International Monetary Economics

CHAPTER X

MONETARY PROBLEMS ARISING FROM ECONOMIC NATIONALISM

A. Introductory Remarks

IN the present chapter some problems will be dealt with which arise when the “international mechanism” analysed in Chapter VIII is prevented from functioning and when, in consequence, international monetary stability is either endangered or destroyed.

The principal interferences with the working of the “international mechanism” are due to the adoption of either of the following policies:

(1) economic nationalism in the narrower sense of the word, defined as “the policy of national self-sufficiency”;1

(2) a search for national economic “autonomy” as regards, in particular, trade cycle developments. This may be called economic nationalism in a wider sense of the word.2

The first type of policy represents a corollary and a symptom of political nationalism and is determined by political, not by economic, objectives. The second is a result of certain doctrines relating to methods of obtaining economic stability within a country.

Thus, certain political considerations and certain economic doctrines converge towards the destruction of monetary internationalism. This consideration must be kept in mind when envisaging the conditions of maintaining that monetary order and of re-establishing it once it has been destroyed.

Whenever the mechanism of re-establishing equilibrium in international payments is prevented from functioning, two consequences inevitably follow. In the first place, the international circulation of whatever constitutes the monetary standard (e.g. the circulation of gold under the gold standard) gets disturbed and accumulations develop in certain countries while others see their reserves depleted. In the second place, if the monetary standard is given up by certain countries or by all of them, in consequence of maladjustments brought about by that deficient circulation of the standard commodity, exchange instability inevitably develops. Such are the two stages of the disintegration that take place in international monetary relations when the “international mechanism” gets out of order.3 Now instability of foreign exchange quotations is a very undesirable phenomenon on account of the disturbances which it creates in international trade, in long-term credit operations and, particularly, in international movements of short-term funds. As has already been pointed out, these latter disturbances tend to intensify to a very large degree the fluctuations in foreign exchange rates; thus a “vicious circle” easily develops, which the advocates of flexible exchanges and those of fixed exchanges alike are anxious to prevent.

Monetary internationalism, in realizing the importance of the mechanism of re-equilibrium, aims at the maintenance of conditions which make its smooth operation possible. Thus it is closely linked with economic internationalism based on the observance of certain rules4 and on a friendly collaboration between the competent authorities of the various countries. It will be observed that international co-operation either prevents major economic disturbances from taking place or can reduce their impact upon the working of the “international mechanism”.

Monetary nationalism, on the other hand, as a corollary of economic nationalism (in both the wider and the narrower meaning of that phrase), contributes to making the functioning of the international mechanism more difficult while at the same time instability of exchanges, a consequence which then inevitably develops, is considered to be undesirable. It is in this contradiction that one finds the origins of exchange control. We shall see presently that exchange control represents a device which not only eliminates exchange instability in a nationalistic world but brings forth, through the internal logic of the system, other types of restrictions on international transactions and becomes an important instrument both of autarchy and of State socialism. The important point, which will be argued more fully in a later section of this chapter, consists in realizing that exchange control is a necessary consequence of the endeavour to combine exchange stability with economic nationalism. It is also important to realize that a policy aiming at self-sufficiency can be carried out much more easily with exchange control than without it. The same applies in a varying degree, to policies of national economic “autonomy”. Since this is the platform on which monetary nationalism has received most support in some leading academic circles, it is by inquiring into this question that I shall start the present phase of this investigation. This will be followed by a further elucidation of the causes of exchange control and of the “internal logic” of that system. The establishment of exchange equalization (or stabilization) funds, which in turn will be briefly examined, has been another method of safeguarding a certain degree of exchange stability amidst conditions working in favour of instability. Exchange Equalization Funds, however, can be used, as exchange control cannot, with the view of making a transition towards monetary internationalism.5

B. National Monetary “Autonomy”

The crudest form of the argument in favour of “insulating” a national economy by means of fluctuating exchanges from “undesirable” foreign price developments has been already referred to in the preceding chapter. This argument was advanced by Mr. Keynes in 1923 in his well-known and much-discussed Tract on Monetary Reform6 and has exercised a great influence upon the monetary thought of the past fifteen years. While the argument has been further refined in Keynes’s Treatise on Money, it is worth while to quote in extenso its first version.

“Since . . . the rate of exchange of a country’s currency with the currency of the rest of the world (assuming for the sake of simplicity that there is only one external currency) depends on the relation between the internal price-level and the external price-level, it follows that the exchange cannot be stable unless both internal and external price-levels remain stable. If, therefore, the external price-level lies outside our control, we must submit either to our own internal price-level or to our exchange being pulled about by external influences. If the external price-level is instable, we cannot keep both our own price-level and our exchanges stable. And we are compelled to choose. . . .7

“The right choice is not necessarily the same for all countries. It must partly depend on the relative importance of foreign trade in the economic life of the country. Nevertheless, there does seem to be in almost every case a presumption in favour of the stability of prices, if only it can be achieved. Stability of exchange is in the nature of a convenience which adds to the efficiency and prosperity of those who are engaged in foreign trade. Stability of prices, on the other hand, is profoundly important for the avoidance of the various evils described in Chapter I.”8

The reasoning can be found variously formulated in most writings advocating fluctuating exchanges and stable internal prices. Let us examine its validity. Its basis is the very simple equation:

PA = EA,B. PB

where PA and PB denote respectively the “price level” of country A and that of country B and EA,B is the exchange rate between the two currencies. Let us leave aside the implication regarding the resulting identity of price levels—that question has been discussed in the preceding chapter and need not be taken up again here. What I wish to point out is that the whole reasoning is based on the concept of purchasing power parities, which as we have seen presents various serious shortcomings and does not stand up to a careful examination. This disposes of the basis of Mr. Keynes’s argument. Furthermore, the concept of price level is used here as though it were a precise and unequivocal numerical magnitude; since this is not the case, a second element of the argument must be abandoned. Two consequences follow:

(1) Even if the theory of purchasing power parities were acceptable, various changes in individual prices could occur without provoking exchange fluctuations;

(2) since, however, exchange rates depend on various other elements besides the prices in the various countries of goods entering international trade, the range of price movements which are compatible with the maintenance of stable exchanges may be considerable and certainly is undetermined.

