Aspects of the Pathology of Money

9 Fixed Parities and Fluctuating Exchanges as Objectives of Monetary Policy1

An international stabilization of currencies is not one of the problems which are in the foreground of current economic discussion. This results from two causes: in the first place, because political conditions are not ripe for any such manifestation of international co-operation; and, in the second place, because the prevailing fashion among economists favours the idea that to link national currencies to one another by bonds of fixed parities is not only undesirable but harmful.

If, in spite of this, the present subject has been chosen for discussion, it is because underneath the current glorification of monetary nationalism one can find a desire for stability. As Professor John H. Williams so rightly observes:2

‘After cutting loose from the gold standard, what every country has done—save for the exchange control countries, where it seems obvious that some further action will be necessary—has been, in one degree or another and in one way or another, to tie back on again. . . . There is no evidence of any desire for a really flexible currency.’

A mere declaration by the President of the United States or by the British Chancellor of the Exchequer to the effect that stabilization is desirable would suffice to bring the whole problem back into the limelight from which it has temporarily disappeared. A further reason for investigating these problems nowadays is precisely the remoteness, or apparent remoteness, of any constructive policy. During such periods it becomes the duty of economists, having then the leisure, to inquire into the mechanics of the solution of those problems which remain unsolved. It is in this spirit that the question of monetary stabilization will be discussed in the pages that follow.

The Problem of Monetary Stability

The question which must be dealt with at the very outset of our analysis is the following: is monetary stability on an international scale a monetary problem in the technically narrow sense of the word, or is it, broadly speaking, an economic problem directly bearing upon the economic policies which relate to international trade and finance? Is it a problem susceptible of a monetary solution, or does its resolution imply the adoption of more complex measures, such as a revision of tariff policies, of regulations of foreign lending, and so forth?

Before answering this, let us define what is meant by international monetary stability. The term describes that situation in which the monetary units of the various countries bear a determined relationship one to another and in which this relationship remains steady in time. This, in turn, implies that balances of payments of the different countries remain in a state of durable equilibrium. Such equilibrium can result, however, only through the adoption of certain policies which will make it possible for corrective forces to be set in motion each time the balance of payments of a country shows a change—either surplus or deficit. Those corrective forces and the policies which release them are usually described as mechanisms of readjustment of balances of payments. Under the traditional gold standard, such mechanisms work through the dual instrumentality of changes in internal monetary circulation and the effects of such changes upon the internal prices of the various countries, on the one hand, and through differential changes in rates of interest on the other hand. I have attempted to show elsewhere, at greater length, that these two instrumentalities are the only ones susceptible of maintaining a long-run equilibrium in international payments.3

To put it briefly, a disturbance of equilibrium can be remedied either through changes taking place in the balance of trade of the countries in question, or through changes in the stream of financial operations. Provided there is no major cause of disturbance, momentary deficits or surpluses of balances of payments result principally from the uneven distribution in time of receipts and expenditures taking place across political boundaries. On account of this, a country may, at a certain time, receive many more payments from abroad than it has to make abroad, while later the reverse may be true. Short-term credit operations, which take place in response to differential shifts in rates of interest, will bridge over such maladjustments and smooth the course of international settlements.

Thus far there appears no need for the compensatory transactions to involve shifts in internal prices. It is very doubtful whether such shifts took place, to any appreciable extent, during the pre-war period of the functioning of the gold standard. While sufficient statistical information is unfortunately still lacking, it appears a likely hypothesis that the pre-war gold standard functioned, in the main, through the operation of the rate of interest and short-term credit transactions. There were, of course, certain general implications regarding price movements, about which a word will be said later, but it is unlikely that important changes in internal prices were associated with the working of the gold standard.

The situation becomes more intricate when balances of payments are subjected to major disturbances. Such disturbances may result from outside forces which are beyond human control, such as natural cataclysms of various sorts. They may be a consequence of changes in technique and in taste, which have repercussions upon the structure of international trade. Furthermore, they may result from political disturbances, either internal or international. And, finally, they may be due to systematic divergencies between the national economic and monetary policies pursued by various governments. This last point calls for further comment.

