If a government fixes the parity of its domestic credit or fiat money against gold or foreign exchange at a higher point than the market--that is, if it fixes maximum prices for gold and foreign exchange below the potential market price--the effects appear which Gresham's Law describes. A state of affairs results which--very inadequately--is called a scarcity of foreign exchange.
It is the characteristic mark of an economic good that the supply [p. 801] available is not so plentiful as to make any intended utilization of it possible. An object that is not in short supply is not an economic good; no prices are asked or paid for it. As money must necessarily be an economic good, the notion of a money that would not be scarce is absurd. What those governments who complain about a scarcity of foreign exchange have in mind is however, something different. It is the unavoidable outcome of their policy of price fixing. It means that at the price arbitrarily fixed by the government demand exceeds supply. If the government, having by means of inflation reduced the purchasing power of the domestic monetary unit against gold, foreign exchange, and commodities and services, abstains from any attempt at controlling foreign exchange rates, there cannot be any question of a scarcity in the sense in which the government uses this term. He who is ready to pay the market price would be in a position to buy as much foreign exchange as he wants.
But the government is resolved not to tolerate any rise in foreign exchange rates (in terms of the inflated domestic currency). Relying upon its magistrates and constables, it prohibits any dealings in foreign exchange on terms different from the ordained maximum price.
As the government and its satellites see it, the rise in foreign exchange rates was caused by an unfavorable balance of payments and by the purchases of speculators. In order to remove the evil, the government resorts to measures restricting the demand for foreign exchange. Only those people should henceforth have the right to buy foreign exchange who need it for transactions of which the government approves. Commodities the importation of which is superfluous in the opinion of the government should no longer be imported. Payment of interest and principal on debts due to foreigners is prohibited. Citizens must no longer travel abroad. The government does not realize that such measures can never "improve" the balance of payments. If imports drop, exports drop concomitantly. The citizens who are prevented from buying foreign goods, from paying back foreign debts, and from traveling abroad, will not keep the amount of domestic money thus left to them in their cash holdings. They will increase their buying either of consumers' or of producers' goods and thus bring about a further tendency for domestic prices to rise. But the more prices rise, the more will exports be checked.
Now the government goes a step further. It nationalizes foreign exchange transactions. Every citizen who acquires--through exporting, for example--an amount of foreign exchange, is bound to sell it at the official rate to the office of foreign exchange control. If this provision, which is tantamount to an export duty, were to be [p. 802] effectively enforced, export trade would shrink greatly or cease altogether. The government certainly does not like this result, but neither does it want to admit that its interference has utterly failed to achieve the ends sought and has produced a state of affairs which is, from the government's own point of view, much worse even than the previous state of affairs. So the government resorts to a makeshift. It subsidizes the export trade to such an extent that the losses which its policy inflicts upon the exporters are compensated.
On the other hand, the government bureau of foreign exchange control, stubbornly clinging to the fiction that foreign exchange rates have not "really" risen and that the official rate is an effective rate, sells foreign exchange to importers at this official rate. If this policy were to be really followed, it would be equivalent to paying bonuses to the merchants concerned. They would reap windfall profits in selling the imported commodity on the domestic market. Thus the authority resorts to further makeshifts. It either raises import duties of levies special taxes on the importers or burdens their purchases of foreign exchange in some other way.
Then, of course, foreign exchange control works. But it works only because it virtually acknowledges the market rate of foreign exchange. The exporter gets for his proceeds in foreign exchange the official rate plus the subsidy, which together equal the market rate. The importer pays for foreign exchange the official rate plus a special premium, tax, or duty, which together equal the market rate. The only people who are too dull to grasp what is really going on and let themselves be fooled by the bureaucratic terminology, are the authors of books and articles on new methods of monetary management and on new monetary experience.
The monopolization of buying and selling of foreign exchange by the government vests the control of foreign trade in the authorities . It does not affect the determination of foreign exchange rates. It does not matter whether or not the government makes it illegal for the press to publish the real and effective rates of foreign exchange. As far as foreign trade is still carried on, only these real and effective rates are in force.
In order to conceal better the true state of affairs, governments are intent upon eliminating all reference to the real foreign exchange rate. Foreign trade, they think, should no longer be transacted by the intermediary of money. It should be barter. They enter into barter and clearing agreements with foreign governments. Each of the two contracting countries should sell to the other country a quantity of goods and services and receive in exchange a quantity of other goods [p. 803] and services. In the text of these treaties any reference to the real market rates of foreign exchange is carefully avoided. However, both parties calculate their sales and their purchases in terms of the world market prices expressed in gold. These clearing and barter agreements substitute bilateral trade between two countries for the triangular or multilateral trade of the liberal age. But they in no way affect the fact that a country's national currency has lost a part of its purchasing power against gold, foreign exchange, and commodities.
As a policy of foreign trade nationalization, foreign exchange control is a step on the way toward a substitution of socialism for the market economy. From any other point of view it is abortive. It can certainly neither in the short run nor in the long run affect the determination of the rate of foreign exchange. [p. 804]