Sample Pages From Monetary Reform and the Bellagio Group

8/12/2019 Sample Pages From Monetary Reform and the Bellagio Group

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87

BALANCE OF PAYMENTS, INTERNATIONAL

TRADE AND ECONOMIC DEVELOPMENT,

194956

From the end o the 1940s to the early 1960s the discussion o internationalmonetary problems was ocused on the idea o dollar shortage in non-dollarcountries. Machlup argued that two conditions ailed these countries: rst, thatthey were trying to maintain the oreign-exchange rates o their currencies atlevels that overvalued them relative to domestic prices and incomes, partly inconsequence o excessive expansions o credit; and second, with capital stocksdepleted in the war and post-war period, they had not yet been able to buildup adequate monetary reserves. Te rst problem was a problem o the owsupply o oreign exchange, inadequate because they were paying too little orit; the other was a problem o the stock supply o oreign exchange, inadequate

because it takes time to accumulate reserves even afer the inow has respondedto appropriate adjustment measures. In Machlups view, the dollar-shortage the-orists, like the balance-o-payments theorists afer the First World War, did notunderstand that monetary policy and misaligned exchange rates were the stra-tegic variables. Tey looked or some structural explanations o a supposedlychronic dollar shortage.

In this environment, Machlup presented Tree Concepts o the Balanceo Payments and the So-Called Dollar Shortage at an IMF meeting in 1949.Te three basic concepts are the market balance o payments, a balance o sup-

ply and demand; the programme balance o payments, a balance o hopes anddesires; and the accounting balance o payments, a balance o credits and debits.Te marketbalance is purely hypothetical and addresses questions such as how

would the quantity o oreign currency offered or sale increase or decrease ithe price o oreign currency were 5 per cent higher, with no expectations beingentertained regarding a urther rise or subsequent reduction in that price, and

with no change occurring in the domestic money supply and in national income.Teprogrammebalance may be part o a ormal national plan, a orecast consist-ent with national targets, a projection o past experiences into national planning.


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88 Monetary Reform and the Bellagio Group, Volume 1

Teaccountingbalance is an arrangement o statistical data derived rom records,reports and estimates, organized by conventional categories and with all itemsoperationally dened. Te meaning o equilibrium or disequilibrium, surplus ordecit, depends on ones denition o balance o payments.

Whether and under what conditions the trade balance o a country wouldbe improved by a depreciation or devaluation o its currency in the oreign-exchange market had been debated with reerence to elasticities and/or torelative monetary expansion; in his remarks on Te Elasticity Argument orForeign Exchange Restrictions to the International rade Meeting o theEconometric Society, Machlup took on the arguments made by Guy Orcutt andRaymond Mikesell.

In his paper Measurement o Price Elasticities in International rade Orcutthad argued that statistically estimated price elasticities are unreliable or use in

predicting the effects o a relative depreciation and probably considerably under-estimate the effectiveness o such a depreciation.1Mikesell argued that incomeand price elasticities o demand, based on a historical relationship betweenincome, imports and relative prices, were subject to error and were mislead-ing. He urged more attention to the probable reaction o oreign and domesticsuppliers o individual commodities in order to reach conclusions on tariff andoreign exchange policies.2

In Machlups view, elasticities are relevant i one discusses given conditions osupply and demand, otherwise monetary variables have the leading roles. When

the elasticity pessimists contended that actual elasticities were too low to prom-ise any improvements in the trade balance, Machlup attempted to show whytheir pessimism was not justied. When balance-o-payments theorists disre-garded or downgraded the role o monetary policy, Machlup attempted to showthat the role o money in the play o market orces was strategic.

In Replies by Economists in Monetary Policy and the Management o thePublic Debt, Machlup addressed the impact o rising interest rates and creditexpansion on business investment, as well as direct controls and credit con-trols in a system o ree enterprise in his response to a series o questions putorward by the Joint Committee on the Economic Report, Subcommittee onGeneral Credit Control and Debt Management (1952). He offered his recom-mendations or non-inationary economic developmentin his notes or a speech

(1955) and paper on Te Finance o Development in Poor Countries: ForeignCapital and Domestic Ination (1956).

Notes1. Report o the New York Meeting,Econometrica18:3 (1950), pp. 264309, on p. 284.2. Ibid., pp. 2845.


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89

Fritz Machlup Papers, Hoover Institution, Box87, Folder 26, Three Concepts of the Balance ofPayments,Paper, International Monetary FundSeminar, Washington, DC, typewritten outline,

21 October 1949. Copyright Stanford University.

October 12, 1949Miss Gertrude Lovasy

International Monetary FundWashington 6, D. C.

Dear Dr. Lovasy:Tank you or your letter o October 7. I noted that Friday, the 21st, is an

agreeable date or my perormance beore your Seminar. Te title o my paper

is Tree Concepts o the Balance o Payments. I am enclosing a separate sheetwith a ew lines on its contents.I am usually in Washington on Fridays, working in the Library o Congress. I

can thereore arrange to have lunch with some o your group. Please let me knowwhat time you want to have me. I doubt that I can accept your kind invitation tocome to your house afer the Seminar. I have quite a bit o work scheduled and

will be anxious to get back to Baltimore afer the Seminar.Very cordially yours,Fritz MachlupEnclosure /

HREE CONCEPS OF HE BALANCE OF PAYMENS

Paper by Proessor Fritz Machlup, Johns Hopkins University, to be Presented beoreTe International Monetary Fund Seminar on Friday, October 21, 1949, 4 p.m.

