This paper is an expanded version of a lecture delivered on March 18, 1963 to the Graduate Seminar in International Economics, University of Michigan, Ann Arbor, Michigan. The opinions expressed are entirely those of the author.


This paper is an expanded version of a lecture delivered on March 18, 1963 to the Graduate Seminar in International Economics, University of Michigan, Ann Arbor, Michigan. The opinions expressed are entirely those of the author.

This paper is an expanded version of a lecture delivered on March 18, 1963 to the Graduate Seminar in International Economics, University of Michigan, Ann Arbor, Michigan. The opinions expressed are entirely those of the author.

THIS AFTERNOON, I would like to discuss the way in which views regarding an appropriate system of adjustment for international disequilibria have developed in the postwar period, and may develop in the future. In particular, I shall inquire how these views are likely to respond to recent developments in the international economic environment. However, a brief outline of the major system of thought that prevailed on these matters at the end of World War II will provide a useful backdrop to our discussion. In what I have to say, I shall be concerned primarily with the means of dealing with disequilibria between industrial countries; a separate lecture would be required to consider the special problems of the less developed parts of the world.

The Postwar Orthodoxy

In the later years of the war, and in the early postwar years, there prevailed a novel orthodoxy regarding the type of international payments arrangement that should obtain after a transition period of postwar relief and reconstruction—an orthodoxy squarely opposed to the old faith in the gold standard that had determined international financial policy after World War I. This new orthodoxy, largely the work of Maynard Keynes, was incorporated, with some admixture of U.S. views not entirely compatible with it, into the Articles of Agreement of the International Monetary Fund (IMF) and the General Agreement on Tariffs and Trade (GATT).

The essential presupposition of the new doctrine was that national authorities were to be free to direct their monetary and fiscal policies toward purely domestic objectives which, it was hoped, would be those of maintaining full employment without price inflation. The maintenance of external equilibrium was to be entrusted, after the transitional period, to three or four main instruments: (1) exchange rate adjustment, (2) the use of gold and foreign exchange reserves and other forms of compensatory official financing, including drawings on the IMF, (3) restriction of capital outflow, and (4) restriction of imports. There were, however, to be no exchange restrictions that would impede multilateral settlement of current transactions.

Of these instruments of adjustment, only capital restriction was to be applied entirely at the discretion of national governments. Exchange rates were to be altered on the initiative of the government concerned, but only with the consent of the international community as expressed through the IMF, and only for the purpose of correcting a fundamental disequilibrium. Temporary disequilibria were to be met by the use of external liquidity—that is to say, by drawing on national reserves and, within prescribed limits, on the resources of the IMF. Import restriction was to be applied only to the extent that was allowed by the Contracting Parties to the GATT, with the advice of the IMF, to be necessary to safeguard the balance of payments, or more precisely, to defend the reserves, of the restricting country. Save during the postwar transitional period, any restrictions on imports were to be on a nondiscriminatory basis.

The general aim of this system was to adjust payments disequilibria with the least possible impairment of full employment, of freedom of international trade, and, in a sense, of exchange stability. It was designed to avoid the faults alike of the gold standard, of Schachti-anism, and of the currency chaos of the 1930’s. The system was remarkable for simplicity and, up to a point, for logical consistency. However, not only was it admittedly unsuitable to the circumstances of the postwar reconstruction period—so that provision had to be made for a special and much more permissive regime during that period—but even for application to more normal times it had grave weaknesses, some of which were visible from the start.

In the first place, though the system was intended, among other things, to promote exchange stability and to minimize restrictions on international trade, it imposed no specific obligation on countries to refrain from inflationary domestic policies that might necessitate undue resort to devaluation and/or import restriction. The Fund could protest to members about their monetary and economic policies. It could deny the use of its resources to countries that might be held to be using them in a manner contrary to the Fund’s purposes, in that they were not using them to avoid policies destructive of national or international prosperity. But inflation was never mentioned in set terms.

A second weakness lay in the provisions regarding exchange rate adjustment, which could take place only on the initiative of the member and with the concurrence of the Fund. This arrangement, while admittedly designed to prevent competitive devaluations of the sort that had occurred during the 1930’s, was held by some British critics to be too rigid to enable exchange rates to play the role which properly belonged to them in a system in which monetary policies were directed single-mindedly toward the maintenance of domestic full employment. True, the Fund was obliged to agree to any changes in rates that might be required to correct a fundamental disequilibrium, even if that disequilibrium had been brought about by perverse domestic policies, such as inflation. But, in the first place, “fundamental disequilibrium” is a fuzzy and ambiguous concept. To an economist, an equilibrium rate of exchange, even a long-term equilibrium rate, is something that is liable to change, gradually but continuously, with changing international relationships with respect to productivity, wage levels, normal capital exports, normal degree of employment, and so on. Such a gradual slipping away from fundamental equilibrium is particularly likely to ensue if monetary and fiscal policies are determined without regard to the balance of payments situation. However, all the architects of the Fund Agreement, including the British, were clearly of opinion that par values of currencies, once established, should stay put for longish periods of time, and be changed only at infrequent intervals—that is to say, when fundamental disequilibrium in the economist’s sense has become substantial. As Professor Meade, among others, has pointed out,1 this system of the “adjustable peg,” as he calls it, invites disequilibrating speculative capital movements at periods when a fundamental disequilibrium appears to be developing but has not yet reached a point at which an exchange adjustment will be made to correct it. However, in the early postwar period, when capital controls were widely and vigorously applied, this danger did not, perhaps, appear to be too serious.

