ACOUNTRY’S external liquidity consists of such resources as are readily available to its monetary authorities for the purpose of financing deficits in its balance of payments and defending the stability of its rate of exchange. These resources may take the form of liquid assets, such as gold and foreign exchange, or of facilities for borrowing such assets from abroad.
The first part of this paper sets forth criteria for determining, in principle, the most desirable aggregate amount, composition, and, to a lesser extent, country distribution of external liquidity in the world. The second part deals with the instrumentalities that are, or might conceivably be, used to attain or approach these optima.
Much that has been written in the postwar period about the adequacy of world reserves or world liquidity would appear to rest on uncertain logical foundations. One frequent approach is to estimate a figure for required or optimal reserves, by starting from some past date when total reserves are supposed to have been roughly satisfactory and adjusting this total for the growth in the value of world trade between the base date and the present time. While the value of world trade is, admittedly, a relevant consideration, there are many other dynamic factors affecting the need for reserves. This is emphasized in many of the writings in which such historical comparisons appear.1 It is not surprising, therefore, that calculations starting from different base dates, at each of which reserves may have been roughly satisfactory, yield enormously different results. Moreover, if it is possible to say that reserves were or were not adequate at the base date, one wonders if it is not possible to apply the same criteria to the present situation and judge the adequacy of present reserves less indirectly. Another approach is to estimate the world’s need for reserves on the basis of the amounts that individual countries would need if they were to behave appropriately (by some standard) with respect to the various types of payments fluctuations they may have to face.2 It should be fairly obvious, however, that any fruitful approach to this problem must be based not on how countries ought to behave but on how they actually behave. A third approach that is sometimes adopted is to estimate optimal world reserves by adding together the reserves that individual countries show, by their behavior, they would like to hold. Sometimes this seems to mean merely that whatever is, is right. Countries should have the reserves they effectively demand, and what they effectively demand is shown by what they actually have. In the more sophisticated variants of this theory, the adequacy or inadequacy of reserves, relative to the demand for them, is said to be shown by the policy reactions of governments.3 This is getting nearer to the truth, but is still somewhat wide of the mark. Policy reactions are relevant to the question of reserve adequacy, not so much because of their symptomatic significance (i.e., because they show that the country would like to have larger or smaller reserves) as because they have effects on the welfare both of the country in question and of other countries.
I. Criteria for Determining Amount, Composition, and Distribution of External Liquidity
Our own approach, therefore, is to go back to first principles and consider the probable effects of any change in liquidity on the economic welfare of the world. Liquidity is optimal if no change having a desirable effect on economic welfare can take place. Of course, there are various types of international liquidity and near-liquidity, and the most desirable aggregate amount of liquidity will depend on the proportions in which these various types are combined, and on their distribution among countries. It will therefore be a function of the particular methods by which the amount of liquidity in the world is varied. However, to start with, we can ignore all that and assume only one type of international liquidity—a reserve asset of some sort—and one method by which the supply of this reserve asset can be varied, presumably by the act of some international organization or by some intergovernmental decision.
Policy effects of reserve changes
As it happens, practically all the important economic effects of reserve changes come to pass by way of their effects on national policies; namely, monetary and budgetary policies, policies with respect to restrictions on international trade and capital movements, and policies with respect to exchange rates. The main exception to this is the direct effect that the amount of national reserves has on private international capital movements of a speculative type. But, even here, the direct effect is probably minor, owing to the widespread tendency of monetary authorities to offset the effects of such movements on the money supply and on interest rates. Since these movements tend to accentuate the inadequacy of already inadequate reserves by transferring them from countries that need them to countries that do not, their main importance probably is to reinforce the effect on government policies that changes in aggregate reserves would, in any event, tend to exercise.
Any increase in countries’ reserves relative to the amounts that they consider it desirable to hold will encourage (1) more expansionary financial policies, particularly monetary policies, (2) less severe restrictions on imports and capital imports, and (3) less frequent resort to currency devaluation (or increased resort to revaluation). Since in any given country these reactions are likely to be stronger if that country is in an adverse than if it is in a favorable payments situation, an increase in actual, relative to desired, reserves will evoke an increased tendency to meet payments fluctuations by the use of reserves rather than by variations in financial policies, restrictive policies, or exchange rates.
Up to World War II, the adequacy of world reserves or of gold supplies was judged primarily with reference to effects on the stock of money and on the trend of prices. In the course of the interwar period, however, with the spread of quotas and the breakdown of the gold standard, it became clear that the level of reserves acted not only on prices and employment but also on trade restrictions and exchange rates. In the early postwar period, when there was no longer any question of an automatic link between reserves and money supply, discussion tended to highlight the bearing of international liquidity on the freedom of international transactions. It is important, however, that all types of policy reaction should be held in mind simultaneously.
Diminishing marginal utility of increases in reserves
An evaluation of increases in reserves involves both factual and ethical judgments, on which opinions may differ. Most people, however, would consider liberalization of imports to be, in general, desirable, and monetary expansion to be good or bad according as conditions are otherwise deflationary or inflationary. The effects on exchange rate policy would be good to the extent that exchange depreciations in the face of short-run or cyclical payments weakness are avoided, and bad insofar as adjustments to more fundamental disequilibria are postponed.4 As reserves rise, in any given set of circumstances, the marginal effects of raising them further will probably dwindle, in the sense that a given increase from a high level will have a less powerful impact on policy and will react less quickly on the balance of payments than would a similar increase from a lower level. Moreover, their character will alter and their welfare significance will change. After abnormal restrictions on imports have been removed, further liberalization becomes less likely and less important. The higher the level of reserves, the less likely are the expansionary effects on monetary policy of further reserve increases to exercise a useful effect on the economy, and so on. Generally speaking, there is a diminishing, and ultimately a negative, marginal utility of reserve increases; it is this that ensures the existence at any time of an optimal level. In a generally deflationary situation, when no amount of reserves can do much harm, the optimum will be a gentle eminence in a plateau; only in a generally inflationary situation will it be more like a peak.
