Ten years ago a combination of rising inflation and incipient recession signaled the end of the Soaring Sixties. Yet few contemporary observers perceived that the end of the long postwar expansion was at hand, or that the coming decade would perhaps one day be labeled the Sagging Seventies.

The contrast between the two periods is indeed marked. During the great postwar boom, from 1958 to 1973, the average annual rate of growth of the gross national product, adjusted for inflation, exceeded five percent in the seven largest industrial countries, Britain, Canada, France, Germany, Italy, Japan and the United States. This growth rate was high not only compared to the period since 1973, but also historically. Yet from 1973 to 1979, the average annual growth of the same seven economies fell to only two and one-half percent. And, as growth collapsed, inflation surged. Prices in the same countries, which had advanced at only three and one-half percent in the earlier period, speeded up to eight percent from 1973 to 1979.

Persistent, high inflation and low, halting growth, along with high unemployment, unstable exchange rates and sluggish investment are the symptoms of an economic disease that economists call stagflation, a rare malady that had not previously afflicted the industrial West. Because its onset dates from the first show of muscle by the Organization of Petroleum Exporting Countries (OPEC) in the winter of 1973-74, many observers have been led to lay the problem at OPEC's door.

The conclusion is plausible, especially right now when OPEC's latest round of oil-price hikes promises to aggravate the current recession in the United States, much as the first oil shock deepened and prolonged the worldwide recession of 1974-75. But a closer look suggests a different conclusion. The most important causes of stagflation in advanced industrial countries are not external. They are rooted in economic policies followed by these countries since the early 1960s and, more fundamentally, in the social values and political priorities those policies express. In short, our worst economic wounds are self-inflicted. Their healing therefore depends on our own efforts.

To understand stagflation, one must understand the postwar boom that preceded it. Broadly speaking, from the early 1950s until the early 1960s, a favorable conjuncture of factors on the supply side of the industrial economies made possible a period of unusually rapid growth without much inflation. Thereafter these unusual sources of growth faded, but growth of GNP was strong into the early 1970s, mainly because the United States employed highly stimulative monetary and fiscal policies in order to finance simultaneously domestic social programs and the Vietnam War. Although these policies brought about an unusually rapid rise in output and employment throughout the industrial world, they also led to accelerating inflation, a breakdown of the international monetary system and erosion of public confidence in money and its management. The end result was stagflation. The public's loss of confidence in the management of money is, we believe, the core of the stagflation malady.

Trust in money, once undermined, is not easily restored. Yet the prestige of governments and their command over economic resources is directly affected by what the market thinks of their currencies and the voters of their economic management. Here is a potential source of international discipline over national monetary policies. It could in time help to rebuild that trust. Such, at any rate, is the hopeful thesis of this essay.


In its first phase, which lasted through the 1950s, the postwar boom owed its unusual vigor to the special opportunities for growth created by the preceding two decades. Depression and protectionism in the 1930s, followed by rearmament and five years of destructive war, had held down investment and slowed the advance of nonmilitary technology, creating an unusual abundance of labor relative to the stocks of capital and technology. Economic conditions were therefore ripe for a powerful upswing in capital spending, induced by the prospect of high profits and returns on investment.

To realize this potential for a growth "miracle," fundamental changes in the political and institutional environment were required. For expansion was constrained by wartime and postwar controls on prices, wages and foreign exchange and by uncertainty born of unsettled political conditions and the cold war. Moreover, inflation had to be checked, exchange rates stabilized, currencies made convertible again, and national markets reopened to foreign competition. The postwar climate of military insecurity had to give way to peaceful coexistence. Hostility to private enterprise in Western Europe had to be dissipated. Remarkably, by the end of the 1950s all this had been accomplished.

Particularly important was the restoration by the late 1950s of domestic price stability in the United States. This crucial achievement enabled other industrial countries to "import" price stability by eliminating exchange controls on current transactions and pegging their currencies firmly to the dollar. This was accomplished by 1959, under the aegis of the monetary system designed at Bretton Woods 15 years earlier.

Under that system, the U.S. commitment to keeping the dollar convertible into gold served to assure other countries that the Federal Reserve would put price stability ahead of competing considerations in determining the supply of dollars, as in fact the Fed did until the mid-1960s. Since other central banks were committed to pegging their currencies to the dollar, the supply of dollars largely determined the supply of other currencies. Thus U.S. monetary policy exerted a powerful stabilizing influence on price levels in other countries. The result was a low, predictable rate of inflation throughout the industrial world.

