BULLETIN of the OXFORDUNIVERSITY INSTITUTE ofECONOMICS and STATISTICS

OLD FALLACIES AND NEW REMEDIES: THE SDRs INPERSPECTIVE

By THOMAS BALOGH

I

Introductory

The history of International Monetary Reform since the end of the war j aschequered one. It is a case of too little, a little late. No doubt two or threeimportant advances were made and the return to the misery of the inter-warperiod was avoided. Employment was maintained and material progress wasachieved on an unprecedented scale both in the highly developed and in thepoorer countries. Moreover, technical and resource aid to poorer nations wasmade available by the richer countries on a scale never before equalled in peace-time.

But for these successes the war-time reform of the International MonetarySystem at Bretton Woods can hardly claim much credit. The monetary arrange-ments elaborated during the war broke down in 1947. If the Marshall Plan hadnot acted as a parachute, a severe crisis, indeed a breakdown of the Westerneconomic system could not have been avoided. When American aid flagged, USmilitary expenditure and private investment abroad rose to altogether unex-pected heights. It was not so much deliberate contrivance as the fundamentallynew factors of high external expenditure and payments of the US, and politicalpressure sustaining wage incomes in most fully developed areas which created thecompletely different economic ambience and prospect. But expansion is nowslowing down, and there were at least two occasions in 1968 when an acutemonetary crisis much like that of 1931-33 was only just avoided. The need forfurther monetary reform has at last been accepted. But the action that hasfollowed the autumn of 1968 still seems in the pattern of too little, a little late.

In the present paper I shall first enquire into the causes of the increasinginternational economic imbalance. Secondly, I shall try to demonstrate thatmonetary contrivance alone will not bring about its reversal. Finally, I shallpoint to changes in economic policy and international institutional arrangementsA 81

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which seem needed if the steadiness of expansion with all its inestimable socio-political advantage is to be preserved. We have to plan not for a system ofestablished equilibrium from which small deviations can be smoothly and quicklycorrected by slight movements of the price mechanism, but for a system, the verynature and dynamics of which make for large and continuously recurring imbalances.

The basic reason for these imbalances has been the consistent underestim-ation of the economic significance of differences in the history, institutions,policies, economic strength and dynamism among the major countries; eachdifference aggravating the others. Immediately after the war the relation of thewar-weary or war devastated countries and the US produced the major inter-national imbalance.1 In the late 1950's Germany superseded the US as the mainpacemaker in the oligopolistic struggle for reserves. The novel feature of theproblem after 1960 became the combination of an acceleration of the rise inprices with a slowing down of the rhythm of expansion. This can be explained bythe difference in the socio-political impact of the continuous inflationary pressurein various countries; a difference which still remains largely neglected.2 In somecountries, especially Germany, wage-pressure was mitigated by the fear of theTrade Unions of the odium of responsibility for inflation and monetary break-down. In others, on the contrary, the rise in prices exacerbated the rise in wagesand costs.3 This ruptured the harmony of readjustment postulated by conven-tional theory and, worse still, rendered adjustments difficult4 and lengthy.

Marked differences between the institutional and historically determinedbehavioural patterns of leading countries tend not only to increase imbalances oncurrent account but also to make them more persistent than they would be in amore homogeneous world. This is so irrespective of the policy-ends pursued bymember countries, i.e. whether priority is given to stability of prices, to thebalancing of international payments or to full employment. 'Freedom' for themovement of capital (especially the movement of 'hot' funds) also tends toexacerbate the imbalances because of exaggerated anticipations.5 Inasmuch asthe policies adopted or enforced by the imbalances react on prices (and wages),the imbalances will riot necessarily be corrected. They might become aggravated.This in turn might induce a further cumulation of anticipatory sales or purchasesand still further worsen the problems of weaker, more socially conscious or moresluggish areas.

1 See Unequal Partners, Oxford 1960, especially Vol. 1, Theoretical Introduction.Neo-classical liberal authors seem insistent on analysing contemporary problems in a

static framework of a peculiarly unrealistic kind. By assuming constant or decreasing returnsto the scale of production and the possibility of automatic adjustment of imbalances in inter-national payments through the price mechanism, they rule out, rather than provide a frame-work for, the analysis of contemporary economic problems.

In France this happened through periodic explosions, in Britain through a relentless leap-frogging of wages far in advance of increases in productivity.

Especially striking is the divergent reaction of the 'Anglo-Saxon' and the 'Continental'(and Japanese) economies to fiscal or monetary pressure.

Some authorities attribute the difficulties of certain countries to the low level of the ratioof their reserves to imports. The British balance of trade has been less subject to fluctuationthan the capital balance (especially short term). The encouragement by the Authorities ofwhat are called 'Complementary Money Markets' has been as foolish from a long-run viewpointas the tolerance of capital exports at a time when resources were not available. The incompre-hension of bankers of the mechanism of payments and the real reason for the need of reservesis rather ominous

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II

Bretton Woods and After

During the war a number of economists perceived the need for a decisivefurther development of the idea of a closer monetary collaboration initiated on aconservative-liberal basis by the Central Bankers through the formation of theBIS just before the outbreak of the crisis of 1931. That institution, found com-pletely wanting during the crisis, was later condemned for alleged collaborationwith the Nazis. In any case war-time experience pointed towards the need forgovernments, rather than central bankers, to control any international institutionfashioned to help in maintaining external balance, because external balance wasseen as a means of attaining full employment and expansion while safeguardinginternal stability. The experience of the ragged boom of the 1920s and thecatastrophe of the 1930s was still vividly in mind The preambles of all inter-national economic agreements paid obeisance to the need to avoid a repetition-even on a minor scale.

