BALANCE OF PAYMENTS, INTERNATIONAL TRADE AND ECONOMIC DEVELOPMENT, 194956

From the end of the 1940s to the early 1960s the discussion of international monetary problems was focused on the idea of dollar shortage in non-dollar countries. Machlup argued that two conditions ailed these countries: first, that they were trying to maintain the foreign-exchange rates of their currencies at levels that overvalued them relative to domestic prices and incomes, partly in consequence of excessive expansions of credit; and second, with capital stocks depleted in the war and post-war period, they had not yet been able to build up adequate monetary reserves. The first problem was a problem of the flow supply of foreign exchange, inadequate because they were paying too little for it; the other was a problem of the stock supply of foreign exchange, inadequate because it takes time to accumulate reserves even after the inflow has responded to appropriate adjustment measures. In Machlups view, the dollar-shortage theorists, like the balance-of-payments theorists after the First World War, did not understand that monetary policy and misaligned exchange rates were the strategic variables. They looked for some structural explanations of a supposedly chronic dollar shortage. In this environment, Machlup presented Three Concepts of the Balance of Payments and the So-Called Dollar Shortage at an IMF meeting in 1949. The three basic concepts are the market balance of payments, a balance of supply and demand; the programme balance of payments, a balance of hopes and desires; and the accounting balance of payments, a balance of credits and debits. The market balance is purely hypothetical and addresses questions such as how would the quantity of foreign currency offered for sale increase or decrease if the price of foreign currency were 5 per cent higher, with no expectations being entertained regarding a further rise or subsequent reduction in that price, and with no change occurring in the domestic money supply and in national income. The programme balance may be part of a formal national plan, a forecast consistent with national targets, a projection of past experiences into national planning.

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Notes
1. 2.

The accounting balance is an arrangement of statistical data derived from records, reports and estimates, organized by conventional categories and with all items operationally defined. The meaning of equilibrium or disequilibrium, surplus or deficit, depends on ones definition of balance of payments. Whether and under what conditions the trade balance of a country would be improved by a depreciation or devaluation of its currency in the foreignexchange market had been debated with reference to elasticities and/or to relative monetary expansion; in his remarks on The Elasticity Argument for Foreign Exchange Restrictions to the International Trade Meeting of the Econometric Society, Machlup took on the arguments made by Guy Orcutt and Raymond Mikesell. In his paper Measurement of Price Elasticities in International Trade Orcutt had argued that statistically estimated price elasticities are unreliable for use in predicting the effects of a relative depreciation and probably considerably underestimate the effectiveness of such a depreciation.1 Mikesell argued that income and price elasticities of demand, based on a historical relationship between income, imports and relative prices, were subject to error and were misleading. He urged more attention to the probable reaction of foreign and domestic suppliers of individual commodities in order to reach conclusions on tariff and foreign exchange policies.2 In Machlups view, elasticities are relevant if one discusses given conditions of supply and demand, otherwise monetary variables have the leading roles. When the elasticity pessimists contended that actual elasticities were too low to promise any improvements in the trade balance, Machlup attempted to show why their pessimism was not justified. When balance-of-payments theorists disregarded or downgraded the role of monetary policy, Machlup attempted to show that the role of money in the play of market forces was strategic. In Replies by Economists in Monetary Policy and the Management of the Public Debt, Machlup addressed the impact of rising interest rates and credit expansion on business investment, as well as direct controls and credit controls in a system of free enterprise in his response to a series of questions put forward by the Joint Committee on the Economic Report, Subcommittee on General Credit Control and Debt Management (1952). He offered his recommendations for non-inflationary economic developmentin his notes for a speech (1955) and paper on The Finance of Development in Poor Countries: Foreign Capital and Domestic Inflation (1956).
Report of the New York Meeting, Econometrica 18:3 (1950), pp. 264309, on p. 284. Ibid., pp. 2845.

Fritz Machlup Papers, Hoover Institution, Box 87, Folder 26, Three Concepts of the Balance of Payments, Paper, International Monetary Fund Seminar, Washington, DC, typewritten outline, 21 October 1949. Copyright Stanford University.

Dear Dr. Lovasy: Thank you for your letter of October 7. I noted that Friday, the 21st, is an agreeable date for my performance before your Seminar. The title of my paper is Three Concepts of the Balance of Payments. I am enclosing a separate sheet with a few lines on its contents. I am usually in Washington on Fridays, working in the Library of Congress. I can therefore arrange to have lunch with some of your group. Please let me know what time you want to have me. I doubt that I can accept your kind invitation to come to your house after the Seminar. I have quite a bit of work scheduled and will be anxious to get back to Baltimore after the Seminar. Very cordially yours, Fritz Machlup Enclosure /

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October 12, 1949 Miss Gertrude Lovasy International Monetary Fund Washington 6, D. C.

