Aspects of the Pathology of Money

1 Equilibrium in International Payments1

A.Introductory Remarks

The problem of maintaining the equilibrium of balances of international payments, and of restoring it once it has been disturbed, is one of the most discussed questions in the field of international economics. The interest attached to it can be accounted for by the national and international difficulties which disequilibrium in international payments brings about if it is sudden and large or protracted and cumulative. It is the frictions caused by deficits in international payments of a country which have brought the problem of balances of payments2 into the important position it occupies in international relations, and which have provided the incentive for an extensive literature of the subject, which I cannot hope to discuss or even quote in the pages that follow. As has been pointed out by various writers, the problem of international payments acquires an importance which that of interregional payments does not possess, on account of the existence of various national monetary systems and of more or less uncoordinated national monetary and, more generally, economic, policies. This plurality of currencies results in the problem of foreign exchanges, which is an international and not an interregional one and is closely linked with that of balances of payments. We have seen that fluctuations of foreign exchanges are due to changes in international payments; and that these fluctuations tend to equalize the demand and the supply on foreign-exchange markets, and thus equalize payments made and payments received by a country. As Professor Angell rightly points out, ‘if the foreign exchange rates are free to move without limit in either direction, their movement will in itself keep the two current streams of credit and debit payments always equal . . .’.3 We shall see presently, however, that under flexible exchanges the problem arises of a possible cumulative devaluation of a currency and of its avoidance, and that the exchange fluctuation itself sets in motion forces affecting the size of transactions from which international payments result. The problem of equilibrium in international payments has its fullest significance upon the assumption of stable exchanges. The question can then be formulated in the following way: given stable exchanges, or given the desire to keep exchanges stable, how can equilibrium be restored in international payments once it has been disturbed? The restoration of equilibrium in international payments is thus a means of maintaining monetary parities by rigorously limiting exchange fluctuations. This in turn is inspired by the consideration that wide exchange fluctuations are undesirable, a position that calls for investigation. The limitation of movements of foreign exchanges calls for a ‘mechanism’ for adjusting balances of payments, and one finds that various ‘mechanisms’ can be constructed as abstract models but that only some of them can operate in the actual economic world. Most writings on this subject fall therefore into one of two groups: (1) construction of ‘models’ of ‘mechanisms’ that are conceivable in abstracto and (2) inquiry into the nature of ‘mechanisms’ that actually did operate in given circumstances.4 The fundamental problem is not complicated: if payments to be made and payments to be received at a particular moment do not cancel out, and if equality is not obtained through a continuous modification of the exchange relation between the respective currency units, then transactions must occur which will compensate the deficit and restore the balance (since over longer periods of time, payments received must be equal to payments made). Let us for the sake of clarity group the various questions that arise in this context and investigate each group separately. Before proceeding to this examination let us first explicitly state an important assumption that underlies all the reasonings to follow. We are going to discuss processes that are taking place in a free economic community, where there are no governmental interferences, other than tariffs, in the economic relations between countries. More precisely, it is assumed that individuals are not interfered with in either the commercial or the financial transactions which they wish to carry out.5

B.The Notion of Long-run Equilibrium in International Payments

Payments are said to be in equilibrium when amounts received are equal to amounts paid. It is generally claimed that over longer periods of time international payments are of necessity in equilibrium, even though they are in disequilibrium at any particular moment of time. However, one may wonder why this should be so; in answering the question we shall examine what happens in the case of each of the principal types of monetary systems if this assumption is not realized. There remains a net balance to be paid in cash whenever payments are not in equilibrium.

(A)GOLD CURRENCY

In this case we assume that gold is the only money in circulation in the various countries; we further assume that no changes will be made anywhere in the price of gold and that, therefore, there are fixed parities (mint-par) between the various gold currencies. Every net payment between countries is made in gold, and results in a reduction of the amount of circulating medium in a country which has a deficit in its balance of payments, and in a net increase in the amount of circulating medium in countries having a surplus in their balances of payments. We shall discuss later6 the repercussions of these changes upon the various transactions between the countries concerned and the various policies that may be adopted in response to gold movements. Let us merely point out in the present context that should a country have a persistent deficit in her international payments, the deflation caused by losses of circulating medium may become very drastic. By reason of the frictions that this involves, the country which is going through such an experience may be tempted to change its monetary system. If this should be the case and if the country in question should abandon the system of gold currency, international frictions will follow. Thus while payments in gold can always momentarily restore equilibrium in international payments, changes in international economic transactions themselves must take place if a breakdown of the monetary system is to be avoided. As it happens, however, losses of gold may set in motion some ‘mechanism’, which will be discussed presently, and help to obtain an appropriate adjustment of commercial and financial transactions.

(B)GOLD CURRENCY STANDARD

In a monetary system linked to gold but in which there are means of payment other than gold in circulation, the situation will be somewhat different. The difference will consist mainly in the internal effect of gold losses and acquisitions, and in the nature of the ‘mechanisms’ that they call into play. While under this system also international payments are always ultimately equalized through gold movements, the maintenance of the system depends (just as in the case previously examined) upon the reactions that gold movements will have, directly or indirectly, upon commercial and financial transactions. Gold movements are not in themselves the final equilibrating factor.

(C)FREE PAPER CURRENCIES

Here payments will be equalized through movements of foreign exchange quotations. An inconvertible paper currency can usually serve as means of payment only in the country in which it has been issued; therefore all net payments abroad made in the currency of the paying country must eventually be either spent or held in that country. If the receiving country wishes to do neither, exchange rates will move ‘against’ the paying country and the depreciation of that country’s currency will go on until the situation gets reversed. This may occur either as a result of new spontaneous developments in international transactions or as a result of the action of one or another of the ‘mechanisms of adjustment’. If no such mechanism works, then the depreciation is likely to become very considerable, and the disequilibrium in international payments a chronically recurrent one, while adjustments of balances of payments through further devaluations play havoc with international economic relations.

We are thus led to the following conclusions:—

If one is ready to accept any international or national friction, no problem of disequilibrium in international payments can arise. The problem of maintaining equilibrium is therefore only one of method; it arises if one wants to produce readjustments without any friction or with as little friction as possible. The frictions that are particularly disturbing to national and international economic processes are respectively a cumulative deflation of internal prices and a cumulative depreciation of currencies. It will be demonstrated in a further section of this chapter that under conditions of international co-operation both can be avoided simultaneously.

C.‘Mechanisms of Adjustment’ in a System of Fixed Parities

As it has been pointed out above, there are two different ways of approaching this question. One is to indicate the mechanism by which policies adopted in response to a break of equilibrium can bring about compensatory operations, and thus durably restore the disturbed equilibrium of the balance of payments. The other approach consists in demonstrating that disequilibrium releases through its very existence forces which tend to bring about the necessary adjustments in international transactions. The one type of approach arrives at a theory of what I propose to call ‘induced re-equilibrium’, while the other arrives at a theory of ‘automatic re-equilibrium’7. This terminology will be justified by the discussion that follows. It will become clear too that the two theories are complementary, not alternative, and that one needs them both in order to explain empirically-known phenomena in a completely satisfactory way. It is to be regretted that most writers on the subject so little realize the complementary character of the various approaches to the problem of re-equilibrium in international payments.

(A)INDUCED RE-EQUILIBRIUM

This theory is the old, basic theory of the mechanism bringing about equilibrium in international payments. It has been formulated for the case of the gold standard and we shall discuss it in greater detail when analysing that monetary system. The mechanism in question is intimately connected with the international movements of gold which take place in response to each particular movement of the balance of payments. Losses of gold are followed by a policy of increasing the bank rate, which has a twofold effect upon the monetary situation: (1) the increase of the bank rate tends to reduce the portion of monetary circulation which is backed not by gold but by commercial paper, and thus tends to restore the percentage of gold cover of the total amount of central bank money; (2) that same increase of the rate of interest tends to attract short-term funds from abroad. Now the currency restriction tends to bring about a fall of prices and thus makes imports relatively more expensive and exports cheaper. This is accentuated by the reverse tendencies taking place in countries receiving gold; there a lowering of the rate of interest induces an increase of the monetary circulation and a rising tendency of prices, and further encourages movements of short-term funds out of the gold-receiving country and towards the gold-losing one.

The classical ‘mechanism’ realizes all these effects by the single means of changes in the bank rate. Under modern banking conditions additional policies may be called for, since the monetary circulation not covered by gold is only to a small extent backed by commercial paper and to a very large extent by government securities. In order to obtain the reduction in monetary circulation which the ‘classical’ theory demands, ‘open market’ operations must supplement the movements of interest rates. It will be noted that there is, both in the ‘classical’ and in the ‘modern’ version of this mechanism, a considerable amount of judgment to be exercised by the central banking authorities; thus the mechanism in question is by no means an automatic one.8

A question which requires careful attention is the following: does the described mechanism work mainly through changes in internal prices in the respective countries, or mainly through movements of short-term funds? The question is easily put but cannot be easily answered. Short-term funds can move very rapidly in response to differential changes, even small ones, of interest rates. Price-changes, on the other hand, require time. It will furthermore be noted, first that the ‘quantity theory’ of money in its crudest form is not exact, and the further one is removed from a situation in which it might be verified, the less direct and the less rapid will be the response of price movements to changes (usually not very considerable) in the volume of circulating medium; and secondly that the effects of price-changes upon the ‘terms of trade’ and thus upon the size of import or export surpluses may be a further slow process; on the other hand the readjustment of balances of payments to an equilibrium position is a short-run or a medium-run process. Logic would thus seem to give movements of short-term funds the priority over price movements as motor of the mechanism of readjustment. But our reasoning was based on explicit assumptions regarding the comparative speed with which the various factors work—and these assumptions may be verified or not by the actual processes. The final answer lies with experience, not with reasoning; nor can any general rule be stated. One may only emphasize that adjustment through short-term credit operations works more quickly and that it is likely that important price adjustments would have to take place only in the case of protracted disequilibria. These may be due to some fundamental change in long-term credit transactions or to some previous developments affecting the size and structure of the external trade of the country in question. Thus if the lending habits change and a country cannot obtain in the future the accustomed amount of new long-term credits, some lasting changes in the structure of that country’s foreign trade have to take place, and the instrument of adjustment is a change in prices. If, moreover, prices in the particular country have become so high in comparison with prices abroad as to weaken that country’s competitive position, a price adjustment would have to take place in order to restore equilibrium. In such cases, short-term credit operations cannot lastingly restore the equilibrium of international payments; if they take place, however, basic adjustments can be made gradually, occasioning less friction than is caused by sudden and important movements of internal prices.

We thus get a better insight into the meaning of the phrase ‘international price equilibrium’. Prices are internationally co-ordinated if in no country prices move ‘out of step’ with prices in other countries (under prevailing stable exchanges), thus changing the competitive position of that country’s industries and disturbing the equilibrium of its balance of payments. The mechanism here described provides an instrument by means of which price movements in various countries can ‘keep in step’.

It can be said that long-term equilibrium in international payments exists if short-term credit operations are always sufficient to restore the balance whenever it is disturbed. Thus Professor Angell gives a definition, which in the light of the foregoing analysis appears to be judicious and acceptable, and according to which international payments of a country are in equilibrium if ‘the net balance of the aggregated commodity, service, interest and dividend and long-term capital operations, so far as these operations entail actual payments, is zero’.9 Or, reciprocally, ‘a country’s international payments are “out of equilibrium” whenever short-term funds are moving to or from it, net (that is, whenever the net balance of all the other international payment items is greater or less than zero)’.10 In other words, international payments are in durable equilibrium if, in order to maintain that equilibrium, and in the absence of any new disturbances, no changes in the structure of foreign trade or credit operations are required.

