International Monetary Fund. External Relations Dept.
Published Date:
January 1990
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The European Payments Union

Jacob J. Kaplan and Gunther Schleiminger

Financial Diplomacy in the 1950s

Oxford University Press, New York, NY, USA, 1989, vii + 396 pp., $72.

The European Payments Union (EPU) was a financial arrangement among the 18 members of the Organization for European Economic Cooperation (the forerunner of the OECD) that lasted from 1950 until 1958. Yet its history is well worth reading more than three decades later. That history deals with subjects of perennial concern to the IMF and the World Bank: finding the correct mixture of adjustment and financing for countries in serious balance of payments disequilibrium and promoting policy cooperation among countries through mutual and international pressure. The two authors were active participants in the second half of the life of the institution, Kaplan as the US observer on the EPU Managing Board, and Schleiminger as its German alternate member.

In the early postwar years, trade in Europe was conducted under a grid of bilateral payments arrangements with limited credit margins, which were nearing exhaustion by 1947. Shortage of foreign exchange induced bilateral debtors to cut back on imports, thus blocking the growth of intra-European trade, which was essential for the economic recovery of the continent. It took the Europeans and ECA (the Economic Cooperation Administration, the US agency that administered the Marshall Plan) three years to design and agree on a mechanism that could break through this impasse.

The main features of the scheme were: a sharp reduction of quantitative restrictions on European trade, without the United States insisting on simultaneous liberalization for dollar imports; monthly multilateral settlement of European surpluses and deficits, under formulas that allowed for partial settlement in credit up to an agreed quota for each country, and fully in dollars beyond the quota; and a crucial capital contribution of dollars by the ECA to cover differences between the dollar payments that the EPU might receive and pay out.

The OEEC established an eight-member Governing Board to keep an eye on the functioning of the EPU mechanism, which many hoped would be largely automatic and for which the Bank for International Settlements acted as the financial agent. Almost at once, however, the Board found itself drawn into actions to keep the institution alive, as one crisis after another (starting with a large German deficit) pushed countries to the limits of their quotas or beyond.

By force of necessity, the Governing Board assumed many of the functions exercised by the Executive Directors of the IMF, and some exercised by the Fund staff. It held hearings to listen to member country delegations, passed judgments on members’ policies, and backed them up with special credits or enlarged quotas. It also took the lead in the annual negotiations for the renewal of the EPU that often involved changes in the mechanism; and its discussions prepared the ground for the acceptance of de facto convertibility by most EPU members at the end of 1958. Because the EPU constituted a closed settlement mechanism with total monthly deficits equaling total monthly surpluses, the Board was under equal pressure to find solutions for unusually large surpluses and deficits—a notable difference from the IMF. Like the Fund, the EPU often struggled with members unwilling to make timely adjustment or adopting retrogressive adjustment policies that only worsened the problems some months later. The authors describe at considerable length the episodes of the “Perils of Pauline” through which the EPU went while members pursued often inadequate solutions for successive (or simultaneous) debtor and creditor crises.

Before its creation, and in its early years, the EPU was sharply opposed by the US Treasury and the IMF, who feared that the partial financing of balances with credit would perpetuate a discriminatory soft-currency area and would lead to an indefinite postponement of convertibility. Against this, protagonists of EPU, in ECA and in Europe, stressed the immediate benefit of breaking through the stifling bilateralism of the late 1940s to large-scale liberalization, at least within Europe. They also expected that the limits on credit and the possibilities of “hardening” the settlements over time would gradually steer the system toward full dollar settlement, convertibility, and worldwide nondiscrimination.

The latter view proved to be the correct one. Settlement in credit turned out to be important in the first two years of EPU only. Over the next six and a half years, as quotas became exhausted, credits taken earlier needed to be repaid and settlement ratios were “hardened,” the credit component in settlement fell on average well below 10 percent. The ultimate success in the achievement of convertibility, on the basis of which the EPU was able to engineer its own liquidation, justifies the warm sentiments for the institution that old timers continue to feel and that the authors make no attempt to hide.

J.J. Polak

The International Debt Crisis in Historical Perspective

Barry Eichengreen and Peter H. Lindert (editors)

MIT Press, Cambridge, MA, USA, 1989, 282 pp., $25.

Debt and Crisis in Latin America

Robert Devlin

The Supply Side of the Story

Princeton University Press, Princeton, NJ, USA, 1989, xvi + 320 pp., $35.

The emergence in the early 1980s of widespread debt-servicing problems has prompted a multitude of studies seeking to analyze the nature and implications of debt creating flows. The two volumes reviewed here attempt to push the discussion forward through analysis of historical precedents and of factors determining the supply of commercial credit.

The volume edited by Eichengreen and Lindert brings together seven historical studies summarized nicely in the overview chapter. The focus is primarily on the nature of private sector international lending and on the mechanisms for restoring normal creditor-debtor relations, with a view to drawing implications for the current debt situation.

The post-1973 lending boom differed from earlier episodes in the predominance of commercial bank credit as opposed to bond financing. The studies show that the change in the nature of financing affected the response of the official sector in creditor countries. While in earlier periods creditor governments tended to play a relatively passive role—with some notable exceptions—threats to the integrity of the banking system in the 1980s contributed to a more centralized and concerted debt settlement process.