A more important defect of the system of exchange rate adjustment, as soon appeared, was the fact that countries might not wish to devalue their currencies, even when—perhaps as a result of inflationary pressure—these had clearly got out of line. Since overvaluation, by creating payments difficulties, entitled deficit countries to impose import restrictions against surplus countries without fear of retaliation, thereby permitting them to maintain relatively favorable terms of trade, the incentive to devalue, at any rate in a world in which the unemployment problem had been overcome, might be unduly weak.

In these circumstances, the system was likely to tolerate the perpetuation of disequilibria, and thus to put an undue strain on the remaining instruments of adjustment, the use of liquidity or compensatory official financing, and the application of import restrictions on balance of payments grounds.

Owing to U.S. influence, the role of international liquidity in the postwar adjustment mechanism as actually established was much more modest than had been envisaged by Keynes in his Clearing Union plan. Not only were IMF quotas smaller than those of the Clearing Union but there was very soon established an interpretation of the Articles of Agreement of the IMF under which the use of these quotas was considerably less automatic than many countries—though not the U.S. delegation—thought had been agreed at Bretton Woods. On the other hand, the stock of “two-way” liquidity, in the form of gold, foreign exchange reserves, and Fund drawing rights, was supplemented, to meet the special needs of the reconstruction period, by “one-way” facilities for official compensatory financing in the form of long-term U.S. loans to the United Kingdom, France, etc., and, later, in the form of Marshall Plan aid. (I call these “one-way” facilities because their use did not give rise to liquid claims in the hands of the lending country.) Whether there was too much or too little international liquidity of all sorts in the early postwar years it is impossible to say; the relevant criteria point in opposite directions. For the purpose of minimizing the need for payments restrictions on imports, there was too little liquidity; for the purpose of discouraging inflationary policies, and promoting adequate adjustment of exchange rates or relative cost levels, there was too much. Given the somewhat perverse attitudes of governments toward the remaining instruments for adjusting payments disequilibria, and given the overpermissive character of the transitional period arrangements, of which I shall speak later, no satisfactory treatment of the problem of international liquidity was then possible.

The outcome of these various weaknesses, in the early postwar years, was an excessive reliance on restriction of imports and restriction of capital outflows as means of keeping external payments and external receipts in balance. This tendency was encouraged by the special circumstances of those years: the urgent need to rebuild the war-shattered economies; the fervor with which full employment policies were pursued, especially in the northern European countries; the existence of a functioning apparatus of controls over trade and payments, backed up by a system of rationing of consumer goods and allocation of raw materials; and, finally, the existence, under the Fund and GATT agreements, of a transitional period regime, especially permissive of restrictions and discriminations of all sorts. Even in its posttransitional aspect, however, the Fund-cum-GATT system would have encouraged this tendency by permitting capital controls unconditionally, and by authorizing countries whose reserves were low or falling to impose import restrictions for an indefinite period without much fear of retaliation from surplus countries. It is also cause for regret that the type of import limitation for which the greatest facilities were given, viz., quantitative restriction on imports, was precisely that which was least amenable to a market test, and hence most arbitrary in its incidence. Had special import surcharges or special import exchange rates been substituted for quantitative restrictions as the preferred instrument for dealing with temporary payments difficulties, it would have been easier to distribute scarce foreign exchange among the different types of imports in a rational way, easier to avoid meaningless discrimination, and, with the revenue that would have accrued to the authorities, easier to counteract inflationary pressures. But balance of payments import duties were regarded with aversion by ministries of commerce and were not permitted by the GATT, while multiple exchange rates were condemned by monetary authorities, both national and international, with even more severity than were quantitative restrictions.

The Transitional Period Regime

I do not wish to dwell on the arrangements for international payments adjustment that prevailed during the so-called postwar transitional period. As far as practically all the industrial countries are concerned, these arrangements have lapsed with the restoration of convertibility and are—one hopes—not very relevant to the problems of the future. The essence of the transitional system2 was that countries were allowed to retain, and even adapt to changing circumstances, restrictions on imports, restrictions on payment for imports—including, naturally, restrictions on the transfer of import proceeds to third country accounts—and hence the whole network of trade and payments agreements based on the principle of bilateral or regional balancing.

One point about this system, or lack of system, is not always realized, viz., that even if it had not already come into existence before the Fund and the GATT started their operations, its emergence was inevitable once it was granted that import restriction was an appropriate means of meeting the widespread payments difficulties that resulted from a combination of heavy demand pressures, unevenly distributed as between Europe and America, and a distorted structure of initial par values.

Briefly, the connection is this. If many countries are simultaneously applying import restrictions on payments grounds, and if they seek to apply these restrictions in a nondiscriminatory fashion, they will find that they are restricting imports from each other and thus worsening each other’s payments problems. To provide each other with an incentive to liberalize their mutual trade, it was natural for pairs of such countries in the early postwar years to set up financial arrangements under which the proceeds of exports from one partner to the other could not be converted into hard currency but had to be used for payment of imports from the other, or else allowed to accumulate. The distortion of trade involved in such bilateral balancing was, of course, considerable, but it was deemed preferable to the curtailment involved in putting all trade on a “hard currency” basis. The existence of currency inconvertibility was often invoked as a justification for trade discrimination. The true relation was the contrary; inconvertibility could be justified, if at all, only as providing a financial climate propitious to trade discrimination.

The basic trouble, as I said, was that of differential inflation and distorted exchange rates. A number of tendencies in the early postwar years induced industrial countries other than the United States to maintain exchange rates that were overvalued relative to the dollar. On the one hand, the reconstruction effort in Europe naturally tended to generate inflationary pressures. On the other hand, special circumstances rendered devaluation temporarily unattractive. In the first place, given the prevalence of underpricing and associated supply shortages, little expansion in export volumes could be expected from devaluation to offset its adverse influence on the terms of trade.3Again, overvaluation and the balance of payments difficulties resulting therefrom not only entitled a country to impose discriminatory import restrictions without fear of retaliation from the hard currency countries but even tended to enhance its claim to aid in the form of grants and loans. It is no wonder that the transitional period arrangements gradually withered away only in the mid-1950’s and were still technically applicable to European countries 15 years after the end of World War II.

