Lecture IV INTERNATIONAL CAPITAL MOVEMENTS 1

For the purposes of this lecture, by international capital movements I shall mean the acquisition of claims on persons or of rights to property in one country by persons in another country, or the disposal of such claims or property rights in another country to people in that country. This definition is meant to exclude from capital movements the purchase and sale of commodities which pass from one country to the other at the same time as they are paid for and change their owners. But it also excludes any net movement of gold (or other international money) in so far as these movements are payments for commodities or services received (or “unilateral” payments) and therefore involve a transfer of ownership in that money without creating a new claim from one country to the other. This is of course not the only possible definition of capital movements, and strong arguments could be advanced in favour of a more comprehensive definition, which in effect would treat every transfer of assets from country to country as a capital movement. The reason which leads me to adopt here the former definition is that only on that definition it is possible to distinguish between those items in international transactions which are, and those which are not, capital items.

The first kind of capital item of this sort and the one which will occupy us in this lecture more than any other is the acquisition, or sale, of amounts of the national money of one country by inhabitants of the other.[1] The form which this kind of transaction to-day predominantly takes is the holding of balances with the banks of one country on the part of banks and individuals in the other country. Such balances will to some extent be held even if there is a safe and stable international standard, since, rather than actually send money, it will as a rule be cheaper for the banks to provide out of such balances those of their customer’s requirements which arise out of the normal day to day differences between payments and receipts abroad. And if it is possible to hold such balances either in the form of interest-bearing deposits or in the form of bills of exchange, there will be a strong inducement to hold such earning assets as substitutes for the sterile holdings of international money. It was in this way that what is called the gold exchange standard tended more and more to supplant the gold standard proper. In the years immediately preceding 1931 this assumed very great significance.

If there exists a system of fluctuating exchanges, or a system where people are not altogether certain about the maintenance of the existing parities, these balances become even more important. There are two new elements which enter in this case. In the first place it will then no longer be sufficient if banks and others who owe debts in different currencies keep one single liquidity reserve against all their liabilities. It will become necessary for them to keep separate liquid assets in each of the different currencies in which they owe debts, and to adjust them to the special circumstances likely to affect liabilities in each currency. We get here new artificial distinctions of liquidity created by the multiplicity of currencies and involving all the consequential possibilities of disturbances following from changes in what is now called “liquidity preference”, Secondly there will be the chance of a gain or loss on these foreign balances due to changes in the rates of exchange. Thus the anticipation of any impending variation of exchange rates will tend to bring about temporary changes of a speculative nature in the volume of such balances. Whether these two kinds of motives must really be regarded as different, or whether they are better treated as essentially the same, there can be no doubt that variability of exchange rates introduces a new and powerful reason for short term capital movements, and a reason which is fundamentally different from the reasons which exist under a well-secured international standard.

Foreign bank balances and other holdings of foreign money are of course only part, although probably the most important part, of the volume of short term foreign investment. It is here that the impact effect of any change in international indebtedness arising out of current transactions will show itself; and it is here that there will be the most ready response to changes in the relative attractiveness of holding assets in the different countries. Once we go beyond this field it becomes rather difficult to say what can properly be called movements of short term capital. In fact, with the exception of non-funded long-term loans almost any form of international investment may have to be regarded as short term investment, including in particular all investments in marketable securities.[2] But for the monetary problems with which we are here concerned it is mainly the short term credits which are of importance, because it is here that we have to deal with large accumulated funds which are apt to change their location at comparatively slight provocation. Compared with these “floating” funds, the supply of capital for long term investment, limited as it will be to a certain part of new savings, will be relatively small.

Now the chief question which we shall have to consider is the question to what extent under different monetary systems international capital movements are likely to cause monetary disturbances, and to what extent and by what means it may be possible to prevent such disturbances. It will again prove useful if we approach this task in three stages, beginning with a consideration of the mechanism and function of international capital movements under a homogeneous standard. Then we shall go on to inquire how this mechanism and the effects are modified if we have “mixed” currency systems organized on the national reserve principle but with fixed exchange rates. And finally we shall have to see what will be the effects of the existence of variable exchange rates and the way in which fluctuations of the exchange and capital movements mutually influence one another.

