THE THEORY OF

INTERNATIONAL TRADE

WITH ITS APPLICATIONS TO COMMERCIAL POLICY

BY

GOTTFRIED VON HABERLER

ASSOCIATE PROFESSOR IN HARVARD UNIVERSITY;

MEMBER OF THE FINANCIAL SECTION AND ECONOMIC INTELLIGENCE SERVICE OF THE LEAGUE OF NATIONS

TRANSLATED FROM THE GERMAN BY

ALFRED STONIER and FREDERIC BENHAM

LONDON EDINBURGH GLASGOW

WILLIAM HODGE & COMPANY, LIMITED

German edition ^ 1933

Spanish translationy 1936

English translation {revised hj the Author):

First impression^ 1936 Second impression, 1937 Third impression, 1950 Fourth impression, 1950 Fifth impression y 1954 Sixth Impression, 1956 Seventh impression, 19 5^9 Eighth impression, 1961

MADS AND PftINTKD IN UKKAT BRITAIN BT

WILLIAM HODCtr. AND COMPANT, LTD. LONDON, EDINBURGH, AND GLASGOW

PREFACE TO THE ENGLISH EDITION

I am very conscious of the various shortcomings of this book as published in German two years ago. Ifevertheless I have agreed to the publication of an English translation without substantial changes from the German original, because I hope that, even in the present form, it will be of some use.

Apart from improvements in detail and statistical researches with a view to verifying and applying to concrete cases the general, theoretical statements, it seems to me that the theory of inter- national trade, as outlined in the following pages, requires further development, in two main directions. The theory of imperfect competition and the theory of short-run oscillation (business cycle theory) must be applied to the problems of international trade. It will soon he possible to do this in a systematic way, since much progress has been made in both fields in recent years.

With regard to the first of these questions, there is the litera- ture which centres around the two outstanding books, Monopolistic Competition by Professor E. Chamberlin and Imperfect Com- petition by Mrs. Joan Robinson. In the second field where further development is required, it is not so easy to refer to a body of accepted theory. But it seems to me that a certain measure of agreement as to the nature of the cumulative processes of general economic expansion and contraction is gradually beginning to emerge. By starting or reversing, accelerating or retarding these cumulative processes, changes in the international economic rela- tions of a country may give an unexpected and perplexing turn ^to events, not predictable on the basis of a more rigidly static analysis. There is certainly a wide field of international economic problems which promises a rich crop if tilled with the aid of imperfect competition and business cycle theory. The theory of commercial policy, in particular, will profit therefrom.^

Being occupied by work on a different subject, I have, unfor-

1 Cf.^ e.g., G. Lovasy, “ Schutzolle bei unvollkommener Konkurrenz *' in Zeitschrift filr Nctionalohonomitf vol. 5 (1934).

VI

PREFACE TO THE ENGLISH EDITION

tunately, had no time to revise the book thoroughly along the lines indicated above. I hope, however, to be able to do this on a later occasion.

During the last two years great progress has been made in the technique of Protection. Not only have tariffs been piled on tariffs and quotas on quotas ; not only have the old methods been used much more boldly and unhesitatingly than before ; but new devices have been invented : clearing and compensation agree- ments, export and import monopolies, discriminating exchange rates, methods of controlling tourist trafhc and expenditure, stand- still agreements and so on, with an infinite number of variations in detail. Many interventionist measures, which seemed two years ago either technically impossible or so manifestly undesirable as to be quite out of the question, are to-day adopted without reluct- ance. I have tried elsewhere^ to go a little more deeply into the details of the new commercial policy. In the present book I have confined the discussion for the most part to fundamentals. After all, the general principles and the technique of analysis have remained unaltered and are Just as applicable to the new as to the old methods. If one has a firm grasp of these principles, it is comparatively easy to apply them to the new techniques of Protection,

Chapters I- VIII have been translated by Mr. Alfred Stonier (with assistance from Mr. Hugh Gaitskell), and Chapters IX-XXI by Mr. Frederic Benham. In translating they both have, I think, improved the original version and eliminated a number of inaccuracies. I am also indebted to Mr. Ragnar Nurkse, who has read the greater part of the manuscript and proposed many improve- ments. I have taken this opportunity of revising the whole manuscript and making a number of small changes in the tesi. The section on exchange control has been largely rewritten.

Gottfried v. Haberler.

Geneva, Augmt, 1935.

2 Libemle und planwirtschaftliche Handelspolitik, Berlin, 1954.

PREFACE TO THE GERMAN EDITION

{Abridged)

This book aims at a complete and systematic treatment of the main problems arising from international economic transactions. It attempts, especially, to give a thorough theoretical analysis of these problems. ... I have not followed the traditional practice of beginning with the ‘ pure ’ theory, treating this as the dominating topic and the question of the monetary mechanism as subsidiary. On the contrary, I begin at once, in section B of Part I, with the exposition of the monetary problems: that is, of the mechanism which determines the exchange-value of a currency, equalises the balance of payments, and makes possible the transfer of unilateral payments. This is followed, in section C, by the ^ pure theory.’ Here I have endeavoured to combine all the valid and relevant doctrines into a systematic whole. For these doctrines are mostly not mutually exclusive, but, on the contrary, supplement one another, either covering different parts of the field, working on different levels of abstraction, or employing different methods of analysis.

I have also endeavoured to avoid the too common practice of placing the theory of international trade and the discussion of trade policy in quite separate compartments without any connection between the two. Instead, I have tried to apply the theoretical analysis to every question arising from trade policy. Indeed, any discussion of trade policy which attempts more than a mere account of the legal and administrative devices in force, or than a state- ment of the criteria by which the various policies should be •evaluated must inevitably consist in the application of economic theory.

In the various places where facts have been cited, they have been introduced not for their own sake but in order to illustrate the argument. The only exception to this is section C of Part II, which attempts a systematic account of the various measures which have served as instruments of trade policy. .

viii

PEEFACE TO THE GEEMAN EDITION

Some readers will doubtless be surprised that the policy of Free Trade, which is in glaring contrast to the policy actually adopted by nearly every country in the world, should be advocated in this book. The universality of Protection inspires an instinctive distrust of a theory whose conclusions are nowhere accepted in practice. Can a policy which is rejected with such unanimity be correct ?

But this is not an argument. It would be absurd to expect economic science to reverse the verdict of its analysis, based upon accepted judgments of value, just because in practice it is con- sistently ignored. Nobody would dream of asking medical science to change its findings just because everybody followed some custom which it had pronounced injurious to health.

Nevertheless it cannot be denied that the principles stated in ^ this book as ‘ economically correct have hardly ever been com- pletely applied. The disagreeable task of having to declare current practice misguided, thereby provoking the accusation of unfruitful doctrinairism, is one which the present volume shares with most scientific writings on international trade. Economists are nearly as unanimous in favour of a liberal trade policy as are Governments in favour of the contrary. It is true that very few writers attempt the hopeless task of proving a 'priori that no case is conceivable in which the ‘ general welfare ' would be promoted by some kind of intervention. Most economists, including the present writer, concede that cases are both conceivable and liable to occur in practice in which tariffs or other restrictions on international trade would be advantageous. At the same time, there is fairly general agreement among them that such cases are on the whole unimportant, so that a policy of complete Free Trade would diverge only slightly from the optimum. The vast majority of economists are convinced that the actual trade policies* of nearly all countries are founded upon the crudest errors and have no shadow of justification. Upon this point there is surprising agreement of expert opinion not only among liberals but also among socialists.

1 The meaning of this phrase is discussed in chaps, xiii and xiv.

PREFACE TO THE GERMAN EDITION

IX

The fact that nearly all economists unite in condemning Pro- tection . explains why some of them devote so much ingenuity to constructing hypothetical cases in which a tariff might he bene- ficial and why economic works give so much space to such cases. Exceptions are always more interesting, to the scientific mind, than mere illustrations of the general rule. . . . But experience has underlined the truth and wisdom of Edgeworth's judgment :

As I read it, protection might procure economic advantage in certain cases, if there was a Government wise enough to discriminate those cases, and strong enough to confine itself to them; but this condition is very unlikely to be fulfilled."

... I am very grateful to Dr. Erich Schiff, of Vienna, for his help with the statistical work. G. H.

Vienna, May, 1933.

CONTENTS

PAGE

Introduction, 3

1. The Problem of Definition, ------- 3

2. The Political Conception of Foreign Trade, ... 6

3. Questions of Exposition, 8

PART I THEORY

A— THE MONETARY THEORY OF INTERNATIONAL TRADE

CHAP. SEC.

I. Introductory,

13

II. The Balance of Payments, -

1. Classification of Items,

2. Different Senses of the Term,

3. Supply and Demand Analysis,

4. The Case of more than Two Countries,

16

18

19

21

III. The Gold Standard,

1. Definition,

2. ^ The Gold Points, - - - -

Mercantilist Ideas, ‘ -

The Classical Theory and Its Critics,

23

,24

26’

IV. Inconvertible Paper Currencies, - - - - 30

“ 1. The ‘ Balance of Payments ^ Theory and the ‘ Infla- tion ’ Theory, _ . . . - 30

V ' 2. The Theory of Purchasing Power Parity, - - 32

3. Problems of Statistical Verification, _ . - 38

’ V. Further Details op the Exchange-Mechanism, - 41

1. Preliminary Remarks on Monetary Theory in

General, 41

2. Price-Stability versus Exchange-Stability, - - 44

3. Methods of Preserving Exchange -Stability (Gold-

Bullion Standard, Gold-Exchange Standard), - 46

4. Discount-Policy, 48

5. The Influence of Bank-Credit, - - - - 51

Xll

CONTENTS

CHAP. SEC.

VI. Exchanges during Inflation, . _ _ -

1. The Significance of Static Analysis, - _

2. The Transition from One Equilibrium to Another.

(Price-Levels and Exchange-Rates during Inflation), -

3. Depreciation as Interpreted by the Balance-of -Pay-

ments Theory and the Classical Theory respec- tively, --------

4. Statistics of the German Inflation,

VII. The Transfer Problem,

1. Introductory,

2. Raising and Transferring Payments. Creation of

the Export Surplus,

3. The R61e of Price-Changes in the Mechanism of

Transfer, -

4. Unilateral Payments and International Movements

of Capital, -------

5. The Limits of Possible Transfer, . - - -

6. The Transfer Mechanism in Times of Crisis,

7. Exchange Control, - - - - -

PAGE

54

57

61

63

65

66

76 ^ 78 80 83

VIII . Historical Illustrations of Unilateral Transfer, 9 1

1. General Remarks, ------- 91

2- The French Indemnity of 1871, - - - - 92

3. Canadian Imports of Capital 1900-1914, - - 96

4. German Reparations, 101

5. Inter-Allied War-Debts, - - - - - 113

B— THE PURE THEORY OF INTERNATIONAL TRADE

IX. Introduction, - - - - - - - 121

1. The Problem Stated, - 121

-2. The Available Theoretical Systems, - - - - 122

0^- " Theory of Comparative Cost, - - - - 125

r vl. The International Division of Labour and the Difler-

ence in Production Costs, - - - - 125

2. Absolute arid Comparative Differences in Production

Costs, - - 127

3. The Order of Treatment to be followed, - - - 131

4. Comparative Costs expressed in Money, - - - 132

^5. The Theory of Comparative Cost applied to. more

than Two Goods, ------ 136

6. Costs of Transport, - - - - - - 140

'7. Variable Costs of Production, - - - - 142

CONTENTS

Supply and Demand in International Trade,

. 1. Introductory,

MilTs Theory of International Values, - ^•*3. MarshalTs Generalisation of the Theory of Inter- national Values, -

4. The Eelation between the Marshallian Curves and the Usual Supply and Demand Curves,

" 5. The Elasticity of Demand, -----

6. The Terms of Trade and their Statistical Measure-

ment, - - .

7. Statistical Illustrations, -

„ 8. The Direct Effect of International Trade upon Price

and Sales, - - - - -

International Trade and General Equilibrium, -

1. The Labour Theory of Value Discarded, -

2. The Theory of Comparative Cost Eestated, with

Special Eeference to Specific Factors,

3. The Influence of International Trade upon the Dis-

tribution of the National Income,

4. Decreasing Costs and International Trade, -

PART II TRADE POLICY A--INTRODUCTION

XIII. The Scientific Treatment of the Subject of Trade Policy, -------

1. The Order of Treatment which will be followed,

2. Value- Judgments upon International Trade and

upon Measures of Trade Policy,

B THE CONSEQUENCES OF DIFFERENT SYSTEMS AND

MEASURES OF COMMERCIAL POLICY, FREE TRADE AND PROTECTION

Arguments for Free Trade, - - - -

1. The Presumption that Free Trade is advantageous,

2. Other Arguments for Free Trade,

3. The Aims of Free Traders, -

XIV

CONTENTS

CHAP. SEC.

XV. -- The Effects of Tariffs,

1. The Direct Effects of a Particular Import Duty upon .

the Price and Sales of the Commodity,

2. The Indirect Effects of Duties, . - - -

"3. Import Duties on Means of Production,

XVI. General Arguments for Tariffs,

1. Introductory,

2. Revenue Duties and Protective Duties,

,/3. Economic and Non-Economic Arguments for Tariffs, yi. The Economic Arguments for Tariffs,

\ XVII.

1.

2.

..3.

u4.

■

V Q

7.

XVIII.

1.

3.

4.

5.

6.

7.

XIX..

1.

2.

3.

4.

Particular Arguments for Tariffs, -

Arguments which do not merit serious discussion, - The Protectionist Theory of Richard Schuller, Tariffs and Unemployment, - - _ - -

The Import of Means of Production as a Result of a

Tariff,

Infant-Industry Tariffs, ----- The Dangers of an Unbalanced Economy which Exports Manufactures, ----- Emergency Tariffs and Tariffs to Ensure the 'Market, Tariffs as a means of Improving the Terms of Trade (‘ The foreigner pays the duty -

Dumping, Cartels, Monopolies, and Export Bounties,

Intioduction,

The Nature and Forms of Dumping, - - -

The Theory of the Dumping-Price,

Economic Appraisal of Dumping, -

Export Bounties, -------

Anti-Dumping Duties, - - - - -

International Monopolies of Raw Materials and International Cartels, -----

C--THE TECHNIQUE OF TRADE POLICY.

The Content and Form of Tariff Laws and their Application. Other kinds of Protection,

Introductory,

The Tariff Schedule and the Customs Area, - Specific and Ad Valorem Duties, - - -

Sliding-scale Duties,

PAGE

227

233

235

237

239

241

245

245 253 259 ,

273

278

285

289

290

296

302

313

317

322

324

337

341

343

CONTENTS XV

CHAP. SEC. PAGE

5. Import Prohibitions, Export Prohibitions, and

Quotas, - - 346

• 6. Other Protectionist Devices, - - - - - 349

7. Administrative Mitigations of Tariff Protection, - 353

8. The Concept of ' The Height of a Tariff ’ and the

Methods of measuring it, - . - - - 356

XX. Commercial Treaties: The Facts, - - - - 360

1. Content and Form, 360

2. The Content and Forms of the Most Favoured Nation

Clause, -------- 362

XXI. Commercial Treaties : Appraisal of the various

Systems, 372

-*'’1. The Commercial Treaties of Free Trade Countries, 372

2. The System of Kigid Tariffs, - - - - 372

3. Tariff Treaties and the Principle of Exchanging

Particular Tariff Concessions, - - - 374

4. The Dispute over the Most Favoured Nation System, 377

5. Preferential Duties, 383

6. Customs Unions, - 390

7. Tactical Considerations upon the Path to Free Trade, 391

Index,

395

INTRODUCTION.

INTERNATIONAL TRADE.

INTRODUCTION.

§ 1. The Peoblem of Definition.

The only really systematic theory of international trade we possess is the so-called classical theory, of which practically all the component parts were worked ont hy such early writers as Hume, Adam Smith and Ricardo.^ It is characterised, on the one hand, by the doctrine of ‘comparative costs and, on the other hand, hy the principle that prices, exchange rates and money flows provide a mechanism which links together the monetary systems of different countries and ensures the automatic adjustment of the balance of payments. In England the classical theory still holds the field and it is accepted by the more theoretically-minded economists in the United States.^ In continental countries, however, with the partial exception of Italy, it has never found much favour. Criticisms have been frequent, but the critics have not succeeded in substituting for it anything that deserves to. be called a new theory of international trade. Certain details of the classical theory have had to be modified, and there has been, of course, much interesting statistical and descriptive work. But the only important theoretical advance has been the application, notably by Pareto, of general equilibrium analysis^ to the problems of international trade. The classical doctrine — in particular the theory of compara- tive costs — ^is exhibited as a special case of the more general theory.

The classical theory starts from the fact that in international trade, as in all other economic activities, it is the individual economic subject who buys and sells, pays and is paid, grants and receives loans, and, in short, carries on the activities which, taken as a whole, constitute international trade. It is not, for example, Grermany and England, but individuals or firms located in Germany and England, who carry on trade with one another. The first question, therefore, which has to be answered is whether these economic activities call for a special theory at all. The mere

1 Cf, the exhaustive bibliography in Angell, Theory of International Prices

by those Tinder the influence of Professor Taussig.

^ Cf, “ Teoria matematica dei cambi forestieri/’ Giorncde degli Economisti

C, and “ Teoria matematica del commercio internazionale,’* Giornale degli misti (1895) ; also Cours d'iconomie 'politique^ vol. 2, § § 862-78.

3

4

INTERNATIONAL TRADE

fact that a political boundary is involved and that the persons in question are nationals of different countries and, perhaps, speak different languages, is economically irrelevant. It cannot there- fore be taken as the criterion of demarcation between one branch of economic theory and another.

The classical school believed nevertheless that there was a fundamental difference between home trade and foreign trade. They pointed out that labour and capital moved freely from one branch of production and from one district to another within a single country. B'etween different countries, on the other hand, mobility was totally, or at any rate to a great extent, lacking. In the latter case, complete adjustment (i.e. the establishment of the same rate of wages and the same rate of interest everywhere) did not take place. Immobility was accepted quite naively by the classical school as the criterion of international trade. They based their argument upon it without attempting to justify its ^ selection on methodological grounds and thus laid themselves open to various objections which have been raised from time to time, particularly in recent years.

An obvious criticism, which certainly has some truth in it, is that the difference in question can only be one of degree. On the one hand, the factors of production are not perfectly mobile within national boundaries; on the other hand, large and, indeed, enormous movements of the factors of production do sometimes take place across these boundaries.^

Of course, the classical school did not overlook this fact. Adam Smith stressed the importance of emigration, and J. S. Mill recognised that capital was becoming steadily more mobile and cosmopolitan. Moreover, it is common knowledge that Cairnes introduced the conception of ‘ non-competing groups ' (i.e.

sharply defined groups of labour between which there was no free movement) and pointed out that where such groups existed within a country, the theory of international trade applied to them. Professor Taussig, to whom we owe the latest and most carefully* worked-out version of the classical theory, devotes a good de^l of space to the imperfect mobility of labour and to the consequent differences of wages rates. It can, perhaps, be maintained that the classical school and their successors have paid fo.o little attention to the significance of these phenomena for the economic development

^ This point is stressed by Prof. J. H. Williams, “ The Theory of International Trade Beconsidered,” Economic Journal (1929), vol. 39, and by Prof. Ohlin “1st eine Modernisierung der Anssenhandelstheorie erf orderlich ? ” W eltwirtschaftliches Archiv (1927), vol. 26, p. 97 j “Die Beziehung zwischen internationalem Handel nnd internationaler Bewegnng von Kapital nnd Arheit,' ' Zeitschrift fiir National- dkonomie (1930), vol. 2, and Interregional and InternationcA Trade (1933).

INTEODUCTION

5

of the modern world. One may speak with Nicholson of a lost idea — lost^ that is to say, since the days of Adam Smith. ^ There can, however, be no question oi a logical error on their part. If the mobility of labour® and capital between different countries were to increase in the further course of economic development, there would be, according to the classical school, no need for a separate theory of international trade. For the phenomena which it tries to explain would have disappeared and with them the distinc- tion between home and foreign trade. But one must be careful to distinguish between the empirical question whether the assumptions of the classical school apply to any particular epoch, and the logical question whether their conclusions follow from those assumptions.

