Aspects of the Pathology of Money

6 The International Aspects of Inflation1

I Inflation: A National or an International Problem?

The term ‘inflation’ will be used throughout this chapter to denote a sustained and progressive decline of the buying power of the monetary unit, a decline either generated or made possible by the credit policies of the banking system, or by fiscal policies of the government, or both. This definition applies to what is most commonly known as ‘inflation’ but there are situations, not covered by it, which an economist might also include.2

Inflation forms a chapter in the pathology of monetary circulation; it is, therefore, essentially, a domestic problem of various national economies. Politically, the world is divided into separate countries, which look upon the control of national budgets and money supply as fundamental prerogatives of sovereignty. Since inflation results from a maladjustment between the flow of goods and the flow of money through an economic system, and since the flow of money is nationally controlled, inflation is primarily the result of domestic policies adopted by governments or central banks. The situation would be different if the world were organized into a federation with a single centre of monetary control.

As between the extremes, a complete division of the world into independent units and its federal unity, there is, of course, room for intermediate positions. Individual countries can be linked together through an international monetary system governed by rules followed in practice by all participating countries. The gold standard was the most inclusive and the most successful international monetary system and, while it was in existence, inflations were not a phenomenon of individual national economies alone. When the monetary systems of various countries are linked together, inflation—and its prevention—becomes an international problem.

Even in the absence of an international monetary system, however, inflation, albeit primarily a domestic phenomenon of individual countries, is far from being exclusively that. Even though various countries have ‘independent’ monetary systems (about which more will be said later), inflation taking place in any one nation may have—and often does have—repercussions which go beyond that country’s confines. This is especially true if the country experiencing inflation is an important economic unit. A British inflation or a French inflation would, around 1900, have wide repercussions throughout the world. This is even truer of an American inflation in our day. An economically important country, if it experiences inflation, can generate inflation elsewhere. The same is, of course, true of deflations which follow upon the breakdown of an inflationary process. Thus, even in the absence of an international monetary system, important economic units can transmit the ‘virus’ of inflation to other countries. Their domestic monetary and credit policies become, thereby, a matter of international concern.

It follows, therefore, that a country may experience inflation without its own monetary or fiscal policies being primarily responsible. This is especially true of the relatively small and weaker economies. For the governments of such ‘innocent-bystander countries’ inflations originating somewhere else create very serious problems.

So far in our discussion, we have seen: (1) that inflations are primarily national in origin, (2) that an international monetary system can link inflationary movements of various countries into a single pattern, and (3) that countries not experiencing inflation can be affected by inflationary pressures originating somewhere else. This list of possibilities would be incomplete if we failed to mention a fourth: the simultaneous inflationary impact which an ‘extraneous’ factor can exercise on the economies of a number of countries independently of the existence of an international monetary system. An example of this last possibility is afforded by the rise in raw materials prices which took place in the second half of 1950 under the impact of the rearmament generated by the Korean War.

The following four sections of this chapter are devoted to a more detailed discussion of each of the possibilities briefly described above. In conclusion, we shall look into the possibilities of an international attack upon inflationary forces.

II International Inflations under an International Monetary System

Because the world is divided into a number of separate political units, there is no way of controlling, from a central place, the world’s money supply. Under an international monetary system, however, fluctuations in the money supply of various countries are interconnected. When people living in any one country make more payments to the rest of the world than they receive, there results a deficit in that country’s balance of payments, while at the same time some other country or countries have a surplus. Monetary equilibrium demands that in such a case the supply of money in the former country should decline and that it should expand in the latter. This can be achieved under an international monetary system, such as the gold standard. Indeed, unless such is actually the case, the international monetary system must eventually break down under the strain of the growing balance-of-payments maladjustments. It is this connexion between the conditions of a country’s balance of payments and its internal money supply that represents the essential characteristic feature of an international monetary system.3 Such a system tends to restore a country’s external equilibrium whenever it is disrupted. This is a very important function; in the present context, however, another question must be considered with particular care: does an international monetary system like the gold standard encourage inflationary developments in the world economy or does it, on the contrary, discourage them?

It has been argued by opponents of the gold standard that the mechanism of that system results in a succession of inflations and deflations in the countries that operate under it. The mechanism of adjusting balances of payments requires, according to these critics, inflationary developments in the countries which have a surplus in their balances of payments and a deflation in those faced with a deficit.

