Mohamed Adlouni

                                                                                                ECO 357L 11AM section

                                                                                                Article #1

 

Richard N. Cooper “The Dollar and the World Economy,” Agenda For the Nation, Brookings 1968

 

Outline:

1)     Formal features of the present International Monetary System as agreed upon at Bretton Woods, New Hampshire 1944.

2)     A look at some of the unexpected emerging developments and strains resulting from this system

3)     US Balance of payments deficit as both a cause and a consequence of the emerging strains

4)     Consideration of measures which should (or could) be adopted in order to not leave these strains unmitigated

 

Background:

The present monetary system, instituted in Bretton Woods, was a response to the political and economic mishaps of the 1930’s, which began with the stock market crash of 1929. This came at the end of a prolonged period of prosperity, and was characterized by a downturn in the business cycle, which did not come up again by itself. The breakdown of the Business Cycle as the chief regulatory mechanism, and the breakdown of the International Economic adjustment mechanisms spread the economic hardships from one country to another, because of their interdependent relationships with one another. The background context in which Cooper frames this article begins in the winter and spring of 1967-68, when 14 currencies were devalued, including the British Sterling. There was also a rush to buy gold, and a flight from the French Franc. Many political ideologies and methodologies were being tested throughout the 30’s.

 

Inflationary demands rose sharply in the United States after 1965, and Germany 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.

Cooper alludes to a general uneasiness in the psyche of the average labor worker, because such developments can influence employment opportunities, prices, wages, and the standard of living.

Cooper goes on to say that even if there were growth from the 40’s on through the 60’s, that there remain certain dangers, tensions and internal contradictions, that threaten the continuation of this prosperity unless new and imaginative policies are adopted to cope with them. That being said, the rest of the article addresses parts 1-4 of the aforementioned outline.

 

The Present International Monetary System:

During the 30’s, economic depressions and financial collapse had been transmitted rapidly from one country to another. Each country was trapped in a web of economic relationships of which it could not influence, nor escape from in case of a crisis. The postwar international monetary system was set up to make sure that each country kept it’s end of the deal, by maintaining full employment, and by fostering efficient use of the world’s resources.

The main objective of the system was to establish a world economic order between the interdependent nations, by adopting rules and guidelines 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 it’s currency would exchange 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 are roughly what would apply to any country with a single, usable, tradable currency.

Some important differences were that the governments of nations could restrict their citizens when it came to purchasing securities, making loans, or establishing businesses. Another important factor was the exchange rates between currencies were allowed to fluctuate within +/-  1 % of the declared “fixed” rate.  To add to that, so-called “fixed” exchange rates could be changed under conditions of fundamental balance of payments, and with international agreement. In theory, most changes could fluctuate both positively and negatively, but in practice over 95% of all changes have been downward. This has no correlation to weather or not the nation had a balance of payments surplus or deficit.

In order to finance the inevitable imbalances in payments there had to be adequate international reserves before allowing for residual financing. By long tradition gold provided the most important form of international reserve. It was accepted among banks and governments, and could be used to settle debts between countries.

But gold was also likely to be insufficient in amount and inappropriately distributed among countries. Due to this new twist, the IMF (international monetary fund) was established as the policeman of the International Monetary System, to make sure that the rules of international behavior were being followed and to provide financial services, and support to member countries. This was to be done through the IMF’s own lending operations. Only when a countries foreign trade position could not be sustained indefinitely, that is to say when a country is in fundamental disequilibrium, would a change in the exchange parity be in order.

Under the pre-1913 gold standard, a country experiencing a deficit in it’s international payments could finance that deficit by selling gold, which would contract the domestic money supply, pushing interest rates up, crowding out investment, and reducing business transactions. Cyclical changes in the business cycle were passed along from one country to the next. For a downturn in one country would reduce its imports, causing a payment deficit, which means that a country can’t pay off it’s debts, causing contractions elsewhere. After World War I countries had to carefully balance their need for stabilization policies, along with their duties to the Bretton Woods agreement to maintain a balance of payments. Both of which were conflicting interests. The presence of the Great Depression of the 30’s strongly enforced the need to stabilize domestic agendas and set the international gold standard as the only way to finance balances of payments, making it accepted by all.

Other factors affecting trade and currencies were social speculation and direct government control over international transactions. Speculation for or against a particular currency, by keeping it’s value too high or depressing it excessively, often impeded needed processes of adjustment and contributed either to economic depression or rampant inflation.

The result of governmental direct control over international payments are inefficiencies which led to bilateral agreements, trade discrimination, diplomatic manipulation, and a general disruption of political relations. This would prove too inviable a system of international trade and payments.

