"Imported Inflation" and the Balance of Payments
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K.7 * (#705 in RTD Sertes)
INTERNATIONSL FINANCE DISCUSSION PAPERS
“IMPORTED INFLATION" AND THE BALANCE OF PAYMENTS
by
mo ,
Samuel I, Katz.
"Discussion Paper No. 32, September 14, 1973
Division of International Finance
Board of Governors of the Federal Reserve System
STE EEE eee The analysis and conclusions of this paper represent the views of the author and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve ‘ ) System or its staff. Discussion papers in many cases are circulated in preliminary form to stimulate discussion and comment and are not to be cited or quoted without the permission of the author,
ne
"Imported Inflation" and the Balance of Payments
Introduction .
International transmission under pegged exchange rates ange-rate flexibility om external inflation
Channels of transmission with exch Insulating the national economy fr
European inflation and U.S, external de
World inflation: the measurement Price movements in the Common Mark
“Imported inflation": the European exp What the banking statistics showed
Recent econometric Yesearch ry Monetary policy and European stabi
ficits .....ee
problem .., et countries
erience, 1960
Reserve accruals and central banking offsets ,
e e e e e e e
lization .,
to 1970 .. surpluses
Non-monetary channel: domestic income effects of export
The German recovery and European i
Non-monetary channel: — rising goods pri
Direct price effects and international inflation
Domestic prices under pegged exchange rates ....,
“Adjustment-inflation" and domesti The "high-inflation" compromise The “low-inflation" compromise , Controversy over "low inflation" ¢
Exchange-rate policy: export-oriented
Effects of an exchange-rate change Exchange-rate policy and domestic
Concluding observations ....., ee
; Emphasis on liquidity factors . , Lo The role of price elements .., ; Exchange-rate policy ...... Domestic effects of external eurpl
nflation ..
ces abroad .,
c prices. e
ompromise
adjustment .
stabilization
. oe e
in. Germany
oeo3eeewmwm ew ee ele e
oe3eoeee8e8 @
uses and deficits
. e e e e
ow SS
1l
“Ul
15 19 21 23 26 30 35 39 4l 42 47 47 50 52 55 38
58 59
' 64
64
69 71
7
"Imported Inflection" end the Belence of Payne
. Samuel I, Katz
The world-wide character of recent price and wage advances has inevitably focused attention on inflation as an international phenomenon. The authorities in the industrial countries have found internal stability threatened by inflationary forces from abroad. Increasingly, international factors--the expansion in world trade and investment flows, the official efforts in recent decades to eliminate restrictions on private cutreut-accuunt aid Capdial isansactious, the growth of multinational corporations and the development of international privete banking facilities of unprecedented efficiency for the transfer of private funds across national borders--have limited the effectiveness of national programs to protect the internal economy from external disturbance.” This attention to the international aspects of the inflation process was further stimulated in 1971 and 1972 when country after country found the domestic stabilization effort threatened by inflows of funds from ebroad. ae
* The analysis and conclusions of this paper represent only the personal opinions of the author and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve
System or of members of its staff, The author is indebted to Peter B. Clark and Charles J. Siegman for comments and suggestions,
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.In this environment, it no longer seemed to make sense to view inflation merely as a collection of individual national phenomena, Instead, economists and government officials turned their attention to the international, as distinguished from the internal, elements which were contributing to world price trends, Many of them found a clearly-evident process of transmission of inflationary impulses from country to country through the balance of payments. Some economists, in addition, offered the fact of the unprecedented outpouring of dollars from the United States, especially in 1971 and
1972, as evidence that the United States was exporting inflation
‘to the rest of the world,
in retrospect, however, this attention to the international transmission of inflation marked a return to a theme widely
discussed in Europe during the mid-1950's, There was at that time
- a widely-held view which attributed their domestic. stabilization
difficulties to “imported inflation"; specifically, it was asserted that the European economies were being subjected to the inflationary effects of the U.S. balance of payments deficits, and especially to the need of the European central banks (under the parevalue system) to buy accruing dollars and, in the process, finance the U.S. deficits, This emphasis upon the U.S. role in European inflation was bound to intensify when the U.S. inflation accelerated after 1955 and especially when its balance-of-payments
deficits were greatly enlarged after 1970.
36
This emphasis was particularly congenial to the thinking
of economists who found in the global aspects of balance-of-payments
adjustment under fixed rates a framework to understand the inter-
national transmission of inflation, as they perceived the process, To these economists, explanations which neglected the underlying Global elements and, instead, emphasized only local developments-such as "wage explosion''--were "largely beside the point; they
assign causality to the mechanisms by which more fundamental causes
operate to diffuse the world inflationary process ,1/ According to
Johnson, the direct cause of the global inflation was "primarily ,,,
the excessively expansionary monetary policy pursued by the United
States in recent years, and diffused to the rest of the world through the U.S. balance of payments deficit ,"2/ Mundell had expressed a similar view: "the world inflation has a monetary cause and eee Che U.S.-dollar and the Eurosdollar are at the center
of it ,13/ In this view, the United States as the werld's reserve center was the main determinant of world price trends, Johnson explained that, "LE the reserve currency country begins to inflate
at an immodest pace, ... (it) then becomes an active source of
SCENES 1/ Harry G. Johnson, "Inflation and World Trade: A 'Monetarist!
View," Journal of World Trade Law, Jan,-Feb, 1972, p, 16, 2/ Ibid., p. 17,
3/ Robert A. Mundell, "World Inflation and the Eurodollar," Note
Economiche, n.2, 1971, ed. Monte dei Paschi di Siena, p. 18,
“so
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inflation within the System, through the direct influence of its own prices on world prices, through the demand-injecting influence of a deterioration in its current account, and through the monetary implications for others of a vastly enlarged outflow of its currency, "'2/ International transmission under persed exchanre rates - This paper will review the international transmission of inflation among the. industrial countries in an increasingly interdependent world economy, as distinguished from purely domestic causal factors, We will be particularly concerned with the international channels of transmission for countries with balance-of-paynents surpluses under a system of pegged exchange rates for the period from 1958 to 1973. because of the massive recent internationai private capital flows, there has been much attention to the monetary aspects of world inflation. But attention to these monetary factors may lead economists to neglect the role of non-monetary channels in the international transmission process. A reconsideration, of European experience during the 1960's reveals that (1) income and (ii) price as well as (iii) monetary mechanisms of transmission can be distinguished for analytical purposes, A country is likely to experience an impact on its domestic economy from external distur-
bance through each of. them.
eeu enenenSeebanisstunnatnnensneseanane 1/ Harry G. Johnson, "The Bretton Woods System, Key Currencies,
and the ‘Dollar Crisis' of 1971, The Three Banks Review, June 1972, Pp. 18,
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The monetary aspects of the transmission mechanism have long been emphasized by economists. Under any system of pegged or officially-supported exchange tates, the central bank augments internal liquidity when it purcheses the foreign-currency receipts of the customers of the local banks. There was a widely-held view that these internal liquidity effects of a balance-of-payments surplus or deficit were the primary element in the mechanics of world inflation long before the extraordinary monetary flows after 1970 revived professional interest in an international monetary explanation of the transmission process, The foreign exchange purchases by the central
bank are bound toaugment the domestic monetary base; as a result,
‘economists have been led to explore how, and to what extent, the
monetary authorities misht offset the additional primary reserve balances or, failing that, might limit any secondary credit creation by the banking system, ee
A concern with purely monetary phenonena, however, ought not lead to the neglect of other key elements in the process of world inflation, In particular, current-account surpluses can directly add to domestic incomes and have inflationary effects apart from the monetary expansion associated with central bank purchases of foreign currencies, Through the foreign-trade multiplier, added export sales can stimulate domestic investment (as the entrepreneur adds to his
plant or inventory capacity) and then consumption, There was in
practice in the surplus Suropean countries and in Japan a clearly
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defined cycle of internal business expansion which was export-led: that is, an initial growth in export seles often induced a cycle of domestic investment and then a boom in consumer spending. When the authorities checked the consumer boom, their restraint program often provided the basis for a further surge in export sales,
The importence of a second non-monetary transmission channel has recently been underscored: the key role played by price developments as an independent mechanism for spreading inflation from country to country, If there is an inflation in country A, there will be a rise in the price of its exports and the higher prices which its trading partners pey for A's goods can push up their local prices at the raw matorial, iutermediate and/or final goods stage. Similarly, an inflation in goods prices abroad will push up prices on A's imports and then’.. its internal costs and prices, The channels through which
these price effects are transmitted can be complex, as we shall discuss
o
later in this paper,
Because these diréct price effects are necessarily associated with the movement of commodities and labor écross national boundaries, the phenomenal post-World War II expansion in international trade and investment has undoubtedly increased the importance of this channel of transmission. The price effects associated with a erowing flow of G00ds, labor and capital among the European countries have also strengthened the role of regional--as compéred with global--factors
in spreading inflation among the Common Market countries.
r -7J- -
In addition to prices of traded goods and services, price developments of an expectational character have also been a key element in recent domestic economic disturbance among the industrial countries. The difficulties these countries have had in controlling cost-push inflation, even with less than full utilization of internal economic capacity, and in avoiding stubborn inflationary expectations at home help to explain why inflationary price developments abroad can directly and indirectly add to the internal disturbance, Evidence that these direct and expectational price factors have become powerful elements in the international transmission of inflation under contemporary conditions is found in the surge in prices, both in world commodity markets and in the dome stic economies of the major industrial countries
in early 1973.
Channels of transmission with exchense-rate flexibility - The oe nnnennenenge rete flexibility
channels of transmission of world inflation wold necessarily be different in a systen of flexible exchange rates, 4n increased foreien demand would then not add to the internal monetary base but merely push up the spot rate, The domestic income effects would also differ. An increased denend for A's merchandise exports would push up the exchange rate and not produce as large an expansion in total export sales as would have occurred had the Spot rate been pegged, An
increased demand for /'s finencial assets would also push up the
spot rate; but there could be in this case an actual reduction in
export sales and hence in the profits and incomes of affected export
se-.
om.
