COUNCIL ON FOREIGN RELATIONS, IªC.

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NEW YORK, N. Y. 10021

58 EAST 68TH STREET

CABLE ADDRESS: FORAFFAIRS, NEW YORK
AREA CODE: 212 LEhigh 5-3300

January 6

Henry -

Enclosed is my recent <u>Foreign Affairs</u>
article on the monetary problem. When you
finish the article, please read the next
paragraph.

...

I may have muddied the presentation of
my final and preferred alternative by lumping
together a prescription and a prediction. My
<u>prescription</u> is for greater exchange rate
flexibility. (I focused on the band because I
think it is more saleable than the sliding
parity, being less of a departure from the present
system; but I would favor the two together.) My
<u>prediction</u> is that it would lead to a few,
widespread currency areas. Tactically, we should
negotiate straightforwardly for the former while
preparing for the latter in our analysis and
planning.

C. Fred Bergsten

Visiting Fellow

FOREIGN AFFAIRS
AN AMERICAN QUARTERLY REVIEW

JULY 1968

VIET NAM

<table><tr><td>If Negotiations Fail</td><td>Herman Kahn</td></tr><tr><td>The Bases of Accommodation</td><td>Samuel P. Huntington</td></tr><tr><td>One Thing We Learned</td><td>Bill D. Moyers</td></tr><tr><td>Keeping the Strategic Balance</td><td>Carl Kaysen</td></tr><tr><td>Moscow and the Mediterranean</td><td>Curt Gasteyger</td></tr><tr><td>The Agricultural Revolution in Asia</td><td>Lester R. Brown</td></tr><tr><td>Foreign Policy Premises for the Next Administration</td><td>Henry Owen</td></tr><tr><td>Taking the Monetary Initiative</td><td>C. Fred Bergsten</td></tr><tr><td>The Limits of Détente</td><td>Robert Conquest</td></tr><tr><td>The Coalescing Problem of Southern Africa</td><td>Ernest A. Gross</td></tr><tr><td>Two Revolutions</td><td>Datus C. Smith, Jr.</td></tr><tr><td>What's Wrong with the Philippines?</td><td>Benigno S. Aquino, Jr.</td></tr><tr><td>Recent Books on International Relations</td><td>John G. Stoessinger</td></tr><tr><td>Source Material</td><td>Donald Wasson</td></tr></table>

HAMILTON FISH ARMSTRONG
*Editor*

PHILIP W. QUIGG
*Managing Editor*

*Editorial Advisory Board*

MCGEORGE BUNDY
ALLEN W. DULLES
ALFRED M. GRUENTHER

GEORGE F. KENNAN
HENRY A. KISSINGER
WILLIAM L. LANGER

JOHN J. McCLOY
PHILIP E. MOSELY
ISIDOR I. RABI

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Copyright 1968, Council on Foreign Relations, Inc.
PRINTED IN U. S. A.

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# TAKING THE MONETARY INITIATIVE

By C. Fred Bergsten

A WORLD economy must be managed (de facto or de jure) by a mix of national dominance and international policy coordination. As the dominance of the United States shrank over the past decade—in fact if not in the consciousness of all U.S. policy-makers—some degree of integration of policy became necessary, at least among the major nations. The alternative was to risk the benefits of international intercourse by reverting to uncoordinated exercise of autonomous national policies.

The realization of this need, however, was fostered only by crises, such as the London gold flurry in 1960, the convulsions surrounding exchange-rate changes of major currencies in 1961 and 1967, increasing concern about the gold convertibility of the dollar, and most recently by the gold rushes of late 1967 and early 1968. Despite the successive deepening of these perturbations, policy integration progressed far enough each time only to satisfy the decision-makers that they could now avoid repetition of the previous outburst. The plans of the central bankers, like those of the generals, were usually directed to the last battle. It is the thesis of this article that fundamental decisions are needed to place the world economy on a foundation sufficiently firm to avoid fear of disruption by international monetary forces and to prevent the *next* crisis.

There is nothing new in a call for change in the international monetary system. Most of the proposals, however, have failed in at least one of three respects. Many have concentrated on only one aspect of the international monetary problem, such as the need for assured additions to total world reserves. Many have focused on the major industrialized countries and virtually ignored the problems of the rest of the world. And, most important, many have failed to recognize the very special role of the United States in the world economy and to allow for it systematically in any new monetary arrangements.¹

The international monetary problem has three component parts: the *adjustment* of imbalances in individual countries' balances of payments; the amount of *liquidity* available in the sys-

¹ This third element is a common shortcoming in the proposals of many leading authorities in the field, including Edward M. Bernstein, Fritz Machlup and Robert Triffin.

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tem to finance such imbalances; and the maintenance of confidence in the ongoing stability of the system itself. The adjustment and liquidity problems are linked inextricably. Adjustment and liquidity are perfect substitutes for each other: the more that is available of one, the less is needed of the other. The crucial question is the tradeoff between the two. How much liquidity should the system provide and how much adjustment should it require?