One of the assumptions implicitly underlying not only the traditional gold standard, but also any system of monetary internationalism, consists in the similarity of policies pursued in the different countries during the business cycle. While stable monetary conditions in the world help to bring about international co-ordination of cyclical movements and to produce an international spread of cyclical fluctuations, the adoption in the various phases of the cycle of similar policies is an important condition of the maintenance of that monetary stability.

There are a number of reasons for this interrelationship. The following two seem to be of outstanding importance:

In the first place, the fact that various countries find themselves at one and the same time in different stages of the business cycle, so that certain of them are depressed while others are prosperous, affects to a considerable extent capital movements. Not only will short-term credit transactions fail to take place in a way requisite to the functioning of the mechanisms of adjustment, but long-term investments will be made in favour of the prosperous countries and not of the depressed ones, with the further consequence that the former will tend to become more prosperous and the latter more depressed. We may infer, therefore, that the lack of synchronization of the cyclical movements will tend to increase the amplitude of such movements in all countries concerned. It is clear that under the strain of such conditions, unless controlled, monetary stability would break down sooner or later.

In the second place, the adoption of different types of business-cycle policy by countries which are at a given time in the same phase of the cycle will lead to important and systematic divergencies in the price developments taking place in each of the countries involved. This will affect the foreign trade of those countries and therefore their balances of payments, and it will be found that the effect will be both enduring and cumulative.

Since, in the absence of an internationally co-ordinated business-cycle policy, both types of consequences will follow, it is clear that there is an inescapable choice between national autonomy in economic policies and international monetary stability. Thus the problem of monetary stabilization is obviously much more than a question of one form or another of technical monetary organization. It involves the deeper-lying issue between economic nationalism, on the one hand, and economic internationalism, on the other.

Frequently, when discussing international stabilization, one refers to the notion of monetary parities. It is interesting to note that this term, which appears so often in economic literature, is very rarely properly defined. The definition proposed here envisages monetary parity as being that rate of exchange between two currencies which can be maintained over long periods of time without exercising any strain either on the internal economic life of the country concerned or on the state of international economic relations.

When, in the midst of a period of international currency disturbances, we discuss the future of monetary stability, obviously we are confronted with the task of postulating, at some time in the future, new parities between currencies (provided, of course, that one favours stabilization as the goal of future policies). In this case, is it possible to say beforehand, and on the basis of the available economic data, what the appropriate relation between any two currencies will be? The prevalent view seems to be that such an a priori determination of parities is possible, at least with a certain degree of precision. The school of thought which holds this view most consistently adheres to the conception of what Professor Cassel has called ‘purchasing power parities’. The notion is too familiar to require detailed discussion here. Briefly, the theory is based on the idea that changes in parities are entirely due to changes in national price levels. It infers from that postulate a method of calculating a new parity, after a period of monetary disturbances. The procedure is very simple. One applies to the old parity the quotient of changes in price levels taking place during the period envisaged, and thus one obtains the new parity. There are numerous economists who consider this merely a general indication of the order of magnitude of the new parity, and who allow for a certain elasticity in determining the new relation. But the general idea is that, starting with the available data, one can figure out an approximately correct relationship between currencies.

Personally, I am inclined to doubt whether such a position is acceptable. It would be valid in a world in which there existed no financial transactions whatever and in which international trade was uniquely determined by differential changes in price levels. But such is not the world in which we happen to live. In our universe, financial transactions play an extremely important part, and international trade depends on many other elements than changes in the statistical construction known as the price level. The influence of financial transactions seems to be all too often disregarded or to be emphasized inadequately. If a rate chosen as parity is not one in the enduring character of which financial circles in the various countries have full confidence, credit operations of different types will result, not excluding flights of capital, and this may suffice completely to upset the stability of such a rate, even in the absence of any further price movements.

It is very instructive, from this point of view, to investigate the French monetary developments between 1937 and 1939. Even if it should appear to be less satisfactory, from an intellectual point of view, than a priori parities, the notion of a posteriori parities must, I think, be given preference over the former. It is always better to deal with a concept which is clumsy, but adequate, than with one which is inadequate, though elegant.

Has the Gold Standard Been a Failure?

