CHAPTER 7. THE GENERAL THEORY IN AN OPEN ECONOMY*

*This paper was published in A Second Edition of The General Theory, vol. 2, edited by G. C. Harcourt and P. Riach (Routledge, London, 1996)

Keynes's General Theory of Employment Interest and Money1 is developed primarily in a closed economy context. Keynes did, however, introduce an open economy analysis when he noted that

[a] trade could modify the magnitude of the domestic employment multiplier [p. 120],

[b] reductions in money wages would worsen the terms of trade and therefore reduce real income, while it could improve the balance of trade [p, 263], and

[c] stimulating either domestic investment or foreign investment can increase domestic employment growth [p. 335].

In a world where governments are afraid that deliberately stimulating any domestic spending will unleash inflationary forces, export-led growth is seen as a desirable alternative path for expanding domestic employment. A "favorable balance [of trade], provided it is not too large, will prove extremely stimulating" to domestic employment [p. 338], even if it does so at the expense of employment opportunities abroad.

In a passage that is particularly a propos for today's global economic setting, Keynes noted that "in a society where there is no question of direct investment under the aegis of public authority [due to fear of government deficits per se], the economic objects, with which it is reasonable for the government to be preoccupied, are the domestic interest rate and the balance of foreign trade"[p. 335]. If, however, nations permit free movement of funds across national boundaries, then "the authorities had no direct control over the domestic rate of interest or the other inducements to home investment, [and] measures to increase the favorable balance of trade [are]...the only direct means at their disposal for increasing foreign investment" [p. 336] and domestic employment.

Keynes was well aware that the domestic employment advantage gained by export-led growth "is liable to involve an equal disadvantage to some other country" [p.338]. When countries pursue an "immoderate policy" [p. 338] of export led growth (e.g., Japan, Germany and the NICS of Asia in the 1980s), this aggravates the unemployment problem for the surplus nations' trading partners2. These trading partners are then forced to engage in a "senseless international competition for a favorable balance which injures all alike" [pp. 338-9]. The traditional approach for improving the trade balance is to make one's domestic industries more competitive by either forcing down nominal wages (including fringe benefits) to reduce labor production costs and/or by a devaluation of the exchange rate3. Competitive gains obtained by manipulating these nominal variables can only foster further global stagnation and recession as one's trading partners attempt to regain a competitive edge by similar policies.

Unlike the classical theorists of his day (and our day as well4) Keynes recognized that "the mercantilists were aware of the fallacy of cheapness and the danger that excessive competition may turn the terms of trade against a country" [p, 345] thereby reducing domestic living standards so that, as President Clinton noted in his 1992 campaign, "people are working more and earning less".

Keynes realized that if every nation did not actively undertake a program for public domestic investment to generate domestic full employment, then the resulting laissez-faire system of prudent fiscal finance in tandem with a system of free international monetary flows would create a global environment where each nation independently sees significant national advantages in a policy of export-led growth even though pursuit of these policies simultaneously by many nations "injures all alike" [pp. 338-9]. This warning of Keynes however, went virtually unrecognized in the 1980's while mainstream economists waxed enthusiastically about the export-led economic miracles of Japan, Germany and the Pacific rim Newly Industrialized Countries (NICS) without noting that these miraculous performances were at the expense of the rest of the world.

In a laissez-faire world, when governments do not have the political will to stimulate directly any domestic component of aggregate spending to reduce unemployment, "domestic prosperity [is] directly dependent on a competitive pursuit of [export] markets" [p, 349]. This is a competition in which all nations cannot be winners! When, in the late 1980s the United States began to take steps to reduce its huge trade deficit with the "miracle economies" of the early 1980s by both depressing its domestic demand and trying to make its industries more competitive in order to gain a larger share of existing world markets, the whole world was plunged into a stagnating slow-growth recessionary era.

For a nation to break out of a global slow-growth stagnating economic environment, the "truth", Keynes insisted, lay in pursuing a "policy of an autonomous rate of interest, unimpeded by international preoccupations, and a national investment programme directed to an optimum level of employment which is twice blessed in the sense that it helps ourselves and our neighbors at the same time. And it is the simultaneous pursuit of these policies by all countries together which is capable of restoring economic health and strength internationally, whether we measure it by the level of domestic employment or by the volume of international trade" [p. 349, italics added].

From 1982 to 1986, the Reagan Administration unwittingly pursued this Keynesian truth by increasing military (public investment) spending and cutting taxes to stimulate consumption. By mid-1982, the Federal Reserve helped by reducing interest rates to avoid a massive international debt default. As a result of the U.S. acting as the "engine of growth" between 1982 and 1986, most of the OECD nations rapidly recovered from the greatest global recession since The Great Depression. Unfortunately, as recovery occurred, most of the major trading partners of the US did not engage in a "simultaneous pursuit of these policies" of increasing public spending and reducing interest rates. These nations neither remembered nor understood Keynes's recommendation that only by the concurrent public investment policies of all nations could global economic health and strength be restored5. Instead, some of America's trading partners took advantage of Reagan's "Keynesian" policy, which stimulated US demand for imports, to pursue an export-led growth policy.

Until we understand Keynes's General Theory lessons in an open economy context, we are doomed to repeat the past errors encouraged by "the inadequacy of the theoretical foundations of the laissez-faire doctrine" [p. 339] and by "orthodox economists whose common sense has been insufficient to check their faulty logic" [p.349] which presumes global full employment so that free trade must increase the global wealth of nations by reducing each nation's aggregate supply constraints through the law of comparative advantage6.

In a passage that is amazingly prescient for the economic environment since Bretton Woods, Keynes warns that the law of comparative advantage is only applicable after all nations have domestic demand management policies assuring full employment. Whenever nations operate under a laissez-faire mentality that produces significant global unemployment, then

"if a rich, old country were to neglect the struggle for markets its prosperity would droop and fail. But if [all] nations can learn to provide themselves with full employment by their domestic policy...there need be no important economic forces calculated to set the interest of one country against that of its neighbors. There would still be room for the international division of labour and for international lending in appropriate conditions. But there would no longer be a pressing motive why one country need force its wares on another or repulse the offerings of its neighbor, not because this was necessary to enable it to pay for what it wished to purchase, but with the express object of upsetting equilibrium in the balance of payment so as to develop a balance of trade in its own favor [i.e., export-led growth policy]. International trade would cease to be what it is, namely, a desperate expedient to maintain employment at home by forcing sales on foreign markets and restricting purchases, which, if successful, will merely shift the problem of unemployment to the neighbour which is worsted in the struggle, but a willing and unimpeded exchange of goods and services in conditions of mutual advantage" [pp. 382-3 italics added].

