Deficits and the Money Supply

A country may have a balance of payments deficit, on current and ordinary capital account, for various reasons. When the deficit is large and persistent, one cause is almost certain to be excessive aggregate expenditure. Such a deficit shows that the money supply is larger than is necessary to finance an appropriate level of domestic expenditure at stable prices. The excessive money supply may have arisen from the creation of credit for the government, business, or consumers. The deficit in the balance of payments will tend to reduce the money supply. In the absence of other factors, including import restrictions, the balance of payments deficit would continue until its cumulative effect is to reduce the money supply and aggregate domestic expenditure to a proper relationship to home output plus the net inflow of capital.

In any system in which the monetary authorities sell gold and foreign exchange to the public for making foreign payments, a balance of payments deficit will lead to a direct reduction in the money supply and in bank reserves. As noted at the time of the Bretton Woods discussions, these effects are the same whether the monetary authorities use their own reserves or acquire the reserves from transactions with the Fund.¹ Where the currency of the country is held by other countries as reserves, e.g., dollars or sterling, a deficit in the balance of payments may be accompanied by an increase in banking liabilities to foreigners rather than a decrease in foreign exchange assets. Even so, if the money supply is defined as the amount of currency and deposits held by residents, the immediate effect of a balance of payments deficit will be to reduce the domestic money supply.

Of course, the effect of a balance of payments deficit on the money supply will be offset if credit is expanded to finance a government deficit, investment by business, or spending by consumers. Similarly, if the government acquires foreign exchange from the Fund to meet the balance of payments deficit and then uses the national currency counterpart to finance its own expenditure or to repay debt to the public, there may be no net change in the money supply. In such cases, the absence of any change can best be explained in terms of two offsetting factors: (1) a cash-reducing balance of payments deficit and (2) a cash-increasing transaction of the government or expansion of bank credit. Obviously, monetary and fiscal policy must be concerned with any measures (whether expansion of bank credit or government use of the counterpart) which offset the effect of a balance of payments deficit on the money supply.

Fund Transactions and the Money Supply

It may be helpful to follow the transactions consequent on a balance of payments deficit financed by the use of resources drawn from the Fund. Assume, first, that the central bank acquires foreign exchange from the Fund. The assets of the central bank (in foreign exchange) and the liabilities of the central bank (to the Fund) will be increased. When the exchange is sold, the assets of the central bank (in foreign exchange) and the domestic monetary liabilities of the central bank (currency notes plus deposits) will be decreased by an equal amount. The over-all effect on the accounts of the central bank, after it has sold an amount of exchange equal to what it acquired from the Fund, will be an increase in its liabilities to the Fund and an equal decrease in its liabilities to the public—that is, a reduction in the money supply.²

More often, the government itself acquires the foreign exchange from the Fund. In such cases, the government generally sells the foreign exchange to the central bank for national currency. If the government then deposits the currency to the credit of the Fund with the central bank, the effect on the money supply is the same as if the central bank had undertaken the transaction on behalf of the member: after the exchange is sold, there will be an increase in the central bank’s liabilities to the Fund and an equal decrease in its liabilities to the public. On the other hand, if the government sells the exchange to the central bank and then substitutes noninterest-bearing notes for the national currency, the ultimate effect on the money supply will depend upon the use to which the government puts the currency.³

The effect on the money supply is somewhat more complicated when the government acquires the exchange from the Fund and turns it over to an Exchange Equalization Account, placing noninterest-bearing notes of the government to the credit of the Fund with the central bank or treasury. The government’s liabilities (to the Fund) and its assets (claims on the Account) will be increased by an equal amount. In turn, the Exchange Equalization Account’s assets (in foreign exchange) and its liabilities (to the government) will be increased by an equal amount. The effect on the money supply will take place when the Account sells the foreign exchange. At that point, the foreign exchange assets of the Exchange Equalization Account will decrease and its national currency assets will increase. If the Account retains these assets as a deposit with the central bank, the money supply will be decreased by an equal amount. On the other hand, if the Account uses the national currency derived from the sale of exchange to repay its obligations to the government, the government will have increased assets in the form of national currency and increased liabilities to the Fund which may be evidenced by noninterest-bearing notes. The ultimate effect on the money supply will depend upon how the government deals with the national currency turned over to it by the Exchange Equalization Account.

