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november/december 1976 £ REVIEW Money Growth, Jobs, and Expectations: Does a Little Learning Ruin Everything? A Lower Profile for the U .S . Balance of Pay ments http://fraser.stlouisfed.org/ F E D E R A L R E S E R V E B A N K of P H IL A D E L P H IA Federal Reserve Bank of St. Louis IN THIS ISSU E... r MONEY GROWTH, JOBS, AND EXPECTATIONS: DOES A LITTLE LEARNING RUIN EVERYTHING? Donald }. Mullineaux A 3-10 .. .It might, the author suggests. The effec tiveness of monetary policy in producing jobs may well depend on how people expect prices to behave. A LOWER PROFILE FOR THE U.S. BALANCE OF PAYMENTS Janice M. Westerfield as 11-17 . . . Recent changes in world trade conditions, including the shift from fixed to floating currency-exchange rates, have reduced the importance of surpluses and deficits. Accord ingly, the U.S. has altered its trade policies and modified its system for reporting interna tional transactions. V___________________________ w FEDERAL RESERVE BANK OF PHILADELPHIA Business Review November/December 1976 On Our Cover: American Commissioners of the Preliminary Peace Negotiations with Great Britain. Oil on canvas by Benjamin West (1738-1820). Courtesy, The Henry Francis du Pont Winterthur Museum. Born in Springfield, Pennsylvania, West early showed an aptitude for painting. At the age of nine he studied in Philadelphia with the English portraitist, novelist, and mariner William Williams,and by thetime he reached eighteen he had established himself as a painter. He left America to study in Europe in 1759 and settled in London in 1763. West enjoyed the patronage and friendship of King George III for several decades, and he served as president of the Royal Society from 1792 forward. Although he never returned to this country, West exercised an important influence on American painting through his students John Singleton Copley, Charles Wilson Peale, Rembrandt Peale, Gilbert Stuart, and John Trumbull. This unfinished painting depicts the American commissioners at Paris in 1782—John Adams, Benjamin Franklin, John Jay, and Henry Laurens—with William Temple Franklin, who was their secretary and Dr. Franklin's grandson. West showed the picture to John Quincy Adams when the latter was in London in 1817. Adams pronounced the likeness of Jay “ striking,” those of the Franklins “ also excellent,” and those of his father and Laurens, though less perfect resemblances, yet “ very good.” West told him, Adams records, that he could not complete the canvas because Richard Oswald, the British Plenipotentiary, had died without leaving any likeness of himself. The Treaty of Paris, ratified in 1783, recognized United States sovereignty, set the northern and western boundaries, regulated the use of fishing grounds and rivers, and recommended efforts to restore to loyalists the property they had lost. BUSINESS REVIEW is edited by John J. Mulhern for the Department of Research. Artwork is directed by Ronald Williams. Please direct requests for copies and subscriptions to the Department of Public Services, Federal Reserve Bank of Philadelphia, Philadelphia, Pennsylvania 19106, telephone (215) 574-6115. NOVEMBER/DECEMBER 1976 Money Growth, Jobs, and Expectations: Does a Little Learning Ruin Everything? By Donald J. Mullineaux* Should the Federal Reserve actively adjust the rate of money growth to try to affect the pace of economic activity, or should it announce a money-growth target and stick to it regardless of the state of the economy? Economists have debated this important question for many years. The way people form expectations bears directly on the impact of a change in money growth, and the present article surveys some recent developments concerning this issue. Until more evidence is accumulated, however, the question whether the Fed should sponsor an active or a passive money-growth stance must remain open. Money is a veil, but when the veil flutters, real output sputters.—John Gurley. publicizing this fact that Congress has con sidered legislation—the Full Employment and Balanced Growth Act of 1976—that requires the Federal government to set a numerical target for the unemployment rate. If such a bill became law, the Federal Reserve would be required to adjust its policies, including its target for growth in the money supply, to help achieve this unemployment goal—or, alter natively, to explain to the Congress and the public why it chose not to do so. This legislation would mandate that the Fed do what it at times has done on its own initiative—speed up money growth to stimu late the economy and create new jobs in Professor Gurley's clever comment high lights a fact well known to monetary econo mists: that changes in the quantity of money can affect the pace of economic activity and hence the number of people holding jobs. Indeed, economists have done so well at *D o nald j. M u llin e a u x , Research O ffic e r and Eco no mist at the Ph iladelp hia Fed, jo in e d th estaff upon re c e iv ing his Ph .D . from Boston C o lle g e in 1971. He w rites on fin an cial institutions and m arkets as w ell as on m onetary th eo ry and p o licy. 3 BUSINESS REVIEW NOVEMBER/DECEMBER 1976 periods of higher unemployment. But it also would make the target rate of unem ployment—3 percent of the adult labor force1 in the Balanced Growth Act—a matter of public record. At present, neither the Fed nor the Congress announces an unemployment rate target. The Balanced Growth Act takes for granted that policymakers are able to achieve a certain unemployment rate whenever they want to. But this assumes that money growth is linked firmly and permanently to jobs. Unfortu nately, it seems that faster money growth produces more jobs only in the short run. In the long run, many economists believe, more money yields only higher prices; employ ment is not affected. The policymaker is faced with a dilemma. Should the government act on Keynes's fa mous dictum—“ in the long run, we are all dead” —and tinker with the money-growth rate to take advantage of the temporary rela tion money has to jobs? Or should it set a steady course for money growth, regardless of the pace of economic activity, to minimize the threat of fluctuations in prices and pro duction? Almost all the market-oriented economies in the world have opted for at least some tinkering. Some economists have suggested, however, that a reassessment of these policies may be in order. They argue that once we acknowledge the simple fact that people learn from their mistakes, the best policy is to set a money-growth rate and stick to it what ever the momentary state of the economy. While the call for constant money growth hardly is new, the logic in its favor recently has been bolstered, ironically enough, by in vestigations of the reasons for the short-run link of money to jobs. As early as the eighteenth century, econo mists realized that accelerating the growth rate of money (typically defined today as the sum of currency and checking accounts in the hands of the public) would stimulate produc tion of goods and services and hence create more jobs. David Hume declared in 1750, for example, that “ in every kingdom, into which money begins to flow in greater abundance than formerly, everything takes on a new face; labour and industry gain life, the mer chant becomes more enterprising, and even the farmer follows his plow with greater alac rity and attention.” 