold standard, about the time of the Napoleonic Wars. Stable exchanges became essential to the very existence of English economy; London had become the financial center of a growing world trade. Yet nothing else but commodity money could serve this end for the obvious reason that token money, whether bank or fiat, cannot circulate on foreign soil. Hence the gold standard—the accepted name for a system of international commodity money—came to the fore.

But for domestic purposes, as we know, specie is an inadequate money just because it is a commodity and its amount cannot be increased at will. The amount of gold available may be increased by a small percentage over a year, but not by as many dozen within a few weeks, as might be required to carry a sudden expansion of transactions. In the absence of token money business would have to be either curtailed or carried on at very much lower prices, thus inducing a slump and creating unemployment.

In its simplest form the problem was this: commodity money was vital to the existence of foreign trade; token money, to the existence of domestic trade. How far did they agree with each other?

Under nineteenth-century conditions foreign trade and the gold standard had undisputed priority over the needs of domestic business. The working of the gold standard required the lowering of domestic prices whenever the exchange was threatened by depreciation. Since deflation happens through credit restrictions, it follows that the working of commodity money interfered with the working of the credit system. This was a standing danger to business. Yet to discard token money altogether and restrict currency to commodity money was entirely out of the question, since such a remedy would have been worse than the disease.

Central banking mitigated this defect of credit money greatly. By centralizing the supply of credit in a country, it was possible to avoid the wholesale dislocation of business and employment involved in deflation and to organize deflation in such a way as to absorb the shock and spread its burden over the whole country. The bank in its normal function was cushioning the immediate effects of gold withdrawals on the circulation of notes as well as of the diminished circulation of notes on business.

The bank might use various methods. Short-term loans might bridge the gap caused by short-run losses of gold, and avoid the need for credit restrictions altogether. But even when restrictions of credit were inevitable, as was often the case, the bank’s action had a buffer effect: the raising of the bank rate as well as open-market operations spread the effects of restrictions to the whole community while shifting the burden of the restrictions to the strongest shoulders.

Let us envisage the crucial case of transferring one-sided payments from one country to another, such as might be caused by a shift in demand from domestic to foreign types of food. The gold that now has to be sent abroad in payment for the imported food would otherwise be used for inland payments, and its absence must cause a falling off of domestic sales and a consequent drop in prices. We will call this type of deflation “transactional,” since it spreads from individual firm to firm according to their fortuitous business dealings. Eventually, the spread of deflation will reach the exporting firms and thus achieve the export surplus which represents “real” transfer. But the harm and damage caused to the community at large will be much greater than that which was strictly necessary to achieve such an export surplus. For there are always firms just short of being able to export, which need only the inducement of a slight reduction of costs to “go over the top,” and such a reduction can be most economically achieved by spreading the deflation thinly over the whole of the business community.

This precisely was one of the functions of the central bank. The broad pressure of its discount and open-market policy forced domestic prices down more or less equally, and enabled “export-near” firms to resume or increase exports, while only the least efficient firms would have to liquidate. “Real” transfer would thus have been achieved at the cost of a much smaller amount of dislocation than would have been needed to attain the same export surplus by the irrational method of haphazard and often catastrophic shocks transmitted through the narrow channels of “transactional” deflation.

That in spite of these devices to mitigate the effects of deflation, the outcome was, nevertheless, again and again a complete disorganization of business and consequent mass unemployment, is the most powerful of all the indictments of the gold standard.

The case of money showed a very real analogy to that of labor and land. The application of the commodity fiction to each of them led to its effective inclusion into the market system, while at the same time grave dangers to society developed. With money, the threat was to productive enterprise, the existence of which was imperiled by any fall in the price level caused by use of commodity money. Here also protective measures had to be taken, with the result that the self-steering mechanism of the market was put out of action.

Central banking reduced the automatism of the gold standard to a mere pretense. It meant a centrally managed currency; manipulation was substituted for the self-regulating mechanism of supplying credit, even though the device was not always deliberate and conscious. More and more it was recognized that the international gold standard could be made self-regulating only if the single countries relinquished central banking. The one consistent adherent of the pure gold standard who actually advocated this desperate step was Ludwig von Mises; his advice, had it been heeded, would have transformed national economies into a heap of ruins.

