Aspects of the Pathology of Money

5 Inflation and Overproduction1

Inflation and overproduction are words whose meanings are too unsettled in current usage to be at all clear. Inflation itself is a particularly uncertain term, for it is a word that can be made to mean almost anything. Some speak of inflation as equivalent to an excessive issue of greenbacks; others prefer to use it in relation to credit. Some apply it in both connexions; while still others call depreciated exchange, inflation. Elsewhere, rising prices, or even exaggeratedly high profits, are intended. What is common in all cases is the conception of overexpansion of some economic factor. Possibly an exception might be found in depreciated exchange, which sometimes is a consequence of monetary overexpansion, while sometimes it is not. In no case, however, ought exchange distortion be called inflation. It should be limited to definite cases in which it appears as a consequence of inflation.

Overexpansion is not an absolute notion, but must always be used in relation to some standard of comparison which is taken as normal. It may be that by stating what is normal, we shall be led to conclude that a deviation from it, due to monetary factors, is inflation, if it consists in an expansion, and deflation, if it consists in a contraction.

The term overproduction, likewise, calls for analysis. It clearly offers another comparison between a state of things considered as not normal and some state of things to be considered as normal. Moreover, the deviation from normality is thought of as moving upwards. Such an analysis, however, cannot include in its scope every phase of economic phenomena that may be considered by all or by some as features of inflation. It must, rather, be limited to defining those monetary developments which are properly to be called inflation in their relation to production.

First of all, however, it is desirable to consider what is meant by normality. We shall speak of it in terms not of a static state, but of a dynamic process. A process should be called normal if, throughout its course, it maintains a state of interior balance.2 A state of moving balance of the economic system signifies a process in which balance is maintained between: (1) costs and prices, and (2) income and debt; and in which, furthermore, there is no cumulative unemployment and no accumulation of commodity stocks. This definition implies a number of other features of the system, one of which is its working at an ‘optimum’ average employment of technical productive capacity.

This definition set forth, it is now desirable to define, on the one hand inflation, and, on the other, overproduction. The following propositions will lay a foundation for these definitions.

1. What is called overproduction or underconsumption is the result of an absence of balance in the cost–price structure. While supply price is based on costs of production, demand price is a result of the structure, both of individual utility schedules and of the income structure of society. Within a given experimental period of time, the former can be assumed as given, while the demand price will depend upon the structure of incomes. It must be further added that demand price and supply price are not independent. What is seen from one angle as income, constitutes somewhere else, cost.3 Every income figures twice in economic bookkeeping—once as cost and once as income. This consideration shows immediately how fallacious it is to think that a disequilibrium in the cost-price structure (due to insufficiency of incomes to realize a demand price which would equalize costs and, therefore, a supply price) can be corrected by merely increasing incomes. An increase of incomes becomes also an increase of costs. It is then not at all sure whether, after such an increase of costs and incomes, the relation between costs and prices will be more closely balanced, or less closely balanced, than before. This will depend upon the structure of costs and the structure of income schedules.

2. The balance between debt and income covers a number of elements which are often stated as separate problems.

When we speak of ‘overindebtedness’, we have in mind a situation in which current income cannot pay carrying charges on the outstanding debt of income earners, without influencing effective demand for goods. This applies to any demander, whether a consumer in the strict sense of the word, or a producer. The debt service, however, contributes an element of income for the lenders of the original capital or their successors. So a readjustment of the income-debt relation, by cutting down debt, affects another sector of the community’s income; while readjustment, by increasing income, affects costs and therefore cost-price structure.

So, ultimately, the problem of economic balance is a matter of equilibrium between costs and market prices of commodities and services, and a matter also of the distribution of national income.

With a given income schedule, the direction of incomes into different channels may affect the economic balance. Thus arises the much-discussed problem of balance between savings and investment, the analysis of which need not be repeated. Let us, however, observe that, even if there is over a period of time a balance between savings and investments, there may occur a situation in which ‘excessive’ invested savings will result in overinvestment. This might happen if, owing to the investment—over a period of years—of a certain proportion of the national income, the remaining part should finally prove insufficient (in spite of the increase of the national income) to absorb finished products (mainly consumption goods) when they arrive in the market, at a price which would cover costs of production.

