The Online Library of Liberty

A project of Liberty Fund, Inc.

• Preface
• Studies In the Theory of International Trade
• Chapter I: English Theories of Foreign Trade, Before Adam Smith: I
• I. Introduction
• II. “ Mercantilism” and “bullionism”
• III. the Balance-of-trade Doctrine
• IV. Reasons For Wanting More Bullion
• V. Employment and the Balance of Trade
• Chapter II: English Theories of Foreign Trade, Before Adam Smith: Ii
• I. Legislative Proposals of Mercantilists
• II. the Collapse of Mercantilist Doctrine
• III. Some Modern Interpretations of English Mercantilism
• Chapter III: The Bullionist Controversies: I. The Inflation Phase
• I. the Participants In the Controversy
• II. the Factual Background
• III. Premium On Bullion As Evidence of Excess Issue: the Bullionist Position
• IV. Qualifications Conceded By the Bullionists
• V. Possible Objections to the Bullionist Position
• VI. the Anti-bullionist Position
• VII. the Balance of Payments Argument
• VIII. the Possibility of Excess Issue By Banks
• IX. Responsibility For the Excess Issue: Bank of England Vs. Country Banks
• X. Responsibility For Excess Issue: the Credit Policy of the Bank of England
• Chapter IV: The Bullionist Controversies: II. The Deflation Phase
• I. the Resumption of Cash Payments
• II. Responsibility of Resumption For the Fall In Prices
• III. the Economic Effect of Changing Price Levels
• IV. Ricardo's Position On the Gold Standard
• V. Reform Without Departure From the Metallic Standard
• VI. Paper Standard Currencies
• Chapter V: English Currency Controversies, 1825–1865
• I. Introduction
• II. the “currency School” -“banking School” Controversy
• III. the “palmer Rule ”
• IV. the Bank Act of 1844
• V. the Possibility of Overissue of Convertible Bank Notes
• VI. the Role of Deposits, Bills of Exchange, and “credit” In the Currency System
• VII. the Technique of Credit Control
• VIII. the Relation Between Bank of England Operations and Specie Movements
• IX. Currency Reform Proposals
• Chapter VI: The International Mechanism Under a Simple Specie Currency
• I. Introductory
• II. the Mechanism According to Hume
• III. an Omitted Factor? Relative Changes In Demand As an Equilibrating Force
• IV. Prices In the Mechanism: the Concept of “price Levels ”
• V. the “terms-of-trade” Concept
• VI. the Prices of “domestic” Commodities
• VII. the Mechanism of Transfer of Unilateral Payments In Some Recent Literature
• VIII. a Graphical Examination of Pigou's Analysis 1
• IX. Some Elaborations On the Basis of Pigou's Analysis
• X. an Alternative Solution
• XI. Types of Disturbance In International Equilibrium
• XII. Specie Movements and Velocity of Money
• XIII. Commodity Flows and Relative Price Levels
• XIV. Exchange Rates
• XV. A Criticism of the Purchasing-power Parity Theory 1
• Chapter VII: The International Mechanism In Relation to Modern Banking Processes
• I. Automatic Vs. Managed Currencies
• II. Primary and Secondary Expansion of Means of Payments
• III. Short-term Loans In the International Mechanism
• IV. Primary and Secondary Expansion In Canada , 1900–13
• V. the International Mechanism and Business Cycles
• Chapter VIII: Gains From Trade: the Doctrine of Comparative Costs
• I. the Nature and Origin of the Doctrine
• II. the Division of the Gain From Trade
• III. Trade In More Than Two Commodities
• IV. Trade Between More Than Two Countries
• V. Transportation Costs
• VI. Increasing and Decreasing Costs
• VII. Prices, Money Costs, and Real Costs
• VIII. Dependence of Comparative Cost Doctrine On a Real-cost Theory of Value
• IX. Differences In Wage Rates In Different Occupations
• X. Variable Proportions of the Factors and International Specialization
• XI. Variable Proportions of the Factor and Comparative Real Costs
• XII. “ Opportunity Cost” Analysis As a Substitute For Real Cost Analysis
• Chapter IX: Gains From Trade: the Maximization of Real Income
• I. “ Mass of Commodities” and “sum of Enjoyments”: Ricardo and Malthus
• II. Reciprocal Demand and the Terms of Trade
• III. Terms of Trade and the Amount of Gain From Trade
• IV. “ Net Benefit” In International Trade: Marshall
• V. Total Net Utility Derived From International Trade: Edgeworth
• VI. the Gain From Trade Measured In Money
• Appendix: a Note On the Scope and Method of the Theory of International Trade

III. An Omitted Factor? Relative Changes in Demand as an Equilibrating Force

In Hume's account, changes in price levels thus play the predominant role in bringing about the necessary adjustment of trade balances, and are assisted only by fluctuations in exchange rates, held to be a factor of minor importance. In recent years a number of writers, most notably Ohlin, have contended that such an account leaves out of the picture an important equilibrating factor. These writers insist that much, or even all, of the equilibrating activity commonly attributed to relative price changes is really exercised by the direct effects on trade balances of the relative shift, as between the two regions, in the amounts of means of payments or in money incomes; that when disturbances in international balances occur, the restoration of equilibrium will or can take place unaccompanied by relative price changes or accompanied by only minor changes in relative prices; and that such changes if they do occur will not be, or are not likely to be, or need not necessarily be—which of these is supposed to be the fact is not always made clear—of the type postulated in the later classical doctrine as expounded by J. S. Mill or Taussig. While none of these writers seems to have applied his doctrine to a currency disturbance such as postulated by Hume, where the need for at least temporary price changes of some kind would seem most obvious, it may be assumed, nevertheless, that they would hold Hume's analysis of the mechanism to be inadequate even when confined to such cases.

