FOR SOME YEARS, economists have devoted lavish attention to the “assignment problem”—the question of how to select a set of economic policies in order to realize a series of specified objectives for income, the balance of payments, and so on. In strong contrast, the parallel question of how to determine those objectives has been largely neglected. This is particularly true of the balance of payments target, where—with the exception of the literature on the optimal level of reserves—most authors have simply assumed a goal of “external balance,” which was usually interpreted as a zero change in reserves. The traditional definition of “adjustment” as “the process by which deficits and surpluses are eliminated” 1 is typical in taking it as axiomatic that payments equilibrium is a desirable goal, despite the obvious fact that a zero change in reserves would be a quite inappropriate target for a country with a shortage or an excess of reserves. Moreover, it is not merely the desirable change in reserves that deserves analysis: the structure of the balance of payments is also important. Once these facts are recognized, it becomes natural to redefine adjustment as “the process by which payments flows are altered so as to realize payments objectives.”
Payments targets have received the most explicit consideration in the discussions in Working Party No. 3 of the Organization for Economic Cooperation and Development and in the negotiations that led up to the Smithsonian agreement. It is almost inevitable that discussion in these contexts will be dominated by the concern to further what are perceived to be short-run national interests. There is a danger that such discussions will be reduced to horse trading in the absence of an analytical framework that is potentially capable of modifying countries’ perceptions of their national interests and of identifying occasions when they have a responsibility to moderate pursuit of such interests by concern for the general good. Since payments objectives that are effective—in the sense that an outcome inconsistent with the objective prompts the adoption of real adjustment policies rather than declarations of faith—have significant implications for economic welfare, one might hope that the necessary type of framework might be provided by treating the selection of payments objectives as a problem in applied welfare economics.
The balance of payments accounting required for discussion of the selection of payments objectives is rudimentary:
The composition of the current account is a problem in the allocation of resources and that of the capital account is a problem in portfolio management. The selection of payments objectives therefore has two degrees of freedom: the desired change in reserves, and the desired structure of the balance of payments (i.e., the division between current and capital accounts).
This paper represents an attempt to examine the principles that welfare economics would suggest should guide these two decisions. Section I examines the case where capital is immobile (i.e., where y = 0), so that the only decision to be made concerns the desired reserve change, which is necessarily equal to the current account target. Section II considers the case of a country with a freely floating exchange rate without official intervention, where again there is only one degree of freedom in the selection of payments objectives, since the current account is the mirror image of the capital account (since x + y = 0). Section III attempts to combine the two analyses to consider the general case.
I. Capital Immobility
If capital were completely immobile, it might well be true that official intervention in the foreign exchange market would be essential to prevent the initial perverse effects of exchange rate changes on the current account from leading to dynamic instability in the foreign exchange market.2 However, it is more natural to interpret the assumption of capital immobility as referring to a state in which the capital flows that are required to ensure stability net out to zero over a reasonably short period. The first question that requires consideration is the sources of the welfare gain that can result from the use of reserves under this assumption. There appear to be two such sources: the mitigation of adjustment costs, and the attainment of a more efficient pattern of absorption over time.
Most policies that are used to adjust the current account involve adjustment costs. The use of exchange rate policy imposes the frictional costs of redirecting output between markets, and usually of reallocating resources to change the mix of output as well. The use of demand management policy may superimpose the costs of price inflation, or output deflation, on these frictional costs. In this latter case, particularly, the cost of adjustment may increase not merely with the extent of the adjustment required but also with the speed with which it is effected. The use of controls and restrictions causes distortions in the allocation of resources (although there can be occasions, as when tariffs are raised and existing tariffs are below optimal tariffs, when the burden of these falls entirely on foreigners). It is possible, however, to conceive of instances when altering payments flows can permit an increase in welfare. Examples are provided by the removal of undesired restrictions on payments, or the stimulation of aggregate demand in an underemployed economy, that would be permitted by an increase in reserve ease. What seems to be true is that such instances can occur only if the previous policy was nonoptimal, just as immiserizing growth can occur only as a result of the presence of distortions.3 That is, any country that has adjusted optimally to one current account target and is then faced with the need to adjust to a different one will encounter a cost in the process of transition if one excludes techniques that are nonoptimal in the long run. In general, therefore, adjustment of the current account is costly. Consequently, a policy of financing transitory and reversible payments disequilibria through changes in reserves can increase welfare by enabling countries to reduce adjustment costs.4
The second source of welfare gain can be appreciated most clearly by considering a country whose export supply is constant in the short run, whose import prices are constant and determined exogenously on world markets, and whose export prices are determined exogenously on world markets but fluctuate with the state of world demand. The preservation of current account balance in a country in this situation would involve a level of absorption (consumption plus investment) that varied capriciously with the level of world demand and bore no necessary relation to the time path of absorption that would maximize welfare subject to the total income received over time. Welfare would normally be increased by a policy of accumulating reserves in periods of strong export demand and running them down in periods of weak export prices.5 Clearly, this conclusion is much more general than the extreme example introduced to illustrate the nature of the welfare gain.