The question cuts to the heart of the international monetary problem because a country has only three choices when faced with a payments imbalance, whether surplus or deficit. It can finance the imbalance, which for a deficit country generally means losing reserves—a response that can be carried on only so long. It can adjust the balance indirectly, through internal measures to affect the growth of the economy, interest rates, etc. Or it can adjust by acting directly on external transactions, by changing the exchange rate, instituting controls on trade or capital movements, or by changes in government expenditures overseas.

Either of the adjustment approaches may be painful, since the policies required to meet the balance-of-payments objective may conflict with those required to meet other national objectives. A surplus country with full employment (e.g. Germany in 1965) may not want to expand its economy further, in order to reduce the surplus, because of the risk of inflation. A deficit country with unemployment (e.g. the United States in the early 1960s) may resist depressing domestic demand, in order to reduce the deficit, because the unemployment problem would be exacerbated. A surplus country may not wish to let its exchange rate appreciate, in view of the unfavorable effect on its competitive position, while a deficit country may not wish to let its exchange rate depreciate because of the potential losses of national income (and prestige). And controls over international transactions are undesirable, since they reduce economic efficiency and hence overall welfare. Adjustment may thus be an anathema to both surplus and deficit countries and neither may want to adopt policies necessary to effect it. If adjustment does take place, however, both surplus and deficit countries will be affected, regardless of who initiates the action, since a deficit can be reduced only if the corresponding surplus is reduced at the same time.

Here enters the link to liquidity. If all countries resist adjustment, it is possible to finance imbalances over an extended period

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of time. However, excessive financing would permit deficit countries to drain real resources away from surplus countries and hence "live beyond their means" for prolonged periods. On the other hand, insufficient financing could force countries to undergo a major recession or institute controls over trade and investment flows, doing harm not only to their own national objectives but to the welfare of the world. A balanced international monetary system should thus provide enough liquidity to permit avoidance of undesirable adjustment policies but not so much liquidity that transfers of international resources are permitted to persist for lengthy periods of time. The definitions of "enough" and "lengthy" are of course the key components of the issue.

But the need for international liquidity goes further because most industrialized countries desire regular increases in their reserves. They want to increase their capabilities to avoid adjustment of future payments imbalances, since such imbalances are likely to rise as the scale of international transactions rises. Unless *total* world liquidity is rising, increases in one country's reserves can take place only if there is a corresponding decline in another's and no country is willing to see its reserves decline by any sizable amount for any sustained period of time. The universal desire for increasing reserves could thus generate a series of restrictive internal and external policies, such as the escalation of world interest rates now fully in evidence, with a consequent slowing of world trade and economic growth as happened in 1967. The situation would obviously be worse if liquidity were to decline through conversions of dollar or sterling balances into U.S. or British gold.

An insufficiency of liquidity can thus have a decidedly deflationary impact on the world economy by forcing precipitate adjustment of payments imbalances and even by encouraging policies to build reserves where deficits do not exist. Too much liquidity, on the other hand, can permit postponement of needed adjustment and hence promote inflationary tendencies around the world. A reconciliation between the two must be a major goal of any changes in the international monetary system.

The confidence aspect of the problem is simply the modern equivalent of Gresham's Law. When any monetary system contains more than one monetary asset, there is a possibility of shifts from one to another in ways that undermine the entire system. The present international monetary system is highly susceptible

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since it contains four such assets: gold, dollars, sterling and claims on the International Monetary Fund. The Special Drawing Rights (SDR) at the Fund will be a fifth. Since gold, dollars and sterling are also held by private citizens around the world, such shifts can occur beyond the reach of the monetary authorities, as evidenced so vividly by the recent series of gold rushes.

The present lack of confidence has been seriously affecting the liquidity-adjustment tradeoff. First, until mid-March, private gold purchases were draining gold from world monetary reserves so that the gold component of world liquidity was constantly being reduced and the problem of the adequacy of reserves intensified. Second, uncertainties about the continued convertibility of the dollar into gold at $35 per ounce jeopardized the potential contribution to liquidity of further increases in dollar balances, increased the possibility of actual reductions in world liquidity through conversion of dollars into gold, and hence increased the pressure on the United States to adjust. As far as the dollar is concerned, the confidence problem is purely a gold problem since no other currency rivals it for either private or official use. The two-price gold system adopted on March 17, which seals off all gold now in official hands and greatly reduces the likelihood that the monetary authorities will support the private gold price, was directed precisely at these problems.

The special nature of the U.S. role in the world economy extends far beyond this matter of confidence, however. The impact of international transactions on the U.S. economy differs greatly from their impact on any other noncommunist country. Exports of goods and services represent only about 6 percent of our gross national product, while the like percentages in other major countries range from 13 percent in France to 42 percent in the Netherlands. The United States would thus have to generate massive changes in its national income to affect significantly its external position; a large part of a whole year's growth would probably have to be foregone, and never made up in the future, to reach a zero balance solely through deflation. One consequence would be sharply increased unemployment. Such a policy would be a classic case of permitting the tail to wag the dog.²

² In the recent past the United States has permitted its economy to overheat and it should attempt to eliminate the excesses on domestic grounds alone. Success in these efforts would, of course, have favorable external effects, because it would help reduce the payments deficit from its recent excessive level and heighten foreign confidence in U.S. economic management. But this must be distinguished from deflationary policies undesirable from the purely domestic standpoint and undertaken solely to meet international needs.

