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For release at
2:30 p.m. EST
Wednesday, Nov. 30, 1966




How the Federal Reserve Looks at the Balance of Payments
Remarks of George W. Mitchell
Member, Board of Governors of the Federal Reserve System
before the
American Management Association
Washington, D. C.
November 30, 1966

How the Federal Reserve Looks at the Balance of Payments

It is the job of several other speakers during this briefing session
to provide detailed discussions of particular aspects of the U.S. balance of
payments problem.

It therefore seemed most useful for me to try to present

an institutional point of view.

How do we in the Federal Reserve System tend

to analyze and make judgments about the balance of payments in light of our
particular responsibilities?
Federal Reserve Policy Goals
It is just as well to start with first principles by reminding you
of the multiple policy objectives which condition the Federal Reserve's view
of economic events and which underlie all our decisions on the application of
monetary policy.

These objectives may conveniently be summarized by such

expressions as full employment, price stability, sustained and orderly growth
of the economy, and a satisfactory state of balance in external transactions.
Needless to say, these policy goals are not peculiar to us at the Federal
Reserve.

They are the major economic goals sought by the Administration

and are widely accepted outside the Government as well.
Some of these policy goals are not ultimate, but only intermediate,
objectives.

For example, price stability or balance in external transactions

are not intrinsically desirable goals in the same sense as maximization of
output and employment.

Our really basic economic and social objectives

probably cannot adequately be characterized by any simple unqualified
expression.

We do believe, nonetheless, that there is a fairly close con­

nection between our more basic objectives on the one hand and the proximate
attainment of full employment, price stability, high growth, and external
I am indebted to Ralph C. Bryant, Economist in the Board's Division of Inter­
national Finance, for assistance in preparing these remarks




-

balance on the other.

2-

Thus these four goals can usefully serve as a shorthand

characterization of the main objectives which guide Federal Reserve decision
making.

If policy goals are numerous, and if policy tools to promote the
achievement of those goals are either weak, limited in number, or uncertain
in their effects, all the policy goals may not, at any given time, be
simultaneously attainable.

This simple, unpleasant fact of life is too often

forgotten or de-emphasized.

One can imagine plausible economic situations in

which any pair of the four goals mentioned earlier could be in short-run
conflict.

For a classic illustration of the conflict between full employment

and external balance, for example, one need only recall the difficult dilemma
confronting U.S. economic policy in the first half of the I9601s.
Precisely because policy goals are numerous, and because they may not
all be simu11aneously attainable in the short run, concern with any single one
of them cannot be compartmentalized.

The most appropriate package of economic

policies--and here I am thinking not just of monetary policy but of all the
instruments of economic policy subject to governmental control and influence-is that package which promises to bring about the best attainable combination
of our multiple policy goals.
Of all the tools of economic policy, monetary policy is perhaps
the most capable of immediate and flexible action.

The reconciliation of

potentially competing policy objectives is necessarily, then, the daily concern
of those responsible for formulating monetary policy.
goal

In those times when the

of external balance seems to require policy action somewhat at odds with

the policy action required to achieve domestic economic objectives, it is fair
to say that we in the Federal Reserve are peculiarly and painfully distressed.




-3The unique, central position of the dollar in the world monetary system
necessarily requires us to be deeply concerned with any developments that
threaten the dollar's international acceptability.

Yet it would clearly

be tantamount to sacrificing basic ends to intermediate means if policy
actions were allowed seriously to jeopardize domestic prosperity just in
order to achieve or to maintain external balance in the short run.
The Nature of the U.S. Payments Problem
I propose to return later on in my comments to the difficulties of
attaining a number of different policy goals simultaneously.

Before doing so,

however, let me review briefly with you some salient features of our balance
of payments problem as they appear to me.
With the exception of the years 1953 and 1959, the United States
has had large surpluses in the current account of its balance of payments
throughout the last twenty years.

This surplus has, of course, varied with

business cycle conditions here and abroad.

But taking the long view, it has

been an enduring, structural feature of our balance of payments.

Barring an

unforeseen, radical change in world trading relationships, it will continue
large in the future.
It is important to remember that this current account surplus
builds up the U.S. international investment position at the same time that
it makes real resources available to the rest of the world.

This transfer

of resources is both natural and desirable for a wealthy, developed country
like the United States.
It is true that over the past year we have observed an unprecedented
boom in imports and a consequent large deterioration in our current account




-4surplus.

These developments, however, have been a manifestation of a boom

at home that we are resolved, for domestic reasons, to bring under control-and in fact appear to have done so.

