Full text of Review (Federal Reserve Bank of St. Louis) : November 1971

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FEDERAL RESERVE BANK
OF ST. LOUIS
NOVEMBER 1971




M onetary Policy and Relative Prices
Germ an Banks as Financial Department
Stores .................................................... 8
The Flexible Exchange Rate: G ain or
Loss to the United States ....................... 14
Regional and Multilateral Dimensions of
the United States Balance of Paym ents.....21

Monetary Policy and Relative Prices
in an Incomes Policy
by R. ALTON GILBERT

M

ONETARY policy will have an important influ­
ence on the effectiveness of the President’s program
for achieving price stability through direct controls of
wages and prices. Lasting price stability requires a
prudent course of monetary action.
The prospects for achieving price stability and full
employment sooner with wage and price controls than
with traditional monetary and fiscal actions alone de­
pend on the ability of the wage and price controls to
dampen expectations of inflation. Until expectations of
inflation are substantially reduced, inflationary pres­
sures will remain strong even though measured prices
are constrained by government controls. The role of
monetary policy is to keep the expansion of aggregate
demand in line with the expansion in productive
capacity.1 Given an excessive rate of monetary expan­
sion, inflation will break into the open as soon as
government controls are removed.
Besides the rate of monetary expansion, the viabil­
ity of a system of price and wage controls may depend
upon how closely the individual prices and wages
fixed by administrative decisions correspond to the
relative prices and wages that would exist without
controls. A program for slowing the rate of inflation
through direct controls is implemented through con­
trols on wages and prices in individual industries,
whereas under traditional stabilization policies the
structure of wages and prices among industries is
!This statement about the role of monetary policy does not
imply that price stability is the only objective of monetary
policy. Full employment is also a policy objective. There is
assumed to be no long-run trade off between the rate of
inflation and the unemployment rate, and therefore, price
stability and full employment can be achieved simultane­
ously if the rate of monetary expansion remains moderate.
For a discussion of the inflation-unemployment trade off, see
Roger W. Spencer, “The Relation Retween Prices and Em­
ployment: Two Views,” this Review (March 1969), pp.
15-21.
Digitized for Page 2
FRASER


determined by the price system. The rate of eco­
nomic recovery will probably be influenced by the
impact the decisions of the pay board and price com­
mission will have on the profit and labor shares of
income. The allocation of output among industries
will be influenced by the structure of wages and
prices established by the control boards.
The role of monetary policy in an incomes policy of
wage and price controls is analyzed in the first part of
this article. Inflation is analyzed as a response to rapid
monetary expansion. The prospects for achieving price
stability through wage and price controls are dis­
cussed in terms of the monetary explanation for
inflation. The prospects for economic expansion and
an efficient allocation of resources under wage and
price controls are discussed in the second section of
the article. The issues analyzed are:
(a ) the relation between economic recovery and the
profit share of income, and
( b ) the effects of individual wage and price deci­
sions on the allocation o f investment, employ­
ment, and output among industries.

Monetary Policy and Inflation
Two Views on Inflation and Controls
The success that wage and price controls can be
expected to have in dampening inflationary pressures
depends upon the type of forces that initiate inflation
and the reasons for persistent inflation when resources
are no longer fully utilized. In one view, inflation is
the result of increases in the market power of firms
and labor over the prices they charge. Inflation
due to rising market power is considered relatively
insensitive to traditional monetary and fiscal policies.
According to this view of the inflationary process, one
means of dealing directly with inflationary forces is
wage and price controls.

FEDERAL RESERVE BANK OF ST. LOUIS

An alternative explanation for inflation, the explana­
tion followed in this article, is that the rate of inflation
is determined by the trend of aggregate demand.2
The rate of increase in aggregate demand has been
observed to be directly related to the rate of growth
of the money stock.3 With the cconomy at full em­
ployment, the rate of inflation is related to the rates
of increase in aggregate demand and productive ca­
pacity. If aggregate demand increases faster than
productive capacity, prices will rise to clear the
markets for output.
After prices have been rising for some time due to
excessive growth in aggregate demand, expectations
of continued inflation begin to affect negotiations for
wages and prices. Even as the rate of output expan­
sion declines because of a reduction in the rate of
monetary expansion, prices may continue to rise due
to the general expectation of inflation and the wage
and price demands of the workers and firms who have
not yet adjusted their wages and prices to the inflation
that has already occurred. Inflationary pressures can
be gradually eliminated through moderate monetary
expansion. With a moderate expansion of the money
stock, aggregate demand does not rise fast enough to
purchase full-employment output at the price level
that is generally expected to exist. Wages and prices
then gradually respond to the emergence of excess
capacity.

Slowing Inflation as an Adjustment Process
The emergence of inflation since 1965 can be an­
alyzed in terms of the monetary explanation for infla­
tion. From the second quarter of 1965 to the first
quarter of 1969, the money stock rose at a 5.6 per cent
annual rate, compared to a 2.9 per cent rate in the
previous 5 years. In the three and a half years from
the second quarter of 1965 to the fourth quarter of
1969, total spending rose at about an 8 per cent
annual rate, compared to a 6 per cent rate in the
previous 5 years. The rate of growth in the money
stock slowed in 1969, rising at a 2.8 per cent annual
rate from the first quarter to the fourth quarter of
1969, compared to a 7.9 per cent growth in the previ­
ous year. Due to the lag in the effects of a change in
the rate of money growth on spending, the growth
rate of aggregate demand did not slow significantly
until the fourth quarter of 1969.
2For a more thorough discussion of the market power and
monetary^ expansion explanations for inflation, see Keith M.
Carlson, “ Slowing in Money Growth: The Key to Success in
Curbing Inflation,” this Review (October 1971), pp. 2-5.
3See Leonall C. Andersen and Keith M. Carlson, “ A Mone­
tarist Model for Economic Stabilization,” this Review (April
1970), pp. 7-21.



NOVEMBER 1971

The economy had reached full employment by
1965, so that increases in output were constrained by
the growth of productive capacity, estimated at about
4 per cent per year. The general price level rose at
about a 4 per cent annual rate from the second quarter
of 1965 to the fourth quarter of 1969, compared with
a 1.4 per cent rate of increase in the previous 5 years.
The money stock rose 5.1 per cent from the fourth
quarter of 1969 to the fourth quarter of 1970. Due to
restrictive monetary policy in J989 and moderate mon­
etary expansion in 1970, spending rose 4.3 per cent
during the 1969-70 recession, compared with 6.5 per
cent in the previous year. The general price level rose
5.7 per cent from the fourth quarter of 1969 to the
fourth quarter of 1970, compared with a 5.1 per cent
increase during the previous year. The decline in the
rate of economic activity in late 1969 failed to retard
price increases because of cost pressures and the ex­
pectations of continued inflation. The continued cost
pressures resulted from demands for higher nominal
wages by workers who had their real wages reduced
by unanticipated inflation and the inflationary an­
ticipations of workers gradually formulated during
the 1965-69 period.
Total spending in the economy has increased 7.7
per cent since the third quarter of 1970, a signifi­
cant acceleration from the 4.6 per cent rise in the
previous year. The expansion in aggregate demand
is partially a response to the rapid growth in the
money stock in the first half of 1971. Due to the
continuing adjustments outlined above, however, most
of the increase in total spending has been translated
into price increases. The 4.7 per cent annual rate of
increase in the general price level from the fourth
quarter of 1970 to the second quarter of 1971, com ­
pared with a 5.7 per cent increase in the previous
year, shows the rate of inflation started to slow before
the price freeze was initiated.

The Current Role of Monetary Policy
The success of the government’s program for re­
ducing inflationary pressures through direct controls
on wages and prices is now discussed in terms of the
monetary explanation for inflation. One condition for
success of the program is a faster reduction in infla­
tionary expectations than with traditional stabiliza­
tion policies alone. If expectations of inflation can
be reduced more quickly through wage and price
controls, the economy can attain full employment and
price stability sooner. The success of the New Eco­
nomic Program also depends upon the rate of expan­
sion in aggregate demand during the period of con­
trols. If aggregate demand expands rapidly, consum­
Page 3

FEDERAL RESERVE BANK OF ST. LOUIS

NOVEMBER 1971

Lab or Sh are of G N P Produced in Private Sector
(All Em ployees)
Per C e n t

8

C o rp o ra te Profits A fte r T a x e s a s a Per Cent of G N P Pro duce d
in Private Sector

Jj

PerCent

I I I
J r \IaJL,
J I
\M
I 1I
/
I I
1 1 1
:

PerCent

=

\l
f
I ,’

Source: U.S. Department of Commerce
Shaded areas represent periods ol business recessions os delined by the National Bureau ol Economic Research,
latest doto plotted: 2nd quarter 1971
Source: U.S. Deportment ol lobor
Shaded areas represent periods ol business recessions os defined by the Notionol Bureau of Economic Research,
lotest data plotted: 3rd quarter 1971

ers will demand more goods and services than firms
wish to supply at the officially established prices. In
such a situation, there would be pressures to evade
the wage and price controls. Inflation could take
such forms as quality deterioration and the develop­
ment of black markets.
The role of monetary policy in controlling inflation
under an incomes policy is the same as the role with­
out an incomes policy — to keep the expansion of
aggregate demand in line with the growth of poten­
tial output. If the relations observed in the past be­
tween changes in the money stock and aggregate
demand continue to hold during the New Economic
Program, the rate of increase in aggregate demand in
the near future will be partially determined by past
monetary actions. The rate of monetary expansion
was rapid earlier this year. The money stock increased
at a 10.5 per cent annual rate between December and
June and has increased at a 1.6 per cent rate since
June. With the lagged effect of changes in the money
stock on total spending, the near term outlook is for
expansion of total spending in the economy. Current
monetary expansion will influence how rapid the ex­
pansion in aggregate demand will be in the near
term.

Incomes Policy and the Adjustment Process
In attempting to deal with overall wage and price
inflation through direct controls, the pay board and
the price commission will influence the allocation of
income between wages and profits and the relative
wages and prices among industries. The allocation of
income between wages and profits and relative wages
and prices were in a process of change through the
price system before the wage and price controls were
Digitized for Page 4
FRASER


established. This allocation of income in the near
future is likely to affect the rate of economic recovery
through the effect the profit share has on investment.
The degree to which changes in relative wages and
prices among industries in the near future replicate
the changes that would have occurred without wage
and price controls will determine the degree to which
resources will be allocated efficiently. Resources are
allocated efficiently if they are used to produce the
combination of goods and services that yields the
greatest consumer satisfaction. An incomes policy that
allows for changes in wages, prices, and income dis­
tribution consistent with the goals of overall price sta­
bility, economic recovery, and efficient allocation of
resources will be difficult to design.

The Allocation of Income
One of the most prominent effects of the rapid
economic expansion initiated in 1965 was a relatively
large shift in income distribution of the private sector
between labor income and returns to capital. The ac­
companying charts show after-tax corporate profits
and compensation of employees as portions of total
private product. Both the profit and labor shares of in­
come have varied cyclically. The labor share tends to
rise, and the profit share tends to fall during a period
of economic expansion; the pattern is reversed during
periods of recovery.4 Since 1965 labor compensation
4For additional information on the cyclical pattern of the
profit share of income, see Thor Hultgren, Cost, Prices, and
Profits: Their Cyclical Relations, (New York: National Bu­
reau of Economic Research, 1965), pp. 78-97. There is an
inconsistency in the tax treatment of the income shares used
in this article in that profits are measured after taxes and labor
compensation is measured before the taxes workers pay. Both
corporate profits before taxes and corporate profits after taxes
could be used to measure the profit concept in this article.
Profits after taxes are used as a better estimate of the re­
turns on investment. These two measures of profits as a
fraction of income have similar cyclical patterns.

NOVEMBER 1971

FEDERAL RESERVE BANK OF ST. LOUIS

unit of output rose faster than prices during
the 1965-70 period, the share of the firms’
revenues allocated to wages increased; a
smaller share of revenue was left for other
income categories.

Table 1

W ages,

Prices c nd Em ploym ent b y Industry
(A n n u al Rates of C hange)

1 96 0 -1 96 5

Construction
Services
Trade
Finance
Manufacturing
Communication
Transportation
Utilities
M in in g
Agriculture

Produc­
tivity3

3 .0 %
3.1
2.4
2.8
1.9
3.5
2.9
3.2
2.5
3.5

4 .2 %
4.4
3.6
4.0
4.0
4.4
4.0
4.4
3.7
4.6

-0 .7 %
1.1
2.9
3.0
4.6
6.7
5.5
5.0
4.5
4.7

4 .9 %
3.1
0.7
1.0
-0 .6
— 1.9
— 1.4
-0 .6
-3 .5
0.0

2.3 %
3.2
2.0
2.3
1.5
0.9
-0 .5
0.3
-1 .9
— 2.9

2 .8 %

4.0 %

3.3 %

0 .6 %

1 .7 %

-2 .0 %
-0 .4
+ 0 .5
-0 .8
1.2
3.3
2.5
3.6
3.3
3.8

9 .5 %
7.4
4.6
6.9
4.1
2.1
3.5
2.5
3.3
4.8

1 .6 %
3.9
3.4
4.0
1.4
5.0
1.1
2.0
-0 .3
-3 .5

Real
W age s

5 .2 %
3.1
0.9
1.3
0.3
— 0.1
0.3
-0 .1
-1 .2
1.5

All Private Industries

1 .1 % *

Construction
Services
Trade
Finance
Manufacturing
Communication
Transportation
Utilities
M in in g
Agriculture

8 .2 %
6.0
4.2
4.2
2.3
0.1
2.0
0.6
1.5
3.8

EmployUnit
Labor Cost ment

W age s2

Prices

1 9 6 5 -1 97 0
3 .5 %
3.1
1.4
2.3
1.6
1.7
2.3
2.4
2.9
4.9

7 .2 %
7.0
5.1
6.1
5.3
5.5
6.1
6.1
6.7
8.8

If adjustments in the profit and wage
shares are allowed to continue in accord
with free market forces, and if historical pat­
terns prevail, the profit share will tend to
rise over the near term, and labor’s share of
income will tend to fall. With the economy
monitored by wage and price boards, a rise
in the profit share and a decline in the labor
share in the near future may be interpreted
by some observers as an undue concession
to business. However, such a reallocation is
to be expected during the recovery phase of
a business cycle in an economy without con­
trols on wages and prices. Any attempt to
thwart such a change in income shares
might hamper economic recovery.