Much o the conusion in the discussion o the dollar shortage and the dollarbalance o payments goes back to continued equivocation. Tree undamentallydifferent ideas are continually called by the same name. What is indiscriminatelycalled the balance o payments may be: I a market balance, i.e., a balance o sup-


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ply and demand; or II a program balance, i.e., a balance o hopes and desires; orIII an accounting balance, i.e., a balance o credits and debits.

Te meaning o a decit in the balance o payments is, o course, categori-cally different or each o the three basic concepts. Even within each conceptthere may be several different decits, depending on a number o arbitrary de-nitions, assumptions, hypotheses, judgments, or objectives.

I. A dollar decit in a countrys market balance o payments may be tenta-tively dened as an excess o dollar amounts effectively demanded at the givenexchange rate by would-be purchasers (who are not restricted by speciallyadopted or discretionary government control measures) over the dollar amountssupplied at that exchange rate by would-be sellers (who are not motivated by adesire to support the exchange rate).

II. A dollar decit in a countrys programme balance o payments may bedened as an excess o dollar amounts needed or desired / or some specied

purposes (assumed to be important with reerence to some accepted standards)over the dollar amounts expected to become available rom regular sources.

III. A dollar decit in a countrys accounting balance o payments maybe dened as an excess o dollar amounts entered on the debit side o certainaccounts in the annual record o its international transactions over the dollaramounts entered on the credit side o the same accounts, the accounts beingselected rom the ull, necessarily balancing statement in order to throw lightupon problems connected with market or programme balances o payments.

Te concept o compensatory offi cial nancing recently proposed by theInternational Monetary Fund is a novel attempt to do the impossible. It suffersrom several contradictions but chiey rom an ambition to think simultane-ously o market balances and program balances.1


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91

Fritz Machlup Papers, Hoover Institution, Box 87,Folder 28, The Elasticity Argument for ForeignExchange Restrictions, remarks, International TradeMeeting, Econometric Society. Holograph and

typewritten abstract, 28 December 1949. CopyrightStanford University.

December 28, 1949

Te Elasticity Argument or Foreign Exchange Restrictions

Many economists distrust or dislike the working o the market mechanism inoreign exchange markets and advocate direct restrictive controls. Among the

economic rather than chiey political reasons which they give or their posi-tion, the ollowing three stand out:

1. Te terms o trade argument:Te disequilibrium exchange rates and exchange rationing give us better

terms o trade than we could have with equilibrium exchange rates and withoutexchange rationing. In other words, the national income would be smaller i themarket equilibrium were to be established through depreciation.

2. Te income distribution argument:Te disequilibrium exchange rates and exchange rationing are essential or

their effects upon domestic income distribution. In other words, the nationalincome distribution would be less equitable i market equilibrium were to be

established through depreciation.

3. Te elasticity argument:Equilibrium exchange rates are not attainable because the elasticities

o demand or imports and exports are too low or exchange rate changes toimprove the market balance o payments. In other words, market equilibriumcannot be established or approached through depreciation.


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wo o the papers presented today, Orcutts and Mikesells,1were addressed tothe elasticity argument and my comments will be conned to it. Both papers

were critical o the elasticity pessimism expressed in recent years. Since I toobelieve that the elasticity pessimism is not justied, I intend to conrm, ratherthan criticize the contentions o the two speakers.

Te elasticity pessimism expresses itsel in two ways: First, in underesti-mating the actual magnitude o the elasticities. Second, in overestimating themagnitude o the elasticities required or remedial effects o depreciation.

Why the actual elasticities have been underestimated.

1. Te statistical techniques used by those who computed price elasticitieso demand or imports imply index number techniques which have astrong bias toward underestimation. Tis was shown yesterday in paperby Harberger.2

2. As Orcutt has shown, the data used in the computations are over a periodo twenty years, during which certain shifs in the demand situationinvolve a bias toward low estimates.

3. As Orcutt has shown, errors o observation are more likely on prices andincomes than on quantities. Tis implies, or statistical reasons, anotherbias toward underestimation.

4. Te data used were chiey those concerning goods whose prices didchange more signicantly, hence goods with low demand elasticities; the

goods or which demand is likely to be more elastic were not adequatelyrepresented in the data.

5. Te computations were conned to short-term effects, whereas it is thelong-term effects which involve higher elasticities.

6. Te observations were only or small price changes, while larger pricechanges, or which elasticities are probably greater, are more relevant or

problems o depreciation.7. Te computations did not assume any time lags, whereas no one may

expect real adjustments to come about without time lags.

Implied in these propositions are the ollowing points which deserve explicitemphasis:

A. Tere are products which become exportable below a certain price,but are not exported when the price is higher. Such goods were notincluded in the computations.

B. Tose who take pessimistic elasticity estimates made or one period andapply them to another implicitly assume that the elasticities are nearlyconstant (a) overtime, (b) or different income levels, and (c) over di-erent price ranges. On the basis o general theory, the presumption is


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Te Elasticity Argument for Foreign Exchange Restrictions 93

that elasticities will be quite different. Tis is especially so with regardto different price ranges. Te elasticity o demand between $4.00 and$3.50 may be altogether different rom that between $3.50 and $3.00.One should not apply an estimate derived rom small variations at one

price level to variations by different margins and at different levels.Both Orcutt and Mikesell have made this quite clear.

C. Te neglect o time lags in elasticity computations has three resultsall o which may result in underestimations. (a) rade gures imme-diately afer price changes cannot well reect the response to the

price changes. A period o six or even twelve months must thereoreinclude a signicant portion during which trade was not yet affectedby the new prices. (b) I price reductions are gradual, expectationso urther reductions will affect trade in the opposite direction romthat resulting rom a price reduction that is regarded as the one andonly change. rade gures working with annual price averages with-out lags will include these temporarily perverse reactions o trade.(c) Te more signicant long-term adjustments are excluded by theshort-period trade data without lags.

