HOW far is it true that a large domestic or internal national debt, as contrasted with an external or foreign debt, is a relatively negligible burden? Does the payment of an internal debt, requiring merely the transfer of wealth or income from some persons to others within the same country, put no formidable strain upon that country's economic energies? How far is it true, by way of contrast, that Germany's capacity to make reparations payments, or the capacity of any nation to make large foreign payments, is narrowly and rigidly limited by its ability to maintain a favorable balance of commodity exports over commodity imports?

At first the very real differences between the burdens imposed by external and by internal debts were ignored in popular discussions and flouted in the policies of governments. That fact explains and justifies the emphasis competent critics, in increasing number, have put upon those differences. But despite the great value of the educational work they have done, some of these critics have drawn too straight a line between the two kinds of debts.

We may find a helpful approach to the problem if we look first at several different ways of appraising a country's ability to pay a heavy and burdensome foreign debt.

In the first place, there is the now familiar method which relies upon an inventory of a country's present foreign assets coupled with an estimate of its capacity to maintain a favorable balance of trade through a series of years. This latter estimate is generally based upon an analysis of the country's pre-war trade and its possible rate of growth, together with a consideration of the degree in which the war has affected the country's productive resources and its markets. This is the method used by Mr. Keynes in "The Economic Consequences of the Peace," and by Messrs. Moulton and McGuire in "Germany's Capacity to Pay." In competent hands it leads to important results. It is worth observing that, despite the highly conjectural character of some of the figures that must be drawn upon, the better estimates that have been made in this way are not far apart.

Such studies of a debtor country's possible balance of trade are indispensable. They are a necessary preliminary to any reasoned judgment upon that country's capacity to make foreign payments. But it is wrong to rest content with them,--to regard them as complete and adequate estimates of capacity to pay. They make no room for the play of various elastic factors. In particular they take no account of the readjustments in the economic and financial relations of the different nations of the world that are bound to be brought about as a result of the very operation of paying a heavy foreign debt.

In the second place, we may turn to the arguments of those who hold that the effort to pay a large foreign debt has the curious effect of greatly increasing the debtor country's real capacity to pay,--provided that the currency of the debtor country is inconvertible paper. Under such conditions, it is even contended, a country's ability to make foreign payments is really limited only by its ability to produce more than it consumes. The gist of the argument is as follows: To make payments on its external debt the government must buy foreign bills of exchange in large quantities. The price of such bills, and along with it the prices obtained (in domestic currency) for exported goods, will be pushed up rapidly, so that finally a considerable differential will be established between the general domestic price level and the prices that can be had for exports. This differential operates, so the doctrine runs, virtually as a bonus on exports. It will induce business men to turn a larger share of their energies to producing goods for the export rather than for the domestic market. Why should German producers, for example, sell goods at home when more marks could be got for them by selling them (or other goods produced at no larger cost) abroad for credits in dollars or pounds or francs which could then be sold to the government at high prices? So long as this bonus on exports can be maintained by the pressure of the government's continuing demand for the means of making foreign payments, so long, in a quasi-automatic way, the country's production of goods for the export market will be increased, while in equal measure its production of goods consumed at home will be decreased. Its capacity to pay, therefore, will be limited in the long run only by its maximum productive capacity on the one hand and its minimum domestic industrial and subsistence needs on the other.

Now this theory is based upon a perfectly sound principle, but it runs that principle into the ground by fantastically exaggerating its possibilities. The first of the two methods we have considered, taken by itself, is too inelastic. This second method errs in the other direction. It ignores a number of very important inelastic factors. It takes no account, for example, of the inelasticity of the demand of the world's markets for the exports of any one country or of the inelasticity of that country's demand for imports. It passes over the fact that a country like Germany must shape its exports very largely from imported raw materials and that the prices that must be paid for imported goods, in domestic currency, generally rise at least as rapidly as the prices that can be realized for exports. It disregards the way in which such price differentials react upon the whole structure of industry and finance within the debtor country. It forgets the inevitable lowering of the standard of living and the disintegrating effects of maladjustments in the delicate interrelations of the country's system of prices. Financial and industrial wreckage, rather than an increasing export surplus, is the certain result of the pressure of an unduly large foreign debt.