It will be conceded at once that, in the case, for instance, of the initiation of continuing unilateral remittances, the aggregate demand for commodities, in the sense of the amounts buyers are willing to purchase at the prevailing prices, will, in the absence of price changes, fall in the paying country and rise in the lending country,1 and that unless there is an extreme and unusual distortion of the relative demands for different classes of commodities from their previous proportions this shift in demands will of itself contribute to an adjustment of the balance of payments to the remittances. The problem is rather to explain why this fairly obvious proposition should not sooner have received general recognition and to determine to what extent its recognition constitutes, as some contend, a major revolution in the theory of the mechanism requiring wholesale rejection of what the older writers had to say. To the first question, even though I have sinned in this connection myself, I have no answer, except that it is difficult to judge, after something has been clearly pointed out to us, how obvious it would or should be to others not so circumstanced. While, however, the account of the mechanism given by Hume and by many later writers gives no indication of recognition that the direct influence on the trade balance of relative changes in demands in the two countries would be an equilibrating factor, such recognition was by no means wholly lacking on the part of the major writers of the nineteenth century.

That imports pay for exports, and that an increase in imports, by providing foreigners with increased means of payment, would operate to increase exports, was pointed out even during the mercantilist period. But the following account will disregard incidental recognition of the relationship between amount of income and extent of demand, which has always been common, even with laymen, and will deal only with cases where such recognition is to be found incorporated as an integral part of a more or less formal exposition by nineteenth-century writers of the mechanism of adjustment of international balances.2

Wheatley, Ricardo.—Henry Thornton, in 1802, had applied the Hume type of explanation generally to any type of disturbance of the balance of payments, and specifically to the disturbance resulting from a crop failure which made necessary greatly increased imports of grain,3 and to a change in the English demand for foreign commodities as compared to the foreign demand for English commodities.4 Wheatley and Ricardo, on the other hand, denied that this explanation was applicable to such disturbances of a non-currency nature and offered different explanations of the mechanism of adjustment to such disturbances. While Wheatley's discussion was in part earlier, Ricardo's was less significant for the point at issue, and it will be convenient to dispose of it first. Ricardo denied that crop failures or the payment of subsidies would disturb the balance of payments at all and denied, therefore, that any mechanism of adjustment would be necessary.5 The only justification for this position which he offered was that if a crop failure should be permitted to disturb the balance of payments, since the disturbance would prove to be temporary and after it was over things would be as they had been before, any movement of specie—and presumably also any corresponding change in relative price levels—would have to be offset later by a return movement of equal size, a waste of effort which would not be indulged in:

The ultimate result then of all this exportation and importation of money, is that one country will have imported one commodity in exchange for another, and the coin and bullion will in both countries have regained their natural level. Is it to be contended that these results would not be foreseen, and the expense and trouble attending these needless operations effectually prevented, in a country where capital is abundant, where every possible economy in trade is practiced, and where competition is pushed to its utmost limits? Is it conceivable that money should be sent abroad for the purpose merely of rendering it dear in this country and cheap in another, and by such means to insure its return to us?6

This exaggerates the extent to which individual traders can foresee whether a drain of gold would be temporary or not, or would find it in their interest to check it even if they were convinced that it was temporary.7 Seasonal movements of specie are still permitted to occur, even though their seasonal character is generally known.

Wheatley defended his denial that crop failures or foreign subsidy payments would disturb the balance of payments by more adequate reasoning. He maintained that crop failures, or the payment of subsidies, would immediately alter the relative demands of the two regions for each other's products in such manner and degree that the commodity balance of trade would at once undergo the manner and degree of change necessary to maintain equilibrium in the balance of payments. This shift in relative demand would result from the alteration brought about by the crop failure or the subsidy in the relative ability of the two countries to buy each other's commodities:

If, then, it be correct in theory, that the exports and imports to and from independent states have a reciprocal action on each other, and that the extent of the one is necessarily limited by the extent of the other, it is obvious, that if no demand had subsisted in this country from 1793 to 1797 for corn and naval stores, the countries that furnished the supply would have possessed so much less means of expending our exports, as an inability to sell would of course have created an equal inability to buy. It is totally irregular, therefore, to infer, that our exports would have amounted to the same sum, had the import of the corn and naval stores been withheld, as those who provided the supply would have been utterly incapable of purchasing them.8

On similar grounds, Wheatley held that under an inconvertible paper currency the exchanges would not be affected by a crop failure or the payment of a subsidy, and could move against a country only if there had developed a relative redundancy of currency in that country.9 Wheatley carried his doctrine so much further than he clearly showed to be justified that even the bullionists rejected it, and in doing so overlooked the important element of validity underlying it.