Advocates of the gold standard, on the other hand, claim that the system provides an automatic guarantee against major inflations because it prevents the creation of money by either governments or central banks far in excess of the country’s gold reserves. A country, they say, cannot indulge in domestic inflation without developing balance-of-payments deficits, losing gold, and running into a monetary crisis.

These contradictory appraisals of the gold standard contain, each of them, a certain element of truth, but, actually, both are based on a misconception as to how the system worked during the sixty years or thereabouts of its successful operation.4

It is true that the theorists of the gold standard used to explain its functioning through changes in relative prices brought about in various countries by the effects of incoming or outgoing gold. In actual practice, the system did not work, however, in that way.5 The central bank of a country losing gold would increase the discount rate, while the opposite would be done by central banks of countries receiving gold. These differentials in interest rates induced movements of short-term balances between banks of one country and those of another and it is these movements of short-term funds which maintained balance-of-payments equilibrium. In case the disequilibrium was due to some more fundamental causes, measures of a more basic character (changes in wage rates, etc.) would be called for, not necessarily of a monetary nature. There is no evidence, however, that the mechanism of adjustments of international payments under the gold standard has had, by itself, inflationary or deflationary effects in the countries concerned.

To say this is not to give support to those advocates of the gold standard who claim that it offers automatic protection against inflation. There are two ways, actually, in which inflations of an international scope can be generated and propagated under the gold standard. Neither of these, as will be shown, is inevitable, and a ‘managed’ gold standard (as distinct from an ‘automatic’ one) may avoid these particular pitfalls.

In the first place gold production can exercise an influence upon long-term price trends when the supply of money in the various countries is directly linked to the size of gold reserves (as it is under the gold standard). All through the nineteenth century and up to World War I, gold production did exercise an influence upon long-term price trends. This influence was due to the fact that the rate of expansion in the supply of money of the various countries was primarily determined by additions to the gold stock. We thus had, during the century that lies between the end of the Napoleonic wars and the outbreak of World War I, long periods of rising prices, followed by long periods of falling prices, succeeded, in turn, by rising prices, and so forth. These were mild inflationary and mild deflationary movements and they could legitimately be attributed to the functioning of the gold standard.

In the second place, a country occupying a leading economic position in the world could, even under the gold standard, engage independently in a moderate inflation even though smaller economic units did not have that latitude. The strong and important unit, if it followed an inflationary policy, would, of course, lose gold. It might be in a position, however, to endure a loss of gold for a long enough period to stimulate inflationary movements elsewhere without having to reverse its own monetary policies. Once all countries of the system followed suit, their balances of payments could be maintained in an equilibrium position. As has been often asserted by the students of the gold standard, that system requires its members to ‘keep in step’ with each other as regards their internal price movements. It does not require, however, that there should be price stability. ‘Keeping in step’ means following roughly the same price trend: it can be an upward trend, a downward trend, or a horizontal one. A major economic unit, in a strong financial position, can influence the trend up to a point; smaller and weaker units must either follow the trend or drop out of the international system. Thus, as long as the gold standard was in operation, there was relatively very little scope for independent national inflations. These became the rule, rather than to be exceptions, when the gold standard broke up in the thirties, after its short-lived reconstruction in the twenties, and when monetary nationalism became the fashion of the day.

The experience of the twenties adds another page to the study of connexions that exist between an international monetary system and an inflation. When a substantial part of the world returned to the gold standard in the middle twenties, the level of prices was considerably above the pre-war level, while the world price of gold (as expressed in dollars or sterling) was at the 1914 level. There developed considerable apprehension, therefore, concerning the impending ‘scarcity of gold’6 and various devices were adopted to ‘economize’ on the monetary use of gold. The most important form of what might be described as the ‘gold-economy standards’ was the Gold Exchange Standard. It consisted in the use by some countries, for central banking reserves, not of actual gold but of what might be described as ‘potential gold’, i.e. currencies freely convertible into that metal (such as were, at that time, the dollar or the pound sterling). This led to a pyramiding of monetary expansion on the basis of a given amount of gold reserves and had a strong inflationary impact upon the international situation between 1925 and 1929. The Gold Exchange Standard was a ‘managed’ form of the gold standard but the kind of management adopted proved unsuccessful.

