Standard policy proposal concerning gold flows took a number of forms for Austrians economists, with two being most common. Lionel Robbins expressed what appears to be the standard Austrian view that if gold inflows were the result of monetary expansion by another central banks, the central bank receiving them were under no responsibility to expand:
Broadly speaking they [the “rules of the Gold Standard game”] are simply these: that centres receiving gold should expand credit, and centres losing gold should contract credit. In detail, they require that the expansions and contractions should more or less counterbalance each other. . . (1934, 28).
Robbins’s view, those receiving gold had no responsibility to expand the base money stock due to inflows were the result of over expansion by another central bank. On this point, he agrees with Austrian economist Murray Rothbard (2000, 148). Hayek conveyed several opinions at the time, one which is also closely in line with what Murray Rothbard considered a second best central banking policy (Rothbard 2000, 95). Hayek suggested that the central bank should stabilize the ratio of gold reserves to the broader money stock:
The only real cure would be if the reserves kept were large enough to allow them to vary by the full amount by which the total circulation of the country might possibly change. (1937, 33)
Hayek appears to have though that such a policy would help neutralize the real effects of changes in the broader money stock. This policy prescription was both impractical to administer and at odds with the “rules of the game.” Hayek expressed other opinions throughout the 1930s, including that monetary expansion was merited during times of “acute crisis”, that an MV stabilization norm is theoretically most attractive, and that passive increases in the monetary base due to gold inflows were appropriate even in the context of loose monetary policies from other countries (1935, 123-125; 1999, 153). The latter of these was also expressed by Lionel Robbins (1934, 24-29), although this is at odds with the above quotation from the same chapter! Elsewhere, Hayek also considered the need for central banks with relatively large stock of gold to reduce their demand in order to allow other central banks to readopt the gold standard:
Now the present abundance of gold offers an exceptional opportunity for such a reform. But to achieve the desired result not only the absolute supply of gold but also its distribution is of importance. In this respect it must appear unfortunate that those countries which command already abundant gold reserves and would therefore be in a position to work the gold standard on these lines, should use that position to keep the price artificially high. The policy on the part of those countries which are already in a strong gold position, if it aims at the restoration of an international gold standard, should have been, while maintaining constant rates of exchange with all countries in a similar position, to reduce the price of gold in order to direct the stream of gold to those countries which are not yet in a position to resume gold payments. Only when the price of gold had fallen sufficiently to enable those countries to acquire sufficient reserves should a general simultaneous return to a free gold standard be attempted. (1937, 86)
Here, Hayek formulates precisely the same argument that Hawtrey and Cassel had made for at least two decades (Cassel 1920a, 1920b, 1923; Hawtrey 1919). It is apparent that there was not a consistent Austrian position concerning central bank reaction to gold flows. This confusion occurred because gold flows were not included as an element in the ABCT.
I have mentioned in a previous post that the merit of the international gold standard was, as Hayek phrased it, that it approximated an “international currency system” where all countries essentially used the same money (1937, 2). This merit depended on the stability of exchange rates. If distortions in exchange rates persisted, the benefits of an international money was lost. It is for this reason that stabilization of exchange rates under the gold standard was the most appropriate policy (Cassel 1922, 256). Participation in the international gold standard inherently necessitated this. If stability of exchange rates was not possible, then the benefits of the gold standard were lost.
Depreciation of a nation’s currency by the lowering of a central bank’s reserve ratio promoted gold outflows which, if not curtailed, would threaten the gold basis of the currency. Increases in the reserve ratio accomplished the opposite feat: the currency gained value relative to other currencies and initiated gold inflows. In either case, relative prices between countries are distorted, and both production and exchange are hampered. A central bank regime whose rule of thumb is to curtail domestic price inflation, no matter the cause of that inflation, ignores the mechanisms that enable the international gold standard to promote international trade. Whether or not economists at the time agreed, the “rules of the game” demanded that central banks respond passively to gold flows, expanding the broader monetary base as gold came in and contracting it as gold flowed out.
This presents a problem not previously confronted by the Austrian Business Cycle Theory. The central bank receiving resultant gold inflows (outflows) must choose between two bads. The central bank can import foreign inflation (deflation) and inherit all arbitrary changes in nominal factors. This will distort the structure of production. Or, it can try to offset the change in prices domestically by practicing either passively sterilization, allowing reserve levels to rise (fall) as gold flows in (out) or by engaging in active sterilization. Either option in the second case may minimize relative price changes domestically, but strengthens (weakens) the domestic currency relative to all other currencies. Imports are made cheaper (more expensive) and domestic producers face diminished (increased) demand for their products. Relative prices of goods and services residing in different countries are distorted by not allowing exchange rates to move back toward their old parity. Trade is harmed as changes in the relative prices of foreign goods and services alter profit margins for domestic producers who buy inputs from foreign suppliers and also for domestic producers who sell their goods to foreign markets. Whether a central bank keeps reserve ratios constant or sterilizes gold flows, the structure of production changes. In the second case, the burden of relative price changes are exported to countries where central banks hold reserve ratios constant. This has the added effect of endangering the international gold standard, clearly an inferior result compared to a simple adjustment in the structure of production. In sum, the appropriate policy suggestion, in light of Austrian capital theory and given an international gold standard where central banks practice fraction reserves, is for central banks to maintain stable exchange rates, not to offset changes in the domestic price level that occur due to gold inflows and outflows.