Why the required elasticities have been overestimated.3

5. Many o the pessimistic observers regard elasticities as too low or com-ort because they believe the critical value o the sum o price elasticities

o demand or imports and exports is unity, whereas this can be true onlyor innite elasticities o supply. For smaller elasticities o supply thesum o the two demand elasticities may be well below unity or remedialeffects upon the market balance o payments.

6. Most o the pessimistic observers orget that the socalled critical valueo elasticities has been determined by theorists or a situation in whichexports and imports are initially equal. Since countries which thinko currency depreciation as a rule have an import demand in excess oexports, the critical value o elasticities is much lower. For example,i exports are 100 while the import demand is 200, and i the supplyelasticities are innite which is the worst possible case and i theelasticity o the oreign demand or exports is only -.4, the balance willbe improved by exchange deprecation i the elasticity o the domesticdemand or imports is higher than -.32. Te critical value o a sum othe two elasticities is only 7.2. For supply elasticities below innity, thecritical values may be still smaller.

10 % depreciation reduces exports by 4%, i.e. by $6.4 increases dollar demand or imports .32%, i.e. by $6.4


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7. Te hope, expressed by Mikesell, that the recent exchange rate adjustmentwill give us a chance to learn a great deal about the relevant elasticitiesthrough observations o the results as reected in the trade statisticssoon to become available, is in vain. We must not orget that the mar-ket demand or dollars is not reected in any trade gures when oreignexchange rationing is used. Te most signicant effect o depreciationmay be the reduction o the unsatised excess demand or dollars. Temarket balance o payments may be improved, that is, the excess demandor dollars may be reduced in consequence o the depreciation while thestatistics may record a reduction in the supply o dollars. Tose who areuntrained in economic theory will shout that the depreciation is a ailurei it reduces the visible dollar supply; they ail to see the reduction in thedemand or dollars because that demand, being suppressed by the authori-ties, has been invisible. Under a system o dollar rationing a reductionin the excess demand or dollars, in consequence o a depreciation o anational currency, will not be reected in any international trade statistics.

Te Neglect o Supply Elasticities

o concentrate attention, in the analysis o the effects o exchange rate changes,on the elasticities o (oreign) demand or exports and o (domestic) demandor imports, and to neglect the elasticities o the supply o these imports andexports, has a very denite result. For it is not possible to neglect the sup-

ply elasticities without making implicit assumptions about them. When ananalyst assumes that a certain percentage change in the exchange rate changesthe price o the imports accordingly, he implies that the oreign price o theimported goods remains unchanged. But in postulating that the oreign price isunchanged although the quantity o goods purchased is increased or reduced, heimplicitly assumes that the elasticities o supply are innite.

Te result o this implicit assumption upon the analysis o the effects oexchange rate changes is very serious. We can see this by a very simple example,

without algebra, geometry, or calculus. Assume that the Italian lira is depreci-ated by 10 percent, that the elasticity o Italian demand or imports is -0.5 andthe elasticity o the oreign supply o these imports is innite. In this case theItalian prices o imports must increase by 10 percent, the physical volume oimports will decrease by (approximately) 5 percent and, since the dollar prices othe imports are unchanged, the dollar value o imports will likewise be reducedby (approximately) 5 percent. Now we shall change the assumptions by givingthe elasticity o the oreign supply o imports a smaller value; we shall, in orderto avoid complications in the computation, assume it to be numerically equal tothe elasticity o Italian demand, that is, +0.5. As the depreciation raises Italianimport prices and reduces Italian purchases o imports, oreign prices will all.

With equal demand and supply elasticities, each country will bear one hal o


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the price movement. Tus, Italian prices o imports will increase by (approxi-mately) 5 percent and the oreign prices decrease (approximately) by 5 percent,in consequence o the 10 percent depreciation. * Te physical volume o Italianimports will decrease by (approximately) 2 percent, and the dollar value willbe reduced by (approximately) 7.4 percent. (Te Italians will buy 97.5 percento the previous imports at a unit price o 95 percent, i.e. or 92.6 percent o the

previous dollar amount). Te difference in the assumption regarding the sup-ply elasticity accounted or a difference o 47 percent (7.4 as against 5) in theresulting reduction o the dollar value o imports.

Te effects o depreciation upon export values are analogously distorted bythe implicit assumption o innite elasticities o supply o exports. With an elas-ticity o (oreign) demand or (Italian) exports o -0.5, a 10 percent depreciationo the lira will, with unchanged Italian prices, reduce the oreign prices o theexports by 10 percent, increase the physical volume o exports by (approximately)5 percent and reduce the dollar value o exports by (approximately) 5.5 percent.(Te oreigners will buy 105 percent o the previous physical volume o exportsat prices which are 90 percent o the ormer prices, hence they will pay 94.5 othe previous dollar amount). I we now change the assumptions concerning theelasticity o supply o Italian exports and make it, or the same reason as beore,numerically equal to the demand elasticity, namely + 0.5, we have to gure withan increase in Italian export prices, as physical exports increase, until these pricesare up by 5 percent in lira and down 5 percent in dollars. Te physical volume o

exports will consequently be increased by only 2.5 percent, and the dollar valueo exports reduced by only (approximately) 2.6 percent. (Te oreigners will buy102.5 percent o the previous physical volume o exports and pay 95 percent othe previous prices, hence 97.4 o the previous amount o dollars).