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In addition, we bear an extremely costly foreign-exchange burden—about $1.5 billion yearly since 1960—to maintain troops in Europe to meet our NATO commitments.³ U.S. troops are in Europe at the request of the host governments and in full accord with NATO strategy and political judgments. Our expenditures in this respect clearly respond to a multilateral decision. There is thus good reason for our NATO allies, at least, to be tolerant of this element of our payments deficit.

A third major difference is the U.S. role as the world's chief banker. The combination of our abundant national savings, our highly developed capital markets, the relatively underdeveloped capital markets in the rest of the world, the leadership of U.S. corporations in pursuing the multinational operations on which the world economy of the future may well rest and which today are important in helping to bridge the "technology gap," and the apparent preference of European savers for higher liquidity—all these have produced capital outflows from the United States which have contributed appreciably to our deficits. Their persistence, despite the presence of ever-tightening controls since 1963, clearly reveals the demand for them on both sides of the Atlantic. The anguished reactions of a number of countries when our controls were tightened on January 1 reinforce this conclusion. To the extent that foreign dollar holdings—and hence our deficit, as usually defined—rise along with increases in our long-term assets, we are simply performing a desirable international banking function which requires special world recognition if it is to continue.

But the uniqueness of the U.S. role goes far beyond these national characteristics. Our balance-of-payments position has been the core of the liquidity and adjustment aspects of the international monetary problem since 1945. During the first part of the postwar period—the era of “dollar shortage”—our payments position was unanimously considered too strong for the health of the world economy, although it was in deficit (under all present definitions) consistently after 1949. There was widespread agreement that the deficit was not large enough—it averaged about $1.5 billion annually—and that the disequilibrium was one of

³ Any “offsets” that we may have achieved through sales of military equipment to our allies would probably have occurred even if our troops had not been there, perhaps on an even larger scale, since the Europeans would then have been more responsible for their own conventional defense. The financial offsets of the past year are simply a statistical exercise. The hugely significant effect of our present “offset” agreement with Germany will be discussed later.

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excessive dollar strength. Any necessary adjustment needed to be in the direction of increasing the U.S. deficit, and we obliged through the Marshall Plan, tolerance of foreign discrimination against our exports, encouragement of American travel and investment in Europe and promotion of foreign procurement under U.S. aid and military programs. Our deficits were the main source of increases in world reserves, providing an umbrella under which Europe could rebuild without balance-of-payments constraints and under which trade and payments liberalization (and the creation of the European Economic Community) could proceed.

Around 1958, however, the situation changed. The U.S. deficit increased sharply to $3 billion or more and fears of excessive availability of dollars began to be heard. The declining ratio between the U.S. gold stock and foreign short-term dollar holdings contributed to a deterioration of confidence in the dollar and hence in the entire system. However, the accumulation of dollars continued. This was because, first, as the volume of international transactions increased, businessmen needed to build their holdings of internationally acceptable money and no currency could begin to rival the dollar in this regard. Second, the supply of gold becoming available to monetary authorities remained insufficient to provide the growth in total reserves which was sought, so the dollar maintained its position as the main engine of reserve growth. Third, any greater conversion of dollars into U.S. gold would force us to adjust, and the measures involved would create intensely unhappy repercussions throughout the world. The United States had exported a depression in the inter-war period and other countries were wary of forcing us to do so again. They certainly did not want a devaluation of the dollar in terms of their currencies, for this would have improved further our already strong competitive position. And either of these approaches, if applied in the traditional non-discriminatory manner, would have hit hardest the other deficit countries which could least afford it.

Recent history thus displays the central role of the United States in the international monetary system. The dollar has provided the world with most of its desired increase in liquidity throughout the postwar period. The amounts, however, have seldom seemed quite right; they were too little at first, too much of late. Thus adjustment was called for between the United States and Western Europe. The United States did adjust when increases in our deficit were required and Europe fully acquiesced.

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But the reverse situation—a European surplus and a U.S. deficit —has remained intractable for a decade. The United States can- not effectively adjust through conventional means, because it would be disastrous for its domestic economy or ruinous to the monetary system, or both. Under such circumstances, reform in the system is inevitable; the question is “how.”

