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The Political Economics of International Money

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Miss Prism, instructing Cecily Cardew to read her Political Economy, added a warning to omit the chapter on the Fall of the Rupee: "It is somewhat too sensational Even these metallic problems have their melodramatic side," And so they do; but my story will not do it justice. I believe that the story of international money, and of our own balance of payments, allows no place for villains and little, even, for fools. To be specific: my contention is that the difficulties which we have faced in international finance have not been the result of American wickedness or irresponsibility or foolishness, or, indeed, of the wickedness of mythical short men in Zurich or mystical tall men in Paris.

The standard view, I recognize, is otherwise. It holds that the leading cause of the trouble has been the deficit in our balance of payments: the flow of unwanted deficit dollars into the hands of foreign central banks. There is a school solution: the United States must move promptly to eliminate its deficit. This version makes the U.S. Government if not the villain, at least the heavy.

One suspects that those who hold this view-that we should have done whatever was necessary to eliminate our deficit-are following the example of the man, who, when judging a contest between two singers, thought it necessary to listen only to the first competitor before awarding the prize to the second. The truth is that the international monetary arrangements in force until very recently-before the agreement on Special Drawing Rights (SDR) and before the institution on March 17 of the two-tier system for gold-were almost certain to land the world in hot water irrespective of the behavior of the U.S. payments deficit. Moreover, it is very likely that surgical action by the United States on a scale sufficient to eliminate the deficit would have compounded the trouble. Given the choices open to us during the past few years, the right policy has been, in my judgment, to avoid any such surgery, to live with the deficit, and in the meanwhile work hard to reform what I will call the rules of the game.

One would be foolish to assert that the U.S. Government has done everything just right in its balance-of-payments policy. It has not. Some things we did could have been done better. As one example, the original version of the direct-investment program (February 1965) should have had more bite. More to the point, some things that should have been done were not done at all. As everybody knows, there was a powerful domestic as well as an international case for a tax increase to cool off the economy in late 1965 or early 1966. Failing that, the 1968 surcharge certainly should have been put into effect long before it was.

For what it is worth, I think the blame belongs with the Congress. But the point of substance is that even if these necessary things had been done, and the domestic economy kept on an even keel, with quarterly increases in total demand kept to some $13-14 billion (in line with potential output) instead of $20 billion as in the first quarter of 1968; with the wholesale price index behaving more in the way it did between 1961 and 1964 instead of in the way it behaved during the winter of 1965-66 and again during the past several months-that even then, with the domestic economy just right, we would still be suffering a large underlying payments deficit. A significant portion of that underlying deficit would be hidden by the costly, if appropriate, temporary measures the Government has adopted since 1961 to keep the visible deficit within tolerable limits: tying of aid, "Buy American" policies, voluntary restraints on direct investment and bank lending, and the like. Still, it is more than likely that a deficit of significant size would have remained on the books. To eliminate that remaining deficit, further severe measures would have been necessary. In my judgment, they would have been a mistake. The remedy would have been more dangerous than the disease.

II

Having half followed the rule of exposition most recently propounded by Mr. Acheson-start off with your conclusions, never mind about protecting your flanks-I must make the case for the central proposition that the primary fault lies not in the dancers but in the music-in the arrangements, the set of rules and practices, that have governed international finance since Bretton Woods. After attempting to explain why these rules and practices spell trouble, I will try to sketch the possible shape of a reformed system and then come back to the choices we have faced in picking a U.S. strategy designed to move the world from here to there while breaking as little crockery as can be managed.

The elements of the system which, in combination, have given rise to the problem are as follows:

The commitment to fixed exchange rates, with any change in cross-rates between major currencies generally regarded by politicians and financial people both as evidence of failure and as a massive gamble-and, in one critical instance, the case of the dollar, probably unacceptable to most governments.

The practice of holding reserves largely in the form of gold and in dollars and sterling, with gold the only external source of new net reserves for the world as a whole.

The U.S. commitment to maintain the price of gold at $35 an ounce.

Why will these conditions, taken together, give trouble?

