I. Liquidity and the Adjustment Process

International liquidity consists of both owned reserves and conditional borrowing rights. To some extent, these two sources of liquidity are substitutable for one another, and the implications of such substitutability will be examined in more detail later in the paper. It is generally assumed, however, that countries do not regard borrowing rights as a perfect substitute for owned reserves, and that a policy of global liquidity management should give attention to the need for proper balance between conditional and unconditional sources of liquidity. This paper is primarily devoted to questions concerning the management of unconditional liquidity (i.e., reserves), although the implications of the growing availability of conditional liquidity will be considered.

The availability of international liquidity, that is, of assets and credit facilities that can be used to finance payments deficits, is recognized to be important because it may influence governments’ decisions on balance of payments adjustment policies. In the words of a report by the Group of Ten: “The supply of reserves should … be such as to promote a proper functioning of the adjustment process.”⁶ Difficulty of access to liquidity may mean that deficit countries must seek faster adjustment than is appropriate from the point of view of domestic economic objectives, or that they feel compelled to impose trade and exchange controls. Too easy access to liquidity may encourage unduly expansionary demand policies, postponement of balance of payments adjustment, and an unwanted and unwarranted transfer of real resources from surplus to deficit countries. For this reason, many economists have accepted Fleming’s view of reserve creation as a policy instrument that should be consciously used by the international authorities to improve world welfare.⁷

At the level of principle, there is widespread agreement, in the words of Fred Hirsch, “that the satisfactory working of the adjustment process can be hampered by an imbalance in either direction between the supply and demand for world reserves.”⁸ That this may have implications also for the level of world economic activity is reflected in the criteria established by the Fund’s Articles of Agreement for decisions in respect of allocations of special drawing rights (SDRs): “to meet the long-term global need, as and when it arises, to supplement existing reserve assets in such manner as will … avoid economic stagnation and deflation as well as excess demand and inflation in the world.”⁹

The mechanism by which the availability of reserves affects governments’ policies is through changing the perceived relative costs of different means of responding to balance of payments disturbances. The holding of reserves imposes costs and yields benefits.¹⁰ Countries will be satisfied with the level of reserves they hold and will thus refrain from changing their policies when the costs and benefits from the marginal unit of reserves are felt to be equal. The relevant costs and benefits are, of course, not easy to calculate. The costs are related to the difference between the yield on reserve assets and that on other forms in which national resources could be invested. The benefits come from the contribution that a reserve cushion can make to other national objectives, chief of which is the avoidance of fluctuations in real income and prices resulting from overrapid adjustment to disturbances in the balance of payments.

Governments normally react to incipient balance of payments disequilibria through some combination of financing by use of owned reserves and credit facilities, and adjustment through changes in domestic policies, in exchange rates, or in the use of restrictions on international transactions. The availability of reserves is clearly an important element in determining the relative emphasis placed on financing and adjustment and, in particular, the speed of adjustment to payments disturbances.

A higher stock of global reserves tends to lower the utility of marginal reserve holdings, thus reducing the benefits such holdings confer relative to their costs. As a result, countries may view the consequences of balance of payments deficits as less serious and of surpluses as less desirable. By altering their policies in such a way as to increase the possibility of a deficit and diminish the possibility of a surplus, countries can increase the utility of reserves at the margin and thus restore equilibrium between the cost of and the return on liquid assets.

One way of making such an alteration is to change the exchange rate (or allow it to appreciate). But while such a policy can enable a single country acting alone to restore its desired level of reserves, it does so by shifting excess reserves to other countries, and thus cannot eliminate a generalized excess of reserves. A generalized excess of reserves can be eliminated only by policies that increase the global demand for liquidity relative to the supply. In the absence of mechanisms for canceling reserves, this means policies that cause countries’ long-term desire to hold reserves to rise—for example, through an expansion of aggregate demand or a reduction in payments restrictions—leading to an increase in the nominal value of world trade and in the associated balance of payments fluctuations.

The availability of liquidity affects primarily the relative emphasis placed on financing as against adjustment of balance of payments disequilibria. It has always been recognized that it does not directly influence the choice among various available adjustment policies. If it were desired, for example, to restrain demand and to contain inflationary pressure in the world economy, a contraction in the rate of growth of liquidity would be called for; but it could not be guaranteed that a reduction in the volume of liquidity would in fact result in demand restraint, rather than in increased resort to devaluation or the imposition of restrictions on international transactions. Bearing this qualification in mind, however, reserve management can still be used in such a way as to improve world welfare. Williamson has put the point as follows: “The optimum rate of reserve growth is characterised by beneficial effects in the form of higher employment and fewer restrictions being equal at the margin to the untoward effects of inflation and the resource misallocation implied by larger reserve flows.”¹¹

The likelihood that countries will react to changes in the availability of liquidity by adopting external policies that have consequences for the economic welfare of their trading partners is, of course, the justification for regarding the mechanism by which liquidity is made available as an international concern. In this connection the objective, since the question was first explicitly raised at the Genoa Conference of 1922, is to find a means of providing liquidity in forms and amounts that contribute to the smooth working of the adjustment process and promoting the general objectives of high levels of economic activity with reasonable price stability.

