Lecture III INDEPENDENT CURRENCIES 1

When the rates of exchange between currencies of different countries are variable, the consequences which will follow from changes which under an international system would lead to flows of money from country to country, will depend on the monetary policies adopted by the countries concerned. It is therefore necessary, before we can say anything about those effects, to consider the aims which will presumably guide the monetary policy of countries which have adopted an independent standard. This raises immediately the question whether there is any justification for applying any one of the principles according to which we might think that the circulation in a closed system should be regulated, to a particular country or region which is part of the world economic system.

Now it should be evident that a policy of stabilization, whether it be of the general price level or the general level of money incomes is one thing if it be applied to the whole of a closed system and quite another if the same policy is applied to each of the separate regions into which the total system can be more or less arbitrarily divided. In fact, however, this difficulty is generally ignored by the advocates of Monetary Nationalism, and it is simply assumed that the criteria of a good monetary policy which are applicable to a closed system are equally valid for a single country. We shall have to consider later the theoretical problems here involved. But for the moment we can confine ourselves to an examination of the working of the mechanism which brings about relative changes in the value of the total money holdings of the different nations when each nation follows independently the objective of stabilising its national price level, or income stream, or whatever it may be, irrespective of its position in the international system.

The case which has figured most prominently in these discussions in recent years, and which is apparently supposed to represent the relative positions of England and the United States, is that of two countries with unequal rates of technological progress, so that, in the one, costs of production will tend to fall more rapidly than in the other. Under a regime of fixed parities this would mean that the fall in the prices of some products produced in both countries could be faster than the fall in their cost in the country where technological progress is slower, and that in consequence it would become necessary to reduce costs there by scaling down money wages, etc. The main advantage of a system of movable parities is supposed to be that in such a case the downward adjustment of wages could be avoided and equilibrium restored by reducing the value of money in the one country relative to the other country.

It is, however, particularly important in this connection not to be misled by the fact that this argument is generally expressed in terms of averages, that is in terms of general levels of prices and wages. A change in the level of prices or of costs in one country relatively to that of another means that, in consequence of changes in relative costs, the competitive position of a particular industry or perhaps group of industries in the one country has deteriorated. In other words the lower prices in the one country will lead to a transfer of demand from the other country to it. The case is therefore essentially similar to that which we have been considering in the last lecture and it will be useful to discuss it in the same terms. We shall therefore in the first instance again consider the effects of a simple shift of demand if rates of exchange are allowed to vary and if the monetary authorities in each country aim either at stability of some national price level, or—what amounts very much to the same thing for our purpose—at a constant volume of the effective money stream within the country. Only occasionally, where significant differences arise, I shall specially refer to the case where the shift of demand has been induced by unequal technological progress.

Now of course no monetary policy can prevent the prices of the product immediately affected from falling relatively to the prices of other goods in the one country, and a corresponding[1] rise taking place in the other. Nor can it prevent the effects of the change of the income of the people affected in the first instance from gradually spreading. All it can do is to prevent this from leading to a change in the total money stream in the country; that is it must see that there will be offsetting changes of other prices so that the price level remains constant. It is on this assumption that we conduct our investigations. For purposes of simplicity, too, I assume that at the outset a state of full employment prevails.

2

It will be convenient to concentrate first on the country from which demand has turned away and from which under an international monetary system there would in consequence occur an outflow of money. But in the present case not only would a real outflow of money be impossible, but it would also be contrary to the intentions of the monetary authorities to sell additional quantities of foreign exchange against national money and to cancel the national money so received. The monetary authorities might hold some reserves of foreign exchange to even out what they regarded as merely temporary fluctuations of exchange rates. But there would be no point in using them in the case of a change which they would have to regard as permanent. We can, therefore, overlook the existence of such reserves and proceed as if only current receipts from abroad were available for outward payments.

