Under the gold standard and the gold exchange standard, the possibility of redemption in gold kept exchange rates stable and foreign trade was unaffected by shifting currency values (usually brought about by devaluations).  Gold or gold-backed money flowed amongst countries and kept prices and balances of payments moving towards equilibrium.

This system, from the governments’ points of view, was too restrictive, and they moved to a flexible exchange rate standard.  When unemployment began to be a permanent part of the world’s economies, and the unions had gained enough political power that they could refuse a reduction in nominal wages, governments resorted to currency devaluation as a way to lower real wages and decrease unemployment.  This would also cause commodity prices to rise, favor debtors at the expense of creditors, and increase exports while decreasing imports, at least until goods prices rose.  Governments, however, tried to hide their true goals with talk of domestic and foreign price level equilibrium and lowering domestic costs of production (which would come about through lower real wages and decreased real business debt).

Unfortunately for the economic planners and interventionists, the effects of devaluation are only temporary, as other countries will catch on and devalue their currencies also.  A race to the bottom ensues, while more devaluations become necessary since the supposedly beneficial effects to foreign trade and the balance of payments are only felt during the time between the devaluation and change in the exchange rate and the later adjustment of domestic prices and wages.

The citizens in the devaluing country are getting less and paying more in this time interval, and must restrict consumption.  On the other hand, those who borrowed money for real estate or business or own stock in indebted companies benefit from the ability to pay loans in devalued currency.  This of course comes at the expense of those who own bonds, insurance policies, or who hold money.

Under a gold standard, domestic money market rates are tied to international rates through redemption and the consequent stability among currencies.  A flexible rate system, however, allows governments to adjust domestic rates to fit current political objectives.  Interest rates are not a monetary phenomenon, they are a real economy and time preference phenomenon, and cannot be held down forever without severe distortions in the production structure, making the economy susceptible to the business cycle.

Finally, the main reason for the devaluations in the first place, the reduction of real wages, begins to be anticipated by the unions, who demand real wage increases instead.  The intervention’s objectives are not met, wealth has been redistributed, and the economy is left distorted.

Credit Expansion

Fiduciary media is not the product of government, but of private banking, policy, as banks began keeping less than 100% reserves on hand and banknotes became fiduciary media.  For example, checking accounts backed by less than 100% reserves will increase the money supply without the necessity of increasing base money.

Government has adopted credit expansion as its main tool for controlling the market economy.  With this tool the government attempts to lessen the scarcity of capital, to lower interest rates below market levels, to finance deficit spending, and re-direct wealth to favored groups.

If interest rates are lowered without a credit expansion, a boom will not be created.

The objective of credit expansion is to benefit some groups at the expense of others.  Some policies attempt to direct credit to specific groups like the producers of capital or consumer goods or to the housing sector, but all policies of credit expansion will lead to an increase in the stock market and then to an increase in investment in fixed capital through the false signals coming from the stock market.

Under the gold standard, a country that expanded credit faster than its trading partners would bring upon itself a drain of its gold stocks and its foreign reserves as holders of its currency would demand gold or stronger currencies in exchange for its over-valued money.  If the government believes that this drain is the result of an unfavorable balance of payments, it might seek to limit demand for its reserves by enacting policies such as tariffs which lessen demand for imports.  This will lead to a drop in exports, however, as locals use the domestic currency on domestics goods instead, causing a rise in domestic prices and a decrease in exports.

The country would then have to restrict credit in order to stop the outflow of reserves, causing a recession or depression.  Businesses in other countries would defensively increase borrowing in the face of this downturn, causing their governments to restrict credit to avoid a drain of their reserves, leading to an international recession.

Under the flexible rate system, governments are able to devalue their currencies instead of restricting credit.