Longfield, Torrens, Joplin.—In 1840, Longfield, discussing the effect of increased imports of grain owing to a harvest failure in England, pointed out that this would result in a relative shift in the amounts of money available for expenditure in England and in the grain-exporting countries, and that this shift would contribute, even in the absence of price changes, to a rectification of the trade balance. Longfield denied, however, that this contribution would be sufficient to make price changes unnecessary:

A certain equilibrium exists between our average exports and imports. This is disturbed by the importation of corn. England suddenly demands a large quantity, perhaps six millions worth of corn. She may be ready to pay for them by her manufactures, but will those who sell it be willing to take those manufactures in exchange? Will the Prussian or Russian landowner, whose wealth has been suddenly increased, be content to expend his increased wealth in the purchase of an increased amount of English manufactures? We say that the contrary will take place, and that his habits will remain unchanged, and his increase of wealth will be spent in nearly the same manner as his former income, that is to say, not one fiftieth part in the purchase of English goods. His countrymen will, in the first instance, have the advantage of his increased expenditure. It will not be felt in England until after a long time, and passing through many channels.... Thus the English have six millions less than usual to expend in the purchase of the commodities which they are accustomed to consume, while the inhabitants of the corn exporting countries have six millions more.... The commodities, therefore, which the Russians and Prussians consume, will rise in price, while those which the English use will undergo a reduction. But a very great proportion, much more than nineteen-twentieths of the commodities consumed in any country, are the productions of that country. English manufactures will therefore fall, while Russian and Prussian goods will rise in price. The evil, after some time, works its own cure.10

Torrens, in 1841–42, in the course of an attempt to demonstrate that retaliation against foreign tariffs would be beneficial to England even if such retaliation did not lead foreign countries to reduce their tariffs, placed main emphasis on the role of relative price changes in adjusting the international balances to tariff changes, but in his well-known Cuban illustration the restoration of equilibrium was made to result directly from the relative shift in the amounts of means of payment, as well as indirectly from the relative shift in prices resulting from this shift in means of payment. He assumed, first, that all the demands for commodities in terms of money in each country had unit elasticity, and that Cuba was exporting to England 1,500,000 units of sugar, at a price of 30 shillings per unit, in return for 1,500,000 units of English cloth, at a price also of 30 s. per unit. Cuba then imposes a duty of 100 per cent on cloth, with the result that the price of cloth rises to 60 s. in Cuba, and the Cuban consumption falls by 50 per cent, to 750,000 units. Sugar continues for a time to flow to England at the original price and in the original quantity. There results an unfavorable balance of payments for England, and specie moves from England to Cuba. The price of sugar rises, and the price of cloth falls. The Cuban consumption of cloth increases to more than 750,000 units, apparently because of both the fall in the price of cloth and the increase in the amount of money available for the purchase of cloth in Cuba. Conversely, the rise in the price of sugar and the decrease in the quantity of money in England result in a decline in the English consumption of sugar to less than 1,500,000 units. Specie continues to flow from England to Cuba, the amount of money to fall in England and rise in Cuba, the price of cloth to fall and the price of sugar to rise, until the exports of cloth to Cuba had expanded and the exports of sugar to England contracted sufficiently to restore equilibrium in the balance of payments between the two countries. Under this final equilibrium, Cuba would be importing annually 1,500,000 units of cloth, at a price before duty of 20 s., and after duty of 40 s. per unit, and would be exporting 750,000 units of sugar at a price of 40 s. per unit.11 These results, it is to be noted, could not have resulted from the changes in prices alone, given the postulated elasticities of demand. They imply changes in money incomes in each country, and consequent changes in each country, the same in direction as the changes in money incomes, in the quantities which would be demanded of both commodities if the prices had remained unaltered.

Joplin, in his many tracts, repeatedly expounded the mechanism of adjustment of international balances in terms only of relative price changes, but in one passage, by exception, he stressed the direct influence on the course of trade of the relative change in demand for each other's commodities resulting from the transfer of money from one of the countries to the other, with the change in relative prices mentioned only as a by-product of, rather than as an essential factor in, the equilibrating process:

Now, when the balance of payments is against one and in favor of another nation, it arises from the inhabitants of the former having a greater demand for the productions of the latter, than the inhabitants of the latter have for the productions of the former. But after a transmission of the balance in money, an alteration must necessarily be experienced in the state of this demand. The inhabitants of the country from whence the money was sent would be unable, from their reduced monetary incomes, to purchase so large a quantity of the products of the money-importing country as before; while they, the inhabitants of the importing country, would be enabled, by the increase in their monetary incomes, to purchase more of the commodities of the nation from which the money had been received. Thus the trade would again be brought to a balance in money, and be thereby rendered an exchange of commodity for commodity: the nation receiving the money gaining by the improved terms on which the barter would be thereafter conducted.12

J. S. Mill, Cairnes.—John Stuart Mill, in the exposition of the mechanism which he gives in his Principles, appears to attribute to relative changes in prices sole responsibility for bringing about a trade balance such as would restore equilibrium in a disturbed balance of payments.13 At one point, in fact, he appears explicitly to say so. Discussing a case where “there is at the ordinary prices a permanent demand in England for more French goods than the English goods required in France at the ordinary prices will pay for,” he states that “the imports require to be permanently diminished, or the exports to be increased; which can only be accomplished through prices.“14 At another point, however, he expressly includes, as a factor operating to restore equilibrium, the relative shift in the amount of monetary income in the two countries resulting from the transfer of specie. He is tracing the consequences of a cheapening of the cost of production of a staple article of English production:

The first effect is that the article falls in price, and a demand arises for it abroad. This new exportation disturbs the balance, turns the exchanges, money flows into the country ... and continues to flow until prices rise. This higher range of prices will somewhat check the demand in foreign countries for the new article of export; and will diminish the demand which existed abroad for the other things which England was in the habit of exporting. The exports will thus be diminished; while at the same time the English public, having more money, will have a greater power of purchasing foreign commodities. If they make use of this increased power of purchase, there will be an increase of imports: and by this, and the check to exportation, the equilibrium of imports and exports will be restored.15

The ordinary interpretation of Mill's theory as explaining the adjustment of international balances solely in terms of relative price changes probably should be accepted, and this passage therefore regarded as indicating only an accidental perception by Mill at one moment of the presence in the mechanism of an additional factor rather than as a statement of an integral element in his theory. But it may be an error to do so. The exposition in the Principles is a restatement, in some respects less detailed, of an earlier exposition by Mill,16 in which the relative change in monetary income in the two countries resulting from a movement of specie is expressly incorporated in the exposition of the mechanism as, together with the elasticities of demand in terms of money prices, determining the extent of the response to price changes of the volume of purchases of each other's commodities by the two countries. Even here the emphasis is mainly on relative price changes, but this can in part be explained by the fact that Mill treats a rise in the prices of a country's own products as necessarily involving also a rise in its money incomes,17 as well as by the fact that he is here primarily concerned with the effects of disturbances on the “gains” from trade, rather than with the mechanism qua mechanism.18

Cairnes, in his better known expositions of the mechanism of international trade,19 makes no reference to the relative shift in means of payment, or in demands for commodities in terms of money, as a factor contributing to the adjustment of international balances. But in an earlier essay he emphasized the role it plays, and showed that he was aware that he was adding something not in the usual version:

... it is not true that the motives to importation and exportation depend upon prices alone; and, should the fall in prices be very sudden and violent, I conceive its effect on the whole would be rather unfavorable than otherwise on the exportation of commodities. ... if any circumstance should occur to render industry less profitable, or to diminish the general wealth of the country, the means at the disposal of the community for the purchase of foreign commodities would be curtailed. Without supposing any alteration in prices, therefore, the demand for such commodities would decline and consequently the amount of our imports would fall off. And conversely, if the opposite conditions should occur, if the wealth of the country were to increase, we should each on an average have more to spend; a portion of this increased wealth, without necessarily supposing any fall in prices abroad, would go in extra demand for foreign commodities; and our imports would consequently increase ... and what takes place here will of course take place equally in foreign countries. It follows, therefore, that the relation between our exports and imports, and, by consequence, the influx and efflux of gold, depends not only on the state of prices here and abroad, but also on the means of purchase which are at the command, respectively, of home and foreign consumers.

[In the cases of crop failures, military remittances abroad, etc.] The transference of so much gold from this country to foreign countries—though it need not interfere to any great extent with the proceedings of commerce at home—yet alters the disposable wealth comparatively of this and other countries; their means of expenditure is proportionally altered, and consequently their demand for each other's goods. There is thus, in the circumstances attending a transmission of gold from this country, a provision made for its return, quite independently of the state of prices, or of the circulation....20

Bastable, Nicholson.—Bastable in 1889 defended, against Mill, Ricardo's doctrine that an international loan would not result in a transmission of specie or in relative changes in prices, by invoking the direct effect of the relative change in “purchasing power” or money incomes in the two countries on their trade balances:

Suppose that A owes B £1,000,000 annually. This debt is a claim in the hands of B, which increases her purchasing power, being added to the amount of that power otherwise derived.... [It is also doubtful whether in case of interest payments or repayments of previous loans] Mill is correct in asserting that the quantity of money will be increased in the creditor and reduced in the debtor country. The sum of money incomes will no doubt be higher in the former; but that increased amount may be expended in purchasing imported articles obtained by means of the obligations held against the debtor nation.... Nor does it follow that the scale of prices will be higher in the creditor than in the debtor country. The inhabitants of the former, having larger money incomes, will purchase more at the same price, and thus bring about the necessary excess of imports over exports.21

A few years later Nicholson presented a similar criticism of Mill's reasoning, worked out in some detail, and accompanied by a denial, based on crudely fallacious reasoning, that price changes and specie movements played any part in the mechanism.22

A number of the most important nineteenth-century writers on the theory of international trade thus recognized that relative shifts in the amounts of means of payment, or of incomes, exercised, independently of relative price changes, an equilibrating role in the mechanism of adjustment of international balances to disturbances.23 But there were important divergences of doctrine between these writers. It was common doctrine for all of them that a change in relative money incomes resulting, say, from loans would contribute to the adjustment of the balance of payments to the loans through its influence on the relative demands of the two countries for each other's commodities. But one group (i.e., Ricardo, Longfield, J. S. Mill, Cairnes) either explained this shift in relative incomes as resulting from a prior transfer of money or conceded that a transfer of money would result from it, whereas another group (Wheatley, Bastable, and Nicholson, and, at one point, Cairnes) denied that any transfer of money need take place. One group (Longfield, Joplin, Cairnes, J. S. Mill) left an important place in the mechanism for relative price changes, whereas another group (Wheatley, Ricardo, Bastable, Nicholson) denied, or questioned, the necessity of relative price changes for the restoration of equilibrium.