Since the reader has come across similar considerations in the preceding chapters, I will not continue this line of argument. There is only one case in which the maintenance of exchange stability is not compatible with internal price stability9 and that is if the world at large experiences a considerable and more or less sudden, rise or fall of prices. The dilemma exists, generally speaking, between, on the one hand, adapting the national price developments to those which occur abroad and, on the other hand, giving up the stability of exchanges. Now situations in which the evolution of prices throughout the world might interfere to an appreciable extent with the internal economic stability of a country are quite exceptional save for business cycle fluctuations. Even there one should beware of exaggerations; international relations have been so disorganized ever since 1914 that the large price movements which have been taking place during the last twenty-five years cannot be considered as “normal” cyclical fluctuations. As Professor John H. Williams rightly observes:

“Under more normal conditions . . . it will probably be found that the dilemma between the aims of external and internal monetary stability is more apparent than real, and that it arises very largely out of a too literal acceptance of the abstractions of gold-standard theory.”10

In the light of the whole argument of the present book this matter hardly needs further comment; my insistence on the weakness of this conception that there is a dilemma between price stability11 and exchange stability is due only to the continuous re-appearance of such arguments as Mr. Keynes’s in economic literature12 and to the practical harm that can be done by a widespread acceptance of that apparent dilemma as true.

In the Treatise on Money Mr. Keynes advances a different type of argument in defence of his thesis that, even under the gold standard, a wider range of fluctuations must be admitted than those determined by the traditional gold points.13 After pointing out that, under a régime of fixed exchanges, there would be a tendency of interest rates to be the same all over the world, because funds would move from the low-interest places to the high-interest ones, thus bringing about the equalization of rates by a process of arbitrage, Mr. Keynes points out that nevertheless “circumstances may exist in which, if a country’s rate of interest is fixed for it by outside circumstances, it is impracticable for it to reach investment equilibrium at home. This will happen if its foreign balance is inelastic, and if, at the same time, it is unable to absorb the whole of its savings in new investment at the world rate of interest. It will also tend to happen even when the foreign balance is elastic, if its money costs are sticky. There are moreover all sorts of other reasons why the day-to-day preservation of local investment equilibrium may require some departure of the local rate of interest from the international rate.”14

This reasoning appears, on the first glance, to be much less vulnerable than the one previously discussed. Nevertheless, I think that it cannot be accepted as valid. A detailed discussion and criticism of Mr. Keynes’s argument would take us into the heart of an important economic debate in which the last word is far from being said. For the present purpose this can be dispensed with since there is one consideration which disposes of the very basis on which Mr. Keynes’s argument rests. I refer to the assumption that the interest rate, from which it depends whether “investment equilibrium” is reached in a country or not, is the prevailing bank rate. Now it should be observed that the former rate must be that which is quoted on the capital market, considering that it equalizes (or fails to equalize) the demand for and the supply of, savings15; the bank rate, on the other hand, is a money rate of interest. I have pointed out in Chapter V that a clear distinction should be made between cash and short-term funds on the one hand, and long-term funds, saved and made available for investment (which I called “capital”), on the other hand16; while both represent funds of purchasing power, these two types of funds differ as to their economic significance, i.e. as to the part that they play in the economic process. The supply of and demand for “short-term funds” are not determined by the same factors as the supply of and demand for “capital”; it is therefore reasonable to expect that prices quoted respectively on the money market17 and on the capital market should not at any particular moment of time be identical, even though they may be indirectly connected with one another (owing particularly to institutional arrangements which make it easy to use “short-term funds” as though they were “capital” and vice versa). It is equally reasonable, in view of the foregoing argument, to consider that “investment equilibrium” is not governed by the bank rate. Hence Mr. Keynes’s argument, being based on an inacceptable hypothesis, cannot be admitted as valid.18

Thus far the case for “national monetary autonomy” is not very strong. It does not appear that stable exchanges should endanger the internal economic stability of any country. Let us examine, however, one more argument before dropping this subject. This argument can often be encountered amongst advocates of fluctuating exchanges, and it refers to business cycle policy.19 Its principal elements are the following:

(1) owing to the necessity for national price structures20 to keep in touch with one another under a system of fixed exchanges, that system favours the international spread of cyclical movements; if a country wants to preserve itself from cyclical fluctuations coming as it were from abroad, it cannot maintain fixed exchanges with foreign currencies;

(2) if a country wants to carry out a policy of reflation while no such policy is being adopted abroad, the maintenance of an international monetary standard would result for that country in a drain of monetary reserves which, if it “played the game” according to the rules, would cause a restrictive credit policy to be adopted and reflation to be stopped. As Mr. R. F. Harrod, one of the principal exponents of the doctrine of monetary autonomy, puts it:

“If a country is resolutely determined to combat trade depression by all means in its power, depreciation of its currency may be the inevitable consequence of measures it takes.”21

Now the question is, of course, open to discussion whether it is worth a country’s while to adopt such a policy or not, and whether the international instability which is most likely to ensue from the adoption by a country of an independent business cycle policy will be compensated by the effects, which after all are not certain, of such a policy for that country’s economic conditions both at the time of the particular emergency and later on.

The point at issue is really this: one must not overestimate the beneficial effects that might follow from an independent national policy,22 nor underestimate the consequence that will follow in the field of international relations.

As Mr. Harrod himself admits, a policy of using exchange depreciation as an instrument of national policy is open to serious objections:

“It would . . . probably provoke reprisals. And not altogether unjustifiably. For it is of its nature predatory. It involves an attempt to use the external world as a lever to hoist up the country’s own prosperity without regard to the depressing effect which the process may have on the world outside.”23

With that view I find myself in entire agreement; whatever the efficiency of a policy of exchange depreciation might be as regards the improvement of the internal economic conditions of a country (and that effect is by no means as certain as it is considered to be in certain quarters),24 there is no doubt as to the highly disturbing effect it is bound to have upon other countries and upon the state of international relations. Furthermore, and this point is only mentioned briefly here since I have dealt with it at greater length before, the exchange instability which results from such national policies as we are now discussing is bound to affect international financial transactions, discouraging long-term lending and disorganizing movements (of an increasing volume) of short-term funds.

