-13-

the ground merely to store it in vaults under the ground. We learned long
ago that it is not necessary to use a valuable commodity for settlement of
domestic debts, and substituted instead banknotes and other forms of legal
tender.

A similar substitution can be effected for settlement of international
debts, and it is currently in the process of being worked out. It is a more
rational solution, for it avoids diverting a useful metal to monetary pur-
poses; but it is also more complicated than a rise in the official price of
gold. Two steps have been taken toward this solution, the first carefully
planned and under discussion for some five years, the second adopted hurriedly
under crisis conditions. The planned step involves creation of a man-made
substitute for gold for use in international settlements; the unplanned step
separated official gold from private gold, and allowed supply and demand to
determine the price of the latter, as with other metals.

The proposed substitute for gold takes the form of a Special Drawing
Right (SDR, for short) on the International Monetary Fund. It is to be
created and allocated by joint international agreement in amounts that seem
to be required to serve the purposes of the international monetary system.
SDRs have been approved, and the required changes in the IMF and in national
laws may be expected to take effect in 1969. SDRs should be created soon
thereafter, although there is a certain reluctance among some European
countries to create them so long as the United States is running a payments
deficit.

SDRs will be transferable claims, like cash, on all members of the IMF,
and they can be converted into the currency of any member. They will not

-14-

circulated generally, however; like gold in the major countries, they will be
used for settlement only among central banks. Nor will they supplant mone-
tary gold, at least for a very long time. But they can substitute for gold
where it counts, as increments to international reserves, and can thereby free
the payments system from its heavy dependence on gold.

Widespread belief in this dependence led to heavy speculation in the
winter of 1967-68 on an increase in the price of gold. Central banks sold
over $3 billion worth of gold to private markets in an effort to keep the
price of gold from rising substantially above the official price of $35 an
ounce. Then in a historic decision in mid-March the central banks split the
market for gold into two distinct parts: an official "market" where gold
transfers would take place at the official price, and a private market in
which the price of gold would be governed by supply and demand, without of-
ficial intervention. The decision furthermore seemed to break the link
between these two markets, at least temporarily, by arguing that in view of
the new SDRs central banks no longer saw any need either to sell to the pri-
vate market nor significantly, to buy from it. Following this creation of
a two-price system, the private price of gold rose above $35 an ounce. But
it rose remarkably little, considering the fact that South Africa greatly
reduced its gold sales. Users' needs were thus supplied by small producers
and, evidently, by substantial dishoarding.

The two-price system leaves unsettled the question of what happens if
the gap widens between the two prices, when and how official gold will be
disposed of, and what becomes of any "capital gain," if any, arising from
disposition of the gold. These questions may become important at some time,

-15-

but they are not urgent today. One proposed solution would have all monetary gold turned into a central IMF account in exchange for transferable certificates, the gold to be disposed of later by joint decision. But central banks are not likely to agree to such a proposal until they have had several years of successful experience with SDRs.

## The Dollar as an International Currency

The shortage of monetary gold would have been far more acute had it not been for another development, much earlier the emergence of the U.S. dollar as an acceptable reserve asset, a reserve currency. Rebuilding war-depleted reserves around the world required some redistribution of gold from the United States in the late 1940s, but even such a redistribution would have been inadequate to support the large growth in trade that subsequently took place. Fortunately, many countries were willing to build up their reserves with dollars -- in practice, bank deposits and U.S. Treasury securities. The dollar was widely acceptable in settlement of debts. By using dollars, foreign monetary authorities could avoid transactions costs on gold, and in the meantime earn some interest on their unused dollar balances.

A more technical reason for emergence of the dollar as a reserve currency lies in the detailed functioning of the payments system. Under the pre-1913 gold standard, gold circulated freely, major banks converted gold into national currencies at a fixed price, and gold arbitrage -- or the expectation of a change in exchange rates within narrow bounds. After the Second World War, only the United States and Switzerland officially bought and sold gold for domestic currency at a fixed price, and there was no inclination in

-16-

some countries, including the United Kingdom and the United States, to permit residents to deal freely in gold. But all adherents to the IMF rules were obliged to keep their exchange rates within certain prescribed margins around parity, and they needed a mechanism for doing so. The one adopted by most countries was to hold the exchange rate with the *dollar* within the prescribed margins by buying and selling dollars against the local currency in question. Private arbitrage could be relied on to assure consistency with other exchange rates. By virtue of this arrangement, the dollar became an "intervention currency," and countries needed at least working balances in dollars for day-to-day intervention in the exchange markets. (The pound sterling played a similar role for countries comprising the sterling area.) Formal symmetry among national currencies thus gave way to a marked asymmetry, dictated not merely by differences in national size but also by the mechanism itself, with the dollar playing a pivotal role.

Use of the dollar as a reserve currency relieved the potential shortage of international reserves, for they could grow despite limited gold supplies to the extent that other countries accumulated dollars and so long as the United States did not regard such dollar liabilities -- for dollar reserves represented claims on the United States -- as an equivalent loss to its own reserves. But emergence of the dollar in this role also posed two problems for the payments system.

First, relief from gold shortage was purchased at the price of a gradual weakening of the credibility of continued convertibility of dollars into gold at a fixed price. The U.S. Treasury stands ready to convert foreign official dollar claims into gold at foreign initiative. But as the dollar

(10)

-17-

claims grow, the Treasury's ability to do this lessens. A watershed was passed in 1965, when dollar claims of official holders exceeded the U.S. gold stock for the first time, a gold stock that was only subsequently relieved of a legal obligation to back part of the domestic currency. There is no magic in equality between the U.S. liabilities represented by those claims and the value of the U.S. gold stock, not least because of large foreign private claims on the United States. Moreover, commercial banks thrive on having short-term liabilities (to their depositors) far in excess of their quickly mobilizable assets in confidence that not all their depositors will wish to withdraw at the same time. And indeed total U.S. claims on foreigners far exceed foreign claims on the United States. So far, there have been few direct conversions of outstanding dollar holdings into gold -- France's billion dollar conversion in 1965 was an exception rather than the rule. But a number of central banks are restive about having to accumulate and hold additional dollars, and the possibility of large-scale conversion is there. If foreign dollar reserves continued to rise, the gap between them and U.S. reserves would continue to widen, possibly posing a threat to the stability of reserve holdings; if they did not continue to rise, the world would sooner or later face a reserve shortage. The new SDRs, once they come into being, can break the dilemma.

To refer, as is sometimes done, to the deteriorating liquidity position of the United States as a "confidence problem," reflecting a gradual loss of confidence in the dollar, is misleading. Large-scale official conversion of dollars into gold could occur even while individuals and businesses around the world are willingly adding substantial dollar-denominated claims,

-18-

including cash, to their assets. The loss of "confidence" at issue here is
in the ability of the United States to maintain the gold-convertibility of
the dollar at $35 an ounce, an attribute that affects directly only other
central banks, and then only so long as they regard gold as a superior asset.
The value of the dollar in terms of goods and services has been maintained --
and is likely to continue to be maintained -- better than that of any other
major currency. The "confidence problem" at issue here is thus really a prob-
lem of official speculation in favor of gold. It is therefore also a problem
of the degree of cooperation that major governments can maintain in managing
the international monetary system.

The second problem posed by the reserve currency role of the dollar con-
cerns the apparent removal of restraint on U.S. payments deficit that this
role implies. Indeed, U.S. payments deficits have been large and have become
a source of controversy and strain. The complaints have taken on political
overtones. The United States has been accused of "printing" international
money to finance its ventures abroad. General De Gaulle regards the reserve-
currency role of the dollar as merely one aspect of American hegemony in the
world, and he has referred to the "exorbitant privilege" of the reserve cur-
rency countries to finance payments deficits through foreign accrual of their
national currencies. Two particular abuses of the international printing
press have been alleged: the sharp rise in American investment in Europe,
and the large increase in overseas expenditures associated with the war in
Viet Nam. The first development gave rise to the charge that the United
States was buying up Europe and being financed by the European central banks
to do so; the second to the charge that Europeans were financing an American

-19-

military adventure on which the Europeans were not seriously consulted and of
which a great many Europeans disapproved.

Wilful abuse of the "privliege" is unnecessary to create a problem for
the international monetary system, for the net flow of dollars to central
banks around the world results from myriad decisions of businessmen and indi-
viduals, deciding how and when and where to spend their money, rather than
being geared to world demands for additional reserves. While U.S. monetary,
fiscal, and other policies can influence these flows, the U.S. authorities
may find it inexpedient to make their ideas about world reserve needs the
sole or even principal criterion for exerting such influence. As is well
illustrated during the past several years, monetary policy has been called
on to serve a variety of objectives, and the monetary authorities have oc-
casionally found themselves caught between persuasive considerations for
easing the monetary reins and equally persuasive considerations for tighten--
ing them.

Foreign central banks may attempt to influence these difficult policy
decisions in the direction of measures to reduce a U.S. payments deficit by
converting into gold unwanted dollars acquired over the foreign exchanges,
as France did after 1963 with the silent approval of many other European
countries. But they undertake these conversions only at the risk of under-
mining more rapidly the convertibility of dollars into gold on which the
payments system is thought to rest. Moreover, the use of gold conversions
to influence U.S. policies that in turn influence the course of the world
economy represents a rather clumsy and ineffectual method of coordinating
economic policies. Cooperation would be preferable.

-20-

The absence of satisfactory and smoothly operating methods for control-
ling imbalances in international payments is perhaps the major weakness of
the present international payments system. But because of the pivotal role
of the dollar in international finance, this weakness takes the particular
form indicated here: the haphazard linkage between the supply of additional
reserves, provided by U.S. payments deficits, and the demand for them, com-
bined with the great disruption that would result from applying to the United
States the IMF prescription for changes in exchange parities.

This discussion has been couched in terms of the dual role of the
dollar in international finance. In fact both the pound sterling and the
French franc play similar dual roles, but they have been quantitatively less
important as a substitute for gold in international reserves. Official
holdings of sterling are about half the size of foreign official dollar
holdings; but the holdings of sterling have not increased during the past
two decades, so while they have posed a continuing problem of management
to the British authorities, they have not contributed to the growth in
international reserves. French franc holdings, largely by the former French
colonies in Africa, have risen rapidly but in total remain less than one
billion dollars equivalent. Thus the focus of attention and concern has
been on the dollar.

Greater Economic Interdependence

More significant for the long run than the strains associated either
with gold or those associated with use of the dollar as an international
currency, and certainly more perplexing for policy, is the growing economic

-21-

interdependence among countries, a growth that will result in more intense clashes between national and international considerations in framing economic policies. This growing interdependence is due in large measure to vast improvements in transportation and communication which make the world smaller in every sense but physical. International transport has become faster and more reliable, and it has also become cheaper relative to the value of the goods shipped. Business familiarity with foreign markets has increased greatly, and this familiarity combined with modern fast communications permit firms to take advantage of market opportunities that in previous times would have been ignored.

But the growth in interdependence derives too from the success of the payments system itself. Among industrial countries, tariffs have been sharply reduced and quantitative restrictions on industrial products have been virtually eliminated. Currencies have become more readily usable, and the risks and uncertainties in dealing with other countries have diminished.

Improvements in communication and increased familiarity have been especially significant for the movement of funds between countries. The rapid growth of the Eurodollar market from the late fifties and the even more rapid growth of the international bond market since the early sixties are both consequences of these developments. By the end of 1967 total deposits in the Eurodollar market -- a market made by European banks (including branches of American banks) in dollar deposits and short-term claims -- amounted to $16 billion, larger than the total money supply of many individual European countries. The international bond market brings together long-term borrowers and long-term lenders outside of any single national securities market.

-22-

Borrowers are large firms of international reputation, many of them American, plus a number of governmental entities that find it too difficult or too costly to float issues in their home markets; lenders are from all over the world, with roughly half the funds coming immediately through Switzerland, on behalf of customers elsewhere. Most of the issues are denominated in U.S. dollars. Although smaller than the Eurodollar market, it has grown ever more remarkably, from new issues amounting to less than $200 million in 1963 to well over $2 billion in 1968.

Both markets have become large enough in size to influence developments in national financial markets. Short-term investors have the opportunity to hold their funds in national currency or to place them in Eurodollars. Which option they choose depends on relative yields and risks. Similarly, long-term investors have the option of putting their funds directly into national markets or putting them into the international bond market. The existence of these new options tends to tie national markets together, making it increasingly difficult for national interest rates to get very far out of line from those prevailing in the international market, except in periods of heavy speculation on changes in exchange parities, or through the use of restrictions to isolate national markets from these international influences.

Interdependence has also grown outside the areas of trade and financial flows. Business firms increasingly look beyond national boundaries in deciding where to locate. Individuals move across national boundaries more readily in response to economic incentives, the substantial movement of skilled individuals having been dubbed the "brain drain." In short, the strictly national orientation of economic behavior, at least within the

-23-

industrialized countries, is declining; the revolution in communications and transportation is increasing the responsiveness of capital, labor, and commodities to differences in earning opportunities spanning national boundaries. The extent of this responsiveness should not be exaggerated; there is still much attachment to traditional sources of supply and to traditional locations. But these attachments are gradually being eroded as firms and individuals develop an increasingly international outlook.

The implications of these developments are profound, in two respects. First, the great increase in the international mobility of capital makes the international payments system as laid down a quarter of a century ago all the more difficult to operate effectively, for the prospect of discrete changes in exchange parities gives rise to huge speculative flows of capital. This prospect in turn has strengthened official inclinations against changes in exchange rates, both to discourage such speculative flows and to avoid rewarding the speculators.

More basically, however, high economic interdependence circumscribes governmental freedom of action to pursue widely divergent economic policies. So long as nations are effectively separated by barriers of ignorance and uncertainty, language and law, custom and customs, business and labor response to divergences in national policies remaining minor and tolerable. But as foreign commerce and international capital flows become more sensitive to such divergences, the impact on other countries of any one country's economic and other policies becomes more important. Different policies that had been tolerable in the past begin to strain both the ability of nations to pursue divergent policies and the smooth functioning of the payments system itself

-24-

as countries take defensive actions to protect themselves from unwanted side effects. The constraints imposed on local government by the mobility of business and individuals are familiar to Americans. Taxes and business regulations in any community cannot be far out of line with those in surrounding areas or even in distant competing areas, for firms and individuals are free to locate where taxes and regulations are less onerous, and they have shown increasing readiness to do so. While local or state governments are legally free to regulate and tax, their actual freedom is sharply curtailed when labor and capital can locate where the interests of both are best served and where the product of their effort can be sold anywhere, unimpeded by barriers to trade.

At the international level the constraints on national policies imposed by international mobility of goods and factors are not yet so binding. But the movement is clearly in that direction. The growing constraint on monetary policy as an instrument of domestic stabilization provides one example of tightening money to curb a domestic boom often pulls in capital from abroad, for instance, while easing monetary policy induces capital outflows; in both cases, the effect of a given monetary action on domestic expenditure is tempered. Businesses have shown increasing willingness to locate in response to tax incentives, and this in turn produces strong pressure for tax harmonization, for example within the European Common Market. International mobility even exerts pressures on the redistributive and social policies of countries, as illustrated by the high exodus of British doctors in response to low salaries and other restraints imposed on them under the National Health Service.

-25-

These developments pose a key question: How is the average degree of monetary tightness, or of business regulation, established for the community of nations as a whole? Without cooperation, the resulting policies may well work to the disadvantage of all. In particular, interest rates are likely to be higher than is in the interests of most countries, each nation having responded defensively to developments in neighboring countries; and business regulation is likely to be less comprehensive. Just as increasing constraint on freedom of governmental choice at the local level has led to a gradual extension of federal authority within the United States -- authority which over-reaches the mobility of goods, capital, and labor and hence is not so circumscribed by national mobility -- so increasing constraint on national policy imposed by higher international mobility calls for increased international cooperation and, on some issues, even for joint decisions among nations.

The degree of such international cooperation also influences the amount of international reserves needed to finance imbalances in the face of temporarily divergent and conflicting national policies, illustrating at least one relationship between growing interdependence and the strains concerning gold and the dollar. The more cooperation, the more carefully coordinated national policies are in timing and nature, the lower the need for international liquidity to finance imbalances. If, for example, two neighboring countries are both experiencing unwanted business booms, and one tightens its monetary policy while the other raises taxes, the resulting payments imbalance will be far greater -- as interest-sensitive funds rush from the second country to the first -- than if both countries raise taxes of if both

-26-

pursue tighter monetary policy.

Reactions to these increasing "spillover" effects have been various, including indeed much closer communication among governments on their economic policies than has occurred in the past. Central bank officials from eight major countries meet monthly in Switzerland to discuss topics of common interest, and government financial officials meet six or seven times a year in Paris to review the economic outlook and to recommend monetary, fiscal, and balance-of-payments policies compatible with the collective interest. But measures have also been taken to insulate national markets partially from international repercussions, to reduce the spillovers. Taxes and other measures have been introduced to counter the effects of monetary policies on international flows of capital. Moreover, territorial application of national rules and regulations, such as Securities and Exchange Commission application of its disclosure requirements to certain Canadian firms or U.S. Treasury extension of its regulations prohibiting trade with certain Communist countries to the foreign subsidiaries of American firms, is simply another manifestation of the same phenomenon. National regulatory authorities, frustrated or potentially frustrated by the movement of firms outside their jurisdiction, reach out across national boundaries in order to accomplish their mandates, irritating in the process the countries with foreign-owned firms within their borders.