It seems probable that the recent

deterioration in our current account surplus may already have been reversed.
U.S. Government transactions play an important role in several
sectors of the balance of payments.

Perhaps the single most important point

to make about these transactions is that they mirror rather closely the United
States' large foreign-policy commitments and obligations throughout the world.
These commitments and obligations are not sacrosanct.
evaluated constantly.

They should be re­

Nevertheless, without major changes in our foreign

policy, few of them can be quickly or easily abandoned.
The U.S. private capital outflow has been very large, rising
especially rapidly through 1964.

This capital outflow, as befits a major

capital exporter, has been predominately in longer-term, relatively illiquid
assets.

There has also been a large foreign private capital inflow to the

United States, although not so large as to offset that part of the U.S.
capital outflow (Government and private) that was not covered by the current
account surplus.

This foreign inflow has been primarily in the form of an

acquisition of liquid assets.
A number of different reasons for these private capital-flow
developments can be given.

Without attempting to deal with these explanations

in detail or to pass judgment on their relative importance, let me mention
some of them briefly:




(a)

Some capital movements seem closely related to rates

of growth and levels of resource utilization and development

-5-

here and abroad.

Direct investment by U.S. corporations, for

example, has been stimulated by the growth and evolution of the
Common Market, although a great deal of direct investment has
also gone into resource development, manufacturing, and
distribution outside the EEC countries.
(b) Foreign industrialized countries have tended to rely
rather heavily on monetary policy for stabilization purposes,
with the result that interest rate levels have been high abroad
relative to what they would have been had there been a more
active use of fiscal policies.

This has meant in turn that

differentials between U.S. and foreign interest rates often
have provided strong incentives to move capital abroad.
(c) Changes in relative confidence in other currencies
vis-a-vis the dollar have sometimes led to large capital move­
ments, both into and out of the dollar.
(d) The strength, flexibility, and competitiveness of the
U.S. capital market and the large, growing volume of U.S.
saving combined with the underdevelopment of, and restrictions
imposed in, the capital markets of other industrialized countries
have all contributed to heavy borrowing by foreigners in the
United States.
All these explanations for private capital flows are either
directly related to or else heavily influenced by the importance of the
United States as the dominant international financial and banking center.




-6To summarize a very complex institutional situation:

the processes of lending,

borrowing, and the accompanying financial intermediation that take place
across national borders in today's economically integrated world are in
substantial measure channeled through (or indirectly involve) the U.S.
financial and business communities.

Hence the balance of payments of the

United States reflects many complicated exchanges of assets and liabilities
which defy simple analysis or interpretation.
The final, critical feature of our balance of payments problem on
which I must touch has to do with the changes in our monetary reserve assets
and the changes in our reserve liabilities to foreign central banks and
governments.

U.S. reserve assets have been steadily declining since 1957

(they also declined in the early 1950's) and our reserve liabilities have
been, at least until recently, just as steadily increasing.

In the early

postwar years declines in our swollen reserves and increases in our reservecurrency liabilities— representing as they did a needed redistribution and
augmentation of the world's stock of reserve assets— were highly desirable
and were universally regarded as such.

The day is long since past, however,

when a sizable decline in U.S. reserve assets can be viewed with equanimity
within the U.S. Government.
From the foregoing brief description of our complex balance of
payments problem, it should be abundantly clear that the United States is
not suffering from the type of payments problem typically described as
"living beyond one's means."

There is no meaningful sense in which the

United States has been getting poorer internationally.

The fact that we

have been running, year in-year out, large current account surpluses means,




-

7-

of course, just the reverse; our total assets abroad have been rising much
faster than our total liabilities.
Another view about the U.S. payments problem frequently heard is
that we have been unwisely following a course of lending long and borrowing
short.

As already noted, however, the United States and U.S. institutions

are heavily engaged in the business of providing banking, brokerage, and
financial intermediary services to the rest of the world.

One of the

traditional roles of a financial system is to lend long and borrow short;
that is the essence of financial intermediation.

Some country or countries

will necessarily have to provide the world with these services.

It is no

cause for alarm in itself that the U*S. balance of payments reflects these
complicated exchanges of assets and liabilities.
On the other hand, of course, there is some limit as to how far
the process of financial intermediation can and should go.

Prudent bankers

do lend long and borrow short, but they do not push this process so far that
they are unduly exposed to (and hence perhaps even induce) sudden large
losses of deposits.