On this assumption it is clear that the immediate effect of the adverse balance of payments will be that foreign exchange rates will rise. But the full amount that importers used to spend on buying foreign exchange is not likely to be spent on the reduced supply of foreign exchange; since with the higher price of imported goods some of the money which used to be spent on them will probably be diverted to home substitutes.[2] The foreign exchanges will therefore probably rise less than in proportion to the fall in supply. But via the sale of foreign exchange at the higher rate those who continue to export successfully will receive greater amounts of the national currency. For those whose sales abroad have not been unfavourably affected by the initial change in question this will mean a net gain and the price of their products will correspondingly rise in terms of the national currency. And those whose exports have fallen in price will find that this reduced price in terms of the foreign currency will now correspond to a somewhat greater amount in the national currency than what they could obtain before the exchange depreciation, although not as much as they received before the first change took place.

This impact effect of the rise of exchange rates on relative prices in terms of the national currency will however be temporary. The relative costs of the different quantities of the different commodities which are being produced have not changed and it is not likely that they will go on being produced in these quantities if their prices have changed. Moreover all the changes in the direction of the money streams caused by the rise in exchange rates will continue to work. More is being spent on home goods, and this, together with the increased profitability of those export industries which have not been adversely affected by the initial change, will tend to bring about a rise of all prices except those which are affected by the decreased demand from the declining industry and from the people who draw their income from it.

It seems therefore that the argument in favour of depreciation in such cases is based on a too simplified picture of the working of the price mechanism. In particular it seems to be based on the assumption (underlying much of the classical analysis of these problems) that relative prices within each country are uniquely determined by (constant) relative cost. If this were so, a proportional reduction of all prices in a country relatively to those in the rest of the world would indeed be sufficient to restore equilibrium. In fact, however, there can be little doubt that the changes in the relative quantities of goods to be produced by the different industries which will become necessary in consequence of the initial change, can be brought about only by changes in the relative prices and the relative incomes of the different kinds of resources within the country.

Without following the effects in all their complicated detail it must be clear that the ultimate result of depreciation can only be that, instead of prices and incomes in the industry originally affected falling to the full extent, a great many other prices and incomes will have to rise to restore the proportions appropriate to cost conditions and the relative volume of output now required. Even disregarding the absolute height of prices, the final positions will not be the same as that which would have been reached if exchanges had been kept fixed; because in the course of the different process of transition all sorts of individual profits and losses will have been made which will affect that final position. But roughly speaking and disregarding certain minor differences, it can be said that the same change in relative prices which, under fixed exchanges, would have been brought about by a reduction of prices in the industry immediately affected is now being brought about largely by a corresponding rise of all other prices.

Two points, however, need special mention. One is that the decrease of the comparative advantage of the export industry originally affected cannot be changed in this way; and that to this extent a contraction of the output of this industry will remain unavoidable. The other is that at least in certain respects the process which brings about the rise in prices will be of a definitely inflationary character. This will show itself partly by some industries becoming temporarily more profitable so that there will be an inducement to expand production there, although this increase will soon be checked and even reversed by a rise in cost; and partly by some of the cash released by importers finding its way, via the repayment of loans, to the banks, who will be able to increase their loans to others and, in order to find lenders, will relax the terms on which they will be ready to lend. But this too will prove a merely temporary effect, since as soon as costs begin generally to rise it will become apparent that there are really no funds available to finance additional investments. In this sense the effects of this redistribution of money will be of that self-reversing character which is typical of monetary disturbances. This leads, however, already to the difficult question of what constitutes an inflation or deflation within a national area. But before we can go on to this it is necessary to consider what happens in the converse case of the country which has been put in a more favourable condition by the change.

3

Let us first assume that the monetary authorities here as in the other country aim at a constant price level and a constant income stream. The industry which directly benefits from the initial shifts in demand will then find that, because of the fall of foreign exchanges, the increase of their receipts in terms of the national currency will not be as large as would correspond to the increase of their sales in terms of foreign money, while the other export industries will see their receipts actually reduced. Similarly those home industries whose products compete with imports which are now cheaper in terms of the national currency will have to lower their prices and will find their incomes reduced. In short, if the quantity of money in the country, or the price level, is kept constant, the increase of the aggregate value of the products of one industry due to a change in international demand will mean that there has to be a compensating reduction of the prices of the products of other industries. Or, in other words, part of the price reduction which under a regime of stable exchanges would have been necessary in the industry and in the country from which demand has turned away, will under a regime of independent currencies and national stabilisation have to take place in the country towards which demand has turned, and in industries which have not been directly affected by the shift in demand.