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firms, Had the exchange rate been peaged, by contrast, the cepital inflow would have been added to the offictal reserves and the export industries would not face a loss in foreign business,
Similarly, foreien price developments would also affect the domestic economy under ‘flexible exchange rates, If there is inflation abroad, there should be a tendency for the exchange rate to eppreciate and cushion the domestic impact of foreign price rises,
To the extent that the higher spot rate cuts back export seles or reduces the local-currency prices of foreign imports, the direct price effects willbe less under flexible than under fixed rates. On the other hand, a declining exchange rate tends to push up domestic prices, both in the higher direct costs of imports and in stimulating foreign sales, often at rising local-currency prices. The price effects from exchange-rate fluctuations can be particularly disturbing when the authorities are attempting to ‘bring cost-push or
‘° °
expectational domestic inflation under control,
_ imsuleting the national economy from external inflation - The national authorities have tried to insulate their economtes from the contagion of foreign inflation, They have devised neutralizing measures which can be grouped under the four headings which Friedman! alluded to in connection with the policy options available to correct balanceof-payments disequilibria:
““Y/ iilton Friedman, "ine Case for Flexible Exchange Ratec,"
reprinted in Forcien Trade ard Financa ed. by W.R. Allen and C.L. Allen, (New York: The Nacmillan Co., 1959), pp. 315f£,
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(1) To alter the exchange rate; (2) Yo impose controls;
(3) To finance external surpluses and deficits out of the official rescorves; end
(4) To deflate the economy,
A wide variety of governmental measures which countries with external surpluses and a concern about "imported inflation" could take can be identified under each of these headings, We heve already mentioned the anti-inflationary impacts of allowing the exchenge rate to rise, Among control measures, the surplus countries in Europe and Japan have been concerned to reduce foreign capital inflows, not outflows, and have introduced regulations eimed at limiting (1) borrowings abroad by local entrepreneurs and financial institutions and (Li) the acquisition by non-residents of many types of local-currency assets,
Thirdly, the central benk can absorb. the incoming foreign currencies into the netionel ofticial reserves, In this case, the authorities must find ways: to offset their effects upon “the domestic monetéry base end upon the credit-extension capabilities of local financial institutions, There is a substantial professional literature concerned with technical and policy aspects of the offsetting process, Finally, the authorities can attempt to insulate the domestic econony by reducing the rate of growth in internal incomes in step with the
domestic expansionary effects of added foreign sales,
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The national stabilization programs of the industrial countries have encompassed widely di: ffering combinations of measures under these four broad policy options. ‘The limited effectiveness of these ‘Stabilization efforts is demonstrated by the generality of inflationary trends in all of them. Can this lack of success be attributed to the inadequacy of national stabilization programs to contain the domestically-generated inflation or does it reflect insteed the international transmission of inflation which has created forces powerful
enough to negate attemots at national autonomy in an inflationary
world economic environment? Our attention will be focused on the ways in which international factors have impinged directly to threaten internal economic stability in the industrial count eries,
apart from the purely domestic sources of inflation, We begin with
a summary of the main facts ebout world inflationary trends,
ta
-- 4 . ne ae 7
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Europeen inflation and U.S. external deficits
The inflation after 1965 in U.S. prices and costs was so severe and the balance-of-payments deficits in 1971 and 1972 so unprecedented that it was not difficult to find evidence that the United States was the center of, and the primary contributor to, a world inflationary surge. When prices also accelerated in other industrial countries, especially after 1968, economists and government cfificials began to perceive a Process of world inflation emanating from a reserve-currency center which was creating an excess of domestic and of international liquidity to other industrial countries. The economic facts after mid-1965 were thought to document this hypothesis, .
World inflation: the Measurement problem - The report TE measurement problem
released late in 1970 by the Grganization for Economic Co-operation
and Development on Inflation: The Present: Problem appeared to
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support the hypothesis ofa global inflationary surge emanating from the United States. The report found that the general level of vrices in the OES) countries as a group increased from a yearly average of 2.6% in 1960-1955 period to an estimated 5.5% for 1979 while U.S. prices rose from 1,5% to 5.1%, (See Table 1.)
, (Insert Table 1)
The international character of the trensmission mechanism
was further supported by the fact that "prices in international
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Summary of Price Developments in OECD Area Ce A A Qe ONE Net eee anny (Percentage changes at annual rates)
: 1960-1955 1965-1968 1959 1970 IT IIHS IGG 1970
United States 1.5 3.3 4.7 5.1 Other major OECD countries 4.0 3.3 4.8 5.9 Smaller OECD North 4.3 4.4 4.1 5.1 Other . 4&9 4.5 (3.5) (4.8) Total OECD , 2.6 3.4 4.7. 3.5
enema
i/ GDP deflators at constant 1968 exchange rates based on the national
.accounts of the OECD countries and on Secretariat estimates.
SOURCE: Inflation: The Present Problem, OECD, ‘Paris, December 1970, p. 15. nent ee . .
tee ne
trade have been rising as fast--anc, recently, faster--than overall
domestic price levels ,2/ In addition, it was found that "there has
been noticeably more synchronization in price movements than in demand conditions,"2/ on the basis of the OZCD data, for exemple, Caves has compared average annual retes of change in consumer prices for 20 OZCD countries for the 1959-64 and 1964-69 periods; he found that the mean inflation zate rose from 3.1% to 4.2%; that
the standard deviation fell slightly from 1.3 to 1.2; and that the
coefficient of variation dropped sharply from 0.49 to 0.30,3/
These facts could be viewed as evidence to support the world-inflation hypothesis ,4/
Vatortunetely, world tuZiation is an altogether ambiguous concept, For a national currency, value can be defined either in terms of goods or of a financial numeraire, The decline in its value can be measured by either of these stendards, Economists usually measure the decline in the domestic value of a curzency in terms of goods, ‘It is the rise in goods prices, and not the decline in the numeraire value of the currency, which has the more profound
economic and social impact of en inflation on the general public,
nr by eer -eeererestener ry emeeenee ‘ . L/ Inflation: The Present rroblem, Organization for Economic Co-
Operation and Development, December 1970, p. 23,
2/ Ibid., p. 7.
3/ R.E. Caves, “Looking At Inflation in the Open Economy," Harvard Institute of Econonic Research, Discussion Paper number 285, iiarch 1973, mimeo., footnote 39, (p. 38).
4/ fMundell, op, cit., p. 14,
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How we ought to measure world inflation is less clear-cut, For example, Mundell recognizes the uncertainty of the definition of world inflation as "a systematic decline in the value of international money ,"/ There is after all no world money and no clear concept of what we ought to regard it to be, ifundell resolves these uncertainties by a pragmatic judgment: "when prices in the U.S., U.K., Italy, France, Germany and Cenada are going up by not less than 5 per cent a year, there is no ambiguity in the concept of world inflation even if one or more of the smaller countries allows an exchange rate variation." (pp. 4-5.)
By contrast, the OZCD study measured world inflation in terms of a composite index of GNP deflators for each member country, weighted by its relative GNP for 1965, This index showed a rapid
acceleration in price changes for the OECD area for 1959 and 1970,
(See Table 1.) -° , * : oe
But this sharp acceleration in the summary number, we find, is less a measure of area-wide price developments than of price rises in North fmerica, Canada and the United States accounted for neerly 50% of aggregate output for these countries and the movements in the summary number obviously reflect the price acceleration in
those countries... In brief, the measure of world inflation provided
in the study probably more fairly represents conditions in North
1/ imundell, “World Inflation and the Euro-dollar," op. cit., p. 3.
acceleration in price changes for the OECD are
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How we ought to measure world inflation is less clear-cut, For example, liindell recognizes the uncertainty of the definition of world inflation as "a systematic decline in the value of international
1/
money." There is after all no world money and no clear concept of what we ought to regerd it to be. Mundell resolves these uncertainties by a pragmatic judgement: “when prices in the U.S., U.K., Italy, France, Germany and Canade are going up by not less than 5 per cent a year, there is no ambiguity in the concept of world inflation even if one or more of the smaller countries allows an exchanse rate variation.” (pp. 4-5.)
By contrast, the OZCD study measured world inflation in terms of a composite index of GHP deflators for each member country, weighted by its relative GNP for 1968, This index showed a rapid
a for 19569 and 1970. (See Table 1.) .- = : +
But this sharp acceleration in tha summary number, we find, is less a measure of area-wide price developments than of price rises in North America. Canada and the United States accounted for nearly 50% of aggregate output for these countries and the movements in the summary number obviously reflect the price acceleration in
those countries, In bricf, the measure of vorld inflation provided
in the study probably more fairly represents conditions in North
enone . . l/ Wundell, "World Inflation and the curo-dollar," op, cit., p. 3.
ee een ee ee oe
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America--for the period up to late 1970 covered in the computations-than it measures price developments in the other industrial countries. The study itself recognizes this difference: "giving equal weight to the price performance in individual countries, there remains evidence of an acceleration in the peice rise, although it is less clear-cut "2! This aspect is further supported by the data in Table 1 which show that 1969 prices were close to the average for the 1960-65 period for the three regional groupings outside the United States. (See Table 1.)
Price movements in the Cormon Market countries - The lack of synchronization between price developments in the Common Market countries and in the United Staies during the years covered by ihe OECD survey is further demonstrated by the data on price changes in major European countries found in Table 2. The rate of price increase for the (six) Common Market countries averaged 4.2% in the 1961-65 period compared to 4.0% in the 1966-70 period. (See Tadle 2.) Furthermore, Zuropean price’ advances were particularly high between 1962 and 1964 when U.S. prices were rising at an annual rate of about 1.5% (See Table 1.) European price increases actually slowed down perceptibly between 1964 and 1968 when U.S. prices were accelerating rapidly. During the earlier period, the index
of European prices reflected the impact of demand inflation and
l/ OECD study, Ibid., p. 15,
ee a me a mer mm tte ee one ne ree ee rene eee sone cae wee ee
then a wage explosion in Italy in 1962-63 and then in the Netherlands in 1963-64, together with excess demand in France from 1962 to 1964, The subsequent slowdown in the combined index between 1965 and 1968 reflected mainly the impact of stabilization in France and Italy and, during 1957 and 1968, the German recession,
(Insert Table 2)
The European view during the mid-1960's was to explain their domestic inflations of the 1960 to 1966 period in terms of “imported inflation." The "imported inflation" was explained for the Nethezlands in terms applicable to each of them: there was a "monetary expansion in the surplus countries, as well as income and price inflation, which will not cease until bLhat indiaiion aud ihe consequent rise in costs have gradually redressed the balance,"'2/ Many European economists attributed their domestic inflations to the liquidity effects of central-bank purchases of accruing foreign exchange, and the resetve-asset accruals to the U.S, external deficits, ” oo
U.S. economists, however, could not agree that the United States was the primary source of the European inflation, On the contrary, they thought that the balance of statistical evidence supported an hypothesis that the United States was exerting a
deflationary, not an inflationary, influence on the world economy,
EEE 1/ Netherlands Bank Report for the Year 1965, p. 24,
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TABLE 2
Change from
preceding
years France Germany Italy 1961 3.3 4.4 2.7 1962 4.8 4.0 5.7 1963 6.0 3.1 87 1964 4.0 2.8 6.3 1965 2.4 3.6 3.8 1966 2.9 3.4 2.2 1967 2.9 ° -°%3 3.0 1968 4.7 1.6 1.5 1969. 8.0 3.5 4.1 1970 5.5° 7.2 6.3 1971 5.0 7.7 6.9 1972 5.8 6.1 5.8
rr a eee
selected European countries, 1950 to 1972
Netherlands
2.4 3.3 5.0 8.0 5.8 6.0 4.1 3.6 5.7 4.6- 7.5 9.5
Belgium
1.1 1.1 2.9 4.7
7] —
4.4
3.0
5.8 6.0
3.8° 5.1
Total Common Market 1/
3.4 4.4 5.2 4.3 3.5 . 3.3 2.4 2.7 5.2 6.2 6.6 6.2
United
Kingdem
3.2 3.7 2.1 3.0 4.7 4.4 3.1 4.1 5.0 7.2 9.0
6.7
a eS SS SS aaa ND a
1/ GNP deflators weighted by 1970 relative GNP values for the original six European countries only. Price data from OECD National Accounts, 1960-1970,
p. 13.
7 4
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The wapidly growing U.S. export surplus after 1960 was adding substantial resources to the rest of the world, if not to the European countries, and not withdrawing them, Further, U.S. prices were increasing much more slowly than those in the Common Market countries between 1950 and 1955. In addition, the U.S. rate of monetary expansion was the lowest among the industrial countries, at least until 1967,
As it turned out, the source of Europe's inflation in the early 1950's was widely debated, and never resolved, as between U.S. and European economists and officials. Because this debate took place in a period when the reserve-center country was achieving an impressive domesticestabilization performance, a fresh review of the controversy may add to our understanding of the transmission of inflationary impulses from country to country. It may
provide insight into a dimension of the process of world inflation
which may be neglected in a period of substantial inflation in the
reserveecenter country.
