What Kind of Convertibility?

October 18, 1954

Last week I pointed out here that after nine years of exchange control, Britain has acquired a morbid fear of any return to currency freedom. Primarily this irrational dread was caused by the breakdown of the 1947 experiment in convertibility, followed by a complete misinterpretation of the causes of that breakdown. It came chiefly because Britain foolishly made a pound worth about $3 convertible into $4. The result was that everybody who had a pound was eager to get $4 for it, and nobody who had $4 wanted a pound for them. The conversion was all one way; England’s gold and dollar reserves drained out alarmingly. Conversion had to be stopped after a few weeks.

Now strangely, though there is in Britain great fear of a repetition of this consequence, when the British seriously talk of restoring convertibility at all, they usually talk of restoring the same kind of fixed-rate convertibility that collapsed in 1947. They talk of restoring convertibility at a rigid $2.80. But this would mean either putting the pound on a dollar-exchange basis (which would be neither flattering to British pride nor very wise), or it would mean an immediate return to a fixed external gold standard, which the British are supposed to view with horror. And if the real equilibrium rate for the pound turned out to be less than $2.80, it would mean an indefinite drain on British gold and dollar reserves.

Fortunately there is a sensible alternative. This is to restore convertibility (both of the pound and other currencies) at flexible rates, at free market rates, at what is now disparagingly called floating rates. This is what our neighbor Canada has so successfully done in the last few years. This, in fact, is what Britain itself did in the period from 1931 to 1938. When the conversion rate is a free market rate, reserves do not have to be enormous. Any one-way drain on them stops as soon as the rate for the domestic currency has fallen to the real equilibrium rate.

There has developed incredible confusion of thought about the implications of such free rates. We are told that they mean still another “devaluation.” The experience of Canada, whose dollar is actually at a premium with the American dollar, should be itself a sufficient refutation of this. Whether a currency rate falls or rises is in the long run for that nation’s own monetary managers to decide. If a freed pound began by falling 10 percent, say (in terms of dollars), then Britain’s imports would cost about 10 percent more in terms of dollars. This would raise average British living costs. But British exports would be purchasable for 10 percent less in terms of dollars. (Or some British exporters would be able to raise their sterling prices and make higher profits.) The tendency, in other words, would be to cut down imports, to increase exports, and to bring Britain a more “favorable” balance of trade.

If the British monetary managers did not wish the pound to fall 10 percent, they could restore its value in the free market by increasing confidence in it—chiefly by making pounds more scarce, which could be done in turn chiefly by boosting internal interest rates. With a free exchange market to guide them, the monetary managers would have the enormous advantage of knowing at all times how the outside world valued the pound and what stabilizing steps to take.

Britain has asked for all sorts of assurances from the United States before it consents to go back to convertibility. But the chief external assurance it needs is not from us, but from other European countries. It needs assurance that they too will go back to convertibility to relieve undue pressure on the pound. But this is exactly what Germany, Holland, and Belgium now seem eager to do.

Our own government should not prod Great Britain to return to convertibility. Such a return would be primarily to the advantage of Britain itself. But it is high time that we stopped subsidizing European exchange control as we have been doing for the last nine years by monetary handouts and encouragement of discrimination against American goods.