Unconditional Redemption for Gold
The governments of almost all countries are engaged in a campaign against the capitalists. They are intent upon expropriating them by means of taxation and monetary measures. The capitalists are eager to protect their property by keeping a part of their funds liquid in order to evade confiscatory measures in time. They keep balances with the banks of those countries in which the danger of confiscation or currency devaluation is, for the moment, less than in other countries. As soon as the prospects change, they transfer their balances into countries that temporarily seem to offer more security. It is these funds that people have in mind when speaking of "hot money."
The significance of hot money for the constellation of monetary affairs is the outcome of the one-reserve system. In order to make it easier for the central banks to embark upon credit expansion, the European governments aimed long ago at a concentration of their countries' gold reserves with the central banks. The other banks (the private banks, i.e., those not endowed with special privileges and not entitled to issue banknotes) restrict their cash holdings to the requirements of their daily transactions. They no longer keep a reserve against their daily maturing liabilities. They do not consider it necessary to balance the maturity dates of their liabilities and their assets in such a way as to be any day ready to comply unaided with their obligations to their creditors. They rely upon the central bank.
When the creditors want to withdraw more than the "normal" amount, the private banks borrow the funds needed from the central bank. A private bank considers itself liquid if it owns a sufficient amount either of collateral against which the central bank will lend or of bills of exchange that the central bank will rediscount. (All this refers to European conditions. American conditions differ only technically, but not economically. However, the hot-money problem is not an American problem, as there is, under the present state of affairs, no country that a capitalist could deem a safer refuge than the United States.)
When the inflow of hot money began, the private banks of the countries in which it was temporarily deposited saw nothing wrong in treating these funds in the usual way. They employed the additional funds entrusted to them in increasing their loans to business. They did not worry about the consequences, although they knew that these funds would be withdrawn as soon as any doubts about their country's fiscal or monetary policy emerged.
The illiquidity of the status of these banks was manifest: on the one hand large sums that the customers had the right to withdraw at short notice, and on the other hand loans to business that could be recovered only at a later date. The only cautious method of dealing with hot money would have been to keep a reserve of gold and foreign exchange big enough to pay back the whole amount in case of a sudden withdrawal. Of course, this method would have required the banks to charge the customers a commission for keeping their funds safe.
The showdown came for the Swiss banks on the day in September 1936 on which France devalued the French franc. The depositors of hot money became frightened; they feared that Switzerland might follow the French example. It was to be expected that they would all try to transfer their funds immediately to London or New York, or even to Paris, which, for the immediate coming weeks, seemed to offer a smaller hazard of currency depreciation. But the Swiss commercial banks were not in a position to pay back these funds without the aid of the national bank. They had lent them to business — a great part to business in countries that, by foreign exchange control, had blocked their balances.
The only way out would have been for them to borrow from the national bank. Then they would have maintained their own solvency. But the depositors paid would have immediately asked the national bank for the redemption, in gold or foreign exchange, of the banknotes received. If the national bank were not to comply with this request, it would thereby have actually abandoned the gold standard and devalued the Swiss franc. If, on the other hand, the bank had redeemed the notes, it would have lost the greater part of its reserve. A panic would have resulted. The Swiss themselves would have tried to procure as much gold and foreign exchange as possible. The whole monetary system of the country would have collapsed.
The only alternative for the Swiss national bank would have been not to assist the private banks at all. But this would have been equivalent to the insolvency of the country's most important credit institutions.
Thus, for the Swiss government, no choice was left. It had only one means to prevent an economic catastrophe: to follow suit forthwith and to devalue the Swiss franc. The matter did not brook delay.
By and large, Great Britain, at the outbreak of the war in September 1939, had to face similar conditions. The city of London was once the world's banking center. It has long since lost this function. But foreigners and citizens of the dominions still kept, on the eve of the war, considerable short-term balances in the British banks. Besides, there were the large deposits due to the central banks in the "sterling area." If the British government had not frozen all these balances by means of foreign-exchange restrictions, the insolvency of the British banks would have become manifest. Foreign-exchange control was a disguised moratorium for the banks. It relieved them from the plight of having to confess publicly their inability to fulfill their obligations.