chapter  4
The Dollar and World Liquidity: A Minority View (with Emile Despres and Walter S. Salant)
Pages 11

There is room, however, for a minority view which would oppose this agreement with a sharply differing analysis. In outline, it asserts the following counter propositions: (1) While the USA has provided the world with liquid dollar assets in the postwar period by capital outf low and aid exceeding its current account surplus, in most years this excess has not reflected a deficit in a sense representing disequilibrium. The outflow of US capital and aid has filled not one but two needs. First, it has supplied goods and services to the rest of the world. But secondly, to the extent that its loans to foreigners are offset by foreigners putting their own money into liquid dollar assets, the USA has not overinvested but has supplied financial intermediary services. The 'deficit ' has reflected largely the second process, in which the USA has been lending, mostly at long and intermediate term, and borrowing short. This financial intermediation, in turn, performs two functions: it supplies loans and investment funds to foreign enterprises which have to pay more domestically to borrow long-term money and which cannot get the amounts they want at any price, and it supplies liquidity to foreign asset-holders, who receive less for placing their shortterm deposits at home. Essentially, this is a trade in liquidity, which is profitable to both sides. Differences in their liquidity preferences (that is, in their willingness to hold their financial assets in long-term rather than in quickly encashable forms and to have short-term rather than long-term liabilities outstanding against them) create differing margins between short-term and long-term interest rates. This in turn creates scope for trade in financial assets, just as differing comparative costs create the scope for mutually profitable trade in goods. This trade in financial assets has been an important ingredient of economic growth outside the USA. (2) Such lack of confidence in the dollar as now exists has been generated by the attitudes of government officials, ccntral bankers, academic economists and journalists, and reflects their failure to understand the implications of this intermediary funct ion. Despite some contagion from these sources, the private market retains confidence in the dollar, as increases in private holdings of liquid dollar assets show. Private speculation in gold is simply the result of the known attitudes and actions of governmental officials and central bankers. (3) With capital markets unrestricted, artempts to correct the 'deficit ' by

ordinary macro-economic weapons are likely to fail. It may be possible to expand the current account surplus at first by deflation of US income and prices relative to those of Europe, but gross financial capital flows will still exceed real transfer of goods and services ( that is, involve financial intermediation, lending long-term funds to Europe in exchange for shortterm deposits) so long as capital formation remains high in Europe. A moderate rise of interest rates in the USA will have only a small effect on the net capital outflow. A drastic rise might cut the net outflow substantially, but only by tightening money in Europe enough to stop economic growth, and this would cut the USA's current account surplus. Correcting the US deficit by taxes and other controls on capital, which is being attempted on both sides of the Atlantic, is likely either to fail, or to succeed by impeding international capital flows so much as to cut European investment and growth. (4) While it is desirable to supplement gold with an internationally created reserve asset, the conventional analysis leading to this remedy concentrates excessively on a country 's external liquidity; it takes insufficient account of the demands of savers for internal liquidity and of borrowers in the same country for long-term funds. The international private capital market, properly understood, provides both external liquidity to a country and the kinds of assets and liabilities that private savers and borrowers want and cannot get at home. Most plans to create an international reserve asset, however, are addressed only to external liquidity problems which in many cases, and especially in Europe today, are the less important issue.