I

WITHIN the past two years the status of the enormous inter-governmental obligations produced by the war has been fundamentally changed. In the summer of 1923 England made an agreement for the settlement of her debts to the United States. Some twelve months later the Dawes Plan came into operation, and now at last promises to bring order out of the reparations chaos. Finally, since the beginning of 1925 most of the Continental Allies have opened formal or informal negotiations looking to the regularization of their debts.

The world is thus entering on an era, almost certainly of prolonged duration, in which very large annual payments from certain governments to certain other governments will become a part of the normal course of events. The crux of the situation, in the first instance, lies in German reparations. If reparations payments actually reach the anticipated volume, the further economic problems created by the liquidation of the Inter-Ally debts will become comparatively insignificant. The net debt payments, regarded as a matter of governmental finance alone, will be largely or entirely offset by the receipts from Germany, and the direct burden they impose will really fall upon the German budget. But ever since the Treaty of Versailles the most serious doubts and forebodings have been expressed on this whole question, both in Germany and in other countries. It is said that Germany cannot pay reparations of substantial size without ruining her foreign exchanges and currency, and paralyzing her economic life; that similar results will attend the effort to pay off the Inter-Ally debts; and that the wisest practical course, whatever the ethics of the situation, is to wipe all of the larger inter-government obligations off the books and start afresh.

This latter view, however, seems to me largely if not wholly erroneous. Granted the exercise of certain monetary and banking precautions, which before the war would have been regarded as reasonable and ordinary, and granted a certain amount of sincerity on the part of Germany, it will be entirely possible to make reparations transfers of the desired size. Nor need distressing or threatening consequences of a permanent character appear.

From the strictly economic point of view (it is impossible to inquire into moral and political questions here), there are three principal problems. First, can Germany accumulate a recurring net surplus of funds of the required size--600 million dollars a year or more--within her own borders? Second, can these funds be steadily converted into foreign currencies, without simultaneously endangering the German foreign exchanges and the German monetary system? Finally, can the creditor countries themselves receive the reparations transfers, except at the price of injuring some part of their own industrial or financial organizations?

The problem of taxation, so far as Germany is concerned, will be, intrinsically, much the least difficult. The path ahead may be painful, but it is clear. The reparations charges will hardly do more than take the place of interest payments on the cancelled national debt, if indeed they do as much as that. Their accumulation within Germany itself will require good faith on the part of the government, and a measure of sacrifice on the part of the people, but no insuperable obstacles of a strictly economic character are involved. It may fairly be doubted if the relative tax burden on Germany will be as great as that on the principal Allied countries, even with allowance made for their anticipated reparations receipts. There seems to be no serious question as to Germany's ability to meet it. This is not to minimize the political and psychological difficulties that will undoubtedly arise. But we must either make certain assumptions as to the honesty of Germany's intentions, or else abandon all hope of a peaceful solution.

II

The problem of transferring reparations payments out of Germany, on the other hand, is far more serious. It has been regarded with the gravest fear, both in Germany and in the Allied countries, and is often treated as the one insuperable obstacle to any productive settlement of the nominal German obligations. But that fear, much competent opinion to the contrary notwithstanding, is in very large part groundless. This conclusion follows from an examination of the various forms in which such payments must actually be made.

Suppose Germany has placed the necessary funds in the hands of the Transfer Committee. Disregarding for the moment the technical operations of the foreign exchange market, the funds can then be transmitted to the Allies in one or more of three principal ways. Germany can export more commodities than before, relative to the quantity she imports; she can export securities and other titles to her property and income; or she can export her services. The export of specie may also be adopted as a temporary expedient, but evidently cannot be kept up long without undermining the monetary standard.

Of these, the export of services is not important. The transactions involved are reflected in such payments to Germany as result from the receipt of ocean freight charges, foreign tourists' expenditures within the country, remittances from Germans who are resident abroad, and so on. The net volume of the payments may indeed be large, but there is little historical evidence to show that they fluctuate in any very close relation to the movement of capital between countries.[i] An increase in the export of capital from Germany, such as the reparations transfers will involve, will not of itself affect them in significant degree. It will not lead to a material increase in their volume.