Time-horizon of effects of reserve changes
The policy effects of any general change in the level of international reserves, though partly temporary, may nevertheless extend quite far into the future; and some of them may be permanent. On certain assumptions, however, all the policy effects of a general change would be temporary. Starting from a position of constant prices, an increase in reserves would result in expansionary monetary policies, rising prices, a rising value of international transactions, and a rising demand for reserves, which would continue until the demand for reserves had caught up with the supply and the inflation came to a stop. In the end, according to this view, prices and reserves will have increased in the same proportion, and any increase in production or liberalization that may have occurred in the transition to the higher price level will be reversed. This, however, does not appear to be a realistic picture of how reserve changes act on the economy. Some of the effects of such changes—on restrictions, on exchange rates, on investment, on output, on ways of dealing with disequilibria—may well be virtually permanent.
In any event, the effects of any given reserve change clearly take a long time to manifest themselves in full. There is, first of all, the interval that probably elapses between the change in reserves and the change in official policies, then the time it takes for the policies themselves to take effect on activity and trade, and then the period during which prices are adjusting themselves. Finally, there is, possibly, a period during which costs adjust themselves to the new demand situation. One corollary of this is that to evaluate the effects of any once-for-all reserve change would require a forecast of its effects extending over several years. The making of such a forecast would be difficult enough under the most stable economic conditions. The difficulty is further increased by the fact that both the response of governments to given reserve changes and the desirability of given responses are constantly changing with changes in the general economic situation.
Dynamic factors affecting need for reserves
In the two preceding sections, we have spoken loosely of the demand for reserves as if it were an absolute magnitude, and of the equality or inequality between the demand for and supply of reserves as being manifested by the trend of prices. However, it would be more in keeping with the analysis in this paper to regard the ratio between the demand for and the supply of reserves as tending to affect the policies adopted in a variety of spheres. If this is done, we can no longer hope to quantify the demand for reserves as such but only the changes in that demand. Thus, a country’s demand for reserves may be said to increase if, without any change in the amount of its reserves, developments occur in its monetary, commercial, and exchange policies similar to those which would have been evoked by a decline in reserves. More precisely, if a country’s demand for reserves rises (or falls) by the same amount that its supply rises (or falls), and if other factors affecting policies remain unchanged, the policies themselves will not alter. Other things being equal, a change in the demand for reserves will involve a similar change in the need for (i.e., the optimal level of) reserves. However, changes in economic conditions may alter the need for reserves quite apart from any effects they may have on the demand for reserves.
Space does not permit an extensive discussion of the various dynamic factors affecting the demand, or the need, for reserves. One obvious trend factor is the growth in the value of international transactions. Any increase in the level of these transactions, given their composition and degree of stability, will tend to evoke a proportionate increase both in the demand for and in the need for reserves.5 Again, anything that increases the magnitude (relative to the value of international transactions) of international payments deficits of a short-run or cyclical character will tend to increase the demand, and the need, for reserves. On the other hand, the emergence of persistent disequilibria in international payments, though likely to evoke some of the policy reactions characterizing an increase in the demand for reserves, may not lead to any increase in optimal reserves since higher reserves, while tending to mitigate policies of deflation or restriction in deficit countries, would also tend to delay a desirable adjustment of overvalued currencies.
The emergence of deflationary tendencies in the world economy might well involve, at first, a substantial increase in the optimal level of reserves, both because of the international disequilibria with which it would probably be attended and because of the importance of assisting governments in their efforts to counteract the deflationary pressures. However, in the longer run, insofar as the deflationary tendencies, while themselves disappearing, leave behind them a permanent legacy of lower prices in the world, the need for reserves will be pro tanto reduced.
The initial effect of the emergence of inflationary conditions on the optimal level of reserves is more doubtful than the effect of deflationary tendencies: considerations of anticyclical policy would favor a reduction of reserves, while the attendant payments disequilibria would argue for an increase. In the longer run, the effect would be to increase the need for reserves.
Changes in policy attitudes directly affect the demand, and hence the need, for reserves. Thus the optimal level of reserves will be increased, at any rate initially,6 by an intensification of the tendencies of governments to deflate or to restrict international transactions, and will be reduced in the opposite case. Changes in policy attitudes that intensify one of these tendencies while attenuating the other are ambiguous in their effects on optimal reserves. The need for reserves will also be enhanced, in principle, by any increase in the flexibility or variability of commercial, monetary, or exchange rate policies that follow changes in reserves, provided that this increased flexibility is not confined to situations in which reserves are high, i.e., that it is not associated with a net decline in the demand for reserves.
Importance of reserve flexibility
It follows from what we have been saying that, in considering the desirability of any once-for-all change in reserves, we have to anticipate not only a train of effects stretching into the future, but also the economic and political conditions under which these effects will operate. Clearly, such conditions are extremely difficult to predict with any approach to accuracy. In the circumstances, it would seem that the assessment of an optimal level of reserves must be an extremely hit-and-miss affair.
Our problem would be somewhat eased if we had at our disposal methods whereby the level of reserves, or of international liquidity, could be adjusted up or down at fairly frequent intervals. If this were the case, and if the economic effects of reserve changes followed with little or no delay the reserve changes themselves, we could take the leap of faith and assume that the liquidity needs of the farther future would be looked after by future adjustments in the supply of liquidity and that all that matters in determining the ideal level of present liquidity is the situation prevailing at present and expected to prevail in the immediate future. However, even complete flexibility in the means of adjusting international liquidity would not enable us to attain the thermostatic ideal of adjusting liquidity in the light of current requirements. Not only do the effects of reserve changes run on for a long time, but they probably do not reach their maximum intensity until after a considerable time lag. Financial authorities take time to react to changes in their external liquidity and, as has been emphasized particularly by Professor Friedman,7 domestic financial policies themselves may take six months or more before they exercise their full effects on monetary demand. The reaction of reserve changes on trade restrictions and hence on trade may be somewhat speedier.