A slight modification of this case may be worth describing. Assume that a country uses its reserves and then acquires foreign exchange from the Fund to replenish its reserves. There may be no further decline in reserves after the transaction with the Fund. The Exchange Equalization Account, which holds the reserves, will be indebted to the government for the amount of exchange acquired from the Fund, and the government will be indebted to the Fund for an equal amount which may be evidenced by noninterest-bearing notes. The transaction with the Fund will have had no apparent impact on the money supply—it may simply be treated as an accretion of reserves by the Account, financed by borrowing from the government. Fundamentally, the effect of the transaction on the money supply will depend on the manner in which the government previously handled the national currency acquired from the sale of foreign exchange by the Exchange Equalization Account which is later replenished by the transaction with the Fund.

Three Types of Government Use of the Counterpart

A reduction in the money supply is always associated with the sale of foreign exchange acquired from the Fund, unless there is offsetting action in connection with a substitution of noninterest-bearing notes of the government for the national currency deposit, or a simultaneous credit expansion. When there is a substitution of noninterest-bearing notes, the effect on the money supply will depend upon what the government does with the national currency it acquires in this way. This can be seen by considering three alternative uses of the national currency counterpart by the government.

First, the government may use the money to repay a debt to the central bank. Such use of the money does not offset the reduction in the money supply resulting from the balance of payments deficit. The liabilities of the central bank in the form of currency and deposits will be reduced. Its assets in the form of claims against the government will also be reduced. There may be a contingent effect, however, that should be noted: If the indebtedness of the government to the central bank is limited by law to a prescribed ceiling, the repayment of the debt to the central bank will make it possible for the government to borrow again. And if the government borrows and uses a sum equivalent to the debt it has repaid, the effect is the same as if it had used the national currency counterpart for the purposes discussed below.

Second, the government may use the national currency counterpart to repay maturing indebtedness to the public. If the government uses the national currency in this way, the cash balances of the public and the cash reserves of the banking system will be restored to about the same position as before the deficit.⁴ The central bank may be able to offset these public debt transactions with open market operations; but positive steps by the monetary authorities would be required to integrate their operations with the fiscal operations of the treasury. In some countries, there are no institutional facilities for open market operations. The central bank could perhaps reduce its own credit operations with the public or with banks and to some extent offset the consequences of the government’s public debt operations. In any case, there may be some difficulty in preventing a consequent expansion of the money supply, if the government uses the national currency counterpart to repay its obligations to the public.

Third, the government may use the national currency counterpart to finance expenditure that it might not otherwise have undertaken. The financing of expenditure in this way will restore the cash balances of the public and the reserves of the commercial banks. The contraction in the money supply resulting from the balance of payments deficit will be offset by the expansion in the money supply resulting from the budgetary deficit financed with the national currency counterpart of the transaction with the Fund. Although the effect on the money supply and the cash reserves of the banks will be approximately the same as that attributable to repayment of government debt, use of the counterpart to finance additional government expenditure will differ from its use to repay debt in two respects: (1) the public’s holdings of government securities will not be reduced and (2) aggregate expenditure of the government and private sectors combined may be increased. Use of the national currency counterpart of a transaction with the Fund to finance additional government expenditure is in contradiction to the policy that is required to deal with a large and persistent balance of payments deficit.

Special Cases

There is no doubt that the principal cause of the large and persistent balance of payments deficits that a number of countries have experienced in recent years is excessive aggregate expenditure—that is, inflation. In such a case, a contraction of the money supply is an essential part of any program for restoring a balanced payments position. There may be other instances, however, in which the decline in reserves is attributable to causes of a temporary character, and the monetary authorities may be reluctant to permit a contraction of the money supply in some of these cases.

Suppose, for example, that the export receipts of a country decline because of a cyclical recession in importing countries, which may be expected to pass in a relatively short time. A contraction of the money supply consequent upon a balance of payments deficit may reduce the general level of economic activity, since aggregate expenditure is not excessive. In such a case, the monetary authorities may properly offset all or part of the reduction in the money supply that accompanies a balance of payments deficit. A similar consideration might justify a partial offsetting of the contractive effects of a balance of payments deficit resulting from a crop failure. The point is that a deficit which is expected to be moderate and temporary does not call for a general contraction of credit.

Considerable caution is required in concluding that a balance of payments deficit is likely to be moderate and temporary. Even if the decline in export receipts is attributable to a change in world markets, it does not follow that the monetary authorities would be justified in offsetting the effects of the balance of payments deficit on the money supply. Thus, a fall in export receipts may be caused by an increase in world supply rather than by a reduction in world demand for certain export products. The balance of payments deficit under such conditions may be large and persistent unless remedial action is taken by the monetary authorities. Whatever other measures may be necessary, a contraction of the money supply is called for, and the effects of the balance of payments deficit on the money supply should not be offset.