When we assumed the elasticities o supply o imports and exports to beinnite, and the elasticities o demand or imports and exports each to be -0.5,

we ound that the depreciation by 10 percent would result in a 5 percent reduc-tion in the dollar value o imports and a 5 percent reduction in the dollar valueo exports. Tere was, thereore, no net balance created by the depreciation

provided exports and imports initially were equal. When we assumed the elas-ticities o supply to be numerically equal to the elasticities o demand, which

were again -0.5 or imports as well as exports, we ound that 10 percent depre-

ciation resulted in a 7.375 percent reduction in the dollar value o imports anda 2.625 percent reduction o the dollar value o exports. I exports and imports

were initially equal, the depreciation would have created an export surplus o4.750 percent o the precious dollar value o exports.

* Te price changes will be closer to 4.76 percent, because 110 (100 4.76 ) = 100(100+4.76)


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Te Neglect o Supply Elasticities4

How seriously will the results o our thinking be affected i, in the analysis o theeffects o exchange rate changes we concentrate on the elasticities o (oreign)demand or exports and o (domestic) demand or imports and neglect the elas-ticities o the supply o these exports and imports?

It is logically impossible to neglect the supply elasticities without mak-ing implicit assumptions about them. When an analyst assumes that a certain

percentage change in the exchange rate will change the price o imports accord-ingly, he implies that the oreign price o the imported goods remain unchanged.But in postulating that the oreign price is unchanged although the quantity o

goods purchased is increased or reduced, he implicitly assumes that the elastici-ties o supply are innite.

Te assumption o innite elasticities o supply may be highly unrealisticwithout being atal to an argument based on it. It may simpliy the analysiswithout invalidating it. Making a check in this respect or the simple case ounitary demand elasticities, we can readily see that it would make no differenceat all whether the supply elasticities are small, large or innite. I the elasticityo the demand or exports is -1.0, the oreigners will spend a constant amounto dollars regardless o the price o the export goods. I the elasticity o thesupply o these exports is innite, so that their domestic price is unchanged, theoreign price will be reduced exactly by the percentage by which the currencyo the export country, say, the Italian lira is depreciated. I the elasticity o the

supply o Italian exports is less than innity, the prices in lire will increase as thequantity o exports increases and thus, the oreign prices will not all by the ull

percentage o the depreciation. But be this as it may, with a unitary elasticityo the oreign demand or Italian exports, the total amount o oreign exchangesupplied by exporters will remain unchanged, and, thereore, is independent othe elasticity o supply o exports.

Te same is true with regard to the amount or oreign exchange demandedby importers. I the elasticity o demand or imports is -1.0, the amount odomestic money spent on imports remains unchanged when the domestic priceso imports change. Depreciation will increase these domestic prices by the ull

percentage o the depreciation i the elasticity o the (oreign) supply o importsis innite and by less than that percentage i the elasticity is smaller. But in anycase, the unchanged amount o lire will represent an amount o oreign exchangealling short o the amount demanded beore the depreciation by exactly the per-centage by which the lira is depreciated. Tus, the demand or oreign exchangeis not affected by the elasticity o the oreign supply o imports i the elasticity othe (domestic) demand or them is unity.


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Higher Demand Elasticities

We must not conclude rom this check that the elasticities o supply will alwaysbe irrelevant or the supply and demand o oreign exchange. An example withdemand elasticities numerically greater than unity will show that the supply elas-ticities may matter very much.

Assume that the Italian lira is depreciated by 10 percent, that the elasticity oItalian demand or imports is -2.0, and that the elasticity o the oreign supply othese imports is innite. In this case the Italian prices o imports must increaseby 10 percent, the physical import demand will decrease by (approximately*)20 percent and, since the dollar prices o the imports are unchanged, the dollar

value o import demand will likewise be reduced by (approximately) 20 percent.We shall now change the assumptions by giving the elasticity o the oreign

supply o imports a value smaller than innity; we shall, in order to avoid com-plicated computations, assume it to be numerically equal to the elasticity oItalian demand that is, +2.0. As the depreciation raises Italian import pricesand reduces Italian purchases o imports, the oreign prices o these imports willdecline. With numerically equal elasticities o demand and supply, each country

will bear one hal o the price adjustment. Tus, Italian prices o imports willeventually have increased, and the oreign prices decreased, by (approximately)5 percent as a result o the 10 percent depreciation o the lira. Te physical

volume o imports demanded by Italians will decrease by (approximately) 10percent and their dollar value by (approximately) 14.5 percent. (At dollar prices

95 percent o their previous level, Italians will demand 90 percent o the importspreviously demanded, thus imports in a dollar value o 85.5 percent o the pre-depreciation value).

Te difference in the assumption regarding the supply elasticity accountedor a considerable difference in the demand or dollars; with the smaller supplyelasticity the amount o dollars demanded by importers ell by only 14.5 percent,rather than 20 percent as it did with the innite supply elasticity.

Te effects o depreciation upon export values are analogously distorted bythe implicit assumption o innite elasticities o supply o exports. A 10 percentdepreciation o the lira will, with unchanged Italian prices, reduce the oreign

prices o the exports by 10 percent; with an elasticity o the (oreign) demandor (Italian) exports o -2.0, the physical volume o exports will increase by(approximately) 20 percent and the dollar value o exports by (approximately) 8

* I a ormula or demand elasticity is used which satises the conventional consistencytests, the quantity o imports should all only y 16.6 % because 83.33 is the gure whichis raised to 100 by an increase o 20%.

Te price changes will be closer to 4.76 percent, because 110 (100-4.76) = 100 (100 +4.76).


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percent. (Te oreigners will buy 120 percent o the previous physical volume oexports at prices which are 90 percent o the ormer prices; hence, they will pay108 percent o the previous dollar amount).