-27-

### III. The U.S. Payments Deficit

Although the U.S. payments deficit has been in the focus of international financial discussion during much of the past decade, it cannot really be considered apart from the matters considered in the preceding section. It has been an important aggravating circumstance to the strains in the payments system, a proximate cause; but it has also been a consequence of those strains, which have been more fundamental features of the system in the sense that a U.S. deficit¹ of half the actual size would not have avoided them, but would merely have affected the timing with which they became manifest.

#### Sources of the Deficit

The sources of the U.S. payments deficit are complex and diverse. By putting undue emphasis on single causes and neglecting the inter-relatedness of the balance of payments, we can attribute the deficit in the late fifties to a deteriorating competitive position of American products in world markets; in the period 1960-65 to an enormous increase in capital outflows, more than offsetting a marked improvement in the competitive position; and since 1965 to large increases in military expenditures at home and abroad, with some resulting deterioration in the

1. I will bypass the important but technical question of how the U.S. payments deficit should be measured. Several concepts vie for leading place, and this fact alone illustrates the difficulty in characterizing simply and directly the international financial position of a country whose financial role in the world is as complex as that of the United States. Differences among the various concepts hinge principally on how various types of capital flow should be treated. The reader interested in these matters might consult my "The Balance of Payments in Review" in the *Journal of Political Economy* for August 1966.

-28-

competitive position. Even in the most recent period, however, the United
States has not been "living beyond its means," by false analogy to a
family consuming more than it is earning. A better analogy would be to
a dynamic corporation that is borrowing heavily at short term to supple-
ment its own large earnings in financing an ambitious investment program.
Indeed, Americans increased their *net* claims on foreigners very sharply,
from $45 billion in 1957 to $49 billion in 1962 to $68 billion at the
end of 1967.¹ U.S. investment abroad reached such a magnitude, in fact,
that it began to alarm some foreigners. In effect, Americans were lending
long (and acquiring equity) by borrowing short to cover *some* of the new
investment, the remainder being financed out of domestic savings. The
character of American investment operations vis-a-vis the rest of the world
has led some observers to emphasize the role of the American capital
market (taken broadly, to include individuals, firms, and banks) in pro-
viding financial intermediation for the rest of the world, converting
liquid (foreign) savings into long-term (foreign) assets. But a large
amount of U.S. savings has also been invested abroad.

Although in the course of heated debate partisans of one view or
another often argue that since expenditure X is the cause of the payments
deficit, expenditure X should be reduced to improve the deficit, in strict
logic there is no relationship between the proximate "cause" of the deficit
and the most desirable or least costly method for correcting it. To

1. Net claims on foreigners are calculated to include the U.S. gold stock, which declined by nearly $11 billion during this ten year period.

-29-

take an obvious and relevant example, most observers might agree that
the build-up of U.S. military forces in Viet Nam was largely responsible
for the payments deficit during the past few years, but it does not
follow that the appropriate approach for reducing the balance-of-payments
deficit is to withdraw the forces; that should be decided on grounds
transcending balance-of-payments considerations. Similarly, an increase
in domestic demand that reduces the unemployment rate from 4-1/2 percent
to 3-1/2 percent may be expected to worsen the trade position, and did
after 1965; but that may be judged a socially desirable development which
should not be reversed on balance-of-payments grounds.

Past and Proposed Balance-of-Payments Policies

The American administration early expressed concern about the size
of the payments deficit. The extraordinary tightening of monetary
and fiscal policy in 1959, leading to the recession of 1960-61, can be
attributed in part to balance-of-payments considerations. Subsequently,
deliberate deflation was rejected as a balance-of-payments measure, on
the ground that it was far too costly both to the United States and
to the rest of the world. But many other expenditures were adopted
instead. Some involved the manipulation of monetary or fiscal policy, as
when the Administration held short-term interest rates above normal re-
cession lows in 1961-62, even while attempting to reduce long-term interest
rates. Others involved measures designed to restrict particular balance-
of-payments outflows; the major measures in this category are shown on
the accompanying table, with the dates of adoption. Broadly speaking the

-30-

Administration attempted first to limit the balance-of-payments impact of government programs, without, however, reducing the scale of those programs; it then turned to restrictions on private capital outflows. Still other measures were taken to promote foreign expenditures on U.S. exports, on travel to the United States, and on U.S. securities. A number of actions were also taken to improve the appearance of the balance of payments (on a particular measure of the deficit). Finally, the presence of the deficit influenced countless minor government decisions, and perhaps private ones too, in the direction of restraining expenditures abroad.

Because a large payments deficit has persisted, still other measures have been proposed to reduce it. These include a tax or other restrictions on foreign travel by Americans, a tariff surcharge on imports, tighter restrictions on private capital outflows, greater emphasis on indirect taxes in the Federal tax system, and drastic reductions in foreign aid and overseas military expenditures, the last aimed especially at Europe. These diverse proposals, typically advanced by different groups, reflect agreement on the desirability of reducing the deficit but sharp disagreement on the most desirable way to do it.

Disagreements about methods for improving the balance of payments arise on two quite different grounds: differences in social priorities and differences in assessment of their effectiveness. In the debate over policy, the two grounds are often commingled. Thus businessmen typically oppose existing or new restrictions on capital outflows _because_ (they say) foreign investment really helps the balance of payments rather

-31-

Major Restrictive Actions to Reduce the U.S. Deficit

<table>
  <tbody>
    <tr>
      <td>1959 and subsequently</td>
      <td>
        <ul>
          <li>foreign aid expenditures increasingly restricted to procurement of U.S. goods and services</li>
        </ul>
      </td>
    </tr>
    <tr>
      <td>1960</td>
      <td>
        <ul>
          <li>abortive attempt to recall military dependents from Germany</li>
        </ul>
      </td>
    </tr>
    <tr>
      <td>1961</td>
      <td>
        <ul>
          <li>first military offset agreement with Germany</li>
        </ul>
      </td>
    </tr>
    <tr>
      <td>1962</td>
      <td>
        <ul>
          <li>Defense Department applied price differential in favor of U.S. good and services, shortly thereafter, raised to 50 percent and higher on big contracts.</li>
        </ul>
      </td>
    </tr>
    <tr>
      <td>1963</td>
      <td>
        <ul>
          <li>interest equalization tax applied to U.S. purchases of foreign securities; later extended to cover bank and other lending.</li>
        </ul>
      </td>
    </tr>
    <tr>
      <td>1965</td>
      <td>
        <ul>
          <li>voluntary program established to restrict lending to foreigners and business investment abroad</li>
        </ul>
      </td>
    </tr>
    <tr>
      <td>1968</td>
      <td>
        <ul>
          <li>mandatory limits placed on outflows of enterprise capital and retained earnings of U.S.-owned firms operating abroad.</li>
        </ul>
      </td>
    </tr>
    <tr>
      <td>1968</td>
      <td>
        <ul>
          <li>tax on foreign travel requested but denied by Congress</li>
        </ul>
      </td>
    </tr>
  </tbody>
</table>

-32-

than hurting it, returning more than enough in additional exports and earnings to cover the investment outflow in a short period of time. AID officials oppose cutting foreign aid on balance-of-payments grounds because (they say) that will help the balance of payments only negligibly, since virtually all foreign aid is currently tied to purchases of U.S. goods and services. A debate that is really about social priorities is focused on alleged effectiveness. In fact, the evidence for both of these claims to ineffectiveness is quite doubtful. The most complete quantitative study to date on the relationship between direct investment and the balance of payments suggests that in the best of circumstances an additional dollar of direct investment (in Europe) would not be re-couped in the balance of payments for 6-1/2 years, and more likely the period would be over 10 years. Under these circumstances direct investment outflows that continued to grow at 25 percent a year, as direct investment to continental Europe did from 1960 to 1966, would in aggregate never help the balance of payments. Similarly, the difference in impact on the balance of payments between tied and untied aid is far less than that dichotomy would suggest, since on the one hand untied aid was often in fact spent in the United States, owing to the convenience of purchasing here or the competitiveness of American products, whereas on the other hand tied aid is often simply substituted for products that would have been imported from the United States in any case.

-33-

Even if it were true that direct investment abroad is completely recouped within a period of six years, a decision to restrict new outflows is not obviously foolish. It was noted above that the United States was not living beyond its means. To carry the analogy with a family one step further, it has been investing its savings (and more) in foreign equity and debt. But that the typical family should never reduce its purchases of stocks to improve its cash position or even to take a vacation is a precept that surely most businessmen would neither recommend nor follow themselves.

The internationally-minded business community has focussed on reductions in overseas military expenditures as a substantial source of improvement in the balance of payments, thereby implying basic changes in foreign policy without spelling the alternatives out explicitly.¹ Some domestically-oriented businessmen have urged the use of import quotas, but there is more than a suspicion that this position represents a self-serving protectionist measure clothed in a balance-of-payments rationale.

## Criticisms of Restrictive Measures

Many academic economists are skeptical about the effectiveness of the past and proposed piecemeal corrective measures and are unhappy with the inefficiencies to which they give rise.

1. The military posture proposed by Carl Kaysen in this volume, entailing a substantial withdrawal of forces from continental Europe and a reduction in commitments elsewhere in the world, would permit such improvement. It is recommended on grounds other than balance of payments.

-34-

The skepticism is based on two quite different types of analysis. First, there is thought to be a high degree of substitutability among international transactions, so that patchwork restrictions and artificial incentives simply result in a re-arrangement of existing transactions to accommodate these changes, without altering appreciably the overall payments position of the country. As indicated above, tying foreign aid to U.S. goods and services leads aid-receiving countries to impute to their foreign aid receipts goods and services that they would have imported from the United States in any case, thus freeing earned foreign exchange for purchases elsewhere in the world. Similarly, restraining or taxing some types of capital outflow is likely merely to change the form without changing the total. Imposition of the interest equalization tax on foreign bond issues in the United States was followed by a sharp increase in term bank lending; extension of the tax to cover term bank lending found direct investment outflows greatly enlarged; and so on. So long as money is substantially cheaper in the United States than elsewhere, foreigners -- and American firms abroad -- will be tempted to borrow here, one way or another. Most forms of capital outflow by American residents are now covered by some kind of restraint; but no similar restraint applies to the repatriation of foreign capital in the United States, nor of course to foreign funds which might normally be expected to come to the United States. The textent to which these loopholes vitiate the various restraint programs depends on the overall substitutability of one type of funds for another. This substitutability is undoubtedly a good deal higher than officials reckon when they first impose new and selective restraints, especially in the long run; but it is also less than perfect, even in the long run.

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The second ground for being skeptical about the effectiveness of the measures taken or proposed is quite different: it hinges on the alleged refusal of other countries to allow a decline in their payments surpluses or a rise in their payments deficits -- changes that are obviously necessary if the United States is to reduce its payments deficit. This refusal rests in part on a desire by other countries to add to their international reserves (or a reluctance to part with the reserves they have), in part on mercantilistic objections to a deterioration in their trade balances. For example, after years of arguing that the United States had maintained excessively easy monetary policy, Germany in early 1966 tightened its own monetary policy -- pleading a weakened balance of payments as one reason -- when the Federal Reserve did raise U.S. interest rates. The Germany economy lapsed into recession, generating the largest current account surplus of its long history of surpluses. U.S. exports to Europe declined as a result. Other countries, too, have been quick to prevent or to reverse a worsening of their payments positions, and they have often been urged by the international financial community to do so. But surpluses in the rest of the world imply -- apart from small increments to monetary gold stocks up until 1966 -- a corresponding deficit for the United States. Indeed, this is simply the obverse of the point discussed in the preceding section, that the dollar has come to make up for the deficiency in additions to monetary gold. It underlines the dilemma of the deficit: too little leads to reserve shortage, yet too much undermines the position of the dollar.

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Unhappiness with the piecemeal measures arises less from their in-
effectiveness than from the inefficiencies that they introduce into the
allocation of scarce resources. The tying of foreign aid, for example,
can greatly reduce the real value of such aid to recipient countries. In
some cases, the price of aid-financed imports has been increased by
50 percent or more as a result of aid-tying, so that the efficiency of
a dollar's worth of aid is correspondingly reduced. Balance-of-payments
considerations also distort the allocation of foreign aid; because donors
emphasize the direct financing of imported goods, recipient countries
have unduly geared development projects toward those with large require-
ments for imported capital goods, away from the use of local goods and
services. Similarly, giving American suppliers a 50 percent advantage
over foreign suppliers in government procurement has not only enlarged
the government budget (and thereby lent some truth to Congressional
charges of government inefficiency), but has also provided protection
for American suppliers against healthy competition from abroad. Restricting
capital outflows inhibits the use of capital where it is most productive.¹
Finally, promoting arms sales around the world, while perhaps not "in-
efficient" in the narrow sense of the economist, hardly seems conducive
to efficiency in a larger social sense.

1. This is the most complicated and debatable of the efficiency points. Efficient allocation of real savings among countries requires the corresponding transfer of goods and services. But if the surplus on goods and services were large enough, there would be no balance-of-payments problem. Moreover, funds move abroad for reasons other than search for the socially most productive uses; taxes, tariffs, industrial incentives, and business regulations all distort international capital flows, and the efficiency argument for freedom of capital movements presupposes more harmonization in these policies than now exists.

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While many economists agree in condemning what has been done, they disagree among themselves on "efficient" techniques of adjustment that should have been undertaken. Three broad schools of thought can be distinguished (not all equal in membership). The first emphasizes the total supply of dollars available; so long as this is "too great," dollars will flow abroad through one channel or another and will end up being acquired by foreign central banks. The only sure way to stop the deficit is thus to reduce the total supply of dollars relative to the supply of foreign currencies, i.e. to maintain tight money.

The second school of thought insists that a change in exchange rates is required. The numerous ad hoc measures taken to improve the payments position have represented piecemeal devaluation of aid-dollar, the government procurement dollar, the investment dollar and (proposed) the travel dollar relative to other currencies, but only for certain transactions and by varying amounts. These should be consolidated into a single, uniform depreciation of the dollar relative to the currencies of the surplus countries, thereby avoiding inefficiencies of the type described above.

While the first school of thought emphasizes adjustment in the quantity of dollars and the second school adjustment in the price of dollars, the third school argues that the U.S. payments deficit represents a vast misunderstanding, fostered by the way it is officially reckoned, that it does not represent "disequilibrium" in any important sense, and that it is simply a manifestation of the position of the United States as a financial intermediary in the world economy. The United States no more has a "deficit" than a commercial bank does when it accepts sight

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deposits and lends a portion of them at long term to businesses and
home-owners. On this view, all the measures that have been taken are
erroneously aimed at a non-problem, and they run the risk of greatly
disrupting a well-working international financial system in a misguided
attempt to reduce the deficit for the sake of improving that system.

Whatever one's shade of opinion on these issues, there is certainly
enough ground for doubting their effectiveness to justify caution on
further piecemeal measures. The United States is not simply one country
in a world of many, able to assume a given world economic environment
when it takes measures to improve its own payments position. Such measures
have wide-ranging repercussions abroad, and these feed back onto the
U.S. balance of payments, often reducing the effectiveness of the measures
taken. Furthermore, some measures taken may badly damage international
relations, and at a minimum set an undesirable example for others. Put
another way, the potential damage caused by measures taken to reduce the
U.S. payments deficit exceeds the gains by much more than for any other
country and this fact should given American officials pause in adopting
new measures.

To its credit, the U.S. Government has avoided deflation, with its
very high attendant costs per dollar of gain to the balance of payments;
and it has avoided restrictions on private imports, a move which in iso-
lation might set off a round of protectionism reminiscent of the interwar
period. It has undoubtedly moved too far and too unevenly in restricting
government procurement to U.S. sources, although the domestic politics
of foreign aid perhaps dictated virtually complete tying to preserve the
foreign aid program at a reasonable level during the early and mid-sixties.
And the restrains on private capital outflow have failed to follow canons
of comprehensiveness and efficiency.

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IV. U.S. Actions Within the Existing Payments System

Continuing disagreement persists on the proper course of action, if any, for the United States because of the great difficulty in comprehending clearly the complex and manifold role of the United States in the world economy. Disagreement has also persisted, however, because of an uneasy sense that any actions likely to have a major impact on the balance of payments would necessarily transform the existing international order, but not in a clear or well understood direction. Uncertainty has urged caution, and caution has led largely to first aid rather than major surgery.