Mr. Harrod might agree with all that, since he recognizes that “greater international monetary co-operation is urgently required”,25 but he reconciles this last-quoted view with his argument for free exchanges by the following considerations, which I find it difficult to admit as valid:

“It is impossible to lay too much emphasis on the distinction between a depreciation which occurs as the natural and inevitable result of strenuous internal measures undertaken by a country to secure higher activity and greater employment at home, and depreciation artificially engineered as a means of stimulating activity.”26

Of course, if depreciation has to have any beneficial effect at all on the economy of a country which adopts that policy, it must be accompanied by a policy of reflation at home; but where is one to draw the line? And will the attitudes of foreign countries and the effects on international finance be different in one case from those in the other? One may be permitted to doubt it. The choice between exchange instability and exchange stability remains as acute as ever; the former must almost certainly disorganize international relations, without necessarily being useful to any country for any length of time, while the latter does not exclude any policy of fighting trade depressions provided such policy is based on international co-operation. Speaking of “cheap money” as a means of reflation, Professor Gregory rightly observes that “in so far as it (i.e. ‘cheap money’) depended upon the deliberate action of the monetary authorities, it would have been possible, given international agreement, to arrive at a co-ordinated policy in this respect even without the abandonment of the parities hitherto prevailing”.27 This statement represents a point of view the importance of which I consider as capital. There can be no doubt whatever in the light of both theoretical and empirical knowledge that the results which could be obtained through international co-operation exceed both in kind and in durability those that can be brought about by independent national policies leading up to an international anarchy.

The doctrine of monetary nationalism has been inspired considerably by such exceptional experiences as the artificial re-valuation of the pound in 1925 and its consequences, and by developments in more recent years caused by the complete absence of international co-operation throughout the last depression. It is dangerous, however, to draw conclusions from conditions where co-operation was missing and where national emergency policies were adopted as a pis-aller, to the absolute advantage of such policies as compared with policies of economic internationalism.

Mr. Keynes is in a somewhat ironical mood when he says that:

“The lack of an international standard of value is assumed to be just one more of those foolish hindrances to international mobility, such as tariffs, which can only serve to impoverish the whole world in the misguided attempt to benefit some separate part of it.”28

If that sentence were to be taken literally and therefore not in the spirit in which it was written, it would, in my opinion, correctly represent the situation. And Mr. Keynes himself seems to recognize the fundamental merits of monetary internationalism, when he arrives, in a later part of the book, at “the tentative conclusion that subject to certain safeguards and compromises for securing a reasonable measure of domestic autonomy, the ideal currency for the immediate future should probably conform to an international standard”.29

C. Exchange Control

The subject of exchange control is very vast and it will be treated here only in brief outline and only from a particular point of view. Neither the intricate technicalities of the various methods of control nor the important problems of administration and enforcement will be dealt with here; what will, however, be analysed, is the way in which exchange control fits into the general system of international monetary relations, and the nature of some of its ultimate consequences.

Exchange control has been variously defined; Dr. Einzig, for example,30 includes under this denomination all interferences by monetary authorities on the foreign exchange markets, a definition which I find too wide to be useful. In order to reach a definition which covers the more restricted field of interventions usually implied by the phrase “exchange control”,31 let us look back at the operation of the foreign exchange markets and of the “mechanisms” whose action maintains the long-run equilibrium of international payments. Two points need particularly to be recalled in the present context:

(1) the rate of exchange is a price resulting from the position of demand and supply in the foreign-exchange markets;

(2) mechanisms of re-equilibrium stimulate some operations and discourage others by means of discount policy and of influencing the volume of circulating medium, and thus provide the correctives that are necessary in order to equalize over longer periods of time payments made by a country and payments received by it and thus to maintain the long-run stability of monetary parities.

These two points are characteristic of a situation in which dealings in foreign exchange are free, and, more generally, in which international commercial and financial transactions can be freely conducted.32 Whenever mechanisms of adjustment fail to operate, stability of exchange rates is endangered.

Now, whenever “exchange control” is introduced, the situation gets profoundly modified.

Exchange control consists in the centralization of all dealings in foreign exchange in the hands of a public authority (treasury, central bank or an institution created ad hoc). The State (through one of its organs) assumes the exclusive right of buying and selling foreign exchange at rates fixed by its authority. These may be rates corresponding to the parities which existed at the time when exchange control is being introduced, but they may be other rates.

Thus the exchange rates cease to be market prices33, and, since they are legally imposed, it follows that the freedom of market dealings must be given up. It is the authority to which the administration of the control of foreign exchange is entrusted that must so determine the supply of and the demand for foreign exchange as to preserve the stability of the legally prescribed price. This is bound to produce far-reaching consequences. These will be the greater the more permanent the system of exchange control becomes; it takes time for all the consequences to develop, and if the control, after having been introduced for reasons of acute emergency, is quickly abandoned, only some of them will follow. Much will also depend, as will be shown presently, on the general attitude of the government with regard to the economic life of the country.

It is clear that exchange control constitutes an interference with the working of the price mechanism; other forms of governmental (or central-bank) intervention on foreign exchange markets may utilize that mechanism (and, in fact, often do so).

Experience has shown that the fixation of a legal price for some goods or other does not in itself suffice to maintain at that level the prices actually quoted. If at the legal price demand exceeds supply, there will be a tendency to trade in that commodity (or foreign currency) on other, unofficial and illegal, markets. Such practices were very widespread in the first post-war period of monetary instability, nor are they wholly absent in the second one. Their effect is to stultify to a greater or lesser degree the fixing of rates by the authorities and the operation of exchange control. In order to prevent this as far as possible, it is necessary that the government should be able to control both the supply of, and the demand for, foreign exchange. The power to do this is secured (1) by forbidding all unauthorized exports of gold and foreign exchange (and by limiting also, of course, the amounts of national currency that may be exported freely from the country); (2) by making illegal the sale of foreign exchange by anybody except authorized agents and to anybody except to these agents, and by introducing severe penalties for infractions of that prohibition; by imposing an obligation on all who receive payments from abroad to sell the corresponding amounts of foreign exchange to the central bank or other authorized agents.

These regulations centralize all the trade in foreign exchange in the hands of the government. Since, however, “leakages” are possible in spite of severe penalties, a further regulation tends to make it not worth while to smuggle the local currency out of the country and to sell it abroad at a more or less depreciated rate. This is the interdiction on re-importing the national currency from abroad (except some small amounts). Thus the foreign market for the smuggled currency becomes very restricted, since such currency has to be smuggled back in order to be spent.