Friedman argues that, given the existence of this time lag between monetary changes and their effects, and given the impossibility—as he believes—of successfully predicting business conditions, it is better to renounce any attempt to regulate the stock of money for short-term stabilization purposes, and to be content with maintaining a steady moderate rate of growth of the money stock over time. A similar thesis might be advanced with respect to the supply of international liquidity—that the best course is to maintain a steady rate of growth corresponding to an assumed trend rate of growth in the need for such liquidity. However, Friedman’s argument rests on a further premise—that in the long or medium run a stable relationship exists between money stock and money incomes. No such stable long-run relationship—e.g., between external reserves and the value of international transactions—exists in the international sphere. Quite apart from short cyclical fluctuations, considerable changes take place over longer periods in the equilibrium ratio of reserves to transactions. Thus even if a target rate of growth were fixed for international transactions, this would not suffice to determine the trend in the need for reserves. On the other hand, it would seem unduly pessimistic to doubt the possibility of using intelligent anticipations regarding those elements in the economic situation that are relevant to the need for international liquidity in order to make adjustments in the supply of such liquidity that are, on the whole, worthwhile.
Nevertheless, awareness of the difficulty of predicting economic conditions over periods even as short as one to two years provides a useful warning against attempting to bring about wide variations in the supply of liquidity to meet the needs of temporary situations. Another consideration pointing in the same direction is that reserve changes in the vicinity of the optimum are probably much less effective in time of slump, when the optimum is high relative to the value of transactions, than in time of boom, when it is low. If, therefore, there is any difficulty in making actual reserves decline as steeply between slump and boom as would short-run optimal reserves, it is better to fall well short of the optimal level in time of slump than to exceed it appreciably in time of boom.
International distribution of reserves
Our main concern in this paper is with the general level of reserves or external liquidity. However, the effects of raising or lowering the general level of reserves will differ according to the manner in which increases or decreases are distributed among the different countries. Some attention must therefore be paid to the effects of redistributing reserves as distinct from changing their aggregate magnitude. An increase in the reserves of any country will tend, sooner or later, to be passed on to other countries and thus widely diffused. The attitudes of different countries toward the holding of reserves give rise, as long as they persist, to something like a normal reserve distribution toward which the actual reserve distribution, subject to the vicissitudes of international payments balances, will tend. Thus, most of the effects of any change in the distribution of reserves are likely to be temporary. However, they may well be important. A transfer of reserves from countries which would have used them to inflate unduly, or to maintain an overvalued exchange rate, to countries that will use them to avoid deflation, import restriction, or undue devaluation—or an increase in the reserves of the latter rather than of the former group of countries—will have beneficial effects. It is, however, seldom possible to withdraw liquidity selectively from those that are likely to make bad use of it, though it may be possible, if liquidity is in any case to be increased, to steer it in the first instance toward countries that will make good use of it.
A danger that frequently presents itself is that, if additional liquidity is provided to countries that need it and would make good initial use of it, it will, when diffused among countries in general, turn out to be excessive, e.g., too inflationary. This dilemma may occur even if no net increase takes place in the aggregate amount of liquidity, but merely a transfer from countries in whose possession it would otherwise have remained unused. Unless, therefore, it is possible to withdraw the liquidity so transferred not from countries that would have kept it unused but from countries that would have used it in a relatively undesirable way, any improvement in the distribution of liquidity is likely to involve some decline in its optimal aggregate level.
Conditional and unconditional liquidity
Thus far, we have been assuming that there is only one sort of international liquidity, which, while it can be created or destroyed at the will of some authority, is nevertheless, as long as it exists, unconditionally at the disposal of the country possessing it. Let us call this “unconditional liquidity.” But there may be another broad category of liquidity consisting in a potential access to reserves, an access which, however, is subject to the observance of certain conditions as to the use to be made of it or as to the general policies to be pursued by the recipient. One usually thinks of such liquidity as consisting of borrowing facilities, but the use of assets also might be subjected to certain conditions, whereas access to borrowing facilities might be unconditional.
We now have two types of liquidity, the amounts of which have to be optimized. To make actual use of conditional liquidity involves transforming it into unconditional liquidity. In order to prevent a continual expansion of the latter at the expense of the former, means must be taken to ensure that the use of conditional liquidity is merely temporary. If this is done, and if access to conditional liquidity is controlled by a presumptively wise international authority, there can scarcely be too much conditional liquidity in the world. By hypothesis, it can be used only by countries that are pursuing suitable policies, and such countries should have all the liquidity they need.
There remain the rather tricky questions of how the fact that conditional liquidity is available will affect (1) the amount of unconditional liquidity that is needed and (2) the criteria on the basis of which that need is assessed. On the assumption, for the moment, that there is no change in the criteria as previously discussed, the existence of conditional liquidity—to some extent a substitute for unconditional liquidity—will of course reduce the need for the latter. However, the two types of liquidity are not perfect substitutes. The difficulties of utilizing conditional liquidity at short notice, its unsuitability as a war chest, the undesirability of accumulating too many repayment obligations, and the reluctance that some countries may feel at accepting the conditions under which it is made available—all these set a minimum to the demand and need for unconditional liquidity. Moreover, this reluctance to accept policy conditions suggests a new consideration to be taken into account in determining the optimal amount of reserves or unconditional liquidity. A reduction in the level of reserves that might lead some countries to impose undesirable restrictions on trade might lead others to dismantle their restrictions in order to obtain access to liquidity of the conditional variety. Therefore, the importance of minimizing restrictions and exchange rate instability argues less strongly than was previously suggested for keeping reserves higher than would be desirable in the interest of internal financial stability alone.
