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April 5, 1971
MEMORANDUM FOR PETER G . PETERSON
Subjects
The U.S.Balance of Payments and the International
Monetary Systems An Overview of the Policy Issues
This memorandum is in response both to Point 4 of the
CIEP Study Memorandum #1 and to the reguest to Mr. Houthakker
from the Ad Hoc Group for a survey of the major issues relating
t ©"abapiereview«?f theAdministration’s approach to the
ba|>a®@#ef»f?payments and internationalmonetary problems *** _,
-§H£?J| areview is essentialat this time, whenmounting pressures
in international economic relations threaten to make us lose
f|Lg|^v,o£,i;£iii*d$pental=i.o|^ef^^
should take place
as-'^arly a? possible inCIEP'separations, in orderto provide
a coherent framework for subsequent policy decisions and before
a legacy of past decisions impinges on the broad scope which
such a.,:
.reviewshould ideallyjhave. ?■
f TheNature o f t h e Problem
oeto
A thorough and definitive exploration of these problems
at
I®!?**5is^needfd for at least two reasons. First,
concern that a more vigorous domestic economy woulde^large the
dej^fit-- further.* through drawing
aee^|«r5t|^,',V ,:>
.giosfr of iraportsr causes many t o b e reluctantabout vigorojjplfy
expansionist monetary and fiscal policies. In fact, there
is considerable historical .evidence,-; that economic upswings inr
t ^ ifpnitadi^at#s-,are-iasss9c l a t ^ f . i f i t h ' '•\
as deterioration In the balafece on \
current account is more -than offset by capital -account ,1#
improvement in response to the investment opportunities offered
by a vigorously expanding economy. And the productivity improve
ments which must form the basis for any sustained improvement in
piur trade balance are more likely to be achieved in a vigorQi^ly
growing., economy, than in a stagnating one-,,./’But none'
is to deny the possibility of an interim problem of the type %e
seem to be experiencing now, as the policies of monetary ease
whichshould leadultimately to strong growth and an enlarged %
dpmeistic demand for funds temporarily have the opposite
V
^|e^.,oaJdcaae!StiC' credit, markets, leading to falling interest |
rates and an outflow of funds. Given this present conteaft, if ;
we are reluctant to pursue adequately expansionist domestic
economic policies during this year, our troublesome balance
of payments position will be one reason.
REPRODUCED AT THE NATIONAL ARCHIVES
K <W *
2
A second reason for concern is that an external payments
position widely considered to be ’'weak’* is an international
political•liability. At p r e s e n t ■■in •particular, ■European
apprehensionabout the stateof the U.S. balance of payments
and offi«iaiattitua#s toward it appears t© be mounting
for th#«ii r^&SOfisi Firsts ssost of the major European currencies
have been &t or near their ceilings vis a vis the dollar for sane
time. As a resmlt, several countries have been piling up dollars
in support of the exchange rate at a substantial and in come cases
accelerating rate, leading to a steady increase in the volume of
official dollar holdings which constitute a potential claim on
our gold stock. This stock, which as late as year-end 1957
was $23 billion, is now $11 billion. The plleup of dollars in
the hands of foreign official holders appears to be due not to
the underlying deficit of the United States, which was about the
same in iff© as in 196?, but to short-term capital flows resulting
from interest-rate differentials which reflect different positions
in the economic cycle ift the United States andabroad. In the
past f e w d a y s , these capital outflows appear to have Included also
a Speculative component.
\
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"W
Second, the Administration's firm commitment to a program of /)
economic expansion for 1971 has been a concern of many
/
Europeans, who fear this will be associated with a deterioration
fll
in the U.S. balance of payments. Finally, a "passive* or
"benign neglect** Approach to the U.S. balance of payments situation
has been advoeatedby several academic economists, some with
£ai% or present consultative connections* Reeentofficial
statements and actions on the part of the United States, however,
appear to have gone some way toward alleviating•this1concern. .
The real1dangerhere is not the international situation
itself, Which Is an annoyance rather than a genuinethreat
t o a c o u n t r y as large and powerful as the United states, but
rather that it may lead us — and others — to take actions
for balance-of-payments reasons which have an undesirable
effect on international relationships or on the domestic
economy. Balance-of-payments considerations have led us in
the past to adopt policies, such as the tytatojjg of foreign aid,
which reduce the effectiveness of programs relating to foreign
policy.