(B)AUTOMATIC RE-EQUILIBRIUM

While induced re-equilibrium is obtained by the means of policies adopted in response to symptoms of disequilibrium, such as gold-flows from country to country, automatic re-equilibrium is a direct consequence of the maladjustment of international payments. There may be two conceptions of this type of adjustment: (1) there are symptoms of maladjustment such as flows of gold, but no policy needs to be adopted since the consequences (or symptoms) of maladjustment bring themselves the cure that is required; (2) the disequilibrium has direct consequences which prevent even the appearance of the symptoms of maladjustment, considered as the ‘normal’ ones. The first case is that of the ‘classical’ mechanism of adjustment working within the monetary system of a ‘simple specie currency’11 where there are no credit operations whatever.12 The second represents the most ‘modern’ tendencies that prevail in investigations of equilibrium in international payments.

(1) The mechanism of adjustment in the case of simple specie currency, e.g. the pure gold currency, is in its essence very clear and direct: the net deficit in international payments is paid by gold shipments; this amounts to a contraction of the circulating medium in the country losing gold and to an expansion in the other country (or countries). In consequence, prices tend to fall in the former and to rise in the latter country, which discourages the former country’s imports and encourages her exports, while the reverse happens in the latter country. Thus as the result of changes in the terms of trade brought about by price movements, the balance of trade is brought into equilibrium again. The country which originally had a deficit in foreign payments may now realize a surplus which will start the mechanism moving again in the opposite direction. We assume throughout this reasoning that the only international economic transactions are trade operations and that the balance of payments is identical with the balance of trade. Thus the situation is oversimplified as compared with empirically-known situations. When we move on to more complicated assumptions, we must introduce an element of policy (except for the most recent theory which will be discussed presently), and we thus find ourselves in the case which was previously analysed. It is important to note that it is only under such simplified conditions that gold movements ‘automatically’ restore equilibrium in international payments. This point is very vital in appreciating the ‘automatic’ or ‘non-automatic’ character of the gold standard. We see that not even gold currency (as distinct from the gold standard) can provide an automatic mechanism of re-equilibrium in international payments unless no credit operations take place. As for a currency which is only linked to gold, the element of management comes in to an even larger extent, as we shall see presently when analysing the nature and scope of the international gold standard.

(2) The modern school of thought, representing what has been called here ‘the theory of automatic adjustments’, consists of ‘those who postulate shifts of international demand schedules to right or to left without any necessary intermediation of gold flows’.13 Iversen traces this point of view to an article written in 1889 by C. F. Bastable,14 in which, in opposition to John Stuart Mill, the fact is brought out that changes in purchasing power of the respective countries brought forth by the disequilibrium in balances of payments may in themselves, and without the help of any additional policy, effect changes in the volume and direction of trade between these countries.15 Thus to formulate the problem briefly, the question consists in finding out whether gold movements on the one hand, and price-changes on the other, are indispensable in order to bring international payments into a new equilibrium. According to the theory which we are now discussing, neither of the two elements is absolutely necessary for an equilibrating mechanism to work. This point of view has been brought to the foreground of economic debate in the course of the reparations discussion.16 More recently Harrod17 and Whale18 make an extensive use of the same mechanism. While there are various nuances as between the different presentations, the essential process here involved consists in changes that are supposed to take place in reciprocal demand schedules that exist in each of the countries for the other country’s products. Thus the country whose balance of payments shows a deficit would buy less goods of the other country (assuming two countries in presence) while the latter country would increase her importations from the former. Since these surplus imports will be financed through the spending of sums due by the debtor country, no price-changes are necessary in order to bring about the adjustment.

This is indeed a very summary statement of the process and the reader will find it useful to turn to the literature quoted in the last few footnotes. My object here is not to give a detailed exposition of this mechanism but merely to indicate its principal elements. While there can be no doubt that changes in demand schedules, brought about by payments from country to country, affect trade between these countries in a way which tends to re-establish equilibrium of international payments, this mechanism cannot explain the entire process of adjustment. It represents a factor which is always at play, but which is only one of several forces acting in the direction of re-equilibrium.

It is certainly conceivable that the net payment will be made by the means of an appropriate change in the balance of trade brought forth by shifts in demand schedules, without either gold movements or price changes, but is it likely to happen? It will be observed that changes in the structure of trade require time, while gold shipments in response to a certain situation in the foreign-exchange market take place on a very short notice; it is therefore likely that gold movements will take place even before changes in the structure of trade could occur. Inasmuch as gold movements affect the supply of money in the countries concerned, price movements are thus likely to take place with a more or less considerable time-lag. Is it possible that these changes in the supply of money should affect the volume and direction of trade between the particular countries without first causing price-changes? This will depend upon the particular shape of the various demand curves. If the increased demand by the ‘creditor’ country for foreign goods offsets the decrease of internal demand on the markets of the ‘debtor’ country; and if the increased internal demand on the markets of the ‘creditor’ country offsets the fall in exports formerly bought by the ‘debtor’ country; then the price structure will remain intact in both countries.19 The off-setting would have to take place, however, not only in total values, but in each individual market as well. That this might happen is just conceivable but the probability of its happening is very small. In the contrary case changes in price structures are inevitable. It seems reasonable to conclude that: (1) changes in national price structures are practically unavoidable if equilibrium is to be realized through adjustments of the balance of trade; (2) the fact of net payments from country to country may affect the size and direction of trade between the countries concerned even in the absence of major price movements; changes in the structure of prices would then take place in each country as a consequence of changes in demand schedules; (3) the need of price movements is considerably reduced when the mechanism of re-equilibrium works primarily through credit operations (but in this case it ceases to be automatic).

At the root of the problem, and here the various approaches to it coincide, lie changes which disequilibrium in international payments brings forth in the various national money markets. These changes must, even in the absence of any special policy, alter the structure of international trade and of internal demand. Both result in price movements. Thus far everything can be said to be automatic. In an economic system, however, in which credit exists, the automatic process will be supplemented and probably impaired through various elements of credit policy. In consequence of the policies adopted, the internal supply of money will be modified as compared to what would happen under the system of a simple specie currency, and furthermore international credit operations will take place (under the influence of changes in the bank rates); a certain part of the burden of adjustment will thus be taken away from international trade and assumed by international finance. In the combination of all these factors lies the complementary character of the automatic and the induced adjustments to which reference has been made above. Purely automatic methods of obtaining re-equilibrium can work only—the point is sufficiently important to be repeated—in a system of simple specie currency (the same in the various countries) which ignores all credit instruments.

D.Exchange Fluctuations as Instrument of Re-equilibrium

We have assumed so far that rates of exchange between the various national currencies remain fixed throughout the whole process of restoring equilibrium in international payments. When this is the case, all the necessary adjustments must be brought about by means of either commercial or financial transactions. Exchange fluctuations tend to restore equilibrium of international payments by equalizing demand and supply on foreign-exchange markets. The question is to know how durable such a re-equilibrium will be and what effect exchange fluctuations exercise upon the constituent elements of the balance of payments. The changing situations in the foreign-exchange markets and the fluctuations of exchange rates are interdependent, not connected by the link of one-way causality; fluctuations of rates set into motion ‘mechanisms of adjustment’ which operate mainly through alterations in the volume and direction of trade. It will be seen that these mechanisms tend to limit the amplitude of exchange fluctuations. Let us assume, in the first place, that there are no international credit operations but merely commercial transactions. The direct effect of one national currency depreciating in terms of the other (as result of a deficit in that country’s international payments) is to alter the relation between prices prevailing in the two countries. Let us call the country whose balance of payments shows a deficit (or debtor) country A, the other country B. If prices in B remain stable in terms of B currency, they will increase in terms of A currency; and, reciprocally, A prices, if nominally stable, will fall in terms of B currency. Of course, nominal prices in A will tend to rise, and prices in B to fall as result of the indicated price-changes; but for B it will nevertheless be relatively more advantageous than before to buy in A, and for A it will be relatively less advantageous to buy in B. Thus the balance of trade will tend to show a surplus of exports in A and a surplus of imports in B; this will reverse the original situation and exchanges will now tend to move against B. The depreciation of the A currency in terms of the B currency will have been stopped by changes in the balance of payments (here identical with the balance of trade) and in due course the A currency will appreciate again. We shall thus have exchange fluctuations around some ‘equilibrium rate’ and not a progressive and lasting devaluation of the A currency.

Thus far the process described has been ‘automatic’; it can be supplemented, however, by appropriate monetary policies. Thus the monetary authorities of the country having a deficit in its international payments may adopt a restrictive credit policy at home and cause a fall in nominal prices; similarly the monetary authorities of the country having a surplus in its balance of payments may adopt a more liberal credit policy and cause a rising price-tendency at home. In acting this way the respective policies would achieve voluntarily what is obtained automatically under a simple specie currency20 and would speed up the process of adjustment described above.

If we complete the picture by introducing international financial operations, the adoption of certain appropriate policies becomes imperative. As we have seen, a system of freely fluctuating exchanges does not eliminate the possibility of a long-run stability (as distinct from fixity) of exchange rates. If this is the object of policy we find ourselves in a position which is not vitally different from the one described in the preceding section of this chapter. It is quite conceivable that the fluctuation of exchanges around an equilibrium position should (by keeping international payments balanced) be itself an instrument of maintaining a long-run exchange stability. This conception of exchange fluctuations as a mechanism of re-equilibrium is very important, since it conflicts with the view according to which exchange chaos is the only alternative to fixed parities. Now for various reasons fixed parities may appear to be preferable to a long-run stability of fluctuating exchanges; this latter possibility must, however, not be overlooked since it represents an interesting intermediate solution. If it is adopted as a declared objective of policy, capital and money movements may continue on the basis of anticipated long-term exchange stability; in the contrary case the anticipated instability will disorganize financial operations and thus become a real instability. Thus the real opposition is that of organized versus disorganized international monetary relations, not that of one method or organization versus another method (that is of one monetary system versus another system). The choice of methods must then depend on various other considerations, not on that of a long-run stability of foreign exchanges.21

The mechanism of re-equilibrium through exchange fluctuations can be greatly assisted by a bank-rate policy consisting in an increase of the bank rate in the country whose exchange is depreciating and in a lowering of the bank rate in the country whose exchange is appreciating. This is a policy analogous to the one which is adopted under the gold standard in response to movements of the metal. In both cases the bank rate is changed when symptoms of disequilibrium are ascertained; but while under the gold standard it is movements of bullion which indicate that international payments do not balance, under the system of free paper currencies, it is movements in exchange rates.

E.Elements of a General Theory of Re-equilibrium in International Payments

In the preceding two sections I have endeavoured to give a brief outline of the principal ‘mechanisms’ through which international payments are or can be equilibrated once their balance has been disturbed. As has been pointed out above, the various mechanisms that operate under conditions of fixed parities can work together; what actually happens in any particular situation can be ascertained only by means of empirical inquiries. While some such investigations have been carried out,22 very much remains still to be done. This is indeed a fitting subject for institutional research: in order to make the results of such inquiries readily comparable they ought to be carried out by a group of scholars in agreement amongst themselves on the methods to be used and on the problems to be investigated. In the absence of more and better knowledge of actual processes, most detailed discussions of the ‘mechanism’ of re-equilibrium remain in the sphere of the intellectually conceivable; they are precious tools of thought for inductive research. The most that can be said is that actual situations represent variously set-up compounds of these multiple hypothetical methods of adjustment. It is only when our empirical knowledge is more developed that really significant results will be obtained through applying and testing the various abstract ‘models’. In the present study I should like to bring out certain fundamental similarities between the various ‘mechanisms’, in particular the analogies which exist between ‘mechanisms’ moving on the basis of fixed parities and those which work through exchange fluctuations. Some elements of this comparison have been already mentioned in section D of this chapter and in the light of these observations there appears a possibility of formulating a theory of re-equilibrium which would apply to any monetary system. This is what I shall now attempt very briefly to do.