2 Yet Hume and other classical economists recognized the transitory nature of the money-jobs nexus. Hume went on to say that “ some time is required before the money circulates through the whole state, and makes its effect be felt on all ranks of people. At first, no alteration is perceived; by degrees the price rises, first of one commod ity, then another; til the whole at last reaches a just proportion with the new quantity of specie [money] which is in the kingdom. In my opinion, it is only in this interval or inter mediate situation, between the acquisition of money and the rise of prices, that the increas ing quantity of gold and silver is favorable to industry.” With over two hundred years of hindsight, many economists believe that Hume cap tured the essence of the effects of changes in money growth on the economy. What has been far less clear all along, however, is why boosting the growth rate of the money supply has a permanent effect on price levels— inflation—but only a temporary effect on such real-sector items as jobs and production. Several explanations have been suggested, and one increasingly popular view attributes the money-jobs tie-in to imperfect informa tion. Buyers and sellers make plans based on the current state of the economy and their best guesses of what lies ahead. If they make mistakes either in assessing the present situa tion or in forecasting the future, they'll have to revise their plans. When they do, the pace M e m b e rs of Congress thus far have had som e tro ub le agreeing about th e ap propriate d e fin itio n of ‘ad u lt’. 2David H u m e, “ O f M o n e y ,” Essays (O x fo rd : O xfo rd U niversity Press, 1750). JOBS AND GROWTH IN THE MONEY SUPPLY 4 FEDERAL RESERVE BANK OF PHILADELPHIA of economic activity will be affected. Thus the answer seems to be that the short-run effects of changes in the money-growth rate differ from the long-term results because people act on imperfect information and, hence, frequently make mistakes. Relative Prices: The Key Information Varia ble. In a free-market economy, both busi nesses and households face a plethora of complex decisions. Firms must consider how much output to produce and how many workers to hire, households must calculate how many hours to work and what basket of goods to purchase. Buyers and sellers could rely on divine inspiration for guidance; but, instead, they turn to more mundane signalsto tell them what to do. The information is contained in changes in market prices. An increase in wages relative to machine rentals, for instance, signals employers to hire fewer workers and buy more machines. Similarly, an increase in demand for some item a firm produces relative to demand for other goods and services induces a price rise; and the price rise signals that this item has become more profitable and that production sche dules should be accelerated. If the price of television sets, for example, rises 5 percent relative to the price of everything else (as measured by, say, the price index for GNP), then television manufacturers can increase their profits by upping production. But if the price tags on all other goods and services also are marked up 5 percent, then the relative price of television sets is unchanged and manufacturers shouldn't speed up produc tion. The reason is that, in this case, the cost (or price) of everything used in making televi sion sets is 5 percent higher too, so that bringing more TVs to the market won’t payoff in higher earnings. Relative prices are the key items that firms need to consider in everyday decisionmak ing, and the same is true for households. Unfortunately, however, it’s often hard to recognize a change in relative prices. Busi nessmen probably become aware of changes in demand and price developments in markets for their own products sooner than they recognize changes in the overall level of prices. Dress manufacturers, for example, probably will take note of an increase in garment prices before they perceive that the prices of other goods and services reflected in the GNP price index also are rising. Hence, when inflation—a general rise in all prices—is just getting underway, or when it’s accelerat ing or decelerating unexpectedly, firms may interpret a change in the price of their own product as a relative price change when in fact its price is changing at the same rate and in the same direction as everything else. It’s this tendency to think one sees relative price changes during periods of inflation and defla tion that allows policymakers to use the lever age of changes in money growth to affect output and jobs.3 More Money, More Jobs? Suppose that the money supply has been growing for some time at 2 percent a year, that there has been no inflation to speak of, and that the unem ployment rate is 5 percent. The Fed then speeds up money growth to, say, 6 percent, to create more jobs. What will be the impact of this policy change? As the money supply increases, people will acquire more money than they want to hold at prevailing interest rates. They’ll attempt to get rid of their excess money by spending it on assets such as government or corporate securities, and perhaps on goods and services as well. Interest rates will fall; and since more funds will be available for lending, it will become cheaper to finance expenditures with borrowed funds. As a result, the sum total of demand for goods and services in the economy (aggregate demand) will begin to rise, and the increase in demand will put upward pressure on prices. Businessmen in 3Som e econom ists argue that jobs are linked to m oney by other u ncertainties as w ell as by m isperceptions of this kin d. See, for e xa m p le , James T o b in , “ Inflation and U n e m p lo y m e n t,” A m erica n E co n o m ic R e v ie w 62 (1972), pp. 1-18. A cco rd in g to T o b in , this lin k , far from being m erely tem p o rary, may carry over into the long run. 5 BUSINESS REVIEW individual markets will recognize that demand is on the rise, but, because there has been no inflation for some time, they'll con clude that there has been a relative shift in demand for their own products rather than an increase in demand for all goods and services. In response to the perceived shift in demand, businessmen will begin to increase prices for their own goods. And because they haven’t recognized yet that other prices also are rising (including their costs for labor and machin ery), they'll step up production in concert. To produce more output, firms will hire more workers and the unemployment rate will fall—much as Hume said it would. But as Hume recognized, this euphoric state is temporary. Eventually, businessmen wake up to the fact that inflation makes them pay more for labor and materials; so