On the other hand, the export of securities and of other titles to property and income is of the greatest importance. Indeed, several writers have expressed the opinion that such exports are the principal way in which the reparations transfers will actually be effected.[ii] With respect to the fairly immediate future, say the next five or ten years, there is much to be said for this view. At the present time Germany is an attractive market to foreign investors. She needs capital, will pay well for it, and can give reasonably good guarantees. But with respect to longer periods, it is much less certain that the importation of capital will maintain any very large volume. As the economic reorganization of Germany progresses, as her own savings, together with investments by foreigners, fill up the larger gaps in her supply of productive equipment, the earning power of funds placed with her will fall. Germany quite obviously needs new capital now, but there is no evidence to show that she is really starved for it. It will not take her very long, therefore, to fill the more pressing of these needs--and hence to offer a lower price for new supplies. Investors abroad will then begin to turn to other and more profitable fields, and the annual importation of new capital will dwindle. Indeed, it may be suspected that before many years have passed Germany will not only be increasing her own foreign investments, but will actually be exporting more capital (apart from reparations) than she imports.

There are two further difficulties in the way of making any very large and continued part of the reparations payments in the form of security exports. In the first place, the actual volume of new investment has hitherto simply not been large enough, if the available data are at all accurate, to warrant any very sanguine hopes as to its future growth. It might be expected that the substantial guarantees of financial and monetary stability provided by the Dawes Plan would cause this investment to reach large proportions. But the combined investment by England and the United States--probably the two principal foreign sources of capital--does not seem to have exceeded 150 million dollars in 1924; and the total of all foreign investment in Germany at the end of that year is estimated at only 300 million dollars (excluding the loans floated in connection with the inception of the Dawes Plan, which are not recurrent). Yet the standard reparations payment is 600 million dollars annually. In the second place, foreign investment in a country evidently leads to a subsequent outward flow of interest and profits and amortization payments. With a given constant rate of new investment, this outward flow would entirely offset the inward movement in fifteen years or so, and leave no surplus for use on reparations account. The rate of foreign investment in Germany would therefore have to increase steadily in order to produce a continued surplus of substantial size; a situation which will hardly arise, unless it be in the next two or three years alone.

III

It must be admitted that the extent of the future importation of capital into Germany is nevertheless problematical, and that the view just outlined is not necessarily more accurate than the one to which it is opposed. But this much seems clear and beyond debate: that by no means all of the reparations payments can be transferred in the form of securities and services alone; and that an increase in German commodity exportation, relative to importation, will therefore be necessary. In particular years this excess of commodity exports may prove to account for only a small part of the reparations transfers, but in other years, when the export of securities and services has temporarily or permanently declined, it will account for the largest fraction. In a sense it is the last resort, the elastic residual element which can always be brought into operation when other forms of transfer have proved inadequate. Yet how can an increase in commodity exports relative to imports be secured?

When an exporter sends goods to another country he receives a bill of exchange on that or some other foreign country in payment. He takes the bill to his bank and sells it--discounts it--in exchange for the currency of his own country. The bank's holdings of foreign bills are thus increased. At the same time the total volume of purchasing power in circulation in the country is built up in corresponding degree. If the exporter sells his bill for cash, the quantity of money in circulation is augmented; while if he sells it in return for a balance at the bank, the volume of bank deposits is enlarged. On the other hand, when an importer buys goods from another country he must pay for them in the currency of that country. He therefore goes to his bank and buys a bill of exchange, payable there or in some other foreign country. The bank's holdings of foreign bills are thus diminished, and the volume of purchasing power in circulation in the country is decreased. For if the bill is bought with cash, money is drawn from active circulation into bank reserves; while if it is bought with a check, the volume of bank deposits falls as soon as the inter-bank balances are liquidated. There is thus a continuous process of building up and tearing down. The banks' holdings of foreign bills, and the volume of purchasing power in circulation, are being continually increased at one end and continually diminished at the other.

In the absence of large international capital movements, these two forces of increase and decrease ordinarily operate to keep the volume of bill-holdings and the volume of purchasing power in circulation at what may be called "normal" levels. Although the levels are not fixed, they vary primarily in response to internal changes alone--with seasonal and cyclical fluctuations in trade and industry, with general economic growth, and so on. But an export of capital, such as is involved in the transfer of reparations payments, will break up this equilibrium for a time and shift it to a new position. Moreover, the new state of affairs will be such that the country's commodity exports will be increased relative to its imports.