There are, therefore, two reasons for regarding the pursuit of a continuous balance on current account as an inappropriate objective that would be detrimental to welfare. In the absence of international capital flows, reserve changes provide the only method by which countries can seek to mitigate adjustment costs and improve the pattern of absorption over time. The question that then arises is what determines the optimal level of reserves that should be held for these purposes. A number of models of optimal reserve holding have been constructed to illuminate this question, although most of them are based on rather restrictive assumptions, such as fixed prices and exchange rates, the exclusive use of expenditure-changing policies to achieve adjustment, random payments disturbances, and the absence of fundamental disequilibria. The general character of these models involves the location of a trade-off between the benefits of a larger target (and, therefore, average) level of reserves in terms of the increased ability of a country to avoid or mitigate adjustment in response to transitory imbalances, and the cost of larger reserve holding in terms of the diversion of resources from productive investment to the holding of lower-yielding reserves. When reserve changes are essentially random in character, as opposed to reversible, reserve holding cannot enable countries to avoid entirely the costs of adjustment, because a series of random shocks in the same direction would carry the reserve stock away from its target level and adjustment policies would be required to restore reserves to the target. The acceptance of fluctuations in the level of reserves, however, can enable countries to reduce the costs of adjustment and the variability in the level of absorption. An optimal payments strategy involves simultaneous optimization of the level of reserves and the speed of adjustment, which are related inversely. It has been shown that under these circumstances the target reserve level is an increasing function of payments variability and the cost of adjustment, and a decreasing function of the opportunity cost of reserve holding.6
The effects of generalizing the assumptions usually employed in the literature on optimal reserves would not seem to reverse the general nature of the conclusions reached. It has been shown that an essentially similar analysis can be constructed where the adjustment mechanism involves changes in prices rather than in output,7 and this presumably implies that the analysis also carries over to the case where exchange rates are changed. Where payments imbalances are persistent (fundamental disequilibria) rather than merely random, reserves still serve a function in increasing the freedom of action of countries in selecting policies to eliminate the underlying imbalances. Where payments imbalances are reversible, their financing by reserve changes can be of even greater value than portrayed by the literature on optimal reserves, because it can raise the average level of income as well as reduce its variance.
One particular source of reversible payments imbalances is provided by cyclical variations in demand. It has already been argued that, where these variations are external in origin, a government with adequate ability to stabilize internal demand will be able to raise welfare by smoothing the time path of absorption, which involves accumulating reserves in times of strong foreign demand and running them down when external demand is weak. If the government does not have much power to stabilize internal demand, however, a cycle generated by variations in external demand would be intensified by the adoption of a fixed exchange rate and the associated reserve variations, as opposed to a policy of allowing the exchange rate to float. In contrast, if cyclical variations are generated internally—a condition that presumably arises only where the government’s power to stabilize demand is limited—a policy of exchange rate stabilization and acceptance of the resulting reserve fluctuations acts as a valuable built-in stabilizer to the level of demand.8
With the exception of a country whose cycles are generated externally and whose authorities are unable to mitigate the domestic impact of those cyclical variations better than would be achieved by a policy of floating, one can draw the following conclusions: (a) that adequate reserve holding raises welfare, and that this is achieved by allowing reserves to fluctuate; (b) that a deviation of reserves from their target level requires measures that will tend to restore them to target, to the extent that there are no forces already at work tending to achieve that result; and (c) that when both reserves and income are at their optimal levels, the marginal social yield of reserves (comprising both the pecuniary yield and the liquidity services of mitigating the need for adjustment) is equal to the marginal social return on investment.