We shall now change the assumptions concerning the elasticity o supply oItalian exports and make it, or the same reason as beore, numerically equal tothe elasticity o demand or these exports, namely + 2.0. As physical exportsrom Italy increase, in consequence o the depreciation, their prices will rise untilthey are up (approximately) 5 percent in lire and down (approximately) 5 per-cent in dollars. Consequently, the physical volume o exports will be increasedby (approximately) 10 percent and the dollar value o exports by (approximately)4.5 percent. (Te oreigners will buy 110 percent o the previous physical vol-ume o exports and pay 95 percent o previous dollar prices, hence 104.5 percento the previous total amount o dollars). Te increase is only 4.5 percent, asagainst the 8 percent when the elasticity o the supply o exports was innite.

Te neglect o the elasticities o supply o exports and imports would, inthis example, give an unduly optimistic picture o the effects o exchange depre-ciation o the trade balance.

Lower Demand Elasticities

Simple arithmetic examples have the great advantage over demonstrations withhigher orms o mathematics that they can be more generally understood.Teir disadvantage is that they may mislead into illegitimate generalizations.

Someone given to quick generalizations may conclude rom the preceding exam-ple that a less than innitely elastic supply o exports makes it harder to improvethe balance o payments by means o exchange depreciation. Such a conclu-sion would be wrong. We need only try another example, this time one withlower demand elasticities, in order to nd out that lower supply elasticities canalso pull in the opposite direction, that is, can strengthen the remedial efforts odepreciation upon a balance o payments decit.

[Note rom Machlup: Keep or later]

Neglecting the supply elasticities by implicitly assuming them to be innite,some economists regard unity as the critical value o the sum o demand elas-

ticities; critical in the sense that elasticities o the demand or imports and o thedemand or exports adding up, numerically, to less than 1 would be too low ordepreciation to improve the trade balance, and indeed would make depreciationoperate in the reverse direction.

We shall see how depreciation will affect the importer demand and export-ers supply o oreign exchange i the two demand elasticities are only -0.5, so thatthey add up to -1.0, and i two supply elasticities are rst innity and then just aslow as the demand elasticities.


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January 13, 1950Mr. William B. Simpson

Managing EditorEconometric Society

University o ChicagoChicago 37, Ill.

Mr dear Simpson:Afer much struggle I was able to condense the abstract o my remarks5at

the International rade meeting o the Econometric Society to exactly eighteenlines, as prescribed in your circular letter o December 19. I am enclosing theabstract in this letter.

Sincerely yours,Fritz Machlup

Enclosure

FRIZ MACHLUP: Fear that the magnitudes o the relevant elasticities aresuch as to prevent the ree-market mechanism rom working satisactorily maybe called elasticity pessimism. Elasticity pessimism in international-trade theorymakes many economists advocate oreign-exchange restrictions. Most o themunderestimate the actual price elasticities o demand or imports and exports,and overestimate the price elasticities required or exchange depreciation to haveremedial effects. Te underestimation o the actualelasticities is chiey due to the

statistical techniques and erroneous interpretations o data. Mikesell, Orcott, andHarberger have enumerated several reasons why estimates have been too low. Teoverestimation o the required elasticities is due chiey to two errors o reasoning:(1) it is wrong to regard unity as the critical value or the sum o the elasticitieso demand or exports and imports except i the elasticities o supply are innite.

With lower elasticities o supply, depreciation may have remedial efforts even ithe sum o the elasticities o demand is below unity. (2) Where initially an importsurplus exists, the critical value o demand elasticities is still lower, because a per-centage reduction in the value o imports will be absolutely more signicant thana similar percentage reduction in the value o exports.


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100

Fritz Machlup Papers, Hoover Institution, Box 88,Folder 18, Replies by Economists, in MonetaryPolicy and the Management of the Public Debt,United States Congress, Joint Committee on the

Economic Report, Subcommittee on General CreditControl and Debt Management, 1952. Typescript.Includes printed copy of questions. CopyrightStanford University.

QUESIONS FOR ECONOMISS

1. What are your views o the effects o credit policies resulting in relatively smalland relatively large changes in interest rates, respectively, upon (a)the lending

policies o commercial banks, (b)the lending policies o nonbank investors, (c)consumer saving, (d)business plant expenditure programs, (e) business inven-tory policy?

2. How important do you consider the expansion o credit to be in the totalityo actors underlying the post-Korean inationary boom? Te postwar boom in194548? How would you appraise the effectiveness o (a)general and (b)selec-tive credit policy in coping with (i) a high level o private capital investment, (ii)a high level o consumer spending, (iii) large present or prospective Governmentexpenditures, (iv) the wage-price-arm support spiral?

3. What do you believe to be the appropriate roles o direct (e. g., price andwage) controls, selective credit controls, and a general tightening o credit asmeans o restraining ination (a)when the reasury is not expected to be a largeborrower in the oreseeable uture, (b)when a large volume o reasury reund-ing operations will have to be effected in the oreseeable uture, (c)when it isexpected that the reasury will be a large net borrower during the oreseeableuture, (d)under conditions o total war?


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Replies by Economists 101

4. Do you believe that it would be (a)desirable and (b)possible to insulate pub-lic debt securities in whole or in part rom the impact o restrictive credit policiesdesigned primarily to discourage the growth o private debt? Do you have anyconcrete suggestions or action in this regard?

5. o what extent do you believe that the demand or Government and otherhigh-grade, xed-interest-bearing securities by nonbank investors is inuencedby (a)the current level o interest rates, (b)expectations with respect to changesin interest rates, (c)other actors?