they cut back on production and lay off workers. Business activity returns to previous levels and the unemployment rate returns to 5 percent; but, unless the money-growth rate is re duced, inflation proceeds at a higher rate. Many economists would accept this as a long-run scenario. They agree that as people become aware of inflation and adjust their expectations of the future to reflect it, the Fed will find it harder and harder to reduce unem ployment, even by following ever more expansionary monetary policies. At the same time, however, they disagree about the appropriateness of changing the moneygrowth rate to try to alter the pace of eco nomic activity in the short run. One school of thought suggests that the Fed should seldom if ever tinker with the growth rate of the money supply. This policy prescription—that the money supply should be expanded at the same rate year in and year out—isn't new.4 Its popularity is growing now, however, as a result of recent research into how households 4 o econom ists from the U n ive rsity of C h ica g o have Tw been the strongest propon ents of constant m oney grow th. H enry Sim ons argued the position in the 1930s, and M ilto n Friedm an has secon ded it on in n u m erab le occasions sin ce the 1950s. NOVEMBER/DECEMBER 1976 and businesses form expectations about the outlook for future prices. EXPECTATIONS AND MONETARY POLICY: HOW LEARNING CAUSES COMPLICATIONS The information that buyers and sellers possess plays a key role in determining the impact of a change in the money-growth rate. When people make mistakes and interpret a general increase in prices as a relative price change, their behavior affects the economy both at the time they err and also when they correct their mistakes. Indeed, these misper ceptions are at the root of the relations money growth has to production and jobs. In fact, monetary policy must generate unexpected increases in prices in general in order to add to the number of jobs. For if the inflation that results from an increase in money growth is expected, it will not boost production (since people will not err in perceiving inflation as a relative price rise). This is why some economists believe that shifts in money growth can't have a perma nent effect on the unemployment rate and that the Fed isn't able to peg the rate wher ever it wants to. Suppose the demand and supply of workers are consistent with an unemployment rate of 5 percent (the unem ployed are those in transition from job to job or out of work on their own initiative seeking employment). The Fed can depress the unem ployment rate temporarily by accelerating money growth and causing people to believe that relative prices have changed. As people become aware of inflation, however, unem ployment will move back toward 5 percent. In order to maintain a low unemployment rate permanently, the Fed would have to generate the appearance of relative price changes on a continuing basis. Most economists would agree that keeping the public in the dark about inflation would be a difficult job. People eventually will catch on to the process that produces inflation simply because it's in their economic interest to do so. And once they stop making syste matic errors in recognizing and forecasting 6 FEDERAL RESERVE BANK OF PHILADELPHIA inflation, then changes in money growth won't affect the production and employment picture. The fact that people won't stay ignorant of the influences that make for inflation is a source of bedevilment to policymakers. When people recognize that changes in money growth affect the inflation rate, they'll learn to take money growth into account as they form expectations about the future. As stock market analysts frequently say, people will discount the effects of policy changes; they'll build this information into their deci sions. When the money-growth rate in creases, they'll respond by raising their infla tion forecasts. Similarly, any other develop ments that affect inflation, such as fiscal policy moves, will be taken into account in generat ing a forecast. Economists refer to this method of forming expectations—where all the avail able information is built into the forecast—as a rational expectations process. If people become aware of what normally causes inflation (if expectations become rational), policymakers will have a hard time bringing about unexpected inflation. One thing they might try is generating unexpected changes (on average) in money growth. The Fed currently announces its long-term targets for money growth. If the public believes these declarations, then the Fed should be able to generate unexpected money growth by sys tematically missing its target. The Fed proba bly would come under heavy attack if it was off target all the time; but even if this weren't so, it's doubtful that the public would con tinue to accept the announced targets at face value. For, after watching the actual money-growth numbers, people eventually would figure out what the Fed was respond ing to and then would use this information to predict the actual (rather than announced) rates of money growth and inflation. So unex pected money growth probably won't do as a systematic source of unexpected inflation.5 5 e m oney stock is not pe rfectly co n tro llab le , h o w Th ever, so that it is q u ite like ly that exp ectations about 7 The consequences for monetary policy are radical. The spread of rational expectations would shatter the link that connects employ ment to the money supply. When people at large use all available information to forecast inflation, accelerating money growth will produce only higher prices, not more jobs; slowing money growth, though it will check inflation, won't affect employment either. In this scheme, if policymakers were satisfied with the rate of inflation, there would be no justification for changing the money-growth rate. In fact, the best policy would be to let the money supply grow at some constant rate year in and year out. In a world where expec tations are rational, a variable money-growth rate simply makes the level of economic activity more uncertain. This happens because changes in money growth cloud the picture and make it more difficult for busi nessmen and households to recognize shifts in relative demands and supplies. Consider the shoe producer who notices an increase in his orders. He must ask whether this represents an increase in demand for shoes relative to everything else (so that he should step up production) or whether the demand for everything, shoes included, is on the rise (and production should not be increased). If the Fed has sworn off a policy of tinkering with money growth, the shoe manufacturer can be more confident that the increase in orders represents a relative demand shift. A constant growth rate in money, however, would not mean constant growth in income and production. Unpre dictable factors that affect economic activity, such as weather, wildcat strikes, and political upheavals, will continue to produce varia tions in income. But constant money growth m oney growth fre q u e n tly w ill