It has been argued that, even within the bounds of a single country, real capital cannot readily be transferred from one line of production to another,^ and, further, that the cost of transport- , ing capital goods from one part of a country to another is some- times much greater than from one country to another. But this argument is irrelevant, since it refers only to specific capital goods already in existence. For capital theory, however, the criterion of perfect mobility is the equality of interest rates. This refers to alternative ways of investing liquid or money capital. If the cost of transporting capital goods from one place to another is high, considerable differences in the price of capital goods will probably exist. But, nevertheless, interest rates may very well tend to equality. The rate of interest need not be higher in San Francisco than in New York, because there is a mountain range and a distance of 2500 miles between them. It must, however, be granted that, if a country is completely shut off from the rest of the world — ^in the sense that there can be neither movements of labour nor trade in commodities of any kind — no capital can be transferred, even if money as such is able to flow in and out. The necessary and sufficient condition is the existence of some international trade, even if it consists entirely of consumption goods and services (e.g. tourist traffic) and sufficient flexibility JbO allow an import or export surplus to develop. As will be shown later, capital may then move in the shape of increased imports or decreased exports of consumption goods, thus releasing factors of production for employment in other directions.

The international mobility of capital is restricted not by trans-

5 Cf. A Project of Empire (1909), p. 12.

6 In spite of his internationalism, which was characteristic of the whole classi- cal school, Ricardo spoke of the ** natural disinclination which every man has to quit the country of his birth . . . These feelings which I should be sorry to see weakened ” — Principles (ed. McCulloch), p. 77.

7 This applies particularly to fixed capital, i.e. to buildings and machinery.

6

INTERNATIONAL TRADE

port costs but by obstacles of an entirely different character. These consist in the difficulty of legal redress, political uncertainty, ignorance of the prospects of investment in a foreign country, imperfection of the banking system, instability of foreign currencies, mistrust of the foreigner, &c., &c.

In actual fact, there is to-day very considerable immobility of the factors of production, particularly of labour. Apart from the ' natural ' obstacles, such as the cost of emigration, ignorance of foreign languages, and lack of initiative, nearly all countries impose restrictions on immigration. Moreover, the War and the post-war inflations have seriously restricted the international mobility of capital. This is proved by the persistence of large discrepancies between the rates of interest in different countries. The chief reason is, undoubtedly, that owners of capital have lost faith in the political stability of the debtor countries, where rates are high. Hence they fear expropriation by a depreciation of the , exchanges or by exchange restrictions, moratoria, standstill agreements, and other devices of the same kind now in vogue.

Immobility of labour and capital is by no means the only possible criterion for defining international trade. Various alterna- tive criteria, such as the existence of separate currencies and the independent control of monetary policy in different countries have been suggested. Each definition of this kind draws attention to different phenomena, and we shall have to investigate them all in due course; but it is meaningless to inquire which is the ‘ correct ’ criterion of international trade.

§ 2. The Political Conception of Foreign Trade.

The distinction made by governments between home trade and foreign trade is not based on any objective economic criterion, but simply on a judgment of value or a rule of law. Home trade means simply trade within that area, the prosperity of which interests the government in question or is subject to its jurisdiction.

The line of demarcation between domestic and foreign trade generally coincides nowadays with the national frontiers, and* foreign trade is identified with trade between different countries.

Of course, this need not be the case. For instance, a British statesman may regard trade with Canada as domestic trade. On the other hand, it sometimes happens that people living in a particular district consider trade with other parts of the same country as foreign trade. . They may even try, by local tariffs and other means, to protect their own district from "foreign com- petition.^

INTEODUCTION

The judgments of value, which determine the political distinc- tion between home trade and foreign trade, are not based on the sort of “theoretical criteria which we have been discussing. For a Frenchman or for a German, trade between France and Germany is foreign trade, whether capital and labour are mobile between the two countries or not. It would remain so, even if both countries adopted the same currency, though this is unlitely to happen because of the attitude (i.e. the judgments of value) of statesmen in the two countries. The comparative homogeneity of the economic system of one country and its comparative isolation from other countries are the effect rather than the cause of the attitude of statesmen to the distinction between their own country and the outside world.

It is, at any rate, ambiguous to speak, as some German writers have done, of the ‘ unity of the national economy.’ One can understand by a unified national economy an economy which is carried on by a single organisation, e.^., the collectivist economy of Soviet Russia, Or one can understand by it a totality of separate economies, which are more or less closely connected by trade and exchange- This is, obviously, the sense in which one speaks of the French or German economy. But one can speak in the same sense of the European economy, since the various national economies are inter-related and interdependent. The difference is only one of degree. One can even speak in this sense of the unity of the world economy, though its interdepen- dences are not of a very close character.

Some countries are linked together much more closely than others. It would, therefore, be interesting to classify the various types of connection from this point of view. Thus, at one end o.f the scale, there are countries which exchange only commodities industrial for agricultural products). The interdependence between debtor and creditor countries is appreciably closer. Then there are countries with a common currency or a common banking- system, &c., &c. It may be useful to study the consequences of ^ these various degrees and kinds of relationships, but nothing is gained by attempting to draw a sharp line between those relation- ships which do and those which do not constitute a single economy.

It must, finally, be emphasised that, in a deeper philosophical sense, even the planned collectivist economy of a country or a family can only be grasped individualistically.8 Every branch of economics has to do with human actions

s This is the principle of methodological individualism. Cf. Max Weber, G^sammelte Aufsatze zur Wissmschaftslekre, pp. 503 seq.^ and Wirtschaft und Gtsdlschaft (1922), chap i. Cf. also Schumpeter, PTesen und Hauftinhalt der theoretischm N ationaldhonomie (1908).

8

INTEENATIONAL TEADE

and human behaviour,^ Other phenomena interest the economist only so far as human activity is directed towards them (commodities), or so far as they affect Human activity (environment). Economic activities are determined on and carried out by individual persons in a collectivist no less than in an individualist economy. The difference is not that in the latter case economic activities are carried on by individuals, and in the former by the community. It is merely that they are governed by different motives and considerations — ^in the planned economy by the policy of the central planning authority, in the exchange economy chiefly by the desire for money, power or property.

§ 3. Questions oe Exposition.

Tjbe theory of international trade has to he regarded as a par- ticular application of general economic theory. The theory of marginal utility, which interprets and explains the individuaPs economic activity as such, must therefore be applicable to those economic activities which, in their totality, constitute international trade. The same holds true also of the propositions of price theory which follow from the laws of supply and demand.^ We shall, therefore, have to make constant use of these general propositions applying them to the specific assumptions which characterise inter- national trade. How far it is appropriate to assume that the reader is already familiar with these propositions, and how far it is neces- sary to trace their deduction from the corpus of general economic theory, is of course a difficult problem of exposition.

The arrangement of the present work is as follows. Part I deals with the various phenomena selected by different authors as the criterion of international trade. Section A of Part I is concerned with the problems which arise from the fact that different money circulates in different countries, and that each country has its own central hank and controls its own monetary policy. This phenomenon gives rise to the problem of foreign exchange. Closely connected with it is the problem of the trade-balance and of the mechanism which equalises the balance of total payments and renders possible unilateral payments such as the transfer of reparations.^

Section B of Part I deals with the phenomena which result from

9 The question in what way economic activities differ from other human activities cannot be discussed here.

1 “ The general conditions which determine equilibrium are the same for both ^ecies of trade [home or domestic trade and international trade] ; the principal difference is that in the case of home trade there are one or two more equations.”

“ The pure theory of international values ” in Pavers relating to Political Economy (1925), vol. 2, p. 5.

^ We need not discuss the question whether this problem belongs to the theory of international trade in the strict sense or not. The fact that one can also speak of a balance of payments between different parts of a single country with only one currency and complete mobility of the factors of production, shows that the phenomenon in question is by no means confined to the international sphere.

INTRODUCTION

9

tke immobility of labour and capital, i.e. witb. tbe tbeory of com- parative cost and all that follows from it. It will have to be sbowu how th^ theory of comparative cost is based on the general theory of economic equilibrium. This section is, therefore, concerned with what is usually called the ‘ pure ’ theory of international trade.

The method of discussing, first, the monetary problems and then the phenomena which ^ give rise ’ to them, is not the most usual. ^ But, as will be shown later, the ‘ real ’ factors (or what- ever one likes to call the subject matter of ‘ pure theory are in no way logically or objectively prior to the monetary phenomena. The reversal of the usual order of treatment does not, therefore, lead to different results; it is merely an expository device which appears to offer certain advantages.

In Part II the theory of international trade is applied to the , problems of commercial policy. There more use will have to be made of general economic theory than in Part I. For, as already explained, the political conception of foreign trade is determined not by theoretical criteria but by spheres of economic interest. What is foreign trade to the statesman may be home trade from the theoretical point of view. In that case only the propositions of general economic theory and not those of the theory of inter- national trade are applicable to it.

3 It has, however, been adopted widely of recent years. Cf. Prof. Ohlin*B important work, Interre-giorud and International Trade, and among earlier writers Nicholson’s Princi'ples of Political Economy.

PART I.

A— THE MONETARY THEORY OF INTERNATIONAL TRADE.

CHAPTEE I.

IJSTTEODTrCTOEY.

Our problem is to examine on the one hand the factors which determine the rates of foreign exchange, i,e,, the exchange ratio between the currencies of different countries, and on the other hand the mechanism which brings the balance of payments into equilibrium.

It will be best to approach these questions with the help of an example.

Let us imagine a closed economy in static equilibrium. All economic processes have been repeating themselves year by year. Supply and demand, consumption and production, capital deprecia- tion and investment exactly balance one another in every branch of industry and each individual firm is itself in static equilibrium.

Suppose, now, that a political frontier is drawn through the middle of this area, so that it no longer forms a single country, but two countries^ with separate administrative organs. Clearly this change creates no new economic problem. Erom the economic point of view, the redistribution and increase of taxation due to the reorganisation and partial duplication of the administrative machine is the same thing as a redistribution of the burden of taxation between taxes and rates. Either one can ignore this change altogether, or one can assume that the new static equilibrium appropriate to it has already been reached.

Suppose, next, that each of the new countries decides to have a separate currency of its own. A law is passed providing that,

whereas in one country payments shall continue to be made in

^ crowns,’ in the other country the crowns which are in circula- tion shall be changed into ^ dollars ’ at the fixed rate of five crowns to one dollar; in the dollar country, debts must hence- forward be contracted and payments made in dollars. As a result, all prices and all liabilities expressed in money will be divided by five.^

1 For the case of more than two countries, c/. chap, ii, § 4.

2 This change in the unit of money which affects equally and simultaneously

the monetary expression of all transactions, must not be confused with a deprecia- tion or appreciation of the currency. The^ latter is produced by an increase or diminution of the amount of money, which leaves the raising or lowering of prices to the forces of supply and demand. The transition to the new price-level

IS achieved not at a stroke but step by step. Obligations already contracted

remain nominally unchanged, while the real purchasing power which they repre- sent diminishes or increases.

13

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INTERNATIONAL TRADE

The new situation, thus created, differs from the preceding one only in the fact that every payment from one place to another across the political boundary now involves an extra act of exchange. A payment from the dollar country to the crown country will require an exchange of dollars into crowns, whereas, beforehand, the amount was simply made payable in terms of the single currency then existing.

It is clear that, under the assumption of static equilibrium, the introduction of a second currency need not in itself produce any economic change. No matter where the boundary is drawn,® all economic activities will proceed as before. At the rate of exchange originally fixed the demand for dollars is equal to their supply, and equilibrium will therefore be maintained at this rate. A moment’s reflection shows that this must be the case. It has been assumed that each individual’s balance of payments is in equilibrium ; his receipts exactly equal his expenditure over the appropriate period of time. This implies that the balance of payments between any* economic group and the rest of the economy must also be in equilibrium; for the external balance of payments of a group is merely an aggregate of the balances of payments between members of the group and persons outside it.'^

Of course, this does not imply that the same firms which make payments to the foreigner necessarily receive the payments which balance them. It only implies that, when an individual A in the dollar country pays 100 to the crown country, there must be an individual B in the dollar country whether he is identical with A or not, who is in receipt of 100 from the crown country. This is an obvious corollary of the postulate that every individual balance of payments is in equilibrium.

It is also a matter of indifference whether the debtor or the creditor actually changes dollars into crowns. The importer in the dollar country normally sells the imported commodity for dollars, and the exporter in the crown country pays for his means of pro- duction in crowns. The dollars must, therefore, be changed into crowns at some point in this chain of transactions.

In actual fact, the persons who have to make payments abroafi, are not normally those who receive from abroad the payments which balance them. Indeed, the two groups are not necessarily

3 It need not be a territorial boundary at all. One might assume that all red-headed men decide to use a special currency for trade with one another.

^ One speaks, for short, of ‘British exports’ and ‘Germany’s balance of trade.’ But to analyse these conceptions one must split them up into their com- ponent parts, i,e,, into the actions of individuals. The “ equality between private expenditures and private incomes tends ultimately to produce equality between the commercial exports and imports ” (Thornton, An Enquiry into the Nature and Effects of the Paper Credit of Great Britain (1802), p. 118).

INTRODTJCTORT TO THE MONETARY THEORY 15

in direct contact at all. An organisation of some kind is, therefore, required to provide a link between them, so tbat tbe supply of foreign carrency can meet tbe demand for it.

Tbe simplest method would be a bureau de change prepared to exchange on demand crowns for dollars and dollars for crowns at tbe current rate of 5:1. It would have to start with a certain amount of capital to allow for temporary fluctuations, e.g., seasonal fluctuations due to tbe harvest. But, under the assumptions made hitherto, all fluctuations would in the long run cancel out.

The modern economic system does, as a matter of fact, . contain an arrangement of this kind. A sort of clearing market exists where foreign debts and claims are cancelled against each other. The banks in the various trading countries do business with each other, and there is a foreign exchange market where the various currencies are bought and sold. Moreover, under the gold standard, the central banks act as bureaux de change.

The means of payment in international transactions are not for the most part cash, which is only used for small amounts (e.^., by travellers abroad), but bills of exchange, cheques and telegraphic transfers. The distinction between the various means of payment is a legal rather than an economic one; the technical details need not, therefore, concern us.^ The illustration, favoured by the ordinary textbook, is as follows. The exporter draws a three months’ bill on the foreign importer and the latter accepts it, i.e., makes a legally binding promise to pay. The exporter then sells the bill to someone who is buying or has bought goods from abroad. The latter gives it in settlement of his own debt to the foreign firm supplying him, which in its turn receives cash for it from the original acceptor. But it makes no essential difference whether the two payments are made in this way or not. They may just as well be made by means of a book transaction or by the sale and purchase of ready money. It is sufficient to note that there are various different means of payment and that these compete with one another, thus forming in effect a single market where the supply of foreign money confronts the demand for it.

In the stationary economy postulated above, this market is in equilibrium. Our main problem will be to consider what happens when equilibrium is disturbed. But, first of all, it is necessary to classify the items which make up the balance of payments and the different senses in which this latter term is used.

5 account of them will be found, in the following works : Goschen,

The Theory of Foreign Exchanges; article on Foreign Exchange in the Encyclo- pedia of the Social Sciences (1931), vol. 6; Flux, Foreign Exchanges (1924); Whitaker, Foreign Exchange (1933), 2nd ed.

CHAPTER II.

THE BALANCE OF PAYMENTS.

§ 1. Classification of Items.

Before proceeding to the qualitative analysis, let ns glance at the more important of the quantitative computations which have been made.

Since 1922 detailed statistics have been published annually by the American Department of Commerce of the balance of payments of the United States.® For some years now the Economic Intel- ligence Service of the League of Nations has published an extensive annual survey of the balance of payments of the more important countries.'^ The most exhaustive investigation of this kind for any '' single country was that conducted by the German ^ Enq'uete- A'lissch'iiss which based itself on a system of classification worked out by the International Chamber of Commerce in Paris.

(a) The chief item in the balance of payments is the inter- national trade in commodities. A comparison of the value of imports and exports yields the balance of trade.® The German system of classification just mentioned distinguishes on the export side the following items : goods exported in the ordinary way, ships sold to the foreigner, fish sold at foreign ports, home products sold from ships located abroad, international mails carried, electricity supplied to foreign countries, and, finally, goods smuggled out. Some of these items do not appear in the official statistics of foreign trade, which cover only commodities passed through the customs. Such items must be computed separately, but the classification has no theoretical significance.

Of much the same type as payments for commodities are pay- ments for services. These are appropriately called invisible exjpqrts and imports. They represent transport services, shipping freights, passenger fares, harbour and canal dues, postal, telephone andr

6 The Balance of Internation<d PaymenU of the United States in 1922, (T.I.B. No, 144), based on Prof. J. H. Williams, “ Balance of International Payments of the United States for the year 1921,” in the Review of Economic Statistics (1922).

7 Memorandum on Balances of Payments, published in English and French.

8 Ausschuss zuT Untersuchung der Erzeugungs- und Ahsatzhedingungen der deutschen Wirtschaft: die deutsche ZaMungshilanz, in Verhandlungen und Bericht des Unterausschusses fur allgemeine Wirtschaftsstruhtur (1950). This work has been continued on the same lines and the results have been published at intervals in Wirtschaft und Statistih,

9 The question whether a passive balance of trade should be regarded as an unfavourable symptom is not relevant at this stage.

16

BALANCE OF PAYMENTS

17

telegraph fees, commercial services (fees and commissions), financial services (brokers’ fees, &c.), and services connected with the tourist trafldc. There is always the risk that some items may be counted twice over. Thus, if an imported commodity is re-exported at an enhanced price, the difference, even if due to services included in ‘ invisible exports,’ will be reflected in the price statistics of imports and exports. In such a case therefore it should not be counted separately.

The balance of trade and the balance of services can be grouped together under one heading and contrasted with the balance of credit.

(6) The credit balance consists, on the one hand, of the interest balance, or balance of payments on capital, and, on the other hand, of the capital balance, or balance of payments (and repay- ments) of capital.

The interest balance includes fixed interest on Government, ""municipal and private loans, variable profits and dividends, rents, &c., and perhaps also the yield of patents, copyrights, cartel dues and so forth.

Under the heading of capital balance one should distinguish between long term and short term investments. Long term capital exports consist in the purchase of shares in foreign undertakings, the repurchase of home securities or repa^^ment of loans contracted abroad, the purchase of foreign holdings in property located at home, &c., &c. Short term capital exports any increase

in the volume of bank balances held abroad, or in the holdings of foreign bills, and any decrease in the volume of commercial indebtedness to foreign countries.

The flow of long term capital is closely connected with the flow of short term capital, and changes in the one tend sometimes to be compensated by opposite changes in the other, so that only fluctuations in both combined affect directly the demand or the supply of foreign currency. Thus, if a German firm floats a loan of 10 million dollars in New York, it need not mean that the supply of dollars and the demand for marks in the foreign exchange market are immediately increased by 10 million and by 25 million respectively. What happens is that a New York bank opens an account in favour of the German firm, on which the latter draws gradually according to its requirements. The long term debt is, therefore, compensated by the creation of a short term asset, and there is no effective demand for currency until and so far as the latter is used up.^

1 Of course, it may happen that a short term debt is created first and that it is consolidated later by* the issue of long term bonds,

B

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INTERNATIONAL TRADE

(c) Furtlier items in the balance of payments are Government

transactioiis (salaries of diplomatic representatives, subsidies, reparations, &c.) and gifts of money such as remittances sent home by emigrants.

§ 2. Diffeeent Senses oe the Term.

Having classified the items which make up the balance of pay- ments, we must now analyse the concept itself. The term ^ balance of payments ’ is used in a number of difierent senses, which are apt to be confused with one another. It is very important to distinguish carefully between them, as the failure to do so has led to serious misconceptions.

(a) The term is sometimes used for the amounts of foreign currency bought and sold within a given period of time. In this sense the balance of payments is, of course, always in equilibrium, since the amount bought must necessarily equal the amount sold. ^ The proposition is a mere tautology which follows from this (not very helpful) definition of the concept.

(b) It may refer, secondly, to the payments made, within the -^period, to and from foreign countries. This is not the same thing

since payment can be made not only by the purchase of dpreign money, but also by the transfer of foreign money already ’ held.^ If the volume of payments made is greater than the volume * ' c received, the deficiency will be made up in this way. The balance \ of payments in sense (6) may, therefore, very well be passive. It bahnot, however, remain passive longer than the stock of money lasts. Moreover, it must have been active at some earlier point of time, since otherwise the stock could never have been acquired. Over a long period, therefore, the balance of payments must be in equilibrium in this sense too.®

(c) The term is frequently used in the more restricted sense of the balance of payments ^ on income acGount. - This includes the interest balance and the balance of trade and services. If it

^s passive, then either the capital balance is active, or there is a transfer of gold or foreign currency. An ‘ unfavourable balance'^' i^Jhen equivale^^ to an increase in indeb|edness (including the export of shares, and any increase in holdings by foreigners) or to a loss of gold.

(d) There are no accurate figures of the balance of payments in any of the above senses. One must, therefore, be content with

2 Including gold, if the country receiving payment is on the gold standard.

3 Only a gold-pioducing country can have a permanently passive balance— if one does not prefev to regard gold in such cases as a commodity rather than money.