These arrangements might have continued to be effective in practice even longer than they actually did but for a chance combination of circumstances. The existence of the sterling area meant that a large part of the world could finance its payments deficits by converting balances held in the United Kingdom. A drain of this sort, together with the United Kingdom’s own deficit, drove that country to devalue in 1949, during the recession of that year, when it seemed that the period of postwar inflation and shortage might be coming to an end, and an adjustment of exchange rates might therefore be of value in promoting exports. Sterling devaluation, in its turn, brought about devaluation on the part of continental countries. Had all these countries been able to foresee the great expansion in U.S. demand caused by the Korean conflict, they would probably have postponed their devaluations. However that may be, the adjustment of relative costs then brought about, reinforced by the fact that productivity in Europe tended to grow faster than in the United States, bore fruit in the middle 1950’s, when improving payments situations made it possible for European countries gradually to free their imports from restrictions imposed on payments grounds.

I do not wish to dwell on the process of liberalization and restoration of convertibility, which began by being confined to the transactions of European countries with each other and with other soft currency areas and was later extended to their transactions with the dollar area.

The Revival of Financial Methods of Adjustment

As the opportunity arose to get rid of restrictions on trade and payments, the European countries were glad to take advantage of it. The technique of restriction had become unpopular. Controls over external transactions were difficult to administer without matching controls over domestic transactions which, having become even more unpopular, were everywhere disappearing. It became generally recognized that the whole system of controls was not only arbitrary in its application but also a drag on efficiency and progress. And as the restrictions were progressively relaxed, the bureaucratic apparatus that had administered them was dismantled and it became more and more difficult to contemplate their reintroduction.

This, however, would have created a gap in the armory of weapons for dealing with payments disequilibrium, had not something been found to take the place of import restriction as a means of dealing with temporary deficits in the balance of payments. Though the reserves of European countries were increasing, international liquidity by itself was certainly not sufficient to accommodate all disequilibria other than those deemed suitable for correction by exchange rate adjustment. The gap was filled by a revival of the use of financial policy—particularly monetary policy—for the purpose of influencing the external as well as the internal situation of a country. Originally, while it was recognized that the prevention by each country of domestic inflation would help to avoid the generation of unnecessary external disequilibria, it had not been part of the doctrine underlying the postwar institutional setup in the international economic field that, merely in order to correct a payments deficit, disinflation should be carried further than might be necessary for the preservation of internal stability. Now the conviction grew that monetary policy could be used, not merely to check short-term disequilibria arising from capital movements, overstocking, and the like, but also to influence the rate of increase of money costs and thus check at an early stage emergent tendencies toward a fundamental disequilibrium—and this without more than transitory repercussions on employment and output.

The spread of optimism in this regard was encouraged by the special circumstances prevailing during the 1940’s and 1950’s. Throughout those years, despite occasional slight recessions in the United States, a condition of high demand pressure prevailed almost continuously in industrial countries outside the Western Hemisphere. In such an environment, a country experiencing temporary payments difficulties could generally restore external equilibrium by disinflationary measures, the adverse effects of which on its employment, production, or economic growth were relatively slight and short-lived. Even countries that have tended to get into fundamental disequilibrium—whether, like the United Kingdom, because wages tended to rise too fast relative to the rate of productivity growth, or, like the United States, for more complicated reasons—have been able to prevent too serious a deterioration in their basic balance of payments at the cost of a degree of underemployment and underutilization of capacity that has not until recently been considered excessive.

In these circumstances, the view that external as well as internal equilibrium is a legitimate object of financial and, particularly, monetary policy gained increasing acceptance in official quarters and among economists.4 The early postwar examples provided by Belgium and Italy of the effectiveness of financial restraint in producing a strong balance of payments had been associated with levels of unemployment generally considered to be excessive. More convincing were the examples provided by the Federal Republic of Germany in 1950, by Japan on various occasions, and by France in 1958—albeit that, in the last case, the adoption of a program of financial restraint was accompanied by devaluation.

The growth of confidence in the possibility of using financial instruments to prevent long-term disequilibria from getting out of hand without undue repercussions on domestic prosperity led logically to a declining emphasis on currency devaluation as an instrument of adjustment, and an increased tendency to interpret the Bretton Woods Agreement in the sense of a virtual fixity of exchange rates, save in the most exceptional circumstances. The acceptance of this point of view was furthered by the fact that the long persistence of inflationary tendencies, and the repeated failure of heralded recessionary tendencies to appear, naturally strengthened the influence in each country of the monetary authorities, whose aversion both to devaluation and to inflation has always been particularly marked.

The proposition that the inflationary pressures of the postwar period caused a trend toward greater exchange stability and greater reliance on financial policies as means of equilibrating international payments naturally holds primarily for deficit countries, where the policies to be applied were those of monetary restraint. Surplus countries have generally been almost as reluctant as they were during the interwar period to have deliberate resort to expansionary policies for the sake of correcting their payments imbalances. Indeed, at times, rather than import inflationary pressures from abroad, countries have contemplated, or actually embarked upon, currency revaluations. Thus in the immediate post-Korean inflation of 1950-51, some European countries were thought to be considering such a step, while Canada allowed her currency to appreciate rather than endure the inflationary pressures resulting from the great influx of capital. Finally, in 1961, Germany and the Netherlands carried out a slight revaluation in their currencies rather than make the relative cost adjustments, which their chronic surpluses appeared to require, entirely by upward movements in wages and prices. However, it is noteworthy that both these countries, in 1961 and 1962, in the interest of restoring the fundamental position of the U.S. dollar, showed a willingness to facilitate increases in wages and prices that must have been unwelcome from a purely domestic standpoint. Moreover, while generally reluctant to follow the “rules of the gold standard game,” most creditor countries have shown considerable willingness to provide financial assistance, accelerate debt repayment, and promote outward capital movements by various means, including low discount rates, to the extent that this could be done without creating too much inflationary pressure at home.

