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• 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

VII. The Mechanism of Transfer of Unilateral Payments in Some Recent Literature

Recent discussion of the problem of the effect of international unilateral payments on the terms of trade has made it clear that the older writers (including myself) had not sufficiently explored the problem and had failed to realize its full complexity. There follows an account of some recent attempts at a more definitive solution of the problem.1

Wilson.—Wilson examines the effects on relative prices, and especially on the commodity terms of trade, of trade, of a continued import of capital, with the aid of an elaborate series of arithmetical illustrations of an ingenious type.2 He concludes that relative price changes will ordinarily be necessary for restoration of equilibrium, but that the type of change will depend on the particular circumstances of each case, and may be unfavorable the paying country. He believes that he demonstrates that the changes in export and import prices, relative to each other, make no direct contribution to bringing about a transfer of the loan in the form of goods instead of in money, but that the role of these changes is solely to determine for each country to what extent the transfer shall take place through a change in exports or a change in imports, and to bring the two countries to a uniform decision, and that it is the relative changes in prices between domestic and international commodities which, together with the shift in demands resulting from the transfer of means of payment from lender to borrower, brings about the transfer of the loan in the form of goods.3 Wilson's account marks a distinct advance over previous attempts, because it takes more of the variables simultaneously into account and deals with some of them with a greater measure of precision of analysis than had previously been achieved. While he carries the problem forward toward a solution, there are, however, some defects in his mode of analysis which seriously detract from the significance of the concrete results which he obtains.

Wilson's mode of analysis and the nature of the results which he obtains can for present purposes be made sufficiently clear by reference to two of his arithmetical examples, I and IV,4 which are here presented in somewhat modified form to simplify the exposition. It is assumed in both examples that production is under conditions of constant cost; that in the absence of price changes the transfer of the payments will not change the proportions in which either country would desire to distribute its expenditures as between the classes of commodities available to it; and that the amount to be paid is 9 monetary units. In Wilson's example I there are no domestic commodities in either country, while in his example IV there are domestic commodities in each country. Purchases are measured in monetary units uniform for both countries. The paying country's export commodity is represented by P, and its domestic commodity by D_p; the receiving country's export commodity is represented by R, and its domestic commodity by D_r.

Granted Wilson's assumptions, his example I is an adequate demonstration of the possibility that payments can be transferred without resulting in any movement of the terms of trade. Under the conditions given, the receiving country is willing in the absence of price changes to increase its purchases of each of the commodities to an extent just sufficient to offset the decreases in purchases by the paying country, and therefore no price changes are necessary for the restoration of equilibrium. This example suggests a general principle already formulated by a previous writer in this connection that “If the borrower wants what the lender does without, no change in prices is necessary.” 5 It is to be noted, however, that in example I one of the countries spends a substantially larger amount on foreign than on native commodities. It will be found upon experimentation that, given the assumption that in the absence of price changes the international loan or tribute will not cause either country to desire a change in the proportions in which it had hitherto distributed its expenditures between native and imported commodities, the transfer of the loan or tribute will necessarily result in a movement of the terms of trade unfavorable to the paying country unless before reparations the unweighted average ratio of expenditures on native to expenditures on foreign commodities for the two countries combined is unity or less, an improbable situation when there are domestic commodities.

In example I there were assumed to be no domestic commodities. To show that his conclusion—that the transfer of payments will not necessarily involve a movement of the terms of trade against the paying country and may even involve a movement of the terms of trade in its favor—is not dependent on the assumption that there are no domestic commodities, Wilson presents his example IV, in which domestic commodities are introduced for both countries but otherwise the same assumptions are followed as for example I.

Comparing separately for each commodity the amounts which in the absence of price changes the two countries combined would be willing to purchase after the payments with the amounts they purchased before the payments, Wilson concludes that while the price of the receiving country's domestic commodity would rise, and the price of the paying country's domestic commodity would fall, the aggregate demand for the receiving country's export commodity will at unaltered prices have fallen more (from 60 to 58) relatively than the aggregate demand for the paying country's export commodity (from 50 to 49) and therefore the price of the former will probably have to fall relatively to the price of the latter to restore equilibrium. For the relations of the price levels of the internationally-traded commodities, he reaches the general conclusion that: “No matter what be the original proportions of total demand, that class of goods will be higher relatively in price to the other, for which the borrowing country has the greater relative demand as compared with the lending country.”6

No significance can be attached, for constant cost conditions, to the results derived by Wilson from his example IV, since it fails to take into consideration the necessary relationship between the prices in each country of domestic and export commodities resulting from their competition for the use of the same factors of production. If in either country the prices of domestic commodities rose or fell relative to export commodities, factors of production would be diverted from the low-price to the high-price industry until the earning power of the factors in the two industries was equalized, and under constant costs this would mean that in neither country could there be relative changes

between the prices of domestic and export commodities. What the direction of relative change of the prices of the products of the respective countries will be as the result of international payments will depend on what effect the payments have on the relative aggregate demands of the two countries for all the products, and therefore for the factors of production, of the respective countries. In Wilson's example IV, the payment results, in the absence of price changes, in an increase in the aggregate demand for the products of the receiving country (275 after the payment as compared to 270 before the payment) and in a decrease in the aggregate demand for the products of the paying country (85 after the payment as compared to 90 before the payment). The prices of the factors, and consequently the commodity terms of trade, must therefore move against the paying country if equilibrium is to be restored.