Unfortunately, as evident from the political slogans that surrounded the successful conclusion of the NAFTA agreement and the Uruguay round of the GATT talks in 1993, most governments have been led by mainstream economists to believe that free trade per se is job creating globally. Keynes's General Theory suggests otherwise.

The post-Bretton Woods international payments system has created perverse incentives that set trading partner against trading partner to perpetuate a world of slow growth (if not stagnation). Generalizing Keynes's General Theory to an open economy provides a rationale for designing an international payment system that creates incentives for each nation to pursue domestic demand policies that ensure full employment without the fear of a balance of payments constraint. Only then will the gains from the law of comparative advantage become relevant.

KEYNES'S GENERAL THEORY AND AN OPEN ECONOMY

A consistent theme throughout Keynes's General Theory is

that classical logic has assumed away questions that are fundamental to a market-oriented, money using economy. These problems are particularly relevant for understanding the current international payments relations that involve liquidity, persistent and growing debt obligations, and the importance of stable rather than flexible exchange rates.

An example of the sanguine classical response to Post Keynesians raising these issues is Professor Milton Friedman's response to me in our "debate" in the literature. Friedman stated: "A price may be flexible...yet be relatively stable, because demand and supply are relatively stable over time.... [Of course] violent instability of prices in terms of a specific money would greatly reduce the usefulness of that money"7. It is nice to know that as long as prices or exchange rates remain relatively stable, or "sticky" over time, there is no harm in permitting them to be flexible. The problem arises when exchange rates display volatility. Should there be a deliberate policy that intervenes in the market to maintain relative stability or should we allow a free market to determine the exchange rate? Keynes helped design the Bretton Woods Agreement to foster action and intervention to stabilize exchange rates and control international payment flows. Friedman sold the public on the beneficence of government inaction and the free market determination of exchange rates.

Nowhere is the difference between the Keynes view and the view of those who favor laissez-
faire arrangements more evident than in regards to these questions of international capital movements and payments mechanisms and the desirability of a flexible exchange rate system. Keynes's General Theory analysis suggests that government monitoring and, when necessary, control of capital flows is in society's interest. Such controls are not an infringement on the freedom of economic agents any more than the control of people's right to shout "fire" in a crowded theater is an infringement of the individual's right of free speech.

CAPITAL MOVEMENTS

Old Keynesians (e.g., Samuelson, Tobin) as well as New Keynesians have little to say about exogenous capital movements and their potential detrimental effects on the balance of payments and global employment8. Keynes, on the other hand, recognized that large unfettered capital flows can create serious international payments problems for nations whose current accounts would otherwise be roughly in balance. Unfortunately, in a laissez-faire system of capital markets there is no way of distinguishing between the movement of floating and speculative funds that take refuge in one nation after another in the continuous search either for speculative gains, or precautionary purposes, or for hiding from the tax collector, or laundering illegal earnings vis-a-vis funds being used to promote genuine new investment for developing the world's resources.

The international movement of speculative, precautionary, or illegal funds (hot money), if it becomes significantly large, can be so disruptive to the global economy as to impoverish most, if not all, nations who organize production and exchange processes on an entrepreneurial basis. Keynes warned "Loose funds may sweep round the world disorganizing all steady business. Nothing is more certain than that the movement of capital funds must be regulated"9.

One of the more obvious dicta that follows from Keynes's revolutionary vision of the importance of liquidity in open economies is that

"There is no country which can, in future, safely allow the flight of funds for political reasons or to evade domestic taxation or in anticipation of the owner turning refugee. Equally, there is no country that can safely receive fugitive funds which cannot safely be used for fixed investments and might turn it into a deficiency country against its will and contrary to the real facts"10.

Even in these days of global electronic communication, nations can monitor and control international capital flows if they have the will and the necessary cooperation of other nations to do so. Monitoring and control of capital fund movements is a technical matter involving the reporting of records that are kept in the accounting system of every banking community. As long as governments have the power to tax and central bankers have the power to audit and regulate their respective domestic banking systems, large scale international capital flows can be monitored and regulated provided there is international cooperation in this matter. As long as currency is issued only in small denominations, the physical bulkiness of moving large currency sums secretly across borders can not be a major threat to any capital monitoring and control policy.

In recent years, however, governments' willingness to avoid capital fund monitoring has made it easy to hide not only legally earned income and wealth from tax collectors but also profits from drug and other illegal activities from law enforcement agencies. This laissez-faire attitude encourages uncivilized behavior by self-interested economic agents -- and thereby imposes an important, if often neglected, real cost on society. During the 1980s flight capital drained resources from the relatively poor nations towards the richer ones, resulting in a more global inequitable redistribution of income and wealth.

Cooperation between nations in monitoring, reporting and controlling disruptive capital funds movements among nations can be readily accomplished by the international payments mechanism described in this chapter11. Moreover the successful implementation of our proposed international payments scheme in coordination with some rules for coordinating incomes policies among nations would insure very inelastic expectational elasticities regarding the rates of exchange among various nation's monies. These inelastic expectations would mean that individuals will no longer be impelled to engage in disruptive international speculative and precautionary financial transactions. Thus, within a very short span of calendar time after a new payments scheme similar to the one proposed here is implemented, problems of speculative and precautionary "hot money" flows, as well as the international movements of income and wealth to avoid the tax collector or law enforcement officers will quickly shrink to relative insignificance.

The free world embarked on its great classical experiment of floating rates in 1973. Since 1973 there have been periodic bouts of great inflation, increasing rates of global unemployment, a persistent growth of international debt, and an increasingly inequitable international distribution of global income. Some of the rich nations got richer, while most of the poor nations became poorer and suffered huge "flight capital" losses.