The framework of the present system was designed to provide exchange stability, by allowing for changes in exchange rates, to avoid the straightjacket of the gold standard.

 

Further Developments and International Strains:

Important developments occurred, which impeded the 1944 agreement from being realized in practice. They were the emergence of the US currency as an international currency, accepted widely as a reserve asset equal to gold, and the increased dependence of nations on one another. These developments caused the original plan to digress from its basic framework.

Gold : At the end of the second world war, most of the officially held gold was in the hands of the US. By 1947, the US held more than 70 percent, allowing it to determine the world price of gold at $35 an ounce. This would prove to cause one of the inefficiencies of the system, because of the high concentration of gold in US assets, and the US’s surplus balance of payments. Many countries had insufficient reserves to balance payments, even when the IMF stepped up to lend a financial hand.  As noted before, the international payments system depends heavily on the financing of international imbalances. This payment system funded by gold meant only one outcome, inadequate supplies to satisfy competing private and official demands at a fixed price of $35 an ounce. Excess demand puts upward price pressure on the economy.

One way to mitigate this excess demand is to raise the price of gold. There are 4 objections to this course of action.

1)     Revaluing $40 billion in official gold, would be inflationary, and would be difficult to compensate using restrictive fiscal and monetary policies.

2)     The distribution of the capital gains would be heavily skewed in favor of the wealthiest countries, who account for most of the gold. There are a few side beneficiaries, most notably South Africa who produces 75% of all newly mined gold.

3)     Eventaually, a further increase would be needed.

4)     Finally, revaluing gold would impose the real costs of taking gold from the ground merely to store it in vaults underground.

 

There was another development that occurred, which did not require the use of a precious metal for monetary purposes. It involved the creation of a man made substitute for gold for use in international settlements, and it distinguished between official gold and private gold (allowing market forces of supply and demand to determine the price of the latter. The substitute for gold is in the form of a Special Drawing Right (SDR) on the IMF, and is to be allocated between countries at certain levels in order to help the International Monetary System function smoothly. These required changes were planned to take effect by 1969. Among European countries, there was a reluctance to accept this so long as the US was running a large 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, they will be used like gold for settlements between central banks. SDRs will not 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.

In March of 1968 the major banks split the market for gold into two parts, and official sector where transfers would occur at an official price, and a private sector where price was determined by demand and supply.

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 the capital gains arising from the disposition of the gold. Essentially, this is a question dealing with transfer of capital from reserves in the US to other central banks, most likely the European Investments Transacations to the EU Allies. For example, the Netherlands is the biggest European owner of US wealth. There are also countries in the Middle East like Saudi Arabia who own a lot of US wealth from such oil companies like Aramco.

 

The $ as an International Currency:

After WWII, rebuilding reserves around the world meant a redistribution of gold from US reserves to that of other countries.  Such a plan would have been insufficient to support the subsequent boom in international trade, but fortunately for the US, most countries were willing to build up their reserves with dollars in the form of bank deposits and US treasury securities. The rationale here was to avoid gold transaction costs, and in the meantime to earn interest dollar balances. Most countries adopted the method of holding the exchange rate with the dollar within the rules of the IMF parities. This way the dollar was seen as an intervention currency, which countries needed on a day to day basis to satisfy exchange markets. 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. This way, reserves could increase even if the supply of gold were limited, so long as countries saved up dollars and so long as the US didn’t mind such liabilities. This posed two new problems to the payments system.

1)     Dollar claims of official holders exceeded the US gold stock for the first time in 1965. Total US claims on foreigners, including private US investment abroad, far exceeded foreign claims on the US. If foreign dollar reserves continue to rise, the gap between them and the US reserves will widen, threatening the stability of reserve holdings. If they do not continue to rise, the world will face a reserve shortage. The new SDRs were the solution to this problem. But for how long before more reserve substitutes are needed?

2)      US payments deficits have caused much controversy and strain, political jabs at the US being that they are printing money to finance their international ventures. This is alleged due to the apparent sharp increase in American investments in Europe, and the large increases in expenditures financing the Vietnam War.

France tried to convert their dollar reserves into gold, at the risk of compromising the convertibility of dollars into gold, on which the payments system depends on. Moreover the use of gold conversions to influence US policy is an ineffectual way of coordinating policies. The absence of satisfactory, smoothly operating methods for controlling imbalances in international payments is perhaps the major weakness of the present international payments system. Because of the importance of the dollar in international finance, the linkage between the supply of additional reserves, provided by US payments deficits, and the demand for them, combined with the great disruption resulting from applying IMF prescription for fundamental disequilibrium to the US, has forced the US to weigh the benefits of reducing the deficit against a desire to avoid measures for reducing the deficit that would be destructive of domestic objectives and international order.