~
“yy
"Imported inflation": The European exnerience 1950 to 1970
The main facts about the combined balances of payments of the six original Common Market countries which form the background for this trans-Atlantic debate about the character of "imported inflation" are surmarized in Table 3, Between 1956-1957 and 1958-1961, the Common Market countries as a group achieved a major increase in their surplus on current transfers (goods, services and unilateral transfers) of nearly $2.0 billion per year; there were comparable additions to their official reserves. (See Table 3.) In the next period, from 1962 to 1965, the surpluses were reduced somewhat but remained large: the surpluses amounted to about $1.6 billion and reported additions to official reserves to $1.3 billion, 7
(Insert Table 3) "oe
The debate centered on one key question: were the domestic liquidity effects of the U.S. deficits the primary source of the European inflation? The United States was recording a growing export surplus, and outstanding domestic price stability; hence, it followed that attention would be turned to the effecta on the European domestic economies of the substantial increases in their reported official reserves between 1958 and 1966. Central bank purchases of foreign currencies were adding materially to domestic liquidity, especially in the smaller European countries, and so it
seemed to follow that an international monetary explanation was
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TABLE 3
European Economic Community: Surmary Balance of Payments, . Annual Averaces for Period, 1956 to 1956 Se OE eres te oe 0 9d
(in millions of dollars)
1956-57 1958-61 195 2-66 eg en re tennegpeenne
Goods, services, and private unilateral transfers 630 2,510 1,560 Official unilateral transfers ) -760 °1,020 ) -766 Official capital ) 690 #420 Prepayment of official debt 0 - 350 #315 Direct Investment ) ' 50 500 ) 152 Other private long-term capital ) 780 815 Net military transactions a, ore RAS 44 Non-bank short-term capital and errors and omissions 321 #145 -290 ; a Balance on non-monetary transactions 337° 2,290 1,170 ITI LS TL LES Financing bh Change in official reserves 368 * 25330 1,270 Short-term banking flows - --150 #40 -100
, A t-te P ryegrass
a Not separately available for these years.
b Does not add because, in French accounts, transactions between the Overseas franc area and the non-franc area affected through banks and other institutions in France (thus affecting French monetary reserves) have been excluded so that the totals will not balance out.
SOURCE: 1958 to 1966, U.S. Treasury Department, Maintaining the Strength of the U.S. Dollar in a Strong Free World Econom » January 1968, Table 22, p. 118; and for 1956 to 1957, International Monetary Fund.
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relevant to their "imported inflation." These central-bank purchases of foreign currencies were at the same time (i) enlarging the reserve base of the banking system; and (ii) facilitating a secondary expansion in commercial bank deposits and, as they added to their earning assets, in agsregate bank credit.
Reserve accruals and central banking offsets - There was the conviction among many European economists that, in a world of fixed exchange rates and privete capital mobility, "the Central bank is bound to lose control of the money supply, and therefore over the
level of total spending, "L/
Even if the central bank could "for a time at least, prevent the secondary deposit expansion by the com-
mercial banks," the banking system was bound to acquire "sufficient
_Cash to support the primary deposit expansion which derives directly
from the sales to them of foreign exchange by their customers." Scott and Schmidt were more optimistic: "Both the potentfal primery and secondary expansions ... could be prevented through open market sales," a conclusion subsequently challenged, in part on technical grounds, by Oppenheiner .2/
—— 1/ Friedrich A, Lutz, International Payments and Monetary Policy
in the World Today, Wicksell Lectures, 1961 (Stockholm: Almquist and Wiksell, 1951), p. 37.
2/ Ira 0. Scott and Wilson E. Schmidt, "Imported Inflation and Monetary Policy," Banca Nazionale del Lavoro Quarterly Review, No. 71 (Dec. 1964), p. 395; Peter ii. Oppenheimer, “Imported Inflation and Monetary Policy: A Comment" and the rejoinder by Scott-Schmidt, Ibid., No. 73 (June 1955), pp. 191-200.
Terme 2 mma serra e < ammmmae —*-8 em oe ne came AO URN NE St Re Se RE ne te ce ee ee ee apes wee Ce te me ee ee ee ett nated
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At first the experiences of the European central banks seemed to support a pessimistic judgment. Even though they raised
discount rate on five occasions between mid-1959 and mid-1950, the
German authorities were unable to regain cortrol of the domestic
monetary base during this period of substantial surplus. On the contrary, attempts to tighten domestic liquidity in Germany merely induced unwanted inflows of short-term funds from abroad. The authorités first decided to relax their internal restraints late in 1960 and, shortly thereafter in March 1961, to revalue the Denmark,
The debate then concentrated upon the question of whether the European countries were or were not able to sterilize the domestic monetary effects of the reserve accruals. From a
statistical point of view, the debate tended to revolve around
the extent to which the European central banks added to- their domestic assets during the period, If they did so, it was argued by Scott-Schmidt2/ and later by Bafet ,2/ domestic credit creation could not heve been the involuntary result of the inability of European central banks to offset the domestic effects of their reserve accruals, as Lutz and others had suggested. On the contrary, the argument ran, the acquisition of domestic assets could only ~2/ Scott and Schnidt, op. cit., pp. 390-403,
2/ Paolo Saffi, "Western Zuropean Inflation and the Reserve
Currencies," Banca Nazional2 del Lavoro Quarterly Review, No. 04,: March 1958, ; .
p. Ll. ;
Oe Diesen oe am
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mean that the central banks wanted to add to the local monetary base, Had the central banks wanted to pursue more restrictive credit policies, Daffi was convinced, they would have introcuced the new policy tools earlier; it was his view that technical centyal-banking or institutional considerations "would not have really prevented the edoption of a more severe policy line if in the judgment of the monetary authorities the situation had called for it ull What the banitine statistics showed - The European banking data showed that the central banks in the larger Common iiarket countries added substantially to their domestic assets, suggesting that the countries had domestic credit needs beyond the liquidity created by the reserve accruals. Only in Belgium and the ietherlands was the acquisition of domestic assets negligible or negative. Goldstein, for example; found that the increase in domestic assets
°
as @ percentage of total central bank assets from 1958 to-1971
. oy °
varied as follows: 2/ Italy 697 Belgium “4% Germany 437 Netherlands 1% France: 35%
He concluded that “we can only infer that the secular expansion in
the money base provided by the foreign-exchange accruals was insuf-
ficient to meet official monetary growth objectives." (p. 7.) He l/ Ibid., p. ll.
2/ Henry N. Goldstein, "Imported Inflation--A Phrase in Search of & Phenomenon,’ unpublished manuscript, August 1972, mimeograph, p. 3S.
-24-
also found that periods of exceptioncl reserve accruals were not associated with above-average rates of monetary expansion.
This simple procedure could not be extended to measure the secondary liquidity creation of local financial institutions on the basis of the additions to primary liquidity, The relationship between changes in primary liquidity and in the lending capacities of the commercial banks has proved to be, in the experience of the Bundesbank, "far from being accurately predictable,+/ even with the use of behavior models of the banking system in the national econony,
As an alternative, the OECD staff compared the expansion in primary liquidity (measured by the country's surplus on nonmonetary transactions) in terms of the GNP. They proposed as a rough and arbitrary measure that the U.S. payments deficit would be judged to have had “significant monetary repercussions" on the surplus country when the expansion in primary Liquidity (i.e. the surplus on non-monetary transactions) would exceed 17% of GNP.
The findings on the basis of this criterion were largely
negative, at least until the massive outflows of 1971 and 1972.2/
Between 1965 and 1967, the U.S. external defictt itself was small
in relation to the expansion in money supply in the “other' OECD
bene peeemererne e 1/ Report of the Deutsche Bundesbank for the Year 1970, pp. 25ff.
2/ “The International Transmission of Inflation," The O£CD Economic Outlook, July 1973, pp. 88££,
CO ER ree AREA AE a Se cone eu eet meg ne ee ooo eee 7 REE ERT
-25-
countries, The external surpluses of these countries fell mostly
in the 1 to 2 and 2 to 3 per cent range. For the period, 1968 and 1969, the monetarist hypothesis could hope for little statistical
support because the temporary surplus in the U.S. balance of pay-
ments (on an official reserve transactions basis) would produce
a small contractionsry imsect on Turopean money supplies.2!
The OFCD anelysis aleo found in the evidence from 1979 * to 1972 only limited support for a monetary explanation of the international mechanism, Even in 1970, the external surplus was equivalent to only 18% of the additions to primary liquidity for these countries as a group and the consequent expansion in the internal money supply at an annual rate of 13% "was itself only ‘normal’ by past standards «ee which implies that the 'extra' “inflows of liquidity were, on the average, sterilized.2/ In 1971, however, the growth in money supply reached 17-1/2% and the external surplus was equivalent to 24% of the increase in the national monetary base. In 1972, the increase in money supply increased further to 20% even though the external surpluses declined in step with the lower U.S. payments deficit.
Even the facts for 1971 and 1972 were regarded as only limited support for a role for liquidity creation through external ~ 1/ Ibid., p. 90. The average percentage contribution to the growth in the money supply was (-)2% in 1968 and (-)4% in 1969. Italics found in the original text.
2/ Ibid., p. 90.
orn
oe
-26-
payments surpluses in the international inflation cycle. The OECD Study concluded that "sinee ... price increases remained high or accelerated despite an easing of demand pressures, &n a priori case could be made for attributing an important causal role to the international monetary transmission process, "2/ But it could find only “one specific causal chain which appears plausible, whereby high rates of monetary expansion have a direct effect on the price of land and other real property, and sharp "speculative" rises in these prices ... (push) up inflationary expectations in the economy as a whole." The expansion of central banking funds through involuntary official dollar purchases had more direct effects on private liquidity in the European countries in 1971 and 1972 than these conclusions would suggest. Even the study itself agrees that large capital inflows complicated the task of implementing monetary policy, especially in Germany and Switzerland, and to this extent the effectiveness of their demand-management efforts. was impaired.
There remains at issue, however, the question of whether the impairment associated with these liquidity leakages was or was
not a significant source of internal inflation,
Recent econometric research ~ The OECD attempt to measure the domestic liquidity effects from foreign capital inflows rested upon a relatively limited analytical model, Two recent studies have attempted much more broadly to measure the extent to which
1/ Ibic., p. 90.
—_— eae
errr 2s ere Eeee = . awe . TT SIRS meee ee ee nee eS A A Ae Ne + ee REET - or eee meen me ew ee reer a ata one na atte Bemteeaeel
-27-
the German authorities have been able to control the domestic money supply in an open economy with fixed exchange rates. Willms concluded from an econometric model of the German money-supply process that, for the period from 1958 to 1970, "the German authorities have been relatively successful in neutralizing the impact of the noncontrolled or indirectly controlled components of the money supply process by changing directly the controlled components, "L/ The most important instruments they used to offset the growth in central bank holdings of foreign currencies were: (1) changes in required reserves; and (2) placements of deposits of the public authorities and other governmental bodies with the Bundesbank .2/ Willms distinguished between the "controlled" portion of the total change in the monetary base (the dependent term of the basic equation) and the changes in base money due to changes-in the centrai bank's foreign assets. _He concluded that the authorities were able, by varying the controlled component through their policy instruments, to offset about 86% of the changes in monetary base associated with changes in foreign assets.
Subsequently, Porter reached the opposite conclusion. Using a monthly instead of quarterly model as Willms had done, he found that changes in reserve requirements were regularly “1/7 Manfred Willms, “Controlling Money in an Open Economy: The
German Case," Federal Reserve Bank of St. Louis Review, April 1971, p. 10, °
2/ Ibid., p. 24.
a ae ne ae Ne ne one neem ammo RR FF eR NR TE RL NR CEN S EET ce rs ne sneme ee -
we”
; 2
-28-
“substantlally and rapidly offset in their effect on bank liquidity by capital inflows recorded mainly in the errors and om{ssions component of the balance of paynents, "e/ Porter explicitly found that
2 "the changes in required reserves induced the capital inflow," and
that an offset of 80% would take place by the end of the month in which reserve requirements had been altered, .
