Against the Tide

XIII

The Dilemma of Imported Inflation*

I

Among the difficult and increasingly pressing problems of any policy to counteract the inflationary tendencies of an overheated boom, the question of international complications deserves particular attention at this moment. This question can perhaps best be studied in the case of Germany, where a dramatic worsening of the situation is giving rise to a lively discussion. The essential points involved are of such outstanding general interest that it is worth extending the German discussion to the international scale.

Germany is an especially striking example of a country whose countercyclical economic policy has landed it in an apparently paradoxical situation, precisely because of the international complications involved. While in Germany an altogether exemplary attempt is being made to dampen the boom by a restrictive credit policy, unusually high surpluses keep recurring month after month in the German balance of payments and are a dangerous source of expansion counteracting the restrictive credit policy and, to a large extent, offsetting its anti-inflationary effects. A country that, quite rightly, tightens credit domestically, because it is afraid that overexpansion of the economy may lead to a progressive deterioration of the currency, finds that this selfsame currency is much in demand on the international market as a “hard” currency, of which there is a “shortage”—all characteristics that are not at all those of inflation. And the more that country does to resist internal inflation of its currency, the more stubbornly the balance of payments keeps registering a surplus, with all its expansionary effects.

The case is not peculiar to Germany alone; there are other countries in a similar position, including Switzerland. The point is that alongside domestic credit expansion, external economic relations have proved to be another dangerous source of inflation, because of the monetization of the balance-of-payments surplus. How to plug this source is a question much debated in Germany at present. Should imports be encouraged, and by what means? Should exports be curtailed, and by what means? Could tariff reductions of a politically feasible magnitude be expected to give any appreciable relief? If not, would it help to export capital, especially in the form of the advance redemption of Germany’s foreign debts? Is the surplus in the German balance of payments going to last, or is it merely the result of forces whose effect is temporary, so that it is safe to just sit back and wait? Or, on the contrary, is the external equilibrium of the country so fundamentally disturbed that one has to think seriously of revaluing the mark unless certain other countries, especially France and England, devalue their currencies? And if this idea is to be seriously entertained, what would be the best technique of revaluation? Instead of taking the risky step of fixing a new par value for the D-mark, would it not be better to let the exchange rates float within a wider margin?And to this end, would it not be enough to relieve the central bank of its obligation to purchase foreign exchange and to limit its functions to mere intervention?

These are some of the most important questions on which the discussion in Germany turns. It is tempting to comment upon them, and maybe one might even hope in this way to make a clarifying contribution here or there. On this occasion, however, I prefer to refrain and instead to do my best to be of service by trying to define in precise terms the general nature of the problem now under discussion in Germany. I shall also try to demonstrate that no reasonable decision can be taken otherwise than in the light of a grave dilemma that countries like Germany, Switzerland, and Belgium have to face at present. I anticipate. A way out has to be found from an extremely grave dilemma, and unless this is clearly grasped there is little point in waxing indignant at the idea of revaluing the currency—in the lenient form, say, of broadening the margin within which exchange rates are allowed to fluctuate —and to do so in the name of the unexceptionable ideal of stable exchange rates, or in marshaling a lot of plausible enough reasons for rejecting as dangerous the sort of countercyclical tariff policy that Germany is timidly trying today. I have in mind the dilemma of imported inflation.

For a long time now, most of the countries of the free world have been pursuing budgetary, wage, and credit policies that must inevitably result in creeping inflation with all the consequences that we know only too well. It is, incidentally, a kind of inflation that, because of its now chronic nature, its extent, its causes, and its motives, is not comparable with the mild inflations of previous boom periods. Whether we can get the better of this chronic inflation of our time depends, in the sphere of ideas, on monetary cynicism’s being defeated by the unshakable conviction that honest money is a paramount necessity and, in the sphere of interests, on the victory of the anti-inflationists over the inflationists. The prospects of such a double victory are extremely uncertain because of the erosion of monetary standards and of the growth of inflationary interests, in which trade unions and employers largely present a common front. The main factor of uncertainty is perhaps the extent to which we must, in any case, expect the sort of “democratic” or “social” inflation that has its roots in the great catchphrases of our time—such as “full employment,” to name only one.