At the same time, the continuing deficit and the implied weakening in the liquidity position of the United States has led to considerable uneasiness both at home and abroad. This uneasiness has been reinforced from time to time by a feeling that international financial relations have gotten out of control -- a feeling applicable not only to the United States, but also, on occasion, to Canada, France, Germany, Italy, the United Kingdom, and other major countries. Created by uncertainties, the uneasiness in turn creates uncertainties in a payments system whose purposes emphasize certainty and stability. The uneasiness is contagious, and could lead to hedging behavior or even to irrational actions on the part of governments as well as firms and individuals. For psychological reasons, therefore, the United States, as the pivotal country in the international payments system, must behave in such a way as to restore some sense of control. This behavior involves not only, or even mainly, measures aimed directly at the balance of payments; it concerns domestic economic policy as well, an ability to keep the U.S. economy growing

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on an even keel, with neither excessive unemployment nor excessive inflation.

(The income tax increase of 1968 was helpful in this regard, but it came two
years too late, after much damage had been done.) But it also involves some
show of ability to control the country's balance-of-payments position. This
does *not* mean reducing the deficit, as officially measured, to zero; that is
neither necessary nor desirable. It does mean establishing a sense of de-
liberateness, of being on top of things. Sometimes this might involve a con-
scious decision to run a deficit and to finance it out of reserves or official
borrowing; at other times, the United States might decide that reducing the
deficit was appropriate.

Yet actions open to the United States to reassert this sense of control
over the balance of payments within the framework of the existing system, and
even stretching it a bit, are not numerous. Two approaches are discussed here,
(using that term somewhat more broadly than is customary --)
both involving the use of monetary policy --/as a regulator. Both approaches
involve giving greater weight to external considerations in framing economic
policy, but the first presses toward closer international coordination of
policies whereas the second consciously retreats from such coordination.

On the first approach, general monetary policy would be geared much more
heavily than it has been to the balance of payments. To reduce a deficit,
monetary conditions would be deliberately tightened with a view to slowing
down capital outflows or attracting capital inflows. Assigning general mone-
tary policy to this role, however, requires other instruments of economic policy
to be sufficiently flexible to take over some of the roles that monetary policy
is now expected to play, such as stabilization of the domestic economy, sub-
sidization of housing, and so on. The monetary authorities cannot be expected

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to pursue many divergent aims simultaneously, nor should they be blamed for
not succeeding at such a hopeless task. If the domestic economy softens when
the balance of payments is weak, the Federal Reserve will face a dilemma, as
it did in 1960 and again in 1967, in directing monetary policy. Given present
perspectives and objectives, such dilemmas have been resolved generally (but
not wholly) in favor of domestic objectives, and given the practical con-
straints on other actions this was generally the right thing to do. But future
dilemmas can be avoided or eased by providing other, equally flexible instru-
ments suitable for the attainment of domestic objectives.

Fiscal policy could be made sufficiently flexible to take over most of
the role of maintaining domestic economic stability. We would need far greater
flexibility than fiscal policy has had in the past -- it took over three years
to get the tax cut of 1964 and two and a half years to get the tax increase of
1968, from the time each should have taken effect. In 1962 President Kennedy
requested presidential authority to make uniform reductions in the personal
income tax, subject to Congressional veto. This idea, or something like it,
should be revived. Alternatively, the President might propose annually an
appropriate tax surcharge (positive or negative) for examination and action
by Congress in that year, with a view to implementing quickly any necessary
tax changes. Monetary policy might still have to be used for short-run ad-
justments; but more flexible fiscal policy, desirable in any event, would
partially free monetary policy from its domestic stabilization role.

While the flexibility of monetary policy makes it valuable for economic
stabilization, the level of interest rates maintained by monetary policy
influences other aspects of the domestic economy. If monetary policy is

geared more to external considerations, other measures will have to be used to compensate for unwanted side effects at home. For example, some analysts have argued that the United States should maintain an easy monetary policy along with a tight fiscal policy, at full employment, so as to encourage private investment for economic growth. In this role, changes in tax structure, such as the investment tax credit, provide a potential substitute for monetary policy. Another practical problem arising from the higher interest rates that might well result, on average, from giving greater weight to international considerations is the increased debt burden placed on state and local governments, school boards, and other bodies that rely on the bond market to finance durable public services. Again, larger Federal grants or tax-sharing arrangements could be used to compensate for this higher debt burden in areas where local tax resources have already been stretched to the limits of their capacity.

For monetary policy to be an effective regulator of the balance of payments, it must not be neutralized by foreign actions.

If other countries take monetary tightening in the United States as a signal for deliberate monetary tightening abroad, the United States may derive no help to its balance of payments. The possibility is not merely theoretical. Many other countries have even less flexible fiscal policy than does the United States, and they rely even more heavily on monetary policy for domestic stabilization. Caught between high tax rates and strong political pressures for rising government expenditures, several countries feel they must compensate for the resulting fiscal expansion through tighter monetary policy. Such countries may welcome tighter monetary conditions in the United States because it permits them to curb excess expenditure at home, something they could not

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otherwise do through monetary action because of the large capital inflows which would be induced if relatively easy monetary conditions were obtained in the United States.

Under these circumstances, devoting U.S. monetary policy to the balance of payments would help ease the stabilization problems of some other countries, but it would not help the U.S. balance of payments; on the contrary, it might hurt the balance of payments in the long run, by slowing down the rate of inflation abroad. The United States would in effect be taking on the task of stabilizing its own economy (through fiscal policy) and certain foreign economies (through monetary policy). It would, moreover, lead to a higher level of world interest rates. This in turn might aggravate the difficulties of domestic economic policy in still other countries, countries whose monetary authorities would have to tighten credit defensively for balance-of-payments reasons; and it would hurt countries heavily dependent on foreign capital.

Thus the suggestion that the United States devote monetary policy increasingly to the balance of payments needs to be reformulated: U.S. monetary authorities should give greater weight to the world's monetary requirements in framing monetary policy. The U.S. balance of payments is too narrow a focus. The United States sets the monetary "tone" for the world. Such a reorientation raises the question of the extent to which there should be foreign representation in the framing of U.S. monetary policy, both to achieve closer coordination in the formulation of monetary policy for the world and because, as implied above, world monetary requirements depend in part on the success other countries have in managing fiscal policy. Thus all major countries have quite a legitimate interest in the "domestic" policies of their large trading partners, and their mutual concern for a

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prospering world economy is best served by considering the formulation
of policies jointly rather than separately. If flexibility in domestic tax
policy at home and abroad sufficient to relieve general monetary policy
from its domestic roles is lacking, an alternative approach is possible.
The internal and external roles of monetary policy might be separated through
institution of a flexible tax, such as the interest equilization tax (IET),
over external capital transactions. With sufficiently broad coverage this
tax could be varied according to the amount of capital outflow thought to
be consistent at any point in time with the overall balance-of-payments
position. Such a tax would insulate domestic from foreign monetary condi-
tions, thereby permitting greater scope to use monetary policy for domestic
purposes.

Under the IET Extension Act of 1967 the President did receive discre-
tionary authority to vary the IET from zero to 22-1/2 percent on equities
and long-term bonds, with correspondingly lower rates for loans with
shorter maturities.¹ The present tax covers only securities of developed
countries, and it does not cover direct investment outflows. When inter-
est rates are lower in the United States, firms will be tempted to finance
their foreign investment through their home office. At present this loop-
hole is blocked by the mandatory controls on direct investment outflows,
but that program is inherently temporary and must soon be replaced or dis-
carded. One possibility would be to extend coverage of the IET to include

¹. This tax is levied on the total value of the transaction at the time it occurs, but the tax schedule is designed so that a maximum of 15 percent is equivalent to about one percentage point in yield over the life of a loan.

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direct investment outflows and retained earnings.

Even then the substitution of such a flexible tax for monetary policy
would be far from complete: short-term bank lending, suppliers' credits,
and individuals' deposits abroad would be stimulated by large discrepancies
between U.S. and foreign interest rates. To cover all these sources ef-
fectively would require full registration of all foreign exchange trans-
actions, a prospect not pleasant to contemplate.

Finally, the IET would not of course cover foreign capital; that al-
ready inside the country could be withdrawn freely, and that outside could
fail to enter. An IET covering only U.S. capital outflows would thus repre-
sent only one side of the supply-demand "scissors" when it comes to in-
fluencing international capital flows through changes in monetary conditions.

These weaknesses are not decisive. Money and capital markets are not
yet so perfect that each form of capital movement represents a perfect
substitute for any other, and some effective separation of national finan-
cial markets can undoubtedly be preserved in this way. Flexible use of a
tax on a broad class of capital outflows would function with respect to
international capital movements much like the use of general monetary policy,
especially if the tax were varied by small amounts, and general monetary
policy could continue to serve largely domestic ends. But as with the income
tax, this kind of tax would require extensive reporting and surveillance.

Either of these approaches would establish an important instrument of
control over international capital movements, and either could influence
capital movements for a long time. Neither, however, would be suitable for
correcting "fundamental disequilibrium." That would require more basic
remedies.

V. Changes in the Payments System

Whether or not either of the foregoing courses of action, or some com-
bination of them, proves to be adequate for the United States, it remains
incontrovertible that correction of payments imbalances under the existing
system has been clumsy and inefficient. Recent U.S. measures are not
isolated exceptions. Other countries too have relied on a host of re-
strictions over international transactions, including trade as well as
capital movements, to correct or prevent imbalances; and some have resorted
to a degree of domestic deflation that was undesirable on other grounds.
Any sharp adjustment from one situation to another is bound to cause some
dislocation, but the discrete changes in exchange parities sanctioned
under the existing monetary system are especially vulnerable. Parity
changes tend to be delayed too long, postponed in fact by the use of re-
strictions on international transactions, and the prospect of discrete
devaluation stimulates heavy currency speculation by offering a one-way
option under which speculators can gain but not lose. It is a system, in
fact, which presupposes a very low international mobility of capital,
brought about if necessary by tight and effective controls, although that
was never explicitly made a part of the system. Furthermore, internal
political and international prestige considerations often weigh heavily
against changes in exchange rates. Finally, the pressures for adjustment
bear heavily on the countries in deficit, only lightly on countries in
surplus, since the ability to finance deficits is inherently limited
whereas the capacity to accumulate reserves is not.

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It would be nice if in the course of time we could expect the magni-
tude of payments imbalances to diminish, so that we need not worry so much
about methods for correcting them. Unfortunately, the recurrence of
balance-of-payments disturbances is inevitable. They will arise because
of the differential effects of national growth on trade and because of
divergent national choices between inflation and unemployment. As a result
of the first factor, some countries' imports will grow more rapidly than
their exports, and as a result of the second factor some countries' price
levels will rise more rapidly than those of their major competitors. Un-
less countries gear both their rates of economic growth¹ and their employ-
ment levels to the requirements of the balance of payments, imbalances
will arise sooner or later and adjustment will be required. This will be
true even under circumstances when national economic policies are far
more closely coordinated among countries than they are today, so long as
national aims with respect to growth, employment, inflation, and even
the distribution of income diverge from that consistent with the maintenance
of payments equilibrium over time.

Can correction of payments imbalances be made smoother and less
inefficient? The present system, relying on discrete changes in exchange
parities, could be made to operate more efficiently if capital were not
free to move in anticipation of such changes. Use of tax regulators, as

1. Growth in an economy's capacity can of course arise from several quite different sources: increased investment, increased skills of the labor force, improved use of all inputs, etc., and the impact of growth on the balance of payments will depend very much on the source of growth.

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described in the preceding section, would reduce anticipatory movements of capital. But even that could not eliminate currency speculation because of the inseparability of trade from short-term credit and the possibility of speculation through alteration of the timing of payments for imports and exports -- a development that has often plagued Britain. Moreover, the inhibitions of national prestige concerning the foreign value of each currency would remain.

A second possibility would be to concentrate corrective measures on trade (including some services as well as goods), to the exclusion of capital transactions. During the 1960s both Britain and Canada used import surcharges to improve their payments positions by restricting imports. Such surcharges contravene the General Agreement on Tariffs and Trade, and they were used only temporarily in these cases. But such use could be regularized, along with rules of conformance regarding broad coverage and uniformity of the surcharges, to avoid their use for protecting particular industries. It would be possible and desirable, if this route were taken, to go even further and permit the simultaneous subsidization of exports at the same uniform rate of surcharge applied to imports. Such action would take advantage of the essential similarity in effect on trade between the imposition of uniform surcharges on imports and subsidies to exports and an equivalent change in exchange rate. Speculation on anticipated changes would not be wholly absent under this kind of system, but it would be far less than at present because of the inherently greater cost in speculating with commodities.

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This kind of system would mark a sharp break with past practice,
which has attempted to maintain a fairly clear (though somewhat artificial)
separation between trade policy and financial policy. Many economists would
find such a system repugnant, even though the great English economist
Keynes recommended something similar 40 years ago.

A third possible way to correct imbalances in payments, favored by
a number of academic economists, involves abandonment of the system of fixed
exchange parities in favor of complete flexibility in the prices at which
one national currency exchanges for another, determined in the market
like other prices. The advantages claimed for flexible rates are three.
First and foremost, they would provide a system of adjustment to balance-
of-payments disturbances devoid of the numerous inefficiencies and slippages
accompanying alternative methods. The currency of a country experiencing
an increase in payments or a fall in receipts would depreciate, and this
depreciation would both stimulate exports (because they would be more
competitive) and retard imports, thus restoring balance. Second, the
adjustment would be gradual, rather than once-for-all as under the pre-
sent system, so that speculators would not enjoy a one-way option; they
would have to decide how far a depreciating currency would depreciate,
not merely whether it would depreciate. Finally, flexible rates would
insulate national money and capital markets from one another by intro-
ducing greater exchange risk.

A system of flexible exchange rates is intellectually attractive,
but it would mark a radical departure from the present international
monetary system, based on fixed but changeable exchange parities, a sys-
tem which it has already been noted has performed extraordinarily well

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by historical standards. Moreover, extensive use of flexible rates is historically untested except during the hyper-inflations of the early 1920s and the deep depression of the early 1930s. On neither occasion did they perform outstandingly, and on both occasions they were abandoned as soon as more stable internal conditions were re-established. The economists' claim that a system of flexible rates is smooth, neutral among objectives, and socially costless reflects the assumptions underlying their idealization of such a system, and we cannot be sure that they are valid in the real world.

A system of flexible rates between major currencies might even-
tuate, however, if the pressure becomes too great on other instruments
of policy, and while that would by definition represent a "failure" of
the existing system, it should not be regarded as a disaster. It would
indicate that the degree of international cooperation under the present
system is not up to the strains that are placed on it. A switch from
fixed parities to flexible rates is most likely to come about during a
financial crisis, during which the United States, with a large payments
deficit caused or aggravated by heavy outflows of capital, suspends con-
vertibility of the dollar into gold, thereby confronting other countries
with the choice between maintaining existing exchange rates and accumu-
lating dollars on the one hand, or pegging their currencies to gold
(which no other country, with the semi-exception of Switzerland, now does)
and allowing the dollar to depreciate in terms of their currencies.

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Indeed, to some this outcome looks sufficiently attractive that it has been urged as a basis for U.S. policy, implying the creation of a "dollar area" of countries whose currencies were linked to the dollar, with flexible rates between these and currencies outside the area. Such an arrangement would relieve U.S. authorities from preoccupation with the balance of payments, for dollar area countries would accumulate any dollar earnings they chose not to spend, whereas incipient imbalances with the rest of the world would be self-correcting through changes in the exchange rate.

Objection to encouraging this route to flexible rates is primarily political rather than economic: it would mark a sharp unilateral break by the United States with international economic cooperation. Moreover, it should not be assumed that the major trading nations would maintain rational policies during such a crisis; an alternative outcome, which should be even more offensive to the advocates of flexible exchange rates than the present system, would be a large-scale return to protectionism and controls over international transactions.

Two more modest variants of flexible exchange rates have been suggested. The first would enlarge the range within which exchange rates are permitted to fluctuate around exchange parities. Under the IMF rules, this range is limited to a maximum of two percent for each currency with respect to the dollar (hence four percent between any two other currencies), but in practice it is less. The range of permissible flexibility might be widened, without changing parities, from two to six or even to ten percent. Such a step would fall short of complete flexibility, but it would increase the scope for market-directed exchange rate adjustment

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between countries in payments imbalance while at the same time preventing
wild movements in rates generated by speculative excesses. It would
also inhibit large interest-sensitive short-term capital movements, which
are disruptive of national monetary autonomy. It would not, however, cope
with substantial and persistent sources of imbalance.

A second variant is designed to introduce greater long-term inter-
national price flexibility but still to retain major features of the
present system. This proposal would involve changes in exchange rate
parities in small steps, and more or less continuously -- depreciation for
countries in deficit, appreciation for countries in surplus. Such a
system has been called the "crawling peg," to distinguish it from the
"adjustable peg" of the present fixed parity system. The gradual change
in parities would alter the competitive trade positions of countries in
the direction of equilibrium. Small adjustments would avoid the very
large movements of capital associated now with relatively large pros-
pective changes in exchange rates. A crawling peg would not, however,
avoid speculative capital movements altogether, since the prospect of
steady (albeit gradual) appreciation of a currency would add to the
attractiveness of assets denominated in that currency. Monetary policy
would not therefore be freed from concern about the balance of payments.
This proposal might, however, be combined with the wider exchange margins
to yield some of the benefits of each.