An important question about the Porter model is whether the short-term capital flows which occurred were primarily a monetary or an exchange-rate phenomenon or both. The degree of statistical association between changes in reserve requirements and in shortterm capital inflow wes significcntly higher when the “errors end omissions" residual was combined with recorded short-term capital inflows than it was with recorded flows alone. For most of the large treding countries, the “errors and omissions" item is as sensitive to exchange-rate speculation (under pegged rates) as to changes in internal credit conditions, if not more 80. The big swings in this residual are ordinarily associated with the timing and currency of commercial payments for ordinary transactions--that is, they are largely "leads and lags" which usually respond to exchange-rate expectations,
There is in general an absence in the Porter work of a good proxy for the effects of exchange-rate speculation on German
a Seer l/ Michal Gc, Porter, "Capital Flows as an Offset to Monetary Policy: The German Experience," IMF Staff Pa ers, July 1972, p. 395.
2/ Ibid., p. 415. Italics in original.
femme ee fn ee ee ee ee ee pene eee ae ee eee omen em ee
cD)
-29-
short-term capital flows, He himself noted that "the total explanatory power of the regressions estimated in this study is substantially less than would be obtained by supplementing the analysis with variables capturing speculative capital flows, but the explanation of speculative flows is likely to be a complicated and possibly somewhat arbitrary procedure, "L/ He did introduce dummy variables for periods of obvious speculation but there is no basis for evaluating their accuracy. His use of the covered interest rate differential as an independent variable, he also noted, “is inconplete in times of speculation, since in order to cepture the speculative flows it would be necessary to use ... the uncovered interest rate differentials,"2/ In practice, the short-term capital inflows, especially during disturbed periods, were prompted by exchange-rate speculation as well as by credit-restraint considerations, Each of the
two factors frequently reinforced the incentive provided by the
other. In the absence.of a good measure of speculative- expectations, it is bound to be difficult to separate these two incentives for capital inflow.
There is thus an area of ambiguity in this econometric work: the identification of the chain of causation between variables with a high degree of statistical association. Porter in fact relies 1/ Ibid., p. 417.
2/ Ibid., p. 401.
bee”
-30-
on this argument to challenge Willms! contrary findings. He noted tha: the results of Willms study “are consistent with the totally different interpretation advanced in this paper-enamely, that the changes in required reserves induced the capital inflow. "2/ Porter would suggest that the changes in the "controlled" component of the monetary base was responsible for the changes associated with the fluctuations in foreign assets, and not the other way around,
. There can be no doubt that short-term capital inflows, and especially the unrecorded “errors and omissions" residual, were sensitive to changes in Germany's international position. Periods of export expansion often sparked domestic business expansion and were associated with central bank action to slow dow the growth in demand, often inducing German firms to borrow abroad, But the strong export position also stimulated expectations of exchange~ rate change and induced inflows of non-resident funds, especially on commercial transactions, ‘as @ prudent precaution against the possibility that the Demark might appreciate, often speeding up the pace of monetary restraint by the central bank. Whether it was the credit restraint which induced the capital inflows or the capital inflow which forced the authorities to tighten credit cannot be determined on the basis of the statistical evidence,
Monetary policy and European stabilization - When we look
back over the entire period from 1958 to 1972, however, it is evident that the European authorities depended upon monetary policy
[ater enema 1/ Ibid., p. 415. Italics in the original text,
wn eke — a eer ern omen cae Nee ey) oe EERE ee a a oe
TS RR oR RR ON Oy SNL Fe GUD OT GRE ee ee}
=31-
as the primary instrument of domestic economic Stabilization, often without significant support from fiscal policy. Despite the balanceof-payments surpluses, the European central banks were not prepared to abandon what they regarded as their primsry responsibility to promote domestic economic stability and to protect the purchasing power. They proceeded, on occasion even through a disorderly
process of trial and error, to fashion new tools of central banking or to introduce novel adaptations of traditional ones .+/ Their success in these efforts varied fron country to country and, within & particular country, from time to time. But these efforts to offset the domestic liquidity effects from external sources were not overwhelmed until the U.S. payments deficits became massive
and the European countries took exchange-policy action (floating, dual exchange markets and comprehensive controls over private shortterm capital inflow) to protect their domestic economies,
As a practical matter, then, statements that central banking policy was impotent because it induced offsetting capital inflows are challenged by the preeminent role of monetary policy between 1958 and 1972 in the demand-management policies of the larger Europeen countries. On the other hand, the full role of the
monetary element in the international inflation mechanism cannot be
1/ The technical instruments utilized by the European central banks are reviewed in detail in my study, External Surpluses, Canital Flows, and Credit Policy in the European Economic Community, 1958 to 1967, Princeton Studies in International Finance No. 22, 1969.
a - - Sollielliadethentaetth eaten otal aaa sateen aeeteaseadieimeiamnet den meets tee tate tee ee ed
ee
-32-
measured by the extent to which the central banks were able to control the external contribution to primary liquidity. For the monetary flows had substantial secondary liquidity effects, Entrepreneurs in non-bank sectors found their current cash flows augmented by export sales and by access to foreign money markets or by financial transactions with foreign residents, Finally, there is the "same year" fallacy: that is, important monetary effects are likely to be neglected when attention is focused upon year-to-year movements in key economic variables when there are substantial, if uncertain, lags between additions to private liquidity and increases in private spending in the larger European economies,
Accordingly, the recent OECD study may understate the
monetary role in the mechanics of "imported inflation" in the Common
‘Market countries. The German authorities, it will be remembered,
have emphasized their difficulties in controlling the growth in nonbank liquidity, © They récently reported that the central bank achievement of the “complete neutralization of the liquidity inflows to domestic banks ... prevents the banks from stepping up their lending to domestic customers on the grounds of their additional liquidity, but it does not curb the expansive effects exerted by the inflows of funds from abroad to non-banks on the money stock, "t/
The recent Japanese experience also underscores the direct
contribution to major internal price advances in 1972 and 1973 made
AS i/ Honthly Report of the Deutsche Bundesbank, March 1973, p. 3.
1 Oo eC eR ee mE So RTT Ak NRE SRE. S- NORE UREN os SS TC TT LT
-33-
by the growth in private liquidity from massive export surpluses and imports of funds from abroad, The large trading companies (which handle the bulk of export sales) drew on their current cash flows to finance speculative activities. The expansion in private liquidity was much more general: a survey of some 460 corporations revealed that their "ready liquidity" had risen from 1.00 month in 1970 to 1,60 months in mid-1972,2/ The boom in stock prices during 1972 “has been caused by a buying campaign by general corporations, who now are said to own much more of the entire listed stocks than
oN private stock holders, and it is quite understandable in view of the sharp increase in corporate liquidity, Alleged cornering of land by big corporations may be only a quite natural development."2/
These corporate purchases during 1972 became so prominent,
in fact, that. they became the subject of an extraordinary government inquiry. It was found, according to a report in the. United Kingdom press, that the six largest Japanese trading houses in 1972 "had made profits of £268 m from ‘speculative! purchases of land, securities and local commodities. Of this, real estate profits provided £175 m, security profits £35 m, and the balance of £58 m arose from ‘hoarding and stock piling’ of seven key commodities, "'3/ Their purchases also
had a measurable impact on prices in some foreign markets. It is
a 9 i/ The Oriental Economist, April 1973, p. 11.
i)
/ Ibid., p. 11.
Jo
/ The Economist (London), April 7, 1973, p. 94,
oe ee ene. FO NN TY Se NRL ET Se NY ST Re oe NNER ee = eee oe eed Se e-news nee ee -
-34-
estimated, for example, that Jepan absorbed during the month of February (1973) as much as three-quarters of the supplies reaching world wool markets. Their purchases in lunber, soybeans and certain other commodities contributed to the sharp advences in U.S. prices early in 1973. By the spring of 1973, Japanese domestic prices were rising rapidly. On @ year-over-year basis, the aggregate wholesale price index was up 11% in Narch and 11.4% in April, the Tokyo consumer price index was up $% in March and 10.1% in April.
Nonetheless, a purely monetary explanation of domestic inflation would neglect two key transmission elements important in recent experience: (i) the domestic income effects of current account surpluses; and (ii) the direct effects of rising prices abroad. The Oriental Economist recently emphasized the importance of the nonmonetary sources of Japanese inflation; it attributed "the current soaring of commodity prices! in Japan to five factors: (i) import inflation from price advances abroad (even after the yen costs had been reduced by the appreciation of the currency); (ii) demand shifts from rising fiscal and housing spending; (iii) cost push from higher wages; (iv) the cyclical business upswing; and (v) "imaginary demand based on speculative operations. "L/ We shall also find these nonmonetary channels important in the German experience as we review the domestic effects of Germany's large export surpluses after 1966 in the next section of this study.
1/ The Oriental Economist, April 1973, p. 5.
SIRT Sn men Ne NS ee Een | ee ee en eee = eee
-35-
Non-monetary channel: domestic income effects of expert surpluses
The Common Market countries as a group had current-account as well as balcence-of-payments surpluses throughout the period under review. Their’ surpluses on goods, services and unilateral transfers increased from an annual average of $630 million for 1956-57 to $2.5 billion between 1958 and 1961 and to $1.6 billion between 1962 and 1966. (See Table 3.) These surpluses represented primarily a surge in export sales. For the 1959 to 1961 period, Baffi has estimated that the combined current~-account surpluses of the six Common HNarket countries as a group averaged 2% of their cnp,2/
These current-account surpluses directly added to private liquidity. Even when the liquidity effects were neutralized by the central benk, the export expansion itself remained a potent external source of domestic business expansion. Through-the foreign-trade multiplier, the surge in export sales after 1957 directly impinged upon the output of goods and services and upon the demand for labor. Because the export boom after 1957 occurred in a period of full employment, rapid growth and optimistic entrepreneurial expectations, it also helped to set into motion a secondary process of wageprice inflation. Excess pressures on the labor market produced a “wage explosion" in Italy in 1962-63 and in the Netherlands in
1/ Paolo Baffi, "Western European Inflation and the Reserve
Currencies," Banca Nazionale del Lavoro Quarterly Review, No. 84, (March 1968) pp. 14-15.
,
ae
-36-
1963-64 and less explosive but continuing wage-price spirals in France, Germany and Belgium in the mid-1960's,
The growing regional integration contributed to a "Spill over" of excess demand from country to country. The 1963-64 erowth in German exports can be attributed not to the U.S. external deficit but to excess demand in Italy and France, Similarly, German demand for Dutch manpower contributed to the excess demand for labor and to the "wage explosion" in late 1963 in the Netherlands. With the Common Market countries as a g§roup in continuous external surplus, one or more of them were exacerbating the domestic stabilization difficulties of their trading partners,
The acceleration of European inflation in the 1962-64 period (See Table 2) suggests a process of “imported inflation" more complex and subject to more substantial lags than is suggested by explanatory models which emphasize year-to-year changes in monetary or other key economic ageregates, For example, Baffi cited the year-to-year increases in European prices as compared to the percentage declines in the ecurrent-account as & proportion of GNP after 1959 as evidence that "the movement of prices was to a large extent
governed by changes in the domestic origin in the volume of demand, 11/
As a second example, some economists have interpreted the substantial
| year-to-year growth in domestic (as compared to the foreign) assets
— 1/ Baffi, "Western European Inflation and the Reserve Currencies,"
op. cit., p. 16,
-37-
of European central banks as evidence that the authorities desired-on purely domestic grounds--growth in the internal monetary base beyond the amounts derived from external sources =!