Suppose that in a selected standard year the German Government has placed the required 600 million dollars in the hands of the Transfer Committee. Since German currency is of course not a legal form of payment in the Allied countries, the Transfer Committee will go to the banks and other dealers, and--like an importer, or anyone else having payments to make abroad--will attempt to buy bills payable in foreign centers. These bills will be claims either to Allied currencies, or to currencies that can be converted into them, and will therefore serve to liquidate the German obligation. But suppose further that the net export of German commodities and securities and services, in the selected year, has amounted to only 400 million dollars. The Transfer Committee will buy the foreign bills resulting from these exports, but will still be left with 200 million dollars of reparations not yet transferred.

If the Committee goes ahead and buys still more foreign bills with this 200 million dollars of German currency--as it should, --evidently the bills can be secured only by cutting into the average bill holdings of the German banks and dealers. The excess of current supply over current demand--the 400 million dollars of surplus available bills resulting from the net export of German commodities and securities and services--has already been used up. A further 200 million dollars can be drawn from the market only if the banks sell off bills more rapidly than they buy them: only if they allow their average holdings to fall.

In other words, the transfer of more reparations payments than can be accounted for by the current excess exportation of commodities and securities and services will cause a decline in the average volume of the banks' holdings of foreign bills. (The possible drawing of finance bills may postpone this process, but cannot prevent it. The finance bill rests on a loan operation, and must later be repaid.) Now such a decline in average bill holdings, it has already been shown, involves a corresponding decrease in the volume of purchasing power in circulation, relative to its "normal" levels. The decrease is ultimately effected at the expense of those who pay taxes. The taxes are larger than they would have been in the absence of reparations, and the proceeds go permanently out of the country. There has been no diminution, however, in the quantity of goods produced and offered for sale within Germany itself; and the decrease in the volume of purchasing power will therefore soon be followed by a fall in German prices. Or rather, prices will fall relative to the levels they would otherwise have reached. If the world price movement is upward they may remain constant, or even rise gradually. They will, however, be definitely below the levels in other countries. This difference in prices, by a familiar process, will stimulate German commodity exportation, since Germany has now become a good place in which to buy. Conversely it will check importation, since Germany is now a poor place in which to sell. The combined result will be an increase in the excess of exports over imports. Finally, the supply of bills of exchange will be increased by the increase in exports, while the commercial demand for them will fall, from the decline in imports.

This process--a decline in bill holdings, purchasing power in circulation and prices, and an increase in the "favorable" balance of trade--will go on until a certain point is reached. It will go on until the increase in the supply of bills, relative to the commercial demand, is great enough to take care of the new demand from the Transfer Committee itself. When that point is reached, there will be no occasion for a further impairment of German bill holdings, and hence no occasion for further disturbances in other directions. The process will thus be almost literally automatic. The very attempt to transfer reparations will give rise to a series of changes which will themselves make a final form of transfer possible. Most of the fears of both Allied and German economists with respect to the economic difficulty of effecting the transfers are, therefore, simply beside the point.

One fundamental condition, however, must exist. The process will be automatic only if the general monetary situation is kept stable, and only if the banks exercise the necessary precautions. The decline in the volume of purchasing power in circulation, as reparations work up to their full volume, will certainly cause distress. It may even produce a temporary crisis, and a depression lasting for some little time. Pressure will then be brought to bear on the Government to issue more currency, and on the banks to grant more credit. If the Government fails to maintain a gold-standard or gold-exchange basis for its monetary system, this pressure will be almost irresistible; while if the banks do not adopt a strong and courageous policy they will be unable to oppose the similar demand for increased credit. Yet to increase the volume of either currency or of credit in circulation (allowance being made for the "normal" seasonal and cyclical oscillations) would be tantamount to new inflation, since on the average there has been no increase in the number of commodities in the country--in the volume of production. In either event the buying of additional bills by the Transfer Committee will then operate to depreciate the currency and the exchanges, rather than to reduce the level of prices within Germany. For unless the increased demand for bills is allowed to produce a decline in the volume of purchasing power in circulation, and a consequent decline in general prices, no change will appear in the commodity balance of trade, and hence no increase in the supply of bills (relative to the commercial demand for them). Under such circumstances the transactions of the Transfer Committee will result simply in forcing up the price of foreign bills, to whatever point is necessary to displace a corresponding part of the commercial demand. If the pressure is at all severe the price will inevitably go beyond the specie point. The exchanges, that is, will depreciate, and will tend to carry the internal value of the currency with them. When this happens, under the provisions of the Dawes Plan, further transfers must of course cease.