II. Methods far Controlling International Liquidity
Let us turn, now, to some of the concrete methods that are available—or might become available—for influencing and controlling the amount and distribution of international liquidity. And let us consider how far these various techniques can be used to bring the levels of unconditional and of conditional liquidity closer to the ideal. The possible methods fall into two main classes: those involving changes in the price of gold in terms of the principal currencies; and those involving the extension of credit, directly or indirectly, between monetary authorities. The second category of techniques is a vast one and splits into several subcategories. Thus, there may be arrangements affecting the proportion of external reserves that monetary authorities hold in the form of foreign exchange of various kinds, or arrangements between monetary authorities more specifically directed toward the provision of mutual financial assistance. Again, and most important of all, there may be changes in the amount of resources entrusted to international credit institutions, in the credit policies of these institutions, and in the willingness of countries to make use of them.
We may begin by considering gold revaluation as a method of altering the real value of international reserves. Article IV, Section 7, of the Articles of Agreement of the International Monetary Fund contains a provision whereby that institution can take the initiative in bringing about a uniform proportional change in the price of gold in terms of all member currencies. Now it is fairly obvious that this provision is unlikely, in practice, to be used to reduce the value of gold in terms of national currencies, thus reducing the real value of central bank reserves. The accounting difficulties that this would create for central banks, whose assets would be reduced relative to their liabilities, is a sufficient reason, as the world goes, why such an operation would never be undertaken. A uniform increase in the price of gold in terms of currencies and in the real value of gold reserves is theoretically possible, and might occur in some extreme situation or other. However, even an upvaluation of gold presents legal difficulties. To bring it about would require the consent of the United States and the United Kingdom8 to the operation as a whole as well as the consent of each individual country to a change in its own par value. A general increase in the real value of gold reserves is much more likely to take place, as it did in the 1930’s, as a result of a straggling sequence of devaluations on the part of individual currencies.
It is clear that, whether practicable or not as a once-for-all measure, gold revaluation would be a very cumbersome technique for adjusting the amount of international liquidity to an optimal level which, as we have seen, is itself likely to vary substantially in the short run with variations in the world payments situation and in the world demand situation. In addition, gold revaluation has certain side effects, some of which are helpful and some the reverse. A rise in the foreign-currency price of gold would lead not only to a once-for-all increase in the level of real reserves but also to an expansion of gold production and thus to a rise in the rate of growth of reserves. This, while open to objection on grounds of tying up labor and capital in unnecessary mining operations, has a rather useful effect on the long-term trend of reserves. On the other hand, the anticipation of an increase in the price of gold would induce both private individuals and monetary authorities to switch from holding currencies to holding gold. Such speculative reactions, which were seen in a mild form during the “gold scare” in the closing months of 1960, would have the perverse effect of drawing down the level of reserves at the very time when, by hypothesis, an increase in their real value is aimed at. The distribution by countries of reserve changes resulting from gold revaluation is clearly not very selective, being proportioned to the existing distribution of gold stocks. The desirability of using gold revaluation as a means of acting on the level of reserves cannot, of course, be assessed without due consideration of alternative techniques. Even at this point, however, it would seem that, while it may be a useful or even indispensable instrument for very occasional use in bringing about changes in the long-term trend of reserves, it is not a suitable instrument for adjusting international liquidity to shorter term changes in the need for it.
Holding of foreign exchange in official reserves
The level and trend of international reserves and liquidity depend not only on gold stocks and production but also on the proportion of reserves that countries hold in the form of foreign exchange. Any increase in international liquidity resulting from an increase in the ratio of foreign exchange to gold will be partly—but only partly-offset by an increase in the need for liquidity that arises from the existence of short-term liabilities in the reserve currency countries. The growth of reserves will then depend on such factors as national propensities to hold foreign exchange reserves, interest rates obtainable on official balances, the degree of confidence in the future gold value of reserve currencies, and the distribution of reserves as between two groups of countries: those which hold little or no foreign exchange (such as the reserve currency countries themselves) and those which hold a high proportion of their reserves in this form. Those relationships are too complicated to go into here.9 Suffice to say that there is no reason at all to think that, by itself, the practice of holding foreign exchange would give rise to anything approaching an optimal level of reserves or even a tolerably steady rate of growth of reserves. On the contrary, while I think Professor Triffin has exaggerated the inevitability of the collapse of the exchange standard,10 it is obviously an extremely unstable system which is liable to lead to a great reduction in reserves whenever, as is likely from time to time, a principal reserve country runs into balance of payments difficulties and confidence in its currency declines.
It would be possible for the reserve currency countries to remedy the worst instabilities of the system by offering to guarantee the value, in terms of gold or foreign currency, of all foreign central bank balances held in their respective currencies, provided the balances in question are held in an approved form. Even if the political difficulties of this course were overcome, however, it still would not provide a satisfactory method of regulating the volume of reserves. World liquidity would grow faster whenever the reserve currency countries were in deficit and decline or grow less fast whenever they were in surplus.11 In order to begin transforming the gold exchange system into some sort of reliable instrument for controlling the volume of world liquidity, it would be necessary to arrive at international agreements under which countries would assume obligations as to the proportions of their reserves to be held in the form of foreign exchange. The provisions regarding the composition of existing reserves might be different from those regarding the composition of reserve increases or decreases. Even so, it would be enormously difficult to reach any agreement of this kind in view of the very great differences of practice between countries in regard to the holding of foreign exchange. Some countries would want to stick to their present proportions, others to change them substantially. Moreover, to be effective for the purpose of controlling the level of world reserves, the agreement would have to contain not merely provisions as to initial proportions but also a mechanism for changing these proportions from time to time according to developing needs. It seems likely that such an agreement would be beyond the sphere of practical possibility. Moreover, the distributive effects of this method of controlling liquidity would be bad. Reserve increments would be concentrated, in the first instance, on the reserve currency countries, which is not necessarily where they are most required. Other countries would be affected only when the diffusion process had run its course.
Just as one would not wish to preclude the possible need for a very occasional revaluation of gold for the purpose of accelerating the long-term trend of reserve growth, so the possibility of some sort of agreement regarding holdings of foreign exchange, should this appear expedient for the purpose of avoiding a possible collapse of the reserve structure, need not be entirely excluded. However, for adjusting international liquidity to needs in the short or medium run, or even for providing an adequate rate of growth of international liquidity over the longer run, we must turn to instrumentalities of a different order.