This emphasis upon the domestic origin of inflationary impulses appears seriously to underestimate the delayed impact of the surge of European exports upon the course of their internal business developments after 1958, In German experience, for example, we can identify a rough pattern of export growth followed (along familiar forelen-trade multiplier lines) by an induced expansion in investment demand and then in domestic consumpticn, In 1959 and 1960, the sleck from a falling off in the rate of increase in private consumption was taken up by a growth in exports: foreign sales accounted for more than 30% of the growth in GNP in the two years, (See Table 4.) Gross investment also jumped in 1959 and reached a peak in 1960, but private consumption did not become the main sustaining force of the boom until 1961 and did.not reach a peak until 1962, There was a renewed stimulus from export sales by 1963
when the growth in gross investment Slackened,
(Insert Table 4)
1/ Scott and Schmidt, "Imported Inflation and Monetary Policy,"
op. cit., pp, 390-403. Baffi compared the growth in foreign and in domestic essets for the 1959-1966 and found that, for small countries, the foreign assets accounted for the entire growth in the monetary base but, for the larger European countries, there was a significant domestic component." (See Baffi, op. cit., pp. 3-22.) Goldstein
bas also recently come to the same conclusion in his unpublished paper of August 1972, "Imported Inflation--A Phrase in Search of a Fbenomenon,"' (mimeo.) pp, 6ff,
Reed
-38- TABLE 4
Germany: Chanze in Ageresate Final Demand (includine exports) and Contribution of Solsctad Comnonents to Total Chance, rE Rom monents to Total Chance
1951 - 1972
GNP at market price Contribution to change (per cent)
Billions
Percentece
Gross Exports Investment
Private Consumption
1951 120 22.1 = [3473] _ 19.4 47.7 1.4 1952 137 14.3 19.9 > [2705 47.4 5.2 1953 147 7.7 31.4 31.4 ~~ ~-(7403} -37.1 1954 158 . 7.30 [50-0). 42.6 50.9 -43.5 1955 180 14.2 25.8 ~~ |47,6]__ 35.1 -8.5 ™~, 1956 199 10.2 40.8 3.6 ~~|63.0] 717.4 ~/ 1957 216 8.8 [48.0] 17.1 59. 224.5 1958 232 7.0 11.2 _ 15.1 {67.5! 11.2 1959 251 8.4 33.0] ~~ 141.8 45.4 -20.2 1960 302 11.5 31.8 44.3}-~. 47.9 -15.0 1961 333 10.0 8.3 30.7 54.8 6.2 1962 361 8.3 11.6 25.8 8.9 3.7 1963 384 6.6 | 30.5] 14.2 54.4 1.4 1964 -421 9.6 22.8 ~ ~~ .[47.4| 45.5 -15.7 1965 460 9.4 20.3 34.2 ~~ eae -14.5 1956 491 6.6 | 37.6| -8.6 - 63.4 7.6 1967 a/ 495. 0.8 = (210.3) 23. : ) (151. 3) 1968 540 9.2 29.3]. _ -18.1 1969 605 12.1 27.8 -16.3 1970 686 13.3 20.8 “7.9 1971 758 10.6 19.8 8.3 1972 828 9.2 21.1 7.3
SOURCE: 1951 to date, Wirtschaft und Statistik, Break in Series in 1980 when Saar and Berlin were added,
a/ Because absolute change was so small percentage changes in component e) series are without significance,
-39-
The German boom was set off by a sizeable trade surplus after mid-1963, largely the result of inflationary developments in France and Italy. The authorities steadily tishtened credit conditions in 1964 and 1965, as the strength of the business expansion was maintained. By the second quarter of 1965, in fact, there was the first substantial current-account deficit in Germany since 1951. The cumulative effects of the government's program intensified, however, and by 1966 the German economy was entering what proved to be the most protracted recession in the past-war period.
As we can see in Table 4, exports became once again the major stimulus to the German recovery. Bernstein, in fact, offered this German experience as evidence that "fixed parities ... contribute(s) to monetary and economic stability in a more fundamental
1/
sense." For the marked export expansion in 1966 to 1968 had
moderated the effects on internal output and employment of an inade-
quate growth in home demand, Net exports grew from -0.1% of GNP in
the boom year of 1965 to 1.4% in 1966 and to 3.3% during the recession year, 1967. This export surge "was a major factor in preventing a serious recession from emerging in Germany, "!2/
The German recovery and European inflation - The German recovery did not proceed as planned, The expectation was that
er renee ey 1/ £E.u. Bernstein, "Flexible Exchange Rates and International
. Adjustment" in The Economics of International Adjustment edited by
R. Hinshaw (Baltimore: The Johns Hopkins Press, 1971), esp. pp. 160f£.
2/ Ibid., p. 161.
To memmescwwryyen ies ers 6 gemma ena a tS ag RS Ne A RIE Sn Le LE eR QMO Ree UTRe Om = —Fe aRRRNEEERNORpEEUNNE n= Se nani
-40-
the large export surplus of 1966-67 would be reduced as the German economy shook off the recession and advanced toward full employment. But the export surplus persisted into 196, largely because of an unexpected surge in foreign demand. German firms then responded strongly to the upsurge in foreign demand. The currentaccount surplus, amid a domestic boom, led private entrepreneurs to expect a revaluation of the Dil by late 1968, Thereafter, there were unprecedented inflows into Germany on repeated occasions and the authorities found it necessary to revalue in 1969, to allow the Dil to float in 1°70 and 1971 and to revalue and float again
in 1973,
The German experience underscores that critical dimensions of the processes of “imported inflation" can be neglected by & preoccupation with purely monetary phenomenon. For German business activity closely followed a pattern of cyclical expansion in which the growth in exports served an exogenous role, and the subsequent expansion in domestic investment and private consumption, an endogeneous role. In this extended and interrelated dynamic model, it was no longer clear how external and internal stimuli
to German business expansion could be neatly separated,
<n ae ee ene = = + ae ane aeeee en teers ss arene meneame carne <n Saat eee ee ee OSCE PET = ERE TO
so
-4l-
iTieces abroad
Non-monetary chenn2l: risine coods
In retrospect, the failure of the Common liarket to respond
“more quickly to the post-1965 inflation in the United States can be
explained in part by German economic developments. German wages
and prices advanced only slightly in the 1967 and 1968 recession years, The extreme moderation union leaders adopted in wage negotiations in 1968 and even in 1269 undoubtedly reflected the extended business slowdown. But this moderation also led to increasing worker dissatisfaction, even to work stoppages of an irregular character, and in 1970 and 1971 to the only dramatic "wage explosion" in post-war German history when wage increases averaged for
the overall economy between 12% and 14%,
In the view of the Bundesbank, however, "the labor market
acted like a focal point for the tendencies towards overstrain in
the economy" and "the upsetting of the internal. balance had its primary cause in .., Germany's fundamental external disequilibrium, "2/ What happened in Germany, in brief, was a combination of domestic
and export spending which built up demand pressures to unprecedented levels, In 1970, for example, the rate of capacity utilization in industry averaged 93% or about 6% higher than the previous cyclical peak. As a result, the German economy experienced a further accelera-
tion in price increases and unprecedentedly steep rises in unit labor
rt eee 1/ Report of the Deutsche Bundesbank for the Year 1969, p. 7,
u . sal
coy
. ~42-
costs. The willingness of employers to grant extraordinary wace boosts undoubtedly reflected-the ease with which they were able to pass through these added costs to foreign as well as to domestic customers, The surge in exports: after 1966 is: undeiitted evidence that German prices of traded goods had lagged behind those in foreign countries end helps to explain the greater willingness of German entrepreneurs to grant wage increases than in earlier periods of cyclical expansion. The cost-push element contributed to a direct convergence between the infletion rate in Germany and abroad,
It had been expected that German price advances would slacken as excess demand pressures eased in 1971 and as the value cf the Dii drifted upwara. ust as the strong boon in Germany from 1968 to mid-1970 had generated strong expansionary forces in its major trading partners, “however, the acceleration of price advances abroad impeded the deceleration of German price and wage advances thereafter, For example, the Bundesbank reported that, despite the higher value for the DM, exporters were able to raise their Dil prices more steeply as business activity picked up abroad in 1972; in addition, on the import side, the "stability gain" from lower DM costs of foreign goods was "Zoregone within a short period" by the world-wide intensification of inflationary tendencies .2/
Direct price effects and international inflation - The continued buoyancy of foreign demand, even when the German business
a 1/ Report of the Deutsche Bundesbank for the Year 1972, p. 12. Aeport ox the Deutsche Bundesbank for the Year 1972
enema A ea NN Aa ee Se ony eNO Soe ae ce OAT ameter RT TENTS IROS
©)
eh3-
recovery gained substantial momentum, Supported the views within Germany of an important school of economists who have emphasized the direct effects of traded- -goods prices in the world inflation process, In this view, inflation is transmitted fron country to country directly through the immediate adjustment of prices of traded goods and not, as is often assumed, indirectly via an increase in liquidity caused by 8 favorable balance of payments of the country that is trying to resist | inflationary pressures from abroad, Haberler has reported that the German Council of Economic Advisers held this view: namely, in an epen economy the adjustment of prices to the world price level is @ireet and eutomatic, and no prior increase in international liquidity is required; but, he added, representatives of the German central
bank have taken a different position.2/
These direct price effects are obviously associated with
international movements of commoditt es and labor, “Because of the
grewing flows of goods, labor and capital within the Common Market, this factor explains why price trends within the area could have a regional momentum of their own, apart from price or balance-of-pay-
ments developments in the United States, These effects were even
more importent for the smaller European economies than for the larger
enes; for, in the view of the O£CD, the econometric evidence shows
that the problem of "imported inflation" through trade price effects
Gottfried llaberler,
Book review, Zeitschrift fur Nationalekonomie, 1968, pp. 107-110.
-44-
4s particularly serious and intractable for the smaller open European
1/
econonles =
This study found three main channels for the transmission of price inflation:
&@. Noncompetitive imports were the most obvious form of "imported inflation" through their effects either on industrial costs or on prices of consuner goods;
b. Competitive imports directly interacted with the pricing policy of domestic competitors and influenced the latter's prices for the home market; and
€. Price-following exporters. induced a chain of events in which exporters (with improved profits on foreign sales) pay higher wages and stimulate wage pressures in sectors sheltered from foreign competition. The inflation-transmitting effects of-prices of traded goods could be traced through several mechanisms. In-the first place,
the country's exposure to foreign price inflation varied with the size and composition of its foreign trade sector (including goods end services). There has been within the Common Market a gradual inerease in the share of the foreign trade sector in natimal GNP. The changes (measured as the average of exports and imports of goods aod services) as a percentage of GNP were estimated at:
“Uf “The International Transmission of Inflation," op, cit., p. 81.
Q
-45-
Average Averaze Change 1960-62 1668-70
Netherland 50.2 49.2
Belgiun | 35.5 43.9 Germany 18.8 . 21.9 Italy 15.6 19.0 France 12.8 15.6
+824
+3.1 +3.4 +2.7
Source: "International Transmission of Inflation,'' Ibid., p. o4,
Within the Community, then, the trade impact varied between around
50% for the Benelux countries to around 15%-22% for the three larger
member countries,
In the second place, the transmission impact varied with
the sensitivity of traded gocds prices to (a) foreign versus (b)
domestic price influences. The study found that a small country
with a large foreign trade sector might find its export and import
prices "dictated" by world trade prices, In the Nordic countries,
for example, prices in the export sector which-were set abroad
directly determined profits and hence wages paid by export firms;
these wage increases spread out to the lower productivity "sheltered"
sector through national wage bargaining. The study found in Swedish
experience, for example, "a national pattern of wage bargaining
hinging upon the competitive position of the exposed sector, "!/
1/ Ibid., p. 85.