If this argument (stated though it be in skeleton outline and reviewed here only for the sake of completeness and because it seems to involve an important issue) is correct, then the maintenance of economic balance and the avoidance of overinvestment would also assume the maintenance of a rate of savings to be regarded in every economic period of analysis as optimum. We may, accordingly, assume that that thesis is correct which postulates, as a condition of equilibrium, a balance between savings and investments.

According to this assumption, there may be two sources of relative overinvestment, followed by relative overproduction.

Relative overinvestment means that there has been created a situation in which the optimum output of the built equipment cannot be sold at remunerative prices, i.e. at prices covering costs of production, while restriction of output below this optimum point would increase overhead costs per unit and thus further distort the cost–price relation.

There are different lines of economic development along which such a situation of relative overinvestment may be arrived at. Leaving aside the controversial and insufficiently explored case of absolute oversaving, there remain two alternatives. One of these is universally recognized and usually designated by the name of inflation. The other—seldom if ever mentioned in this connexion—is deflation. The circumstances in which relative overinvestment may be produced by either of these processes are different. We shall show, however, why it is absolutely necessary, in any study of inflation and overproduction, to assign an important place to deflation.

Let us now consider a monetary development which leads to a temporary increase of the community’s purchasing power (in terms of money) beyond what it would have been ‘normally’ in the given situation. Such increase induces an increase of demand for goods and a tendency towards building up a larger equipment than that which would otherwise have been provided. Prices rise, or fail to fall, with decreasing costs. Industry, getting unusually high profits,4 determines to bring about more investment while, taking the community as a whole, the phenomenon of forced saving sets in. Thus a part of the community’s purchasing power, which would otherwise have been spent on consumption goods, is being diverted into investment.

In the first stage of this process, more is invested than is actually saved. In the second stage, consumption is cut down by ‘forced saving’. However, inflationary investment was originally induced by the assumption that the effective demand5 would go on increasing, and would be rendered possible by additional profits, owing to the fact that prices were increasing faster than costs. These are contradictory assumptions, for costs mean income; and, if prices rise more than incomes, effective real demand must ultimately fall, with the inevitable consequences of such recession.

Such a fall is always to be noted where inflation ultimately breaks down. Even if we stop short of a real breakdown, the additional equipment has no market for its produce, pending an economic development leading to an increase in the national income. Then, also, owing to the distribution of income and other dynamic factors, some parts of the equipment created in the period of inflation may not be needed by the economic community.6

One point of especial significance in the preceding analysis must be emphasized: we have assumed that the initial expansion of purchasing power, beyond what may at that time be the money income of the community, occurred to disturb a previous position of balance of the economic system. Let us add that the effect of a relative overinvestment, so obtained, is, if the additional capacity be used, a relative overproduction of the finished product. If this capacity remains unused, the increase of overhead makes it impossible to maintain the same cost of production for the output that was being developed prior to the new investment.

As indicated above, relative overinvestment may, however, also be a result of deflation. In this sense deflation means a decrease of the amount of money spent in a given unit of time, i.e. of effective money demand below what it was in the preceding time unit, other things remaining the same. Of course if starting from a position of balance, deflation sets in, other things do not remain the same. On the contrary, the products of existing equipment cannot be sold in the same quantities and at the same prices as before. If prices fall, industries cannot cover their costs, and if prices remain but real demand falls off, then overhead costs per unit of output increase, and the price–cost balance is destroyed. Thus we have again a case of relative overcapacity or relative overinvestment, and the external effects are much the same as those which are witnessed when the effects of inflationary overexpansion make themselves felt.

From the monetary point of view, deflation means hoarding, i.e. withdrawal from circulation of a part of currently available purchasing power.