Whereas the holding of foreign exchange reserves by monetary authorities enhances international liquidity by increasing the aggregate amount of reserves, other forms of official lending reduce the need for liquidity by transferring reserves to the countries that require them most. This happens, for example, when central banks in a strong payments position extend credit to those in a weak payments position. Even when, as is usually the case, the exchange risk is assumed by the borrowing country, the asset acquired by the lending country cannot be a very liquid one if the terms of the loan are such as will meet the needs of the borrower; so that, as the liquidity of the borrower increases, that of the lender will decline. The improvement in the distribution of liquidity will result, however, in a temporary decline in the aggregate amount of liquidity required in the world. If permanent arrangements are set up for the provision of mutual aid by monetary authorities, not only will the distribution of liquidity be improved and the need for it reduced but the expectation of being able to receive such assistance, when required, will itself constitute an addition, of a sort, to the liquidity of potential borrowers. However, the setting up of permanent arrangements of this kind, presumably on a mutual basis, is already a halfway house to the setting up of an international credit institution and raises all the problems of such institutions, which we shall now proceed to consider.
Role of international credit institutions
As domestic banks can increase the supply of domestic liquidity, so international credit institutions can increase the supply of international liquidity. In the first place, such institutions provide a means—and possibly the only means—whereby credit can be made available, subject to the adoption by the borrowing countries of policies desirable from an international point of view. In other words, they constitute practically the sole source of that conditional liquidity which, we have said, should be available in virtually unlimited supply.
The effect of the existence of international financial institutions on the supply of external liquidity in the unconditional form, i.e., on the level of reserves, is more complex. Insofar as these institutions absorb gold, and insofar as their operations lead countries to reduce their holdings of foreign exchange, such institutions tend to bring down reserves; but insofar as they incur liquid liabilities (including any liabilities to provide unconditional borrowing rights) that countries in effect include in their reserves, they tend to raise reserves. Since countries’ holdings of foreign exchange plus that part of their claims on institutions which they regard as a substitute for foreign exchange are held in some positive relation to their gold holdings plus the part of their claims on institutions which they regard as a substitute for gold, the total amount of countries’ reserves will depend on their holdings of gold plus the part of their claim on institutions which they regard as a substitute for gold. Therefore, the net effect of an institution’s existence on the supply of unconditional liquidity in the world will be favorable as long as its holdings of gold (which are ipso facto withdrawn from national reserves) are less than the part of its liquid liabilities that is regarded by the holders as a substitute for gold reserves. The more the institution reduces its gold stock or increases its liquid liabilities, i.e., the more it expands credit, or contracts its nonliquid liabilities, the greater will be its expansionary effect on world reserves—though there will be some corresponding decline in the amount of discretionary lending facilities that it can provide.
It is obvious that the supply of liquidity can be varied more flexibly over time and distributed more selectively between countries by an international credit institution or institutions than by any other method. Within the limits of its resources, such an institution can behave like a central bank, increasing its willingness to lend, as well as its actual lending, during periods when an increase in liquidity appears likely to be beneficial, and curtailing them at other times. By varying its willingness to lend it can affect the amount of conditional liquidity, and by varying its actual lending it can affect the amount of unconditional liquidity.
Again, to the extent that it has discretion in its lending operations, an international credit institution can steer liquidity—whether newly created or currently withdrawn from countries repaying their debts to the institution—toward those countries where it will do the most good and the least harm.
The amount of international liquidity that an institution can create depends to a considerable extent on the amount of resources that countries are willing to subscribe to it, lend to it, or deposit with it. Much also depends, however, on psychological attitudes. For example, the more countries are inclined to regard their claims on the organization as an integral part of their reserves, the more willing they are to borrow from the organization; and the more they regard their borrowing rights as a substitute for reserves, the more liquidity will be felt to exist, and the more will actually exist in the world. Finally, the legal structure and acquired functional characteristics of the institution in question will affect not only the amount and character of the liquidity it creates but also the variability of the liquidity through time and the extent to which it can be steered into appropriate channels.
Differentiating characteristics of international credit institutions
There are innumerable types of possible international credit institutions. Some of the apparent differences between them are matters of form rather than of substance. For example, there is far less difference than is commonly believed between the Keynesian Clearing Union plan, which took the form of a deposit bank, and the International Monetary Fund, which takes the form of an exchange fund, or “bag of currencies,” as it has been described. It is not a matter of fundamental importance whether a country’s net claims against an institution are reckoned in the form of a “bancor” balance, as in the Clearing Union, or in the form of an initial subscription less the institution’s holdings of the country’s currency, as in the International Monetary Fund.
The really substantive differences between international credit institutions relate to such matters as the following.
Manner in which institution is provided with resources
The institution may obtain its resources (1) through countries voluntarily depositing gold or foreign exchange on long term or short term, (2) through the calling up, in advance of actual use, of gold or foreign exchange subscribed by members in accordance with a general agreement, or (3) through members undertaking in advance (a) to provide gold, foreign exchange, or domestic currency, up to a given maximum amount, as and when required by the institution for its lending operations, or (b) to maintain a given proportion of their reserves in the form of claims on the institution, if necessary by depositing gold or foreign exchange. The Bank for International Settlements, though it has a small subscribed capital, relies very largely on (1). Apart from an initial contribution by the United States, the European Payments Union operated on the basis of permanent lines of credit extended as necessary by special arrangement, whereby each member financed a portion of any cumulative payments surplus with other members of the Union (method 3a). The European Fund relies partly on (2) and partly on (3a).12 Subscriptions to the International Monetary Fund, insofar as they consist of gold, fall into category (2); insofar as they consist of domestic currency, they have the same effect as undertakings of type (3a) since, as long as they remain unused in the possession of the Fund, the amounts subscribed are in effect re-lent to the subscribing members. Dr. Bernstein’s suggestion for the use of stand-by arrangements to finance a special fund primarily concerned with offsetting capital movements13 is an example of method (3a). Professor Triffin’s scheme14 for a renovated International Monetary Fund relies partly on (1) and partly on (3b), reinforced by a prohibition against holding more than a minimum amount of reserves in the form of balances with other countries.