Furthermore, even though some of the advantages claimed might be secured by export industries if export and domestic prices and the differential between them could be maintained at a moderate and stable level, such advantages would disappear when, as would be inevitable, the export and domestic price levels continued to advance. An increasing differential between export and domestic prices will not always stimulate exports. Some exporters will prefer to wait for a higher differential later. Some importers, on the other hand, will be induced to bring in foreign goods, at whatever cost, in order to sell them later when the margin between the prices of imports and the general level of domestic prices is larger.

A third method of approach to the problem of the maximum manageable size of a foreign debt is suggested by the proposals that Germany's payment should be made in a lump by turning over shares in German industries to Germany's creditors. There have been some such proposals, on the part of Germans, that have had an official or semi-official character. A distinguished German statistician, Dr. R. R. Kuczynski, has gone even further, proposing a heavy capital tax upon German property of whatever sort, the proceeds, in the form of mortgages, bonds, shares, and the like, to be handed over en bloc in acquittance of reparations obligations.

It is going too far to hold that such methods of payment "do not constitute actual payments at all."[i] I do not suppose that it is claimed by Dr. Kuczynski or by others who have made similar proposals that a final or economic payment could be achieved by such a transfer. A legal payment might conceivably be made and a receipt in full secured by assigning or transferring securities which would themselves be nothing more than evidences of debt. A public debt might be converted into a mass of private debts. The contention merely is that the final economic settlement of the debt could be reached more easily and more efficiently if it were removed from the field of international politics, and if the mechanism of the payment were controlled by the free play of economic forces, rather than by the attempts of governments to collect the payments in one form rather than in another.

There is no reason to doubt the sincerity and good intentions back of these proposals, and it is in some respects a matter for regret that any large reliance upon such methods is neither wise nor practicable. The difficulties, both political and economic, are manifold. For one thing, the assets thus secured, if large and miscellaneous, would shrink greatly in value in the markets of the world.

Back of such proposals, nevertheless, there is a thoroughly sound notion which supplements and corrects the rigid export-surplus doctrine. If the reparations debt were fixed at a reasonable amount and if Germany were left free to find her own ways and means of payment, it is fairly certain that a situation would develop in the end which would somewhat resemble--though on a reduced and moderate scale--the situation which these proposals contemplate as the result of a single operation. By the time the reparations payments were completed, other countries --not Germany's present creditors alone--would hold considerable amounts of German securities, both public and private. In various ways, planned or spontaneous, a fairly large proportion of the reparations debt would be refunded into these other forms. Legal payment would be completed and the German Government acquitted of its liability long before the final economic payment had been made. Indeed, the continual shiftings of the world's balances of international debts and payments might make it impossible to say with certainty at any one time that the final payments had been made.

It is likewise difficult to think that France will receive any large part of her share of reparations in the form of such manufactured goods as Germany might produce. It is distinctly more probable--her own external debts aside--that France's increased imports, like Germany's increased exports, would be diffused over the whole surface of world trade, and that her foreign holdings of various sorts, her investments in other parts of the world, would be measurably increased, although not necessarily in exact proportion to the increase of Germany's "refunded" foreign liabilities. Such changes in the world's international balance sheets would, beyond doubt, react upon and modify the currents of international trade in commodities,--but the discussion of such matters would take us far afield.

All of the differences between external and internal debts are bound up with the fundamental fact that the former call for foreign payments. Such payments create problems in foreign trade and foreign exchange. So long as the payments continue, the debtor country, except so far as it can refund the debt, must produce more than it can consume or add to its accumulated domestic capital. The monetary units in which payment must be made and which therefore measure the amount of the debt are not within the arbitrary control of the debtor government. Domestic inflation makes these foreign monetary units dearer, not cheaper. Deliberate repudiation, complete or partial, of external debts is not, as a rule, practicable. Such are some of the more important characteristics which external debts have, but which internal debts lack.

Let us turn now to points which they have in common. We note, in the first place, that the payment of an internal, as of an external debt, requires taxation, calling for sacrifices and exercising a repressive effect upon trade and industry.