But the exercise of ordinary banking precautions and a measure of governmental fortitude will suffice to avert the danger. The foreign exchanges are now tied to gold, and the budget is in balance, so that no genuine excuse for the issue of excessive quantities of paper money can be offered. With respect to the banking situation, a courageous and forehanded raising of the discount rate will suffice to check the demand for credit. It will also stop the probable tendency to a dangerous drain of gold, and will accelerate the necessary fall in prices. As the country's prices and general economic conditions adapt themselves to the new situation--to the effecting of large and recurring reparations transfers--the discount rate can be relaxed, and depression will give way to prosperity. As long as the transfers continue to be made, however, the volume of purchasing power in circulation will be relatively low, and German prices will be somewhat under the world level. In these conditions lie not the only possibility of effecting the transfers themselves, but also the possibility of maintaining currency stability and a healthy economic life within Germany itself.

There is, finally, one other and far from unimportant danger. If the Transfer Committee invests the surplus of funds in its hands in German securities on any very large scale, instead of attempting to buy bills with them--as it is empowered to do, within certain limits--it will defeat the very object in view. The purchasing power secured from taxation will then be turned back into internal circulation, instead of being withdrawn, and the essential (relative) fall in prices will be impeded or even prevented. Except as a strictly temporary means of alleviating pressure on the foreign exchanges, the Committee ought never to resort to investment within Germany. The sooner it forces the actual transfers up to the successive stipulated levels, the sooner will the necessary adjustments of prices and the trade balance be accomplished, and the initial distress terminated. The power to prevent exchange and currency depreciation, and the real responsibility for it, does not lie with the Transfer Committee. It lies with the German Treasury and the German banks.[iii]

IV

The third and last problem involved in the payment of reparations by Germany is this: Even if Germany can accumulate the necessary sums within her own borders, and even if she can acquire a sufficient quantity of foreign bills each year to transfer these sums to the Allied governments--thus liquidating her legal obligations--can she continue to find markets for her increased commodity exports? And can the Allies receive these exports, without imperilling their own industry and commerce?

It is frequently urged that the inelasticity of the world's demands for imported products, and the erection of protective tariff barriers, will cause the whole transfer mechanism to break down. But a more optimistic view of the situation is justifiable. In the first place, by no means all of the reparations payments will be effected in the form of net commodity exports. The net export of securities and services will play an important though not a dominating part. In the second place, the very conditions which will make the German balance of trade more "favorable" will make the balance of the other countries less favorable. Germany will be remitting large annual sums, and her prices will fall relative to the world level. The Allies will be receiving large annual sums, and their prices will rise. Their imports, in consequence, will increase relative to their exports. Moreover, it is at least logically possible that the entire change in the Allied trade situation will be concentrated on their exports alone. If they export less than before, by the full amount of their reparations receipts, evidently no change whatsoever need take place in the volume of their imports. They will not have to buy more foreign goods, and the question of the elasticity of demand will not arise. Finally, such additional imports as come from Germany may simply replace imports that were previously received from still other countries. This is the more probable, because German prices will be distinctly under the world level. Here again no increase in the total volume of the Allied commodity importation will be required. It will simply be a matter of substituting one source of supply for another.

Whatever its details, there is no escape from this process. Either there will be a net increase of importation into the other countries of the world; or a substitution of German products for those of her competitors; or--more probably--a combination of the two. The great weapon in Germany's hands, if she will use it, is that fall in her prices which the effort to make reparations transfers will itself entail.

It is also objected that the erection of protective tariff barriers will prevent Germany from acquiring the requisite export surpluses. That may be true as between Germany on the one hand and producers in the protected area on the other--say the United States. But as between Germany and a third country, such as England, both competing for whatever available market remains in the United States, it is not. Other things being equal, the price situation will be almost entirely in Germany's favor.

All this is not to say that irritation and even distress will not result in the other countries of the world in consequence of the severe new commercial and industrial competition from Germany; a distress that may well be felt most acutely in the countries which are the chief beneficiaries, directly or indirectly, of the reparations payments. But such considerations are outside of our present problem. Regarded as a strictly economic process, it will evidently be entirely possible for Germany to effect the desired reparations transfers under reasonable conditions, and for the Allied countries to receive them.