II

The de facto reforms of the present decade have proceeded on two planes. At the perimeter of the system, the major industrial- ized countries have coöperated to the degree they felt necessary to prevent its total collapse. Most of their steps were aimed at immediate problems of confidence and did not deal with the more fundamental difficulties. In the early 1960s they set up the gold pool to preserve confidence in the fixed price between the dollar and gold; they established and subsequently expanded greatly the swap networks to offset short-term capital flows and thereby preserve confidence in the exchange rates of individual currencies; and they created the General Arrangements to Borrow to supple- ment the resources of the IMF when major currencies needed substantial financial support for a longer period. Most recently they agreed to adopt the two-price gold system to preserve exist- ing liquidity and to try to convince the world that the official price of gold would not be raised.

This coöoperation among the major countries at the perimeter can be likened to the coöoperation in the military field between the United States and the Soviet Union. The nuclear superpowers can agree on such risk-limiting devices as the test ban treaty, the barring of nuclear weapons in outer space and the nonprolifera- tion pact. But within those limits—where they seek to prevent a holocaust that would engulf them both—their competition rages unabated. Just as the whole world stood at the brink in the Cuban missile crisis of October 1962, the monetary world stood at the brink on the Ides of March of this year, when the gold rushes threatened finally to overwhelm the monetary system. So far the perimeter defenses in both the monetary and nuclear fields have held, but neither can be guaranteed if the difficulties under- lying them cannot be more fully resolved.

Within the perimeter, de facto monetary reform has been ac- complished through evolution toward a tripartite world composed of a largely informal dollar area, an equally informal gold bloc

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and the more formalized sterling area. National membership in any of these groups can be judged by observing whether a country has financed imbalances in its payments position in dollars, gold or sterling. There are some borderline cases and a few countries have shifted from one group to another, but most are clearly in one of them.

A majority of countries have preferred to join the dollar area by building dollar holdings rather than converting them into U.S. gold and hence bringing pressure on the United States to reduce its deficits. Some of them have done so because their economies were so closely linked to ours that they had no real choice; among the major powers, Canada and Japan fit into this category. Others, however, have joined the dollar area despite the clear possibility of staying out. The most notable case—and one of the few formalized ones—is Germany, which in March 1967 agreed to continue indefinitely its policy of not buying gold from the United States. The pledge emerged from the trilateral talks among the United States, Britain and Germany concerning NATO troop levels and their balance-of-payments consequences; Germany clearly opted to provide financing for us rather than risk adjustment through a large withdrawal of American and British troops which would have jeopardized its national security.⁴

Canada and Japan had previously joined the dollar area to obtain special treatment under our capital control measures. The less developed countries have received special treatment under all of the U.S. balance-of-payments programs and most of them can be considered dollar (or sterling) area members. The favored treatment for the United Kingdom under our latest program, while primarily a recognition of Britain's own difficult financial situation, also reflects a tendency toward merger of the dollar and sterling areas in contradistinction to the gold bloc.

A few countries have drifted toward de facto creation of a new gold bloc. Not surprisingly, the charter members are the same countries which stuck to gold the longest during the 1930s: France, Switzerland, the Netherlands and Belgium. They have been joined by a few others including South Africa, Spain and Austria. When they have run large balance-of-payments surpluses, their desire for gold has brought pressure on the United States.

⁴ Germany also agreed to purchase $500 million of medium-term U.S. bonds in U.S. fiscal year 1968. Such purchases are simply a shift from short-term to long-term dollar holdings. However, they do affect some U.S. balance-of-payments statistics, which have some importance for world confidence in the dollar.

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The world's liquidity arrangements are grossly inadequate as a result. Since the amount of gold available to monetary authorities is no longer rising, the gold-bloc countries can add to their reserves only by placing great pressure on the reserve centers or by joining the dollar area. The United States is in jeopardy as long as there are surpluses in the gold bloc, even though most countries consider moderate U.S. deficits to be in the world's interest, and our liquidity needs (beyond the dollars accumulated by dollar-area countries) have been met only through short-term expedients such as the swaps and IMF drawings, which must be reversed. Even the dollar and sterling-area countries face problems because the United States and the United Kingdom fear that any surpluses they run, although financed by dollar and sterling holdings, might at some point be transferred to the gold-bloc countries and hence exacerbate the basic pressure in the system.

The alternative, of course, is adjustment. Among the gold-bloc countries adjustment has been achieved essentially by management of the internal economy because there was no feasible alternative. Dollar and sterling-area members have been able to obtain financing from the United States and Britain as long as their credit lasted, which really meant as long as their domestic economic policies were adequate. They were forced to adjust only when their credit-worthiness came into question, which generally occurred when domestic adjustments were needed anyway.

The problem of the sterling area differed fundamentally from that of the dollar area because of the real weakness of the British economy and the fact that it was "living beyond its means;" this was finally settled by the devaluations of last November. But the "imbalance" between the dollar area and the gold bloc has remained, creating difficulties each time it has risen above $2 billion or so. The surplus countries of the gold bloc have been unwilling to take any initiatives toward adjustment and the pressure has inevitably fallen on the deficit dollar area, since reserves are finite. Thus, the United States has been forced to act.