Recent Changes in the International Economic Environment

In recent years, a number of tendencies that have, or might have, important implications for the international payments system have been at work in economic life. In the first place, there has been a considerable increase in the international mobility of capital. This is connected, no doubt, with the relaxation of capital controls in European countries and with the improvement in facilities for covering exchange risks. It is also a result of the fact that U.S. capital, which was always free to leave the country, has in the last few years been attracted by the relatively high rates of profit prevailing in European countries and by the increased relative strength of European currencies.

Other developments of importance are the slowing down in the growth of international reserves and the increased precariousness of the international reserve structure that has resulted from the decline in the strength of the U.S. dollar, relative to the currencies of other main industrial countries. Up to a point, deficits in the United States and the United Kingdom tend to increase the level of world reserves because of the propensity of other countries to hold part of their marginal reserves in the currencies of these two countries. But beyond that point, the underlying weakness of these currencies has tended to check the growth of foreign exchange holdings, and to create a problem of inducing other countries to hold on to the exchange holdings which they already have.

Another factor is the growing appreciation of the importance of “cost-push” elements in the determination of price levels. Prices can rise uncomfortably fast at a time when there is slack and underemployment in the economy. And wages may react not only to the state of the labor market, but also to other factors more or less independent therefrom, such as the cost of living as affected by import prices, or the general state of political or industrial sentiment.

Finally, we come to a development which looks as though it were taking place but which may or may not prove permanent, viz., the ending of the period of high demand pressure that followed World War II. This period of pressure has been longer since World War II than it was after World War I, perhaps because of such factors as a more plentiful supply of international liquidity, a higher level of public expenditure, especially for defense, the absence of a precarious structure of international short-term indebtedness, more skillful and determined full employment policies, and a more expansionary demographic development. But it has been weakening for some years and, unless there is an exacerbation of the “cold war,” seems unlikely to recover its former strength. Up to now, this weakening has been marked only in the United States, Canada, and the United Kingdom, while several continental countries continue to be concerned about rising prices. But this price inflation is largely of a wage-cost character, and, though demand continues to be buoyant in Europe and Japan, the countries in which it is flagging are responsible for a large proportion of world industrial output. If the payments disequilibrium between the two halves of the industrial world were rectified, the existence of a general easing of demand pressures might become patent to all.

Increased International Mobility of Capital

The enhanced international mobility of capital has three main immediate consequences. In the first place, it adds to the instability of the balance of payments as a whole by introducing an element that is itself inherently less stable than most of the other items in the international accounts. Second, it expands the volume of interest arbitrage, or, more generally, the volume of capital that moves in response to international discrepancies in interest or profit rates. Finally, it increases the magnitude of the flows of hot money that occur when changes in exchange rates are believed to be imminent.

Owing to the second and third of these consequences, capital mobility tends to intensify certain types of payments disequilibria while mitigating others, and has an important bearing on the relative effectiveness of alternative adjustment policies.

Thus, suppose that a short-term change in world market conditions affects a country’s balance of trade, and thereby threatens to disturb the country’s internal equilibrium between total demand and total supply. In the absence of capital mobility, it might be possible to offset the external balance of payments effects by the use of reserves, while offsetting the internal over-all demand effects by credit policy. With high capital mobility, however, credit policy, as an instrument for maintaining internal equilibrium, is undermined. Any attempt that a deficit country may make, by lowering interest rates, to prevent a decline in its exports from leading to domestic recession will induce an outflow of funds which may exhaust its reserves; while a surplus country that wants to avoid “importing inflation” may, at least, have technical difficulties in reducing the money supply and raising interest rates. Moreover, if the large reserve movements that are apt to result from an attempt to apply offsetting credit policies in the situation described give rise to fears of devaluation (or revaluation), the disequilibrating flow of interest-motivated funds will be reinforced by a flow of speculative funds in the same direction.

Consider, now, a different kind of disequilibrium, brought about, say, by a temporary recession that occurs in some countries but not in others. In the absence of capital mobility, the countries experiencing the recession would tend to develop a payments surplus—thus relieving their own deflationary pressure by visiting on other countries both deflationary pressure and payments difficulties. With high capital mobility, however, though the deflationary pressure will still be exported, the payments surplus of the recession countries will be reduced by an outflow of capital resulting from the fall in interest rates there. With very great capital mobility, the balance of payments of the recession countries may even deteriorate. The enhanced capital mobility, while it will not necessarily mitigate the payments dis-equilibria arising out of recessions, will always make it easier for other countries to maintain prosperity.

By and large, however, there is little doubt that the enhanced international mobility and volatility of capital, though it occasionally acts as a stabilizing force, more often aggravates the difficulties of countries that are trying to combine internal stability and high employment with external equilibrium. One way of dealing with the most disturbing type of capital movement, viz., speculative movements, is to try to influence the exchange rate anticipations that give rise to them. For example, contractionary monetary and budgetary policies may be applied to restore “confidence” in a currency. Such policies may be justified, even if their ultimate effect on output and employment, if persisted in, would be bad, provided that they act so quickly on the flow of capital that they can be speedily terminated or reversed.