In the later literature there continue to be presented explanations of the mechanism of adjustment which do and others which do not assign an equilibrating role to the relative shift in demands, and some writers who at one time take pains to point out its significance at other times permit it to drop out of their exposition and revert to an explanation in terms solely of relative price changes. Mainly owing to Ohlin, however, there has been a growing awareness of the issue, and an increasing readiness to give weight to this factor.

Taussig, Wicksell.—In an article published in 1917, and dealing primarily with the mechanism of adjustment under a paper standard currency, Taussig argued that in the case of an international loan under a metallic standard that part of the proceeds not used immediately by the borrowers in purchase of foreign goods would enter the borrowing country in the form of goods only after a remittance of specie from lender to borrower had raised prices in the borrowing country and lowered them in the lending country.24 In a reply to this article, Wicksell claimed that the increased demand for commodities in the borrowing country, and the decreased demand for commodities in the lending country, would “in the main” be sufficient to call forth the changes in the trade balance necessary to restore equilibrium in the balance of payments. He held that it would not make any difference if the increased power of purchase in the borrowing country were directed toward its own products rather than imported products:

... this of course would diminish the imports, but if the value of imports surpasses the value of exports by precisely the amount borrowed during the same time, there would be no occasion for sending or receiving gold.

Gold would move to the borrowing country, but only because, and after, it had acquired additional commodities, and not before the transfer of the loan in the form of goods.25

Taussing, in his brief rejoinder, confined his discussion in the main to other points and did not adequately meet the fundamental issue raised by Wicksell as to the role played by changes in demand in the equilibrating process. To Wicksell's denial of the necessity of specie movements at an early stage of the process of adjustment, he made an effective reply: “I find it difficult to conceive how ‘increased demand for commodities’ will cause a rise in the price of commodities, unless more money is offered for them; and no more money can be offered for them unless the supply of money is larger.” 26 This may seem to imply an acceptance by Taussig of Wicksell's doctrine at least to the extent of recognition that changes in demand do play an equilibrating part aside from price changes, for if there is an increase in demand it operates to increase the amount taken at the same prices as well as to increase the prices, but I cannot find a clear statement to this effect either here or in his later writings. Taussig also pointed out that Wicksell's denial of the possibility that relative price changes could be an important equilibrating factor, since, transportation costs aside, commodities tend to have uniform prices everywhere, overlooked the existence of “domestic” commodities not entering into international trade, whose price movements could diverge from the movements of the prices of international commodities and thus contribute to the establishment of a new international equilibrium.27

“Canada's Balance.”—In 1924, reviewing this discussion between Wicksell and Taussig, I conceded, as had Taussig in his original article, that to the extent that the new spendable funds in the borrowing country resulting from the loan were used in the purchase of foreign commodities which otherwise would not have been imported there would be a contribution to adjustment independent of relative price changes. I also accepted the argument, which I attributed to Wicksell,28 that the use of the proceeds of the loans to purchase home-produced commodities which otherwise would have been exported would similarly contribute to adjustment. I concluded, however, that there was no a priori reason to expect that these two factors would suffice to bring about adjustment, on the grounds that: (1) the theoretical expectation would be that in the absence of price changes the same percentage of the additional, as of the original, spendable funds would be used in the purchase of “domestic” or non-international commodities; and (2) unless in the absence of price changes none of the borrowed funds would be used in the purchase of “domestic” commodities, there could not be adjustment of the balance of payments without relative price changes.29 As will appear later, this last proposition was an error, resulting from my failure, at this point,30 to bear in mind that a diversion of productive factors from production of exportable commodities for export to production of domestic commodities for domestic consumption would, by restricting the volume of exports, contribute as much to the adjustment of the balance of payments as would an equivalent increase of imports or of domestic consumption of products hitherto exported.

Keynes, Ohlin.—The discussion of the transfer aspect of the German reparations problem gave rise to intensified discussion of this issue, but the contributions of Ohlin and Keynes can alone be dealt with here. Ohlin, in an article published in 1928, laid strong emphasis on the role which a relative shift in demand for commodities, in terms of money, upward in the receiving countries, downward in Germany, would play in adjusting the German balance of payments to the reparations payments, thus making relative price changes adverse to Germany a subsidiary and probably unnecessary part of the mechanism, and easing the task of transfer of the reparations in the form of goods.31 In this article, it appears to me, he took a position with respect to the lack of significance of relative price changes in the international mechanism more extreme than the treatment in his later book (which still seems extreme to me). He argued that when international unilateral remittances occurred a change in price favorable to the paying country was as likely to take place as one unfavorable to that country, and that in the absence of knowledge of the particular circumstances it must be presumed that no relative change in prices will occur.32 He further claimed that even if a relative price change unfavorable to the paying country did occur, it would only be at the beginning of the payments, and would not persist long enough to be significant.33

In 1929, Keynes, in a pessimistic article on the possibility of transfer of the German reparations, which stressed the difficulties which Germany would encounter even if she succeeded in providing for the payments in her government budget, did not take into account, as a factor facilitating economic transfer of the payments, the shift in the demands for commodities which would result from an initial transfer of means of payment from Germany to the receiving countries. Ohlin replied, invoking this shift as a factor which would lessen the seriousness of the transfer problem, and there resulted a further exchange of views between the two writers, in which neither succeeded in converting the other.34 Ohlin did not state his views as clearly as he has since presented them, and on one essential point he made an unnecessary concession to Keynes.