We have thus shown that relative overinvestment can be the result of either inflation or deflation. Usually, however, overinvestment in the economic system is attributed to prior inflation. Some, using the term ‘underconsumption’ as opposed to ‘overproduction’ (which follows overinvestment), attribute it to deflation. As a cure for depression, the former group of theorists advocate deflation, the latter, inflation.

We have seen, however, that the mere observation that there is a relative overinvestment, followed and expressed by a relative overproduction or (at this stage it is one and the same thing) by a relative underconsumption, is not a sufficient diagnosis of the cause of maladjustment. Such a cause may lie either in a prior inflation or in a deflation. What is even more important is that it may lie in both. Indeed, in economic depressions, as they are observed in reality, inflation and deflation have both their share in bringing about a sizeable relative overproduction.

In testing the course of reasoning thus set forth, we may properly begin with an inflationary course of economic development. When it breaks down, inflation is followed by deflation. Production then breaks down. Capital-goods industries suffer first. Unemployment becomes chronic and cumulative. Considering that prior to inflation most unemployed were in gainful employment, the fact that they now have incomes next to nothing is itself a deflationary phenomenon. But in other groups incomes shrink also to pre-inflation levels and below. This is deflation, not only as compared with the peak of inflation, but even as compared with a hypothetical balanced situation. Of course, consumption goods and service industries suffer also. Production falls off, not only as measured by what was induced by the process of inflation, but more. This is well known, but it means that the relative overinvestment of the depression is the effect not only of the prior inflationary building up of means of production, but also of a non-utilization caused by deflation.

It is understandable that a breakdown of an inflation, by being a considerable economic catastrophe—happening in a primarily unbalanced situation and therefore causing unemployment and losses of income—by discouraging the spirit of enterprise and inciting hoarding, finally causes progressive deflation.

If, as we have attempted to show, the relative overinvestment and the apparent overproduction are due to two sets of causes—effects of (1) inflation, and (2) deflation7—it is not possible to correct the situation by any simple remedy based on a diagnosis of one of these two phenomena as the sole cause of depression. The effects of inflation evidently cannot be cured by more inflation; and yet there are many who advocate such a remedy, putting upon deflation the whole burden of responsibility for the depression.

On the other hand, however, effects of deflation cannot be cured by more deflation; and yet this remedy also finds many advocates, those, namely, who see the whole cause of the trouble in the preceding inflation. What happened is, in fact, that one illness of the economic system has produced another; but once this has happened, we have two diseases to cure instead of one.

The two economic diseases are not of such a nature that one could cure the other. Contrary to many current views, deflation is not a cure for inflation, and inflation is not a cure for deflation. They are two diseases and need each a particular and well-adapted cure.

Let us call ‘liquidation’ the cure for inflation, and ‘reflation’ the cure for deflation, and see what is then involved in each of these terms.

Liquidation

The net result of inflation is twofold: (1) a change in income distribution and in the structure of prices (we shall disregard this aspect in the present discussion); (2) the building up of excessive productive equipment. This implies that the process of readjustment must consist in the provision of a waiting period, during which the progress of economic growth will make an excessive plant ‘normally’ necessary, and during which some of the plant will become obsolete and thus destroyed. From the point of view of capital-goods industries, it is important that the process of obsolescence should take place; for pending such obsolescence, there will be but a limited new demand for capital goods. A post-inflation economy resembles a child which has received, besides the suits of clothing he immediately needs, some that are too large. If a waiting period is granted, the too-large suits will fit him in due time. But some may never be worn because their shape becomes unfashionable, while the cloth of which others are made will not keep in good condition long enough. The economic system comprises, however, not only the child, but also the tailor—and it is to the interest of the tailor that new suits should be ordered both next year and the year after.

Pending the material readjustment which would absorb into the ‘normal’ economic process a part of the excessive equipment, and destroy another part by making it obsolete, it is most important that production be continued on the highest possible level. In order to realize this result, the capital invested in the excessive equipment must be written down to as near zero as possible. Should it not be so written down, overhead costs for the output of the previously existing plant will be increased by the interest charge on the additional equipment, and thus the price–cost structure will be disturbed over a longer period.8

Thus, the financial liquidation of inflation consists in writing down industrial debt and industrial capitalization to what corresponds to their real earning capacity.9 This means a loss of capital to some owners, of course. But such loss is merely the acknowledgment of a previous bad investment.