Nor would the United States be acting prudently if it

allowed its external reserve assets to continue to decline sharply while
our liquid liabilities to foreigners go on rising.
What Do We Mean By "Equilibrium"?
Earlier I described one of the Federal Reserve policy objectives
as l a satisfactory state of balance in external transactions."
f

But what

does it mean for the United States to "restore equilibrium" in its balance
of payments?

What, in other words, is the definition of success?

How do we

tell if or when we have actually achieved the goal of satisfactory external
balance?




Unfortunately, the notion of "equilibrium" is an elusive one and
there is no simple target or formula which the Federal Reserve or anyone
else can use.

The much-discussed controversy over how to measure the

"deficit" in the U.S. balance of payments has brought this fact out quite
clearly.
For example, there are several reasons why, in my view, a balance
of zero calculated on the liquidity basis would not be a desirable long-run
policy objective; such a goal, if achieved, would not be likely to signify
payments equilibrium in any economically meaningful sense.

To cite one

reason: a secular rise of some amount in U.S. liquid liabilities to
foreigners— particularly private foreigners--is a natural, welcome con­
comitant of the rising volume of international trade and financial trans­
actions.

If the U.S. long-run policy objective were to attain a balance

of zero on the liquidity basis, private foreigners could only increase their
dollar holdings to finance expanded world trade to the extent that our
official reserves rose or foreign central banks reduced their own dollar
reserves.
There are also good reasons for not mechanically taking a zero
"official settlements" balance as a policy target.

More generally still,

regardless of which definition of the balance is used, one should probably
be skeptical of the magic appeal of the number zero, or zero * x.
"Equilibrium" or "payments balance" are essentially analytical concepts
that do not have exact statistical counterparts.

An accounting deficit—

however defined— is only a summary indicator of how things have been going.
It is not a complete diagnosis, nor should it be interpreted as a policy
prescription.




-

9-

I trust that nothing I have said so far will be misinterpreted as
an attempt to minimize the seriousness of our current balance of payments
difficulties.

That would be a grave misinterpretation.

The full seriousness

of our balance of payments problem is unambiguously evident in the persistent
decline in our reserves that has continued throughout the current decade.
However one wishes to define a "satisfactory1 state of balance in our external
1
transactions, it seems to me abundantly clear that a continuation of this
persistent decline increasingly exposes us to the necessity of drastic action.
It cannot continue much longer without putting an intolerable strain on the
international monetary system as presently constituted.
These considerations lead me to the conclusion that a minimum
balance of payments target for the medium-term future should be a decisive
cessation of the loss of U.S. monetary reserves.

For the longer-run future,

we will need to think in terras of a dynamic definition of payments equilibrium-one that will take into account specifically both the desired evolution of our
own reserves and also the desires of foreigners to add to (and in some cases,
to run down) their key-currency and reserve-currency holdings of dollars.
The Role of Monetary Policy in Restoring and Maintaining External Balance
I earlier referred to the Federal Reserve's multiple policy goals
and the impossibility of compartmentalizing our concern with the balance of
payments.

I should like now to consider one of the difficult questions

arising out of this multiplicity of policy goals: How much weight should be
given to balance of payments considerations in determining the course of
monetary policy?




-10At the outset, it should be clear there is no precise answer to this
question in a world where circumstances are constantly changing.

And one needs

to have a judgment in some depth as to just how and to what extent changes in
monetary policy have an impact on the balance of payments.

We know that the

influence of monetary policy on the balance of payments is often quite indirect
and that the precise response is extremely difficult to predict.

In fact,

this uncertainty about the quantitative impact of monetary policy on the
balance of payments as well as on growth and stability is one of the reasons
why it is difficult to deal with the question I have put before you.
There are many differing views about the role that monetary policy
should play in restoring and maintaining external balance.

I propose, in

my following remarks, mainly for expository reasons, to caricature for you
two of the more extreme views that are currently popular.

The first of these,

which for convenience I will refer to as Guideline A, holds that general
monetary policy should be devoted primarily to the goal of external balance
while other policy instruments are being used to regulate the pressure of
demand in the domestic economy.

The second view, which I shall call Guideline B,

is that domestic considerations are so overwhelmingly important in the United
States that monetary policy should not be markedly different from what is
deemed appropriate on domestic grounds alone.
The rationale for Guideline A — that monetary policy should be
largely dictated by balance of payments considerations— is roughly as follows.
The degree to which it is possible simultaneously to achieve the two goals of
full employment and price stability, it is argued, is not very sensitive to
the "mix1 of monetary and fiscal policies.
'




Given this relative invariance

-11of the trade-off between inflation and unemployment to the composition of
overall demand, the argument continues, then the most appropriate mix of
policies to achieve any given targeted level of overall demand can be
decided on other grounds.