More generally, the moral which some experts and monetary authorities tend to draw from the enhanced mobility of capital is that exchange rates should be fixed even more firmly and irrevocably than under the par value system. If all possibility of exchange rate alteration could be removed, at least among a limited group of countries—for example, by the adoption of a common monetary unit—currency confidence would be complete, the volume of funds responsive to interest differentials would increase still further, and the balance of payments could easily be kept in line through interest policy. However, it is not clear how, under this system, internal financial stability would be maintained; and it would seem impossible to correct serious disequilibria in the basic balance of payments without doing undue damage to output and employment in deficit countries.

Quite opposite conclusions are drawn from the same factual premises by many of the most distinguished academic economists, who advocate the adoption of flexible or floating exchange rates more or less tempered by national intervention on foreign exchange markets. Experience, both in Europe in the 1920’s and in Canada in the 1950’s, suggests that, if appropriate policies to maintain internal stability are pursued, the floating rate system does tend to elicit equilibrating rather than disequilibrating exchange speculation. Moreover, floating rates may be applied, as they were by Canada in the 1950’s, to miti-gate the inflationary or deflationary pressures that would otherwise arise from capital flows which, though nonspeculative, are essentially irregular or nonrecurrent. However, there is some danger that an outward movement of capital, by depressing the exchange rate and raising the cost of imports, might, in the absence of suitable counter-measures, set off a wage-price spiral. Again, it is difficult to see how, under this system, the danger against which the par value system was devised (viz., that of competitive exchange depreciation) could be properly guarded against. Professor Meade’s suggestion5 for an international fund actively intervening in exchange markets to minimize undesirable fluctuations, while undoubtedly attractive, seems to me Utopian. Governments do not, unfortunately, trust international officials that much! In the unlikely event of the floating rate system being adopted by industrial countries generally, the best way of preserving the element of international control would probably be to retain par values and the requirement of international consent for any change in these values; to permit actual rates to deviate from par values by rather wide margins—5 per cent or so; and to lay down rules limiting the right of national authorities to intervene within the margins. The hope would be that equilibrating capital movements would generally keep actual rates from fluctuating to the full permitted extent.

Apart from schemes such as these, a principal purpose of which would be to alter the psychological climate in which certain types of speculative movement take place, other devices have recently been applied or advocated to obviate the adverse effects that capital movements of various kinds may have on the maintenance of internal and external stability. One school of thought would like to return to the technique envisaged at Bretton Woods for dealing with the problem of speculative or other unwelcome capital movements, viz., the application of restrictions enforced by exchange controls. This, however, is probably against the trend of the times.6 Monetary authorities are frequently unable or unwilling to apply such restrictions effectively. In any event, capital restrictions are just as crude and arbitrary in their incidence as quantitative restrictions on imports; the most noxious types of capital movement are frequently the most difficult to control.

A somewhat more promising approach, which has recently been developed both theoretically7 and practically, is that of distinguishing between the various instruments and applications of financial policy, and directing some instruments and applications primarily to external, others primarily to internal, ends. Thus, a country suffering simultaneously from payments difficulties and an unduly low level of demand and employment could seek to reflate by reducing taxes or increasing public expenditures while raising interest rates so as to attract funds from abroad. Or, within the field of monetary and debt management policy, it could seek to lower long-term interest rates to stimulate investment while raising short-term rates to attract funds from abroad. By such means, the enhanced mobility of capital might be made to serve, instead of frustrate, the aim of maintaining simultaneously internal and external equilibrium.

These techniques, however, have serious limitations. Interrelationships between the long and the short ends of the capital market set limits to the power of the authorities to determine short-term interest rates without reference to long-term rates, and vice versa. Again, the device of directing interest policy toward the achievement of external, and budgetary policy toward that of internal, equilibrium is not only subject to practical difficulties but also open to objections of principle. Thus, in many, perhaps most, countries the budget is too inflexible to be relied upon as the sole means of maintaining internal stability. Again, even where there is sufficient fiscal flexibility to make the policy-mix a technically feasible one, it may be disadvantageous, from a national standpoint, to rely upon it exclusively, and it will be disadvantageous, from a general standpoint, to apply it on a purely national basis.

Thus, if a country’s cost level is out of line with those of its competitors, any attempt to maintain full employment by fiscal means alone is likely to result in a chronic budget deficit and a persistently low level of national savings and growth, unless factors are at work, or other policies are applied, which will ultimately restore the country’s competitiveness. Again, even if no fundamental international disequilibrium exists, the combination of policies under discussion is one which, if adopted as a general rule by all countries, clearly could not work satisfactorily without a measure of international coordination. If each country were to determine its interest rate with reference to its balance of payments, taking as given the interest rates prevailing in other countries, the rates in the world as a whole would be indeterminate, and there is no guarantee that they would suitably reflect propensities to save and invest. Thus, there might be a situation in which interest rates were everywhere unnecessarily high, and governments were generally forced to run budget deficits to maintain full employment. To avoid such situations, the best method would be to regulate the geographical structure of interest rates through cooperative international action. The aim of such regulation would be to obtain an average level of rates in industrial countries appropriate to the state of demand pressure in the world as a whole, and rate differentials between countries that would provide the necessary assistance to those with weak reserve positions.

Another device for dealing with international capital movements that has become more widely used in recent years is official intervention in the forward exchange market. By supporting its own forward exchange rate, i.e., by speculating in favor of its own currency, a central bank or Treasury can attract short-term funds from abroad. This instrument is particularly appropriate as a means of countering adverse currency speculation on private account. Its scope is, however, limited, since it can influence only such short-term funds as are sensitive to the forward exchange rate, i.e., mainly covered interest arbitrage funds.