First: With fixed exchange rates, there is no built-in mechanism of balance- of-payments adjustment such as would avoid persistent deficits and surpluses. In a world subject to rapid changes in technology and in consumer tastes-a world, moreover, in which there are legitimate differences in the domestic economic objectives of countries-deficits and surpluses are bound to arise, and they are not likely to be self-limiting. Correction is likely to require purposeful action by governments.

Second: Except under fortuitous circumstances, when the economics of adjustment seem painless or even enjoyable-perhaps because the steps needed for payments adjustment happen to coincide with the needs of the domestic economy-governments generally regard the need to take action to correct their balance of payments as a painful prospect, whether in terms of their domestic or international politics. Not enough consensus exists on who should do what and when to protect against retaliation a government that imposes economic discomfort on its citizens, or on the citizens of other countries, for balance-of-payments reasons.

Third: Governments tend to regard the prospect of being forced to take action to cure a payments deficit as much more unpleasant than the prospect of facing a surplus. There are a lot of reasons; some are sensible in terms of economics, others are not, but still make good sense in domestic or international politics. Underlying all the reasons is the implicit power relationship between deficit and surplus countries. In terms of the choices open to it under the present rules, the deficit country is in much more trouble than the countries with the corresponding surpluses. Reserves can be run down only so long as they are there, while the accumulation of reserves knows no limit. Given the presumedly greater cost of having to fix one's deficit-as against the lesser cost of being subjected, while in surplus, to the adjustment actions of others-it is not surprising that governments of the advanced industrial countries are scared to death by the prospect of a persistent deficit, but smug about a persistent surplus. The nightmare of running out of reserves (while being lectured by those in surplus as they happily build up their nest-egg of reserves, rejecting corrective action for themselves)-that nightmare would be enough in itself to make governments subject to deficit-phobia. But it is reinforced by the political bite of the morality play which equates deficits and devaluation with sin, and surpluses with virtue. In terms of the moral scoring system which is in vogue in this business, the proposition that it takes two to dance-as well as danceable music-is generally ignored. The deficit country is invariably regarded as the sinner.

Fourth: Governments do not merely desire to be spared deficits; they wish to hedge against future failure by building up their reserves in some relationship to output and trade. Everyone wants his reserves to grow; everyone wants to be in balance-of-payments surplus. That some are bound to fail is an arithmetic truism, even apart from the deficit bias in the way governments tend to keep their books-unless, that is, the sum of the desired surpluses, worldwide, should be no greater than the increase in the externally provided supply of owned reserves: under pre-SDR rules, the increase in the stock of monetary gold. With consistent accounting practices, and leaving aside errors purely of measurement, if one adds together the surpluses and deficits of all countries one arrives at an algebraic total which will be a surplus figure just equal to the increase in the supply of net reserves, that is, monetary gold. To take an example: if the increase in the stock of monetary gold is just $1 billion in a particular year, and gold is the only source of new net reserves, then the sum total of all the surpluses of all the surplus countries, less the sum total of all deficit countries' deficits, will add up exactly to $1 billion (ignoring inconsistency and statistical error). This is merely a consequence of the definition of surplus and deficit. If, then, governments seek surpluses totaling more than $1 billion, some will fall short.

Fifth: Precise quantitative knowledge of the reserve or balance-of-payments targets of governments is lacking. Even less is known about how particular governments, when put to it, would trade off reserves, or protection of the exchange rate, against other goals having to do with employment, growth and the like. But there is powerful circumstantial evidence that, as things are, the balance-of-payments target of all governments taken together-the total desired annual increase in net reserves-is in fact a good deal larger than the overall supply of new monetary gold, even in the absence of any speculative absorption of gold by private hoarders.1 The balance-of- payments objectives of governments are in the aggregate inconsistent. Everybody wants to be taller than the average. This is not just a matter of exchange rates between currencies being out of kilter. There does not exist any infrequently adjusted set of exchange rates between currencies which would eliminate the excess demand for gold, even in the absence of private speculation, as long as gold is the only source of external net reserves to the world as a whole, the price of gold remains at $35 per ounce, and the U.S. commitment to purchase gold at $35 per ounce makes that price a credible floor.

