Aspects of the Pathology of Money

10 Fixed Parities and International Order1

I

Stripped of technicalities and of short-run considerations the controversy over exchange rates: fixed or flexible, is essentially an aspect of the broader controversy over international economic integration (on the basis of the price mechanism and a common standard of value) as opposed to economic nationalism. The latter takes the form, in the area of monetary relations, of concern over a country’s ‘monetary independence’. Flexible or floating exchange rates have, in the opinion of their advocates, the great virtue of allowing a country (i.e. a government) to adopt an internal monetary, financial and, indeed, economic policy without concern for balance-of-payments equilibrium. As Professor Friedrich A. Lutz wrote in the December 1954 issue of the Banca Nazionale del Lavoro Quarterly Review: ‘The main advantage that can be claimed for a policy of flexible exchange rates is that it allows a country both to avoid quantitative import controls and to follow . . . an “independent” monetary policy, i.e. a policy that is unaffected by deficits or surpluses in its balance of payments.’

Several years ago, writing in the same vein, Professor Alvin H. Hansen of Harvard University spoke of a revolution in monetary thinking:2 ‘In the interwar decades a new standard of monetary policy increasingly won its way—emancipation from the adjustment process dictated by the gold standard; freedom to pursue a programme of internal stability and full employment without regard to the balance of payments.’ I have italicized the last words of the quotation; they express, as does the earlier quotation from Professor Lutz, one of the widespread and yet very fallacious aspirations of certain governments (their number has happily shown a substantial decline of late) and of altogether too many learned economists, aspiration to ‘do as one pleases’ without suffering any adverse consequences. A very human aspiration indeed—but also one that has been proved time and again to be unattainable—and one in which it is rather unwise to persevere.

If Hansen speaks of the ‘emancipation from the adjustment process dictated by the gold standard’, Lutz expresses the opinion that ‘the orthodox gold standard policy of dealing with a deficit in the balance of payments is at the present time outside the realm of practical possibilities’. And, rather prematurely, he adds: ‘No country is likely to subject itself to the discipline which the gold standard imposes.’3 These lines were published in December 1954—two months later the British Treasury and the Bank of England were adopting a set of measures to deal with a balance-of-payments deficit judged excessive, which could not have been different were the United Kingdom still on the gold standard. One must never regard as impossible or undesirable what one judges, subjectively, to be ‘unlikely’. As a matter of fact, ever since 1949 or thereabouts, one government of Western Europe after another turned away from what Hansen called ‘a revolution in monetary thinking’. Internal monetary stability came to be regarded once again as a major objective of national policy and that means that balance-of-payments difficulties are no longer viewed with the complacency which prevailed in the immediate post-war years. An important landmark in this evolution is provided by the report: The Internal Financial Situation, prepared in the summer of 1952 for the O.E.E.C. by ‘a group of independent experts’, including C. Bresciani-Turroni (Italy), E. R. Lindahl (Sweden), A. W. Marget (U.S.A.), M. Masoin (Belgium), L. C. Robbins (U.K.), J. Rueff (France), and E. Schneider (Germany).

‘It is obvious’—wrote these distinguished experts—‘that any country can get into serious external difficulties by a policy of excessive financial expansion. An upward movement of national expenditure, outstripping any increase of national output and exceeding upward movements which are taking place elsewhere, is bound to lead to trouble. At a fixed rate of exchange, it must lead to disequilibrium in the balance of payments, both through encouragement of imports and through its discouragement of exports. This is the classic case of disequilibrium caused by inflation.’

Nor is this all.