All the adjustment processes described here require the cooperation of many countries to bring them into effective existence. These methods are not at the disposal of the United States alone, and hence they do not offer immediate improvement in the U.S. payments position. But international discussion of further improvements in the payments system should involve an open-minded examination of all these various devices for improving the mechanism for correcting imbalances, as well as a discussion of balance-of-payments objectives, which must be compatible among countries before any corrective mechanism can work. Such discussion might have the not incidental consequence of removing the moralizing tone that often surrounds consideration of balance-of-payments deficits and of increasing general tolerance for payments imbalances when the alternatives are viewed realistically.

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VI. <u>Conclusions: Gold, the Dollar, and International</u>
<u>Economic Cooperation</u>

The international monetary system has performed extraordinarily
well, but it is subject to certain strains. Some of these strains are well
on their way to resolution, while others are likely to become more acute.
The United States can provide direction both in its own behavior and in
its efforts to persuade others.

With respect to gold, we should place increasing reliance on man-
made money as a substitute for gold money at the international level,
as we did years ago at the national level, to satisfy growing demand for
international reserves. Great strides have been made in this direction
during the past few years, with agreement finally reached in 1968 to es-
tablish Special Drawing Rights at the International Monetary Fund. It
now remains to get SDRs into circulation and use. Gold will continue to
play a significant role as monetary reserves for some time, but it will
be one of steadily diminishing importance. The only questions concern
the pace at which gold is displaced and the future disposition of existing
monetary gold stocks totalling $40 billion, over 25 times current annual
production. These issues are likely to arise only after several years of
satisfactory experience with SDRs, combined with a private market price
of gold above $35 an ounce and rising. At that point central bankers might
well re-enter the market as sellers of gold -- not to drive the price
down, but to moderate the rise. A rise in the official price of gold is
neither necessary nor desirable.

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The future role of the dollar is more complex. Even more than with
gold, it depends very much on how useful the SDRs are in practice. Some
central banks will want to continue to hold dollars for reasons of con-
venience and yield. Others will switch to SDRs, a prospect that should
not be regarded with dismay by the United States, even at the cost of some
U.S. reserves.

Private dollar holdings are another matter. The dollar plays a cen-
tral role in world commerce -- a role too useful for the world to want to
give up in the absence of an obviously superior substitute, of which
there is none now on the horizon. A common medium of exchange, like a
common language, smooths the path of economic and social intercourse
among nations. Growing world trade implies growing holdings of liquid
dollar assets by foreigners and a continuation of extensive use of the
dollar in international trade and payments.

Large private dollar deposits -- domestic as well as foreign -- do
hold out the possibility of large withdrawals, analogous to a run on the
bank, if at some future time large numbers of private holders should become
skittish about the value of the dollar relative to other currencies. Under
the present system of fixed exchange rates, any such run should be
covered by central bank cooperation on the scale required -- either
directly through present swap arrangements between central banks, amount-
ing now to nearly $10 billion, or in the future perhaps indirectly by
endowing the IMF with powers to lend on a scale and with a speed that it
is not now able to do.

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All these developments hinge on successful cooperation among the major industrial countries, not by all countries in all matters, but by most of them in most matters. The proposals presuppose a basic convergence of national interest in the directions to be taken by the international economy and a common perception of that convergence of interest. As noted earlier, the required cooperation goes well beyond the reserve base of the monetary system; it also encompasses adjustment to payments imbalances and, increasingly, even questions of national regulation and taxation.

The fundamental weakness of the present payments system, its lack of an orderly and efficient procedure for correcting payments imbalances that will inevitably arise, remains unresolved. How this deficiency should be resolved hinges on a strategic and fundamentally political choice: do we want the international payments system to cater to, even to compel, close economic cooperation among major countries? Or do we want it to preserve the widest possible degree of national economic autonomy? Growing economic interdependence among countries outdates the nation-state as an instrument of control and calls for international -- even supra-national -- formulation of policy. But the growth in interdependence, due in part to technology, in part to postwar foreign economic policy, may outpace our capacity to respond suitably, evoking instead destructive national reactions.

Closer direct cooperation in the formulation of objectives and the framing of policy will substantially reduce disturbances to international payments, but it will not eliminate them. Pushing toward closer cooperation

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therefore demands ample financing for payments deficits or considerable
forbearance by trading partners with respect to the temporary use of
selective taxes or other devices to influence trade and investment flows.
The use of restrictions or taxes on international transactions permits
some insulation of national economies, and therefore weakens the inte-
grative pressures of trade, capital movements, and business investment
abroad; but it also provides an occasion to define and police rules con-
cerning acceptable types and duration of such measures, and thereby
strengthens the machinery for inter-governmental cooperation and even
joint effort -- illustrative of the "process vision" discussed by Francis
Bator.

A movement toward greater flexibility in exchange rates generally
caters to greater national autonomy, both by introducing greater uncer-
tainty into international transactions and by permitting individual
governments greater freedom of unilateral action. A system of slowly
changing exchange parities would preserve many of the integrative
pressures, but would also introduce a more orderly procedure for achieving
long-run adjustment than we now have.

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RICHARD N. COOPER

THE DOLLAR AND THE INTERNATIONAL
MONETARY SYSTEM

International monetary relations were badly unsettled in the winter and spring of 1967-68 by devaluation of the pound sterling and thirteen other currencies, a massive rush to buy gold, and a flight from the French franc, all in rapid succession. These disturbances were aggravated by failure to keep the world's two largest free enterprise economies on an even keel. Inflationary demands rose sharply in the United States after 1965, and Germany, in contrast, experienced its first true recession since the end of the Second World War. As a result, the balance-of-payments deficit of the United States became alarmingly large.

Such developments do not directly touch the man in the street, except perhaps by making him vaguely uneasy. But he should not be indifferent to the nature and operation of the international monetary system—the formal rules and the informal conventions which govern international trade and payments—for they in fact strongly influence his opportunities for employment, the prices he pays, and the wages he receives—in short, his standard of living.

In these terms, the present international monetary system has served the world extremely well. The past two decades have seen unparalleled growth in world production and trade, and in standards of living. Even the laggards in economic growth, such as Britain, have grown rapidly by historical standards. And while the less developed countries have not shared fully in this rapid growth, taken as a group they too have performed well by the standards of the past. Furthermore, the world economy has been maintained on a relatively smooth course over the period, and inflation in major countries has been moderate.

While there is ample room for self-congratulation, there is also a danger of becoming smug. The year 1929 also followed a prolonged period of prosperity. Although the present international monetary system has done well, it contains tensions—internal contradictions, Marxists would call them—that threaten the continuation of this prosperity unless new and

204—Brookings Agenda for the Nation sec 290

The strains...

imaginative policies are adopted to cope with them. The pages that follow attempt to describe the formal features of the present international monetary system, to outline the unexpected developments and strains that emerge from it, to discuss the U.S. balance of payments deficit as both a cause and a consequence of those strains, and to consider measures that might be adopted, both within the present system and by changing it, to relieve them.

The Present International Monetary System

The basic outlines of the present monetary system, agreed upon at an international conference in Bretton Woods, New Hampshire, in 1944, were in direct response to the economic and political disasters of the 1930s. At that time, economic depression and financial collapse had been transmitted rapidly from one nation to another. Each country felt itself trapped in a web of relationships which it was too small to influence and from which it could not escape. Some, such as Germany, turned to radical political solutions and broke sharply with the international order; others, to varying degrees, stayed with it and suffered the economic consequences.

The postwar international monetary system was designed therefore to serve the objective of protecting [from international intrusion] the commitment, recently adopted by virtually all major governments, to maintain full employment, and to do so while fostering efficient use of the world's resources. More fundamentally, its aim was to introduce monetary order into a world of interdependent nations: to define and police certain rules of international behavior. The rules of conduct called on each nation to specify a fixed and single rate at which its currency would be sold for others and to eliminate artificial restrictions on the freedom of its residents to make payments to other countries for the purchase of goods and services. These rules approximate those that prevail within a single country, with a single, freely usable currency. There were several important differences, however. First, the injunction against restrictions did not extend to purchasing securities, making loans, or establishing businesses—movements of capital, in the economist's jargon. Second, exchange rates between currencies were not absolutely fixed. They were permitted to vary within 1 percent on either side of the declared parity, allowing some flexibility. More important, exchange parities could be changed occasionally, but

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only under conditions of fundamental balance-of-payments disequilibrium and only with international agreement. In principle, such changes could be either upward or downward; in practice, with only three exceptions, all changes have been downward, despite the fact that balance-of-payments surpluses have been quite as numerous as deficits.

The logic of fixed and only rarely changed exchange rates in combination with freedom from controls over foreign trade in goods and services required adequate international reserves to finance the inevitable imbalance in payments—differences between total payments to foreigners and total receipts from foreigners, before allowing for the residual financing. By long tradition, gold provided the most important form of international reserve. It was almost universally acceptable among banks and governments, and could therefore be used to settle residual debts between one country and another. But, for reasons to be given below, gold was likely to be insufficient in amount and inappropriately distributed among countries to fulfill this role adequately in the new system. The International Monetary Fund (IMF) was therefore established to police the new rules and to provide occasional financial support to member countries, through its own lending operations, to make adherence to the rules possible. Only when it became clear that a country's foreign trade position could not be indefinitely sustained—when it was in "fundamental disequilibrium," in the undefined terms of the IMF—would a change in exchange parity be in order.

The main features of this system for dealing with financial interactions among countries can be etched more sharply against the background of the principal alternative arrangements that prevailed at various times and to various degrees in earlier years. These systems involve, respectively, completely fixed exchange rates, flexible exchange rates, and extensive resort to direct controls over international transactions.

Under the pre-1913 gold standard, national currencies were tied to gold—immutably, it was thought—at fixed prices, and this in turn implied fixed exchange rates between currencies, except for a small margin arising from the cost of shipping gold from one country to another. Under this system, a country experiencing a deficit in its international payments would finance it by selling gold. The outflow of gold in turn would reduce the domestic supply of money, tending to push interest rates upward and to produce a decline in business activity. Unemployment was likely to result, at least temporarily. In addition, savings in the business cycle were

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205—Brookings Agenda for the Nation sec 290

(LL)

transmitted rapidly from country to country, for a downturn in one country would reduce its imports, causing payments deficits and inducing contractions elsewhere. An attempt was made to restore this system after the First World War, but even then countries were becoming more desirous of gearing monetary policy, still in its formative stages, to stabilization of the domestic economy, an assignment that often conflicted with balance-of-payments requirements. Engulfment of the world in the Great Depression strongly reinforced this desire and doomed continued acceptability of an international gold standard.

In the years immediately following the First World War, and again for a brief period in the 1930s, flexible exchange rates seemed to offer relief from the rigors of the gold standard system. Exchange rates, far from being tied rigidly one to another, were allowed to vary freely from day to day according to the dictates of supply and demand, like prices in the commodity markets. This arrangement was not fully satisfactory either. In the unsettled postwar years, speculation for or against a particular currency, by keeping its value too high or depressing it excessively, often impeded needed processes of adjustment and contributed either to economic depression or to rampant inflation. Later, in the 1930s, some governments deliberately depressed the international value of their currencies to stimulate domestic employment—but at the expense of employment in other countries. In neither period did flexible rates prove workable.

Direct governmental controls over international transactions—regulations concerning which payments could be made, to whom, and for what—first came into prominence during the First World War. They were revived by several countries, notably Nazi Germany, in the 1930s and became widespread during and after the Second World War. Such controls badly disrupted the trading world. To mitigate the obvious inefficiencies they introduced, such as resulted when two countries in serious payments difficulty restricted trade with each other, pairs of countries entered into bilateral trading arrangements. These usually led to trade discrimination, often became instruments of diplomatic manipulation, and always were highly disruptive of political relations between participants and nonparticipants. By the late 1940s it was widely recognized that extensive and indiscriminate use of direct controls did not represent a viable system of international trade and payments.

The framework of the present payments system was designed to provide exchange stability, yet, by allowing for changes in parities, to avoid the straitjacket of the gold standard. It was designed to preclude the need for

controls over trade by providing adequate financing for temporary balance-of-payments deficits, yet also to provide a suitable mechanism for correcting lasting imbalances. Above all, it was designed to provide a forum and a frame of reference in which international economic cooperation could supplant economically disruptive and politically damaging competition among national policies designed to protect each nation's balance of payments.

As noted at the outset, this system has been highly successful. Thanks largely to vast improvements in the use and direction of domestic economic policies, depressions have been avoided and economic growth has been both substantial and relatively steady. Although many less developed countries have countered the trend, direct controls by the major industrial nations were drastically reduced by the mid-1960s. Serious balance-of-payments disturbances have not disappeared, but the system has provided enough flexibility to prevent these, in most cases, from becoming a substantial bar to progress. International trade has flourished.

## Further Developments and Emerging Strains

The payments system laid down in 1944 was not entirely realized in practice, however, due to certain subsequent developments. Chief among these were the emergence of the U.S. dollar as an international currency and, indeed, as a widely accepted reserve asset, like gold; and the great increase in the degree of economic interdependence between nations, especially as reflected in the international mobility of capital. Both these developments, which will be discussed below, represented natural but nonetheless significant departures from the basic design. First, however, a word should be said about the role of gold in the present international payments system, as a prelude to discussion of the dollar.

## GOLD

The payments system outlined in 1944 depended heavily for its efficient operation on the use of international reserves, of which far and away the most important component was gold. But at the close of the Second World War most of the officially held gold was in the hands of the United States; by 1947 the U.S. share exceeded 70 percent. The U.S. Treasury determined the world price of gold by offering to buy or sell gold at a fixed

206—Brookings Agenda for the Nation sec 290

price of $35 an ounce, plus or minus a small commission, in dealings with other monetary authorities "for legitimate monetary purposes." It also supplied gold to U.S. users, such as dentists and jewelers, to fill the gap between U.S. production and U.S. consumption.

The international monetary system could not function properly with gold so heavily concentrated in the hands of one country, particularly a country that had a surplus in its international payments. Reserves elsewhere were simply not sufficient, even when supplemented by the meager lending powers of the IMF, to finance the large imbalances of the late forties which developed in the absence of stringent controls over international payments.

The maldistribution of gold, however, merely aggravated a difficulty which was bound to arise, though possibly not for a long time. For use of gold as a commodity and use of gold as an international money, at a fixed and unvarying price, are basically incompatible in today's world. The demand for gold as a commodity is affected by the growth in world income and by the prices of those commodities, such as silver, platinum, and palladium, that compete with gold in desirable properties. Recently the commodity demand for gold has been rising sharply, even apart from speculative demands, about which more will be said below.

The demand for gold as a monetary reserve could also be expected to grow rapidly. As noted above, the international payments system depends heavily on the financing of international imbalances. The more successful the system—the more rapid the growth in income and trade—the larger these financing requirements would be, even though they would not rise proportionately.

New supplies of gold amount to just under $1.5 billion a year. Seventy-five percent of newly mined gold comes from South Africa, and this is supplemented from time to time by gold sales by Russia. Given a fixed price for gold, new supplies—apart from sales by the USSR which depend largely on harvest conditions there and are entirely arbitrary as far as western needs are concerned—depend on the costs of mining gold. With wages and other costs rising and with the best mines gradually being exhausted, an expanding or even steady production of gold depends crucially on technological improvements in mining. These have not been absent, nevertheless, production has declined in most gold mining countries, with the important exception of South Africa. And there too production has levelled off.

A payments system based on gold reserves thus confronted the world

with a grim prospect: inadequate supplies to satisfy competing private and official demands at a fixed price of $35 an ounce. That being so, speculators have gambled on a rise in the price of gold, and private speculative demands in the mid-sixties added heavily to the already large demand for gold for industrial and artistic uses.

Raising the official price of gold offers a way out. A higher price would at once increase the value of existing production and stocks, and would undoubtedly stimulate new production. There are four standard objections to this course of action. First, revaluing $40 billion in official gold, plus large additional amounts in private hands, (by the stroke of a pen) would be strongly inflationary, creating pressures that in practice could be compensated by restrictive monetary and fiscal policies only with difficulty, if at all. Second, the distribution of the capital gains would be heavily skewed in favor of the wealthy countries, which hold most of the monetary gold; and the principal continuing beneficiaries of the price increase would be South Africa and the Soviet Union, both of which have already benefited greatly from what amounts to a commodity price support scheme for their major export product. Third, a once-for-all price increase would offer only a temporary solution to the problem of inadequate supplies; eventually (though perhaps not for a long time) a further increase would be required. Finally, and most fundamentally, revaluing gold would ratify its continued use for international settlements and would impose the real costs of taking gold from the ground merely to store it in vaults under the ground. We learned long ago that it is not necessary to use a valuable commodity for settlement of domestic debts, and substituted instead banknotes and other forms of legal tender.

A similar substitution can be effected for settlement of international debts, and it is currently in the process of being worked out. It is a more rational method, for it avoids diverting a useful metal to monetary purposes; but it is also more complicated than a rise in the official price of gold. Two steps have been taken toward this solution, the first carefully planned and under discussion for some five years, the second adopted hurriedly under crisis conditions. The planned step involves creation of a man-made substitute for gold for use in international settlements; the unplanned step separated official gold from private gold, and allowed supply and demand to determine the price of the latter.