BALANCE OF PAYMENTS

19

statistics of liabilities falling due. If these are all settled, the result is equivalent to the balance of payments in sense (d),

(e) From the balance of liabilities falling due during a given period, it is only a short step to the computation of the total volume of claims and liabilities outstanding at a given moment. This yields the ‘ balance of international indebtedness.^

(/) For the explanation of the exchange rate it is not sujfficient to measure the amount of liabilities outstanding at a given moment or failing due during a given period ; nor does it help to record eo! post facto all the payments actually made during a given period. Economic analysis cannot start with a certain amount of existing liabilities it has to -consider how they are contracted. The willingness to buy and to sell at this or that price (exchange rate) must be studied. In other words the apparatus of demand and supply must be applied to our particular market. The term ‘ balance of payments ^ is then used in the sense of the whole ’’demand-and-supply situation and in this sense it will be used in the following pages.

§ 3. Supply and Demand Analysis.

The exchange rate between the means of payment of two countries is dete^rmined, like all other prices, by supply and demand. Since the supply of one currency constitutes the demand for the other and vice versa, we may treat either of them as a commodity and the other as money. In the following exposition the foreign currency will be treated like a commodity for which there is monetary demand, and we shall speak of its price in terms •of the domestic currency.®

In the accompanying diagram, prices (i.e., exchange rates defined as number of units of domestic currency per unit of foreign currency) are measured along the vertical axis, and amounts of foreign money bought and sold along the horizontal axis of a rectangular system of co-ordinates. The demand curve (DD) slopes downwards from left to right. This expresses the fact that people are willing to buy larger amounts of foreign currency at a lower price. This one can explain provisionally by the fact that foreign

^ This point was stressed by Eicardo in his discussion with Malthas. “ You appear to me not sufficiently to consider the circumstances [which] induce one country to contract a debt to another. [In] all cases you bring forward you always suppose the [debt] already contracted.” Letters of Bicar do to Malthus, ed. bv J. Bonar (1887}, p. 11.

5 This is in accordance with ^ the method of quotation used on the continent, where exchange rates are expressed as so and so many units of domestic money per 100 units of foreign money. Rates quoted in London mean, on the •other hand, so and so many units of foreign money per £1.

20 INTEENATIONAL TRADE

conimo dities become cheaper in consequence of the cheapening of the foreign currency and larger quantities will be imported. The supply curve (SS) slopes upwards from left to right. This. expresses the fact that people are willing to sell larger amounts at a higher price, which is to be explained by the stimulation of exports due to the fall of prices of domestic goods in terms of foreign currency.® The two curves intersect at P. This means that there is an exchange rate at which the amount of foreign money which can be disposed of is equal to the amount offered for sale. If this price obtains, there is market equilibrium.

Suppose now that demand increases, because of an unfavour- able change in the balance of payments in sense {d). In other words there is added to the existing demand the demand of those who. now have to discharge additional debts to foreigners. This is represented by a shift of the demand curve from DD to D'D'. R. now intersects the supply curve at P'. The exchange rate has risen and the amount of foreign money sold has increased. A rise in the exchange rate may also be due to

a reduction in supply, owing, to a fall in exports. If the

supply curve shifts from SS to S'S', the price will rise from P to P" and the amount sold will decrease.

6 The statement that the supply curve slopes upwards from left to right needs qualification. If the amount of money in each of the two countries is held con- stant, there will be a P^oint at which the supply curve curls backwards and slopes upwards to the left. This means that, if demand increases beyond that point, the amount of foreign money offered for sale will actually diminish (elasticity <t>f supply 0) ; for the smaller amount of foreign money offered can buy a larger amount of domestic money. In the limiting case when the price of the foreign cur- rency approaches infinity, i.e., when the price of domestic money in terms of foreign money falls to zero, the supply of foreign money will become very small. (It should be noted that the supply and the demand curve are not symmetrical. The point where the supply curve turns to the left corresponds to that point in the demand curve when the area of the inscribed rectangle begins to diminish.)

These oases are, however, of no practical importance. They are remote from reality chiefly because of the assumption that the quantity of money remains con- stant. If the quantity of money changes and, therefore, prices change, the demand and supply curves shift. The mechanism of adjustment consists precisely of more or less automatic changes in the circulating medium which produce appro- priate shifts of the demand and supply curves.

BALANCE OF PAYMENTS

21

Here it is necessary to recall tlie distinction, worked out in | 2, between tbe balance of payments in sense and tke balance of payments in sense (/). Sense (a) refers to OQ (demand actually satisfied, or supply actually sold) ; sense (/) refers to tlie whole demand-and-supply situation as represented by the two curves. In sense (a) the two sides of the balance of payment are equal by definition and a statement to the effect that they are equal is a tautological statement. But if we say that the balance of payment is, at a given moment, unfavourable, we mean that at the then prevailing rate (or at a rate which is considered as normal) demand exceeds supply, because the demand or supply curve or both have shifted. The balance of payment in sense (/) is in disequilibrium at a given rate, but equilibrium can be restored by a change in the exchange rate.

In view of the fact that changes are constantly occurring in the innumerable items which make up the balance of payments, It might be supposed that the rate of exchange would continually fluctuate like the price of commodities of which the supply-and- demand curves are liable to shift. But experience shows that under normal conditions the exchanges remain practically stable. There must, therefore, exist a mechanism which regulates supply and demand.^

We shall discuss in the next chapter this mechanism under the working of the gold standard. Chapter IV is concerned with the mechanism which operates under a paper currency, and Chapter V provides a synthesis of the two cases.

§ 4. The Case of moke than Two Countries.

Throughout the preceding argument it has been assumed that only two countries are involved. But the modern economic system is composed of a number of different countries, each of which trades with each of the others. There is no reason to expect that one country’s balance of payments with any other individual country will be in equilibrium. The analysis given above is applicable, therefore, only to a country’s balance of payments with all the other countries combined. The mechanism of adjustment operates, however, through the so-called triangular trade, by influencing the balance of payments between countries other Than the one directly concerned. In equilibrium the position is as follows. Germany, for instance, pays for its imports from the United States partly by selling machinery to South America, while the South American countries export raw materials to the United States. On the monetary side we can imagine the American exporter receiving in. payment from his German customer a bill on Brazil, and selling it

7 In terms of our demand and supply curves the working of the mechanism must be conceived as follows : There is an equalising source of supply {gold reserve of the central bank or exchange equalisation fund) ; the curve of total supply is therefore horizontal over a certain range. To avoid a depletion of the gold reserve, forces are set up which tend to shift the demand and the supply curve in an appropriate way; prices are changed and the flow of capital is influenced by mean.s of changes in the rate of interest.

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INTEENATIONAL TKADE

to an importer of Brazilian coffee. Actually the whole set of transactions will be financed by the banks, probably via the London money market, but that makes, no essential difierence. The modern banking system acts simply as^ a partially decentralised clearing-house.

When more than two countries are involved there will be more than one ex- change-ratio. Between three countries there will be three ratios (e.g. 1 : 2, 1 : 3, 2 : 3), between four countries six ratios (e.^, 1 : 2, 1 : 3, 1 ; 4, 2 : 3, 2 : 4, 3 : 3) and between n countries ~ ratios. Since the various foreign exchange markets

are connected by telephone and telegraph, the different ratios must bear a deter- minate relation to each other. If, for instance, the dollar rate for marks were to rise, while the dollar rate for pounds, and the sterling rate for marks, remained constant, it would pay to change marks into dollars, dollars into pounds, and pounds into marks, until — assuming the dollar rate for pounds to be in equilibrium — the sterling rate for marks had risen proportionately. It is true that if the international money market is broken up by the severance of communications in war- time, temporary discrepancies may arise, s but experience shows that they will disappear very soon, even when rates are fluctuating widely.® There may, of course, be different rates for cash, telegraphic transfers, bills payable at sight, three months’ bills, &c., all in terms of the same currency. But these exceptions are only apparent, since they refer to price discrepancies between what are,, in effect, slightly different means of payment.

The situation, however, changes completely when a rigid exchange control supersedes the forces of the market. Then more or less fictitious and indepen- dent rates prevail and there is no necessity for a rapid adjustmeAt between them. The problems resulting from this will be discussed later.

s This applies also to a single exchange ratio, which may be different even in the two countries directly involved.

® <7/. Graham, Elxchange. Prices and Production in Ht/'per-Iniiation : Germany^ mo-ms (1930).

CHAPTER III.

THE GOLD STANDARD.

§ 1. Definition.

Tiie term ^ gold standard ’ may be used in a narrower or in a wider sense. In tbe narrower sense it signifies a monetary system under wbicb gold coins of standard specification, or gold certifi- cates with 100 per cent, gold backing, form the circulating medium. In the wider sense it covers also the case where notes or silver coins are legal tender, provided they are convertible into gold at a fixed rate. There must, of course, be no prohibition of the melting down of gold coins. ^ Under these conditions the value of money and the value of gold are rigidly linked together and cannot diverge from one another.

If two or more trading countries are ^ on the gold standard, and if there are no obstacles to the import and export of gold, then the different currencies are rigidly linked together. For instance, if an ounce of gold can be coined into a definite number of pounds sterling and into twenty times as many marks, then — still under the provisional assumption that no costs are involved — one can convert at will twenty marks into one pound and vice versa. A good analogy, which will be worked out in Chapter V, is that of two vertical cylinders joined by a connecting pipe.

§ 2. The Gold Points.

So long as the balance of payments is in equilibrium the ordinary means of international payment (bills, cheques, &c.) cancel out and there is no need for the transport and recoinage of gold. But suppose, to take a concrete example, that, owing to a failure of crops or the necessity of paying reparations, Germany’s balance of" payments with England becomes passive. What happens then?

The effect is that the demand for bills on England becomes greater than their supply. Consequently the value in marks of sterling bills goes up. If the actual cost of recoinage is zero, marks can still be converted into pounds at the rate of 20: 1. Nevertheless, firms which have payments to make in England are prepared to give a somewhat higher price for sterling bills, since

^ There have been many such prohibitions in the course of economic history, but they were always difficult to enforce.

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INTEENATIONAL TEADE

they can in this way avoid the expense of transporting gold. If, however, the price of bills rises above the so-called ' upper gold point/ it will pay to export gold and to have it recoined abroad rather than to pay the enhanced price. ^ The position of the gold point is determined by the costs of transporting gold; these include, of course, the insurance premium and the loss of interest involved. Corresponding to the upper or export gold point there is a lower or import gold point, which is likewise determined by the cost of transmitting gold. Under modern conditions the actual trans- mission of gold is undertaken, not by the merchant himself, but either by a banking house which specialises in this line of business or by the central bank itself. The bank is enabled in this way to open an account abroad. It can then draw cheques and sell them at the enhanced rate. After the War it became the practice, instead of actually shipping gold, to earmark it on foreign account. If the Bank of France wished to import gold from America, it would simply have the bullion placed in a special account at New York, ready for shipment should the necessity arise. The Bank of International Settlements has tried to set up an international clearing system to supersede gold movements altogether; but since 1929 there has been to some extent a reaction in favour of the traditional practice.

The complications due to the existence of international borrow- ing will be considered later. For the present it is assumed that a passive balance of trade cannot be adjusted, even temporarily, in this way.

§ 3. Mebcantilist Ideas.

Suppose now that, owing to some factor the effects of which are not purely transitory,^ the balance of trade becomes passive and the rate of foreign money rises above the gold export point. How long can the outflow of gold continue? Is there any limit to the amount of gold which will be withdrawn from circulation ? Must the Grovernment intervene to prevent an inconvenient drain on the currency, or is an appropriate distribution of gold between different countries secured automatically?

It is common knowledge that the mercantilists advocated the restriction- oL imports and the encouragement of exports, with a view to inducing an active balance and an inflow of gold. The

2 Goschen’s of Foreign Exchanges contains a classical statement of the

theory. For a detailed catalogue of the determining factors, cf. Einzig, Inter- national Gold Movements.

^ E.g., a series of poor harvests, the necessity of paying reparations over a long period, or the permanent contraction of a foreign market.

THE GOLD STANDARD

25

ordinary means to increase onr wealth and treasure is by foreign trade, wherein w^e must ever observe this rule ; to sell more to strangers yearly than we consume of theirs in value.'

It is only fair to remember that the mercantilist doctrine was a great advance^ on the ^ bullion system ’ which was dominant in England till after the beginning of the seventeenth century. This consisted in the rigid control of each separate transaction with foreign countries, with a view, on the one hand, to reducing com- modity imports to the bare minimum and, on the other hand, to ensuring that exports should be paid for by an actual inflow of gold. All payments passed through the hands of the ‘ King’s Exchanger,’ who had a legal monopoly in the transaction of foreign business.

The mercantilists showed that it was absurd to try and regulate every single transaction, since the only thing that mattered was the balance of total payments. Thomas Mun even went so far as to say that a passive balance of trade with one country should not be interfered with so long as it led indirectly to an active balance with another country. It was on the initiative of the mercantilists, and particularly of Mun himself, that the most burdensome of the restrictions on foreign trade were removed."

The mercantilists are often criticised for taking into account only the balance of trade instead of the total balance of payments; but this criticism is unwarranted. Even in the sixteenth century there was an international credit system and a well-organised inter- national money market. Many of the mercantilist writers referred explicitly to items in the balance of payments other than the trade balance. For example, Thomas Mun mentioned, amongst other things, expenditure on foreign travel, the transmission of gold to Rome, and military expenditure abroad. Certain other items which are familiar today were non-existent or of negligible pro- portions in the seventeenth century, and it is hardly surprising that the mercantilists ignored them. In any case, omissions of

^ Thomas Mun, England's Trsasme by Forraign Trade (written about 1628, published posthumously in 1664).

5 Prof. Schumpeter calls the doctrine of the trade balance “ the first step towards an analysis of the economic system.” Of. EpocJien der Dogmen- and Methodengesc/iichte (2nd ed. 1924), p. 3S.

Of, Tawney’s Ijitroduction to Thomas Wilson, .1 Discourse upon Usury (1572), reprinted in Classics of Social and Political Science (1925). Prof. Tawney observes with some justification, that the devices employed by the Tudors are exactly the same as those resorted to during the War — and also, it may be added, during the depression from 1931 onwards. Of. chap, vii, § 7.

^ The best discussion of the mei’cantilist doctrine is to be found in Viner, “ English Theories of Foreign Trade before Adam Smith,” Journal of Political Economic (1930), vol. 38, pp. 249 seq. and 404 seq., and ” The Balance of Trade ” in the Encyclopaedia of the Social Sciences (1930), vol. 2, p. 399, Professor Viner confines his attention to the English mercantilists. Of. also Heckscher, Mercan- tilism (1935) (2 vols.).

26 IFTEENATIONAL TRADE

this kind are -uiiiiEiportaiit compared with other defects of the doctrine.

The mercantilists based their whole attitude to problems of com- mercial policy on the idea that the accumulation of gold meant an increase in the real wealth of a country. This view was, of course, erroneous. But even if there were any sense in trying to increase the amount of gold in circulation, the method they advocated — namely, Government interference with foreign trade — would not in fact produce this result. Moreover, the fear that there might be an indefinitely large drain of gold unless such action were taken, was totally unfounded. The whole theory rested on very crude notions about the balance of payments. Mercantilism received its death-blow in 1752 when Hume published his Political Discourses. This was the first appearance in a systematic form® of the ‘ classical theory,’ which was later refined and extended by Adam Smith, Thornton, Ricardo, Senior,® John Stuart Mill, Cairnes, Bastable, Taussig, &c.^ It must now be considered in detail.

§ 4. The Classical Theouy and Its Ceitics.

Our problem is to explain how equilibrium is restored after the balance of trade has become passive and gold has begun to flow out. The classical solution is as follows. The outflow of gold decreases the volume of money in circulation. Consequently prices fall, exports are stimulated and imports are reduced. In the foreign country where the balance of payments has become active the opposite happens.^ Gold flows in, the volume of currency in circulation expands, prices rise, imports are stimulated, and exports are reduced. The movement of gold, which is the same thing as the cash payments necessitated by the passive balance of trade, produces a gap between the price levels of the two countries. This in its turn stimulates a flow of goods in the same direction as the original flow of gold, and the flow of goods induces a flow of gold in the opposite direction. The two gold movements, therefore, cancel out and the balance of payments is restored to equilibrium

® It was demonstrated by Friedrich Raffel that every one of the elements com- posing it could be found in earlier writers. Of. “ Englische Freihandier vor Adam Sraith/^ Zeitschrift Hit die gesamten Staatswissenschaften, supplementary vol. 18. Cf. also Viner, loc. cit.

9 Hie Three Lectures on the Transmission of the Precious Metals from Coun- try to Country and the Mercantile Theory of Wealth (1828), reprinted in London School of Economics Series of Be'prints No. 3, 1931,

^ A detailed account of the historical development and a practically exhaus- tive bibliography are to be found in Angell, The Theory of International Prices (1926).

3 Some writers have expressed a fear that the balance of payments may become passive for all countries simultaneously. But this is unlikely to happen until trade connections are established with another planet !

THE GOLD STANDARD

27

by tbe movement of commodities. Thus, payment is made “pro- visionally in gold, but finally in goods. To put the same thing in another way : if a country is suddenly called on to make additional payments to foreign countries, its volume of exports and consequently the supply of foreign bills will increase. Simul- taneously the demand for these bills diminishes, because imports contract. The bill market returns, therefore, to equilibrium and the exchange falls once more below the gold point.

This mechanism thus preserves equilibrium in the balance of payments. It prevents a complete loss of gold by any one country and ensures an appropriate distribution of gold among the gold standard countries which participate in world trade. The mechanism of the gold standard regulates the movement of gold automatically. It therefore renders state intervention at once superfluous and ineffective. The exportation of the specie may at all times be safely left to the discretion of individuals. ... If it be advantageous to export it, no laws can effectively prevent its exportation. Happily, in this case, as in most others in commerce, where there is free competition, the interests of the individual and that of the community are never at variance.’’^

Ricardo never tired of pointing out that, for purposes of inter- national trade, money is simply that commodity which is most readily exchangeable. It, therefore, gravitates like other com- modities— only with particular ease — ^to the place where its value ia highest, or, in other words, where the price level is lowest. ‘‘ If in France an ounce of gold were more valuable than in England^ and would therefore in Frjance purchase more of any commodity common to both countries, gold would immediately quit England for such purpose, and we should send gold in preference to anything else, because it would be the cheapest exchangeable commodity in the English market ; for if gold be dearer in France than in Eng- land, goods must be cheaper; we should not therefore send them froin the dear to the cheap market, but, on the contrary, they would come from the cheap to the dear market and would be exchanged for our gold. Ricardo was only putting the same thing differently in the many passages where he attributed the outflow of gold to its ‘ redundance.’ By relative redundance then I mean, relative cheapness, and the exportation of the com- modity I deem, in all ordinary cases, the proof of such cheapness.”^ Discussion of the particular questions at issue between Ricardo

3 Ricardo, The High Price of Bullion (1911), 4th ed., reprinted in Works, ed. :\Ic(^n]loch (1846), p. 265.

^ Op. cit., p. 266.

3 Betters to Malthus, ed. Bonar (1887), p. 13.

28

INTERNATIONAL TRADE

and Malthas must be postponed till Chapter VII, where the classical treatment of the ' transfer problem ’ is compared with the very- similar discussions of recent years. At the present stage it is more convenient to deal with certain misconceptions of the scope and implications of the classical theory as a whole.

On the Continent the classical theory has never found much favour/ criticism being generally directed against the ' quantity theory of money/ on which it is based. But two varieties of the quantity theory must be distinguished. The more rigid one asserts that a given percentage increase or diminution in the quantity of money will necessarily change prices in the same proportion. But the classical theory of international trade clearly does not require so drastic an assumption. It need only postulate that an increase in the quantity of money tends to raise prices, and that a diminu- tion in the quantity of money tends to lower them, without saying by how much. The quantity theory in this less rigid sense can hardly be disputed. There is no advantage in substituting, as Professor Aftalion wishes to do, for ^ quantity of money ^ the expression ^ total incomes.’’' Naturally the quantity of money influences the price level only when it is actually spent, and thus constitutes an efiective demand for goods. Without altering in any way the meaning of the classical theory one could say ‘ total money incomes fall,’ ^ the supply of money shrinks ’ or ^ the demand for goods becomes smaller ’ instead of saying ‘ the quantity of money diminishes ’ or ‘ there is an outflow of gold.’ One could also speak with Professor Ohlin of a ‘ shift in (nominal) purchasing power.’