When so forced, we have rejected deflation, beyond what was needed domestically, or devaluation for reasons already outlined. We have relied primarily on selective controls over external transactions: tied aid, Buy American rules for government procurement, export promotion devices, reductions in the duty-free allowance for returning travelers, the Interest Equalization Tax,

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and ever-tightening voluntary and then mandatory controls on private capital outflows. The more important measures have generally excepted dollar-area countries. Such favored treatment is quite rational economically, because the inability of most of these countries to withstand the adverse effects of our restrictions would have offset much of any gain in the U.S. payments position. (The latest program, announced by President Johnson on January 1, accelerated the trend toward both emphasis on controls and discriminatory application thereof.) In return, some of the dollar-area members outside the United States have begun to undertake transactions specifically aimed at improving the area's position vis-à-vis the gold bloc. Some have also shifted large portions of their dollar balances into assets which can be presented publicly as reducing the size of our deficit, enhancing world confidence in the dollar and reducing the pressure on us to adjust.

None of the U.S. measures, however, has been very effective in reducing the key international payments imbalance. The gold-bloc countries have imitated our tying of aid, adopted similar government procurement rules and export incentives, and let their interest rates rise to offset our increases. They have generally been unwilling to accept their share of adjustment, which by definition they must if the imbalance is to be reduced. And some of the money checked by our capital controls goes out through other uncontrolled channels and perhaps, since area-wide coöoperation is only beginning, through exempted dollar-area countries.

Adjustment in the major imbalance thus has not occurred. What has become clear is that most countries do not want it to occur badly enough to sacrifice other national objectives. The United States is unwilling or unable to take unilateral steps to eliminate the deficit. The rest of the dollar area clearly prefers to finance our deficits rather than force us to adjust. The gold-bloc countries seem unwilling to go further than seems necessary to avoid a crisis of confidence. Such views are perfectly rational since balance-of-payments equilibrium—like a balanced national budget—should be only a means to other ends. But adequate adjustment has been absent as a result. With no agreement on financing or on the proper balance between adjustment and financing, the seeds of crisis have been planted and given due time to grow, which they most clearly have.

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### III

Convincing changes are therefore needed if confidence in the system is to be regained and if it is to provide a safe basis for world growth and prosperity. The major countries must decide how to mix national autonomy, national dominance and international policy integration. The choice will reflect the several basic differences in views between the United States and the EEC: the greater impact of external transactions on European economies than on ours; the relatively higher priority attached by the most influential continental Europeans to price stability and the relatively higher priority attached by U.S. policymakers (and those in most of the rest of the world) to full employment and growth; the more global responsibility felt by the United States compared with the more insular views of the continental Europeans, which affects foreign military expenditures, aid and even liberalization of trade and payments; and the purely political objectives of each. Political considerations are important, since Europe has its strongest voice relative to the United States in the field of international finance, given the present "rules of the game." There is an obvious incentive for Europe to retain this advantage as a psychological offset to U.S. dominance in the strategic and other military fields and in economic size, technology and management.

On liquidity, two important steps have already been taken. Both move decisively away from international monetary reliance on gold, and an increase in the official price of gold—which would not in any case solve the basic problems—has thus become increasingly unlikely. The decision of the major central bankers to stop selling gold to meet private demand assures preservation of the present stock of that component of reserves. Much of the needed growth in reserves will come from Special Drawing Rights, 70 percent of which will be fully usable by participating governments to settle their international payments imbalances. Legislation has now been submitted to IMF member governments for ratification, and activation of this new international money is probable; but the crucial question is *how much* SDR will be created. This decision will be one of the next steps in the transatlantic monetary power struggle.

But the SDR, although they will be extremely helpful, are not the answer to the whole international monetary problem or

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even the liquidity aspect of it. For few observers would deny that world demand for dollars will continue to rise. Private demand certainly will, as businessmen of all countries seek to add to their working balances to finance the growing volume of international transactions. Many monetary authorities are likely to feel the same way and for the same reason. The higher yield on dollars will be decisive for many countries in determining the composition of their reserves beyond working balances. Some will wish to hold dollars in U.S. banks so that their nationals can borrow against them. The risk in holding dollars will continue to be nil for all countries so closely aligned to the United States that they would emulate any change in the dollar's exchange rate. And some will continue to want to hold dollars to finance part of any future U.S. deficits and thereby avoid forcing us to adjust. There will thus be widespread desire for the dollar to continue to play a major role in the international system.

But the U.S. deficits which might thus persist could continue to jar confidence in the system unless basic agreement is reached on how to handle adjustment and its relation to liquidity. The intra-area adjustment arrangements already developed can continue. For the basic imbalance, between the United States and Europe, there are essentially five possibilities.