be d isapp ointed . These surprises w ill p ro d u ce unexp ected tem p orary inflation and a consequen t effect on pro d u ctio n and em ploym ent. The u n co n tro lla b le random factors that push and pull m oney growth away from its exp ected path w ill tend to cancel each oth er o ver tim e, h o w e ve r, so that on average the Fed w ill not be ab le to alter pro d u ctio n in som e arbitrarily chosen fashion. NOVEMBER/DECEMBER 1976 BUSINESS REVIEW Should policymakers accept the rational expectations view and passively peg the growth of money at some constant rate? Those who answer No and favor an activist monetary policy believe that the rational expectations scenario isn't now and isn’t likely to become a faithful representation of the real world. They emphasize reasons for thinking that changing money growth will affect the pace of production and the number of jobs available. It has been pointed out, for instance, that if policymakers have better information than the public about the state of the economy or the way money growth will be altered, then monetary policy can affect employment despite the fact that expecta tions are rational. Policy works when the public has an information disadvantage because the Fed can induce buyers and sellers to behave in ways that create additional jobs. It seems doubtful, however, that the Fed possesses better information than the public. Economic data are made available with only a short lag in the U.S. and are well publicized in the media. And forecasts of economic activity can be purchased from a number of private firms that use methods quite similar to those employed by the Fed. Thus it seems reasona ble to conclude that the relevant information is there for those who want it—including the outlook for future money growth which the Fed announces each quarter—and that infor mational advantages for policymakers cannot establish a firm foundation for an activist monetary policy.6 Others have argued for an activist policy by contending that predictions become rational (correct on average) only over a very long period of time. On this view, there’s consider able room for monetary policy to operate during the transition period. In fact, though, very little is known about how fast people learn and how long it takes them to adjust their expectations accordingly. But even if they learn only gradually, policymakers still may have a problem. The difficulty is that the Fed’s forecasts of the outcomes of policy changes assume there will be virtually no learning at all. Thus, to the extent that people gradually are catching on and adjusting their expectations, the Fed’s predictions of the effects of a change in policy will be systemati cally wrong.7 In other words, to take advan tage of the time lag in getting to a state of rational expectations, the Fed must know how people learn and adjust their behavior. Researchers only now are beginningto tackle this problem. Hence, there remains some doubt that the Fed currently has enough information to temper fluctuations in eco nomic activity despite the lag in forming rational expectations. Finally, there is a school of thought that questions the assumptions employed in the rational expectations argument. The rational expectations scenario presumes, it’s argued, that prices are flexible—that they change promptly when there’s a shift in demand or supply. Yet there seems to be a lot of evidence that many prices are sticky—that they have little tendency to go down and that they go up fairly gradually, at least in the beginning stages of an inflationary period. In a world where prices don’t change at all, any disturb ance to the economy (such as a drought, an oil embargo, or a change in the money-growth rate) must be reflected by quantity adjust ments rather than price changes. If prices are rigid and some workers are unemployed 6lf the Fed does have better inform ation than the p u b lic, changing the m oney-grow th rate is not the only way it can stabilize p ro d u ctio n . It can ach ieve its goal also by sim ply m aking its su p erio r inform ation available to the public. rThis point has been argued fo rce fu lly in Robert E. Lucas, “ Eco nom etric Policy Evalu atio n : A C rit iq u e ,’’ in Karl B ru n n er, ed ., The Phillips C u rv e and La b or M arkets (1976), supplem ent to the Jo u rn a l o f M o n e ta ry E co n o m ics. would eliminate one source of income varia tion so that, on average, income changes should be less uncertain. IS THERE SCOPE FOR AN ACTIVIST POLICY? 8 FEDERAL RESERVE BANK OF PHILADELPHIA against their wishes, then an increase in money growth will stimulate production and create new jobs. In reality, of course, prices are neither perfectly flexible nor completely rigid. Some economists have argued that there's enough stickiness in prices to justify an activist mone tary policy. One way to resolve this issue is to ask whether what has happened in the past is consistent with the notion that monetary policy can affect production and employment systematically. Over the last fifteen to twenty years, economists have amassed a great deal of evidence which shows that increasing the money-growth rate would produce more jobs (but at the cost of higher prices). None of these studies, however, considered the impact of learning on people's behavior. A recently completed investigation took a dif ferent tack and assumed that people do form expectations rationally. No evidence emerged which tended to show that money growth is related to employment.8While one study hardly amounts to a closed case, these results do indicate that expectations are an important factor and that more effort should be devoted to studies of how people forecast and how they adjust their behavior to what they expect. TIME FOR AN EXPERIMENT? Policymakers themselves still haven’t “See Thom as J. Sargent, “ A C lassical M acroeconom etric M o del for the U nited States, “ Jo u rn a l o f Political E co n o m y 84(1976), pp. 207-237. bought the view that a little learning destroys the jobs-money nexus. The Fed hasn't sworn off adjusting money growth to changes in the state of the economy, and Congress hasn't stopped considering ways to influence the Fed’s targets for money growth. But the rational expectations argument at the very least should have increased our skepticism about what policy can do. After all, it's hard to quarrel with the notion that people act in their own best interest and use all the infor mation they profitably can get their hands on to do so. Indeed, once economists discard this notion, they find it quite difficult to justify their analyses and predictions of how people will behave. Monetary policy of late has been directed toward gradual reductions in money-growth rates. The Fed is aiming for a reduced rate of inflation along with an adequate recovery in production. Once inflation has slowed to a satisfactory rate, it might well be desirable to consider an experimental period of constant money growth. After subjecting an announced policy of unchanged money growth to the acid test of a real-world experi ment, the