Assuming that the system as a whole contains a level of reserves that would permit all countries to achieve their reserve targets simultaneously, the international community would benefit from each country pursuing adjustment policies that would tend to restore their reserves to target. In particular, this would ensure that adjustment policies were consistent rather than competitive. If the level of reserves in the world is in fact appropriate, this result would be achieved by countries pursuing their enlightened self-interest.
II. The Capital Account
It is convenient to introduce consideration of the problems involved in selecting payments objectives where capital is mobile by abstracting from the considerations discussed in the preceding section. This can be done by considering a country whose authorities believed that the private sector could be relied upon to provide the optimal quantity of stabilizing speculation, and who therefore adopted a policy of allowing the exchange rate to float freely without official intervention. This would imply that the current account was the mirror image of the capital account. Assuming that the speculators did in fact achieve the optimal measure of stabilization and that these short-run flows netted out to zero over a reasonable time horizon, this would provide an environment in which any other flow of financial capital would generate a corresponding transfer of real resources, so that there would be only one degree of freedom in the choice of payments objectives: the structure of the balance of payments.
There are four types of motivation for “underlying” capital flows—as opposed to the short-run flows intended to profit from exchange rate changes, which are being neglected by virtue of the assumption that they net out to zero. The first three of these are similar in that they provide motivation for reciprocal capital flows without any necessary net transfer of real resources. First, direct investment permits a firm that has acquired knowledge, technology, or intangible property to apply its particular expertise more profitably than it could do by confining production to its domestic economy. Second, portfolio investment permits savers to acquire a more diversified portfolio than is possible on the basis of the securities issued in their home country alone. Third, portfolio investment permits savers in one country to acquire a different maturity structure of assets to the liabilities that the borrowers of that country prefer to issue; that is, it may permit international financial intermediation.9 With each of these three types of motivation, a two-way flow of financial capital that need not (if the flows happen to balance exactly) involve a transfer of real resources can increase welfare in both countries.
The fourth motivation is the search for a higher rate of return than is available domestically. Capital flows prompted by differential rates of return differ from those considered in the previous paragraph in that they are necessarily one way, and therefore they necessarily generate a transfer of real resources. Indeed, it is the transfer of real resources that leads to the welfare gain from this type of investment; resources are (typically) transferred from capital-rich countries where the rate of return is relatively low to capital-poor countries where it is relatively high, with a consequential gain in the productivity of investment. Capital flows determined by the classic forces of “thrift and productivity” permit the investment decision to be divorced from the consumption /savings decision, and thereby permit a potential gain in welfare for the citizens of both the capital-rich countries, who can obtain higher returns than would be available domestically, and the capital-poor countries, who can sustain higher levels of investment without unduly depressing national consumption.
The classical prescription of free capital movements is based on the welfare gains available from both two-way and one-way international investment. However, a number of reasons may prompt national governments to neglect the classical prescription, and these reasons require analysis before one can suggest the appropriate attitude of the international community toward capital account policies. Some of the reasons that are empirically most important arise from the fact that governments do not in fact accept the presuppositions on which the analysis of the present section is based; that is, governments attempt to defend particular exchange rates and therefore seek to thwart capital flows that threaten that aim, and because of such rigid exchange rates it need not be true that a net flow of private capital will generate a corresponding transfer of real resources. These factors are considered later in this paper; for the present, attention is confined to the restrictions on free capital movements that might arise in the environment postulated at the beginning of this section.
One factor that sometimes causes governments to limit the inflow of foreign direct investment is the desire to prevent what is frequently conceived as being a danger of excessive foreign control of the domestic economy.
A second factor arises from the existence of a wedge between the social rate of return and the private rate of return to the investor. There are ordinarily three main components of this wedge: corporate taxes on the profits stemming from the investment, the marginal increase in wages prompted by the greater capital stock, and the pollution created by the increased production. All three components accrue to the country where the investment is located, rather than to the country of the investor. From a national point of view—that is, from the standpoint of a national government interested in maximizing national wealth—the optimal condition for a capital-exporting country is that the private rate of return on foreign investment be equal to the social rate of return on domestic investment, while private investors would of course seek to equate the private rates of return on domestic and foreign investment. If, as it seems reasonable to assume, the first two components of the wedge usually outweigh the third so that the wedge is positive, the government of a capital-exporting country would seek to restrain capital outflows to a lower level than that sought by private investors. In contrast, a capital-importing country would have reason to welcome capital inflows up to and even beyond the point found profitable by private investors, because such flows would bring net advantages in the form of the wedge.