By the use of method (3a)—uncalled subscriptions, stand-bys, domestic currency subscriptions—an institution can obtain resources (i.e., acquire lending power) with less initial loss to national reserves of gold or foreign exchange than under methods (1), (2), or (3b), though the impact on external liquidity of raising resources by these methods will depend on the nature of the claims that countries thereby acquire on the institution itself. Method (3a) also gives the institution more power than do other methods to determine from which countries it will draw resources at any time, and hence which countries will incur a loss in gold and foreign exchange reserves corresponding to the gain in the borrowing countries. This, however, will affect the liquidity of the creditor countries only to the extent that claims on the institution are less than fully liquid.
Liquidity of liabilities
An important question, related to, but distinguishable from, that just discussed, is the degree of liquidity attaching to members’ claims on the institution. Such claims may be convertible into gold or foreign exchange on demand, as is true of some Bank for International Settlements deposits. They may be automatically available to finance a proportion of any payments deficits with other members of the organization, as was the case in the European Payments Union. They may, in practice, be convertible almost without question into foreign currency when the need arises, and yet not be fully accepted as constituting reserves, as is true of creditor positions in the International Monetary Fund.15 They may be time deposits. Or they may be highly illiquid, as in the case of the called-up capital of the European Fund.
The greater the liquidity of the claims that countries acquire on surrendering gold or foreign exchange to the institution under methods (1), (2), and (3b) outlined above, the less will be the initial net loss of liquidity in subscribing countries. More generally, any increase in the liquidity of such claims will increase the potential contribution of the institution to the supply of unconditional liquidity in the world, both directly and by making countries more willing to acquire such claims and thus provide the institution with additional resources, when needed. This statement, however, needs qualification, insofar as the liquidity of its liabilities induces the institution, for its own protection, to maintain relatively high gold reserves, and to hedge round with burdensome conditions the credit facilities that it provides.
Certain devices are employed, or have been suggested, with the object of preserving the liquidity of claims on the institution while safeguarding the liquidity of the institution itself. Thus, though creditor positions in the International Monetary Fund are almost as useful for meeting payments deficits as if they had been convertible on demand, various safeguards exist against any excessive or arbitary drawing down of such positions. The repayment provisions of the Fund are such that even a member with a creditor position (not exceeding the gold portion of its subscription) can, in principle, draw on the Fund’s resources to finance only half of its payments deficit, the other half having to be financed out of reserves, and must restore its creditor position, to the extent of its gold subscription, when its reserves recover.16 Moreover, even creditor positions in excess of the gold subscription, if drawn upon by a member in a strong payments position, may be restored through drawings of its currency from the Fund by other members. The arrangement suggested by Triffin, described above as method (3b), is intended to achieve an even more complete reconciliation between the liquidity needs of the institution and those of its creditors. Such of the deposits in his New Model International Monetary Fund as are held not voluntarily but under the deposit requirement provision and are kept proportional to national reserves are unlikely to decline in aggregate amount, so that, though under all ordinary circumstances they would be usable by individual holders in conjunction with other reserves, they would present no threat to the liquidity of the institution, which need therefore maintain very little backing for them in the form of gold.17
Netting of assets and liabilities
In certain institutions, such as the Bank for International Settlements or Triffin’s New Model International Monetary Fund, a country can be simultaneously a creditor and a debtor, and its rights and obligations vis-à-vis the institution are determined by the amount of its gross claims and gross liabilities, respectively. In other institutions, such as the European Payments Union and the International Monetary Fund, a country’s claims and liabilities are offset against each other, and its rights and obligations are determined by its net position. The main effect of the practice of netting claims against liabilities is to reduce the volume of claims and to increase the amount of unused borrowing facilities. Where, as in the European Payments Union, both creditor positions and borrowing rights are automatic, this has no very great significance. But where, as in the International Monetary Fund, the liquidity afforded by claims on the organization is much less conditional than that afforded by borrowing rights, the effect of the netting practice is to reduce the amount of virtually unconditional liquidity that arises from a given amount of lending.
Liquidity of members’ borrowing rights
Corresponding to the differences that may exist in the liquidity of claims on international financial institutions, there are also possible differences in the liquidity—or the conditionality—of borrowing facilities. Thus, borrowing facilities may be subject to the discretion of the institution, as in the European Fund or the higher credit tranches of the International Monetary Fund, or they may be dependent on the payments deficits cleared through the organization, as in the European Payments Union, or they may be available on relatively easy conditions, as in the first credit tranche of the International Monetary Fund. One of the aspects of the International Monetary Fund system is that the Executive Board, if it so desired, could extend the automaticity of its lending to larger and larger percentages of the quotas and thus, rather simply, transform conditional into unconditional liquidity.
Quantitative limitations on members’ borrowing rights
The amounts that a member is allowed to borrow from the institution, in specific circumstances or subject to specific conditions, may depend, as in the case of the European Payments Union or the International Monetary Fund, on the amounts that it is obligated in other circumstances to lend to or through the institution, or they may be at the discretion of the institution, as in the Bank for International Settlements or Triffin’s New Model Fund. The second system obviously confers on the institution greater flexibility in lending and a greater power to steer liquidity toward the countries that most require it. On the other hand, it is difficult to combine with any degree of automaticity in members’ borrowing rights.