Our basic goal is, of course, an international monetary
system which will promote international harmony and encourage\
the maximum freedom for trade and investment across international
boundaries. This may mean maintenance of the present systeaal
which has been associated with an unprecedented growth of wpr\ld
income, trade, and investment during the postwar period* dr ifcjnay
• ? ’>
\
mean the evolutionary development of an even better system
which works more smoothly because it is subject to fewer
strains. But it certainly does not mean a system born in an
atmosphere of crisis and restriction, developed in response
to fears about the U.S. balance of payments situation. Given
the importance and magnitude of our economic goals, both at home
and internationally, it is essential that our actions on both
the foreign and the domestic economic policy fronts be evaluated
on their Intrinsic merits, and not primarily in terms of their
balance of payments impact.
The Dual Role of the United States In the World Economy
It is essential to keep in mind here the dual role that
the United States plays in the world economy. We are the
world's largest trader. In 1970 our imports were more than
$40 billion, compared with close to $30 billion for Germany
(the next largest) or just over $20 billion for the U.K. The
paradox, of course, is that our trade is so large in the world
economy and is so small relative to our domestic economy. Our „
occasionally casual actions abodt this small component of
"
our own economic activity often pertain to matters of urgent
importance to others.
The United States is also,in effect a banker to the rest
of the world. Though other nations understandably dislike
admitting it explicitiy, the world at present comes close
to being on a de facto dollar standard. The exchange rates for
most currencies are"set in terms of the U.S. dollar* Moreover,
U,S. dollars are bought or sold by foreign authorities to keep
a currency's exchange rate stablfe'in the foreign exchange market
making the dollar an "intervention currency.” Finally, dollars
are widely held by foreign private holders as working balances
for international trade and finance, and by other nations as
foreign exchange reserves. -
Why the Persisting U.S. Balance of Payments Deficits?
This country hag had a deficit in its balance of payments
most of the time during the postwar period. For several
years, a modest U.S. deficit was welcomed by other nations
anxious to rebuild their war-depleted monetary reserves. Since
about 1958, however, the deficits have been larger, and some
other countries have voiced a growing reluctance to accept the
dollars implied by continuing large deficits in our payments
situation. This concern has often taken the form of urging the
United States to pursue stern fiscal and monetary policies
to keep the domestic economy on a tight leash — thereby improving
our competitive price position, dampening U.S. demand for imports,
and preventing an outflow of funds due to lower domestic
interest rates.
Why have the deficits been so persistent? An economy
with inflationary pressure# of course, will tend to have a
deteriorating balance on current account. The demand for
imports is then heavy, and higher prices and costs make hard
going for exports, From 1967 to 1968, for example, our imports
rose 23 percent, as this overload of demands on the domestic
economy spilled abroad, and for external as well as domestic
reasons it was essential to cool off the long overheated U.S.
economy.
Clearly, however, the problem is more complex than simply
domestic inflation, because we also had a balance of payments
"problem” in the early 1960s when there was slack, a: fairly
stable price level,and unemployment* The deficits, in short,
have persisted through all kinds of domestic economic conditions
— in a period of stable prices and unemployment from 1958-1964,
and in the inflation of 1965 to 1970.
A second diagnosis runs in terms of structural problems that
cause some heavy special drains on our balance of payments. Our
military forces and installations abroad result in an:’’outflow"
j
of almost $5 billion per year. The foreign investment activitiesr
of U.S. corporations involve capital outflows of $2 t o $3 billipn
each year. And our aid programs naturally require substantial
balance of payments outflows. This is not to say that any
specific item can be identified as the "cause" of the problem.