The basis of the theory is to be found in the notion of the balance of payments. Since payments made and payments received by a country must balance over longer periods of time, every temporary deficit must be made good through an appropriate surplus following later on. Thus operations must be stimulated which will result in payments to be received by the country whose balance has been showing a deficit while operations giving rise to payments made by that country must be to a certain extent discouraged. This is really a principle of arithmetic and it is valid for any monetary system. If, on the contrary, the tendencies which have resulted in a deficit of receipts are allowed to go on or even are amplified, disequilibria will go on growing, the effect of which may be a complete collapse of monetary stability. What exactly is implied by this notion of ‘collapse’ will be explained presently. A ‘mechanism of re-equilibrium’ is just a method of obtaining the necessary compensation of a deficit by a surplus. Let us now go one step further. International economic transactions are either commercial or financial, the latter consisting of movements of either capital or short-term funds. Therefore any mechanism of adjustment must operate through the medium of operations listed below; there is no other way of obtaining equilibrium in international payments. These operations are:

In case of a Deficit	In case of a Surplus
Stimulation of exports (goods and services)	Stimulation of imports (goods and services)
Restriction of imports (goods and services)	Discouragement of exports (goods and services)
Stimulation of foreign investments at home	Stimulation of national investments abroad
Discouragement of national investments abroad	Discouragement of foreign investments at home
Encouragement of entries of foreign short-term deposits	Stimulation of movements abroad of short-term balances
Discouragement of purchase of short-term deposits abroad by nationals	Discouragement of entries of foreign short-term deposits

It follows that under any monetary organization the country experiencing a deficit in its balance of payments must adopt certain policies or allow a certain automatic process to take place; and that the country whose balance of payments shows a surplus must similarly adopt appropriate policies or make the operation of an appropriate automatic process possible. If this is not the case, deficits and surpluses will become cumulative and symptoms of disequilibrium will grow in strength and ultimately result in the collapse already mentioned.

Symptoms of disequilibrium in international payments can be only one of two kinds:23 (a) flows of gold (under the gold standard);24 (b) depreciation of one currency in terms of the other. If deficits and surpluses are cumulative, then (a) losses of gold2 by the country in deficit will go on until this particular monetary system breaks down, or (b) the depreciation of the currency of the country in deficit will continue without limitation and monetary instability will set in. It will be noted that even if one starts from the situation (a) one ultimately lands in the situation (b) provided that the cumulative character of the maladjustments lasts long enough. Now currency depreciation, to which there is no known limitation, destroys all regularity in flows of capital and introduces into the economic process more or less wide and erratic movements of short-term funds. The destruction of confidence brings an end to financial and monetary stability; considerations of safety and not considerations of returns guide financial operations henceforth.

If the disintegration of international monetary and financial relations, i.e. the collapse of monetary stability, is to be avoided, a ‘mechanism of re-equilibrium’ must be made to act. This brings us back to the limited number of operations by the means of which it can act. In actual life they will all be combined within the same process, but emphasis may be greater now on one of them, now on another. Adjustments may be sought principally through changes in the orientation of international trade or through modifications in the flow of capital and of short-term funds. What instrument of adjustment will mostly operate depends on the nature of particular situations. More precisely, it depends on the structure of the balances of payments of the countries in question and on the causes that brought about the disequilibrium in international payments that is to be ‘cured’.

Most of the ‘mechanisms’ described in the economic literature, and summed up above, work on the assumption that international trade is the principal source of payments that take place from country to country. This easily leads to confusing the balance of trade with the balance of payments and to reducing the disequilibrium in the latter to that in the former. Whenever this is done, conclusions obtained cannot be applied, without more or less serious qualifications, to cases where financial transactions are an important source of international payments. In the assumption that no financial transactions whatever are taking place, the whole readjustment in international payments has to be obtained through export surpluses realized by the country in deficit. If the adjustment is to be made under a system of simple specie currency, the deficit of the balance of payments causes a change in the supply of money in the countries concerned and thus affects trade, (a) directly via shifts in demand schedules brought about by changes in the supply of money; and (b) indirectly through price changes resulting from movements of specie from country to country. The greater the price adjustment, the quicker will the necessary alteration in the balance of trade be obtained. It will be observed that the necessary price adjustment will be smallest when trade is free25 and that progressive protectionism may seriously interfere with the process of re-equilibrium.

Let us now move to a more complicated system, where paper money and bank money exist along with specie, and where there is more or less scope for credit policy, but let us maintain the assumption that no international financial transactions take place. It is clear that, in order to obtain a new equilibrium in international payments, policies must be adopted which will in effect stimulate exports and discourage imports of the country (or countries) in deficit, while the opposite effects must be obtained in the country (or countries) experiencing a surplus. The appropriate policy is one of credit restrictions in the country in deficit and of credit expansion in the country having a surplus. This may be obtained by modifying appropriately the bank rate or by applying open-market policies aiming at the same results. In the latter case the short-term rate of interest is likely to move also, in the end, in consequence of the changed situation on the respective money markets. The choice of method will have to depend ultimately on the nature of assets held against the portion of notes not covered by specie. If they consist of commercial paper, changes in the bank rate will rapidly affect their volume; if on the other hand they consist of government securities, open-market operations will be more effective. Of course when resorting to open-market operations one must apply them in a proper way; that is in order to restrict the monetary circulation in the country in deficit and to expand it in the other one. In actual practice this method has been all too frequently used to hamper rather than to help the mechanism of adjustment in its action; the typical example is that of central banks buying securities when gold is flowing out of the country, thus counteracting the necessary restriction of circulating medium. Such policies and the reasons for which they are adopted will be dealt with later; here it suffices to point out that (1) these policies, by making the mechanism of re-equilibrium inoperative or diminishing its efficiency, tend to prolong and to aggravate disequilibria, and (2) the fact that open-market operations have in the past been used in a wrong way does not constitute any valid argument against using them at all. I insist on that last point since it deals with an argument that is often made against open-market operations by those who prefer the instrumentation of bank-rate policy. Both types of policy are important means of action and can be used in combination with one another or the one in preference to the other according to the situation in which re-equilibrium is to be obtained.

The time has now come to drop the assumption which consisted in limiting international economic relations to commercial transactions. Under modern economic conditions capital movements and short-term credit operations play too important a part to be left out of consideration. On the contrary, they ought to be introduced into the problem of international settlements with a far greater emphasis than is generally the case. If financial transactions are important components of international economic relations, then trade adjustments cannot be regarded any longer as the only, or even as the principal, factor in the process of re-equilibrium.26

International long-term credit operations, i.e. capital movements, can hardly be regarded as an instrument of re-equilibrium, though a change in their volume and direction may become an important cause of disequilibrium in international payments. It is therefore short-term credit operations which we must now envisage. We have seen what part they play in the various ‘mechanisms’. We know also that under conditions of prevailing confidence these transactions are principally determined by differences between rates of interest quoted in the various money markets. Thus the bank-rate policy comes into the picture again; this time there is, however, no alternative policy that could bring forth the necessary movement of short-term funds. It is very likely that the bank-rate policy carried out under the pre-war gold standard affected international credit operations much more than national prices, and that the adjustments were more often made through movements of money-funds than through changes in balances of trade. Thus far, however, we have no adequate knowledge of what really was taking place during that long period of monetary stability and I have therefore no means of proving the contention I am putting forth. This contention I wish to complete by a second, equally hypothetical, namely that in the absence of credit operations gold movements and price fluctuations would have been much larger and the process of re-equilibrium much slower than was the case in reality. In order for all this to be achieved short-term interest rates must move up in countries with a deficit balance of payments and down in countries with a surplus. The movement of interest rates affects not only the international flow of money but also the monetary situation within each country and, more slowly, national price movements and international trade. Thus all the various re-equilibrating forces are set into motion, while open-market operations may speed the process up, if properly applied.

Let us now ascertain whether this interest-rate policy is indispensable for obtaining re-equilibrium or whether, on the contrary, a mechanism is conceivable which leaves the rate of interest quite outside the process of adjustment. Should the interest rate become dissociated from the mechanism of re-equilibrium, then, under normal conditions of confidence, international credit operations would cease to operate as an instrument helping to bring about equilibrium of international payments. As far as I can see it, there is no means of attracting to a country short-term balances other than offering them a sufficiently high reward, and this can be achieved only by means of an appropriate bank-rate policy. If now, international credit operations cease to take place, the whole load of adjustment is thrown upon the balance of trade. Important consequences follow. Credit operations of the type which we are considering here reduce the net deficit (and surplus) in international payments and reduce in consequence the size of net balances which have to be settled and the volume of ‘real transfer’ which has to carry out the final settlement.27 The suppression of compensatory credit transactions has the contrary effect. Now it is clear that the greater is the size of adjustments to be brought about by trade items, the greater will be the need for changes in the supply of money on the respective national markets and for differential price movements. These changes in the supply of money may be carried out through open-market operations under conditions which were specified above. Whenever this method can be applied the bank rate need not be changed as soon as the mechanism of re-equilibrium begins to work. It will, however, be noticed that the change of rates is thus merely postponed. Relative changes in the supply of money call sooner or later for changes in short-term interest rates; these cannot be indefinitely avoided if re-equilibrium is to be obtained. Movements in interest rates can only be avoided if one adopts measures the final effect of which is to make the functioning of the mechanism of adjustment impossible. It is hardly necessary, after all the foregoing analysis, to emphasize further the fact that international payments are not likely to be brought into equilibrium if neither short-term credit operations, nor changes in the supply of money and in national prices, are allowed to take place.

The argument here advanced must be completed by a reference to the conclusions that were reached about fluctuating rates of exchange as an instrument of adjustment. As we have seen, this type of mechanism is not vitally different from the one which operates on the basis of fixed parities. Just as the ‘mechanism of adjustment’ (operating through the triple instrumentality of changes in international flows of short-term funds, changes in national money supplies, and price movements) is necessary in order to limit specie movements, so it is necessary in order to limit the depreciation of the currency of the country in deficit. No advocate of adjustment through exchange fluctuations does in fact advocate unqualified and unlimited currency devaluations as the means of restoring equilibrium in international payments. But if fluctuations are to be limited and reversible, the same type of fundamental adjustment is necessary as in the case of fixed parities. If this is granted, as I think it must be, then the opposition between ‘flexible exchanges’ and movements in interest rates and prices, as alternative methods of obtaining equilibrium in international payments, must be abandoned as more apparent than real. It is a pseudo-opposition which, though at first glance suggestive, does not stand a thorough analysis.

We are thus led to a most important conclusion: the process of re-equilibrium is essentially the same for all monetary systems. This conclusion should not seem surprising in fact, since evidently adjustments must ultimately be brought by a limited number of economic operations, the nature of which does not depend on the monetary system adopted. The real opposition is one between international monetary and economic stability and international monetary instability leading to a disorganization of both commercial and financial relations between countries. The mechanism which we are led to consider as an indispensable condition of stability has hitherto been considered as an exclusive feature of the gold standard; and it was assumed by many writers that by abandoning that monetary system one could maintain stability through the use of other methods. This view has to be given up. Under any monetary system, free paper currency not excluded, the described mechanism must be allowed to function if stability is to be maintained. Every escape from it is a step on the road to disorganization.