2

If exchange rates were regarded as invariably fixed we should expect capital movements to be guided by no other considerations except expected net yield, including of course adjustments which will have to be made for the different degrees of risk inherent in the different sorts of investments. This does not mean that there would not be frequent changes in the flow of capital from country to country. There might of course be a permanent tendency on the part of one country to absorb part of the current savings of another at terms more favourable than those at which these savings could be invested in the country were they are made. Quite apart from these flows of capital for more or less permanent investment however, there would be periodic or occasional short term lending to make up for temporary differences between imports and exports of commodities and services.

Now there is of course no reason why exports and imports should move closely parallel from day to day or even from month to month. If in all transactions payment had to be made simultaneously with the delivery of the goods, this would mean, in external trade no less than in internal, a restriction of the possible range of transactions similar in kind to what would occur if all transaction had to take the form of barter. The possibility of credit transactions, the exchange of present goods against future goods, greatly widens the range of advantageous exchanges. In international trade it means in particular that countries may import more than they export in some seasons because they will export more than they import during other seasons. Whether this is made possible by the exporter directly crediting the importer with the price, or whether it takes place by some credit institution in either country providing the money, it will always mean that the indebtedness of the importing country to the exporting increases temporarily, that is, that net short term lending takes place.

At this point it is necessary especially to be on guard against a form of stating these relations which suggests that short term lending is made necessary by, or is in any sense a consequence of a passive balance of trade—that the loans are made so to speak with the purpose of covering a deficit in the balance of trade. We shall get a more correct picture if we think of the great majority of the individual transactions in both ways being credit transactions so that it is the excess lending in one direction during any given period which has made possible a corresponding excess of exports in the same direction. If we look on the whole process in this way we can see how considerable a part of trade is only made possible by short term capital movements. We can see also how misleading it may be to think of capital movements as exclusively directed by previous changes in the relative rates of interest in the different money markets. What directs the use of the available credit and therefore decides in what direction the balance of indebtedness will shift at a particular moment is in the first instance the relation between prices in different places. It is of course true that where each country habitually finances its exports and borrows its imports, any absolute increase of exports will tend to bring about an increase in the demand for loans and therefore a rise in the rate of interest in the exporting country. But in such a case the rise in the rate of interest is rather the effect of this country lending more abroad, than a cause of a flow of capital to the country. And although this rise in money rates may lead to a flow of funds in the reverse direction, that will be more a sign that the main mechanism for the distribution of funds works imperfectly than a part of this mechanism. There is no more reason to say that the international redistribution of short-term capital is brought about by changes in the rates of interest in the different localities than there would be for saying that the seasonal transfers of funds from say agriculture to coal mining are brought about by a fall of the rate of interest in agriculture and a rise in coal mining or vice versa.

Changes in short term international indebtedness must therefore be considered as proceeding largely concurrently with normal fluctuations in international trade; and only certain remaining balances will be settled by a flow of funds, largely of an inter-bank character, induced by differences in interest rates to be earned. It is of course not to be denied that, apart from changes in international indebtedness which are more directly connected with international trade, there may also be somewhat sudden and considerable flows of funds which may be caused either by the sudden appearance of very profitable opportunities for investment, or by some panic which causes an insistent demand for cash. In this last case indeed it is true that the flow of short term funds may transmit monetary disturbances to parts of the world which have nothing to do with the original cause of the disturbance, as say a war-scare in South-America might conceivably lead to a general rise in interest rates in London. But, apart from such special cases, it is difficult to see how under a homogeneous international standard, capital movements, and particularly short term capital movements, should be a source of instability or lead to any changes in productive activity which are not justified by corresponding changes in the real conditions.