Effective resistance against this wave of inflation is not equally strong in different countries. We know well enough how things are going in such important countries as England and France. But even as regards the leading country of the Western world, the United States, we are more and more forced to recognize that, no doubt against the better judgment of the authorities responsible, the Federal Reserve System is proving to lack the strength for a credit policy strict enough to compensate the inflationary pressure of an expansionist wage policy now culminating in the steel strike. This means that we must expect the increasingly inflationary credit expansion of the United States to continue (perhaps even cumulatively), without being able to say with precision when and how it will come to an end. What dangers this spells for the future of the dollar has been shown by such experts as Melchior Palyi, of Chicago, or Philip Cortney, of New York. Their warnings cannot fail to impress, even though one essential reservation needs to be made, which is that, even allowing for an estimated total of close to fourteen billion dollars of the United States’ short-term foreign indebtedness, six billion dollars of foreign investments in U.S. securities, and an indeterminable amount of dollar notes in foreign hands, the strain on the American balance of payments will be offset to the extent that the rest of the world keeps step with the American inflation or, on the average, even outpaces it. It need hardly be mentioned that this is in fact the case, and thus we have a repetition of the situation that developed immediately after the last war—in flat contradiction, it will be remembered, with the forecasts ventured by Keynes.

There are, on the other hand, just a few countries where the government or the central bank, or both, are not only wise enough but also independent and politically strong enough to put up an effective resistance against domestic inflationary pressures by means of an adequate discipline in monetary, credit and financial policy. But even if these countries, the most striking example of which is Germany, do manage to keep their domestic cost and price increases below the average of other countries, they find themselves with balance-of-payments surpluses that, as a symptom of the currency’s “hardness,” seem to contradict the warnings against the internal dangers of an inflationary overheating of the boom. In actual fact, of course, there is no contradiction, because what matters for the rate of exchange between currencies is not the absolute but the relative degree of inflation in any country. It’s the old story of the one-eyed man’s being king among the blind. However great the danger of domestic inflation in any country may be, if other countries on the average keep the reins even slacker, the first country’s balance of payments will, at rigid rates of exchange, get into surplus, and its currency will be in short supply on the international market, just as though that country were deflating, while in effect it is still doing the contrary and struggling with inflation like Laocoon with the serpents.

What is so insidious about this situation, as we know, is that it is precisely that balance-of-payments surplus that opens up a new source of inflation, and one, to boot, that flows all the more copiously the more the domestic source of inflation is stopped up—or does so, at any rate, so long as other countries on the average let their domestic inflation gush along merrily. Given that it is uncontrolled inflation abroad that creates a balance-of-payments surplus for the country concerned, and given that this balance-of-payments surplus finds expression in an increase of the domestic money supply, it is correct to say that this is a case of imported inflation.

Now, the dilemma of such an imported inflation arises when we ask ourselves whether a country determined to defend the purchasing power of its currency should not have the right and the possibility of defending its currency from imported inflation as well. If the answer is to be affirmative, then one must accept also the means required for effective defense —and there can be no doubt that these means include an alteration of the exchange rate as a last resort, when all other methods fail and in particular in the absence of devaluation on the part of the countries that export inflation. If, on the other hand, we give a negative answer to the question, the strict implication is that countries such as Germany, Switzerland, or Belgium are condemned to leave the fate of their currency at the mercy of the American steelworkers, the election tactics of the Republican party, the trade unions of England, and the confusion of political factions in France. For if nothing is done to make the balance-of-payments surpluses disappear, and if the circumstances that generate them continue, then one would have to expect the restrictive policy at home eventually to be worn down by the contradiction of the persistent external surplus. Most probably the external hole opened up by imported inflation would gape all the wider, the more effectively the internal hole is plugged.

However, there are two circumstances that are likely to put an early end to this bizarre game. First of all, it is hard to imagine that balance-of-payments surpluses such as have recently occurred in Germany (especially vis-à-vis the European Payments Union) can go on for any length of time without disrupting the mechanism of international payments and without forcing the countries that export inflation to protect their curency reserves, either by putting up obstacles against German exports and subsidizing their own or by devaluation. Secondly, in the absence of drastic measures to re-establish the external equilibrium of a country like Germany, strong forces will be at work tending to bring about the same result via a rise in the internal level of costs and prices. Somewhere or other the fox must come out of the hole. The only question is whether this will fit our ideas of what is desirable.

The dilemma with which we are concerned can be described also in another way. The case of Germany—and it bears repetition that much the same applies to Switzerland and Belgium—has revealed a situation in which any serious determination to defend the currency and thus to meet the paramount requirement of sound monetary policy implies contemplating so unorthodox a measure as softening up the stability of the rate of exchange. Even those who, such as the author, find such a prospect profoundly distasteful must admit that any softening up of the domestic purchasing power of money would be far worse.