The balance of payments account is a double-entry arraying of
our international financial transactions« T h e tw o sides, of
course/ "balance." The "deficit^ is simply a collection of
those items that are worrisome, and different problems call
for differentdefinitions of the deficit* Any one item could
be what it is without causing trouble if another item were
sufficiently different. And some of the large "leakage" items
contain a measure of self-financing. Our loans and grants under
the foreign aid program, forexample, are spent primarily on U.S.
exports, and the inflow of income from American investment abroad
was over §5billion last year. Yet it does remain truethe
"leakages"in some areas must be covered by larger surpluses for
other itemsiin the balance of payments, if ameasured deficit in
our balaac4 ©f payments is to be avoided,
A third diagnosis is that the dollar may be overvalued,
relative to ©ther leading currencies r owing to the basic nature
of the international monetary and financial system itself*
Countries~ are 'far more■'reluctant■to revalue ■thetri.exchange rates
upward than downward. A weak currency is more likely to be
devalued than an overly strong currency is to be appreciated.Thus
theretends to be a net bias toward devaluation against the standard
and that standard Is the O.S. dollar. Advice from abroad to the
United States to strengthen>its balance of payments is,therefore,
ad^c(r'%©;
.;n»iieuve3r'®ur domestic economy in order to reconcile
inconsistent external payments objectives among nations. Should we
succeed in strengthening our payments balance, the inevitable
weakeningof some other countries* balances would tend to produce
a devaluation oftheireurreneies, and the whole cycle might start
over again.
The same sort ofasyiraftetrical behavior results from countries'
attitudes towards international reserves. That is, countries whose
reserves are "too low” or decreasing feel much more urgency about
taking is^ftion than; 4b -those whose reserves are "toc high” or
increasing. The effeet of this Is that a general feelingof
"reserve shortage** appears to persist, Judging frcaa countries'
behavior, even with the present magnitude of mew SDR allocations.
If> l>n balance), c^aiftrleis db ind e ^ %mnt to increase their dollar
holdings over the long run, this would imply that the present
measures of the U.S. deficit tend to overstateourbalance of
payments problem, since non# of them takes into account growth
in- foreign demand for U.S. dollars.
Impllcations for Policy
■What are the implications of this for policy? There are
at least two areas that are directly within the axnbit of U. S.
actions. W© do have an external as well as a domestic obliga
tion to manage our own economy in order to keep it oft a
reasonably stable and orderly path, which is likely to mean
a better-than-average price performance compared' to '-other
industrialized nation®, We eannot, however, agree to chronic
uneraployment or deflation for external reasons, particularly
when the objective may com® down to attempting the reconcilia
tion of inconsistent bala»c@~of-payments objectives among
nations, and this view of the nature ana limits of the American
responsibility t© the international system has been made clear
to other industrialized nations, both publicly and privately,
in recent months.
We could, of course, also institute measures to affect
certain categories © f o u r balance directly. Indeed we have
already taken steps of this sort, such asaid-tying and our
various capital-control programs. But;- quite -apart from
questions about their effectiveness, measures taken for balance
ofpaymehts purposes may not always be in the interest of our
broader economicgoals, foreign or domestic* And, finally, no
such measure is purely unilateral? at the very least, other
countries can counter with similar measures and thus neutralize
their impact.
In general, then, if there are persistent payments disI
equilibria remaining in the international system one© our
I
cfom eeoncsasy is stabilised, the remedies will lie largely
I
outside the United States. The rest of the world would then
((
have four alternatives from which to choose. First, the surplus,
countries- can maintain their -existing exchange-rate parities by^
continuing to accumulateofficial dollar balances. The general1
Indications are that most surplus countries are prepared to see
their dollar balances continue to grow, at least in the near
future, rather than to face the consequences to their trade of
appreciating their'currencies
They probably will not, however,
want to continue accumulating dollars at the present rate — •
although Germany, which has had the largest accumulation of
dollar balances in recent months, is explicitly committed to
doing So under its 1967 pledge, made in connection with the
maintenance of U. Si troops in that country, not to buy U. S.
gold.
(It is mutually agreed that a future German repurchase
of the $500 million in gold which it sold to the United states
in 1969 would not be regarded as a departure from this pledge.)
The United States could offer surplus countries a variant
of this first option, incidentally, fey bprrowjrig Explicitly,
either through the IMF or directly, rather than borrowing
implicitly through increases in. their dollar balances, Such
a "funding" of foreign/ official dollar balances raight be worth
consideration, both because it raight ease the situation from
a foreign-policy viewpoint and because it would induce a
desirable shift in the structure of our international invest
ment position, substituting long-term for short-term liabilities.
Second, these nations could reduce their official dollar
balances by using them to buy gold from the United States at
the parity rate .-of $35 per ounce, at leastin the..short run.