3

This conclusion has, however, to be somewhat modified if, instead of a homogeneous international currency, we consider a world consisting of separate national monetary and banking systems, even if we still leave the possibility of variations in exchange rates out of account. It is of course a well-known fact that one of the main purposes of changes in the discount rate of central banks is to influence the international movements of short term capital.[3] A central bank which is faced with an outflow of gold will raise its discount rate in the hope that by attracting short term credits it will offset the gold outflow. To the extent that it succeeds it will postpone the necessity of more drastic credit contraction at home, and—if the cause of the adverse balance of trade is transitory—it may perhaps altogether avoid it. But it is by no means evident that it will attract the funds just from where the gold would tend to flow, and it may well be that it only passes on the necessity of credit contraction to another country. And if for some reason all or the majority of central banks should at a particular moment feel that they ought to become more liquid and for this purpose raise their discount rates, the sole effect will be a kind of general tug-of-war in which all central banks, trying to prevent an outflow of funds and if possible to attract funds, only succeed in bringing about a violent contraction of credit at home. But although the fact that central banks react to all major gold movements with changes in the rate of discount may mean that changes in the volume and direction of short term credits will be more frequent and violent if we have a number of banking systems organized on national lines, it is again not the fact that the system is international, but rather that is creates impediments of the free international flow of funds which must be regarded as responsible for these disturbances.

Again we must be careful not to ascribe this difficulty to the existence of central banks in particular, although in a sense the growth of the sort of credit structure to which they are due was only made possible by the existence of some such institutions. The ultimate source of the difficulty is the differentiation between moneys of different degrees of acceptability or liquidity, the existence of a structure consisting of superimposed layers of reserves of different degrees of liquidity, which makes the movement of short term money rates, and in consequence the movement of short term funds, much more dependent on the liquidity position of the different financial institutions than on changes in the demand for capital for real investment. It is because with “mixed” national monetary systems the movements of short term funds are frequently due, not to changes in the demand for capital for investment, but to changes in the demand for cash as liquidity reserves, that short term international capital movements have such or bad reputation as causes a monetary disturbances. And this reputation is not altogether undeserved.

But now the question arises whether this defect can be removed not by making the medium of circulation in the different countries more homogeneous, but rather, as the Monetary Nationalists wish, by severing even the remaining tie between the national currencies, the fixed parities between them. This question is of particular importance since the idea that the national monetary authorities should never be forced by an outflow of capital to take any action which might unfavourably affect economic activity at home is probably the main source of the demand for variable exchanges. To this question therefore we must now turn.

4

The chief questions which we shall have to consider here are three: will the volume of short term capital movement be larger or smaller when there exists uncertainty about the future of exchange rates? Are the national monetary authorities in a position either to prevent capital movements which they regard as undesirable, or to offset their effects? And, finally, what further measures, if any, are necessary if the aims of such a policy are to be consistently followed?

We have already partly furnished the answer to the first question. Although the contrary has actually been asserted, I am altogether unable to see why under a regime of variable exchanges the volume of short term capital movements as well as the frequency of changes in their direction should be anything but greater.[4] Every suspicion that exchange rates were likely to change in the near future would create an additional powerful motive for shifting funds from the country whose currency was likely to fall or to the country whose currency was likely to rise. I should have thought that the experience of the whole post-war period and particularly of the last few years had so amply confirmed what one might have expected a priori that there could be no reasonable doubt about this.[5] There is only one point which perhaps still deserves to be stressed a little further. Where the possible fluctuations of exchange rates are confined to narrow limits above and below a fixed point, as between the two gold points, the effect of short term capital movements will be on the whole to reduce the amplitude of the actual fluctuations, since every movement away from the fixed point will as a rule create the expectation that it will soon be reversed. That is, short term capital movements will on the whole tend to relieve the strain set up by the original cause of a temporarily adverse balance of payments. If exchanges, however, are variable, the capital movements will tend to work in the same direction as the original cause and thereby to intensify it. This means that if this original cause is already a short term capital movement, the variability of exchanges will tend to multiply its magnitude and may turn what originally might have been a minor inconvenience into a major disturbance.

Much more difficult is the answer to the second question: can the authorities control these movements; since what the monetary authorities can achieve in a particular direction will largely depend on what other consequences of their action they are willing to put up with. In the particular case the question is mainly whether they would be willing to let exchange rates fluctuate to any degree or whether they would not feel that although moderate fluctuations of exchange rates were not worth the cost of preventing them, yet they must not be allowed to exceed certain limits, since the unsettling effects from large fluctuations would be worse than the measures by which they could be prevented. In practice we must probably assume that even if the authorities are prepared to allow a slow and gradual depreciation of exchanges, they would feel bound to take strong action to counteract it as soon as it threatened to lead to a flight of capital or a strong rise of prices of imported goods.