It is a particularly unpleasant dilemma to face a country precisely when it is determined to keep its money sound. All the more severe judgment will have to be passed on the circumstances creating such a dilemma. It should be unnecessary even to mention that it would be a complete perversion of the facts to put the blame on a country like Germany and to reproach it for not emulating the pace of inflation elsewhere, but instead to feel that at this juncture the right policy is one of credit restriction. It is beyond comprehension that certain voices abroad—regrettably including, it would seem, the Organization for European Economic Co-operation—seriously advocate vigorous domestic expansion as one of the measures to be taken by Germany in order to re-equilibrate its balance of payments. Of course, the countries that are right are those that hold back and put the brake on, because they are alarmed at the dizzy pace of the drive, and not those that are reckless or weak enough to permit this pace, which is bound to end in catastrophe.

It is true that a country of Germany’s type, which restricts credit in a situation of persistent balance-of-payments surplus, is doing exactly the opposite of what the gold standard would have prescribed. But it hardly needs stressing that this is not a serious argument against such a policy, though it is a very weighty one speaking in favor of the much maligned gold standard. If we still had the gold standard, there simply would not be, as indeed there never was in the history of the gold standard, an international inflation of today’s dimensions, which is creating the dilemma of imported inflation for any country that is reasonable. It is a strange logic, indeed, to blame a country such as Germany for not behaving as would have been natural under the gold standard, when it is precisely the nonexistence of the gold standard, and indeed the absence of any genuine international monetary system, which has created this distasteful dilemma. For there is another thing that we are forced to admit, and that is that such international differences in the degree of inflation as now exist, together with the extreme developments in external payments, prove that we were under an illusion when we believed that after smashing the gold standard we had constructed a new, valid, and resilient international monetary system.

And here we have also the answer to another objection, to wit, that adjustment to international cyclical changes is the price to be paid by every single country if it desires genuine integration into the world economy. While this argument is justified as such, it does presuppose that the cyclical fluctuations, and thus the extent of deflation or inflation to be accepted by individual countries, remain within tolerable limits, and that the country principally responsible for world economic conditions, the United States, lives up to its international responsibilities in this respect and does not, instead, pursue some ideal such as a chronic “controlled inflation.” But since we are getting rather far from this condition, the admonition of internationally responsible behavior is certainly to be addressed to countries other than those that are defending the last vestiges of reason in monetary and counter-cyclical policy, even at the cost of thereby being saddled with the dilemma of imported inflation.

But here I cannot forgo a remark directed more especially to Germany. Before such countries try to escape the dilemma by raising the value of their currency, they should first exhaust all other possibilities. Above all, they will have to remember that this ultimate step would be illogical so long as they have not removed the last remnants of exchange control, which is the mark of a soft and not of a hard currency. Present-day events in Europe surely drive home the lesson that those who, two years ago, considered that it was premature to want to reestablish currency convertibility were wrong. No one can fail to realize that what is happening now could not have happened if we had at that time succeeded in bringing off the bold venture we had in mind. In the meantime, the situation has become so serious that we must ask even more pressingly whether the time has not come for Europe’s hard-currency countries, which are determined to fight inflation on all fronts, to proceed to joint action and, among other things, jointly to seize the initiative in at long last re-establishing convertibility. The urgency and the gravity of this question, however, will be grasped only by those who have some inkling of what is at stake for the free world.

II

A few weeks ago I discussed in this newspaper the grave consequences that follow from the extremely unequal inflationary pressure in individual countries, especially for those where that pressure is weak. That article was criticized by some, approved by others, but at any rate seems to have aroused so much interest that I am led to believe it would not be unwelcome if I were to take up the subject once more, to add a few more considerations in an attempt to clarify some controversial points, and to examine in depth the phenomenon we call imported inflation, which is as interesting as it is troublesome in practice.

Nobody will contest that the dilemma of imported inflation has lost nothing of its importance in the meantime. If anything, the tension between the few countries with low inflationary pressure, and consequently a balance-of-payments surplus, and the numerous countries with high inflationary pressure, and consequently a balance-of-payments deficit, has increased rather than diminished, and so the oneway flow of gold and foreign exchange from the latter to the former countries has, on the whole, continued unabated. In the case of Germany this flow has indeed reached an unprecedented maximum. While the surplus countries seem to be relying on an attitude that the physicians maliciously call “expectative therapy” and, by and large, to be behaving like so many Micawbers perpetually hoping that “something will turn up,” the deficit countries are feeling the pinch more and more from one month to the next, from one week to the next. Unless there is some decisive change, we can see the moment coming when measures to end this extreme tension in international payments will brook no further delays, from whatever side they are introduced. Since the situation of a balance-of-payments surplus, together with its inflationary tendencies—which can be offset by domestic credit restrictions, even if these entail the maintenance and possible exacerbation of the tension—is indubitably far less immediately alarming and menacing than the opposite situation of a balance-of-payments deficit, it is the deficit countries that are more likely to introduce drastic measures, insofar as we must expect any initiative in this direction to come from the force of circumstances rather than from farsighted wisdom.