THREE CONCEPTS OF THE BALANCE OF PAYMENTS

Paper by Professor Fritz Machlup, Johns Hopkins University, to be Presented before The International Monetary Fund Seminar on Friday, October 21, 1949, 4 p.m. Much of the confusion in the discussion of the dollar shortage and the dollar balance of payments goes back to continued equivocation. Three fundamentally different ideas are continually called by the same name. What is indiscriminately called the balance of payments may be: I a market balance, i.e., a balance of sup-

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ply and demand; or II a program balance, i.e., a balance of hopes and desires; or III an accounting balance, i.e., a balance of credits and debits. The meaning of a deficit in the balance of payments is, of course, categorically different for each of the three basic concepts. Even within each concept there may be several different deficits, depending on a number of arbitrary definitions, assumptions, hypotheses, judgments, or objectives. I. A dollar deficit in a countrys market balance of payments may be tentatively defined as an excess of dollar amounts effectively demanded at the given exchange rate by would-be purchasers (who are not restricted by specially adopted or discretionary government control measures) over the dollar amounts supplied at that exchange rate by would-be sellers (who are not motivated by a desire to support the exchange rate). II. A dollar deficit in a countrys programme balance of payments may be defined as an excess of dollar amounts needed or desired / for some specified purposes (assumed to be important with reference to some accepted standards) over the dollar amounts expected to become available from regular sources. III. A dollar deficit in a countrys accounting balance of payments may be defined as an excess of dollar amounts entered on the debit side of certain accounts in the annual record of its international transactions over the dollar amounts entered on the credit side of the same accounts, the accounts being selected from the full, necessarily balancing statement in order to throw light upon problems connected with market or programme balances of payments. The concept of compensatory official financing recently proposed by the International Monetary Fund is a novel attempt to do the impossible. It suffers from several contradictions but chiefly from an ambition to think simultaneously of market balances and program balances.1

Fritz Machlup Papers, Hoover Institution, Box 87, Folder 28, The Elasticity Argument for Foreign Exchange Restrictions, remarks, International Trade Meeting, Econometric Society. Holograph and typewritten abstract, 28 December 1949. Copyright Stanford University.

Many economists distrust or dislike the working of the market mechanism in foreign exchange markets and advocate direct restrictive controls. Among the economic rather than chiefly political reasons which they give for their position, the following three stand out: 1. The terms of trade argument: The disequilibrium exchange rates and exchange rationing give us better terms of trade than we could have with equilibrium exchange rates and without exchange rationing. In other words, the national income would be smaller if the market equilibrium were to be established through depreciation. 2. The income distribution argument: The disequilibrium exchange rates and exchange rationing are essential for their effects upon domestic income distribution. In other words, the national income distribution would be less equitable if market equilibrium were to be established through depreciation. 3. The elasticity argument: Equilibrium exchange rates are not attainable because the elasticities of demand for imports and exports are too low for exchange rate changes to improve the market balance of payments. In other words, market equilibrium cannot be established or approached through depreciation.
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Two of the papers presented today, Orcutts and Mikesells,1 were addressed to the elasticity argument and my comments will be confined to it. Both papers were critical of the elasticity pessimism expressed in recent years. Since I too believe that the elasticity pessimism is not justified, I intend to confirm, rather than criticize the contentions of the two speakers. The elasticity pessimism expresses itself in two ways: First, in underestimating the actual magnitude of the elasticities. Second, in overestimating the magnitude of the elasticities required for remedial effects of depreciation.

Why the actual elasticities have been underestimated.

1. The statistical techniques used by those who computed price elasticities of demand for imports imply index number techniques which have a strong bias toward underestimation. This was shown yesterday in paper by Harberger.2 2. As Orcutt has shown, the data used in the computations are over a period of twenty years, during which certain shifts in the demand situation involve a bias toward low estimates. 3. As Orcutt has shown, errors of observation are more likely on prices and incomes than on quantities. This implies, for statistical reasons, another bias toward underestimation. 4. The data used were chiefly those concerning goods whose prices did change more significantly, hence goods with low demand elasticities; the goods for which demand is likely to be more elastic were not adequately represented in the data. 5. The computations were confined to short-term effects, whereas it is the long-term effects which involve higher elasticities. 6. The observations were only for small price changes, while larger price changes, for which elasticities are probably greater, are more relevant for problems of depreciation. 7. The computations did not assume any time lags, whereas no one may expect real adjustments to come about without time lags.

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Implied in these propositions are the following points which deserve explicit emphasis: A. There are products which become exportable below a certain price, but are not exported when the price is higher. Such goods were not included in the computations. B. Those who take pessimistic elasticity estimates made for one period and apply them to another implicitly assume that the elasticities are nearly constant (a) overtime, (b) for different income levels, and (c) over different price ranges. On the basis of general theory, the presumption is

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5. Many of the pessimistic observers regard elasticities as too low for comfort because they believe the critical value of the sum of price elasticities of demand for imports and exports is unity, whereas this can be true only for infinite elasticities of supply. For smaller elasticities of supply the sum of the two demand elasticities may be well below unity for remedial effects upon the market balance of payments. 6. Most of the pessimistic observers forget that the socalled critical value of elasticities has been determined by theorists for a situation in which exports and imports are initially equal. Since countries which think of currency depreciation as a rule have an import demand in excess of exports, the critical value of elasticities is much lower. For example, if exports are 100 while the import demand is 200, and if the supply elasticities are infinite which is the worst possible case and if the elasticity of the foreign demand for exports is only -.4, the balance will be improved by exchange deprecation if the elasticity of the domestic demand for imports is higher than -.32. The critical value of a sum of the two elasticities is only 7.2. For supply elasticities below infinity, the critical values may be still smaller. 10 % depreciation reduces exports by 4%, i.e. by $6.4 increases dollar demand for imports .32%, i.e. by $6.4