The theory that by keeping exchange rates flexible a country could prevent dear money abroad from affecting home conditions is of course not a new one. It was for instance argued by the opponents of the introduction of the gold standard in Austria in 1892 that the paper standard insulated and protected Austria from disturbances originating on the world markets. But I doubt whether it has ever been carried quite as far as by some of our contemporary Monetary Nationalists, for instance Mr. Harrod, who declared that he could not accept exchange stabilisation “if thereby a country is committed to an interior monetary policy which involves raising the bank rate of interest”.[6] The modern idea apparently is that never under any circumstances must an outflow of capital be allowed to raise interest rates at home, and the advocates of this view seem to be satisfied that if the central banks are not committed to maintain a particular parity they will have no difficulty either in preventing an outflow of capital altogether or in offsetting its effect by substituting additional bank credit for the funds which have left the country.

It is not easy to see on what this confidence is founded. So long as the outward flow of capital is not effectively prevented by other means, a persistent effort to keep interest rates low can only have the effect of prolonging this tendency indefinitely and of bringing about a continuous and progressive fall of the exchanges. Whether the outward flow of capital starts with a withdrawal of balances held in the country by foreigners, or with an attempt on the parts of nationals of the country to acquire assets abroad, it will deprive banking institutions at home of funds which they were able to lend, and at the same time lower the exchanges. If the central bank succeeds in keeping interest rates low in the first instance by substituting new credits for the capital which has left the country, it will not only perpetuate the conditions under which the export of capital has been attractive; the effect of capital exports on the rates of exchange will, as we have seen, tend to become self-inflammatory and a “flight of capital” will set in. At the same time the rise of prices at home will increase the demand for loans because it means an increase in the “real” rate of profit. And the adverse balance of trade which must necessarily continue while part of the receipts from exports is used to repay loans or to make new loans abroad, means that the supply of real capital and therefore the “natural” or “equilibrium” rate of interest in the country will rise. It is clear that under such conditions the central bank could not, merely by keeping its discount rate low, prevent a rise of interest rates without at the same time bringing about a major inflation.

5

If this is correct it would be only consistent if the advocates of Monetary Nationalism should demand that monetary policy proper should be supplemented by a strict control of the export of capital. If the main purpose of monetary management is to prevent exports of capital from disturbing conditions of the money market at home, this clearly is a necessary complement of central banking policy. But those who favour such a course seem hardly to be conscious of what it involves. It would certainly not be sufficient in the long run merely to prohibit the more conspicuous forms of sending money abroad. It is of course true that if there are no impediments to the export of capital the most convenient and therefore perhaps the quantitatively most important form which the export of capital will take is the actual transfer of money from country to country. And it is conceivable that this might be pretty effectively prevented by mere prohibition and control. To make even this really effective would of course involve not only a prohibition of foreign lending and of the import of securities of any description, but could hardly stop short of a full-fledged system of foreign exchange control. But exchange control designed to prevent effectively the outflow of capital would really have to involve a complete control of foreign trade, since of course any variation in the terms of credit on exports or imports means an international capital movement.

To anyone who doubts the importance of this factor, I strongly recommend the very interesting memorandum on International Short Term Indebtedness which has recently been published by Mr. F. G. Conolly of the staff of the Bank for International Settlements in the recent joint publication of the Carnegie Endowment and the International Chamber of Commerce.[7] I will quote only one paragraph. “It has been the experience of every country whose currency has come under pressure”, writes Mr. Conolly, “that importers tend not only to refuse to utilise the normal period of credit but to cover their requirements for months in advance; they prefer to utilise the home currency while it retains its international value rather than run the risk of being forced to pay extra for the foreign currency necessary for their purchases. Exporters, on the other hand, tend to allow foreign currencies, the proceeds of exports already made, to lie abroad and to finance their current operations as far as possible by borrowing at home. Thus a double strain falls on the exchange market; the normal supply of foreign currencies from export dries up while the demands from importers greatly increase. For a country with a large foreign trade the strain on the exchange market due to the effects of this change over in trade financing may be very considerable.”[8] What Mr. Conolly here describes amounts, of course, to an export of capital which could only be prevented by controlling the terms of every individual transaction of the country’s foreign trade, an export of capital which may be equally formidable whether the country carries on its foreign trade “actively” or “passively”,[9] that is whether it normally provides the capital to finance the trade herself or borrows it. Indeed to anyone who has had any experience of foreign exchange control there should be no doubt possible that an export of capital can only be prevented by controlling not only the volume of exports and imports so that they will always balance, but also the terms of credit of all these transactions.