Turning now from the lessons of the past to the problems of the future, one may perhaps safely anticipate that gold will once again be used as a standard in a revived international monetary system. In the course of the past two unsettled decades the prestige of gold as a ‘store of value’ and as an international means of payment has increased rather than declined. Hence, to keep to the context of the present paper, the question which we must now envisage is: how to avoid inflation under a new gold standard? The following observations may be offered on the basis of the foregoing discussion:

1.There is no threat of inflation inherent in the equilibrating mechanism of the gold standard. This mechanism will have probably to be redesigned in order to take account of conditions of the modern world, where small differentials in discount rates are not likely to produce the compensatory movements of short-term funds from country to country which were a distinctive feature of the old gold standard.

2.The inflationary (or deflationary) influence of a changing rate of gold output can be minimized through appropriate changes in the price of gold. The International Monetary Fund (whatever its weaknesses may be) provides an instrument for adapting the world price of gold to major changes in conditions.

3.The influence that a leading member of an international monetary system can exercise upon the price trends is likely to be greater in the future than it has been in the past. When Great Britain was the ‘leader’ of the gold standard, it operated on relatively very small gold reserves and its economy was highly sensitive to changes in the balance-of-payments situation. The United States, by contrast, has an extraordinarily large stock of gold and is far less dependent upon foreign trade than Great Britain was in the nineteenth century. It is much easier, therefore, for the United States to engage independently upon an inflationary course and to transmit it by ‘contagion’ to other countries. This is a further reason why a new gold standard will have to be a ‘managed’ standard and why a heavy responsibility will rest upon the internal monetary management of the United States.

4.Should a new gold standard be established, with the United States earning the confidence of the other members of the system through a successful management of its domestic monetary affairs, and should the world price of gold be properly determined, then an important safeguard will have been established against the widespread practice of independent national inflations (about which more will be said in the next section of this chapter).

III International Inflations under ‘Independent’ Currency Systems

The possibility and desirability of ‘insulating’ a national economy against inflationary pressures (or indeed deflationary pressures) originating from abroad has received a great deal of attention in the economic literature of the past thirty years. J. M. Keynes’s Tract on Monetary Reform, published in 1923, was a major opening shot in the battle for national monetary autonomy. The quest for that ‘autonomy’ has aggravated economic nationalism for the past three decades and was given final recognition in the Havana Charter for an International Trade Organization.

Article 6 of that now-abandoned Charter is entitled: ‘Safeguards for Members Subject to Internal Inflationary or Deflationary Pressure’ and stipulates that ‘the Organization shall have regard, in the exercise of its functions . . . to the need of Members to take action . . . to safeguard their economies against inflationary or deflationary pressure from abroad’. It follows from the general context of the other provisions of the Havana Charter that such action could involve quantitative restrictions on trade and payments, i.e. import quotas and exchange control, as well as the use of discriminatory measures for foreign trade. However justified the desire of some countries might be to safeguard themselves from foreign-born inflations, in actual practice such an ‘insulation’ can only be achieved at the heavy price of disrupting international trade and international payments.

What are the benefits a country can derive through ‘insulation’? The first answer that Keynes gave to that question (in 1923), was: internal price stability. The second answer (given in his Treatise on Money, 1930) was: internal economic stability. The third answer given by Keynes, in 1933, in his essay on ‘National Self-Sufficiency’,7 was: freedom of economic and social experimentation. In the twenties and thirties the advocates of ‘independent’ national currencies followed one or another of these three lines of approach.

The first argument was based on too ready an acceptance of the notion that the equilibrating mechanism of the gold standard led to a disruption of price movements in the various countries concerned. The second argument is more sophisticated, and, in the case of Keynes’s Treatise on Money, is based on a confusion between the effects of changes in the discount rate upon economic activity and changes in the long-term rate of interest.8

The third argument, namely securing conditions under which a country could freely engage in economic and social experiments involving major departures from world economic trends, is more serious in its implications and has actually become, in the thirties and forties, a predominant principle of national policy. Policies of independent national economic planning have received the support of a number of documents drawn up during and after World War II, such as the United Nations Charter, the Bretton Woods Agreements, the Havana Charter, etc. More recently a reaction is setting in, under the pressure of events, and the dangers of ‘independent planning’ are becoming more widely recognized.