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Why the required elasticities have been overestimated.3

that elasticities will be quite different. This is especially so with regard to different price ranges. The elasticity of demand between $4.00 and $3.50 may be altogether different from that between $3.50 and $3.00. One should not apply an estimate derived from small variations at one price level to variations by different margins and at different levels. Both Orcutt and Mikesell have made this quite clear. C. The neglect of time lags in elasticity computations has three results all of which may result in underestimations. (a) Trade figures immediately after price changes cannot well reflect the response to the price changes. A period of six or even twelve months must therefore include a significant portion during which trade was not yet affected by the new prices. (b) If price reductions are gradual, expectations of further reductions will affect trade in the opposite direction from that resulting from a price reduction that is regarded as the one and only change. Trade figures working with annual price averages without lags will include these temporarily perverse reactions of trade. (c) The more significant long-term adjustments are excluded by the short-period trade data without lags.

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7. The hope, expressed by Mikesell, that the recent exchange rate adjustment will give us a chance to learn a great deal about the relevant elasticities through observations of the results as reflected in the trade statistics soon to become available, is in vain. We must not forget that the market demand for dollars is not reflected in any trade figures when foreign exchange rationing is used. The most significant effect of depreciation may be the reduction of the unsatisfied excess demand for dollars. The market balance of payments may be improved, that is, the excess demand for dollars may be reduced in consequence of the depreciation while the statistics may record a reduction in the supply of dollars. Those who are untrained in economic theory will shout that the depreciation is a failure if it reduces the visible dollar supply; they fail to see the reduction in the demand for dollars because that demand, being suppressed by the authorities, has been invisible. Under a system of dollar rationing a reduction in the excess demand for dollars, in consequence of a depreciation of a national currency, will not be reflected in any international trade statistics.

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The Neglect of Supply Elasticities

To concentrate attention, in the analysis of the effects of exchange rate changes, on the elasticities of (foreign) demand for exports and of (domestic) demand for imports, and to neglect the elasticities of the supply of these imports and exports, has a very definite result. For it is not possible to neglect the supply elasticities without making implicit assumptions about them. When an analyst assumes that a certain percentage change in the exchange rate changes the price of the imports accordingly, he implies that the foreign price of the imported goods remains unchanged. But in postulating that the foreign price is unchanged although the quantity of goods purchased is increased or reduced, he implicitly assumes that the elasticities of supply are infinite. The result of this implicit assumption upon the analysis of the effects of exchange rate changes is very serious. We can see this by a very simple example, without algebra, geometry, or calculus. Assume that the Italian lira is depreciated by 10 percent, that the elasticity of Italian demand for imports is -0.5 and the elasticity of the foreign supply of these imports is infinite. In this case the Italian prices of imports must increase by 10 percent, the physical volume of imports will decrease by (approximately) 5 percent and, since the dollar prices of the imports are unchanged, the dollar value of imports will likewise be reduced by (approximately) 5 percent. Now we shall change the assumptions by giving the elasticity of the foreign supply of imports a smaller value; we shall, in order to avoid complications in the computation, assume it to be numerically equal to the elasticity of Italian demand, that is, +0.5. As the depreciation raises Italian import prices and reduces Italian purchases of imports, foreign prices will fall. With equal demand and supply elasticities, each country will bear one half of

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the price movement. Thus, Italian prices of imports will increase by (approximately) 5 percent and the foreign prices decrease (approximately) by 5 percent, in consequence of the 10 percent depreciation. * The physical volume of Italian imports will decrease by (approximately) 2 percent, and the dollar value will be reduced by (approximately) 7.4 percent. (The Italians will buy 97.5 percent of the previous imports at a unit price of 95 percent, i.e. for 92.6 percent of the previous dollar amount). The difference in the assumption regarding the supply elasticity accounted for a difference of 47 percent (7.4 as against 5) in the resulting reduction of the dollar value of imports. The effects of depreciation upon export values are analogously distorted by the implicit assumption of infinite elasticities of supply of exports. With an elasticity of (foreign) demand for (Italian) exports of -0.5, a 10 percent depreciation of the lira will, with unchanged Italian prices, reduce the foreign prices of the exports by 10 percent, increase the physical volume of exports by (approximately) 5 percent and reduce the dollar value of exports by (approximately) 5.5 percent. (The foreigners will buy 105 percent of the previous physical volume of exports at prices which are 90 percent of the former prices, hence they will pay 94.5 of the previous dollar amount). If we now change the assumptions concerning the elasticity of supply of Italian exports and make it, for the same reason as before, numerically equal to the demand elasticity, namely + 0.5, we have to figure with an increase in Italian export prices, as physical exports increase, until these prices are up by 5 percent in lira and down 5 percent in dollars. The physical volume of exports will consequently be increased by only 2.5 percent, and the dollar value of exports reduced by only (approximately) 2.6 percent. (The foreigners will buy 102.5 percent of the previous physical volume of exports and pay 95 percent of the previous prices, hence 97.4 of the previous amount of dollars). When we assumed the elasticities of supply of imports and exports to be infinite, and the elasticities of demand for imports and exports each to be -0.5, we found that the depreciation by 10 percent would result in a 5 percent reduction in the dollar value of imports and a 5 percent reduction in the dollar value of exports. There was, therefore, no net balance created by the depreciation provided exports and imports initially were equal. When we assumed the elasticities of supply to be numerically equal to the elasticities of demand, which were again -0.5 for imports as well as exports, we found that 10 percent depreciation resulted in a 7.375 percent reduction in the dollar value of imports and a 2.625 percent reduction of the dollar value of exports. If exports and imports were initially equal, the depreciation would have created an export surplus of 4.750 percent of the precious dollar value of exports.
* The price changes will be closer to 4.76 percent, because 110 (100 4.76 ) = 100 (100+4.76)