In the second place, there is an analogy--not merely fanciful, although it would be easy to push it too far--between a country's taxpayers and the holders of its internal debt, on the one hand, and debtor and creditor countries, on the other. Taxpayers and holders of the public debts are, in part, two different groups. The interest and principal of the debt enter into the balance of payments as between the taxpayers and the owners of government securities. For many years the taxpayers, as such, must produce more than they can consume or save, while the government's creditors will receive more than, at the time, they are producing. If the debt absorbs any large proportion of the national income, as in France, England, and other European countries, the resulting reactions upon the distribution of incomes, upon the general standard of living, upon the demand for goods, and upon the general structure of industry, may be considerable. Much depends, of course, upon the way in which the burden of taxation is apportioned, upon whether taxes fall more or less heavily upon necessities, upon luxuries, upon incomes, or upon accumulated capital. But at the best the strain upon the country's economic activities is likely to be heavy, even though the complications and special difficulties attending transactions in foreign exchange are absent.

In the third place--and this I believe to be the most important point of similarity--heavy internal debts, like external debts, strike at the heart of a country's economic life by bringing disorder into its currency. That inflation, unbalanced budgets, and disordered exchanges have been among the chief factors delaying Europe's economic recovery is pretty generally known, but it is not so well understood as it should be that the sequence of cause and effect, particularly in the period following the war, has not been inflation, unbalanced budgets, disordered exchanges, but unbalanced budgets, disordered exchanges, inflation.

Before the war the world had an international money--gold--which not only stabilized (albeit imperfectly) but tied and held together the currencies of the great commercial countries. The mechanism of international payments operated with deceptive ease and smoothness. The price system was, in very large measure, international. The market for loanable funds, whether of long or short maturity, was also, in a very considerable degree, international.

At present a large part of the western world is cut up, artificially, into separate economic districts within which purely national currencies rule. The worst thing about these new artificial barriers is that they fluctuate continuously and uncertainly,--inviting hazardous speculation, but discouraging the steady flow of trade.

The war was financed, as we know, partly by taxes and to some extent by voluntary savings, but mostly by diluting the purchasing power of money. Inflation was the mechanism by which war debts, we might say, were created. All this is now very generally understood. But there appears to be no adequate appreciation of the intimate and necessary connection between debt reduction, on the one hand, and the deflation and stabilization of paper currencies, on the other hand.

This relation between debts and the status of paper currencies holds whether the debts be external or internal, although the mechanism by means of which the increase or decrease of the debt operates upon the currency is different in the two cases. Consider, for a moment, some of the monetary effects of a burdensome foreign debt. The wrecking of Germany's monetary system affords an instructive example.

The Government's demand for foreign funds, added to similar demands on the part of importers and of others having foreign payments to make, was greatly in excess of the available supply. The only way of securing foreign exchange was to bid its price up to a point where some of the competing demand was eliminated. The price of dollars, of sterling, and of francs went up out of all proportion to the difference between the domestic purchasing power of marks within Germany and the domestic purchasing power of the other currencies in the countries in which they circulated. But the prices in marks of imported and exported goods--of goods, that is, for which there is an international market--were driven rapidly up by the advance in the price of foreign exchange. Tied to the prices of the international market in a thousand indirect and intricate ways, the domestic price level, though until recently lagging considerably behind, advanced haltingly but irresistibly. Inflation, though accelerated by an unbalanced budget, followed--it did not precede--the advance of prices. During the past four years the per capita circulation of money in Germany, measured in terms of its domestic purchasing power, has been much smaller than before the war. Measured in terms of its gold value the shrinkage of the currency has been even more striking. In large measure inflation has been the result rather than the cause of the depreciation of the value of the currency.

I have reviewed these matters again in order to give point to the emphasis I shall put upon what I believe to be the indispensable key to an understanding of the vagaries of the behavior of the depreciated currencies of Europe. I refer to the dominating part played by speculation. It makes all the difference in the world whether men's actions are prompted by the belief that a depreciated currency will increase in value or by the belief that its future trend will be downward.

The turning point in Germany's financial fortunes came in the first half of 1922, following upon the adverse decision with respect to Northern Silesia, late in the autumn of 1921. Up to that time many people in and out of Germany had maintained a persistent if unreasoned faith in the future of the mark. That circumstance measurably retarded the inevitable decline of the mark, and did much to lighten Germany's financial burden. It made exports of German goods larger than they would otherwise have been. It led people in other countries to make large speculative purchases of marks and of securities payable in marks. It was one of the things that induced persons in other countries to invest heavily in German property. During that period, it is safe to say, Germany's imports of capital, in various invisible forms, were distinctly larger than her invisible exports. Part of the favorable balance was available for reparation payments.