This much is common ground and is very familiar from the existing large literature on the subject. The justification for returning to the issue in the present paper is to consider whether the changes that have taken place recently in the international monetary system require a change in the analytical framework that has traditionally been used.

At some risk of oversimplification, this framework has been based on the following propositions: (i) that the demand for reserves is a reasonably stable function of a few determining variables; (ii) that the supply of liquidity is determined “outside” the system. These two propositions have the consequences that the demand for reserves has to adapt to the supply and does so by a mechanism that involves accommodating changes in the factors governing the demand for reserves, for example, income, interest rates, prices, and the level of world trade (where the last factor is taken as a proxy for potential payments imbalances).

It should not be pretended that either (i) or (ii) was ever thought to hold in an extreme form. Elements of instability were always recognized to exist in the demand for reserves, and some authors (Machlup¹² is perhaps the most notable example) considered that the irrational elements in the demand of individual countries made estimation of a stable function almost impossible. Likewise on the supply side, few observers failed to recognize that there was a certain amount of elasticity in the way in which U.S. dollars were supplied to the system in the 1950s and 1960s.

More recently, however, the changes that have taken place in the international monetary system have raised more serious questions about the validity of those two propositions. Greater flexibility in the exchange rate mechanism, and a greater willingness to use financing mechanisms other than reserves, obviously have implications for the level of reserve demand associated with a given level of world trade, and also make it necessary to reconsider the issue of the stability of the demand for reserves. And the use of national and international capital markets to expand the volume of national currencies held in reserves casts doubt on the hypothesis that the supply of reserves can be considered in any meaningful way as determined “outside” the system. In the next two sections, these two issues are addressed in turn. Since reserve management policy involves influencing the availability of reserves relative to the demand for them, the problem of control can then be seen as a question of comparing the costs and benefits of different ways of influencing the supply of liquidity.

II. The Demand for Reserves

The demand to hold a stock of readily realizable international reserves arises from a number of considerations, including a desire for a “war chest” against unforeseen political emergencies, the desire to promote confidence and facilitate capital inflows, and in some cases the lack of any satisfactory alternative outlet for the investment of the national wealth. Most theoretical and empirical studies of the demand for reserves, however, recognize that the primary purpose served by liquidity is to provide a cushion against disturbances in the balance of payments.¹³ Such a cushion can avoid the need for a country to take adjustment action in the face of temporary and reversible disturbances to the balance of payments, and can enable adjustment to be spread over an optimum time period in the event of more permanent change in the pattern of a country’s external payments.

Although many factors combine to determine a country’s demand for reserves, it is perhaps not too much of a simplification to say that the two most important are as follows: (i) the size of potential payments disturbances to which a country is subject; and (ii) the availability of reserves relative to alternative means of financing, or adjusting to, balance of payments disequilibria.

The key empirical question is how stable the global demand for reserves is. If, on the one hand, it is reasonably predictable on the basis of a few determinants, and if these determinants themselves can be forecast with reasonable reliability, then the level of reserves that is needed in a given situation can be predicted fairly well, and there will be a presumption in favor of devising institutional mechanisms to ensure that the supply of reserves grows in step with demand. If, on the other hand, the demand for reserves is not at all predictable, or depends on determinants that cannot themselves be predicted, the question naturally arises whether the benefits of control over international liquidity are worth the institutional costs of putting the necessary control mechanisms in place. In such circumstances, an alternative approach might be to have an elastic supply mechanism that enabled countries to have the reserves they desired. This would preclude using reserve management as a discretionary economic instrument, but by the same token would avoid the adverse consequences that would result from setting world reserves at an inappropriate level.

Concerning the stability of countries’ demand for reserves, there is little doubt that reserve demand is somehow related to such factors as the level and variability of external payments and the cost and availability of alternative means of responding to payments disturbances. Most studies conducted in the 1960s¹⁴ did discover quite well-established empirical regularities in the demand for reserves, both across countries and over time. At the same time, many observers have pointed to differences between the world demand for reserves and the demand for money in individual countries—differences that generally suggest the former relationship is likely to be less predictable than the latter. Two papers that explore these differences in some depth are those by Polak¹⁵ and Cooper.¹⁶

In the domestic economy, it can reasonably be assumed that the fluctuations in the financial position of individual transactors that cause them to wish to hold money will grow roughly in step with economic activity. Although institutional changes do occur over time that affect the relationship between the need for money balances and the level of income (e.g., introduction of credit cards, movement from weekly to monthly payment of salaries), such changes take place relatively slowly and do not significantly affect the year-to-year stability of the relationship. There is, however, no such broad correspondence between the pattern of international payments disturbances and the level of world trade, at least in the short run. Table 2, for example, shows there is substantial variability in the relationship between payments imbalances and the level of world trade.