A market economy works best with a reasonably stable price level and in a climate of economic liberalism. It works badly in an environment of inflation and political uncertainty, particularly when the inflation is highly variable and is partially suppressed by controls. Much of the postwar surge in economic growth in the industrial countries is explained by a transition from the second of these states to the first. Credit for making the transition possible goes in no small measure to the United States and its special role and influence in the postwar world-the American guarantee of Western security and monetary stability and the U.S. dedication to restoring an open, liberal economic system.

However, the unusual sources of growth that got the postwar boom off to a running start were inherently self-limiting. By the beginning of the 1960s, they were largely exhausted. Remaining barriers to investment, to trade and to domestic labor mobility were low. The backlog of unapplied technology had been largely used up. Little scope remained for major institutional reform that would accelerate growth in the industrial countries by allowing their economies to realize their full potential.

Nevertheless, growth continued to accelerate into the 1960s, thanks again to the United States and the stimulative fiscal and monetary policies of the Kennedy and Johnson Administrations, which gave the fading postwar boom a powerful shot in the arm from the demand side. Through the newly established system of fixed exchange rates, the stimulus spread to the rest of the industrial world.

President Kennedy's election pledge was to "get the country moving again." So far as monetary policy was concerned, this meant urging the Federal Reserve to depart from the cautious policy it had followed in the 1950s, and which had, by 1960, restored domestic price stability. Accordingly, U.S. money growth accelerated gradually through the first half of the 1960s.

At first, the effect was almost entirely favorable; output accelerated and unemployment fell while prices hardly rose. After a decade in which U.S. monetary management had been preoccupied with price stability, the public at home and abroad did not anticipate that the speedup in money growth would sooner or later raise the price level. Then, after Lyndon Johnson's election as President in 1964, U.S. monetary and fiscal policies became still more expansive. The shift reflected important changes in social values and economic priorities that developed during the 1960s. Americans, aware of their new affluence, began to take rapid economic growth for granted. Their collective conscience became more sensitive to the plight of the hard-core unemployed and others whose share in the new affluence was slight.

The moderate policies of growth during the Kennedy years accordingly gave way to policies designed to achieve very low rates of unemployment and to social programs designed to redistribute income in a massive way: Johnson's Great Society and his War on Poverty. With the budget costs of the war in Southeast Asia also escalating, accelerated monetary expansion became unavoidable, for the President was unable, politically, to finance an unpopular war by raising taxes or by noninflationary borrowing, and he was unwilling out of personal conviction to choose between guns and social justice. This fateful decision-or failure to decide-led with tragic inevitability to the collapse of the postwar boom and the condition of stagflation we now endure.

The end game was long and eventful. The Indochina War and social programs continued to compete for funds, and the first Nixon Administration and the Democratic Congress ratified President Johnson's decision to authorize both. In 1969, as inflation accelerated, the Federal Reserve resisted this approach, tightening money sharply. The economy slumped. Inflation, however, barely abated. By 1970, the public's expectations of inflation had been ratcheted up to the higher pace of inflation prevailing since 1965, and the slowdown in money growth was too brief to alter these expectations materially. In consequence, when the Federal Reserve's policy again turned expansive in 1970-71, the resulting recovery was weak. Rising prices absorbed much of the stimulus to demand caused by more rapid money growth.

Now the Administration was in real trouble. The 1972 presidential election was approaching, and the sluggish recovery and high unemployment figures had become a major political liability. The Administration therefore prevailed upon the Federal Reserve to increase the rate of U.S. money growth still more. Although this policy did speed the recovery, it also undermined the basis of the fixed exchange rate regime. By virtue of the size of the U.S. economy relative to the other members of the Bretton Woods system, domestic demand and supply conditions in the United States tended to determine the prices of goods traded on world markets. Thus, U.S. monetary policy occupied a unique position in the Bretton Woods system. It set the rate of inflation in the United States; and through the commitment of other countries to peg their currencies to the dollar, it also tended to fix the rate of inflation in other countries.