The British and Americans at Bretton Woods, probably for the last time,collaborated on an equal footing. The pattern of the negotiations was very muchas it has remained ever since, though with suitable changes in the protagonists.The potential creditor countries (then under the leadership of the US andfollowed closely, if quixotically, by the UK) took a rather laissez-faire1 restric-tionist viewpoint, fearful lest an inflationary wave should be imported into theireconomy or that their export surplus would disappear through the creation ofdirect controls without causing economic sacrifice and loss to the deficit countriesthrough an enforced deflation and unemployment ('discipline'). Both devalua-tion and direct controls were to be made difficult, if not impossible, without USconsent. The debtor countries in their turn foresaw that in a slump the whole ofthe burden of readjustment would have to be shouldered by them. They weretherefore anxious to provide means by which recalcitrance on the part of persis-tent creditors could be overcome by international action. They had no luck.What emerged therefore was a compromise favouring the potential creditorUSstandpoint. Instead of the Clearing Union there appeared the InternationalFund.

My opposition to the pre-Bretton Woods Proposals as they emerged from theAnglo-American negotiations and to the Final Act was based on my belief thatthey tried to enforce rules based on the jejune (if not more sinister2) notion thatthe actual war-torn world economy could be regulated on the basis of principlesderived from a perfectly competitive theoretical model with constant or decreas-ing returns to the scale of production. In other words it was assumed thatharmony of interest exists in the world economy, and that 'world income' (what-ever that may mean) could be in some sense 'optimised' by making trade andpayments and the convertibility of currencies as free as possible, irrespective ofthe policy the creditor countries would be pursuing.

1 More accurately a stand against direct, and in favour of global (monetary and fiscal),controls.

2 The role of Mr. H. D. White will never be wholly satisfactorily explained (see UnequalPartners, Vol. II, especially, p. 7).

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I always thought this a hopelessly wrong view. The true character of theworld economy, especially because of the deep fissures inflicted and rigiditiesproduced by the war and the self-sufficient nature of the dominant Americaneconomy and its technical superiority, was far from this picture of perfection.The size of the imbalances in international payments, unless heavy unemploy-ment were tolerated, was likely to be so large as to render derisory the con-templated provision of additional international liquidity through the Fund.Keynes sensed the gravity of the problem when he first took over the idea of aClearing Union early in the war, perhaps 1942 or 1943.' To avert the risk of ashortage of liquidity, he therefore originally provided for a very large Fund,growing automatically with world trade. His opponents argued that an auto-matic release of so large an amount of additional liquidity might cause too rapidan expansion of demand in a hungry world starved of commodities. Thisargument prevailed in the US; and the American negotiators forced Keynesto concede increasingly stringent limitations and conditions on the availabilityof additional reserves. At the end he defended his concessions to the US view byarguing that adequate safeguards to prevent the emergence of large imbalanceshad been built into the system. They comprised:

(j) the imposition of quotas on imports by countries in balance of paymentsdifficulties in accordance with the rules laid down in the plans for theInternational Trade Organisation (later GATT);the mandatory control over exports of capital by countries making useof their quotas to purchase foreign currencies;2 and, last but mostimportant,the scarce currency clause3 which was to permit debtor countries to rationpayments for the exports of a country in persistent surplus and thus bydirect action to restore the basic current balance of payments.

Unfortunately for the supporters of Bretton Woods, these ingenious con-trivances, which were designed to reduce the size of probable imbalances andquicken their readjustment, turned out to be useless, as some of us predicted atthe time.4

The most recent Letter of Intent signed by Mr. Jenkins,5 which forswears (j)and (ii), shows that the Fund, the Bank of England and possibly the Treasuryregard these clauses as obsolete. In an answer to a parliamentary question theGovernment spokesman stated6 that the prohibition of the use of funds borrowedfrom the TMF to sustain a persistent capital export (Art. VI Sec. I (a)) had onJuly 28th, 1961, been relaxed by the Executive Board of the IMF. This robs the

Cf. Unequal Partners, Vol. II.2 The disguise of borrowing as 'purchases' of foreign currencies should have guaranteed the

unconditional use of the Fund up to the limit of the full quota. In actual fact this uncon-ditionality was whittled down and confined to the first (gold) tranche.

For a discussion of this tragi-comic episode, see my Unequal Partners, Vol. II, HistoricalReflections, Sec. 3, pp. 8-10, and an essay dating from 1944 republished in that volume onpp. 96-8.

See a letter to the Times, January 1946, from Sir Hubert Henderson, reprinted in TheInter-War Years, p. 377.

Countries less important than the UK have had to sign much more far-reaching pledges,all in strict contradiction of the letter and the spirit of the Bretton Woods Agreement.

6 Lords Hansard, vol. 304, col. 117/9, July 25, 1969.

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Fund of one of the most important safeguards and one on which Keynes laidspecial stress.1

The scarce currency clause, on paper the most forceful instrument, has neverbeen invoked. In the decisive early post-war years, as I foresaw, it could not beused against the US because, though individual countries were short of dollars,the Fund itself was not.2 In the 1960s, when the Fund itself was short of Deutsch-marks so that the clause could have been invoked, the Americans--still thinkingas a creditor countryprevented this happening.

The Marshall Plan and related schemes put at the disposal of the less privi-leged world a multiple of the original Bretton Woods allotments. Without thosefunds a severe crisis would not have been avoided. The IMF was completelybypassed: mainly on US insistence. Since then a repeated enlargement of thequotas of the IMF has taken place, by 50 per cent in 1958 and by another 25per cent in 1965. Nevertheless the relief afforded has been insufficient, partlybecause the use of these schemes is hindered by restrictions and conditions.International liquidity in the first decade or so has increased only because of acontinued creation of liquidity through an overall 'deficit' in the Americanbalance of payments.4 Yet it was already clear in 196O that this deficit couldonly lead to undermining of the credibility of reserve currencies.6

This duly happened. Since 1960 the Fund's holdings of both Sterling andDollar have been liquidated. This liquidation resulted in a precipitate decline inUS gold holdings. The drain would have been faster and larger (especially inthe case of Sterling) had Central Banks7 not intervened. At the instance oftheir governments they agreed through the 'General Arrangements to Borrowto put at the disposal of the IMF currencies required to combat speculation.These were followed by swap facilities and by the first of the Basel arrangementsall under the aegis of Central Banks, which regained much of the loss ofstanding and influence during and immediately after the war. Finally came thesecond Basel arrangementthe so-called recyclingby which a country underspeculative attack could (semi-) automatically reborrow the funds it lost.Unfortunately the Central Banks at the same time encouraged the rise of theEuro-currency markets which made it difficult if not impossible to identify theextent and originsand therefore the actual movementof speculative funds.8

1 Lords Hansard, vol. 131, col. 844, 23 May 1944.2 The US quota in the Fund was very large, those of all other countries rather small. Thus,

even if the other countries had drawn large shares of their quotas in dollars it would have takena few years for the Fund's store of dollars to be exhausted. But the US in any case was entitledto veto dollar drawings by other countries of more than 25 per cent of their quotas in any oneyear.