III

Two questions come to mind. Is it really so? And if so, is it bad? To begin with the second: Why should it be bad that the balance-of-payments goals of governments, taken together, are inconsistent? Is it not good for the soul to have built into the system some competition for reserves? To make a judgment one must look at the likely consequences-will it be a competition in virtue or in sin? What will tend to happen in a world where governments tilt against each other for inconsistent surpluses and extra reserves-some by choice, others because, lacking finance, they have no choice but to try to protect themselves against deficits?

A parable may help. Imagine a world of just two countries, in which the increase in the supply of external reserves is zero. Assume that initially the two countries are in exact payments balance, and that there are no artificial barriers to trade. Last, assume that, one day-and in the face of growing income, output and trade-each country wakes up to the possibility that it may face periods of heavy deficits and hence decides, in self- defense, to build up its reserves. (Each government has come to accept, as a moral law, that its first obligation is to protect the exchange rate.) What will happen,?

Each country will try to jockey itself into a surplus position. It can try to do so by taking restrictive measures at home to slow down the growth of domestic demand, and/or by directly restricting imports, subsidizing exports, closing off its capital market, reducing foreign aid to nonexistent third countries. But whatever each country may do, they cannot both succeed in achieving a surplus and building up reserves. On the other hand, and as long as neither throws in the towel, they can both succeed in creating progressively severe deflation at home and going thoroughly protectionist. The prospect would be for an open-ended competition in trade and capital controls or deflation or both-a cumulative sequence of beggar thy neighbor tit for tat.

The parable has no natural, self-ordained ending. What is clear is that, over time and most of the time, the "winner" will be the government that is relatively more willing and able to impose and sustain deflation and unemployment at home, or more willing to go protectionist or to impose capital controls. Not merely will it tend over time to gain reserves at the expense of the other country. Far more important, it will win in the sense that its values and preferences will tend to dominate with respect to the rules that govern trade and payments, and/or with respect to the inflation- unemployment trade-off-not merely within its borders, but also in the other country, that is, in the rest of the world. This is, I believe, the really fundamental point; it goes back to the earlier reference to the power relations between deficit and surplus countries. In a fundamental sense, in this kind of world, the country less willing to tolerate unemployment and slack for the sake of balance-of-payments surpluses, or more persistently committed to liberal trade and payments, will have imposed on it the more restrictionist or protectionist preferences of its adversary.

Some will argue that the anti-inflationary discipline built into this sort of situation is desirable. They believe that fiscal and monetary policies are apt anyway to be too loose, that the natural inclination of governments is to let total demand run way ahead of potential output, with rapid inflation the result. In this view, if the process of tilting for inconsistent payments surpluses forces governments to compete in restraining demand at home-with the most Calvinist-minded government calling the tune-that is all to the good.

Looking at the economic history of the advanced industrial countries since the recovery after World War II, and contemplating the social and political consequences of stagnation and substantial unemployment, it is not clear to me that the bias in the Atlantic world has been in the direction of too much inflation and not enough slack and unemployment. To be sure, it would have been nice to have less inflation-other things equal. But other things would not have been equal. And I for one would have voted against paying the necessary price in terms of unproduced output, unused capacity, lost real profits and wages and jobless labor. (Admittedly, this is in important part a matter of personal values as well as of one's apprehensions about social and political consequences. Admittedly, also, when it comes to the United States, I have in mind not the last year or so, but the period between 1957 and 1964, during which we lost in unproduced output and in real profits and wages some $34 billion per year, with the overall unemployment rate fluctuating between 5 and 7 percent, and the associated Negro unemployment rate between 9 and 13 percent.2)

In reality, however, the relative distastefulness of unemployment and lost output, on the one hand, and of inflation on the other can be left on one side. The odds are overwhelming that the principal outcome of a competition in pursuit of irreconcilable payments goals would be a competition not in domestic deflation, but rather in protectionist restrictions on international trade and on capital movements, leading straight to autarky. The likely result is not a world without inflation, but rather a disintegrated, chopped-up world of comprehensive trade and exchange controls-an economic world of jungle warfare.

