From Bretton Woods to World Inflation, by Henry Hazlitt, Chicago: Regnery Gateway, 179 pp., $10.95
A sampler of Henry Hazlitt's lively essays written from 1934 to the present, From Bretton Woods to World Inflation, offers prophetic insights into the rise and fall of the postwar international monetary order. That monetary order, called the Bretton Woods system, writes Hazlitt, "put an excessive burden and responsibility on one nation" and "assumed that the American managers, at least, would always stay sober." The system provided that only the dollar was to be "convertible on demand into a definite and fixed quantity of gold," and only foreign central banks were to be granted that guarantee. Foreign countries were supposed to adjust their economic policies to keep their currencies tied to the dollar and thus to gold.
In the Vietnam era the system was strained as people exercised an indirect influence over the quality of money. Excess dollars were loaned, spent, or invested abroad, where they were ultimately exchanged for local currencies. Foreign central banks thus found themselves with a growing mountain of dollars and began to ask for gold. Just as the Federal Reserve had perversely tightened in the face of gold inflows in 1920 and 1929, the Fed now refused to tighten in the face of prolonged gold outflows in the 1960s. Instead, the outflows were "sterilized"—while the Treasury mopped up surplus dollars at the gold window, the Fed kept adding dollars at the open market desk. Such procrastination was made possible by running down the huge gold stockpile at Fort Knox and later by pressuring foreign governments not to exchange dollars for gold.
Under the monetary system, inflationary policies overseas, fueled by excess dollar reserves, could be papered over for too long with International Monetary Fund (IMF) loans, or with bank loans encouraged by the prospect of IMF bailouts. Writing 40 years ago, Hazlitt prophesied that "the proportion of bad loans and defaults seems certain to be high, under the Bretton Woods regime." He was mainly concerned that there would be "no provisions for applying the corrective to wrong policies of debtor nations." What is now happening instead is that the IMF often insists on wrong policies—perpetual devaluations, punitive tax rates, protectionism, price controls, and encroachments on property rights.
At times, Hazlitt seems to suggest that sound money always requires a literally balanced budget. A lengthy 1944 essay, however, correctly points out that government borrowing need not jeopardize a gold standard, so long as people believe the debt can and will be honestly serviced. Austrian economist Ludwig von Mises went further, saying that government borrowing from the public (not the central bank) is "irrelevant to the treatment of monetary problems."
As Hazlitt writes, "monetary chaos and world inflation could have been stopped, or at least greatly diminished," even as late as 1969 or 1971. Raising the discount rate to 6 or 7 percent might well have stopped the flight from dollars—ironically, such an interest rate sounds low today. Even if the dollar had to be devalued, with gold at $70 to $100, that would have been far less inflationary than letting the dollar collapse until gold was $800 an ounce. The $35 rate established under the Bretton Woods system had survived three major wars, after all, which would strain any monetary system.
Hazlitt, like Mises, was equally intolerant of deliberate deflation, as well as inflation. "Trying to force down prices and wages from the level they have reached," wrote Hazlitt, "may result in economic stagnation, in unemployment, in a throttling of production." In 1949, when the British pound collapsed as abruptly as it has recently, Hazlitt observed that the rising dollar, "by lowering the dollar price of imported commodities and forcing reductions in the dollar price of export commodities…will increase our problems." Indeed, US wholesale prices dropped 10 percent in that recession, though service prices kept rising by 5 percent.
By 1971, even Hazlitt threw in the towel, urging that "the U.S. should openly announce that it can no longer convert dollars into gold at $35 an ounce. It owns about $1 in gold for every $45 paper dollars outstanding." That comment reflected a common confusion, in which saving "our" gold reserve or "backing" is supposedly more important than maintaining convertibility. Yet the gold standard did not exist for the purpose of filling Fort Knox; instead, the only purpose of gold reserves was to defend the standard. Only currency was convertible, so the 45-to-1 ratio vastly exaggerated the issue, even at a $35 price, by including even time deposits (why not add bonds?). Consider, for example, the situation of private bankers. They are obligated to convert demand deposits into currency, but they do not need a dollar of currency in the vault for every dollar of deposits. The currency monopolist (the Fed) does not need a 100 percent reserve either. As currency is exchanged for gold, the value of remaining currency is strengthened, so the process is self-limiting. A huge gold hoard just fosters procrastination.
What killed the Bretton Woods monetary system was an idea, and that idea had seduced Hazlitt, as it had the rest of us, by 1971. He wrote that "paper currencies should be allowed to 'float' …the daily changes in prices will serve as early warning signals…to the managers." But Hazlitt had it right the first time, in 1934, when he wrote that "there is no more a 'natural value' for an irredeemable currency than there is for a promissory note of a person of uncertain intentions to pay an undisclosed sum at an unspecified date."
To favor floating money is to favor floating prices and floating contracts. There can be no free market in nationalized currencies, because central banks have monopoly control over currency and bank reserves. The issuers of currency must define and guarantee their notes in terms of some generally accepted tangible asset, or the value of those notes will gyrate unpredictably in terms of commodities and foreign currencies. The value of fiat money is simply a matter of opinion, so it is inherently unstable.
For all its faults, the gold-dollar foundation of Bretton Woods provided far more predictable money than the chaos that followed when President Nixon severed the gold-dollar link in 1971. Industrial commodity prices varied cyclically, for example, but were the same in July 1971 as they had been 20 years earlier. The growth of world trade and output before floating was twice as fast as it has been since. Even in the late 1960s, when the United States had abandoned most institutional constraints on the Fed and the foxy Soviets were actually importing gold, the uncertain gold hedge behind dollar assets still continued to keep long-term interest rates near gold-standard levels of 4–5 percent.
It is possible to learn from the mistakes involved in creating the Bretton Woods system and from the greater mistakes in discarding Bretton Woods. This book is a good place to begin the reconstruction. Anything by Hazlitt is worth reading at least twice, and this is no exception.
Alan Reynolds is vice president of the economic consulting firm Polyconomics.
This article originally appeared in print under the headline "Order and Disorder: The Postwar Monetary System".