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ple supply pesos than demand them. In the exam-
ple, suppliers offer to sell 8 billion pesos per year, E
but purchasers want to buy only 4 billion. This gap 0.50
between the 8 billion pesos that some people wish
to sell and the 4 billion pesos that others wish to
buy is what we mean by Argentina™s balance of
payments deficit”4 billion pesos (or $4 billion) D
per year in this hypothetical case. It appears as 4 8
the horizontal distance between points A and B in Billions of Pesos per Year
Figure 5.
How can governments flout market forces in
this way? Because sales and purchases on any market must be equal, the excess of quan- The balance of payments
tity supplied over quantity demanded”or 4 billion pesos per year in this example” deficit is the amount by
must be bought by the Argentine government. To purchase these pesos, it must give up which the quantity supplied
of a country™s currency (per
some of the foreign currency that it holds as reserves. Thus, the Central Bank of
year) exceeds the quantity
Argentina would be losing about $4 billion in reserves per year as the cost of keeping demanded. Balance of
the peso at $1. payments deficits arise
Naturally, this situation cannot persist forever, as the reserves eventually will run out. whenever the exchange rate
This is the fatal flaw of a fixed exchange rate system. Once speculators become convinced is pegged at an artificially
that the exchange rate can be held for only a short while longer, they will sell the currency high level.
in massive amounts rather than hold on to money whose value they expect to fall. That is
precisely what began to happen to Argentina in 2001. Lacking sufficient reserves, the Ar-
gentine government succumbed to market forces and let the peso float in early 2002. It
promptly depreciated.
For an example of the reverse case, a severely undervalued currency, we can look at
contemporary China. Figure 6 on the next page depicts demand and supply curves for
Chinese yuan that intersect at an equilibrium price of 15 cents per yuan (point E in the di-
agram). Yet, in the example, we suppose that the Chinese authorities are holding the rate The balance of payments
at 12 cents. At this rate, the quantity of yuan demanded (1,000 billion) greatly exceeds the surplus is the amount by
quantity supplied (600 billion). The difference is China™s balance of payments surplus, which the quantity
demanded of a country™s
shown by the horizontal distance AB.
China can keep the rate at 12 cents only by selling all the additional yuan that foreign- currency (per year) exceeds
the quantity supplied.
ers want to buy”400 billion yuan per year in this example. In return, the country must Balance of payments
buy the equivalent amount of U.S. dollars ($48 billion). All of this activity serves to in- surpluses arise whenever
crease China™s reserves of U.S. dollars. But notice one important difference between this the exchange rate is pegged
case and the overvalued peso: at an artificially low level.

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370 The United States in the World Economy

The accumulation of reserves rarely will force a
central bank to revalue in the way that losses of
D reserves can force a devaluation.
Thus China has been keeping its currency underval-
E ued and accumulating huge dollar reserves for
Price of a Yuan

years, although it has shown some recent signs of
(in dollars)