This misplaced confidence in the future of the mark waned rapidly after the failure of the attempt to stabilize its value in December, 1921, and a complete reversal of the general trend of speculation followed. With a bear market for marks the difficulties of the German Government were multiplied. Then came the unrelenting drift of events into the reparations crisis of a year ago, with its costly and ominous sequel.

With the conviction once established that the value of the mark, in terms of other currencies, was bound to continue to depreciate, its depreciation was accelerated. Commodity exports were retarded and imports stimulated. The direction of the current of invisible elements in the balance of international payments was reversed. Capital began to flow out of Germany more rapidly than into it. The rapid decline of the mark under the pressure of these forces only added to their strength. The mechanism of financial disintegration worked in a cumulative way.

Some absurdly exaggerated stories are afloat respecting the amount of German capital that has gone during the last year and a half into bank deposits and into the purchase of securities in the United States, Canada, Switzerland, and other countries with relatively stable currencies. But underneath these exaggerations there is reasonable ground for presuming that Germany's exports of capital have been significant in amount.

We do not have to attribute these developments to a concerted plot on the part of German business men, abetted by the German Government, to evade their reparations obligation. It is reasonably certain, of course, that the fear of drastic taxation helped to create a preference for foreign holdings. But the major compelling force back of the export of German capital has been the loss of confidence in the mark. The particular methods by which such transactions are effected do not matter greatly. The general result is that the foreign credits created by exports and in other ways are allowed to remain abroad instead of being offered for sale to the government. In any case the transaction is essentially a bear operation in marks. As such it is easily explainable. It is wrong only in so far as it involves a violation or evasion of the laws regulating the purchase and sale of foreign bills of exchange.

I cannot believe that the real attitude of the French Government toward this matter, or, at any rate, the attitude of the economic advisers of the French Government, has been correctly reported, or that it is adequately expressed in the official statements of that government. A very definite impression has been given that the French Government objects to the removal of "wealth" from Germany, and that it insists that ways and means of bringing it back again must be found. This, it appears, is a problem upon which one of the committees of experts now attached to the Reparations Commission is at work. On the face of it this attitude is paradoxical, for so long as German wealth remains in Germany it can be used only with difficulty for reparations payments. German-owned dollars, francs, and sterling, on the other hand, are precisely the stuff out of which reparations payments can easily be fashioned.

The real ground of the French complaint must be that these privately-owned foreign funds, which have been accumulated at such heavy cost to Germany, might, at no greater cost, have been acquired by the German Government and then applied to the payment of reparations. The French Government does not really desire that these foreign funds be brought back into Germany in the form, let us say, of imports of merchandise. Its real and legitimate interest is that the German Government should be able in some way to possess itself of these foreign assets and turn them over to Germany's creditors.

It is impossible that this legitimate end should be obtained by ferreting out these foreign holdings or by any amount of pressure and intimidation. But it would be accomplished promptly and easily if a stable monetary system could be established in Germany. With the motive for the concealment and expatriation of funds destroyed, the German Government could get hold of them by paying a fair market price in German currency.

It will be granted, perhaps, that the history of the German mark illustrates and confirms the principle that a stable currency and an excessive external debt are incompatible. A similar relation holds as between a country's currency and an excessive internal debt, although only a part of the mechanism by which external debts affect the price level operates when the debts are internal. An excessive internal debt makes it difficult to balance the budget, and an unbalanced budget calls for further advances by the banks, or for further sales of government securities, attended by an increase in the volume of bank credit. These new creations of purchasing power, as we know, exert a continued upward pressure on prices.

Here again, speculation plays a very important part. The movement of prices in a period of continuing inflation is not a direct effect of the sheer mechanical impact of the offer of new supplies of money in the market for goods and services. Speculation anticipates these consequences, and, by anticipating them, puts into operation a new mechanism of its own. Except in the initial, and perhaps the very last, stages of inflation, the price of foreign exchange and of imports and exports generally keeps in advance of the general movement of domestic prices, even when external debts are not exerting a steady pressure upon the foreign exchange market. The general level of domestic prices, though again lagging behind, follows the course marked out for it by the appraisal of the value of the country's currencies in the international market. Thus, for example, fresh issues of paper money to cover a deficit in the budget may, merely by altering the expectations people have formed respecting the deflation or stabilization of the currency, lead to a sharp advance of prices, which in turn will call for and in a manner justify further creations of bank credit. In a similar way, any really effective steps taken toward deflation will produce a powerfully cumulative downward influence. Under a régime of inconvertible paper money, it is barely a step from a stable to an extremely unstable equilibrium. So far as I know, all of the world's experience with inconvertible paper money illustrates and confirms these principles.