3 In addition special adjustments were made to bring certain countries like Germany andJapan up to their required importance. A further review is now in progress.

' Gold holdings are (1968 4th quarter) practically at their 1961 level. Foreign exchangeholdings increased in the same period by 50 per cent from $19.3 billion to $31 billion.

See my paper 'International reserves and liquidity', Economic Journal, 1960, p. 368.6 In the case of Britain only 30 per cent of the overall deficit and the liquidation of sterling

balances could be financed by using IMF quotas. Much the mostover 50 per centwas drawnfrom other Central Banks. Cf. Financial Statement and Budget Report, 1969-70, Table 36, p. 15.

Of Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzer-land, the US and the UK.

8 The leads and lags of the 'normal' balance of payments and the 'speculative' losses areci iffi cult if not impossible to differentiate.

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In the end the US was constrained to enforce the dissolution of the so-calledgold pool and to restrain gold losses into private hoards by suspending sales toprivate buyers of gold at the official price. They were successful in preventingother Central Banks from selling in the 'free' market despite an initially highpremium of 25 per cent.

III

The SDR Compromise

This double crisis of gold and of the reserve currencies has convinced nearlyall economists of the need for a further international monetary reform. Adecreasing number would 'float the dollar', i.e. increase the price of gold. Anincreasing number have opted for an 'artificial' increase of international liquidity.This would inaugurate a newera of conscious regulation of international monetaryaffairs akin to the transformation of the domestic monetary scene through theacceptance by Central Banks of the function of lender of last resort, i.e. the dutyto provide liquidity against good assets.

What is equally clear is that the diagnoses of our troubles differ widely.While those who would increaseperhaps double or even treblethe price ofgold have been defeated, the scheme which has emerged from the prolongeddiscussions is a compromise which is only too patently labelled as such. Thequestion is whether it will prove yet another insufficient effort which has to berescued by emergency operations (which are no doubt better than passivity),still further shifting the power of decision towards the Central Bankers, i.e. thefinancial community, which has so often signally failed in maintaining stabilityand expansion. A restatement of the problem is therefore urgently required.

The activation of a Special Drawing Rights scheme is an important first stepto a sane solution of the liquidity problem, but no more. The SDRs are backedby the credit of all participating countries in that they undertake to providedomestic currency in exchange. They are therefore not subject to the fatalweakness of an 'unfavourable'1 overall balance of international payments of acountry with a reserve currency. Moreover, unlike ordinary IMF quotas, theymay he counted in Central Bank reserves. Thus a distribution of newly 'created'SDRs will constitute a net 'gain' in reserves. This will obviate the need forcreditors to accept a balance of payments deficit in order to overcome the per-sistent debtors' difficulty in securing a 'surplus'. At the same time the volume ofthe accretion to international reserves is determined by common consent andnot by the fiat of the reserve currency country.

In addition a number of variants can and have been devised to favour poorercountries by allocating special quotas to them, to be used for development.2

1 In the case of the US paradoxically this 'unfavourable' balance has been parallelled by theacquisition of assets of rapidly increasing value and income.

2 See, e.g., UNCTAD, International Monetary Issues and the Developing Countries, Reportof the Group of Experts (UN. 66.II.D2); also UNCTAD, International Monetary Reform andCo-operation for Development, Report of the Expert Group on International Monetary Issues,TD/B/285. The device could even be used as a counter-cyclical instrument in addition tosecuring a steady increase in aidthe transfer (as against the resource) problem having beensolved.

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The SDRs thus can be regarded as 'owned' reserves rather than as specialcredits, and their 'reconstitution' (i.e. repayment) insisted on by France and someother Continental countries, does not in principle detract from this fact. Withoutan increase of 'owned' reserves the basis for a steady expansion would be lacking.1The amount to be credited initially is $9,500 billion over three years, or some7 per cent of the liquid reserves in the West. So far so good.

Where the SDR scheme shows defects is in its rigidity, the obligation torepay (reconstitution) which reduces it to a 'borrowed' reserve up to 30 per centof the original allocation, the slowness of the mechanism of enlarging the amountsavailable and the lack of discretionary powers for exceptional creation ofadditional (large) sums to stifle crises of confidence. We still lack an internationallender of last resort. Thus on the international plane we are still exposed to therisk of liquidity crises such as those which struck Britain up to the middle of thelast century and persisted in the US until the creation of the Federal ReserveSystem in 1913-44. Progress is very slow.

IvThe Present Malaise

The basic imbalance between leading industrialised countries is the conse-quence partly of divergences in the behaviour of costs and partly of capitalmovements which are not justified by resource availability or are speculative incharacter.2 This itself is partly a reflection of the different attitudes and organisa-tion of their Trade Unions, their different historical backgrounds, and theirdifferent growth rates.

German Trade Unions, for example, are more sensitive than those in the USor the UK to charges of causing a rise in prices. The memory of the monetarycollapse of 1923 and 1945-8 is still vivid and a potent political force. Thereluctance of the creditor countries to shoulder some of the readjustment byexpanding domestic demand is partly motivated by their righteous indignation

1 Even the extremist monetary school concedes that a steady expansion of 'money', i.e. onthe international plane, of universally acceptable reserves, is needed.