At first indeed, and so long as discrepancies between national rates of interest are not too big and people have not yet fully learnt to adapt themselves to fluctuating exchanges, much less thoroughgoing measures may be quite effective. I can already hear some of my English friends point out to me the marvellous discipline of the City of London which on a slight hint from the Bank that capital exports would be undesirable will refrain from acting against the general interest. But we need only visualize how big the discrepancies between national interest rates would become if capital movements were for a time effectively stopped in order to realize how illusionary must be the hopes that anything but the strictest control will be able to prevent them.

But let us disregard for the moment the technical difficulties inherent in any effective control of international capital movements. Let us assume that the monetary authorities are willing to go any distance in creating new impediments to international trade and that they actually succeed in preventing any unwanted change in international indebtedness. Will this successfully insulate a country against the shocks which may result from changes in the rates of interest abroad? Or will these not still transmit themselves via the effect such a change of interest rates will have on the relative prices of the internationally traded securities and commodities? It is probably obvious that so long as there is a fairly free international movement of securities no great divergence in the movement of rates of interest in the different countries can persist for any length of time. But Monetary Nationalists would probably not hesitate at any rate to attempt to inhibit these movements. It is not so generally recognised however that commodity movements will have a similar effect and perhaps this needs a few more words of explanation.

It will probably not be denied that a considerable rise in the rate of interest will lead to a fall in the prices of some commodities relatively to those of others, particularly of those which are largely used for the production of capital goods and of those of which large stocks are held, compared with those which are destined for more or less immediate consumption. And surely, in the absence of immediate adjustments in tariffs or quotas, such a fall will transmit itself to the prices of similar commodities in the country in which interest rates at first are not allowed to rise. But if the prices of the goods which are largely used for investment fall relatively to the prices of other goods this means an increased profitability of investment compared with current production, consequently an increased demand for loans at the existing rates of interest, and, unless the central bank is willing to allow an indefinite expansion of credit, it will be compelled by the rise of interest rates abroad to raise its own rate of interest, even if any outflow of capital has been effectively prevented. Although the supply of capital may not change, the kind of goods which under the changed circumstances it will be most profitable to import and export will still alter the demand for capital with the same effects.[10]

The truth of the whole matter is that for a country which is sharing in the advantages of the international division of labour it is not possible to escape from the effects of disturbances in these international trade relations by means short of severing all the trade ties which connect it with the rest of the world. It is of course true that the less the points of contact with the rest of the world the less will be the extent to which disturbances originating outside the country will affect its internal conditions. But it is an illusion that it would be possible, while remaining a member of the international commercial community, to prevent disturbances from the outside world from reaching the country by following a national monetary policy such as would be indicated if the country were a closed community. It is for this reason that the ideology of Monetary Nationalism has proved, and if it remains influential will prove to an even greater extent in the future, to be one of the main forces destroying what remnants of an international economic system we still have.

There are two more points which I should like specially to emphasize before I conclude for to-day. One is that up to this point I have, following the practice of the Monetary Nationalists, considered mainly the disturbing effects on a country of changes in the demand for capital originating abroad. But there is of course another side to this picture. What from the point of view of the country to which the effects are transmitted from abroad is a disturbance is from the point of view of the country where the original change takes place a stabilising effect. To have to give up capital because somewhere else a sudden more urgent demand has arisen is certainly unsettling. But to be able to obtain capital at short notice if a sudden unforeseen need arises at home will certainly tend to stabilise conditions at home. It is more than unlikely that fluctuations on the national capital market would be smaller if the world were cut up into watertight compartments. The probability is rather that in this case fluctuations within each national territory would be much more violent and disturbing than they are now.