This at least should be the case if the principle of national stabilization were consistently applied. But it is of course highly unlikely that it ever would be so applied. That in order to counteract the effects of a severe fall of prices in one industry in a country other prices in the country should be allowed to rise, appears fairly plausible. But that in order to offset a rise of prices of the products of one industry which is due to an increase in international demand, prices in the other industries should be made to fall sounds far less convincing. I find it difficult to imagine the President of a Central Bank explaining that he has to pursue a policy which means that the prices of many home industries have to be reduced, by pointing out that an increase of international demand has led to an increase of prices in an important export industry, and it seems fairly certain what would happen to him if he tried to do so.

Indeed, if we take a somewhat more realistic point of view, there can be little doubt what will happen. While, in the country where in consequence of the changes in international demand some prices will tend to fall the price level will be kept stable, it will certainly be allowed to rise in the country which has been benefited by the same shift in demand. It is not difficult to see what this implies if all countries in the world act on this principle. It means that prices would be stabilized only in that area where they tend to fall lowest relatively to the rest of the world, and that all further adjustments are brought about by proportionate increases of prices in all other countries. The possibilities of inflation which this offers if the world is split up into a sufficient number of very small separate currency areas seem indeed very considerable. And why, if this principle is once adopted, should it remain confined to average prices in particular national areas? Would it not be equally justified to argue that no price of any single commodity should ever be allowed to fall and that the quantity of money in the world should be so regulated that the price of that commodity which tends to fall lowest relatively to all others should be kept stable, and that the prices of all other commodities would be adjusted upwards in proportion? We only need to remember what happened, for instance, a few years ago to the price of rubber to see how such a policy would surpass the wishes of even the wildest inflationist. Perhaps this may be thought an extreme case. But, once the principle has been adopted, it is difficult to see how it could be confined to “reasonable” limits, or indeed to say what “reasonable” limits are.

4

But let us disregard the practical improbability that a policy of stabilization will be followed in the countries where, with stable exchanges, the price level would rise, as well as in the countries where in this case it would have to fall. Let us assume that, in the countries which benefit from the increase of the demand, the prices of other goods are actually lowered to preserve stability of the national price level and that the opposite action will be taken in the countries from which demand has turned away. What is the justification and significance of such a policy of national stabilization?

Now it is difficult to find the theoretical case for national stabilization anywhere explicitly argued. It is usually just taken for granted that any sort of policy which appears desirable in a closed system must be equally beneficial if applied to a national area. It may therefore be desirable before we go on to examine its analytical justification, to trace the historical causes which have brought this view to prominence. There can be little doubt that its ascendancy is closely connected with the peculiar difficulties of English monetary policy between 1925 and 1931. In the comparatively short space of the six years during which Great Britain was on a gold standard in the post-war period, it suffered from what is known as overvaluation of the pound. Against all the teaching of “orthodox” economics—already a hundred years before Ricardo had expressly stated that he “should never advise a government to restore a currency, which was depreciated 30 p. c., to par”[3]—in 1925 the British currency had been brought back to its former gold value. In consequence, to restore equilibrium, it was necessary to reduce all prices and costs in proportion as the value of the pound had been raised. This process, particularly because of the notorious difficulty of reducing money wages, proved to be very painful and prolonged. It deprived England of real participation in the boom which led up to the crisis of 1929, and, in the end, its results proved insufficient to secure the maintenance of the restored parity. But all this was not due to an initial shift in the conditions of demand or to any of the causes which may affect the condition of a particular country under stable exchanges. It was an effect of the change in the external value of the pound. It was not a case where with given exchange rates the national price or cost structure of a country as a whole had got out of equilibrium with the rest of the world, but rather that the change in the parities had suddenly upset the relations between all prices inside and outside the country.