Income Shares by Industry

The degree to which the labor share of
output rose between 1965 and 1970 varied
2 .4 %
All Private Industries
5 .8 %
0 .7 %
5 .0 %
3 .7 % *
2 .0 %
significantly among industries. As shown in
’ The real wage rate is calculated as compensation per employee divided by implicit
Table I, the relations between the rate of
price deflator for private GNP.
2
The wage rate is calculated as labor compensation per full-time equivalent employee.
change in prices and the rate of change in
Productivity is calculated as output per full-time equivalent employee.
unit labor cost varied among industries dur­
4This rate o f price change is for the private sector, which includes all of the above
private industries plus government enterprise and rest o f world.
ing the 1965-70 period. The labor shares for
Source: U. S. Department o f Commerce, Office o f Business Economics, Survey of
Current Business.
individual industries in 1965 and 1970 are
given in Table II.8 The rates of increase in
has accounted for a rapidly increasing portion of
labor shares were highest in the finance and com­
private income, rising from 52.8 per cent in 1965
munication industries, the industries in which the
to 56.7 per cent in 1970. During the same period
rates of increase in employment were highest between
corporate profits after taxes changed little on aver­
1965 and 1970 (see Table I). The rates of increase
age and accounted for a sharply decreasing portion
were lowest in the trade and agriculture industries.
of private income, from 7.5 per cent to less than
The annual rates of increase in the labor shares varied
from 2.6 per cent for the finance industry to 0.4 per
5 per cent.
cent for the trade industry.
The patterns of change in wages, prices, and pro­
Some of the variation in the rates of change in
ductivity demonstrate the forces behind the recent
labor shares may be due to differences among in­
decline in the profit share. Productivity increased
dustries in the degrees to which the labor shares
slowly in the 1965-70 period relative to the rate of
fluctuate over the business cycle. Trends in the labor
increase in previous years (see Table I ). With a rapid
shares vary among industries due to such factors as
increase in wages, unit labor cost rose at a 5.0 per
changes in the labor intensity of production. The rates
cent annual rate in private industries during the 1965of decrease in labor share can be expected to vary
70 period while output prices rose at a 3.7 per
cent rate in the private sector.5 Since labor cost per
5Unit labor cost equals labor compensation divided by physical
output, or the labor cost per unit of output.



6Only labor shares are given by industry and not profit shares
since the profit shares that would correspond to the overall
profit share in the accompanying chart are not available by
industry.
Page 5

FEDERAL RESERVE BANK OF ST. LOUIS

NOVEMBER 1971

Table II

Table III

Labor Sh are o f Incom e A m o n g Industries
1965

1 97 0

A n n u al Rate
of Change

Construction

7 3 .2 %

7 7 .8 %

60.9

64.9

1.3

Trade

56.5

57.6

0.4

Output

1 .2 %

Services

Allocation o f O utput an d Employment A m o n g
Private Industries

1 95 2
Construction

5 .3 %

Services

10.0

1 96 0
5 .0 %

1965
4 .2 %
10.3

1 97 0
3 .5 %
10.5

Finance

20.1

22.9

2.6

Trade

18.2

10.7
18.8

18.8

19.5

Manufacturing

65.7

71.8

1.8

Finance

12.9

14.7

14.9

14.9

Communication

43.8

48.4

2.0

M anufacturing

34.3

32.3

34.1

33.3

Transportation

65.7

70 .7

1.5

Communication

1.8

2.3

2.6

3.3

Transportation

6.1

5.2

5.1

5.2
3.2

Utilities

31.8

34.9

1.9

Utilities

2.1

M in in g

2.8

2.9

35.6

38.9

1.8

M in in g

3.4

3.0

2.7

2.6

Agriculture

14.1

14.8

1.0

Agriculture

5.8

5.3

4.5

3.9

Private Sector1

5 2 .8 %

5 6 .7 %

1 .4 %

1 96 5

1 97 0

Employment

1The private sector includes all o f the above private industries plus
government enterprise and rest o f world.
Source: U. S. Department o f Commerce, Office o f Business Econom­
ics, Survey o f Current Business.

1 95 2
Construction

6 .1 %

1 96 0
6 .1 %

6 .3 %

6 .1 %

Services

17.7

19.1

20.5

Trade

among industries during the current recovery because
of the cyclical and trend effects if wages and prices
change as they would without wage and price controls.

14.9
20.5

21.2

21.5

22.6

4.4

5.3

5.5

5.9

37.8

35.9

35.6

34.0

Finance
M anufacturing
Communication

1.8

1.8

1.7

1.9

Transportation

6.3

5.1

4.5

4.3
1.2

Utilities

The allocation of investment expenditure is directly
related to the relative rates of return on capital among
industries. The control boards will influence this allo­
cation to the extent that they influence the rates of
increase in the profit shares among industries. An in­
comes policy that is neutral with respect to the allo­
cation of investment seems difficult to design.

1.3

1.3

1.2

M in in g

2.1

1.5

1.3

1.1

Agriculture

5.0

4.1

3.3

2.4

Source: U. S. Department of Commerce, Office of Business Econom­
ics, Survey of Current Business.

private sector increased most rapidly in the services
and finance industries and decreased most rapidly in
the mining and agriculture industries.

Relative Prices and W ages
Reallocations of output and employment among in­
dustries will be necessary for efficient production in
the near future due to continuing changes in con­
sumer tastes and technology. The wage and price
boards should allow wages and prices to rise faster in
some industries than in others to avoid excess demand
for output in some industries and excess supply in
others. As an indication of trends in the reallocation
of output and employment among industries, Table
III shows the distribution of output and employment
among a ten industry breakdown of the private sector
in selected years. Between 1952 and 1970 the shares
of output produced in the agriculture, mining and
construction industries declined most rapidly, while
the shares in the communication, utilities, finance,
and trade industries increased most rapidly. During
the past 18 years, the shares of employment in the
Page 6



In a market economy this reallocation of output and
employment is achieved through the price system. Un­
controlled wages and prices respond to such forces as
changes in consumer taste and technology of produc­
tion.7 Table I shows the rates of change in prices and
real wages by industry for the periods 1960-65 and
1965-70 to give an indication of the degree of change
in relative wages and prices among industries during
the last ten years.
Firms and workers in different industries have been
adjusting their prices and wages to inflation at dif­
7Relative wages and prices also respond to such forces as
changes in the distribution of market power and the applica­
tion of laws, such as the minimum wage law. An examina­
tion of Tables I and III indicates that wages did not necessarily
rise fastest in the industries in which employment rose the fast­
est, and prices did not necessarily rise the fastest in industries
in which output rose the fastest.

NOVEMBER 1971

FEDERAL RESERVE BANK OF ST. LOUIS

ferent rates. Variation in the length and expiration
date of labor and output contracts affects the degree
to which expectations of inflation influence current
transactions. Wages and prices tend to rise faster at
those firms in which both the workers and manage­
ment have higher than average expectations of infla­
tion. For these reasons, the relative prices and wages
that exist at any one point in the adjustment process
of reducing the rate of inflation may not be consistent
in the long run with the existing composition of
demand for output among industries. Maintaining the
relative wages and prices that existed immediately
before the price and wage controls were initiated
could slow an adjustment process necessary for an
efficient allocation of resources, even if there were no
change in the allocation of demand among industries.8
8The economy tends to be in a state of disequilibrium in the
formation of relative wages and prices among industries
and the allocation of resources in response to continuing
changes in the allocation of demand among industries. As
indicated above, there were additional reasons for disequilib­
rium at the time when price and wage controls were initiated.
For a more thorough discussion of price formation in a
changing economy, see Armen A. Alchian and William R.
Allen, University Economics (Belmont: Wadsworth Publish­
ing Co., 1967), pp. 274-355.




Conclusion
The success of the President’s New Economic Pro­
gram in achieving full employment and price stability
is dePendent upon several important, and somewhat
neglected, aspects:
1. An effective system of wage and price controls
can reduce inflationary pressures faster than with
traditional stabilization policies alone if it suc­
ceeds in eliminating expectations of inflation
sooner than otherwise.
2. A moderate rate of monetary expansion is essen­
tial to the maintenance of a rate of increase in
aggregate demand consistent with the dampen­
ing of fundamental inflationary pressures.
3.

The rate of econom ic recovery will be influenced
by the increase in the profit share o f income
allowed b y the pay board and price commission.

Relative wages and prices among industries should
be relatively free to change in response to changes in
consumer tastes and technology if resources are to be
allocated efficiently and the progress of economic re­
covery is not to be hampered.

Page 7

German Banks as Financial Department Stores
by DIETHER H. HOFFMANN

This paper was presented by Dr. Diether H. Hoffmann, Member of the Board of
Management of Bank fur Gemeinwirtschaft, Frankfurt, at Ohio State University, Co­
lumbus, Ohio, on November 30, 1970. He also discussed the paper in the Research
Department at the Federal Reserve Bank of St. Louis.

j ^ E W DEVELOPMENTS in the banking industry,
greater demands for more adequate services, and the
necessity to finance much larger operations have in
recent years led many persons in the United States
to ask whether the U.S. banking structure is adequate
or whether changes should be made. For a discussion
of such problems, it is useful to look across borders.
Of course, it is impossible to simply copy the system
of another country, because both the historical de­
velopment and the interrelationships with other sys­
tems in that country have a bearing on the function­
ing of a banking system. But a comparison, for ex­
ample, of the German with the U.S. banking structure
at least clarifies alternatives, and even raises certain
questions which may not arise if all the elements of a
system are taken for granted.

savings institutions and their central banks; 7,072 co­
operative banks and their central institutions; 46 long­
term banks; 180 finance companies; and 102 institu­
tions which have special functions discussed later.
In addition, we have building societies with total
deposits of 40 billion marks (D M ) as deposits in the
giro system and almost 10 billion DM as savings
deposits.2

German Financial Institutions

A unique and significant feature of the German
banking system is the importance of our savings in­
stitutions, most of which are owned by the munici­
palities. These institutions were established during

The credit institutions reporting to our central bank,
the Bundesbank, have total deposits from the non­
bank public of 447 billion DM. Distribution of these
deposits among the credit institutions indicates their
relative importance. Commercial banks hold 113 bil­
lion DM (59 billion DM are held by three banks).
Savings institutions and their central banks hold 188
billion DM, of which 126 billion DM are savings de­
I
do not think it is appropriate for me to take a
posits. These savings deposits are very steady money
position on the current discussions in the United
which a banker can almost consider as long-term
States. This is your discussion, and you as citizens will
money, even though most of them can be withdrawn
have to work out the appropriate answers. I shall,
on three months’ notice. The cooperative banks and
therefore, restrict myself to describing how the bank­
their central institutions hold 55.5 billion DM , the
ing system is organized in Germany. I shall try not to
largest portion of the remaining 146 billion DM. The
delve too deeply into our history; rather, I shall de­
credit institutions also have issued bonds amounting
scribe the present situation and some of the discus­
to 119 billion DM.
sions prevailing in Germany.1

In the Federal Republic of Germany we have about
8,500 credit institutions: 305 commercial banks; 844
iAll data, unless otherwise stated, are as of December 31,
1970.

Page 8


2The mark-dollar exchange rate has been about 3.65.

NOVEMBER 1971

FEDERAL RESERVE BANK OF ST. LOUIS

Table I

A ssets a n d Liabilities o f B an k in g Institutions in G e rm a n y
(M illio n s of M a rk s)
Assets

Liabilities

Year

Total
Volume of
Business

Total
N o n ban k
Loans

Savings
Deposits

Total
N onban k
Deposits

All Banking
Groups

196 0
1964
196 7
1970

2 5 2 ,5 1 8
4 0 8 ,0 3 8
5 6 2 ,8 4 6
8 22 ,15 8

154 ,89 8
2 6 1 ,2 1 9
3 5 6 ,2 2 8
5 1 0 ,5 9 8

5 2 ,8 6 4
9 3 ,5 0 0
144 ,67 2
2 0 8 ,6 8 7

104,051
2 3 3 ,4 9 9
3 1 9 ,8 5 6
4 4 7 ,0 5 8

Commercial
Banks

1 96 0
1 96 4
1967
197 0

6 1 ,6 2 6
91,581
1 24 ,08 5
2 0 3 ,6 0 9

36 ,0 9 7
5 5 ,7 3 9
74,0 0 5
115 ,94 2

8,161
14,055
24,9 5 0
34,211

20 ,224
5 4 ,9 0 6
75,851
113 ,01 3

Savings Bank Sector
(G iro Institutions &
Savin gs Banks)

1 96 0
196 4
1967
197 0

9 0 ,3 3 9
1 49 ,42 9
2 14 ,87 8
3 1 4 ,9 5 3

52 ,6 8 5
9 3 ,0 1 9
130 ,8 5 3
191 ,96 5

33,811
5 9 ,8 4 9
89,752
126 ,3 1 6

4 8 ,4 9 7
96,0 5 5
1 33 ,87 7
187,461

Cooperative Bank
Sector (Central
Institutions & Credit
Cooperatives)

1960
1 96 4
1 96 7
1 97 0

21 ,683
39,2 0 5
5 9 ,8 5 5
9 4 ,4 1 7

11,100
19,773
28,686
45 ,8 9 2

Other Banking
Institutions*

1 96 0
196 4
1967
197 0

7 8 ,8 7 0
127 ,82 3
1 64 ,02 8
2 0 9 ,1 7 9

5 5 ,0 1 6
9 2 ,6 8 8
1 2 2 ,6 8 4
1 56 ,79 9

G roup

♦Mortgage banks, finance institutions, banks with special functions, and
offices.
N OTE: The mark-dollar exchange rate in December 1970 was 3.6480.

the last century to safeguard the small saver — the
laborer, the artisan and the small shopowner — against
criminal or immoral practices in general and to en­
courage the spirit of saving. Considering the size of
their deposits, they did very well in fulfilling this
task. They also serve their communities by being very
active lenders, holding about 23 per cent of all loans
extended by credit institutions to the nonbank public.
During the last ten years, they have become partners
as well as competitors in almost all the other fields in
which commercial banks operate. Their central banks,
the Girozentralen, are established in each state and
are particularly active in loans to big corporations and
in long-term lending. Table I further illustrates the di­
vision of business among the various credit institutions.

Competition in the German Banking Industry
Competition in the German banking industry is
very keen. Until a few years ago, however, we had
several regulations limiting competition. Government
fixed the rates for deposits and loans and even told
banks how to advertise and approach their customers.
All these limitations were rescinded in 1967. Now the
only constraints are those imposed by the market and
the cost/eamings structure of each bank, which limit



the interest rates paid or de­
manded. Banks are no longer
required to refrain from cer­
tain methods of advertising or
soliciting new customers, as
long as these methods do not
violate the national laws on
competition, which are strict­
er than those prevailing in
the United States. This new
freedom has led to sophisti­
cated promotional incentives
for the saver. Debtors are
more aware now that interest
rates are not dictated by the
banks, but can be negotiated.