In the early 1960s this arrangement had produced price stability in the industrial world. By the late 1960s, however, the other members of the Bretton Woods system were discovering the dark side of their fixed exchange rate agreement with the United States. They were learning that a fixed rate system is compatible with any rate of inflation, as long as it is common to all the currencies in the system. As soon as the United States began to finance the Vietnam War and the Great Society simultaneously through printing money rather than through taxation or borrowing, they found that the Bretton Woods system functioned as an engine of worldwide inflation.

With inflation escalating, the need to create additional international liquidity or world money seemed apparent to many participants in the international financial arena in the late 1960s. Without additional reserves it was felt that countries could not continue to expand trade, investment and employment. The world supply of money became increasingly a function of the demand for money-a demand swollen by rising prices.

Gradually, however, different concepts emerged. They implicitly recognized that the amount of liquidity required to finance a certain volume of trade depended critically on the prices of the goods concerned. The lower these prices, the less liquidity needed. Hence, a search began for alternative sources of liquidity, i.e., currencies whose purchasing power over goods and services would not deteriorate as rapidly as the dollar's.

At first, the other members of the Bretton Woods system turned to gold, a monetary unit in relatively fixed supply. However, much of the world's supply of gold remained in the coffers of the United States, which had agreed to convert dollars into gold at $35 per ounce. In the late 1960s, as their confidence in the management of the dollar waned, other governments began to utilize the conversion privilege at a rapid rate; by 1971 the United States faced the unpleasant choice of losing its entire remaining gold stock or of initiating the classic gold-standard remedy of domestic deflation in order to restore confidence in the dollar. In fact, the United States chose to avoid both these alternatives; it simply suspended the convertibility of the dollar into gold in August 1971. This left the Federal Reserve free to continue its highly stimulative monetary policies.

The drama's climax followed swiftly. Rapid U.S. monetary expansion in 1971-72 produced in 1972-73 a final surge in economic growth both at home and abroad. However, it also destroyed the last remnants of the Bretton Woods system which the Smithsonian Agreement (December 1971) on new exchange-rate parities had managed to preserve. After 1973, the search for alternative sources of international liquidity intensified; the other members of the Bretton Woods system, especially Germany, Japan and Switzerland, realized that their continued adherence to the fixed exchange rate regime would inevitably condemn them to the same high rate of inflation that the United States had chosen.

Gradually, these countries came to believe that their own currencies would serve their international liquidity needs perfectly well, if their supply were limited. Thus, the flexible exchange rate regime was born, full of the bright promise that countries would be able to utilize monetary policy against inflation or unemployment as they saw fit without having to encounter the severe balance-of-payments crises that had emerged during the latter stages of the Bretton Woods system.

At the very time the fixed exchange rate system was breathing its last, OPEC made its stunning decision in the winter of 1973-74 to quadruple the price of oil. This capped the climax, dealing a harsh blow to real incomes in all oil-importing countries. Along with a simultaneous tightening of money in major countries, it plunged the world economy into deep recession. The great postwar boom was at an end.


At first, no one saw it that way. The 1974-75 recession, it seemed, was just another business downturn, though an unusually severe one. Another round of demand stimulation, it was thought, would soon bring the industrial world back to full employment. In 1975 or 1976, the economic authorities in Britain, Canada, France and Italy followed this prescription. Each adopted a highly stimulative monetary policy in response to serious unemployment.

Then came a shocking discovery. The expansionary policies made hardly a dent on unemployment, but, instead, soon produced spiraling inflation and falling exchange rates. These countries were then forced to rein in money growth. Since then, all four have proceeded cautiously, daring neither to reexpand vigorously nor to tighten sharply. There has been some improvement in inflation but growth has been sluggish or halting.

The new reality is a mutation in economic psychology, caused not simply by the 1974-75 slump, but by the succession of monetary traumas of the early 1970s. As rapid inflation became a fact of economic life and fixed exchange rates broke down, participants in financial markets, in labor markets and in markets for commodities and for every kind of product in the industrial countries, began to form their economic expectations in new ways. Having lost faith in a stable or reasonably predictable price level, private decision-makers now try to anticipate the behavior of prices and exchange rates by paying close attention to what the monetary authorities are doing.