policymakers and the public would be in a better position to judge the case for a passive monetary policy on its merits. No one, of course, can guarantee that such an experi ment would reduce fluctuations in economic activity. But neither can anyone show from past experience that policy activism has a strong claim on our confidence. X RATIONAL EXPECTATIONS: A READING LIST Barro, Robert J. “ Rational Expectations and the Role of Monetary Policy,” Journal of M onetary Economics 2 (1976), pp. 1-32. Friedman, Milton. “ The Role of Monetary Policy,” American Econom ic R eview 58 (1968), pp. 1-17. Gordon, Robert J. “ Recent Developments in the Theory of Inflation and Unemploy ment,” Journal o f Monetary Economics 2 (1976), pp. 185-219. Lucas, Robert E. “ Econometric Policy Evaluation: A Critique,” in Karl Brunner, ed., The 9 BUSINESS REVIEW NOVEMBER/DECEMBER 1976 Phillips Curve and Labor Markets, a lournal of Monetary Economics supplement (1976). --------------- “ Expectations and the Neutrality of M oney” , Journal of Economic Theory 4 (1972), pp. 103-124. Sargent, Thomas J. “ A Classical Macroeconometric Model for the United States/' Journal of Political Economy 84 (1976), pp. 207-237. Sargent, Thomas J. and Wallace, Neil. “ Rational Expectations and the Theory of Economic Policy," Journal of Monetary Economics 2 (1976), pp. 169-183. Taylor, John B. “ Monetary Policy During a Transition to Rational Expectations," Journal of Political Economy 83 (1975), pp. 1009-1021. ECONOMICS of INFLATION Though inflation has fallen off sharply, it could become severe again. Can policymakers curtail it? If so, how much will their actions cost society? Are there ways of living with inflation that cushion its impact? Six articles reprinted from the Philadelphia Fed's Business Review address these questions in detail and seek to promote an understanding of the problem among both policymakers and the general public. Copies are available free of charge. Please address all requests to the Department of Public Services, Federal Reserve Bank of Philadelphia, Philadelphia, Pennsylva nia 19106. 10 FEDERAL RESERVE BANK OF PHILADELPHIA A Lower Profile for the U.S. Balance of Payments By Janice M. Westerfield* People reacted with surprise last May when the government accepted an advisory panel’s recommendation that it stop publishing sum mary payments balances. Not long ago, the balance of payments was front-page news. Continuing U.S. payments deficits caught the attention of policymakers at the highest lev els, and they responded with programs to combat deficits and maintain the value of the dollar—in a word, to prevent devaluation. Payments imbalances posed a serious threat to international stability when the U.S. and its trading partners bought and sold one anoth er’s currencies at fixed exchange rates. But since 1973, when the fixed-rate system was abandoned, deficit and surplus measures no longer mean what they used to. Many econo mists believe that the payments restrictions of the fixed-rate era, which were intended to *Janice M . W e ste rfie ld , w ho jo in ed the bank in 1973 and received her P h .D . fro m the U niversity of Pennsylva nia the fo llo w in g year, w rites fre q u e n tly on international fin an ce and trade. 11 reduce deficits, may have outlived their use fulness. And now these restrictions are being eased in the belief that relaxed payments policies will foster economic health in an atmosphere of expanded consumer and investor choice. THE BALANCE OF PAYMENTS AND FIXED EXCHANGE RATES It’s usual to define a nation’s balance of payments as a record of the transactions its residents have carried on with foreign resi dents over a period of time. This record follows the principles of double-entry book keeping: every credit is balanced by an offset ting debit somewhere on the statement. The credit and debit entries can be grouped into different accounts which bring out distinct features of the payments picture. A payments balance yardstick often used by policymakers was the balance on current account and long-term capital—the basic balance. This measure was designed to pick out long-term trends in the balance of pay- NOVEMBER/DECEMBER 1976 BUSINESS REVIEW merits by excluding volatile capital flows. The current account portion of this balance records sales of goods and services as well as remittances and government grants. This account reflects all international transactions except capital movements. It's the mirror image of changes in capital flows (excluding errors and omissions). Thus a deficit in the current account is matched by a surplus of roughly the same size in capital accounts. Payments balances and the financing of deficits were items of central importance to the international economic system that was established after World War II. Policymakers were very much interested in the stability of this system. Balanced international trade and fixed currency exchange rates both were considered important for achieving stability. But there wasn't much give in the system. Imbalances in international payments threat ened to change currency exchange rates and vice versa. A nation that imported more goods and services than it exported had to make up the difference with financing or reserves—whose effect may be to make a currency more available and drive down its value against other currencies. Under the fixed-rate system, however, central banks stepped in to hold a currency's value steady if it threatened to move outside agreed-on limits. Where fundamental changes occurred in a nation's economic circumstances, the monetary authorities were able to set a new official value for that nation's currency in terms of other currencies and gold. But it was expected that the United States, with the cooperation of other countries, would main tain the value of the dollar in terms of gold. U.S. policymakers were faced with a choice: either take domestic measures to keep exchange rates and trade balances in order, or face international pressures to redress imbal ances. They reacted by developing a combi nation of domestic economic policies and exchange controls to correct international financial difficulties. WHY DEFICITS WERE TABOO International currency exchange is a many sided enterprise, and policymakers had many reasons for trying to avoid deficits. Some were economic, others were political; some had to do with the economy of a single nation, others with the economies of several nations. Deficits Drain Off Reserve Assets. During the late 1950s and 1960s, the U.S. was piling up deficits in its basic balance and other overall balances. Stocks of gold, foreign cur rencies, and other reserve assets were used to ensure the value of the dollars that were used to cover deficits with trading partners. There was little bodily movement of metals or cur rency; gold wasn't shipped out of Fort Knox every month. But as time went on and deficits continued, many U.S. dollars—or dollar credits—were accumulated by foreigners. As the foreign dollar holdings grew larger, the willingness to accept still more dollars sof tened and so the