In an ideal world, all undesirable movements in private capital would be countered by officially sponsored movements in the opposite direction, i.e., by compensatory official financing. This, of course, includes the use of gold and foreign exchange reserves as well as official borrowing from international institutions, other governments, or private lenders. It is only when, and to the extent that, deficit countries are unable without undue risk to defend their currencies by compensatory official financing that it may become desirable for them to apply such mixed financial policies as I have just described. Both types of policy aim to affect net capital flows, but the mixed financial policies make it necessary, if suitable levels of over-all demand are to be preserved, to adopt budgetary policies not otherwise desirable, while compensatory official financing has no such disturbing side effects. However, there may not be sufficient external liquidity in the world, or it may not be possible to create enough to meet the needs of deficit countries without giving rise to too much inflation in the world as a whole. One way of getting round the latter difficulty is to provide liquidity in a form in which it will be available only in certain circumstances—for example, when required to meet payments disturbances of external origin—or under certain policy conditions—for example, avoidance of inflation. At present, the IMF is the principal source of such “conditional” liquidity in the world.

The Gold Exchange Standard and International Liquidity

In addition to the enhanced danger of erratic capital movements, other factors are making for an increased need for international liquidity. These include two of the four main developments in the international economic environment that I mentioned earlier, viz., the faltering of the gold exchange standard and the dwindling of inflationary forces in the world. It is easy to see how a need for more international liquidity might arise from the increase in the international mobility of capital and from the slowing down in the expansion of international reserves. The change in the inflationary climate has, as will appear, a rather more complex bearing on the subject. One aspect, however, is fairly obvious. Among the objections to increasing external liquidity is that it may encourage countries to give too slack a rein to expansionary financial policies and thus cause too much inflation in the world. A dwindling of inflation on other grounds obviously weakens the force of this objection.

Liquidity, as I have pointed out, may be available in unconditional form, or in a form the use of which is conditional on the observance of certain policies. This distinction does not necessarily correspond, but in actual fact often does correspond, in a rough way, to the distinction between liquidity derived from a country’s own liquid assets or reserves and that derived from borrowing facilities.

Proposals for controlling and expanding the level of international liquidity pursue either the institutional approach or the intercentral bank approach. The first approach is in a sense multilateral; the second is usually bilateral. The first is governed by rules and regulations; the second is much more ad hoc. According to the institutional approach, the necessary international liquidity would be built up in the form of claims on an international institution, such as the IMF, and in the form of facilities for borrowing from—or drawing on—this institution. Some advocates, such as Professor Triffin, lay major emphasis on the creation of liquid claims, or deposits, with the institution;8 others, such as Dr. Bernstein, lay more emphasis on the power to borrow from or through it.9 The recent extension of the resources of the IMF through the establishment of lines of credit with ten major industrial countries10 has the object of safeguarding its ability to provide the second sort of liquidity, but would, incidentally, permit the creation of liquidity of the first or reserve type, since the lending countries would acquire highly liquid claims on the IMF. The intercentral bank approach is itself, as it were, a two-lane highway, one lane being concerned with the practice of holding reserves in the form of foreign exchange, and the other with the provision of short-term or medium-term intercentral bank credits. Ideas on the systematization of the gold exchange standard on a reciprocal basis, with many reserve centers, have been studied by Professor Posthuma. More immediately practical, but tentative, steps in the construction of a network of credit arrangements have been pursued on the initiative of the U.S. monetary authorities, while the British have made suggestions designed to make these arrangements operate in a more multilateral way. The question of international liquidity is a vast and complex one, about which I cannot hope to say anything worthwhile within the scope of an already overcharged lecture. I shall therefore pass on, having simply indicated the place it occupies within the framework of the general payments problem.

Growing Importance of Cost-Push Factors

In regard to the third development of which I spoke earlier, namely, the growing prominence of cost-inflationary, as distinct—but not separate—from demand-inflationary factors, it is not possible to speak with much confidence about the bearing of these factors on the effectiveness of mechanisms of international adjustment. Clearly, any tendency of wages or other cost elements to move erratically without close relation to market factors is apt to give rise to international disequilibria of a “fundamental” sort. Moreover, any decline in the sensitivity of wage movements to the demand/supply situation in the labor market increases the difficulty of using financial policies to correct incipient disequilibria in international payments without undue damage to employment and output. To this extent, cost-inflationary factors make it more difficult to avoid resort to exchange depreciation. On the other hand, cost-inflationary mechanisms have a bearing, though an uncertain one, on the effectiveness of exchange depreciation itself as an instrument of international adjustment. One result of the existence of monopolistic elements in the labor market is that money wages tend to be responsive, not only to demand and supply conditions in that market but also to movements in the cost of living. Now, insofar as devaluation tends to raise the cost of living, it may tend to react on wage rates, so that a bigger devaluation than would otherwise be necessary is required to do the job. However, this may be outweighed by another consideration. Trade unions in industrial countries are amenable to fears of inflation, and generally dislike devaluation almost as much as central banks. They may therefore be particularly responsive to calls for restraint in situations in which devaluation becomes necessary. It is interesting to note that in Britain the greatest restraint in the postwar period was in fact shown just after the devaluation of 1949. Contrariwise, it was after the revaluations of the deutsche mark and the guilder in 1961 that German and Dutch wage rates showed their biggest increases.

The challenge provided by the growing recognition of cost-inflationary mechanisms has begun, in most industrial countries, to evoke a response in the form of what are euphemistically termed incomes policies, but are really attempts on the part of the authorities to influence the formation of wage rates and, occasionally, profit margins. Save in prewar Germany and postwar Netherlands, peacetime attempts in this direction have been highly tentative. Contrary to what is often asserted, no issue of individual liberty would seem to be involved in the strictest wage and price control as such. The extent to which democratic authorities will be able to enforce such controls, or even influence the general rate of growth of wages and administered prices, is still doubtful, however. It is also doubtful whether authorities of whatever stamp, if they were in a position to determine relative wages and prices, would pay enough attention to market considerations to avoid the emergence of serious distortions and diseconomies. If governments ever do succeed in gaining control over general wage and price levels, the problem of international adjustment of fundamental disequilibria will, of course, be completely transformed.11 That day, however, is still to come.