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The Neglect of Supply Elasticities4

How seriously will the results of our thinking be affected if, in the analysis of the effects of exchange rate changes we concentrate on the elasticities of (foreign) demand for exports and of (domestic) demand for imports and neglect the elasticities of the supply of these exports and imports? It is logically impossible to neglect the supply elasticities without making implicit assumptions about them. When an analyst assumes that a certain percentage change in the exchange rate will change the price of imports accordingly, he implies that the foreign price of the imported goods remain unchanged. But in postulating that the foreign price is unchanged although the quantity of goods purchased is increased or reduced, he implicitly assumes that the elasticities of supply are infinite. The assumption of infinite elasticities of supply may be highly unrealistic without being fatal to an argument based on it. It may simplify the analysis without invalidating it. Making a check in this respect for the simple case of unitary demand elasticities, we can readily see that it would make no difference at all whether the supply elasticities are small, large or infinite. If the elasticity of the demand for exports is -1.0, the foreigners will spend a constant amount of dollars regardless of the price of the export goods. If the elasticity of the supply of these exports is infinite, so that their domestic price is unchanged, the foreign price will be reduced exactly by the percentage by which the currency of the export country, say, the Italian lira is depreciated. If the elasticity of the supply of Italian exports is less than infinity, the prices in lire will increase as the quantity of exports increases and thus, the foreign prices will not fall by the full percentage of the depreciation. But be this as it may, with a unitary elasticity of the foreign demand for Italian exports, the total amount of foreign exchange supplied by exporters will remain unchanged, and, therefore, is independent of the elasticity of supply of exports. The same is true with regard to the amount for foreign exchange demanded by importers. If the elasticity of demand for imports is -1.0, the amount of domestic money spent on imports remains unchanged when the domestic prices of imports change. Depreciation will increase these domestic prices by the full percentage of the depreciation if the elasticity of the (foreign) supply of imports is infinite and by less than that percentage if the elasticity is smaller. But in any case, the unchanged amount of lire will represent an amount of foreign exchange falling short of the amount demanded before the depreciation by exactly the percentage by which the lira is depreciated. Thus, the demand for foreign exchange is not affected by the elasticity of the foreign supply of imports if the elasticity of the (domestic) demand for them is unity.

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Higher Demand Elasticities

We must not conclude from this check that the elasticities of supply will always be irrelevant for the supply and demand of foreign exchange. An example with demand elasticities numerically greater than unity will show that the supply elasticities may matter very much. Assume that the Italian lira is depreciated by 10 percent, that the elasticity of Italian demand for imports is -2.0, and that the elasticity of the foreign supply of these imports is infinite. In this case the Italian prices of imports must increase by 10 percent, the physical import demand will decrease by (approximately*) 20 percent and, since the dollar prices of the imports are unchanged, the dollar value of import demand will likewise be reduced by (approximately) 20 percent. We shall now change the assumptions by giving the elasticity of the foreign supply of imports a value smaller than infinity; we shall, in order to avoid complicated computations, assume it to be numerically equal to the elasticity of Italian demand that is, +2.0. As the depreciation raises Italian import prices and reduces Italian purchases of imports, the foreign prices of these imports will decline. With numerically equal elasticities of demand and supply, each country will bear one half of the price adjustment. Thus, Italian prices of imports will eventually have increased, and the foreign prices decreased, by (approximately) 5 percent as a result of the 10 percent depreciation of the lira. The physical volume of imports demanded by Italians will decrease by (approximately) 10 percent and their dollar value by (approximately) 14.5 percent. (At dollar prices 95 percent of their previous level, Italians will demand 90 percent of the imports previously demanded, thus imports in a dollar value of 85.5 percent of the predepreciation value). The difference in the assumption regarding the supply elasticity accounted for a considerable difference in the demand for dollars; with the smaller supply elasticity the amount of dollars demanded by importers fell by only 14.5 percent, rather than 20 percent as it did with the infinite supply elasticity. The effects of depreciation upon export values are analogously distorted by the implicit assumption of infinite elasticities of supply of exports. A 10 percent depreciation of the lira will, with unchanged Italian prices, reduce the foreign prices of the exports by 10 percent; with an elasticity of the (foreign) demand for (Italian) exports of -2.0, the physical volume of exports will increase by (approximately) 20 percent and the dollar value of exports by (approximately) 8
* If a formula for demand elasticity is used which satisfies the conventional consistency tests, the quantity of imports should fall only y 16.6 % because 83.33 is the figure which is raised to 100 by an increase of 20%. The price changes will be closer to 4.76 percent, because 110 (100-4.76) = 100 (100 + 4.76).