A continuing surplus in the balance of payments (that is, an external account that has to be balanced by an inflow of gold and foreign exchange) tends to expand the money supply in the country concerned and thus may become an autonomous source of inflation. This much is an elementary proposition that is surely generally undestood. This relative inflationary effect of a balance-of-payments surplus is matched in other countries by the relative deflationary effect of a balance-of-payments deficit. Since the balance-of-payments surplus is a result of high inflationary pressure in these other countries, inflation is in this way “imported” from countries with a higher inflationary pressure to countries with a lower one. It must be added, though, that this effect takes place only on two conditions.

First, it must be assumed that the rates of exchange do not adjust to changes in the ratio of the different countries’ monetry pressure and purchasing power, but remain fixed. This is the point to keep in mind as an explanation of why there was no such thing as an “imported inflation” during the period of the great postwar inflation after World War I. The reason is simply that at that time the rates of exchange between the countries suffering inflation and the others were movable. “Imported inflation” had to wait for our own age, which harbors the strange belief that gaping divergences in the monetary policy of individual countries can be reconciled with fixed rates of exchange. This is a pious fiction of monumental dimensions, which was only possible in the first place because our newly constructed international monetary system, whose architects pride themselves so much on their achievement, skill lacks one essential element, namely, free and genuine currency convertibility. Without this fatal defect the present situation of tension could never have arisen, let alone continued for so long.

This is one of the conditions of “imported inflation.” The other is failure to offset this “import” by restrictive credit policy in the surplus country. If anyone would argue that the whole theory of “imported inflation” was unconvincing because, after all, in Germany the surpluses had by no means regularly generated the increase in money supply and rise of prices predicted by the theory, then this argument simply would prove how successful domestic credit restrictions were in compensating for external expansion. Unfortunately, the dilemma of imported inflation is precisely that successful disinflationary policies at home constantly reproduce or even reinforce the cause of the balance-of-payments surplus, that is, relatively lower inflationary pressure at home than abroad. If things were left to themselves both in the surplus and in the deficit countries, without counteracting, respectively, the inflationary effects of the surplus by restrictions, or the deflationary effects of the deficit by further expansion, the tension would eventually solve itself. But it would be a solution to be paid for by the surplus country with inflation of the “imported” kind.

Naturally enough, the surplus countries defend themselves and thereby attract further flows of gold and foreign exchange. The deficit countries resent this. Instead of blaming themselves and their undisciplined monetary policy, they turn on the surplus countries—and especially on Germany, which is their most important and most striking representative, and in any event a country at which everyone is quite used to throwing stones—and reproach them with violating all the rules of propriety by failing to turn the tap of credit full on, in spite of the balance-of-payments surplus. This argument is supported by certain circles that sympathize with the deficit countries and their lax monetary policy (among others, the Economic Commission for Europe).

It should at long last have become clear that such reproaches are as foolish as they are unjust. Their ultimate implication is that any country should allow its own strength in fighting inflation, this scourge of our age, to be paralyzed by other countries’ failure to muster the same strength. What these reproaches seem to say is this: if we are politically and socially too weak to cope with this “black spider,” then you should not be better off either. Just how biased this attitude is will be clear if we reflect that none of those who are so ready with such reproaches would dream of contesting any country’s right to defend itself against “imported deflation,” the exact opposite of imported inflation, of which there was so much talk in the early postwar years. Does all this by any chance conceal the belief that we should apply unequal yardsticks in the two cases, and that the fight against inflation is no longer to be counted among the foremost aims of monetary policy? If that is so, it should be stated frankly. The surplus countries would know what to answer: we do not happen to hold such perverse views, and we have no intention of letting yours be imposed upon us.

One of the first points to be quite clear about is the monetary origin of the balance-of-payments surpluses that bring inflation into the country. These still seem to be not generally understood. The present situation is the clearest possible evidence of something we should have learned by experience, namely, that whenever there is any appreciable differential between the strength of inflationary pressure in different countries, the country with weaker inflationary pressure will have a balance-of-payments surplus and a “hard” currency and the country with stronger inflationary pressure a balance-of-payments deficit and a “soft” currency. That was the reason that, in spite of considerable inflation in the United States, there was a dollar shortage after the war (because inflation was a good deal stronger in the European countries than in the United States), and that the position previously occupied by the United States in relation to the rest of the world is now occupied by the group of hard-currency countries (Germany, Switzerland, Belgium) in relation to the rest of Europe. We have gotten to know a D-mark shortage and have watched with our own eyes how such a thing comes about.

