Knowledge that Transforms

THEORIES of monetary and financial markets are generally concerned with the behavior of broad aggregates. As yet, economists have not successfully blended the rich variety of institutional details that make up the financial markets with the theory of relative prices. Perhaps as a result of our procedures and the state of knowledge, our policy recommendations are often suggestions for pervasive changes in institutional arrangements. Many of our perennial policy debates are concerned with issues such as whether or not the Federal Reserve should be replaced by an immutable rule or whether banks should be prevented from independently creating money

T HE crisis will no doubt be surmounted. dollar will be saved. Its parity will be successfully maintained, and world will be spared that ultimate and unmentionable calamity whose consequences are more dreaded for never being described. The world monetary system will stay afloat, and its captains on both sides of Atlantic will congratulate themselves on their seamanship in weathering storm. But storm is in good part their own making. And if financial ship has weathered it, it has done so only by jettisoning much of valuable cargo it was supposed to deliver. Currency parities have been maintained, but full employment has not been. The economic growth of half advanced noncommunist world has been hobbled, to detriment of world trade in general and exports of developing countries in particular. Currencies have become technically more convertible but important and probably irreversible restrictions and discriminations on trade and capital movements have been introduced. Some government transactions of highest priority for foreign policy of United States and West have been curtailed. Others have been tied to a degree that impairs their efficiency and gives aid and comfort to bizarre principle that practices which are disreputably illiberal when applied to private international transactions are acceptable when government money is involved. These are costs. Were, and are, all these hardships necessary? To what end have they been incurred? They have been incurred in order to slow down and end accumulations of obligations in hands of European central banks. It is fair to ask, therefore, whether these accumulations necessarily involved risks and costs serious enough for countries concerned and for world at large to justify heavy costs of stopping them. Which is easier? Which is less disruptive and less costly, now and in long run? To stop private or public transactions that lead one central bank to acquire another's currency? Or to compensate these transactions by official lending in opposite direction? I do not suggest that answer is always in favor of compensatory finance. But issue always needs to be faced, and especially in present case. Several courses were open to European countries whose central banks had to purchase dollars in their exchange markets in recent years. (a) They could have built up their holdings quietly and gladly, as they did before 1959. (b) By exercising their right to buy gold at United States Treasury, they could have forced devaluation of or suspension of gold payments. (c) They could have taken various measures to correct and reverse chronic European payments surpluses. (d) By occasional withdrawals of gold and by constant complaints they could have brought tremendous pressure for discipline upon United States without forcing a change in parity. European central banks and governments chose fourth course, with token admixtures of third. They have made world opinion, and American opinion, believe there is no other choice. Almost everyone agrees that pressure of balance of payments deficit upon United States is inescapable arithmetic rather than deliberate policy of foreign governments. Yet for almost ten years previously, United States deficits were no problem. Clearly it is a change in human attitude and public policy, not inexorable circumstance, which has compelled us to take corrective actions. It is true that concern of financial officials about the dollar was only an echoand a subdued echo at that of fears, hopes, anxieties, and speculations that arose in private financial circles in late 1950's. But financial officials do not have to follow private exchange markets; they can lead instead. By an equivocal attitude toward private suspicions of dollar, European officials kept pressure on United States. Never did they

CONTEMPORARY governments appear to J have embraced too easily three incompatible goals; full employment, prices, and an inflexible exchange rate. More sensible policies could be pursued if one or possibly two of these goals were abandoned. Clearly, the least fundamental of the three is the foreign exchange rate, and if it could be shown that a flexible rate is not all that damaging, the step would be made much easier. The central arguments against a variable rate are that it would discourage trade and lending, and that it would encourage noxious speculation. The force of both these objections is lessened if the market can be satisfactorily stabilized. A simple procedure for the market will be discussed in this note. Since this problem of flexible rates was first discussed in the thirties, notably by Professor Harris, a great deal of experience has accumulated to show how extraordinarily effective feed-back control methods are for a great variety of mechanisms. If it could be shown that there exist reasonably simple and successful exchange rate stabilization policies, then a more rational discussion of policy alternatives should be possible. I shall assume a free foreign exchange market with complete convertibility, the exchange rate being set and maintained by a monetary authority which makes up any deficit and absorbs any surplus in foreign exchange at the announced rate. The aim is to stabilize this market in the sense that the rate may bend but will not break. Yet there is a fundamental ambiguity in the meaning of which we encounter in the question of stabilizing the market. Technically, by degree of we mean the rapidity of approach to equilibrium (defined here as equality of supply and demand). Thus with a given amount of disturbance, the more a market is the closer it will tend to be to its equilibrium. However, for a market with shifting supply and demand curves, the equilibrium price will hop about, so that the more stable, in this sense, a market is the more agitated its price will be. This contradicts our commonsense notion of stability and, what is much more important, is normally undesirable. In fact we want the market, as dominated by the authorities, to be markedly sluggish, to be stable in the popular sense and not very stable in the technical sense. More specifically, I assume that ideal behavior for the exchange rate is to be insensitive to short-run fluctuations in supply and demand. Thus the authorities are to try to equate supply and demand but only in the long run, not in the short run. They are to use the behavior of the market itself as a guide to altering the rate to accomplish this purpose. Consequently they will be acting on sound feed-back principles; technically they will be simulating a zeroing servo, that is one that aims to reduce to zero the difference between supply and demand. They will never quite accomplish their object, of course, since new disturbances are always disrupting their course. Given these aims the authorities are to alter the exchange rate continually in the light of two criteria, (1) the difference between actual and desired holdings of foreign exchange, and (2) the current payments gap. They must so weight their reactions that the former outweighs the latter, which it will naturally tend to do since it is the cumulated current payments gap. If they always alter the rate so as to push actual foreign exchange back towards the desired level, they will, in the long run, tend to maintain the level of foreign exchange constant and hence equate supply and demand. A more sophisticated approach could take the desired level of foreign exchange, m*, as variable, say, with the average domestic demand for foreign exchange. Purely for simplicity I shall treat m* as a constant. Our basic control routine for the exchange rate p, is then

IT becomes immediately apparent in analyzing any national economy that some resources are scarce only in the economic sense, but also in the more popular interpretation of that word. Because of international trade these shortages frequently impose no great hardship on the not nation; for example, the absence of tea and coffee plantations in the United States does prevent Americans from consuming prodigious quantities of these beverages. However, in the event of an hostility these resource scarcities can create a serious problem, especially if they happen to include some of the so-called strategic materials. It is with these materials, which are both vital to the country's defense and in short domestic supply, that this paper is concerned. Some of the more publicized scarce resources which have been regarded as critical by the United States include: tin, uranium, manganese, rubber, quinine, diamonds, and possibly plants manufacturing heavy machinery and precision instruments.' The very heterogeneity of this group augurs strongly against finding a single solution or even a unique mode of attack to the problem of how best to assure an adequate supply of these resources under all political conditions. Nevertheless, while the details of any possible solution may vary enormously with the individual material, almost without exception the available policy measures can be fitted into one of the following categories: 1. Importation under all conditions 2. Subsidized domestic production and research 3. Stockpiling 4. Conservation 5. Substitution