Although surplus countries, particularly thesraaller Ones.#
■have, isiade occasional purchases in recent years, there has not
been large-#eaier- use of the "gold window'' since theestablishwent of the "two-tier" gold price..system in ’Inarch;'. 196 8. This
.away to© in part because of a general recognitloriofthe dangers
■to'the stability of the eysteru inherent in any large-scale gold
drawings. It laay also,.be because, the ma^cr surplus countries
of recent years — particularly Germany and Japan — have made
commitments, with different degrees of explicltness, not', to
take such actions, while the xaajor gold buyer of the past,
frai^c®'>:,-has ,iBot- until recently' been in a balance of payments
position which would enable it to take such action. However,
there are some indications that the magnitude of these purchases
coulfi increase in. the future.’
’
While we would not object to further modest demands on our
gold stock, this alternative is not a satisfactory solution,
because of the very real danger that such demands might become
cumulative and threaten a serious drain on our gold holdings.
(It is the view of the Justice Department that the Gold Reserve
Act-o f■1934 ■give© the President discretionary authority to suspend
gold payments, partially or totally, without Congressional
■approval..),
..
-Depending, on the nature and degree- o£\ suspension^, .'ahel the
response of other countries, such a step might alter opr position
with respect to our obligations to the International Monetary
Fund. Tim IMF accepts (or at least has not challenged,) the
present international monetary arrangements, including' the twotier gold system, as, satisfactorily discharing the tjpite# States*
convertibility and exchange-rate-stability obligations ui^deJT the
Articles of Agreement. Should we suspend gold sales to official
foreigners, or restrict them further, we iftight hav^ tosfirsdOther
ways of fulfilling these obligations or find ourselves in violation
©f the Articles ©I Agreement,. There is also the awkward question
of deciding the point at which the reduction of our gold'Stock
warrants invoking a partial or total suspension.
:
,v
-8~
Third, the surplus nations can revalue their own currencies
upward with respect to the dollar. This would moderate the
tendency to accumulate dollars further, but it would make their
exports higher priced in world markets (and imports cheapen)♦
The Germans did appreciate, 'after a transitional period','of
floating rates, in October 3.969 » So, in ©ffeet did Canada
lajpt May by going to a floating rate. ,(The exchange rate of
the Canadian dollar then rose significantly.) Among the list
of other countries for which revaluation seems most probable
at some point, Switzerland and Japan are perhaps mentioned most
often, although the Swiss Have indicated that they would not
uncle^take ..such' a step alone..
The important point here is that the initiative on exchangerate changes must come, if at all, from the surplus countries.
The United States is in no position to take unilateral action
on. dollar devaluation, since this can be done only by raising
the price of gold. The Bretton Woods Agreement Act explicitly
requires prior Congressional approval for such a step, and any
request for legislation on the price of gold would lead to
impossible complications domestically. Such a move would also
have a variety of undesirable effects on the international
financial system, Including giving windfall gains to goldproducing countries (primarily. South Africa and the USSR)
arid those .who hold gold rather than dollar -.reserves, and’the
possibility of a widespread loss of, confidence in the dollar
as a key currency. Finally, this is.again not really a
unilateral option, since it is highly unlikely that most of
our major trading partners would permit theresulting change in
the dollar-value of their own currencies to stand, an<l it is
only.if there were such a change that we would get any adjust
ment .effect in our balance of payments.
From the point of view of the United states’ own economic
interests, it would seem to be a matter of indifference whether
surplus countries continue to accumulate dollar balances or
reduce them via revaluation. However, financing via continued
accumulation does create pressures which could at some point
affect undesirably our International relationship and the
workings of the international monetary system. Therefore, it
is in our. interest to encourage steps which would make revalua
tion easier for those who prefer the adjustment alternative.
Given the heavy political element inherent in exchange-rate
decisions as the international system operates at present, any
modifications which would make such action less politically
charged would be helpful. This, of course, is the main purpose
of the lengthy continuing investigation under IMF auspices
of possibilities for limited exchange-rate flexibility within
the framework of the Bretton Woods System.
-9~
Finally, surplus countries can achieve ”backdoor" revalua
tion by measures such as taxes or-Quantitative, restrictions on
exports or on inflows of foreign capital. Such measures are
not always obviously recognizable as such. ©ie extraordinary
reserve requirements against foreign deposits in German banka,
and the resulting nonpayment of interest on such deposits, are
examples of measures used to discourage capital inflows.