Moreover, since 1982, one nation -- the United States -- has been able to take advantage of the existing international payments system to obtain a "free lunch", that is, to run massive perpetual trade deficits. Although residents of most other nations may resent the ability of the United States to use the present system to obtain this "free lunch", they are hesitant to change a system that is heralded by modern classical economists as the only mechanism that permits every one the freedom to choose. To be against the existing system is considered to be anti-free market and for controls by government is a particularly unpopular position in these days when State planning has apparently failed so spectacularly in Eastern Europe. In the absence of a complete collapse of the international monetary payments system, however, unless an attractive feasible alternative to the current system is put on the public agenda for discussion and development, the status quo will remain. It is an old adage in political science that "you can't beat somebody with nobody!"

Any suggestions for reforming the international payments mechanism should build on whatever advantages the current system possesses, while providing rules to prevent any one nation from enjoying a free lunch -- unless a free lunch is available to all. It is possible to provide all with a free lunch (i.e., increased global employment) if a new payments system has a built-in expansionary bias that encourages all nations to operate closer to full employment than the existing system does.

Before developing our suggestion for an international payments scheme which does provide such an expansionary bias, it is necessary to elaborate on why the existing flexible exchange rate system tends to encourage national policies that inhibit efforts to achieve global full employment and instead imparts a slow growth, deflationary bias.

FLEXIBLE EXCHANGE RATES AND EXPORT LED GROWTH

Because of the success of the Keynesian Revolution in stimulating domestic full employment policies between the end of World War II and the mid-1960's, the problem of wage-cost inflation became endemic to most of the developed countries of the world. Without the persistent threat of large-scale unemployment, workers in many OECD nations and labor unions especially became more truculent in their wage demands. By the late 1960's many developed nations were forced to pursue so-called "stop-go" policies that generated small planned recessions to reduce the market power of labor to demand inflationary wage increases. These recessions were then followed by expansionary domestic spending Keynesian policies moving the economy back towards full employment until the next round of inflationary wage demands were tabled by workers. Thus the nomenclature of "stop-
go" policies.

In a flexible exchange rate system, successful export-led growth policies permit a nation to export to its trading partners not only its unemployment but also any inflationary tendencies. In a fixed exchange rate system, on the other hand, export-led growth policy does not provide to a nation any advantage in permitting more employment and growth with lower inflation rates compared with Keynesian policies that stimulate domestic aggregate demand to achieve greater employment. Moreover, under a fixed exchange rate system, it is possible for all nations to simultaneously pursue coordinated growth oriented policies by stimulating domestic components of effective demand without necessarily running into balance of payments difficulties as long as the ratio of each nation's growth rate relative to its trading partners' growth rate is equal to the ratio of the elasticity of demand for its exports compared to the its elasticity of demand for imports (according to Thirlwall's Law12).

In other words, a flexible exchange rate regime guarantees that for every "successful" economy that pursues a mercantilist trade surplus policy that can promote employment growth without significant inflation, there must be one or more offsetting "failure" nations importing inflation and unemployment while being plagued with persistent trade deficits. For every winner on the flexible rate system, there must be one or more losers. A fixed exchange rate regime in tandem with intelligent domestic demand and incomes management policies, on the other hand, can provide entrepreneurs with profitable expansionary market opportunities in a global environment where all nations are winners. A fixed exchange rate system combined with intelligent international cooperative Keynesian policies, therefore, holds out the promise that all nations can be winners of a free lunch.

In a world operated according to classical axioms, export-led growth should be no more desirable in terms of generating employment without inflation than internally generated demand growth. Classical economics assumes that the economy will track the long-run full employment growth trend no matter what the primary source of demand growth. Yet the facts of the 1980's demonstrate that all "successful" economies tend to pursue export-led growth rather than domestic demand induced expansion. Nations such as West Germany, Japan, Taiwan, Singapore, Hong Kong, and South Korea are not only applauded for their economic miracles by leading Monetarist and Old and New Keynesian scholars, but they are held up as shining examples of the proper functioning of a classical economy operating free from oppressive government intervention. Yet there is nothing in classical theory that justifies relying primarily on export-led growth!

WHY THE PREFERENCE FOR EXPORT LED GROWTH?

In a flexible exchange rate world, governments can have an incentive to pursue export policies rather than stimulating internal components of aggregate demand if growth without inflation is an objective. To demonstrate the existence of this incentive, let us, for simplicity, assume labor is the only variable factor of production. The money wage (w) divided by the marginal product of labor (MPL) is equal to the marginal cost of domestic industry (MC). Accordingly in a purely competitive economy

[w/MPL] = MC = Pd	(1.1a)

where Pd is the price level associated with domestic output. If there is given degree of monopoly (m) at any level of employment, where 0< m < 1, then Pd > MC, and

(w/MPL) = MC = (Pd)(g)	(1.1b)

or

Pd = w/[(MPL)(g)]	(1.1c)

where g equals one minus the average degree of monopoly in the system13. Thus in a purely competitive system where m = 0, g = 1, the more general equation (1b) is reduced to the specific case of equation (1a).

Equation (1b) can be rewritten as:

(w/Pd) = (MPL)(g)	(1.2)

Mainstream economists claim that the aggregate marginal productivity of labor curve is the demand curve for labor when g = 1. Post Keynesians, on the other hand, have argued that the marginal productivity of labor curve (multiplied by any value for the scalar g) can be envisioned as a real wage determining curve, or in Patinkin's terms a "market equilibrium curve", rather than a demand curve for labor14. This is not the place to revive this analytical dispute. In either case, it appears that the real wage at each level of employment is related to the marginal product of labor schedule15.

A downward sloping MPL curve means that industry "is subject to decreasing returns... so that the marginal product...necessarily diminishes as employment increases"16. Accordingly, marginal costs for domestic industries are rising as domestic employment increases. Figure 1 presents a downward sloping marginal product curve (multiplied by g) for domestic output. If production occurs instead under constant returns, then the marginal product and the MPL (g) curves will be horizontal (as shown in Figure 2).

