PREFACE

The purpose of this book is to collect for the convenience of the reader the ‘basic documents’ of a recently-developing new approach to the theory of the balance of payments and of balance-of-payments policy, the so-called ‘monetary approach to the balance of payments’, together with some avowedly highly tentative attempts to subject the new approach to empirical testing. The items included have been chosen from the work of economists associated with the Workshop in International Economics at the University of Chicago, where the new approach has been developed most persistently and systematically thus far. But, as will be documented in the Introductory Essay, the new approach is basically a return to the long historical tradition of international monetary theory, after some thirty years of departure from that tradition occasioned by the international monetary collapse of the 1930s, the ‘Keynesian Revolution’ in monetary theory, and the long period of war and post-war reconstruction in which the international monetary system was fragmented by exchange controls, currency inconvertibility, and controls over international trade and capital movements. It is also necessary to acknowledge that fundamentally the same approach has been developed contemporaneously by economists associated not at all with either the University of Chicago or its international monetary theorists, economists whose contributions will be mentioned in detail later in this preface as well as in the introductory essay. And, finally, it is a matter of pleasure that economists in other centres have begun serious large-scale work on the same general range of problems: we mention specifically the International Monetary Research Programme at the London School of Economics, the Programme on World Inflation at the University of Manchester, research of the Graduate Institute of International Studies of Geneva, and the recent research of the International Monetary Fund and of the Board of Governors of the Federal Reserve System.

This book presents the key articles and studies in the development of the monetary approach to the balance of payments as expressed in the work of economists associated with the Chicago Workshop. There is actually no intention to claim exclusivity for Chicago economists in the development of the new approach. A number of other important contributors to the early development of the theory are cited in the introductory essay. To these should be added as more recent contributors Victor Argy, until recently at the International Monetary Fund, Ryutaro Komiya of the University of Tokyo, Japan, and Pentti Kouri and Michael Porter, who have done important empirical work under the auspices of the International Monetary Fund. In addition mention should be made of Chicago Workshop members of the crucial period whose contributions are not included in the volume, notably Russell Boyer and Douglas Purvis among the recent graduate students and Arthur B. Laffer of the faculty of the University of Chicago Graduate School of Business.

The book is divided into two parts, theoretical and empirical. In the introductory essay, Frenkel and Johnson summarise the essential concepts and the historical origins of the monetary approach to the balance of payments. Following the introductory essay, the theoretical section is further subdivided into two sections. The first contains the basic article by Johnson, generalising the Meade and Alexander approaches into a basically monetary theory, although the generalisation is largely in terms of a framework within which the conventional post-Keynesian theory can be conveniently summarised; and an article by Mundell which introduces the connecting lines between classical international monetary economics and the theory of barter, and between classical and Keynesian concepts and methods of analysis. Mundell’s thinking on the problem of the balance of payments evolved rapidly through a series of scattered articles, so that it is difficult if not impossible to select one, or a few places, as possessing the status of ‘the classic article’. This paper does, however, seem the closest to a classic statement of the difference between the Keynesian approach and the monetary approach that can be found in the phase of Mundell’s transition from one to the other approach.

The second subsection comprises theoretical contributions and extensions based firmly on the new approach. Mundell’s contribution, only one of many in the literature, deals with the extension to a growing economy of an analysis that was in a sense central to the contribution made by Hume’s price-specie-flow analysis—the international distribution of money. In this chapter Mundell provides a framework that links inflation, interest rates, money stocks, rates of credit expansion, and the balance of payments. Frenkel’s chapter, one of his several contributions concerned with long-run changes in the structure of the balance of payments, integrates the monetary and the real sectors; it develops explicitly the dynamic behaviour of the secular evolution of the various balance-of-payments accounts, and thereby disposes of the criticism that the monetary approach ignores the capital account. Johnson’s first chapter in this section describes at some length the development of Keynesian balance-of-payments theory and the defects in its formulation that led to the monetary approach, and presents the algebra required to apply the analysis of money and the balance of payments in a growing international economy to a small country in a large world system, a closed world system based on a fixed amount of international money, and a system in which, in addition to gold, reserves are provided by a reserve currency country.

Dornbusch’s chapter emphasises the monetary aspects of devaluation using a model which includes non-traded as well as traded goods, thereby disposing conclusively of the criticism that the monetary approach is limited by its assumption that there is a world market price for all goods produced. The title of Mussa’s chapter masks policy dynamite: tariffs, usually thought of as a means of improving the balance of payments as an alternative to devaluation, have nothing at all to do with the balance of payments, except to the extent that the price-raising effects of their imposition create an increase in the demand for money that is supplied by a transient balance-of-payments surplus.