After four years during
which German banks have
worked in this more liberal
atmosphere, I feel justified in
3,283
2 2 ,649
stating that this greater free­
5,208
5 9 ,8 4 7
6,895
8 9 ,8 3 0
dom has assisted in enhanc­
10,006
9 1 ,0 6 5
ing growth in the economy in
postal giro and savings bank
general, and in particular,
has aided the smaller cus­
tomer. Competition for small
deposits and personal loans only became effective
after the former limitations were rescinded. Now,
banks too have to prove their efficiency to their cus­
tomers in the free market. In general, they have
succeeded in this effort. The fear that increased com­
petition could easily lead to more bankruptcies of
smaller banks was unjustified; very few banks have
failed during these years.
7,609
14,388
23,0 7 5
3 8 ,1 5 4

12,681
22,691
2 0 ,298
5 5 ,5 1 9

One of the first promotional incentives was a special
savings certificate for the small saver, with interest
rates which are not fixed according to the contracted
time of deposit, but which rise according to the ac­
tual time of deposit. This complements the theory that
small deposits have a tendency to stay for a much
longer period than agreed upon when the deposit is
made. Another incentive was a casualty insurance for
the saver. The German insurance authority, however,
permitted this practice only under the condition that
the saver pay a special premium for the insurance,
making such an incentive unattractive as a tool of
competition since the premium would have to be de­
ducted openly from the interest rate.
The interest rate for three-month savings deposits,
the rate generally considered the guideline for all
Page 9

FEDERAL RESERVE BANK OF ST. LOUIS

savings and time deposit rates, is currently about 4.5
per cent; for four-year deposits it is up to 7 per cent.
Larger sums deposited over the year-end as regular
term deposits could earn up to 8.5 per cent. Demand
deposits generally bear Vs per cent interest. Table II
shows the development of the rates for three-month
term deposits of sums under one million DM.
The discount rate of the Bundesbank is the guide­
line for bank loan rates. Short-term business loans are
issued at a margin above the discount rate. The prime
rate is about 3.5 per cent above the Bundesbank
discount rate. Bates for customers which do not get
the prime rate are about 1 per cent higher. W ho gets
prime interest rates generally is decided by the stand­
ing of the borrower; other circumstances, such as the
amount of business the customer conducts at the
bank and his total deposits, are only of secondary
importance in this respect. The rates are either flat
rates or subject to additional charges, particularly
those linked to the turnover on the accounts; the in­
strument of compensating balances is not in use.
Although there is competition among the banks as
far as the margin above the Bundesbank rate is con­
cerned, in general, the Bundesbank’s discount rate
affects directly the cost of borrowing from a bank.
German bankers are discussing the American system
of setting the prime rate themselves, which would
allow them to consider not only the Bundesbank
rate, but also other factors influencing the cost of
money, including the domestic money market. We
have made slight changes in this direction during the
last two years, but it is too early to forecast our fur­
ther course in rate policy.
The picture of our short-term lending activities
would not be complete unless I describe a special
type of short-term financing practiced by German
banks. W e discount bills from our customers. These
bills must be due within three months, bear two
“good” signatures, and must be drawn in connection
with a sale of goods. Then, they are rediscounted by
the Bundesbank. W e add a small margin above the
Bundesbank rate. This margin is lower than for loans
for which this special method of refinancing is not
provided. For many years it was .5 to 1 per cent; with
recent increases in the cost of money, it has risen to
2 per cent. This method reduces considerably the
average cost of short-term financing for clients who
can use this kind of credit. Other methods of financing
have only minor importance in the short-term market.
The U.S. system — especially with its commercial
paper market — seems to be far more sophisticated.
Page 10



NOVEMBER 1971

Table II

A v e ra g e

Interest Rate for T hree-M onth
Term Deposits
(Under O n e M illion M a rk s)

Reporting Period

A verage Interest Rate

1968 March
June
September
November

2.8 2 %
2.84
2.85
3.08

196 9 February
May
August
Novem ber

3.01
3.24
4.16
4.88

1 9 7 0 February
M ay
A ugust
November

6.95
7.93
7.67
7.49

1971 January
February

6.64
6.56

While the rates for short-term loans are flexible,
long-term rates and consumer credit rates are fixed.
This applies to long-term loans when issued by mort­
gage banks and paid out of the proceeds of mortgagesecured bonds, which only these special banks can
sell. These rates recently have been above 9 per cent.
They cannot be changed by the bank or the customer
during the time of the loan, which may be up to 33
years. Long-term loans not given by these special
banks, but by commercial banks or savings institutions
are, of course, linked either to the Bundesbank rate or
to the cost of money. For consumer loans the rates
are fixed at the time they are made, thus allowing
the banks to quote a fixed amount for both amortiza­
tion and interest which the client has to pay each
month.

Loan Activity Abroad
With the Deutsche Mark freely convertible, and
since for a long time we have had little exchange con­
trol, German bankers are allowed to make loans to
any foreign company anywhere in the industrialized
world as well as in developing countries. In 1969 es­
pecially, German banks were large exporters of capi­
tal. They made loans of almost 25 billion DM, a large
portion of which was long-term money. This capital
export continued through April of 1970 with an in­
crease of 2.5 billion DM. But then it stopped, and
there was a light counterflow, since the burden had
been too heavy for the German banking system as a
whole. Most of these loans have been portfolio in­
vestments rather than regular export financing. For
export financing, our banks, not the government, set

FEDERAL RESERVE BANK OF ST. LOUIS

up a special institution to make loans at compara­
tively low rates.

Scope of Business
Most of the functions mentioned so far can be per­
formed by both the commercial banks and the savings
institutions. They all are allowed to make short-term
commercial, long-term, and consumer loans, and to
accept demand, time and savings deposits. They par­
ticipate in the clearing system for money transfers
established by the Bundesbank, and their customers
can use their services by drawing checks or signing
transfer orders, which is the more common method of
paying a bill in Germany. Only mortgage banks and
the Girozentralen, the central banks of the savings
institutions, can issue and sell mortgage-secured
bonds. The Girozentralen have the largest range of
activities; they are permitted to do all things savings
institutions and commercial banks can do, in addition
to selling mortgage-secured bonds. It is therefore no
wonder that the largest bank in the Federal Republic
is the Westdeutsche Landesbank, the Girozentrale
serving the heavy industrial Ruhr area.
Regular mortgage banks, in extending long-term
loans against first mortgages on buildings or to public
authorities, are limited to the use of funds received
from the sale of their bonds. They may not accept
regular deposits, which prevents them from extend­
ing short-term loans. This rule has two important ex­
ceptions: because their charter was issued in the mid­
dle of the last century, two Bavarian banks have the
same right as the Girozentralen; that is, they can per­
form all the activities in short- and in long-term
business.
Further limitations apply to special institutions;
finance companies may extend only installment loans,
both as consumer credit and as loans financing the
sale of machinery to smaller companies. Other credit
institutions are factoring and leasing companies. The
latter have only recently been established and have
not been too active — partly because tax problems
remain to be solved.

Bank Structure
Our banking laws thus are very liberal. There are
two major prerequisites for opening a bank in Ger­
many: sufficient capital of 5 million DM (although
several smaller banks established earlier only have 1
or 2 million DM as capital plus reserves) and com­
petent management. Until 1962 the banking authority
had the right to decide whether there was an eco­



NOVEMBER 1971

nomic need for the establishment of a. new bank;
however, this provision was found unconstitutional
by our Supreme Administrative Court and was
rescinded.
Once a bank is established, the number of branches
it wishes to operate is unlimited. There is little or no
restriction as to the area where these branches may
be opened. Legally, all banks could have branches all
over the country. Only the savings institutions are
restricted; their charters limit them to the municipal­
ity to which they belong. Similar restrictions limit the
Girozentralen to the states of the savings institutions
they represent. Nevertheless, we only have four
banks which have nationwide branches — Deutsche
Bank, Dresdner Bank, Commerzbank and Bank fur
Gemeinwirtschaft. To give you a picture of their size,
Deutsche Bank has total assets of 31 billion DM, and
Bank fur Gemeinwirtschaft has 12 billion DM. The
four banks together attracted about 12 per cent of the
total deposits held by German credit institutions.
There are more than 32,000 branches of credit in­
stitutions in Germany. This, added to the 8,500 es­
tablished head offices, means that altogether there are
over 40,000 locations in which the services of a bank
or some other financial institution are offered. Com­
pared with a population of over 60 million, there is
one bank location per 1,500 inhabitants. I understand
that in the United States, one bank or savings bank
serves an average of 5,700 inhabitants.
The picture becomes clearer when one breaks
down these figures by groups of credit institutions;
of those 40,000 offices, over 16,000 belong to the sav­
ings institutions and their central banks, more than
18,000 to the cooperative banks, and 5,300 to the
commercial banks, of which the four banks operating
on a nationwide basis have almost 3,000. If you think
of the amount of savings deposits drawn in by Ger­
man savings institutions and their network of
branches, it is understandable why even the smallest
child thinks first of the Sparkasse (the savings in­
stitution) when he is asked to put some money aside.
Of the 40,000 offices mentioned, 47 are operated by
24 foreign banks, mostiy U.S. banks. Although the
banking authority could refuse a concession to them
on the grounds that the German constitution guaran­
tees the freedom to do business only to indigenous
corporations, it has been very liberal and granted the
concession if the applying bank was of good standing
and provided qualified management for the branch.
Difficulties arose in only one case — the Intra Bank of
Beirut which discontinued operations — but no credi­
Page 11

FEDERAL RESERVE BANK OF ST. LOUIS

tor in Germany was hurt since the branch had enough
capital at its disposal, and business inside Germany
had not contributed to the failure of this bank.
German laws, on the other hand, do not impose
any limitation on German banks if they want to go
abroad. However, operations within our economy
have, so far, proven to be more appealing than for­
eign opportunities. Thus, you find only a few branches
or subsidiaries of German banks in other countries.
New forms of international cooperation with German
banks as partners have been developed only recently.

Regulations and Limitations on German Banks
So far you have heard only of very liberal provi­
sions of the law and a very liberal attitude of the
banking authority in Germany. You might, therefore,
wonder if the banks in our country are free from
controls. The answer to this question is clearly no.
Rather strict regulations limit the activities of a bank
in its lending by stipulating that the total amount
of its loans must be in certain proportions to its capi­
tal plus reserves, to its long-term and savings de­
posits, and to its total liabilities. This is a rather com­
plicated, but very effective, regulation. So far it has
prevented serious cases of bankruptcies of German
banks. In the few cases where bankruptcy has oc­
curred, other banks have provided the money neces­
sary to insure the smaller savers against loss.
There is no state insurance for depositors as in the
United States. However, in 1969, the banking com­
munity established several funds which would pay
up to 10,000 DM to each depositor in case of a bank­
ruptcy. Further limitations include minimum reserve
requirements, which were particularly effective dur­
ing recent months when the Bundesbank tried to re­
strict the inflow of money from abroad.

Other Activities of German Banks
This may all sound familiar to the American banker
so far. There are, however, two other specific func­
tions of German banks. They can own stock in other
companies — banks or nonbanks — and they can op­
erate as stock brokers.
The banking crisis which occurred in our country
in 1931 was due mainly to bad management in loan
operations. If the government had not intervened,
heavy losses on loans would have led to the bank­
ruptcy of several leading banks. It was the loan and
not the stock market business which was at the root
of the difficulties. Therefore, the question which was
discussed at great length in your country after 1929
Digitized forPage 12
FRASER


NOVEMBER 1971

— whether banks should continue to do business on
the stock exchange — was not considered very impor­
tant in Germany. Banks continued to be the only
agents of the stock exchange — both for their custo­
mers and their own portfolios. This means that in
practice almost all transactions in shares are done
through the banks, and the orders must be executed
at the stock exchange, although there is no legal pro­
vision to this effect.
Again and again the question arises as to whether
the example of the United States, in which broker
and bank business is separated, should be followed.
Only serious examples of mismanagement, however,
could lead German legislators to change a structure
which so far seems to have worked rather satisfac­
torily. Two arguments are raised whenever this ques­
tion is discussed. First of all, it is said that banks are
interested in making loans; therefore, they may use
their influence to keep corporations from attracting
funds in the stock market. However, this argument
neglects the main obstacle against the issue of new
shares: corporations prefer to pay interest on a loan
rather than leaving half of their earnings to the tax
authorities. As long as there is this differential tax
treatment of interest and dividends, corporations will
prefer to borrow from banks to acquire funds.
Compared with the United States, we have an un­
derdeveloped stock market. German savers invest in
a more speculative manner, such as buying stock,
only after having put a certain amount of money into
a savings deposit. To be objective, one must admit
that until recently German banks were not very eager
to sell stocks or mutual funds. Although some of
these funds were already established in the 1950’s,
it was the promotional activity and success of Investors
Overseas Services Ltd. (IOS) and other American
organizations that caused bankers to realize that
their customers were interested in this service also.
Now, German commercial banks are trying to inno­
vate in this field. Mutual fund sales totaled 390 mil­
lion DM in 1960; in 1969 the German public pur­
chased 5.5 billion DM of mutual funds, while foreign
mutual funds sold 2.1 billion DM.
The Investors Overseas Services Ltd. crisis brought
a sharp reduction in total mutual fund sales during
1970; all funds sold totaled only 1.5 billion DM. New
changes may result from the discussion of whether
savings institutions should form holding companies
and sell shares of these companies to their clients,
especially to the small savers.
The second argument brought forth against the
banks in their capacity as brokers is that they exercise

NOVEMBER 1971

FEDERAL RESERVE BANK OF ST. LOUIS

an enormous influence on the German economy by
means of directorships in most of the important Ger­
man companies. Bear in mind that the German
stockholder generally leaves his shares with his bank
and gives the bank power-of-attomey to represent
him at shareholders’ meetings, exercising all his rights
for him including his voice. This, of course, makes it
easy for the banks to have their officers elected as
directors of the companies. Until a new law in 1966
limited to ten the number of directorships one person
could hold, one banker was a director of more than
30 companies. Now, of course, he and his colleagues
in the banking community are limited by law, but it
cannot be denied that their influence through direc­
torships is rather strong.
The only question I am asking in this connection
is whether there really is a better method of safe­
guarding the interests of the small shareholder. I per­
sonally am not sure that the method prevailing in
your country, which in general results in management
electing the directors of a company, really provides a
better system of control than ours.

ing this guideline, we have participations in our own
banks and finance companies in Switzerland, Israel,
Luxemburg, and the Netherlands, a merchant bank,
two finance companies, two mortgage banks in Ger­
many, three insurance companies, and a travel
agency. In addition, we own one-third of the stock of
the wholesale company of the German consumers’
cooperatives.
Other banks do not follow similar guidelines re­
stricting their policy for participations. They are also
important shareholders in large industrial corpora­
tions. Deutsche Bank alone owns more than 25 per
cent of the following large corporations: Germany’s
biggest shipping company, Hapag Loyd; the large
sugar company, Siiddeutsche Zucker; and one of the
two largest department store chains, Karstadt. An­
other 25 per cent of the latter is held by Commerz­
bank, which at the same time is a major stockholder
in the other big department store chain, Kaufhof.
Furthermore, Commerzbank is involved as share­
holder in breweries, another construction firm, and
a hotel chain.

Of course, this influence of banks on the economy
becomes even stronger when backed by an important
participation by the bank itself. This leads us to the
other feature which I mentioned before. German
banks are only limited in one way as far as participa­
tions are concerned. Their investments in participa­
tions and real estate must not be higher than their
capital plus reserves.