2 The treatment of this phenomenon in terms of global income and price elasticities (such aswas attempted by, e.g. Professor H. S. Houthakker and S. P. Magee, 'Income and price elasti-cities in world trade" Review of Economics and Statistics, May 1969, pp. 111-125) completelyignores the intimate connection between exports and imports as well as income and incomedistribution. As an 'explanation' the results are trivial. What can be said is that if past trendsin productivity and wages continue, then the past performance might be significant for thefuture. They remark (pp. 114-5): 'The most striking of these is Japan, where the exportelasticity is estimated to be nearly three times the import elasticity. This means that even ifJapan's income grows three times as fast as the income of the rest of the world (relative pricesand exchange rates remaining constant) Japan's imports will still not get out of line with itsexports. In fact Japan has enjoyed an exceptional rate of growth (though perhaps not threetimes as fast as the rest of the world), and in addition it has had considerable inflation, yet ithas not had any chronic balance of payments problems.' To say this is to forget that it was theincursion of Japan into shipbuilding, motor cars and vans and into the optical and electronicfield which secured the maintenance of her domestic expansion. The export-led boom mightwell continue but as a predictive certainly it depends on a host of factors which the two authorsdo not consider. Like much of the neo-classical 'dynamics' these relationships are regarded asconstants when they are really the result of special circumstances. To describe them as 'elas-ticity' merely gives a 'scientific' name to tautology. Cf. T. Balogh and P. P. Streeten, 'What isElasticity?' reprinted in Unequal Partners. p. 177. Inasmuch as the mathematical treatmentexcludes a time element the calculations are even on this faulty basic methodology subject to gravedoubt.

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at being forced to accept 'imported inflation' from countries where cost 'creep'is faster than their own, indeed so fast as to be political unacceptable to thecreditors. This poses grave problems for the mechanism of readjustment if thedifferences in the rate of inflation are considerable.

Now it is true that a revaluation would help to keep inflation in check andrestore international balance; and, for reasons which will presently becomeclear, it is likely to avoid these grave drawbacks which render devaluation sorisky. This difference is due to the asymmetrical behaviour of wages. A devalu-ation might lead to anticipatory increases in prices and wages, thus justifyingfurther attacks on the currency and renewed depreciation. An up-valuation onthe contrary is most unlikely to result in a compensatory decline in wages andcosts. Thus it should contribute to the restoration of balance in internationalpayments.

An export surplus due to 'under-valuation' of the currency, however, hasgreat socio-political attractions especially for conservatives in any country. ForGerman public opinion it seemed to have special political allure. Germany'sposition in recent years as a persistent creditor seemed an admirable onefor regaining strength and prestige after a lost war. A country cannot forever incur balance of payments deficits because its creditors will not lend to itindefinitely. In contrast, a country can forever maintain a surplus and, on thebasis of the surplus, it can grant or refuse credits to developed debtors, and grantor refuse aid to developing countries. Thus a persistent creditor country canact as a Great Power, and this is exactly what the German Ministers were ableto do in the autumn of 1968. This was hardly an advantage to be given uplightheartedly.

There are also substantial domestic advantages, especially for a conservativegovernment. A substantial balance of payments surplus permits the maintenanceof full employment and production without internal demand being expandedproportionately. Profits can increase as a proportion of national income withouthindering the expansion of demand, and a high capacity to sell exports permitsthe adoption of more efficient production methods through the exploitation ofeconomies of scale. The rapid growth in exports thus stimulates an acceleratedincrease of productivity. This, in turn, further tends to increase competitivenessprovided the relative rate of increase in wage costs per unit of output remainslow. The fact that real wages are increasing faster despite a distribution ofincome which is less favourable to wages than in more sluggish economies likeBritain, or even the United States, reduces the opposition of the Trade Unionsto this policy.1 Although the direct effect of revaluation would amount to anincrease in the real purchasing power of the lower income classes and in con-sumption generally, indirectly, the decrease in Germany's competitiveness inforeign markets might react on investment and thus weaken the mechanism ofgrowth in real income.

This is a formidable deterrent against 'progressive' policies, and explains thehostility, at the time of the Bonn Conference in the autumn of 1968, of a wide

The net real advantage is marked. German real wages were 30 per cent below the Britishas late as 1950. They are now at least 10-15 per cent above the British level.

THE SDRs IN PERSPECTIVE 89

stratum of the German population to suggestions by the US and UK Govern-ments to up-value the Mark. The German Social Democrats took a considerablerisk in advocating revaluation.

In the event the extent of the German revaluation, 9.2 per cent against thedollar, was markedly greater than the reported proposal of the German CentralBank (Bundesbank), some 6.5 per cent. At the behest of the Christian Democratsand especially Herr Strauss, it was accompanied by a brusque abolition of thefrontier tax-bounty system. This had been introduced after the refusal of theGermans at the Bonn Conference to revalue the Mark. It amounted nominallyto 4 per cent. But as it was not extended to all trade its total effect was some-what less, perhaps 3 per cent. The Bundesbank proposal would therefore haveamounted to only a 3 per cent advantage to the rest of the world. At presentsocial and production trends this might have been eroded once more in a yearor so. As it was, the advantage to foreign countries was double that figure.1

The victory of the Social Demoacrats was incomplete. They had to take theLiberals into Coalition. Thus their courage is even more commendable. Nodoubt the up-valuation will tend to arrest the inflationary pressure on prices. Itcannot help to that extent also having a restrictive influence on activity andpossibly on investment. Should these be marked, the Coalition might breakdown with the more Conservative wing of the Liberals making common causewith the Christian Democrats. The latter successfully maintained expansionuntil 1966, though they then fell into the trap of trying to control price move-ments by brusque monetary measures and caused the only marked recession inpost-war Germany.

The best hope for the Social Democrats lies in the fact that Germany'sinternational competitive power has been based on deep-seated social causes,that the revaluation will not lead to a cut in investment and that a possible slackwill be taken up by an expansion of the domestic market.2 If, however, theeffects of revaluation were aggravated by a burst of successful wage demandsand this resulted in unfavourable longer-run expectations and a decline ininvestment, the outlook for the new Coalition would be bleak. The reactionmight then jeopardise the recent improvement of the balance of the internationalmonetary system by a reversion to previous German policy.