There is in the same context another misapprehension which ought to be dispelled. It is usually claimed by those who advocate the system of ‘flexible exchanges’ in opposition to that of fixed parities, that the latter imposes upon countries which are practising it the strains of repeated deflations, or rather of an alternation of inflations and of deflations. This strikes me as a rather fanciful representation under normal conditions. Price movements which enter into a process of adjustment of international payments are not likely to be of an amplitude which would seriously disturb economic activity and amount to a deflation (or inflation).28 If we had the necessary quantitative information about the pre-war times, we could settle the matter conclusively. While waiting for an adequate documentation to be produced we must depend on the logic of the economic system and be very careful not to exaggerate what probably consisted of relatively minor price movements; very likely the greatest part of current adjustments was carried out (as I pointed out before) by credit operations. The underestimation of the part played by international movements of short-term balances had led to an exaggeration of the rôle of price movements and of their size. A further source of confusion is the lack of differentiation between current adjustments of transactions carried out with a view to maintaining long-run equilibrium in international payments, and adjustments to violent breaks of equilibrium due to special causes and to exceptional circumstances. Under ‘normal’ conditions29 there is no need to choose between stable prices and stable exchanges. Not only can both be stable at the same time, but it clearly follows from all the foregoing analysis that they must be stable simultaneously, if equilibrium is to be preserved.30

F.Re-equilibrium in the Case of Major Disturbances

We have left out of consideration, so far, the problem of re-equilibrium that arises in case of major disturbances, due to: (a) divergent price movements in the various countries; (b) changes in the volume and direction of international capital movements; (c) movements of short-term balances from country to country in search of safety. The principal elements which can explain the origins of and the cure for major maladjustments in international payments are:

(a) If price movements in different countries take place quite independently of one another and we then get ever further away from an ‘international price equilibrium’,31 cumulative changes in balances of trade are due to take place. This must not, and is not likely to, happen when price movements take place but are internationally co-ordinated. I am not speaking of price fluctuations which are a part of a process of adjustment and bring about equilibrating changes in balances of trade; the price movements referred to in the present context are not fluctuations of a minor amplitude but cumulative tendencies of prices to rise or to fall over longer periods of time.32 Thus if two countries practise in the downward phase of the cycle, the one an expansionist policy, the other a deflationary policy, frictions are likely to occur, since prices in the former country will rise in relation to prices in the latter: which is bound to affect trade between them. Unless other transactions compensate this development of balances of trade, the strain on foreign exchanges may become considerable. It will be noted that to pursue such divergent price policies is possible in the long run only when the individual countries in question disregard the rules governing mechanisms of adjustment and adopt policies which are in contradiction with those rules. The characteristic feature of the ‘rules of adjustment’ is that they demand the adoption of policies which go counter to the disturbing tendencies; policies which, on the contrary, strengthen these tendencies, such as inflationary or deflationary ones, make the functioning of mechanisms of re-equilibrium difficult or impossible while they accentuate the causes of disequilibrium. The situation is, of course, different when all the countries adopt an expansionist, or when they all adopt a deflationary, business cycle policy. Here the problem of re-equilibrium meets that of business cycle theory as a basis of policy. The divergencies existing between leading theories thus become real causes of disequilibria in international payments and of instability in international economic relations, inasmuch as some of these theories become the guide to action in some countries and others in other countries.

(b) The sudden diminution or cessation of international capital movements, particularly of new foreign loans, may be, and has been, an important source of disequilibrium in balances of payments. Since such changes occur only in conditions of economic or political instability, their causes cannot be analysed in detail apart from the historic context in which these changes have taken place. As in movements of short-term funds, considerations of safety play a very important part in causing the sudden and large changes. Occasionally, exceptional anticipations of profits in some national market may keep in that market funds that would otherwise seek foreign investments and even attract funds from the ‘debtor’ countries. Such was the case during the last phase of the 1927–9 boom in the New York stock market. Insecurity may be due to political or to economic reasons. In consequence of what I have called before a ‘heterogeneous distribution of confidence in the world’ there may occur geographical changes in the currents of investment or changes in the volume of capital as compared with that of short-term funds. Should this last change take place, effects are likely to be particularly disturbing to monetary stability.

Adjustment to changes in capital movements must be made through changes in trade balances, since short-term credit can, by definition, provide only temporary relief. Moreover, the reasons which bring about changes in capital movements are likely to affect short-term credit operations as well, in such a way that the maladjustment in international payments will be increased rather than diminished. Adjustment through international trade can be most easily obtained if the disequilibrium is relatively small in comparison to the value of trade transactions; and again, the fewer the obstacles that are put in the way of international trade, the easier it will be. The larger is the relative size of the maladjustment and the more drastic and active is protectionism, the less easily can the adjustment be obtained.33 Much will also depend upon the nature of exports and imports of the country in deficit and on the respective elasticities of demand for various goods in question.34 Should a country be unable to obtain the necessary adjustment then only two courses remain open: either financial assistance by means of international action, or else a cumulative loss of gold in the case of a gold-standard country and cumulative exchange depreciation in a country forced off the gold standard or in a country with a system of inconvertible currency. We shall see presently how exchange control comes to be adopted in consequence of a continuing situation of the second type.

(c) Finally, a short comment on the disequilibrating effects of movements of short-term funds. Since it is most unlikely that long-term lending could bring in an element of compensation, the whole burden of adjustment falls on the balance of trade. Here the same observations can be made as have been formulated in connexion with changes in capital movements. The maladjustments brought about by massive movements of short-term balances are the most difficult of all to adjust on account of the size they can have and of their suddenness. Since they are due to lack of confidence, only a restoration of confidence can bring an end to them; exchange controls, which are most often introduced in response to ‘flights of capital’, stop a symptom without curing the ill and this explains to a large extent why they are so difficult to abolish. When credit operations are directed by considerations of safety, not of comparative yield, one most important element of mechanisms of re-equilibrium cannot operate, and monetary disequilibrium is likely to follow. Now the lack of a ‘homogeneous distribution of confidence’, and, more important still, the changeability of conditions of confidence, are a consequence of either political unrest or of particular national economic policies. Those two factors are at the root of most disturbances in international payments connected with long-or short-term financial operations. Both are amplified by a spirit of nationalism and attenuated or even eradicated by a spirit of internationalism, of international co-operation and co-ordination. The same applies, of course, to divergencies in price developments that take place in the various countries. Thus the following conclusions may be formulated. Major disturbances in international payments are either caused or amplified by nationalism, economic and otherwise. Unless equilibrium can be restored through commercial transactions (which economic nationalism tends to hinder), monetary instability inevitably develops, leading up to the abandonment of free economic intercourse between countries.

 

35 Chapter VIII of the author’s book, International Monetary Economics, published by Messrs Longmans, Green & Co., in 1939 and ‘bombed out of print’ during the blitz over London.

36 Or, in the older literature, of the balance of trade.

37 James W. Angell, ‘Equilibrium in International Payments: the United States, 1919–1925’, in Explorations in Economics, Notes and Essays Contributed in Honor of F. W. Taussig, New York, 1936, p. 14, footnote (2).

38 Vide infra, p. 28, a bibliographical footnote on inductive studies.

39 This is an assumption which, in fact, underlies the whole of this book.

40 Vide infra, pp. 23 et seq.

41 In using the term ‘re-equilibrium’ for ‘restoration of equilibrium’, I adopt a term introduced by Professor Aftalion, L’équilibre dans les relations économiques internationales, Paris, 1937.

42 The reader will find it useful to supplement this very summary statement by the excellent treatment of the subject in Jacob Viner’s Studies in the Theory of International Trade, New York and London, 1937, Chapter VII, pp. 388–436.

The ‘automatic’ mechanism which operates in the case of a ‘simple specie currency’ will be discussed in the next section of this chapter.

43 James W. Angell, ‘Equilibrium in International Payments’, op. cit., p. 17.

44 Ibid., p. 14. Of course no such definition can be quite rigorous and one must keep in mind, here, that short-term credit transactions occur also otherwise than in response to disequilibrium in international payments.

45 See Jacob Viner’s Studies in the Theory of International Trade, op. cit., Chapter VI pp. 290–387.

46 This qualification is indispensable; whenever there are credit operations the bank-rate policy appears in order to influence their size and direction.

47 James W. Angell, ‘Equilibrium in International Payments’, op. cit., p. 15.

48 ‘On Some Applications of the Theory of International Trade’, Quarterly Journal of Economics, 1890. Quoted in Iversen, Aspects of the Theory of International Capital Movements, Copenhagen and London, 1936, p. 202.

49 As Bastable puts it in the article quoted above, the inhabitants of the creditor country ‘having larger money incomes will purchase more at the same price’, and thus bring about the ‘necessary excess of imports over exports’. Iversen, op. cit., p. 203.

50 See the discussion between Ohlin and Keynes in the Economic Journal for 1929. Ohlin, in fighting Keynes’s argument about the difficulties of transfer, introduces shifts in demand schedules as a factor making the transfer of reparations easier. Cf. Viner, op. cit., PP. 307–11 and 326–38; Bertil Ohlin, Interregional and International Trade, Cambridge, Mass., 1935, particularly Chapter XX; Keynes, A Treatise on Money, London, 1930, vol. I, Chapter XXI.

51 R. F. Harrod, International Economics, London and Cambridge, 1933, Chapter VI, also The Trade Cycle, Oxford, 1936, pp. 145–58.

52 P. B. Whale, ‘The Working of the Pre-War Gold Standard’, Economica, February 1937.

53 Provided that there are no disturbing time-lags.

54 Under the gold standard (as opposed to an all-gold currency) this result is obtained by a combination of automatic factors and of appropriate policies.

55 Vide the following section of this chapter.

56 Jacob Viner’s Canada’s Balance of International Indebtedness is a ‘classic’ among ‘inductive’ studies relating to this problem. Let us mention also the important studies by: John H. Williams (Argentine International Trade under Inconvertible Paper Money, 1880–1900, Cambridge, Mass., 1920); H. D. White (The French International Accounts, 1880–1913, Cambridge, Mass., 1933); W. E. Beach (British International Gold Movements and Banking Policy, 1881–1913, Cambridge, Mass., 1935); F. D. Graham (‘International Trade under Depreciated Paper. The United States, 1862–79’, Quarterly Journal of Economics, vol. XXXVI, 1922); R. S. Sayers (Bank of England Operations, 1890–1914, London, 1936).

57 Assuming, as we do, the continued existence of free exchange markets.

58 Or, more generally, of the commodity used for money or for the monetary standard.

59 Import tariffs imposed by the country in deficit would, of course, help adjustment. But why should countries with a deficit in international payments have a monopoly of protectionism? and would they have it in fact? To the latter question the most likely answer is in the negative. Tariffs imposed by the country in deficit would be likely to provoke retaliatory measures and in the end adjustment would be rendered more difficult rather than easier. Therefore the argument favouring import tariffs as an instrument of readjustment does not appear to be a strong one. Cf. The Macmillan Report (Committee on Finance and Industry Report), London, 1931, H.M.S.O., Cmd. 3897, Addenda I and III.

60 The position of the problem here is different from the position of the transfer problem. It clearly results from the notion of balance of payments that a net capital payment must be made by means of an export surplus in the balance of trade of the paying country and of an import surplus in the balance of trade of the receiving country (unless transfer is deferred through credit transactions). In the problem of transfer (or, as some authors call it, of real transfer) the solution depends upon the mechanism of obtaining an export surplus. For our present problem, however, it is indifferent whether equilibrium in international payments is obtained by the means of a ‘real transfer’ of the balance due on current account or through financial operations.

61 Vide footnote, p. 32.

62 A similar attitude is adopted by Professor von Hayek in Monetary Nationalism and International Stability, London, 1937, pp. 23–4.

63 i.e. whenever there is no exceptional maladjustment of the type to be examined in the next section of this chapter.

64 A similar thesis is developed at greater length in the two very interesting books anonymously published by a well-known Belgian economist and banker under the title La crise de l’étalon-or, Brussels, 1935, and Révision de valeur, Brussels, 1937.

65 Vide supra, p. 22.

66 As in a business cycle.

67 Vide, footnote, p. 31.

68 It will be noted, as an example of great adaptability of foreign trade to changing conditions, that Germany had in 1927 a surplus of merchandise imports of 2,890 million Reichsmark, while in 1930 there was a surplus of exports of 1,644 million Reichsmark. (League of Nations, Balances of Payments, 1931 and 1932, Geneva, 1933, p. 99.) See the interesting comments on that German experience by Jacques Rueff in his lecture ‘Défense et illustration de l’étalon-or’ published in Les doctrines monétaires à l’épreuve des faits, Paris, 1932, and reprinted in Travaux du Congrès international des Sciences économiques, Paris, 1937, Paris, 1937, vol. I, pp. 275–307.

