Other expedients may be employed

As in many other departments of human endeavor, however, the "ounce of prevention," in this problem of international gold movements, is often worth more than the "pound of cure." There are of course some movements of gold which are perfectly normal and unavoidable, but there are other movements which are induced by conditions, which, had they been understood and foreseen, might have been altered. Wherever the exportation of gold results from excessive credit expansion at home, such exportation might have been prevented by the seasonable restriction of credit.

While there is some difference of opinion as to the exact manner in which credit inflation leads to exportation of gold no such difference exists as to the fact itself. The expansion of credit may lead to a depression of the discount rate in the domestic market, and this may lead bankers to wish to transfer their loanable resources to more profitable markets. Or such credit expansion may lead to an inflation of domestic prices upsetting the normal relation between exports and imports both of commodities and of securities. In either case, or in both cases, the resulting tendency is pressure on the demand side in the foreign exchange market with the possible outcome of an advance in rates to the gold export point.

With the entrance of America into the arena of world finance another somewhat more subtle form of credit extension deserves mention. This involves extension of credit to the foreigner. To the extent that financial operations in the markets of the world may be transacted in terms of the money of any given country, as was largely the case before the Great War in the almost universal employment of the pound sterling, banking institutions in such a country may, through the acceptance and discounting of bills of exchange, give foreign borrowers heavy claims in domestic funds. Such funds ultimately redeemable in gold may be used by the foreigner to withdraw gold from the country where the funds originated, and such withdrawals might in turn seriously embarrass that country's domestic markets.

Prevention better than cure

Inflation as a cause of gold exports is preventable

Credit may be extended to foreigners

It was pointed out above that under adequate management of centralized reserves, undue expansion of credit at home can be successfully forestalled. Similarly, under such a system, excessive credit extension to the foreigner can be prevented. The reserve-holding bank, being in last analysis the arbiter of credit, has means of keeping itself informed as to conditions in the market. If "finance bills" - which are the media normally relied upon in the extension of credit to foreigners - appear in threatening volume, the central bank can adopt whatever expedients may be requisite to limit their supply. In England a mere hint from the Bank of England has been all that was needed, but where such delicate expedients are not adequate, there is always the possibility of effectively raising the discount rate. This hits the home borrower as well as the foreigner, but that is one of the costs that must be borne when a country becomes a world-wide supplier of funds. The foreigner's borrowings quickly diminish as the discount rate advances, and his ability to weaken the home market through the withdrawal of gold naturally diminishes in equal degree.

Nationally and internationally, therefore, the ability effectively to control the discount rate is a powerful weapon in the protection of the ultimate reserves. Yet it is necessary to observe the limitations which characterize it. An increase in the discount rate is a tax on the home borrower. It is effective only when it enhances the value of funds in the domestic market and that means that every individual obtaining funds in such a market pays a higher price than he would have paid had there been no increase in rate. From the immediate borrower or purchaser of funds the burden tends to be shifted to the ultimate consumer, although the exact distribution of the burden can never be accurately ascertained. In general, it means in the end a higher cost of production and a higher cost of living. Of course the higher cost also hits the foreigner borrowing in the domestic market, but he is bearing in any event only a small part of the total burden. Furthermore, increasing the discount rate can prevent gold exports only under two conditions, viz., first, when the foreign holder of domestic credits can be appealed to on the basis of profit, or, secondly, when the home country is a lending country and can dictate the terms on which it will lend. If the foreign holder of domestic credits chooses to redeem his credit in gold and to have the gold shipped to him nothing short of arbitrary interference can stop him. But if the withdrawal of gold proceeds, as it normally does, simply on the basis of higher profit elsewhere, through a readjustment of the possible profits, the withdrawal may be prevented. Similarly, if a given country is, on the balance of international transactions, the debtor, and if the ultimate creditors insist upon final payment, no amount of tinkering with the discount rate can prevent the exportation of so much bullion as is necessary to settle the debt. But if the country considered is a lending country its position is different. It can, as a lender, dictate the terms on which it will lend, or it may refuse to lend altogether. Owing to the limitations of the discount method of reserve control most countries have to couple with it other means of protection. Most of the central banks of the continent keep a considerable portfolio of foreign bills and make arrangements for loans of gold or of credit, while at the same time they may throw obstacles in the way of gold exports.

This can be prevented

Limitations of dependence on discount method

Foreigner must be appealed to on basis of profit or home nation must be creditor

European banks sometimes employ supplementary expedients

Selected References

C. A. Conant, Principles of Money and Banking (1905), Book V, Chapter IV (Elasticity Of Bank Credit: Mobility And Expansion).

Robert Giffen, Essays in Finance (1886), "Gold Supply; the Rate of Discount, and Prices."

J. Laurence Laughlin, Editor, Banking Reform (1912), Chapter XXII.