increasing supply of dollars overseas threatened to undercut the value of U.S. currency and upset the fixed-rate sys tem. The U.S. and its trading partners cooper ated to head off sharp movements in currency exchange rates, but they did so at a cost. Foreign central banks bought up excess dol lars with their own currencies, and they could present these dollars to the U.S. Treasury for payment in gold. Thus the U.S. lost a lot of its gold to dollar holders in the late 1960s. With no end to balance-of-payments deficits in sight, the threat of a continuing gold loss persuaded the U.S. to suspend its redemp tion of dollars in 1971. The end of dollar-togold convertibility touched off other changes—including the shift from fixed to floating exchange rates—that have altered our outlook on payments deficits. U.S. Deficits Produce Resentment Abroad. . . During the Vietnam conflict, the U.S. supplied more and more dollars, over loading currency markets. Other nations had to absorb these dollars to avoid revaluing and, under the fixed-exchange-rate system, they usually bought them up with their own cur rencies. The West German government, for 12 FEDERAL RESERVE BANK O F PHILADELPHIA example, had to buy up dollars with marks in order to prevent the mark from gaining in value against the dollar. But pumping more marks into circulation swelled the German money supply; and as the money supply expanded, prices shot up. The German government, stuck with dollars it didn't want and with inflation besides, traced many of its difficulties to U.S. policies. And Germany was not the only nation that blamed its high inflation rates of the late 1960s and early 1970s on the U.S. . . . and at Home. Many Americans also were unhappy about their country's owing money to foreign creditors, but that's what happens when the payments balance shows a deficit. With deficits piling up year after year, the nation had to borrow continually to finance its spending. Since the total balance—counting goods and services, capital, and reserve assets—must be zero, dollar outflows in one portion of the statement must be offset by dollar inflows in another. So, for example, if the U.S. has a deficit (net dollar outflow) in the current account, it ordinarily would show a surplus (net dollar inflow) in the capital account, say from foreign purchases of U.S. Treasury securities. And such a net inflow of short-term private capital may mean that the U.S. is borrowing money abroad to tide itself over instead of paying cash on the barrelhead for consumption and investment goods. It's been argued that the U.S. lived beyond its means by running up large international bills this way, especially in the later 1960s, and that neither a nation nor a household can run up a lot of bills without making arrangements to repay its creditors. Without an expansion of national output large enough to liquidate foreign debt as it comes due, a trading coun try faces the possibility of default and of difficulty in obtaining further credit. Any nation that runs deficits for a prolonged period must gear up to transfer sizable resources to other nations in the future. No wonder international deficit financing goes against the grain of people who don’t like to 13 owe anything to anybody. Interest Groups Fear Loss of Jobs and Prof its. Some groups oppose payments deficits for reasons peculiar to their own situation. Labor unions, for example, use media spots and billboard advertisements to tell the story of U. S. workers knocked out of jobs by foreign imports. Of course, domestic industries may be vulnerable even in times of surplus; it doesn't take a deficit to imperil workers in an industry that faces stiff foreign competition. But labor groups have lobbied consistently in favor of tariffs, quotas, and international agreements to restrict the influx of foreignmade goods. Policymakers have had to reckon with the likelihood that large deficits would galvanize labor into taking further political action and would revive the coun try’s latent but deep-seated protectionism. Nor is industry all out for free trade. Indus try may oppose deficits for much the same reason as labor—fear of competition from abroad. It's believed in many quarters that budding domestic industries have to be helped along until they’re able to compete with established foreign producers in world markets. The infant company is supposed to grow up and throw off its protective blanket after a while, but that isn't always the way it works. Many well-established U. S. industries retain powerful lobbies to keep trade controls that were set up when those industries were just getting off the ground. And American industry is not unique in its protectionist tendencies. Foreign producers often lobby to obtain similiar protection from their own governments. The Government Responds. The combina tion of fixed exchange rates with declining reserve assets, resentment at home and abroad, and pressure from special interest groups led the U . S . to adopt deficit-reducing policies during the 1960s. These policies pro duced restrictions on long-term foreign investment by American citizens, guidelines for bank lending to foreigners, and ceilings on overseas direct investment—all programs designed to slow capital outflows. In another BUSINESS REVIEW program, called Operation Twist, policymak ers attempted to encourage economic growth by lowering long-term interest rates while raising short-term rates to attract for eign capital. Other measures subsidized export credits with loans at below-market rates and lowered duty-free allowances for tourists bringing home foreign goods. The government increased its preferences for goods from domestic suppliers. Even defense and foreign aid were affected by the balance of payments. The Armed Services Procure ment Regulations required military depart ments to buy munitions at home under the Buy American program despite the higher cost. And receipt of foreign aid was tied to purchase of American goods. Throughout, the government acted to maintain a fixed exchange rate for the dollar. These initiatives may have held down the size of succeeding deficits. But since they were in basic conflict with an open trade and payments system, they were not without costs of their own. Capital controls restricted prof itable U.S. investment abroad. Higher short term interest rates raised the cost of domestic borrowing at home. Restrictions on the entry of foreign goods narrowed the range of choices for the U.S. consumer at the same time that export subsidies increased his tax burden. And the Buy American program raised the cost of maintaining a defense estab lishment which already had come under intense public scrutiny for high spending. Any measures to reduce deficits would have produced costs somewhere, and under fixed rates policymakers wanted deficits kept small to maintain international economic stability. But now fixed exchange rates are gone, and deficit figures no longer mean what they used to. Yet some of the policies linger on. EVENTS OUTMODE POLICIES The system of fixed but adjustable ex change