Nevertheless this experience has created among many British economists a curious prepossession with the relations between national price- and cost- and particularly wage-levels, as if there were any reason to expect that as a rule there would arise a necessity that the price and cost structure of one country as a whole should change relatively to that of other countries. And this tendency has received considerable support from the fashionable pseudo-quantitative economics of averages with its argument running in terms of national “price levels”, “purchasing power parities”, “terms of trade”, the “Multiplier”, and what not.

The purely accidental fact that these averages are generally computed for prices in a national area is regarded as evidence that in some sense all prices of a country could be said to move together relatively to prices in other countries.[4] This has strengthened the belief that there is some peculiar difficulty about the case where “the” price level of a country had to be changed relatively to its given cost level and that such adjustment had better be avoided by manipulations of the rate of exchange.

Now let me add immediately that of course I do not want to deny that there may be cases where some change in conditions might make fairly extensive reductions of money wages necessary in a particular area if exchange rates are to be maintained, and that under present conditions such wage reductions are at best a very painful and long drawn out process. At any rate in the case of countries whose exports consist largely of one or a few raw materials, a severe fall in the prices of these products might create such a situation. What I want to suggest, however, is that many of my English colleagues, because of the special experience of their country in recent times, have got the practical significance of this particular case altogether out of perspective: that they are mistaken in believing that by altering parities they can overcome many of the chief difficulties created by the rigidity of wages and, in particular, that by their fascination with the relation between “the” price level and “the” cost level in a particular area they are apt to overlook the much more important consequences of inflation and deflation.[5]

5

As I have already suggested at an earlier point, the difference of opinion here rests largely on a difference of view on the meaning and consequence of inflation and deflation, or rather in the importance attached to two sorts of effects which spring from changes in the quantity of money. The one view stresses what I have called before the self-reversing character of the effects of monetary changes. It emphasizes the misdirection of production caused by the wrong expectations created by changes in relative prices which are necessarily only temporary, of which the most conspicuous is of course the trade cycle. The other view emphasizes the effects which are due to the rigidity of certain money prices, and particularly wages. Now the difficulties which arise when money wages have to be lowered can not really be called monetary disturbances; the same difficulties would arise if wages were fixed in terms of some commodity. It is only a monetary problem in the sense that this difficulty might to some extent be overcome by monetary means when wages are fixed in terms of money. But the problem left unanswered by the authors who stress this second aspect is whether the difficulty created by the rigidity of money wages can be overcome by monetary adjustments without setting up new disturbances of the first kind. And there are in fact strong reasons to believe that the two aims of avoiding so far as possible downward adjustments of wages and preventing misdirections of production may not always be reconcilable.

This difference in emphasis is so important in connection with the opinions about what are the appropriate principles of national monetary policy because, if one thinks principally in terms of the relation of prices to given wages and particularly if one thinks in terms of national wage “levels”, one is easily led to the conclusion that the quantity of money should be adjusted for each group of people among whom a given system of contracts exists. (To be consistent, of course, the argument should be applied not only to countries but also to particular industries, or at any rate to “non-competing groups” of workers in each country.) On the other hand, there is no reason why one should expect the self-reversing effects of monetary changes to be connected with the change of the quantity of money in a particular area which is part of a wider monetary system. If a decrease or increase of demand in one area is offset by a corresponding change in demand in another area, there is no reason why the changes in the quantity of money in the two areas should in any sense misguide productive activity. They are simply manifestations of an underlying real change which works itself out through the medium of money.

To illustrate this difference let me take a statement of one of the most ardent advocates of Monetary Nationalism, Mr. R. F. Harrod of Oxford. Mr. Harrod is not unfamiliar with what I have called the self-reversing effects of monetary changes. At any rate in an earlier publication he argued that “if industry is stimulated to go forward at a pace which cannot be maintained, you are bound to have periodic crises and depressions”.[6] Yet for some reason he seems to think that these misdirections of industry will occur even when the changes in the quantity of money of a particular country take place in the course of the normal redistributions of money between countries. In his International Economics there appears the following remarkable passage which seems to express the theoretical basis, or as I think the fallacy, underlying Monetary Nationalism more clearly than any other statement I have yet come across. Mr. Harrod is discussing the case of unequal economic progress in different countries with a common standard and concludes that “the less progressive countries would thus be afflicted with the additional inconvenience of a deflatory monetary system. Inflation would occur just where it is most dangerous, namely in the rapidly advancing countries. This objection appears in one form or another in all projects for a common world money”.[7] And the lesson which Mr. Harrod derives from these considerations is that “the currencies of the more progressive countries must be made to appreciate in terms of the others”.[8]