To an objection to his analysis made by some unspecified person7 to the effect that the flow of gold from lending to borrowing country, by raising money prices and incomes generally in the borrowing country, and lowering them generally in the lending country, will make the prices of the productive services and therefore also of their products, in domestic and export industries alike, rise in the borrowing country and fall in the lending country, Wilson replies that: “mere changes in money costs of production are not sufficient in themselves to cause a change in prices. If prices are to be affected by changes in costs of production, it can only come about through a change in the relative demand and supply of those goods whose money costs of production are affected,” and that the relative changes in price which such changes in cost would tend to produce would tend to be checked by diversion of expenditures to or from other classes of goods not so affected.8 This reply bears only on the degree of relative price changes needed, whereas the issue is whether any price changes are needed, and if so, in what directions. It, moreover, misses the character of the valid objection to which his analysis is open, which is not the common but fallacious argument that relative changes in the amounts available for expenditure in the two countries must necessarily result in changes in the same direction in the prices of the productive services and therefore also in the money costs of production of the two countries,9 but that changes in the relative aggregate demands for the commodities of the respective countries will do so. If, as is possible, but, as will later be shown, improbable, a transfer of funds on loan from country A to country B results in an increase in the aggregate demand of the two countries for A's products and a decrease in their aggregate demand for B's products, it will be the prices of A's, and not of B's, factors of production which will rise.

Yntema.—Yntema applies to the problem a powerful mathematical technique, and analyzes it on the basis of a wide range of assumptions.10 For cases such as those contemplated by the older writers, he reaches conclusions substantially in accord with theirs, especially with reference to the relative movement of the prices of the domestic commodities of the two countries and of their double factoral terms of trade.11 But Yntema's analysis rests throughout on certain assumptions which seriously limit the significance of his results. He assumes that when a relative change in the amount of money in two countries occurs as a result of loans or tributes or other disturbances in the international balances, there will occur in the country whose stock of money has increased a rise not only in all of that country's demand schedules (in the simple Marshallian sense), but also in the prices of the factors of production and in the supply schedules of that country's products, and that there will similarly occur in the country whose stock of money has decreased a fall not only in all of that country's demand schedules, but also in the prices of its factors of production and in the supply schedules of that country's products, though these rises or falls need not be uniform in degree within each country. But a rise in all the demand schedules of a country does not necessarily lead to or require a rise in its supply schedules or in the prices of its factors of production. What will be the effect of an international transfer of income on the direction of the relative movement of the prices of the factors in the two countries is itself the question relating to the equilibrating process awaiting solution, but in Yntema's analysis it is unfortunately decided by arbitrary assumption. Yntema's conclusion that under constant cost the terms of trade must necessarily shift in favor of the receiving country results from his assumption that the prices of the factors and the money costs of production will necessarily rise in the receiving country. As had been argued above, this is not a valid assumption.

Ohlin.—In his important treatise,12 Ohlin gives an elaborate account of the mechanism, whose most important contribution is the convincing demonstation that not price changes only but also relative shifts in demands resulting from the transfer of means of payment, are operative in restoring a disturbed equilibrium in the balance of payments. On the question immediately at issue, i.e., the specific mode of operation of relative changes in sectional price levels in the mechanism of adjustment, he is extremely critical in tone in his treatment of the older writers, although as long as he adheres to the traditional assumptions he follows the traditional reasoning and conclusions only too closely. Ohlin claims that the older writers exaggerated the importance of relative price changes in the equilibrating process both because they overlooked the direct influence on purchases of the shift in means of payment and because the ordinarily high elasticity of foreign demand for a particular country's exportable products makes a small change in price exert a large influence on the volume of trade. Subject to the qualification that I believe I have shown that recognition of its validity was not nearly as rare among the classical expositors of the theory of international trade as he appears to take for granted, I concede his first point. But on the second point, at least a partial defense can be made of the position of the older writers. When two factors are necessarily associated in a complex economic process, there is rarely a satisfactory criterion for measuring their relative importance, even if all the quantitative data that could be desired were available. Ohlin appears to regard the relative degree of price change as between different classes of commodities as an appropriate measure of the importance of such price changes in the equilibrating process. A more appropriate criterion, if it could be applied, would be the proportion of (1) the equilibrating change in the trade balance which results from relative price changes to (2) the total change in the trade balance necessary to restore equilibrium. Since foreign demands for a particular country's products ordinarily have a high degree of elasticity, small price changes in the right direction can exert great equilibrating influence. But the emphasis which Ohlin gives to the question of the degree of change seems to me a novel one, as far as discussion of mechanism is concerned, and I cannot recall a single instance in the older literature where a definite position was taken as to the extent of the price changes necessary to restore a disturbed equilibrium.