The familiar phrase that nothing succeeds like success applies to monetary systems as it does to human individuals. We might add that nothing seems to fail so much as lack of success. This may explain the discredit into which the gold standard has fallen in many circles since 1930. It is true that advocates of that system can point to the great expansion of international trade and of national prosperity during the fifty years prior to the world war, during which the gold standard became a generalized monetary system. It is also true that they can point to the distress that accompanied the breakdown of international monetary stability. But critics of the gold standard can answer that the depression was deepest before the breakdown of international monetary stability, that the gold standard did nothing to prevent the depression, that after 1931 the sterling area, which was off the gold standard, fared economically very much better than the gold-bloc countries, and that improvement in economic conditions in France followed the surrender of the gold standard.

But do such appeals to historic facts decide the issue in favour of or against gold? It seems clear that they do not. All of them exemplify the dangerous logical procedure called argumentum post hoc propter hoc. There were many reasons for the expansion of international trade and of prosperity in the pre-war days. It was the growth of economic internationalism which rendered possible the extension of monetary internationalism, which in turn became a factor favouring greater international co-operation. It is equally true that a system of monetary internationalism could not survive an almost complete collapse of international co-operation in other spheres of economic life. If the gold standard broke down, it was on account of the conditions under which it had to work. It was not within the powers of the system to affect those conditions. The gold standard was neither the cause of prosperity nor the cause of distress. It was simply and solely a monetary system that could work only under certain conditions, which failed to be satisfied long before the ultimate collapse of the system.

The modern criticism of international monetary stability (and of the gold standard) seems to be very much influenced by historic experiences, some of which have already been cited. Let us look carefully into one or two of these experiences.

England after 1925.—It is true that after the return to gold, England entered upon a period of economic difficulties from which the country did not emerge until after 1931. To be sure, this has been attributed more often to the parity at which gold payments were resumed in 1925 than to the fact of returning to gold. But the implication remained that England was more prosperous after going off the gold standard than during the six years of adherence to the system. While essentially in agreement with the thesis according to which England mistakenly returned to a parity that was too high, and therefore had to undergo a process of deflation which was both painful and difficult to carry out, I should nevertheless like to point to certain more fundamental factors, which may explain England’s difficulties in the late twenties.

In the first place, there was a growing trend towards economic nationalism, which found expression in the difficulties of England’s export trade. Certain industries were affected by technological changes abroad. Consequently, there was much need for internal industrial adjustments, which at that time failed to be realized. André Siegfried’s England’s Crisis4 will be found of interest in this connexion. No amount of monetary manipulation could have helped England out of difficulties due to such important structural factors. The period after 1931 was not only one of monetary changes, but also one of considerable reorganization in certain British industries, and it will be noted that the so-called spatial areas continue to exist, in spite of the depreciation of sterling, in spite of the young British protectionism, and in spite, even, of the development of war economy.

France’s experiences after 1931 supply another favourite argument for those who object to the gold standard. However, the situation of France and the gold bloc is rather peculiar. The gold bloc was formed, it will be remembered, at the London Conference of 1933, and during its short life it was nothing more than a designation covering a group of five countries which persisted in keeping the pre-depression price of gold, while the world price of gold was changed by between 40 and 50 per cent. This way of putting it is perhaps not quite correct, but the circumstances referred to are as follows.

After 1931, the countries of the so-called sterling area devalued their currencies by about 40 per cent. In 1933 the United States devalued the dollar by 49 per cent. From December 1933 until the autumn of 1938, the relation between the dollar and sterling was almost stable. We may therefore speak of a change in the price of gold taking place de facto over the greater part of the world. Under these conditions, it was France, Belgium, Holland, Switzerland, and Poland which carried out what I have described before as an autonomous economic policy. For once, the adherence to gold was an expression of non-co-operation rather than of co-operation, a paradoxical situation, to be sure, but one the particular characteristics of which should be clearly recognized. It was only after the collapse of the gold bloc that a chance for rebuilding monetary internationalism reappeared. For the time being, of course, nothing was done in this direction. We must emphasize once more the fact that while France was on the gold standard, this was in no correct sense an international gold standard, because at that time there happened to be no such thing in existence.

It follows from the foregoing observations that the facts of recovery in countries off the gold standard and of a continued depression in countries on the gold standard in the years 1933–36 are not proof of the adequacy or non-adequacy of an international gold standard as a monetary system. They do demonstrate, however, the advantages of international co-operation and of the stability of exchanges. It will be noted that during the period 1931–33 exchange rates were fairly stable within the sterling area, and that after the end of 1933 stability existed within the sterling-dollar area. It is also apparent that under these circumstances there was a notable improvement in trade among countries belonging to this area. In this sense, one can speak of a gradual revival of a de facto monetary internationalism within a limited group of countries.