Closely connected with this is the second point, on which I can touch only even more shortly. I have already mentioned the probability that the restrictions on capital movements involved in a policy of Monetary Nationalism would tend to increase the differences between national interest rates. This would of course be due to the fact that while instability of exchange rates would tend to increase the volume and frequency of irregular flows of short term funds, it would to an even greater degree decrease the volume of international long term investment. Although by some this is regarded as a good thing, I doubt whether they fully appreciate what it would mean. The purely economic effects, the restriction of international division of labour which it implies, and the reduction in the total volume of investment to which it would almost certainly lead, are bad enough. But even more serious seem to me the political effects of the intensification of the differences in the standard of life between different countries to which it would lead. It does not need much imagination to visualize the new sources of international friction which such a situation would create.[11] But this leads me beyond the proper scope of these lectures and I must confine myself to drawing your attention to it without attempting to elaborate it any further.

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[1] This is not to be interpreted as meaning that I subscribe to the view that all money is in some sense a “claim”. The statement in the text applies strictly only to credit money and particularly to bank deposits, which will be mainly considered in what follows. But it would not apply to the acquisition of gold by foreigners for export. The gold coins so acquired would thereby cease to be “national” money in the sense in which this term is here used, that is, they would not be assets belonging to the country where they have been issued.

[2] Even the intentions of the lender or investor would hardly provide a sufficient criterion for a distinction between what are short and what are long term capital movements, since it may very well be clear in a particular case to the outside observer that circumstances will soon lead the investors to change their intentions.

[3] If this effect was disregarded in the discussion of changes in the discount rates in the two preceding lectures, this was done to make the effects discussed there stand out more clearly; but this must not be taken to mean that this effect on capital movements is not, at any rate in the short run, perhaps the most important effect of these changes.

[4] The only argument against this view which I find at all intelligible is that, under the gold standard, movements to one of the gold points will create a certain expectation that the movement will soon be reversed and thus provides a special inducement to speculative shifts of funds. But while this is perfectly true, it only shows that the defects of the traditional gold standard were due to the fact that it was not a homogeneous international currency. If the same arrangements applied to international as to infranational payments the problem would disappear. This would be the case either if within the country as much as between countries the costs of transfers of money were not borne by some institution like the central banks and consequently (as in the United States before the establishment of the Federal Reserve System) rates of exchange between the different towns were allowed to fluctuate, and if at the same time gold were freely obtainable near the frontier as well as in the capital, or on the other hand, if the system of par clearance were applied to international as well as national payments. On the last point compare below, lecture V, p. 84.

[5] Since it is being more and more forgotten that the period before 1931 was, on pre-war standards, already one of marked instability—and uncertainty about the future—of exchange rates, it is perhaps worth stressing that in particular the accumulation of foreign balances in London during that period was almost entirely a consequence of the fact that Sterling was regarded as relatively the most safe of the European currencies. Cf. on this T. E. Gregory, The Gold Standard and its Future, Third edition, 1934, pp. 48 et seq.

[6] Cf. Report of the Proceedings of the Meeting of Economists held at the Antwerp Chamber of Commerce on July the 11th, 12th, and 13th 1935, published by the Antwerp Chamber of Commerce, p. 107.

[7]The Improvement of Commercial Relations Between Nations. The Problem of Monetary Stabilization. Separate Memoranda from the Economists consulted by the Joint Committee of the Carnegie Endowment and the International Chamber of Commerce and practical Conclusions of the Expert Committee appointed by the Joint Committee. Paris, 1936, pp. 352 et seq.

[8]Ibid., p. 360.

[9] Cf. N. G. Pierson, The Problem of Value in a Socialist Community. Collectivist Economic Planning, London, 1935.

[10] Cf. on this L. Robbins, The Great Depression, London, 1934, p. 175.

[11] Cf. in this L. Robbins, Economic Planning and International Order, pp. 68 et seq.