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Lower Demand Elasticities
[Note from Machlup: Keep for later]

percent. (The foreigners will buy 120 percent of the previous physical volume of exports at prices which are 90 percent of the former prices; hence, they will pay 108 percent of the previous dollar amount). We shall now change the assumptions concerning the elasticity of supply of Italian exports and make it, for the same reason as before, numerically equal to the elasticity of demand for these exports, namely + 2.0. As physical exports from Italy increase, in consequence of the depreciation, their prices will rise until they are up (approximately) 5 percent in lire and down (approximately) 5 percent in dollars. Consequently, the physical volume of exports will be increased by (approximately) 10 percent and the dollar value of exports by (approximately) 4.5 percent. (The foreigners will buy 110 percent of the previous physical volume of exports and pay 95 percent of previous dollar prices, hence 104.5 percent of the previous total amount of dollars). The increase is only 4.5 percent, as against the 8 percent when the elasticity of the supply of exports was infinite. The neglect of the elasticities of supply of exports and imports would, in this example, give an unduly optimistic picture of the effects of exchange depreciation of the trade balance.

Simple arithmetic examples have the great advantage over demonstrations with higher forms of mathematics that they can be more generally understood. Their disadvantage is that they may mislead into illegitimate generalizations. Someone given to quick generalizations may conclude from the preceding example that a less than infinitely elastic supply of exports makes it harder to improve the balance of payments by means of exchange depreciation. Such a conclusion would be wrong. We need only try another example, this time one with lower demand elasticities, in order to find out that lower supply elasticities can also pull in the opposite direction, that is, can strengthen the remedial efforts of depreciation upon a balance of payments deficit.

Neglecting the supply elasticities by implicitly assuming them to be infinite, some economists regard unity as the critical value of the sum of demand elasticities; critical in the sense that elasticities of the demand for imports and of the demand for exports adding up, numerically, to less than 1 would be too low for depreciation to improve the trade balance, and indeed would make depreciation operate in the reverse direction. We shall see how depreciation will affect the importer demand and exporters supply of foreign exchange if the two demand elasticities are only -0.5, so that they add up to -1.0, and if two supply elasticities are first infinity and then just as low as the demand elasticities.

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January 13, 1950 Mr. William B. Simpson Managing Editor Econometric Society University of Chicago Chicago 37, Ill. Mr dear Simpson: After much struggle I was able to condense the abstract of my remarks5 at the International Trade meeting of the Econometric Society to exactly eighteen lines, as prescribed in your circular letter of December 19. I am enclosing the abstract in this letter. Sincerely yours, Fritz Machlup

Enclosure
FRITZ MACHLUP: Fear that the magnitudes of the relevant elasticities are such as to prevent the free-market mechanism from working satisfactorily may be called elasticity pessimism. Elasticity pessimism in international-trade theory makes many economists advocate foreign-exchange restrictions. Most of them underestimate the actual price elasticities of demand for imports and exports, and overestimate the price elasticities required for exchange depreciation to have remedial effects. The underestimation of the actual elasticities is chiefly due to the statistical techniques and erroneous interpretations of data. Mikesell, Orcott, and Harberger have enumerated several reasons why estimates have been too low. The overestimation of the required elasticities is due chiefly to two errors of reasoning: (1) it is wrong to regard unity as the critical value for the sum of the elasticities of demand for exports and imports except if the elasticities of supply are infinite. With lower elasticities of supply, depreciation may have remedial efforts even if the sum of the elasticities of demand is below unity. (2) Where initially an import surplus exists, the critical value of demand elasticities is still lower, because a percentage reduction in the value of imports will be absolutely more significant than a similar percentage reduction in the value of exports.

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Fritz Machlup Papers, Hoover Institution, Box 88, Folder 18, Replies by Economists, in Monetary Policy and the Management of the Public Debt, United States Congress, Joint Committee on the Economic Report, Subcommittee on General Credit Control and Debt Management, 1952. Typescript. Includes printed copy of questions. Copyright Stanford University.

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QUESTIONS FOR ECONOMISTS

1. What are your views of the effects of credit policies resulting in relatively small and relatively large changes in interest rates, respectively, upon (a) the lending policies of commercial banks, (b) the lending policies of nonbank investors, (c) consumer saving, (d) business plant expenditure programs, (e) business inventory policy?

2. How important do you consider the expansion of credit to be in the totality of factors underlying the post-Korean inflationary boom? The postwar boom in 194548? How would you appraise the effectiveness of (a) general and (b) selective credit policy in coping with (i) a high level of private capital investment, (ii) a high level of consumer spending, (iii) large present or prospective Government expenditures, (iv) the wage-price-farm support spiral? 3. What do you believe to be the appropriate roles of direct (e. g., price and wage) controls, selective credit controls, and a general tightening of credit as means of restraining inflation (a) when the Treasury is not expected to be a large borrower in the foreseeable future, (b) when a large volume of Treasury refunding operations will have to be effected in the foreseeable future, (c) when it is expected that the Treasury will be a large net borrower during the foreseeable future, (d) under conditions of total war?