[insert Figures 1 and 2 here]

As far as labor is concerned, its real wage is determined by its money wage divided by the price level (Pc) of the consumer products (wage goods) bought by labor. In other words, the equation for the real wage, whether the economy is open or closed is

wr = (w/Pc)	(3)

where wr is the real wage. As a first approximation, one may assume that the price level of domestically produced consumer goods (Pcd) is equal to (Pd), the price level associated with the all the domestically produced goods (i.e., the GNP price deflator)17. Hence, for a closed economy, equation (3) can be written as

wr = (w/Pc) = (w/Pcd ) = (w/Pd ) = (MPL)(g) (4)

In an open economy, on the other hand, the price level associated with domestic consumption expenditures (Pc) is given by

Pc = (Pcd ) (1 - ) + (Pcm) ( ) (5)

where Pcm is the price of consumer good imports in terms of domestic currency and is the proportion of aggregate domestic consumption expenditures spent on imports. Assuming Pcd = Pd, substituting equation (5) into equation (3), then the real wage in an open economy is

w

wr = w/Pc = ----------------------	(6)

Pd (1 - ) + Pcm ( )

w

= ------------------------	(7)

(Pd) (1/k)

where

(1/k) = [ (1 - ) + (Pcm/Pd)( ) ]. (8)

Since the prices of imported goods are necessarily lower than the price of domestic goods that they replace in domestic markets, then Pcm/Pd is necessarily less than one, and therefore according to equation (8), 1/k must be less than unity.

Substituting the right side of equation (1c) for Pd in equation (7) gives the real wage rate in an open economy as

wr = MPL(g)(k)	(9)

where k > 1. Thus, in figure 1, SL is the aggregate supply curve of labor while real wage determining equation (2) in a closed economy is drawn as the MPL(g). Comparing equation (9) with equation (2) it is obvious that the real wage determining curve in an open economy (b1 in Figure 1) will be some multiple (k) of (MPL)(g). This b1 curve lies above the MPL(g) curve as the price level of imported goods is lower than the price level of domestic goods at any employment level and > 0. Moreover the more open the economy, (the greater ), ceteris paribus, the greater the vertical distance between MPL(g) and MPL(g)(k). If the exchange rate should appreciate, and imported products become even cheaper, then k will be even larger and the real wage determining curve will shift upwards to b'1, even if the proportion of imports purchased ( ) is unchanged.

Consequently, for any given proportion of imports in total domestic expenditure, there will be a higher real wage determining curve for each employment level, the more the exchange rate appreciates. In Figure 1, at N0, the real wage Wo/Po exceeds the minimum real wage required to bring N0 workers18 into the labor market Wo/P1. Given the existence of involuntary unemployment in the system, if the government (or the central bank) initiates a policy of domestic expenditure expansion so that employment expands to N1 in Figure 1, then the real wage would fall to Wo/Po' as the average price level rose (inflation) due to the law of diminishing returns. As drawn in Figure 1, N1 is still a less than full employment level, but the economy is experiencing rising prices with every increase in employment because of diminishing returns. If, moreover, workers insist on cost of living adjustments (COLAs) as prices rise, then the resulting money wage inflation will exacerbate the inflationary problem induced by domestic demand expansion.

If, on the other hand, the government was to wait for export led growth (due to an initial expansion in one's trading partner's economy), then, the real wage determining curve would shift upwards from b1 to b'1 as the improved export-import relationship of the domestic economy leads to an appreciation of the exchange rate19. In Figure 1, the real wage remains at wo/Po (by construction) as employment rises from No to N1. Thus, even though domestic output prices rise due to diminishing returns, the domestic consumer does not experience inflation in the price level of the market basket of goods purchased as the cost of living is modified by lower import prices.

Accordingly, there would be less pressure for higher money wages for COLAs as the domestic economy expands. Moreover, the appreciating exchange rate improves the competition of foreign firms with domestic producers while making potentially cheaper foreign workers available to multinationals currently operating factories domestically. These competitive factors threaten domestic workers and thereby weaken worker's bargaining power for higher money wages. Simultaneously it strengthens any anti-labor resolve of the government and consumers to resist giving into strikers demands for higher money wages. Finally, previously employed workers (No) do not experience any decline in their real wage as additional workers are employed. Hence they are not likely to become restive.

Export-led growth can, therefore, lead to expansion without inducing any inflationary pressures that might otherwise arise if a domestic component of demand was exogenously increased. Simultaneously export led growth weakens labor unions' ability (and the rank and file's desire) to raise money wages20. Internally stimulated growth in aggregate demand, on the other hand, would lead to expansion with inflation due initially to diminishing returns which lower real wages and may then induce wage-price inflation as workers vainly attempt to reestablish the original real wage through COLAs21.

In sum, in a flexible exchange rate system, export-led growth can permit policy makers in any one nation to achieve higher employment without inflation provided some trading partner is willing and able to take on the task of acting as an initial engine of economic growth. In a world of fixed exchange rates, on the other hand, there can be no exchange appreciation and therefore the price of imports will not fall when the nation experiences a trade surplus. In Figure 1 under a fixed exchange rate regime, employment expands only through a movement down the b1 curve. Consequently, there would be no significant difference in the rate of inflation experienced in the nation whether growth was due to being export-led or whether growth was driven by some increase in an internal component of domestic demand22.

The story does not change significantly if domestic industries operate under constant returns rather than diminishing returns. If, in a flexible exchange rate system, the economy's MPL curve is horizontal as in figure 2, then export-led growth that results in exchange rate appreciation leads to higher real wages and a falling price level for the consumer's market basket, as long as money wages are unchanged. For example, as the economy moves from No to N1 under export-led growth in figure 2, the real wage would rise from w/Po to w/P'o. In this constant returns case, export led growth leads to simultaneous rising real wages, rising employment, and falling prices23. This situation may resemble West Germany's experience between 1985 and 1989.

Of course, this delightful situation of rising employment, real wages and little or no inflation that the export-led growth nation enjoys, does not imply that global inflation and unemployment problems have been resolved. These problems are, as in the card game of Old Maid, merely being passed on as the Black Queen to some other players in the international economy. Inflationary tendencies (and unemployment if the authorities undertake orthodox policies to stop inflation) will appear in those trading partners whose rising trade deficits lead to depreciating exchange rates. This may merely exacerbate inflationary tendencies if the deficit nation tries to maintain employment and workers demand real wage protection either through cost-of-living adjustments, or catch-up negotiations in new labor contracts.

