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.
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.