Independent national economic planning is inspired in practice by one of two considerations: ‘full employment’ or ‘economic development’. In each case the object is to direct the resources of a country in a way that corresponds to a blueprint adopted by the country’s government, though it might be at odds with the currents of the world economy. Experience has shown that centralized planning, whether it be for ‘full employment’ or ‘economic development’, tends to initiate inflationary processes. If the country engaging in such planning were a member of an international monetary system, its capacity to engage independently in an inflationary course of policy would be seriously limited. Hence the impatience of national planners with an international monetary system and their predilection for measures of ‘insulation’, if not of autarky.

Policies of ‘insulation’ tend to break up international economic relations. The early monetary ‘autonomists’ thought in terms of stable price levels at home and fluctuating exchange rates between currencies. On paper such a scheme had its attractions; in practice it proved unacceptable even to the planistic governments. Exchange fluctuations incited speculation and led to crises of confidence; ‘flights of capital’ ensued. The international chaos, following upon the break-up of an international monetary system, proved very favourable to the growth of ‘hot money’. Governments faced with crises of confidence and capital flights found exchange control and restrictions on foreign payments the easiest way out. Thus the world found itself with an entirely different picture from that anticipated by Keynes in his Tract on Monetary Reform.9 Instead of stable internal price levels and fluctuating exchange rates between currencies, the practice developed of ‘pegging’ foreign exchange rates protected by exchange control and associated with internal inflations.

To sum up: Under an international monetary system only the major unit or units have a free hand as regards the adoption of inflationary policies; all the other participants cannot start an inflation, not even a moderate one, without experiencing balance-of-payments difficulties and having to choose between a continuation of inflationary policies and continued membership in the international system. If the major unit or units refrain from inflationary policies, only ‘extraneous’ factors (about which more will be said presently) can bring about international inflations. The freedom of action, on the other hand, which individual countries, large or small, have in the absence of an international monetary system makes it possible to have a large number of national inflations going on simultaneously, differing in intensity and sheltered by exchange controls and import restrictions adopted by the respective governments. These simultaneous and concurrent national inflations are a characteristic feature of a world of ‘independent’ currency systems ‘insulated’ from one another and ‘protected’ by national ‘full employment’ and ‘development’ programmes.

The record of the years 1945–51 is an instructive example of such a condition of the world economy. In view of the discussion that precedes, it is hardly necessary to emphasize the disintegrating effect these developments have upon world trade and international capital movements. In addition, habits of inflation become so widely accepted that inflation as a ‘way of life’ comes to be regarded by many politicians and even economists as entirely rational and acceptable.

IV Inflations due to National—or Regional—Manifestations of a Common Cause

So far we have discussed two types of international inflations: one which is associated with the functioning of an international monetary system, another which results from a simultaneous appearance of independent national inflations. Let us now turn to a third type of international inflations, inflations which are international not because of the nature of the monetary system and not for fortuitous reasons but because a number of countries are concurrently affected by the same ‘extraneous’ inflationary forces. Such ‘extraneous’ factors create an international inflation regardless of whether there exists an international monetary system in the world or a multitude of separate national systems.

The most important of such factors is war; next to it comes fear of war and preparation for a possible war. In either case countries find their public expenditures greatly increased and frequently are unable to meet these expenditures out of current public revenues. Budgetary deficits follow. Although budgetary deficits and inflationary war finance are a matter of national policy, and although the extent of inflation varies widely, war and its economic consequences are a common cause of these developments. Inflations resulting from every major war have extended to a wide area and the aggravation of inflationary pressure since the middle of 1950 is the most recent manifestation.

The fact that a number of countries are engaged in a war economy creates, almost inevitably, a relative shortage of basic commodities. This shortage hits the national economies not only of the countries which are engaged in war or in armament expenditures but also countries which are outside of the immediate threat of hostilities.10 The scarcity of raw materials and basic foodstuffs and the rise in their prices as compared with the prices of manufactured goods is another leading inflationary factor affecting a number of countries, as it were, from the outside.

To admit the existence of the ‘extraneous’ causes of inflation is by no means tantamount to saying that inflations due to these causes are inevitable. The requirements of a war economy can be met without inflation if governments are wise enough to design appropriate policies and if the public is willing to accept rigorous restrictions on its current living standards. The inflationary effect of rising raw materials prices can be countered by measures of international co-operation, which are discussed in a later section.