From a global perspective, the existence of flexible exchange rates can encourage each nation to try to resolve problems of unemployment and inflation by merely pushing it off, in an uncivilized way, to others. If all act this way, then the result can be a global recession and stagnation (or even global stagflation). If, however, one nation acts as the engine of growth, as long as it continues to expand -- even as it runs a balance of payment deficit -- the trading partners who pursue export led growth will experience an economic miracle that they may attribute to their virtuous ways and even to their superior central bank that would willingly accept a recession rather than permit any wage inflation.

THE FACTS VS. THE THEORY OF FLEXIBLE EXCHANGE RATES

Since the breakdown of Bretton Woods, it has been popular to assume that freely fluctuating exchange rates in a laissez-faire market system are efficient. Every well trained mainstream economist, whose work is logically consistent with a Walrasian, Arrow-Debreu microfoundation, "knows" that the beneficial effects of a freely flexible exchange rate include [1] the impossibility of any one country running a persistent balance of payments deficit and [2] each nation is able to pursue monetary and fiscal policies for full employment without inflation independent of what is occurring in its trading partners24.

The facts since the breakup of Bretton Woods, however, do not appear to be consistent with these Panglossian promises. Between 1982 and 1990 when the United States (perhaps unwittingly) took over the engine of growth role for the global community, it has run persistent annual deficits, which, barring a Great Depression, are expected to continue into the twenty-first century. Also, since 1980, the major trading nations of the developed world have felt a greater necessity for coordinating monetary and fiscal policies, rather than running independent policies. When, in September 1987, the United States and Germany publicly clashed over incompatible monetary policies, the great October 1987 crash of world financial markets followed. This experience has reinforced the idea among the Central Bankers of the developed nations that if they don't all hang together they will all hang separately.

Finally, flight capital has drained resources from the relatively poor nations towards the richer ones, resulting in a global inequitable redistribution of income and wealth, thereby increasing the immiseration of a majority of the people on this planet.

In sum, then, during this period of floating rates, the world has not achieved the sate of economic bliss promised by classical theory. If anything the economic situation for a majority of the world's population has deteriorated.

REFORMING THE INTERNATIONAL PAYMENTS SYSTEM

The current international payments system does not serve the emerging global economy well. The Financial Times and The Economist, both previously strong advocates of the existing floating rate system, have acknowledged that the system is a failure and was sold to the public and the politicians under false advertising claims25. Can we not do better?

Too often professional economic discussions on the requirements for a good international payments system have been limited to the question of the advantages and disadvantages of fixed versus flexible exchange rates. Although this issue is important, the facts of experience plus Keynes's revolutionary analysis indicate that more is required than simply choosing between fixed and flexible exchange rates if a mechanism is to be designed to resolve payments imbalances and simultaneously promote global full employment economic growth and a long-run stable international standard of value.

The post-war world has conducted several experiments with the international payments system. For a quarter of a century after the war, there was a fixed, but adjustable, exchange rate system (1947-1973) set up under the Bretton Woods Agreement. Since 1973, we have operated under a flexible exchange rate system.

The 1947-1973 period was "an era of unprecedented sustained economic growth in both developed and developing countries"26. The growth in real Gross Domestic Product per capita in OECD nations escalated to 2.6 times that of the interwar period (4.9% annually compared to 1.9%). Moreover, this real growth rate was almost double the previous peak growth rate exhibited by the industrializing nations during the period from 1820-1914, while the growth in productivity during the Bretton Woods era was more than triple that of 1820-191427.

This unprecedented prosperity was transmitted to developing nations through world trade, aid, and foreign investment. The real per capita GNP growth rate for all developing nations rose to 3.3%, more than triple the growth experienced by the early industrializing nations between 1820 and 1914. Real total GNP growth of developing nations was almost the same as in developed countries28.

During the Bretton Woods epoch, free economies experienced unprecedented real economic growth. Moreover, during this period, there was "a much better overall record of price level stability" vis-a-vis either the post-1973 period or the previous era of fixed exchange rates under the gold standard (1879 - 1914)29.

The free world's economic performance in terms of both real growth and price level stability during the Bretton Woods period was unprecedented. Moreover, even the record during the earlier gold standard-fixed exchange rate period was better than the experience during the 1973-1991 period of flexible exchange rates. The dismal post-1973 experience of recurrent unemployment and inflationary crises, slow growth in OECD countries, and debt-burdened growth and/or stagnation (and even falling real GNP per capita) in developing countries contrasts most sharply with the experience during the Bretton Woods period.

What can we surmise from these facts? First, several hundred years of experience support the thesis that a fixed exchange rate system provides an international environment that is more compatible with greater real economic growth and price stability compared to what was experienced under a flexible exchange rate regime. To reduce entrepreneurial uncertainties and the possibility of massive currency misalignments Keynes recommended the adoption of a fixed, but adjustable, exchange rate system. More significant, however, is that the superior performance of the free world's economies during the Bretton Woods fixed rate period compared to the earlier gold standard fixed rate period suggests that there must have been an additional condition besides exchange rate fixity that contributed to the unprecedented growth during the 1947-73 period.

That additional condition had been described by Keynes, in developing his proposals for an international payments scheme. The "main cause of failure" of any traditional payments system -- whether based on fixed or flexible rates-- was its inability to foster continuous global economic expansion when persistent current account imbalances among trading partners occurred. This failure, Keynes wrote,

"can be traced to a single characteristic. I ask close attention to this, because I shall argue that this provides a clue to the nature of any alternative which is to be successful."

"It is characteristic of a freely convertible international standard that it throws the main burden of adjustment on the country which is the debtor position on the international balance of payments - that is, on the country which is (in this context) by hypothesis the weaker and above all the smaller in comparison with the other side of the scales which (for this purpose) is the rest of the world"30.

Keynes concluded that an essential improvement in designing any international payments system requires transferring "the onus of adjustment from the debtor to the creditor position," and aiming "at the substitution of an expansionist, in place of a contractionist, pressure on world trade"31. In other words, to achieve a golden era of economic development requires combining a fixed, but adjustable, rate system with a mechanism for requiring the surplus trading nation(s) to initiate most of the effort necessary to adjust a payments imbalance, without removing all discipline from the deficit trading partner.

During the first half of the Bretton Woods era, the world's major creditor nation, almost accidentally, accepted responsibility for curing deficits in the current account balance via the Marshall Plan and other forms of foreign and military aid.