First, the United States could reject hope of any coöoperation and go it alone. We could unilaterally cut the link between gold and the dollar, declare ourselves ready to let our exchange rate fluctuate, and leave all the decisions up to the rest of the world. Other countries could then either accumulate dollars and finance any future U.S. deficits; or let the dollar depreciate with respect to their currencies, permitting us to improve the competitiveness of our trade position and hence adjust to any imbalance; or adopt measures to restrain their own surpluses, probably through the capital account, thus evading the other alternatives; or they could choose some mixture of the three. This approach might "work" in the sense of freeing the United States from external constraints—whichever option Europe chose. But it could undo the coöoperation which has already developed, and if Europe chose the third option—as it well might, in response to such a unilateral U.S. step—it could generate a proliferation of uncoöordinated national controls and possibly risk a breakdown of the international economy and even of transatlantic political relations. It is small solace to know that, in view of our greater

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economic and political independence, we would lose least from such a débâcle. This course can thus be recommended only as a last resort, although its availability should help persuade all parties to reach agreement on a more sensible solution.

Second, things might simply work out without any major new action. There are developments which suggest that the imbalance might be reduced to a low level and even eliminated: an end to the war in Viet Nam, the mounting return on U.S. foreign investment, the increasing attraction of U.S. securities for foreign investors, the possibility of some U.S. troop withdrawals from Europe and the inevitable improvement of European financial markets. However, these events can take place only over a considerable period of time. Even then, they could be offset by failure to keep our domestic economy on an even keel or by other developments adversely affecting our trade balance, increased aid programs, new Viet Nams or increased expenditures on foreign travel. This course is uncertain and very risky, given the fragile nature of confidence and the deterioration of our competitive position. It suggests indefinite retention of our present balance-of-payments measures and would add to the pressures to err on the side of conservatism in the management of our domestic economy at a time when full utilization of our resources is absolutely necessary to help cope with racial and urban crises. It can therefore not be counseled prudently if there are acceptable alternatives.

The third possibility is real coöoperation between the United States and Europe through a mix of financing and adjustment. Some Europeans might have to swallow their objections to holding more dollars and assure the United States, as has Germany, that they would not try to unload them. We might have to accept more unemployment and Europe more inflation. Defense arrangements might have to change, or Europe might have to accept more of the foreign-exchange burden of our NATO costs. Agreement might be needed on a permanent reduction in the net flow of U.S. capital to Europe and coöoperative steps taken to assure that market forces would not upset it. (Either side could of course "coöperate" unilaterally: the United States could "put its house in order" through draconian domestic measures, pervasive external controls or abandonment of basic foreign-policy objectives. This outcome is highly unlikely, as it should be.)

Even under such an arrangement, the United States could al-

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low the dollar to continue to play its central role only if modifications were made to protect us. Our modern domestic banking system can work effectively only because there is a lender of last resort, the Federal Reserve System, and also a Federal Deposit Insurance Corporation; similarly an international banking system based on a national currency is safe only with such support. It would thus have to be made publicly clear that the swap network, which now exceeds $10 billion and is thus large enough, is in fact the "lender of last resort," which would back the dollar to the hilt in any crisis; and the United States would have to provide insurance to monetary authorities by guaranteeing the gold value of their dollar holdings.

Both sides have so far resisted the various facets of this approach. We must not be misled by the present situation where the Europeans are "coöperating" in the adjustment process by pursuing economic growth policies wholly desirable for purely domestic reasons; it would not be prudent to assume that they will suddenly come to prefer full employment in the United States to price stability at home in order to help alleviate the payments imbalance. The fundamental differences in views cited above militate against the likelihood of its adoption.

An extension of present policy is the fourth alternative. At the perimeter, it would require maintenance of the devices presently in place. At the more fundamental level, it would lead to further evolution of the present tripartite world, probably with increasing formalization of the dollar area (perhaps joined by the sterling area) and the gold bloc. (Formalization of the dollar area between the United States and Canada is already virtually complete.) The other dollar-area countries, to maintain their favored treatment under the U.S. balance-of-payments measures, would begin more systematically to shift their external transactions in favor of area members and against the non-dollar world. The shifts would come first in capital movements and government procurement and might not go further—depending on who joined the area and on the magnitude of any imbalance remaining between dollar area and gold bloc.

When such area-wide preferences became necessary, European dollar countries—especially Germany, but also others such as Sweden and the United Kingdom, if the sterling area merged into the dollar area—would face acute dilemmas over which way to turn. The lure of the U.S. economy, U.S. capital and U.S.

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military power might prevail, particularly if full confidence in U.S. economic policy were reëstablished. Developments within Europe itself would be critical; if the EEC was thought likely to atrophy, for example, some of its members might be willing to assume a monetary relationship with an outside power. In such a situation, all but the most politically recalcitrant might be drawn in and a virtually global dollar standard would prevail once more.

Despite the political problems, this solution might be viable for quite a while, particularly if its development were handled skillfully. It could easily avoid the pitfalls of its forebear, the sterling area. The much greater size of the United States relative to the dollar area than of the United Kingdom to the sterling area, past or present, would enable us to meet the capital needs of the area's members as long as they assured us that dollars would not "leak" through them and improve the payments position of the gold bloc. The much greater independence of our economy from external transactions, once freed from constraints due to the balance of payments itself, would enable us to play a more independent role than was ever possible for Britain, and thereby fulfill one of the basic criteria for a reserve center.