Other measures, of an administrative character and of growing complexity, follow the same lines. All this, however, does not go far enough. In order to control efficiently the supply of, and the demand for, foreign exchange, it is indispensable that the government should also have control over foreign trade and foreign financial transactions. Not only is it therefore necessary to have a special authorization to conclude an import contract, since the carrying out of such contracts involves outward payments, but it is necessary also that the government should be informed of export contracts so as to prevent exporters from depositing in foreign banks the proceeds of their sales instead of selling this foreign exchange to their national central bank. Thus the whole of foreign trade comes under governmental supervision.

As regards financial transactions, all new ones involving payments abroad are under control and practically eliminated. New transactions involving an inflow of foreign exchange are, of course, also subjected to control. To former foreign commitments, such as interest and dividend payments to foreigners, restrictive measures are applied: either payment is made in full, but its transfer into foreign currencies is discontinued; or a part only is transferred; or amounts due are reduced and that reduction is the price paid by foreign investors for the possibility of receiving abroad the payment of one part at least of what remains. Various “moratoria” are declared. The institution of “blocked accounts” is introduced; these are accounts owned by foreigners; by “blocking” them one prevents their owners not only from converting them into a foreign currency (this being subjected to restrictions in any case), but even from utilizing them freely for purchasing goods and paying debts within the country. This last point calls for some comment. Why should a foreign owner of a bank balance in a country having exchange control not be free to use his money as he wishes to, provided this money does not leave the country? Because he might use it to pay for foreign imports of that country’s merchandise or to pay foreign debts, either his own or somebody else’s. Thus a new source of “leakage” might develop, if the owner of the aforesaid balance utilized it on behalf of a foreign importer or debtor who reimbursed him abroad in a foreign currency, and the supply of foreign exchange might diminish in the country practising exchange control.34 A further “refinement” consists in allowing various “degrees of freedom” to “blocked accounts” of various origins, and in authorizing, in certain cases, the purchase of foreign exchange with the blocked money at specified rates, which corresponds to a larger or smaller depreciation of the national currency. Thus a system develops in which the national money supply gets divided into parts which are inconvertible one into another, and the utilization of which is variously restricted. Foreign-exchange rates are differently quoted for the various parts of the money supply, but since there is no possibility of arbitrage there can be no tendency towards equalizing these rates. The homogeneity of the national currency is destroyed. A given number of units of the national currency is worth a varying number of units of another currency according to the sort of account from which they come and according to what use can be made of them.

In the present context I want to emphasize not so much the administrative complexity of the system, its obvious interference with economic internationalism, and the more or less considerable degree of expropriation to which it gives rise,35 as the degree of government control that it involves. In the end, every single foreign transaction made by the nationals of the country, and every single transaction, whether foreign or domestic, made by a foreigner must be agreed to by the authorities. And, since the system can only be worked if no “leakages” are allowed to happen, the policing must be excellently organized and penalties must be severe enough to act as an efficient deterrent. One may find that capital punishment is a rather exaggerated penalty for an offence in the field of foreign exchange dealings; fierce though it is, it is quite in keeping with the internal logic of the system. It is difficult to escape the impression that exchange control, if allowed to develop indefinitely in the direction in which its “logic” carries it, must involve a transition from a liberal to an authoritarian form of political organization within the country which practises that system. Ultimately, exchange control leads to State Socialism. This is the reason why the introduction of such a system and the degree of its development depend upon the general political and social orientation of the country in question. In a liberally constituted country, exchange control will be introduced more hesitatingly and abandoned more readily than in a country with an authoritarian government. What must be, however, particularly emphasized is that while a liberal government may find itself induced to adopt exchange control under the stress of circumstances, particularly in response to “flights of capital”, it may keep that system by the effect of inertia and of pursuing the path of the least effort; and that the country may wake up one day to the realization that under the inexorable logic of the system of control adopted, its government has ceased to be liberal. It is therefore of vital importance to realize what one is doing in introducing exchange control—and to realize it soon enough, so that one either resists the temptation to introduce it, or abandons it before too much harm is done—unless, of course, State Socialism is what one desires and intends to have.36

The allotment of foreign exchange by the competent authority involves further interventions of the State into economic life and necessitates a more or less substantial degree of State planning of economic activity. As the League of Nations’ Report on Exchange Control37 points out, the intervention of the State with regard to allotting foreign exchange takes place at four different stages; decisions must be reached concerning:

(1) how much to allot for different purposes;

(2) how to distribute this amount among different countries;

(3) how much to allot, pro rata, for imports of each particular commodity;

(4) allotment among individual firms.

The last point is of interest only inasmuch as it gives ample opportunities for discrimination and abuse. The second point gives rise to discrimination in the field of international economic relations, further increased by systems of bilateral clearings and agreements of various kinds.38 Points one and three call for an economic plan; if the control of foreign exchanges is merely a temporary emergency measure there may be no need for a plan, and decisions would be reached partly empirically and partly arbitrarily. But if the system lasts, a plan of action must almost necessarily be worked out, and this may make exchange control a powerful weapon in the hands of a government bent on economic planning, particularly in the direction of autarchy. In any case, monetary autonomy can be much more “safely” pursued under the “shelter” of exchange control. In consequence, internal prices get out of touch with foreign prices, the international “price equilibrium” is utterly destroyed and the competitive power of national industries on foreign markets may be (and usually is) diminished to a point which calls for either subsidizing the export trade or losing foreign markets. Thus a system of exchange control tends to become associated with a more or less elaborate system of export subsidies.