6. Discuss the merits and demerits o the proposal or the issuance o a bond, thevalue o which would be guaranteed in terms o purchasing power.

7. What types o securities do you believe should be the principal vehicles oGovernment borrowing (a)under present conditions, (b) in the event o thenecessity or substantial net Government borrowing?

8. Under what conditions, i any, do you believe it would be desirable to resort tocompulsory methods in the sale o Government securities to (a)banks, (b)othernancial institutions, (c)other corporations, (d)individuals?1/

January 8, 1952Te Honorable Wright Patman, Chairman

Sub-Committee on General Credit Control and Debt ManagementCongress o the United States

Washington, D. C.Attention: Dr. Murphy

Dear Sir:I should very much like to make a slight correction in the answers which I

submitted a ew weeks ago to your questions or economists. On page 6 o myanswers in line 7 when I dened total war as one in which at least hal o thegross national product goes or military and deense expenditures, I should liketo have national income substituted or gross national product. I hope that thiscorrection can be effected.

Sincerely yours,Fritz Machlup /


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ANSWERS O HE QUESIONS FOR ECONOMISSOF HE SUB-COMMIEE ON GENERAL CREDI

CONROL AND DEB MANAGEMEN OF HE JOINCOMMIEE ON HE ECONOMIC REPOR

I. Effects o Credit Policy Resulting in Changes in Interest Rates.

Several attempts have been made in recent years to prove at the same time thatinterest rates have little or no inuence upon economic activity and that anincrease in interest rates has a bad effect and should be avoided. It takes no great

intelligence to recognize that it is impossible or both o these statements to betrue. As a matter o act, both are alse. Changes in the interest rate may have

very denite effects upon economic activity, and an increase in interest rates maysometimes be a necessary part o a program designed to avoid excessive ination.

Note: It is necessary or an understanding o the problems involved to give asuffi ciently extensive interpretation to the meaning o interest rates. In particu-lar, we must not restrict the meaning o this term to discount rates or contractualrates on bank loans or on industrial advances, but we must include the actual

yields on bonds and stocks. We must also include the effects o credit rationingupon the internal calculations o borrowers because, afer all, a smaller ration ocredit available to a business rm is equivalent to a higher rate o interest. Teterms increase or reduction o interest rates should thereore not be under-

stood too literally but in the wider meaning just indicated.

(a) Effects on Lending Policies o Commercial Banks.Te traditional textbook theories are still valid. It is possible through

appropriate policies o the Federal Reserve Banks to bring about an increase ininterest rates that will cause commercial banks to restrict their lending activities.Reduced excess reserves o commercial banks and higher yields o Governmentbonds will tend to reduce the incentive o banks to grant mortgage loans, con-sumer loans, and even business loans either at the same interest rates or in thesame amounts as they otherwise would have. Tat is to say, suffi ciently increased

yields o Government bonds restrict the availability o unds to home owners,consumers, and business rms, and thereore restrict private expenditures that

compete with Government / or scarce resources and drive up prices.

(b) Effects Upon Lending Policies o Non-Bank Investors.Here the chie effects will be on the kinds o earning assets that non-bank

investors seek or their portolios. For example, at a low yield o Governmentsecurities, insurance companies may invest large amounts in mortgage loans orconstruction programs; when the yield o Government securities is higher the


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insurance companies may preer to give their unds to the Government. Tiswould make new bank credit less necessary or unnecessary to nance Govern-ment expenditures, and thus would reduce inationary pressures.

(c) Effects upon Consumer Saving.Many economists are too near-sighted to see these effects, which work

chiey in three ways:First, consumer spending is enhanced by capital gains, and reduced by capi-

tal losses; higher interest rates depress the value o securities and other durableassets; consumers will reduce their expenditures when they have suffered capitallosses and their wealth is reduced in relation to their income.

Secondly, many consumers nd it more attractive to save when interest ratesare higher and they can expect higher interest income rom their assets and havebetter chances or capital gains in the uture when the depressed security pricesmay rise again.

Tirdly, higher interest rates raise the prices consumers have to pay or thingsbought on installment plans. For example, at higher interest rates given amountso monthly installments will buy less automobiles or rerigerators than at lowerinterest rates. Tus, given amounts o consumers outlay will make smallerdemands on scarce resources. /

(d) Effects upon Business Plant Expenditure Programs.Increased interest rates may have only small direct effects on business invest-

ment programs, but the indirect effects are important. Te direct effects oincreased interest rates, the increased diffi culty o obtaining mortgage loans ando selling new securities to raise unds in the capital market, may extend to rela-tively ew people, but the repercussions o the reduced purchases o even a ewmay be o considerable importance in reducing business investment programs. Inother words, the indirect effects o increased interest rates reach most business-men in a disguised orm, namely, as reductions in the demand or their products.For example, i only a ew residential builders were directly inuenced by higherinterest rates to postpone their projects, the demand or thousands o productsthat go into residential construction would thereby be reduced and incentives toexpand plant capacity or thousands o producers goods would be dampened.

Note: Tere are those who try to learn about the effect o interest rates upon

business investment by asking the businessman How are you affected by anincrease in the interest rate? But the businessman never knows, since what he

would notice is merely a slackening in the demand or his product and he wouldhave no reason to connect this with interest rates. It is the economists job tounderstand the relationships which the businessman cannot see. I economics

were so simple that we could nd out matters by asking businessmen, we wouldhave no use or economists.