It has been objected that the gold movements which occur in practice are too insignificant to overcome such large disturbances as often arise in the balance of payments. This objection cannot be dealt with at the present stage, where the assumption is still made of a purely automatic, ‘ unmanaged ’ gold standard. Under modern conditions every monetary system is influenced by the deliberate policy of the central bank and by the mechanism of international credit.^ As will be shown later, gold movements provoke changes in the volume of purchasing power many times greater than themselves. Under a ‘ pure ’ gold standard, where

6 As typical of the French and German attitude, cf. the various writings of Prof. Nogaro, and Helfterich, Money, p. 599 {vol. 2).

Cf. his article, “ Die Einkommenstheorie des Geldes ” [W irtschaftstheorie der Gegenwart (1932), vol. 2, p. 376). Prof. Schumpeter has shown conclusively that there is no antithesis between ‘ income theory ’ and ‘ quantity theory * : cf. Das Sozialprodukt und die Rechenpfennige {Archiv fur Sozialwissenschaft (1918), vol. 44).

® For the objection that tariffs, &c., prevent the attainment of equilibrium, cf. chap, vii, § 5.

THE GOLD STANDAED

29

the circulating medium consisted exclusively of gold, such move- ments would, therefore, have to be on a much larger scale,

Profe’ssor L. Laughlin^ has objected that between modern markets which are connected by railroads, telegraph, telephone, &c., price differences cannot exist long enough to produce suffi- ciently large movements of goods. This criticism of the classical doctrine can be disposed of by pointing out that modern means of communication equalise prices by inducing transactions between the cheap and the dear market; far from being an objection, this state- ment calls attention to circumstances which make for a rapid functioning of the mechanism.

It is perhaps worth while to think out the classical theory in terms of inter-regional trade. ^ Suppose that, owing to a redis- tribution of taxation, London or the County of Middlesex has to make increased payments to Scotland. In that case Scotland’s purchasing power rises at the expense of the South. If the Scots- men who now have more to spend buy the same commodities as would have been bought by the Londoners whose incomes have been reduced, the only effect is a movement of goods from London to Scotland. More will be consumed in Scotland and less in London. If, however, the Scotsmen spend their money at home on commodities other than those which the Londoners have previously been in the habit of buying, the process of adjustment is more complicated. The volume of money in Scotland (which forms the demand for goods there) has increased, whereas in London it has diminished. Prices, therefore, rise in Scotland and fall in London, and the discrepancy between the two price- levels causes goods to flow from London to Scotland. This is exactly the same process which has been expounded above as the standard case in international trade. The problem will be further analysed in chapter VII.

9 Principles of Money (1903), p. 369,

Of. p. 11. As Ricardo himself pointed out, “ The money of a particular country is divided amongst its different provinces by the same rules as the money of the world is divided amongst the different nations of which it is composed ” \The High Price of Bullion; Worhs, p. 282).

CHAPTER IV.

INCONVERTIBLE PAPER CURRENCIES.

I 1. The ' Balance oe Payments ’ Theory and the ' Inflation '

Theory.

The last chapter dealt with currencies rigidly linked together by convertibility into gold. The present chapter is concerned with the opposite extreme, with inconvertible paper currencies, the relative values of which are determined by supply and demand in the open market. The value of one in terms of the other is subject to variations like the price of ordinary commodities. There are no fixed parities or gold points, and a passive balance of payments will cause, not an outflow of gold, but a depreciation of the exchange. There is no fixed point at which depreciation will cease, corresponding to the gold export point in the previous example. On the other hand, depreciation cannot go on indefinitely, except under a progressive inflation. For the relative price changes which are necessary to reduce imports, stimulate exports, and restore equilibrium — and which under the gold standard are induced by the outflow of gold — are here produced by variations in the rate of exchange.^ The problem is now to find the general principle which determines how far depreciation will go.

During the War, when the gold standard was suspended by one country after another, this question became again one of practical politics ; and it was debated keenly, above all in Germany. Two explanations were put forward of the steady depreciation of the mark in terms of foreign currencies. The ofl&cial view, which was mercantilist in spirit, ascribed it to the passive balance of payments; the critics, on the other hand, attributed the whole responsibility to inflation.

1 Prof. Hollander points out that this factor operates to some extent ev& under a gold standard — ^within the limits set by the gold points (“ International Trade under Depreciated Paper : a Criticism.” Quarterly Journal of Economics [1918], vol. 32, p. 678). He concludes that absolute price changes are not required But as Malthus showed in his review of Eicardo*s High Price of Bullion^ “ we know indeed that such a demand (i.e., for goods of the country whose balance of trade has become passive owing to a failure of the harvest) will to a certain degree exist, owing to* the fall in the bills ui)on the debtor country, and the consequent opportunity of purchasing its commodities at a cheaper rate than usual. But if the debt for the corn or the subsidy be considerable, and require prompt payment, the bills on the debtor country will fall below the price of the transport of the precious metals. A part of the debt will be paid in these metals, and a part by the increased exports of commodities” [Edinhurgh Review XW eh, 1811], vol. 17, pp. 544-5). €f, also Viner, Canada* s Balance of International Indebtedness, p. 194.

30

INCONVERTIBLE PAPER CURRENCIES

31

Tlie ^ balance of payments ’ theory in its naive form merely asserts that exchange rates are determined by the balance of pay- ments, in the sense of supply and demand. There can be no objection to this ' theory/ but the question is : what determines supply and demand?

The balance of payments theory in its more sophisticated form does try to answer this further question. It asserts that the balance of payments is determined chiefly by factors which are independent of variations in the rate of exchange. In addition to fixed pay- ments, such as reparations and the interest on foreign debts, the demand for many imported raw materials is inelastic because they are not to be had at any price except from abroad.

The fatal weakness of this theory is that it assumes the balance of payments to be a fixed quantity. To use an appropriate metaphor suggested by Mr. Keynes/ it applies the theory of solids where that of liquids would be more appropriate. The balance of trade (and also some invisible imports and exports) depends on the relation between price-levels at home and abroad. Even the demand for imported foodstuffs has a certain elasticity. For the same physiological needs can be satisfied either by cheap commodities like bread and potatoes, or by expensive ones like meat and fruit. In a word, the balance of payments is partially dependent on the exchanges; it cannot, therefore, be used to explain them.

This objection was raised by theorists of the ‘ inflation ’ school.^ They pointed out that the mark would never have depreciated so far if the volume of currency had not been continually increased. It was only the rise of domestic prices that prevented the expansion •of exports and the contraction of imports. Otherwise equilibrium would have been restored by the change in relative prices. Exactly the same, point had been made more than a hundred years ago by Ricardo, who asserted that ‘ the exchange accurately measures the depreciation of the currency.'*^ The situation in England during the Napoleonic wars was very similar to that in Germany from 1914 to 1920. The twentieth century has added but little to our understanding of these phenomena, and the correspondence

^ Cf, “ The German Transfer Problem/’ Economic Journal (1929), p. 6. Mr. Keynes himself compares the balance of trade to a sticky mass.

3^7/. the various writings of Prof. Cassel; Mises, / Zahlungsbilanz und Devisenkurse ” (in Mitteilungen des Verhandes der dsterreichischen BanJcen und Bankiers [1919]); Machlup, Die Goldkernwahrung, chap. 15; and Hahn, “ Handel- bilanz — ^ZahiungslDilanz — ^Valuta — Guterpreise “ and “ Statische und dynamische Wechselkurse ’’ in Geld und Kredit (1924).

^ Letters, p. 15. Cf, also High Price of Bullion, passim, and the celebrated Bullion Beport which was produced under his influence (reprinted in Cannan, The Paper Pound of 1797 ^mi).

32

INTERNATIONAL TRADE

between Maltbns and Ricardo still provides tbe best discussion of tbe points at issue.

§ 2. The Theory of Purchasing Power Parity.

The view that a fall in tbe exchange is due to inflation rests on tbe tlieory of ' purcliasing power parity.’ This theory asserts that the relative value of different currencies corresponds to the relation between the real purchasing power of each currency in its own country. The term ' purchasing power parity ’ was first introduced by Professor Cassel, who enunciated the theory in its most extreme form. But he did not invent it^ and his formula- tion was in any case very much over-simplified. His assertion that the demand for foreign money is determined by its purchasing power abroad is simply not true. Foreign money is normally purchased to settle a debt, and debts are contracted either without reference to prices at all (political debts) or with reference only to particular prices (commercial debts). General purchasing power is rarely considered.

But it is not difficult to guess what Professor Cassel really means. In so far as particular prices tend to equality in different countries, prices in general, or the value of money, will show the same tendency. But experience teaches that absolute equality of all particular prices is never realised. Nevertheless, one can speak of the equalisation of general price-levels, though hardly any of the purchasing-pow^er-parity theorists except Marshall have tried to show in detail in wffiat sense this is possible.

Obviously one cannot mean that the price of every single com- modity must be the same in different countries. It is only trans- portable goods which react directly to price discrepancies at all, and even here discrepancies cannot be reduced in this way to less than the cost of transport. Every commodity has an export point and an import point. The distance between the two ‘ com- modity points is determined by the cost of transport, including tariffs, insurance, uninsurable risks, interest (since transport take^ time), cost of advertisement in the foreign market, &c., &c.^ If

5 The theory is older even than Ricardo. According to Prof. Angell, the first writer to formulate it clearly was John Wheatley (Bemarhs on Currency and Commerce [1802]). It was also extremely well set out by William Blake [Ohserva- turns on the Principles which JRegulate the Course of Exchange; and on the Present Depreciated State of the Currency [1810]). Blake spoke of the relation between Real Exchange (t.e., purchasing power parity) and Nominal Exchange.

6 As one may call them by analogy with the gold points. It should be noted that the export point is the lower commodity point in terms of domestic price.

7 Most of these factors are not peculiar to international trade, however the- latter concept may be defined.

INCONVERTIBLE PAPER CURRENCIES

33

in a country the p^ice of a given commodity rises above the import point j imports will increase, if it falls below the export point, the commodity will be exported.

Professor Angell has recently urged that, An addition to trans- port costs, there are other factors which produce permanent price iiprepancies. Following Professor Schiiller, he mentions lack of information, lack of initiative, selling costs in a new market. None of these factors represents permanent costs of transport (indeed, the first two can hardly be regarded as costs at all), but for that very reason they do not lead to permanent price discrepancies.® How long discrepancies due to them will persist is, of course, another question. Some markets react more promptly than others. The stock exchanges and the markets for staple commodities in different countries are connected by telephone and telegraph, and speculation is highly organised. They therefore react to price discrepancies within a few hours. Other markets take days or even weeks to react; but in modern times improved communica- tions and the collection of more and more detailed information about foreign markets have reduced substantially the ‘ reaction period ^ of all markets.

Professor Angell draws attention to another fact which in his view is the chief cause of disproportionate price differences. The increase of production which is necessary if exports to the country with the high price-level are to expand, will normally involve rising costs. Under perfect competition this cannot prevent the equalisation of prices. But, according to Professor Angell, there are many cases in practice where it will pay manufacturers to produce the smaller amount at a lower marginal cost, thus making larger profits per unit of the product. Now it is true that market conditions may be of this type, but, even so, they will not give rise to price discrepancies; for exports can be increased without an expansion of total output. Indeed, manufacturers may not eten know what proportion of their output will be exported by the traders who buy from them.

^ The case of dumping (z.e., price discrimination in favour of the foreigner) also provides no exception to the rule, since com- modities can be reimported if the price discrepancy is greater than the costs of transport.®

Within the limits set by the cost of transport the price of a commodity may vary between different countries. In many

^ As Ricardo pointed out [Ldtters to Malthm^ p. 18), lack of information as a disturbing factor could be urged against almost every law of political economy. ^ For a general discussion of dumping cf. chap, xviii below.

34

INTERNATIONAL TRADE

cases tke two coBimodity points are . a long way apart, and tlie limits are correspondingly wide. If transport is impossible, or if it is disproportionately expensive,^ there will be no direct connec- tion at ail between prices at home and abroad.

Thus it is possible to. distinguish, roughly, between goods which are and. goods which are not ‘ internationally traded. All commodities which are regularly exported or imported, even if only in small quantities, should be classified as international goods; but it is perfectly conceivable that a commodity which is exported from country A to country B may be produced in countries C and D for the home market and neither imported nor exported. Moreover, the list of international goods is continually changing. Whether at any particular moment a given commodity is ‘ inter- national ’ or not depends on whether the cost of transport is smaller or greater than the difference between the marginal costs of production in the countries concerned.

The question what goods are ^ international ^ depends therefore on the particular circumstances; and the boundary is continually shifting. Goods which have previously been imported will be produced at home if costs in general are reduced (e.^., by deflation), if their particular costs of production are diminished {e,g., by a new invention) or if their costs of transport are incre&,sed (e.y., by a tariff). Shifts of this kind may be permanent or transitory or periodic seasonal). A great many domestic goods are

potentially international goods. The nearer their cost of production is to the export or to the import point the more likely they are to become international goods, as a result of small changes either in the cost of production or in the cost of transport.

The price of international goods in the exporting country coincides with the lower or export commodity point, and in the importing country with the upper or import point. ^ The difference between them is equal to the cost of transport. If it were greater, the flow of goods would increase ; if it were less,

1 The first applies to land, houses, labour and commodities with prohibitive

tariiBfs, the second to certain building materials and so forth. ^

2 In trade statistics a single class of goods may frequently be found both among the imports and among the exports of the same country. This may occur for several reasons. Thus the imported commodity may differ slightly in quality from the exported commodity, although they are classified for statistical purposes under the same heading. Moreover, goods of the same type may be imported and exported at different moments of time (e.g. seasonal fluctuations), or they may be imported into one part of the country and at the same time be exported from another 'part of the country. Thus for many years wheat was imported into Western Germany and exported from Eastern Germany. Further, certain goods are imported from one country and then re-exported to another. Finally, there may be occasional exceptions due to imperfection of the market. But the distinction between regular exports and imports does not thereby become meaningless, Cf, Taussig, jSome Aspects of the Tariff Question (1031), 3rd ed.

INCONVERTIBLE PAPER CURRENCIES

35

tlae flow of goods would diminisii. Tlie price of each, international good in one country has, therefore, a determinate relation to its price in the other country; and both prices move together. The same argument applies to the price of international goods taken as a whole. Their average price-level is generally higher in one country than in another, since the cost of transport varies between different goods. But if there is no change in transport costs the average price-level rises or falls everywhere in the same pro- portion; it cannot possibly go up in one country and down in another. If all goods were internationally traded the theory of purchasing power parity would, therefore, require no further proof. But there are also domestic goods; and it is theoretically possible that their price-level may vary even inversely to that of inter- national goods. The theory of purchasing power parity has, there- fore, to prove that the two price levels do, in fact, move together.

It seems probable that there is a fairly close connection of this kind.^ Even if the proportion of international to domestic goods is small,^ it must not be forgotten that the former include most of the important raw materials, which influence considerably the price of their products. Moreover, the number of international and of potentially international goods is continually being increased by improvements in transport.

We are now in a position to state the theory of purchasing power parity in a precise form and with the necessary qualifications.

(a) It is not true that prices must be the same in all trading countries. Owing to differences in the cost of transport there will *15e differences in the price of particular articles. It is impossible to say beforehand whether in any particular case they will cancel out, leaving average prices the same, or not.

(b) The theory cannot, .therefore, be applied to absolute levels of prices, but only to changes in the price levels.® Moreover, there

"is a direct and. rigid connection only between the prices of inter- national goods in different countries, though probably the connec- tion between the price of international and of domestic goods within each country, and, therefore, by way of the former between the general price levels of different countries, is fairly close.

Let Pa be the general price level of country A and Pb the general price level of country B. Let R be the exchange rate

3 Of. Zapoleon, “ International and Domestic Commodities and the Theory of Prices ” (Quarterly Journal of Economics [May 1931], vol. 45, ]^. 409 et aeg.). Mr. Keynes is of the opposite opinion. Of. A Tract on Monetary Meform, p. 93.

4 For the United States it is computed at between 5 and 8 %, but the figures are not very reliable. In smaller countries one would naturally expect the proportion to be higher.

^ Of. Pigou, Essays in Applied Economics, p. 166.

36

INTERNATIONAL TRADE

of currency A in terms of currency B. Tken PA=PBxRxk, k representing tke difierence "between the value of money in A and

in B respectively. Thus R = fraction expresses

the relation between the two price levels, and k the divergence from purchasing power parity.

Let 1 and 2 represent different points of time. Then

R. : R.

Pa,

If the degree of

divergence

from

''2 "~Pb, xk, ‘ PB^ xkg purchasing power parity remains constant throughout if in

both countries the general price level moves parallel with

the price level of international goods), then k, = k2 and In this case the change in purchasing power

R.

Rg —

Pa, PAo

Pi, * PBg

18

parity, i.e., the relative movement of the two price-levels reflected by a proportionate variation of the exchange-rate.

The simplest form of the theory is represented by the equation R Pa

13^ =— which holds when the general price-level in country R2 Pb-

B remains unchanged (so that 5-^ =1), while an inflation takes

place in A. In other words, the change in the purchasing power of money in country A is here reflected in a corresponding varia- tion of the exchange rate.

(c) It is obvious that the theory of purchasing power parity stands or falls with the hypothesis that k does in practice remain fairly constant. There is no logical necessity for this. The extent to which k changes depends primarily on the comparative import- ance of international and domestic goods. If the volume of international trade is small, it may even change very considerably. In such cases the theory breaks down completely.

Suppose, for example, that Canadian exports to England consist of wheat — representing agricultural produce in general — and English exports to Canada of electrical machinery, both to the value of 100 million. If, now, England’s demand for wheat increases, more will be imported and the price will rise^® England has then to choose between two alternatives. She can directly stimulate exports and discourage imports by letting the exchange depreciate. On the other hand, she can hold the exchange constant by reducing the amount of money in circulation. Under a gold standard of the rigid type this is brought about auto- matically by an outflow of gold, but under a paper currency credit must be restricted in order to secure stability of the

^ Similar results follow a change in supply.

INCONVEETIBLE PAPEE CUEEENCIES

37

exchange;^ in either case there has to be deflation in England. The prices of all commodities produced at home, including electrical machinery, go down and wheat becomes comparatively dearer. Thus equilibrium is finally restored, in this case, too, by an increase of exports and a diminution of imports.®

In both cases k has changed. The price of international goods is once more, apart from transport costs, identical in both countries. In England the general price-level has fallen, compared with the price of wheat. The price of electrical machinery is affected in the same way as that of other commodities produced at home. The price-level of imports and exports together has therefore risen, relatively to the general price-level in England. In Canada, on the other hand, the prices of international goods have fallen more than the general price-level in Canda, since electrical machinery is now cheaper than before. This is clearly an exception to the theory of purchasing power parity.

An example of the type just analysed was suggested by Ppf§ssor Viner in a debate with Professor Cassel.® In reply. Professor Cassel admitted that the rate of exchange was determined not only by purchasing power parity but also by the conditions of demand for imports. But he maintained that his theory was meant to apply only to the effect of monetary changes operating ceteris farihus,

'^Jd) In the modern world sudden and violent changes of k are prevented by the reserve of potentially international goods. But over a period of years quite appreciable changes can take place. The question therefore arises whether the theory of purchasing power parity is anything more than an extremely rough approxima- tion to the facts. The answer must be that for one group of phenomena, namely monetary changes, the theory holds true with a high degree of precision. During the post-war inflation, perhaps 99 per cent, of the depreciation of the German mark was due to

7 Cf. chap. V below.

8 Apart from the two cases analysed in the text, there is a third possibility. The increased demand for wheat in England implies a decreased demand for other commodities. Productive resources may therefore be liberated for use in the export industry, and the price of electrical machinery may fall, without dis- turbance either to the exchange or to the price system as a whole. If purchasing power parity is to be maintained, Canada must expend the whole surplus derived from the sale of wheat on the purchase of electrical machinery.

9 At Chicago in Jan., 1928 Prof. Viner pointed out, further, that prices can rise in one country and fall in the other if the cost of transport in one direction goes up and in the other direction goes down. The same point has also been made by Prof. Pigou (op. cit.) in a more general form. He points out that any impediment to trade in one direction only will upset the purchasing power parity. Prof. Gregory admits that there are exceptions to the purchasing power parity theory, but con- siders them to be negligible. Cf. “ Geldtheorie und Handelsbilanz ” in Die Wirtchaftstheorie. der Gegenwart (1932), vol. 2, pp. 370-1.