If one makes the “neutral” assumption that there is no a priori reason to expect the size of the wedge to differ in one direction rather than the other as between capital exporters and importers, a cosmopolitan welfare function of the traditional Paretian character would recommend that the national governments of capital-exporting nations refrain from limiting capital outflows so as to capture the wedge, since this gain occurs at the expense of a greater loss in the capital-importing countries. The principal exception arises when the wedge is caused not by the factors discussed in the previous paragraph but by fears of political instability or attempts to evade domestic taxation; both of these result in an abnormally large wedge in the capital-exporting country, which would justify restraints on the export of capital if the aim is to equalize the social rate of return in different countries. An international code of conduct to guide capital account policies should therefore endeavor to restrain controls on capital outflows, except where these can be shown to result from an abnormally large wedge. This guideline is reinforced if there is any element of egalitarianism in the welfare function—that is, if marginal gains in income are valued more highly when they accrue to low-income than to high-income countries—because, in general, capital exporters are capital-rich (and therefore rich) countries, while capital importers are generally capital-poor (and therefore poor) countries; when capital is exported from capital-poor countries, it is generally the result of “political” fears that are, in any event, a legitimate ground for restriction.
As long as the wedge is positive, limitations on capital inflows would impose an economic cost on the country that imposes the restriction; this leads to a presumption that inflows will be restricted only where the noneconomic benefits are judged to make this sacrifice worthwhile. Although it is less likely that a capital-exporting country would be economically harmed by restraints on capital inflows by capital importers than vice versa, there will be times when this occurs, either because the potential rate of return in the capital-importing country is very high or because the capital-exporting country lacks alternative investment outlets. It might well be important for an international capital code to limit restraints on capital inflows as well as outflows because sizable investment funds are now accruing to certain countries—some of the oil producers—that have limited domestic investment opportunities.
Benefits would therefore result from a liberal code of conduct regarding capital flows. It is natural to think of an international self-denying ordinance, similar to that provided by the General Agreement on Tariffs and Trade with respect to tariffs, as the channel through which such a code could be effected. Unlike the tariff case, however, mutual reduction of capital controls would often be beneficial to only one party—usually the capital importer, according to the foregoing argument—insofar as the flow was motivated by “thrift and productivity.” It is only insofar as flows are motivated by direct investment or the better satisfaction of portfolio preferences, so that reciprocal financial flows occur without a real transfer, that there is strong reason to expect a community of interest in mutual restraint similar to that regarding trade restrictions. This suggests that it would be difficult to negotiate an optimal degree of capital liberalization.
It is paradoxical that the preceding analysis would lead one to expect international tension to be caused most often by overrestrictive policies on the part of capital exporters, whereas the more common complaint in recent years has been that capital exporters have been insufficiently active in curtailing capital outflows. It is conceivable that the assumption that the wedge is generally positive is incorrect, which would resolve the paradox, but this explanation seems improbable. The paradox would also be explicable if the desire of capital importers to see their inflows cut off was caused by resentment at the fact that the counterpart to capital inflows has sometimes been excessive reserve accumulation rather than transfer of real resources, although this explanation is inconsistent with the asserted reluctance of some capital importers to accept the deterioration in the current account that would be needed to accomplish the real transfer. The most common explanation no doubt would be that many governments still regard current account surpluses as a useful prop to the level of employment; if this is in fact the explanation, after a quarter century when unemployment has been a less persistent problem than inflation and the tools of demand management policy have been generally available, it is sad comment on the state of economic literacy. It is possible, however, to visualize a more esoteric variant of this explanation, which centers on the rate of growth rather than the level of demand. The growth rate (of capacity) is dependent on the rate of investment, which can be limited either by the available resources (as is implicit in the preceding analysis) or by the inducement to invest (in a more Keynesian world). With output constant, a higher exchange rate would result in a bigger current account deficit and therefore larger resources to devote to investment; but it also might decrease the incentive to invest in that country, particularly if the deficit were to give rise to fears of deflationary policies. The selection of a growth-maximizing exchange rate will involve a trade-off between these two factors, and there seems no a priori reason to exclude the possibility that this criterion would lead many countries to seek current account surpluses and therefore to promote capital exports. If there were such a conflict between the national interests of different countries, it would reinforce the need for a code of conduct on capital flows to provide for a uniform minimum standard of behavior in accepting capital inflows. It would also suggest the desirability of improving the ability of those countries whose investment constraint exceeds the savings constraint to finance their current account deficits.