After World War II, the economic recovery of the free capitalist world required the European nations to run huge import surpluses to feed their populations and rebuild their stock of capital. Under the rules of free market economies, this implied that the United States would have to provide enormous credits to finance the required export surplus to Europe. The resulting European indebtedness would be so burdensome that it was unlikely that, even in the long run, the European nations could ever service this debt. Moreover, U.S. policy makers were mindful that reparation payments after World War I were financed by U.S. investors lending Germany foreign exchange and Germany never repaid these loans. Given this history and existing circumstances it was obvious that private lending facilities could not be expected to provide the credits necessary for European recovery.

Under the fixed exchange rate system of Bretton Woods, the only mechanism available for redressing this potentially lopsided global import-export trade flow was for the debtors to accept the main burden of adjustment by "tighten their belt" and reduce their demand for imports to what they could earn from exports32. The result would have been to depress further the standard of living of Western Europeans. This could have induced political revolutions in most of Western Europe.

Instead, the United States produced the Marshall Plan and other foreign grants and aid programs. The Marshall Plan provided $5 billion in aid in 18 months and a total of $13 billion in four years. (In 1991 dollars this is equivalent to over $100 billion.)

Marshall plan transfers represented approximately 2 per cent per annum of the GNP of the United States.33 Yet no U.S. resident felt deprived of goods and services. Real GNP per capita in the United States during the first year of the Marshall Plan was still 25% larger than in the last peacetime year of 1940. Per capita GNP continued to grow throughout the 1950s.34 There was no real sacrifice associated with this export surplus. These exports were produced by employing what otherwise would have been idle resources. For the first time in its history, the United States did not suffer from a severe recession immediately after the cessation of a major war. The world experienced an economic "free lunch" as both the potential debtors and the creditor nation gained from this "give away". It was the failure of the Bretton Woods system after the 1950s to perpetuate this creditor nation action that led to its ultimate abandonment and the end to the golden era of economic development.

By 1958, although the U.S. still had a goods and services export surplus of over $5 billion, U.S. governmental and military transfers exceeded $6 billion, while there was a net private capital outflow of $1.6 billion.35 The post-war U.S. surplus position on current account was at an end. As the U.S. current account swung into deficit, other nations began to experience current account surpluses. These nations converted a portion of their dollar current account surpluses into gold. For example, in 1958, the U.S. lost over $2 billion in gold reserves. These trends accelerated in the 1960s, partly as a result of increased U.S. military and financial aid responses to the construction of the Berlin Wall in 1961 and later because of the U.S.'s increasing involvement in Vietnam. At the same time, a rebuilt Europe and Japan became important producers of exports so that the rest of the world became less dependent on the U.S. exports.

The U.S. maintained a positive merchandise trade balance until the first oil price shock in 1973. More than offsetting this trade surplus during most of the 1960s, however, were foreign and military unilateral transfers plus net capital outflows. The Bretton Woods system had no way of automatically forcing the emerging surplus nations to step into the adjustment role that the U.S. had been playing since 1947. Instead they continued to converted some portion of their annual dollar surpluses into calls on U.S. gold reserves. The seeds of the destruction of the Bretton Woods system and the golden age of economic development were sown as surplus nations drained gold reserves from the United States.

When the U.S. closed the gold window and unilaterally withdrew from Bretton Woods, the last vestige of Keynes's enlightened international monetary approach was lost -- apparently without regret or regard as to how well it served the global economy.

A NEW INTERNATIONAL PAYMENTS SYSTEM

The following proposal for an international payments system builds on Keynes' proposals that have proved successful for producing the expansionist pressure on world trade and development during the 1947-73 period.

In an interdependent world economy, some degree of economic cooperation among trading partners is necessary. Our proposal, however, does not require the establishment of a Supranational Central Bank to create a Unionized Monetary System (UMS) -- even if this is believed desirable on other grounds. Keynes's original "bancor" plan for the post World War II environment was developed around the idea of a single Supranational Bank. At this stage of the evolution of world politics, however, a global UMS with a Supranational Central Bank is not feasible36. Our suggestion is a more modest one aimed at obtaining an international agreement that does not require surrendering national control of local banking systems and fiscal policies.

Keynes provided a clear outline of what was needed when he wrote:

"We need an instrument of international currency having general acceptability between nations .... We need an orderly and agreed upon method of determining the relative exchange values of national currency units.... We need a quantum of international currency... [which] is governed by the actual current [liquidity] requirements of world commerce, and is capable of deliberate expansion.... We need a method by which the surplus credit balances arising from international trade, which the recipient does not wish to employ can be set to work... without detriment to the liquidity of these balances"37.

What is required is a closed, double-entry bookkeeping clearing institution to keep the payments score among the various trading regions plus some mutually agreed upon rules to create and reflux liquidity while maintaining the international purchasing power of the international currency. The eight provisions of the clearing system suggested in this section meet the criteria laid down by Keynes. The rules of our proposed system are designed [1] to prevent a lack of global effective demand38 due to any nation(s) either holding excessive idle reserves or draining reserves from the system, [2] to provide an automatic mechanism for placing a major burden of payments adjustments on the surplus nations, [3] to provide each nation with the ability to monitor and, if desired, to control movements of flight capital39, and finally [4] to expand the quantity of the liquid asset of ultimate international redemption as global capacity warrants.

Some elements of such a clearing system would include:

1. The unit of account and ultimate reserve asset for international liquidity is the International Money Clearing Unit (IMCU). All IMCU's are held only by central banks, not by the public.

2. Each nation's or UMS's central bank is committed to guarantee one way convertibility from IMCU deposits at the clearing union to its domestic money. Each central bank will set its own rules regarding making available foreign monies (through IMCU clearing transactions) to its own bankers and private sector residents40.

Since Central Banks agree to sell their own liabilities (one-way convertibility) against the IMCU only to other Central Bankers and the International Clearing Agency while they simultaneously hold only IMCUs as liquid reserve assets for international financial transactions, there can be no draining of reserves from the system. Ultimately, all major private international transactions clear between Central Banks' accounts in the books of the international clearing institution.