Keynes reasoned throughout, on the conventional lines, as if the only factor tending to adjust the German trade balance to its reparations obligations could be an increase in German exports relative to imports resulting from a fall in German prices relative to outside prices. Taking an extreme case to emphasize his point, namely, where the foreign (simple “Marshallian”) elasticity of demand for products of Germany was assumed to be less than unity, and abstracting from the possibility of a reduction in the value of German imports, he concluded that “in this case, the more she exports, the smaller will be the aggregate proceeds. Again the transfer problem will be a hopeless business” —i.e., the reparations in this case could not be transferred even if relative price changes did occur. Keynes therefore concluded that the elasticities of demand of the two countries might be such as to make transfer in kind wholly impossible, and that for such transfer to take place in any case, “the expenditure of the German people must be reduced, not only by the amount of the reparation-taxes which they must pay out of their earnings, but also by a reduction in their gold-rate of earnings below what they would otherwise be,” that is, German money wages, etc., must fall even aside from taxation thereof.35 This Ohlin denied.

At a later stage of the controversy, Keynes explained that he had attributed little (no?) importance to changes in demand conditions, because he had assumed that Germany was not in a position to export large quantities of gold, and because if Germany did ship gold her products would have to share the benefits of the resultant increase in demands outside Germany with the products of the rest of the world, so that the gain to her export trade would be negligible.36 To this it could be replied that the ratio of gold shipments to aggregate reparations payments over the entire period would not have to be large, since a given transfer of gold will continue to keep up the level of foreign demand in terms of money for German goods by some fraction (or multiple) of itself per unit period as long as the gold stays abroad; it will operate not only to raise the foreign demand for German goods but to decrease the German demand for foreign goods; and if in the first instance all, or most, of the receiving country's increase in demand is directed to the products of third countries, these countries will acquire the specie surrendered by Germany, and their demands for foreign commodities, including those of Germany, will rise. But Keynes, apparently to the last, failed to understand Ohlin's argument that the initial transfer of specie, or its equivalent, would result in a relative shift in an equilibrating direction of the demands in terms of money prices of the two countries for each other's products, regardless of their elasticities. He still argued that if the world's demand for German goods had an elasticity of less than unity, “there is no quantity of German-produced goods, however great in volume, which has a sufficient selling-value on the world market, so that the only expedient open to Germany would be to cut down her imports.” 37 But elasticity of demand of less than unity for German exports would set a definite limit on the value of such exports only if no increase in the foreign demand for German commodities in terms of money resulted directly from the transfer abroad by Germany of specie.38

The failure of the two writers to make themselves clear to each other, and especially the failure of Ohlin to convert Keynes, was probably due in part to an ambiguous and otherwise unsatisfactory use by both writers of the treacherous term “purchasing power.” Ohlin's argument that a relative shift in demand for each other's products would occur rested on the doctrine that the payment of reparations would commence with a transfer of “purchasing power” from Germany to the receiving countries and that the resultant relative change in the amounts of “purchasing power” in the respective areas would bring about this relative shift in demands for commodities. In reply, Keynes presents a hypothetical case, where Germany, having succeeded by some means in developing a net export surplus of £25,000,000, meets her reparations obligations to the extent of £25,000,000 out of the proceeds of this export surplus. Exploiting to the full the ambiguities of the term “buying power,” he then claims that “the increased ‘buying power,’ due to the fact of Germany paying something ... will have been already used up in buying the exports, the sale of which has made the reparation payments possible,” whereas “Professor Ohlin has to maintain that the ‘increased buying power’ is more than £25,000,000, and—if his repercussion is to be important—appreciably more.” 40 Ohlin, instead of pointing out that the increase of “buying power” in France which could be counted on to bring about real transfer of reparations would precede rather than follow the real transfer, and would not be “used up” by the French import surplus of a particular year, merely replied: “Surely it is easier to sell many goods to a man who has got increased buying power, even though after buying them he has no longer greater buying power than he used to have!” 40 a reply which conceded too much to Keynes, and left his argument intact instead of refuting it.

For Keynes, the real transfer of £25,000,000 of reparations was due to a fortuitous development of an export surplus by Germany, payment for which Germany was willing to accept in credits against her reparations liabilities. Suppose, however, that Germany's first step in her attempt to meet her reparations obligations was the payment of £25,000,000 in gold to France, and that in France this increase in gold had its normal effects on the total volume of means of payments. Suppose also that thereafter at each reparations payment date, Germany credited France anew with £25,000,000 in German funds at German banks. Frenchmen would now have both increased willingness to buy German goods at the same prices and increased power to pay for them in French currency, and there would therefore tend to be recurrent French import surpluses with respect to Germany. These import surpluses could be liquidated internationally by drafts against the reparations credits in favor of France periodically set up by the German government in German banks. As long as Germany continued, in the narrow financial sense, to meet her reparations obligations, the increase in the French willingness to buy and power to pay, as compared to the pre-reparations situation, would never be “used up,” but would be everlasting. But the question of the place of willingness to buy and power to pay for foreign commodities in the mechanism of transfer of unilateral payments will be dealt with in a more fundamental manner later, after a needed digression on the role of price changes in the mechanism.