Most of the confusion existing in monetary theory was due to the separation of politics and economics, this outstanding characteristic of market society. For more than a century, money was regarded as a purely economic category, a commodity used for the purpose of indirect exchange. If gold was the commodity so preferred, a gold standard was in being. (The attribute “international” in connection with that standard was meaningless, since for the economist, no nations existed; transactions were carried on not between nations but between individuals, whose political allegiance was as irrelevant as the color of their hair.) Ricardo indoctrinated nineteenth-century England with the conviction that the term “money” meant a medium of exchange, that bank notes were a mere matter of convenience, their utility consisting in their being easier to handle than gold, but that their value derived from the certainty that their possession provided us with the means of possessing ourselves at any time of the commodity itself, gold. It follows that the national character of currencies was of no consequence, since they were but different tokens representing the same commodity. And if it was injudicious for a government to make any effort to possess itself of gold (since the distribution of that commodity regulated itself on the world market just as that of any other), it was even more injudicious to imagine that the nationally different tokens were of any relevance to the welfare and prosperity of the countries concerned.

Now the institutional separation of the political and economic spheres had never been complete, and it was precisely in the matter of currency that it was necessarily incomplete; the state, whose mint seemed merely to certify the weight of coins, was in fact the guarantor of the value of token money, which it accepted in payment for taxes and otherwise. This money was not a means of exchange, it was a means of payment; it was not a commodity, it was purchasing power; far from having utility itself, it was merely a counter embodying a quantified claim to things that would be purchased. Clearly, a society in which distribution depended upon the possession of such tokens of purchasing power was a construction entirely different from market economy.

We are not dealing here, of course, with pictures of actuality, but with conceptual patterns used for the purposes of clarification. No market economy separated from the political sphere is possible; yet it was such a construction which underlay classical economics since David Ricardo and apart from which its concepts and assumptions were incomprehensible. Society, according to this layout, consisted of bartering individuals possessing an outfit of commodities—goods, land, labor, and their composites. Money was simply one of the commodities bartered more often than another and, hence, acquired for the purpose of use in exchange. Such a “society” may be unreal; yet it contains the bare bones of the construction from which the classical economists started.

An even less complete picture of actuality is offered by a purchasing-power economy.^* Yet some of its features resemble actual society much more closely than the paradigm of market economy. Let us try to imagine a “society” in which every individual is endowed with a definite amount of purchasing power, enabling him to claim goods each item of which is provided with a price tag. Money in such an economy is not a commodity; it has no usefulness in itself; its only use is to purchase goods to which price tags are attached, very much as they are in our shops today.

While the commodity money theorem was far superior to its rival in the nineteenth century when institutions conformed in many essentials to the market pattern, since the beginning of the twentieth century the conception of purchasing power gained steadily. With the disintegration of the gold standard, commodity money practically ceased to exist, and it was only natural that the purchasing power concept of money should replace it.

To turn from mechanisms and concepts to the social forces in play, it is important to realize that the ruling classes themselves lent their support to the management of the currency through the central bank. Such management was not, of course, regarded as an interference with the institution of the gold standard; on the contrary, it was part of the rules of the game under which the gold standard was supposed to function. Since maintenance of the gold standard was axiomatic and the central banking mechanism was never allowed to act in such a way as to make a country go off gold, but, on the contrary, the supreme directive of the bank was always and under all conditions to stay on gold, no question of principle seemed to be involved. But this was so only as long as the movements of the price level involved were the paltry 2–3 percent, at the most, that separated the so-called gold points. As soon as the movement of the internal price level necessary to keep the exchanges stable was much larger, when it jumped to 10 percent or 30 percent, the situation was entirely changed. Such downward movements of the price level would spread misery and destruction. The fact that currencies were managed became of prime importance, since it meant that central banking methods were a matter of policy, i.e., something the body politic might have to decide about. Indeed, the great institutional significance of central banking lay in the fact that monetary policy was thereby drawn into the sphere of politics. The consequences could not be other than far reaching.

They were twofold. In the domestic field, monetary policy was only another form of interventionism, and clashes of economic classes tended to crystallize around this issue so intimately linked with the gold standard and balanced budgets. Internal conflicts in the 1930s, as we will see, often centerd on this issue which played an important part in the growth of the antidemocratic movement.

