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.