The bearing of these considerations upon what we may call the international problem of national debts is obvious. The stabilization of European currencies (I do not mean their drastic deflation), is the indispensable prerequisite to the economic recovery of Europe. The one indispensable instrument of stabilization is the balancing of budgets. The burden of debts, external and internal, blocks the way. If the debts can be taken care of, the monetary situation would take care of itself. This is what makes of national debts, seen as an aggregate, an international problem,--and no shutting of our eyes to it will alter the fact.

I am not one of those who believe that the payment of the interest and principal of an international debt does more harm than good to the nation receiving the payment. Nor do I believe that the payment of an international debt strengthens rather than weakens the nation making the payment. But I am convinced that the present debts of European nations, including reparations, interallied debts, and internal debts, are so large that, as they now stand on the books, they cannot be paid in full. Moreover, no considerable part of them can be paid without perpetuating and perhaps increasing the disorders of the currency. There is, I grant, one possible alternative. These debts might within the next generation be reduced to manageable proportions by the persistent use of taxation of unprecedented severity. I doubt that this is politically practicable. Even if it were, I doubt that the game would be worth the candle. There would be long periods of business depression, lowered standards of living, and new injustices in the distribution of wealth. It would be better to release the world's economic energies; to permit deflation to be accomplished, so far as it is desirable, by increasing the volume of production and trade rather than by drastic reductions in the volume of the currency.

On the whole there is less pessimism respecting the general economic condition of Europe than there was a few years ago. Despite the enforced retrogression of Germany during the past year, Europe as a whole continues to go forward and not backward. But her complete recovery will be delayed indefinitely if there are to be either further increases of debt and further inflation, or a steady general reduction of debts and deflation of currencies.

The whole subject of international debts, including their relations to internal debts, would profit by a candid and open international discussion. The central unifying theme which would bind the different parts of the discussion together would be the stabilizing of the world's currencies so as to get rid, so far as possible, of the distorting and destructive influence of international currency speculation, and to provide a dependable mechanism of international payments.

The United States cannot always hold itself aloof from such discussion, if only because, as the ultimate creditor, it holds what may prove to be the master key to the whole problem. I do not question the present wisdom of the policy regarding the debts owed to us which President Coolidge has reaffirmed. The debts of other countries as well as of England are valid and binding international obligations. We are right in insisting that they be recognized as such, that they should be rated higher than a mere offset to Class C German reparations bonds. But it is one thing to consolidate our power; it is another thing to use that power wisely.

These considerations gain weight from the fact that the uncertainties of Germany's creditors respecting the relative status of one as compared with that of each of the others have done as much to delay a reasonable solution of the reparations problem as have their doubts concerning Germany's attitude, and more than any disagreement respecting the aggregate amount Germany can pay. Reciprocal jealousies, disputes over priorities, maneuverings for positions of advantage, are dominant elements in the sorry history of the last four years. Reparations are hardly more an issue between Germany and her joint creditors than they are a bone of contention among the creditors themselves. Each of the creditor countries appears to have been mainly concerned, first of all with small immediate gains that could be used for political window-dressing at home, and, second, with the ultimate net advantage secured.

My argument does not necessarily lead to the conclusion that our own claims should ultimately all be cancelled. It merely means that they should not be viewed as a separate, inviolable, and sacrosanct item, as something apart and distinct from the general structure of external and internal debts. We should be candid enough to admit that in this, as in other ways, the reparations problem is in part our problem, that it is part and parcel of the problem of the whole international debt structure and its future. We should be prepared to make whatever modifications and adjustments are necessary to bring the whole body of debt into manageable form. Along that course lie our own interests, as well as those of Europe.

[i]Moulton and McGuire, "Germany's Capacity to Pay," p. 18.

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  • ALLYN A. YOUNG, Professor of Economics, Harvard University; Chief of the Division of Economics and Statistics of the American Commission to Negotiate Peace
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