In the foreign field the role of national currencies was of overwhelming importance, though this fact was but little recognized at the time. The ruling philosophy of the nineteenth century was pacifist and internationalist; “in principle” all educated people were free traders, and, with qualifications which appear ironically modest today, they were no less so in practice. The source of this outlook was, of course, economic; much genuine idealism sprang from the sphere of barter and trade—by a supreme paradox man’s selfish wants were validating his most generous impulses. But since the 1870s an emotional change was noticeable though there was no corresponding break in the dominant ideas. The world continued to believe in internationalism and interdependence, while acting on the impulses of nationalism and self-sufficiency. Liberal nationalism was developing into national liberalism, with its marked leanings towards protectionism and imperialism abroad, monopolistic conservatism at home. Nowhere was the contradiction as sharp and yet as little conscious as in the monetary realm. For dogmatic belief in the international gold standard continued to enlist men’s stintless loyalties, while at the same time token currencies were established, based on the sovereignty of the various central banking systems. Under the aegis of international principles, impregnable bastions of a new nationalism were being unconsciously erected in the shape of the central banks of issue.

In truth, the new nationalism was the corollary of the new internationalism. The international gold standard could not be borne by the nations whom it was supposed to serve, unless they were secured against the dangers with which it threatened the communities adhering to it. Completely monetarized communities could not have stood the ruinous effects of abrupt changes in the price level necessitated by the maintenance of stable exchanges unless the shock was cushioned by the means of an independent central banking policy. The national token currency was the certain safeguard of this relative security since it allowed the central bank to act as a buffer between the internal and the external economy. If the balance of payment was threatened with illiquidity, reserves and foreign loans would tide over the difficulty; if an altogether new economic balance had to be created involving a fall in the domestic price level, the restriction of credit could be spread in the most rational fashion, eliminating the inefficient, and putting the burden on the efficient. Absence of such a mechanism would have made it impossible for any advanced country to stay on gold without devastating effects as to its welfare, whether in terms of production, income, or employment.

If the trading class was the protagonist of market economy, the banker was the born leader of that class. Employment and earnings depended upon the profitability of business, but the profitability of business depended upon stable exchanges and sound credit conditions, both of which were under the care of the banker. It was part of his creed that the two were inseparable. A sound budget and stable internal credit conditions presupposed stable foreign exchanges; also exchanges could not be stable unless domestic credit was safe and the financial household of the state in equilibrium. Briefly, the banker’s twin trust comprised sound domestic finance and external stability of the currency. That is why when both had lost their meaning bankers as a class were the last to notice it. There is indeed nothing surprising either in the dominating influence of international bankers in the 1920s, nor in their eclipse in the 1930s. In the 1920s, the gold standard was still regarded as the precondition of a return to stability and prosperity, and consequently no demand raised by its professional guardians, the bankers, was deemed too burdensome, if only it promised to secure stable exchange rates; when, after 1929, this proved impossible, the imperative need was for a stable internal currency and nobody was as little qualified to provide it as the banker.

In no field was the breakdown of market economy as abrupt as in that of money. Agrarian tariffs interfering with the importing of the produce of foreign lands broke up free trade; the narrowing and regulating of the labor market restricted bargaining to that which the law left to the parties to decide. But neither in the case of labor nor in that of land was there a formal sudden and complete rift in the market mechanism such as happened in the field of money. There was nothing comparable in the other markets to the relinquishing of the gold standard by Great Britain on September 21, 1931; nor even to the subsidiary event of America’s similar action, in June, 1933. Though by that time the Great Depression which began in 1929 had swept away the major part of world trade, this meant no change in methods, nor did it affect the ruling ideas. But final failure of the gold standard was the final failure of market economy.

Economic liberalism had started a hundred years before and had been met by a protectionist countermove, which now broke into the last bastion of market economy. A new set of ruling ideas superseded the world of the self-regulating market. To the stupefaction of the vast majority of contemporaries, unsuspected forces of charismatic leadership and autarchist isolationism broke forth and fused societies into new forms.

* The underlying theory has been elaborated by F. Schafer, Wellington, New Zealand.