Table 2.

Payments Imbalances and World Trade, 1956–76

Table 2.

Payments Imbalances and World Trade, 1956–76

	Imports	Payments Imbalances	Payments Imbalances/Imports
1956–60	91	8	8.8
1961–65	127	9	7.1
1966–70	212	15	7.1
1971–75	444	49	11.0
1966	173	6	3.5
1967	178	10	5.6
1968	204	15	7.4
1969	234	14	6.0
1970	269	31	11.5
1971	309	68	22.0
1972	323	39	12.1
1973	401	36	9.0
1974	604	60	9.9
1975	581	45	7.7
1976	684	…	…

View Table

Table 2.

Payments Imbalances and World Trade, 1956–76

	Imports	Payments Imbalances	Payments Imbalances/Imports
1956–60	91	8	8.8
1961–65	127	9	7.1
1966–70	212	15	7.1
1971–75	444	49	11.0
1966	173	6	3.5
1967	178	10	5.6
1968	204	15	7.4
1969	234	14	6.0
1970	269	31	11.5
1971	309	68	22.0
1972	323	39	12.1
1973	401	36	9.0
1974	604	60	9.9
1975	581	45	7.7
1976	684	…	…

Another difference between the demand for money domestically and the demand for reserves internationally lies in the much smaller number of independent agents in the international economic system. There are 133 members of the International Monetary Fund: the 2 largest reserve holders alone account for some 25 per cent of world reserves, and the 7 largest hold over half of all reserves. This means that one cannot count on the law of large numbers to offset aberrant behavior by individual countries. A change in reserve-holding or intervention policy by a single large country might have a significant effect on the world demand for reserves, even though there was no change in the systematic factors affecting the demand for reserves.

The implication of all these considerations, at least under a fixed exchange rate regime, is that the demand for reserves may well be less stable than is the demand for money in domestic economies, at least over the short to medium term. This is perhaps the main reason why most discussions of the need to supplement liquidity emphasize the need to eschew attempts at fine-tuning the reserve supply and to concentrate on a stable long-run expansion in reserves. The report of the Group of Ten stressed the point thus: “… by its very nature it [the deliberate provision of reserve assets] cannot be used as an instrument for short-term ‘demand management’ on an international scale.”¹⁷

The interesting question in relation to the demand for reserves, mentioned earlier, is whether recent changes in the international monetary system have changed the degree of confidence with which it is possible to predict future reserve needs. An important development in this regard is the adoption of floating exchange rates among most major industrial countries. In principle, perfectly flexible exchange rates could eliminate the need for countries with floating currencies to hold reserves against balance of payments disturbances, so that their demand for reserves would be based on the other considerations mentioned at the beginning of this section (war chest, etc.). In fact, of course, even countries with floating rates feel a need to hold reserves against external disturbances, and a number of theoretical studies have shown that it is perfectly rational for them to do so.¹⁸ Furthermore, the large majority of Fund members either have adopted some kind of pegging arrangement or have an active policy of managing a flexible rate. There is, therefore, no compelling reason to expect the adoption of more flexible exchange rate arrangements, in itself, to remove the need for a stock of reserves that grows over time with the volume of world trade.

It must be recognized, however, that changes in the degree of flexibility in the exchange rate regime do have implications for the needed level of global reserves. Floating has been generally assumed to reduce the demand for reserves, and some empirical evidence for the past few years tends to confirm this.¹⁹ Williamson, however, has pointed out that this need not be true if, under fixed exchange rates, a peg acts as a credible focus for stabilizing speculation.²⁰ In any event, insofar as changes in exchange arrangements may be harder to predict than other determinants of reserve needs, this may make the effective stability of reserve demand less than in the past.

The other major change in the international monetary system, besides more exchange rate flexibility, is the greater use of conditional sources of liquidity for financing balance of payments deficits. Since conditional liquidity serves some of the same purposes as unconditional reserve holdings, it might appear that the changing availability of conditional sources of finance would have an unpredictable impact on countries’ desire to hold owned reserves.