[1]This much must be regarded as implicit even in the Hume-Thornton-Taussig type of formulation, since otherwise the changes in prices which they postulate would have no immediate explanation. What is in issue is not, therefore, whether a relative shift in demands occurs, but whether this shift in demands, of itself and aside from its effect on relative prices, exercises an equilibrating influence.

[2]These writers, however, had been anticipated by an eighteenth-century Frenchman, Isaac de Bacalan in a memoir written in 1764, although not published until 1903, after its discovery by Sauvaire-Jourdan:

Supposerons-nous qu'un seul État fournisse aux autres plus de marchandises qu'il n'en retire et que toutes les nations soldent avec cet État en argent?... Croit-on de bonne foi que cette situation serait durable, et que cet État absorberait peu à peu tout l'argent qui existe dans le mond? Non, sans doute. L'augmentation de la quantité d'argent en diminuerait le prix; le luxe croitrait et avec lui la consommation des denrées soit nationales, soit étrangères. II enrésulterait donc que cet État transporterait aux autres une moindre quantité. Ainsi il swerait obligé à sort tour de payer en argent et la circulation ae rétablirait. (“Paradoxes philosophiques sur la liberaté du commerce entre les nations” [ms. 1764], first printed in F. Sauvaire-Jourdan, Isaac de Bacalen et les idées libre-échangistes en France, 1903, p. 43.) Cf. also Issac Gervaise in 1720, supra, pp. 80-81.

[3]Paper credit of Great Britain, 1802, pp. 131 ff.

[4]Ibid., pp. 242–43.

[5]High price of bullion, Works, pp. 268–69, and appendix to 4th ed., ibid., pp. 291 ff. For a detailed analysis of Ricardo's argument and of Malthus's reply thereto, and for some later qualification to his argument made by Ricardo in his reply to Malthus, see Jacob Viner, Canada's balance, pp. 193–201.

[6]Ricardo, High price of bullion, appendix, Works, p. 292. Cf. also Wheatley, Report on the reports, 1819, pp.20–21, for a similar argument.

[7]Ricardo apparently thought that the fact that specie movements created more serious problems of adjustment for the country as a whole than would equivalent movement of other commodities would in some manner result in the liquidation of new foreign obligations in goods instead of in specie, but he did not indicate the mechanism whereby this would be brought about. Cf. Ricardo, op. cit., p. 293: “Any of these commodities [i.e., other than gold] might be exported without producing much inconvenience from their enhanced price; whereas money, which circulates all other commodities, and the increase or diminution of which, even in a moderate proportion, raises or falls prices in an extravagant degree, could not be exported without the most serious consequences.” But these consequences, if serious, would be serious not for the individual exporters of the specie, but for the community as a whole.

[8]An essay on the theory of money, vol. 1, 1807, p. 238.

[9]Ibid., pp. 180–81; Report on the reports, 1819, pp. 21–29.

[10]“Banking and currency, Part I,” Dublin University magazine, XV (1840), 10.

[11]R. Torrens, The budget, a series of letters on financial, commercial, and colonial policy, 1841–44, Letter II.

[12]Thomas Joplin, Currency reform: improvement not depreciation, 1844, pp. 14–15.

[13]Principles of political economy [1848], Ashley ed., bk. iii, chap. 21.

[14]Ibid., p. 620. (Italics not in original.) There is an unfortunate ambiguity here, since it is impossible to say with certainty whether Mill meant that prices will necessarily operate alone to restore equilibrium, or merely that price changes were necessary.

[15]Ibid., pp. 623–24. (Italics not in original text.) Mill notes also that foreign consumers “have had their money incomes probably diminished by the same cause” (ibid., p. 624) but does not expressly point out that this will be an additional factor operating to reduce English exports and thus to restore equilibrium. Breaciani-Turroni (Inductive verification of the theory of international payments (1932, p. 91, note) points out the significance of the passage cited in the text.

[16]Essays on some unsettled questions, 1844, Essay 1.

[17]Cf. ibid., p. 16: “As the money prices of all her other commodities [= her own products] have risen, the money incomes of all her producers have increased.”

[18]Cf. ibid., pp. 26-27 (Mill is discussing the effect on the gains from trade of an import duty imposed by England on German linen): The equilibrium of trade would be disturbed if the imposition of the tax diminished in the slightest degree the quantity of linen consumed ... the balance therefore must be paid in money. Prices will fall in Germany, and rise in England; linen will fall in the German market; cloth will rise in the English. The Germans will pay a higher price for cloth, and will have smaller money incomes to buy it with; while the English will obtain linen cheaper, that is, its price will exceed what it previously was by less than the amount of the duty, while their means of purchasing it will be increased by the increase of their money incomes.

[19]Some leading principles of political economy newly expounded, 1874, pp. 360 ff.; Essays in political economy, 1873, pp. 24 ff.

[20]An examination into the principles of currency, 1854, pp. 34-36. The words italicized by me involve a falfacy, since a relative decrease in mometary circulation in the paying country is necessary, even when relative price changes are not. See infra, p. 366.