Dwindling Pressure of Total Demand

We come now to the fourth of our environmental developments, viz., a possibly increasing difficulty, at least among industrial countries, in maintaining an adequate pressure of aggregate demand and in avoiding excess capacity and unemployment. If this should, in fact, emerge, countries disfavored by international demand conditions, or less successful in maintaining competitiveness, will no longer be able to count on getting back in line simply by holding inflationary pressures in check for a time; they may find it necessary to curtail employment and output to an extent that will be unwelcome. Surplus countries will, no doubt, be more willing to expand demand in order to eliminate disequilibrium under the assumed conditions than they have been under conditions of general excess demand, but some of them may find it technically difficult to do so.

Under these conditions we may, I think, expect to find countries becoming more anxious to correct their payments disequilibria by measures that involve an improvement in their balances of payments on current account, i.e., by exchange rate adjustment, by curtailing imports, whether through licensing or through special import duties, and by tying aid and capital outflows to national exports.

In other words, we may at last see the emergence of an economic environment closer than was the economic environment of the 1950’s to what the founding fathers of Bretton Woods expected after the postwar transitional period. And it is important that the broad objectives they sought to achieve in those circumstances should be adhered to. The use of techniques, such as import restriction, that are destructive of international trade should be minimized or, if possible, prevented altogether among the developed countries. The tying of aid and of capital outflows is, like outright dumping of exports, a trade-distorting device, and can be justified, if at all, only insofar as it leads to an increased flow of financial assistance to underdeveloped countries. Exchange rate adjustment, though admitted as legitimate, should continue to be subjected to international control with a view to preventing its abuse as a weapon for gaining undue competitive advantages and exporting unemployment.

It is also important—for we cannot afford to dispense entirely with any of the instruments of adjustment—that countries should remain willing to allow a moderate divergence from the degree of over-all demand pressure that would be ideal from the standpoint of internal equilibrium, for the sake of correcting tendencies to fundamental disequilibria in external payments. In a generally deflationary environment, this would be particularly incumbent on surplus countries, as, in an inflationary environment, it is on deficit countries.

However, even assuming that resort to exchange depreciation would be kept under due international control by the IMF, the advent of a situation in which unemployment and stagnation, rather than inflation, were feared would be fairly certain to lead to an increase in the frequency of devaluations. This fact, with the consequential effect on expectations, would be likely to increase the danger of speculative capital movements and thus still further to increase the need for international liquidity, both of the conditional and of the unconditional sort. In the circumstances we are assuming, any effect that an increase in the supply of such liquidity might have in encouraging expansionary policies in industrial countries would, of course, be welcome.


Looking at the situation as it is affected by all the developments we have been discussing, one might believe that we are entering a new phase in the postwar history of the international monetary system, a phase which to some extent represents a return to the sort of situation envisaged in the Bretton Woods Agreement. However, the international mobility of capital and the autonomous cost-push elements in price formation will probably continue to bulk larger in reality than they did in the minds of the architects of Bretton Woods; and the lessons of the transitional period as to the frustrations of restrictionism and the importance of avoiding excess demand are unlikely to be wholly forgotten.

Under these conditions, the mechanism of international adjustment may develop in any of a number of possible directions. Indeed, different solutions to the problems set by the environment may be adopted in different parts of the industrial world.

Thus, for example, groups of industrial countries that are closely knit, such as that formed by the present members of the European Economic Community (EEC), may tend toward the kind of solution envisaged by the EEC Commission,12 in which their mutual exchange rate would be more irrevocably fixed than under the par value system or, for that matter, the gold standard. Under this regime, hot money flows between the members of the group would disappear, and funds would move very readily in response to slight interest differentials. Such a system, however, could hardly hope to ensure full employment to all the countries of the group unless the members were prepared to submit to a thoroughgoing coordination not only of monetary, but also of fiscal and possibly wage, policies; unless they were imbued with a solidarity sufficient to induce those with favorable balances of payments to endure some degree of inflationary pressure for the sake of the others; and unless a high degree of mobility of labor prevailed within the group. Here, the maintenance of employment and activity would become, in effect, a collective, rather than a national, function.

As between countries in which the maintenance of activity remains a national function—including as a single “country” any groups such as those described above—the mechanism of adjustment might develop in a different way. In view of the increasing mobility of capital, monetary policies, here too, are likely to be more closely coordinated by central bank cooperation in the interest of international equilibrium and common prosperity, although it is to be hoped that reserves would be sufficiently plentiful to permit a measure of national independence even with respect to monetary policy. However, the responsibility for maintaining adequate levels of demand and employment would tend to devolve, at least in the medium term, on budgetary policy, nationally applied. Any need for a country to maintain indefinitely a larger budget deficit, on income account, than other countries would, like a chronic payments deficit, or a chronically depressed state of employment, be among the signs of an overvalued currency. Unless there is a resumption of strong demand pressures in the world, or unless incomes policies become much more effective than they have been to date, exchange rate adjustments are likely to be necessary rather more frequently than in the past, but the par value system would presumably be adhered to. Under such a system, large speculative capital movements would have to be expected from time to time. Large counterflows of compensatory financing would, therefore, have to be reliably available. This need, together with those arising out of the secular growth in the value of international transactions, and in the probable magnitude of payments deficits, would probably call for a strengthening and expansion of organized arrangements for the provision of international liquidity, whether through central bank cooperation or, as I would hope, through the IMF, or both.