The problem of substitutability between conditional and unconditional liquidity has been recognized for some time, and was dealt with in the following way in the Fund’s 1965 Annual Report:

Ideally, countries’ needs for additional liquidity could be met by adequate increases in conditional liquidity. In practice, however, countries do not appear to treat conditional and unconditional liquidity as interchangeable. For various reasons, countries which have adequate real resources like to have the major portion of their external liquidity at their free disposal. Even if conditional liquidity were expanded on a substantial scale, some countries might attempt—in preference to relying on these facilities—to increase their own reserves by adopting balance of payments policies which, from a broad international point of view, would have to be regarded as undesirable.²¹

In their report on improvements needed in the international monetary system, the Deputies of the Group of Ten took a similar view and concluded “[credit] facilities, important as they are, cannot be a complete substitute for owned reserves. Countries will wish to hold a significant stock of unconditional liquid assets on which they are able to count unquestionably and under all circumstances.”²²

The implications of these views are that while conditional liquidity can act as a substitute for owned reserves, it is not a perfect substitute. The conclusion from this section, therefore, is that despite the changes that have taken place in the international monetary system, it is still true that the demand for reserves can be expected to respond in a systematic fashion to underlying determinants. Other things being equal, the need for reserves is likely to grow with disturbances in the world economy, and disturbances will in turn tend to grow with the volume of international transactions. However, the relationship between reserve needs and some proxy for international transactions (such as imports) was never a very precise one, and may well have become more difficult to predict because of simultaneous changes that are likely to occur in the willingness of countries to use other forms of balance of payments adjustment, and other means of financing payments imbalances.

III. The Supply of Reserves

Williamson²³ has observed that “from the Genoa Conference of 1922 until quite recently there may well have been more written about the supply of reserves than about any other single topic [in international liquidity].” The mechanism by which reserves are made available, however, has received less general attention in the literature. This is so because most analysis has employed the standard paradigm that the supply of reserves can be considered to be exogenously given. This framework underlies the provisions of the Fund’s Articles of Agreement relating to SDR allocations, which imply that there will be a given volume of reserves forthcoming from other sources with the task of the Fund being to “supplement” these other sources to bring the supply of liquidity into line with global needs.

Even during the heyday of the Bretton Woods system, it was recognized that the standard paradigm was an idealized representation of the processes actually at work. To some extent, the supply of reserves could adapt to changes in the demand for them. Gold could flow in and out of monetary reserves, although the ability of the authorities to influence such flows was limited by the fact that the price of gold was fixed. Also, reserve positions in the Fund grew with the volume of Fund transactions, and this tended to be associated with increases in the level of payments disturbances against which reserves were held. Most importantly, however, countries that wished to accumulate reserves could do so by allowing their holdings of U.S. dollars to rise, and could bring about such a rise through the management of their external policies.

Some observers considered that this possibility introduced sufficient flexibility into the reserve supply mechanism that global reserves should properly be regarded as endogenously determined. This view found some support in academic circles, and was particularly associated with the names of Johnson,²⁴ Kindleberger,²⁵ and McKinnon.²⁶

Although the possibilities of an endogenous expansion of reserves have always been recognized, most official opinion under the Bretton Woods system tended to the view that such a process would be self-limiting. It was expected that countries would become unwilling to accept dollars beyond a certain point, and would insist rather on the settlement of payments imbalances in gold.²⁷ For its part, the United States would be unwilling to countenance an indefinite expansion of its short-term international indebtedness, and would at some stage take action to eliminate the deficit in its overall balance of payments position. The Deputies of the Group of Ten, reporting in 1966, stated that “for a variety of reasons, further substantial increases of dollar reserves are unlikely to occur and in our view it would indeed be undesirable that the increase in the external short-term indebtedness of the U.S. should continue as in the recent past.”²⁸ So, with a certain elasticity of interpretation, it was possible to argue that the stock of global reserves should properly be regarded as determined independently of the demand of countries to hold reserves.

A number of changes in the international monetary system in recent years prompt a reconsideration of this analytical framework. In the first place, the adoption of floating by most major industrial countries has permitted them to avoid undesired reserve movements, and thus to have, on a more continuous basis, reserve holdings that more nearly reflect their underlying demand. In itself, however, this development should influence only the lag with which global reserve demand and supply are brought into balance. Flexible exchange rates are quite consistent with an environment in which the aggregate supply of liquidity is exogenously determined.

More important in this connection has been the growth of international capital markets, and in the willingness of countries to use them for the placement of surplus funds and as sources of finance for balance of payments deficits. This development has reached a stage where, to quite a considerable extent, balance of payments disequilibria generate, endogenously, increases in reserves. The mechanism is very simple, but perhaps may be briefly recapitulated. When an “outside” disturbance, say, a price increase for an important traded commodity, suddenly alters current account flows, the surplus country may choose, in preference to exchange rate adjustment, to place its newly acquired reserves in liquid form, say, as short-term deposits with Eurobanks. These deposits count as part of its reserves, which therefore go up. If the deficit country is unwilling to see a reduction in its reserves, it may borrow to cover its current account deficit. The funds that it borrows are essentially those deposited by the surplus country, but since such borrowing is not counted as an offset to its reserves, it experiences no reserve decline. The global total of reserves therefore increases.