-46-
For the larger countries, the paper reported, domestic influences were predominant in setting export prices in Germany but foreign and domestic influences were about equclly weighted in determining French export prices. (p. 86.)
Accordingly, foreign trade prices are determined by “a simultaneous interdependent set of relationships between all trading countries '"*/ with each country contributing to, and also influenced . by, international price movements, The study also reported that the parity realignment in 1971 and 1972 “appears to have had some stabilizing influence on trade prices." We will therefore turn to the effects of exchange-rate and other balance-of-payments adjustment policies on the course of domestic price trends in the larger
trading countries,
-47-
Domestic prices under persed exchanvze rates
Under a system of pegged exchange rates, balance-of-payments surpluses end deficits have not a neutral but a direct impact upon internal price trends and business conditions. Because the European countries were in substantial surplus during the period under review, there was a direct transmission through the belance of payments of expansionary tendencies in them.
These influences are transferred through the liquidity, the domestic income and the price effects of those surpluses. Even when the monetary effects on the banking system are temporarily sterilized, the expansionary imnacts an incamen and an business spending are likely to speed up internal inflationary trends through the channels we have already reviewed,
‘Adjustment-inflation" and domestic prices - What is of
interest to our inquiry at this point is the recognition that the
-- -
acceleration of internal price and income changes in a surplus country is a key element of the balance-of-payments ad‘ustment process under pegged exchange rates. The domestic expansionary influences constitute "adjustment-inflation" costs imposed through the balance of payments, They are independent of purely internal factors affecting the domestic price level. There is, on the deficit side, a corresponding "adjustment-defiation" cost imposed through the
external payments mechanism,
-40-
With flexible exchange rates, by contrast, balance-of-payments adjustment takes place through the effects of changes in the exchange rate upon the sales and profits of the foreignetrade sector: that is, upon export, import and import-conpeting firms as compared with those producing for the home market. In this case, the home-goods industries are shielded from much of the costs of adjustment and the need for broad movements in the general level of domestic prices is avoided. Accordingly, a country can choose between adjustment by exchange rate action or by domestic inflation and deflation, depencing on whether it chooses to hold the exchange rate or allows it to be altered, In brief, the surplus country can choose between “revaluation and inflation" and the deficit one between “devaluation and deflation,"
Accordingly, under pegged rates, the surplus country cannot escape the costs of Nadjustment-inflation" if the existing parity is
held. Advocates who recommend a fixed-rate world monetary system as
a bulwark against internal inflation may neglecr their significance.
For, in practice, "it is an open question whether on balance the adjust-
ment mechanism under the gold standard ... operates more effectively to
prevent inflations or to spread infletions. A correct reading of the
historical record may suggest the second effect is the stronger one, "/ The expansionary internal economic effects of a surplus,
and deflationary effects of a deficit, in the balance of payments.
~ 1/ Fritz Machlup in Int ernational Payments Problems, Symposium
sponsored by the Americcn Enterprise Institute, Washington, D.C. September 23-23, 1965, pp. 157-58. (Italics in original)
-49-
is the critical characteristic of the adjustment mechanism under pegged exchange rates. For there is a clear tendency in the longrun fixed-rate model toward "one world price level to which national price levels must conform, "L/ The processes of automatic adjustment in the price-specie flow model, Hume assured us, would not ensure a single common world price level but rather "must for ever, in ell neighboring nations, preserve money (i.e. the national price levels) nearly proportionaeble to the art and industry of each nation. =! This tendency for national price levels, or rather their current rates of change, to be brought more closely together when there are balance-of-payments surpluses and deficits is inherent in the pegged-rate mechanism, regardless of the causes of the international disequilibrium. There often are situations where a country's price level has gotten out of line and where price adjustments would be called for. But the same changes in domestic prices and incomes occur in the fixed-rate adjustment model in situations only. distantly related to demand-management policies: a non-price impairment of a country's export capability, either temporary or structural; a crop failure or other form of natural disaster; or adverse developments of
non-economic character. In all these cases, adjustment under fixed
re, i/ Harry G. Johnson, Inflation and the lionecarist Controversy,
Op. cit., pp. 84-05,
2/ David Hume, "Of the Balance of Trade" as reproduced in International Finance, edited by R.N. Cooper (Penguin modern economics, 1969), p. 27.
TT Rn nee rte neem pene seme ae eee een crepemnen oe 2-2 NCEP RENE
-50-
rates takes place through changes in the levels of domestic monetary and spending aggregates.
In practice, then, there are conflicts of national interest as between surplus and deficit countries in sharing these adjustment costs. The surplus country, especially in an inflationary world environment, is concerned to avoid the internal cost of “adjustmentinflation." As a result, officials in surplus countries, especially when beset by internal cost-push dangers, will prefer to have the deficit countries reduce their inflation rate. They will therefore favor world payments arrangements which exert external discipline on deficit countries; this variant of the internetiona adjustment mechanism can be called the "low-inflation" compromise.
By contrast, for its part the deficit country is usually
even more determined to avoid the impact of "adjustment-deflation"'
-
on local employment and the local business situation. Their govern-
ments often find it unrealistic to attempt to defend ‘temporary deflation or even--in recent years--a slowdown in the internal business momentum in the name of international adjustment coopera-~ tion. Accordingly, their officials prefer a “high-inflation" variant of the international adjustment mechanism under pegged exchange rates,
The "high-inflation" compromise - In this variant, the surplus countries accept, either willingly or with reluctance, a
substantial acceleration on the rates of change of domestic prices
Seen ee cee ee Lae eee em TPR Re te ees wate ne ee: ee, ame one teeem See renews oe SORES aR RL A TT ST TREE
-Sl-
and incomes. It has the advantage for the deficit countries of reducing the international pressures upon them to slow down their internal inflation. Such a compromise can be realized in practice only if the deficit countries have access to enough international liquidity to continue their purchases from abroad.
European officials maintained that the Common Market countries had accepted--had, in the opinion of scme, been forced by the workings of the reserve-curtency system to accept--a high-inflation adjustment compromise between 1964 and 1968, Enminger wrote: "This long-drawn-out adjustment eo. illustrates that the burden of adjustment lay very one-sidedly en the shoulders of the Eure pean surplus countries, ‘here was no signiticant deflation on the U.S. side, but a large--and in the end intolerable--measure of inflation on the side of the European surplus countries, te!
Holtrop supported this view: "The surplus countries ... generally lived up to the prescziption of the Brookings Institution report and allowed their economies to be inflated by their surpluses without putting up too much resistance."'2/ He added; “The only objection, within the framework of the fixed-parity system, one could possibly make against these countries! policies is that they “17 Otmar Emminger, "Practical Aspects of the Problen of Balance-of- Payments Adjustment," The Journal of Political Economy, Supplement, August 1967, p. 517.
2/ M.W. Holtrop, "The Adjustment Process, Its Asymmetry, and Possible Consequences" in Anprozches to Greater Flexibility of Exchanee Rates
edited by G.N. Halm (Princeton: Princeton University Press, 1970), p. 136,
-52-
did not stimulate cost- and price-inflation still further, so as to eliminate even more quickly their remaining surpluses," He even maintained that "the adjustment process has lost any trace of Symmetry. Deficit countries do not manage to bring down their unit costs of production. "2/
As we have already seen, U.S. economists challenged this perception, U.S. and European economists céhe to sharply divergent interpretations of the same body of economic facts. These conflicting viewpoints were trenchantly, i£ somewhat harshly, summarized by Mundell; "The U.S. was saying, "Prevent a liquidity shortage, * and the Europeans, 'Cerrect the U.S. deficit." This was real politique at its best, since more liquidity meant more inflation and adjustment in Europe, while more adjustment would imply tougher balence of payments measures in the U.S. and less world inflation,
Each continent wanted to thrust more of the burden.on the other, u3/
The "loweinflation" compromise = In this alternative
variant, the deficit countries accept, either willingly or as a result of externally-imposed adjustment pressures, a perceptible slowdown in the rates of change of their internal prices and incomes, The difficulty with this variant is the fact that the 1/ Ibid., p. 139. | 2/ Ibid., p. 139,
3/ Robert A, Mundell, "A Plan for a World Currency," in Hearings, "Next Steps in International Nonetary Reform," Joint Economic Committee of the U.S. Congress, September 9, 1968, p. i7.
mee emer nema an seme pee ae cee ae ee nee mene a nee cee caeageee
TE
(J
-53~
authorities in deficit countrics are usually not able to improve the internal stabilization performence materially, They are functioning about as effectively as they can end have domestic political incentives to better their performance, if only they could do so.
| In practical terms, then, officials in deficit countries do not need international constraints to remind them that it would be desirable to improve their stabilization efforts, If they cannot do so on their ow volition, it then follows, they will do so under international constraint only at a price: they will have to alter their unemployment, growth or price targets in the name of international cooperation. It is new & familiar preposition that, in any head-on collision between domestic priorities and the requirements of international balance, no industrial country will sacrifice its internal goals merely to improve the balance of payments,
. The pre-1914 international gold standard was the most
effective variant of a "low-inflation" compromise yet devised. There was in its workings a deflationary bias simply because, under it, the deficit country soon found its international financing availabilities depleted. Johnson regards "this criticism ... to be an over-generalization of a particular historical period, for the present argument is that the system has an inflationary bias, 1/
He added: "Countries cannot prevent another country--in particular
t
1/ Harry G. Sctason, Macroeconomics end Monetary Theory (Chicago: The Aldine Publisi:ing Co., 1972), p. 181.
-54-
the United States--from inflating if it wants to. They are instead obliged to import inflation and so finance deficit countries, Surplus countrics have to put up with the inflation of deficit countries,"
But the inflationary bias in contemporary world payments arrangements has been less a matter of United States policies, one way or the other, then the deliberate attempt of the founding fathers at Bretton Woods to achieve "through international cooperation the advantages the international gold standard provides without imposing on other countries the hardships it may entail, "L/ Later, on the 25th anniversary of the Fund, Slater noted that Bernstein now Usuge geste that the oniy difference 1s tnat the Fund system is a gold standard constrained never to introduce deflation anywhere in the system, "4! Samuelson is closer than Johnson to an explanation of the inflationary bias of the Fund system when he writes: "the problem of long-term liquidity of the system seems to me to be fairly trivial, Who could believe that, in the age after Keynes, depressions would ever again be caused by a failure of man to come up with sufficient double-entry bookkeeping items?"!3/
_i/_E.il. Bernstein, “ionetary Stabilization: The United Nations Progran,"' in Economic Reconstruction edited by S.E. Harris (New York: McGraw-Hill, 1946) first edition, second impression, pp. 338 ££,
2/ David W. Slater "Commentary," in Bretton Woods Revisited edited by A.L.K. Acheson et al (Toronto: University of Toronto Press, 1972,
p. 69.