backing away from this policy recently.
0.12 This asymmetry is a clear weakness in a fixed ex-
change rate system. In principle, an exchange rate
Balance of
payments surplus disequilibrium can be cured either by a devaluation
by the country with a balance of payments deficit or
by an upward revaluation by the country with a bal-
ance of payments surplus. In practice, though, only
deficit countries are forced to act.
600 1,000
Why do surplus countries refuse to revalue? One
Billions of Yuan per Year
reason is often a stubborn refusal to recognize some
basic economic realities. They tend to view the dis-
F I GU R E 6
equilibrium as a problem only for the deficit countries and, therefore, believe that the
A Balance of Payments
deficit countries should take the corrective steps. This view, of course, is nonsense in a
worldwide system of fixed exchange rates. Some currencies are overvalued because
some other currencies are undervalued. In fact, the two statements mean exactly the
same thing.
The other reason why surplus countries resist upward revaluations is that such actions
would make their products more expensive to foreigners and thus cut into their export
sales. This, in fact, is the main reason why China maintains an undervalued currency de-
The current account spite the protestations of many other nations. China™s leaders believe that vibrant export
balance includes interna-
industries are the key to growth and development.
tional purchases and sales
The balance of payments comes in two main parts. The current account totes up ex-
of goods and services,
ports and imports of goods and services, cross-border payments of interest and dividends,
cross-border interest and
and cross-border gifts. It is close, both conceptually and numerically, to what we have
dividend payments, and
called net exports (X 2 IM) in previous chapters. The United States has been running
cross-border gifts to and
from both private extremely large current account deficits for years.
individuals and govern- But the current account represents only one part of our balance of payments, for it leaves
ments. It is approximately
out all purchases and sales of assets. Purchases of U.S. assets by foreigners bring foreign cur-
the same as net exports.
rency to the United States, and purchases of foreign assets cost us foreign currency. Netting
the capital flows in each direction gives us our surplus or deficit on capital account. In re-
The capital account
balance includes purchases cent years, this part of our balance of payments has registered persistently large surpluses as
and sales of financial assets foreigners have acquired massive amounts of U.S. assets.
to and from citizens and In what sense, then, does the overall balance of payments balance? There are two pos-
companies of other
sibilities. If the exchange rate is floating, all private transactions”current account plus
capital account”must add up to zero because dollars purchased 5 dollars sold. But if,
instead, the exchange rate is fixed, as shown in Figures 5 and 6, the two accounts need not
balance one another. Government purchases or sales of foreign currency make up the sur-
plus or deficit in the overall balance of payments.

It is difficult to find examples of strictly fixed exchange rates in the historical record.
About the only time exchange rates were truly fixed was under the old gold standard, at
least when it was practiced in its ideal form.4

As a matter of fact, although the gold standard lasted (on and off) for hundreds of years, it was rarely practiced

in its ideal form. Except for a brief period of fixed exchange rates in the late nineteenth and early twentieth
centuries, governments periodically adjusted exchange rates even under the gold standard.

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Chapter 18 371
The International Monetary System: Order or Disorder?

The Classical Gold Standard
Under the gold standard, governments maintained fixed exchange rates by an automatic The gold standard is a
way to fix exchange rates by
equilibrating mechanism that went something like this: All currencies were defined in terms
defining each participating
of gold; indeed, some were actually made of gold. When a nation ran a balance of payments
currency in terms of gold
deficit, it had to sell gold to finance the deficit. Because the domestic money supply was based
and allowing holders of
on gold, losing gold to foreigners meant that the money supply fell automatically, thus rais- each participating currency
ing interest rates. Those higher interest rates attracted foreign capital. At the same time, this to convert that currency
restrictive “monetary policy” pulled down output and prices, which discouraged imports into gold.
and encouraged exports. The balance of payments problem quickly rectified itself.
This automatic adjustment process meant, however, that under the gold standard no
nation had control of its domestic monetary policy. An analogous problem arises in any
system of fixed exchange rates, regardless of whether it makes use of gold:
Under fixed exchange rates, monetary policy must be dedicated to pegging the exchange
rate. It cannot, therefore, be used to manage aggregate demand.
The gold standard posed one other serious difficulty: The world™s commerce was at the
mercy of gold discoveries. Major gold finds would mean higher prices and booming eco-
nomic conditions, through the standard monetary-policy mechanisms that we studied in
earlier chapters. But when the supply of gold failed to keep pace with growth of the world
economy, prices had to fall in the long run and employment had to fall in the short run.