The markets have learned that when a country's monetary policy turns expansive, relative to that in other countries, its exchange rate will depreciate and domestic inflation will accelerate. These results are therefore anticipated; prices are put up and currencies down almost as soon as the new direction of policy becomes clear.

In consequence, governments have lost much of the ability they once had to bring about a rise in output and employment. For the impact of monetary expansion on real income and demand is soon absorbed by an accelerated rise in prices, and this, along with a depreciating currency, soon forces the authorities to tighten money again. Until the late 1960s, as we have seen, exchange rates were assumed to be fixed and the markets still expected prices to remain stable or the going rate of inflation to persist indefinitely. Thus, monetary expansion could successfully raise output and reduce unemployment before its inflationary consequences became apparent. Now, however, monetary expansion raises inflation before it can seriously affect employment.

Germany and Japan, along with Switzerland, demonstrate another variation on this stagflation theme. These countries, unlike those just mentioned, have consistently given a high priority to the fight against inflation. They have successfully kept domestic inflation down. By starting their fight against inflation early in 1972-73, these countries never allowed expectations of high inflation to become embedded in their economic thinking. More important, they resisted the general trend among the industrialized countries in 1975 and 1976 to utilize a stimulative monetary policy as a means of overcoming the recession of 1973-74. As a result, these countries have continued to enjoy relative price stability.

Of course, this victory over inflation has not been without cost. Unemployment did rise, especially among younger workers during 1974 and 1975. Some of this was due to the economic dislocations caused by the oil crisis, some was due to the recession in Germany's major trading partners, and some was due to the decline in the rate of growth of output destined for domestic consumption.

The German government did respond to the plight of its jobless citizens. Like the Swiss government, it slashed the number of foreign workers inside the country through tighter visa and work permit requirements. By the fourth quarter of 1975 the slide in the employment of German citizens had come to a halt. To aid those remaining unemployed the government liberalized unemployment benefits, intensified manpower training and relocation programs and stepped up government spending. Although the budget deficit ballooned, the German authorities resisted the temptation to finance a large portion of it through the additional creation of money. Instead, it reserved monetary policy for the fight against inflation. Now, it seems that these policies are bearing fruit. Inflation remains low and unemployment has dropped.

In summary, over the past five years the German public, and in particular the German trade unions, have been willing to accept this type and amount of unemployment as a cost of securing permanent price stability. They have consistently held wage demands to moderate rates, confident that the central bank will preserve price stability. No doubt this is due to their sophistication, born of historical experience about the connection between money, exchange rates and inflation.

Nevertheless, Germany has been caught in a policy dilemma similar to that encountered by the countries whose fight against inflation has failed. The dilemma arises because its low rate of inflation makes the mark attractive, relative to other currencies, as a store of value and as a speculative investment. Accordingly, the mark is chronically overvalued on the exchange markets; that is, at current exchange rates a mark will purchase a greater volume of goods and services in the United States than it will in Germany. Hence, its exchange rate is above the rate that would be consistent with the mark's domestic purchasing power. This overvaluation cuts into domestic profit margins and potential sales in German exporting- and import-competing industries. It therefore deters investment in those industries, impairing Germany's growth and causing unemployment.

Thus, when the dollar weakens, as it did in the summer and fall of 1978, the Bundesbank (the German central bank) comes under political pressure to intervene in the exchange market to prevent the mark from rising too rapidly against the dollar. As the Bank responds to this pressure, it buys dollars in exchange for marks. This speeds the growth of the German money supply and causes the German public to expect more inflation, and to act on that premise. This reaction alarms the Bundesbank and soon forces it to tighten money again. Thereupon the mark again rises on the exchanges, once again squeezing profits and discouraging investment.

Thus in industrial countries with low inflation as in the others, the public's increased sensitivity to monetary management has made it impossible for governments to conduct economic policy according to the rules of demand management developed in the 1960s.

The stagflation syndrome made its appearance later in the United States than in Europe. Beginning in 1976 and continuing on through 1977 and most of 1978, the Carter Administration and the Federal Reserve followed a classic 1960s prescription for dealing with recession and unemployment. At first, the policy seemed successful. Accelerating money growth beginning late in 1976 had a significant impact on U.S. output and employment and did not cause the dollar to fall and inflation to spurt until 1978. This difference from European experience is doubtless due to the U.S. economy's greater size, which limits or delays the impact of the dollar's fall on domestic prices.