• 1To illustrate, see for example the voluminous and penetrating Annual Reports of the Bank for International Settlements.
• 2The IMF takes an entirely neutral attitude towards the Gold Exchange Standard, neither endorsing nor rejecting it.
• 3James W. Angell, ‘Equilibrium in International Payments: the United States, 1919–1925’, in Explorations in Economics, Notes and Essays Contributed in Honor of F. W. Taussig, New York, 1936, p. 14, footnote (2).
• 4Vide infra, p. 28, a bibliographical footnote on inductive studies.
• 5This is an assumption which, in fact, underlies the whole of this book.
• 6Vide infra, pp. 23 et seq.
• 7In using the term ‘re-equilibrium’ for ‘restoration of equilibrium’, I adopt a term introduced by Professor Aftalion, L’équilibre dans les relations économiques internationales, Paris, 1937.
• 8The reader will find it useful to supplement this very summary statement by the excellent treatment of the subject in Jacob Viner’s Studies in the Theory of International Trade, New York and London, 1937, Chapter VII, pp. 388–436.
• 9James W. Angell, ‘Equilibrium in International Payments’, op. cit., p. 17.
• 10Ibid., p. 14. Of course no such definition can be quite rigorous and one must keep in mind, here, that short-term credit transactions occur also otherwise than in response to disequilibrium in international payments.
• 11See Jacob Viner’s Studies in the Theory of International Trade, op. cit., Chapter VI pp. 290–387.
• 12This qualification is indispensable; whenever there are credit operations the bank-rate policy appears in order to influence their size and direction.
• 13James W. Angell, ‘Equilibrium in International Payments’, op. cit., p. 15.
• 14‘On Some Applications of the Theory of International Trade’, Quarterly Journal of Economics, 1890. Quoted in Iversen, Aspects of the Theory of International Capital Movements, Copenhagen and London, 1936, p. 202.
• 15As Bastable puts it in the article quoted above, the inhabitants of the creditor country ‘having larger money incomes will purchase more at the same price’, and thus bring about the ‘necessary excess of imports over exports’. Iversen, op. cit., p. 203.
• 16See the discussion between Ohlin and Keynes in the Economic Journal for 1929. Ohlin, in fighting Keynes’s argument about the difficulties of transfer, introduces shifts in demand schedules as a factor making the transfer of reparations easier. Cf. Viner, op. cit., PP. 307–11 and 326–38; Bertil Ohlin, Interregional and International Trade, Cambridge, Mass., 1935, particularly Chapter XX; Keynes, A Treatise on Money, London, 1930, vol. I, Chapter XXI.
• 17R. F. Harrod, International Economics, London and Cambridge, 1933, Chapter VI, also The Trade Cycle, Oxford, 1936, pp. 145–58.
• 18P. B. Whale, ‘The Working of the Pre-War Gold Standard’, Economica, February 1937.
• 19Provided that there are no disturbing time-lags.
• 20Under the gold standard (as opposed to an all-gold currency) this result is obtained by a combination of automatic factors and of appropriate policies.
• 21Vide the following section of this chapter.
• 22Jacob Viner’s Canada’s Balance of International Indebtedness is a ‘classic’ among ‘inductive’ studies relating to this problem. Let us mention also the important studies by: John H. Williams (Argentine International Trade under Inconvertible Paper Money, 1880–1900, Cambridge, Mass., 1920); H. D. White (The French International Accounts, 1880–1913, Cambridge, Mass., 1933); W. E. Beach (British International Gold Movements and Banking Policy, 1881–1913, Cambridge, Mass., 1935); F. D. Graham (‘International Trade under Depreciated Paper. The United States, 1862–79’, Quarterly Journal of Economics, vol. XXXVI, 1922); R. S. Sayers (Bank of England Operations, 1890–1914, London, 1936).
• 23Assuming, as we do, the continued existence of free exchange markets.
• 24Or, more generally, of the commodity used for money or for the monetary standard.
• 25Import tariffs imposed by the country in deficit would, of course, help adjustment. But why should countries with a deficit in international payments have a monopoly of protectionism? and would they have it in fact? To the latter question the most likely answer is in the negative. Tariffs imposed by the country in deficit would be likely to provoke retaliatory measures and in the end adjustment would be rendered more difficult rather than easier. Therefore the argument favouring import tariffs as an instrument of readjustment does not appear to be a strong one. Cf. The Macmillan Report (Committee on Finance and Industry Report), London, 1931, H.M.S.O., Cmd. 3897, Addenda I and III.
• 26The position of the problem here is different from the position of the transfer problem. It clearly results from the notion of balance of payments that a net capital payment must be made by means of an export surplus in the balance of trade of the paying country and of an import surplus in the balance of trade of the receiving country (unless transfer is deferred through credit transactions). In the problem of transfer (or, as some authors call it, of real transfer) the solution depends upon the mechanism of obtaining an export surplus. For our present problem, however, it is indifferent whether equilibrium in international payments is obtained by the means of a ‘real transfer’ of the balance due on current account or through financial operations.
• 27Vide footnote, p. 32.
• 28A similar attitude is adopted by Professor von Hayek in Monetary Nationalism and International Stability, London, 1937, pp. 23–4.
• 29i.e. whenever there is no exceptional maladjustment of the type to be examined in the next section of this chapter.
• 30A similar thesis is developed at greater length in the two very interesting books anonymously published by a well-known Belgian economist and banker under the title La crise de l’étalon-or, Brussels, 1935, and Révision de valeur, Brussels, 1937.
• 31Vide supra, p. 22.
• 32As in a business cycle.
• 33Vide, footnote, p. 31.
• 34It will be noted, as an example of great adaptability of foreign trade to changing conditions, that Germany had in 1927 a surplus of merchandise imports of 2,890 million Reichsmark, while in 1930 there was a surplus of exports of 1,644 million Reichsmark. (League of Nations, Balances of Payments, 1931 and 1932, Geneva, 1933, p. 99.) See the interesting comments on that German experience by Jacques Rueff in his lecture ‘Défense et illustration de l’étalon-or’ published in Les doctrines monétaires à l’épreuve des faits, Paris, 1932, and reprinted in Travaux du Congrès international des Sciences économiques, Paris, 1937, Paris, 1937, vol. I, pp. 275–307.
• 35The fifties were a period of increasingly obvious recovery, both in world monetary affairs and in the economic life of individual countries. The great opportunities offered during that decade, however, for carrying out a sweeping international monetary reform have not been utilized. True, the European Payments Union had been formed at the beginning of the decade, to be dissolved, due to improved conditions in Europe, towards the end of it. But this was at best an attempt at making inconvertibility more liveable with and at undoing part of its evil effects on intra-European commerce. The International Monetary Fund (established by the Bretton Woods Conference in June 1944) could have blossomed up, but did not do so, during the fifties, whereas what actually did take place was a great revival of the Gold Exchange Standard, amplified into the so-called ‘key currency system’. It should also be noted that the alleged (though never really existing) ‘dollar shortage’, which caused rivers of scholarly ink to flow for many years, has been reversed and a far more real dollar glut took its place at the end of the fifties as a result of the large balance-of-payments deficits which the U.S. started to experience in 1958.
• 36The fifties were a period of increasingly obvious recovery, both in world monetary affairs and in the economic life of individual countries. The great opportunities offered during that decade, however, for carrying out a sweeping international monetary reform have not been utilized. True, the European Payments Union had been formed at the beginning of the decade, to be dissolved, due to improved conditions in Europe, towards the end of it. But this was at best an attempt at making inconvertibility more liveable with and at undoing part of its evil effects on intra-European commerce. The International Monetary Fund (established by the Bretton Woods Conference in June 1944) could have blossomed up, but did not do so, during the fifties, whereas what actually did take place was a great revival of the Gold Exchange Standard, amplified into the so-called ‘key currency system’. It should also be noted that the alleged (though never really existing) ‘dollar shortage’, which caused rivers of scholarly ink to flow for many years, has been reversed and a far more real dollar glut took its place at the end of the fifties as a result of the large balance-of-payments deficits which the U.S. started to experience in 1958.
• 37The problem of maintaining the equilibrium of balances of international payments, and of restoring it once it has been disturbed, is one of the most discussed questions in the field of international economics. The interest attached to it can be accounted for by the national and international difficulties which disequilibrium in international payments brings about if it is sudden and large or protracted and cumulative. It is the frictions caused by deficits in international payments of a country which have brought the problem of balances of payments into the important position it occupies in international relations, and which have provided the incentive for an extensive literature of the subject, which I cannot hope to discuss or even quote in the pages that follow. As has been pointed out by various writers, the problem of international payments acquires an importance which that of interregional payments does not possess, on account of the existence of various national monetary systems and of more or less uncoordinated national monetary and, more generally, economic, policies. This plurality of currencies results in the problem of foreign exchanges, which is an international and not an interregional one and is closely linked with that of balances of payments. We have seen that fluctuations of foreign exchanges are due to changes in international payments; and that these fluctuations tend to equalize the demand and the supply on foreign-exchange markets, and thus equalize payments made and payments received by a country. As Professor Angell rightly points out, ‘if the foreign exchange rates are free to move without limit in either direction, their movement will in itself keep the two current streams of credit and debit payments always equal . . .’. We shall see presently, however, that under flexible exchanges the problem arises of a possible cumulative devaluation of a currency and of its avoidance, and that the exchange fluctuation itself sets in motion forces affecting the size of transactions from which international payments result. The problem of equilibrium in international payments has its fullest significance upon the assumption of stable exchanges. The question can then be formulated in the following way: given stable exchanges, or given the desire to keep exchanges stable, how can equilibrium be restored in international payments once it has been disturbed? The restoration of equilibrium in international payments is thus a means of maintaining monetary parities by rigorously limiting exchange fluctuations. This in turn is inspired by the consideration that wide exchange fluctuations are undesirable, a position that calls for investigation. The limitation of movements of foreign exchanges calls for a ‘mechanism’ for adjusting balances of payments, and one finds that various ‘mechanisms’ can be constructed as abstract models but that only some of them can operate in the actual economic world. Most writings on this subject fall therefore into one of two groups: (1) construction of ‘models’ of ‘mechanisms’ that are conceivable in abstracto and (2) inquiry into the nature of ‘mechanisms’ that actually did operate in given circumstances. The fundamental problem is not complicated: if payments to be made and payments to be received at a particular moment do not cancel out, and if equality is not obtained through a continuous modification of the exchange relation between the respective currency units, then transactions must occur which will compensate the deficit and restore the balance (since over longer periods of time, payments received must be equal to payments made). Let us for the sake of clarity group the various questions that arise in this context and investigate each group separately. Before proceeding to this examination let us first explicitly state an important assumption that underlies all the reasonings to follow. We are going to discuss processes that are taking place in a free economic community, where there are no governmental interferences, other than tariffs, in the economic relations between countries. More precisely, it is assumed that individuals are not interfered with in either the commercial or the financial transactions which they wish to carry out.
• 38The problem of maintaining the equilibrium of balances of international payments, and of restoring it once it has been disturbed, is one of the most discussed questions in the field of international economics. The interest attached to it can be accounted for by the national and international difficulties which disequilibrium in international payments brings about if it is sudden and large or protracted and cumulative. It is the frictions caused by deficits in international payments of a country which have brought the problem of balances of payments into the important position it occupies in international relations, and which have provided the incentive for an extensive literature of the subject, which I cannot hope to discuss or even quote in the pages that follow. As has been pointed out by various writers, the problem of international payments acquires an importance which that of interregional payments does not possess, on account of the existence of various national monetary systems and of more or less uncoordinated national monetary and, more generally, economic, policies. This plurality of currencies results in the problem of foreign exchanges, which is an international and not an interregional one and is closely linked with that of balances of payments. We have seen that fluctuations of foreign exchanges are due to changes in international payments; and that these fluctuations tend to equalize the demand and the supply on foreign-exchange markets, and thus equalize payments made and payments received by a country. As Professor Angell rightly points out, ‘if the foreign exchange rates are free to move without limit in either direction, their movement will in itself keep the two current streams of credit and debit payments always equal . . .’. We shall see presently, however, that under flexible exchanges the problem arises of a possible cumulative devaluation of a currency and of its avoidance, and that the exchange fluctuation itself sets in motion forces affecting the size of transactions from which international payments result. The problem of equilibrium in international payments has its fullest significance upon the assumption of stable exchanges. The question can then be formulated in the following way: given stable exchanges, or given the desire to keep exchanges stable, how can equilibrium be restored in international payments once it has been disturbed? The restoration of equilibrium in international payments is thus a means of maintaining monetary parities by rigorously limiting exchange fluctuations. This in turn is inspired by the consideration that wide exchange fluctuations are undesirable, a position that calls for investigation. The limitation of movements of foreign exchanges calls for a ‘mechanism’ for adjusting balances of payments, and one finds that various ‘mechanisms’ can be constructed as abstract models but that only some of them can operate in the actual economic world. Most writings on this subject fall therefore into one of two groups: (1) construction of ‘models’ of ‘mechanisms’ that are conceivable in abstracto and (2) inquiry into the nature of ‘mechanisms’ that actually did operate in given circumstances. The fundamental problem is not complicated: if payments to be made and payments to be received at a particular moment do not cancel out, and if equality is not obtained through a continuous modification of the exchange relation between the respective currency units, then transactions must occur which will compensate the deficit and restore the balance (since over longer periods of time, payments received must be equal to payments made). Let us for the sake of clarity group the various questions that arise in this context and investigate each group separately. Before proceeding to this examination let us first explicitly state an important assumption that underlies all the reasonings to follow. We are going to discuss processes that are taking place in a free economic community, where there are no governmental interferences, other than tariffs, in the economic relations between countries. More precisely, it is assumed that individuals are not interfered with in either the commercial or the financial transactions which they wish to carry out.