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4. Do you believe that it would be (a) desirable and (b) possible to insulate public debt securities in whole or in part from the impact of restrictive credit policies designed primarily to discourage the growth of private debt? Do you have any concrete suggestions for action in this regard? 5. To what extent do you believe that the demand for Government and other high-grade, fixed-interest-bearing securities by nonbank investors is influenced by (a) the current level of interest rates, (b) expectations with respect to changes in interest rates, (c) other factors? 6. Discuss the merits and demerits of the proposal for the issuance of a bond, the value of which would be guaranteed in terms of purchasing power. 7. What types of securities do you believe should be the principal vehicles of Government borrowing (a) under present conditions, (b) in the event of the necessity for substantial net Government borrowing? 8. Under what conditions, if any, do you believe it would be desirable to resort to compulsory methods in the sale of Government securities to (a) banks, (b) other financial institutions, (c) other corporations, (d) individuals?1 / January 8, 1952 The Honorable Wright Patman, Chairman Sub-Committee on General Credit Control and Debt Management Congress of the United States Washington, D. C. Attention: Dr. Murphy

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Dear Sir: I should very much like to make a slight correction in the answers which I submitted a few weeks ago to your questions for economists. On page 6 of my answers in line 7 when I defined total war as one in which at least half of the gross national product goes for military and defense expenditures, I should like to have national income substituted for gross national product. I hope that this correction can be effected. Sincerely yours, Fritz Machlup /

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ANSWERS TO THE QUESTIONS FOR ECONOMISTS OF THE SUB-COMMITTEE ON GENERAL CREDIT CONTROL AND DEBT MANAGEMENT OF THE JOINT COMMITTEE ON THE ECONOMIC REPORT I. Effects of Credit Policy Resulting in Changes in Interest Rates.
Several attempts have been made in recent years to prove at the same time that interest rates have little or no influence upon economic activity and that an increase in interest rates has a bad effect and should be avoided. It takes no great intelligence to recognize that it is impossible for both of these statements to be true. As a matter of fact, both are false. Changes in the interest rate may have very definite effects upon economic activity, and an increase in interest rates may sometimes be a necessary part of a program designed to avoid excessive inflation. Note: It is necessary for an understanding of the problems involved to give a sufficiently extensive interpretation to the meaning of interest rates. In particular, we must not restrict the meaning of this term to discount rates or contractual rates on bank loans or on industrial advances, but we must include the actual yields on bonds and stocks. We must also include the effects of credit rationing upon the internal calculations of borrowers because, after all, a smaller ration of credit available to a business firm is equivalent to a higher rate of interest. The terms increase or reduction of interest rates should therefore not be understood too literally but in the wider meaning just indicated.

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(a) Effects on Lending Policies of Commercial Banks. The traditional textbook theories are still valid. It is possible through appropriate policies of the Federal Reserve Banks to bring about an increase in interest rates that will cause commercial banks to restrict their lending activities. Reduced excess reserves of commercial banks and higher yields of Government bonds will tend to reduce the incentive of banks to grant mortgage loans, consumer loans, and even business loans either at the same interest rates or in the same amounts as they otherwise would have. That is to say, sufficiently increased yields of Government bonds restrict the availability of funds to home owners, consumers, and business firms, and therefore restrict private expenditures that compete with Government / for scarce resources and drive up prices. (b) Effects Upon Lending Policies of Non-Bank Investors. Here the chief effects will be on the kinds of earning assets that non-bank investors seek for their portfolios. For example, at a low yield of Government securities, insurance companies may invest large amounts in mortgage loans or construction programs; when the yield of Government securities is higher the

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insurance companies may prefer to give their funds to the Government. This would make new bank credit less necessary or unnecessary to finance Government expenditures, and thus would reduce inflationary pressures. (c) Effects upon Consumer Saving. Many economists are too near-sighted to see these effects, which work chiefly in three ways: First, consumer spending is enhanced by capital gains, and reduced by capital losses; higher interest rates depress the value of securities and other durable assets; consumers will reduce their expenditures when they have suffered capital losses and their wealth is reduced in relation to their income. Secondly, many consumers find it more attractive to save when interest rates are higher and they can expect higher interest income from their assets and have better chances for capital gains in the future when the depressed security prices may rise again. Thirdly, higher interest rates raise the prices consumers have to pay for things bought on installment plans. For example, at higher interest rates given amounts of monthly installments will buy less automobiles or refrigerators than at lower interest rates. Thus, given amounts of consumers outlay will make smaller demands on scarce resources. /

(d) Effects upon Business Plant Expenditure Programs. Increased interest rates may have only small direct effects on business investment programs, but the indirect effects are important. The direct effects of increased interest rates, the increased difficulty of obtaining mortgage loans and of selling new securities to raise funds in the capital market, may extend to relatively few people, but the repercussions of the reduced purchases of even a few may be of considerable importance in reducing business investment programs. In other words, the indirect effects of increased interest rates reach most businessmen in a disguised form, namely, as reductions in the demand for their products. For example, if only a few residential builders were directly influenced by higher interest rates to postpone their projects, the demand for thousands of products that go into residential construction would thereby be reduced and incentives to expand plant capacity for thousands of producers goods would be dampened. Note: There are those who try to learn about the effect of interest rates upon business investment by asking the businessman How are you affected by an increase in the interest rate? But the businessman never knows, since what he would notice is merely a slackening in the demand for his product and he would have no reason to connect this with interest rates. It is the economists job to understand the relationships which the businessman cannot see. If economics were so simple that we could find out matters by asking businessmen, we would have no use for economists.