III. The General Case
The preceding sections were based on artificial assumptions in order to isolate the factors relevant to formulating payments objectives where only one degree of freedom exists. In this section the two analyses are combined to consider the realistic case where countries formulate implicit or explicit objectives with respect to both changes in reserves and the structure of the balance of payments.
Section II was based on the assumption that in an environment of freely floating exchange rates private speculation not only would be stabilizing but also would provide the optimal degree of stabilization from the standpoint of achieving the objectives considered in Section I. If this is not true—which would apply a fortiori if speculation were destabilizing and would be more likely, the greater the stochastic shocks that influence capital movements—there would be scope for fruitfully complementing private capital flows by official ones, that is, by reserve changes.
If the authorities had perfect information concerning investment opportunities and consumption preferences, they would be able to solve an intertemporal optimization problem in order to discover the optimal transfer of real resources, or current account balance, at each point in time. Under such circumstances, the authorities would have no need to take account of flows of financial capital as a guide to the current account targets at which they should aim. However, the fact is that the authorities rarely possess enough information to reach an informed decision regarding the desirable real transfer by such a direct approach. The alternative is to treat the underlying flow of financial capital that materializes after the adoption of policies in accordance with the principles developed in Section II as a guide to the target current account balance.
The analysis in Section II therefore remains relevant to the selection of policies with regard to the underlying capital flow. The analysis in Section I becomes relevant to variations in the “basic balance” (interpreted as the sum of the current account and the underlying capital flow) rather than to variations in the current account alone. Nonunderlying private capital movements might partially or wholly meet the needs analyzed in Section I, or they might aggravate them. It follows that the appropriate underlying current account target should reflect both the underlying capital flow and a contribution to restoring a target level of reserves. If
|K||=||underlying capital account balance;|
|R||=||reserve level, adjusted for reversible factors;|
|R*||=||target reserve level;|
then C*, the target underlying current account balance, would (assuming that a simple partial adjustment mechanism is appropriate) be given by
The optimal reserve level, R*, and the speed of adjustment, a, are determined simultaneously by an optimizing analysis of the character developed in the literature on optimal reserves. The final term in the equation covers the need for secular growth in the level of reserves.
This formulation raises certain questions. The first is whether there is any reason to suppose that, by intervening in the market (under whatever exchange rate regime) and guiding their adjustment policies (whatever form these may take) by these principles, governments will in fact be able to achieve results that are superior to those that would result from allowing the exchange rate to float freely without official intervention. It has been argued that because the stabilization of prices and incomes has the characteristics of a public good, which will not carry proper weight with private speculators, the answer must necessarily be in the affirmative.10 This is unpersuasive; the question is an empirical one, the answer to which depends on the intelligence with which governments intervene, as well as the characteristics of speculative activity. Since this paper is not intended to add to the copious literature on the merits of free exchange rates, no attempt will be made to answer the question. Those who have sufficient faith in the wisdom and foresight of private speculators relative to those of governments may interpret this section as an attempt to advise governments on how to minimize the harm that they do.
In one important respect, however, the introduction of private capital flows significantly modifies the rationale developed in Section I for an element of fixity in exchange rates with its corollary of accepting reserve fluctuations. This concerns the argument that under a fixed exchange rate the foreign sector will act as a built-in stabilizer to moderate domestically generated cyclical fluctuations. Since interest rates tend to rise during an upswing, a floating rate may still enable the foreign sector to perform this function: with capital mobility, a current deficit would be associated with a capital inflow motivated by the rise in interest rates rather than causing a depreciation in the exchange rate. It is conceivable that the optimal policy might involve procyclical variations in reserves and/or the exchange rate rather than the anticyclical swings envisaged by the traditional theory.11
The second question is the relationship of the preceding analysis to Mundell’s proposal to vary the fiscal-monetary mix to achieve, simultaneously, internal objectives relating to the level of demand and external objectives concerning payments equilibrium.12 The effect of this proposal would be to induce capital flows that would offset whatever current account imbalance happens to result from the pursuit of full employment policies. The fundamental objection to this proposal is that it involves manipulating the financial capital flow independently of those considerations of thrift and productivity analyzed in Section II that should determine real capital transfers on grounds of economic efficiency, thus failing to provide a mechanism for adjusting real transfers to the level required for efficient allocation of resources.13 However, from the standpoint of an individual country,14 a legitimate although limited role remains for a Mundellian manipulation of the fiscal-monetary mix when reserves are so low that the country would otherwise be faced with a choice between reserve depletion and peremptory adjustment. Such manipulation, however, should be regarded as a method of financing rather than of adjusting an imbalance. Adjustment, interpreted as the changes required to make payments flows conform to objectives, cannot in general be accomplished by manipulating capital flows.