Faced with the inflationary impact of higher costs of imported raw materials, a country could adopt restrictive credit policies and other anti-inflationary measures. In practice, however, this presents serious difficulties. An economy affected by external inflationary pressures and internal restrictive policies would develop maladjustments in its cost–price structure which might likely lead to a depression. If occurring in a number of countries, this development would tend to reduce the demand for ‘scarce’ materials and thereby bring their prices down to a more reasonable level. But would many countries be willing to accept transitional depression as a price for avoiding inflations due to the abovementioned cause? And under conditions of international insecurity could they afford the social unrest that such a depression might bring about? The most probable answer to both questions is in the negative. It follows that a relative world-wide scarcity of raw materials (whatever its causes, but especially if due to political and military conditions) will lead to credit expansion and price inflation in many, or most, of the countries concerned.

V Inflationary Forces in the World Economy since the Outbreak of the Korean War

All that has been said in general terms in the preceding section applies, in particular, to the developments that have taken place in the world subsequent to the outbreak of hostilities in Korea. These hostilities dramatized the need for a far more active rearmament programme and the first manifestation appeared in the field of strategic raw materials. The second half of 1950 showed a greatly increased demand for raw materials which, in competitive world markets, led to a sharp increase in the prices of many of them.

The effect of the increase in raw materials prices upon the economies of the Western world was twofold. In the first place, the dollar resources of the United Kingdom, of the Sterling Area generally, of France, etc., rose considerably. In the second place, however, the ‘terms of trade’ of these countries worsened11 and their balance-of-payments position was adversely affected. Also, and this is particularly important from the point of view of the present inquiry, an upward—and distorting—push was given to the price structure of many countries by the rise in raw materials prices. Under elastic credit conditions, this inflationary pressure spread throughout many economies, a process which at the time of the present writing has not been fully completed.

In addition to the inflationary impact of rising raw materials prices, the events in Korea and other conflicts of varying intensity that were occurring elsewhere in the world resulted in a considerable amount of ‘scare buying’ on the part of the public, in anticipation of a possible outbreak of even wider conflicts and of still greater future restrictions on the production of durable consumer goods.

This ‘scare buying’ was more noticeable in the United States than in Western Europe but it was recorded to a varying degree in most countries. As the anticipated shortages of durable consumer goods have failed to materialize, ‘scare buying’ gave way to a more circumspect attitude on the part of the public, and 1951 proved, in the United States at least, to have been a year of exceptionally high individual savings. Restrictive credit policies, mild in the case of the United States, more pronounced in the case of certain other countries, helped to bring the inflationary pressures of 1950—at least temporarily—under control.

Let us now look more closely at the part played by the United States in bringing about the exceptional rise of raw materials prices which, as has been noted above, has provided such a strong upward pressure upon price movements in Western Europe and elsewhere.

Table I

UNITED STATES COMMODITY PRICES

12 Flask of 76 lbs. equal to 34.5 kilogrammes.

Source: Twenty-Fifth Annual Report, April 1, 1950–March 31, 1951, Bank for International Settlements, p. 76.

Table 1 records the changes which have taken place in recent years in the United States in prices for eighteen basic commodities. It will be noted that for a number of raw materials, such as lead, copper, tin, zinc, mercury, there has been a more or less pronounced fall in prices between 1949 and 1950. This fall was not only reversed in the course of 1950 but the rise that followed was in some instances very dramatic, e.g. in the case of mercury of which the price was trebled between April 1950 and April 1951. The price rise between 1950 and 1951 also affected a number of foodstuffs, thereby increasing the cost of living in the countries which are heavily dependent on food imports.

Table 2 illustrates the fact that the United States has drawn upon a far larger proportion of the world supply of certain basic materials in 1950 than it had done in the three pre-war years, 1936–38. In the case of aluminium, for example, the United States’ share in world consumption was 30 per cent in 1936–38 and 62 per cent in 1950. For copper the figures were 32 and 54 per cent; for lead 28 and 52 per cent, and so forth. This is further borne out by the data of Table 3, below, which provides information on the United States’ net exports or net imports of certain basic materials.

Table 2

CONSUMPTION OF SELECTED RAW MATERIALS

13 Excluding the U.S.S.R. and Eastern Europe, but including net exports to these countries.

14 Hard-coal equivalent.

15 1938 = 100.

16 Pre-war 1934/35–1938/39; post-war 1949/50.

17 1934–38 = 100.