Under such a system the United States would no longer worry much about its balance-of-payments position vis-à-vis members of the dollar area, which would be committed to hold any dollars which they earned, and could in fact redefine its "deficit" accordingly. Nor would we have to worry about the dollars already held in countries within the area; we should then, in fact, redefine our "liquidity ratio," the ratio between our reserve assets and liquid liabilities, to include only those liabilities outside the dollar area. Our responsibility would be to manage our domestic economy properly, through the pursuit of a reasonable combination of full employment and price stability, and to be sure that our foreign policy did not so antagonize important dollar-area members that they would shift to the gold bloc. To strengthen confidence further, the members of the area might wish to sell their present non-dollar reserves to us for dollars, as Canada has already done to some extent, creating a reserve pool. In return, the United States would offer all members of the area a gold-value guarantee on their dollar holdings. The members of the area would consult on how to distribute the "burden" of any necessary adjustment vis-à-vis the gold bloc.

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This arrangement, however, would clearly formalize U.S. dominance unless we were willing to accept a significant foreign voice in our domestic decision-making; and our unwillingness to do so is at the very heart of my pessimistic assessment of the acceptability of the third option. It could thus create underlying political dissatisfaction of great potential importance.

Fortunately, there is a final alternative which makes greater economic and political sense. It, too, would recognize that many countries wish to hold dollars and to maintain close links with the United States. But it would be based on the assumption of a steadily integrating Europe, perhaps beyond the confines of the present EEC, whose members will be increasingly dependent on each other and increasingly less dependent on countries outside Europe. It would achieve adjustment between the two major areas through greater exchange-rate flexibility.

It is well known that the majority of academic economists favor flexible exchange rates. It is equally well known that the majority of financial practitioners, private and public, abhor the thought of them. Both take extreme views. It is true that chaos might result if the exchange rates of *all* currencies were to fluctuate completely freely in terms of all other currencies. But a system of fixed exchange rates loses its value if it can be maintained only through increasingly tight restrictions on the very international transactions which it seeks to maximize. Such restrictions are clearly important now and are likely to proliferate unless alternative adjustment devices are developed. And unless policy integration proceeds very far indeed, countries will always resort to changes in rates anyway—with traumatic results, under the present system, as the British devaluation last November portrayed so vividly.

A middle ground is thus needed. Exchange rates would remain fixed within the dollar area and within "extended Europe," as they should in view of the high and increasing degree of interdependence among the economies in each. But the exchange rate between the dollar and the European currencies would be freed to fluctuate up to perhaps 5 percent on either side of their fixed parities, which would be retained. The impact on the two relatively self-contained economic units of changes in the exchange rate would be small, so neither should fear economic disruption as a result. Either could, in fact, prevent any fluctuation by the simple expedient of adding to its holdings of the currency of the

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other; Europe could prevent depreciation of the dollar (appreciation of its currencies) by acquiring dollars. Each side would retain the present choice to finance the other, but a functioning adjustment mechanism would be put into place in addition. In fact, the likelihood that Europe would prefer to prevent the dollar from depreciating very much is a key reason to think that a "band" of 10 percent around the existing parity might be large enough.

The response of some important countries to such a two-bloc world is difficult to predict. Britain, for example, might pursue its financial ties with the United States or its political desire to join Europe; or it might be tempted to remain aloof from both, at least at the outset. The other EFTA countries and the members of the present gold bloc would presumably "join" Europe for international monetary purposes. If the sterling area were to dissolve, its present independent members would probably either follow Britain's lead or divide between the dollar area (Australia, Malaysia, New Zealand) and Europe (perhaps India, Pakistan and some of the Middle Eastern oil countries).

In such a system the dollar would continue to play a dominant role within the dollar area. Financing and adjustment within each area would occur as at present. The United States, recognizing the widespread demand for the dollar, would be willing to have it continue to play an international role as long as protective safeguards were built into the system. Such safeguards would include a requirement that dollar-area members not convert their dollar holdings into U.S. reserves as long as they remain in the area. Perimeter cooperation between the dollar area and "extended Europe" could continue. The SDR would strengthen the reserves of each area; this would be desirable since they would still be needed when the limits of the exchange-rate "band" were reached and perhaps within it to smooth out fluctuations.

Inter-area adjustment would occur via the exchange rate and there would be no need for discrimination between the areas. Its relatively small fluctuations should not deter much trade or even direct investment, where long-term market position and profitability considerations should far outweigh the effect of rate changes. Countries would be under no political pressure to choose membership in any particular area. As long as certain rules were observed, they could even shift from one area to an-

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other if their perception of their interests changed. Our present
balance-of-payments controls could be lifted and the threat of
further American restrictions preëmpted. Domestic policy on
both sides of the Atlantic would become freer to deal with domes-
tic problems. An important source of strain between the two
pillars of the Atlantic Community would be removed.