• 39The problem of maintaining the equilibrium of balances of international payments, and of restoring it once it has been disturbed, is one of the most discussed questions in the field of international economics. The interest attached to it can be accounted for by the national and international difficulties which disequilibrium in international payments brings about if it is sudden and large or protracted and cumulative. It is the frictions caused by deficits in international payments of a country which have brought the problem of balances of payments into the important position it occupies in international relations, and which have provided the incentive for an extensive literature of the subject, which I cannot hope to discuss or even quote in the pages that follow. As has been pointed out by various writers, the problem of international payments acquires an importance which that of interregional payments does not possess, on account of the existence of various national monetary systems and of more or less uncoordinated national monetary and, more generally, economic, policies. This plurality of currencies results in the problem of foreign exchanges, which is an international and not an interregional one and is closely linked with that of balances of payments. We have seen that fluctuations of foreign exchanges are due to changes in international payments; and that these fluctuations tend to equalize the demand and the supply on foreign-exchange markets, and thus equalize payments made and payments received by a country. As Professor Angell rightly points out, ‘if the foreign exchange rates are free to move without limit in either direction, their movement will in itself keep the two current streams of credit and debit payments always equal . . .’. We shall see presently, however, that under flexible exchanges the problem arises of a possible cumulative devaluation of a currency and of its avoidance, and that the exchange fluctuation itself sets in motion forces affecting the size of transactions from which international payments result. The problem of equilibrium in international payments has its fullest significance upon the assumption of stable exchanges. The question can then be formulated in the following way: given stable exchanges, or given the desire to keep exchanges stable, how can equilibrium be restored in international payments once it has been disturbed? The restoration of equilibrium in international payments is thus a means of maintaining monetary parities by rigorously limiting exchange fluctuations. This in turn is inspired by the consideration that wide exchange fluctuations are undesirable, a position that calls for investigation. The limitation of movements of foreign exchanges calls for a ‘mechanism’ for adjusting balances of payments, and one finds that various ‘mechanisms’ can be constructed as abstract models but that only some of them can operate in the actual economic world. Most writings on this subject fall therefore into one of two groups: (1) construction of ‘models’ of ‘mechanisms’ that are conceivable in abstracto and (2) inquiry into the nature of ‘mechanisms’ that actually did operate in given circumstances. The fundamental problem is not complicated: if payments to be made and payments to be received at a particular moment do not cancel out, and if equality is not obtained through a continuous modification of the exchange relation between the respective currency units, then transactions must occur which will compensate the deficit and restore the balance (since over longer periods of time, payments received must be equal to payments made). Let us for the sake of clarity group the various questions that arise in this context and investigate each group separately. Before proceeding to this examination let us first explicitly state an important assumption that underlies all the reasonings to follow. We are going to discuss processes that are taking place in a free economic community, where there are no governmental interferences, other than tariffs, in the economic relations between countries. More precisely, it is assumed that individuals are not interfered with in either the commercial or the financial transactions which they wish to carry out.
• 40In this case we assume that gold is the only money in circulation in the various countries; we further assume that no changes will be made anywhere in the price of gold and that, therefore, there are fixed parities (mint-par) between the various gold currencies. Every net payment between countries is made in gold, and results in a reduction of the amount of circulating medium in a country which has a deficit in its balance of payments, and in a net increase in the amount of circulating medium in countries having a surplus in their balances of payments. We shall discuss later the repercussions of these changes upon the various transactions between the countries concerned and the various policies that may be adopted in response to gold movements. Let us merely point out in the present context that should a country have a persistent deficit in her international payments, the deflation caused by losses of circulating medium may become very drastic. By reason of the frictions that this involves, the country which is going through such an experience may be tempted to change its monetary system. If this should be the case and if the country in question should abandon the system of gold currency, international frictions will follow. Thus while payments in gold can always momentarily restore equilibrium in international payments, changes in international economic transactions themselves must take place if a breakdown of the monetary system is to be avoided. As it happens, however, losses of gold may set in motion some ‘mechanism’, which will be discussed presently, and help to obtain an appropriate adjustment of commercial and financial transactions.
• 41As it has been pointed out above, there are two different ways of approaching this question. One is to indicate the mechanism by which policies adopted in response to a break of equilibrium can bring about compensatory operations, and thus durably restore the disturbed equilibrium of the balance of payments. The other approach consists in demonstrating that disequilibrium releases through its very existence forces which tend to bring about the necessary adjustments in international transactions. The one type of approach arrives at a theory of what I propose to call ‘induced re-equilibrium’, while the other arrives at a theory of ‘automatic re-equilibrium’. This terminology will be justified by the discussion that follows. It will become clear too that the two theories are complementary, not alternative, and that one needs them both in order to explain empirically-known phenomena in a completely satisfactory way. It is to be regretted that most writers on the subject so little realize the complementary character of the various approaches to the problem of re-equilibrium in international payments.
• 42The classical ‘mechanism’ realizes all these effects by the single means of changes in the bank rate. Under modern banking conditions additional policies may be called for, since the monetary circulation not covered by gold is only to a small extent backed by commercial paper and to a very large extent by government securities. In order to obtain the reduction in monetary circulation which the ‘classical’ theory demands, ‘open market’ operations must supplement the movements of interest rates. It will be noted that there is, both in the ‘classical’ and in the ‘modern’ version of this mechanism, a considerable amount of judgment to be exercised by the central banking authorities; thus the mechanism in question is by no means an automatic one.
• 43It can be said that long-term equilibrium in international payments exists if short-term credit operations are always sufficient to restore the balance whenever it is disturbed. Thus Professor Angell gives a definition, which in the light of the foregoing analysis appears to be judicious and acceptable, and according to which international payments of a country are in equilibrium if ‘the net balance of the aggregated commodity, service, interest and dividend and long-term capital operations, so far as these operations entail actual payments, is zero’. Or, reciprocally, ‘a country’s international payments are “out of equilibrium” whenever short-term funds are moving to or from it, net (that is, whenever the net balance of all the other international payment items is greater or less than zero)’. In other words, international payments are in durable equilibrium if, in order to maintain that equilibrium, and in the absence of any new disturbances, no changes in the structure of foreign trade or credit operations are required.
• 44It can be said that long-term equilibrium in international payments exists if short-term credit operations are always sufficient to restore the balance whenever it is disturbed. Thus Professor Angell gives a definition, which in the light of the foregoing analysis appears to be judicious and acceptable, and according to which international payments of a country are in equilibrium if ‘the net balance of the aggregated commodity, service, interest and dividend and long-term capital operations, so far as these operations entail actual payments, is zero’. Or, reciprocally, ‘a country’s international payments are “out of equilibrium” whenever short-term funds are moving to or from it, net (that is, whenever the net balance of all the other international payment items is greater or less than zero)’. In other words, international payments are in durable equilibrium if, in order to maintain that equilibrium, and in the absence of any new disturbances, no changes in the structure of foreign trade or credit operations are required.
• 45While induced re-equilibrium is obtained by the means of policies adopted in response to symptoms of disequilibrium, such as gold-flows from country to country, automatic re-equilibrium is a direct consequence of the maladjustment of international payments. There may be two conceptions of this type of adjustment: (1) there are symptoms of maladjustment such as flows of gold, but no policy needs to be adopted since the consequences (or symptoms) of maladjustment bring themselves the cure that is required; (2) the disequilibrium has direct consequences which prevent even the appearance of the symptoms of maladjustment, considered as the ‘normal’ ones. The first case is that of the ‘classical’ mechanism of adjustment working within the monetary system of a ‘simple specie currency’ where there are no credit operations whatever. The second represents the most ‘modern’ tendencies that prevail in investigations of equilibrium in international payments.
• 46While induced re-equilibrium is obtained by the means of policies adopted in response to symptoms of disequilibrium, such as gold-flows from country to country, automatic re-equilibrium is a direct consequence of the maladjustment of international payments. There may be two conceptions of this type of adjustment: (1) there are symptoms of maladjustment such as flows of gold, but no policy needs to be adopted since the consequences (or symptoms) of maladjustment bring themselves the cure that is required; (2) the disequilibrium has direct consequences which prevent even the appearance of the symptoms of maladjustment, considered as the ‘normal’ ones. The first case is that of the ‘classical’ mechanism of adjustment working within the monetary system of a ‘simple specie currency’ where there are no credit operations whatever. The second represents the most ‘modern’ tendencies that prevail in investigations of equilibrium in international payments.
• 47(2) The modern school of thought, representing what has been called here ‘the theory of automatic adjustments’, consists of ‘those who postulate shifts of international demand schedules to right or to left without any necessary intermediation of gold flows’. Iversen traces this point of view to an article written in 1889 by C. F. Bastable, in which, in opposition to John Stuart Mill, the fact is brought out that changes in purchasing power of the respective countries brought forth by the disequilibrium in balances of payments may in themselves, and without the help of any additional policy, effect changes in the volume and direction of trade between these countries. Thus to formulate the problem briefly, the question consists in finding out whether gold movements on the one hand, and price-changes on the other, are indispensable in order to bring international payments into a new equilibrium. According to the theory which we are now discussing, neither of the two elements is absolutely necessary for an equilibrating mechanism to work. This point of view has been brought to the foreground of economic debate in the course of the reparations discussion. More recently Harrod and Whale make an extensive use of the same mechanism. While there are various nuances as between the different presentations, the essential process here involved consists in changes that are supposed to take place in reciprocal demand schedules that exist in each of the countries for the other country’s products. Thus the country whose balance of payments shows a deficit would buy less goods of the other country (assuming two countries in presence) while the latter country would increase her importations from the former. Since these surplus imports will be financed through the spending of sums due by the debtor country, no price-changes are necessary in order to bring about the adjustment.
• 48(2) The modern school of thought, representing what has been called here ‘the theory of automatic adjustments’, consists of ‘those who postulate shifts of international demand schedules to right or to left without any necessary intermediation of gold flows’. Iversen traces this point of view to an article written in 1889 by C. F. Bastable, in which, in opposition to John Stuart Mill, the fact is brought out that changes in purchasing power of the respective countries brought forth by the disequilibrium in balances of payments may in themselves, and without the help of any additional policy, effect changes in the volume and direction of trade between these countries. Thus to formulate the problem briefly, the question consists in finding out whether gold movements on the one hand, and price-changes on the other, are indispensable in order to bring international payments into a new equilibrium. According to the theory which we are now discussing, neither of the two elements is absolutely necessary for an equilibrating mechanism to work. This point of view has been brought to the foreground of economic debate in the course of the reparations discussion. More recently Harrod and Whale make an extensive use of the same mechanism. While there are various nuances as between the different presentations, the essential process here involved consists in changes that are supposed to take place in reciprocal demand schedules that exist in each of the countries for the other country’s products. Thus the country whose balance of payments shows a deficit would buy less goods of the other country (assuming two countries in presence) while the latter country would increase her importations from the former. Since these surplus imports will be financed through the spending of sums due by the debtor country, no price-changes are necessary in order to bring about the adjustment.