18 Wood-pulp and paper products; the figures relate to 1937 and 1949.

Source: Economic Survey of Europe in 1950, p. 82, Table 38.

In the case of steel, for example, we note a drastic decline of exports between 1936–38 and 1950 and an appearance of net imports in the last quarter of 1950. In the case of iron and steel scrap, the United States exported close to three million tons a year between 1936 and 1938, while the annual rate of imports for the fourth quarter of 1950 stood at 1.3 million. A similar picture is presented by copper and lead. In the case of zinc, imports have increased by, roughly, twenty-five times between 1936–38 and 1950, and in the case of wool they have trebled.

Table 3

UNITED STATES NET EXPORTS (+) OR NET IMPORTS (—)
(Thousand tons)

19 Annual rate.

Source: Economic Survey of Europe in 1950, p. 81.

In other words, the United States has drawn to its shores an increasingly large share of the world’s basic resources (for which it was able to pay in the much-sought-after dollars), thereby reducing the supply of these materials at the disposal of the rest of the world, increasing their ‘scarcity’ and driving up their prices. There can be no doubt but that in the second half of 1950 the United States’ stock-piling policies (which are at the root of the described developments), and the maintenance of internal consumption at high levels, bear a heavy responsibility for the increase in the world prices of basic commodities and for the inflationary tendencies that appeared—or were strengthened—in consequence.

We have an object lesson here of two types of international inflationary developments, one where a common cause affects a number of countries at the same time (in this case the shortage of basic materials), the other where the policies of one important economic unit result in inflationary pressures upon the world economy.

VI Components of an International Attack on Inflationary Forces

In the late autumn of 1951 the Secretariat of the Organization for European Economic Co-operation in Paris (O.E.E.C.) published a substantial and informative report on Financial Stability and the Fight Against Inflation. The report rightly emphasized that ‘the fundamental reason for the inflationary development [since June 1950] was a large increase in demand’. It went on to note that ‘the rise in demand which started the upward movement in prices was not due to any significant extent to actual expenditures on defence. In principle, therefore, it would have been possible for concerted action to have been taken throughout the area which could have gone a long way to prevent the serious disturbances which took place. . . . In particular, common action was needed for this sphere of raw materials.’

After the rise in raw materials prices had gone on for some time, a means of co-operation was established in the form of the International Materials Conference (located in Washington). In times of sharply increased demand due to defence needs, it is unwise, of course, to leave markets for strategic materials uncontrolled. Such has been the experience of every modern war economy. The lesson has been applied eventually and to good effect and the question of how to launch an international attack against inflationary forces has thereby been given at least a partial answer. At the same time, the United States curtailed some of its own stockpiling (as in the case of tin), thus helping to bring about a decline of raw materials prices from their high peaks.

Another and most important element of an anti-inflationary programme must be looked for in the domestic policies of the various countries. The O.E.E.C. report is very explicit on this subject:

‘Most of the measures required to prevent inflation in the year ahead are of the sort that can only be taken by each separate government, and can only be successful if the people of each country lend their support. A strict budgetary and monetary policy, and restraint over personal incomes, are unpleasant steps to take or to urge. But the example of necessary though unpleasant measures taken in neighbouring countries should make it easier for the authorities in each country to call for a similar sacrifice of sectional interests in their own countries.’20

An observation of more general scope may not be out of place at this juncture. One thinks too often about international co-operation as something that lies outside of the internal policies of the various countries, in a kind of international ‘no man’s land’. Actually, the opposite is true. International economic co-operation, if it is to be meaningful and effective, must be deeply rooted in internal policies of the individual national governments. This is so, of course, in the field of commercial policy. It is equally true in the field of monetary policy. The most effective way to co-operate in that field is to adopt common rules of action by the policy-makers of the different countries. Since the supply of money is nationally controlled, there is no way of influencing the monetary supply of the world otherwise than by a co-ordinated action on the part of the monetary authorities of individual countries. An agreement to curtail credit is a most effective international measure by which to combat international inflation. In addition, whenever there appears a common cause, such as a relative shortage of raw materials, an international agreement, e.g. to distribute equitably the goods in short supply among the various countries, without resorting to competitive bidding in a sellers’ market, is the best way to avoid unwanted price increases. For the immediate future, these are the most effective avenues of attack against international inflation.