Theoretically, surplus countries could achieve effective
partial revaluation ecpiaily well by liberalizing or eliminating
existing restrictions on imports and/or capital outflows. Ex
perience has indicated, however, that this is not the way the
problem is resolved, on balance, in practice. Rather, efforts
to achieve ^backdoor" changes in parities tend to result in a
spreading network of barriers to trade and capital movements,
which can only have a negative impact on growth, efficiency,
and price-stability in participating countries. For this
reason, this last alternative appears to be, for the long run,
an undesirable one.
The United States, iji short, h^s important responsibilities
to the international monetary and financial system, but there
are problems beyond our own policies. And we may, indeed,,
have, a persistent balance of payments, 'problem beyond the dif
ficulties caused by outflows of short-term capital, but it is
in ttiiy■case overstated by our:measured balance of p a y m e n t s
deficit, whichever measure is used. Failure to make" these
distinctions more sharplyraaykeep us unnecessarily on the
defensive, arid in practice lead the system in an illiberal
direction through a growing array of direct controls and trade
restrictions in order to prop up a seemingly weak dollar and
to strive to'force an equilibrium which cannot... be achieved
as long as balance of payments objectives are Inconsistent.
Major policy issues
The list of questions attached to your memorandum to the
Ad Hoc Group seems to touch on .the major policy issues In
this area. In the light of the preceding background analysis,
I would suggest that they be phrased for discussion as follows:
1.
Balance of Payments Targets
The difficulty with balance of payments target© is that
there seems to be a natural inclination to define them in "aero"
or "balance* terms. A majoir exception is a current account
target? we have suggested to the OECD’s Working Party 3 that a
current account surplus of between 1/2 and 3/4 of one percent
of GNP would seem to be appropriate to our long-run position
as a net exporter of capital (for 1975, this would toe a
projected current-aecount surplus of $7-$10 billion). A
zero overall balance target {whether defined in "basic",
"liquidity" or "official aettlenjents” terms*) would be. appro
priate if it were felt either that foreign demand for dollar
balances will not grow further, or that it would not fee in
our interest to satisfy such a demand, ..With respect to the.
official coraponentof such demand (corresponding to the
official settlements balance), our view depends heavily
on what we foresee as the future relationship among dollars,
SDR’s a n d other possible reserve assets. I would urge, there
fore , that #e avoid?setting balance of payments targets# at
l<&a#t for the present, with the possible exception of a current
account target. There remains the further question of whether
-Wis’^shottM ■'■'Set a trade-surplus target within the current-aifeotot.target? m y initial reaction would be to,■avoid locking
ourselves in this fashion, .since this would necessarily imply
also a target:, for the remaining items in the current account.
2.
Balance of payments Policies
Even if we eschew quantitative balance of payments targets,
it is quite possible to regard a particular balance of payments
situation as satisfactory or unsatisfactory; thus, the question
of policy measures directed at the balance of payments could
remain valid even in the absence of targets as such. Any
policy directed at a particular category of the balance of
payments needs to be scrutinized carefully in the light of
three criteriat (1) It# relationship to the overall goal of
■ilreedOrasof international trade and investment; ■
> (2) its; probable
loiig-run effectiveness, in the light of the tendency , in
other market-oriented economies, for offsetting developments
to appear in other balance of payments categories? and (3) Its
effect on the achievement of domestic economic goals.
With respect to the present capital-control programs, we
have long argued that they should not become a permanent component
of our foreign economic policy. We feel that this particular
time would be inausploious for their total abolition, partly
for psychological reasons, in view of the European jitteriness
mentioned earlier, and partly because the present relationship
between domestic and foreign Interest rates is particularly
unfavorable. 'There is reason to expect, however, that the
second half of this year may see a reconvergence of interest
rates here and abroad, at which time abolition could become
a viable possibility. In the interim, the liberalization
momentum should be maintained, or at least further restrictive
ness avoided.
REPRODUCED AT THE NATIONAL ARCHIVES
-IQ-
The question of how to finance deficits, again, should
be considered in the light of the desired evolution of the
international, monetary system and, if possible, there should
be multilateral discussion of a mutually satisfactory solution.