3/ PA. Samuelson, "Heretical doubts about the international
mechanisms," Journal of International Economics 2 (1972), p. 449, nnn eernational Economics
Controversy over "low inflation" compromise = During the
mid-1960's the European surplus countries resisted “adjustmenteinflation" in the name of international adjustment. Even in a system of rigid exchange rates in which exchange rates were to be altered "relatively rarely among the OECD countries, "2/ it was the majority view that "countries in surplus positions because of their competitive strength cannot realistically be called on deliberately to adjust their price levels upwards, 12/ Earlier, in 1964, there had been a formal decision of the Common Market countries to essien to internal price and cost stability a "priority over all other aims of economic policy and of policy in other fields, "'2/
U.S. economists were critical of what they regarded as a European unwillineness to contribute to better balance in international payments, For example, Haberler pointed out in 1967: “Emninger ‘does not mention that, while the surplus countries had to put up with more inflation than they liked, the United States had to-permit a level of unemployment which the Europeans would regard as intolerable 14! Hore pointedly, Cooper observed that the reaction of the European surplus countries to the “imported inflation" of the 1960's
einen er er een L/ Zhe Balance of Payments Adjustment Process, (Paris: Organization for Economic Co-operation and Development, August 1966), para. 6, p. 8.
2/ Xbid., para, 46(a), p. 20.
B/ Report of the Deutsche Bundesbank for the Year 1964, p. 25.
4/ Haberler, "Comment," Journal of Political Economy, August 1967,
Op, cit,, p, 535,
-56-
was to choose "between price stability in Europe and unemployment in the United States, "L/
Tt was the "ad justment-inflation'! tendencies created by the European payments surpluses which finally convinced gome European officials to accept exchangeerate policy as a preferred alternative
adjustment policy, The late Herr Blessing described the process by
which he altered his vicy point; he began by asking "whether it would
| not be more appropriate for the sick to devalue than for the healthy
to revalue ,,, Until a few years ago, it had been my Opinion that the eick ought to undergo an operation and not the healthy, "2/ But the cumulative domestic inflationary effects of Germany's enormous expert surpluses over @ period ox years forced him "to admit that we
live in a world which is no longer ,.. prepared to Accept really
_ Severe disinflationary Measures, and that the healthy cen protect
himself against inflation only by means of a change in parity." Similarly, Netherlands Bank President Holtrop concluded that, among "possible alternatives to adjustment by inflation," currency appreciation was a preferred policy choice, 2/ He even came to rejoice in seeing an innovation in the System that would bring to a potentlal surplus country the option between either combining a less infla-
l/" Richard hi, Cooper, The Economies of Interdependence (New York:
NeGraw-Hill, 1968) p. 202. Italics in original,
2/) Werr Karl Blessing, late President of the Bundesbank, speech
; before the German Cooperatives at Mainz, Germany, on October 10, 1969,
3/ Holtrop, op. cit,, pp. L40£F,
“57-
tionary behavior with a gradually rising parity, or sticking to a fixed parity, but then accepting on one's ow vesponsibility the inflationary consequences of it." (p. 143.)
It was a major breakthrough among European officials in the late 1960's when some central bankers began to assert a preference for greater domestic price stability even at the cost of a currency appreciation. As a result, there came to be a gradual acceptance among them of greater flexibility of exchange rates as a means both of reducing international disequilibrium and of protecting the domestic price levels in the economies of the surplus countries from "imported inflation." Interestingly, there appears to have been a similar debate about exchange-rate policy in Japan. When the Minister of International Trade and Industry made a speech in favor of more Nad justment-inflation" in Japan, The Oriental Economist reported that a “group of businessmen and economists who bitterly opposed" such inflation. included central bank officials. Because of their fears that domestic inflation would accelerate, the article
added, the opinion was gaining ground emong some of the policy planners
of the Government and the Bank of Japan "that another currency realign-
ment should not be averted, "L/ We will therefore turn to the use of exchange-rate policy as an instrument for domestic economic stabilization in the larger trading countries.
.
1/ The Oriental Economist, September 1972, pp. 22-23.
von oq
~58-
Exchanze-rate nolicy: export-oriented adjustment axcoan
Exchange-rate policy has had an important role both in the transmission and in the slowing down of inflationary impulses in ‘European price experience since 1968, In particular, the German authorities permitted the Spot value of their currency to rise in an effort to cut back the persistent trade surplus and to slow down the internal inflation, To this end, they have allowed the effective value of the De-mark to rise against the dollar by 60% over the past four years through a series of revaluations of the DM parity and throush periods of upward’ floating in the foreien exchange | market,.
Effects of an exchanze-rate change - The German experience with exchange-rate policy has been particularly interesting because domestic prices have continued a Steady rise in the period. Revaluation should slow down price advances. The price effects of a revaluation policy are concentrated in the traded-goods sector and the adjustment costs are not distributed as widely or as uniformly (as between the forelgn-trade and home-goods sectors) as they are under
pegged exchange rates, In analytical terms, an appreciation initially
‘imposes windfall losses (in terms of local currency) upon the export
end import-substitution industries at home. These losses are not shared by home-goods industrics, There are also windfall gains to
German importers as the DM price of foreign goods is reduced,
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The differential price changes (in terms of local currency) have differential effects on entrepreneurial profits, In particular,
the German exporter finds it relatively less profitable then before
-. to sell his output to a foreign customer and relatively more attrac-
tive to sell it to a local one. In this way, appreciation provides an initial incentive for the entrepreneur to divert deliveries from foreign to local customers.
Fron.a stabilization point of view, this diversion of deliveries from foreign to home consumers occurs without the need for local prices and disposable incomes to rise. Under pegged rates, by contrast, such a diversion would have required local spending aggregates and local prices to be pushed up before the desired expansion in net domestic absorption could be attained. It is an
advantage of appreciation that it avoids the need for the surplus
' country to advance wages and incomes--a necessary. part of adjust-
ment under pegged rates--if the paynents balance is. ‘to. be restored. Exchange-rate policy and domestic stabilization in Cermany -
The authorities have put into effect for Germany a policy of small
and frequent changes in exchange rates as a key element in their
domestic stabilization program. There were (1) a revaluation in
1969; (2) a period of floating and then a revaluation in 1971; and
(3) a renewed floating and two revaluations in 1973. Yet throughout
the period, the domestic inflation has not been reduced to what
the authorities would regard as an acceptable level nor has the
German export expansion been brought under control,
C)
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The main clerents in the German inflation since 1968 have
been (1) the wage explosion and associated expansion in private
consumption spending; (2) an unexpected strength in export sales
‘with associated effects on business investment; and (3) massive
inflows of short-term funds which have from time to time temporarily immobilized central bank instruments to control domestic liquidity, In 1968, before the first revaluation, the Bundesbank reported that the large current-account surplus added substantial resources to German non-benks as "a crucial monetary prerequisite for the start of a domestic adjustment process which ... would be bound finally to raise the nriee level at hama and ta reduce the external surpluses on current account ,"2/ The current-transactions surpluses were being offset by record exports of long-term capital, especially by German banks. But this form of offset was unsatisfactory for two reasons: (1) the exports in 1968 "alone equalled one-fifth of' the total longer-term domestic monetary capital formation" (p. 16); and (2) through a “boomerans" effect, there was "a direct connection between exports of capital ... and additional German exports of goods," (p. 18.) The authorities "never thought of correcting the external imbalance by permitting ... prices and costs in Germany to adjust itself to that in foreign countries." (p. 18.) Revaluation was finally announced in the fall of 1969 after
a debate on the issue between the two main parties in the Federal
ee 1/ Report of the Deutsche Bundesbank for the Year 1968, p. 16.
wee ee - SS te ee emer ee ee. eee e SE
1 ' end
-61-
election, Afterwards, as large amounts of funds flowed out of the
country, the entire financial climate in Germany changed rapidly after
1/
revaluation,— But exports failed to diminish as had been expected,
“in part because price rises abroad neutralized a substantial part
of the costs to exports of the revéeluation, The surge in corporate profits after 1967 contributed to an investment boom which "far exceeds all its predecessors in strength." (p. 3.) In turn, the Bundesbank saw evidence of a "fundamental" external disequilibriun in (1) the failure of the trade surplus to decline in the business recovery; (2) the statistically denonstrable price and cost dis- _ parity with Germany's main trading partners; and (3) the inflows
of funds from abroad which monetary policy was powerless to prevent, (p. 8.) The Bank recognized that the revaluation "came very late" and that “at home ... an adjustment process had started which, in itself, was operating to remove differences of price level between Germany and the rest of the world." (p, 15.) —
By 1970, there was a slight easing of demand pressure evidenced by reduced capacity utilization by a growing number of enterprises, With price rises mainly attributable to domestic factors, there was a shift from demand-pull to cost-push inflation
and the most broadly based stimulus to domestic spending was found
not in business investment but in private consumption. The unprece-
l/ Report of the Deutsche Bundesbank for the Year 1969, p. l,
~
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dented wage ircreases in 1969 and 1970 contributed to the domestic disequilibrium, The Benk also thousht that, - because “the revaluation was too long delayed, it was possible for the inflationary tendencies abroad to Spread unimpeded to Germany at that time, 'L/ In its view, the appreciation of the DM in October 1969 'Wwas unable to slow dow the growth of domestic price and costs" because "for one thing, it took place very late, and for another, it was presuaably too emall in quantitative tems, "2/
In 1971, the very high private capital inflows were so large at times as to deprive "internal stabilization measures
eee OL any chance of success," (p. 1.) In the Bank's view, the relaxation of U.S. credit policy was. tranomitte? ts othec countries by international payment flows and especially by credit transactions via the Euro-dollar market, (p. 22.) On the other hand, there was evidence that wage increases "were by no means only ‘market induced’ but had en influence on the movement of prices
in their own right." (p. 13.)- Against domestic wage developments,
therefore, it was not unexpected that private consumer demand was
initially the main driving force of a renewed German business expansion in 1972, But the current account surplus also increased
steadily from SDR 170 million in 1971 to SDR 380 million in 1972,
1/ Report of tha Doves
che Bundesbank for the Year 1970
» Pp. ll,
2/ Report of the Deutsche Bundesbank for the Year 1971, p. 11.
en Nee ee aes es neem Leeman mee es ee os =e p CE
Nene
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By late 1972 German consumer prices were rising at an annual rate of close to 8%. Despite currency revaluation and a lower rate of wage cost increase, prices failed to slow dow their advances. On those grounds, the authorities introduced a major series of stabilization measures in May 1973, including (1) a temporary investment tax
of 11%; (2) a 10% personal income tax surcharge on higher income
brackets; (3) a suspension until April 30, 1974 of special deprecia-
tion allowances on new plant and equipment and an owner-occupied houses and apartments; (4) a DM 2 billion cut in Federal and Lander spending; (5) compulsory reduction in public bodies borrowing plans; and (6) the issue of "stability bonds" with proceeds to be blocked and some Di 3 billion of social security funds to be transferred to the central bank. The German authorities had decided that a broadlybased package of "domestic" measures was required to contain the
inflationary difficulties confronting their country, -
- i eee te ay ee ree eer ree Th ete ne ee te nee eee mm cee me em ee 7 a hn alin eT
OO
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Concluding observations
The international transmission of inflation from country to country can be traced through three channels of impact: through the liquidity, the internal income and the price effects on the domestic economy from developments abroad, The liquidity effects of external payments surpluses have been given much attention among European officials and economists over the past decade. As a result, there has been widespread interest in a reserve-center explanation of world inflation under fixed rates in which the United States plays the strategic role in the international transfer process,
Emphasis upon liquidity factors - The recent empnasis upon the monetary transmission of world inflation can be attributed to the massive dollar inflows into European countries and Japan, especially Since 1970, But this recent scale of disorderly international capital
movements may eventually be judged, in the light of hindsight, to have
constituted an exaggerated measure of the importance of the purely
monetary elements in the transmission mechanism.
