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Statement by
Henry C. Wallich
Member, Board of Governors of the Federal Reserve System
before the
Subcommittee on International Finance and Resources
of the
Committee on Finance
United States Senate

14, 1974

I am glad to have this opportunity of discussing inter­
national economic problems and their domestic repercussions before
this distinguished subcommittee.
If a broad-brushed picture of the international economic
scene in recent years is drawn, several major features stand out.
The international economy has been upset by a number of severe dis­

Foremost among the recent disturbances have been the oil

embargo and the jump in the international price of oil.

More broadly,

the international prices of commodities have moved dramatically,
rising particularly rapidly during late 1972 and early 1973.


rises in the price of oil and other commodities have contributed to
the worldwide inflation which is currently raging, but inflation can
by no means be exclusively attributed to the commodity sector.


recent years, aggregate demand in many countries has become over­
heated; too many have tried to do too much too quickly.
But if disturbances and change have been major unsettling
features of the international economy in recent years, its resilience
has offered some reassurance.

In spite of the disturbances, there have

been solid gains in the volume of trade and other transactions among

For the United States, for example, exports of goods and

services have increased more rapidly than total GNP, rising from
5.9 per cent of GNP one decade ago to 7.8 per cent of GNP during
the past year.

Looking at goods only, foreign markets have become


even more important to U.S. producers, since exports of goods last
year amounted to more than 10 per cent of our domestic goods production,
compared to 8.2 per cent in 1964.

These gains in international trade

reflect elements of strength in the international economy -- the
reductions in tariffs which have been painstakingly negotiated in
recent decades, the highly developed and continuously improving
system of transportation and communication, and the rapid growth
in world production.
While the over-all level of international transactions has
expanded rapidly, the trade balance of the United States has moved
unevenly in recent years, sliding into deficit in 1971 and 1972, and
then temporarily recovering to a small surplus in 1973 as agricultural
exports boomed and as the effects of the devaluations of the dollar
began to have their effect.

Elements of strength continue to benefit

U.S. export trade, but they have been overwhelmed by increases in
the price of oil, with the result that our trade balance is now
back in deficit.

During the second quarter, the deficit amounted to

$6.8 billion at an annual rate (seasonally adjusted).

During that

quarter fuel imports were running at an annual rate $20 billion above
last year.
It seems unlikely that the trade balance will improve very
much, if at all, over the next 12 months.

Much depends on the size

of the harvests here and abroad and on the price of oil.



1973, following upon poor crops abroad, our agricultural exports
rose to 25 per cent of our total merchandise exports, compared to
a figure of 19 per cent in 1972.

In 1974, this percentage is likely

to decrease.
The degree of exchange rate flexibility which has developed
in recent years has contributed to the ability of the international
economy to withstand shocks.

Indeed, it is difficult to see how the

disturbances of the past few years could have been absorbed as smoothly
as they in fact were if exchange rates had been pegged and rigidly

As a result of the negotiations recently conducted by the

Committee of 20 of the International Monetary Fund, the evolving
system of exchange rate flexibility can be put on a more systematic

A major feature of the reform effort has been a set of guide­

lines for floating, which define what countries should and should not
do in the way of intervening in foreign exchange markets.


development of guidelines for intervention should limit potential
conflicts among nations over exchange rates and limit swings in
rates, and this tends to ease some of the concern that we may
feel with respect to the system of floating rates.

But while exchange rate flexibility has increased the
shock resistance of the international economy, it has produced problems
of its own, such as the speculative losses that have affected some


financial institutions in recent months.

Market swings have been

unnecessarily wide, and have from time to time permitted declines
in the value of the dollar which have contributed to inflationary

In any event, exchange flexibility can at best make

only a marginal contribution to the very real longer run difficulties
engendered by the increase in the price of oil.

The difficulties

with which I specifically want to deal in this testimony are balanceof-payments problems, financial strains, and domestic repercussions.
When the oil-exporting countries receive their huge
additional payments, they basically have two ways of using their
great windfall.

They can import additional goods; or they can

acquire assets in the oil-importing countries.

Insofar as they

do the former, a course of action which is limited by their
absorptive capacity, the total current account deficits of the
oil-importing countries are reduced.

Of course, this partial

solution of their balance-of-payments problem cannot be considered
a painless outcome for the oil-importing countries, since they will
of necessity then have to give up the resources needed for the
production of their additional exports to the oil producers, with
a consequent reduction in their living standards.

Insofar as the

oil exporters take the second option -- acquiring assets, and in
a broad sense, investing in the oil-importing countries -- they
are automatically recycling the oil receipts to the oil importers


as a group.

In general, money not used for imports must be deposited

or invested somewhere, and wherever it goes, it is available to the
oil-importing countries.
But the automatic recycling occurs only with respect to
the oil-importing countries as a group.

