Inflation and the Deficit in the US. Balance of Payments

1 The rise in foreign-owned short-term dollar balances, of which over $9 billion are held by foreign official institutions· (mostly central banks) reflects the fact that the D. S. has become the world's foremost banker. Many countries hold a large part of their international reserves in dollars rather than in gold1 These are all year-end figures. The facts have been much discussed and· are by now so well known that we need not recount them in greater detail. The figures can be found in the Survey of Current Business, Federal Reserve Bulleti1J, and Internat£onal Fin~nc£al Stat£st£cs,and have been repeatedly analyzed, e.g." in the Economic Report of the President and "International Effects of u.s. Economic Policy," by E. M. Bernstein. (Study Paper No. 16, Joint Economic Committee, 86th Congress, 2nd Session, January,' 1960.) [64 ] the world is on a dollar exchange standard and no longer on a· gold standard.

It is generally agreed that it would be dangerous if the deficit in the U. S. balance of payments were allowed to continue for much longer at the present level, because it might undermine the confidence of the world in the soundness of the U. S. dollar and lead to a with drawal. of foreign balances in the form of gold. In v~ew of the fact that the law requires that the currency in circulation be covered 25 percent by gold, which at present binds more than $12 billion of the gold stock, large withdrawals of gold would be a serious matter. 2 The question that primarily interests us in this study is-what has been the role of inflation in the deterioration of the U. S. balance 6£ payments? The answer which one often hears is that inflation has nothing to do with the external deficit on the ground that during the last five years or so prices in the U. S. have risen less, or at least not more, than in the great majority of foreign countries.

In one sense, this answer has some foundation in the facts, but is misleading; in another sense, it is entirely wrong and irresponsibly complacent. It is true that since the early 1950's the U. S. indices of wholesale prices, consumer prices, wage rates, and wage costs have not risen more than the corresponding indices in most foreign coun tries, with two or three exceptions-and even·in the exceptional cases (Germany, Switzerland, and Belgium) the difference is rather small and depends on which base year is taken. But for certain important commodities U. S. prices h~ve risen much faster than those in com peting countries. This is especially true of steel where wage push has been especially strong. Moreover, U. S. export prices (as distin guished from the price lev~l in general) definitely seem to have risen substantially more from 1953 to 1959 than European or Japanese export prices.

2 It is true that the Federal Reserve Act (Sec. II, par. 4) gives the Federal Reserve Board authority to suspend reserve requirements at any time for specified periods, thus making available virtually all our gold for international use. But the necessity to invoke this emergency clause might be taken as a sign of weakness. [ 65 ] The rapid deterioration in the U. S. trade and payments position since 1957 has to be attributed mainly to the rapid recovery of in dustrial Europe and Japan from war destruction and dislocation and to the fact that these countries have increasingly adopted sound financial policies which have greatly improved their competitive positions vis-a-vis the U. S. From this it does not follow, however, that U. S. inflation has nothing to do with our payments position. On the contrary, it means that in view of the changed competitive position the U. S. can no longer afford even a Ulittle" inflation without losing gold. Moreover, disinflation or at least holding the pace of inflation below that of our principal competitors is the main prerequisite for a correction of the imbalance.

Here is not the place to discuss other measures that could be taken to improve the balance-elimination of discrimination against dollar exports, larger contributions by Europe for mutual defense and for economic aid to underdeveloped countries, tied loans, and so. on. The effect on the balance of payments of all these measures combined will probably be insufficient to eliminate the deficit and, at any rate, it could be easily wiped out by loose financial policies. The position of the U. S. as the world's foremost banker and of the dollar as the world's principal reserve currency greatly increases our responsibilities. At the same time, it excludes easy solutions which would be open to others. Thus if Canada were confronted with a large deficit in her inter11ational balance she would let her dollar. drop a few points and that would take care of the problem. The U. S. cannot tamper with the gold value of the dollar without committing a crass breach of the confidence of all those who have entrusted us with keeping their international reserves and without provoking an international financial crisis which would greatly weaken American leadership in the Free World. Only a radical change in the existing international payments methods and arrange ments could alter this situation.

The conclusion is that, from now on not only considerations of international stability and sustained growth, but also the inter national position of the U. S. imperatively require that inflation be [66 ] stopped. The U. S. monetary policy is no longer exempt, as it was or many thought it was, from external restraints. Every effort must be made to avoid a serious clash between the requirements of external and internal stability. If, for example, excessive wage push and downward rigidity of wages put us in a position where only an inflationary price rise could prevent serious unemployment, we would find ourselves in a dangerous spot in view of our external vulnerability. Or, as E. M. Bernstein has pointed out, if the U. S. entered the next recession with a large deficit in the balance of payments, vigorous·anti-depression policy by means of easy money, as it was practiced rather successfully in earlier postwar recessions, may be seriously hampered; for low interest rates may well induce large withdrawal of foreign funds in search of higher yields elsewhere.

All this adds to the urgency of preventing any further price rises, or still better-and safer-of working for a gradual price decline. If we maneuvered ourselves into serious balance of payments difficul ties, every solution available--deflation and unemployment, trade or payments restrictions, devaluation of the dollar-would be in varying degrees painful, detrimental, humiliating, and repugnant to accepted economic principles and policy objectives. [67 ] ANTI-INFLATION POLICY MUCH HAS been said already in the course of our analysis, explicitly or implicitly, on how to avoid, prevent, or stop inflation. It remains to pull together and summarize what has been stated or implied. One conclusion is certain and cannot be stressed too strongly: In principle, it is always possible, in developed as well as under developed countries, to manage in such a way that chronic inflation is avoided without creating prolonged and serious lapses from full employment and without endangering economic growth. This follows from classical equilibrium theory as well as from Keynesian econo mics. If inflation seems to become unavoidable or if, compared with practical alternatives, a policy of letting prices rise appears as the lesser evil, it is always due to faulty monetary, fiscal, and wage policies. These include: Excessive government spending; inability to tax sufficiently; impotence or unwillingness to curb labor unions and to prevent them from pressing for wage increases in excess of the average rise in labor productivity; .and last but emphatically not least, lack of monetary discipline which either produces demand pull of its own or gives way to cost push and provides inflationary finance for government deficits.