The Importance of International Economic Co-operation

All our foregoing observations tend to the same conclusion: international co-operation is an essential condition of monetary stability. In the light of this conclusion, it will be interesting to analyse the post-war monetary reconstruction. It will be found that this reconstruction was not based on any comprehensive degree of economic co-operation. While the international conferences of Brussels (1920) and of Genoa (1922) emphasized the importance of such co-operation, and while the latter of these conferences suggested that a meeting of central banks be called to discuss the common problem of monetary reconstruction, nothing has been done in that direction.5 Events thus led to the adoption of a monetary system which was developed amidst a growing trend towards economic nationalism. Like a skyscraper built on quicksands, the construction collapsed under the impact of the first storm. It is interesting to note that not even the founding of the Bank for International Settlements was preceded by a conference of central banks, nor by the elaboration of an international monetary convention. The Bank, it is true, was the outcome of a desire for monetary internationalism and of an attempt to solve the reparations problem. And it is also true that the latter attempt died out, prematurely and unregretted.

In effect, therefore, a centre of international monetary co-operation was established in the first year of the depression. But it was given very inadequate powers to achieve wider objectives and it was forced to work under extremely unfavourable conditions. It is an institution, therefore, which still has to prove itself and which will be unable to do so until there is a revival of economic co-operation in the widest sense of the word.

The first post-war decade was pervaded by an atmosphere of compromise, and nowhere was the compromise more evident and less regarded than in the contrast between the growth of commercial nationalism, on the one hand, and the attempts at monetary reconstruction, on the other. The Gold Exchange Standard was, to a certain extent, the outcome of this compromise.

While it would lie beyond the scope of the present discussion to consider in detail the causes of the monetary breakdown, we may say that its occurrence marked the victory of nationalism over internationalism, in the post-war world. We are still living under the consequences of this victory.

Objectives of Policy

What are the conclusions which may be drawn from the foregoing discussion, as regards the outlook for the future?

As indicated in our title, the alternatives, in terms of monetary technique, are a return to fixed parities, on the one hand, and the maintenance of a system of fluctuating exchanges, on the other. The ultimate answer will depend on the solution found for the broader issue of nationalism versus international cooperation. At the present time, there is a considerable section of professional opinion which favours so-called flexible exchanges. What does this suggestion imply?

Flexible exchanges are apparently such movements of exchange rates as would correspond to changes in the relative price levels in the various countries. More precisely, on the assumption that the various countries have divergent price movements, flexible exchanges will bring about the needed adjustment among the national currencies. The system, therefore, is intended to combine a considerable degree of national autonomy with a not-inconsiderable degree of stability in international trade. In the words of one of the leading advocates of flexible exchanges, the following state of affairs can be achieved: ‘If, instead of absolute stability of exchange rates, an attempt were made to adjust rates proportionately to shifts in the relative domestic purchasing powers of the several currencies it would be possible for any nation to pursue whatever internal monetary policy it judged appropriate to its interest without significant disturbance of international commercial and financial relations.’6

It is hoped, therefore, to reconcile the apparently hostile objectives of nationalism and internationalism. Personally, I confess I cannot entertain such hopes. National monetary and economic autonomy leads to the adoption of more and more nationalistic measures, as the experience of the last ten years clearly shows. I have already mentioned some of the consequences of nationally independent business-cycle developments. Let us add that, under such conditions, a resumption of long-term investment abroad is neither likely nor advisable, while short-term credit transactions are likely to continue to be large and erratic. If this is so—and there seems to be much to confirm this view and little to contradict it—then exchanges which are not stable will be subjected, under certain conditions, to fluctuations, the scope of which will render inadequate the use of the term flexible—they will be chaotically unstable. Were it not for the desire for stability, we would have seen, within the last few years, much wider fluctuations of exchange rates than those actually experienced.