3. The exchange rate between the domestic currency and the IMCU is set initially by each nation -- just as it would be if one instituted an international gold standard. Since enterprises that are already engaged in trade have international contractual commitments that would span the change-
over interval, then, as a practical matter, one would expect that the existing exchange rate structure (with perhaps minor modifications) would provide the basis for initial rate setting.

Provisions #7 and #8 infra indicate when and how this nominal exchange rate between the national currency and the IMCU would be changed in the future.

4. Contracts between private individual's will continue to be denominated into what ever domestic currency permitted by local laws and agreed upon by the contracting parties. Contracts to be settled in terms of a foreign currency will therefore require some announced commitment from the central bank (through private sector bankers) of the availability of foreign funds to meet such private contractual obligations.

5. An overdraft system to make available short-term unused creditor balances at the Clearing House to finance the productive international transactions of others who need short-term credit. The terms will be determined by the pro bono publico clearing managers.

6. A trigger mechanism to encourage any creditor nation to spend what is deemed (in advance) by agreement of the international community to be "excessive" credit balances accumulated by running current account surpluses. These excessive credits can be spent in three ways: (1) on the products of any other member of the clearing union, (2) on new direct foreign investment projects, and/or (3) to provide unilateral transfers (foreign aid) to deficit members. Spending by way of (1) forces the surplus nation to make the adjustment directly through the balance on goods and services. Spending by way of (3) permits adjustment directly by the current account balance; while (2) provides adjustment by the capital accounts (without setting up a contractual debt that will require reverse current account flows in the future).

Consequently, proviso #6 provides the surplus country with considerable discretion in deciding how to accept the "onus" of adjustment in the way it believes is in its residents best interests. It does not, however, permit the surplus nation to shift the burden to the deficit nation(s) through contractual requirements for debt service charges independent of what the deficit nation can afford41. The important thing is to make sure that continual oversaving42 by surplus nations can not unleash depressionary forces and/or a building up of international debts so encumbering as to impoverish the global economy of the 21st century.

In the unlikely event that the surplus nation does not spend or give away these credits within a specified time, then the clearing agency would confiscate (and redistribute to debtor members) the portion of credits deemed excess43. This last resort confiscatory action by the managers of the clearing agency would make a payments adjustment via unilateral transfer payments in the current accounts.

Under either a fixed or a flexible rate system, nations may experience persistent trade deficits merely because their trading partners are not living up to their means -- that is because other nations are continually hoarding a portion of their foreign export earnings (plus net unilateral transfers). By so doing, these oversavers are creating a lack of global effective demand. Under provision #6, deficit countries would no longer have to deflate their real economy merely to adjust their payment imbalance because others are oversaving. Instead, the system would seek to remedy the payment deficit by increasing opportunities for deficit nations to sell abroad.

7. A system to stabilize the long-term purchasing power of the IMCU (in terms of each member nation's domestically produced market basket of goods) can be developed. This requires a system of fixed exchange rates between the local currency and the IMCU that changes only to reflect permanent increases in efficiency wages44. This assures each central bank that its holdings of IMCUs as the nation's foreign reserves will never lose purchasing power in terms of foreign produced goods, even if a foreign government permits wage-price inflation to occur within its borders. Consequently, the rate between the local currency and the IMCU would change with inflation in the local money price of the domestic commodity basket.

If, however, increases in productivity lead to declining nominal production costs, then the nation with this decline in efficiency wages [say of 5 per cent] would have the option of choosing either [a] to permit the IMCU to buy [up to 5 per cent] less units of domestic currency, thereby capturing all (or most of) the gains from productivity for its residents while maintaining the purchasing power of the IMCU, or [b] to keep the nominal exchange rate constant. In the latter case, the gain in productivity is shared with all trading partners. In exchange, the export industries in this productive nation will receive an increasing relative share of the world market.

By altering the exchange rate between local monies and the IMCU to offset the rate of domestic inflation, the IMCU's purchasing power is stabilized. By restricting use of IMCUs to Central Banks, private speculation regarding IMCUs as a hedge against inflation is avoided. Each nation's rate of inflation of the goods and services it produces is determined solely by (a) the local government's policy towards the level of domestic money wages and profit margins vis-a-vis productivity gains, i.e., the nation's efficiency wage. Each nation is therefore free to experiment with policies for stabilizing its efficiency wage to prevent inflation. Whether the nation is successful or not, the IMCU will never lose its international purchasing power. Moreover, the IMCU has the promise of gaining in purchasing power over time, if productivity grows rapidly more than money wages and each nation is willing to share any reduction in real production costs with its trading partners.

Provision #7 produces a system designed to maintain the relative efficiency wage parities amongst nations. In such a system, the adjustability of nominal exchange rates will be primarily (but not always, see Provision #8) to offset changes in efficiency wages among trading partners. A beneficial effect that follows from this proviso is that it eliminates the possibility that a specific industry in any nation can be put at a competitive disadvantage (or secure a competitive advantage) against foreign producers solely because the nominal exchange rate changed independently of changes in efficiency wages and the real costs of production in each nation.

Consequently, nominal exchange rate variability can no longer create the problem of a loss of competitiveness due solely to the overvaluing of a currency as, for example, experienced by the industries in the American "rust belt" during the period 1982-85. Even if temporary, currency appreciation can have significant permanent real costs, e.g., industries may abandon markets and the resulting idle existing plant and equipment may be cast aside as too costly to maintain.

Proviso #7 also prevents any nation from engaging in a beggar-thy-neighbor, export-thy-
unemployment policy by pursuing a real exchange rate devaluation that does not reflect changes in efficiency wages. Once the initial exchange rates are chosen and relative efficiency wages are locked in, reductions in real production costs that are associated with a relative decline in efficiency wages is the main factor (with the exception of provision #8) justifying an adjustment in the real exchange rate.

Under provision #7 of our proposal the IMCU would provide its holders with an invariant international monetary standard no matter whether the domestic rates of inflation in the various nations converged (or not) or accelerated (or not).

Although provision #6 prevents any country from piling up persistent excessive surpluses this does not mean that it is impossible for one or more nations to run persistent deficits. Consequently proposal #8 infra provides a program for addressing the problem of persistent export-
import deficits in any one nation.