The Bretton Woods System
The gold standard collapsed for good amid the financial chaos of the Great Depression of
the 1930s and World War II. Without it, the world struggled through a serious breakdown
in international trade.
As the war drew to a close, representatives of the industrial nations, including John
Maynard Keynes of Great Britain, met at a hotel in Bretton Woods, New Hampshire, to de-
vise a stable monetary environment that would enable world trade to resume. Because the
United States held the lion™s share of the world™s reserves at the time, these officials natu-
rally turned to the dollar as the basis for the new international economic order.
The Bretton Woods agreements reestablished fixed exchange rates based on the free
convertibility of the U.S. dollar into gold. The United States agreed to buy or sell gold to
maintain the $35 per ounce price that President Franklin Roosevelt had established in
1933. The other signatory nations, which had almost no gold in any case, agreed to buy
and sell dollars to maintain their exchange rates at agreed-upon levels.
The Bretton Woods system succeeded in refixing exchange rates and restoring world
trade”two notable achievements. But it also displayed the flaws of any fixed exchange
rate system. Changes in exchange rates were permitted only as a last resort”which, in
practice, came to mean that the country had a chronic deficit in the balance of payments of
sizable proportions. Such nations were allowed to devalue their currencies relative to the
dollar. So the system was not really one of fixed exchange rates but, rather, one in which
rates were “fixed until further notice.” Because devaluations came only after a long run of
balance of payments deficits had depleted the country™s reserves, these devaluations often
could be clearly foreseen and normally had to be large. Speculators therefore saw glowing
opportunities for profit and would “attack” weak currencies with waves of selling.
A second problem arose from the asymmetry mentioned earlier: Deficit nations could
be forced to devalue while surplus nations could resist upward revaluations. Because the
value of the U.S. dollar was fixed in terms of gold, the United States was the one nation in
the world that had no way to devalue its currency. The only way the dollar could fall was
if the surplus nations would revalue their currencies upward. But they did not adjust fre-
quently enough, so the United States developed an overvalued currency and chronic bal-
ance of payments deficits.
The overvalued dollar finally destroyed the Bretton Woods system in 1971, when Presi-
dent Richard Nixon unilaterally ended the game by announcing that the United States
would no longer buy or sell gold at $35 per ounce.

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372 The United States in the World Economy

Under the Bretton Woods system, devaluation was viewed as a last resort, to be used only
after other methods of adjusting to payments imbalances had failed. What were these
other methods?
We encountered most of them in our earlier discussion of exchange rate determination
in free markets. Any factor that increases the demand for, say, Argentine pesos or that reduces
the supply will push the value of the peso upward”if it is free to adjust. But if the ex-
change rate is pegged, the balance of payments deficit will shrink instead. (Try this for
yourself using Figure 5 on page 369.)
Recalling our earlier discussion of the factors that underlie the demand and supply
curves, we see that one way a nation can shrink its balance of payments deficit is to reduce
its aggregate demand, thereby discouraging imports and cutting down its demand for
foreign currency. Another is to lower its rate of inflation, thereby encouraging exports and
discouraging imports. Finally, it can raise its interest rates to attract more foreign capital.
In other words, deficit nations are expected to follow restrictive monetary and fiscal
policies voluntarily, just as they would have done automatically under the classical gold
standard. However, just as under the gold standard, this medicine is often unpalatable.
A surplus nation could, of course, take the opposite measures: pursuing expansionary
monetary and fiscal policies to increase economic growth and lower interest rates. By in-
creasing the supply of the country™s currency and reducing the demand for it, such actions
would reduce that nation™s balance of payments surplus. But surplus countries often do
not relish the inflation that accompanies expansionary policies, and so, once again, they
leave the burden of adjustment to the deficit nations. The general point about fixed
exchange rates is that
Under a system of fixed exchange rates, a country™s government loses some control over
its domestic economy. Sometimes balance of payments considerations may force it to
contract its economy in order to cut down its demand for foreign currency, even though
domestic needs call for expansion. At other times, the domestic economy may need to
be reined in, but balance of payments considerations suggest expansion.
That was certainly the case in Argentina in 2002, when interest rates soared to attract
foreign capital and the government pursued contractionary fiscal policies to curb the
country™s appetite for imports. Both contributed to a long and deep recession. Argentina
took the bitter medicine needed to defend its fixed exchange rate for quite a while. But
high unemployment eventually led to riots in the streets, toppled the government, and
persuaded the Argentine authorities to abandon the fixed exchange rate.

In view of these and other problems with fixed exchange rates, why did the interna-
Fisher from cartoonbank.com. All Rights Reserved.

tional financial community work so hard to maintain them for so many years? And
SOURCE: © The New Yorker Collection 1971, Ed


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