For individual countries

and institutions serious problems may nevertheless arise.


the oil-exporting countries may want to hold their funds in only
a limited number of large banks.

A great increase in deposits, for

instance, could strain the capital positions of these banks.


desire for high liquidity on the part of the oil-exporting countries,
causing them to hold their funds in the form of short-term deposits,
would strain the banks1 liquidity positions.

Second, some countries

may suffer severe financing difficulties if their ability to finance
imports by drawing on reserves or by borrowing them falls short of
Both problems can be mitigated to the extent that the
oil exporters are prepared to make appropriate financial arrangements.
To the extent that the oil-exporting countries decide to hold some
of their assets in forms other than bank deposits, the problems of
the financial institutions will be lessened.

If, further, oil

exporters were willing to acquire assets in the importing countries
in approximate proportion to the need of the importing countries to
pay for oil, the danger that some countries may not get enough


recycling would be obviated.

We are beginning to see encouraging

developments along these two lines.

As of this time, however,

one cannot expect that the problems of financial institutions and of
balances of payments will be fully met by developments such as these.
The normal workings of the market will ease some of the
problems growing out of the vast payments to the oil producers.


the OPEC countries, like other recipients of windfalls, initially
hold most of their new wealth in liquid bank balances, they will
compel banks to tighten up the conditions on which they will accept
these funds.

This would give the Organization of Petroleum

Exporting Countries (OPEC) an incentive to look for other invest­
ments, either of a debt or equity nature.

If a country receives less

recycling than needed to meet its current account deficit, it may be
able to borrow from countries that receive more than they require.
The market has a major role to play in redistributing funds according
to need.

This applies both to the Eurodollar market, and to the

national capital markets of countries.

The ability of capital

markets to fulfill their function as intermediaries between
countries with plentiful and relatively scarce supplies of capital
has been enhanced by recent moves towards freer capital markets.
Situations may develop that the market cannot handle,

Such situations will be more frequent if the price

of oil remains at anything like the present level.



instance, where credit risks are perceived by private financial inter­
mediaries as excessive, facilities in addition to those that the market
can supply may be required.

Some international steps are now being

taken to make financing available to needy countries, most notably
through the IMF oil facility.

The financial facilities of the

European Economic Community have been drawn upon by Italy.


strains on the international financial system are to a large
degree attributable to the actions of the OPEC countries, it is
urgently desirable that they contribute to the easing of the
situation by lowering the price of oil, and by making funds
available increasingly for official financing arrangements.
Potential strains on the international financial system
can be reduced if steps are taken to keep some fair balance among
the current account positions of the oil-importing countries.


a group, the oil-importing countries will run large current account
deficits into the foreseeable future -- unless the oil problems
are reduced by a major price rollback.

How these deficits should

best be distributed has been a matter of concern, both within inter­
national organizations such as the Organization for Economic
Cooperation and Development (OECD) and within national governments.
It must be borne in mind that the oil deficits are
occurring in addition to deficits and surpluses that particular
countries were already experiencing as a consequence of domestic



policies and other factors.

Where good policy calls for elimination

of these deficits, every effort should now be made to eliminate them.
But a country cannot eliminate its oil deficit without increasing
the deficit of some other country, since the surplus of the oilexporting countries, for reasons already stated, cannot be eliminated
in the short run.

Individual countries might, of course, nevertheless

attempt to eliminate their oil deficits.

But such attempts, if

pursued too vigorously, could lead to general contraction -- since
the standard ways to eliminate a deficit are to restrain aggregate
demand, restrict imports and other payments, and possibly depress
exchange rates.

The danger, so to speak, is that the oil-importing

countries may be lured into a game of musical chairs with their
combined deficit.

The deficit will remain, but the game itself

can become mutually destructive.
But while mutually contradictory attempts to eliminate
current account deficits represent a danger, there is no fully
satisfactory basis for agreeing on how the deficits should be

It is frequently suggested that countries should

attempt to balance their current account receipts and expenditures
exclusive of the deficits attributable to the increase in the price
of oil.

Alternatively, it has been suggested that countries adjust

their trade balances in such manner that each oil-importing
country accepts a deficit proportionate to its GNP.

Neither of


these criteria provides an adequate guide, if only because some
countries may be unable to borrow enough in the market, and then
would have to cut down their deficit unless they receive aid.
It is appropriate that countries that face both large
current account deficits and strongly inflationary domestic
conditions should take firm steps to control domestic demand.
Each country, of course, should frame its policy in full awareness
of the fact that, collectively, large current account deficits
cannot be avoided by the oil-importing countries.

But the prospective

oil deficits do not mean that countries should ignore the prudent
fiscal and monetary policies needed to put their domestic house in
In summarizing this review of the financial repercussions
of the high price of oil, I would say this.

We have good markets

and institutions, and public policy makers are not without guides
as to what to do in the face of this situation.