8. If a country is at full employment and still has a tendency towards persistent international deficits on its current account, then this is prima facie evidence that it does not possess the productive capacity to maintain its current standard of living. If the deficit nation is a poor one, then surely there is a case for the richer nations who are in surplus to transfer some of their excess credit balances to support the poor nation45. If it is a relatively rich country, then the deficit nation must alter its standard of living by reducing its relative terms of trade with its major trading partners. Rules, agreed upon in advance, would require the trade deficit rich nation to devalue its exchange rate by stipulated increments per period until evidence becomes available to indicate that the export-
import imbalance is eliminated without unleashing significant recessionary forces46.

If, on the other hand, the payment deficit persists despite a continuous positive balance of trade in goods and services, then there is evidence that the deficit nation might be carrying too heavy an international debt service obligation. The pro bono officials of the clearing union should bring the debtor and creditors into negotiations to reduce annual debt service payments by [1] lengthening the payments period, [2] reducing the interest charges, and/or [3] debt forgiveness47.

If any government objects to the idea that the IMCU provisions provide governments with the ability to limit the free movement of "capital" funds, then this nation is free to join other nations of similar attitude in forming a regional currency union [UMS] and thereby assuring a free flow of funds among the residents of the currency union.

CONCLUSION

Our suggested provisions for a new international payments system are not unalterable for practical reasons. Instead they should provide the basis for the beginning of a sound analytical discussion of how to prepare for a 21st century international monetary system.

The problems facing the international payments system are not easily resolved. If we start with the defeatist attitude that it is too difficult to change the awkward system we are enmeshed in, then no progress will be made. We must reject such defeatism at this exploratory stage and merely ask whether these particular proposals for improving the operations of the international payments system to promote global growth will create more difficulties than other proposed innovations. The health of the world economic system will not permit us to muddle through!

APPENDIX: THIRLWALL'S LAW - AN EXTENSION OF THE KEYNES'S MULTIPLIER

Professor A. P. Thirlwall48 has developed Keynes's multiplier mechanism into a demand driven model of economic growth that does not make the classical presumption of continuous global full employment.

Xa = (Pd/Pf)zYerw	(1)

Ma =(Pd/Pf)uYea	(2)

where Xa and Ma are exports from nation A and imports into A during a period, (Pd/Pf) is the ratio of domestic prices to foreign prices expressed in terms of the domestic currency of A, z is the price elasticity of demand for A's exports, u is A's price elasticity of demand for imports, ea is A's income elasticity of demand for imports, and erw is the rest of the world's income elasticity of demand for A's exports. If either z and u are small and/or relative prices do not change significantly, then, as a first approximation, one can ignore substitution effects and concentrate on income effects. Taking the natural logs of equations (1) and (2) and ignoring substitution effects, one obtains Thirlwall's Law of the growth of income that is consistent with an unchanged trade balance as

ya = x/ea	(3)

where ya is the rate of growth of Nation A's GNP, x is the rate of growth of A's exports, and ea is A's income elasticity of demand for imports. Since the growth of exports for A depends primarily on the rest of the world's growth in income (yrw) and the world's income elasticity of demand for A's exports (erw), i.e.,

x = (erw)(yrw)	(4)

equation (3) can be written as

ya = [erw yrw ]/ea	(5)

The rate of growth that a nation can maintain without running into a balance of payments problem depends on the rest of the world's growth and the relevant income elasticities for imports and exports. If the growth of imports is to exactly equal the growth in the value of exports,

erwyrw = yaea	(6)

then,

[ya/yrw] =erw/ea	(7)

the ratio of the growth of income in nation A compared to growth in income in the rest of the world is equal to the ratio of the income elasticity of demand for A's exports by the rest of the world to A's income elasticity of demand for imports. Thus, for example, if erw/ea < 1, and if growth in A is constrained by the need to maintain balance of payments equilibrium, then nation A is condemned to grow at a slower rate than the rest of the world.

If, for example, less developed nations (LDCs) of the world have a comparative advantage in the exports of raw materials, and other basic commodities for which Engel's curves suggest that the developed world will have a low income elasticity of demand, while the LDCs have a high income elasticity of demand for the manufactured products of the developed world, then for most LDCs

[erw/eldc] < 1	(8)

Accordingly, if economic development and balance of payments equilibrium is left to the free market, the LDCs are condemned to relative poverty, and the global inequality of income will become larger over time.

Moreover, if the rate of population growth in the LDCs (pldc) is greater than the rate of population growth in the developed world (pdw), that is, if pldc > pdw, then the rate of growth of GNP per capita of the LDCs will experience a greater relative decline to the standard of living of the developed world, i.,e.,

[yldc/pldc] < <[ydw/pdw]	(9)

In the absence of Keynesian policies to stimulate growth, the long term growth rate of the developed world taken as a whole tends to be in the 1 - 2.5 per cent range. As long as the developed world's population growth is less than its long-term growth rate, however, these nations can still enjoy a rising living standard.

If, however, we accept the reasonable values for the parameters implied in inequality (9), then since yldc < ydw, while 1 < ydw <2.5, a dreary prognostication for the global economy emerges. As long as the world permits the free market to determine the balance of payments constraint on each nation, then a shrinking proportion of the world's population may continue to get richer (or at least hold their own), while a growing proportion of the earth's population is likely to become poorer. Moreover, the slower the rate of growth in income of the rich, the more rapidly the poor are likely to sink into poverty.

Thus, there is an obvious case to explore if there are some policy interventions that can be developed to prevent market determined balance of payments constraints from condemning the majority of the world's population to increasing poverty. Only if the rich can achieve the historically high real rates of growth experienced in the first 25 years since World War II (where Keynesian rather than free market policies were actively pursued domestically and internationally by the developed world) can we hope to significantly improve the economic lot of the poorer nations of the world.

Since the US has apparently not been significantly constrained by payments deficits, equation (8) can be interpreted in a different light for the U.S. Given the U.S. rate of growth under Reagan since 1982, then, if one assumes the import and export income elasticities of demand (erw and ea) are fixed, then solving equation (8) for yrw yields the income growth that would have been required of the US's trading partners in order to eliminate the US trade deficit. Alternatively, if yrw is presumed unchanged, then solving for erw would be the required income elasticity necessary to avoid a US trade deficit.

Thirlwall's analysis demonstrates that international financial payment imbalances can have severe real consequences, i.e., money is not neutral in an open economy.

ENDNOTES