I

6

m

I

38

INTERNATIONAL TRADE

tke rise in prices and only 1 per cent, to ctanges in relative, demand. It is improbable tbat inflation or deflation will permanently affect k, by cbanging tbe relative demand for international and for domestic goods respectively, if tbe basic conditions of consumers’ tastes and technical knowledge remain constant.^ Moreover, in a violent inflation the disturbing effect of changes in relative demand is clearly quite imperceptible.^

[e] The experience of recent years has shown that it is possible, to a quite unexpected extent, to isolate, by means of rigid import restrictions, one country’s price-levels from those of the outside world and thus to maintain for a long period an exchange-rate which is quite out of line with purchasing power parity in the ordinary sense. In the more exact terminology of our theory one would have to say that it is possible to produce rapidly large changes in k by the imposition of tariffs and quotas; but, of course, only at the cost of drastically restricting the international division oriabour.^*''

- 3^Xthough the theory of purchasing power parity has therefore only a restricted field of application, the fundamental conception which distinguishes it from the balance of payments theory is both correct and important. While the price-levels of different trading countries may diverge, their price systems are nevertheless inter- related and interdependent, although the relation need not be that of equality. Moreover, as will be shown in the next chapter, supporters of the theory are quite right in contending that the exchanges can always be stabilised at any desired level by appropri- ate, though not necessarily by proportionate, changes in the volume of money.

§ 3. PnoBLEMS OF Statistical Verification.

If the theory of purchasing power parity is to be tested statis- tically, care must be taken to select for comparison those prices which are relevant to it. This presupposes a theoretical analysis.

Attention has generally been concentrated on the index of wholesale,, prices. But this relates to raw materials, semi-manu- factured commodities and foodstuffs, which are mostly international goods. The high degree of correlation® which has been established affords, therefore, not much support to the theory of purchasing power parity.

1 The problem of temporary changes will be discussed in chap. vi.

3 In the above-mentioned discussion Prof. Cassel made it clear that his theory had been devised primarily to meet this case, and that it presupposed, strictly speaking, fixed demand functions.

Of. chap, vii, § 7.

3 In chap, vi it will be shown by statistical examples that even in this field discrepancies persist for fairly long periods when inflation is going on.

INCOKVERTIBLE PAPER CURRENCIES

39

Of greater significance is tlie beliavioiir of retail prices or tlie ^ cost of living ’ ; for retail commodities are, clearly, domestic goods. ’Statistical enquiry stows ttat the absolute price-level of retail goods is usually higher in rich than in poor countries. This is due partly to differences in the cost of retailing, but partly also to the fact that many commodities which appear in statistical tables under the same heading are of higher quality in the more pros- perous countries.^ Moreover, taxes on retail trading and restric- tions and regulations of various kinds work in the same direction. All these factors produce absolute price discrepancies and they also prevent the movements of retail prices from corresponding so closely in different countries as those of wholesale prices. It is, therefore, of great theoretical interest that a considerable degree of correlation has been observed.

The problem of comparison between goods of better quality and goods of poor quality exemplifies one of the main difl3.culties of statistical work. The price levels of different countries include different commodities. Even staple commodities are not completely standardised, and no two markets operate in exactly the same way. A strict comparison is, therefore, impossible. Moreover, the • statistical data are very incomplete. Apart from a few raw materials, there are not even the weekly quotations which would be necessary for detailed comparisons, while information about rebates, discounts, &c., cannot usually be obtained at all. On detailed problems of this kind a great deal of work remains to be done. In the meantime one must refrain from drawing hasty conclusions about the relation between the price systems of different countries from the ordinary crude statistics.

The most usual method of determining whether the exchange- rate between two countries is in equilibrium and whether it corresponds to purchasing power parity is as follows. The price- indices of Great Britain and the United States are both put equal to 100 for 1928, when the exchange-rate is assumed to have been in equilibrium. Changes in the two price levels are then calculated ^relatively to the common base year, and the divergence between them is compared with movements of the exchange. If, e,g,, the English price-index fell between 1928 and 1932 from 100 to 90 and the American index from 100 to 60, then the value of the pound in terms of dollars should have decreased by one-third.

This method is, however, inadequate, quite apart from any deficiencies of the statistical data. For one cannot be sure whether

4 This applies not only to the goods themselves but also to the conditions under which they are sold.

40

INTEENATIOJSTAL TEADE

tEere was equilibrium in tlie base year, or to wliat extent k lias changed. Moreover, even in the simplified case when all goods are internationally traded, and there are no costs of tfansport, the method is still inaccurate.

Let us consider two periods and two countries. Individual prices change differently from period one to period two, but there are no price differences in either period between the two countries. Then the purchasing power parity would clearly hold in both periods ; if each price is the same in both countries, a fortiori, the price-level must be the same too, however we define this ambiguous term. From that it does not, however, follow that the price-level in each country will be found to have changed to the same extent between the first and the second period. At least, if W'e take for each country price index numbers which use values of production or consumption as weights, any difference between the weighting ' systems of the two countries will produce a divergence in the calculated change of the price-level in the two countries between periods one and two.®

This paradox is due to the fact that only fixed-w'eight index formula fulfil the so-called ^ circular test.’® This puzzle exists also if we drop the assumption that each price is the same in both countries; but it is then veiled by the influence of the price dis- crepancies. It seems to follow that index-numbers designed for the verification of the purchasing-power-parity theory, should not use figures of national consumption or production as weights.

5 Of. Nurkse, Internationale Kapitalbewegungen (1935), p. 151.

^ Of. Haberler, Der Sinn der Indexzahlen (1927), p, 48 et seq. Irving Fisher, The Making of Index Numbers, 3rd ed. (1927), p. 274 et seq..

CHAPTEE V.

EUETHEE DETAILS OF THE EXCHANGE-MECHANISM.

§ 1. Preliminahy Eemauks on Monetary Theory in General.

The last two chapters have sketched in outline the w’orkings of a pure gold-standard and of inconvertible paper-currencies respectively. But the monetary systems of the modern world repre- sent generally neither of these two extremes. In the present chapter it will be shown how exchange-rates are kept more or less automatically stable under certain modified types of gold- standard, and hoAv they are deliberately controlled by means of discount-policy.

It has often been pointed out that money finds its purest expres- sion in ‘ token-money ’ — such as currency-notes — which as a com- modity has practically no value at all. In other words, monetary problems can be expressed in their most general form when we assume a pure paper-currency. Most of the conclusions reached under such an assumption — in particular what has been said about price-adjustments and purchasing-power parity — can therefore be applied without qualification to the special conditions of the gold- standard and of the intermediate types as well.

Before doing so, however, it is convenient to illustrate some of the fundamental conceptions of monetary theory by means of a familiar analogy. In fig. 2 the monetary systems of two countries are represented by vertical cylinders as follows : —

A B

Fig, 2.

^ In each case the amount of water stands for the quantity of money, the depth of water for the price-level, and the width of the cylinder, as measured by the area of its base, for the volume of transactions, or amount of work which the money has to perform. The functioning of the gold-standard may be represented by a pipe connecting the two cylinders below the water-line and thus ensuring that, should water be removed from one cylinder into the other, a corresponding amount would flow back through the pipe. Thus the level of water in the two cylinders could not in the long run be different. With inconvertible paper-currencies, on

41

42

INTEENATIOlSrAL TRADE

tie otter hand, price-cliaiiges would be reflected in relative cbanges of the two water-levels, representing a shift of the exchange-rate. Changes in purchasing-power parity (±k) would in both eases be represented by the raising or lowering of one cylinder compared with the other.

The volume of transactions is determined, broadly speaking, by (a) the volume of goods and services to be exchanged, (6) the degree of vertical integration or differentiation,^ (c) the habits of payment, or methods of settling accounts, and the extent of payments by instruments of credit.

Factors (b) and (c) are usually grouped together under the rather vague heading, ^Velocity of Circulation of Money.’ But the method of classification is really a matter of convenience. Thus one can contrast, with Professor Mises, the ^ stock of money ’ with the ^ demand for money,’ and understand by the latter the volume of trade in the wider sense, i.e,, the width of the ^ cylinder ’ as determined by factors (a) to (c). On the other hand, one may consider it more appropriate to distinguish between determining forces ^ on the money-side ’ (quantity of money, velocity of circula- tion, methods of payment which dispense with cash, &c.) and determining forces ^ on the commodity-side ’ (quantity of goods to be exchanged, &c.) — though the line of distinction is not always clear-cut. One can treat the methods of payment which dispense with cash (settlement at a clearing house and credit as a means of payment) as an increase either in the quantity of money or, with Wicksell,^ in the velocity of circulation of cash. The method of classification chosen is to a large extent immaterial : the import- ant thing is to analyse the various factors in detail and not merely lump them together under ^ demand for money ’ or ‘ velocity of circulation,’ as the case may be.

^ Bank-money ’ deserves special notice. A large proportion of payments — in the Anglo-Saxon countries, where the use of cheques is very widespread, the great majority of payments, on the Continent of Europe a considerable part — is made not in cash but by the transfer of hank-credit from one account to another. Bank-money is also called ^deposit-money’ or ^credit-money.’ ‘ Average volume of short-term liabilities of the hanks ’ x ^ rate of turnover ’ = ^ total clearing figures ’ shows roughly the magnitude of these transactions.®

Of, notably Hayek, Prices and Production; Holtrop, Ornloopsnelheid van het Geld,192Bf p. Ill; and the German edition of the latter work, “ Umlaufsgeschwin- digkeit des Geldes ” in Beitrdge %ur Geldtheorie^ 1933, ed. by Hayek, pp. 144 et seq.

2 Cf, Lectures on Political Economy, vol. 2 (1935).

^ Of, Neisser, TJmlaufsgeschwindigkeit der Bankdepositen ” in Handwdrter- hvch aes Banhwesens (1933).

DETAILS OF THE EXCHANGE-MECHANISM

43

One can regard the expansion of hank-credit as an increase either in the quantity of money or in the velocity of circulation or efficiency of ^ real money ^ ; or, again, as a decrease in the demand for money or in the work which real money has to perform. But since bank-money is quantitatively so important and since the banks are able to create and destroy it, the expression ‘ changes in the quantity of money ’ seems most appropriate.

Some writers even commence their exposition of monetary theory by postulating a pure credit-system, and introduced cash-payments only at a later stage. ^ But this procedure has the disadvantage of obscuring the fundamental principle that money — of whatever kind — has economic value only because its quantity is limited.

But whichever terminology or, method of exposition one adopts, it is necessary to find an expression for the following two relations. On the one hand, there must be a definite relation between cash and bank-money. Needless to say this ratio is not absolutely fixed but varies from time to time. On the other hand, the creation of bank-money under given circumstances has a determinate influence on prices — whether one calls it an increase in the quantity of money or in the velocity of circulation.

We are now in a position to state those elementary propositions of monetary theory which are relevant to the main argument. If the volume of trade and the velocity of circulation (habits of payment, &c.) — or in terms of our analogy the width of the cylinder — ^remain constant, then the price-level rises with every increase in the quantity of money. If in a progressive economy the quantity of money and the velocity of circulation (habits of payment, &c.) remain constant while the production of goods increases, then the price-level must fall, &c., &c.

It will hardly be disputed that the only easily-regulated factor among the forces determining the price-level is the quantity of money, including credit. The other factors — the quantity of goods to be exchanged and the habits of payment (velocity of circula- tion)— cannot be influenced so quickly, if at all. A monetary policy therefore which aims at stabilising the price-level or the exchanges must regulate the quantity of money. In this way one can usually counteract other influences on prices, and thus maintain the existing price-level. If, for example, in the course of economic development the quantity of goods to be exchanged increases, prices will tend to fall. Unless this tendency is offset by a change in the habits of payment (e.g^., by a growth of methods

^ Of., e.g., Haiin, V olkswirtschaftliche Theorie des Bankhredits, 3rd edn., 1930; Hawtrey, Currency and Credit, 3rd edn., 1928; and Keynes, Treatise on Money.

44

INTERNATIONAL TRADE

of payment other than by cash) it can be prevented only by an increase in the quantity of money. In other words, a larger quantity of money is required to carry through a larger volume of transactions at the same level of prices.

The rate of exchange is determined, as we have shown, by P

the equation R= Assuming, to avoid complications, that

1: jgttl

P

k remains relatively constant, it follows that must be held

constant if it is desired to stabilise the rate of exchange. Any

P

changes in k must be compensated by changes in p-. In either

case the desired eSect can normally be produced by regulating the quantity of money.

§ 2. Price-Stability versus Exchange-Stability.

Governments generally choose to stabilise either the price-level or the rates of foreign exchange. These two lines of policy are compatible with one another only if foreign countries also follow a policy of stabilising the price-leveP — that is to say, only by international agreement. But if in foreign countries the price- level is rising or falling, the country in question is faced with the dilemma of either stabilising the exchange rate and letting the domestic price-level move in sympathy with the foreign price- level, or stabilising domestic prices and allowing the exchange rate to move in inverse ratio to the movement of the foreign price-level. In general, stabilisation of the exchange-rate is the line of least resistance, unless price-levels abroad are subject to very wide fluctuations. Movements of the exchange-rate leap to the eye, whereas small changes in the price-level are less clear-cut and attract less attention. When the exchange rate of a country depreciates by 10%, everyone sees what is happening. A 10% rise in the price-level is, on the other hand, not such an unambiguous and striking phenomenon. Both commercial and financial relations with foreign countries are at once sensibty affected by fluctuatioi^s of the exchanges. Speculation in the foreign-exchange market® develops, unless rates are kept absolutely stable, and international credit-operations of a normal kind are seriously hampered hereby. In financially weak countries — particularly where the memory of inflation is still fresh — every deviation of the exchange from gold-

5 And if k remains constant. If k changes, the exchange and the price-level can both remain constant only if the price-level abroad happens to have shifted exactly parallel with k.

6 Cf. chap vi.

DETAILS OF THE EXCHANGE-MECHANISM

45

parity, or even any likeliliood of such deviation must lead to a crisis of confidence and to withdrawals of credit. This has been demonstrated once more by events in Germany in 1931 and 1932.

The repeated runs, during the last few years, on the currencies of. the Gold Bloc have shown that fluctuating exchanges produce very unpleasant long-period effects. The gains and losses which can be made from the unexpected depreciation of one currency or another have come to be realised more and more widely. People therefore try to invest their money in as liquid a form as possible, in order to be able to convert it at the first sign of danger into some other currency which appears at the moment to offer greater security. The desire for liquidity has led to the hoarding of gold on a large scale and has very considerably strengthened the tendency to deflation, particularly in the gold-standard countries.

For smaller countries in whose economic system foreign trade plays a large part, stabilisation of the exchange is the only possible policy. Particularly if they are dependent on foreign capital, they must sacrifice stability of prices to stability of the exchange, at any rate so long as there are important countries abroad with a fairly stable monetary system to which they can attach them- selves. For strong countries another policy is conceivable. Thus Mr. Keynes has for many years advocated for England a policy of stabilising the price-level, with the aim of smoothing out cyclical fluctuations, even at the cost of an unstable exchange-rate with the gold-standard countries. The arguments in favour of stabilising the price-level rather than the exchange cannot be examined here.’’ For this would involve a detailed treatment of trade-cycle theory and trade-cycle policy, and particularly of the problem of price- stabilisation as a means of smoothing out cyclical fluctuations.

Recent years have provided extremely interesting experiences in this field. Since departing, in September 1931, from the gold- standard, England has followed more or less deliberately and with the support of many English economists a policy of stabilising the price-level.® This policy enabled the Scandinavian countries an^ the Dominions to reap the advantages of stable exchange-rates with England— still the centre of world-trade— and with other members of the sterling-group, and to maintain stability of prices relatively to one another.

But as already mentioned the instability of the exchange-rate between the gold- and the sterling-currencies has led to serious

Of. Harrod, /nternaiional Economics (1933).^ This able discussion is howevei’ based on a theory of short-run (cyclical) fluctuations which cannot be accepted as

definitely established. /inxo\

s (7/. Benham, British Monetary Policy (196^).

46

INTERNATIONAL TRADE

disadvantages. The conclusion seems therefore justified that stable exchange-rateSj or in other words an international standard of one kind or another, is indispensable in the long run for any extensive exchange of goods and credit on an individualistic basis. A collapse of the international money-system would have to lead sooner or later to a rigid control, in the first instance, of the capital-market. This would necessitate, as will be shown in § 7, chapter VII, also a rigid superintendence of trade in commodities. Whether the international system must take the form of the- gold standard is another question. From the purely economic point of view one could equally well picture an international sterling-standard, such as already operates over a considerable part of the world. This is in fact only to a small extent a question of economic theory, and to a much greater extent a question of international politics.

I 3. Methods oe Pueserving Exchange-Stability (Gold-Bullion Standard, Gold-Exchange Standard).

(a) The simplest method of preserving a stable exchange is a gold standard in the rigid sense. As already pointed out, its mechanism, which has been described in Chapter III, may be compared to a pipe connecting our two cylinders and ensuring automatically that the level of water shall always be the same in each.

(J) Stability of the exchange can however equally well be main- tained under a less rigid type of gold standard. There is no need for the circulating medium to consist entirely of gold.

International payments are normally made not in cash but by cheque or by a bill of exchange. Gold is used only for a small proportion of total payments and that only when equilibrium has been disturbed. Here one can distinguish three main cases. (1) A sudden payment in one direction which does not evoke a simul- taneous payment in the opposite direction. This may be compared to an overflow of water out of one cylinder into the other; but a corresponding quantity would flow back through the pipe. (2)'^A permanent increase in one country’s volume of trade, or a decrease in the velocity of circulation. This would be represented by an increase in the diameter of one cylinder; water would flow into it and stay there permanently. (3) An increase in the amount of money. This would mean, in terms of our analogy, that water was poured into one cylinder; a corresponding amount would then drain off into the other cylinder. Experience shows that large movements of gold are required only in the third case. For, in

DETAILS OP THE EXCHANGE-MECHANISM

47

the first case, a traiisier of goods is soon stimulated® and, in the second case, the expansion, which necessarily takes time, is facili- tated by the normal increase in the world’s stock of gold.

It should be noted that the policy of preventing any increase in the total amount of moneys leads in the latter case to imfavonr- able results. There are reasons for the view, widely held by economists,^ that if in a closed economy productivity per head increases, it is better to keep the amount of money constant than 4o stabilise prices. This argument must however be applied with caution to the international sphere. Suppose that productivity per head increases in the United States but remains constant in Europe. Unless the total amount of money increases, there must be a change in the international distribution of gold if the gold-parity is to be maintained. In the United States prices fall, exports increase, imports diminish, gold flows in and prices rise again. In the European countries the amount of money has to fall, although conditions at home do not call for deflation. This would be avoided if the quantity of money in the United States was increased from the start.

To return to the main argument. Since under normal condi- tions only a small proportion of the gold in circulation is ever likely to flow out, the gold standard can be maintained even if a considerable part of the currency consists of paper-money with only a relatively small gold-backing. To use a picturesque metaphor of Adam Smith’s, a sort of waggon-way (is provided) through the air.” This means an appreciable saving to the country concerned, since a substantial amount of gold, which is more expen- sive than paper, can be dispensed with. If other countries follow suit, prices rise all along the line and the only advantage is that gold can be used more freely for industrial purposes and that factors can be transferred to the production of other commodities.

It is only a further step in the same direction to use the whole stock of gold as a reserve for emergency payments to foreign countries and to make paper-money the sole legal tender.^ This is called the ^ Gold-Bullion Standard.’

'(c) If the whole stock of gold is in the hands of the central bank, the latter can use it to buy short-term foreign investments, which, on the one hand, yield interest and, on the other hand,

^ Of. chajp. vii.

^ Of. Hay ek, ‘Prices and Production and Monetary Theory and the Trade Oycle.

2 Of. the references in Hayek, ** Paradox of Saving ** in Mconomica^ May 1931,

p. 161.

3 Of. Maclilup, Die Goldhernwdhrung, 1925. Eicardo was the first to advocate a ^oid-standard of this tsrpe (Proyosods for an Economical and Secure Ourrency,

48

INTERNATIONAL TRADE

are readily convertible into gold. This device, which is called the ' Gold-Exchange Standard/ was practised, even before 1914, especially by the Austro-Hungarian B’ank, but also to same extent elsewhere.^ When the Central European currencies were stabilised after the war, most of the countries concerned adopted a dollar- exchanffe standard/ because at that time the United States was the only country really on the gold standard. But Holland, Switzer- land and the Scandinavian countries made a similar use of sterling- bills after England returned to the gold standard. When she again abandoned it, in 1931, they suffered heavy losses. Since then the practice has gone out of fashion to some extent, except within the sterling area.’

Clearly gold-exchange standards in the proper sense presuppose that at least one country remains on a gold standard of the tradi- tional type. It is conceivable that two countries might adopt a gold-exchange standard relatively to one another. If, for instance, the United States sent gold to Great Britain® for investment in sterling-bills, the Bank of England would be enabled in its turn to purchase American bills by the same method, and so on indefi- nitely. This procedure might be called ‘ reciprocal inflation.’