It is interesting to inquire in what sense inflation and deflation are here represented as additional inconveniences, superimposed, as it were, on the difficulties created by unequal economic progress. One might think at first that what Mr. Harrod has in mind are the extra difficulties caused by the secondary expansions and contractions of credit which are made necessary by the national reserve systems which I have analyzed in an earlier lecture. But this interpretation is excluded by the express assertion that this difficulty appears under all forms of a common world money. It seems that the terms inflation and deflation are here used simply as equivalents to increases and decreases of money demand relatively to given costs. In this sense the terms could equally be applied to shifts in demand between different industries and would really mean no more than a change in demand relatively to supply. But the objection to this is not only that the terms inflation and deflation are here unnecessarily applied to phenomena which can be described in simpler terms. It is rather whether in this case there is any reason to expect any of the special consequences which we associate with monetary disturbances, that is, whether there really is any “additional inconvenience” caused by monetary factors proper. We might ask whether in this case there will be any of the peculiar self-reversing effects which are typical of purely monetary causes; in particular whether “inflation” as used here with reference to the increase of money in one country at the expense of another, “stimulates industry to go forward at a pace which cannot be maintained”; and whether deflation in the same sense implies a temporary and avoidable contraction of production.

The answer to these questions is not difficult. We know that the really harmful effects of inflation and deflation spring, not so much from the fact that all prices change in the same direction and in the same proportion, but from the fact that the relation between individual prices changes in a direction which cannot be maintained; or in other words that it temporarily brings about a distribution of spending power between individuals which is not stable. We have seen that the international redistributions of money are part of a process which at the same time brings about a redistribution of relative amounts of money held by the different individuals in each country, a redistribution within the nation which would also have to come about if there were no international money. The difference, however, in the latter case, the case of free currencies, is that here first the relative value of the total amounts of money in each country is changed and that the process of internal redistribution takes places in a manner different from that which would occur with an international monetary standard. We have seen before that the variation of exchange rates will in itself bring about a redistribution of spending power in the country, but a redistribution which is in no way based on a corresponding change in the underlying real position. There will be a temporary stimulus to particular industries to expand, although there are no grounds which would make a lasting increase in output possible. In short, the successive changes in individual expenditure and the corresponding changes of particular prices will not occur in an order which will direct industry from the old to the new equilibrium position. Or, in other words, the effects of keeping the quantity of money in a region or country constant when under an international monetary system it would decrease are essentially inflationary, while to keep it constant if under an international system it would increase at the expense of other countries would have effects similar to an absolute deflation.

I do not want to suggest that the practical importance of the deflationary or inflationary effects of a policy of keeping the quantity of money in a particular area constant is very great. The practical arguments which to me seem to condemn such a policy I have already discussed. The reason why I wanted at least to mention this more abstract consideration is that, if it is correct, it shows particularly clearly the weakness of the theoretical basis of Monetary Nationalism. The proposition that the effects of keeping the quantity of money constant in a territory where with an international currency it would decrease are inflationary and vice-versa[9] is of course directly contrary to the position on which Monetary Nationalism is based. Far from admitting that changes in the relative money holdings of different nations which go parallel with changes in their share of the world’s income are harmful, we believe that such redistributions of money are the only way of effecting the change in real income with a minimum of disturbance. And to speak in connection with such changes of national inflation or deflation can only lead to a serious confusion of thought.[10]