Some will respond-and this takes us back to my first question above-that events have not in fact gone that way at all. The economic history of the industrial world since the early 1950s shows rapid expansion in income, output, trade and the movement of capital: the very opposite of my bleak picture. So it does, and for good reason. Until recently, the real world has differed in one enormous respect from the assumptions built into the above model and the parable. The biggest player of the lot, the United States, has simply not played the game according to the above five-step description of the way governments behave. Through most of the postwar period the problem of inconsistency has been masked-and the world spared the damaging effect-because the United States, with the coöperation of the rest of the world, has been prepared not merely to stay out of the competition for reserves, but to play the role of world central bank, pumping out liquidity, letting others satisfy their desires for surpluses and reserves, while at the same time running down its gross reserves and increasing the nation's liquid liabilities.

The system worked precisely because the United States was so long immune to deficit phobia. Until the early 1960s we barely noticed our balance of payments. More recently, while feeling increasing pain, we have nevertheless resisted the temptation and the pressure to take drastic action to move into surplus and build up our own reserves.

The moral is not that we should keep on trying to do in the 1970s what we did in the 1950s: running deficits indefinitely and thereby providing the world with the liquidity it needs. That is not feasible under the present rules.

Economists usually discuss these matters under three headings: adjustment, liquidity and confidence or stability. During the 1950s and the early 1960s the flow of deficit dollars provided, more or less, the liquidity that was needed to lubricate the international economy in the absence of a workable, acceptable mechanism of adjustment. Over time, this very mode of lubrication was bound to give rise to a problem of confidence. The reasons are familiar: The process of providing the rest of the world with reserve assets in the form of dollars involved an increase in U.S. liquid liabilities relative to U.S. liquid assets, notably gold. Eventually, this was bound to raise doubts about our capacity to make good on the commitment to convert dollars into gold for all monetary authorities at the fixed $35 price-the more so because of the free-ride feature of the U.S. commitment, which enabled central banks, when scared, to shift into gold relatively costlessly (at least for short periods) without any risk of a capital loss. In part because $35 was a credible floor, it became an increasingly non- credible ceiling, and in this sort of situation non-credibility tends to be self-confirming.

As an aside, one mildly paranoid but not inaccurate way to describe the history is this: without in any way intending it, the United States found itself playing surrogate central bank to the world, doing what banks do: borrowing short and lending long, providing liquid assets for savers abroad and long-term money for investors. Monday through Thursday the world approved. But on Friday it discovered that our liquid liabilities were running ahead of our liquid assets and proceeded, encouraged by our own pronouncements of guilt, to lecture us about living in deficit sin and to threaten us with a run on our gold.3 This is not a game we can or should be prepared to play much longer; something has to give. What have been and are the choices?

IV

They are of two kinds: choices that have to do with the design of a new reformed system-Bretton Woods Mark II; and choices pertaining to American strategy: how the United States should conduct itself to help move the world from here to there with minimum cost and risk.

Let me first comment on the likely shape of a reformed system, under the three headings: adjustment, liquidity and confidence.

1. Adjustment will prove, very likely, the hardest problem to crack. Yet eventual improvement is vital. There will never be enough liquidity-indeed, there should not be-to void the need for more workable mechanisms for correcting surpluses and deficits. Some of my academic colleagues would argue that adjustment is the problem, that the only way to get out of the corner defined by the five-step model is drastically to reduce the demand for reserves by building in a quasi-automatic mechanism of adjustment. They have flexible exchange rates in mind.

The central truth about a system of flexible rates, whether fully flexible or managed, is that no one can be certain how it would work in practice when applied widely between major currencies. One can list the standard arguments in favor: all the advantages of letting prices do their job of mediating supply and demand, of clearing markets. Equally, one can cite the arguments against: the double risk of destabilizing speculation and of inhibiting trade and international investment if exchange risks cannot be fully covered. But in the end we still do not know how well or badly such a system would work.