It should help to clarify matters if we reflect that the calamity of the balance-of-payments surplus is merely the mirror image of the opposite misfortune of the balance-of-payments deficit. This latter is one with which we are familiar, and we have finally learned that it is not an act of God and has nothing to do, directly, with the laziness or poverty of the country’s inhabitants but is the resultant of all the forces that, at a given rate of exchange, cause demand on the foreign exchange market to exceed supply. There are few who would deny that among these forces crucial importance attaches to “relative” inflation, or the “monetary ratio,” as one might call it for short, with a view to characterizing the well-known divergence between monetary and credit policy at home and abroad.

We merely need to look at this the other way around to understand the case of the balance-of-payments surplus. Just as Sweden has a “soft” currency, not because it is poor or unproductive, but only because it indulges in a stronger dose of inflation than is the rule in the leading industrial countries, so Germany has today a “hard” currency, not because it is in any way particularly industrious, efficient, or rich, but because it rations itself to a much lower dose of inflation than is the rule elsewhere. The “monetary ratio” is favorable to Germany, as it is favorable to Switzerland and Belgium, not because these countries are particularly virtuous, but because others sin much more—which doesn’t prevent the sinners, as we have seen, from denouncing the lesser sinners as “cynical” (to repeat a term actually used in England!).

Since, at unchanged rates of exchange, the “monetary ratio” is at the core of the tension, these considerations unfortunately also suggest that measures that do not touch this core cannot bring any genuine solution, even though they certainly are not totally ineffective. This applies more particularly to the reduction of import restrictions in the surplus country. So long as the above-mentioned basic cause of the tension remains, this cannot be expected to do more to remove the German external surplus than a solution of the dollar shortage could be expected from the reduction of American import tariffs alone. However, if the reduction of import restrictions is going to do less for the re-establishment of international equilibrium than many people expect, this is, of course, no reason against any such reduction, but, on the contrary, a reason for pushing it as far as is politically possible and defensible.

In this connection it is well, too, to pour plenty of cold water on the hopes which many Micawbers—to call once more on the immortal character from David Copperfield—in Germany pin on the moment when the growing impetus of rearmament will call forth large imports of military supplies. No doubt this will have some effect, but it is hard to see how much increases in imports can, in themselves, bring about a turning point. Either these rearmament imports will, as is desirable and to be expected, be financed in such a way as to cause no inflationary effects, in which case the purchasing power skimmed off for rearmament purposes by taxation or government loans will not be available for a corresponding amount of civilian imports or for sales of domestic civilian products, which thereby will be freed for additional exports. Taking an overall view, nothing would then have changed in the mechanism of the balance-of-payments surplus. Or else we assume that rearmament will be accompanied by a certain amount of additional inflation, in which case the tension will be relaxed not by arms imports, but by inflation. But this solution can be had at any time, even without rearmament—except, of course, that there are strong reasons for resisting it.

Capital exports, on the other hand, are incontestably a powerful means of counteracting balance-of-payments surpluses and their inflationary effects. But in this respect there is a radical difference between Germany and Switzerland. Switzerland is structurally a capital-exporting country with a relative abundance of capital and, accordingly, low rates of interest, and hence this method of relieving the balance of payments is a natural one. For Germany it would not make sense, because Germany is a country with a relative shortage of capital and, accordingly, high rates of interest, both unequaled among other industrial countries, and hence it is natural for Germany to have an inflow and not an outflow of capital. But if, in the present situation of persistent balance-of-payments surpluses, Germany gave free rein to these tendencies, the situation would only get worse. The external surplus would become even larger and the inflationary pressure generated by it even stronger, and to counteract this latter development Germany paradoxically would have to respond to capital imports with further domestic credit restrictions.

Thus, it is only logical that the authorities in Germany resist capital imports, however natural and economically reasonable these may be as such. What is left of German exchange control serves essentially no other end than to fight this capital flight in reverse. But it is logical only in the context of a wider paradox that, in the case of Germany, exacerbates the ordeal of the dilemma of imported inflation—the paradox, that is, that a country with a relative capital shortage finds that its successful fight against domestic inflation forces it to behave as though it had an abundance of capital, merely because of the tensions generated by fixed exchange rates and widely divergent purchasing power parities. The dilemma of imported inflation is bad enough. But if the “dilemma of capital imports” is superimposed upon it, then it is hard to think how the situation could be more contradictory.

* Neue Zürcher Zeitung, July 28, 1956, and October 7, 1956.