The proposed substitute for gold takes the form of a Special Drawing Right (SDR) on the International Monetary Fund. It is to be created and allocated among countries by international agreement in amounts that

207—Brookings Agenda for the Nation mcc 299

seem to be required to serve the purposes of the international monetary
system. SDRs have been approved, and the required changes in the IMF
and in national laws may be expected to take effect in 1969. SDRs should
be created soon thereafter, although there is reluctance among some Euro-
pean countries to create them so long as the United States is running a
payments deficit.

SDRs will be transferable among all members of the IMF, like cash, and they will be convertible into the currency of any member. They will not circulate generally, however, like gold in the major countries, they will be used for settlement only among central banks. Nor will they supplant monetary gold, at least for a very long time. But they can substitute for gold where it counts, as increments to international reserves, and can thereby free the payments system from its dependence on gold.

Widespread belief in this dependence led in the winter of 1967-68 to heavy speculation on an increase in the price of gold. Central banks sold over $3 billion worth of gold to private markets in an effort to keep the free market price of gold from rising substantially above the official price of $35 an ounce. Then in a historic decision in mid-March, the major central banks split the market for gold into two distinct parts: an official sector in which gold transfers would take place at the official price, and a private market in which the price of gold would be governed by supply and demand, without official intervention. The decision furthermore seemed to break the link between these two markets, at least temporarily. In view of the new SDRs, central banks stated that they no longer saw any need either to sell to the private market or, more significantly, to buy from it. Following creation of this two-price system, the private price of gold rose above $35 an ounce. But it rose remarkably little, considering the fact that South Africa virtually cut off its gold sales. Users' needs were thus supplied by small producers and, evidently, by substantial disharding.

The two-price system leaves unsettled the question of what happens if
the gap widens between the two prices, when and how official gold will be
disposed of, and what becomes of any "capital gain" arising from disposi-
tion of the gold. These questions may become important at some time, but
they are not urgent today. One proposal would have all monetary gold
turned into a central account in exchange for transferable certificates, the
gold to be disposed of later by joint decision. But central banks are not
likely to agree to such a proposal until they have had several years of suc-
cessful experience with SDRs.

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THE DOLLAR AS AN INTERNATIONAL CURRENCY

The shortage of monetary gold would have been far more acute had it not been for another, much earlier development—the emergence of the U.S. dollar as an acceptable reserve asset. Rebuilding war-depleted reserves around the world required some redistribution of gold from the United States in the late 1940s, but even such a redistribution would have been inadequate to support the large growth in trade that subsequently took place. Fortunately, many countries were willing to build up their reserves with dollars—in practice, bank deposits and U.S. Treasury securities. The dollar was widely acceptable in settlement of debts. By using dollars, foreign monetary authorities could avoid gold transaction costs, and in the meantime earn interest on their unused dollar balances.

A more technical reason for emergence of the dollar as a reserve currency lies in the detailed functioning of the payment system. Under the pre-1913 gold standard, gold circulated freely, major banks converted gold into national currencies at a fixed price, and exchange rates were held within narrow bounds. After the Second World War, only the United States and Switzerland officially bought and sold gold for domestic currency at a fixed price, and there was no inclination in some countries, including the United Kingdom and the United States, to permit residents to deal freely in gold. But all adherents to the IMF rules were obliged to keep their exchange rates within prescribed margins around parity, and they needed a mechanism for doing so. Most countries adopted the method of holding the exchange rate with the dollar within the prescribed margins by buying and selling dollars against the local currency. By virtue of this arrangement, the dollar became an “intervention currency,” and countries needed at least working balances in dollars for day-to-day intervention in the exchange markets. Thus the surpluses countries earned initially took the form of dollar accumulations. It was convenient and profitable to retain reserves in this form and the dollar also became a reserve currency. (The British pound played a similar role for countries within the sterling area.) Formal symmetry among national currencies thus gave way to marked asymmetry, dictated not merely by differences in national size but also by the mechanism itself, with the dollar playing a pivotal role.

Use of the dollar as a reserve currency relieved the potential shortage of international reserves, for reserves could grow despite limited gold supplies

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to the extent that other countries accumulated dollars and so long as the United States did not regard such dollar liabilities—for dollar reserves of other countries represent claims on the United States—as an equivalent loss to its own reserves. But emergence of the dollar in this role also posed two problems for the payments system.

First, relief from the gold shortage was purchased at the price of a gradual weakening of the credibility of continued convertibility of dollars into gold at a fixed price. The U.S. Treasury stands ready to convert foreign official dollar claims into gold at foreign initiative. But as the dollar claims grow, the Treasury's ability to do this lessens. Dollar claims of official holders exceeded the U.S. gold stock for the first time in 1965. There is no magic in equality between the U.S. liabilities represented by those claims and the value of the U.S. gold stock, however, not least because of large foreign private claims on the United States. Just as commercial banks thrive on having short-term liabilities to their depositors far in excess of assets, which can be quickly mobilized, in confidence that not all depositors will wish to withdraw at the same time, the United States as banker to the rest of the world need not have liquid reserves as large as its liabilities. Indeed, total U.S. claims on foreigners, including private U.S. investment abroad, far exceed foreign claims on the United States.

Nevertheless, the U.S. payments deficit persisted and the United States found its gold reserves declining and its liabilities to the rest of the world increasing. Under these circumstances, a number of central banks are restive about having to accumulate and hold additional dollars, and the possibility of large-scale conversion is there. If foreign dollar reserves continued to rise, the gap between them and U.S. reserves would continue to widen, possibly posing a threat to the stability of reserve holdings; if they did not continue to rise, the world would sooner or later face a reserve shortage. The new SDRs, once they come into being, can resolve this dilemma.

The second problem posed by the emergence of the dollar as a reserve currency concerns the apparent absence of restraint on U.S. payments deficits that this role implies. Indeed, U.S. payments deficits have been large and they have become a source of controversy and strain. The complaints have taken on political overtones. The United States has been accused of "printing" international money to finance its ventures abroad. General de Gaulle regards the reserve currency role of the dollar as merely one aspect of American hegemony, and he has referred to the "exorbitant privilege" of the reserve currency countries to finance payments deficits

through foreign accrual of their national currencies. Two particular abuses of the international printing press have been alleged: the sharp rise in American investment in Europe, and the large increase in overseas ex-

through foreign accrual of their national currencies. Two particular abuses of the international printing press have been alleged: the sharp rise in American investment in Europe, and the large increase in overseas expenditures associated with the war in Vietnam. The first development gave rise to the charge that the United States was buying up Europe and that the purchase was being financed by European central banks; the second to the charge that Europeans were financing an American military adventure about which they were not consulted and of which a great many of them disapproved.

Willful abuse of the "privilege" is not required to create a problem for the international monetary system, for the net flow of dollars to central banks around the world results from myriad decisions of businessmen and individuals about how and when and where to spend their money, rather than from world demands for additional reserves. While U.S. monetary, fiscal, and other policies can influence these flows, U.S. authorities may find it inexpedient to make their ideas about world reserve needs the sole or even principal criterion for exerting such influence. As has been plainly illustrated during the past several years, monetary policy has been called on to serve a variety of objectives, and the monetary authorities have occasionally found themselves caught between equally persuasive considerations for easing the monetary reins on the one hand, for tightening them on the other.

By converting unwanted dollars into gold, foreign central banks may attempt to exert pressure for measures which reduce the U.S. payments deficit; France did this gradually after 1963, with the silent approval of many other European countries. But they undertake these actions only at the risk of compromising more rapidly the convertibility of dollars into gold, on which the payments system is thought to rest. Moreover, the use of gold conversions to influence U.S. policies that in turn influence the course of the world economy represents a clumsy and ineffectual method of coordinating economic policies. Cooperation in framing policies would be preferable.

The absence of satisfactory, smoothly operating methods for controlling imbalances in international payments is perhaps the major weakness of the present international payments system. But because of the pivotal role of the dollar in international finance, for the United States this weakness takes the particular form indicated here: the haphazard linkage between the supply of additional reserves, provided by U.S. payments deficits, and the demand for them, combined with the great disruption that

209—Brookings Agenda for the NationMcC 290

would result from applying the INIF prescription for fundamental dis-
equilibrium to the United States. In dealing with its payments deficit, the
United States has had to thread its way delicately between a desire to re-
duce the deficit to prevent too rapid a rise in liabilities relative to U.S. gold
holdings, and the fact that effective measures for reducing the deficit
would be destructive of domestic objectives or international order.

GREATER ECONOMIC INTERDEPENDENCE

More significant for the long run than the strains associated either with
gold or with use of the dollar as an international currency, and certainly
more perplexing for policy, is the growth of economic interdependence
among countries that will result in more intense clashes between national
and international considerations in framing economic policies. This inter-
dependence is due in large measure to vast improvements in transportation
and communication which make the world smaller in every sense but the
physical. International transport has become faster and more reliable, and
it has also become cheaper relative to the value of the goods shipped. Busi-
ness familiarity with foreign markets has increased greatly and, combined
with rapid communications, permits firms to take advantage of market
opportunities that in previous times would have been ignored.

But the growth in interdependence derives also from the success of the
payments system itself. Among industrial countries, tariffs have been
sharply reduced and quantitative restrictions on trade in industrial prod-
ucts have been virtually eliminated. Currencies have become more readily
acceptable, and the risks and uncertainties in dealing with other countries
have diminished.

Improvements in communication and increased familiarity have been
especially significant for the movement of funds between countries. The
rapid growth of the Eurodollar market from the late fifties and the even
more rapid growth of the international bond market since the early sixties
are both consequences of these developments. By the end of 1967 total
deposits in the Eurodollar market—a market made by European banks
(including branches of American banks) in dollar deposits and short-term
claims—amounted to $16 billion, more than the total money supply of
many individual European countries. The international bond market
brings together long-term borrowers and long-term lenders outside of any
single national securities market. Borrowers are large firms of international
reputation, many of them American, plus a number of governmental

entities that find it too difficult or too costly to float issues in their home markets; lenders come from all over the world, with roughly half the funds coming immediately through Switzerland, on behalf of customers elsewhere. Most of the issues are denominated in U.S. dollars. Although smaller than the Eurodollar market, the international bond market has grown even more remarkably, from less than $200 million of new issues in 1963 to well over $3 billion in 1968.

Both markets have become large enough to influence developments in national financial markets. Short-term investors can elect to hold their funds in their national currency or to place them in Eurodollars. Which option they choose depends on relative yields and risks. Similarly, long-term investors can put their funds either directly into national markets or into the international bond market. The existence of these new options tends to tie national markets together, making it increasingly difficult for national interest rates to get far out of line with those prevailing in the international market, except in periods of heavy speculation on changes in exchange parities, or through the use of restrictions to isolate national markets from international influences.

Interdependence has also grown outside the areas of trade and financial flows. Business firms increasingly look beyond national boundaries for locations. People move across national boundaries more readily in response to economic incentives, a fact that leads, in the case of the skilled, to the "brain drain." In short, the strictly national orientation of economic behavior, at least within the industrialized countries, is declining; the revolution in communications and transportation is increasing the responsiveness of capital, labor, and commodities to differences in earning opportunities spanning national boundaries. The extent of this responsiveness should not be exaggerated; there is still much attachment to traditional locations and sources of supply. But these attachments are gradually weakening as firms and individuals develop an increasingly international outlook.

The implications of these developments are profound, in two respects. First, the great increase in the international mobility of capital makes the international payments system as laid down a quarter of a century ago all the more difficult to operate effectively, for the prospect of changes in exchange parities gives rise to huge speculative flows of capital. This condition in turn has strengthened official inclinations against changes in exchange rates, both to discourage speculative flows and to avoid rewarding the speculators.

210—Brookings Agenda for the Nation meeting 290

More basically, however, high economic interdependence circumscribes governmental freedom to pursue widely divergent economic policies. When nations are effectively separated by barriers of ignorance and uncertainty, language and law, custom and customs, the responses of business and labor to divergences in national policies remain minor and tolerable. But as foreign commerce and international capital flows become more sensitive to such divergences, the impact on other countries of one country's policies becomes more important. Policy differences tolerable in the past begin to strain both the ability of nations to pursue divergent policies and the functioning of the payments system itself as countries take actions to protect themselves from unwanted side effects.

The constraints imposed on local government by the mobility of business and individuals are familiar to Americans. Taxes and business regulations in one community cannot differ widely from those in surrounding areas or even in distant competing areas, for firms and individuals are free to locate where taxes and regulations are less onerous, and they have shown increasing readiness to do so. Whatever their legal powers, the actual freedom of state and local governments to regulate and to tax is sharply curtailed when labor and capital can locate where their interests are best served and when the product of their effort can be sold anywhere, unimpeded by barriers to trade.

The constraints on national policies imposed by international mobility of men, goods, and money are not yet so binding. But the movement is clearly in that direction. The growing constraint on monetary policy as an instrument of domestic stabilization provides one example: tightening money to curb a domestic boom often pulls in capital from abroad, while easing monetary policy induces capital outflows; in both cases, the effect of monetary action on domestic expenditure is tempered. Businesses have shown increasing willingness to locate in response to tax incentives, and this in turn produces strong pressures for tax "harmonization," for example, within the European Common Market. International mobility even exerts pressures on the redistributive and social policies of countries, as illustrated by the exodus of British physicians in response to low salaries and other restraints imposed on them under the National Health Service.

These developments pose a key question: How is the average degree of monetary tightness, or of business regulation, established for the community of nations as a whole? Without international cooperation, the resulting national policies may well work to the disadvantage of all. In particular, interest rates are likely to be higher than may be in the interests

of most countries, each nation having responded defensively to develop-
ments in neighboring countries. Business regulation is likely to be less
comprehensive than is required. Just as increasing constraint on freedom
of governmental choice at the local level has led to a gradual extension
of federal authority within the United States—authority which reaches
beyond the mobility of goods, capital, and labor and hence is not so cir-
cumscribed by national mobility—so increasing constraint on national
policy imposed by higher international mobility calls for increased inter-
national cooperation and, on some issues, even for joint decisions among
nations.

The reactions to this increasing interdependence, and to the constraints
on national policies that it implies, have pulled in two directions. On the
one hand, it has stimulated much closer communications among govern-
ments on their economic policies. Central bank officials from eight major
countries meet monthly in Switzerland to discuss topics of common inter-
est, and government financial officials meet six or seven times a year in
Paris to review the economic outlook and to recommend to each other
monetary, fiscal, and balance-of-payments policies compatible with the
collective interest. On the other hand, measures have also been taken to
insulate national markets partially from international repercussions, to
reduce the interdependence. Taxes and other measures have been intro-
duced to counter the effects of monetary policies on international flows of
capital. Moreover, extra-territorial application of national rules and regu-
lations—such as imposition by the Securities and Exchange Commission
on certain Canadian firms of its disclosure requirements or U.S. Treasury
extension to the foreign subsidiaries of American firms of its regula-
tions prohibiting trade with certain Communist countries, is simply an-
other manifestation of the same phenomenon. National regulatory author-
ities, frustrated by the actual or potential movement of firms outside their
jurisdiction, reach across national boundaries to accomplish their man-
dates, (irritating in the process) the countries with foreign-owned firms
within their borders.

The U.S. Payments Deficit

Although the U.S. payments deficit has been the focus of international
financial discussion during much of the past decade, it cannot be con-
sidered apart from the matters dealt with in the preceding section. It has

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been an irritant in the payments system, a proximate cause of its strains; but it has also been a consequence of those strains, which are more fundamental features of the system and which would have become manifest, if with different timing, had the U.S. deficit been half of its actual size.¹

## SOURCES OF THE DEFICIT

The sources of the U.S. payments deficit are complex and diverse. If undue emphasis is laid on single causes and the complex relation among components of the balance of payments neglected, the deficit can be attributed in the late fifties to a deteriorating competitive position of American products in world markets; in the period 1960-65 to an enormous increase in capital outflows, which more than offset a marked improvement in the competitive position; and since 1965 to large increases in military expenditures at home and abroad, with some resulting deterioration in the competitive position. Even in the most recent period, however, the United States has not been "living beyond its means," by false analogy to a family consuming more than it is earning. A better analogy would be to a dynamic corporation that is borrowing heavily at short term to supplement its own large earnings in financing an ambitious investment program. Indeed, Americans increased their net claims on foreigners very sharply, from $45 billion in 1957 to $49 billion in 1962 to $68 billion at the end of 1967.² U.S. investment abroad reached such a magnitude, in fact, that it began to alarm some foreigners. In effect, Americans were lending long (and acquiring equity) by borrowing short to cover some of the new investment, the remainder being financed out of domestic savings. The character of American investment operations vis-à-vis the rest of the world has led some observers to emphasize the role of the American capital market (taken broadly, to include individuals, firms, and banks) in providing financial intermediation for the rest of the world, converting liquid (for-

2. Net claims on foreigners are calculated to include the U.S. gold stock, which declined by nearly $11 billion during this ten-year period.

foreign) savings into long-term (foreign) assets. But a large amount of U.S. savings has also been invested directly abroad.