The case for giving thought to permitting exchange rates to move is that it is not clear where else we can turn. Domestic fiscal and monetary instruments are just barely a match, even on paper, for domestic objectives pertaining to the balance between demand and potential output (and between inflation and slack); the division of demand and of output between personal consumption, public consumption, private investment and public investment; and, last, the distribution of income.4 Limiting travel is distasteful and, in the long term, intolerable. Trade controls are miserable economics and poisonous international politics. Capital controls are apt to have a relatively short half-life in terms of effectiveness: they tend to get leakier with use; and they, too, are wasteful. That a country as rich as the United States should feel itself hobbled, by the sheer mechanics of the process, in transferring some small fraction of its own real resources to the rest of the world, especially to the very poor countries, is ridiculous.

Sadly enough there are no other cards to be played. We are back where we started: with rigidly fixed exchange rates, there is no efficient instrument for correcting payments imbalance. The system is over- determined. In terms of the formal linear mathematics of economic theory, the number of independent equations, each representing a constraint or goal, exceeds the number of variables.

If, after exploring what might be accomplished by way of exchange-rate arrangements-e.g. by much wider gold points or devices such as the so- called "crawling peg"-we do not want to go down that road, then the alternative lies not in the status quo, but in a determined effort to work out some international code of adjustment behavior that will command wide acceptance, and to have built into it incentives and sanctions less one- sided than the present rules, which put pressure on deficit countries and let surplus countries go scot-free.

The trouble with this route is that it calls for advance agreement on rules to govern domestic economic policies-rules with sharp teeth with respect to fiscal and monetary policy. One should be clear about this. Negotiating a code of adjustment behavior that goes beyond declaring for virtue and against sin involves striking international bargains in advance on matters such as, for instance, the rate of increase in prices that it is right to suffer for the sake of reducing the unemployment rate by a given amount. (To be sure, no adjustment mechanism will be workable in the long pull unless it reflects a measure of implicit political consensus on how to reconcile conflicting goals. Not even a flexible rate system can avoid the underlying issue of conflicting goals, if-as it would have to be-it is subject to management.)

Thus it continues to make sense to leave the question of adjustment reform to the last, and to deal with liquidity and confidence first. Adjustment reform will be hard to negotiate, at best. Moreover, any attempt to agree on greater exchange flexibility would raise the problem of "how to get there," especially while supposedly unwanted dollars exist in the hands of foreign central banks. In this respect, too, dealing with adjustment reform last, in a setting where liquidity and confidence are in better shape, will be much easier.

2. With no easy way to reduce the demand for reserves by facilitating the process of adjustment-indeed, with near certainty that even following reform in the mechanics of adjustment the world will still need extra reserves-the alternative has been to do something about increasing the supply. The main choices have been three: raising the price of gold, crowning the dollar and inventing a new kind of international money.

Raising the price of gold was judged by the U.S. Government, rightly I think, a medieval expedient, inefficient in providing for the need (which is for a continuous, relatively smooth expansion in reserves); inequitable in its first-round benefits; and last, given the history, politically out of the question.

What about crowning the dollar? If not more gold, why not more dollars? With the rules as they are (or as they were before March 17 of this year) the reasons are plain. But why not change the rules and insulate the system against gold conversion by central banks? There are good reasons why not. However, lest anyone is tempted to dismiss this option as outrageous on its face, it is worth recalling that a journal as comfortably on the middle- aged side of the generation-gap as the London Economist has labeled this the "first and best" solution. Evidently, as The Economist recognized, some of our Continental friends do not like the idea and will regard The Economist's soft spot for the dollar as an Anglo-Saxon aberration. The United States could override their dislike by taking unilateral action to induce most of the world to shift fully to a dollar basis, simply by demonetizing gold. Those who demurred would have the option of letting their currencies float against the dollar, perhaps in a residual gold bloc; not many would take up that option. But it would be a bad thing for the United States to do, unless absolutely forced to it by others. As long as there is a chance for a reasonable, coöperative solution by consensus, it is wrong for a great power to settle matters by force majeure.