Other methods of financing imbalances (apart from using reserves) include borrowing reserves, for example, by drawing on the International Monetary Fund. A second method is restricting capital flows. Either of these might be preferable to peremptory adjustment when there is a threat of reserve depletion.15 Furthermore, capital controls might be used to repel disequilibrating capital inflows motivated by anticipated exchange rate changes without any adverse welfare consequences, provided, at least, that payments objectives are being determined rationally so that speculative capital movements are not a necessary condition for undertaking desirable exchange rate changes. The common feature of these examples is that welfare would not be promoted by a real transfer corresponding to the potential flow of financial capital. If the real transfer is undesirable, then the relevant question to be asked in deciding whether to handle a potential capital flow by financing through reserve changes or reserve borrowing, suppression through controls, or neutralization via the fiscal-monetary mix, is which of these three courses of action will minimize the costs of distortions and any undesired redistribution of income.
In such cases as those considered in the previous paragraph, where a real transfer would not benefit economic welfare, it would obviously be undesirable to allow a potential or actual financial flow to influence the current account objective. The formula in equation (1) recognizes this, since K is defined as the underlying capital flow and R as the reserve level adjusted for reversible factors. There is, however, one case in which the formula as it stands is inappropriate, and that is when a capital inflow is attracted by distortion of the fiscal-monetary mix, or an underlying capital outflow is thwarted by controls, so as to prevent peremptory adjustment. In this case, reserves are being held “artificially” higher than the level that would correspond to underlying portfolio preferences. This should be reflected in the formula in equation (1) by deducting from R a sum equal to the extent of the distortion.
The third question is the implications of the analysis for the policies that should be adopted to deal with a maldistribution of reserves. A maldistribution arises when a succession of payments imbalances causes a distribution of reserves that is quite different from one that would correspond to each country holding its optimal stock of reserves. Such a maldistribution of reserves could in principle be corrected by either (a) reserve borrowing and lending; (b) capital account policies, involving either Mundellian interest rate policies or controls; (c) current account adjustment. Which policy is appropriate?
Either reserve borrowing or capital account policies may be useful in the short run, so as to reduce the costs of current account adjustment that arise when the reserve disequilibrium is first identified and when it has been corrected. The implication of equation (1), however, is that ultimately reserves should be redistributed wholly through current account adjustment, except to the extent that the maldistribution is itself the result of reversible (rather than underlying) capital flows. For example, in the textbook case where capital is perfectly mobile and payments imbalances are caused solely by rates of monetary expansion that are inconsistent with real growth rates, the complete solution to the resulting maldistribution of reserves is a reversal of the monetary policies that caused it; the adjustment is entirely in the capital account. This is not inconsistent with the analysis, provided that one adopts the natural course of defining the capital flows that are to be considered reversible with reference to a neutral rule on monetary policy.16
Let me examine the objections to the alternatives to current account adjustment. Either of them would tend to undermine the influence of the real forces of thrift and productivity in determining the world distribution of the stock of wealth and/or capital. However, the emphasis traditionally given to the goal of flow equilibrium in the balance of payments might be interpreted as indicating that many economists have judged that the avoidance of distortions depends on flow rather than stock factors, and hence that after a disequilibrium has been ended it is sufficient to maintain flow equilibrium in the future and to let bygones be bygones. Clearly this would not be sensible if, because of imperfect capital mobility, the maintenance of reserves at an optimal level required the perpetuation of high interest rates that depressed investment and resulted in a marginal efficiency of investment that was permanently higher than in the rest of the world. If, however, the reserves were borrowed directly by the authorities rather than indirectly via the private market, that particular distortion could be avoided, and the same would be true if capital mobility were perfect. What would remain would be the possibility of freezing a nonoptimal distribution of the ownership of wealth. If the initial imbalance was a result of overspending in country A that reduced that country’s wealth/income ratio beyond the point preferred by the residents of A, remedying the maldistribution of reserves by transferring securities from the residents of A to those of the rest of the world would do nothing to restore wealth to a more satisfactory level. To achieve that objective, it is necessary that absorption be curtailed in A and that a current surplus be established.17
In this paper it has been argued that greater use of economic analysis should be made in examining the balance of payments objectives that countries should pursue. It has been argued that such analysis points to a target for the overall balance of payments that directs adjustment policies toward the gradual elimination of any persistent deviation between the actual and target reserve levels, while deliberately financing transitory and reversible imbalances by reserve changes rather than allowing them to initiate adjustment. “Adjustment” means essentially current account adjustment. Capital flows should influence the current account target, if they are of the underlying character discussed in Section II, or they may act as an alternative way of financing current imbalances; but their manipulation does not provide a method of balance of payments adjustment, interpreted as the process by which payments flows are altered so as to promote the objectives that would be consistent with the maximization of economic welfare.