• 49(2) The modern school of thought, representing what has been called here ‘the theory of automatic adjustments’, consists of ‘those who postulate shifts of international demand schedules to right or to left without any necessary intermediation of gold flows’. Iversen traces this point of view to an article written in 1889 by C. F. Bastable, in which, in opposition to John Stuart Mill, the fact is brought out that changes in purchasing power of the respective countries brought forth by the disequilibrium in balances of payments may in themselves, and without the help of any additional policy, effect changes in the volume and direction of trade between these countries. Thus to formulate the problem briefly, the question consists in finding out whether gold movements on the one hand, and price-changes on the other, are indispensable in order to bring international payments into a new equilibrium. According to the theory which we are now discussing, neither of the two elements is absolutely necessary for an equilibrating mechanism to work. This point of view has been brought to the foreground of economic debate in the course of the reparations discussion. More recently Harrod and Whale make an extensive use of the same mechanism. While there are various nuances as between the different presentations, the essential process here involved consists in changes that are supposed to take place in reciprocal demand schedules that exist in each of the countries for the other country’s products. Thus the country whose balance of payments shows a deficit would buy less goods of the other country (assuming two countries in presence) while the latter country would increase her importations from the former. Since these surplus imports will be financed through the spending of sums due by the debtor country, no price-changes are necessary in order to bring about the adjustment.
• 50(2) The modern school of thought, representing what has been called here ‘the theory of automatic adjustments’, consists of ‘those who postulate shifts of international demand schedules to right or to left without any necessary intermediation of gold flows’. Iversen traces this point of view to an article written in 1889 by C. F. Bastable, in which, in opposition to John Stuart Mill, the fact is brought out that changes in purchasing power of the respective countries brought forth by the disequilibrium in balances of payments may in themselves, and without the help of any additional policy, effect changes in the volume and direction of trade between these countries. Thus to formulate the problem briefly, the question consists in finding out whether gold movements on the one hand, and price-changes on the other, are indispensable in order to bring international payments into a new equilibrium. According to the theory which we are now discussing, neither of the two elements is absolutely necessary for an equilibrating mechanism to work. This point of view has been brought to the foreground of economic debate in the course of the reparations discussion. More recently Harrod and Whale make an extensive use of the same mechanism. While there are various nuances as between the different presentations, the essential process here involved consists in changes that are supposed to take place in reciprocal demand schedules that exist in each of the countries for the other country’s products. Thus the country whose balance of payments shows a deficit would buy less goods of the other country (assuming two countries in presence) while the latter country would increase her importations from the former. Since these surplus imports will be financed through the spending of sums due by the debtor country, no price-changes are necessary in order to bring about the adjustment.
• 51(2) The modern school of thought, representing what has been called here ‘the theory of automatic adjustments’, consists of ‘those who postulate shifts of international demand schedules to right or to left without any necessary intermediation of gold flows’. Iversen traces this point of view to an article written in 1889 by C. F. Bastable, in which, in opposition to John Stuart Mill, the fact is brought out that changes in purchasing power of the respective countries brought forth by the disequilibrium in balances of payments may in themselves, and without the help of any additional policy, effect changes in the volume and direction of trade between these countries. Thus to formulate the problem briefly, the question consists in finding out whether gold movements on the one hand, and price-changes on the other, are indispensable in order to bring international payments into a new equilibrium. According to the theory which we are now discussing, neither of the two elements is absolutely necessary for an equilibrating mechanism to work. This point of view has been brought to the foreground of economic debate in the course of the reparations discussion. More recently Harrod and Whale make an extensive use of the same mechanism. While there are various nuances as between the different presentations, the essential process here involved consists in changes that are supposed to take place in reciprocal demand schedules that exist in each of the countries for the other country’s products. Thus the country whose balance of payments shows a deficit would buy less goods of the other country (assuming two countries in presence) while the latter country would increase her importations from the former. Since these surplus imports will be financed through the spending of sums due by the debtor country, no price-changes are necessary in order to bring about the adjustment.
• 52(2) The modern school of thought, representing what has been called here ‘the theory of automatic adjustments’, consists of ‘those who postulate shifts of international demand schedules to right or to left without any necessary intermediation of gold flows’. Iversen traces this point of view to an article written in 1889 by C. F. Bastable, in which, in opposition to John Stuart Mill, the fact is brought out that changes in purchasing power of the respective countries brought forth by the disequilibrium in balances of payments may in themselves, and without the help of any additional policy, effect changes in the volume and direction of trade between these countries. Thus to formulate the problem briefly, the question consists in finding out whether gold movements on the one hand, and price-changes on the other, are indispensable in order to bring international payments into a new equilibrium. According to the theory which we are now discussing, neither of the two elements is absolutely necessary for an equilibrating mechanism to work. This point of view has been brought to the foreground of economic debate in the course of the reparations discussion. More recently Harrod and Whale make an extensive use of the same mechanism. While there are various nuances as between the different presentations, the essential process here involved consists in changes that are supposed to take place in reciprocal demand schedules that exist in each of the countries for the other country’s products. Thus the country whose balance of payments shows a deficit would buy less goods of the other country (assuming two countries in presence) while the latter country would increase her importations from the former. Since these surplus imports will be financed through the spending of sums due by the debtor country, no price-changes are necessary in order to bring about the adjustment.
• 53It is certainly conceivable that the net payment will be made by the means of an appropriate change in the balance of trade brought forth by shifts in demand schedules, without either gold movements or price changes, but is it likely to happen? It will be observed that changes in the structure of trade require time, while gold shipments in response to a certain situation in the foreign-exchange market take place on a very short notice; it is therefore likely that gold movements will take place even before changes in the structure of trade could occur. Inasmuch as gold movements affect the supply of money in the countries concerned, price movements are thus likely to take place with a more or less considerable time-lag. Is it possible that these changes in the supply of money should affect the volume and direction of trade between the particular countries without first causing price-changes? This will depend upon the particular shape of the various demand curves. If the increased demand by the ‘creditor’ country for foreign goods offsets the decrease of internal demand on the markets of the ‘debtor’ country; and if the increased internal demand on the markets of the ‘creditor’ country offsets the fall in exports formerly bought by the ‘debtor’ country; then the price structure will remain intact in both countries. The off-setting would have to take place, however, not only in total values, but in each individual market as well. That this might happen is just conceivable but the probability of its happening is very small. In the contrary case changes in price structures are inevitable. It seems reasonable to conclude that: (1) changes in national price structures are practically unavoidable if equilibrium is to be realized through adjustments of the balance of trade; (2) the fact of net payments from country to country may affect the size and direction of trade between the countries concerned even in the absence of major price movements; changes in the structure of prices would then take place in each country as a consequence of changes in demand schedules; (3) the need of price movements is considerably reduced when the mechanism of re-equilibrium works primarily through credit operations (but in this case it ceases to be automatic).
• 54Thus far the process described has been ‘automatic’; it can be supplemented, however, by appropriate monetary policies. Thus the monetary authorities of the country having a deficit in its international payments may adopt a restrictive credit policy at home and cause a fall in nominal prices; similarly the monetary authorities of the country having a surplus in its balance of payments may adopt a more liberal credit policy and cause a rising price-tendency at home. In acting this way the respective policies would achieve voluntarily what is obtained automatically under a simple specie currency and would speed up the process of adjustment described above.
• 55If we complete the picture by introducing international financial operations, the adoption of certain appropriate policies becomes imperative. As we have seen, a system of freely fluctuating exchanges does not eliminate the possibility of a long-run stability (as distinct from fixity) of exchange rates. If this is the object of policy we find ourselves in a position which is not vitally different from the one described in the preceding section of this chapter. It is quite conceivable that the fluctuation of exchanges around an equilibrium position should (by keeping international payments balanced) be itself an instrument of maintaining a long-run exchange stability. This conception of exchange fluctuations as a mechanism of re-equilibrium is very important, since it conflicts with the view according to which exchange chaos is the only alternative to fixed parities. Now for various reasons fixed parities may appear to be preferable to a long-run stability of fluctuating exchanges; this latter possibility must, however, not be overlooked since it represents an interesting intermediate solution. If it is adopted as a declared objective of policy, capital and money movements may continue on the basis of anticipated long-term exchange stability; in the contrary case the anticipated instability will disorganize financial operations and thus become a real instability. Thus the real opposition is that of organized versus disorganized international monetary relations, not that of one method or organization versus another method (that is of one monetary system versus another system). The choice of methods must then depend on various other considerations, not on that of a long-run stability of foreign exchanges.
• 56In the preceding two sections I have endeavoured to give a brief outline of the principal ‘mechanisms’ through which international payments are or can be equilibrated once their balance has been disturbed. As has been pointed out above, the various mechanisms that operate under conditions of fixed parities can work together; what actually happens in any particular situation can be ascertained only by means of empirical inquiries. While some such investigations have been carried out, very much remains still to be done. This is indeed a fitting subject for institutional research: in order to make the results of such inquiries readily comparable they ought to be carried out by a group of scholars in agreement amongst themselves on the methods to be used and on the problems to be investigated. In the absence of more and better knowledge of actual processes, most detailed discussions of the ‘mechanism’ of re-equilibrium remain in the sphere of the intellectually conceivable; they are precious tools of thought for inductive research. The most that can be said is that actual situations represent variously set-up compounds of these multiple hypothetical methods of adjustment. It is only when our empirical knowledge is more developed that really significant results will be obtained through applying and testing the various abstract ‘models’. In the present study I should like to bring out certain fundamental similarities between the various ‘mechanisms’, in particular the analogies which exist between ‘mechanisms’ moving on the basis of fixed parities and those which work through exchange fluctuations. Some elements of this comparison have been already mentioned in section D of this chapter and in the light of these observations there appears a possibility of formulating a theory of re-equilibrium which would apply to any monetary system. This is what I shall now attempt very briefly to do.
• 57Symptoms of disequilibrium in international payments can be only one of two kinds: (a) flows of gold (under the gold standard); (b) depreciation of one currency in terms of the other. If deficits and surpluses are cumulative, then (a) losses of gold2 by the country in deficit will go on until this particular monetary system breaks down, or (b) the depreciation of the currency of the country in deficit will continue without limitation and monetary instability will set in. It will be noted that even if one starts from the situation (a) one ultimately lands in the situation (b) provided that the cumulative character of the maladjustments lasts long enough. Now currency depreciation, to which there is no known limitation, destroys all regularity in flows of capital and introduces into the economic process more or less wide and erratic movements of short-term funds. The destruction of confidence brings an end to financial and monetary stability; considerations of safety and not considerations of returns guide financial operations henceforth.
• 58Symptoms of disequilibrium in international payments can be only one of two kinds: (a) flows of gold (under the gold standard); (b) depreciation of one currency in terms of the other. If deficits and surpluses are cumulative, then (a) losses of gold2 by the country in deficit will go on until this particular monetary system breaks down, or (b) the depreciation of the currency of the country in deficit will continue without limitation and monetary instability will set in. It will be noted that even if one starts from the situation (a) one ultimately lands in the situation (b) provided that the cumulative character of the maladjustments lasts long enough. Now currency depreciation, to which there is no known limitation, destroys all regularity in flows of capital and introduces into the economic process more or less wide and erratic movements of short-term funds. The destruction of confidence brings an end to financial and monetary stability; considerations of safety and not considerations of returns guide financial operations henceforth.
• 59Most of the ‘mechanisms’ described in the economic literature, and summed up above, work on the assumption that international trade is the principal source of payments that take place from country to country. This easily leads to confusing the balance of trade with the balance of payments and to reducing the disequilibrium in the latter to that in the former. Whenever this is done, conclusions obtained cannot be applied, without more or less serious qualifications, to cases where financial transactions are an important source of international payments. In the assumption that no financial transactions whatever are taking place, the whole readjustment in international payments has to be obtained through export surpluses realized by the country in deficit. If the adjustment is to be made under a system of simple specie currency, the deficit of the balance of payments causes a change in the supply of money in the countries concerned and thus affects trade, (a) directly via shifts in demand schedules brought about by changes in the supply of money; and (b) indirectly through price changes resulting from movements of specie from country to country. The greater the price adjustment, the quicker will the necessary alteration in the balance of trade be obtained. It will be observed that the necessary price adjustment will be smallest when trade is free and that progressive protectionism may seriously interfere with the process of re-equilibrium.