In the persistent debtor countries, especially the UK,3 restraint on incomes,especially wages, was successful on a number of occasions4 and a favourablebalance of payments was secured. Such restraint was successful only when therewas either

(a) a degree of unemployment politically (in the medium run, i.e. includingelections) unacceptable, or

1 It is probable that the Germans will absorb a (large) proportion of the increase in costs interms of foreign exchange by cutting profit margins to preserve markets.

2 They had to concede complete compensation to the German farmers whose costs arehigher than the French.

The US balance of payments poses basically different problems as the current balance islikely to snap back into surplus once the Asiatic war is ended.

Cf. R. Solow, 'Price expectations and the behaviour of the price level', to be publishedshortly by the Manchester University Press. See also his and Professor Phelps-Brown's con-tributions to Guidelines, 'Informal controls and the market place', Record of a conferenceedited by G. E. Shultz and R. Z. Aliter, Chicago/London 1966.

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(b) a sufficient consensus obtained on the need for it.The grave problem which confronted and confronts British Governments1 inparticularand which none of them has facedis that the pattern of incomedetermination has to be adapted to the state of full employment in whichdemands for wage increases seem self-justifying because they provide thepurchasing power needed to sell the goods at prices which cover the increase inmoney wage costs. Trade Union 'reform', as has been advocated by someauthors in Britain, could only provide a solution if it so weakened unions'bargaining power as to permit secure stability without excessive unemployment.This is unlikely. In Germany such restraint was achieved by the trauma causedby the two monetary catastrophes resulting in an annihilation of money andgrave hardship to the broad masses of voters (while the owners of real assetsbenefited).

The new factor which is threatening the world monetary system is that theleadership in trade and credit hasat least temporarily until the end of theVietnam Warpassed from the Americans to the Germans and to a lesserextent to the Continental countries in general. So long as they remained per-sistent creditors even the Americans prevented the acceptance of rules whichwould have required creditors to contribute their share to the process of balancedreadjustment by expansion. Once the convertibility crisis was upon us in 1947,however, the US abruptly changed their policy and provided a stable basis forpost-war reconstruction. The danger at the moment is that the Continentalcountries might not be as quick in adapting themselves to the requirements ofa moment should an acute crisis erupt threatening the monetary and creditstructure of the world.

Moreover these countries seemed so eminently successful in practical inter-national economic affairsalbeit because of the toleration by other countries ofthe transfer of their economic problems through export surplusesthat anumber of influential people both in the United States, in the internationalagencies, and consequently also in Britain, were persuaded of the relevance ofthe orthodox neo-classical monetary doctrines based on a simplified version ofthe quantity theory of money.

Professor Friedman, high apostle of this approach, when challenged dis-claims any close relationship between the volume of money and spending.2

'The fact that inflation results from changes in the quantity of moneyrelative to output does not mean that there is a precise, rigid, mechanicalrelationship between the quantity of money and prices, which is why theweasel-word "substantial" was sprinkled in my initial statement of theproposition.'

If policy based on regulating the quantity of money is to work smoothly andsubtly, a close relation is required.3 Otherwise even a sharp boom could he'carried' by an increase in the velocity of circulation which would have to befollowed by measures to check it before it got out of hand. Only if spending

1 In France the pattern was very different; Trade Union compliance alternated with violentexplosions leading to devaluation and/or repression.

2 Guidelines, op. cil., p. 26.Cf. Symposium on Monetary Policy, BULLETIN, 1957.

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were markedly interest-sensitive would this type of policy succeed. All post-war experience is in conflict with the assumption that spending is closelydependent on such variations.

Pre-war experience on the other hand suggests that monetary policy usuallyworked through an 'overkill'. At 'best' it reduced investment and slowed downthe increase in productivity and thus aggravated the basic problem of keepingmoney costs down. At 'worst' it was (as in 1968 in Britain) ineffectual. No-onehas ever solved the problem of rising prices by 'global' monetary weapons exceptby causing a crisis.1 Historical evidence shows clearly that when monetarymeasures 'worked', and 'work' they did, they 'worked' by causing the optimismof boom-periods to break. Pessimism and unemployment ensued. Prices fell.Changes in psychology work not by subtly, slowly and painlessly changing costsand incomes. They work explosively, destructively and at immense cost in lostoutput.2 The growing affluence, by making people less price-sensitive, and therise in taxation increasingly reduced these 'non-violent' effects of monetarypolicy, i.e. its effects on costs.3 The impact of interest rates on costs is furthermitigated by business taxation. Fiscal measures on the other hand can beoffset by mobilising assets and reserves, by reducing saving and increasing wagedemands. The existence of vast stocks of durables, the replacement of whichcould be postponed over long periods, might make a future slump far moredestructive than slumps before the Second World War.

The 'liberal'-conservative Keynesian idea that all will be well if demand isstabilised at a level not less than assuring, but no more than assuring, fullemployment, has been shown to be all but impossible to achieve. Indirect, globalattempts at stabilisation, advocated by the anti-interventionist school of thought,have proved ineffectual in debtor countries. Wage demands and increasingprices continued to chase each other in anticipation of further wage 'rounds'.Price stability was nowhere achieved. The prosperity of the post-Second Warperiod was caused not by the Keynesian revolution nor the invention nor use ofnew economic weaponry. It was achieved because government expenditure roseprecipitously (especially war expenditure in the US) and internal demand wasmaintained. But I am sure that recurrent old-type crises were avoided onlybecause monetary policy was handled rather gingerly by people who still remem-bered the aftermath of the monetary experiments of Montagu Norman andGovernor Strong in 1928-1933. This has now changed. The disappointmentwith the Keynesian remedies, with the direct government (thoughglobal) influence on spending and income through Budget policies has led to arecrudescence of the crudest type of the 'quantity' theory, i.e. of the view that

1 President Nixon's advisers periodically announce success in gently slowing down businessactivity. As yet there is no sign of this success and it is to be hoped that when success doescrown their efforts it will not have destructive consequences.