Exchange control is usually adopted in response to instability resulting from major disturbances in international payments. The reader is referred in this connection to Chapter VIII, Section F, which supplements the present discussion. As may be inferred from the preceding analysis, nationalism, political and economic, is at the root of the major cumulative price-maladjustments and of the major “crises of confidence”, and out of these two there tends to develop instability which ultimately leads to the adoption of exchange control. We have seen what the “internal logic” of that system is and how it tends to become a lasting mode of economic organization even if adopted at first in response to an exceptionally difficult situation. Since that system tends to cause economic and monetary internationalism to disintegrate further, it is difficult to give it up once it has been adopted. Exchange control is, in the last analysis, an effect of nationalism; only a return to international co-operation can help to abandon it. The system will be more lasting and more completely developed if the government of the country which has adopted it wants to use it as an instrument for furthering State Socialism and (or) autarchy; it will remain less developed if the government wishes to re-establish eventually a free exchange market. In theory both things are possible; in actual practice the former is the more likely to happen. If it does, the chain becomes complete: nationalism, political and economic; disintegration of international economic relations and the growth of their instability (depreciation of the currency); adoption of exchange control and the development towards State Socialism.39

D. Exchange Funds40 and the Future of Monetary Internationalism

The establishment, in 1932, of the British Exchange Equalization Account41 followed in 1934 by the establishment of a Stabilization Fund in the United States and in 1936 of one in France, not to mention several others, has started a new type of monetary administration, which is the result of instabilities often referred to in the course of this chapter42 and may become an important instrument for rebuilding monetary internationalism. Exchange Equalization (or Stabilization) Funds are large governmental funds intended for systematic, planned intervention in foreign exchange markets. The purpose of their establishment was the desire to reduce exchange fluctuations in that period of great instability by discouraging speculation and by counteracting the various more or less fortuitous causes of exchange fluctuations, without however interfering with exchange movements brought about by divergent movements of national prices and other factors whose influence on the exchange situation has a more durable character. Used with these objectives in view, Exchange Funds are an instrument of stabilization in an unstable world; and while they may fall short of achieving a long-run de facto stability of exchanges, their operation can introduce into international relations an element of stability which otherwise would be missing. It must be observed, however, that since the objectives of governmental interventions may change and a Fund may be used in furtherance of other aims than the maintenance of stability, there exists in a “system” based on the operation of Exchange Funds an element of arbitrariness and uncertainty.

Exchange Equalization (or Stabilization) Funds and exchange control are the two principal modes of government interference in the operation of foreign-exchange markets.43 The contrast between the two is most illuminating. Exchange Funds use the market mechanism and intervene as buyers or sellers of more or less important quantities of gold or foreign exchange and thus influence prices, i.e. exchange rates. Exchange control, on the other hand, suppresses the market mechanism altogether and replaces it by a system of concentration of foreign exchange in the hands of a governmental agency and its allotment by the government. The various other restrictions and interferences discussed briefly in the preceding chapter result from that method of intervention. This opposition of methods is quite general in the field of economic policy.44 Now interferences based on the suppression of the price mechanism always lead to further direct interventions of the same arbitrary kind, and the free market economy tends to be replaced, in consequence, by the economic planning of State Socialism. The so-called “crisis of capitalism” is probably largely due to the fact that governmental and other interferences have made the functioning of the price mechanism more difficult and less reliable. It would take us too far away from the main line of our argument to discuss further this important matter; it seemed nevertheless worth while to draw the reader’s attention to the wider issue involved in contrasting such technical devices as exchange control and stabilization funds.

It is beyond the scope of this book to discuss in detail the technical operations of Exchange Funds and to give a historical account of their past functioning.45 The theory of these funds presents, on the other hand, very few problems that have not already been discussed in various parts of this book. Since Exchange Funds are rarely disposed to supply information about their activity and since, on the other hand, a certain part of that activity can be traced, the exchange-fund literature is to some extent an exercise in economic detection. This secrecy of Exchange Funds has been often criticized and there is little to be said in its favour. It was defended on the grounds that information about these operations would incite speculation, but this argument is hardly strong enough if one considers that one of the purposes of Exchange Funds is to fight speculation; moreover estimates made of their operations have been fairly accurate, which proves that secrecy, besides being of a very doubtful utility, cannot really be achieved.46 It must be added that the “veil of secrecy” is more recently being lifted, at least to a certain extent.

That question of secrecy, though much discussed, is, of course, merely a side issue. The two more important questions which we must elucidate are the following: (1) What are the relations of Exchange Equalization Funds to monetary internationalism and to monetary nationalism respectively? and (2) whether the functions of those funds could not be carried out by central banks?

As regards the first question, everything depends upon the policies adopted. Exchange Funds are nothing else than considerable intervention funds depending on the treasuries and usually administered by the central banks. They can carry out large-scale offsetting operations47 and in this respect they are simply large-scale open-market operations. It has been pointed out before that such operations can help or hinder the functioning of mechanisms of re-equilibrium; in the former case they are in accordance with monetary internationalism, in the latter case they are opposed to it. Now under stable conditions there is no justification for offsetting operations, unless one adopts the policy of national monetary autonomy; but when the world is passing through a period of instability, when adjustments are difficult to make on account of growing restrictions on trade and of a cessation of foreign long-term lending, and when disturbances are large because of great international movements of short-term balances caused by crises of confidence, a case can be made for taking certain exceptional measures. It is important that large inflows of short-term funds, even if followed by an inflow of gold, should, in such circumstances, exercise no influence upon the internal monetary situation of the country to which they come, the same being true for an outflow of such funds. Therefore a case can be made out for sterilizing inflowing short-term funds and the gold inflow which follows. While sterilization must be considered as harmful when monetary internationalism operates, one can make out a case for it in a system where international economic relations are disorganized and unstable. As regards, on the other hand, outflowing short-term funds, the situation is different according to whether it is a “flight of capital” or a repatriation of funds to the countries from which they formerly fled. In the latter case, the same reasoning applies as in the case of inflows of such funds from abroad. If the inflow has been “offset” the outflow can easily be “offset” too and the internal situation of the country of “refuge” will have remained unaffected by the whole process. Here appear some functions proper to be exercised by Exchange Funds. In the case of “flights of capital” the situation is different. What is then of primary importance is not the offsetting of adverse effects which the “flight” might have upon the economic life of the country from which it takes place (by means of open-market operations), and not the prevention of the “flight” (by means of exchange control), but doing away with the causes of the uncertainty to which the outward movement of short-term funds is due. So long as the causes remain in operation, offsetting operations can bring no lasting remedy—while in the meantime the carrying out of some adjustments, which might be both necessary and feasible, would become less urgent and therefore be neglected.

Thus the operations of Exchange Equalization Funds can prevent an inflow of short-term balances to a country and their later outflow from exercising any influence upon the internal monetary developments in that country; but they could not be very helpful (and would be rather harmful) in countries experiencing an outflow of short-term funds seeking safety abroad.

Furthermore, Exchange Funds, if they are sufficiently large, can discourage speculation from upsetting foreign-exchange markets; this is a very important function in times of instability.