• 60The time has now come to drop the assumption which consisted in limiting international economic relations to commercial transactions. Under modern economic conditions capital movements and short-term credit operations play too important a part to be left out of consideration. On the contrary, they ought to be introduced into the problem of international settlements with a far greater emphasis than is generally the case. If financial transactions are important components of international economic relations, then trade adjustments cannot be regarded any longer as the only, or even as the principal, factor in the process of re-equilibrium.
• 61Let us now ascertain whether this interest-rate policy is indispensable for obtaining re-equilibrium or whether, on the contrary, a mechanism is conceivable which leaves the rate of interest quite outside the process of adjustment. Should the interest rate become dissociated from the mechanism of re-equilibrium, then, under normal conditions of confidence, international credit operations would cease to operate as an instrument helping to bring about equilibrium of international payments. As far as I can see it, there is no means of attracting to a country short-term balances other than offering them a sufficiently high reward, and this can be achieved only by means of an appropriate bank-rate policy. If now, international credit operations cease to take place, the whole load of adjustment is thrown upon the balance of trade. Important consequences follow. Credit operations of the type which we are considering here reduce the net deficit (and surplus) in international payments and reduce in consequence the size of net balances which have to be settled and the volume of ‘real transfer’ which has to carry out the final settlement. The suppression of compensatory credit transactions has the contrary effect. Now it is clear that the greater is the size of adjustments to be brought about by trade items, the greater will be the need for changes in the supply of money on the respective national markets and for differential price movements. These changes in the supply of money may be carried out through open-market operations under conditions which were specified above. Whenever this method can be applied the bank rate need not be changed as soon as the mechanism of re-equilibrium begins to work. It will, however, be noticed that the change of rates is thus merely postponed. Relative changes in the supply of money call sooner or later for changes in short-term interest rates; these cannot be indefinitely avoided if re-equilibrium is to be obtained. Movements in interest rates can only be avoided if one adopts measures the final effect of which is to make the functioning of the mechanism of adjustment impossible. It is hardly necessary, after all the foregoing analysis, to emphasize further the fact that international payments are not likely to be brought into equilibrium if neither short-term credit operations, nor changes in the supply of money and in national prices, are allowed to take place.
• 62There is in the same context another misapprehension which ought to be dispelled. It is usually claimed by those who advocate the system of ‘flexible exchanges’ in opposition to that of fixed parities, that the latter imposes upon countries which are practising it the strains of repeated deflations, or rather of an alternation of inflations and of deflations. This strikes me as a rather fanciful representation under normal conditions. Price movements which enter into a process of adjustment of international payments are not likely to be of an amplitude which would seriously disturb economic activity and amount to a deflation (or inflation). If we had the necessary quantitative information about the pre-war times, we could settle the matter conclusively. While waiting for an adequate documentation to be produced we must depend on the logic of the economic system and be very careful not to exaggerate what probably consisted of relatively minor price movements; very likely the greatest part of current adjustments was carried out (as I pointed out before) by credit operations. The underestimation of the part played by international movements of short-term balances had led to an exaggeration of the rôle of price movements and of their size. A further source of confusion is the lack of differentiation between current adjustments of transactions carried out with a view to maintaining long-run equilibrium in international payments, and adjustments to violent breaks of equilibrium due to special causes and to exceptional circumstances. Under ‘normal’ conditions there is no need to choose between stable prices and stable exchanges. Not only can both be stable at the same time, but it clearly follows from all the foregoing analysis that they must be stable simultaneously, if equilibrium is to be preserved.
• 63There is in the same context another misapprehension which ought to be dispelled. It is usually claimed by those who advocate the system of ‘flexible exchanges’ in opposition to that of fixed parities, that the latter imposes upon countries which are practising it the strains of repeated deflations, or rather of an alternation of inflations and of deflations. This strikes me as a rather fanciful representation under normal conditions. Price movements which enter into a process of adjustment of international payments are not likely to be of an amplitude which would seriously disturb economic activity and amount to a deflation (or inflation). If we had the necessary quantitative information about the pre-war times, we could settle the matter conclusively. While waiting for an adequate documentation to be produced we must depend on the logic of the economic system and be very careful not to exaggerate what probably consisted of relatively minor price movements; very likely the greatest part of current adjustments was carried out (as I pointed out before) by credit operations. The underestimation of the part played by international movements of short-term balances had led to an exaggeration of the rôle of price movements and of their size. A further source of confusion is the lack of differentiation between current adjustments of transactions carried out with a view to maintaining long-run equilibrium in international payments, and adjustments to violent breaks of equilibrium due to special causes and to exceptional circumstances. Under ‘normal’ conditions there is no need to choose between stable prices and stable exchanges. Not only can both be stable at the same time, but it clearly follows from all the foregoing analysis that they must be stable simultaneously, if equilibrium is to be preserved.
• 64There is in the same context another misapprehension which ought to be dispelled. It is usually claimed by those who advocate the system of ‘flexible exchanges’ in opposition to that of fixed parities, that the latter imposes upon countries which are practising it the strains of repeated deflations, or rather of an alternation of inflations and of deflations. This strikes me as a rather fanciful representation under normal conditions. Price movements which enter into a process of adjustment of international payments are not likely to be of an amplitude which would seriously disturb economic activity and amount to a deflation (or inflation). If we had the necessary quantitative information about the pre-war times, we could settle the matter conclusively. While waiting for an adequate documentation to be produced we must depend on the logic of the economic system and be very careful not to exaggerate what probably consisted of relatively minor price movements; very likely the greatest part of current adjustments was carried out (as I pointed out before) by credit operations. The underestimation of the part played by international movements of short-term balances had led to an exaggeration of the rôle of price movements and of their size. A further source of confusion is the lack of differentiation between current adjustments of transactions carried out with a view to maintaining long-run equilibrium in international payments, and adjustments to violent breaks of equilibrium due to special causes and to exceptional circumstances. Under ‘normal’ conditions there is no need to choose between stable prices and stable exchanges. Not only can both be stable at the same time, but it clearly follows from all the foregoing analysis that they must be stable simultaneously, if equilibrium is to be preserved.
• 65(a) If price movements in different countries take place quite independently of one another and we then get ever further away from an ‘international price equilibrium’, cumulative changes in balances of trade are due to take place. This must not, and is not likely to, happen when price movements take place but are internationally co-ordinated. I am not speaking of price fluctuations which are a part of a process of adjustment and bring about equilibrating changes in balances of trade; the price movements referred to in the present context are not fluctuations of a minor amplitude but cumulative tendencies of prices to rise or to fall over longer periods of time. Thus if two countries practise in the downward phase of the cycle, the one an expansionist policy, the other a deflationary policy, frictions are likely to occur, since prices in the former country will rise in relation to prices in the latter: which is bound to affect trade between them. Unless other transactions compensate this development of balances of trade, the strain on foreign exchanges may become considerable. It will be noted that to pursue such divergent price policies is possible in the long run only when the individual countries in question disregard the rules governing mechanisms of adjustment and adopt policies which are in contradiction with those rules. The characteristic feature of the ‘rules of adjustment’ is that they demand the adoption of policies which go counter to the disturbing tendencies; policies which, on the contrary, strengthen these tendencies, such as inflationary or deflationary ones, make the functioning of mechanisms of re-equilibrium difficult or impossible while they accentuate the causes of disequilibrium. The situation is, of course, different when all the countries adopt an expansionist, or when they all adopt a deflationary, business cycle policy. Here the problem of re-equilibrium meets that of business cycle theory as a basis of policy. The divergencies existing between leading theories thus become real causes of disequilibria in international payments and of instability in international economic relations, inasmuch as some of these theories become the guide to action in some countries and others in other countries.
• 66(a) If price movements in different countries take place quite independently of one another and we then get ever further away from an ‘international price equilibrium’, cumulative changes in balances of trade are due to take place. This must not, and is not likely to, happen when price movements take place but are internationally co-ordinated. I am not speaking of price fluctuations which are a part of a process of adjustment and bring about equilibrating changes in balances of trade; the price movements referred to in the present context are not fluctuations of a minor amplitude but cumulative tendencies of prices to rise or to fall over longer periods of time. Thus if two countries practise in the downward phase of the cycle, the one an expansionist policy, the other a deflationary policy, frictions are likely to occur, since prices in the former country will rise in relation to prices in the latter: which is bound to affect trade between them. Unless other transactions compensate this development of balances of trade, the strain on foreign exchanges may become considerable. It will be noted that to pursue such divergent price policies is possible in the long run only when the individual countries in question disregard the rules governing mechanisms of adjustment and adopt policies which are in contradiction with those rules. The characteristic feature of the ‘rules of adjustment’ is that they demand the adoption of policies which go counter to the disturbing tendencies; policies which, on the contrary, strengthen these tendencies, such as inflationary or deflationary ones, make the functioning of mechanisms of re-equilibrium difficult or impossible while they accentuate the causes of disequilibrium. The situation is, of course, different when all the countries adopt an expansionist, or when they all adopt a deflationary, business cycle policy. Here the problem of re-equilibrium meets that of business cycle theory as a basis of policy. The divergencies existing between leading theories thus become real causes of disequilibria in international payments and of instability in international economic relations, inasmuch as some of these theories become the guide to action in some countries and others in other countries.
• 67Adjustment to changes in capital movements must be made through changes in trade balances, since short-term credit can, by definition, provide only temporary relief. Moreover, the reasons which bring about changes in capital movements are likely to affect short-term credit operations as well, in such a way that the maladjustment in international payments will be increased rather than diminished. Adjustment through international trade can be most easily obtained if the disequilibrium is relatively small in comparison to the value of trade transactions; and again, the fewer the obstacles that are put in the way of international trade, the easier it will be. The larger is the relative size of the maladjustment and the more drastic and active is protectionism, the less easily can the adjustment be obtained. Much will also depend upon the nature of exports and imports of the country in deficit and on the respective elasticities of demand for various goods in question. Should a country be unable to obtain the necessary adjustment then only two courses remain open: either financial assistance by means of international action, or else a cumulative loss of gold in the case of a gold-standard country and cumulative exchange depreciation in a country forced off the gold standard or in a country with a system of inconvertible currency. We shall see presently how exchange control comes to be adopted in consequence of a continuing situation of the second type.
• 68Adjustment to changes in capital movements must be made through changes in trade balances, since short-term credit can, by definition, provide only temporary relief. Moreover, the reasons which bring about changes in capital movements are likely to affect short-term credit operations as well, in such a way that the maladjustment in international payments will be increased rather than diminished. Adjustment through international trade can be most easily obtained if the disequilibrium is relatively small in comparison to the value of trade transactions; and again, the fewer the obstacles that are put in the way of international trade, the easier it will be. The larger is the relative size of the maladjustment and the more drastic and active is protectionism, the less easily can the adjustment be obtained. Much will also depend upon the nature of exports and imports of the country in deficit and on the respective elasticities of demand for various goods in question. Should a country be unable to obtain the necessary adjustment then only two courses remain open: either financial assistance by means of international action, or else a cumulative loss of gold in the case of a gold-standard country and cumulative exchange depreciation in a country forced off the gold standard or in a country with a system of inconvertible currency. We shall see presently how exchange control comes to be adopted in consequence of a continuing situation of the second type.