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(e) Effects upon Business Inventory Policy. Considerable business inventories are held as a protection against rising prices. If the businessman expects that next year the prices of his raw materials will be ten percent higher, it will certainly pay him to keep large inventories. But if the interest rate is ten percent per annum, his incentive to carry large inventories is obviously diminished. Hence, an increase in interest rates tends to reduce the demand for materials to be held in stock. /

II. The Role of Credit Expansion in the Recent Inflation

I am sure the Committee has at its disposal all the statistical evidence showing the large rate of expansion of bank credit in the post-war boom in 194548 and again in the post-Korean inflationary boom. The data are most impressive, and I doubt that anyone can deny the leading role which bank credit expansion played in the inflation during these years. From what was said in answer to question I, it should be obvious that credit policy could have helped reduce (i) the high level of private capital investment, and (ii) the high level of consumer spending. It probably could not have prevented or sharply reduced (iii) the high rate of Government expenditures for national defense or (iv) the expenditures arising out of our farm price support program. On the other hand, it could have put a damper on the wage-price spiral because it was chiefly the high rate of effective demand swelled by increased expenditures by consumers and business that made businessmen yield with little resistance to the demands for higher wages and made trade unions adamant in insisting on them.

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III. Direct Controls vs. Credit Controls.

The use of direct controls over many years may undermine and eventually destroy the free enterprise system. To the extent to which there is a choice between direct controls and credit controls, advocates of the free enterprise system (if they know what they are doing) will fight the use of direct controls and favor the use of credit controls. I suspect that many who have voted for direct controls are not aware that every such vote is a vote against the free enterprise system. / It is true, of course, that in emergencies the use of direct controls for brief periods may be unavoidable and that the comparative roles of credit controls and direct controls are different in the different situations outlined in the questions of the Committee. (a) When the Treasury is not expected to be a large borrower in the foreseeable future, and any inflationary expenditures are thus merely those of businessmen and private consumers, credit controls can remove all inflationary pressures and direct controls are sheer stupidity or measures of avowed advocates of authoritarianism.

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(b) When a large volume of Treasury refunding operations will have to be effected in the foreseeable future, one can understand that the Treasury will not like an increase in interest rates. The first question then is whether we can find ways and means of getting Treasury issues placed at low rates despite the increased interest rates required in an anti-inflationary credit policy. (This might be possible by the adoption of proposals such as the Eccles plan for secondary bank reserves.) If this should not be feasible, the second question is whether it is better to burden the Treasury with higher interest rates or burden the whole economy with the expensive machinery of direct price and allocation controls. In my opinion, the higher interest burden on the Treasury is the much smaller evil from the point of view of the nation. (c) When it is expected that the Treasury will be a large not borrower during the foreseeable future, the alternatives are still the same as under (b). If new issues of the Treasury cannot be placed at preferred rates, it will still be much less costly in the long run for the nation to pay more for the public debt than to put its economy into the shackles of direct economic controls. Higher interest rates along with higher tax rates can / effectively reduce private demand for the resources needed for defense production. The use of direct controls for this purpose for long periods is economically wasteful, even apart from the serious danger which it involves for the survival of a free society. (d) Under conditions of total war the introduction of some direct controls may be necessary. Total war may be defined as one in which at least half of the gross-national income goes for military and defense expenditures. Under such circumstances some of the reallocations of productive resources which the nation has to effect may have to be supported by direct controls. This, however, does not reduce the need for fiscal and monetary controls. Even in total war the chief burden of keeping down the rate of inflation should be on fiscal and monetary policy. That is to say, inflation should be combatted first and foremost by reducing through high tax and interest rates the amounts of money that consumers and businessmen have available for their expenditures.

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IV. Preferred Treatment for Public Debt

As was indicated in the previous question, I believe it is desirable and possible to insulate public debt securities from the impact of anti-inflationary credit policies. Some such plans as modification of reserve requirements to the effect that commercial banks must keep a secondary reserve in the form of Government securities may serve this purpose.

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V. The Demand for Government Securities

The demand for Government securities on the part of non-bank investors is greatly influenced by the current level of interest rates as well as by expectations with respect to changes in interest rates. The demand for / Government bonds is very elastic. If the yield of Government securities is more attractive, such securities will be a favored substitute for other assets. Moreover, if the yield is high, the likelihood of a subsequent fall in security prices is small and investors will be less apprehensive of the possibility of capital losses. A security yielding three percent can easily fall in price because everybody remembers that yields can go much higher. If the yield, however, is increased, the holding of Government securities may despite a momentary shock to large holders become very attractive to those who look for appreciation of their investment as well as to those who look for income.

VI. Purchasing Power Bonds

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The question of bonds guaranteed in terms of purchasing power would never have arisen if the Government had pursued an anti-inflationary monetary policy. Now that we have had inflation for several years. I believe that the issuance of such bonds should be seriously considered. Indeed, we may regard this as a question of ethics as much as of economics. For it is immoral for a government to inveigle its people into buying its securities not secured against deterioration in purchasing power while that government at the same time pursues a policy which must of necessity result in reducing the real value of its money and of its money debts. To advise people to buy bonds while we know that those who do not buy them will be relatively better off, is not far from fraudulent. Those who are perpetrating this deception may be under the delusion that price controls will protect the bondholders. No price controls, however, have ever succeeded in doing this in the long run. Hence, if we wish people / to put their savings into government bonds, we should pursue the strictest anti-inflationary fiscal and monetary policies or we should promise the buyers of bonds that they will not suffer from inflationary policies of the government. FRITZ MACHLUP Professor of Political Economy The Johns Hopkins University December 19, 1951

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Whats Best for the Competitive Enterprise System?