Before I leave this subject I should like to supplement these theoretical reflections by a somewhat more practical consideration. While the whole idea of a monetary policy directed to adjust everything to a “given” wage level appears to me misconceived on purely theoretical grounds, its consequences seem to me to be fantastic if we imagine it applied to the present world where this supposedly given wage level is at the same time the subject of political strife. It would mean that the whole mechanism of collective wage bargaining would in the future be used exclusively to raise wages, while any reduction—even if it were necessary only in one particular industry—would have to be brought about by monetary means. I doubt whether such a proposal could ever have been seriously entertained except in a country and in a period where labour has been for long on the defensive.[11] It is difficult to imagine how wage negotiations would be carried on if it became the recognised duty of the monetary authority to offset any unfavourable effect of a rise in wages on the competitive position of national industries on the world market. But of one thing we can probably be pretty certain: that the working class would not be slow to learn that an engineered rise of prices is no less a reduction of wages than a deliberate cut of money wages, and that in consequence the belief that it is easier to reduce by the round-about method of depreciation the wages of all workers in a country than directly to reduce the money wages of those who are affected by a given change, will soon prove illusory.

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[1] Where the shift of demand has been induced by a reduction of cost and a consequent fall of prices in the one country, this will only be a relative rise and will of course only partly counteract this fall in the price of the final product, but may bring about an actual rise in the prices of the factors used in their production.

[2] The assumption that the demand for the commodities in question is elastic, that is that the total expenditure upon them will be reduced when their prices rise and vice versa, will be maintained throughout this discussion. To take at every step the opposite case into account would unduly lengthen the argument without affecting the conclusion.

[3] In a letter to John Wheatley, dated September 18, 1821, reprinted in Letters of David Ricardo to Hutches Trower and Others, edited by J. Bonar and J. Hollander, Oxford, 1899, p. 160.

[4] The fact that the averages of (more or less arbitrarily selected) groups of prices move differently in different countries does of course in no way prove that there is any tendency of the price structure of a country to move as a whole relatively to prices in other countries. It would however be a highly interesting subject for statistical investigation, if a suitable technique could be devised, to see whether, and to what extent, such a tendency existed. Such an investigation would of course involve a comparison not only of some mean value of the price changes in different countries, but of the whole frequency distribution of relative price changes in terms of some common standard. And it should be supplemented by similar investigations of the relative movements of the price structure of different parts of the same country.

[5] The propensity of economists in the Anglo-Saxon countries to argue exclusively in terms of national price and wage levels is probably mainly due to the great influence which the writings of Professor Irving Fisher have exercised in these countries. Another typical instance of the dangers of this approach is the well-known controversy about the reparations problem, where it was left to Professor Ohlin to point out against his English opponents that what mainly mattered was not so much effects on total price levels but rather the effects on the position of particular industries.

[6]The International Gold Problem, Edited by the Royal Institute Of International Affairs. London, 1931, p. 29. Cf. also, in the light of this statement, the remarkable passage in the same author’s International Economics (London, 1933), p. 150, where it is argued, that “the only way to avoid a slump is to engineer a boom” although only two lines later a boom is still “defined as an increase in the rate of output which cannot be maintained in the long period”.

[7]International Economics (Cambridge Economic Handbooks VIII), London, 1933, p. 170.

[8]Ibid., p. 174.

[9] Without giving disproportionate space to what is perhaps a somewhat esoteric theoretical point it is not possible to give here a complete proof of this proposition. A full discussion of the complicated effects would require almost a separate chapter. But a sort of indirect proof may be here suggested. It would probably not be denied that if without any other change the amount of money in one currency area were decreased by a given amount and at the same time the amount of money in another currency area increased by a corresponding amount, this would have deflationary effects in the first area and inflationary effects in the second. And most economists (the more extreme monetary nationalists only excepted) would agree that no such effects would occur if these changes were made simultaneous with corresponding changes in the relative volume of transactions in the two countries. From this it appears to follow that if such a change in the relative volume of transactions in the two countries occurs but the quantity of money in each country is kept constant, this must have the effect of a relative inflation and deflation respectively.

[10] See on this point also L. Robbins, Economic Planning and International Order, 1937, pp. 281 et seq.

[11] It is interesting to note that those countries in Europe where up to 1929 wages had been rising relatively most rapidly were on the whole those most reluctant to experiment with exchange depreciation. The recent experience of France seems also to suggest that a working class government may never be able to use exchange depreciation as an instrument to lower real wages.