• • balance of payments. While true in a tautological sense (the rate is the price that clears the market), it offers little explanatory power. It does not explain what causes the shifts in the balance of payments itself. It describes the mechanism but not the underlying causes.
• The Psychological Theory
  • Argument: This theory correctly identifies the immense importance of market sentiment, expectations, and confidence. A loss of confidence in a currency can trigger a massive sell-off.
  • Critique: While crucial, these psychological factors are not an independent force. They only influence the exchange rate after they have been translated into quantifiable supply and demand on the market. A feeling of pessimism has no effect until it prompts someone to actually sell the currency.
• The Purchasing Power of Money Theory
  • Argument: This theory posits that the exchange rate between two currencies will tend to reflect the relative price levels of commodities in the two countries. If a basket of goods costs $100 in the U.S. and £50 in the U.K., the exchange rate should gravitate toward $2/£1.
  • Critique: This theory is critically incomplete because it is based on the flawed assumption that international trade in goods is the only significant transaction. It entirely ignores the massive influence of capital movements and short-term fund transfers, which are often driven by interest rate differentials or perceptions of risk, not commodity prices.

5.3 The Special Case of the Gold Standard: Gold Points

The international gold standard introduces a unique mechanism that imposes firm and narrow limits on exchange rate fluctuations. This is achieved through the concept of gold points.

• Gold Parity (Mint-Par): This is the official exchange rate determined by the fixed price of gold in two currencies. If the U.S. defines a dollar as 1/35th of an ounce of gold and the U.K. defines a pound as 4/35ths of an ounce, the gold parity is $4/£1.
• Gold Points: These are the actual upper and lower boundaries of exchange rate fluctuation. They are determined by the cost of physically shipping gold between two financial centers (including transport, insurance, and interest lost during transit).

For example, if the parity is 5 francs to 1 dollar and the cost of shipping gold is 1%, the gold points will be 4.95 (the gold import point for France) and 5.05 (the gold export point for France). If the market exchange rate moves beyond these points, it becomes cheaper for a debtor to buy and ship physical gold than to buy currency on the foreign exchange market. This act of shipping gold ensures the exchange rate can never stray outside the narrow band defined by the gold points.

5.4 Monetary Parities and the Critique of Purchasing Power Parity (PPP)

A monetary parity is a long-run equilibrium exchange rate that can be sustained without causing severe economic disruption. Professor Cassel’s Purchasing Power Parity (PPP) theory was proposed as a scientific method for calculating this “natural” parity, especially for currencies not on a common standard. Heilperin offers a comprehensive critique of the PPP theory, arguing it is flawed on theoretical, logical, and statistical grounds.

1. Theoretical Flaw: The theory is built on the incorrect assumption that international trade is the only significant transaction. It completely ignores capital flows and short-term fund movements, which in the modern era constitute a massive portion of the balance of payments and are not driven by relative commodity prices.
2. Logical Flaw: The theory assumes a one-way street of causation, from domestic price levels to the exchange rate. In reality, the relationship is a two-way street. Fluctuations in the exchange rate have a powerful effect on the domestic prices of imported goods and raw materials, a fact the PPP theory neglects.
3. Statistical Flaw: The calculation of PPP relies on the concept of a “general price level” measured by index numbers. These statistical constructions are methodologically unsound for comparing different economic structures over long periods. The composition of goods, consumer tastes, and production methods change so profoundly that comparing a price index from, for example, 1913 with one from 1936 is an economically meaningless exercise.

Heilperin’s ultimate position is that there is no formula for calculating a “natural” parity. The only valid test of an appropriate parity is a pragmatic one: can it be maintained in the real world without causing a severe internal economic crisis (such as mass unemployment) or a complete collapse of confidence?

Since the viability of a parity depends on its ability to be maintained, the next logical step is to analyze the mechanisms that work to restore equilibrium when it is disturbed.