But one cannot at

this time be sure that the situation will in fact be manageable,
unless there is a substantial reduction in the price of oil.
I now turn to the second group of problems set out earlier,
relating to domestic repercussions of international events.


the oil-importing countries, by far the greatest problems are
encountered by the less developed countries (LDC's).

Facing an

uncertain future at best, a number of them have been put in a grim


position by the increases in the price of oil -- upon which depend
their transportation, their nascent industries, and their supplies
of fertilizer.

Indeed, unless the price of oil is reduced, or

unless the LDC's receive large flows of capital or aid from the
OPEC or OECD countries, the outlook for some of them is very
difficult indeed.

The adverse effects of high oil prices on

the supply and cost of fertilizers and therefore on the price of
food is particularly troublesome.
For the economically developed countries, increases in
the price of oil also have important domestic implications.
Representing a strong autonomous increase in costs, they have
exacerbated the already grave inflationary problems of the United
States and other countries.

The increases in the price of oil have

frequently been compared to a large excise tax paid to foreigners,
having both an effect of pushing up prices, but also tending to
drain real disposable income from the economy, thereby increasing
the dangers of weakness in economic activity.

This source of soft­

ness of demand has, however, tended to be offset by new demands
for capital investment.
Several aspects of the changes in the international economy
have contributed to the need for additional capital, of which the
need to develop substitute sources of energy is only one.


is the fact that, as the current accounts of the United States and


other oil-importing countries show large deficits, there will be
an accumulation of liabilities to the oil-exporting nations.


order to ease the future problems of debt repayment, we should
encourage the growth of our capital stock and productive capacity.
Fortunately, one of the effects of the higher price of
imported oil is to create an opportunity for increased investment
in each oil-importing country's economy.

As already mentioned,

the increase in the price of imported oil, like an excise tax,
removes purchasing power from the domestic economy.

The resources

thus released can advantageously be channeled into investment.
Such an increase in investment could come about, for instance,
if the oil-exporting countries recycle the funds to the importing
countries and acquire assets there.
Neverthless, until the present inflation has been brought
under control, increases in investment must be accompanied by
determined restraint on aggregate demand.

It is here that restraint

in the government budget has a crucial role to play.

Cutting of

government expenditures and a reduction in the volume of government
financing will have desirable direct effects in restraining
inflationary forces.

Furthermore, given the over-all monetary

restraint applied by the Federal Reserve, more fiscal discipline
will mean less government borrowing and hence lower interest both
here and abroad.

The relaxation of pressures on institutions which


finance the housing industry would be especially beneficial.


a strong case for budgetary restraint can be made on the grounds that,
in present circumstances, government expenditures are directly
competitive with home construction.
In our domestic fight against inflation, we must not expect
quick success; perseverance has become the key note.

If we are to

be successful in our anti-inflationary fight -- and it is imperative
that we achieve success -- then we must be determined to fight infla­
tionary pressures over an extended period.

And, just as the inter­

national prevalence of excess demand in recent years has meant
that national inflationary problems have tended to reinforce one
another, so, on the other side, the unwinding of inflation will
be less difficult for each country if there is an international
determination to exercise restraint.
The problems of inflation as well as those of international
finance and balances of payments would be greatly eased by a decline
in the price of oil.

There are reasons for expecting such a decline,

not only on the grounds of a current excess of supply over demand,
but on the grounds of the long-term economic self interest of the oilexporting countries who undoubtedly will want to protect their markets.
But a decline to the prices of past years cannot be expected.


Efforts to cope with inflation are needed almost everywhere.
In the OECD countries, inflation currently rages at rates which
range between 7 per cent and 23 per cent.

Inflation has reached

a stage in which fears are being expressed openly about the survival
of democratic institutions.

Germany, which took anti-inflationary

action earlier in the cycle, has been rewarded by the lowest rate
of inflation among the major industrial countries.

German restrictive

actions in the past year have kept domestic demand approximately
flat in real terms, with the expansion of German economic activity
being completely accounted for by the buoyancy of its exports.


many countries, the combination of a rapid rate of inflation
accompanied by softness on the real side of the economy have added
to current difficulties.

In the United Kingdom, real GNP in 1974

is not expected to be above that in 1973.

In Japan, a 25 per cent

rate of inflation during the first quarter of this year was
accompanied by a fall of 5 per cent in real GNP -- both developments
being due in significant part to Japan's heavy dependence on imported
Given these conditions and policies, the outlook seems to
be for a period of at best moderate growth abroad, as it is at home.
I do not, however, see policies that are deliberately designed to
restrain inflation leading to a serious decline in the world economy,
as prophets of gloom sometimes predict, anymore than I see a crisis


of the world's financial system ahead.

We must not deceive ourselves

about the fact that we face severe difficulties.
in uncharted waters part of the time.

We shall be sailing

But our institutions are

strong, the right policies are at hand, and given the will, I feel
confident that the way will be found.