‘In a world in which there is continual change in the markets in which a country earns its external income and makes its external expenditure’—the experts invited by O.E.E.C. went on to say—‘there is a further possibility of trouble, whose neglect in the past has sometimes led to very inadequate conceptions of policy. If internal finance fails to take account of changes in the conditions of trade which are more than transitory, there is also the likelihood of external unbalance. Suppose that, for some reason or other, important sources of external earnings are restricted. If, in such circumstances, there are not appropriate adjustments of internal finance, the effect on the balance of payments may be similar to that produced by internal inflation. The initiating causes of disturbance are different: in the one case positive financial imprudence, in the other pure external misfortune. Yet, if there is no response to the misfortune and unbalance persists, the final result is the same: disequilibrium is engendered in the balance of payments.’4

The reader will note how far removed we are, in the passages quoted, from the nationalistic demands for ‘monetary independence’. The ‘independent experts’ brought together by the O.E.E.C. recognized—and this is why their report must be regarded as a significant landmark along the arduous road to an integrated international economy—the dual requirement for national policy: to avoid getting out of step with the outside world through overindulgence in domestic inflation; and to make necessary domestic adjustments to external changes. These are, in a nutshell, the basic ingredients of a world-minded national economic policy.

II

But what of exchange rates? In cases where internal inflation has gone very far, or changes in external conditions have been of great scope, our experts expressly refrain from recommending ‘internal financial measures [that] would involve a severe positive contraction of money incomes or employment’; instead, they ‘should hold that a fundamental disequilibrium had developed in the sense of the Statutes of the International Monetary Fund and that some alteration of exchange rates was appropriate’. With this view I find myself in full agreement, albeit with one or two elaborations which will be submitted below. ‘Flexible’ or ‘floating’ rates have not attracted the attention of this group of economists. Instead, they caution against ‘an unnecessarily sensational conception of policy’, when a country is faced with disequilibrium in its international position.

‘Not all instances of external disequilibrium’—they emphasize—are fundamental, especially if they are corrected at a sufficiently early stage; and we think that there often occur cases where measures of internal finance can be effective in restoring equilibrium without resort either to alteration of rates of exchange or severe internal contraction.’

I have italicized the last lines of this important quotation for they express an essential element of the ‘fixed parity’ school of thought. What animates most of the advocates of ‘flexible exchanges’, such as Lutz, Meade, Haberler,5 is the fear of strong deflationary pressures in countries which, faced with an adverse balance-of-payments situation, want to maintain fixed parities. There is widespread misapprehension concerning the alleged deflationary character of the gold standard as it was known prior to 1914. These allegations have never, so far, been backed up by any careful survey of historic evidence. As I have shown elsewhere,6 the experience of the interwar years, 1919–39, is far from conclusive. What is true, is that in academic circles there developed, during these two decades, a revolt against the discipline of the gold standard (as indicated by Alvin Hansen in the passage quoted above from one of his more recent books). This ‘revolt’ had many forerunners; its most eloquent and most influential expression will be found in A Tract on Monetary Reform, published in 1923 by John Maynard Keynes. Since then, an abundant literature grew on both sides of the debate. After the end of the second world war, monetary nationalists seemed solidly entrenched. But events overtook them even while they were proclaiming victory. Inflations had to be checked—and wherever they were brought under control monetary ‘orthodoxy’ came back with beneficial effects for the national economies concerned.

Belgium, Italy, Western Germany, the Netherlands, Austria, Portugal . . . such is the lengthening roster of countries which checked domestic inflations in recent years, contracted credit, got their external position into balance or close to it, countries which adopted, of free will and without commitment to anyone, the time-tested rules of ‘orthodox’ monetary and financial policy, and experienced economic expansion, not contraction, as a result of the courage and determination of their monetary authorities.

The ‘independent experts’ brought together by the O.E.E.C. attached, in 1952, great importance to the part of their statement which I italicized above. Their text goes on as follows:

‘It is just this possibility which we think has tended to escape notice in recent discussion. The requirements of international equilibrium relate to relative rather than to absolute movements of money incomes. In an expanding world system, small changes for the worse in the external conditions of one area can often be checked, not by positive contraction but rather by a slowing down or a temporary stopping of the local rate of advance. To ignore this possibility is apt to lead to an unnecessarily sensational conception of the requirements of policy—to the neglect of very practical and easily accessible methods.’