Taking the case of international loans,13 Ohlin assumes, as a first approximation, that “all goods produced in a country require for their manufacturing ‘identical units of productive power’ consisting of a fixed combination of productive factors.” The lending country B must make initial remittances to the borrowing country A. The assumptions as to the effects on demands are not clearly stated, but seem to be as follows: the aggregate demands in terms of money prices of the two countries combined (1) for the export goods of A and (2) for the export goods of B, are each assumed to remain unaltered;14 (3) the demand in A for A “domestic” goods increases; (4) the demand in B for B “domestic” goods decreases. This “implies” a shift in demand from B factors to A factors, which “raises the [relative] scarcity of the A unit, which means that every commodity produced in A becomes dearer than before compared with every commodity produced in B. The terms of exchage between A's export goods and B's change in favor of A.” 15 So far, therefore, there is no correction of the older doctrines with respect to the kind of price changes necessary to restore equilibrium. But Ohlin attributes these results to the assumption that all industries use identical “units of productive power,” and remarks that it is because they have expressed costs in such units that “men like Bastable, Keynes, Pigou, and Taussig have stopped at the preliminary conclusion in §5 and have found a variation in the terms of trade certain in all cases, at least where the direction of demand is not of a very special sort.” 16

These results, however, arise not from the assumption of the use in each country of identical “units of productive power,” but from Ohlin's assumption that the transfer of funds does not of itself lead to any alteration in the aggregate monetary demand for the export commodities of the respective countries. Even with both these assumptions, they are not necessary results, if it be granted that, without price changes, the increase in funds in A may lead to a decrease in the demand for A “domestic” goods, or that the decrease in the funds in B may lead to an increase in the demand for B “domestic” goods, or both, consequences by no means inconceivable, as, for instance, if A's and B's domestic goods are both predominantly low-grade necessaries of the sort heavily consumed only when there is economic pressure.17 But Ohlin would probably regard—and not without justification—such movements of demand as “of a very special sort” and therefore not calling for consideration.

Abandoning the assumption of identical “units of productive power” and substituting the assumption that different industries use different factors, and use the same factors in different proportions, Ohlin shows that by introducing additional assumptions of non-competing factoral groups, the existence of idle resources, the tendency of the prices of the products to rise more rapidly than the prices of the factors in an expanding industry, and so forth, instances are possible where the commodity terms of trade turn against rather than in favor of the borrowing country.18

It is to be noted that some of these assumptions are of a non-equilibrium nature, i.e., can be valid only temporarily. But granted that Ohlin has shown the possibility that the terms of trade, when such assumptions are made, will turn against the borrowing country, what about the probabilities? Every one of these added factors is as likely, a priori, to accentuate the movement of the terms of trade in favor of the borrowing country as to operate to move them against the borrowing country. Take only one example, sufficiently representative of the others: Ohlin argues that the factors used relatively largely in expanding industries are likely to rise in price, while those used relatively largely in declining industries are likely to fall in price; in the borrowing country, the domestic commodity industries will be expanding, because of the increased demand for their products, while the export commodity industries will be declining, presumably because of decreased demand in the lending country for their products; the prices of the factors used largely in the domestic commodity industries therefore will rise, while those used largely in the export commodity industries will fall. In the lending country, reverse trends will be operating. The export commodities of the borrowing country therefore will decline in price relative to the prices of the export commodities of the lending country; i.e., the terms of trade will move against the borrowing country. But the export commodity industries of the borrowing country are not, a priori, more likely to decline than to expand. The foreign demand for their products, it is true, will tend to fall, but Ohlin overlooks that the home demand for their products will tend to rise, and that there is no obvious reason why the latter tendency should be expected to be less marked than the former and to be insufficient to offset the former.

The “orthodox” conclusions as to the kind of price change which would tend to result from international borrowing thus emerge from Ohlin's critical scrutiny almost unscathed. When he adheres to the usual assumptions, Ohlin reaches the same conclusions. When he departs from them, he succeeds in showing that different results are possible. But he does not succeed in showing that they are probable, or even that they are not improbable.