That brings us to a point, which I think, is the essential one in the present context. In a situation where the various national currencies are not on a common standard, and where international conditions are unstable, the operation of Exchange Funds can diminish the size of exchange fluctuations and eliminate momentary and accidental fluctuations.

If the various currencies are not based on a common standard and if conditions are unstable, no lasting parities can be determined, and Exchange Funds can reduce fluctuations of exchanges but not eliminate them altogether. We have seen at length in the preceding chapters that exchange-rates cannot be stable nor can their movements be reduced to mere oscillations unless international payments are maintained in a condition of long-run equilibrium by appropriate “mechanisms”; wherever that is not possible, exchange instability inevitably develops. Exchange Funds can through their operations limit that instability, but they cannot do more than discourage speculation and eliminate haphazard fluctuations. An Exchange Stabilization Fund cannot replace a mechanism of re-equilibrium.

If, on the other hand, while there is no international standard, mechanisms of re-establishing equilibrium in international payments function smoothly, Exchange Equalization Funds can preserve the parities which have been agreed to. This brings us back to considerations which the reader will find in the last section of the preceding chapter, where monetary internationalism, under free paper currencies was analysed;48 under that system Exchange Funds, set up in the various countries, could act as technical instruments for maintaining parities.

We have thus far examined the rôle of Exchange Funds as instruments of international stabilization. They can, on the other hand, become very effective weapons of monetary nationalism in helping to insulate national price developments, and economic activity in general, from developments which are taking place abroad. Exchange Funds are an instrument which can be used in various ways—the result will depend on the use that is decided upon. The following observations by Mr. Norman Crump seem to me worth quoting, since they give a very able summary of the situation:

“. . . the whole object of the Exchange Account is to insulate our internal credit system from the effects of pressure in favour of or against sterling, whenever such insulation is desirable. . . . Admittedly a monetary system of this kind calls for very careful management, for at times it may be right to allow exchange movements to affect the internal credit base. Our prices may be out of line with those of other countries, or our home activities may need either a stimulus or a curb; and in those circumstances insulation would be definitely harmful. Still, we have a complete system of insulation against the shocks due to fortuitous movements of foreign funds and we have learned how to use it.”49

Let us now, in conclusion, briefly consider the question whether specially constituted Exchange Equalization Accounts are needed for the purpose of achieving the results described and discussed above. Opinions on this subject vary considerably. The view is very widespread, particularly in England, that with the introduction of the Exchange Equalization Account, a new “elastic form of the gold standard”50 has been established, “a new, delicate and complicated piece of financial machinery, originally intended as a stop-gap, but which may become a permanent part of the mechanism of our own and other countries.”51 But other economists are doubtful as to the novelty of the system and claim that a central bank could do anything that the Exchange Funds are doing, provided it were empowered to do so. The relative merits of fixed and of fluctuating exchanges have already been discussed; one might just add to this, in the present context, that their “elasticity” can be administered equally well by a central bank as by a special monetary fund. It is, therefore, very doubtful if one should give to the latter the credit for the possibility of operating a system of flexible exchange. What constitutes a more plausible argument in favour of setting up a separate Exchange Fund in a country in which the central bank is a private institution, is the desire of entrusting the function in question to a public authority rather than to a private organization. This point of view may be accepted or not, but at least it constitutes an argument in favour of a separation of functions. I wish to quote, in concluding the discussion of this question, the following observations by Professor Gregory, with which I find myself in entire agreement:52

“. . . it is undesirable to create organizations which are capable of acting at cross-purposes with the Central Bank. So long as the Central Bank in fact acts for the Fund, it might just as well act in its own name: in the case of differences of opinion between a government and the Central Bank, the existence of an institution, which might, e.g. by the sale of Treasury Bills, contract supplies of open-market funds or e.g. by the repayment of such Bills, expand them, in opposition to the views of the Central Bank, would simply help to bring about a state of anarchy in the money market. Orderly money market conditions require the existence of a single and unique centre of authority, and this should be the Central Bank. If public opinion requires that this institution should be under public control and direction, let this be done by an unequivocal and unambiguous act of state. Nothing is to be gained by the division of functions between two authorities when what is really intended is the ‘insulation’ of the local money markets from (short-term) outside influences through the creation of larger reserves than those previously maintained.”

The amalgamation of Exchange Funds with central banks in the sense indicated in the last sentence of the foregoing quotation would help the realization of the demand for larger central bank reserves which was implied by our discussion of the gold standard. This brings us to the last question to be examined here, that of reconstructing monetary internationalism. International monetary co-operation can start again on the basis of Exchange Equalization Funds without waiting for a previous stabilization of currencies; this has been demonstrated by the development of monetary relations after the conclusion of the “Tripartite Agreement” (soon extended to three more countries).53 As long as the deeper causes of instability remain it is difficult to hope for more than a further consideration of that type of co-operation and its extension to certain other countries. Should countries composing the “sterling-bloc” either explicitly adopt the sterling standard, or join the “Tripartite Agreement”, an important further step towards monetary internationalism would be taken. The next stage of reconstruction goes beyond purely monetary considerations. It covers commercial and financial relations. The “Tripartite Agreement” should in time be extended so as to cover these matters too. Monetary internationalism cannot survive for any length of time unless it is based on economic internationalism.54 A final point bears on the autonomous monetary policies and the strife for autarchy. The latter is justified by political, not by economic motives. If governments decide to adopt such a course of policy, even at an economic loss, there is no economic argument that could dissuade them from it. Monetary and economic internationalism are likely to be confined for some time to come to relations within a more or less limited group of countries, considering that there are countries which will not easily abandon the path of nationalism. This cannot be helped and it does not prevent the reconstruction of monetary internationalism within the group of countries which wish to have it.55

The adoption of “autonomous” monetary policies is due to two main reasons:

(a) The lack of correspondence between the phases of the trade cycle in which various countries find themselves at a certain time; the result is that countries in depression tend to insulate themselves whenever they wish to carry out more safely a policy of reflation, while countries going through a phase of prosperity or at least of good business conditions do the same in order to maintain that prosperity. “Cheap money” policies are adopted on a national scale, and promote monetary nationalism, in spite of the fact that, as has been pointed out before, they could achieve the same ends in agreement with one another and at the same time consolidate international stability. It will, of course, be observed that it is precisely that orientation which—by destroying what (for the lack of a better word) has been called the international price-equilibrium—makes these discrepancies between the cyclical movements in various countries possible. Thus a vicious circle tends to develop which can best be broken through the abandonment of “autonomous” policies and the re-establishment of international co-operation.