Three years later, Messrs Bresciani-Turroni, Robbins, Rueff et al. might still have formulated the same observations. Great progress has been achieved in recent years in the field of practical policy: Western Europe ‘rediscovered money’7 i.e. the bank rate came back into its own as leading instrument of monetary policy—but the discussion, as distinct from action, still lags quite a way behind. In other words, although monetary nationalism is declining in the realm of practical policy, as far, at least, as Western Europe is concerned, its academic defenders are—as was noted above—full of zest, and so are numerous officials in the very countries which have re-adopted international criteria for their national monetary policy. Before attempting to explain what looks at first glance like a paradoxical situation, several observations must be made in order to make quite clear the present writer’s own position in this complex and many-cornered controversy.

III

The first set of observations relates to the very concepts of fixed parities and fluctuating (or flexible or floating) exchange rates. How fixed are to be the former, how ‘flexible’ the latter?

To this, my answer is simple. Parities, if the international economy is to be endowed with something approaching a common measure of values, must be entirely fixed—but, in a changing world, they cannot be immovable. Situations may arise—and the scholars referred to several times in the course of the preceding pages have noted the fact in the O.E.E.C. report of 1952—when a change of parity is the lesser evil. The Bretton Woods system provided for that possibility in Article IV of the IMF Charter, albeit (and that is one of its serious weaknesses, about which a word will be said later) without outlining a proper method of establishing a new and better parity.8

As to ‘flexibility’, its advocates fall into two groups. The most academic and most extreme among them do not want any parities whatever between currencies but would depend on free foreign exchange markets to establish every day the rate which corresponds to the eachtime relation between national price levels, etc. Mostly, they would allow exchange equalization or stabilization funds to be used by central banks or treasuries to counter speculation and neutralize ‘accidental’ causes of fluctuations. They fail, generally speaking, to admit the unsettling effects of speculation, and they place what I should regard as quite excessive reliance upon the stabilizing effect of forward transactions. As regards the question of speculation, my space here is too short to do full justice to the arguments advanced on either side of the debate. May I pay my tribute, however, to the excellent discussion by Sir Donald MacDougall in the ‘Westminster Bank Review’ for August 1954. He refutes, by anticipation, Professor Lutz’s thesis of December 1954,9 minimizing the rôle of speculation, and fails to be convincingly refuted (as far as I am concerned, at least) by Professor Gottfried Haberler in a still more recent article.10

The real trouble with the advocates of indefinitely flexible exchange rates is that they fail to take into sufficient consideration the causes of balance-of-payments disequilibrium. Now these, unlike Pallas Athene from Zeus’ head, never spring ‘full armed’ from a particular economic situation. They have their causes, the most basic of which: internal inflations or major changes in world markets, have been duly stressed in the quoted passages of the 1952 report on ‘Internal Financial Stability’. ‘Fundamental disequilibra’ as they are called (but not defined) in the Bretton Woods Agreements, can—and do—happen. Often, however, they can be avoided: if and when an incipient inflation is brought under control; if and when adjustments to external change are effectively and early made. Now nothing encourages the early adoption of internal correctives more than an outflow of reserves under conditions of fixed parities, always provided, of course, that the country’s monetary authorities are ‘internationally minded’ and do their best to keep external equilibrium by all internal means at their disposal, short of quantitative controls over trade and payments and of excessive domestic contraction.

Advocates of ‘flexibility’ fall, I said, into two groups. The second would be satisfied with widening the range of admissible oscillations around a parity (which at present, for members of the International Monetary Fund, is set at one per cent up and down the parity). This widening of the new ‘gold points’ is mostly advocated by central banking circles of certain countries and their experts, rather than by the academic economists.