When a country acts as a reserve center—that is, its currency is held as reserves by other countries—the significance of a decrease in its reserves is somewhat more complicated. If such a country has a balance of payments deficit on current and ordinary capital account (that is, excluding changes in foreign-held balances of its currency), its payments problem is like that of any other country. Where the balance of payments deficit is large and persistent, and is attributable to excessive aggregate expenditure, including foreign investment, the reduction in reserves should be permitted to bring about a contraction in the money supply. Where the balance of payments deficit is expected to be moderate and temporary, the monetary authorities could properly offset all or part of the consequent contraction in the money supply. If the outflow of reserves, however, is due entirely to deficits in the balances of payments of countries which hold the currency as reserves, this is not an indication that aggregate domestic expenditure is excessive or that a contraction of the money supply is required in the reserve center.

A country like the United States, with ample gold reserves, would have no reason to let the money supply contract if there were an outflow of gold because of payments of U.S. dollars by a Latin American country, say, to a European country which held its reserves in London or in the form of gold. Of course, when a country which is a reserve center is itself hard pressed for reserves, it may have to let the money supply contract when there is an outflow of reserves, for that is the only way it can protect its reserve position. For such a country, monetary policy should in any case be directed toward a rapid restoration of its reserves until they are adequate to meet the payments pressures that are inevitably transmitted from other countries to the reserve center.

Monetary and Fiscal Policy

The proper policy for dealing with a balance of payments deficit cannot be independent of a country’s reserve position. A country with deficient reserves does not have the alternative of letting a temporary balance of payments deficit or an outflow of capital run its course, confident that its payments position is strong and will soon be restored to balance. For such a country, greater flexibility in monetary and fiscal policy, imposed more promptly and with greater force, is necessary to relieve the strain on its limited reserves.

Even a country with adequate reserves cannot be indifferent to its balance of payments. A large and persistent deficit is likely to indicate not only that its international payments are unbalanced but that the economy is inflated. An effective remedy to restore external balance and internal stability must include measures to reduce public and private expenditure, and monetary and fiscal policy will have to be directed toward this end. The effect of a balance of payments deficit in reducing the money supply will facilitate the making of policy. It would be a mistake, however, to assume that the automatic reduction in the money supply will obviate the need for more positive measures.

The sale of foreign exchange by the central bank or the Exchange Equalization Account will reduce not only the cash balances of the public but also the liquidity of the banking system, that is, its reserves of central bank funds. Since banks operate on a fractional reserve, legal or customary, the reduction in bank reserves may induce banks to undertake a further contraction of credit. The extent of the induced contraction of credit will depend on whether the banks had previously held excess reserves, on the normal relationship between bank reserves and deposit liabilities, and on the availability of supplementary reserves through borrowing from the central bank.⁵

The monetary authorities may not be able to wait until the cumulative effect of a continued balance of payments deficit has reduced cash balances and aggregate expenditure sufficiently to restore the payments position. Even with the multiple contraction of bank credit, an adequate reduction in the money supply may require such a large depletion of the foreign exchange reserves that the monetary authorities cannot assume the risks of permitting such a succession of balance of payments deficits. Instead, they will have to take steps to compel a further contraction in bank credit and in aggregate expenditure to a level consonant with a proper balance of payments.

Where the excessive expenditure is due in part to an unbalanced budget financed by the creation of credit, it will not be possible to stop the drain on reserves unless public expenditure is reduced and the budget put in order. Governments that persist in large budgetary deficits can do so only because they have access to the credit-creating power of the monetary system. The remedy in such cases is for the government to recognize the damage done to the economy through the inflation that its spending generates. The monetary authorities, in turn, must resist any attempt by the government to use the monetary system to continue deficit financing.

The monetary authorities cannot rely solely on the self-corrective monetary mechanism to restore the payments position. A persistent payments deficit, large or small, calls for a thorough reconsideration of monetary and fiscal policy. There is no substitute for fiscal responsibility on the part of the government and a determined monetary policy on the part of the central bank. It would be unfortunate if the use of Fund resources were to be regarded as a means of avoiding necessary corrective measures or if the substitution of noninterest-bearing notes were to result in intensifying the monetary or budgetary disorders that have given rise to the payments problem.

The Fund is concerned to see that members that have payments difficulties follow policies that will enable them to deal with their payments problems. In any case in which a member uses the national currency counterpart of a transaction with the Fund to prolong an undesirable fiscal or monetary policy, the Fund will undoubtedly wish to call the attention of the member to the undesirability of such practices. The attitude of the Fund should be the same toward any other practices that encourage an undesirable financial policy. Where the Fund is satisfied that the financial policy of a member is suitable for dealing with its payments problem, it would have no reason to be concerned with the fact that the member may substitute noninterest-bearing notes for national currency.