2 The British neo-classical 'theory' of the business cycle was built on psychological changesactivated by 'real' and 'monetary' causes (cf. Professor Pigou, Industrial Fluctuations, especiallyChapter 23).

The two Symposia on Monetary Policy of the Oxford University Institute of StatisticsBULLETIN 1952 and 1957. This scepticism followed a period of implicit belief in the subtleefficacy of monetary policy from 1950 to about 1957. It resulted in the appointment of theRadcliffe Committee whose Reportmuch to the disgust of the believers in moneywasalmost entirely sceptical.

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there is a stable relationship between the quantity of money and consumption,income and prices, which is usable because reversible for policy-making purposes.There is a grave risk that the optimism and expansion in the Western economieswill not survive the cumulative and increasingly harsh deflationary policies.

The resemblance of the present conjuncture, of the explosive increase ofuncontrolled international lending through the Eurodollar market and painfulrise of interest rates, is shockingly close to the notorious 'brokers' loans anaccount of others' in 1929, which also escaped Federal Reserve regulation, onlyto cause the foundering of credit and banking, thus turning what was a 'normal'into the 'Great' Depression. The crisis that gripped the world was turned into acatastropheresponsible for Hitler and the warby the refusal of the then chiefinternational creditor, France, to help.

It is just possible that the victory of the German Social Democrats, and therevaluation of the Mark will still the doubts in the existing exchange parities.'If, then, the US administration is successful in checking the price-inflationwithout causing a setbacka doubtful stroke of luckBritain might maintainher export target which has recently been attained without further restrictivemeasures, despite the accelerated increase in wages and prices. The injection of$3,500m. of Special Drawing Rights annually under these, marginally sensitive,conditions may well tip the balance towards a lowering of interest rates and astable expansion. Yet the behaviour of wages and productivity in differentcountries is such that the critical situations of 1968 are not unlikely to recur.

V

'Flexibility'The Keynesian solution for stabilisation having seemingly failed, fixed

exchange parities were blamed by the partisans of the 'free' price or marketmechanism. Liberal Conservatives in this respect, too, either do not consider-or reject the problem of anticipatory speculation in their arguments. In theabsence of some purposive policy which keeps the cost-creep in the debtorcountries in check, monetary gadgets such as a floating rate or a creeping peg ora widening of the gold points cannot, in my opinion, provide, as they claim, theelements of an easy yet stable solution. Their belief to the contrary is based onthe assumption that capital movements are necessarily of an equilibrating kind.2There is no justification for this assumption.

1 Downward FlexibilityIf the basic reason for the imbalance, the divergent cost development,

continues, the most likely contingency is that in the 'weak' or 'soft' countries thedownward progress of the value of money in terms of goods and foreign curren-cies could not be halted in a regime of floating rates. This would inevitably setup anticipatory speculative rises including wages and domestic prices. This in

Though there have been rumours of further revaluation.2 This notion, unfortunately, has been put forward not merely by anti-Keynesian economists

but by the Staff of the IMF. See my 'International Reserves and Liquidity', ¡oc. cit.

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turn would react on the foreign exchange markets and accelerate the progress.Thus the creep might be accelerated into a canter and finally into a gallop. Theattitude of the advocates of floating rates' shows the extent to which economictheorising remains under the influence of theoften very--recent past. BrettonWoods banished the fear of uncontrolled and competitive depreciation or even offrequent changes in parity. This was a reaction against the then vivid memoryof critical monetary developments which bedevilled a large part of the Twentiesand Thirties. Now the disadvantage of exchange stability in the midst ofdivergent cost trends obtrudes into consciousness. The impact of exchangeinstability on the internal cost and price instability due to cost-divergence is inits turn neglected.

Upward Flexibility

Very different would be the impact of greater flexibility upwards of 'strong'currencies. This asymmetry of reaction is the result of the fact that wages in agenerally oligopolistic economy behave asymmetrically. They are unlikely to godown consequent to up-valuation, while devaluation or downward floatingmight (and in the longer run is almost bound to) set up a vicious circle of anti-cipatory moves offsetting or more than offsetting the primary balancing effectof the original move. The snag about upward revaluation is the likely politicalreaction, which we have discussed in conjunction with the German problem.2

Creeping Peg

The 'creeping peg' is an ingenious attempt at compromise. But if the costcreep divergence is one way, the problem will re-emerge (as it did after theGerman revaluation in 1961), and the fear of persistent depreciation will wreckthe system, for everybody will want to get out of the weak currencies knowingthat they will droop. Without having first cured the disparity in cost trends thebasic problems would be exacerbated not cured. A differential in interest ratesin favour of the downward-sliding country equivalent to the rate of the 'creep',it is argued, would be sufficient to restore equilibrium. If the differential trendin costs is within the limits of the 'creep' and if its persistence does not lead to itsacceleration through anticipation by trade unions and employers this argumentis valid. But in the struggle between the two sides of industry this fixity ofdepreciation is most unlikely. If the internal depreciation of money accelerates,the rate of the 'creep' itself will lose its credibility, much as the credibility offixed parity was lost, and speculation against the suspect currency would beengendered. Indeed, because of the 'legitimacy' of the downward creep the forceof speculation might be more intense than against the fixed parity itself. Peoplewould begin to suspect that their money assets and savings were endangered.The domestic political consequences of a quickened depreciation might beincalculable. The German example of 1922-4 and 1945--8 should open the eyesof those who conduct economic arguments in a political vacuum.

1 Some clever and influential protagonists of 'floating' rates regard it as a means of enforcingnew discipline on Trade Unions: by making the peril of monetary disintegration clear, it ishoped the policy will enforce unpalatable measures.

See above pp. 13-16.