 

Greater Economic Interdependence:

At the time, one of the underlying advancements was the vast technological breakthroughs that were occurring in the areas of transportation and communication which make the world a lot smaller in every way. Within time, the technological base, which grew over time (Solow Growth Model) accounts for increases in the factors of technology, population growth, and labor is defined in terms of “effective labor.” The idea of perfect information that is readily available to all markets brings business familiarity between foreign markets. Among industrial countries, tariffs have been sharply reduced and quantitative restrictions on trade in industrial products have been virtually eliminated. Currencies’ default risks are diminished. An incentive for a boom in investment and trade.

The growth of the EuroDollar market reached 16 Billion in 1967, a market formed by the European as well as branches of some American banks. The international bond market brings together long term borrowing and lending agreements between countries. Many of the borrowing firms are Large Corporations, mostly American companies, plus several other influential international government entities. An important fact to note is that up to 50% of all the lending in these markets comes directly from Swiss accounts. No wonder they are always neutral. The world could not afford to have capital losses in Switzerland. Central bank officials from eight major countries meet monthly in Switzerland to discuss topics agreements, and government financial officials meet 6 to 7 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 at hand.

These markets are large enough to influence national markets, wether they be Japanese, American, European, the closing numbers for all markets are in the Wall Street Journal everyday because those numbers have vast implications for every human being in every country on earth.

 

The US payments Deficit:

It’s main source is the deficit which accounted upwards to 68Billion dollars by  1967. An analogy would be a dynamic corporation that is borrowing heavily at short term to supplement it’s own large earnings in financing an ambitious investment program. At the time of this article, there were critics of the expenditures financing the Vietnam War, that a reduction was needed to mitigate the deficit.

Past and Proposed Measures designed to restrict outflows:

1)     1959 Foreign aid expenditures increasingly restricted to procurement of US goods and services.

2)     1960 Abortive attempt to recall military dependents from Germany.

3)     1961 First military offset agreement with Germany, under which Germany agrees to purchase arms in the United States to offset US troop costs in Germany.

4)     1962 Defense Department applies price differential in favor of US goods and services, shortly thereafter raising it to 50% and higher on big contracts.

5)     1963 Interest equalization tax applied to US purchases of foreign securities; later extended to cover bank and other lending.

6)     1965 Voluntary program established to restrict lending to foreigners and business investment abroad

7)     1968 Mandatory limits placed on outflows of enterprise capital and retained earnings of US owned firms operating abroad

8)     1968 Tax on foreign travel requested, but rejected by congress.

 

The diverse proposals to fix the balance of payments problem show a general agreement on the objective of reducing the deficit, but disagreements on the proper ways to achieve that goal. To put it into perspective, for every additional dollar that is invested in European markets, that dollar will not be recouped for 6 to 10 years. There are many criticisms of the inefficiencies of these restrictive measures.

1)     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 US residents is restricted, but no similar restraint applies to the right of foreigners to bring their capital home from the United States nor of foreign funds which might normally be expected to come to the united states. There are three schools economic thought to this dilemma.

2)     There are three schools economic thought to this dilemma. The first emphasizing adjustment in the quantity of dollars and the second adjustment in their price, the third argues that the US payments deficit represents a manifestation of the position of the US as a financial intermediary in the world economy.

3)     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.

US Policy Alternatives within the Existing System.

For psychological reasons, therefore, the United States at the pivotal country in the international payments system, must behave in such a way as to restore some sense of control. A balance of maintaining full employment and keeping inflation at bay as well as productivity growth are among its main tasks and responsibilities.

The two ways that a government can influence the economy is through monetary and fiscal policies aimed at sustained growth in all factors of production, reduced costs, low unemployment, no inflation, etc. These stabilizing policies must be balanced with an international strategy, which maintains communications and respect between nations.

The remaining question is can correction of payments imbalances be made smoother and more efficient? One suggestion is that capital should not be allowed to freely move in anticipation of the discrete changes, which it dictates. A counterargument is that this approach is prone to currency speculation resulting in sporadic postponements and advancements for imports and exports.

A second approach is to concentrate measures on trade, to the exclusion of capital transactions.

The third approach is to abandon the current system for completely flexible prices, determined in the market, at which one national currency exchanges for another. This approach is most notable for several reasons but had not been tested much at the time of this article.