Conditions of repayment
Institutions also differ as regards the conditions governing repayment of their loans. Sometimes, the timing of repayment depends on the payments situation of the borrower, as in the case of mandatory repurchases from the International Monetary Fund, where the drawing country repays pari passu with a rise in its net reserves, or as in the case of the European Payments Union, where a predetermined fraction of any payments surpluses with other members served to finance an improvement in the member’s position vis-à-vis the institution. More frequently, as in the case of the contractual repurchases from the International Monetary Fund, repayments become due on a more or less flexible time schedule. In this event, maturities may be on a short-term (as is usual with the Bank for International Settlements), a medium-term (as with the European Fund and the International Monetary Fund), or even a long-term basis. The shorter the period of repayment, the greater for the institution will be (1) its ability, for a given volume of lending, to redistribute liquidity between member countries, (2) its liquidity, (3) its ability to exercise pressure on borrowers to follow appropriate policies for the restoration of equilibrium, and possibly (4) its ability to attract resources in the form of voluntary deposits. On the other hand, if the maturities are too short, this may detract from the usefulness of the loan and give rise to difficulty in finding willing borrowers if an expansion of credit and liquidity should become desirable. From the standpoint of the borrower, provision for repayment on longer term, or as and when the payments situation improves, would be more attractive.
Power of investment
Finally, institutions differ in the extent to which they are empowered, on their own initiative and at their own discretion, to acquire or withdraw investments in balances or securities. The International Monetary Fund is, in principle, passive with respect to demands for credit from member countries, and its powers of investment are narrowly circumscribed.18 The powers of the Bank for International Settlements are quite extensive but must be exercised in agreement with the central banks of the countries concerned. Complete freedom of investment in national markets is probably an unrealizable ideal. A substantial power of investment, however, such as Triffin envisages for his New Model International Monetary Fund, might be very important if the demand for loans, on conditions or for maturities acceptable to the institution, should turn out to be too small to enable the institution to expand its liabilities, and hence the supply of unconditional liquidity, to the extent that would be desirable.
Characteristics of international financial institutions in relation to their tasks
One of the tasks of an international financial institution is to adjust its policies flexibly to short-term changes in the optimal level of international liquidity. To some extent this adjustment will be achieved if the institution is responsive to fluctuations in demand for the use of its resources. However, in the sphere of international, as of domestic, liquidity there is no close correspondence between the need for liquidity and the demand for credit. An institution will be in a better position to fulfill this part of its function the more flexible are its lending criteria, the less binding are the quantitative restrictions on its power to lend to particular countries, the greater is its power to vary the duration of its loans, and the greater is its power to conduct open market operations by buying and selling investments on its own initiative.
Another important function is that of adjusting to short-term changes in the optimal distribution of liquidity. The ability of the institution to influence the distribution of liquidity will be greater the freer it is to switch its assets—and, to a lesser extent, its liabilities—between country and country. It will therefore be better placed to fulfill this function the less it is hampered by quantitative limitations on lending to particular countries, the greater, and the more widespread geographically, is the volume of its short-term loans, the greater is its power of buying and selling investments, and the freer it is to draw resources from whichever countries are currently best able to supply them.
In the event of any widespread decline in the willingness of countries to hold foreign exchange in their reserves, it would be particularly important that the institution should be in a position to take up reserve currencies in large amounts and hold them for a fairly long period of years.
As we have said above (p. 448), the amount of conditional liquidity available to countries on suitable conditions should, in principle, be indefinitely large. If this result is to be achieved by means of an international financial institution, that institution must be able to induce countries to provide it with sufficient resources, and to give its members access to a sufficiently high proportion of these resources in conditional form without providing too much unconditional liquidity. The ability of the institution to raise resources will depend partly on its success in winning the confidence and support of member countries and partly on its possession of a technique of raising resources that is as painless as possible for the contributing countries, e.g., by stand-bys that will be called only when a country is in a strong position and which, when called, confer upon the country claims on the institution that are liquid or otherwise attractive in character. On the other hand, an institution whose liabilities are reserve-worthy may find it difficult, in certain circumstances, to create a sufficient amount of liquidity in conditional form without as a by-product generating too much unconditional liquidity. The provision of a sufficient amount of conditional liquidity with a given volume of resources will be easier if there are no quantitative limits on the amounts that can be lent to particular countries. On the other hand, countries may be more willing to provide the institution with reserves if they thereby acquire some additional rights to borrow, if necessary, from the institution; this is difficult to arrange without some quantitative allocation of borrowing facilities.
Finally, the characteristics of a monetary institution have a bearing on its ability to generate, over the long run, an adequate but not excessive volume of unconditional liquidity in the world without the necessity for any general adjustment, upward or downward, of the price of gold in terms of the principal currencies. Apart from the problem discussed above of how to avoid creating too much unconditional liquidity as a by-product of creating adequate conditional liquidity, there should be no great difficulty in holding down the amount of international liquidity to a desired level. If necessary, gold could be acquired by an institution in exchange for an illiquid liability, and simply sterilized. At the other extreme, there is probably no limit to the amount of unconditional liquidity that can be created on the basis of a given stock of monetary gold, provided (1) that countries can be induced to hold, or to undertake to hold, a sufficiently high proportion of their reserves in the form of claims on the institution, (2) that it can be arranged, by some technique similar to those discussed above (p. 457), that countries only draw on their claims on the institution pari passu with their independently held reserves, (3) that the institution is enabled, through the power of investment or long-term lending, to expand credit to the necessary extent, and (4) that it need not cancel its claims on countries against their claims on it.
From what has been said, it is clear that, if an institution of the deposit bank type envisaged by Triffin were starting de novo, it would be somewhat better fitted than one of the type of the International Monetary Fund for expanding the amount of unconditional liquidity or reserves in the world on the basis of a given gold stock. Even an institution of the latter type, however, could do more than is commonly realized to increase international liquidity by making access to its resources more automatic, not only for creditors but to some extent for borrowers also, particularly if its powers of investment were extended and if it incurred liquid liabilities to members in a form that did not necessarily have to be canceled against its claims on these members.