Such a solution would go far toward meeting the problems of
liquidity and adjustment, and this in turn would help to solve
the confidence problem. The redefinition of the U.S. "deficit"
and "liquidity ratio" so as to treat dollar-area transactions sep-
arately would add to the restoration of confidence in the dollar.
So would any reserve pooling within the dollar area. Potential
difficulties always exist, however, when more than one reserve
asset is in circulation; the system could thus be tidied up if
special issues of SDR were made available to any country in
exchange for assets which it was not prepared to commit itself
to hold except when needed to finance deficits. Such an arrange-
ment would help in the transition to the two-area system since
some European countries might wish to convert some of their dol-
lars and the United States would not then be hurt by such trans-
actions. Present sterling-area countries could use the facility to
retire their sterling balances without hurting the United King-
dom. If countries did not deposit their holdings of reserve cur-
rencies at first, they could do so at a later date and hence "opt
out" of one currency area in favor of another without unduly
pressuring the respective reserve centers. The arrangement could
go even further and require the major countries to hold *only* the
SDR plus necessary working balances. The United States, of
course, would no longer pursue a policy of automatically con-
verting officially held dollars into gold at a fixed price but would
intervene in the exchange markets, when necessary, with assets
of its own choosing.

IV

The choice among these alternative solutions to the interna-
tional monetary problem will and should be based largely on po-
litical considerations, both domestic and international, although
the economics must of course be right as well. It will turn largely
on such domestic U.S. political considerations as the need to focus
our resources on the problems of the cities and of race relations,
the relative acceptability of unemployment or higher prices, and

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the compatibility of controls with the basic nature of the Ameri-
can economy and body politic. It will relate closely to such for-
eign policy considerations as whether the United States will turn
inward in the wake of Viet Nam or maintain an active involve-
ment in world affairs; whether our foreign policy will refocus on
Europe or turn increasingly toward Asia; and whether our Eu-
ropean policy will continue to support integration or back away
from any further increases in power of a major rival.

It will also depend on the Europe which emerges: united or
divided, dynamic or atrophied, enlarged or confined to the Six,
in partnership with the United States or antagonistic toward
us. All of these outcomes are possible; neither the EEC nor
NATO can be assumed eternal. The reëmergence of strong lead-
ership in Europe could generate dramatic changes in present
trends. But two strains do run deeply there: the desire for unity
and the desire for independence, meaning equality with the
United States (with or without Gaullist overtones of transat-
lantic antagonism). Any reform of the international monetary
system must recognize that two great powers—the United States
and Western Europe—exist and that the major international
monetary problem is the relationship between them. Dominance
by one area over the other would be a dubious basis for lasting
reform.

We are thus left with national autonomy and international
policy coördination as alternative bases for transatlantic eco-
nomic relations. The fruits of economic intercourse—comprised
in 1967 of over $30 billion of trade in goods and services and
over $5 billion in capital movements across the Atlantic alone,
despite the existence of controls—are too great to forego. Neither
side, however, is willing to subordinate its national objectives
to international considerations, and properly so as long as these
objectives differ and are believed sincerely by each to enhance
the welfare of its citizens. Thus an arrangement is needed which
will achieve the maximum gains of integration with the mini-
mum costs of loss of autonomy.

Either of the last two alternatives would meet this objective. Either one would contain an element of dominance as well—of the United States in the dollar area and the EEC in a gold bloc or “extended Europe,” but the alternative which would seek adjustment through the application of discriminatory controls would do so to a far greater extent. Either would provide an

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adjustment mechanism and meet the world's liquidity needs. The alternative providing for greater exchange-rate flexibility between the two areas would do so more efficiently, more decisively and with less prospect of damage to the overall political relations between the United States and Europe. It should thus be our first choice. In view of the dangers of continuing to temporize, which have become abundantly clear, we should seek to initiate serious discussion on it.

The new U.S. Administration will have an opportunity to do so. The decision must be made at the political level, for only there can the whole range of national interests which are involved be considered and reconciled. The negotiations with Europe must be carried on at the political level for the same reason. Such talks could provide the needed new initiative for both Atlantic relations and the European unity movement. At the outset of a new Administration in 1961, an American response to a newly vigorous trading Europe was both the seed from which grew the Kennedy Round and an impetus to solution of a whole range of problems within the EEC. Eight years later an obviously vigorous financial Europe may be ready for an American initiative that could be both the catalyst for constructive change in the international monetary system and a possible spur to the whole European movement.

Whatever path we decide to take, we must never forget the over-riding importance of psychology in matters monetary. We must make it clear that we act from great economic strength; that we can go it alone if necessary but prefer to coöperate to the maximum degree possible; that our dollar is the most widely used currency in history; and that its use is growing rapidly and will continue to grow unless we place impediments in the way. Our proposals must stem from confidence, not from panic; they must look to the longer term, not be expedients; and they must be presented in a coöoperative vein without arrogance or intent to dominate. With the right posture and with the right policy we can once more lead the world toward new growth through coöoperation.