In present circumstances, there is an important analytical difference between the mechanisms by which different types of reserves are supplied. Gold and SDRs, and, to a lesser extent, reserve positions in the Fund, may all be thought of as subject to an “outside” supply constraint.²⁹ Holdings of national currencies are subject to a complex interaction of supply and demand conditions, which can be adequately analyzed only within the context of a more elaborate model of portfolio behavior—something that is beyond the scope of the present paper. As a first approximation, however, it is not too misleading to say that the supply of reserve currencies responds to changes in the demand to hold them with something approaching perfect elasticity—at least for countries with satisfactory credit standing in international capital markets.

The implications of this “new” situation for the control of international liquidity depend to a considerable extent on the degree to which holdings of national currencies are substitutable for other types of reserves, and on the ways in which changes in the quantity of “controlled” reserve assets affect uncontrolled assets. At the limit, if reserve currencies were only very imperfect substitutes for primary reserves (SDRs), it would not matter much whether the international community had effective control over the growth of reserve currencies, provided that there was a well-determined demand function for those assets that were under international control. Countries would respond to a shortage or excess of primary reserves by changing their external policies in the appropriate direction. Similarly, if changes in the availability of “controlled” reserves had a predictable effect on the supply of other reserve assets, there would be no diminution in effective control.

This issue has a parallel in the money supply process within national economies. It is now widely accepted that money is sufficiently differentiated from other assets that near-money is only an imperfect substitute. Furthermore, to the extent that substitution takes place between money and near-money assets, the linkages between financial markets are sufficiently close (and supported by legal or conventional ratio requirements) that the action of a central bank in controlling the quantity of high-powered money exercises a pervasive effect on all financial markets.

Such conditions cannot necessarily be extrapolated to the international level, however. While there is some evidence that countries have separate preferences for the different components of reserves,³⁰ the basic function served by holdings of national currencies is much the same as that served by primary reserve assets. So, within quite wide limits, increases in reserve currencies can substitute for increases in SDRs without creating a portfolio disequilibrium for holding countries. Furthermore, changes in the relative availability of “controlled” international assets do not have a chain reaction effect on the availability of national currencies. A shortage of SDRs does not lead to their price (in terms of other reserve assets) being bid up, and therefore is not reflected in a generalized increase in the cost of acquiring and holding liquid reserve assets. The terms and conditions on which national currencies can be held and borrowed are determined by the stance of monetary policy in the issuing countries, and this is not likely to be much affected by the volume of primary international reserves in existence.

The conclusion pointed to by the foregoing argument is that control over the stock of international reserve assets issued by the Fund is not sufficient to enable the international community to influence the overall availability of international liquidity. If liquidity control is to be effectively pursued, new mechanisms would be needed. This could be done, for example, by extending direct control to the total of assets held in international reserves, or by ensuring that action on the controlled component of liquidity has predictable consequences for the remainder.

In the following section, a number of specific techniques for increasing the degree of control over the growth of international reserves are explored. In this discussion, it must be remembered that the purpose of such control is to influence adjustment policies in the desired direction with greater certainty than is presently possible. The limitation of a stock of assets defined as “international liquidity” will be useful only as long as there remains a predictable relationship between the stock of liquidity and adjustment policies. Devices to control the numerical magnitude of liquidity that cause the predictability of this relationship to diminish may therefore be counterproductive.

IV. The Control of Liquidity

Changes in the volume of world liquidity influence countries’ policies by changing the value of marginal reserve holdings relative to the cost of acquiring or using them. If there were a fixed relationship between the global stock of reserves and their cost, there would be no formal difference between a policy that fixed the quantity of liquidity and one that fixed the cost. One would imply the other, and each would have the same effect on countries’ adjustment policies.

There is no such fixed relationship, however, since the “cost” of reserves, like that of any other asset, is determined by the interaction of supply and demand. Shifts in demand can result in changes in cost that are independent of changes in supply. The choice of control mechanism must therefore turn on how practicable it is to influence ultimate objectives (in this case, adjustment policies) by controlling the overall stock of reserves as against other ways of achieving the same result.

The issue of whether to direct monetary policies at the control of some monetary aggregate or at the “cost of liquidity” is one that is familiar from the Keynesian/monetarist controversies of the 1960s. The view of the Radcliffe Committee was that different financial assets were almost perfectly substitutable for one another, so that any attempt to control a particular monetary aggregate would be effectively offset by changes in its velocity of circulation.³¹ Thus, the Radcliffe conclusion was that monetary policy should be directed at the general availability of liquidity, through action on interest rates. The monetarist view was that other assets are not, in practice, substitutable for money, and that controlling the price of credit is a very imperfect way of controlling its availability (in part, because the real price of credit is affected by such nonobservable phenomena as the expected rate of inflation).