1. DELIVERED PRICING and the FUTURE OF AMERICAN BUSINESS: The Cement Case of 1948, which declared that the concerted use of the multiple basing point system of price-making was a violation of the anti-trust statutes. The Federal Trade Commission was particularly alert to price add-ons (over and above the quoted price) based on geographic location as well as collusion among competitors in the adoption of delivered pricing methods. See S. Kittelle and G. Lamb, The Implied Conspiracy Doctrine and Delivered Pricing, Duke University Law Journal, at http://scholarship.law.duke.edu/ cgi/viewcontent.cgi?article=2444&context=lcp [accessed November 2013]. My findings will appear in the form of a book: F. Machlup, The Basing Point System (New York and Philadelphia, PA: Blakiston Company, 1948). Machlup describes basing point pricing, its commercial, legal, economic and political importance, in three representative industries steel, cement and corn products. He also considers the impact of the basing point system on competition, transportation costs, price structure and flexibility, industry concentration in basing point industries and productive capacity.

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Three Concepts of the Balance of Payments

1. It suffers from several contradictions program balances: Machlup would expand this argument in his article, Three Concepts of the Balance of Payments and the So-called Dollar Shortage, Economic Journal, 60:237 (1950), pp. 4668.

The Elasticity Argument for Foreign Exchange Restrictions

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2.

3.

4.

5.

Orcotts and Mikesells: Guy Henderson Orcutt (correct spelling) is associated with time series models through a method known as the Cochrane-Orcutt procedure, introduced in 1949. He presented on Measurement of Price Elasticities in International Trade, Econometrica, 18:3 (1950), p. 284. Raymond Mikesell, formerly an aide to Harry Dexter White, an economist and Treasury official, contributed to the formation of theInternational Monetary Fund and its quota system. Mikesell presented on Application of Statistically Derived Import Elasticities to Practical Problems of Foreign Trade Policy, Econometrica, 18:3 (1950), pp. 2845. Harberger: Arnold C. Harberger, Johns Hopkins University, presented Index Number Problems in Measuring the Elasticity of Demand for Imports, Econometrica, 18:3 (1950), pp. 2756. Why the required elasticities have been overestimated: Machlup crossed out original paragraphs 1 through to 4 in this section, hence the section retains his numbering from 5 onwards. The Neglect of Supply Elasticities: This repeat of the section heading and included material is not an error. Machlup intended the following rewrite of the Supply Elasticities section to be used in an essay. In margin notes he wrote: This can be used for the essay, in the part [of ] Overestimation of required elasticities to precede the part on Underestimation. the abstract of my remarks: Machlups paper Discussion of Problems in the Theory of International Trade, Econometrica, 18:3 (1950), p. 285.

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1. 7. What types of securities 8. Under what individuals?: Machlups margin notes indicate that he did not answer these two questions.

Problems of Exchange Rates and Convertibility

1. FM DRAFT FOR MERRILL CENTRE VOLUME, THORP 1953: Machlups contribution was prepared for Trade, Aid, or What? A Report Based upon a Conference on International Economic Policy at the Merrill Center for Economics, Summer, 1953 (Baltimore, MD: Johns Hopkins University Press, 1954). Machlup, Triffin, Cairncross and many others were at the Summer 1953 Conference on which the report is based. Chapter III: Machlups contribution to exchange rates and convertibility would be re-edited and would form chapters VI (the levels of foreign exchange rates) and VII (problems of convertibility) of the published work. No attribution would be given to any contributor. Machlups name would be misspelled Achlup in the list of conferees on p. xi. Thorp and the Merrill Foundation were very involved in Machlups work on industries in the early to mid-1950s. The Merrill Foundation funded projects at Johns Hopkins which included The Theory of the Growth of the Firm, which Edith Penrose made her own. It is very unlikely Machlup would otherwise have been so tolerant of the piece-part editing of his work or the misspelling of his name on the published report. Ireland besides the United Kingdom: The Republic of Ireland, Eire or the free state, designated a dominion of the Commonwealth. The essential features of the sterling area: Margin notes indicate that this information has come orally from Cairncross. A. K. Cairncross was economic advisor to HM Treasury in 1958. dollar pool: Machlups margin notes suggest here that Triffin-Cairncross tape recorded Machlup delivering his notes at the conference referred to in note 1. diect: direct; typographical error uncaught by Machlup. governemnt: government; typographical error uncaught by Machlup.

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3. 4. 5. 6. 7.

Paradoxes in Economic Development

1. 2. 3. 4. 5. Dev: Development. prop: proportionate. cap: capital. 12: Number (and those following before recommendations represent number of people in group/session who made this recommendation). Galenson: Walter Galenson was a professor of economics first at Harvard 1946, then at UC Berkeley in 1951. He was a labour economist. He had just published Comparative Labor Movements (New Jersey: Prentice Hall, 1955) at the time of Machlups speech. may be stated as follows: Machlups notes end without a statement. He might have said, quoting from his book Essays in Economic Semantics, The basic position of a pure theory of relative wages may be stated as follows: In the absence of obstacles to the movement of workers from the non-industrial to the industrial sector of an economy, and in the absence of differences in the unpleasantness of industrial and non-industrial work, the equilibrium rates of earning would be equal. Essays in Economic Semantics (New York: New York University Press, 1963), p. 296.

6.