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A slow continuous uward creep of the currency of the 'strong' countries--e.g. 1/6 per cent per month, 2 per cent per annummight have some good effectsbecause the speculative urge abroad to exploit the up-valuation would be checkedby its unimpressiveness, while the asymmetry of wage movements, i.e. that wagescannot be cut, would present a disequilibrating speculative movement. But if itis unimpressive in terms of speculative gains it will he equally so in its effects incuring the persistent balance of payments surplus. The basic equilibrium isunlikely to be restored this way; and political support for a 'slow upward creep'is unlikely to persist in the creditor country. Moreover there is a danger that aslight concession to 'flexibility' might unloose speculative forces of great violencein anticipation of being able to enforce greater changes in exchange values. Themaintenance of the balance in the world economy in the longer run depends,in my opinion, on the use of more direct means of intervention to check dis-proportionate cost increases.

The much criticised refusal of the US administration at the WashingtonMeeting of September 1969 to give wholehearted approval to the exploration ofgreater exchange flexibility is, therefore, basically sound, however much it wascriticised at the time by most commentators. Unfortunately it has not yet beenfollowed up by a return to a more active policy of price and income restraint. Inthe case of Britain, too, one would hope that the upward pressure on prices willhe mitigated both by the acceleration of the increase in productivity and by thecreation of an ambience in which Trade Unions will at least accept the seem-ingly unpalatable fact that they are unable by industrial action to increase theshare of wages in real income.

VI

CoNclusion1. The Need for Reserves

The need for international reserves will depend on:(j) the aims and means of economic policy of the leading countries and more

especially on whether the aims of their policies are compatible with oneanother;the differences between leading countries in the institutional pattern ofthe organisation of Trade Unions and Employers' Federations and theirattitude to wage negotiations, which influence wage increases, on the onehand, and the quality of management and the allocation for productiveinvestment, thus on the 'real' (non-monetary) factors governing pro-ductivity growth on the other; andthe role which international reserves can play in assuring harmony in theexecution of policy in relation to other (especially more direct) means.

The need for liquidity is a function not of the volume of trade but of the sizeof likely imbalances in international payments. This in turn is determined by thepolicy framework of the (dominant) members of an open system, in particularthe range of admissible means of readjustment and the ends of policy; theirwillingness and ability to limit surpluses and deficits in international payments;

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the rapidity with which single countries can, under the prevalent rules of thegame, legitimately take steps directly to limit the consequences of the loss ofbalance.'

A very large proportion of total trade and payments is among a few majorpowers. The more self-reliant each of these powers (or the more complementarythe regional grouping of which they are the head) the less they depend on reservesfor freedom of policy making. Shared policy aims between independent powers,whatever their nature (i.e. whether the avoidance of unemployment or securinga balance in international payments) will in any case reduce the need for reserveholding for the world as a whole.

The relationship of major member countries of the world economy to oneanother is therefore one of oligopoly. Countries will trim their behaviour to oneanother. The discouraging feature of this relationship is that, so long as inter-national reserves are relatively scarce, behaviour which will induce gains ofreserves (i.e. restrictive policies) will be at a premium subject to their internalpolitical consequences (e.g. France in 1968), because severe losses of reservesmust induce the sufferers to follow suit in such policies. Thus a scarcity ofreserves is likely to aggravate itself.

Secondly, the greater the differences among countries in institutions and inpolicies affecting relative cost levels and balance of payments, the greater theneed for reserves. More reserves will be needed by countries handicapped by theeagerness and strength of their Trade Unions so as to gain time for a relativelyslow and less painful adjustment. If these countries are moreover prohibitedfrom dealing with their foreign exchange problems at least temporarily by directmeans the need for reserves is even greater.

Should the expansion of an international market for liquid funds be encour-aged, such as the Euro-dollar market, this will obviously further increase theneed for reserves because, in anticipation of a foreign exchange crisis the end ofwhich cannot be foreseen, very large amounts of money are liable to flow fromone country to another. Currency instability or flexibility would obviouslyincrease the desire to hold the funds in liquid form, therefore increase thetemptation to use liquid funds which are relatively cheap, for longer-termpurposes. This in its turn would increase the likelihood of destructive capitalmovements and possibly lead to a shrinkage in the equity values behind thefixed loans and thus to a general liquidity crisis.

2. A Rational SolutionA rational solution should therefore include a new International Central

Bank, a mechanism by which internationally acceptable means of payment,owned and not borrowed, can be created in a sufficient quantity to obviate:

(i) the generation of a general deflationary pressure merely on account ofsurplus countries wanting to increase their reserves further while deficitcountries strive to achieve a surplus. On this score some predeterminedcreation would be needed on the basis of some index taking into accountforeign trade, national income, etc.;

Such as, e.g, direct controls or 'flexibility'.

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a. general confidence crisis leading to a forced devaluation of a maincurrency and thus feeding upon itself. On this score it would be essentialto give some discretion to an international agency for ad hoc action. Inparticular it would be necessary to have sufficient means of manoeuvre tostem a cumulative liquidation in the Euro-currency market; and, finally,to envisage:an eventual consolidation or funding of the reserve countries' liabilities inexchange for short-term liabilities of the IMF or some other inter-national financial conglomerate such as the Special Drawing Right Fund(administered by the IMF). The special debt of the reserve countrieswould automatically be diminished as new SDRs are created and theyreceive new allocations. In the meantime a low rate of interest might bechargeable.

The SDR scheme as at present proposed is dangerously insufficient to achieve(iii), not sufficient to prevent (ii), and hardly enough to prevent (i), especially ifthe creditor countries do not undertake not to switch the new assets into gold.At $9.5 billions over 3 years it amounts to only some 5 per cent of total reservesper annum.

The need to deal with (iii) is, if not the most urgent task, at least the taskwhich will need most effort. It is ironic to reflect that both the Bank of Englandand the US National Bank Currency were based on the principle of grantingbank-note issue rights to an institution against long-tern loans to the State.Nowadays shortest term swap-arrangements are the most that can be expectedas a means of inter-Central-Bank co-operation, though the creditors know fullwell that they will not and cannot be repaid on the due date. It is to be hopedthat the 'advanced' position of Mr. Montagu (Lord Halifax) of the 1790s andMr. Chase of the 1860s will once more be accepted. But the time does not seemyet.'