rates came under increasing pres sure in the late 1960s and early 1970s. This pressure was reflected in larger movements of NOVEMBER/DECEMBER 1976 speculative capital, tighter payments restric tions, and more frequent changes in currency values. When dollar-to-gold convertibility was suspended in 1971, many countries let their currencies float against the dollar. Exchange rates were fixed again, temporarily, by the Smithsonian Agreement, but new monetary crises facing the British pound and other currencies hastened the evolution toward floating rates. By spring 1973, all of the leading currencies were floating jointly or independently. Now thedollar is relatively free to riseorfall in value against other currencies. Capital still moves from country to country, and some countries' balances are in surplus while others are in deficit. But whereas under fixed rates the U.S. would face a loss of reserve assets when the dollar was threatened, under flexi ble rates the exchange-rate mechanism itself makes the required adjustment by letting the dollar fall in value. Nowadays, governments generally avoid trying to fix exchange rates at predetermined levels as they did prior to 1973.1 Monetary authorities still intervene in the exchange markets, but mostly to quiet temporary disorders rather than to mask underlying economic conditions. Thus the floating-rate system eliminates some of the undesirable repercussions of a deficit over the long haul and reduces the usefulness of some traditional measures of the balance of payments (see Box). In fact, floating rates actually tend to cor rect deficits and to move international pay ments balances back toward equilibrium. Suppose, for example, that the U.S. were to run a large current account deficit for a year or two and the dollar excess were to reduce nEven und er floating rates c u rre n cy values are m an aged to som e extent. The most im portant d e p artu re from the floating-rate system as describ ed in the text is the snake— a jo in t float adopted by several co u n tries of the European C o m m u n ity. C en tral banks of the snake c o u n tries intervene to keep c u rre n cy -va lu e fluctuatio ns against one another w ithin narrow lim its, but they allow th eir cu rren cies to float jo in tly against the d o llar and other outside cu rren cies. 14 FEDERAL RESERVE BANK OF PHILADELPHIA BOX NEW DEVELOPMENTS ALTER MEANING OF PAYMENTS MEASURES The new international monetary system not only reduces the importance of balance-ofpayments measures but also makes the old reporting system obsolete. Until recently, the major focus of U. S. balance-of-payments policy was on the three overall balances—the basic balance, the net liquidity balance, and the official reserve transactions balance. As the international monetary system moved to floating exchange rates, these overall measures came to be misinterpreted by the public. As a result, the President's Advisory Committee on the Presentation of Balance of Payments Statistics suggested that none of these balances be used to measure international transactions of the U. S. and that the words 'deficit' and 'surplus' be avoided as much as possible in press releases.* Some partial balances, such as the merchandise trade and current account balances, will be listed as memorandum items, but the emphasis has shifted from concentrating on one of the overall balances to analyzing information on several classes of international transactions. Capital transactions, for example, now are grouped so that foreign assets in the United States are broken down into transactions with foreign official institutions and transactions with foreign banks or individuals. Of the three measures that have been discontinued, the official reserve transactions balance was most closely tailored to the fixed-exchange-rate system. This balance includes merchandise trade, services, and remittances, as well as long-term and short-term capital flows. It indicates the surpluses and deficits arising from all these transactions, which are financed by changes in official reserve assets. (Official reserves include gold, Special Drawing Rights, foreign currencies, and borrowings from the International Monetary Fund). In short, this balance was intended to reflect the extent of official intervention required to maintain fixed exchange rates. A deficit, for instance, was interpreted to mean that foreign countries had intervened to support the dollar. As the system of floating rates evolved, the official reserve transactions balance lost much of its meaning. Exchange market pressures on the dollar now are indicated mainly by changes in exchange rates, not by changes in official reserves. And dollar accumulations by foreign official institutions ordinarily are matters of preference rather than obligation—witness the large investment in dollar assets by oil-producing countries. The net liquidity balance focused on changes in the international liquidity position of the U. S. It included all transactions except liquid private capital flows, liabilities to foreign official agencies, and official reserve assets. Once thought to measure the potential pressure on U. S. primary reserve assets, it was a way of checking that foreign claims did not become so large that the U. S. would be unable to meet them if they were presented for payment. Since the dollar no longer is convertible into gold, this threat is gone. And there are serious statistical problems in the distinction this balance makes of liquid from nonliquid capital transactions. The balance on current account and long-term capital (basic balance) was intended to capture stable underlying economic trends. It included merchandise trade, services, remittances, and long term capital flows. This balance also presented statistical difficulties. Long-term capital flows sometimes have effects quite similar to those of short-term flows. But the arbitrary methods of distinguishing these flows made this balance an unsatisfactory indicator of long-term trends. " “ R epo rt of the A d visory C o m m ittee on the Presentation of Balance of Paym ents Statistics,” Statistical ■ R e p o rte r 76 (1976), pp. 221-238. 