3.
The Development of the International Monetary System
Within the basic goal of international harmony and freedom
of international transactions, our objectives concerning the
international monetary system have two major aspects.
The first aspect has to do with the evolution of inter
national reserves* The main question here is the relative
importance of dollars, SDR's , and any new reserve asset in
future reserve ‘-increases {we are assuming that accretion of
gold to reserves will continue t© be minimal). This Administra
tion 1s strong support for SDK's is well known, but we need to
d e velopaclearerview on the extent to which future SDR activa
tions should sbe tied toreduction or ©liminationof 'the. O.S.
.
deficit. On this, I Would make two observations. U.S. deficits'
are no substitute for the planned creation of unconditional
i
liquidity represented by SDR's . And, the U.S. official settle- (
ments deficit is highly volatile, and any single-year figure
should be viewed in perspective. For the three-year period
1968-70 (or the five-year period 1966-70), for example, the
official settlements deficit averaged about $2 billion per
year, only slightly above the assumptions made when SDR’s
were first approved.
The second aspect has to do with the development o f ,a more
satisfactory mechanismof adjustment. Here, we have already a
expressed our preference for m; system which would expedite
timely and appropriate adjustments of exchange rates. This
is consistent with the President g affirmation of support for
"orderly exchange-rate adjustments" in the report "U,S. Foreign
Policy for the 1970*8." A majortactical achievement of the
exchange-r&fce-flegibility exercise, mentioned earlier, was to
make exchange-rate adjustment, long an unmentionable subject,
once again a respectable topic for discussion.
4.
European Monetary Integration
The implications; for the United States of this projected
integration fall into two categories: the implications for
the interim period before integration is achieved, which is
likely to last for at least a decade and possibly a good deal
longer (assuming ultimate achievement of the integration goal);
and the implications once such integration has been substantially
achieved. The main implication for the interim period is that
Common Market countries will be extremely reluctant to take
any major steps unless they can take them in common, and. they
are still a long way from being able to do the latter. With
respect t© exchange-rate revaluation, in particular, their
natural reluctance will doubtless be compounded during the
interim period by their inability to realfti a common revaluation,
combined with the belief that revaluation by one or some members
of the group but hot all would be a step away from integration.
Should full, int#gratioh,be achieved^ this would be likely
to reduce at"least the.official demand for"dollars'as a reserve
asset. The private demand for dollar balances might also be
reduced, but this is by no. means certain; the dollar would still
retain/’isua^^ojC. its traditional advantages as a vehicle Currency
for private transactions. There, is no reason why any particular
levels og- growthof So^lgli.,
fpar;do liars is1"jr@|ji3i^d-vby '
interests, as long as any shift is sufficiently gradual to
.^ilow time for adjustment/ ..Thus, pur attitude toward European
monetary
<E>ir^ut^miity;^ atA:’
lWife"'toi,r':’
$he¥:present. ’In,
'
'
'
impact of
European"monetary integration ’jpni U.s.iWte^sts;::cannot be
, e^iuated' separately/from the broader question of the impact
of the EEC as a whole. And this, in turn, depends on whether
the EEC takes an outwafd-looking liberalizing stance of an
inward-looking, protectionist position as it proceeds with
the widening and deepening process of expansion.
5.
Movements of Short-Term Capital
_
ItiS; in this area that the conflict between freedom e>£
^t^rnatipEia'l transactions oii the one hand and Independence of
national economic (particularly monetary) policies on the other
is most acute...-/for/tills' reason, the rised for the •'intensive
examination" of the techniques of international monetary
x cooperation called for by
.repoapt
/tp
same ;time, _>
;t e e h n i t i s # © ' ; : ' i l h l M h / Would minimize interference
with private markets and the international allocation of
productive capital. In this light, a search for methods of
increasing flexibility in the monetary-fiscal policy mix might
prove particularly fruitful, since coordination of monetary
policies would jfeein to be the qnly alternative to restriction.
.Such shijPts.,in the _policy raix would,'fefT effective "if,’ asrseems.
likely, international flows of short-term capital induced by
interest-rate differentials, while often large and therefore
disturbing, are also temporary and self-reversing.
Paul W. McCracken
@FedFRASER