On the other hand, an institution of the deposit bank type might find it more difficult than one of the Fund type to extend an adequate amount of conditional liquidity in the form of borrowing facilities without expanding national reserves excessively. In the early postwar years, when the combination of inflationary pressures and widespread restrictions in the world created a need for conditional rather than unconditional liquidity, it was natural that an institution of the International Monetary Fund type should have been set up. Today, on the other hand, when the dwindling of inflationary pressures makes it safer to expand reserves, while weaknesses in the gold exchange standard make it more difficult to maintain their expansion, it is equally natural that the air should be thick with proposals for making over the Fund into something more closely resembling a deposit bank.
In conclusion, it may be well to warn the reader that the achievement of an optimal amount of liquidity, even if the technical means of attaining that objective were available, would probably not do much to remedy the economic ills of the world. The fact that there are multiple criteria for regulating liquidity is itself sufficient to indicate that no one criterion can be completely satisfied. Even apart from the multiplicity of criteria, the regulation of international liquidity is not a sufficiently powerful instrument to ensure, for example, the maintenance of a broadly satisfactory balance between inflation and deflation in the world. Other forms of international cooperation than that required to achieve optimal liquidity might well be more successful in preserving the balance in question. However, external liquidity has some, if only a limited, influence on the general economic situation and therefore merits, as much as many another question, such systematic consideration as the economist can give to it.
Mr. Fleming, Adviser in the Department of Research and Statistics, is a graduate of Edinburgh University. He was formerly a member of the League of Nations Secretariat, Deputy-Director of the Economic Section of the U.K. Cabinet Offices, U.K. representative on the Economic and Employment Commission of the United Nations, and Visiting Professor of Economics at Columbia University. He is the author of numerous articles in economic journals.
For example, see United Nations, Department of Economic Affairs, Measures for International Economic Stability (New York, 1951), pp. 32-33; Roy F. Harrod, “Imbalance of International Payments,” Staff Pavers, Vol. Ill (1953-54), pp. 2-4; “The Adequacy of Monetary Reserves,” Staff Papers, Vol. Ill (1953-54), pp. 198-213; International Monetary Fund, International Reserves and Liquidity (Washington, 1958), pp. 14-30; Robert Triffin, Gold and the Dollar Crisis (New Haven, I960), pp. 38-41.
Traces of this approach are found rather generally in the literature. However, it appears most prominently, perhaps, in “The Adequacy of Monetary Reserves,” op. cit., pp. 185-91.
See International Reserves and Liquidity (cited above), pp. 42-43; Committee on the Working of the Monetary System, Principal Memoranda of Evidence, Vol. 3 (London, 1960), Memorandum of Evidence Submitted by Mr. A. C. L. Day, pp. 71-76; T. de Vries, “International Liquidity,” Economisch-Statistische Berichten, September 24, 1958, pp. 728-33.
There will, of course, be differences of view as to the relative emphasis to be put on price stability and full employment in judging the presence or absence of inflation, and as to the degree of exchange rate stability deemed desirable.
More precisely expressed, the increase in demand for reserves will tend to bear the same proportion to the pre-existing amount of reserves as that by which the value of transactions increases.
If the change in official policies is not checked by a rise in reserves, the decline in prices may ultimately bring the optimal reserves down toward their original level.
Milton Friedman, “A Monetary and Fiscal Framework for Economic Stability,” American Economic Review, Vol. XXXVIII (1948), pp. 245-64; reprinted in Milton Friedman, Essays in Positive Economics (Chicago, 1953), pp. 133-56. See also Employment, Growth, and Price Levels, Hearings Before the Joint Economic Committee of the Congress of the United States (86th Congress, First Session, May 25, 1959), Part 4.
That is, the consent of “every member which has ten per cent or more, of the total of the quotas” (Article IV, Section 7).
For an interesting mathematical treatment of some aspects of this question, on simplified assumptions, see Peter B. Kenen, “International Liquidity and the Balance of Payments of a Reserve-Currency Country,” The Quarterly Journal of Economics, Vol. LXXIV (1960), pp. 572-86.
In particular I would dispute the proposition, suggested on page 67 of his Gold and the Dollar Crisis, that increases in the short-term monetary liabilities of key currency countries, matched by less than one-to-one increases in their own gross reserves, will necessarily tend to bring about a collapse of the system “through the gradual weakening of foreigners’ confidence in the key currencies.” It is surely not necessary, in order to maintain confidence, that key currency countries should have a 100 per cent reserve backing for their short-term liabilities.
This is true on the assumption that the reserve currency countries themselves hold a smaller proportion of their reserves in foreign exchange than do other countries.
The part of its capital called up in advance of actual use consisted of part of the capital of the European Payments Union contributed by the U.S. Government: capital contributed by member governments is called up as required.
Edward M. Bernstein, “The Adequacy of United States Gold Reserves,” American Economic Review, Vol. LI (1961), pp. 439-54.
Gold and the Dollar Crisis, pp. 104-106.
To the extent that members have a creditor position in the Fund, they enjoy the “overwhelming benefit of the doubt,” in any request they make to draw any currency they need to make payments for current transactions, or to meet such capital outflows as the Fund may legitimately finance.
These provisions do not apply when a member’s reserves are low, i.e., less than its quota.
A difficulty with regard to this proposal has been raised by R. F. Harrod in “A Plan for Increasing Liquidity: A Critique,” Economica, Vol. XXVIII (1961), p. 196. He argues that, since countries might feel unable to rely on being able to convert the new International Monetary Fund deposits in time of war, a requirement that they should hold a fraction of their reserves in such deposits would have the effect of increasing the hard core of reserves that they will insist on keeping untouched in ordinary circumstances, and would thus bring about an initial reduction in their liquidity. It is difficult to know how much importance countries still attach nowadays to the possession of a war chest kept in the form of gold on national territory. Certainly, deposits with the International Monetary Fund should be no less safe than foreign exchange or gold held on earmark abroad. To the extent that the difficulty is a real one, it should not be impossible to circumvent or palliate it, e.g., by exempting a fixed amount of reserves in each country from fractional deposit requirements, or by suitable arrangements for geographical dispersion of the Fund’s own gold holdings.
Up to the present they have been used only to acquire earning assets.