In a domestic economic context, it is now fairly well established that the demand for money is quite stable, at least in the medium term. So that while there continues to be debate concerning the desirability of smoothing market conditions over the short run,³² there is little dissent from the proposition that stabilizing the rate of increase of the money supply is a more appropriate medium-term policy than stabilizing interest rates.

However, the conclusion is not necessarily the same when one moves from the domestic to the international level. Sohmen has noted: “If the emphasis of the British Radcliffe Report on the ‘state of liquidity of the whole economy’ as the principal determinant of monetary matters within an economy (in contrast to traditional measures of the money supply) was generally considered too diffuse a concept to be of any use, an analogous notion on the international level would seem to be considerably more promising.”³³ The stock of reserves, by the conventional definition, can be observed with precision, but the relationship of this stock to its opportunity cost, and therefore to adjustment pressures, will depend on how stable is the demand for the particular set of assets included in the conventional definition. As noted earlier, both the demand and supply functions for international liquidity are likely to be less stable than the corresponding demand and supply functions for domestic money. This suggests that a control mechanism, to be effective, will either have to aim at introducing greater predictability into these relationships or concentrate on some other means of influencing adjustment policies.

In addition to the question of the desirability, in principle, of controlling the quantity of liquidity, attention must be paid to the practicability of such a policy. If quantitative targets can be achieved only with a relatively large margin of error, or at the expense of other objectives of economic policy deemed to be important, there may be a case for preferring control mechanisms that, although less satisfactory in principle, do not have these drawbacks.

Additional control over international liquidity could, in principle, be exercised in one of three ways: (i) by influencing the supply of assets and credit facilities; (ii) by influencing the terms and conditions on which countries have access to liquidity; or (iii) by affecting the demand for liquidity directly, through some kind of rationing mechanism.

Direct determination of supply is the most straightforward method, where it is applicable. Much of the discussion of controlling reserves during the early part of the negotiations on international monetary reform concentrated on measures to bring the supply of reserves that were not created by the Fund under some kind of international control. Within the context of a par value system, it was proposed³⁴ that settlement of payments imbalances should take place primarily through the exchange of existing reserve assets, and not through the further accumulation of reserve currency liabilities. Accumulations of reserve currencies beyond certain aggregate limits would therefore involve the presentation of such balances to the issuing country for settlement. Various proposals for introducing elasticity into the arrangement were made, but the essence of the scheme was that the volume of liquidity reserve centers were allowed to create would be subject to some kind of externally agreed quantitative limitation.

In present circumstances, it is unlikely that any such scheme could be used for purposes of regaining control over international liquidity. In the first place, as Kenen has noted,³⁵ it relies on convertibility obligations that proved impossible to negotiate and are not part of the new system. Second, it implicitly rests on the assumption that reserve currency balances are the liabilities of the country whose currency is used in denomination and are, therefore, the counterpart of payments deficits of that country. This is no longer effectively true, since short-term dollar assets can be manufactured by maturity transformation in offshore markets where any country with sufficient credit standing may be the ultimate debtor.

The volume of reserve currency balances, chiefly U.S. dollars, is therefore outside the control of the international community and only to a limited extent under the control of the issuing countries. As noted in Section III, countries that find it attractive to borrow in international capital markets to add to their reserves can do so without causing the reserves of any other country to decline. Similarly, countries that borrow to finance deficits can avoid reserve losses, while surplus countries accumulate reserve assets.

The desire of central banks to add to their reserves is, of course, influenced by the terms and conditions on which reserve currencies can be borrowed and held. These conditions are essentially a by-product of domestic monetary policies in the issuing countries. If credit policy is shifted in the direction of restraint in the United States, this will be reflected in credit conditions in all markets for U.S. dollars, including offshore markets, and will have implications for the willingness of central banks to borrow for the purpose of holding additional balances in dollars.

It might in principle, therefore, be feasible for an issuing country to manipulate the overall availability of credit denominated in its currency so as to cause holdings by a particular group of holders (overseas central banks) to tend toward a desired magnitude. In practice, however, it is doubtful that issuing countries would agree to managing their financial affairs with the primary objective of controlling the volume of their currencies held abroad. Kenen has observed: “If governments are not rewarded by their own citizens for taking the steps necessary to maintain domestic economic health, they cannot expect to be rewarded for submitting to the arcane constraint of reserve scarcity.”³⁶ A similar observation would apply if the constraint was to avoid excess reserves.

The supply method of control is, in fact, applicable chiefly to those components of international liquidity that are provided by the Fund. It is probably for this reason that the volume of these components has fallen, relative to the volume of international liquidity in general. It is unlikely that this method can be relied on, in the foreseeable future, for controlling other components of international liquidity. Only if the availability of reserves provided by the Fund effectively influenced the availability of other kinds of liquidity would it be a suitable technique for influencing global liquidity.