Although the U.S. payments deficit has been the focus of international X is the cause of the payments deficit, expenditure X should be reduced to improve the deficit, in strict logic there is no relationship between the proximate cause of the deficit and the most desirable or least costly method for correcting it. To take an obvious and relevant example, most observers might agree that the buildup of U.S. military forces in Vietnam was largely responsible for the payments deficit during the past few years, but it does not follow that the appropriate means for reducing the balance-of-payments deficit is to withdraw the forces; that should be decided on grounds transcending balance-of-payments considerations. Similarly, an increase in domestic demand that cuts the unemployment rate from 4½ percent to 3½ percent may be expected to worsen the trade position, and indeed did so after 1965; but moderating unemployment may be judged a socially desirable development which should not be reversed on balance-of-payments grounds.

## PAST AND PROPOSED BALANCE-OF-PAYMENTS POLICIES

The American government early expressed concern about the size of the payments deficit. The extraordinary tightening of monetary and fiscal policy in 1959, leading to the recession of 1960-61, can be attributed in part to balance-of-payments concerns. Subsequently, deliberate deflation was rejected as a balance-of-payments measure on the ground that it was far too costly both to the United States and to the rest of the world. But many expedients were adopted instead. Some involved the manipulation of monetary or fiscal policy, as when the administration held short-term interest rates above normal recession lows in 1961-62, even while attempting to reduce long-term interest rates. These were supplemented by the wage-price guideposts, aimed at inhibiting cost and price increases in a period of economic expansion. Others were designed to restrict particular balance-of-payments outflows; these are the measures in this category.

1959 and subsequently: foreign aid expenditures increasingly restricted to procurement of U.S. goods and services.

1960: abortive attempt to recall military dependents from Germany.

1961: first military offset agreement with Germany, under which Germany agrees to purchase arms in the United States to offset U.S. troop costs in Germany.

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1962: Defense Department applied price differential in favor of U.S. goods and services, shortly thereafter raising it to 50 percent and higher on big contracts.

1963: interest equalization tax applied to U.S. purchases of foreign securities; later extended to cover bank and other lending.

1965: voluntary program established to restrict lending to foreigners and business investment abroad.

1968: mandatory limits placed on outflows of enterprise capital and retained earnings of U.S.-owned firms operating abroad.

1968: tax on foreign travel requested but denied by Congress.

Broadly speaking, the administration attempted first to limit the balance-of-payments impact of government programs, without, however, reducing their scale; it then turned to restrictions on private capital outflows. Other measures sought to promote exports, travel to the United States, and foreign purchase of U.S. securities. Steps were also taken to improve the appearance of the balance of payments (on a particular measure of the deficit). Finally, the presence of the deficit influenced countless minor government decisions, and perhaps private ones too, in the direction of restraining expenditures abroad.

Because a large payments deficit has persisted, still other means have been proposed to reduce it. These include a tax or other restrictions on foreign travel by Americans, a tariff surcharge on imports, tighter restrictions on private capital outflows, greater emphasis in the federal tax system on indirect taxes (which can readily be refunded to exporters), and drastic reductions in foreign aid and overseas military expenditures, the last aimed especially at Europe. These diverse proposals, typically advanced by different groups, reflect agreement on the desirability of reducing the deficit but sharp disagreement on the most desirable way to do it.

These disagreements arise on two distinct grounds: differences in social priorities and differences in assessment of the effectiveness of various methods. In the debate over policy, the two grounds are often commingled. Thus businessmen typically oppose existing or new restrictions on capital outflows because (they say) foreign investment really helps the balance of payments rather than hurting it, returning more than enough in additional exports and earnings to cover the investment outflow in a short period of time. AID officials oppose cutting foreign aid on balance-of-payments grounds because (they say) that will help the balance of payments only negligibly, since virtually all foreign aid is currently tied to purchases of U.S. goods and services. A debate that is really about social priorities is

focused on alleged effectiveness. In fact, the evidence for both these claims is doubtful. The most complete quantitative study to date on the relationship between direct investment and the balance of payments suggests that at best an additional dollar of direct investment in Europe would not be recouped in the balance of payments for six and one-half years, and that under ordinary circumstance the period would be over ten years. Direct investment outflows that continued to grow at 25 percent a year, as direct investment to continental Europe did from 1960 to 1966, would in aggregate never help the balance of payments. Similarly, the difference in impact on the balance of payments between tied and untied aid is far less than that dichotomy would suggest, since on the one hand untied aid was often spent in the United States, owing to the convenience of purchasing here or the competitiveness of American products, while on the other, tied aid is frequently substituted for funds that would have been spent in the United States in any case.

The internationally minded business community has focussed on reductions in overseas military expenditures as a substantial source of improvement in the balance of payments, thereby implying basic changes in foreign policy.³ Some domestically oriented businessmen have urged the use of import quotas, but this position looks suspiciously like a self-serving protectionist measure clothed in a balance-of-payments rationale.

## CRITICISMS OF RESTRICTIVE MEASURES

Many observers are skeptical of the effectiveness of past and proposed piecemeal corrective measures and are unhappy with the inefficiencies to which they give rise.

3. The military posture proposed by Carl Kaysen in this volume, entailing a substantial withdrawal of forces from continental Europe and a reduction in commitments elsewhere in the world, would permit such improvement. It is recommended on grounds other than balance of payments.

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The skepticism results, first, because there is thought to be a high degree of substitutability among international transactions, so that patchwork restrictions and artificial incentives simply induce rearrangement of existing transactions without altering appreciably the overall payments position of the country. As indicated above, tying foreign aid to U.S. goods and services leads aid-receiving countries to use foreign aid to buy goods and services that they would have imported from the United States in any case, thus freeing earned foreign exchange for purchases elsewhere in the world. Similarly, restraining or taxing some types of capital outflow is likely to change the form of capital outflow without reducing its total. Imposition of the interest equalization tax on foreign bond issues in the United States was followed by a sharp increase in term bank lending; when the tax was extended to cover term bank lending direct investment outflows greatly increased; and so on. As long as money is substantially cheaper in the United States than elsewhere, foreigners—and American firms abroad—will be tempted to borrow here, one way or another. Most forms of capital outflow initiated by U.S. residents are now restricted in some way; but no similar restraint applies to the right of foreigners to bring their capital home from the United States, nor of course to foreign funds which might normally be expected to come to the United States. The extent to which these loopholes vitiate restraints depends on the overall substitutability of one type of funds for another. This substitutability is undoubtedly a good deal higher than officials reckon when they impose new and selective restraints, especially in the long run; but it is also less than complete, even in the long run.

A second ground for being skeptical about the effectiveness of the measures taken or proposed is quite different; it hinges on the alleged refusal of other countries to allow a decline in their payments surpluses or a rise in their payments deficits—changes that are obviously necessary if the United States is to reduce its payments deficit. This refusal is said to rest in part on a desire by other countries to add to their international reserves (or a reluctance to part with the reserves they have), in part on mercantilistic objections to a deterioration in their trade balances. For example, after years of arguing that the United States had maintained excessively easy monetary policy, Germany in early 1966 tightened its own monetary policy after an increase in U.S. interest rates—pleading a weakened balance of payments. The Germany economy lapsed into recession, generating the largest current account surplus in its long history of surpluses. U.S. exports to Europe declined as a result. Other countries, too, have been quick to

prevent or to reverse a worsening of their payments positions. But surpluses in the rest of the world imply, apart from small increments to monetary gold stocks up until 1966, a corresponding deficit for the United States. Indeed, this is simply the obverse of the point discussed in the preceding section, that the dollar has come to make up for the deficiency in additions to monetary gold.

Unhappiness with piecemeal measures stems less from their ineffectiveness than from the inefficiencies they produce. Tying foreign aid, for example, can greatly reduce its real value to recipient countries. In some cases, the price of aid-financed imports has been increased by 50 percent or more as a result, so that the real value of a dollar's worth of aid is correspondingly reduced. Balance-of-payments considerations also distort the allocation of foreign aid; because donors emphasize the direct financing of imported goods, recipient countries have leaned unduly toward development projects with large import requirements, and thus away from the use of local goods and services. Similarly, the 50 percent advantage American suppliers enjoy over foreign suppliers in government procurement has not only swollen the government budget (and thereby lent some truth to Congressional charges of government inefficiency), but has also shielded American suppliers against healthy competition from abroad. Restrictions on capital outflows may inhibit the use of capital where it is most productive.⁴ Finally, promoting arms sales around the world, while perhaps not "inefficient" in the narrow sense of the economist, hardly seems productive.⁴ Finally, promoting arms sales around the world, while perhaps

While many economists agree in condemning what has been done, they disagree among themselves on which "efficient" techniques of adjustment should have been undertaken. Three broad schools of thought can be distinguished. The first emphasizes the total supply of dollars available; so long as this is "too great," dollars will flow abroad through one channel or another and will end up being acquired by foreign central banks. The only sure way to stop the deficit is thus to reduce the total supply of dollars

4. This is the most complicated and debatable of the efficiency points. Efficient allocation of real savings among countries requires the corresponding transfer of goods and services. But if the surplus on goods and services were large enough, there would be no balance-of-payments problem. Moreover, funds move abroad for reasons other than search for the socially most productive uses; taxes, tariffs, industrial incentives, and business regulations all distort international capital flows, and the efficiency argument for freedom of capital movements presupposes more harmonization in these policies than now exists.

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relative to the supply of foreign currencies, which is to say, maintain tight money.

The second school of thought insists that adjustment in exchange rates is required. The numerous ad hoc measures taken or proposed to improve the payments position represent devaluation of the aid dollar, the government procurement dollar, the investment dollar, and the travel dollar relative to other currencies, but only for certain transactions and by varying amounts. These should be consolidated into a single, uniform depreciation of the dollar relative to the currencies of the surplus countries, thereby avoiding inefficiencies of the type described above.

While the first school of thought emphasizes adjustment in the quantity of dollars and the second adjustment in the price, the third argues that the U.S. payments deficit represents a vast misunderstanding, fostered by the way it is officially reckoned; that it does not represent "disequilibrium" in any important sense; and that it is simply a manifestation of the position of the United States as a financial intermediary in the world economy. The United States no more has a deficit than a commercial bank does when it accepts sight deposits and lends a portion of them at long term to businesses and home-owners. On this view, all the measures that have been taken are erroneously aimed at a non-problem, and they run the risk of greatly disrupting an international financial system that is functioning well in a misguided attempt to reduce the deficit for the sake of improving that system.

Whatever one's shade of opinion on these issues, there is certainly enough justification for caution on further piecemeal measures. The United States is not simply one country in a world of many, able to assume a given world economic environment when it takes measures to improve its own payments position. Such measures have wide-range repercussions abroad, and these feed back onto the U.S. balance of payments, often reducing the effectiveness of the measures. Furthermore, some steps may badly damage international relations, and at a minimum set an undesirable example for others. Put another way, the potential damage caused by measures taken by the United States to reduce its payments deficit exceeds the gains by much more than would be the case for any other country, and this fact should give American officials pause in adopting new measures.

To its credit, the U.S. government has avoided deflation, with its very high attendant costs per dollar of gain to the balance of payments; and it has avoided restrictions on private imports, a move which in isolation

might set off a round of protectionism reminiscent of the interwar period. It has undoubtedly moved too far and too unevenly in restricting government procurement to U.S. sources, although the domestic politics of foreign aid perhaps dictated virtually complete tying to preserve the foreign aid program at a tolerable level during the early and middle sixties. And the restraints on private capital outflow have failed to follow canons of comprehensiveness and efficiency.

## U.S. Policy Alternatives Within the Existing System

Disagreement persists on the proper course of action for the United States because of the great difficulty in comprehending the complex role of the United States in the world economy. Disagreement has also persisted, however, because of an uneasy sense that actions likely to have a major impact on the balance of payments would necessarily transform the existing international order, but not in a clear or well understood direction. Uncertainty has urged caution, and caution has prescribed first aid rather than major surgery.

At the same time, the continuing deficit and the implied weakening in the liquidity position of the United States has led to considerable uneasiness both at home and abroad. This uneasiness has been reinforced from time to time by a feeling that international financial relations have gotten out of control; created by uncertainties, the uneasiness in turn creates uncertainties in a payments system whose purposes emphasize certainty and stability. The uneasiness is contagious, and could lead to hedging behavior or even to irrational actions on the part of government as well as firms and individuals. For psychological reasons, therefore, the United States, as the pivotal country in the international payments system, must behave in such a way as to restore some sense of control. This behavior involves not only measures aimed directly at the balance of payments; it equally concerns domestic economic policy, an ability to keep the U.S. economy growing, with neither excessive unemployment nor excessive inflation. (The income tax increase of 1968 was helpful in this regard, but it came two years too late, after much damage had been done.) But it also involves some demonstration of ability to control the country's balance-of-payments position. This does not mean reducing the deficit, as officially measured, to zero; that is neither necessary nor desirable. It does mean establishing a sense of deliberateness, of being on top of things. Sometimes this might involve

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a conscious decision to run a deficit and to finance it out of reserves or official borrowing; at other times, reducing the deficit would be appropriate.

Yet few means are available to the United States, within the framework of the existing system, to reassert this sense of control over the balance of payments. Two approaches are discussed here, both involving the use of monetary policy (defined more broadly than is customary) as a regulator. Both propose greater weight for external considerations in framing economic policy, but the first presses toward closer international coordination of policies whereas the second consciously retreats from it.

On the first approach, general monetary policy would be geared much more closely than it has been to the balance of payments. To reduce a deficit, monetary conditions would be deliberately tightened with a view to retarding capital outflows or attracting capital inflows. Assigning general monetary policy to this role, however, requires other instruments of economic policy to be sufficiently flexible to take over some of the roles it is now expected to play, such as stabilization of the domestic economy, stimulation of investment, and so on. The monetary authorities cannot be expected to pursue many divergent aims simultaneously, nor should they be blamed for not succeeding at such a hopeless task. If the domestic economy softens when the balance of payments is weak, the Federal Reserve will face a dilemma, as it did in 1960 and again in 1967, in directing monetary policy. Given present perspectives and objectives, such dilemmas have been resolved generally (but not wholly) in favor of domestic objectives, and given the practical constraints on other actions this was generally the right thing to do. But future dilemmas can be avoided or eased by providing other, equally flexible instruments suitable for the attainment of domestic objectives.

Fiscal policy could be made sufficiently flexible to perform most of the task of maintaining domestic economic stability. Far greater flexibility would be required than fiscal policy has had in the past; measured from the time each should have taken effect, it took over three years to get the tax cut of 1964 and two and a half years to get the tax increase of 1968. In 1962, President Kennedy requested presidential authority to make uniform reductions in the personal income tax, subject to congressional veto. This idea, or something like it, including tax increases, should be revived. Alternatively, the President might propose annually an appropriate tax surcharge (positive or negative) for examination and action by Congress in that year, with a view to implementing quickly any necessary tax

changes. Monetary policy might still have to be used for short-run ad-
justments; but more flexible fiscal policy, desirable in any event, would
partially relieve monetary policy from its role in domestic stabilization.

While the flexibility of monetary policy makes it valuable for economic
stabilization, the level of interest rates maintained by monetary policy
influences other aspects of the domestic economy. If monetary policy is
more responsive to external considerations, other measures will have to be
used to compensate for unwanted side effects at home. For example, some
analysts have argued that the United States should maintain an easy mone-
tary policy along with a tight fiscal policy, at full employment, so as to en-
courage private investment for economic growth. In this scheme, changes
in tax structure, such as the investment tax credit, provide a potential sub-
stitute for monetary policy. Another practical problem arising from the
higher interest rates that might well result from giving greater weight to
international considerations is the increased debt burden placed on state
and local governments, school boards, and other bodies that rely on the
bond market to finance public services. Again, larger federal grants or tax-
sharing arrangements could be used to compensate for this higher debt
burden in areas where local tax resources have already been stretched to
their limits. These examples illustrate the close connection between bal-
ance-of-payments policies and more strictly domestic aims and policies.

For monetary policy to be an effective regulator of the balance of pay-
ments, it must not be neutralized by foreign actions. If other countries
view monetary tightening in the United States as a signal for deliberate
monetary tightening abroad, the United States may derive no help to its
balance of payments. The possibility is not merely theoretical. Many other
countries use fiscal policy even less flexibly than does the United States,
and they rely even more heavily on monetary policy for domestic stabili-
zation. Caught between already high tax rates and strong political pressures
for rising government expenditures, several important countries have com-
pensated for the resulting fiscal expansion through tighter monetary
policy. Such countries may welcome tighter monetary conditions in the
United States because they are thus enabled to curb excess expenditures
at home, something they could not otherwise do through monetary action
because of the large capital inflows which would be induced by relatively
easy monetary conditions in the United States.

Under these circumstances, linking U.S. monetary policy to the balance
of payments would help ease the stabilization problems of some other
countries, but it would not help the U.S. balance of payments; on the con-

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trary, it might hurt it in the long run, by slowing down the rate of inflation abroad. The United States would in effect be taking on the task of stabilizing both its own economy (through fiscal policy) and certain foreign economies (through monetary policy). These policies, moreover, would lead to a higher level of world interest rates. This development in turn might aggravate the difficulties of domestic economic policy in still other countries, whose monetary authorities would have to tighten creditatively for balance-of-payments reasons; and it would hurt countries heavily dependent on foreign capital.