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(e) Effects upon Business Inventory Policy.Considerable business inventories are held as a protection against rising

prices. I the businessman expects that next year the prices o his raw materialswill be ten percent higher, it will certainly pay him to keep large inventories. Buti the interest rate is ten percent per annum, his incentive to carry large invento-ries is obviously diminished. Hence, an increase in interest rates tends to reducethe demand or materials to be held in stock. /

II. Te Role o Credit Expansion in the Recent Ination

I am sure the Committee has at its disposal all the statistical evidence showing

the large rate o expansion o bank credit in the post-war boom in 194548 andagain in the post-Korean inationary boom. Te data are most impressive, and Idoubt that anyone can deny the leading role which bank credit expansion playedin the ination during these years. From what was said in answer to question I,it should be obvious that credit policy could have helped reduce (i) the highlevel o private capital investment, and (ii) the high level o consumer spending.It probably could not have prevented or sharply reduced (iii) the high rate oGovernment expenditures or national deense or (iv) the expenditures arisingout o our arm price support program. On the other hand, it could have put adamper on the wage-price spiral because it was chiey the high rate o effectivedemand swelled by increased expenditures by consumers and business that madebusinessmen yield with little resistance to the demands or higher wages and

made trade unions adamant in insisting on them.

III. Direct Controls vs. Credit Controls.

Te use o direct controls over many years may undermine and eventually destroythe ree enterprise system. o the extent to which there is a choice betweendirect controls and credit controls, advocates o the ree enterprise system (ithey know what they are doing) will ght the use o direct controls and avorthe use o credit controls. I suspect that many who have voted or direct controlsare not aware that every such vote is a vote against the ree enterprise system. /

It is true, o course, that in emergencies the use o direct controls or brieperiods may be unavoidable and that the comparative roles o credit controls and

direct controls are different in the different situations outlined in the questionso the Committee.

(a) When the reasury is not expected to be a large borrower in the ore-seeable uture, and any inationary expenditures are thus merely those obusinessmen and private consumers, credit controls can remove all inationary

pressures and direct controls are sheer stupidity or measures o avowed advo-cates o authoritarianism.


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(b) When a large volume o reasury reunding operations will have to beeffected in the oreseeable uture, one can understand that the reasury willnot like an increase in interest rates. Te rst question then is whether we cannd ways and means o getting reasury issues placed at low rates despite theincreased interest rates required in an anti-inationary credit policy. (Tis mightbe possible by the adoption o proposals such as the Eccles plan or secondarybank reserves.) I this should not be easible, the second question is whether itis better to burden the reasury with higher interest rates or burden the wholeeconomy with the expensive machinery o direct price and allocation controls.In my opinion, the higher interest burden on the reasury is the much smallerevil rom the point o view o the nation.

(c) When it is expected that the reasury will be a large not borrower dur-ing the oreseeable uture, the alternatives are still the same as under (b). I newissues o the reasury cannot be placed at preerred rates, it will still be muchless costly in the long run or the nation to pay more or the public debt thanto put its economy into the shackles o direct economic controls. Higher inter-est rates along with higher tax rates can / effectively reduce private demand orthe resources needed or deense production. Te use o direct controls or this

purpose or long periods is economically wasteul, even apart rom the seriousdanger which it involves or the survival o a ree society.

(d) Under conditions o total war the introduction o some direct con-trols may be necessary. otal war may be dened as one in which at least hal

o the gross-national income goes or military and deense expenditures. Undersuch circumstances some o the reallocations o productive resources which thenation has to effect may have to be supported by direct controls. Tis, however,does not reduce the need or scal and monetary controls. Even in total warthe chie burden o keeping down the rate o ination should be on scal andmonetary policy. Tat is to say, ination should be combatted rst and oremostby reducing through high tax and interest rates the amounts o money that con-sumers and businessmen have available or their expenditures.

IV. Preerred reatment or Public Debt

As was indicated in the previous question, I believe it is desirable and possible toinsulate public debt securities rom the impact o anti-inationary credit poli-cies. Some such plans as modication o reserve requirements to the effect thatcommercial banks must keep a secondary reserve in the orm o Governmentsecurities may serve this purpose.


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V. Te Demand or Government Securities

Te demand or Government securities on the part o non-bank investors isgreatly inuenced by the current level o interest rates as well as by expectations

with respect to changes in interest rates. Te demand or / Government bonds isvery elastic. I the yield o Government securities is more attractive, such securi-ties will be a avored substitute or other assets. Moreover, i the yield is high, thelikelihood o a subsequent all in security prices is small and investors will be lessapprehensive o the possibility o capital losses. A security yielding three percentcan easily all in price because everybody remembers that yields can go muchhigher. I the yield, however, is increased, the holding o Government securi-

ties may despite a momentary shock to large holders become very attractiveto those who look or appreciation o their investment as well as to those wholook or income.

VI. Purchasing Power Bonds

Te question o bonds guaranteed in terms o purchasing power would neverhave arisen i the Government had pursued an anti-inationary monetary pol-icy. Now that we have had ination or several years. I believe that the issuanceo such bonds should be seriously considered. Indeed, we may regard this as aquestion o ethics as much as o economics. For it is immoral or a governmentto inveigle its people into buying its securities not secured against deterioration

in purchasing power while that government at the same time pursues a policywhich must o necessity result in reducing the real value o its money and o itsmoney debts. o advise people to buy bonds while we know that those who donot buy them will be relatively better off, is not ar rom raudulent. Tose whoare perpetrating this deception may be under the delusion that price controls

will protect the bondholders. No price controls, however, have ever succeededin doing this in the long run. Hence, i we wish people / to put their savingsinto government bonds, we should pursue the strictest anti-inationary scaland monetary policies or we should promise the buyers o bonds that they willnot suffer rom inationary policies o the government.

FRIZ MACHLUPProessor o Political Economy

Te Johns Hopkins UniversityDecember 19, 1951


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Notes to pages 8199 377

Whats Best for the Competitive Enterprise System?