[21]C. F. Bastable, “On some applications of the theory of international trade,” Quarterly journal of economics, IV (1889), p. 16. (Italics in original.) Ricardo, in his later correspondence with Malthus, while continuing to deny that a crop failure or a unilateral remittance would result in relative price changes, conceded that it would result in a movement of specie from the debtor to the creditor country sufficient to restore the normal relationships in each country between quantity of goods and quantity of money. (See my Canada's balance, pp. 195-96.)

[22]J. S. Nicholson, Principles of political economy, II (1897), 287-93. In the preface, Nicholson made an acknowledgment to Bastable “for his careful revision and criticism of the chapters on the theory of foreign trade.”

[23]It may be significant, as indicating possible indebtedness, that of these writers Longfield, Cairnes, and Bastable had all been associated with Trinity College, Dublin, as students, or professors, or both, and Nicholson had received help from Bastable.

[24]F. W. Taussig, “International trade under depreciated paper,” Quarterly journal of economics, XXXI (1917).

[25]Knut Wicksell, “International freights and prices,” ibid., XXXII (1918), 404–10. Wicksell is here following Ricardo. Cf. supra, p. 303, note 21.

[26]Quarterly journal of economics, XXXII (1918), 410–12.

[27]Ibid. Even if there were no “domestic” commodities, and if the prices of all commodities were necessarily uniform throughout the world, relative price changes could still be an equilibrating factor, since it is the relative changes in prices of different commodities in the same market, not the relative changes in prices of the some commodity in different markets, which is the important price factor in the mechanism. See infra, p. 319.

[28]I cannot now find an explicit statement of this argument by Wicksell. Nicholson, however, had presented it in 1897.—See his Principles, II (1897), 289.

[29]Canada's balance of international indebtedness, 1924, pp. 204–06.

[30]In the analysis, later in the same book, of the influence on its export trade of Canada's import of capital, I did point out the equilibrating influence of this additional factor: It is difficult to explain the decline in the percentage of exports to total [Canadian] commodity production, without reference to the capital borrowings from abroad.... The expansion of manufacturing not only absorbed an increased proportion of the Canadian production of raw materials, but it withdrew labor, from the production of raw materials which otherwise would have been exported, to the construction of plant and equipment and the fabrication, from imported raw materials, of manufactured commodities for domestic consumption. The development of roads, towns, and railroads, made possible by the borrowings abroad, absorbed a large part of the immigration of labor, and these consumed considerable quantities of Canadian commodities which would otherwise have been available for export. Changes in relative price levels resulting from the capital borrowings were also an important factor in restricting exports, operating coordinately with the factors explained above (ibid., pp. 262–63).

[31]“The reparations problem,” Index, April, 1928.

[32]Ibid., p. 9: “There is no direct reason why A's export articles should go up in price or B's go down. In both it is a question of A's increased demand balancing B's reduced demand. In any case an increase in the total demand may just as well apply to B's as to A's international goods. Without a knowledge of the circumstances in each particular case we must presume that no such shifting of prices takes place.”

[33]Ibid., p. 10.

[34]Economic journal, XXXIX (1929): J. M. Keynes, “The German transfer problem,” 1–7; B. Ohlin, “The reparation problem: a discussion,” 172–78; Keynes, “The reparation problem, a rejoinder,” 179–82; Ohlin, “Mr. Keynes' views on the transfer problem: II, a rejoinder,” 400–04; Keynes, “Views on the transfer problem: III, a reply,” 404–08.

[35]Ibid., p. 4.

[36]Ibid., pp. 407 ff.

[37]Ibid., p. 405. Pigou has expounded the same doctrine. Cf. “The effect of reparations on the ratio of international interchange,” Economic journal, XLII (1932), 533:

Thus suppose that Germany is normally sending so much of her exports abroad and buying with them so much imports; and that, on the top of this situation, she is subjected to an indemnity whose amount is expressed in English goods. If the indemnity exceeds the previous sum of English exports sent to her by us, so that it cannot be paid by Germany's dispensing with these exports, and if also the English demand for German goods in respect of enlarged quantities has an elasticity less than unity, Germany cannot, however much she increases her exports to us, provide the means of paying the indemnity. Whether Pigou uses “demand” here in the simple monetary sense or in the reciprocal demand sense, this would not necessarily be true since in either case the English demand for German goods might shift in a direction favorable to Germany as the result of the receipt by England of reparations payments.

[38]Ohiln later pointed this out (Interregional and international trade, 1933, p. 62).

In his later Treatise on money (1930, 1, 340–42), Keynes returns to the problem briefly, but without much addition to his earlier argument. He here stresses the difficulty of surrender of gold by Germany; appears to interpret Ohlin's argument, perhaps rightly, as resting on the assumption that neither relative price changes nor specie movements are necessary for transfer of reparations if the proper credit policies are adopted in paying and receiving countries; and takes it for granted that a loss of gold by Germany, in the absence of a change in credit policy, means a lowering of money wages in out relative price changes, without changes in the usual gold reserve ratios in either country, without a fall in money wages in the paying country or a rise in the receiving country, through the mediation of an initial transfer of specie and its effects on relative demands for commodities in terms of money. See infra, pp. 338 ff., 366 ff.

[39]Economic journal, XXXIX, 181. (Italics in original.)

[40]ibid., p. 402.