An economic system may be inflated financially over long periods of time, if the accumulation of debt exceeds the earning capacity of the indebted plant. If such accumulation goes on long enough, the ultimate result is an exaggeration of costs of production and a disturbance in the cost–price structure which leads to more or less considerable difficulties. It may be said that inflation, as defined in this study, creates such an overindebtedness,10 but there are other ways in which over-indebtedness (or overcapitalization) may arise.11 The readjustment of it is very clearly an important element in the liquidation.

We shall later note some at least of the practical aspects of liquidation. Here it is sufficient to say in conclusion that liquidation is the proper cure for an inflated economy. Let us now turn to reflation, the proposed corrective of deflation.

Reflation

As already stated, deflation consists in a shrinking of business activity below the level which would exist in a state of economic balance. The flow of purchasing power slackens. Less is invested than is saved. The balance is hoarded in one form or another. Deflation may result from purely monetary factors, such as restriction of the circulation of money by increasing the rate of interest, more restrictive and discriminating credit policy of banks, and so on. It may also be due to the falling off of business activity, reflected in a diminished demand for currency and credit facilities. These are the results of a breakdown of confidence, caused by whatever factor. Political unrest, expectation of troubles of all kinds, last but not least the effects of a breakdown of inflation—may provoke a state of mind unfavourable to business enterprise and conducive to deflation.

To fight deflation means to stimulate business. Stimulated business will require a larger amount of monetary purchasing power than would business in its depressed condition. ‘Dishoarding’ follows previous hoarding.

Here an important point must be stressed. Dishoarding is by no means analogous to inflation. It is true that when business is recovering from deflation, prices will have an upward trend, monetary circulation will increase, and so, too, will production and trade. These are also among the symptoms of inflation. The main difference is that reflation is thought of as a movement towards more balance in the economic system, while inflation is a movement away from balance.

Contrary to what is often said about it, reflation is not primarily a monetary policy. It is an economic policy in the broadest sense of the word. It consists in stimulating the productive activity of the community.12 Monetary expansion follows—when the requirements for money increase—but it does not precede activity in trade. One cannot achieve reflation by merely stimulating the flow of money through the economic system. Deflation is the result of destruction of business confidence. It is vain to hope that an aggravation of panic, resulting possibly in a ‘flight into commodities’, will restore the economic balance.

Hence, the means of reflation are twofold: first and foremost, the creation of more confidence among private producers, so as to induce them to resume their activity; second, pending this resumption, a wise use of public funds to finance private production for public use. This may mean a temporary diversion of ‘idle funds’ into the channels of public expenditure; the ultimate objective, however, to be borne in mind is the stimulation of private initiative and enterprise. It should be observed, also, in this connexion, that a reorganization of public finances, with a view to taking into account the fluctuations of business activity, is most helpful in applying reflation policies.

What a government can do to help the process of reflation depends, however, upon specific situations. It is not possible to say, generally and abstractly, which types of public works are appropriate and which are not. In any case, they should be so oriented as to be most efficient as stimuli and most rapid in their effect. They should incite private business and then be discontinued, progressively, as the activity of private enterprise is re-established. Residential-building and capital-goods industries are usually better outlets for public spending than consumption-goods industries and the financing of consumption. In deflation, capital-goods industries suffer most, and their recovery stimulates directly consumers’ goods and service industries.

In still another way can a government be helpful to a revival of confidence—namely, by adopting an appropriate system of guarantees to reduce the high-risk premium of the depression. When the fear of loss is greater than the expectation of gain, the entrepreneur will not embark on a productive venture. The danger that a permanent governmental guarantee against loss entails, must be fully realized; yet it is certain that the wise use of such a device might be a useful (and not too costly) method of inducing business revival.