Therefore, proponents of Guideline A would say,

monetary policy can be freed to respond mainly to the balance of payments
while the desired targeted level of overall domestic demand can be achieved
via fiscal policy (where of course the fiscal action takes due account of
whatever monetary policy does for balance of payments reasons).
The arguments put forward for Guideline A are interesting and,
in some respects, appealing.

The proponents of this view are keenly aware

of the difficulties of simultaneously achieving both domestic objectives and
external balance in a system of fixed exchange rates, and put forward their
guideline as a theoretical alternative for reconciling all these potentially
conflicting policy goals.
The Federal Reserve did move somewhat in this direction earlier in
the 1960!s when the goals of internal and external balance were so clearly
in conflict.

At the same time that tax reductions were carried out in 1964

and 1965 to stimulate demand and reduce high unemployment in the domestic
economy, monetary policy gradually moved away from the easy posture it had
earlier taken.

This change in the mix of monetary and fiscal policies was

deliberate and partially motivated by balance of payments considerations.
There are at least four reasons, however, why Guideline A has not
in the past gained ascendancy as a rule for the application of monetary
policy in the United States and why it is not likely to do so in the future.
First, we do not really yet know enough about the rates at which monetary




-12and fiscal policy can be substituted for each other.

Some experience has

been gained, particularly during the period in the 1960's to which I referred
just a moment ago.

Nevertheless, much more experience and information would

be necessary in order to apply Guideline A with any precision or confidence.
Second, there are many situations in which, if monetary policy were
primarily dictated by balance of payments considerations, the policy goal of
growth would suffer.

In other words, the objective of sustained, reasonably

rapid growth might require an opposite mix of fiscal and monetary policies
from the mix appropriate to correcting a payments imbalance.

Here of course

it could be argued that if we could make the structure of taxation sufficiently
flexible so that it could be regarded as an additional policy instrument— if
special fiscal incentives could be given to various types of investment but
not to consumption expenditures--then this particular objection to Guideline A
would be muted.
The third reason why monetary policy cannot mechanically follow
Guideline A has to do with the way other countries manage their economic
policies.

Many foreign countries tend to rely quite heavily on monetary

policy for regulating their domestic economies.

If Guideline A were to be

followed by the United States but not by other countries, it is doubtful
whether the United States— quite apart from the consequences for our domestic
economy--could even be successful in attaining the goal of external balance
via monetary policy alone.

If Guideline A were ever to be successfully followed

by a large country with well-developed, relatively unrestricted capital markets,
a prerequisite would be a much greater degree of international harmonization
of monetary policies than presently exists in the world.




-13The final reason why monetary policy cannot be dictated by balance
of payments considerations alone is a simple one, but perhaps the most
important of all.

At any given time fiscal action to regulate the pressure

of domestic demand, in accordance with the prescription of Guideline A, may—
whether rightly or wrongly— be thought either inappropriate or else impossible.
Even if they have the wish to do so, moreover, the fiscal authorities may not
be capable of acting quickly enough or with enough flexibility.

Monetary

policy may then have to step into the breach.
In a situation where monetary policy has to do the brunt of the
work both in regulating domestic demand and in restoring external balance,
we are relatively fortunate if we have both domestic and external considera­
tions pointing in the same direction so that two policy goals can be served
by one policy tool.

This in fact has been the case since last winter and

spring: in the absence of fiscal action further monetary tightness was
called for both to curtail the unsustainably rapid advance of the domestic
economy and to prevent the balance of payments from deteriorating.

It goes

without saying, on the other hand, that matters are quite different in a
situation in which the brunt of the work of policy changes is thrown onto
monetary policy while domestic and external considerations are pointing in
different directions.

It is, I'm sure you would agree, difficult enough

to kill two birds with one stone when the birds are both flying away in
the same direction.

Such a task may fairly be termed impossible if they

are flying off in opposite directions.

In such a situation, nothing less

than two stones will do.
What about the other extreme prescription for the application of
monetary policy, Guideline B?




The United States has a very large economy,

-14proponents of this view argue, yet international trade forms a very small
proportion of total GNP.

Hence the balance of payments' tail should not be

allowed to wag the whole dog (i.e., the domestic economy).