There is much internecine fight between the adherents of the two types of ‘flexibility’. It must be admitted that the last-named type may well lose the concrete advantages of exchange stability without acquiring the abstract ones of complete exchange freedom. It commends itself to the attention of the practitioners of the art only if certain conditions are satisfied:

(1) corrective internal measures must be adopted as soon as the lower limit of the former narrower range has been crossed (in substitution for the loss of reserves that would have taken place under the more rigid conditions envisaged by the IMF Charter);

(2) the level of gold and dollar reserves must be initially so low as to justify the limited substitution of exchange depreciation for a loss of reserves. Even so, there can be little doubt that in this case speculation will tend to aggravate the disequilibrium. ‘Contrary to widely held views’, wrote recently Professor Roy Harrod of Oxford, ‘it is likely that, on the occasion of an adverse turn in the balances of payments, it would cost more gold to support sterling within wide margins than within narrower margins. In the latter case assistance could be rendered by a high Bank Rate, in the former not.’11

IV

There is one set of circumstances where a ‘floating rate’ is not merely acceptable but, indeed, necessary. It is when a currency got out of line with other currencies, due to major internal inflation, to external world market circumstances (including a severe depression in one of the major economic centres of the world), or to war, and a new parity for it must be found. In the twenties there were theories, most prominently the so-called ‘purchasing power parities’ theory, which allowed an a priori statistical determination of a new parity. These theories are now discredited12 and the need for an empirical determination of new parities is generally recognized. The following enlightening passage might be quoted from Professor Robbins’ latest book, The Economist in the Twentieth Century (London, 1954):

‘Once internal finances have been stabilized, the next step is the correction of overvalued exchange rates. This prescription wears an air of simplicity which does scant justice to the difficulty and the delicacy of the operations here involved. . . . The exact technique of such operations is doubtless a matter which will vary with circumstances. . . . I can see strong arguments in this context for some temporary resort to a floating rate in order to test the market. I can imagine that if such resort were accompanied by some assurance to the outside world of the limits within which such fluctuation would be allowed, this might be taken as evidence that what was being done was a genuine attempt at equilibration rather than an arbitrary upset in the exchange markets. I should like to see the statutes of the International Monetary Fund modified, or at least “clarified”, to make such a procedure definitely permissible. But I am far from arguing that this is the only method to be adopted; it is easy to conceive of cases where immediate adjustment of an otherwise fixed rate is preferable, any failure to hit the mark the first time being corrected by another operation’ (pages 150–51, italics added).

I have myself advocated in recent years the technique of ‘temporary flexibility’ for France;13 I should be most reluctant, however, to accept it for the pound sterling.

V

This takes me to the final group of considerations I wish to dwell upon in the present article. A few of my academic brethren excepted, nobody really wants international monetary instability. This has been demonstrated time and again, in the past twenty-five years, by the frequency with which exchange control has been used to strait-jacket an unstable foreign exchange rate. More positively, from the international point of view, it has been demonstrated by the ‘Tripartite Agreement’ which, in the late thirties, introduced a modicum of stability into a disrupted international economy. Professor Robbins calls this a ‘craving for fixity’14 and concludes from the experiences to which I have just alluded (and which seem to have impressed him quite as much as they have impressed the writer of the present lines):

‘The idea of a world in which the exchange rates of every sovereign state are perpetually free to fluctuate in terms of the exchange rates of every other, is purely fanciful. It is perfectly realistic to conceive of floating rates between large blocs, the sterling area and the dollar area, for instance. It is not realistic to think of floating rates all round. But if it is so, I suspect that we have not succeeded in banishing from the world the necessity for maintaining equilibrium at fixed rates somewhere. . . . I am left asking whether, if policy has to be directed to maintaining fixed rates in some directions, it may not in the end be thought expedient still to direct it to maintaining fixed rates all round.’

To ask the question, as far at least as I am concerned, is to answer it in the affirmative.