Indeed, even if all governments were eager to shift to a dollar standard, it would still be a mistake for the United States to consent. As a short- term response to a crisis forced on us by others, yes. As a transitional arrangement invulnerable to instability, maybe. But as a long-term arrangement, no. We should not accept the responsibility of exclusive American control of the printing press-of really serving as central bank to the world. Not that I worry much that we would misuse the power from domestic economic motives. We would probably do as well or better than any other control system one might dream up. But it would be very unhealthy in terms of international politics, if for no other reason than that we would be constantly subject to accusations of misuse. No single nation should accept that sort of unilateral power over the affairs of the world-if it can responsibly avoid it.5

What is left is the solution the United States finally came to in 1965: a new reserve asset. In fact, the Special Drawing Rights or SDRs are just what is needed. In terms of the orderly provision of liquidity in the future, I would regard the agreement, which resulted from nearly three years of hard negotiation, with Secretary Henry Fowler in the lead, as a triumph of international good sense.6 With parliamentary ratification of the appropriate amendments to the IMF Articles of Agreement in sight by early 1969, the new machinery for generating reserves is almost fully built. Needless to say, the trick will be to get it operating soon, and at the right speed.

3. Having dealt with adjustment and liquidity, what about confidence or stability? Here the long-term structural problem centers on the difficulty of operating any system that contains more than one kind of reserve asset. If there are several kinds of reserve instruments, and if central banks are free to change the composition of their portfolios by shifting from one kind to another, it is a good bet that instability will result. In this respect, simply adding SDRs to gold, dollars and sterling will not be of much structural help (although it should relieve some of the speculation in gold).

Together with adjustment reform, this is the second major problem on the agenda of negotiation and action for the period following the activation of the SDR. There are many possible solutions. Some, for instance, have advocated a blend of gold, dollars and SDRs in fixed proportion. My own preference would be to crown the SDR as the only reserve asset. Central banks would deposit their existing dollar, sterling and gold balances with the IMF, and get and use SDRs instead. The IMF would move one step closer to being a full-fledged world central bank.

I venture to think that this in fact will be the outcome. But again, the time is not yet. Unless there is a crisis first, which would force a telescoping of the schedule, we should concentrate first on activation of the SDR. (Professor Triffin and others advocate a faster schedule. My own sense of things is that, in the absence of a crisis, no new major step will be negotiable until the SDR is activated. Attempting it would simply increase the chance of a crisis.)

This judgment brings us to the question of strategy. How should the United States conduct itself to try to move the world into this brave new state of a single reserve asset and a more workable system of balance-of-payments adjustment?

V

The central question of American strategy goes straight to our balance of payments. The mere disappearance of the U.S. deficit would not solve the world's monetary ills. But a strong case can be made that nothing would so speed up the pace of reform as a drying up of the supply of deficit dollars. The central problem of inconsistency would be with us still. The shoe would still pinch. But it would pinch the European instead of the American foot for a change. We would have good reason to be pleased-not because of their pain, which would, in itself, be dangerous and might easily lead to economic warfare-but because, one suspects, our European partners would quickly develop a more vivid sense of the need for quick reform.

Powerful as it is, this argument misses the point. It is plain that an armchair is a more comfortable place to sit than the back of a tiger. But that doesn't tell you what to do when you are on a tiger. Trying to jump off may be the worst move. So it is with our deficit. If it just went away, fine; but that is mere fancy. Should we do what is necessary to make it disappear-or, more precisely, to reduce it to an equilibrium level, where the accumulation of dollars by foreign central banks just matches their stable long-term demand for extra dollars for transactions or reserve purposes?

There are two possibilities. If one believes that, in order to achieve that end, it is sufficient to eliminate excess demand at home (excess in terms of our domestic objectives) and to continue the existing tolerable controls on various components of the balance of payments-if one believes that, then the answer is easy. Even then, the problem of correcting the underlying deficit, now masked by the various temporary measures adopted since 1961, would remain. But at least no deficit would be left on the books-no piling up of excess dollars in foreign hands.

If one suspects, as I do, that the combination of existing controls and a fiscal-monetary policy appropriate to our domestic objectives will not suffice to eliminate the visible deficit, then the choices are stark:

1. To try to devalue the dollar relative to the currencies of countries in persistent surplus. We would fail. The evidence is overwhelming that no government is prepared at this stage to accept a revaluation of its currency against the dollar.

