[ 202 ] The Great Transformation
became the founder of the quantity theory of money with his discov-
ery 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 commod-
ity 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 func-
tion as money, and its amount, therefore, cannot, in principle, be in-
creased 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 unac-
companied 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 de-
veloped 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 ar-
tificial 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 cen-
ter 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 stan-
dard—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 in-
creased 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 transac-
tions. 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
Market and Productive Organization [ 203 ]
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 work-
ing 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 en-
tirely 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 de-
flation 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 shift-
ing 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 de-
mand 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
[ 204 ] The Great Transformation
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 domes-
tic 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 irra-
tional method of haphazard and often catastrophic shocks transmit-
ted 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 disorganiza-
tion 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 pro-
ductive enterprise, the existence of which was imperiled by any fall in
the price level caused by use of commodity money. Here also protec-
tive 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 cen-
tral 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 econo-
mies 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
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