To some extent, this influence does operate. If there is less Fundbased liquidity, central banks seek to hold reserves in national currencies. This increase in liquidity preference in national money markets should, ceteris paribus, tend to push up interest rates there and tend to restrain current activity. But three points need to be borne in mind:

(i) As long as SDRs are a very small proportion of total reserves, any marginal change in their availability will have an indistinguishable effect on world demand conditions.

(ii) International reserves are small in comparison with most domestic money supplies, so that any tendency for central banks to hold more national currencies would have a very small effect on national capital and money markets.

(iii) Most countries manage their monetary policy with domestic objectives in mind, so that to the extent that holdings by overseas central banks affected domestic monetary conditions, they would be offset.

If effective control over aggregate liquidity is to be exercised via the Fund’s power to limit the availability of SDRs, therefore, some more direct way is needed of influencing the proportion of SDRs that central banks wish to hold in their reserve portfolios. This involves action on countries’ demand for liquidity, however, and consideration of this is deferred until later in the section.

The second control method seeks to influence adjustment directly through the element of price, that is, through the terms and conditions on which assets may be held or loans obtained. Under this second method, the volume of liquidity emerges as a residual the quantity of which is not determined deliberately, although it is of course limited by the price element. This method starts from the principles (i) that the mere holding of financial reserve assets (perhaps excluding gold, which has an alternative use as industrial material), or the mere access to credit facilities, is in itself neither harmful nor helpful to the international community, and (ii) that countries’ desire for such holdings or access should be accommodated if that can be done in a more or less costless way (e.g., by the stroke of a pen). What can affect world economic conditions, and should therefore be subject to some control, is the use of reserves or credit facilities for balance of payments financing, since this entails real expenditure and transfer of resources.

It is arguable that the temporary use of other countries’ resources should take place at terms and conditions agreeable to both deficit and surplus countries, and that these terms and conditions should, therefore, broadly reflect market yields. A proper market price for lending can, in principle, ensure that the additional real spending of deficit countries is matched by an increase in real saving by surplus countries. If international liquidity is available on market terms in national currencies, then this has the consequence of making the inflationary or deflationary impact of changes in international liquidity simply a reflection of the policy stance of the issuing country. If the issuing country is the United States, and the United States follows a money supply policy that eliminates price inflation in dollars, then this means that the cost of credit is just what is required to ensure ex ante equality of savings and investment at the (by hypothesis, stable) price level.

Nevertheless, there are disturbing features in a reserve supply mechanism that relies on the continuing increase in the role of national currency holdings. Such a process means that international liquidity will become based, to a growing extent, on the liabilities of debtor countries, thus making the system more brittle in the face of disturbances that affect the confidence holders feel in the capacity of debtor countries to repay. Furthermore, as noted earlier, the ability to use international capital markets in the manner described is not equal among countries. Smaller and less creditworthy countries may find themselves unable to finance the increase in reserves they need to cover the growth in their external transactions, or else will be able to acquire needed reserves only by paying much higher rates of interest than do the larger countries.

A related question is the matter of seigniorage. At the time when holdings of reserve currencies were the direct liabilities of the reserve centers, it was clear that any seigniorage element deriving from the issue of international reserves accrued to the reserve currency country. Now that the ultimate debtor standing behind holdings of currency reserves can be any country with satisfactory credit standing, seigniorage (to the extent that it exists) can be much more widely shared. But it is still true that certain countries and institutions will have a market advantage in issuing liabilities denominated in particular national currencies. To the extent that the U.S. dollar continues to be the principal currency held in reserves, it is to be expected that U.S. banks, and other U.S. borrowers, will be able to attract funds more easily than entities resident in other countries, and thus reap some seigniorage advantage from the present reserve supply mechanism.

Another problem in basing global reserve growth on one, or a few, national currencies is that it tends to make the international purchasing power of reserves less stable than it would be if reserves were valued in terms of a basket of major currencies—as is true for SDR holdings. In addition, not only the value of reserves but also the general thrust of world monetary policy tends to be influenced to a greater degree by the policies of the country that issues the currency used in reserves.

In a longer-term perspective, perhaps the most serious consequence of accepting present arrangements as they are is that it retards the objective of making the SDR the principal reserve asset in the system, and moving toward a mechanism in which control over the growth of liquidity could be used as an active rather than a passive instrument of policy.