As Professor Williams remarks:

‘The United States, after going off gold definitively in April 1933, had returned to a fixed buying and selling price of gold by the end of January 1934. England, which is commonly cited as the country least willing or likely to return to the gold standard, has been acting essentially like a managed gold standard country virtually from the day she went off gold. The Equalization Account, as thus far operated, has been a device, not merely for ironing out day-to-day fluctuations, but for preventing a rise, and perhaps at times a fall, in the pound, by means of an international gold flow to and from England. Had England really wanted a flexible currency she would have allowed the pound to rise against the franc as capital took flight to London, which might have prevented the second devaluation of the franc. But no one would have seriously advised such a course. The rise in terms of the franc would have been a rise also in terms of other currencies, including the dollar, which would have recreated England’s problem, and would in any case have led to a subsequent fall when the capital flowed out again. England has, therefore, though officially off gold, accumulated more gold than ever before in her history.’7

That the system of flexible exchanges has worked so well recently, is because ultimate stability, as an objective of policy, has never been entirely lost sight of. There is no doubt that this system provides a workable expedient in peculiarly unstable times. Nobody could be more emphatic than I in warning against too early a return to monetary internationalism, in the midst of a nationalistic world. But one must not confuse an expedient with a solution. To make the best of a bad job must not be mistaken for doing a good job, and we are very far indeed from doing a good job in the field of international economic relations.

Similarly, exchange equalization or stabilization funds cannot be viewed as a radically new departure in the field of monetary organization. They are very useful, indeed, in helping to maintain a maximum of exchange stability amidst unfavourable conditions. They will remain very useful as long as major disturbances in international flows of capital take place without being apparent. Their further existence may, indeed, make the future system of monetary internationalism safer and more stable. But there is nothing in these funds that exceeds the possible scope of operations of a central bank. Given adequate financial possibilities, any central bank could do what exchange funds are doing at the present time.

If exchange funds can and, as I think, should, be integrated into the monetary system of the future, exchange control must of course be abolished. By exchange control I mean the concentration in the hands of a public authority of all the dealings in foreign exchanges. It can be shown, though I refrain from doing so here,8 that exchange control, thus defined, leads progressively to the establishment of a more or less comprehensive control by the state over the economic activity of the country. The continued existence of exchange control stands in direct opposition to the continued existence of democratic political institutions. It is a system of monetary organization that can exist only under a régime of totalitarian state socialism. Since, in envisaging the future organization of the world, one cannot discuss monetary problems in a political vacuum, but must take into account both monetary and non-monetary elements of social life, exchange control must be ruled out by whoever favours democratic and liberal institutions. This may mean, of course, that a revived economic internationalism will be limited to a certain group of countries only. However that be, I wish to emphasize again how very dangerous too much compromise can be.

Fixed parities appear to me to be the objective of that monetary policy which best comports with a revival of economic internationalism and with the maintenance of liberalism. If events should carry us in this direction, it is probable that the re-establishment of fixed parities would be accomplished gradually and progressively. The Bank for International Settlements, with properly revised statutes, would be a very helpful instrument of action, both in administering monetary co-operation among large financial centres and in helping the spread of monetary stability throughout the world. In order to fulfil that function, the Bank should receive, in the form of a monetary convention, the basis it lacks for its operation; while participating membership might have to be restricted to countries which do not practise exchange control.

 

9 Originally published in the volume A Forum on Finance, edited by George B. Roberts for the School of Business of Columbia University. New York, Columbia University Press, 1940, pp. 79–93. (This text reproduces a lecture delivered in the Banking Seminar of Columbia University in the course of the academic year 1938–39.)

10 John H. Williams, ‘International Monetary Organization’, Lessons of Monetary Experience. Essays in Honor of Irving Fisher, New York, 1937, pp. 33–4.

11 M. A. Heilperin, International Monetary Economics, London and New York, 1939, Chapter VIII (reprinted in the present volume, pp. 17 et seq.).

12 London, 1931.

13 William E. Rappard, ‘Post-War Efforts for Freer Trade’, Geneva Studies, vol. IX, No. 2, Geneva, Geneva Research Centre, 1938.

14 Frank D. Graham, Journal of the American Statistical Association, vol. XXXIII, No. 204, P. 773.

15 Williams, op. cit., pp. 33–4.

16 Heilperin, International Monetary Economics, op. cit., pp. 237–45.

• 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.
• 9The 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.
• 10The 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.
• 11The 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.
• 12The 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.
• 13The 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.
• 14In 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.
• 15As 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.
• 16The 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.