Pigou.—In a recent article Pigou has attacked the problem in terms of marginal utility functions, and has reached the conclusion that, under constant costs, there is a strong presumption, but not a necessity, that the commodity terms of trade (which he calls the “real ratio of international interchange”) will turn against the paying country as the result of reparations.19 Pigou's results, it will later be shown, can in part at least be reached by an alternative procedure which is simpler and has the additional virtue that it does not involve resort to utility analysis. But Pigou's analysis can be made to serve the useful function of bringing into clear view the utility implications of this alternative procedure, and thus warrants detailed examination and elaboration.

Pigou assumes a paying country, Germany, and the rest of the world, which he calls “England,” but since the existence of neutral countries, neither paying nor receiving reparations, gives rise to complications which this procedure disregards, I will proceed, for the time being, as if there are only two countries, Germany, the paying country, and England, the receiving country. Pigou makes the following additional assumptions: only one commodity produced in each area; “constant returns” (i.e., constant technological costs); dependence of the utility of any commodity on the quantity of that commodity alone; and linear utility functions throughout.

Pigou writes for the commodity terms of trade before reparations, and for the terms of trade after reparations, where: X, Y, represent the annual pre-reparations physical quantities of English exports and imports, respectively; X + P–P being negative—represents the annual quantity of English exports (or German imports) after reparations payments have been initiated; R represents the annual reparations payments measured by their value in English goods; and Y + Q represents the annual quantity of English imports (or German exports) after reparations payments have commenced. He further writes nX, nY, for the “representative” Englishman's pre-reparations exports and imports, respectively, and mX, mY, for the “representative” German's pre-reparations imports and exports, respectively. He then writes:

φ(nY) for the marginal utility of (nY) German goods to the representative Englishman;

ƒ(nX) for the marginal disutility to him of surrendering (nX) English goods;

F(mX) for the marginal utility of (mX) English goods to the representative German;

ψ(mY) for the marginal disutility to him of surrendering (mY) German goods.

Then, in accordance with Jevon's analysis,

In order that the new terms of trade should be equal to the old, it would therefore be necessary that

which, for linear functions, implies20 that

It can similarly be shown that reparations will cause the terms of trade to turn in favor of Germany if and to turn against Germany if.

[1]A useful account of the more recent literature, with special emphasis on the terms-of-trade issue, is given by Carl Iversen, in his Aspects of the theory of international capital movements, 1935, pp. 243–99. His own position is in all essentials identical with Ohlin's, and his survey of the literature is presented in terms of two sharply contrasting bodies of doctrine, the wrong or “classical” doctrine, on the one hand, and the correct or “modern” doctrine, on the other. The inclusion in the “classical” doctrine of special treatment of the prices of domestic commodities he seems to regard as a peculiar aberration, accidentally in the right direction, of the “classical” writers.

[2]Roland Wilson, Capital imports and the terms of trade, 1931, chap. iv.

[3]Ibid., pp. 75–76. That this proposition is incorrect can be sufficiently shown by the reductio ad absurdum to which it would lead if there were no domestic commodities.

[4]Ibid., pp. 70, 72.

[5][H. K. Salvesen] “The theory of international trade in the U.S.A.,” Oxford magazine, May 19, 1927, p. 498.

[6]Ibid., pp. 73–74. (Italics in original.)

[7]I suspect that I am supposed to be the guilty person.

[8]Ibid., pp. 76–77.

[9]If I correctly interpret him, R. F. Harrod, in his review of Wilson's book, attempts to meet Wilson's example IV by just this argument. Economic journal, XLII (1932), 428 ff.

[10]T. O. Yntema, A mathematical reformulation of the general theory of international trade, 1932, especially chap. v.

[11]Which Yntema calls the “resources terms of trade.” See ibid., pp. 19–21.

[12]Bertil Ohlin, Interregional and international trade, 1933, especially pp. 417–33.

[13]Ibid., pp. 417–20 (chap. xx, §5).

[14]Cf. ibid., p. 418: “the assumption, which has been tacitly made above, that the combined demand of A and B for the export goods from either is in the first place unchanged by the borrowings.”

[15]Ibid.

[16]Ibid., p. 425, note. Cf. also Carl Iversen, International capital movements, 1935, p. 289: Expressing costs in terms of “units of productive power” and similar concepts, one cannot, of course, push the analysis beyond a demonstration that this unit, i.e., productive factors as a whole, becomes more scarce in the capital-importing country, less scarce in the capital-exporting country. And on this premise it is inevitable that the terms of trade will move against the latter country.

[17]I.e., if in each country “domestic” goods are, with respect to export and import goods, “inferior commodities.”

[18]Ibid., pp. 420 ff.

[19]“The effect of reparations on the ratio of international interchange,” Economic journal, XLII (1932), 532–43.

[20]Pigou says that these implications are very simple (ibid., p. 534) and does not trouble to demonstrate them. A demonstration may not be superfluous for some readers:

From (iii)

and