Nevertheless, last November, after two years of swift monetary expansion, the Carter Administration and the Federal Reserve also acknowledged the sensitivity of inflation and the dollar's exchange rate to the acceleration in money growth. The United States now finds itself about where Britain, France and Italy were two or three years ago. Monetary policy has been tightened to cope with high inflation and a falling currency, and the U.S. economy is in recession.

Moreover, the Fed and the Administration are evidently uncertain whether the old demand-management magic can work again. For the exchange markets are now highly sensitive to the connection between U.S. monetary policy and the strength of the dollar. As soon as market participants judge that U.S. policy has become more expansive relative to that of Germany or Japan, they begin to sell dollars against marks or yen, producing a downward spiral of the dollar on the exchange markets. Such was the case in October 1978 and again, to a much lesser extent, in June and July of this year. Thus, the strength of the dollar against the mark and the yen has become a symbol of the competence of U.S. economic management.


This brief analysis of stagflation goes a long way to explain broad developments in the industrial countries during the last few years. It suggests that the key to the problem of inflation is the public's loss of confidence in the ability of the authorities to come to grips with its root cause: too much money. Unfortunately, until very recently governments in much of Western Europe and the United States persisted in seeing inflation as the result of increases in the prices of strategic commodities or of wages, reasoning that inflation could therefore be checked by direct controls.

In the United States, this line of reasoning has been used to justify continuing control of domestic energy prices. But the issue posed by the high world price of oil is a problem which affects the patterns of production and consumption, not the overall price level or the rate of inflation. Confusing the high price of energy with inflation obscures the real issue of the energy crisis: how and how rapidly should the economy be allowed or forced to adjust to a radical increase in the relative price of its most important material input?

Social and economic goals that were accepted in the expansive atmosphere of the 1960s-goals for living standards, income redistribution and environmental quality, for example-assumed implicitly that the price of energy relative to other goods and services would remain stable or continue to fall, as it had for much of the postwar period. Now the need is to divert real resources in a massive way to pay for current energy consumption and for investment in domestic energy production and conservation. The talk about oil and inflation, or about oil and the dollar, only serves to conceal the need for these difficult economic and political adjustments. Moreover, if price and exchange-rate stability were restored by the only effective means-improved monetary management-these fundamental economic and political problems would come to the fore for appropriate discussion and treatment.

Of course, this would be only one of many benefits to the economy of overcoming inflation. The price system would once again be able to fulfill its natural function of providing an efficient guide to investment and employment opportunities. Periodic bouts of tight money would become less necessary; deep and prolonged recessions could be avoided; exchange rates could be stabilized; growth could be stronger and steadier because profit expectations would improve; and the rate of investment would rise. In short, a victory over inflation would bring with it a solution to the tangle of economic problems called stagflation.

For years now, governments of the industrial countries have railed against inflation. Until now, however, most have recoiled against the side effect of the antidote, a lower rate of money supply growth. Initially, such a policy leads to a reduction in the rate of growth of expenditures by consumers and investors on goods and services. Unless firms and workers react to the change in monetary policy by lowering the rate of increase in prices and wages, reduced spending will necessarily be spread over a somewhat smaller volume of production. Inventories accumulate beyond desired levels, output is cut back, unemployment rises.

However, these side effects are temporary. To move unsold goods, firms mark up prices at a slower rate, or actually reduce them. Gradually, inflationary expectations are weakened, new wage bargains reflect a lower inflation premium. It once again becomes profitable to expand output and employment.

But "temporary" has often proved too long a time frame for policymakers conscious of the electorate's displeasure. When unemployment rises, most countries have reversed the monetary restraint in an effort to check the rise in unemployment. Inflation, of course, has revived as a result.

In most countries people have come to anticipate this policy cycle and its effects. Now, stabilization policies lack credibility. The public expects prices and costs to go on rising, and inflation holds up stubbornly in the face of monetary restraint. Investment in new plants and equipment lags, and, as a result, the growth in labor productivity and real wages slows. In countries with restrictions on labor mobility or stringent minimum wage laws, unemployment remains high, often concentrated among youth and disadvantaged groups least able to forego the on-the-job training which a more robust economy would provide. And this joblessness is well-nigh permanent, embedded in the structure of the economy and impervious in the short run to stimulative monetary and fiscal policies. To deal effectively with stagflation, thereby reducing unemployment in the long run, governments first have to win back the confidence of the public in their capacity as economic managers.