I would like to mention briefly the role of service
organizations. Consultant firms for legal and tax mat­
ters are permitted only under private partnerships.
However, banks may enter into the fields of auditing,
accounting, management consulting, and particularly,
computer services. These may be the fields of the
future. So far, banks have not really discovered them.

This legal situation has enabled German banks to
be promoters of new companies, to buy shares from a
major shareholder who wanted to dispose of his hold­
ing, or to take over a company which ran into diffi­
culties. Transactions of this kind have attracted the
attention of the public again and again, not only at
the beginning of the era of industrialization, but also
recently.

Conclusions

It is the philosophy of my bank that permanent
participations should be made only if they are con­
nected either with the services usually rendered by
banks or with the activities of our shareholders, which
are trade unions and consumer cooperatives. Follow­




All this may have given you the impression that
German banks are acting more as conglomerates
than as finance institutions. However, you may be
assured that they have played an important role in
attracting and lending the money necessary for our
reconstruction and growth, and Germany has thus
fared very well. W e do not close our eyes against the
dangers of such a very liberal structure, and interna­
tional comparison is of great importance in this re­
spect. There is hesitancy, however, to forcefully im­
pose changes on a system that has a long tradition
and so far has proven its efficiency.

This article is available as Reprint No. 73

Page 13

The Flexible Exchange Rate: Gain or Loss to the
United States?
Speech by DARRYL R. FRANCIS, President, Federal Reserve Rank of St. Louis
to the Twenty-Second World Trade Conference
International Center of the University of Louisville, November 10, 1971

X

AM PLEASED to have this opportunity to dis­
cuss with you some of the current issues in interna­
tional trade. I am particularly interested in this topic
since the recent decision by President Nixon to sus­
pend dollar convertibility into gold is eliciting highpitched discussion in the world press and, even more
important, this decision has a serious impact on* the
welfare of all consumers in the world.
Although international trade represents only four
or five per cent of the U.S. gross national product, its
impact on domestic welfare is much greater, and the
settlement of current problems and uncertainties will
be felt by all of us for a long time to come. As far as
I am concerned, the agreement on an international
payments mechanism is of far greater importance
than the ten per cent surcharge, and consequently I
will address my remarks to that portion of the new
international economic policy.
First, I will discuss the functioning of the interna­
tional payments system; second, the historical events
leading to the current situation; third, the alternative
solutions available. Finally, I will indicate my choice
of an international payments mechanism.

The Benefits from Trading Internationally
The United States can produce virtually any com­
modity and service that it currently consumes. Why,
then, do we engage in international trade and incur
the risks and crises that have plagued us for the past
Digitized forPage 14
FRASER


fifty years? The answer, of course, is that interna­
tional trade, like domestic trade, is profitable. It is
profitable in the sense that it increases the welfare of
trading countries.
The reason we buy an imported commodity is sim­
ply that we can purchase it cheaper abroad than
we can produce it domestically. W e pay for our
imports by selling goods and services to foreigners
who will accept them only if our goods are cheaper
than the same goods produced by them. Therefore,
the citizens of both trading countries, given their
resources, can consume more goods and services than
they could in the absence of such trade.
The reasons for the relative price differentials are
varied — it may be productive efficiency or it may be
domestic demand conditions. What is important is that
the price of the delivered foreign commodity or serv­
ice is lower than the price of the same commodity
produced at home. Therein lies the benefit from inter­
national trade. If such benefit does not exist, trade
will not take place. Any artificial restrictions which
lower this price differential reduce the amount of
international trade and therefore the welfare gains
that may accrue.
The same reasoning applies to international capital
movements. W e buy foreign capital goods or foreign
securities only if they promise a higher rate of return
than domestic ones. In that sense, a given amount of
resources increases our income and welfare. The

NOVEMBER 1971

FEDERAL RESERVE BANK OF ST. LOUIS

country selling the securities benefits by attracting a
scarce resource to facilitate the efficiency of the pro­
ductive process.
What is important to remember throughout any dis­
cussion of international trade is that benefits accrue
from our ability to consume more; that is, from
imports of goods, services and securities.

The Mechanism of International Payments
Since gains from trade derive from imports, why
don’t we keep importing as much as possible and
forget about exports, reserve balances, and various
exchange problems? Like everything else, imports
must be paid for, and exports are the ultimate means
of payment. But since the barter system is extremely
inefficient in individual transactions, we avoid the
item by item matching of imports and exports by
using the international payments mechanism, just as
we avoid the matching of goods and services in
domestic transactions with the use of money.
To demonstrate international payments, let’s as­
sume that I buy a Japanese radio for $30. I write a
check on my bank and send it to the Japanese ex­
porter who deposits the check in his bank and gets
Japanese money for it. If the Bank of Tokyo can find
an importer who wants $30 to buy something in the
United States, it will sell the draft to him and my $30
finds its way into the account of a U. S. exporter in
a U. S. bank. Under these circumstances, an import
was offset by an export, the quantity of dollars sup­
plied was equal to the quantity demanded, and the
price of the dollar — the exchange rate — remained
the same.
But what if the Bank of Tokyo cannot immediately
find an importer who wants to buy U. S. goods and
services? What can it do with my $30 check? At this
point we must specify the international payments
mechanism that is used by the United States and
Japan. There are three main payments systems that
have been used: the gold standard, the dollar or
sterling exchange standard, and a flexible exchange
standard.
On a true gold standard, the Bank of Tokyo will
sell my check to the Japanese central bank who, in
turn, will buy $30 worth of gold from the U. S. Treas­
ury. Thus, my import of a radio was matched by an
export of gold. The exchange rate, which is fixed in
terms of gold, does not change.
If we are on a dollar exchange standard, as existed
until recently, the price of a dollar is fixed in terms



of gold and the prices of all other currencies are fixed
in terms of the dollar. In order for the exchange rate
to remain constant, the supply of dollars created by
my purchase must be matched by an equivalent
quantity demanded. Since central banks are com­
mitted to maintenance of a fixed exchange rate, in the
absence of private demanders of dollars the central
banks must buy and hold the $30, thus increasing
their foreign reserves.
A flexible exchange standard implies that the price
of the dollar will be determined by market forces
without official intervention. In this instance, the Bank
of Tokyo would offer my $30 on the exchange market.
If there are buyers of U. S. goods and services at
existing prices, the $30 will be purchased by them
and the exchange rate will not change. But if these
importers view U. S. prices as being too high, they
will offer less foreign currency for my $30 check and
the transaction will be consummated only at the
lower price of the dollar. Thus, my import is still
paid by an export, but only when accompanied by
a change in the exchange rate.
To summarize this illustration, my import of the
radio was paid for with either a gold export, a U. S.
liability that a foreign central bank is willing to hold,
or an export of U. S. goods and services.
It should be clear, however, that an excess of im­
ports over exports can be continued under a gold
standard only as long as our gold supply lasts. Sim­
ilarly, under the dollar exchange standard the excess
can continue only as long as foreigners are willing
to supply us with goods and services in exchange for
dollar accounts in U. S. banks. Since we desire imports,
what is there to prevent the United States from ex­
hausting its gold stock or prevent an ever increasing
accumulation of dollar balances by foreign central
banks? In other words, is there an adjustment mecha­
nism which prevents permanent imbalance in trade and
possible breakdown of international economic rela­
tions? Let us examine the adjustment process in each
of the three payments systems I have outlined.

Adjustment Processes
The gold standard, if permitted to function, would
cause an export of gold in our Japanese radio example.
A decline in the U. S. gold stock will cause a contrac­
tion of money supply in the United States and a
decline in nominal income. Exactly the opposite will
occur in Japan. With U. S. income declining, and
Japanese income rising, our purchases of Japanese
goods will decline and our sales to Japan will increase.
Page 15

FEDERAL RESERVE BANK OF ST. LOUIS

This would cause an elimination of any U. S. import
surplus.
Similarly, under the dollar exchange standard, the
accumulation of dollar balances by foreigners would
increase their reserves, which in turn, would lead to
an increase in their money supply and income level.
The opposite could happen here, and again our balance-of-payments deficit would be corrected.
The flexible exchange rate, as we have seen, would
tend to establish a balance between imports and ex­
ports by causing a decline in the price of the dollar
in terms of foreign currencies, which would make
foreign goods more expensive to us and our com­
modities cheaper to foreigners. This change in relative
prices would discourage our imports and encourage
our exports.
All three systems of international payments mechan­
isms facilitate trade, provide adjustments, and have
within them necessary means for prevention of trade
breakdown. Two of them do it with fixed exchange
rates, and one with a flexible rate. Thus, the question
arises as to what are the ultimate differences among
them, and why should a person advocate one ex­
change rate system over another.
The major difference is that within the fixed ex­
change schemes — both the gold and the dollar ex­
change standards — the adjustments which are neces­
sary to maintain an equilibrium in the balance of
payments take place in the domestic economies in
the form of changes in price, income, and employ­
ment levels. In a flexible exchange rate mechanism,
the adjustment is in the form of changes of prices
and quantities of internationally-traded commodities,
and in the welfare aspects generated by the changes
of the terms of trade.
The adjustments required by a fixed exchange rate
system frequently conflict with domestic goals. Virtu­
ally all national governments have adequately demon­
strated that they are committed to the achievement
of stable conditions in domestic economic activity. In
our example, for instance, it is difficult to imagine
that, given an import balance, the United States would
be willing to permit the indicated contraction of do­
mestic production with its inherent probability of
higher unemployment. It is just as difficult to visualize
Japan deliberately submitting to inflation because
their exports have exceeded their imports.
As a result of the strong desire for economic stabil­
ity at home, central banks have generally undertaken
policies which mitigate the adjustments necessary to

Page 16


NOVEMBER 1971

correct a disequilibrium in international trade under
a system of fixed exchange rates. Such actions have
resulted in the development of persistent and funda­
mental trade deficits and surpluses. In turn, these
surpluses and deficits have produced crises requiring
periodic adjustments in the exchange rate, direct con­
trols, and other arbitrary impediments to international
trade.
A flexible exchange rate, on the other hand, does
not necessarily imply domestic fluctuations in income
and employment. It is, therefore, more likely to be
permitted to achieve the adjustments necessary for
the smooth functioning of international trade. In the
choice of different exchange rate systems, it seems to
me, the crux of the matter is not the ability of these
systems to make necessary adjustments; rather, given
the demonstrated political necessity of maintaining
full domestic production and employment, it is a
matter of which one will be permitted to do so.

Historical Background of the Present Crisis
I have sketched the various international payments
mechanisms and have indicated how equilibrium can
be achieved under several exchange rate standards. I
would like to turn now to the specific case of the U. S.
balance-of-payments difficulties and discuss historical
events leading to the “international monetary crisis”
of 1971. In capsule form the history of the U. S. balance-of-payments position is as follows.
From 1790 to 1875, the United States was a net
importer of goods, services, and capital. A developing
economy provides good investment opportunities and
foreign capital flows in. This inflow financed the ex­
cess of merchandise imports. As the economy matured
and the ratio of capital to other resources began to
grow, repayment of foreign loans, and eventually U. S.
foreign investment, began to take place. In the United
States this change occurred approximately in 1875,
and since that time we have been a net exporter of
capital and merchandise.
At the end of World War II, we emerged as virtu­
ally the only industrial country with its productive
capacity intact. In spite of the strong postwar domes­
tic demand, our relative prices were still lower than
those in foreign countries and our export balance
became very large. This excess of exports over im­
ports was financed by private and government lending
and unilateral transfers. After 1950, U. S. private and
government capital outflows began to exceed the ex­
ports of merchandise and services, thus supplying
more dollars to the foreign exchange markets than
foreign importers were willing to absorb. That is, since

NOVEMBER 1971

FEDERAL RESERVE BANK OF ST. LOUIS

1950 the U. S. balance of payments on a liquidity
basis has been in deficit.
The international payments mechanism, as estab­
lished by the Bretton Woods agreements of 1944,
provided that countries can fix their exchange rates
either in terms of gold or in terms of the dollar. As
it turned out, the United States established the price
of the dollar in terms of gold at $35 per ounce and
most other countries defined the prices of their cur­
rencies in terms of the dollar. The exchange rates
were fixed by foreign central bank intervention in the
form of buying dollars when the price of the dollar
was falling in terms of foreign currencies and selling
when the price of the dollar was rising. It isn’t difficult
to see that a persistent deficit in the U. S. balance of
payments and a fixed dollar exchange rate could co­
exist only with the accumulation of dollar balances by
private foreigners and foreign central banks.
Until the latter half of the 1960’s the United States
experienced a significantly lower rate of inflation and
a lower amplitude of cyclical fluctuations than did
other major foreign economies. Therefore, the dollar,
as the most stable of all major currencies, was ex­
tensively used as an international means of payment.
A large portion of the deficit-induced dollar balances
were thus held willingly and provided a service as
international money.
During the late sixties, however, the U. S. balance
in goods and services began to decline while capital
outflows remained virtually constant. At the same
time, domestic monetary and fiscal policies resulted in
large decreases in the purchasing power of the U. S.
dollar, both domestically and internationally. Thus,
in world trade we had an increasing rate of dollars
being supplied and a reduced demand for them, and
under these circumstances something had to give.
With these developments in mind, let’s analyze our
position in the spring of 1971.

U. S. International Position in Spring 1971
1. Expansionary monetary and fiscal policies since
1965 resulted in a rapidly rising price level and
growing expectations of inflation. Attempts to moder­
ate inflationary pressures by restrictive fiscal actions
in 1968 and restrictive monetary actions in 1969 were
reversed in 1970, eliminating any hope of quickly
achieving price level stability.
2. As a result, our imports continued to increase,
while our exports began to decline. A deteriorating
balance in goods and services, coupled with substan­
tial net investment in other countries and government



expenditures abroad, meant an increase in the quan­
tity of dollars supplied without a corresponding in­
crease in demand.
3. The international price of the dollar could re­
main fixed only through sales of gold to foreigners or
through massive accumulation of dollar balances by
foreign private individuals and central banks. Our
gold supply has dwindled to $10 billion, and we were
reluctant to permit its continued depletion. Dollar
accumulation by foreigners reached $45 billion by
March 31, 1971.
4. Foreign exchange dealers and owners of liquid
dollar balances, in anticipation of some kind of a
downward readjustment in the value of the dollar,
began converting dollar holdings into foreign curren­
cies. This forced foreign central banks to purchase
even larger amounts of dollar claims.
5. With these pressures increasing, and with no
hope for redress, Germany, Netherlands, and Belgium
announced that they would no longer purchase addi­
tional dollars, thus floating their currencies and per­
mitting them to appreciate. Meanwhile, Switzerland
and Austria undertook outright revaluation by an­
nouncing that their central banks would continue to
purchase dollars, but only at a lower price.
6. Our deteriorating competitive position and re­
sulting reduction in the export surplus were contribut­
ing to unemployment in the United States.