In the first place, these international disturbances marked the culmination of a period of disequilibrium in the external position of the Ur.ited States vis-a-vis its trading partners, This disequilibrium had persisted for an extended period of time and had grown to unprecedented proportions. It was perhaps unrealistic to have expected that such strains could be corrected without substantial disturbance to the
world economy,
, es
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The severity of the disruptive intexnational capital movements in this period was further augmented by a sharp contrast in the cyclical situations as between the United States and western Europe after 1970. In addition, monetary strains were further enhanced by the determination of the various national authorities to rely heavily upon internal credit policy to resolve their domestic Stabilization difficulties, Finally, exchenge rates of most of the leading currencies prior to mid-1971 fluctuated within margins of less than 1% around the then established parities. In retrospect, it was to be expected that conflicts in cyclical timing and hence in domestic credit policies were tikely to stimulate massive--and at times disruptive--international capital flows between the industrial countries when exchange rate movements were so narrowly circumecribed, With greater flexibility in exchange-rate practices already in effect
and with prompter adjustment of disequilibrium in prospect, there
are reasonable grounds for expecting international movements- of
funds to be a less disruptive factor in the world economy in the
years ahead than they have been in the recent past, though still a big one. For analytical purposes, an undue emphasis upon the role of
the purely monetary channel has a significant cost: a tendency to
neglect the importance or the non-monetary elements in the interna-
tional transmission of inflation, On the direct income side, the
sustained current-account surpluses which the Common Market countries
recorded during the 1960's and Japan at the end of that decade had
ee Ae mmm ee Oe meee - Pe rere =. — -
-66-
expansionary income effects on their domestic economies. Export expansion was a primary stimulant to internal business activity in these countries during this period: for export sales tended to be the exogenous, and induced domestic investment and then consumption endogenous, variables in the European business cycle. Because export growth often led the cyclical business recovery, especially in Germany, it becomes difficult to Separate the external from the internal sources of econcnic growth in the Common Market countries, The economic impact of the income and price effects can also be seen in the evidence that internal prices among the Common Narket countries had a momentum of their own throughout the decade. They were sometimes less affected by developments in the outside world in general and the United States in particular than by demand fluctuetions in neighboring Common Market countries, The tendencies for prices to have a regional--as distinct from a global--momentum reflected the impact of foreign trade volume with régional neighbors and of foreign-trade prices on their domestic price situation, During the decade of the 1960's (prior to the special circumstances — which led to the breakdown in world payments arrangements between 1971 and 1973), the effects of these regional factors were much increased as movements of commodities and services, of labor and
of capital among the Common Market countries were much augmented.
The role of price elements - The domestic effect of price
changes of traded goods was found by the OECD have been of major
importance in the transmission of International inflation, as we
oe)
-67-
have recounted. Whether this experience is merely a reflection of the increasing economic interdependence among member countries or whether lt reflects the temporary effects of the unsatisfactory stabilization performances of the leading industrial countrics remains to be seen,
In retrospect, however, these international transmission effects served to exacerbate domestic inflationary price and expectational factors of unprecedented severity in each of the larger industries countries. These countries have entered a period in which traditional instruments of demand management have proved no longer to be effective means of stabilizing the internal economy under costpush and expectational disturbance. These factors have altcred the economic environment in fundamental ways. The business commun ty hes accepted the expectation of a steadily upward drift of costs and has, accordingly, at times ‘diminished resistance to higher prices for materials, equipnent, or labor. On their part, labor leaders have been bargaining for automatic compensation to offset rising consumer prices as well as to cover expected gains in ‘productivity.
The surge in prices, both in the major industrial countries and in world commodity markets (following the U.S. and other currency adjustments) in early 1973, provides evidence that direct and expectational price effects are powerful elements in the international transmission of inflation under contemporary conditims. Economists
are likely to focus intensified attention on these price elements
-68-
as the statistical data explaining price developments in 1973 become available. Already by August 1 (1973), for example, the U.S. Council of Economic Advisers reported to the Joint Economic Committee about the complex channels through which prices abroad affected the U.S. domestic economy, and their importance, in these words: "There is
no mechanical way to assess the total contribution of rising international prices to the U.S, inflation. However, conditions in the first half of 1973 were such as to make the influence of these prices quite power fu, we!
On the other hand, it must be recognized, the recent international character of price developments has also reflected cyclical and special influences. In particular, there was a major acceleration in business expansion in each of the industrial countrics in 1972 and 1873. It was an exceptional circumstance that the rates of real growth in GNP in all of them would be substantially above the long-term average year-to-year real expansion in output,
In addition, Chere also was at the time an "ecological boom" which swept markets for many primary products, It was unprecedented--for the first time in western history in fact--that the industrial countries would become aware of general, as well as temporary, shortages of foodstuffs, animal feed, energy. and raw materials on an unprecedented scale in a peace-tine situation. The “I/” Press Release of the Statement of Herbert Stein, Chairman,
et al before the Joint Economic Committee on August 1, 1973, mimeograph, p. 10.
ewe eee ae eee Sm pm ee ee me pee wat ee
Ne
-69-
megnitude of this expectational phenomenon becomes concrete when it is recalled that a seat on the New York Stock Exchange sold for $550,000 in the late 1960's and only $92,000 in early 1973; but membership on the Chicago Mercantile Exchange, priced at only $3,000 a few years ago, changed hands in 1973 at $115,000.2/
Exchangeerate policy - Finally, it is evident that exchangerate policy has a role in the international transmission mechanism, However, these effects are complex and the OECD is helpful in reminding us that "there is ho simple answer to the question whether &@ regime of fixed or more flexible exchange rates is more or less ‘inflationary! per se, 12!
. In general, it can be noted, pegged exchange rates impose "adjustment-inflation" costs on surplus and "adjustment-deflation' costs on deficit countries, But surplus countries have resisted internal inflation in the name of international cooperation just as deficit countries have been unwilling to accept domestic deflation
on the same grounds. This conflict in national interest between them--
the surplus countries advocating a "low-inflation" and the deficit
. countries a “Ntsh-inflarion" compromise--helpe tu explain why the
balance-of-paynents adjustment mechanism agreed to in 1944 at Bretton
1/ 8.J. Maidenberg, "Six reasons for sharp rise in commodities dealing," The Times (London), May 9, 1973, supplement, p. v.
2/ “The International Transmission of Inflation," op. cit., p. 81.
Woods proved to be so ineffective.t/ These same differences are also a substantial source of dispute among the larger trading countries in the current international negotiations to reform, or to rebuild, an orderly world payments system.
By contrast, recourse to exchange-rate policy has the effect of avoiding the broad changes in national price levels required in the adjustment process under pegged rates, When exchange rates are altered, the domestic price effects are concentrated in the traded-goods industry sector. In theory, an appreciating rate should have anti-inflationary domestic effects and a declining rate inflationary ones,
The German authorities have carried cut in prectice since yoy what can be described as a policy of small and frequent eppreciations of the Demark, But revaluation has not been as effective as had been hoped either in cutting back the persistent trade surplus or the internal inflation, Three factors have been important in this experience, in the first place, the 1969 revaluation was -regarded by the Bundesbank as an example of "too little and too late." Secondly, inflation abroad was proceeding so rapidly that German exporters were able to maintain foreign sales despite the currency appreciations, One U.K, journalist, in fact, recently attributed "the resilience of German industry" under the impact of successive ———————
l/ See my paper, The Case For The Par-Value System, 1972, Princeton Essays in International Finance, No, 92, March 1972, esp. pp. 17-21.
ao.
ad
currency appreciation to "the absolute deterzination of German industry to hold on to export mavkets,uL/
But the German experience also reminds us ef a third factor: the longer-term repercussions of a revaluation, It is common for the short-term costs of a revaluation to be emphasized and the longer-term benefits to be neglected, But the reduced lecal-currency prices of foreign goods end the incones effects of the reduced trade surplus are long-run as well as short-terg influences for internal stability, As these effects help to slow down the rises in domestic costs, in fact, the country's competitive position begins to improve and its Currency can becone the candidate for &@ new revaluation,
Domestic effects of external surnlusos and deficits - As we
ea Suriusos and deficits look back over the stabilization experience of the industrial ceuntrics from 1958 to 1973, it is evident that from time to time international factors were Significant Sources of internal economic disturbance
in them. Does this experience mean that these countries have now reached a degree of economic -integration, and. the associated flows of goods, Services, capital and labor among them have now reached the volume, that national policy formations which seek a degree of national autonomy have become obsolete?
Emminger has concluded in a recent and exceptionally thoughtful inquiry into the international &sSpects of world inflation
that the Principal sources of inflation in most countries have been
1/ Malcola Rutherford, "German industry rides out revaluation in grand style," The Financial Timas (London), July 11, 1973, p. 22. te ee ee
rd
-72-
domestic in origin. "It would be an exaggeration," he stated, "to put all or even the main responsibility for world inflation on the now defunct international monetary system, It ... is still true
that in most cases the larger part of inflation has been ‘home made.' And it is only fair to edd thet better domestic stability in all the major countries would have prevented the international system from unfolding all its negative features, I find it important to make this 'caveat’ because the international monetary system is too often used as a scapegoat or alibi by national governments wee ttf Clearly attempts by the industrial countries to moderate world inflationary trends will require a package of naticnal, regional and internetionel measures, It is the thrust of Emninger's view that the primary
focus of these efforts must be to improve the domestic stabilization
results in each of them. Only by attaining greater internal price
Stability can these countries hope to keep tendencies toward the
o
international transmission of inflation under control. -- -
On the international Side, however, it is evident in retrospect that the protracted balance-of-payments surpluses and deficits in the major trading countries have been a significant source of domestic economic disturbance in them. Under pegged exchange rates or even under "managed" floats with significant official intervention, “i/ Otmar Eominger, "Inflation and the International Monetary System," the tenth annual Per Jacobsson Lecture, Basle, Switzerland,
June 16, 1973 reproduced in part in the Washington Post, June 17, 1973,
-736
the effects of disturbances in foreign countrles are transmitted through the chenges in douestic liquidity, in incomes and in prices which we have reviewed, Similarly, a domestic inflation in one country is transmitted to trading partners through these same channels, This transmission process continues so long as the conditions of balance-of-payments disturbance are uncorrected.
‘From a nétional point of view, inflationary impulses from country to country are strengthened by balance-of-payments surpluses and deficits of a protracted character among trading partners; they are moderated by the prompt restoration of the external balances among them. But prompt corrective reasuras have costs, Under pepged or officially-supported exchange rates, for exemple, the surplus countries can choose as a deflationary option to revalue or as an inflationary one to postpone corrective action. They often preferred an inflationary option to avoid harm to export firms. Similarly, the deficit countries can choose to restrict demand as a deflationary option or to accept the inflationary impact of a devaluation. They have tended to prefer devaluation in place of deflation and, too often, have been slow in taking the supportive domestic measures needed to ensure the success of the devaluation itself,.
In short, neither surplus or deficit countries have welcomed deflationary adjustment options as realistic choices over the past decade, Furthermore, they have subjected their local economies to
external disturbance by Permitting their surpluser and deficits to
~The
continue over an extended period. For these reasons, the attempts in the current international financial negotiations to agree upon rules and procedures for a prompter and more balanced adjustment of external surpluses and deficits can be regarded as a realistic way to dampen the international transmission of inflation from country
to country, even in a highly interdependent world economy.
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OO)
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Cite this document
Federal Reserve (1973, August 31). "Imported Inflation" and the Balance of Payments. Ifdp, Federal Reserve. https://whenthefedspeaks.com/doc/ifdp_1973-32
@misc{wtfs_ifdp_1973_32,
author = {Federal Reserve},
title = {"Imported Inflation" and the Balance of Payments},
year = {1973},
month = {Aug},
howpublished = {Ifdp, Federal Reserve},
url = {https://whenthefedspeaks.com/doc/ifdp_1973-32},
note = {Retrieved via When the Fed Speaks corpus}
}