Rodriguez’s chapter scotches another casual criticism of the monetary approach, by applying it to an analysis of balance-of-payments adjustment in a Keynesian variable-employment model.

Swoboda’s chapter presents a formal analysis that summarises and integrates a great deal of previous work by others touching on various aspects of the use of monetary policy under fixed rates, and makes original contributions in the analysis of the difference between the results of the monetary approach and the Keynesian approach to the range of problems first dealt with in Keynesian terms under the general rubric of the theory of fiscal-monetary policy mix. Johnson’s second chapter seeks to reformulate Meade’s classical analysis of the theory of balance-of-payments policy, itself an attempt to convert ‘positive theory’ into ‘normative’ guides for the formulation of international economic policy, into a monetary-theory-based as contrasted with a multiplier-model-based analysis of balance-of-payments policies.

In 1971, Mundell left the University of Chicago for the University of Waterloo, leaving behind him a group of graduate students working on the pure monetary theory of the balance of payments, whose supervision through the final stages fell to Johnson. Johnson was convinced, partly on the basis of encounters in policy debates with policy makers stubbornly committed to the elasticity approach to balance-of-payments policy prescription and analysis, that continued concentration on the refinement and elaboration of the pure theory would yield rapidly diminishing returns in terms of theoretical insight, and that to challenge the theories accepted in policy-making circles—mostly based on a crude elasticity analysis if not an even more unsophisticated purely arithmetical exercise—the theory would have to be backed up by solidly based empirical evidence. This emphasis fitted the ‘Chicago’ approach to economics, in general, and in particular attracted the interest of his colleagues Richard Zecher in monetary economics and Donald McCloskey in economic history, as well as students of an empirical rather than abstract theoretical turn of mind. Part Two of the book contains a selection of essays in empirical testing and verification. This part of the book is presented as a very tentative beginning on the problem. On the one hand, the theory of how to do econometrics has run far ahead of knowledge of how actually to do it in studying problems that are economically interesting and important. The man who attempts to apply econometrics he can understand, to a problem he thinks is economically interesting, is generally outnumbered by a factor of at least five by those who will gladly tell him what he has done wrong that makes his conclusions invalid, without feeling obliged to tell him how to do it right, let alone doing it right for him and showing that his method actually leads to wrong answers by comparison with the right method. In presenting this part, we have in mind the long history of attempts to give quantitative form to the Keynesian consumption function, and subsequently the debate over econometric studies of the domestic demand for money, and would stress that empirical studies based on the monetary approach to the balance of payments are at about the same stage as were empirical studies of the domestic demand for money some twenty years ago. We would also stress that confidence in the empirical usefulness of the monetary approach is not based only upon, or limited by, the studies presented here. Other studies, such as those by Kouri and Porter already mentioned, by the members of the Manchester programme of research on world inflation, by Peter Jonson on inflation in Australia, and preliminary results of the London School of Economics International Monetary Research Programme, are all favourable to the monetary approach.

Part Two presents five studies, of which four are studies of specific countries for which the ‘small-country assumption’ is eminently reasonable. Zecher’s study tests and finds support for the hypothesis that Australian monetary policy largely influences the country’s international reserves rather than the traditional credit market and money supply variables that central bankers usually assume that they control. Genberg’s study of Sweden exposes and finds confirmation for the hypothesis, a preliminary requirement of the monetary approach, that Swedish prices and interest rates are connected to world prices and interest rates. After identifying and estimating the demand for money in Sweden, he draws some conclusions on the effects of Swedish monetary policy. Bean’s study of Japan derives special interest from the popular, and mistaken, view that Japan is an inscrutable economic phenomenon. One of the interesting issues that are dealt with is the question of the appropriate price index for use in the empirical work. Guitian’s study of Spain develops the theory to fit some special circumstances of the Spanish economy.

The final study by McCloskey and Zecher, of the gold standard 1880–1913, is the first fruit of a much larger study, currently in progress, which promises to radically change the understanding of how the gold standard worked in its heyday, prevalent among both economic historians and the contemporary monetary theorists. This study is significant both in demonstrating the possibility of extending the monetary approach from the single country to the system as a whole, and in applying the modern refined version of the pre-Keynesian monetary approach to the reinterpretation and deeper understanding of the international monetary system that prevailed while that approach dominated the international application of pre-Keynesian monetary theory.