Mr. Williamson, Advisor in the Research Department, is a graduate of the London School of Economics and Political Science and of Princeton University. He has been a lecturer at the University of York, England, and a consultant to H. M. Treasury and is currently on leave from his post as a professor at the University of Warwick, England. He has contributed a number of articles to economic journals.
In addition to colleagues in the Fund, the author is indebted to members of seminars at the Universities of Rochester and North Carolina for a number of helpful and stimulating comments on a previous draft.
International Monetary Arrangements: The Problem of Choice: Report on the Deliberations of an International Study Group of 32 Economists, ed. by Fritz Machlup and Burton G. Malkiel (Princeton University Press, 1964), p. 25.
A. J. C. Britton, “The Dynamic Stability of the Foreign-Exchange Market,” The Economic Journal, Vol. LXXX (1970), pp. 91–96.
Jagdish N. Bhagwati, “Distortions and Immiserizing Growth: a Generalization,” The Review of Economic Studies, Vol. XXXV (October 1968), pp. 481–85.
The argument that the use of reserves to finance transitory disequilibria leads to a saving in adjustment costs can be queried on the ground that certain transitory disturbances (e.g., a temporary loss of export markets) require adjustments even if reserves are used (e.g., because there are adjustment costs in redirecting output to the domestic market). It is certainly true that the use of reserves does not enable a country to avoid adjustment costs, even if all disturbances are transitory and reversible, unless the disturbances arise solely from variations in the prices of exports or imports. But adjustment costs can be reduced by the use of reserves as long as some of the resources made idle by a decline in exports can be shifted more easily into production for the domestic market than into production for an alternative export market.
This analysis is the obverse of that pioneered by John C. Hause, “The Welfare Costs of Disequilibrium Exchange Rates,” The Journal of Political Economy, Vol. LXXIV (August 1966), pp. 333–52, and developed by Harry G. Johnson, “The Welfare Costs of Exchange-Rate Stabilization,” The Journal of Political Economy, Vol. LXXIV (October 1966), pp. 512–18. They considered the welfare costs of distorting the time path of absorption by holding disequilibrium exchange rates in the face of a constant environment; precisely the same type of welfare cost arises from pursuing short-run payments equilibrium in an environment where reversible changes occur.
See, for example, Peter Barton Clark, “Optimum International Reserves and the Speed of Adjustment,” Journal of Political Economy, Vol. 78 (March/April 1970), pp. 356–76. This and similar models are discussed in John Williamson, “Surveys in Applied Economics: International Liquidity,” The Economic Journal, Vol. 83 (1973), pp. 685–746.
J. A. Frenkel, “Openness and the Demand for International Reserves,” Working Paper No. 10 (Tel-Aviv University, 1972).
A persuasive statement of this argument is made by Edward M. Bernstein, “Flexible Exchange Rates and International Adjustment,” in The Economics of International Adjustment, ed. by Randall Hinshaw (Baltimore, 1971), pp. 157–78.
The welfare benefits of international financial intermediation were explored by Walter S. Salant, “Capital Markets and the Balance of Payments of a Financial Center,” Chapter 14 in Maintaining and Restoring Balance in International Payments, ed. by William Fellner, Fritz Machlup, and Robert Triffin (Princeton University Press, 1966), pp. 177–96.
Herbert G. Grubel, “The Case for Optimum Exchange Rate Stability,” Weltwirtschaftliches Archiv, Band 109, Hefte 3 (1973), pp. 351–81.