From this outline of the theoretical relationships of inflation and deflation, liquidation and reflation, it is clear that in business depressions, as we know them, both causes are present and that therefore correctives for both must be applied.

In older days, when economic life was represented by a large number of relatively small units, and when depressions did not strike at its very fundamentals, taken as a whole, a spontaneous process, called ‘automatic’, often brought a remedy. Its technique was liquidation through bankruptcies and forced sales, on the one hand, and through revival following the building up of confidence, on the other. But this recovery was possible only because of the small size of individual units, because of the great flexibility of the economic system, and because of the smaller geographic spread of the depressions and of their lesser intensity. In the depression which began in 1929, these prerequisites of spontaneous recovery were not present. In older days, there was hardly an adequate analysis made of what really happened during the depressions. In the actual process, there must have been even then a combination of progressive liquidation with progressive reflation.

In our economic condition, in view of the size of units involved, in view of the rigidities of the economic system, and in view of the scope and intensity of the depression, both liquidation and reflation must be carefully planned. To leave the necessary liquidation to ‘its own course’ may result in an all-destructive deflation, while reflation, of course, must be a matter of very careful and thorough study.

It is clear why inflation and the ensuing breakdown provoke deflation. But there is no necessary scope in the depth of deflation that follows an inflation. It does not necessarily follow that because there was overinvestment, there must afterwards be a falling off of production much below ‘normal’. It is not essential that those who were gainfully employed prior to inflation, shall be unemployed (millions of men over a series of years) after it has broken down. There is no unavoidable necessity for the national income to shrink by a high percentage from its normal size during the period of liquidation. The deeper the deflation, the greater the liquidation.

The object of reflation is thus to minimize the loss in national income during the period of liquidation of a previous inflation. This does not imply that liquidation ought not to be thoroughly carried out. Bad assets must unquestionably be eliminated, and the liability side of every balance sheet must be adjusted to the earning value of assets. In the present structure of our economy, such a process implies a very carefully devised programme of action.

Overinvestment and overproduction are thus shown as results, both of past inflation and current deflation. The causes being complex, so must be the correctives. Inflationists and deflationists alike take a too narrow view when they ignore one part of the situation. Their advice is, therefore, inadequate. The cure of industrial evil lies in a combination of liquidation and reflation. In carrying out such a combined and complex policy, much is, of necessity, a matter of judgment.

The theory, as outlined here, does not hint at easy and simple methods of getting out of the depression. Inflationists and deflationists have both in turn suggested general and simple solutions—one group advocating more or less indiscriminate public expenditures; the other, an unhampered course of ‘salutary’ deflation. Neither of these methods is sound nor satisfactory; yet it is impossible to state any alternative panacea; a depression being a complex phenomenon, the cure is also necessarily complex.

There is no general method of reflation. A practical policy destined to achieve proposed ends must, as already intimated, be devised in relation to the existing state of the economic system, and must be based on a careful analysis of this given situation.13

14 Some financial measures of liquidation, available for use at the low point of deflation, may be enumerated as follows:

1. The fixed interest-bearing securities of ‘productive enterprise’ should be converted into equities. They would thus automatically have the value of the assets remaining after a hypothetical repayment of other liabilities, and they would be remunerated only in proportion to the effective earnings of the company. It would then also be easier to reduce the valuation of the productive assets of the company by reducing the capital at the same time. This method is particularly important in the case of United States railroad companies.

2. Mortgages present almost more problems and difficulties than the bonded debt of industrial enterprises, railroads, and utilities. The principle of assessment of the value of land should probably be modified, as the now-prevailing principle makes it too easy to finance land and real-estate speculation by mortgage credit. The ultimate aim is to get a new assessment based upon the earning value of land and real estate, and to reduce the face value of mortgages to fit in with that new valuation. The way leading to it would be to diminish by law the interest on mortgages, so as to make the capitalized value of this interest correspond to the new assessed value. Furthermore, the making of future mortgages should probably be restricted to loans invested in improvements of the earning capacity of the mortgaged property and the period of repayment should be established according to the duration of the improvements thus financed. Something of the sort existed, e.g. in Germany, in the seventeenth and early part of the eighteenth century, and the subsequent change was not a betterment of the mortgage technique. (See W. Hegemann, Das steinerne Berlin, Berlin, 1932, pp. 168–78.)