Alternative Options Available
Given this situation, neither the United States nor
the major trading countries which were running size­
able surpluses could continue under the existing fixed
exchange rate alignment. It was clear that the U. S.
dollar was overvalued with respect to many major
currencies and that the existing exchange rate mechan­
ism was prone to the development of persistent balance-of-payments deficits and surpluses. Any new
system which could remain viable for any length of
time would not only have to alleviate the U.S. defi­
cit, but also provide for a payments mechanism
which would inhibit the persistence of international
disequilibrium.
Three unilateral actions were available to the
United States: the establishment of import controls in
order to equalize exports and imports, the revalua­
tion of gold with the hope that other countries would
permit the exchange depreciation of the dollar, and
the suspension of dollar convertibility into gold, thus
subjecting the international value of the dollar to
market forces.
Page 17

FEDERAL RESERVE BANK OF ST. LOUIS

Import controls, whether in the form of high tariffs
or of direct or exchange quotas, represent a type of
interference with consumer choice. As we have seen
earlier, the benefits from international trade are a
result of satisfying consumer preference for imported
commodities and the consequent reallocation of re­
sources so as to increase the efficiency of the trading
economies. Arbitrary intervention with the consumer
preference pattern will reduce the total volume of
trade and the benefits to be derived from it. The size
of this welfare loss is difficult to measure, but it is of
such magnitude that, even under the most trying cir­
cumstances, governments which are concerned with
the satisfaction of individual citizens’ wants have un­
dertaken such measures only as a policy of last resort.
The revaluation of gold, in spite of its current men­
tion a? a solution, does not produce the desired effects,
particularly when it is unilateral. As we have seen,
exchange rates are fixed at their established parities
by central bank intervention. Devaluing the dollar in
terms of gold does not, by itself, realign exchange
rates and therefore neither improves the U.S. bal­
ance-of-payments position nor provides a payments
mechanism which will preclude persistent deficits or
surpluses.
The suspension of dollar convertibility into gold,
again, as a unilateral action, does not insure that the
dollar will float in response to market forces. W e may
say that the dollar is floating and w e may not inter­
vene in the foreign exchange market, but that does
not prevent foreign central banks from interfering
and fixing the dollar rate of their currencies at some
level desired by them.
It may be asked at this point, why then did the
President suspend the conversion of dollars into gold?
The answer is to be found in the huge dollar balances
accumulated by the central banks of surplus countries.
Without convertibility into gold, these balances can
only be used to buy U. S. goods and services. Since
the accumulation itself is a sign that at current
prices foreigners find it unprofitable to import from the
United States, the probability that they will con­
tinue to support the prevailing price of the dollar is
very small. This was already indicated by the revalua­
tion and floatation of the currencies of several countries
which took place in May 1971. In addition, incon­
vertibility of the dollar into gold, in effect, removed
the cornerstone of the Bretton Woods agreements and
made some multilateral action imperative.
T o sum up, unilateral actions on the part of the
United States, as economically powerful as it may
be, either do not solve the current international eco­
nomic problems or are too costly to undertake and

Page 18


NOVEMBER 1971

enforce. What is required is a multilateral action of all
countries involved to realign the exchange rates and to
agree to a payments system which will provide enough
exchange rate flexibility to forestall another crisis such
as we face today.

Possible Choices of Payments Mechanisms
In view of the discussion up to now and in view
of the sentiments expressed by international authori­
ties and the world press, we are left with two effective
possible payments systems: a multilaterally agreed
upon freely fluctuating exchange rate mechanism or a
multilaterally established fixed exchange rate system
with readjusted par values and with somewhat greater
flexibility around par. I should like to discuss these in
reverse order.
Fixed exchange rate. A fixed exchange rate system
will require a negotiated realignment of exchange
rates. The events of the past few weeks demonstrate
the magnitude of the problem. Surplus countries all
appear to acknowledge the necessity of devaluing the
dollar. However, when it comes to a true commitment,
few countries wish to revalue their currencies to a
true market level at which their surpluses and our
deficits would be eliminated. In short, a surplus to
them at the expense of a deficit to the United States
is “fair.”
Given this attitude, it is difficult to conceive that
the governments involved would pursue the domestic
policies necessary for a fixed rate system to survive,
because fixed rates without balance-of-payments diffi­
culties require that each country maintain a rate of
domestic economic growth approximately equal to
that of other countries. Significantly different growth
rates would again produce persistent balance-of-pay­
ments surpluses and deficits and would again lead
to exchange crises with all the losses of trade that
accompany them.
Increased flexibility around par will permit larger
deviations from a concerted rate of growth but will
not eliminate the possibility of some country being
temporarily successful in using foreign trade as a tool
of domestic policy. So long as such a possibility exists,
some governments will have the incentive to use this
politically expedient economic measure at the ex­
pense of welfare gains to their consumers.
Thus, even if a “correct” exchange realignment is
agreed upon, and the U.S. balance-of-payments prob­
lems are solved, the permanency of such a system is
veiy much in question. Of course, if the established
bands around par were veiy wide, and the par were
to change easily and automatically, my objections

FEDERAL RESERVE BANK OF ST. LOUIS

would be removed. But then, of course, it would not
be a fixed rate system.
Freely fluctuating exchange rate. This leads us to
the consideration of the freely fluctuating exchange
rate. I believe that such a system would best solve
current difficulties and would assure a permanent
exchange rate mechanism which should be free of the
type of trade slowdowns we are experiencing now.
Rates would respond to the forces of demand and
supply and accurately reflect the trading positions of
all nations. Unwanted accumulations of currencies
could not take place; there would be no development
of crises with their resultant losses. And, what is more
important, all governments could pursue totally in­
dependent domestic policies without imposing their
excesses upon others.
An inflationary policy, for example, would cause
an increase in a country’s demand for imports and
a decline in its exports. Instead of running an
extended deficit and exporting its inflation, it will
find that the international value of its currency has
fallen and its import surplus is eliminated. Thus,
domestic excesses would have to be paid for at home.
I believe that the knowledge of this fact will prevent
the use of the international market for domestic goals.
Two major criticisms of the freely fluctuating ex­
change rate are most frequently voiced. First, because
of daily or conceivably even hourly fluctuations in the
rate, it is contended that the increase in uncertainty
will cause a reduction in the volume of trade. Sec­
ond, it is further contended that the freely fluctuating
rate will elicit trade restrictions and unbridled
speculation.
There is little doubt that continuous small changes
in the exchange rates would induce marginally greater
daily risks and therefore somewhat greater costs of
international currency convertibility. This is supported
by the sparse historical evidence and by the recent
behavior of the forward rate. The forward rate, which
among other things reflects the insurance premium
for delivery of some currency at a specified price at
some future date, has increased. Interestingly enough,
however, the increases are minimal where the float is
“clean” and large where central bank intervention is
either present or anticipated. This seems to indicate
that the actual flexibility is a small contributor to in­
creased costs, while intervention, or anticipated official
revaluations as exist under a fixed rate, is the real
culprit.
Most of our domestic commodity, stock and money
markets have hourly fluctuations and the premium



NOVEMBER 1971

associated with frequent changes does not appear to
be prohibitive nor does it impair the efficiency of
these markets. Here too, large fluctuations in forward
prices occur when there are anticipations of some
natural disaster or a strike or some institutional inter­
ference, events not unlike anticipated changes in the
exchange rate.
The question that should be asked is not whether
convertibility costs are higher under a flexible ex­
change rate as compared with the fixed rate, but
whether they are higher than the total trade costs of
periodic real or anticipated revaluations of the fixed
rate. Since 1944, out of 92 countries which have estab­
lished parities under the International Monetary Fund,
forty-five countries have changed par values seventyfour times. Several of these changes were accompanied
by serious international economic disturbances, and
most of them by domestic problems of reallocation of
resources. Every sudden official change in the ex­
change rate causes a movement of resources between
export and import competing industries, and each
movement implies an increase in structural unemploy­
ment. Consequently, the economic costs of a fixed
exchange rate system are sizeable. With a flexible
rate system, on the other hand, resources move grad­
ually and with a minimum of friction, resulting in
lower costs.
Similar remarks can be made about speculation,
an activity which stabilizes rather than destabilizes
prices. Destabilizing speculation, which everyone
fears, occurs as a result of anticipations of forces out­
side the normal economic realm. With freely fluctuat­
ing exchange rates, such forces are much less likely
to materialize than with a fixed rate system which
experiences periodic crises.
An interesting observation is that with fixed ex­
change rates and the associated central bank interven­
tion in exchange markets, a form of speculation is
performed by central banks rather than by those in­
dividuals who voluntarily bear the risks. Thus, the
risk of loss is borne by all taxpayers, whether they
want it or not.
As for the criticism that freely fluctuating exchange
rates will elicit trade restrictions greater than under
fixed rates, one simply has to look at the situation
which existed for the past 27 years. It really all
depends on what one means by trade restrictions. It
seems to me that arguing that a fluctuating rate will
lead to more restrictions is simply saying that where
disequilibrium fixed rates can no longer be used to
pursue domestic goals, alternative means may take
the form of new trade restrictions. In other words, a
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FEDERAL RESERVE BANK OF ST. LOUIS

country, which for purposes of domestic stabilization,
maintained an undervalued currency and an export
balance under a fixed rate system, will now have to
resort to other trade restrictions to achieve the same
goal. It is certainly not an inevitable consequence of
flexible rates, and in any case, it is only a different
manifestation of the same restrictive policy.
The usual example put forward is the economic
warfare of the early thirties. At that time there was
truly a proliferation of various international trade
barriers and for a while the British pound was re­
moved from its convertibility into gold. What these
critics fail to point out is that there was a worldwide
depression under way and that the restraints began
to multiply in 1929 while the pound was not floated
until 1931. A causal relationship is certainly not
indicated.

Conclusion
I believe that the freely fluctuating exchange rate
is far preferable to a fixed one. Whatever the costs
involved, they are less than those imposed by the
present system. There is the chance now to establish
a mechanism which prohibits the exchange exploita­


Page 20


NOVEMBER 1971

tion of one country by another and which therefore
has a better chance of long-run survival.
From reading the reports of the present interna­
tional economic “crisis,” one gets an impression that
the current decline in global trade is caused by the
so called “floating” of exchange rates. It is our view
that nothing can be further from the truth. In the first
place, the crisis existed prior to the floating of the
rates and secondly, the rates are not being allowed
to float freely. The high risks which are instrumental
in the decline of trade are not created by the flexibil­
ity of the exchange rate, but by the anticipations of
a new and unpredictable exchange rate fix.
I do not believe that freely fluctuating exchange
rates will be agreed upon immediately. I would rather
expect that the first agreement will produce a new
exchange rate realignment with wider bands around
the par. Then, the next inevitable crisis will add to it
a crawling peg. From there it is only a small step to
the freely fluctuating exchange rate. So, in spite of all
the terrible disasters that are predicted for flexibility,
I believe that we may yet see an international pay­
ments mechanism which will utilize freely fluctuating
exchange rates and which will assure a maximum of
welfare without artificial obstructions.

Regional and Multilateral Dimensions of the
United States Balance of Payments "
Remarks by ANDREW F. BRIMMER, Member,
Board of Governors of the Federal Reserve System,
Before a Luncheon Sponsored Jointly By The Boards of Directors of the
Federal Reserve Bank of St. Louis and its Louisville Branch
Louisville, Kentucky, October 14, 1971

CONSIDERABLE number of words have been
spoken and written about the United States balanceof-payments problem, and in the last two months vig­
orous steps have been taken to correct the deep and
persistent deficit. However, both before and after the
mid-August actions, explanations of the causes of our
balance-of-payments difficulties have varied widely.
And, as one would expect, these different explana­
tions have led to a variety of conclusions as to the
appropriate cure. Unfortunately, many of these sug­
gested courses have involved the pursuit of partial
and specific targets, rather than focusing more broadly
on the multilateral dimensions of the problem. I be­
lieve we must look to these broader aspects if we are
to achieve lasting improvement.
Among the more specific targets for action to re­
duce the deficit have been the following:
Military expenditures abroad: H ow can the level
be reduced? H ow big a premium should be paid
for procurement in the U.S.?
Private capital outflows: H ow much restraint should
be imposed on purchases o f foreign securities, on
direct investment, and on U.S. bank lending abroad?
Unfair trading practices of foreign countries: What
are the best ways to reduce barriers which discrim­
inate against U.S. exports.
“ I am indebted to several members of the Board’s staff for
assistance in the preparation of these remarks, especially to
Mr. Samuel Pizer, Miss Kathryn A. Morisse, and Mrs. Betty
L. Barker.



Among the more generalized targets have been
the following:
Inflation in the United States: H ow can excess de­
mand be curbed to help check deterioration in our
trade account?
Structural changes and foreign competition: H ow
can we cope with modernization and productivity
improvements abroad which enhance the ability of
foreign countries to compete in merchandise trade
with the United States?
Exchange rate adjustment: Can exchange rate ad­
justments be envisaged that would contribute sig­
nificantly to improving the U.S. competitive position?

Cutting across these categories, the point is often
made (usually in connection with an analysis of mer­
chandise trade flows) that our increasing deficits can
be traced to transactions with a few countries or
regions. Usually Japan and Canada are singled out.
It is then suggested that we should concentrate our
efforts on improving our situation with those countries
in particular.
Clearly we are dealing with a most complex — if
not the most complex — problem in economic analysis
and policy making. Much could be said about each of
the factors or types of international transactions listed.
Yet, a clear lesson to be learned from the collapse of
the payments system this year is that there are many
factors at work — each of which on the surface can be
blamed for a large part of our deficits of the last few
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FEDERAL RESERVE BANK OF ST. LOUIS

years. In fact, if we added up the separate effects of
these different factors, we would quickly come to a
sum that greatly exceeds our deficits. Furthermore,
concentration on one aspect at a time tends to lead
to policy prescriptions that are clearly inadequate.
More importantly, we may be misled into the adop­
tion of direct controls or other protectionist devices
that can only hamper trade in the long run.
Given the complexity of our balance-of-payments
difficulties, and in light of the current efforts to bring
about a fundamental correction of the deficit, we
should strive to increase our understanding of as many
dimensions of the problem as we possibly can. One
way of contributing to this understanding is to look in
some depth at our transactions with various regions
or countries and at the overall international trans­
actions of those regions. There are at least two reasons
supporting such an approach. These relationships are
intrinsically important, and there is a need to look at
them more broadly than in terms of the trade accounts
alone. There is also a need to recognize that adjust­
ment of the U.S. balance of payments involves for
each of these countries or regions, not just a change
in the bilateral relationship with the United States,
but a many-sided adjustment involving their positions
vis-a-vis the rest of the world as a whole.
With this objective in mind, and without attempting
a detailed analysis of trends in U.S. trade and finan­
cial relations with major foreign countries and areas,
a brief review has been made of the regional pattern
of our trade and service transactions and of long-term
private capital flows. The results of the analysis are
presented in the following sections, but a summary
can be sketched here:
The persistent deficit in our overall balance of pay­
ments (which reached an annual rate of some $20
billion in the first six months of this year) was the
result of a fundamental deterioration in our com ­
petitive position which showed no signs of being
checked. At mid-year, the outlook was for a further
worsening in 1972. Thus, a striking change in the
international competitive environment was called for.
The measures announced by the United States on
August 15 were directed at that objective.