15 BUSINESS REVIEW the value of U.S. currency. What would happen? It would take more dollars to buy units of other currencies and commodities priced in other currencies, so the dollar prices of imports would rise and Americans would shift their demand toward domestic goods. At the same time, the foreign currency prices of U. S. goods sold abroad would drop, and foreign consumers would shift their demand toward U.S. goods. After a period of adjustment, the lower dollar value would encourage Ameri cans to buy fewer imports and sell more exports; and both actions would tend to reduce the deficit. Although floating exchange rates make long periods of payments deficits unlikely, some hefty short-term deficits still may occur. Outside forces, such as sharp rises in foreign commodity prices, could push an importing country into a deficit position for several years. The recent jump in oil prices, for exam ple, played hob with the payments balances of many oil-importing nations. Or deficits could be caused by fundamental internal weaknesses, such as the high domestic infla tion rates that are plaguing some nations. Policymakers may well want to take steps that deal with domestic sources of economic weakness. But whether they do or not, the system of flexible exchange rates will lead al most inevitably to currency realignments that tend to reduce deficits and some of their undesirable repercussions.2 2Policym akers in som e co untries are suggesting that the curren t system of floating rates has com e up short on several counts. They contend that exchange-rate fle x ib il ity does not relieve the need to m ake painful dom estic eco no m ic adjustm ents w hen a c o u n try ’s p rices, p ro d u c tion, and trade get out of alignm ent w ith those of sim ilar countries. They argue that floating rates may have w o r sened inflation in such co untries as Britain and Italy. And they m aintain that floating rates may im pose costs not only on individual co untries but also on the intern ation al eco no m ic system itself. For a discussion of both sides of this issue see my “ W ould Fixed Exchange Rates C ontrol In flatio n ?’’ Business R e v ie w , Federal R eserve Bank of Ph iladelp hia, July/A ug u st 1976, pp. 3-10. NOVEMBER/DECEMBER 1976 EASING UP ON RESTRICTIONS Though old ideas die hard, many observers of international economic devel opments now think it better not to direct ad hoc policies toward correcting a U.S. pay ments deficit. The basic strategy under float ing rates is for the government to pursue monetary and fiscal policies that it expects will lead to a desired rate of economic growth and acceptable inflation, and it lets the payments balance fall where it may.3 Current U.S. domestic economic and payments policies have as a goal the stability of the economic system overall. Beyond that, these policies aim toward allowing market forces to play a major role in determining payments positions and exchange rates. Despite some protec tionist provisions in the Trade Act of 1974, the main thrust of U.S. trade policy is directed toward establishing and preserving an open trade and payments system. The limitations on trade and investment that were imposed in the 1960s do not fit well with current U.S. payments policies. Because of this, most controls on capital flows have been removed. The way is open to move further toward dismantling restrictive poli cies, but this movement probably will be gradual. The U.S. may not be in a position to alter its procurement practices or cut off subsidized export credits, for example, until other nations agree to do the same. And that may take time. In the interim, having restric tions may serve the useful purpose of provid ing bargaining leverage with other countries. In sum, the U.S. still seeks economic stability, not only for itself but for all nations. Under the fixed-rate system, stability required the avoidance of payments deficits; but with floating exchange rates, the relative values of currencies constantly readjust to changing international conditions. Therefore deficit and surplus measures don't mean what they used to mean and so they are being deemphasized. Indeed it would be inconsist 3See F. Lisle W id m an , “ U .S . Balance of Paym ents P o licy,” D epartm ent o f the Treasury N ew s, M ay 24,1976. 16 FEDERAL RESERVE BANK OF PHILADELPHIA ent with present developments to tie domes tic and foreign economic policy decisions to these figures in the same way as before, ignoring the flexibility of exchange rates and the complexity of international capital move ments. S AVAILABLE UPON REQUEST ■ ■ • STUDIES IN SELECTIVE CREDIT POLICIES edited by Ira Kami now James M. O’Brien Single copy free. Additional copies $2 each. Requests should be addressed to Studies in Selective Credit Policies, Department of Research, Federal Reserve Bank of Philadelphia, Philadelphia, PA 19106. Checks should be made payable to the Federal Reserve Bank of Philadelphia. 17 BUSINESS REVIEW NOVEMBER/DECEMBER 1976 S e r ie s fo r E c o n o m ie E d u c a tio n THE MYSTERY OF ECONOMIC GROWTH FEDERAL. RESERVE BANK OF PHILADELPHIA S.E.E. is designed for easy understanding and wide distribution. Additional pamphlets will appear at irregular intervals. Multiple copies are available free for distribution by organizations such as businesses, schools, unions, trade organizations, and banks. Copies are available free of charge. Please address all requests to the Department of Public Services, Federal Reserve Bank of Philadelphia, Philadelphia, Pennsylvania 19106. 18 The Philadelphia Fed’s Research Department occasionally publishes RESEARCH PAPERS written by staff economists. These papers deal with local, national, and international economics and finance. Most of them are intended for professional researchers and therefore are highly technical. To order copies, simply mark which ones are desired, detach this order form, place it in an envelope, and send it to the Department of Research, Federal Reserve Bank of Philadelphia, Philadelphia, PA 19106. Your copies will be sent to the address on the mailing label overleaf. CURRENTLY IN PRINT □ 1. Intradistrict Distribution of School Resour ces to the Disadvantaged: Evidence for the Courts, Philadelphia School Project by Anita A. Summers and Barbara L. Wolfe EH 4. Required Reserve Ratios, Policy Instru ments, and Money Stock Control by Ira Kaminow EH 5. The Information Value of Demand Equa tion Residuals: A Further Analysis by James M. O’Brien EH 6. Equality of Educational Opportunity Quan tified: A Production Function Approach, Philadelphia School Project by Anita A. Summers and Barbara L. Wolfe EH 10. EH 11. EH 12. EH 14. EH 15. EH 7. Pennsylvania Bank Merger Survey: Sum mary of Results by Cynthia A. Glassman EH 16. EH 8. Manual on Procedure for Using Census Data to Estimate Block Income, Philadel phia School Project by Anita A. Summers and Barbara L. Wolfe EH 17. EH 9. Block Income Estimates, City of Philadel phia: 1960 and 1970, Philadelphia School EH 18. Project by Anita A. Summers and Barbara L. Wolfe Optimal Capital Standards for the Banking Industry by Anthony M. Santomero and Ronald D. Watson A Unified Model of Consumption, Labor Supply, and Job Search by John J. Seater Utility Maximization, Aggregate Labor Force Behavior, and the Phillips Curve by John J. Seater On the Role of Transaction Costs and the Rates of Return on the Demand Deposit Decision by Anthony M. Santomero Spectral Estimation of Dynamic Economet ric Models with Serially Correlated Errors by Nariman Behravesh Empirical Properties of Foreign Exchange Rates under Fixed and Floating Rate Regimes by Janice Moulton Westerfield A Model of Vacancy Contacts by Job Searchers by John J. Seater The Effect of the Local Public Sector on Residential Property Values in San Mateo County, California by Nonna A. Noto rKDIRAL RE8ERVK DANK FCDKKAL RX8ERVX BANK FEDERAL RESERVE BANK o f PHILADELPHIA PHILADELPHIA, PENNSYLVANIA 19106 business review FEDERAL RESERVE BANK OF PHILADELPHIA PHILADELPHIA, PA. 19106