If the credit-policy of the central banks was determined in the traditional w'ay by the reserve-proportion, the same gold would form a basis for credit-expansion in more than one country, and a world-inflation would ensue.

The quantity of money is controlled under all varieties of gold- standard by its convertibility into gold or foreign exchange. If prices rise or if because payments to foreign countries temporarily exceed payments from them, there is a demand for gold and foreign exchange at the central bank, a corresponding volume of notes will be paid in and thus withdrawn from circulation. The reserve-regulations, which lay down a definite relation between paper-money and cash-reserves, are intended to prevent the bank from issuing too much paper-money.

In addition to this ^ automatic brake ’ there is also a ^ hand brake ’ operated by the central bank, which both directly a^d indirectly influences the rates of foreign exchange. This hand brake is the discount-policy.

§ 4. Discount-Policy.

In all historical cases of the gold standard, only a part of

^ C/. Ansiaux, La 'politique, regulatrice des changes, and Keynes, Indian Currency and Exchange (1913), chap. ii.

^ Of, Machlup, Die neuen Wahrungen in Europa (1927).

s As already pointed out, the actual shipment of gold can, under modern con- ditions, be dispensed with.

DETAILS OF THE EXCHANGE-MECHANISM

49

tile note circulation consists of gold and gold certificates and, in consequence, expands and contracts in direct response to changes in the deniand for and in the supply of bullion. The remaining part of the note circulation is issued by the central bank not in exchange for bullion but by discounting bills of a standard type.^ The rate of discount (Le., the difference between the value at maturity and the price offered by the bank) is called ^ bank-rate.^ It represents the rate of interest at which the central bank is pre- pared to lend money against this type of security.

A rise in bank-rate tends, ceteris farihus, to strengthen the exchange ; a fall in bank-rate tends to weaken it. The mechanism is twofold. Changes in bank-rate affect the .exchange, on the one hand, directly by causing an inflow or outflow of short-term invest- ment, and, on the other hand, indirectly by influencing prices. The former effect is immediate but transitory, the latter gradual but permanent.

(a) The indirect effect is as follows : It is an accepted principle of monetary theory that a rise in bank-rate leads to a fall in prices and vice versa. ^ If the rate is lowered, more bills are offered to the bank for discount and additional money is thus brought into circulation. The goods on which the borrowed money is spent tend to rise in price and gradually other prices rise too. If changes in bank-rate are to be effective, the central bank must, of course, -actually be in the habit of discounting bills. More- over if, e.ff., a fall in bank-rate is offset by a tightening up of conditions regarding security, or if the total amount of bills dis- counted is held constant, then a fall in bank-rate will not cause the amount of money to increase. It has already been shown how changes of price affect the exchange. Here it must be stressed that the relevant commodity-prices only change gradually as the influence of the change in the amount of money spreads through the system.

(b) Experience shows, however, that in most cases changes in bank-rate affect the exchange immediately. This happens as follows. Since an appreciable proportion of short-term lending is supplied by the central bank, the latter exercises within limits a control over the money-market. If bank-rate goes up market-rates

^ Generally with not more than three months to run.

s Cf, A. Marshall, Official PafCTS (1926) ; Wicksell, Geldzins und G-iiUrfTciu, 1898 English translation (1936) ; Lectures on Political Economy, vol. 2, English edn., 1935; Mises, Theory of Money and Credit, English edn., 1935; Hawtrey, Good and Bad Trade (1913) ; Hawtrey, Currency and Credit, 3rd edn., 1928. Keynes, A Treatise on Money, 1930, vol. 1, chap, xiii, “ Modus Operand! of Bank-Rate.*' Hayek, Monetary Theory and the Trade Cycle (1932). Marco Fanno, “ Die reine Theorie des Geldmarktes *' in Beitrdge zur Geldtkeorie, ed. by Hayek, 1933.

C

50

INTEENATIONAL TEADE

as a inle go up too — thougli perhaps not to the same extent. The central bank may be regarded as the marginal lender. Moreover^, a rise in bank-rate has a strong psychological influence. It is regarded by the other lenders as a danger-signal and they restrict supply accordingly.

A rise in the rate of interest implies, ceteris paribus, a fall in the prices of all securities bearing a fixed rate of interest. For instance, if the market-rate of interest rises from 4 to 5%, deben- tures and other fixed-interest securities clearly become less attractive compared with other lines of investment at the same financial centre. But the consequent fall in their price will induce foreigners to buy. The balance of payments is therefore affected in the same way as by a fall in commodity-prices.

This connection between the rate of discount and the price of stocks bearing a fixed rate of interest allows the central bank to reinforce its discount-policy by ^ open-market operations.’ By selling or buying, e.g,, Government stock in the open market, the bank can produce the same kind of effects as by raising or lowering its rate of discount.

The most powerful, however, of the immediate effects of a rise in the market-rate of interest is to attract the flow of short-term investment away from foreign markets. An inflow increases the supply of foreign money and strengthens the exchange.

This does not, of course, imply that there must be the same rate of interest in all countries or that small changes necessarily lead to movements of capital. The tendency to equality of interest- rates must be understood in the same sense as that of commodity- prices. A role corresponding to that of transport-costs, in the wide sense explained about, is here played by the risk-factor. It sometimes requires a considerable difference of interest-rates to induce capital to move. In times of financial disturbances as in large parts of the world since 1931 foreign capital cannot be attracted at any price. All that can be asserted is that a rise of the interest-rate in one country tends, ceteris paribus ^ to attract foreign capital or to prevent it from flowing out.

The form assumed by these short-term capital transactions varies according to the organisation of the money-market. The most significant difference is that some markets react more quickly than others to changes in the rate of discount. This is what will deter- mine whether a given degree of passivity in the balance of pay- ments can be compensated by a small rise in bank-rate or whether most drastic methods of restricting credit must be employed. Under normal conditions a rise in the Bank of England’s rate of dis-

DETAILS OF THE EXCHANGE-MECHANISM

51

'Count is particularly effective.^ This is due to the unique position of London as a financial centre. In London there are always large quantities of sterling-bills from all parts of the world being discounted. If the rate of discount goes up, it will pay a foreigner who has debts to settle in sterling to buy a bill payable at sight or a telegraphic transfer on London, rather than to have a three months’ bill discounted. The increased rate of interest deters him from borrowing. The supply of foreign means of payment therefore increases immediately and the pound is strengthened.

Further technical details cannot be discussed here. The general principle that a rise in bank-rate attracts foreign capital is established by the fact that normally gold-movements are small in quantity. At the first sign of such movements the rate of dis- count is altered.

But this of course merely postpones the problem of making the additional payments to foreign countries which are necessi- tated by the passive balance of payments. Foreigners are induced to lend the difference.^ For the most part, however, they do so only at short term. If therefore the forces making for a passive balance are more than temporary in their operation, the direct effect of a rise in bank-rate is not sufficient to restore equilibrium. If the depth of water in one of the two cylinders threatens to increase permanently, then the exchange can be prevented from falling only by a decrease in the amount of money. This is ensured by the indirect effect of a rise in bank-rate already discussed.®

I 5. The Influence of Bank-Cbedit.^

The mechanism described above is modified by the existence of bank-credit. If the joint-stock banks expand or contract their

1 Of. Hawtrey, Currency and Credit^ 3rd ed., chap, ix, “A Contraction of Credit,” 1928, pp.. 136 e^ scq. Whitaker, Foreign Exchange (1933). “ Report of Committee on Finance and Industry ” (Macmillan Committee) § 295, 1931. Somary, Bankpolitiky 3rd edn. (1934).

2 Obviously this part of the mechanism is particularly liable to disturbance^ and in times of financial panic it may break down completely. Cf. chap, vii, § 6.

i The existence of the direct influence is generally looked ou as an advantage, because it gives the indirect influence time to operate. Mr. Keynes, however, regards the extreme international mobility of short-term lending as dangerous. He thinks that a rise in bank-rate which is insufficient to lower prices may, neverthe- less, be sufficient to attract foreign capital; the central bank may, therefore, be tempted to postpone the adjustments necessary for long-run equilibrium. Mr. Keynes makes certain suggestions for discouraging the international movement of money without weakening the effect of discount policy on prices (c/. Treatise, chap, xxxvi, and Mr. Sawtrey’s illuminating analysis in The Art of Central Banking (1932), pp. 412 et seq.). They are reminiscent of the gold -premium policy followed before the War by the Banque de France (cf. Mises, The Theory of Money and Credit (1935), Part iii, chap, vi, §§ 4, 5).

^ Cf. Taussig, International Trade^ chap. xvii. Viner, Canada's Balance of International Indebtedness, chap. viii. Angell, Equilibrium in International Trade ” in Quarterly Journal of Economics, vol. 42, May 1928. Feis, ** The

52

INTERITATIONAL TRADE

volume of deposits tlie effective amount of money increases or diminishes without changes in the amount of legal tender. Thus it is possible for ‘ nominal purchasing power ’ to expand in one country and to contract in another without the transfer of gold, if the banks in one country expand credit and the banks in the other country contract it. Gold-movements, therefore, no longer play the same prominent part as in the classical mechanism. But this does not mean that the mechanism as a whole ceases to operate ; actually there is no very fundamental difference between the two cases.

The new situation can best be made clear in terms of a world- wide clearing system, such as the founders of the Bank for Inter- national Settlements hoped to introduce. This would mean either that the central banks deposit their stocks of gold at the inter- national bank, or even that gold reserves are superseded altogether by credits held there by the central banks. In either case a passive balance of trade in one country would lead merely to a reduction of the reserves of that country’s bank and to a corres- ponding increase in the reserves of other banks ; there would be no shipment of gold at all. But the mechanism of price-levels, balance of trade, &c., would nevertheless remain fully operative.

This imaginary case is not very unlike what actually happens. Both the central banks and the joint-stock banks keep money on deposit at foreign banks. The first effect of a passive balance of payment is a shrinkage of these accounts. If the banks affected react by restricting credit — as they normally do — and if the disturb- ance is only on a small scale, equilibrium can often be restored without either gold-movements or a fall in the exchange.

Professor Viner has analysed a very striking example of this kind in his examination of the Canadian balance of international indebtedness between 1900 and 1913. Canada was borrowing on a large scale from England and from the United States ; she there- fore had an active balance of payments. This did not however lead to an inflow of gold. The borrowed money was paid into the accounts of Canadian banks at New York, and these ‘ foreign reserves ’ were treated as though they had been cash reserves ; extra notes were issued and advances made. Prices therefore rose and imports came to exceed exports. The difference was paid for out of the accounts at New York and there were no gold-movements at all.

Mechanism of Adjustment of International Trade Balances ” in American Economic Meview, voL 16, December 1926, pp. 593 et seq. E. M. Carr, “ The Eole of Price in International Trade Mechanism in Quarterly Journal of Economics, vol. 45. Angnst 1931.

DETAILS OF THE EXOHAHGE-MEOHAlSriSM

53

According to Mr. Carr^ tlie Canadian example presents certain further peculiarities. He asserts, in contrast to Professor Yiner, that in many cases loans were not floated until after prices had already risen. This he takes to be in strict contradiction to orthodox theory. It must be granted that in the case of a rapidly developing country the order of events may quite conceivably be as Mr. Carr maintains. But even so, the expansion of credit is clearly dependent on the foreign loan, and not vice versa. If a loan is not forthcoming, then the policy of expansion must be reversed ; otherwise the exchange will fall. To determine in concrete how the different phases of such a process are related in time one would require weekly or at least monthly statistics; these are unfortunately not often available. But apparent anomalies of the kind suggested cannot in any case throw doubt on the broad functional relationships worked out above.

5 Of. “ The Bole of Price in the International Trade Mechanism ” in Quarterly .Journal of Economics ^ vol. 45, August 1931, pp. 710 tt seq.

CHAPTER VI.

EXCHANGES DURING INFLATION.

§ 1. The Significance of Static Analysis.

The preceding chapters have dealt mainly with what may be called the static theory of the exchanges. The eqnatation R =

has .therefore been used with reference to the static equilibrium towards which the price- and exchange-relations between two countries tend to gravitate. The present chapter, on the other hand, deals with dynamic or unstable exchange rates, which repre- sent a temporary divergence from equilibrium, and which carry in themselves the seeds of further change.

It is an error to suppose that static theory ignores the pheno- mena of change altogether. On the contrary, static theory takes account of them by contrasting the state of affairs before equili- brium is disturbed by changes of data with the state of affairs after the economic system has reached the new equilibrium appro- priate to them. Any differences between the two states of equilibrium are then imputed to the change in data as effect to cause. This method of approach is called ^ Comparative Statics.’^

Suppose, for example, that under an inconvertible paper currency the amount of money is increased by 20 per cent. Equili- brium analysis shows that when the extra money has had time to circulate throughout the system, prices will be higher than before. If one could assume that this change of data involved no further, permanent changes except the price adjustments, then in the new equilibrium prices would be higher and the exchange would be lower than in the old equilibrium by exactly 20 per cent. But in actual fact the process of inflation always leaves behind it per- mtoent or at least comparatively long-run changes in the volume of trade and in the structure of industry. The impact effect is a change in the direction o.f demand. At the points where the extra money first comes into circulation purchasing-power expands ; else- where it remains for a time unchanged. When the increase spreads - to other points, supply, which has begun to adjust itself to the

^ Cf. Schams, “ Komparative Statik,” Zeitschrift fur Nationaldkonornie^ voL 2.' (1930). V ' ^

54

EXCHANGES DHEING INFLATION

55

original ctange, cannot always be readjusted, since capital will bave been sunk in tbe expectation that tbe shift in purchasing- power is permanent. Moreover, those who owed money when the inflation began gain permanently at the expense of their creditors. It is therefore most unlikely that all prices will have risen equally or that the average price-level and the foreign exchanges will be higher than before by exactly 20 per cent.

The point of this example is to show not that the rigid quantity- theory is inadequate, but that, even when these complicating factors are taken into account, static analysis is still applicable. The object is still to discover what the conditions of the new equili- brium are, towards which the economic system gravitates when the amount of money has been increased.

§ 2. The Thansition peom One Equilibbium to Anotheb. (Pbice- Levels and Exchange-bates dobing Inflation.)

Now it is necessary to supplement the static analysis by examin- ing the intermediate stages between one equilibrium and another. Even in previous chapters this could not be altogether avoided, for the mechanism of adjustment itself involves usually a price- discrepancy incompatible with static conditions. In a country whose balance of payments becomes passive, prices fall, whereas in other countries they rise : this is sometimes necessary to stimulate exports, restrict imports and thus restore equilibrium. The details of this process will be further considered in chapter YII where the transfer problem ’ is discussed.

The present chapter is concerned with certain discrepancies of a rather less transitory kind, which may occur during an inflation. If the successive waves of expansion follow one another so quickly that the economic system has no time to absorb o.ne before the next is upon it, then prices and foreign exchange rates may remain for some time out of equilibrium with each other.

The type of inflation differs according to the point at which tl?e additional money is injected. In a gold-inflation, for example, the producers of gold have the first handling of it;^ in a credit inflation, the entrepreneurs. The case selected for analysis here is that of a ‘ budget-inflation,’ because in other types of inflation prices do; not change sufficiently to show any appreciable dis-

2 For an account of how the additional money spreads from this point, cf. Cairnes, “ The Course of Depreciation/’ reprinted in Essays on Political Economy {1873), pp. 63 et seq. The historical development of the theory is sketched in Hayek, Prices and Production ^ chap, i. Among recent works, c/., Mises,

Theory of Money, pp. 152 et seq.; or S. Budge, Lehre vom Geld^ voi. 1 (1931), pp.

56

INTERNATIONAL TRADE

crepancy compared witli the exchange. In this case the extra money is first spent by civil servants and Government contractors. The goods they purchase rise in price, the firms producing these goods increase expenditure in their turn, and so the rise of prices spreads gradually to other parts of the system.

Sooner or later the exchange must depreciate. If the successive waves of extra money are spent in the first instance on home products, then average prices rise faster than the exchange depre- ciates. If, on the other hand, they are used to buy imports, or if costs increase very sharply in the export industries, then the opposite happens.

The German inflation (1914-23) is an interesting case which illustrates the underlying principles. It may be divided for this purpose into four stages :

{a) During the War Germany's foreign trade was kept practi- cally at a standstill by the blockade. Hence the volume of exports and more particularly of imports could not react to price-changes with the normal rapidity. The mark fell therefore in value less rapidly abroad than at home.

(6) In 1919, when the blockade was lifted, the volume of imports increased, the balance of payments became passive and the exchange depreciated more than in proportion to the rise of prices. Hkd the quantity of money not . been progressively increased, equilibrium would soon have been reached by an expansion of exports and a contraction of imports. As it was, some of the extra, money was even injected directly into the foreign exchange market to pay Reparations.

The chief reason, however, which kept the depreciation of the exchange ahead of the rise in prices was psychological. Whenever inflation is carried beyond a certain point people begin sooner or later to anticipate that prices will go on rising. Speculation comes to dominate the foreign exchange market and depreciation is accelerated. At a later stage the influence of professional specula- tion is reinforced by the action of the ordinary public, who begin to hoard foreign currency.

This last factor presents one aspect of a wider process. In the same way as the exchange depreciates faster than prices rise, both movements proceed faster than the increase in the amount of money. For when people expect a further rise in price they are willing to pay rather higher prices at once for the sake of spending their money as soon as possible. Wages and salaries are paid out at more frequent intervals, and, finally, people resort to barter or use foreign money as the medium of exchange. In these ways

EXCHAJfGES DEEING INELATIOX

5T

the effective velocity of circulation of legal tender is enormously increased, and the volume of work which money has to perform is reduced. -How far the discrepancy between changes in the quantity of money and changes in its value can develop, is shown by the example of the German mark. In November 1922, the total volume of money in circulation was worth in gold at the current rate only l-38th of what it had been worth in 1919. In terms bf the comparison worked out above, one would have to say that the rapid increase in the volume of water caused the cylinder to con- tract. The depth of water increased therefore more than in proportion to its volume.

(c) In the final stages of the German inflation the situation changed once more. A ‘ flight to goods ’ became general, and the rise in prices caught up with the depreciation of the exchange. By 1923 when the inflation reached its height the discrepancy was no longer very large : both movements were proceeding at the same lightning speed. The increase in the quantity of money had meanwhile been left far behind.

(d) This last fact very much simplified the problem of stabilis- ing the currency. Once confidence has been restored the velocity of circulation falls to its normal rate, and the supply of foreign currency increases. This means that if the central bank were to establish a gold-parity corresponding in equilibrium to the amount of money in circulation just before stabilisation, then the exchange would immediately appreciate and prices would have to fall. In that case, however, the bank would be unable to accumulate a gold reserve. Most of the post-war stabilisations were therefore carried out at a parity, somewhat higher indeed than the actual rate of exchange, but lower than would correspond in equilibrium to the ruling price-level. This allowed the central bank to accumulate a gold reserve and at the same time to increase the quantity of money in circulation. Such was the experience of Austria, Germany, France, and various other countries. The possibility or rather the necessity of increasing the quantity of money and raising prices if^the exchange is to be kept stable has indeed the effect of facili- tating stabilisation; but, on the other hand, it is liable to produce an inflationary boom, with a consequent depression later on.

I 3. Depeeciation as Inteepreted by the Balance-of-Payments Theory and the Ciuassical Theory respectively.

It must be emphasised that the preceding analysis only supple- ments the classical theory without in any way contradicting it.

58

INTEENATIONAL TEADE

The classical theory may usefully be contrasted with the balance- of-payments theory, by quoting a passage from Helfferich, which criticises the former from the point of view of the latter, and refers particularly to the time-lag, analysed above, between changes in exchange-rate, price-level and quantity of money.

. . In considering the monetary conditions in Germany, the view widely held, especially abroad, is based on the pure quantity theory, and accordingly regards the increase in the circu- lation of paper-currency in Germany as the cause of the rise in the level of Germany prices and of the depreciation of the currency. On closer examination, however, we find that cause and effect are here interchanged, and that the increase in the amount of paper money circulating in Germany is not in fact the cause but the result of the fall of the German exchanges and of the consequential rise in wages and prices.

. Thus in the twenty months which followed the accept- ance of the London Ultimatum . . . the note issue of the Eeichs- bank (was multiplied) 23 times, the wholesale index number for home* products 226 times, . . . and the dollar-rate 346 times.