Among the major countries and regions of the
world, there is naturally a primary interest in our
trade and payments relations with those countries en­
joying sizable surpluses — particularly Canada, Japan,
and Germany. In what follows, I will focus on trends
in the current and long-term capital accounts so as to
avoid the wide fluctuations in the flows of short-term
capital.

Page 22


NOVEMBER 1971

W ith respect to Canada, a striking and lasting change
has occurred in the United States-Canadian bilateral
relationship since the early 1960’s. In 1970, the over­
all U.S. deficit with Canada amounted to $1.7 billion,
compared with a surplus of $0.8 billion in 1964.
Indeed, Canada’s overall position in the world eco­
nomy has improved dramatically, and a substantial
share of the gain has centered in its trade with the
United States. A significant part o f this strengthening
is a result of the United States-Canadian automobile
agreement. In the quest to correct the deficit in the
U.S. balance of payments, it may be appropriate to
remove the restrictions on exports of U.S. automobiles
to Canada contained in the 1965 agreement.
In the case of Japan, the U.S. bilateral deficit
amounted to $1.6 billion last year; in 1964 the deficit
was much smaller, under $100 million. These grow­
ing deficits with Japan reflected spurts in U.S. im­
ports. W hile voluntary quotas have moderated the
rate of expansion in our deficit with Japan, the
latter’s restrictions on imports have hampered poten­
tial U.S. exports to an even greater degree. Conse­
quently, a reduction of Japanese barriers to U.S.
trade must be a principal objective of the current
negotiations to rebuild the payments system.
The United States overall balance of payments with
Western Europe registered a surplus o f nearly $1
billion in 1970. In 1964, our accounts were in deficit
by $160 million. However, in the first six months of
this year, we recorded a deficit o f $1.6 billion with
Western Europe. Almost half of that total was with
the European Econom ic Community (E E C ). The
noticeable deterioration in the U.S. balance of pay­
ments with Western Europe in the last year or so
reflected the waning o f favorable capital flows and
the passing o f the fortuitous benefits to our trade
from cyclical developments here and abroad. More
fundamentally, however, the greatly strengthened
position of Western Europe can be traced to a basic
change in its competitive stance vis-a-vis the United
States.
Changes in the U.S. bilateral balance o f payments
with other countries have been far less dramatic.
There was no significant change in our position with
respect to other developed countries (Australia, New
Zealand, and South Africa) between 1964 and 1970.
In the case of developing nations, the major change
in flows vis-a-vis the United States has been an in­
crease in the amount of long-term private capital they
have received — which rose from $1 billion in 1964
to $1.6 billion last year. U.S. trade with these areas
has remained virtually static since the early 1960’s,
showing an annual U.S. surplus of about $1.5 billion.
The bilateral balance of payments of the United
States with other regions can show only a part of
the overall payments situation which they face. W e
must look at their surplus or deficit position with the
rest of the world if we are to evaluate the extent to
which they could or should adjust their external
transactions as part o f their contribution to rebuild­

FEDERAL RESERVE BANK OF ST. LOUIS

ing the international payments system. Such a review
shows that the major countries which have large
surpluses with the United States (particularly Can­
ada, Germany and Japan) also have overall surpluses
with the rest of the world. However, taking all the
leading industrial countries as a group, it is clear
that they will have to withstand a sizable diminu­
tion in their aggregate surpluses if the United States
is to make meaningful progress in correcting its own
deficit.

Regional Dimensions of the
U.S. Balance of Payments
The published data on the U.S. balance of payments
enable one to trace our transactions with major foreign
countries and areas. These data are summarized in
Tables I and II.1 Our overall balance on trade, serv­
ices, and long-term private capital transactions (some­
times called the “basic” balance) has been nearly al­
ways in deficit since 1960 — and generally on a rising
scale. By 1970, this underlying deficit was $3 billion
and in the first half of 1971, it reached $4.8 billion (not
an annual rate). This latest increase may have been
exaggerated somewhat by the strikes then in effect or
threatened and by changes in the timing of payments
as traders and investors moved to protect themselves
against the unstable international monetary situation.
But the basic worsening was unmistakable, and projec­
tions for 1972 indicated that a further worsening was
in store unless a striking change in the international
competitive environment was brought about.
The worsening trend appeared in most major cate­
gories of transactions. Our trade balance moved into
an almost unprecedented deficit position in April, and
in the April-August period the United States ran a
1Note on Trade Data, Tables I, II, III, and IV.
Data in Table IV are reported on the same basis as in
Table I and Table II (e.g., balance-of-payments basis — exports
and imports f.o.b.).
The trade data reported in Table III differ from data in
Tables I, II, and IV because:
1. Imports in Table III are derived from export data as
reported by the partner exporting countries. For exam­
ple, exports of the United States to Canada are also,
by definition, Canadian imports from the United
States. These derived Canadian imports will differ
from Canadian imports as reported in Canadian trade
statistics.
2. Export data in Table III are adjusted by the United
Nations to conform to U.N. standards.
3. Western Europe’s trade balances with the United
States, Canada, and lapan, as shown in Table III,
appear to be consistent with those shown in other
sources. However, Western Europe’s trade balances with
the rest of the world, as derived from the United
Nations data, differ markedly from those shown in
other sources, and these differences have not yet been
reconciled.



NOVEMBER 1971

deficit at an annual rate of over $4 billion. Private
long-term capital registered a moderate net outflow of
$1.5 billion in 1970; but in the first six months of this
year, the net outflow totaled $3.3 billion. The net out­
flow associated with U.S. Government economic grants
and capital flows also rose somewhat. The exception
to this trend was a considerable rise in U.S. net re­
ceipts from service transactions, mainly because of an
improvement in net income receipts. This rise was
also to a considerable extent a temporary bulge re­
lated to some special transactions.
Having sketched in the overall trends in these major
accounts, let us now turn to the trends in our dealings
with some of the major regions of the world.
Canada: Between 1964 and 1970, our overall trade
balance deteriorated by $4.7 billion. Of this amount,
$2.5 billion was in trade with Canada. About $1.2
billion of the change in the U.S. trade balance with
Canada was in automobiles, trucks, and parts. How­
ever, even apart from this special factor, U.S. trade
with Canada worsened by over $1 billion during the
1964-70 period. The further worsening in 1970 (apart
from automobiles) resulted from a sizable increase in
U.S. imports, while exports to Canada rose only slightly
because of the weakness of the Canadian economy.
In the first half of this year, the U.S. trade balance
with Canada again declined substantially, as the defi­
cit ran at an annual rate of nearly $2 billion. One
might have expected that reduced trade balances
with Canada would have been offset by increases in
other current account transactions, especially net in­
vestment income. Yet, net receipts from these trans­
actions have grown very slowly and have been only
a minor offset to the losses on trade account.
The flow of private long-term capital to Canada
has been relatively free from restraints, but the volume
has shown no tendency to rise since the middle-1960’s.
In fact, the outflow was relatively small in the first
half of this year (roughly $230 million). In consid­
erable part, the slowdown in these flows reflects ef­
forts by the Canadian Government to reduce the
dependence of Canadian borrowers on the U.S. capi­
tal market.
Looking ahead, as the pace of economic activity
picks up both in Canada and in the United States,
our trade balance with Canada should improve. How­
ever, the net outflow of private capital will probably
expand also. The rise in the exchange rate for the
Canadian dollar should help the trade balance to
become less unfavorable for the United States. Over
the longer run, the bilateral trade balance may also
Page 23

FEDERAL RESERVE BANK OF ST. LOUIS

NOVEMBER 1971

Table 1

R egional Distribution o f the U.S. Balance on Current Account an d Long-Term C a p ital
(m illions of dollars)
1 97 0
1st
Half
1960

1965

1968

1969

1970

1971
2nd
Half

1st
Half

(not seasonally adjusted)

A ll A reas:
Current account and long-term capital
G ood s, services, and remittances
of which: Trade

— 4,8 0 2

— 1,155

— 1,814

— 1,349

2,879

— 3,038

— 2,2 1 0

— 82 9

3,498

6,102

1,321

74 5

2,182

1,838

345

968

4,9 0 6

4,942

62 4

660

2,110

1,662

448

— 41 8

Private long-term capital

— 2,100

-4 ,5 7 7

1,198

— 50

— 1,454

— 1,956

502

-3 ,2 8 4

U.S. Govt, grants and capital1

— 2,553

— 3,340

-3 ,8 6 9

-3 ,5 7 4

-3 ,7 6 6

-2 ,0 9 2

-1 ,6 7 5

— 2,488

-3 3 3

C anad a:
Current account and long-term capital
G oods, services, and remittances
of which: Trade
Private long-term capital
U.S. Govt, grants and capital1

686

32 0

— 51 2

1,367

— 1,651

-4 0 2

— 1,247

1,311

1,71 2

43 3

47

-5 9 6

116

-7 1 2

-7 9

1,024

864

-4 3 5

-7 9 9

— 1,676

— 581

— 1,095

-8 3 8

-6 2 3

-1 ,3 9 8

— 96 3

-1 , 4 1 7

— 1,035

— 522

— 513

-2 3 1

-2

7

19

3

-2 0

4

— 22

— 25

Japan:
Current account and long-term capital
G ood s, services, and remittances
of which: Trade
Private long-term capital
U.S. Govt, grants and capital1
EEC:
Current account and long-term capital

— 131

-4 6 6

— 1,227

-2 ,1 2 9

— 1,577

-6 8 3

-8 9 5

-1 ,9 2 1

— 98

— 479

— 1,374

-1 ,7 7 4

-1 ,5 4 5

-5 8 3

-9 6 1

-1 ,4 3 3

225

-3 8 7

-1 ,1 1 0

-1 , 3 9 0

— 1,246

-4 4 2

-8 0 4

-1 ,3 8 2

— 24

— 49

50

-3 8 3

— 92

— 133

41

— 454

— 9

62

97

28

60

33

25

-3 1

919

1,725

532

39

494

-7 9 4

— 46

497

548

— 50

— 98

150

1,045

1,718

1,029

689

1,527

1,709

— 111

— 549

438

-5 9 1

113

62

146

40

106

-1 0 1

i 1
/ /

G ood s, services, and remittances

-7 2 1

of which: Trade
Private long-term capital
U.S. Govt, grants and capital1

340

O ther W estern Europe:^
Current account and long-term capital
G oods, services, and remittances
of which: Trade
Private long-term capital
U.S. Govt, grants and capital1

— 211

-4 5 0

987

— 614

454

-2 5 8

714

-8 4 8

477

1,166

-6 9 8

-1 , 0 1 2

-5 8 8

-3 1 4

-2 7 3

— 337

2,549

2,683

185

391

1,181

685

496

384

-7 5 2

— 1,723

1,991

63 4

1,146

171

976

64

108

-3 0 6

— 237

— 105

-1 1 5

10

— 436
-7 4

— 1,499

— 1,21 8

— 1,516

— 494

— 796

-9 0 6

105

— 906

1,808

3,703

3,681

3,5 3 0

4,4 1 4

2,071

2,341

2,915

1,108

1,782

1,834

1,413

2,133

971

1,162

1,078

— 1,407

— 1,407

— 593

-1 ,3 6 2

-9 2 3

-4 4 0

-1 ,5 7 2

— 3,5 1 7

— 3,792

-3 ,4 3 0

— 3 ,8 4 7

-2 ,0 5 4

-1 ,7 9 4

— 2 ,2 5 7

All Other:3
Current account and long-term capital
G oods, services, and remittances
of which: Trade
Private long-term capital
U.S. Govt, grants an d capital1

-701
— 2,606

includes U.S. Government nonliquid liabilities to other than official reserve holders,
includes the United Kingdom.
3Includes international organizations, unallocated transactions, and certain long-term liabilities to private foreigners reported by banks not
allocated by area.
4EEC countries are included in “ Other Western Europe” prior to 1966.
N ote: Details may not add to totals because o f rounding.
Source: U.S. Department o f Commerce.

improve, despite the large U.S. demand for Canadianproduced materials of all kinds and the likelihood
that Canada will strive for more self-sufficiency in
manufacturing. Moreover, the United States faces con­
Page 24



tinued keen competition for the Canadian market
from Europe and Japan. Receipts from investments in
Canada should rise more strongly than in the past
as the Canadian economy recovers. The flow of U.S.

FEDERAL RESERVE BANK OF ST. LOUIS

NOVEMBER 1971

Table II

Current and Long-Term C ap ita l Transactions Between the United States
an d M a jo r Foreign A re as
(millions of dollars)
1970
1st
Half

1971
2nd
Half

1st
Half

196 4

196 5

1 96 6

1 96 7

1968

6,831

4 ,9 4 2

3,9 2 7

3,859

62 4

660

2,110

1,662

44 8

77 6
200

8 64
-3 8 7

3,3 7 7

2,683

2,478

1,782

78 3
— 629
1,309
625
1,839

449
— 345
1,015
566
2,174

-435
- -1,1 10
150
1 85
1,834

-7 9 9
-1 ,3 9 0
1,045
391
1,413

-1 ,6 7 6
— 1,246
1,718
1,181
2,133

— 581
— 4 42
1,029
6 85
971

— 1,095
-8 0 4
689
496
1,162

— 838
— 1,382
340
384
1,078

90 3

1,160

393

83

697

85

72

176

-1 0 3

1,386

68 6
-9 2

848
-9 2

1,425

— 1,517

1,734

1,921

936
-2 7 7
— 805
— 851
1,390

589
-2 3 9
— 802
— 651
1,186

868
-2 6 4
-8 7 1
-8 8 3
1,847

84 6
-3 8 4
— 1,091
— 1,403
2,117

1,080
— 29 9
— 1,221
-1 ,7 6 9
2,281

697
-141
-4 8 1
-9 9 9
1,100

383
-1 5 7
-7 3 9
— 769
1,179

75 9
-5 1
— 43 8
-7 2 1
1,837

and remittances

7,734

6,102

4 ,3 2 0

3,942

1,321

745

2,182

1,838

34 5

96 8

C anad a
Japan
EEC
Other W estern Europe1
A ll other2

1,462
108

1,712
— 479

1,038
-5 8 4
213
-8 5
3,360

4 33
- -1 ,3 7 4
-7 2 1
-6 9 8
3,681

47
-1 ,7 7 4
-4 6
— 1,012
3 ,5 3 0

-5 9 6
-1 ,5 4 5
497
— 588
4,4 1 4

116
— 583
548
— 314
2,071

-7 1 2
-961
-5 0
-2 7 3
2,341

-7 9
— 1,433
-9 8
-3 3 7
2,915

Trade balance
C an ad a
Japan
EEC
Other Western Europe1
A ll other2

)
\

1 96 9

1970

(not seasonally adjusted)
-4 1 8

Balance on services and
remittances
Canad a
Japan
EEC
Other W estern Europe1
A ll other2