Thus the suggestion that the United States devote monetary policy increasingly to the balance of payments needs to be reformulated: U.S. monetary authorities should give greater weight to the world's monetary requirements in framing monetary policy. The U.S. balance of payments is too narrow a focus, for the United States sets the monetary tone for the world. Such a reorientation raises the question of the extent to which there should be foreign consultation in the framing of U.S. monetary policy, both to achieve closer coordination in the formulation of monetary policy for the world and because, as implied above, world monetary requirements depend in part on the success other countries have in managing fiscal policy. Major countries have a legitimate interest in the "domestic" policies of their large trading partners, and their mutual concern for a prospering world economy is best served by considering the formulation of policies jointly rather than separately.

If domestic tax policy at home and abroad lacks sufficient flexibility to relieve general monetary policy from its domestic roles, an alternative approach is possible. This approach reduces reliance on close international coordination of economic policies. The internal and external roles of monetary policy might be separated through institution of a flexible tax, such as the interest equalization tax (IET), over external capital transactions. With adequate coverage this tax could be varied according to the amount of capital outflow thought to be consistent at any point in time with the overall balance-of-payments position. Such a tax would insulate domestic from foreign monetary conditions, thereby giving monetary policy greater scope for domestic purposes.

Under the IET Extension Act of 1967 the President received discretionary authority to vary the IET from zero to 22½ percent on equities and long-term bonds, with correspondingly lower rates for loans with

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shorter maturities.⁵ The present tax covers only securities of developed countries, and it does not cover direct investment outflows. When interest rates are lower in the United States, U.S. firms will be tempted to finance their foreign investment through their home offices. At present this loop-hole is blocked by the mandatory controls on direct investment outflows, but that program is inherently temporary and must soon be replaced or discarded. One possibility would be to extend coverage of the IET to direct investment outflows and retained foreign earnings.

Even then the substitution of such a flexible tax for monetary policy would be far from complete; short-term bank lending, suppliers' credits, and individuals' deposits abroad would be stimulated by large discrepancies between U.S. and foreign interest rates. To cover all these sources of outflow effectively would require full registration of all foreign exchange transactions, a prospect not pleasant to contemplate.

Finally, the IET would not, of course, cover foreign capital; that already inside the country could be withdrawn freely, and that outside need not enter. An IET covering only U.S. capital outflows would thus represent only one side of the supply-demand "scissors" when it comes to influencing international capital flows through changes in monetary conditions.

These weaknesses are not decisive. Money and capital markets are not yet so perfect that each form of capital movement represents a perfect substitute for any other, and some effective separation of national financial markets can undoubtedly be preserved in this way. A tax on a broad class of capital outflows, flexibly used, would affect international capital movements much like general monetary policy, and general monetary policy could continue largely to serve domestic ends. But like the income tax, this kind of tax would require extensive reporting and surveillance.

Either of these approaches would furnish an important instrument of control over international capital movements, and either could influence them for a long time. Neither, however, would be suitable for correcting "fundamental disequilibrium." That would require more basic remedies.

## Changes in the Payments System

Whether either of the foregoing courses of action, or some combination of them, proves to be adequate for the United States, it remains incontro-

5. This tax is levied on the total value of the transaction at the time it occurs, but the tax schedule is designed so that a maximum tax of 15 percent is equivalent to about one percentage point in yield over the life of a loan.

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vertible that correction of payments imbalances under the existing system has been clumsy and inefficient. Recent U.S. measures are not isolated exceptions. Other countries too have relied on a host of restrictions over international transactions, including trade as well as capital movements, to correct or prevent imbalances; and some have resorted to a degree of domestic deflation that was undesirable on other grounds. Any sharp adjustment from one situation to another is bound to cause some dislocation. But the fact that under the existing monetary system only discrete changes in exchange rates are sanctioned results in frequent use of that important device. Considerations of internal politics and international prestige often strongly inhibit changes in exchange parities. They therefore tend to be delayed too long, postponed in fact by the use of restrictions on international transactions; and the prospect of discrete devaluation stimulates currency speculation by offering a one-way option under which speculators can gain but not lose. Finally, the pressures for adjustment bear heavily on the countries in deficit, but only lightly on countries in surplus, since the ability to finance deficits is inherently limited whereas the capacity to accumulate reserves is not.

It would be reassuring if we could expect the magnitude of payments imbalances to diminish in the course of time, so that we need not worry so much about methods for correcting them. Unfortunately, the recurrence of balance-of-payments disturbances is inevitable. They will arise because of the differential effects of national growth on trade, because of divergent national choices between inflation and unemployment, and because of differences among countries in the mix of economic policies. As a result of the first factor, some countries' imports will grow more rapidly than their exports, and as a result of the second some countries' price levels will rise more rapidly than those of their major competitors. Unless countries gear both their rates of economic growth and their employment levels to the requirements of the balance of payments, imbalances will develop sooner or later and adjustment will be required. This will be true even when national economic policies are far more closely coordinated among countries than they are today, so long as national aims with respect to growth, employment, inflation, and even the distribution of income are inconsistent with the maintenance of payments equilibrium over time.

Can correction of payments imbalances be made smoother and more efficient? The present system could be made to operate more efficiently if capital were not free to move in anticipation of the discrete changes

which it dictates. Tax regulators, as described in the preceding section, would reduce anticipatory movements of capital. But even they could not eliminate currency speculation because of the inseparability of trade from short-term credit and the possibility of speculation through postponement or advancement of payment for imports and exports—a practice that has often plagued Britain. Moreover, the inhibitions of national prestige concerning the foreign value of each currency would remain.

A second possibility would be to concentrate corrective measures on trade (including some services as well as goods), to the exclusion of capital transactions. During the 1960s both Britain and Canada used import surcharges in an effort to restrict imports and thus to improve their payments positions. Such surcharges contravene the General Agreement on Tariffs and Trade, and they were used only temporarily in these cases. But surcharges could be regulated and rules of conformance imposed regarding broad coverage and uniformity, to avoid their use for protecting particular industries. It would be possible and desirable, if this route were taken, to go even further and permit the simultaneous subsidization of exports at the same rate of surcharge applied to imports. Such action would take advantage of the essential similarity in effect on trade between the imposition of uniform surcharges on imports and subsidies to exports, on the one hand, and an equivalent change in exchange rate on the other. Speculation on anticipated changes would not be wholly absent under this kind of system, but there would be far less of it than at present because of the inherently greater cost of speculating in commodities.

This kind of system would mark a sharp break with past practice, which has attempted to maintain a fairly clear (though somewhat artificial) separation between trade policy and financial policy. Many economists would find such a system repugnant, even though Keynes recommended something similar forty years ago.

A third possible way to correct imbalances in payments involves abandonment of the system of fixed exchange parities in favor of completely flexible prices, determined in the market, at which one national currency exchanges for another. Three advantages are claimed for flexible rates. First and foremost, they would provide a system of adjustment to balance-of-payments disturbances devoid of the numerous inefficiencies and slippages accompanying alternative methods. The currency of a country experiencing an increase in payments or a fall in receipts would depreciate, and this depreciation would both stimulate exports (because they would be more competitive) and retard imports, thus restoring balance. Second, the ad-

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justment would be gradual, rather than once-for-all as under the present system, so that speculators would not enjoy a one-way option; they would have to decide how far depreciation of a currency would go, not merely whether it would occur. Finally, flexible rates would insulate national money and capital markets from one another by introducing greater exchange risk.

A system of flexible exchange rates is intellectually attractive, but it would mark a radical departure from the present international monetary system, based on fixed but changeable exchange parities, a system which it has already been noted has performed extraordinarily well by historical standards. Moreover, flexible rates are historically untested except during the hyper-inflations of the early 1920s and the deep depression of the early 1930s. On neither occasion did they perform outstandingly, and on both they were abandoned as soon as more stable internal conditions were re-established. The economists' claim that a system of flexible rates is smooth, neutral among objectives, and socially costless reflects the assumptions underlying their idealization of such a system, and we cannot be sure that these assumptions are valid in the real world.

A system of flexible rates between major currencies might eventuate, however, if the pressure becomes too great on other instruments of policy, and while that development would by definition represent a "failure" of the existing system, it should not be regarded as a disaster. It would indicate that the mechanism for payments adjustment and the degree of international cooperation under the present system are not up to the strains that are placed on it. A switch from fixed parities to flexible rates is most likely to come about as the result of a financial crisis, during which the United States, with a large payments deficit caused or aggravated by heavy outflows of capital, suspends convertibility of the dollar into gold, thereby confronting other countries with the choice between maintaining existing exchange rates and accumulating dollars on the one hand, and, on the other, pegging their currencies to gold and allowing their currencies to appreciate in terms of the dollar.

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Objection to encouraging this route to flexible rates is primarily political rather than economic: it would mark a sharp unilateral rejection of international economic cooperation by the United States. Moreover, it should not be assumed that the major trading nations would maintain rational policies during such a crisis. An alternative outcome, which should be even more offensive to the advocates of flexible exchange rates than the present system, would be a large-scale return to protectionism and controls over international transactions. Such a development would involve not only considerable economic inefficiencies, but by greatly increasing the scope for using commercial policy for political ends would be highly divisive among nations.

Two variants of flexible exchange rates—more modest in the degree of departure from the present system—have been suggested. The first would enlarge the range within which exchange rates are permitted to fluctuate around parities. Under the IMF rules, the range is 2 percent for each currency with respect to the dollar (hence 4 percent between any two other currencies), but in practice it is narrower. The range of permissible flexibility might be widened, without changing parities, from 2 to 6 or even 10 percent. Such a step would fall short of complete flexibility, but it would increase the scope for market-directed exchange rate adjustment between countries in payments imbalance while at the same time preventing wild movements in rates generated by speculative excesses. It would also inhibit large interest-sensitive short-term capital movements, which disrupt national monetary autonomy. It would not, however, cope with substantial and persistent sources of imbalance.

A second variant is designed to introduce greater long-term international price flexibility but still to retain major features of the present system. This proposal would involve changes in exchange rate parities in small steps with slight but continuous depreciation for countries in deficit, appreciation for countries in surplus. The gradual change in parities would alter the competitive trade positions of countries in the direction of equilibrium. Small adjustments would avoid stimulating the very large movements of capital associated now with relatively large prospective changes in exchange rates. A sliding parity would not, however, avoid speculative capital movements altogether, since the prospect of steady (if gradual) appreciation of a currency would add to the attractiveness of assets denominated

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To bring any of the adjustment processes described in this section into effective existence requires the cooperation of many countries. These methods are not at the disposal of the United States alone, and hence they do not offer immediate improvement in the U.S. payments position. But international discussion of further improvements in the payments system should involve an open-minded examination of all these devices for improving the mechanisms for correcting imbalances, as well as of balance-of-payments objectives, which must be compatible among countries before any corrective mechanism can work. Such discussion might have the not incidental consequences of removing the moralizing tone that often surrounds consideration of balance-of-payments deficits and of increasing general tolerance for payments imbalances when the alternatives are viewed realistically.

## Conclusions: Gold, the Dollar, and International Economic Cooperation

The international monetary system has performed extraordinarily well, but it is subject to certain strains. Some of these strains are well on their way to resolutions; others are likely to become more acute. The United States can provide direction both by its own behavior and by its efforts to persuade others to adjust their behavior.

We should place increasing reliance on man-made money as a substitute for gold money at the international level, as we did years ago at the national level, to satisfy the growing demand for international reserves. Great strides have been made in this direction during the past few years, with agreement finally reached in 1968 to establish Special Drawing Rights at the International Monetary Fund. It now remains to get SDRs into circulation. Gold will continue to play a significant role as monetary reserves for some time, but it will be one of steadily diminishing importance. The only questions concern the pace at which gold is displaced and the future disposition of existing monetary gold stocks totalling $40 billion, over twenty-five times current annual production. These issues are likely to arise only after several years of satisfactory experience with SDRs, combined

with a private market price of gold above $35 an ounce and rising. At that
point central bankers might well reenter the market as sellers of gold—
not to drive the price down, but to moderate the rise. A rise in the official
price of gold is neither necessary nor desirable.

The question of the dollar is more complex. Even more than is the case
with gold, its role depends on how useful the SDRs are in practice. Some
central banks will want to continue to hold dollars for reasons of con-
venience and yield. Others will switch to SDRs, a prospect that should
not be regarded with dismay by the United States, even if it costs some
reduction in U.S. reserves.

Private dollar holdings are another matter. The dollar plays a central
role in world commerce—a role too useful for the world to give up while
there is no obviously superior substitute in the wings. A common medium
of exchange, like a common language, smooths the path of economic and
social intercourse among nations. Expansion in world trade implies ex-
pansion in holdings of liquid dollar assets by foreigners and a continuation
of extensive use of the dollar in international trade and payments.

Large private dollar deposits—domestic as well as foreign—hold the
threat of large withdrawals, analogous to a run on the bank, if at some
future time large numbers of private holders should become skittish about
the value of the dollar relative to other currencies. Under the present sys-
tem of fixed exchange rates, any such run should be covered by central
bank cooperation on the scale required—either directly through present
swap arrangements between central banks, amounting now to nearly $10
billion, or perhaps indirectly in the future through powers granted to the
IMF to lend on a scale and with a speed that it is not now able to do.

The fundamental weakness of the present payments system—its lack
of an orderly and efficient procedure for correcting payments imbalances
that will inevitably arise—remains unresolved. How this deficiency should
be remedied cannot be decided on technical economic grounds; it depends
on the broad political direction we want the community of industrial
nations to take. Do we want the international payments system to en-
courage, even to compel, close economic cooperation among major coun-
tries? Or do we want it to preserve the widest possible degree of national
economic autonomy?

A system of flexible exchange rates caters to national autonomy, both
by introducing more uncertainty into international transactions and by
permitting individual governments greater freedom of unilateral action.
To work, however, it requires both abstention from interference with the

220—Brookings Agenda for the Nation Sec 290

movement of exchange rates, and public willingness to accept whatever short-term changes in the cost of living and the distribution of income such movements may bring about. In practice, such forbearance is unlikely, even if national insulation were desirable or, in the long run, possible.

A system of fixed exchange rates seems to cater to economic integration among nations, but it may not survive conflicts in national objectives, de-generating instead (given present resistance to discrete changes in ex-change parities) into unorganized and disorderly attempts to correct deficits in international payments. A system of sliding parities—gradual movements in exchange rates among major countries—offers a welcome escape from this dilemma. It would exert pressure toward closer economic cooperation among countries, since parities would not be permitted to change rapidly. But it would also provide a mechanism for gradual correction of lasting payments imbalances. Serious consideration of this proposal should be high on the agenda of the new administration.

The United States should respond to the pressure for coordination of monetary policy by improving the flexibility with which fiscal policy can be used to stabilize the domestic economy, with a view to relieving monetary policy from this task. Other major countries should be pressed to move in the same direction. Success here would permit closer effective coordination among countries in framing monetary policy, with respect not only to balance-of-payments requirements, but also to world monetary requirements.

Pressures for coordination of policies would go far beyond this, however, eventually encompassing business regulation, government aids to business and labor, and even domestic taxation. Growing economic inter-dependence outmodes the nation state as an instrument of control and calls for international—perhaps supra-national—formulation of policy. Perhaps we can respond suitably as the growth in interdependence requires joint action. But the pressures may outpace our capacity to respond suitably, evoking instead defensive and mutually damaging national reactions. Allowance should therefore be made for some deliberately disintegrative responses, so as to slow the move toward greater interdependence in an orderly, rather than a disorderly, way. Such responses may involve the coordinated national use of taxes or other impediments to capital movements—not so much for balance-of-payments reasons as to preserve some independence for domestic monetary and other policies. It may even require occasional use of import surcharges. Restrictions or taxes on inter-

DEPARTMENT OF STATE

Washington, D.C. 20520

DEC 1 9 1968

December 17, 1968

Professor Henry A. Kissinger
c/o President-Elect Nixon
Hotel Pierre
5th & 61st Streets
New York, N.Y. 10021

Dear Henry:

If you are still searching for your "Francis Bator",
do make an effort to get Dick Cooper who is now at
Yale. You may already know about how he performed
at the Council of Economic Advisers, in the
Department's Bureau of Economic Affairs, and as
he was involved in Viet-Nam. To good things you
have heard, let me add that I know of no economist
with a greater gift for simplifying and coming to
the heart of things.

This morning's mail brought the text of his remarks
at that Princeton Conference on the Developed World
that I was attending when I saw you at the other
Conference up there. If you glance it over, you
should get some idea of his style.

All the best.

Enclosure:

RNCooper's "Tensions in the
International Economy".

During the past thirteen months, we have been treated to four major international financial crises. There have been runs from or toward sterling, gold, the French franc, and the German mark. Only less dramatic by comparison, crises of confidence also affected the Canadian dollar and other currencies. One might get the impression from these crises that the international payments system -- the basic framework within which international transactions take place -- is not doing very well.