See Herbert Giersch, “On the Desirable Degree of Flexibility of Exchange Rates,” a paper presented at Ditchley Park, England, in January 1973.
Robert A. Mundell, “The Appropriate Use of Monetary and Fiscal Policy for Internal and External Stability,” Staff Papers, Vol. IX (1962), pp. 70–79.
Harry G. Johnson, “Theoretical Problems of the International Monetary System,” The Pakistan Development Review, Vol. VII (1967), pp. 1–28; J.H. Williamson, “On the Normative Theory of Balance-of-Payments Adjustment,” in Monetary Theory and Monetary Policy in the 1970s: Proceedings of the 1970 Sheffield Money Seminar, ed. by G. Clayton, J.C. Gilbert, and R. Sedgwick (Oxford University Press, 1971), pp. 235–56.
From the standpoint of the system, there will sometimes be an additional factor. When domestic cyclical conditions are different from those in the partner countries, it is sociable to emphasize fiscal rather than monetary policy (under fixed exchange rates) because its spillover effects on other countries are smaller. However, this does not establish a general presumption in favor of the Mundellian assignment, because the mix that is optimal from an international standpoint will vary, depending on international conditions.
Capital controls might also be helpful to other countries when monetary policy is being used vigorously for cyclical purposes but the cyclical needs of the country’s partners differ.
With fixed exchange rates and an SDR system that provided the needed growth in reserves on an unearned basis, a neutral monetary policy would be one in which domestic credit expansion provided the increase in the demand for money at full employment and the rate of inflation consistent with a zero change in the current balance.
It is possible to envisage another objection to easy and prolonged reserve borrowing: it would tend to undermine the reserve constraint. The reserve constraint is the social custom of limiting payments deficits to a cumulative size that can be financed from available reserves and feasible reserve borrowing. The easier is prolonged reserve borrowing, the less effective will be the reserve constraint: if this constraint has a functional justification, rather than being merely a historical hangover, this would be undesirable. One is therefore led to ask whether a reserve constraint serves any rational social purpose.
One rationale for retaining a reserve constraint might be that it serves to prevent countries from adopting strategies that are inconsistent with maximzing their utility subject to a wealth constraint; that is, in going continually further into debt and servicing their debt by borrowing ever greater sums. (Technically, this function of a reserve constraint is that of providing countries with an incentive to adopt strategies that satisfy the transversality conditions—a function for which Patinkin hypothesized a “bond market imperfection” in the domestic context. See Don Patinkin, Money, Interest, and Prices: An Integration of Monetary and Value Theory (Evanston, Illinois, 1956), pp. 53 and 140.) Such a strategy must result in ultimate default, that is, in a violation of the wealth constraint. This raises the question as to whether it is desirable to retain a wealth constraint, but of this there can be little doubt. If countries were not required to pay for the real resources they obtained from one another, they would have every incentive to revalue, inflate, and limit exports; the scramble to obtain more goods than each country produced would invite major inefficiencies in the allocation of resources, and without any presumption that the international distribution of income would benefit as a result.
A second rationale might be found in arguments analogous to the criticisms that have been leveled at the “optimum quantity of money” argument in a domestic context (see S.C. Tsiang, “A Critical Note on the Optimum Supply of Money,” Journal of Money, Credit and Banking, Vol. I (1969), pp. 266–81), on the grounds that adoption of interest rates on money equal to the rate of return on physical capital would drive out all nonmonetary assets and could lead to macroeconomic instability. The analogous international argument is that limited reserves ensure that during a world cyclical upswing some countries will be obliged to curtail demand by a shortage of reserves, thus limiting the inflationary movement (Edward Tower and Thomas D. Willett, “More on Official versus Market Financing of Payments Deficits and the Optimal Pricing of International Reserves,” Kyklos, Vol. XXV (1972), pp. 537–52). The argument is weakened to the extent that national governments can be relied on to introduce anti-inflationary policies because of domestic concerns.
A third rationale might be found in a desire to limit the misallocation of resources that results if governments sometimes adopt myopic policies rather than maximize utility over time. Policies that have the effect of generating a false, because temporary, sense of well-being can distort the public’s optimal consumption and investment decisions, but in the process they are prone to generate external imbalances. Limitation of these imbalances serves to restrict the period for which such myopic policies can be pursued.