7_
)

Balance on goods, services,

1,166
3,703

— 3,2 3 7

-3 ,3 4 0

-3 ,3 7 9

-4 ,2 2 6

- -3 , 8 6 9

-3 ,5 7 4

-3 ,7 6 6

-2 ,0 9 2

— 1,675

-2 ,4 8 8

22
50

j

1,952
4,212

)

1,719
— 906
504
— 226
3,2 2 9

7
62

16
-4 4
511
— 2 27
— 3,635

-5 4
-3
60
-3 6 7
-3 ,8 6 2

19
97
113
-3 0 6
- -3 ,7 9 2

3
28
62
-2 3 7
-3 ,4 3 0

-2 0
60
146
-105
-3 ,8 4 7

4
33
40
— 115
-2 ,0 5 4

— 22
25
106
10
-1 ,7 9 4

-2 5
-3 1
-1 0 1
-7 4
-2 ,2 5 7

U. S. Government grants and
capital3
C anad a
Japan
EEC
Other W estern Europe1
A ll other2

|
f

-5 7

108

— 3,252

— 3,5 1 7

Private long-term capital, net

— 4,4 7 0

-4 ,5 7 7

-2 ,5 5 5

— 2,912

1,198

— 1,454

— 1,956

50 2

-3 ,2 8 4

C an ad a
Japan
EEC
Other W estern Europe1
A ll other2

— 1,138
-2 3 5

-1 ,3 9 8
-4 9

— 987
64
— 54
— 426
— 1,509

-9 6 3
50
1,527
1,991
- -1 , 4 0 7

— 1,417
— 38 3
1,709
634
— 593

— 1,035
-9 2
— 111
1,146
— 1,362

— 52 2
-1 3 3
— 549
171
-9 2 3

— 513
41
438
976
-4 4 0

— 231
— 454
— 591
-4 3 6
-1 ,5 7 2

-1 ,7 2 3
— 1,407

+ 28

— 1,814

-1 ,6 1 4

-3 ,1 9 6

- -1 ,3 4 9

— 2,879

— 3,038

-2 ,2 1 0

— 82 9

-4 ,8 0 2

346
— 77
)
)

2,055
— 1,042

)
)

Balance on current account and
long-term capital
C an ad a
Japan
EEC
Other W estern Europe1
All other2

-5 0

-1 ,4 8 2
82
-3 1 0
— 439
— 406

320
— 466

253
— 86 9
70 5
— 892
-8 1 1

-3
— 523
219
— 878
-2 ,0 1 1

-5 1 2
- -1 , 2 2 7
919
987
- -1 ,5 1 6

-1 ,3 6 7
— 2,129
1,725
-6 1 4
-4 9 4

-1 ,6 5 1
-1 ,5 7 7
532
454
-7 9 6

-4 0 2
— 683
39
-2 5 8
-9 0 6

— 1,247
— 89 5
494
714
105

-3 3 3
— 1,921
-7 9 4
-8 4 8
-9 0 6

— 160

— 450

— 81

— 1,218

'Includes the United Kingdom.
includes international organizations, unallocated transactions, and certain long-term liabilities to private foreigners reported by banks not
allocated by area.
includes U.S. Government nonliquid liabilities to other than foreign official reserve holders.
Note: Details may not add to totals because o f rounding.
Source: U.S. Department o f Commerce.

private capital to Canada may also trend upwards,
but perhaps relatively slowly if Canadian capital mar­
kets become better adapted to Canada’s needs.

dramatically, as noted in the following section, and
much of the improvement has centered in its transac­
tions with the United States.

Clearly a striking and perhaps lasting change has
taken place in the United States-Canadian bilateral
relationship since the early 1960’s. Indeed, Canada’s
overall position in the world economy has changed

Japan: In the case of Japan, the U.S. bilateral trade
balance shifted into sizable deficit ($387 million) in
1965; it moved to a still deeper deficit ($1.1 billion)
in 1968, and then dropped sharply to a deficit at an




Page 25

FEDERAL RESERVE BANK OF ST. LOUIS

annual rate of perhaps $2.8 billion in the first half of
1971. These growing deficits reflected spurts in U.S.
imports. Voluntary quotas imposed by Japan have
kept the trade deficit from growing even faster. On
the other hand, Japan’s restrictions on imports have
reduced potential U.S. exports, perhaps by an even
larger amount.
The United States also has a deficit with Japan in
the non-trade sectors of the current account, mainly
direct military expenditures. This deficit also has risen
over the period from about $100 million in 1964 to
about $300 million in 1970. Moreover, there has been
a rising private long-term capital outflow to Japan,
which would probably be substantially larger if re­
strictions were not imposed by both countries. These
outflows rose sharply to nearly $0.5 billion in the first
half of this year, probably reflecting expectations of a
Japanese revaluation. In 1970, Japan’s overall surplus
on current and long-term capital transactions with the
United States was about $1.6 billion, compared to a
surplus less than one-third as large in 1965. In the first
half of 1971, these transactions resulted in a U.S.
deficit of nearly $2 billion with Japan. Although
this total was inflated by anticipatory transactions of
various kinds, the underlying trend was clearly and
sharply adverse to the United States.
W estern Europe: After averaging deficits of about
$350 million annually in 1964-67, the U.S. balance with
Europe on current account and long-term capital was
transformed into a surplus of $2 billion in 1968. The
shift was due mainly to the impact of the tightening
of U.S. controls on private capital outflows. After that,
however, the surpluses diminished, and in the first six
months of this year, we registered a deficit of $1.6
billion in these transactions with Western Europe.
On trade account alone, the surplus with Western
Europe dipped very sharply from 1964 through 1968.
Subsequendy it recovered markedly as the rise in U.S.
imports slowed down while strong demand in Europe
supported a steep rise in U.S. exports to those coun­
tries. The cyclical situation as between the United
States and major European countries was especially
favorable for the U.S. trade balance in 1970, raising
the surplus to $2.9 billion — not far from the peak of
1964. However, over the coming year, as the United
States moves toward more vigorous growth, at a time
when output in the European countries will probably
be lagging, some reduction in die trade balance is to
be expected. Already in the first half of this year, the
U.S. surplus in trade with Europe was only about
$1.25 billion at an annual rate.
26
Page


NOVEMBER 1971

The picture of U.S. transactions with Europe is
significantly different when the whole current account
is taken into consideration. On this basis, the U.S.
position is noticeably weaker. The balance deterior­
ated by nearly $2 billion between 1964 and 1970. Of
this amount, $0.5 billion was in merchandise trade, and
almost $1.5 billion related to current transactions other
than trade with Europe. Principal among these were
larger deficits in tourism, rising military expenditures,
and reduced net receipts on investment income
(especially in 1969 and 1970) due to larger interest
payments from the United States on accumulating
debt.
More than offsetting the worsening of current trans­
actions with Europe from 1964 to 1970 was the sharp
improvement in the private long-term capital accounts.
These long-term capital flows shifted from a net out­
flow to Europe of about $2.1 billion in 1964 to a net
outflow of only $0.7 billion in 1966 (after voluntary
restraints on capital outflows were installed) and to a
net infloiv of about $3.5 billion in 1968 (when man­
datory controls on certain capital flows were initiated).
After that the net inflow of capital from Europe
diminished, although it still remained at about $1
billion in 1970. This year private long-term capital
has again been flowing to Europe from the United
States on an enormous scale, despite the restrictions.
The principal feature of the change in capital flows
between the United States and Europe during the
1964-70 period was the dramatic increase in European
investments in U.S. corporate securities and other obli­
gations. This trend began in 1965, when the United
States started a voluntary program to reduce the
outflow of U.S. funds for direct investments abroad.
The appeal induced U.S. corporations to seek financing
in Europe, although the amounts involved were rela­
tively small until 1968. In that year, the inflow of
private capital from Europe (apart from short-term
funds) rose to $4.5 billion, from less than $1.5 billion
in 1967. The improvement reflected the combined
impact of a tightening of the direct investment con­
trols and stepped-up European purchases of U.S.
stocks in a rising market. However, the inflow has
slackened since then to about $3.5 billion in 1970 and
to less than $1 billion in the first half of 1971.
At the moment, the outlook for capital inflows from
Europe is clouded by many uncertainties, not least of
which is the anticipation of exchange rate changes.
European purchases of U.S. corporate stocks have
dwindled. In any case, after the major portfolio ad­
justment that occurred in 1968-69 (with the help of
vigorous marketing efforts by investment funds) the

FEDERAL RESERVE BANK OF ST. LOUIS

“normal” level of inflows could be expected to be
considerably smaller. U.S. corporations have found it
more difficult to sell long-term debt abroad and in­
stead have turned to shorter-term financing for their
foreign affiliates. European direct investments in the
United States had been rising until recendy, and they
probably will do so again once the international finan­
cial environment has settled.
Flows of U.S. private long-term capital to Europe
have been held down by the controls. The steep in­
crease in plant and equipment expenditures of Euro­
pean affiliates of U.S. companies (from $2 billion in
1968 to a projected $4.4 billion next year) has been
largely financed from foreign sources. Banks have re­
duced their credits to Europe under the Voluntary
Foreign Credit Restraint Program, and the growth of
the European bond market has relieved demands on
U.S. capital markets — not only from European bor­
rowers but also from Canadians and others.
To sum up this brief review, the improvement in
the U.S. bilateral balance with Europe in 1970 de­
pended mainly on a favorable shift in capital flows that
at mid-year was already showing signs of diminishing
and on an enlarged trade surplus that reflected in
large part a favorable cyclical situation. Even though
temporary factors may have contributed a good deal
to the abrupt worsening in these trade and capital
transactions with Europe so far this year, the under­
lying trend was clearly adverse.
Other countries: United States bilateral balances
with other developed countries (Australia, New Zea­
land, and South Africa) did not shift significantly
between 1964 and 1970. As for the developing coun­
tries, the principal change in flows vis-a-vis the U.S.
has been an increase in the outflow of private capital
to them in the last few years. The U.S. trade balance
with developing nations has been nearly static since
the early 1960’s, showing an annual U.S. surplus of
about $1.5 billion.

Overall Position of Major Regions
The preceding review of the bilateral position of
the United States with various regions, in terms of
the balance on current account and long-term flows
of private capital, can show only a part of the overall
payments situation facing each of these regions. It is
only by looking at their overall surpluses or deficits
that we can evaluate the extent to which they could
or should adjust their external transactions. In effect,
the U.S. disequilibrium is the sum of the global disequilibria of other countries. So, when we speak of the



NOVEMBER 1971

adjustment that is needed from the U.S. point of view,,
we are really speaking about some sizable fraction of,
say, the overall German surplus, rather than being con­
cerned only with the German position vis-a-vis the
United States.
The most accessible body of data on country-bycountry transactions relates to international trade. But
it has not been possible to develop an accurate set
of regional flows because of discrepancies in country
statistics. A matrix of regional trade flows has been
constructed as a starting point for discussion (Table
III). However, it can only be used to indicate tenden­
cies over the period and is less accurate for any given
country than the data given in Table IV. Based on
the United Nations data used in the matrix, the
Canadian trade balance improved from a bare surplus
of $0.3 billion in 1965 to $3.7 billion in 1970. Of this
$3.4 billion improvement, $2.7 billion came through
trade with the United States. Canada’s trade balance
with Europe also improved substantially (by about
$600 million), and Canada even recorded an improve­
ment in trade with Japan. Evidently, the Canadian gain
was broadly based, although the brunt of the improve­
ment fell on the United States.
Japan’s trade balance rose about $2 billion between
1965 and 1970. About half of the 1965-70 gain in
trade was with the United States, a little over 35 per
cent with Western Europe, and another 15 per cent
with other countries. Of particular interest in the case
of Japan is the sharp upsurge in the export surplus
since mid-1970. In the last half of 1970, Japanese net
exports jumped to an annual rate of over $5 billion,
and the rate reached $5.7 billion in the first half of
1971 (Table IV ). Although trade with the United
States accounted for about 40 per cent of Japan’s
overall trade surplus in 1970, a larger share of the
gain in 1971 seems to be in trade with this country.
However, there have been several factors operating
recently to bring about a temporary surge in Japan’s
balance with us. American and Japanese traders were
probably attempting to anticipate strikes in the United
States and to avoid being caught in a yen revaluation,
while at the same time the Japanese economy has
been going through a period of slowdown at home.
Although the U.N. data show a large overall trade
deficit for Western Europe as a whole, country data
suggest that (apart from a deficit with the United
States) Europe probably has a surplus with the rest
of the world. The trade positions of the individual
European countries vary widely. These country bal­
ances have been assembled in Table IV. Among Euro­
pean countries, Germany has by far the strongest
Page 27

FEDERAL RESERVE BANK OF ST. LOUIS

Table ill

NOVEMBER 1971

R e g io n a l T r a d e B a la n c e s o f M a j o r W o r ld A re a s , 1 9 6 5 a n d
(f.o.b. value in millions of dollars)
1965

Japan

Western
Europe

Rest of
World

Unallocated
or statistical
error

7,840
8,1 10
-2 7 0

6,840
8,450
-1 ,6 1 0

84,560
79,030
+ 5,530

65,150
63,610
+ 1,540

1,1 10
0
+ 1,110

0
0
0

5,560
4,670
+ 890

2,070
2,510
— 440

9,140
6,190
+ 2,950

10,415
7,523
+ 2,892

5
-3
+ 8

8,1 10
7,840
+ 270

4,670
5,560
-8 9 0

0
0
0

295
215
+ 80

1,920
1,210
+ 710

1,220
859
+ 361

5
—4
+ 9

8,450
6,840
+ 1,610

2,510
2,070
+ 440

215
295
-8 0

0
0
0

1,100
620
+ 480

4,637
3,850
+ 787

-1 2
5
-1 7

79,030
84,560
-5 ,5 3 0

6,190
9,140
— 2,950

1,210
1,920
-7 1 0

620
1,100
-4 8 0

50,840
50,840
0

19,800
21,535
— 1,735

370
25
+ 345

63,610
65,150
— 1,540

7,523
10,415
— 2,892

859
1,220
— 361

3,850
4,637
— 787

21,535
19,800
+ 1,735

29,115
29,115
0

728
-3 7
+ 765

0
1,110
— 1,110

—3
5
-8

—4
5
-9

5
— 12
+ 17

25
370
-3 4 5

-3 7
728
— 765

14
14
0

All
Areas
All areas
Exports
Imports
Balance
United StatesExports
Imports
Balance
Canada
Exports
Imports
Balance
Japan
Exports
Imports
Balance
Western Europe
Exports
Imports
Balance
Rest of the World
Exports
Imports
Balance
Unallocated or statistical error
Exports
Imports
Balance