1. DELIVERED PRICING and the FUURE OF AMERICAN BUSINESS: Te CementCase of 1948, which declared that the concerted use of the multiple basing point systemof price-making was a violation of the anti-trust statutes. Te Federal rade Commis-sion was particularly alert to price add-ons (over and above the quoted price) based ongeographic location as well as collusion among competitors in the adoption of delivered

pricing methods. See S. Kittelle and G. Lamb, Te Implied Conspiracy Doctrine andDelivered Pricing, Duke University Law Journal, at http://scholarship.law.duke.edu/cgi/viewcontent.cgi?article=2444&context=lcp [accessed November 2013].

2. My ndings will appear in the orm o a book: F. Machlup, Te Basing Point System(NewYork and Philadelphia, PA: Blakiston Company, 1948). Machlup describes basing point

pricing, its commercial, legal, economic and political importance, in three representativeindustries steel, cement and corn products. He also considers the impact of the basing

point system on competition, transportation costs, price structure and exibility, indus-try concentration in basing point industries and productive capacity.

Tree Concepts of the Balance of Payments

1. It suffers fom several contradictions program balances: Machlup would expand thisargument in his article, Tree Concepts of the Balance of Payments and the So-calledDollar Shortage,Economic Journal,60:237 (1950), pp. 4668.

Te Elasticity Argument for Foreign Exchange Restrictions

1. Orcotts and Mikesells: Guy Henderson Orcutt (correct spelling) is associated with time

series models through a method known as the Cochrane-Orcutt procedure, introducedin 1949. He presented on Measurement of Price Elasticities in International rade,Econometrica, 18:3 (1950), p. 284. Raymond Mikesell, formerly an aide to Harry DexterWhite, an economist and reasury offi cial, contributed to the formation of the Inter-national Monetary Fund and its quota system. Mikesell presented on Application ofStatistically Derived Import Elasticities to Practical Problems of Foreign rade Policy,

Econometrica, 18:3 (1950), pp. 2845.2. Harberger: Arnold C. Harberger, Johns Hopkins University, presented Index Num-

ber Problems in Measuring the Elasticity of Demand for Imports, Econometrica, 18:3(1950), pp. 2756.

3. Why the required elasticities have been overestimated: Machlup crossed out original para-graphs 1 through to 4 in this section, hence the section retains his numbering from 5onwards.

4. Te Neglect o Supply Elasticities: Tis repeat of the section heading and included material

is not an error. Machlup intended the following rewrite of the Supply Elasticities section tobe used in an essay. In margin notes he wrote: Tis can be used for the essay, in the part [of]Overestimation of required elasticities to precede the part on Underestimation.

5. the abstract o my remarks: Machlups paper Discussion of Problems in the Teory ofInternational rade,Econometrica, 18:3 (1950), p. 285.


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378 Notes to pages 10133

Replies by Economists

1. 7. What types o securities 8. Under what individuals?: Machlups margin notes indi-cate that he did not answer these two questions.

Problems of Exchange Rates and Convertibility

1. FM DRAF FOR MERRILL CENRE VOLUME, HORP 1953: Machlups con-tribution was prepared for rade, Aid, or What? A Report Based upon a Conerence on

International Economic Policy at the Merrill Center or Economics, Summer, 1953 (Bal-timore, MD: Johns Hopkins University Press, 1954). Machlup, riffi n, Cairncross andmany others were at the Summer 1953 Conference on which the report is based.

2. Chapter III: Machlups contribution to exchange rates and convertibility would bere-edited and would form chapters VI (the levels of foreign exchange rates) and VII(problems of convertibility) of the published work. No attribution would be given toany contributor. Machlups name would be misspelled Achlup in the list of confereeson p. xi. Torp and the Merrill Foundation were very involved in Machlups work onindustries in the early to mid-1950s. Te Merrill Foundation funded projects at JohnsHopkins which included Te Teory o the Growth o the Firm, which Edith Penrosemade her own. It is very unlikely Machlup would otherwise have been so tolerant of the

piece-part editing of his work or the misspelling of his name on the published report.3. Ireland besides the United Kingdom: Te Republic of Ireland, Eire or the free state, desig-

nated a dominion of the Commonwealth.4. Te essential eatures o the sterling area: Margin notes indicate that this information has

come orally from Cairncross. A. K. Cairncross was economic advisor to HM reasuryin 1958.

5. dollar pool: Machlups margin notes suggest here that riffi n-Cairncross tape recordedMachlup delivering his notes at the conference referred to in note 1.

6. diect: direct; typographical error uncaught by Machlup.7. governemnt: government; typographical error uncaught by Machlup.

Paradoxes in Economic Development

1. Dev: Development.2. prop: proportionate.3. cap: capital.4. 12: Number (and those following before recommendations represent number of people

in group/session who made this recommendation).5. Galenson: Walter Galenson was a professor of economics rst at Harvard 1946, then at

UC Berkeley in 1951. He was a labour economist. He had just published ComparativeLabor Movements(New Jersey: Prentice Hall, 1955) at the time of Machlups speech.

6. may be stated as ollows: Machlups notes end without a statement. He might have said,quoting from his book Essays in Economic Semantics, Te basic position of a puretheory of relative wages may be stated as follows: In the absence of obstacles to themovement of workers from the non-industrial to the industrial sector of an economy,and in the absence of differences in the unpleasantness of industrial and non-industrial

work, the equilibrium rates of earning would be equal. Essays in Economic Semantics(New York: New York University Press, 1963), p. 296.

Documents

Sample Pages From Monetary Reform and the Bellagio Group