Yet in terms of performance, the world has never had a better payments system. The past two decades are unrivalled in the growth both of total economic output and of world trade, a fact that it is too easy to forget in the midst of the latest crisis. And foreign exchange crises, which were not absent in earlier times, have been prevented from becoming domestic monetary crises. Nonetheless, certain tensions have developed in the international payments system, of which two stand out as of paramount importance for the next decade: 1) the failure of the process of correction of payments imbalances, and 2) the consequences for national sovereignty of growing economic interdependence. A third important tension arising from the conflicting roles of gold as a private commodity and a monetary metal could be added to these two; but this third tension is well on its way toward resolution, after five years of study and negotiation, with the new Special Drawing Rights at the International Monetary Fund.

-2-

All these tensions have political overtones; they give rise to conflicts of national interest. But I believe they are primarily the reflection of certain structural features of the payments system rather than of the political malevolence or ambition of one or more nations.

Let me remind you very briefly of the main features of our international payments system. On the financial side, these are embodied principally in the Articles of Agreement of the International Monetary Fund, agreed almost a quarter century ago at Bretton Woods, New Hampshire. On the side of merchandise trade, ground rules are laid down in the General Agreement on Tariffs and Trade (GATT), dating from 1947. In essence, these two documents call for freedom of international payments for goods and services exchanged among countries, low tariffs, fixed and stable exchange rates, non-discrimination among countries, and the avoidance of direct controls over foreign trade. These rules did not extend to international capital movements, but the dominant country of the postwar period, the United States, has always attached considerable importance to freedom of capital movements, and other countries have increasingly accepted it. Moreover, it has become increasingly clear that in times of financial unrest no sharp separation between current and capital transactions is possible. During the same period, all industrial countries became much more ambitious about the domestic aims of economic policy, and in particular they became committed to the maintenance of full employment.

The first tension mentioned above arises from the inability of this system to eliminate smoothly imbalances in international payments. Under the Bretton Woods system, "fundamental" imbalances -- surpluses as well as deficits -- were to be corrected through discrete adjustments in exchange rates, a procedure that by the time its necessity becomes known to officials is also known to everyone else. It thus offers windfall gains to all those who shift their assets from one currency to another in correct anticipation of a change in exchange rates. Currency speculation has grown very greatly in total volume, to the point at which, it is reported, in mid November nearly $3 billion flowed into Germany in a mere three days.

This system has become unworkable. We still do have exchange adjustments, for example the devaluation of sterling and other currencies in November 1967, but they take place under *force majeure* rather than as an integral feature of a smoothly working adjustment mechanism. Moreover, to avoid such traumatic adjustments, nations have increasingly violated the basic objectives and spirit of the payments system by resorting to a miscellany of ad hoc devices such as tying foreign aid, restricting capital outflows, redirecting government procurement, selling arms, cutting embassy staffs, etc. etc. The system gives rise to considerable debate about where the responsibility for certain imbalances lies, who should do what, who is not doing enough, and so on; it invites pretentious moralizing and contentious politicking, both of which were amply present at the Bonn meeting of Finance Ministers last month.

-4-

If the absence of a satisfactory adjustment mechanism is a basic
defect of our payments system, why is it just catching up with us now?
And is not the same deficiency present <u>within</u> countries, where we also
have fixed exchange rates (indeed, only one currency) and freedom of
trade and capital movement?

The answer to the first question lies partly in the increased inter-
national mobility of capital, to be discussed below, and the enlarged
magnitude of currency speculation which it makes possible. But there are
also two other reasons. First, we did not <u>start</u> with the Bretton Woods
system after the Second World War; that represented the objective, not
the reality. International commerce was severely restricted. During
the fifties a process of <u>differential</u> trade liberalization provided a
de facto adjustment mechanism that was absent in theory. There was heavy
discrimination against American and Canadian goods in Europe and else-
where and discrimination also took place within Europe. As the payments
positions of various European countries improved, they accelerated their
trade liberalization. Those in difficulty slowed down the liberaliza-
tion, and occasionally even reversed it.

This process had largely run its course by the early sixties, but
during the past decade the tensions produced by payments imbalances have
been mitigated by the large U.S. payments deficit, which permitted many
other countries to run surpluses. The reasons for the large U.S. de-
ficit, as conventionally defined, are controversial and need not detain
us here. But its presence made the need for adjustment by other coun-
tries rather less pressing. In its absence, the French-German

-5-

confrontation of this year might have occurred much earlier. It is noteworthy that in 1968 the United States will run a payments surplus, in the sense relevant for this discussion, for the first time since 1957.

In answer to the second question, the same deficiency is present within countries, although we do not recognize it as such. Depressed areas can be regarded as areas that would run payments deficits if they were operating at full employment. Payments adjustment between regions within a country takes place slowly through the migration of labor and through large transfers to the depressed regions through the central government's fiscal system. These mechanisms are barely visible at the international plane.

The absence of an international adjustment mechanism will plague us increasingly in the seventies unless something is done about it. But what? The desirable economic solution depends on the desired political orientation for the community of nations. Many economists urge the adoption of floating exchange rates. Apart from the possibility that it might not work smoothly, such a system would ratify the uncoordinated independence of the nation-state and would mark a sharp turning back from the economic internationalism of the past two decades. Yet I see no escape from the choice between somewhat greater flexibility of exchange rates, on the one hand, and more frequent resort to restrictions and other national interferences with international transactions. A possible compromise, which would provide a long-term adjustment mechanism and at the same time preserve the pressures toward internationalism, would

(1c)

-6-

require exchange parities to change slowly over time, but automatically
and in the direction required for adjustment. Such a system of sliding
parities would provide a reasonable degree of certainty and stability in
the short run, but would at the same time permit the gradual economic
adjustments so necessary in the long run.

This brings me to the second tension in the present international
payments system, a source of strain which I believe is quite separate
from the absence of an adjustment mechanism, although the particular
manifestations of both are often commingled. This tension involves the
growing contradiction between the independent pursuit of national
economic objectives and the increasing economic interdependence among
nations taking place in the framework laid down in the Bretton Woods
Agreement and the GATT. There was always some tension between domestic
and international objectives, even two decades ago. But the initial
strains have become more acute with the extension and refinement of our
domestic economic objectives and with the rapid growth in economic inter-
dependence.

Full employment was accepted as a national economic objective in
the 1940s. Since then, avoidance of inflation through the use of wage
policies, economic growth through increased investment and technologi-
cal change, redistribution of income through government transfers or
through graduated taxation, and low regional employment rates have all
become more important in the galaxy of economic objectives. Each
country has a host of other objectives concerning the regulation of
business to prevent fraud, subsidization of housing or home ownership,

-7-

and so on. This wide range of objectives requires government manipu-
lation of the economy through a variety of techniques and instruments:
monetary and fiscal policies, coercive regulation, regional expendi-
tures, tax incentives and disincentives, to name the major ones.

Problems arise when the domestic objectives of countries are not
in harmony, and the problems become more acute as the degree of economic
interdependence increases. "Interdependence" is used in a particular
sense: the sensitivity of firms and individuals to trading and investing
opportunities outside their own local markets. There is no doubt that
this sensitivity has increased very greatly during the past decade or
two: partly through government action, such as the lowering of tariffs
and removal of quotas; partly through technological developments, such
as the tremendous improvements in long distance communication and the
improved speed and reliability and lower cost of long-distance transport;
and partly through the increased awareness by firms and individuals
of opportunities and developments abroad, difficult to disentangle from
the foregoing factors, but due also to the general shrinking of the world
in terms of travel and information flows.

Several example will illustrate the impact of increased economic
intercourse in domestic policies. The most frequently mentioned con-
cerns monetary policy. Most countries use monetary policy as an instru-
ment of stabilization: tight money cools down a buoyant economy, easy
money stimulates a stagnant one. In addition, monetary policy may be
used to foster certain long run objectives, such as investment for
economic growth or residential construction.

-J-

These purposes are threatened in an era in which corporate managers,
commercial banks, and even private individuals search for investments with
the highest yield not only in their own country but also increasingly
abroad as well. A central bank wishing to stimulate the economy through
easy money will find itself stimulating capital outflow instead, and
one wishing to damp domestic demand will simply attract funds from
abroad. Traditional monetary policy looses its influence over domestic
objectives in a world of high capital mobility.

A second illustration concerns both trade and enterprise investment.
An increasing amount of trade <u>between</u> nations takes place <u>within</u> firms.
From the point of view of the multinational firm as a whole, the prices
of these internal transactions are of little consequence--or would be,
if it were not for differences in national taxation. Differences in rates
of profits tax provide an incentive for firms to price so as to maximize
profits in the low tax countries. They thereby shift income between
countries, improving the tax take of some at the expense of others. This
in turn exerts pressure to harmonize national tax systems--or to tax
"foreign" income.

Labor movements provide a third illustration. Labor is not nearly
so free to move across national boundaries as goods or capital, but even
here there is increasing pressure on national policies. It is said that
some Italian workers in Europe have become astute students of the minimum
requirements under national social security laws, and that they move
around to meet these requirements in a number of Common Market countries.

(le)

-9-

If this kind of arbitrage becomes widespread, national financing arrangements for social security will be undercut; it will be necessary to establish a common system.

The brain drain also illustrates the point. Highly trained individuals increasingly command a *world* market, hence a world price (established largely in the United States). Unskilled labor, to whom international migration is not open for legal reasons, is fragmented into many local markets. This fact limits the extent to which redistribution from rich to poor (or from mobile to immobile) is possible. Heavy taxes or other redistributive measures will result in migration, as it did for doctors from Britain for many years.

These examples illustrate the point that as the mobility of goods, services, capital, business enterprise, technology, and labor increase, divergent national objectives will be increasingly difficult to achieve and national autonomy increasingly threatened. In the face of high international mobility, the nation-state--a very durable form of political organization--becomes outmoded in the realm of economic policy, under the rules conventions of international behavior that the major industrial countries have adopted. This is the internal contradiction in the present arrangements--a contradiction that was far less evident 20 years ago than today.

This phenomenon should be familiar to all Americans, for a parallel development has taken place *within* the United States, and is much further advanced. I attribute growing Federal transgression on matters historically reserved to the states less to a power grab by aggressive

-10-

Federal bureaucrats than to the severe constraints imposed by high
national mobility on state action. This process is well illustrated by
the early attempts by states, starting in the late 19th century, to
regulate corporate financial structure and disclosure for the protec-
tion of the public. Far-ranging regulations were put in force in
Massachusetts, Illinois, and several other states. But they were short-
lived. Under the Constitution free trade prevails and legal contracts
in one state must be honored in others. As the costs of transportation
and communications fell, firms gained greater freedom in their choice
of location. Moreover, firms could incorporate in states by maintaining
only nominal operations there. Under these circumstances, stiff state
regulations resulted in an exodus of firms. Diverse regulations were not
compatible with high mobility and absence of restrictions on trade. States
competed in relaxing the burdens they placed on incorporation. State
regulation failed and was ultimately taken over by the Federal Securi-
ties and Exchange Commission.

The history of state attempts at corporate taxation is similar, and
some states are now pressing for uniform state taxation, imposed if
necessary by the Congress. Air and water pollution control represent
still other areas where Federal involvement is necessarily increasing.

Mobility between nations does not come close to that between states
within the United States. Even so, increased international mobility has
resulted in two types of destructive response, the first involving compe-
tition in policies, the second involving a negation of our international
rules and conventions.

-11-

Competition in policies is not nearly so pronounced at the inter-
national level as it is within countries, where indeed it often completely
paralyzes local government action. Moderation at the international plane
exists in part because the most abusive forms of competition, such as
tariff wars, are prohibited by the rules laid down in the 1940s. But a
tendency to worm around those rules can be increasingly observed. Local
taxes, health regulations, and the like can and do substitute for pro-
tection in the form of tariffs and quotas. Competition is also evident
in government measures to stimulate exports. Direct export subsidies are
prohibited under the rules, but most governments have found ways to stimu-
late exports through the granting of credit guarantees and subsidies to
export credit, practices that become more important over time, as the
durability of export products increases and the extension of medium-term
credit becomes more common. Competition in policies can also be seen in
governmental measures to promote international tourism. Most countries
now have government-financed tourist bureaus, and appropriations for
them typically increase year by year. These are often justified on balance-
of-payments grounds, but since most countries use such devices, their
net effect is more likely to increase total international travel than it is to
improve any single country's balance of payments. Many European coun-
tries subsidize their hotel industry in the same spirit with the same
rationale,--and with the same defect. Finally, some countries have dis-
covered that they may gain temporary advantage in international trade by
exploiting a feature of the trade rules that permits indirect taxes to
be rebated on exports and levied on imports, whereas direct taxes cannot
be so treated. Under these circumstances, there is some incentive to.

-12-

shift a country's tax system from direct to indirect taxes, and such a
relative shift can be observed in a number of countries during the past
decade. Such a shift has furthermore been urged on Britain and the United
States, the two countries still rely very heavily on direct taxes for
principal source of their revenues.

Much of this competition tends to expand international trade. A
second reaction to growing interdependence involves the imposition of re-
strictions on international transactions, especially movements of capital,
in an attempt to reduce the economic interdependence and preserve some
degree of freedom for domestic economic policies, especially monetary
policy. The United States has imposed the interest equalization tax
explicitly for this purpose, and since that time direct controls have
been imposed on other international transactions, including short-term
bank lending and direct investment abroad. Great Britain too has used a
wide range of measures to insulate its domestic monetary conditions from
international considerations.

Such measures may be attributed to the fact that these two coun-
tries have been in balance-of-payments difficulties, and have felt com-
pelled to reduce capital outflows in an effort to prove their payments
positions. More persuasive evidence for the thesis advanced here is
provided by the countries in balance-of-payments surplus that have also
taken steps to reduce the freedom of capital movements, or/least to
influence those movements in such a way as to limit the impact of inter-
national capital movements on domestic monetary conditions. Just as the

-13-

United States in the early sixties wanted to use monetary policy to stimu-
late economic activity, Germany felt the need to use restrictive monetary
policy in order to damp down an economic boom. Germany no more welcomed
a large capital inflow in response to tight monetary conditions than the
United States welcomed capital outflow in response to easy money con-
ditions. In both cases the impact of monetary policy on domestic
activity was blunted by international capital movements. Switzerland,
France, the Netherlands, and other countries also have taken steps to
insulate the domestic economy from international capital flows. In the
process of doing so, however, they break down the integrative tendencies
of international capital movements, and they inhibit what is often de-
sirable international capital movement from an economic point of view.

Another interference in freedom of international transactions in-
volves the attempt by national authorities to reach out across national
boundaries in an effort to prevent circumvention of national regulations.
This practice is clearest in the case of the United States, where the
U.S. government attempts to apply "trading with the enemy" regulations
not only to U.S. firms domiciled in the United States but also to U.S.-
owned firms domiciled abroad--to the considerable irritation of foreign
governments, especially those that do not share U.S. views with respect
to foreign policy toward Cuba and China. The SEC has even issued in-
structions to foreign firms regarding their disclosure requirements, so
long as their securities are traded -- often on no initiative of the firms
themselves -- in the U.S. over-the-counter market. And on occasion the
U.S. Justice Department has extended U.S. anti-trust laws abroad. The

-14-

reasons for these extraterritorial applications of U.S. laws are often
sound from the viewpoint of the U.S. regulatory authorities; failure
to reach U.S.-owned firms abroad, or even some foreign firms, might lead
to circumvention of the U.S. regulatory intent. But the necessity for
reaching into foreign countries illustrates the complications for policy
created by international mobility and can lead to conflicts among govern-
ments.

Let me emphasize again that this problem is quite different from the
U.S. balance-of-payments problem, and it will outlast that
problem.

Even with elimination of the U.S. deficit, the conflict
between national regulation and international mobility will remain,
and indeed intensify as natural and artificial barriers to international
transactions continue to fall. But the existence of large balance-of-
payments deficits and surpluses influences the actions that are in fact
taken to reduce the erosion of domestic economic policies. There is
reason to be concerned about a proliferation of restrictive measures in
a disorderly and inefficient way, imposed one after another by nations
frustrated both by payments imbalances and by difficulty in managing
their domestic economic affairs. I end on a plea that we must have
much more intense efforts than we have had to date to iron out the divergences in national economic policies -- a process that necessarily
impinges on national economic sovereignty as that has been traditionally
conceived -- and to the extent that residual and irreducible divergences
in national aims and policies remain, that we take some orderly steps to

-15-

preserve some degree of insulation of national economies from international
influences. For if we do not arrive at an orderly way to insulate national
economies, we will surely arrive at a disorderly way to do so.

We are in a race between loads and capabilities. Growing interdependencies bring substantial benefits, but they also threaten national autonomy. Thus they tax our capacity to reconcile national differences. Economic cooperation among industrial nations has improved enormously in the past decade; the question is whether international cooperation--even involving controlled insulation--can improve rapidly enough to avoid national-istic backslashes. If such backslashes are successfully avoided, the fragmentary nature of the specific problems requiring solution will create numerous permanent ties among governments, and in the course of time the strictly national definition of problems will be modified in the direction of a more international--or transnational--perspective.