Under the third control method, access to various components of international liquidity would be determined by allotted entitlements. The genesis of such an idea can be found in a number of proposals that had as their objective the rationing of available liquidity in the context of an expected reserve shortage. For example, in the 1966 Emminger Report it was suggested that the problem of gold scarcity could be tackled by harmonizing the proportion of gold held in international reserves. And during the negotiations in the Committee of 20, it was suggested that a “primary asset holding limit” should be established as a means of guarding against excessive concentration of reserves in surplus countries.³⁷

Although these early proposals were aimed at offsetting the consequences of a possible scarcity of primary reserves, a similar mechanism could, in principle, be used to limit potential excesses of reserves. Although prescribing entitlements to hold liquidity can achieve control over the stock of international liquidity, it does so by acting on the demand for liquidity, not on the supply. In one form, the entitlement would be specified as a multiple of countries’ holdings of another asset that is itself under international control. The advantage of this form is that it replaces control over the supply of certain assets, which may be judged to be impracticable, by control over the entitlement to hold them. This approach would, of course, require far-reaching international consensus for countries to agree to the limitation on their portfolio choice and on international borrowing ceilings, as well as periodic renegotiations of quotas, borrowing ceilings, and other elements in the determination of entitlements. Although concentrating on the demand for, rather than the supply of, reserve assets may be more successful in achieving effective control over the stock of liquidity, it may be less suitable as a device for preventing undesirable effects of changes in international liquidity on countries’ policies. If, for example, an expansion of liquidity is primarily feared for its potential inflationary consequences, a limitation on the entitlement to hold foreign assets at a time when access to them becomes more available or cheaper could be counterproductive. This is so because countries would have an incentive to spend on real goods and services from abroad rather than to save and accumulate financial assets.

The proposal to restrict the entitlement to hold reserves thus risks concentrating on the economic instrument (the control of the stock of liquidity) at the expense of the economic objective (the adoption of appropriate adjustment policies). To put the point another way, inflationary pressures are generated not by an increase in the stock of liquid assets per se but by an increase in supply relative to demand. It is the accumulation of liquidity in excess of the holder’s long-term desire to hold such assets that is potentially disturbing—though even in this case it is the ultimate expenditure, and not the initial accumulation, that is the proximate cause of inflationary pressures. The reserve ratio plan has its main virtue, therefore, in its medium-term consequences. That is to say, it helps to prevent an accumulation of liquidity whose later expenditure could prove a threat to the system’s stability.

To improve the effectiveness of such a scheme in achieving the intended consequences for adjustment policies, countries would have to be able to continue to acquire primary reserves freely when they were in surplus. This would remove the incentive for surplus countries to adopt expansionary policies in order to prevent reserve increases from worsening their reserve ratios; and it would sharpen the discipline on deficit countries because deficits would result in losses of primary reserves. To achieve such a result would necessitate either some form of agreed convertibility into primary reserve assets of reserve accruals in other forms or a well-functioning market where SDRs could be exchanged against other reserve assets. A partial alternative might be to use the SDR designation mechanism to ensure that SDRs were transferred from countries with relatively high ratios of primary to other reserves to countries where such ratios were lower.

V. Surveillance and the Control of Liquidity

A last question that needs to be asked concerns the relationship of the international community’s role in exercising “firm surveillance”³⁸ over the adjustment process to its activity in managing the availability of global liquidity. To some considerable extent, these functions are complementary, since surveillance is designed to influence the size of deficits that arise, and liquidity exists to provide the finance for them. But it should also be recognized that the functions are overlapping, in that both surveillance and liquidity control are intended to serve the same ultimate objective: that of timely and effective adjustment.

Going back to first principles, the creation of liquidity in any financial system enables surplus and deficit units to simultaneously meet their spending preferences by adjusting the size of the liquidity cushion they hold. An equilibrium is struck when the liquidity yield of the asset used as a vehicle in transactions is just equal to the opportunity cost of holding it. If there are too many liquid assets at a particular price level, the demand for such assets will fall short of the supply, resulting in inflation. Too few liquid assets at a given price level would produce deflation. A “neutral” monetary policy could be defined as one in which the stock of money equals the ex ante demand at the desired (stable) price level.

At the international level, the demand to acquire reserves is the demand to run overall balance of payments surpluses; and if a country’s reserves exceed the desired level, that country would presumably aim for a balance of payments deficit. The principal interest of the international community in its management of liquidity is to promote a better working of the adjustment process and to achieve an appropriate balance between inflationary and deflationary tendencies. This can be defined as a level of liquidity at which the desire to run surpluses by some countries just balances the deficits desired by others. Note, however, that the stock of liquidity is a means to the end of achieving overall consistency in global payments objectives.

The mechanism of multilateral surveillance, however, is itself designed to produce balance of payments consistency—not perhaps in a precise sense but at least to avoid gross inconsistency. Thus, at the international level, a discrepancy between the global demand for and supply of real resources can, to some extent, be resolved by the mechanism of surveillance. In the domestic economy, by contrast, such a discrepancy can be resolved only by a change in the price level, or in the volume of real output.

To come somewhat closer to reality, it is not expected that countries can use a pure negotiating system to produce consistent policies. Ex ante divergences in objectives could still arise, therefore, and the availability of liquidity would then influence the way in which policy inconsistencies were resolved. But to the extent that surveillance was able to monitor the overall size and distribution of disequilibria, it would tend to reduce the role played by liquidity factors in determining adjustment policies.