19701

United
States

Canada

186,390
186,390
0

20,890
27,190
-6 ,3 0 0

27,1 90
20,890
+ 6,300

1970
All areas
Exports
Imports
Balance
United States^
Exports
Imports
Balance
Canada
Exports
Imports
Balance
Japan
Exports
Imports
Balance
Western Europe
Exports
Imports
Balance
Rest of the World
Exports
Imports
Balance
Unallocated or statistical error
Exports
Imports
Balance

311,600
311,600
0

38,940
42,590
— 3,650

12,480
16,190
-3 ,7 1 0

15,670
19,320
-3 ,6 5 0

144,330
138,060
+ 6,270

98,150
95,410
+ 2,740

2,030
30
+ 2,000

42,590
38,940
+ 3,650

0
0
0

8,810
10,580
- 1 ,7 7 0

4,610
6,020
— 1,410

14,270
1 1,150
+ 3,120

14,910
1 1,206
+ 3,704

-1 0
— 16
+ 6

16,190
12,480
+ 3,710

10,580
8,810
+ 1,770

0
0
0

750'
560
+ 190

3,050
1,760
+ 1,290

1,799
1,353
+ 446

11
-3
+ 14

19,320
15,670
+ 3,650

6,020
4,610
+ 1,410

560
750
— 190

0
0
0

2,920
1,710
+ 1,210

9,800
8,600
+ 1,200

20
0
+ 20

138,060
144,330
— 6,270

11,150
14,270
-3 ,1 2 0

1,760
3,050
-1 ,2 9 0

1,710
2,920
-1 ,2 1 0

92,810
92,810
0

30,080
31,088
-1 ,0 0 8

550
192
+ 358

95,410
98,150
-2 ,7 4 0

11,206
14,910
-3 ,7 0 4

1,353
1,799

8,600
9,800

— 446

-1 ,2 0 0

31,088
30,080
+ 1,008

41,540
41,540
0

1,623
21
+ 1,602

30
2,030
— 2,000

— 16
-1 0
-6

-3
11
— 14

0
20
-2 0

192
550
— 358

21
1,623
-1 ,6 0 2

— 164
-1 6 4
0

1Based on exports, f.o.b., as reported by individual countries to the United N ations. Im ports o f a given. country (o r area) are,. therefore, dec
rived on the basis o f the exports to it from other ■ountries (o r areas) as reported by such other countries (o r areas)
2Based on United N ations statistics. Thus, the data fo r the United States differ som ewhat from official ex p ort and im port statistics, both on
the balance-of-paym ents and Census basis.
S ou rce: United N ations, M onthly Bulletin o f Statistics, June 1971. Special Table B as revised by the U .N . International Trade Statistics Cen­
ter ; H andbook o f Intern ational Trade and D evelopm ent Statistics, 1969, Table 3.1.

28
Page


FEDERAL RESERVE BANK OF ST. LOUIS

NOVEMBER 1971

Table IV

Trade Balances o f Selected Industrial Countries
(billions of dollars, f.o.b. basis)
Half-years
(annual rate, not
seasonally adjusted)
1 97 0

1971

1 96 4
United States

1967

1970

1st
Half

6.8

3.9

2.1

3.43

.0
n.a.
2.4
-.6
-.7

.1
.4
5.2
.0
-.6

.8
.4
5.8
-.3
-.9

.7
.7
4.9
-.5
— .9

.8
.0
6.6
— .2
-.9

.5
1.0
5.4
.1
— .9

— 1.5
— .4
— .4
— .6
— .1
— 1.0

— 1.4
— .5
— .5
— 1.0
— .1
-0 .6

.0
-.7
— .8
— 1.2
— .2
— 1.4

.0
— .5
— .9
— 1.0
— .6
— 1.4

.0
— .9
— .7
— 1.4
.2
— 1.4

.2
— .9
— .7
— 1.4
.4
— 1.6

2nd
Half

1st
Half

1.03

-1 .9 3

Foreign Industrial Countries:
EEC
Belgium
France
G erm any
Italy
Netherlands
EFT A
United Kingdom
Austria
Denmark
N o rw ay
Sw eden1
Sw itzerland1
Canada

.7

.6

3.0

2.6

3.4

2.5

Japan

.4

1.2

4.0

2.9

5.1

5.7

.2
.2
— .7

.0
.1
-.9

.5
.2
— 1.6

.6
.4
— 1.4

.4
.1
— 1.9

Australia
N ew Zealand
South Africa
1Imports on c.i.f. basis.
2First half 1971 is estimated.
Seasonally adjusted annual rates ; 1971
4Based on first quarter only.

Jan.

.3
.4
— 2.4*

July.

Source: International Monetary Fund, International Financial Statistics, September 1971.

trade position, with the other countries normally in
deficit. Recendy, however, several other countries
(Belgium, France, the Netherlands, and the United
Kingdom) have been improving their trade situation.
While these data on trade balances are informative,
they can also be misleading as indicators of a country’s
overall surplus or deficit. For some countries, there are
significant current account transactions apart from the
trade accounts. For instance, statistics on current ac­
count balances in Table V show that much of Ger­
many’s large trade surplus is offset by other current
payments to foreigners — especially wages to foreign
workers in Germany, tourist expenditures, and private
remittances. Thus, although Germany had a trade
surplus of $5.8 billion in 1970, that country’s current
account surplus was only $1.7 billion. For Japan also,
a large part of the trade surplus is offset by net pay­
ments on other current transactions. On the other
hand, nearly all European countries except Germany
derive substantial net receipts from current transac­
tions apart from trade — with tourist receipts often a
major source of income. These other receipts are
especially important for the United Kingdom, Austria,



Italy, and Switzerland. In
fact, for all the European
countries (other than Ger­
many) shown in Tables IV
and V, net current receipts
for non-trade transactions
were approximately $8 bil­
lion in 1970. Receipts from
the United States ($3 billion)
constituted a substantial part
of the total (Table II).

Trends in Reserves of
Industrial Countries
Up to this point, we have
not been considering the ef­
fects of the massive flows
of short-term capital which
have so greatly aggravated
the basic imbalances in world
payments. These flows often
escape the accounting mech­
anisms that have been devel­
oped to record capital flows.
Consequently, we learn that
they have occurred mainly
because official reserves are
changing in excess of the
amounts that can be ac-

Table V

Current Account Balan ces1
(millions of dollars)
1 96 5

1 97 0

United States

+ 6,102

+ 2,182

G erm any
Italy
Netherlands
France
Belgium -Luxem bourg

-7 5 1
+ 2,353
+ 56
n.a.
+ 212

+ 1,658
+ 1,325
— 51 8
+ 12
+ 9 18

n.a.

+ 3,3 9 5

EEC
United Kingdom
C an ad a
Japan
Switzerland
Austria
Denmark
N o rw ay
Sweden

+ 28 0
— 1
+ 1,026
-5 4
-5 5
-1 7 4
-1 4 6
-1 4 6

+ 1,897
+ 1,449
+ 2,1 4 6
+ 5 61 2
— 6
— 2283
— 148
-2 2 5

'Balance on goods, services, and private transfers.
21969 data.
31968 data.
Source: International Monetary Fund, Balance of Payments Year­
book, and U.S. Department o f Commerce.

Page 29

FEDERAL RESERVE BANK OF ST. LOUIS

NOVEMBER 1971

Table VI

Net O ffic ial Reserves1
(millions of dollars, not seasonally adjusted)
Am ounts2

Changes'*

Year-end

1971

196 5
G erm any
Italy
Netherlands
France
Belgium-Lux.
EEC
United Kingdom
C anad a
Japan
Switzerland
TOTAL of above countries
United States
Official reserve assets
Official settlements
balance

1 97 0

March

7,431
4,8 0 0
2,416
6,343
2,3 37
(2 3 ,3 2 7 )

13,61 0
5,2 9 9
3,234
4,351
2,854
(2 9 ,3 4 8 )

15,802
6,024
3,542
4,881
3,081
(3 3 ,3 3 0 )

Years
A ugust
16,713
6,5 2 0
3,505
7,622
3,451
(3 7 ,8 1 7 )

1,097
3,0 3 7
2,152
3,444

998
4,679
4,839
5,132

2,176
4,845
5,898
4,623

4,3 1 0
4,992
12,514
6,581

3 3 ,0 5 7

4 4 ,9 9 6

5 0 ,8 7 2

6 6 ,2 1 4

15,450

14,487

14,342

12,128

*Net reserves include gold, SDRs, foreign exchange and reserve position
IMF credit but excluding other official borrowings.
2
Amounts include SDR allocations in 1970 and 1971.
3Changes exclude SDR allocations.
4January-June 1971, not seasonally adjusted.

counted for by normal transactions. These flows may
sometimes be outright flows of liquid funds from one
currency to another, or they may take the form of
shifting the timing of delivery or payment for ordinary
commercial or financial transactions. Perhaps the best
way to illustrate the size and direction, not only of
these volatile capital flows but also the impact of the
other trends we have been discussing, is to examine
changes in countries’ reserve positions.
As shown in Table VI, between 1965 and 1970, the
net official reserves of the world’s principal industrial
countries (other than the United States) rose almost
40 per cent — from $33 billion to $45 billion. Some of
this gain (about $1.3 billion) represented allocations
of Special Drawing Rights (SDRs). However, most of
it was associated with the U.S. deficit on the official
reserve transactions basis, which totaled $9.5 billion
for the period. Reserves of the countries constituting
the European Economic Community ( E E C ) increased
by over $5 billion — apart from SDR allocations. Most
of the expansion was concentrated in Germany, which
gained about $6 billion. On the other hand, France
was a major net loser of reserves ($2.2 billion) for
that period as a whole.
Other major reserve gainers in the 1966-70 period
were Canada ($1.5 billion), Japan ($2.6 billion), and
Switzerland ($1.7 billion). In addition, some of the
non-industrialized countries not discussed here in­
Page 30



1971

1 9 6 6 -7 0

Jan -A u g

+ 5 ,9 7 7
+ 394
+ 731
— 2,158
+ 44 3
(+ 5 ,3 8 7 )

+ 2,932
+ 1,114
+ 196
+ 3,116
+ 52 5
( + 7 ,884)

creased their reserves con­
siderably. Although the U.S.
deficit on official transactions
was quite large, U.S. reserve
losses were held down to
under $2 billion. The U.S.
deficits were financed largely
by borrowing.

In 1971, of course, there
has been an enormous in­
crease in reserves of foreign
-5 0 9
+ 3,012
countries — a rise of about
+ 1,518
+ 195
$20 billion through August,
+ 2,565
+ 7 ,5 4 7
+ 1,688
+ 1,449
and an additional but rela­
+ 20,0 8 7
+ 10,649
tively minor gain has been
registered since then. The
-1 ,8 3 0
— 3,0 7 6
published U.S. balance-ofpayments data cover only the
— 9,5 4 4
— 1 1 ,8 8 4 *
first half of the year, when
in the IMF, less any use of
the official settlements deficit
reached $12 billion. H ow­
ever, from the figures show­
ing changes in official re­
serves of leading foreign countries, it is evident that
the U.S. deficits in the last few months were enormous.
Gains in reserves this year have been spread among
many nations — most noticeably Germany, France, the
United Kingdom and Japan. But other countries also
had sizable increases relative to their total reserve
holdings. By the end of August, net official reserves of
these major countries had reached $66 billion, com­
pared to $12 billion of reserves held by the United
States. At the end of August, both Germany and Japan
had larger reserves than the United States.
In my opinion, the size of these reserve gains is not
really representative of the size of the U.S. imbalance.
It will be recalled that a dominant feature of the
three-month period prior to August 15 was a massive
flow of liquid funds into those currencies that were
thought to be the best candidates for appreciation.
This flow included foreign funds previously held in
dollar-denominated assets in the United States ( mainly
represented by borrowings by U.S. banks through their
foreign branches) as well as outflows of U.S. funds
either into foreign currencies or into high-yielding
Eurodollar deposits. However, our discussion of the
basic balance-of-paym ents position of the United
States has shown that the situation was not merely
a transitory crisis of confidence. Instead, the funda­
mental weakness in our trade and other transactions
also had much to do with the deteriorating environ­
ment. The cumulative impact of these difficulties was

FEDERAL RESERVE BANK OF ST. LOUIS

too great to permit us to continue the pursuit of the
same balance-of-payments policies.

Exchange Rates and Multilateral Adjustment
Once the need for a change in policy was recog­
nized, there could be no doubt that a large adjustment
in the U.S. accounts was necessary. It was also clear
that the adjustment would have to be distributed over
a considerable number of countries. Part of the ad­
justment question involves specific actions to lessen
discriminations against U.S. goods in world trade and
a more equitable sharing of the burden of defense
outlays.
More lastingly, however, there would have to be
major changes in relative shares of world trade that
could be brought about over time only by some ad­
justment in exchange rates. We could no longer see
any reasonable possibility of effecting such changes
through monetary and fiscal policies to control domes­
tic inflation. There was simply too much lost ground
to be regained.
From the United States’ point of view, we are inter­
ested in a constellation of exchange rates that — along
with other measures in the trade and burden-sharing
areas — assures elimination of our deficit and provides
a safety margin over time. A key to this outcome is
a surplus on current account — which will have to
center mainly in a surplus on trade account.
I am sure there will be agreement on at least one
fact: no one can possibly estimate with any accuracy
the effects on a particular country of the multiplicity
of modifications in relative exchange rates and other
features of the international monetary system that
are currently at issue.




NOVEMBER 1971

This very difficulty of seeing clearly what the effects
of such changes will be in the months and years ahead
is a strong argument, in my opinion, for allowing more
flexibility of exchange rates than we have had during
the last 25 years. Most of the key industrial countries
seem to agree that some increased flexibility is a
necessary feature of the new international monetary
system that will emerge from the present negotia­
tions. However, the crux of the issue turns on the
extent to which those countries with sizable trade
surpluses are prepared to see these balances shaved
somewhat as part of the multilateral effort to make
the payments mechanism function with a reasonable
degree of predictability and efficiency.
In my personal opinion, as I have stated previously,
the most urgent requirement at the present time is for
a wider understanding among the major industrial
nations with respect to the fundamental goals of the
payments system, and for a better coordination of na­
tional goals in the areas of international trade, invest­
ment, and assistance to the developing countries. The
efforts to negotiate new exchange rates and to promote
institutional changes are obviously necessary. But I
remain less than optimistic about the long-run viabil­
ity of such arrangements unless there is a broad con­
census on goals. The recent Annual Meeting of the
International Monetary Fund did result in some move­
ment in that direction, in that ten of its principal
industrial members agreed on a list of priorities for
negotiation and a plan of work over the months ahead.
However, the tough issues of exchange rate adjust­
ment and the reduction of trade barriers remain to
be resolved. If we are successful in resolving these
issues and also in producing fundamental improve­
ments in the payments system, the benefits of in­
creased international trade and investment would be
considerable.

Page 31

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