3. The liquidation activities mentioned in paragraphs 1 and 2 would necessitate some financial adjustments within insurance companies, some banks, etc., and such adjustments might be very serious. This necessitates a further very careful investigation.

4. As to governmental and municipal indebtedness, the necessary readjustments would affect the interest rate, rather than the principal, and can be best effected by the method of conversion.

 

15 Chapter originally published in the volume The Economics of Inflation, by H. Parker Willis and John M. Chapman, New York, Columbia University Press, 1935, pp. 268–79. It reproduces a lecture delivered in the Banking Seminar of Columbia University in the course of the academic year 1933–34. The chapter was written in answer to the specific questions: What is the relation of inflation to overproduction, and is it possible, as many assert, to use inflation as a cure for overproduction?

16 If, on the other hand, we call normal that condition which occurs most frequently, then of course it would mean, in economic terms, a state of changing interior unbalance. Such a definition would not be of much use for the purpose of the present discussion.

17 We are speaking in this essay, of course, of monetary cost and incomes, not of real costs and real income.

18 What Keynes calls ‘windfall profits’. See: A Treatise on Money, London, 1930, vol. I, p. 125.

19 Real demand, i.e. demand in terms of goods.

20 This process is generally recognized. A very able analysis of what happens as an outcome of an inflationary development from an initial position of economic balance is given by Professor F. A. von Hayek in Prices and Production, London, 1931.

21 The fact that deflation has been induced by the effects of such broken-down inflation, does not alter the fact of such a duality of causes.

22 The balance of the cost–price structure is obstructed in any case because of the induced deflation. Here we assume that no such deflation has occurred, but we shall revert to this situation later.

23 Again under the assumption of no induced deflation.

24 The reader should here disregard such sweeping inflations as the post-war ones in Germany, Poland, etc., which practically annihilated much of the industrial debt.

25 See Bassett Jones, Debt and Production, New York, 1933.

26 The reader will observe that the word ‘reflation’ used in this way has a different meaning from the word as used by many economists who call reflation an increase in the money income of the community induced by public spending.

• 1* This monograph was prepared in the years 1943–44 for one of the research institutes in the United States. Circumstances did not allow its publication at the time, although a mimeographed version of my text was circulated to a large body of leading American experts of the day. More recently the institute in question, which wishes to remain unnamed, kindly reverted the copyright to me. May I extend to it my sincere thanks, both for having made the study possible and for having allowed me to publish it now? I should perhaps explain that when this monograph was written, one of the questions which preoccupied American experts a good deal was: how to avoid the inflationary mistakes of the previous post-war period during the years that were to follow the end of World War II. No one of us had the slightest doubt that this end would be victorious.
• 2To illustrate, see for example the voluminous and penetrating Annual Reports of the Bank for International Settlements.
• 3The IMF takes an entirely neutral attitude towards the Gold Exchange Standard, neither endorsing nor rejecting it.
• 4James 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).
• 5Vide infra, p. 28, a bibliographical footnote on inductive studies.
• 6This is an assumption which, in fact, underlies the whole of this book.
• 7Vide infra, pp. 23 et seq.
• 8In 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.
• 9The 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.
• 10James W. Angell, ‘Equilibrium in International Payments’, op. cit., p. 17.
• 11Ibid., 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.
• 12See Jacob Viner’s Studies in the Theory of International Trade, op. cit., Chapter VI pp. 290–387.
• 13This qualification is indispensable; whenever there are credit operations the bank-rate policy appears in order to influence their size and direction.
• 14While 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.
• 15Post-war European Inflations, World War I A Study of Selected Cases*
• 16The 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.
• 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 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.
• 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.
• 21In 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.
• 22As 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.
• 23The 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.
• 24It 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.
• 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.
• 26While 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.