2. To deflate the U.S. economy severely into actual recession and sustained slack, with painful consequences for economic growth throughout the underdeveloped and developed world. Even in the absence of incipient revolution in our cities, the cost, in my judgment, would be too great. Given the relation between aggregate unemployment and Negro unemployment, it would be a social and political disaster.

3. The alternative to deflation or devaluation would involve some combination of even more severe capital controls, locking up of American tourists, going protectionist and making major changes in U.S. foreign policy.

Whatever one's view of Viet Nam or of the need for U.S. forces in Europe, to make major changes in U.S. foreign policy to protect the exchange rate or the gold conversion privilege would be to let the tail wag the dog. Moreover, it is well to remember that, with the current tying and offset arrangements, to make a net saving of as much as $200-300 million a year would require, for example, virtually scuttling the aid program or almost total withdrawal from Europe.

On private capital controls, I think we have been right to do what we have done. Indeed, if anything additional has to be done about the balance of payments, I would tighten up even further on direct investment in industrial countries outside the de facto dollar area, notwithstanding all the golden-egg arguments (which reflect incomplete analysis and too little time-discount of the future). The reasons are as much political as economic. In the international politics of balance of payments, direct investment has been our Achilles heel. There is some truth to the European charge that, in a fit of absent-mindedness, the United States has been using short-term money borrowed in Europe to buy up Europe. This is an area where we and our European friends really will have to get together to sort out our partly coincident, partly conflicting interests: their desire for long-term money and advanced American technology and management; our need for balance-of-payments protection and for fair treatment of past investments made in good faith; and their legitimate concern about the ownership and control of their advanced industries. But these are dicta. At this stage I would vote against any significant tightening of capital controls by the United States acting alone (assuming the New Year's program is working properly).

Trade and tourists remain. Any protectionist move on our part would be a terrible mistake. The forces of protection in the world at large are exceedingly powerful. American leadership in the movement toward freer trade has been crucial; serious American backsliding could easily result in a progressive collapse of the world trading structure, culminating in jungle warfare. One need not attach excessive importance to the mere economic losses from a slower growth of trade-though it is important to distinguish between the case of the United States and that of, say, Belgium or Japan-to believe that the effects on international politics are likely to be poisonous. The principal justification of the fixed exchange-rate system is that it provides a hospitably stable environment for international trade. Significantly to damage the trading system in order to protect a particular set of exchange rates would be upside-down economics and very bad politics.

The coin has another side. The cost of a strategy of living with our residual deficit for the time being-of sweating it out-consists in increasing the probability that, before the slow process of reform is complete, we will be faced not merely by recurrent flurries of private speculation, but by a massive, irreversible bear-raid on the dollar, with the big central banks joining private speculators in a scramble for gold.

I myself think the probability of such a blowup low, even if we follow the balance-of-payments strategy I have proposed. It is entirely up to some nine or ten major central banks and governments. As long as they don't panic, as long as they stand ready temporarily to absorb and hold any dollars dumped by private speculators or small central banks, the system will hold. They have the power to make it hold. Their performance during the past few years, and especially the remarkable March 17 agreement, suggest that they have the will, too. They have demonstrated their preference for gradual reform. They have no reason to be scared into pulling the house down.

The possibility of a collapse nevertheless exists. My conclusion is that to accept the increment of extra risk is the lesser of evils. To anyone who thinks that a collapse would mean the end of the world, that is not an acceptable conclusion. I do not believe that it would be the end of the world. What I believe would happen is that the whole sequence of reform would be telescoped into a matter of a few hectic weeks, and we would emerge with the world I sketched in the previous section. It would be unpleasant; financial markets and international trade would be perturbed. But the notion that we would face really serious and sustained economic trouble seems to me exceedingly unlikely. In any case, I would much rather live with that risk than with the likely consequences of balance-of- payments surgery by the United States.7

What then should be our strategy? We should not just sit still.

