THE INTERNATIONAL ADJUSTMENT MECHANISM

THE INTERNATIONAL ADJUSTMENT MECHANISM

Also by Leonard Gomes FOREIGN TRADE AND THE NATIONAL ECONOMY: Mercantilist and Classical Perspectives INTERNATIONAL ECONOMIC PROBLEMS NEOCLASSICAL INTERNATIONAL ECONOMICS: An Historical Survey

The International Adjustment Mechanism From the Gold Standard to the EMS Leonard Gomes Principal Lecturer in Economics University of Middlesex, Enfield 150th YEAR St. Martin's Press

Leonard Gomes 1993 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced. copied or transmitted save with written permission or in accordance with the provisions of the Copyright. Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tonenham Court Road, London WIP 9HE. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. First published in Great Britain 1993 by THE MACMll..LAN PRESS LTD Houndmills, Basingstoke, Hampshire RG21 :~XS and London Companies and representatives throughout the world A catalogue record for this book is available from the British Library. ISBN 978-1-349-39151-6 DOI 10.1057/9780230375420 ISBN 978-0-230-37542-0 (ebook) First published in the United States of America 1993 by Scholarly and Reference Division, ST. MARTIN'S PRESS, INC., 175 Fifth Avenue, New York, N.Y.!0010 Library of Congress Cataloging-in-Publication Data Gomes, Leonard. The international adjustment mechanism : from the gold standard to the EMS I Leonard Gomes. p. em. Includes bibliographical references and index. l. International finance. 2. Gold standard. 3. Foreign exchange. 4. European Monetary System (Organization) I. Title. HG388l.G6148 1993 332.4'5--dc20 92--44662 CIP

Contents List of Tables and Figures Preface vii ix 1 Introduction: Preliminaries, Concepts and Definitions 1 1.1 The international adjustment mechanism 1 1.2 Money and the balance of payments 33 1.3 The nominal anchor problem 38 2 The International Adjustment Mechanism: Origin and Development of Doctrine 46 2.1 Introduction 46 2.2 The sixteenth-century price revolution and the quantity theory 50 2.3 The 1620s' English debate on the foreign exchanges 58 2.4 International adjustment - from Locke to Smith 59 2.5 The Swedish bullionist controversy (1755-65) 68 2.6 The assignat in the French Revolution 69 2.7 The English bullionist controversy 72 2.8 The currency-banking schools debate 93 3 International Adjustment in the Heyday of the Gold Standard 103 3.1 International monetary doctrines and gold-standard arrangements 103 3.2 Monetary approach vs. price-specie flow mechanism 126 3.3 The transfer problem 139 3.4 How the gold standard worked, 1880-1914 148 4 The Great War, the Fall of the Gold Standard and Bretton Woods 170 4.1 Introduction 170 4.2 The Great War, the gold standard and the great slump 171 4.3 Interwar criticisms: external vs. internal stability 178 v

VI Contents 4.4 The purchasing-power parity theory (PPP) 189 4.5 Floating exchange rates in the 1920s: the case of the French franc 204 4.6 International monetary plans - post-first World War 214 4.7 The design of Bretton Woods and the transition to convertibility 222 5 Keynesian and Contemporary Balance of Payments Models 229 5.1 Keynesian models 229 5.2 The absorption approach and the Mundell-Fleming model 237 5.3 Monetarist models 251 6 The Collapse of Bretton Woods, Exchange-Rate Theories and European Monetary Integration 262 6.1 The collapse of Bretton Woods and the advent of floating exchange rates 262 6.2 Exchange-rate theories 267 6.3 The European Monetary System 292 6.4 Summary and conclusions 314 Notes and References 321 Bibliography 330 Index 342

List of Tables and Figures Tables 1.1 Schema for the balance of payments accounts 9 3.1 United Kingdom balance of payments, 1911-13 153 5.1 Short-run effects of stabilisation policies 247 Figures 1.1 The dynamics of monetary adjustment in an open economy 35 2.1 English, French and Spanish prices, 1525-1618 51 2.2 Hamburg market for bills of exchange 74 3.1 Prices in the nineteenth century 122 3.2 Selected exchange rates, 1860-1913 123 4.1 The French franc, 1919-26 205 5.1 Internal and external balance (Swan's diagram) 242 5.2 The assignment problem (Mundell's diagram) 244 vn

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Preface This book is about the history of thought and policy on the international adjustment mechanism - the changing conceptions about what economic forces come into play to adjust economies to external disequilibria, i.e. payments surpluses and deficits or exchangerate misalignments. Economics emerged as a discipline in its own right largely out of the accumulated reflections, analyses and judgements of a group of writers from the sixteenth to the early nineteenth century who shared a common perspective on matters relating to the adjustment of the balance of payments. The present survey starts with the development of the doctrine at that time (taking account of the policy debates which informed and stimulated theoretical enquires) and continues the story right up to present-day models and issues. Balance of payments analysis is intimately linked to monetary theory, and this has traditionally been the case. However, there are two varieties of monetary theory - one, which might be called the 'classical theory' of money associated with the monetary theory of the balance of payments, and the other, the quantity theory of money associated with the price-specie flow mechanism. In the classical theory, money is convertible into an object of value (gold) and privately produced. The price level is determined by the demand for and supply of gold, so that the quantity of bank money is endogenously determined. Money issued by a competitive banking system (under conditions of convertibility) will never be overissued and consequently the system will provide exactly the right amount of money, given the tie of money to the stock of gold. By contrast, in the quantity theory, money is exogenously introduced into the system and the price level depends on the quantity of such exogenously created high-powered money. The point of the distinction is that quantity-theory reasoning (the view that there is a strict proportionality between money and domestic prices) is not relevant to the case of commodity money supplied endogenously through gold-mining and international specie flows, i.e, the case of a purely metallic currency such as the classical gold standard. The quantity theory comes into its own in the case of inconvertible national currencies or at the global level under fixed exchange rates. IX

X Preface At any rate, the use of different frameworks for monetary analysis led writers to stress different channels for the adjustment of the balance of payments. Theoretical differences among writers also arose from different assumptions about the degree of international economic integration: Is the world economy more like the solar system in which each planet's economy is properly thought of in isolation, or is it more like the different regions of an integrated national economy where all regions face given prices for goods and financial assets? How strong are the economic linkages among countries? Do national borders make a real difference? Changes in international monetary arrangements alter the bonds that tie national economies together - either to weaken or to tighten them - and thus change perceptions concerning the modalities of international monetary adjustment. A survey of the development of the theory of the international adjustment mechanism is wide-ranging, and therefore involves consideration of a mass of writings on money, prices and exchange rates ranging over more than three centuries. In such an enterprise, compression of details is inevitable, especially since the aim is to convey a blend of analysis and historical background. The story of the development of ideas and policies on the adjustment mechanism is an interesting one in its own right. It is also of much relevance to contemporary discussions on the international implications of alternative monetary regimes. Chapter 1 is an introductory piece devoted to a discussion of concepts and definitions useful in balance of payments analysis. Chapter 2 discusses the origin and development of doctrine on the international adjustment mechanism. Chapter 3 deals with theoretical and policy issues touching on the adjustment mechanism and the gold standard from around 1880 to 1914. The development of doctrine and policy during the interwar years is considered in Chapter 4. Chapter 5 is concerned with Keynesian and contemporary balance of payments models, and the final chapter deals with the collapse of Bretton Woods, modern exchange-rate theories and the European Monetary System (EMS). LEONARD GOMES