Under the pre-1914 gold standard, governments sought and won confidence in their currencies by keeping them convertible into gold at a fixed parity. Money creation was linked to, and disciplined by, the supply of monetary gold, which in those days was not subject to political manipulation. Under the Bretton Woods system, as we have seen, the dollar took the place of gold as the regulator of the supply of other currencies, while the Federal Reserve's control of the supply of dollars was qualified by the dollar's convertibility into gold.

Today, however, for the first time in modern history, there is no objective regulator to discipline money creation. Yet money retains its value-that is, its expected purchasing power-only when people have confidence that its supply will remain scarce relative to the supply of goods and services. Finding a new source of monetary discipline is, therefore, the key to the problem of stagflation.

Ideally, the regulator of money should be beyond national control, as gold was under the gold standard. It could be, for example, a supranational International Monetary Fund that would issue an international currency. But that solution is obviously beyond reach. A return to Bretton Woods is most likely out of the question also. Under Bretton Woods, the Federal Reserve played the role of a supranational monetary agency. It was top dog, controlling the international money supply. But the economic growth of Europe and Japan has long since reduced the economic preponderance of the U.S. market that underlay that monetary structure. Even if the purchasing power of the dollar were now to be stabilized, only a politically more balanced international monetary arrangement would prove acceptable today.

Between an ideal but impossible supranational monetary order and the anarchy of the present system, a new path to monetary stability can perhaps be found. An arrangement of this kind may grow out of the present effort of European countries to stabilize their currencies against each other, and to harmonize their monetary policies, under the new European Monetary System or EMS.

Basically, the EMS represents a commitment by each of its members to preserve fixed exchange rates between its own currency and those of the other members. The system started operation in March 1979 with West Germany, Belgium, Luxembourg, the Netherlands, Denmark, Ireland, France and Italy as charter members. A central exchange rate for each country's currency in terms of each of the other currencies was established. Actual exchange rates are permitted to fluctuate up to 2.25 percent above or below the central rate, with the exception of the Italian lira, which is permitted a wider six-percent band on either side of the central rate. To enable countries to overcome any balance of payments problem that may arise, the EMS also contains provisions for short- and long-term credit facilities among member central banks and governments. Thus, in many ways the EMS resembles a Bretton Woods in miniature.1

As was the Bretton Woods system, the EMS will only be as strong as the acceptance by each of its members of the common inflation rate that any well-functioning fixed exchange rate regime implies. And it is for this reason that the EMS holds more promise than earlier European arrangements of the same kind. Those attempts failed because Britain, France and Italy were unable to find a common denominator with Germany for monetary policy. Now, however, the increased sensitivity of markets to monetary policy may also make it possible to bridge that policy gap, because it forces all EMS members, not Germany alone, to give a high priority to fighting inflation. Thus, the improved prospects for the EMS arise not because European governments are less jealous of their independence than they used to be or more willing to sacrifice monetary sovereignty on the altar of the European idea, but for practical reasons. The sensitivity of the exchange markets has exposed the fallacy of attempting to reduce unemployment by fiscal and monetary expansion. Accordingly, policymakers in France and Italy seem to have lost faith in old-style demand management. In this chastened mood, they are ready for a new attempt to stabilize prices and exchanges.

In France, this process is already far advanced. The two-and-one-half-year-old "Barre program" (named for the Prime Minister) has slashed the rate of money growth in France and enabled the country to restore equilibrium in its balance of payments. So far, the French franc has experienced little difficulty in adhering to the EMS. Domestically, however, the program has not yet produced a major improvement in the French rate of inflation, although it has induced a significant rise in unemployment to nearly six percent of the labor force.

In part, French inflation remains high because the economy is adjusting to the last phase of the price decontrol program. However, it is anticipated that these effects will soon wear off, and that the monetary restraint of the past few years will produce a substantial fall in the inflation rate over the latter half of 1979. Thus, France has to a degree already copied much of the German recipe for success against inflation: a lower rate of money growth coupled with liberalized unemployment benefits and heavier use of the bond markets to finance a greater government budget deficit. France has probably already incurred the major cost of price stabilization; to abandon the struggle at this juncture would be to sacrifice whatever gains are to be made on the inflation front and to generate a substantial depreciation of the franc on the exchange markets without boosting employment significantly before the 1981 presidential elections.