‘‘ If ‘ inflation ’ had been the cause, and the depreciation of the German exchanges the effect, then, in accordance with the theory of the classical English economists, events would have developed on the following lines : an increase in the paper circula- tion causes a corresponding rise in the level of prices at home. These higher prices encourage imports and make export more diflScult. They tend, therefore, to make the trade balance, and with it the balance of international indebtedness, unfavourable. When the latter balance is passive, the demand for foreign currency increases and the rates of foreign exchange are forced up. A glance at the figures given above shows, however, that this chain of reasoning does not apply; in fact, it is immediately obvious that in the case of Germany the increase in the note circulation did not precede the rise in prices, and also that the depreciation of the currency followed it but slowly and at some distance >of time. The twenty-three-fold increase of the note circulation cannot possibly be the cause of the 10 times greater rise in prices at home and of the 15 times greater rise ... of the dollar rate. A conception of the general and comprehensive outline of the inter- play of causes in these developments can, in fact, be obtained only if foreign exchange is made the starting-point.

“ For the following, if for no other reason, the collapse of the German exchanges will be seen to be in no way related to the increase of the note circulation. At a dollar rate of 21,546,

EXCHATOES DEEING INFLATION

59

the rate quoted on the 25th January 1923, a gold mark was worth about 5,000 paper marks. The note circulation of the Eeichsbank, which at that time amounted to 1,654 milliard paper marks, thus represented a value of only 330 million gold marks. This is not much more than one-twentieth of the gold value of the German currency circulating before the outbreak of War. . . .

The theory which attributed the collapse of the German currency to ‘ inflation ^ is based on the petitio principii that the foreign value of money, which finds its expression in the rates of foreign exchange, can be determined only by the quantitative factor of the paper circulation. In the above case, however, in which it has Just been shown that the increase in paper remained far behind the currency depreciation, the causes of the collapse in the foreign exchanges, which are independent of the develop- ment of the paper circulation, are quite clear. We are dealing with a country whose international indebtedness, quite apart from payments and deliveries due under the Treaty of Versailles, was passive to the extent of about 3 milliard gold marks, and the London Eltimatum added to the country’s indebtedness an annual payment of ‘ reparations ’ estimated at about 3*3 milliard gold marks. To this were added the payments imposed upon Germany for the ^ clearing ’ of pre-war debts and gold payments to the occupying Powers. The annual passive balance of the German balance of international indebtedness was thereby increased to more than 7 milliard gold marks. . . .

‘ ‘ The chain of causes and effects is, therefore :

“ First came the depreciation of the German currency by the overburdening of Germany with international liabilities and by the French policy of violence. Thence followed a rise in the prices of all imported commodities. This led to a general rise in prices and wages, which in turn led to a greater demand for currency by the public and by the financial authorities of the Reich; and, finally, the greater calls upon the Eeichsbank from the public and the financial administration of the Reich led to an increase in the note issue. In contrast, therefore, to the widely held view, it is not ^ inflation ’ but the depreciation of the currency which is the first link in this chain of cause and effect. Inflation is not the cause of the rise in prices and of the depreciated currency, but the latter is the cause of the higher prices and of the greater volume in the issue of paper money.

This passage does not show a very profound understanding of the theory which it attacks. For the classical theory is strictly

3 Cf. Helfferich, Money, pp. 598-601.

i

I

60

INTERNATIONAL TRADE

static in the sense already explained ; whereas the phenomena instanced by Helfferich to refute it are clearly the very opposite of equilibrium conditions. The whole tendency of the classical doctrine shows that it must be interpreted as a theory of equilibria. These phenomena of inflation, therefore, being clearly anomalies confined to the process of transition, cannot be used in evidence against the theory, as we have formulated it.

The classical theory asserts that in the long run — and not such a very long run at that — ^the functional relations, already worked out, between prices and exchange-rates are valid, and that an increase in the quantity of money must lead both to a rise in prices and to depreciation of the exchange. But it is by no means necessary that the former should precede the latter : the order of events may be in the reverse direction. If prices lag behind, there is in effect a premium on exports and ‘ exchange-dumping ^ takes place. But for this very reason equilibrium would soon be restored if it were not continually prevented by new injections of money. It is true that one must be cautious in the formulation. One should not say as supporters of the theory of purchasing-power parity are fond of doing^ — that the rise in prices is the primary phenomenon, and that the depreciation of the exchange is merely an effect of this. The two changes bear a functional relation to one another and are both effects of the same cause. This is the increase; in the quantity of money, which in its turn is the effect of the budget-deficit.

It cannot be denied that depreciation and rising prices make it more difficult to balance the budget, and that this leads to further inflation, a further rise of prices, and further deprecia- tion. But, as shown by the event, this ^ vicious circle ’ can be broken; and even if it were impossible to cover the budget-deficit — ^because a sound financial policy cannot be carried through, or because the burdens placed on the national exchequer from without {e.g.y Reparations) exceed the taxable capacity of the economy — this does not contradict the hypothetical proposition, that^ if the quantity of money is kept stable, forces are released which bring the movements of prices and of the exchange to a standstill and adjust prices and rates of exchange to one another, as asserted by our modified theory of purchasing-power parity.

The fact that the increase in the quantity of money lags behind the fall in the value of money — so that the quantity of money in circulation, reckoned in gold, becomes smaller — is also not in

^ In Bicardo, for example, there seems nowhere to be a hint that price- move* ments and movements of the exchange may temporarily diverge.

EXCHANGES DUEING INFLATION

61

contradiction with the classical theory, as correctly interpreted. It is fully explained hy the increased velocity of circulation and the contraction in the volume of trade, due partly to the fact that a large proportion of transactions are carried out by other means of exchange. Helfferich’s attempt to refute the quantity- theory by pointing to this fact merely proves his failure to under- stand the theory and his inability to distinguish between equili- brium-conditions and the phenomena of transition.

§ 4. Statistics of the German Inflation.

The qualitative analysis can be supplemented by detailed statistics. In figs. 3, 4 and 5 changes in the rate of exchange between marks and dollars are contrasted with the movement of purchasing-power parity between Germany and America. Price- levels are computed from the wholesale index of the Statistisches Reichsamt and of the Bureau of Labour Statistics respectively, the base being in each case 1913 = 100. Exchange rates are computed from the monthly average of quotations on New York in the Berlin money market.

In figs. 3 and 4 the dollar rate is represented by the continuous ! ! i n I I I I fOOOMrdl I ! I } ^ i T I i i TTl

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IFTEEFATIONAL TEADE

divided by American price-level) by the broken line. In fig. 3 both curves are drawn on the ordinary arithmetical scale. But the figures soon become too unwieldy for this method of presentation; they are therefore drawn separately in fig. 4 on a quasi-logarithmic scale. This is why the two curves appear closer together for January, 1921, than for the end of 1920. It should be noted that fig. 4 is not strictly accurate, since the logarithmic values have not been worked out for smaller intervals than those represented by the horizontal lines.

In fig. 5 changes in the dollar rate are expressed as a percentage

19 )3 ' 1380 1321 1322 1323 1323 1325 1325

Fig. 5.

Fig. 5 Movement of the dollar rate expressed as a percentage of purchasing- power parity.

of changes in purchasing-power parity. Here the broken line represents the same deviation in terms of the more comprehensive index of wholesale prices constructed by the Statistiches Reichsamt for the year 1924. From 1925 onwards the old index was no longer used. For 1924 the two curves show parallel movements, but the more accurate one is closer to purchasing power parity. The statistical evidence must therefore be interpreted with caution. It is, nevertheless, probable that there were not only temporary but also permanent changes of k, since even after stabilisation the curve of the dollar exchange remained somewhat above that of purchasing-power parity.®

5 The most elaborate studies of the German inflation are Graham, Exchange, Price and Production in Hy^er -inflation : Germany, 1920-192S (1930), and Bresciani- Turroni, Ze vicende del Marco Tedesco (1932). Cf. also Zahlen zur Geldentwertumg in Deutschland 1914-23 (published by the Statistisches Reichsamt in 1925).

For Austria, cf. Walre de Bordes, The Austrian Crown (1924), and for France, E. L. Dulles, The French Franc 1914-28 (1929), and J. H. Rogers, The Process of Inflation in France (1929),

Cf. further European Currency and Finance (published by the United States Commission of gold and silver enquiry, 2 vols., Washington, 1925) and Depreciated Exchanges and International Trade (U.S. Tariff Commission, Washington, 1922) Cf. also Angell, op. cit.

CHAPTEE YII.

THE TEANSFEE PEOBLEM.

§ 1. Inthodtjctohy.

The present chapter deals with the unilateral paj^ment of large sums by one country to another. This is in reality only a special case of the phenomena already analysed. But it nevertheless deserves separate treatment because this case has always attracted a great deal of attention, and in discussing it a number of refine- ments will be added to the analysis given in previous chapters.

One must distinguish in international, as indeed also in domestic trade, between unilateral and bilateral transfers. This distinction applies equally to the transfer of money and to the transfer of goods. The prototype of a bilateral transfer is the exchange of Commodities for cash, since the two sides of the exchange here "confront one another directly. Clear cases of unilateral transfer are free gifts and political tribute such as reparations.

Expenditure on transport, by tourists, &c., represents a bilateral transfer, since money is exchanged for real services. The granting or the repayment of a loan occupies an intermediate position. From the point of view of the economic period within which the payment or repayment occurs, they are unilateral transfers. If, on the other hand, one extends the period sufficiently to cover both the point of time when the loan is made and the point of time when it is repaid, then it must be regarded as a bilateral transfer. Ijaterest payments are in a sense bilateral transfers, since the use of capital is a real service. But as this item— the services irF capital — does not appear in the balance of trade and services, interest payments must nevertheless be regarded as a unilateral transfer.

The question now arises why the transfer of unilateral payments should be supposed to involve any special problem pot involved in the transfer of bilateral pay nients. Here it is convenient to draw up a double balance sheet of the economic transactions between one country and the rest of the world. On the one hand, there is the balance of real values, or in other words of goods and services exchanged. On the other hand, there is the balance of the means of payment, in the sense of money payments actually made to foreign countries and received from them. As we have already pointed out, the balance of payments in this latter sense is in the

63

64

INTERNATIONAL TRADE

long run always in equilibrium, unless payment is made out of an existing stock of foreign money or tbe foreign country wishes to accumulate a stock of the domestic money/ In such cases, howeyer, the amounts inyolved' are always small. They are very important from the point of view of monetary policy, as signifying ' confidence in the currency,’ but quantitatively they do not count for very much in the total balance of international payments.

Now if the economic system of one country is connected with the rest of the world only by bilateral transfers (i.e., by the sale and purchase of goods and services) then both the balance of pay* ments and the balanc^e of transfer of real values are in equilibrium. But if there are also unilateral transfers reparations) then

the balance of trade and services must show a surplus, since the balance of payments cannot in the long run be out of equilibrium. In other words, unilateral transfers must be made in kind.^ Capital movements must finally take the form of a transfer of goods and sejvic^s.

In this respect, too, there is really no difference between domestic and foreign trade. The assertion is constantly made that in international trade payments must in the long run be made in goods, whereas in domestic trade payments are made in money. It is of course true that in domestic trade payments are made in the first instance in money, but, normally, the person receiving payment wishes to buy something with the money. In spite of such unilateral payments the individual balances of payment remain intact, because the individual, like a plurality of indivi* duals or a country, cannot in the long run spend more than he receives, unless, indeed, he entrenches on a stock^of cash. This, however, applies equally to international . trade. Thus even in domestic trade unilateral trailers are carried out finally in goods or seigices. But the flow of goods goes unnoticed, because it does not pass a political boundary, and is therefore not recorded.

The assertion commonly made in textbooks that debtor countries have an active, and creditor countries a passive, balance of trade must be received with caution, In the case of capital movements over a long period the state of the balance of tradeofepen^’ on the

1 This played an^ important part dur:xig the German inflation. Foreigners speculated on a rise in the mark and allowed Germany to export marks and to make, as a result of the depreciation, considerable profits.

^ Unless, indeed, the payment is small enough to be made out of existing stocks of foreign means of payment. Unilateral transfers which can be made out of stocks of money present for that very reason no problem. But, clearly, payments of the magnitude of German reparations can only be transferred in the form of an export suiplus.^ The annual payments provided for in the Young Plan amounted to about 2000 million marks. Germany’s whole stock of gold and foreign money would therefore have been exhausted in two years, if the amount had not kept returning in payment for an export surplus.

THE TRANSFEE PROBLEM

65

pJiase readied by tbe process of indebtedness. If a country whose balance of trade is in equilibrinm starts to import capital at a uniform rate, her balance of trade becomes passive. But sooner or later payments for interest and amortisation become larger than the amount of new capital imported. The balance of trade then becomes active. The same holds, mutatis mutandis, for creditor countries. The existence of an active or a passive balance of trade is therefore no sufidcient criterion for distinguishing between s debtor and creditor countries. In the post-war period up to 1929 Germany had a passive balance of trade because she was contracting more foreign debts than she was repaying. In 1929, when the stream of capital dried up, the balance of trade became active. Before the War the United States was a debtor country and had an active balance. The surplus of exports over imports paid for interest and amortisation to the European creditors. During the War the United States became almost overnight a creditor country, and after 1919 her balance of trade remained active because the export of capital continued to exceed receipts for interest and amortisation.

§ 2. Raising and Tkanspereing Paymentis. Ceeation of the

Expoet Sxteplus.

The problem of making unilater|Ll payments from one country to another has two aspects. First, a^sum of money has to be raised at home. In the case of reparations this is a problem for the national exchequer; when private capital is exported, it is a problem for the individual concerned. Secondlj^' however, the sum of domestic money thus raised must be changed into money of the country receiving payment. The transfer can only be regarded as successful if a corresponding export surplus is createdj, and that, moreover, without a collapse or a permanent depreciation of the exchange..

The question how the e^xport surplus is created has already in effect been answered. This is merely a special case of the operation of the mechanism, already described in detail, which keeps the balance of payments in equilibrium. Applied to German Reparations, the process is in essentials as follows. If the sums intended for export are raised by taxation, then the money income or purchasing power of the German nation is rpi^uced. the quantity of money in circulation contracts and prices fall. Conversely, in the countries receiving reparations national income increases, th§ quantity of money expands and prices rise. In this way a gap

66

IKTEENATIONAL TRABE

is created between prices, in Germany and prices elsewbere ; Germany’s exports are stimulated, ber imports are restricted, and tbe export surplus is created. It is therefore not the case, as the stiir popular balance of payments theory supposes, that the possi- bility of transfer depends on an already existing active balance of trade or payments. It is not necessary to wait till the gods present one with an export surplus. On the contrary, the export surplus arises automatically when the mechanism of payment is set in motion.

If the pressure on German prices is insufficient to produce the necessary export surplus at once, and if payment is nevertheless continued, then the foreign exchanges will rise above the gold ppiiit, and the gold and foreign exchange reserve of the German Eeichsbank will decrease. This will cause the Bank to put up its rate of discount, with the double effect, explained in Chapter V, § 4, of increasing the pressure on prices and of encouraging an inflow of short-term credit from abroad.

The importance of reparations and international war debts for economic policy ever since the War, has caused the mechanism of transfer to be widely discussed once more. But the greater part of the relevant literature^ has reached only a low level of scientific attainment. In many cases the political bias was too strong for a really scientific treatment of the problem and not many of the participants in this discussion have realized that the solution of their problem was already contained in the writings of Thornton, Eicardo, Senior, Mill and Cairnes. In the following pages only the few scientific contributions to the transfer discussion will be considered.** These concern mainly the role of price- movements in the mechanism of transfer.

I 3. The R6le ox Peice-Changes iisr the Mechanism op Teanseee.

(a) The Problem Stated, Here two schools of thought can be clearly distinguished, f The first is inclined to minimise the import- ance of price-movements in the mechanism of transfer, and indeed to contest the necessity, for the^ transfer of unilateral payments, of any price-movement at all. 'ijPhe other school lays great stress on the necessity of opposite prfce-movements in the two countries concerned. It considers that under unfavourable circumstances

3 For an exhaustive bibliography, cf. H. Sveistrup, Die Schuldenlmt des Welt- krieges, Quellen und Literatur, 2 vols. (Berlin, 1929 and 1931), and Moulton and Pasvolsky, War Debts and World Pros'perity (1932).

^ Unfortunately Eagnar Nurkse’s Internationale Kapitalbewegungen (1935), which carried the analysis a big step forward, appeared too late for me to make use of it. The same is true of the book of Iversen ; see next footnote.

THE TEANSFEE PEOBLEM

67

tliese price-moTements would have to be so large that serious diffi- culties migM arise, rendering transfer, in extreme cases, absolutely impossible.

The former opinion has been vigorously maintained of recent years by Professor Ohlin, while the most prominent champion of the latter has been Mr. Keynes.^ The discussion between them has revealed much more clearly than before the inner workings of the transfer mechanism. By considering it more closely, we shall therefore be enabled in certain points to extend and modify our previous analysis.

(5) The Controversy het/ween Mr, Keynes and Professor Ohlin, and its Precursors, It is convenient to start with Mr. Keynes’s argument, which is the more closely in line with our previous exposition. According to Mr. Keynes, Germany must increase her exports in order to achieve an export surplus. For this purpose she must lower the prices of her export goods. How large the reduc- tion of price must be, in order to create an export surplus of a given value, depends on the conditions of the foreign demand for German export goods and services. An increase in the volume of exports only yields an export surplus if the elasticity of -demand for German exports is greater than unity.® If the elasticity of demand is equal to, still more if it is less than, unity no increase in exports, however great, could produce a surplus in terms of value, since prices would fall as fast as, or even faster than, the volume of exports increased.’'

^ Cf. {a) Ohlin, “ The R^arations Problem,” in Index, Nos. 27 and 28, March- April 1928; “ Is the Young Plan Feasible? ” in Index, No. 50 (1930), published by the Svenska Handelsbanken ; “ Transfer Difficulties, Real and imagined,” in Economic Journal, June 1929, p. 172, and Sept. 1929, j). 400 (c/. now also Inter- regional and International Trade (1933) whicn appeared after the present chapter had been written); Rueff, Une Erreur Economique: V Organisation des Trans ferts (1928); Les Idees de M. Keynes sur le Probltoe des Transferts,” in JRevue d* Economic Politique 43ieme annee July- August 1929, pp. 1067 et seq,; “ Mr. Keynes’ Views on the Transfer Problem,” Economic Journal, Sept. 1929, pp. 389-390. (6) Keynes, “ The German Transfer Problem,” Economic Journal, vol, 39, 1929, pp, 1 et seq., further pp. 179 and 404; Treatise on Money, chap, xxi; Pigou, “ Disturbances of Equilibrium in International Trade,” Economic Journal, vol. 39, 1929, p. 344. Reprinted in Pigou and Robertson, Economic Essays and Addresses (1931). For a critical review of the whole literature see Carl Iversen, Aspects of the Theory of Capital Movements (1935). Comare also R. Wilson, Capital Imports and the Terms of Trade Examined in the tight of Sixty Years of Australian Borrowings (1931) and H. D. White, The French International Accounts 1880-1913 (1933). The two last-mentioned works came into my hands only after the present chapter had been written.

6 Or more precisely the weighted average of the elasticities of demand for the various export goods. An appropriate hypothesis must also be made as to the existence of potential export goods. Compare also § § 4 and 5 of chap, xi where it is shown that the complex Marshallian demand-and-supply curves take the existence of potential export and import goods into consideration,

7 If elasticity were less than unity, an export surj)lus could be produced by an increase of price and by the restriction of exports, since in that case the volume of exports decreases more slowly than prices fall. But under free competition this could hardly occur.

68

INTERFATIOFAL TRADE

[N'ow Mr. Keynes is of tlie opinion tliat in Germany’s case tlie conditions of demand are sncli th.at only a f^U price could produce an export surplus to tlie magnitude of the ’payments required. This implies ^f or Germany an extra loss over and above the direct burden. For German exports of a given total value now contain^ because of the fall in prices^ a larger volume of goods than before. This is expressed by saying that the ' real ratio of exchange ’ or the ^barter terms of international trade ’ have moved against Germany.® The terms of trade become still more unfavourable if the prices of German imports rise. Germany has therefore to bear a double burden. In the first place, 2 milliard gold marks are. paid to foreign countries. In the second place, a larger quantity of German goods is required to command 2 milliard gold marks, and also to command any given quantity of imports, than before.

The monetary mechanism produces this result ‘ on the com- modity side ’ as follows. First of all, the reparation taxes are collected in Germany. This is the priory' burden. If the neces- sary export surplus is not ^produced, then the cash reserves of the Reichsbank fall, gold and foreign money flow out, and credit must be restricted. This makes prices and incomes fall still further (secondary^ burden). It might be objected that, apart from temporary losses due to labour disputes and so forth, this does not represent an extra burden since incomes and prices have both fallen. But this objection is not valid since only domestic prices fall. The price of imports is unaffected and real wages have therefore diminished. Thus the contraction of credit does involve an extra burden.