V

It is thus clear that, granted good faith and the exercise of reasonable financial precautions, the payment and receipt of German reparations need not give rise to insuperable difficulties. The accumulation of the stipulated sums in Germany itself is well within the capacity of the German budget, and the subsequent process of transfer can be made very nearly automatic. If the Treasury and the banks will at first permit, and later enforce, the requisite preliminary contraction in the volume of purchasing power in circulation, the pressure to effect the transfers will of itself bring about whatever increase in commodity exportation, relative to importation, is necessary. With the volume of purchasing power in circulation diminished, there will be neither an occasion nor an excuse for a new depreciation of the foreign exchanges, or of the internal value of the currency itself.

Substantially similar considerations apply to the economic possibility of transferring net international payments from those countries which are debtors in the Inter-Ally account. If weak financial or monetary administration in Germany, or bad faith, causes reparations receipts to fall below the amount of the net Inter-Ally debt charges, it will then be necessary for the Continental Allies to make payments from their tax revenues to England and the United States. Regarded as a problem in international transfer and bookkeeping alone, however, these payments will not give rise to any such difficulties as will the payment of reparations; and the process can be made equally automatic. The combined net totals annually receivable by England and the United States will probably amount to less than two-thirds of the standard reparations receipts; and the largest possible net payments required of any one country--those due from France--will come to less than one-third of the total German transfers.[iv] If reparations reach any figure higher than two-thirds of the anticipated standard volume, all of the Allied countries will become net creditors in the combined international account.

The principal difficulty, and the principal distress, will arise rather with respect to the preliminary accumulation of revenue surpluses within the Continental debtor countries. In eight or ten years' time, even if reparations should fail to reach a substantial size, the budgets of these countries will be capable of providing the necessary surpluses, without the appearance of any increase in the present real burden of taxation. When their monetary and financial stabilizations are definitely completed, it will become possible for them to refund their enormous internal debts at much more advantageous terms--the charges on which are now much the largest single item in their budgets. A reduction in these charges will greatly augment the current revenue surpluses. Stabilization will also lead to the return of much of the capital which is at present expatriated. The consequent expansion of domestic business will enlarge the yield of taxation, without increasing its real burden.

But if the debtors are called upon to make large payments in the immediate future, before the budget situation has been gotten in hand and before reparations reach the full volume, their position may well become acutely dangerous. Even if budget surpluses could be secured it is doubtful if the governments or the banks are yet strong enough to enforce a material contraction in the volume of purchasing power in circulation. The pressure to make payments abroad will then fail to exert its automatic influences upon prices and the balance of trade, and instead will force down the exchanges. A new cycle of currency depreciation and collapse will appear, and will soon make further payments impossible.

The creditors in the Inter-Ally account, therefore, have every reason to defer the exaction of actual transfers--although they can reasonably demand a recognition of the debts, and a settlement of the terms of payment. If they wait, the direct burden will probably be borne very largely by Germany; and even if the German transfers prove to be inadequate, the process of payment will cause distress only at its beginning. If they do not wait, it is difficult to see how a new economic catastrophe can be avoided.

[i] See the writer's recapitulation of studies of such operations in the past, in "The Inter-Ally Debts," published by National Industrial Conference Board, New York, 1925.

[ii] See A. A. Young, "War Debts, External and Internal" (FOREIGN AFFAIRS, March, 1924) and Professor Young's review of Moulton and McGuire's "Germany's Capacity to Pay" (Journal of the American Statistical Association, June, 1924). Also see G. P. Auld, "Starting the Dawes Plan" (address before Chicago Council on Foreign Relations, Dec. 6, 1924; reprinted separately); and "The Transfer Problem" (The Annalist, June 8, 1925).

[iii] Similar general conclusions have been advanced recently by F. D. Graham in the American Economic Review, June, 1925; and in less detail by B. M. Anderson in the Chase Economic Bulletin, April 28, 1924. Both writers pass directly from taxation, for reparations purposes, to the export of purchasing power from Germany when the reparations are transferred. They say nothing of the intermediary mechanism stressed here, which operates through bill holdings and the volume of purchasing power in circulation. Yet without some appreciation of this it is impossible to understand the process of transfer accurately or to devise means for controlling it.

[iv] Figured at 3½ percent (the terms granted England by the United States) the principal of the German reparations comes to roughly 17 billion dollars. The total of the net Inter-Ally debts due to England and the United States, as of 1923, was 11.5 billion dollars (omitting the Russian debt), of which 5.2 billion dollars was due from France and 4.5 billion dollars from Italy. England's net credit balance, however, is small--less than 1 billion dollars.

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