In this stabilization effort, membership in the EMS has played a central role. Linking the franc to the mark in the EMS has conveyed to market participants the strength of the government's commitment to restoring price stability in France. The ability to maintain a fixed rate with a currency whose purchasing power is known to be stable disseminates important information: it indicates that French monetary policy is following a course which will bring the French inflation rate into line with the low German rate.

This external discipline has also attracted the Italian authorities. As one of its last decisions, the Andreotti cabinet entered the EMS. Although it took advantage of the wider six-percent band of fluctuation for the lira within the EMS, it is already clear that the Bank of Italy has used the EMS to guide its efforts toward internal price stabilization. Here, too, the strength of the lira within the EMS is conveying the information that Italy has started on the path to stabilization.

Of course, its commitment to this policy cannot be considered firm as yet. The new government has barely begun to formulate an economic program. However, looking to the long term, one may retain a certain degree of optimism about the ability of the Italian government to stabilize the domestic purchasing power of the lira. Any return to monetary stimulation would augur only a balance of payments crisis and a collapse of the lira such as occurred in 1976.

In this stabilizing process, Germany's low rate of inflation stands out as a beacon. Ultimately, it will tend to set the European norm, either because firms and individuals will have abandoned their own national currencies for marks, or because governments in other countries will have elected to follow Germany's policy lead. Accordingly, in recent years, many non-German residents have been holding an increasing portion of their wealth in assets denominated in marks. If Italy were to maintain a rate of money growth far above Germany, then firms and individuals in Italy would most likely continue to shift from lire into marks; this, in turn, promotes a depreciation of the exchange rate of the lira vis-à-vis the mark and an acceleration of inflation in Italy. Unless the Italian monetary authorities react to this, they will be increasingly unable to use money creation as a means of financing government expenditure on goods and services. In other words, their money sovereignty will ebb.

In fact, this is just what has been happening over the past few years not only in Italy but also in France. The governments of these countries have now reacted to this process by joining the EMS. Through it they can preserve some portion of their monetary sovereignty. In a world in which capital is relatively free to flow among currencies, monetary sovereignty is indeed dependent on the willingness of the people to hold the government's issues of currency. And that depends on the currency's prospective purchasing power, ultimately on its supply. To prevent people from abandoning their currency entirely and from simply holding German marks in lieu of francs and lire, the French and Italian monetary authorities have started to follow the German policy lead. By accepting membership in the EMS, monetary authorities in Italy and France have acquired the right to participate in decisions concerning the common rate of inflation toward which the fixed exchange rate provisions of the EMS will ultimately push its members. Without their acquiescence, it is likely that firms and individuals would have attempted to create a zone of price stability by shifting their currency holdings to marks.

If France and Italy are counting on the external discipline of the EMS to guide them back to price stability. Great Britain, for the moment, seems to be relying on its own internal discipline to do so. Britain, of course, represents the clearest case of the trials a country faces when it attempts to eradicate the philosophy of fine-tuning the economy through extensive stop-go economic policies. Although former Prime Minister James Callaghan had clearly stated that such stop-go measures only stalled the economy, the electorate has now entrusted Margaret Thatcher with the mandate to reduce inflation and eliminate barriers to production and investment. Largely on the strength of the Conservative Party's dedication to these aims, the exchange markets have bet heavily that the pound sterling will lose its purchasing power at a much less rapid rate in the future. With a hefty majority and a five-year tenure in office and some probability that Britain, too, will join the EMS, the Conservatives seem to have a fair chance to restore price stability in Britain. Their long-run success will depend, of course, on their maintaining a firm monetary stance in the face of the coming rise in unemployment.

Whether from external discipline or internal conviction, the European countries seem, therefore, to have embarked on the path to exchange-rate stabilization and price stability. Policymakers in France, Britain and perhaps Italy have probably seen the dash for growth transform itself once too often into the rush toward inflation and exchange-rate depreciation. In fact, the lack of a viable policy alternative may be the most powerful reason keeping the European economies on the stabilization path.