The particular position and special responsibilities of the United States have already been referred to; these call for one additional comment. Our own rearmament effort has been conducted between the summer 1950 and spring 1952 on the principle: ‘Guns plus butter via increased production.’ This principle, however attractive it may seem at first glance, is open to serious reservations. In the first place, acting on that basis, we tend to draw towards the United States an excessive share of the raw materials supply of the Western world, thereby furthering the already-described inflationary tendencies. In the second place, this pyramiding of production for military needs upon production for undiminished civilian needs may inevitably lead to an over-extension of our productive capacity in the capital goods field, which has particular relevance to the problem of the business cycle. Since the United States has become the world’s ‘leader’ in any major inflationary or deflationary movements, our own policies must be designed with full realization of these responsibilities. An American inflation and overinvestment in American industry are not merely grave domestic problems, they are serious international problems as well.

***

Looking now to a more distant future, when the world will once again be peaceful, the question of an international approach to inflation ties in closely with that of an international monetary system. The discussion in this chapter leads to the conclusion that there is a better chance of controlling inflationary tendencies in a world economy under an international monetary system than under a régime of ‘independent’ national currencies.

The successful operation of an international system involves not only a general adherence to certain ‘rules of the game’ (i.e. the conduct of national monetary policies in such a way as to facilitate the achievement and maintenance of the country’s external balance), but also (a) the avoidance of inflationary policies in the major countries, and (b) an appropriate management of the common international standard. The first of these two points has already been discussed with reference to the special responsibilities of the United States. As regards the second, and assuming that the new international monetary system will be again based on the use of gold as an international means of payments, it will be necessary so to manage (by international agreement) the world price of gold as to avoid long-range price movements either upward or downward traceable to the changing supply of the metallic reserves. With the wealth of experience upon which we can now draw, and with the means of action at our disposal (such as the Bank for International Settlements and the International Monetary Fund), this task should prove to be entirely manageable.

 

21 Paper written in 1952 for The American Assembly, sponsored by the Graduate School of Business, Columbia University, New York. This essay was to be Chapter IV of a collective volume by various experts, but the publication did not, eventually, take place. My thanks are due to The American Assembly for permission to reprint this monograph in the present volume.

22 Special mention might be made of the middle twenties when price stability in the United States dissimulated an inflationary situation of which the international manifestations proved to have been particularly damaging. American credit expansion prevented a decline in the domestic price level which would have resulted from greatly stepped-up productivity and falling costs, while, internationally, the expansion of American credit prevented the downward price adjustments which were made necessary by the condition of supply and demand in world markets for basic commodities from taking their normal course. Eventually there followed a break in the markets and the ‘hidden’ or unacknowledged inflation was followed, as inflations always are, by a wave of depression.

23 See the present writer’s International Monetary Economics, London, 1939, for a detailed analysis of the relationships involved.

24 From the middle of the nineteenth century until the outbreak of World War I.

25 Cf. International Monetary Economics, op. cit., pp. 147–56 (reprinted above, pp. 20–26).

26 The best policy under these circumstances would have been to modify the world price of gold, but this was not considered at the time.

27 Yale Review, Summer 1933.

28 It has never been shown that oscillations in the discount rate made necessary by the operation of the gold-standard mechanism interfered with the establishment of the long-term rate of interest at a level which would bring savings and investments into balance.

29 A line of thought which had many followers on both sides of the Atlantic. Special mention might be made of Charles R. Whittlesey’s book, International Monetary Issues, New York, 1937.

30 Although such ‘aloofness’ is increasingly difficult and rare under modern world conditions.

31 Because raw materials increased in price as compared with manufactured goods, the manufacturing countries had to provide a larger quid pro quo in terms of their own output for the raw materials they were buying abroad.

32 Financial Stability and the Fight Against Inflation, p. 28, par. 66.

• 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.
• 12
• 13GOVERNMENTAL EXPENDITURES AND REVENUE, 1914–18a
• 14
• 15
• 16
• 17
• 18
• 19
• 20This qualification is indispensable; whenever there are credit operations the bank-rate policy appears in order to influence their size and direction.
• 21The 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.
• 22The 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.
• 23The 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.
• 24The 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.
• 25The 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.
• 26In 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.
• 27As 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.
• 28The 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.
• 29It 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.
• 30It 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.
• 31While 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.
• 32While 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.