Often one even

hears it said that the balance of payments problem is a concern of the
second order of magnitude, and that any difficulties with the goal of
external balance should be handled by specific, selective restraints.
Here again such a simple rule must be rejected.

Given the vital

international roles played by the dollar, the interdependence of all economies
in today's increasingly integrated world, and the extent of U.S. political
and economic interest abroad, a continuous shrinkage of our reserves or an
unsustainably rapid expansion in our short-term liabilities can become very
much a problem of the first order of magnitude.
To recommend that our balance of payments problem should always be
dealt with by various selective restrictions, furthermore, may be to take a
near-sighted approach to the problem of reconciling competing policy goals.
Selective restrictions on international transactions are often not, from the
point of view of the whole economy's welfare, costless policy tools to apply-though they may be the least costly alternative in many circumstances.

The

Voluntary Foreign Credit Restraint program and The Interest Equalization Tax
are good examples of appropriately-used selective policies.
measures are not always to be preferred.

But selective

As my fellow Board Member,

J. L. Robertson, noted last spring, just as we should not let dogmatic
orthodoxy prevent us from using selective tools when they are less inappro­
priate than any other policy alternative, we should not let dogmatic
selectivism prevent us from returning to more orthodox methods if selective
tools prove to be too costly or to have outlived their usefulness.




-15Thus neither extreme guideline for the role of monetary policy is
really persuasive.
these two views.

The Federal Reserve seems to be on a middleground between
Monetary policy has ordinarily in the past been heavily

focused on domestic considerations.

This does not mean that in the past

balance of payments developments have always had an insignificant role in
monetary policy decisions.

Nor does it mean that monetary policy in the

future will make little contribution to the restoration and maintenance of
external balance.

The relative weight given to balance of payments considera­

tions in the formulation of monetary policy must clearly vary from time to
time, depending critically on economic (particularly monetary) conditions
abroad, on the availability and suitability of other policy instruments for
influencing the balance of payments, and on the posture of fiscal policy
relative to developments in the domestic economy.
Where Do We Go From Here?
It seems natural in concluding my remarks to advance a judgment
and opinion about the constraints that balance of payments considerations
will exert in the future on the use of monetary policy for domestic objectives.
Are we likely again, from time to time, to be faced with the kind of short-run
conflict between internal and external balance which we confronted in the
period 1960-1964?

Taking fully into account the seriousness of our present

balance of payments problem, what sort of mix of monetary and fiscal policies
is practicable in the near term?

What is the most appropriate role for Federal

Reserve policy tools within the overall U.S. balance of payments policy?

More

generally, how should our overall balance of payments policy in the United
States be coordinated in the future with our trading partners, who benefit from
the exportation of U.S. industrial equipment, know-how, and capital resources?




-

16-

In thinking about the answers to these questions and where we go
from here, let me leave you with three propositions.
First, as international economic relationships become more pervasive
and significant— that is, as we approach "one worldness"— balance of payments
considerations will more frequently be of major concern.

In the future, just

as in recent years, we will have to have an active balance of payments policy,
and this policy should be fully integrated with overall domestic economic
policy.
Second, the immediate problem of simultaneously achieving multiple
policy goals with the aid of only a limited number of policy tools does not
admit of any easy, simple solution.
difficult than in others.

In some periods this problem is less

We do face the possibility, however, that from

time to time either some policy goal will have to be partially sacrificed,
some constraints will have to be broken, or else we will have to use some
additional policy tools out of our tool box that, other things being equal,
we would have preferred not to use.

These choices will be difficult, and I

doubt that— despite claims to the contrary— anyone has a valid, cut-and-dried
prescription available in advance for making them.
Finally, let me remind you that restoring and maintaining payments
balance in a world monetary system based on fixed exchange rates is a twoway proposition.

As presently constituted, the burden of balance of payments

adjustment in our system falls more heavily on deficit countries than on
surplus countries--irrespective of the reasons for the imbalance.

While the

United States fully intends to restore external balance, it is far from clear
that unilateral action by the United States will necessarily and automatically
lead to a better overall world payments equilibrium.

If some European

countries do not actively pursue policies conducive to the reduction of




-17-

their large surpluses, the counterpart of the improving U.S. payments position
may involve seriously deteriorating payments positions elsewhere--for example
in the less developed countries, with corresponding damage to these countries'
attempts to raise their standards of living.

Hence, all countries--those

with surpluses and deficits alike, and particularly within the Group of Ten-have a continuing obligation to bring about a better payments balance.
United States expects to play its part.
parts as well.




The

I expect that others will play their