(b) Divergencies of doctrines relating to the nature of policies to be adopted at the various phases of the trade cycle. Inasmuch as the policies of the various countries are not inspired by the same doctrine, major differences of policy may develop.56 Thus it becomes a matter of the utmost importance that a more general agreement should be reached among economists on theories underlying the various nationally-adopted monetary and economic policies. The realization of better international economic relations depends (at least to a certain extent) upon the further progress of economic science and upon a wider acceptance of its findings. It is most important that there should be more and more co-operation between economists of various countries as regards both research and discussion.

The outlook for monetary internationalism will ultimately depend upon the wish to co-operate, and the spirit of international solidarity, on the one hand, and upon a further progress of knowledge, on the other.

Let us envisage in conclusion the technical features with which a reconstructed system of monetary internationalism could most usefully be endowed. For reasons stated before, my personal preference is for fixed exchanges. It is true that, in pure theory, exchange fluctuations of a limited size and linked with long-run stability of the foreign exchanges are reconcilable with monetary internationalism. But it seems to me that the abstract model is not susceptible of being carried out in practice in a world in which exchange fluctuations are likely to incite international movements of short-term funds of a disturbing character (movements caused by the fear of currency depreciation or by the hope of speculative gains). Furthermore a system of flexible exchanges demands, on the whole, more international co-operation than a system of fixed parities. Finally, it results, I think, from the foregoing analysis that—with the exception of major disturbances and in the absence of “autonomous” national policies—internal economic stability can be quite well maintained under a system of fixed parities. To this I should like to make two reservations: (1) a return to fixed parities cannot be safely effected at present; (2) fixed parities may occasionally, in the case of major accidental difficulties, have to be replaced by more flexible exchanges. In these cases Exchange Funds (or, if the amalgamation has been carried out, central banks) would come prominently into action in order to secure a maximum of stability and the greatest possible smoothness of adjustment to changed circumstances.

It is most important that the return to fixed parities and to an international standard should not be attempted before enough economic and financial co-operation has been achieved between countries. The failure of the reconstruction of the ’twenties should demonstrate that “monetary reconstruction” is not merely a matter of monetary technique.

As regards, finally, the acceptance of a common standard, its main significance lies in that it allows a clear definition of parities and in that we have much experience in achieving on its basis a long-run equilibrium in international payments. Gold is most likely to be again chosen as international standard, but I should advocate the adoption of the gold-clearing method of administering the gold standard. Reasons for it have been indicated above.57 The Bank for International Settlements should be closely associated, from the very outset, with the new monetary reconstruction. Considering that this institution is admirably equipped for that function, it should administer the proposed international gold clearing. Since gold comes into the system only as an expedient of great practical usefulness, no exaggerated importance must be attached to the fact that it is gold and not some other asset that constitutes the monetary standard. The fixing of its price should be done by international agreement in such a way as to secure large monetary reserves and thus make the system as resistant as possible to accidental shocks and disturbances. The success of the new monetary internationalism will ultimately depend upon a firm determination to work the system according to its rules and upon the friendly co-operation of the various countries in the pursuit of a common goal.