. ' Professor Machlup has shown that under a gold or gold-exchange standard, or where the central bank has so large a gold reserve that it need not restrict credit when gold flows out, the same result is produced automatically by the deflationary infinence of the payments themselves. If the first instalment does not depress prices sumciently to create the necessary export surplus, then its influence is reinforced by the second instalnaent. Tariffs and other obstacles to the export trade can be surmounted in the same way, though of course at each step an extra burden is placed on the country paying reparations.®

This ^ secondary burden ^ is the * transfer loss.’ It is therefore appropriate to speak of transfer difffculties^ when an outflow of

s On tjhe significance of this magnitude and on the possibility of measuring it, c/. chap, xi, I 6, also Taussig, International Trade, chap. xxi.

9 “ Transfer u. Preisbewegung in Zeitschrift fur Nationaldhonomie^ yoI. 1, 19S0.

" ^ THE TEAKSFEE PEOBLEM. ■ ^ 69.

gold is caused by tMs extra burden.^® Transfer difficulties need not always take tbe form that on the date when payment falls due^ the foreign exchange required is not forthcoming. They may show themselves in an inability to carry out the adjustments required by the contraction of credit, in labour disputes or in widespread unemployment. Under these circumstances it is also difficult for the State to raise by taxation the money required. Transfer difficulties then take the form of a budget deficit.

If the necessary financial measures are not or cannot be carried out, then gold .will flow out and transffr difficulties in the sense of a shortage of foreign means of payment will arise. This happens if the deflationary jn^uence oJ^^ the ,p|iyments , is neutralised by a liberal credit policy, if the gold winch flows ' out is replaced by newly created bank money, or if the necessity of restricting credit due either to the payments themselves or to other reasons is dis- regarded.^ But the term ^ transfer difficulties ’ has, in this case, nt) very precise significance. A policy of credit expansion always leads to an outflow of gold whether unilateral payments are being made or not.

It cannot therefore always be said whether in a particular case difficulties of this kind are due to the primary burden, to the secondary burden, or to other causes. It is true there is no rigid economic law to the effect that the transfer must be followed by a policy of expansion, or by a failure to deflate sufficiently. Hence it could be argued that the source of the difficulties is really the monetary policy adopted and not the obligation to transfer large sums abroad. But if account is taken of the psychological and political factors, it must be conceded that such a monetary policy, and hence the difficulties which it produces, may inevitably follow from the obligation to transfer. Changes in the terms of trade are generally a good symptom of whether there has been a secondary burden or not. It must however be remembered that the statistical evidence is not in itself conclusive, since the terms of trade may have altered for other reasons. The terms of trade moved, for example, very much in Germany’s favour between 1928 and 1931, because the price of raw materials, which constitute the greater part of Germany’s imports, fell more sharply than the price of manufactured goods, which Germany exports.^ Clearly this was not a result of reparations, although, as will be shown in a moment, such a connection is not quite inconceivable,

io This point is brought out with special clarity by Professor Pigou, c/. op. cit. p. 347.

1 For details, c/. § § 5 and 6 of the present chapter.

2 For the statistical evidence, cf. chap, xi, § 7.

70

INTEENATIONAL TRADE

Mr. Keynes's line of tEouglit lias been criticised by Professor OMin on the ground that it ignores changes on the demand side. Professor Ohlin urges that the payment of reparations by Germany involves ipso facto a transfer of purchasing power to the countries receiving payment. This means that their demand increases and Germany's demand diminishes. We can therefore least of all argue on the basis of unaltered demand. The decisive point for the machinery of capital movements is, on the contrary, that demand has undergone a radical change. . . . There is thus a market in A for more of B's goods than formerly. On the other hand, the market in B for A's goods is not as big as it was before. The local distribution of demand has changed. . . . Prior to the beginning of the movement of capital the two countries were buying so much of all kinds of goods that their value equalled that of the goods produced at home. On the other hand, after the capital movement started, A buys more and B less of their combined production than before," and, it may be added in accord- ance with Professor Ohlin' s argument, the two groups together purchase the same amount as before.® M. Jacques Eueff calls this the principle of the conservation of purchasing power. It simply states that never in the course of the various economic transforma- tions that occur is purchasing power lost or created, but that it always remains constant." The loss of one party is exactly balanced by the gain of the other party. ^ This means in our particular case that the country paying reparations can never lose more purchasing power than the amount of the payments them- selves.® There is therefore, according to this view, no secondary burden.®

3 Of. IndeXi April 1928, pp. 4-5.

4 In parenthesis it may be remarked that a rigid assumption to the effect that the effective quautity of money remains constant, may be necessary in a pre- liminary stage of the analysis j but if strictly adhered to, it will completely block the way to the solution of a number of extremely important problems. For recent analysis in business cycle and monetary theory makes it more and more evident that— as the aggregate result of the actions of private individuals, abstracting altogether from any conscious regulation by the monetary authorities — ^the effective quantity of money (MV) is a much more variable magnitude than traditional theory has assumed. Eecognition of this fact and a careful study of the factors which are likely to determine these variations (changes set up by the transfer of large sums are certainly among them) are indispensable for an understanding of the vagaries of industrial fluctuations. This has been made quite clear by Dr. Thomas Balogh in his paper “ Some Theoretical Aspects of the Central European Credit and Transfer Crisis,” in International Affairs: Journal of the Eoyal Institute of Inter- national Affairs, vol. 11, May 1932. This remarkable paper which contains a penetrating and realistic analysis of many generally neglected aspects of the problem has not received all the attention which it deserves,

5 Cf. Economic Journal, vol. 39, 1929, pp. 389-90.

6 Prof. Ohlin has been accused by Mr. Keynes, amongst others, of a f etitio yrincimi on the ground that there is no shift of purchasing power until the sum paid has actually beep transferred. “ Germany can only acquire such bills if she has already sold the necessary exports ” (Economic Journal, 1929, pp. 407-B).

THE TEANSFER PROBLEM

71

Mr. Keynes's view ttat unilateral transfers necessitate price changes and a shift in the terms of trade can he traced back as far as Thornton^ who propounded it eight years before the publica- tion of Ricardo's High Price of Bullion. '' At the time of a very unfavourable balance (produced, for example, through a failure of the harvest) a country has occasion for large supplies of corn from abroad : but either it has not the means of supplying at the instant a sufficient quantity of goods in return, or . . . the goods which (it) is able to furnish as means of cancelling its debt, are not in such demand abroad as to afford the prospect of a tempting or even of a tolerable price. ... In order, then, to induce the country having the favourable balance to take all its payment in goods, and no part of it in gold, it would be requisite not only to prevent goods from being very dear but even to render them excessively cheap. It would be necessary, therefore, that the bank should not only increase its paper, but that it should, perhaps, very greatly diminish it . . ." {Paper Credit^ &c., pp. 131-2).

This doctrine was afterwards taken over and extended by John Stuart Mill, and it has come to be regarded as the classical doctrine. But it is incorrect to attribute this variant to Ricardo, as is often done.’' On the contrary, Ricardo lent his authority to the other version, maintaining that the shift in purchasing power was sufficient to restore equilibrium without gold movements and without a shift of prices. He criticised the passage from Thornton quoted above as follows : Mr. Thornton has not

explained to us why any unwillingness should exist in the foreign country to receive our goods for their corn; and it would be necessary for him to show, that if such an unwillingness were to exist, we should agree to indulge it so far as to consent to part with our coin,"® In contrast to Thornton, Ricardo asserted that the export of coins was caused by their ‘ cheapness,' i.e., by the high level of prices. It was therefore not the effect but the cause of an unfavourable balance.^ In the following passage he formu- lated the same idea even more clearly. ‘‘ If . . . we agreed to pay a subsidy to a foreign power, money would not be exported

This criticism is however invalid since it is only reasonable to assume that every Central Bank possesses a certain stock of international means of payment^ out of which the first instalment can be paid. If the Bank has no cash reserves or if the country receiving payment does not react to the inflow of gold by standing the circulation, then part of the mechanism is put out of action (c/. § 5 of the present chapter).

7 This has been pointed out notably by Professor Yiner, Canada* s Balance of International Indebtedness, chap, ix, pp. 191 et seq., and Wirtschaftstheorie der Gegenwart, vol. 4, p. 108-9.

® Cf. High Price of Bullion; Worhs, p. 268. ^

® Of . cit. p. 268. It would be more accurate to say ‘ criterion ’ or ‘ syxnptom rather than * cause.*

72

II7TERNATIOI7AL TRADE

whilst there were any goods which could more cheaply discharge the payment. The interest of the individuals would render the exportation of the money unnecessary (op. eit,, p. 269).

The export surplus arises therefore automatically, without having to foe pre- ceded by a movement of gold. “ Thus, then, specie will be sent abroad to discharge a debt only when it is superabundant; only when it is the cheapest exportable commodity ” (op. c^^., p. 269). But Ricardo denied that a failure of the harvest or the granting of a subsidy could produce a redundancy of money. ^

Malthus sided, apart from small differences, with Thornton. In his review of the High Price of Bullion^ he maintained that Ricardo had not shown why the country receiving a subsidy should immediately increase its demand at the old price for goods of the country paying the subsidy. He agreed with Thornton that demand could not be expected to increase until gold had flowed out and prices had fallen.

Malthus considered that the export of specie occurred not only when it was present in superabundance but also “it is owing precisely to the cause mentioned by Mr. Thornton — the unwillingness of the creditor nation to receive a great additional quantity of goods . . . without being bribed to it by excessive cheapness; and its willingness to receive bullion — the currency of the commercial world — without any such bribe . . . whatever variations between the quantity of currency and commodities may be stated to take place subsequent to the commencement of these transactions, it cannot be for the moment doubted, that the cause of them is to be found in the wants and desires of one of the two nations, and not in any original redundancy or deficiency of currency in either of them ** (op. cit., p. 345).

Among more recent writers one of the few to adopt the Ricardian version was Bastable. In 1889 he expounded his view in practically the same words as Pro- fessor Ohlin. “ It is . . . doubtful whether Mill is correct in asserting that the quantity of money will be increased in the creditor and reduced in the debtor country. The sum of money incomes will no doubt be higher in the former; but that increased amount may be expended in purchasing imported articles. . . . Nor does it follow that the scale of prices will be higher in the creditor than in the debtor country. The inhabitants of the former, having larger money incomes, will purchase more at the same price, and thus bring about the necessary excess of imports over exports. “3

(c) The Problem Solved. A tentative answer to the question, ‘"‘..ysrliat part price-movements play in the mechanism of transfer, can now be proposed.^ The truth lies in this case midway between the

1 Ricardo granted, indeed, that in the case of a failure of the harvest there had to be an export of gold. This was not however in order to change prices and thus create an export surplus, but because the failure of the harvest meant a decrease in the volume of trade and hence in the amount of money required^ “ England in consequence of a bad harvest, would come under the case ... of a country having been deprived of a part of its commodities and therefore requiring a diminished amount of circulating medium. The currency, which was before equal to her payments, would now become superabundant and relatively cheap “ (“ Appendix “ to The High Price of Bullion; Worhs, p. 293).

^Edinburgh Beview, vol. 17, pp. 342 to 345, Feb. 1811, quoted by Viner, op. cit.f p. 193.

3 ‘‘ On some Applications of the Theory of International Trade,” Quarterly Journal of Economics; yq\. iv, p. 16 (Oct. 1889).

4 Cf. Haberler, “ Transfer und Preisbewegung,” Zeitschrift fur National- okonomie^ Bd. 1, pp. 548 et seg,, and Bd. 2, pp. ICX) et seq,; Losch, “ Eine Ausein- andersetzung uber das Transferproblem,” Schmollers Jahrbuch, jg. 54, pp. 109 et seq.; Machlup, “ Transfer und Preisbewegung,” Zeitschrift fur Nationatokonomie, Bd. 1, 1930; Wilson, Capital Imports ana the Terms of Trade (1931).

THE TEANSFEE PEOBLEM

73

two conflicting tlieories, botli of wMcli are one-sided and give an over-simplified picture of tlie facts. For in reality one can conceive both cases in which transfer involves changes in the general price level and cases in which it does not involve them. The terms of trade may remain unaffected, they may move against the country paying reparations, or, on the other hand, they may move in favour of it. Transfer may therefore involve a loss, but, on the other hand, it may even involve a gain.®

Professor Ohlin is undoubtedly correct in maintaining that Mr. Keynes ignores the shifts on the demand side produced by the payments themselves. One cannot operate with unchanged demand curves of given elasticity, since the demand curves of the countries receiving payment will have shifted to the right. f\This means that •owung to the increase in money incomes a larger amount than before will be bought even at the old price. In the limiting case it is even possible for the transfer to be made without any fall in the price of German exports. This happens if the fall in Germany’s demand, due to the reduction of the national income by a reparation tax, is offset by an increase in foreign demand for the same goods. It makes no difference whether these are German goods, the export of which now increases, or whether they are goods previously imported into Germany, which are now imported in smaller quantities than before.

Normally, however, the fall in demand and the rise in demand affect different goods and there must, in consequence, be a shift of gri^jj^s and of production. Professor Ohlin admits that the fall in demand will affect primarily goods produced in the country paying reparations and the rise in demand goods produced in the country receiving them. But he contends that production of the former will be restricted and means of production will be released for use in the export industries.® The same argument •applies of course also to the goods foTwhich demand has increased. Their production will expand at the expense of exports, and the balance of trade will censequently be a%cted.

No one disputes that the final result must be an increase in the exports of the country paying reparations and/or a decrease in the exports of the country receiving them, since the export surplus caiinbt be produced in any other way. 3*at the question is, what price changes are brought about by this shift of production?

Here it is important to distinguish two kinds of price change

5 This last possibility has not been considered by either party.

® Cf. Zeits^rift fiir Nationaldhonomie, vol. 1, p. 764.

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INTERNATIOITAL TRADE

wMcli are apt to be confused with one another/ These are, on the one hand, temporary price discrepancies in the transition from the old to the new equilibrium, and, on the other hand, pfermanen^^ shifts of the terms of trade as between the new and the old equilibrium. A single harvest failure or the payment of a single lump sum may give rise to a price discrepancy by which exports are encouraged, imports reduced, and equilibrium thus restored. But differences of price greater than the cost of transport from one country to the other are incompatible Vith equilibrium and cannot, therefore, persist very long. In a frictionless market the adjustment would be instantaneous, and while price changes might very well occur, price discrepancies would be impossible. If, therefore, one operates with this assumption, or if one skips the transitional period and concentrates entirely on the new equilibrium which will finally be reached, it is only logical to deny the possi- bility of price discrepancies. The Ricardian® variety of transfer theory is static in this sense.® Its procedure is not unreasonable in the case of recurring payments such as reparations, j The fact that a price-discrepancy cannot persist very long by no means implies that the terms of trade must remain unchanged.^ The prices of German exports may have to fall and those of German imports may have to rise. But this does not contradict the rule that prices in different countries tend to equality, since the price of German export articles falls both in Germany and elsewhere ; the same argument applies to imports. This shift of prices is to be expected in the normal case where the direct influence of changes in demand on the bali^nce of trade is insufficient to create the necessary export^ surplus, because foreign countries spend only a small part of their receipts for reparations pn the, purchase of Geripian exports.^ . ; , . , , ,, ^ -

«;» ,*■ * ' '► t" ' - 1 , # I ,, " f ' f '■***# 't f’**", ^ ^ i,

7 This has been pointed out in an unpublished memorandum by Dr. Koopmans. In this respect there is perhaps a difference of degree between movements of capital and shifts of demand in international and in domestic trade respectively. In domestic trade one can assume the existence of a homogeneous market, whereas in international trade there are separate markets, between which price equilibrium is then restored by arbitrage. But, of course, there are exceptions and each case muSt be examined on its merits.

® It is, of course, not intended to imply that writers of the opposite school always identify temporary price discrepancies with changes in the terms of trade. That would clearly be a misinterpretation, e.p., of Professor Taussig, who does not speak of price differences in general but of differences in supjiy price.

9 This has become quite clear since Mr. Keynes has returned in the Treatise, on Money to his controversy with Prof. Ohlin. In chap, xxi he distinguishes explicitly between the new equilibrium and the period of transition. He now regards the transfer difficulties as concerning almost exclusively the process of transition.

1 It is true that a price-discrepancy always implies a change in the terms of trade, but this proposition is not reversible : changes in the terms of trade usually do not take the form of price- discrepancies.

3 This is very prob^le since it may reasonably be assumed that foreign countries divide the extra income between domestic goods, export goods and import

THE TRAIfSFEE PROBLEM

T5

By tow much, tte price of German exports must fall depends^ first, on the elasticity of demand abroad/ In contrast to Mr. Keynes, I am of opinion that demand is as a rule very elastic, since the world market is, after all, large compared with the volume of exports from any single country. Moreover, the fact that Germany has no monopoly but competes with other countries also works in the same direction. A fall of prices does not only stimulate demand as a whole but will also drive some foreign com- petitors out of the market. This is rendered easier by the fact that in the country receiving reparations demand for domestic goods has risen, and, in consequence, the necessary adjustment there is already under way.

The extent of the fall in price depends, secondly, on the con- ditions of supply in Germany and also, mutatis mutandis ^ in the competing industries abroad. If, for example, the output of German exports could be expanded under diminishing costs per unit, Germany's difficulties would obviously be reduced. If the law of constant costs prevails in the industries concerned, no shift of prices will occur.

It is not easy to predict on theoretical grounds how these factors will work out. Moreover, the result depends on how long one allows for supply to adjust itself. In general it holds true that the longer one allows, the smaller will be the necessary price changes.^ For, Q^ce the obstacles to an expansion of,, exports have been swept aside by energetic under-cutting, exports can afterwards be maintained in the channels thus opened even at a rather higher price than before.

An accurate summary of all these interdependences is hardly possible without mathematical symbols.® But it should be mentioned that it is theoretically possible for the terms of trade to change in favour of Germany so that the prices of German exports rise and the prices of German imports fall. This leads to the rather paradoxical result that ^old flows into Germany, and the transfer mechanism thus eases the situation of the country paying reparations ! This is not a very probable case, but it

goods in about the same proportion as the old income and because in almost all countries the volume of export and import is small compared with total production.

3 It is a question of the elasticity of the demand curve after the payment had been made and the curve has therefore shifted. Elasticity will probably not be the same as before. The elasticity of the German demand for German export goods is also relevant.

^ Cf. Eucken, Das Meparationaproblem {Verhandlungen det F, List-Geselhchaft, Bsflin, 1929).

3 Cf.y Yntema, A Mathematical Reformulation of the General Theory of International Trade (1932), chap, v, pp. 61 et seq.^ and Wilson, Capital Imports and the Terms of Trade (1931).

7.6

INTEENATIONAL TRADE

■would arise if the increase of foreign demand were for German exports, and the fall in Germany’s demand related to imports,®

These considerations are, however, of theoretical rather than of practical interest, since the relevant factors and their possible repercussions are in concrete examples so complex that the price changes involved by transfer can hardly be worked out. But in any case, as pointed out by Professor Ohlin, it is an oversimplifica- tion to say that prices fall in the country paying reparations and rise in the country receiving them. The analysis must be in terms not of general but of sectional price levels.^

■■■'

I 4,. IFnilatebal Payments and Inteenational Movements of

Capital.

Tke irLfliience of imilateral payments, suck as reparations, on imports and exports of commodities and services and on tke price level is normally obscured for a longer or skorter period by tkeir profound influence on tke international movement of capital.

A country making large unilateral payments will tend to import capital in one form or anotker. In this way tke direct effect of tkese payments on tke balance of trade and services will be suspended or at least weakened. Payment will be made in tke first instance not out of current production but by tke foreign creditors. Transfer is postponed and, provided tkat tke new credits are actually repaid, is made finally in instalments over a period of years.

Tke form in wkick tkese transfer credits are granted and the mechanism connecting them with the unilateral payments may vary considerably. A direct and obvious connection exists where tke loan is made to tke debtor kimgelf, as tke Dawes Loan and tke Young Loan were made to the (lerman Government. Tke transfer of titles to durable property has similar effects. Thus tke surrender of Germany's mercantile marine and of German property abroad affected tke balance of trade not immediately but over tke period during wkick this property would have yielded income.

I But tke view tkat transfer would have been impossible without ! capital imports refers not so muck to direct loans as to tke indirect ; effects of tke payments, in inducing "persons ptker than tke debtor i; himself to import capital.

Tke payments actually made, tke raising of tke sums required,

6 Prof. Pigou DOW supports the view that this is possible. Of. “ Beparations and the Batio of International Exchange/* Economic Journal, vol. 42, Dec. 1952.

7 The analysis has been carried forward by B, Nurkse, Internationale Kapitah bewegungen (1936).

THE TRANSFER PROBLEM

77

and tlie restriction of credit necessary to ensure transfer/ all impose a relative stringency on tlie money and capital markets; the rate of interest rises compared with