If the preceding analysis is correct, a zone of European monetary stability seems a distinct possibility in the mid-1980s. The accompanying implicit or explicit coordination of monetary policies among European countries would add an important element of cohesion to the Common Market. This economic union would not only control the largest share of the world's industrial output but it would also be able to offer wealth-holders several currencies that would be attractive alternatives to dollars in their portfolios.

Under such circumstances a more balanced international economic system would necessarily result. However, the shape of the system and the role of the United States in it remain open. Although the inflation of the past decade has destroyed much of the dollar's central function in the international economy, the size of the U.S. economy and the depth of its capital markets ensure that the decisions of the Federal Reserve concerning monetary policy still have a major influence on economic conditions throughout the world.

However, this remnant of monetary hegemony from the Bretton Woods era is fast evaporating. Even now, important nonresident holders of dollars-OPEC countries, foreign central banks, large international firms-customarily shift a part of their dollar holdings into marks whenever U.S. monetary policy diverges in an expansive direction from German monetary policy. With the addition of sterling and other European currencies to the list of stable currencies, such shifts would swell in volume, shrinking the dollar's sphere of influence at a rapid rate.

Unless the United States reacts to these votes of no confidence in its currency, the dollar seems fated to replicate the long drawn-out demise of sterling as an international currency following World War II, and for much the same reason: a failure by the monetary authorities to preserve the currency's purchasing power. As Britain did in 1976, it is likely that the United States would ultimately confront a situation in which demand-management policies would reveal themselves to be utterly bankrupt.

Expansionary monetary policies would immediately lead to exchange-rate depreciation and an acceleration in inflation without raising output or lowering unemployment. In other words, the United States would find itself in the situation confronted by Britain, France and Italy, countries pointing toward stabilization because they have no other choice. Until then, however, stagflation would continue to rule in the United States and in much of Europe as well. The dollar would continue to slide on the exchange markets and the OPEC countries might view keeping oil in the ground as a better way to preserve the real value of their wealth than investing in financial assets, such as U.S. government securities.

Of course, it is in the power of the United States to short circuit this entire process. It can check the ebb in confidence in the dollar by starting now to stabilize its purchasing power. In so doing it can still aspire to the leadership of a new international monetary system, although never to the hegemony it enjoyed under Bretton Woods. Leadership responsive to European and Japanese interests would be welcomed and serve to strengthen the Western alliance. It would improve domestic economic conditions as well.

However, the United States does not seem ready to embrace a stabilization program out of internal conviction. Perhaps the advantages of price stability for investment and growth are too obscure; the dangers that inflation and a progressive tax structure will erode the wealth of American families, too remote; and the consequences of such a stabilization program for unemployment, believed too abhorrent for the voters or the politicians to enshrine price stability as the primary target of economic policy.

Nonetheless, the problem of inflation and the erosion of the U.S. position in the world economy continues to demand attention from policymakers. If not internal conviction, perhaps external pressure will induce the United States to take action. To some extent, of course, it already has. Last November the rapid fall of the dollar against the mark and the yen persuaded the Carter Administration that some measures were necessary to protect the dollar. The dramatic increase in the discount rate and the subsequent drop in the rate of money growth in the United States did halt the dollar's slide.

Now, however, the first signs of the recessionary side effects of that policy are becoming apparent. Already, some official circles are talking of the need for stimulative measures, such as a tax cut, to spur the economy. Perhaps, therefore, external discipline is the only way policymakers can keep themselves lashed to the mast, so that the U.S. economy may traverse the narrow course toward price stability and more robust economic growth.

Is it not time for the United States to join Europe, and probably Japan and Britain as well, in a broader, looser version of the EMS, in which Washington would agree, first to stabilize its exchange rate against the mark and the yen, and then, after a period of six to 12 months, to generate an appreciation of the dollar sufficient to eliminate the current discrepancies in domestic purchasing power between the dollar and the other major currencies? If rigidly adhered to and implemented by appropriate monetary policies, this commitment could transmit the information needed to convince economic decision-makers both inside and outside the United States that the United States intended to preserve and strengthen its monetary sovereignty by attracting followers to its leadership. This would be a far wiser course than for the United States to attempt to force its hegemony on residents and nonresidents alike by means of controls. And it would certainly be a more far-sighted policy than standing by passively as the dollar is abandoned for other currencies.



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