• 1There is much difference between the views that are widely held in this matter in Great Britain and the United States, and views that are commonly accepted on the Continent. This explains the emphasis laid on that issue. Vide infra, pp. 68 and 69.
• 2The reader may find it useful in this context to contrast the United States’ unified monetary system, now embodying a Federal Reserve System, with what would have existed had each of the 48 States of the Union sovereign powers over its particular monetary system.
• 3The word “international” is used, of course, with utter disregard of its etymological significance; but this usage is universally recognized.
• 4F. A. von Hayek, Monetary Nationalism and International Stability, London, 1937.
• 5loc. cit., p. 4.
• 6Except when a World State exists.
• 7i.e., “real” factors of production (goods), monetary factors (capital) and, thirdly, labour.
• 8“In the last analysis . . . it is the political factor which gives rise to the economic problem of international monetary transfer. If historical accident had not created independent sovereign states . . . no such ‘problem’ would have arisen”. Lionel Robbins, Economic Planning and International Order, London, 1937, pp. 279–80.
• 9To change the weight of a coin (“debasement”) is analogous to the modern forms of devaluation. While, as we shall see presently, the expression “changes in the gold contents of a currency unit” is open to criticism, it shows at least clearly the analogy in question. But what Sovereign Prince of the days gone by would have accepted an international undertaking never to debase the currency? And even if he did accept it, this would be an analogous matter to the type of international monetary convention mentioned in an earlier part of this chapter. The Latin Union was to some extent an example of a limited convention of this kind. But it all goes to show that not even a general limitation of monetary circulation to precious metals would automatically insure a system which would work internationally in the same manner as a monetary system works within a country in regulating the supply of money in the different regions.
• 10loc. cit., pp. 270–80.
• 11Cf. my “Monetary Internationalism and its Crisis”, a chapter in The World Crisis, London, 1938, pp. 348 et seq.
• 12I expect to discuss it at considerable length in my book on the Theory of Banking which is in the course of preparation.
• 13For example England, the United States, etc. Vide infra, chap. ix.
• 14Statements to the contrary which can be found in economic literature rest obviously on a misunderstanding. Thus, for example, Professor Cassel writes (The Theory of Social Economy, New Edition, 1932, vol. ii, p. 458): “On a gold standard there is no sharp division between the quantity of money and the stock of gold.” If Professor Cassel means “an all-gold currency” then this statement is correct; but it is much more likely that the gold standard is really meant: and then this statement is essentially wrong. What is worse is that most of Cassel’s theory on the relations between gold and prices and on the role of gold in the monetary system rests on that assumption expressed in the sentence quoted. One cannot emphasize too often the fact that a gold-standard currency is a paper currency attached to gold (and sometimes convertible into gold); it is not a gold currency. Vide infra, chaps. iii and iv.
• 15It is important to note that the so-called “going-off the gold standard” is not tantamount to the suppression of gold as monetary metal. In the latter case we should have to speak of “demonetization of gold”. Vide infra, p. 177.
• 16Relations between gold and prices are particularly undetermined when the system existing is a de facto system consisting in Central Banks (or Treasuries) buying gold at prices fixed by them, while the regular gold standard is suspended. The price of gold is then subject to variations, but at the price prevailing at every particular moment, monetary authorities are buyers of gold, which as we shall see is one of the features of the gold standard. On the other hand, when the gold standard is suspended there are no longer any provisions about the gold cover of notes, and the value of gold stocks may become indeterminate. All this makes relations between gold stocks and prices very vague indeed, without making them non-existent.
• 17Cf. with the Macmillan Report (Committee on Finance and Industry Report), London, 1931, H.M.S.O., Cmd. 3897, para. 45.
• 18Thus, for example, The Economist wrote the following in its Editorial of 15 May 1937 (p. 404): “The world, in fact, has learned a new lesson. The value of a country’s gold stock does not merely depend upon the physical quantity of gold lying in the vaults of the Central Bank or the Treasury. It depends also upon the price of each ounce of gold expressed in the national currency.” (The italics are mine. I fear that for many it has really been a “new lesson”!)
• 19vide Appendix.
• 20I find myself in substantial agreement with conclusions reached by A. D. Gayer in his book on Monetary Policy and Economic Stabilization, p. 63, though his criticisms are considerably less severe than the ones I have developed in this chapter. Charles O. Hardy says, similarly, in the book Is There Enough Gold?: “Other factors, such as the use of bank deposits as money, and changes in the absorption of gold by India, are brought into Cassel’s analysis to account for the major deviations of the price trend from the ‘relative supply of gold’, (p. 22.) If, as Cassel believes, the increase in the amount of gold stock required to maintain prices during the 60 years before the war corresponded accurately or even approximately to the growth of production, it was because for the period as a whole these other important factors cancelled each other out.” (p. 24.) As a matter of fact these factors did not cancel each other out as there were considerable price movements in the course of these 60 years. Cancellation can only have existed in so far as prices were more stable than they would otherwise have been.
• 21In his study On Quantitative Thinking in Economics, Oxford, 1935, p. 107, Cassel says in this connection the following: “During the period within these limits Great Britain was on the gold standard and, in addition, was essentially a free-trade country. British prices, therefore, may be taken fairly well to represent gold standard prices in the world market, and British index-numbers to reflect the variations of the general price level in terms of gold.” Still it does not follow that prices in Great Britain depend upon the size of world stocks of gold! In the same context Cassel says, rightly, that “the analysis must be confined to a period in which the general system of money has been essentially unaltered”. But in the period 1850–1910 this has not been true even for Great Britain, where the great development of banking took place precisely in the second half of the nineteenth century; the fact of staying on the gold standard does not exclude the possibility of great changes taking place in the internal organization of the monetary system. If the statement that in that period of sixty years “the general system of money has been essentially unaltered” is not true for Great Britain it is much less true for the world at large; thus the condition which Professor Cassel recognizes himself as a necessary prerequisite of his analysis has not been fulfilled in the period to which he applies that analysis.
• 22This, not the “price level”, is the subject that deserves our interest, though it is clear that, thus formulated, the changes cannot be expressed by a single numerical time-series. How to represent them adequately is a problem for statisticians to solve!
• 23A change of the price of gold may, of course, affect quantities produced, besides affecting their value and the value of existing stocks.
• 24Gustav Cassel, The Downfall of the Gold Standard, Oxford, 1936, p. 7.
• 25Neither has Cassel done anything to demonstrate this sweeping statement.
• 26Ibid., pp. 3–4.
• 27Which is merely a statistical construction to be accepted for what it is worth. Vide Appendix.
• 28This is, for example, the position taken by Professor Rist. Vide infra.
• 29And, of course, the policy of commercial banks, which is more or less closely connected with that of the central bank.
• 30In The Theory of Social Economy (1932 edition, vol. ii, p. 494), he says that “there is no obvious reason why an increase of the gold supplies should cause a permanent alteration in the average proportion between means of payment and bank reserves. . . . We shall therefore find it quite natural that the gold supply completely controls the secular variations of the curve of the general price level.” Now the fact is that this proportion did change, and did change very considerably if we include, in the total of existing means of payment, demand deposits transferable by cheque.
• 31The Theory of Social Economy, 1932 edition, vol. ii, p. 495.
• 32In Cassel’s opinion “it is sufficient for upholding the quantity theory, to assume that the total demand for gold is proportional to the general price level” (The Theory of Social Economy, 1932, vol. ii, p. 459); this view is shared by some economists but I think that it is inaccurate and may lead to regrettable misunderstandings. There is no mention of gold as such in the “quantity theory”; it relates the total volume of monetary circulation to the “general price level”, not the “demand for gold”. Gold can be brought into the picture only indirectly, because of institutional arrangements, and never enters into the “quantity theory” as one of the variables.
• 33The Theory of Social Economy, vol. ii, p. 496.
• 34Ibid., pp. 496–7.
• 35Vide supra, chap. ii.
• 36The Theory of Social Economy, vol. ii, p. 497.
• 37See Wicksell’s Interest and Prices (first published in German in 1898; English translation published in 1936).
• 38Vide infra, chap. vii.
• 39See the following publications by Professor Rist:
• 40Rist 1938, pp. 309–10.
• 41Ibid., p. 308.
• 42A limitation which is hardly valid for England and the United States.
• 43Rist 1938, p. 338 (italics are mine).
• 44Vide supra, p. 30.
• 45See, particularly, Rist 1935.
• 46Rist 1935, p. 235.
• 47Ibid.
• 48Rist 1935, p. 236.
• 49Ibid.
• 50Ibid., p. 237.
• 51Rist 1935, p. 237 (the italics are in the text).
• 52I do not repeat again all the objections to price averages and index-numbers of the “general price level”. Vide Appendix for detailed comments on that matter.
• 53For the distinction between gold prices and prices that exist under the gold standard, vide supra, chap. ii.
• 54I must leave aside the question of whether such “eliminations” are at all significant. The critical and sceptical observations which the reader will find in the Appendix apply to this problem as well. I cannot discuss further here the question whether the application of a “linear trend” is at all justified.
• 55“. . . des adversaires de la théorie quantitative qui sont en réalité les adversaires de toute théorie accordant à l’accroissement des métaux précieux une action sur les prix”, Rist 1935, p. 233.
• 56Vide supra, p. 44.
• 57Rist 1935, pp. 237 and 238.