If the entire controversy over fixed parities or flexible rates has bounced up again with such vigour, in recent years, the interwar discussions and experiences notwithstanding, it is clearly because of the debate over sterling convertibility. Advocates of ‘floating sterling’ are impressed either by the relatively low level of the sterling area’s gold and dollar reserves or by the precarious balance of the United Kingdom’s external accounts and the extent of its domestic price inflation contrasted with that prevailing elsewhere.15

The proper answer to be given to these two, highly legitimate, considerations, would appear to be the following:

(1) it is better to postpone convertibility, at fixed rates of exchange (and not limited, as is currently proposed, to non-residents alone), until such day as the problem of international liquidity will have been solved,16 than to settle for a solution known in advance to be inadequate;

(2) it is a great mistake to adopt even ‘non-resident convertibility’ at a ‘floating rate’ before setting the financial and monetary house in order: if adopted under such conditions it may readily become an ‘amiable euphemism’ (to use Charles Rist’s expression) for progressive devaluation of the pound in relation to the dollar. Nor can one reasonably doubt that stern and unpopular measures of monetary discipline, such as were applied by the British authorities during the current year, will prove even less acceptable, should the easier course of ‘downward flexibility’ become readily available. The fate not only of the pound sterling as a world currency, but of international economic order itself is at stake as these lines are being written.

 

17 The original version of this article appeared in the Banca Nazionale del Lavoro Quarterly Review, June 1955.

18 Alvin H. Hansen, Monetary Theory and Fiscal Policy, New York, 1949, pp. 201 et seq.

19 Banca Nazionale del Lavoro Quarterly Review, December 1954, p. 178.

20 O.E.E.C., The Internal Financial Situation, Paris, 1952, pp. 11–12.

21 E.g. F. A. Lutz’s article in Banca Nazionale del Lavoro Quarterly Review, December 1954; G. Haberler’s brochure ‘Currency Convertibility’, American Enterprise Association, New York, 1954, and his article ‘Some Aspects of Convertibility’ in Economia Internazionale, vol. VIII, No. 1, Genoa, 1955; J. E. Meade’s book, Problems of Economic Union, London, 1953, Chapter II, and his article ‘Bretton Woods, GATT, and the Balance of Payments—A Second Round?’, in the Three Banks Review, London, December 1952.

22 See my book, International Monetary Economics, London, 1939; also my chapter entitled ‘Fixed Parities and Fluctuating Exchanges as Objectives of Monetary Policy’, in the volume A Forum on Finance, ed. by George B. Roberts, New York, 1940 (reprinted in the present volume, pp. 212 et seq.). See, further, Chapter III of my more recent book, The Trade of Nations, New York, 1952.

23 M. A. Heilperin, ‘Western Europe Rediscovers Money’, Fortune Magazine, New York, September 1952 (reprinted in the present volume, pp. 243 et seq.).

24 On that and connected issues, see Professor Lionel Robbins’ article, ‘The International Economic Problem’, Lloyds Bank Review, London, January 1953, and his book, The Economist in the Twentieth Century, London, 1954, especially Chapter V.

25 His article already quoted from Banca Nazionale del Lavoro Quarterly Review.

26 In Economia Internazionale, vol, VIII, No, 1, Genoa, 1955,

27 The Financial Times, London, July 19, 1955. The paper adds, editorially, the following comment: ‘In general, it seems that much of the argument in favour of a floating rate is based on the pursuit of a number of incompatible objectives.’ The Economist, though its editors favour—for reasons about which a word will be said later—a ‘floating pound’, admits, in the leading article of the July 23, 1955, issue, that: ‘No imagination at all is required to realize the disadvantages of fluctuating rates . . .’ (p. 287).

28 Cf. M. A. Heilperin, International Monetary Economics, London, 1939, Chapter VII.

29 In Fortune Magazine, New York, February 1954.

30 Robbins, op. cit., p. 101

31 The latter concern is voiced and documented in the article, ‘Fixed or Floating’, appearing in the July 23, 1955, issue of The Economist.

32 See my article, ‘Liquidità internazionale e convertibilità monetaria (1928 e 1955)’, in Rivista di Politica Economica, June 1955.

• 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.
• 17The 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.
• 18The 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.
• 19The 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.
• 20The 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.
• 21The 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.
• 22In 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.
• 23As 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.
• 24The 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.
• 25It 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.
• 26It 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.
• 27While 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.
• 28While 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.
• 29(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.
• 30(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.
• 31(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.
• 32(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.