Some may feel that the systems of adjustment we have been discussing—which by no means exhaust the possibilities—are messy and confusing by comparison with the good old-fashioned gold standard. However, what these modern systems are attempting, under conditions much more difficult than in the heyday of the gold standard, is something far more ambitious, both as to ends and as to means, than was ever attempted then. The conditions are more difficult, in that wages and other prices, e.g., farm prices, are far less responsive to demand and supply than they used to be, and much more responsive to other factors. The aims are more ambitious, in that we are now concerned, much more than in the past, with full employment and stable growth. The means also are more ambitious, in that we are now trying to achieve results not, as in the time of the gold standard, through independent national action, limited only by custom and convention, but through conscious international cooperation, expressed in agreements ranging from informal understandings to legally binding treaties.

Evolution du système des paiements internationaux


Cet article est une étude développée d’une conférence prononcée en mars 1963 à l’Université de Michigan. L’auteur y décrit l’évolution, au cours de la période d’après-guerre, des vues concernant un système adéquat de paiements internationaux et de l’orientation possible de ces vues à l’avenir. Tout d’abord, il y expose à grands traits la doctrine économique prédominante à l’époque où des institutions telles que le Fonds Monétaire International et l’Accord Général sur les Tarifs Douaniers et le Commerce ont été établies. Puis il y fait un compte-rendu des transformations que l’orthodoxie de cette doctrine a subies à la suite d’événements ultérieurs, en particulier de pressions inflationnistes générales et persistantes. Il passe ensuite en revue l’évolution la plus récente du milieu économique international, notamment la mobilité de plus en plus grande du capital par dessus les frontières, l’apparition d’un problème de liquidité internationale, l’importance croissante du facteur coût dans la détermination des prix et une diminution possible de la pression de la demande totale. Il y examine l’influence de cette évolution sur le modus operandi du système des paiements et y fait allusion à la possibilité d’un développement de courants divergents dans différentes parties du monde industriel.

Acontecimientos en el sistema internacional de pagos


Este trabajo es una versión ampliada de una conferencia dictada en marzo de 1963 en la Universidad de Michigan. El autor expone la manera en que los conceptos en cuanto a un sistema internacional de pagos adecuado han evolucionado durante la época de posguerra y cómo podrán evolucionar en el porvenir. Primeramente, esboza las doctrinas económicas que prevalecían en la época en que se establecieron las instituciones como el Fondo Monetario Internacional y el Acuerdo General sobre Aranceles Aduaneros y Comercio. Luego ofrece una reseña de aquellas modificaciones que esos criterios ortodoxos han padecido como resultado de las experiencias posteriores, incluyendo, especialmente, las de las presiones inflacionarias generalizadas y persistentes. Examina después algunos de los acontecimientos más recientes en el ámbito de la economía internacional, notablemente el aumento en la movilidad del capital, el surgimiento del problema de la liquidez internacional, la creciente importancia de los factores que elevan los costos en la determinación de los precios, y la posible disminución en un grado pronunciado de la presión de la demanda total. Considera la forma en que esos acontecimientos inciden sobre el modus operandi del sistema de pagos, y alude a la posibilidad de que haya tendencias divergentes en distintas partes del mundo industrial.


Mr. Fleming, Assistant Director in the Research and Statistics Department, 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.


J. E. Meade, “The Case for Variable Exchange Rates,” The Three Banks Review, No. 27, September 1955, pp. 3–27.


As sanctioned under Article XIV of the IMF and Article XIV of the GATT.


This was one of the considerations that led the IMF to agree to many initial par values which it recognized were unlikely to be realistic in the long run.


The new attitude toward mechanisms of international adjustment engendered by this experience of the effectiveness of financial policy, combined with the growing conviction, of which I have spoken previously, of the harmfulness of quantitative restriction, received expression as early as 1951 in a noteworthy article by 0. Emminger: “Wandlungen der Zahlungsbilanzpolitik” in Wirtschafts-theorie und Wirtschaftspolitik, a volume in honor of Adolf Weber. It is interesting to compare this paper with the early postwar articles by Ragnar Nurkse, such as Conditions of International Monetary Equilibrium (Princeton University, Essays in International Finance, No. 4, 1945) and “Domestic and International Equilibrium,” in The New Economics, Seymour E. Harris, ed. (New York, 1947), pp. 264–92, which provided classic expositions of the then orthodox position on the international adjustment mechanism.


James E. Meade, “The Future of International Payments,” in Factors Affecting the United States Balance of Payments, a compilation of studies prepared for the Subcommittee on International Exchange and Payments of the Joint Economic Committee, U.S. Congress (Washington, D.C., 1962), pp. 241–52.


Since these words were written, a tax restraint on selected types of capital export, the Interest Equalization Tax, has been proposed by the U.S. Administration—without exchange controls.


See Robert A. Mundell, “The Appropriate Use of Monetary and Fiscal Policy for Internal and External Stability,” Staff Papers, Vol. IX (1962), pp. 70–79.


See Robert Triffin, Gold and the Dollar Crisis (New Haven, 1960).


See E. M. Bernstein, “The Problem of International Monetary Reserves,” in International Payments Imbalances and Need for Strengthening International Financial Arrangements, Hearings Before the Subcommittee on International Exchange and Payments of the Joint Economic Committee, U.S. Congress (Washington, D.C., 1961), pp. 107–13.


See International Monetary Fund, Annual Report, 1963 (Washington, D.C., 1963), pp. 28–29.


It is worthy of remark, however, that even complete governmental control over the domestic price level, though it would eliminate the need for exchange rate adjustment, would not necessarily make desirable a return to the gold standard system, under which financial policy was directed toward the maintenance of external equilibrium, while prices adjusted themselves to maintain internal equilibrium. It would probably still be preferable, from a world standpoint, that financial policy should be primarily directed toward the maintenance of internal equilibrium while prices and wages are adjusted in the interests of external equilibrium.


In Action Programme of the Community for the Second Stage (Brussels. October 24, 1962).