Using the Free Market to Resolve the Balance of Payments Problem

Abstract

ISCUSSIONS of U. S. policy with respect to international payments tend to be dominated by our immediate balance of payments difficulties. I should like today to approach the question from a different, and I hope more constructive, direction. Let us begin by asking ourselves not merely how we can get out of our present difficulties but instead how we can fashion our international payments system so that it will best serve our needs for the long pull; how we can solve not merely this balance of payments problem but the balance of payments problem. A shocking, and indeed, disgraceful feature of the present situation is the extent to which our frantic search for expedients to stave off balance of payments pressures has led us, on the one hand, to sacrifice major national objectives; and, on the other, to give enormous power to officials of foreign governments to affect what should be purely domestic matters. Foreign payments amount to only some 5 % of our total national income. Yet they have become a major factor in nearly every national policy. I believe that a system of floating exchange rates would solve the balance of payments problem for the United States far more effectively than our present arrangements. Such a system would use the flexibility and efficiency of the free market to harmonize our small foreign trade sector with both the rest of our massive economy and the rest of the world; it would reduce problems of foreign payments to their proper dimensions and remove them as a major consideration in governmental policy about domestic matters and as a major preoccupation in international political negotiations; it would foster our national objectives rather than be an obstacle to their attainment. To indicate the basis for this conclusion, let us consider the national objective with which our payments system is most directly connected: the promotion of a healthy and balanced growth of world trade, carried on, so far as possible, by private individuals and private enterprises with minimum intervention by governments. This has been a major objective of our whole postwar international economic policy, most recently expressed in the Trade Expansion Act of 1962. Success would knit the free world more closely together, and, by fostering the international division of labor, raise standards of living throughout the world, including the United States. Suppose that we succeed in negotiating far-reaching reciprocal reductions in tariffs and other trade barriers with the common market and other countries.' Such reductions will expand trade in general but clearly will have different effects on different industries. The demand for the products of some will expand, for others contract. This is a phenomenon we are familiar with from our internal development. The capacity of our free enterprise system to adapt quickly and efficiently to such shifts, whether produced by changes in technology or tastes, has been a major source of our economic growth. The only additional element introduced by international trade is the fact that different currencies are involved, and this is where the payment mechanism comes in; its function is to keep this fact from being an additional source of disturbance. An all around lowering of tariffs would tend to increase both our expenditures and our receipts in foreign currencies. There is no way of knowing in advance which increase would tend to be the greater and hence no way of knowing whether the initial effect would be toward a surplus or deficit in our balance of payments. What is clear is that we cannot hope to succeed in the objective of expanding world trade unless we can readily adjust to either outcome.2 Suppose then that the initial effect is to increase our expenditures on imports more than our receipts from exports. How could we adjust to this outcome? One method of adjustment is to draw on reserves or borrow from abroad to finance the excess increase in imports. The obvious objection to this method is that it is only a temporary device, and hence can be relied on only when the disturbance is temporary. But that is not the major objection. Even if we had very large reserves or could borrow large amounts from abroad, so that we could continue this expedient for many years, it is a most undesirable one. We can see why if we look at physical rather than financial magnitudes. The physical counterpart to the financial deficit is a reduction of employment in industries competing with imports that is larger than the concurrent expansion of employment in export industries. So long as the financial deficit continues, the assumed tariff reductions Milton Friedman, one of the country's foremost economists, is Professor of Economics at the University of Chicago. 1. Footnotes appear at end of article.