There is a fundamental difference between up-valuation (or creep) andrepeated devaluation (or downward creep). This difference is due to the asym-metrical behaviour of wages in a generally oligopolistic economic structure.While repeated up-valuation (or creep) will induce speculative movements it willmost certainly not be followed by cumulative effects on internal money costs:wages do not move down.2 In contrast, an anticipation of a devaluation ordepreciation (whether through a 'creep' or 'floating') is likely to engenderanticipatory increases in wages leading to a 'legitimisation' of further downwardmovement. Should the German (and Japanese) undervaluation recur and not bemitigated by a further up-valuation of the mark (or the yen), a demonetisationof gold will probably prove the least objectionable policy. Once this has beenaccomplished, the onus of managing the dollar (sterling)/mark etc. rates wouldbe shifted to the Germans (and other persistent creditors). We should havearrived at a dollar standard, an aim favoured by a number of writers. It isunlikely, however, that a Republican Government in the US would accept sounconventional a solution.

1 Mr. Harold Lever's sensible suggestions on these lines encountered fierce criticism andopposition.

2 Up-valuation might worsen the inflationary trend in the deficit countries. But the rise inimport and export prices through which this would work is of a smaller order of magnitude.

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There are, moreover, very powerful arguments against the acceptance of adollar standard which this would imply. There is, first of all, no reason why theUS should be enabled to exchange low interest bearing liabilities, which depre-ciate in real terms, for high-yielding and steadily appreciating director evenportfolioinvestments. The Gaullist argument in this respect is convincing.Secondly, there is no reason to entrust the US Government with the ultimatedecision as to how much liquidity is to he created. The deliberate crealion ofinternational liquidity and its purposive distribution between the members ofIMF is not only more rational from the viewpoint of international monetarystability (though it cannot be guaranteed by acting on monetary circulationalone), but also much more equitable.

Eventually, therefore, all claims on the Fund should be treated as part of thereserve of member countries and the Fund should be given powers to undertakeopen market operations in the capital markets of member countries withincertain limits. Thus the creation of international liquidity can be managed notonly to relieve acute shortages but to consolidate short-term balances and avoidconfidence crises, without permitting a single country to use its strength tounfair advantage by running a balance of payments deficit.

In the context of further international monetary reform it would be desirableto use an increasing portion of the persistent creditors' balances for long-terminvestment in underdeveloped areas through the creation of additional liquidityto be spent in developed countries, as an alternative to, and not fully as high as,the automatic creation of liquidity would be.1 Such a link between a more orless fully-fledged International Central Bank and a Development Fund to whichlonger-term lending activities are entrusted would lessen the riced for automaticcreation of liquidity. Inasmuch as the surpluses of persistent creditors have beenrather large, this solution would also allow a more even channelling of resourcestowards the less-developed areas than a purely anti-cyclical aid policy.

3. Rules of Good ConductRules are required by which the need for additional international liquidity

could be minimised or at least kept within limits by more direct means, includinga collective supervision of the policies of both persistent creditors and debtors.

(j) From this point of view the creation of equilibrating demand might beone of the possibilities. Plans for such a scheme were elaborated alreadyduring the war by economists working in the Oxford Institute ofStatistics.2 They could be coupled with a purposive boost to the develop-ment of poorer countries to be channelled towards mature deficitcountries.

(ii) There is however no way round the fact that only effective measureskeeping price (and cost) increases in persistent debtor countries within arange acceptable to the persistent creditor countries, i.e. probably less

1 Cf. UNCTAD expert group, Internafional Monetary Reform and Co-operation for Develop-ment.

2 M. Kalecki, E. F. Schumacher and T. Balogh, New Plans for International Trade, Oxford,1943; and The Economics of Full Employment, Oxford, 1944.

B

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than 3 per cent per annum, will maintain balance. As we have seen,attempts at achieving this through budgetary or monetary policy haveeither failed or involved an unacceptable degree of unemployment.

The conclusion is inevitable that both the UK and the US will be driven backtowards incomes or 'guide-post' policy. In default of such a policy the patternof cost and price development may have grave political consequences eitherthrough a persistent inflation of prices leading to speculative attacks on thecurrency, or through unemployment. The regular alternating sequence of thiscycle is the one stable feature of the post-war history of both countries.

A deliberate return to incomes policy would be much facilitated if an acceler-ation in the rate of increase in productivity could be achieved. Given theexpectations for increases in money incomes, the higher is the rate of the increasein productivity the less is the inflation.

Unfortunately it is hardly to be expected that a rational solution will proveacceptable without a crisis giving a sharper edge to an obvious need. Thisapplies as much to the creditor countries' aversion to expansion for fear ofinflation and to handing over power to an international agency, as to the debtors'resistance to incomes policy. Yet without heavier unemployment only anincomes policy can assure a harmonisation of the policies of countries whosesocio-economic structure shows sharp divergence. It becomes more and moreevident that it was the absence of such conscious policy of harmonisation whichwas at the bottom of the much sharper economic fluctuations and social distressbefore the Second World War. Are we going to revert to that pattern, presidedover by Central Bankers?1 The question is wide open.

PostscriptThis paper was written in the autumn of 1969. Its conclusions have been

strengthened by the inanities of the US Government in fighting inflation. It isno longer possible to discount the possibility of global restrictions leading to asevere crisis sparked off by the violent slump in capital values. The urgency offinding a new approach to the solution of the problem of (relative) price stabilityand expansion has very much increased. Such an approach can only be basedon incomes and prices ('guidepost') policy.

Bcslliol College, Oxford

1 The shift of the real power towards them is attested by the increasing importance of theBank for International Settlements which in the early post-war years did little more thanorganise emergency aid in the form of swaps. Even the General Agreement to Borrow arrange-ments seem unduly influenced by financial considerations. The relation of debtor governmentsto Central Bankers has reverted to the position of 1925-31.