At home, we must use fiscal and monetary means better than during the past two years to match the growth of total demand with the growth of potential output. As a matter of international politics, the strategy of living with the deficit while reforming the rules is defensible only if the deficit is not the consequence of poor domestic management. Our domestic performance directly affects our ability to enlist the coöperation of the surplus countries in the short-term measures that are necessary to hold our visible deficit to manageable size. It also affects our bargaining power in the negotiations about long-term reform.8

We should maintain our existing controls on various balance-of-payments components, improving their efficiency where possible. For the time being, they are a necessary evil.

We should keep urging the surplus countries to dismantle any restrictions on imports, to encourage capital exports (especially to the underdeveloped countries), and, if they have let total demand fall behind potential output, to use their fiscal and monetary instruments to accelerate growth at home. The right sort of exhortation is not useless in these matters.

We should continue to cultivate the close coöperation of the important foreign central banks which resulted in the March 17 arrangement, and, in general, keep up the effort to insulate international reserves from fluctuations in the private gold market.

We should keep pushing for early activation of the SDR.

Our objective is not a dollar world of endless U.S. deficits, but an orderly transition to an internationally managed SDR system, with improved procedures of adjustment. We have come a long way since 1965. This is no time to lose our nerve.

1 The arithmetic, though not by itself conclusive, is revealing: The annual supply of new gold has been close to $1.4 billion. With industrial demand taking about half, $0.7 billion has been left over for speculators and central banks. If it were all available to central banks, it would constitute about a 1 percent addition to the stock of world reserves. With trade growing at 7 percent, money income growing at about 5-6 percent, real output and income at close to 4 percent, it seems evident that a 1 percent rate of growth in total reserves is likely, as a matter of trend, to result in unsatisfied demand. For fuller analysis and evidence, see Chapter 8 in R. N. Cooper, "The Economics of Interdependence." New York: McGraw-Hill, 1968, and Willis and Springborn, "The Need for International Reserves," U. S. Treasury Department, 1967.

2 $34 billion was the average annual gap between actual and potential output during 1957-64, measured at 1967 prices. The total loss during the eight-year period came to some $276 billion. All this is based on a conservative definition of potential output. For a detailed discussion, see any recent Annual Report of the Council of Economic Advisers.

3 The problem has been compounded by the widespread use of the U.S. "liquidity deficit" as a measure of disequilibrium. No accounting definition will by itself provide a satisfactory measure. But the liquidity deficit is entirely unsatisfactory. It completely ignores the U.S. role as a financial intermediary and the foreign private demand for growing dollar balances which is a direct consequence of the role of the dollar as the paramount trading currency.

4 I do not believe that the usual qualifications involving twisting yield schedules, changes in the tax structure, etc., significantly weaken the point. To be sure, domestic objectives will on occasion call for the same kinds of fiscal or monetary medicine as the balance of payments. But even then, the appropriate dosages are likely to differ. In general, no reason exists for expecting payments deficits to coincide with excess demand at home and payments surpluses with short-falls in demand.

5 For a fuller discussion of the dollar-standard possibility, and also of a two-bloc dollar/gold world, see "Taking the Monetary Initiative" by C. Fred Bergsten in Foreign Affairs, July 1968.

6 When the full history is written, Henry Fowler's role will loom very large indeed. It was he, encouraged and supported by President Johnson, who got the U.S. Government to move. He personally invented the "contingency planning" formula, without which the negotiations would never have gotten off the ground. Time and again during the bargaining his nerve and judgment, and his persistence and courtesy, saved the day. Throughout, he was ably seconded by Under Secretary Frederick Deming.

7 The above does not address the possibility of a crisis triggered by a decision of a major European government to devalue. Such a decision would certainly force an immediate negotiation with, one suspects, the entire structure of exchange rates (though not the dollar price of gold) on the table. The probability of such a crisis would of course be increased by any substantial U.S. action to fix our deficit. In the absence of such U.S. action, much will depend on developments in France. Regarding sterling, there is every reason for the central banking community to defend the $2.40 rate. In terms of Britain's basic balance-of-payments position there is absolutely no case for a further devaluation.

8 In this connection, it would be a big step forward if the Congress could be brought to adopt some variant of the 1962 proposal of President Kennedy for standby Presidential authority to vary income tax rates within specified limits and for a limited period of time, subject to Congressional veto.

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