Can lessons be drawn from past experiences for the resolution of the current debt problems? The studies suggest that the chances are good for a return by debtor countries to spontaneous market access. The private sector has repeatedly been willing to resume large-scale lending to sovereign borrowers, reflecting the relatively high overall profits on such loans—though less than implied by the initial contractual terms.

The outlook for rapid restoration of market access for the bulk of developing countries with recent debt problems is clouded upon closer investigation of the evidence presented in the studies. Unlike previous debt crises, losses have been borne by a relatively small group of creditors—commercial banks. Other forms of credit, such as bonds, may still be available but are unlikely to compensate fully for the reduction in commercial bank credit facilities. Moreover, increased differentiation among borrowers by creditors suggests that general factors will be subordinated to individual country considerations—thereby emphasizing the need for debtors to restore creditworthiness through the sustained implementation of strong adjustment policies. In any case, the prospect of an eventual return to market access provides little comfort to countries facing severe short-term credit rationing.

Robert Devlin’s book focuses primarily on the supply side of the debt crisis, arguing that banks were a source of instability. Using an oligopolistic market approach and drawing upon empirical data on credit conditions in Latin America, Devlin supports the view that banks engaged in an initial overexpansion of lending, followed by an overcontraction. The resulting disruption for developing countries was accentuated by domestic policy slippages, reflected in an inability to generate sufficient return on debt-financed activities.

Devlin argues that, in seeking to protect the financial integrity of the banking system, the initial management of the debt crisis imposed a disproportionately high cost on debtors. In the context of the recent strengthening of banks’ balance sheets and the associated weakening of banks’ cartel-like behavior, debtor countries are urged to take a more active stance in the management of the debt strategy, including through unilateral limitation of debt service.

Although comprehensive in its analysts of the emergence and gravity of the debt crisis, Devlin’s study is weaker in its discussion of policy responses. The central policy challenge concerns how to support countries’ adjustment efforts with sufficient financing—including debt relief—while maintaining a cooperative framework conducive to safeguarding access to short-term credit facilities and facilitating an eventual return to normal market access. Devlin’s book fails to demonstrate convincingly that the benefits of an openly confrontational approach would not be quickly offset by the potential reduction in access to financing instruments essential for the day-to-day management of trade and other external transactions.

Mohamad EI-Erian

Trade and investment Relations among the United States, Canada, and Japan

Robert Stern (editor)

The University of Chicago Press. Chicago, IL, USA, 1990. viii f 448 pp., $55.

A collection of papers and discussants’ comments that were prepared for a conference held in April 1987, this book provides useful background information on the linkages among the three major Pacific Rim countries in the title. It is based on a detailed statistical analysis of trade patterns, tariff and nontariff barriers, and foreign investment. Although the subject matter is interesting, both from the viewpoint of the three countries and from a global perspective, the discussion is a bit dated as significant events like the ratification of the Canada-US Free Trade Agreement and negotiations between officials of the United States and Japan took place after the conference was held.

The emphasis of the book is more on structural features of the three economies than on macroeconomic issues. For example, there is a good analysis of the impact of informal barriers on imports and the tax incentives (disincentives) on saving in these countries. The integration of trade questions with aggregate demand and supply factors, however, is incomplete. No clear consensus emerges concerning the factors behind US current account deficits and Japanese surpluses: Is it the US fiscal position, or Japanese trade barriers and incentives for private saving? The book gives more attention to the second hypothesis, but on balance, rules against a simple protectionist explanation.

The book is divided into four parts. An overview section contains a good survey of recent macroeconomic developments by John Helliwell, in which he focuses on the saving/investment approach and on the convergence of technology in developed economies. Another paper in this section, by Yoko Sazanami, gives detailed information on trade and investment relations among the three countries. The second section, entitled “International Trade and Structural Adjustment,” contains an analysis of trade in primary products (by Andrew Shmitz), Industrial policies (by Robert Z. Lawrence), tax effects on trade and investment (by John Whalley), and some speculation on how the Asia-Pacific region may evolve (by Saburo Okita).

The third section is likely to be the most interesting for many readers as it considers the question of market access from a much broader perspective than that of tariff levels and quotas or voluntary export restraints. A conceptual paper by Richard Harris argues that cultural barriers and barriers to entry of foreign firms also constitute restrictions on market access. Gary Saxonhouse and Robert Stern attempt a detailed analysis of formal and informal barriers to trade and investment in the three countries, concluding that “there is not much evidence to support the contention that Japan relies on a variety of informal barriers for the purpose of influencing the structure of its trade.” The final section emphasizes the macro-economic issues. Dale Henderson and William Alexander contrast the effects on exchange rate volatility of currency and bond market substitution, while Warwick McKibbin, Nouriel Roubini, and Jeffrey Sachs argue that divergent fiscal policies do a good job in explaining US and Japanese current account and exchange rate developments in the 1980s.

Paul Masson

Income Taxation and International Mobility

Jagdish Bhagwati and John Douglas Wilson (editors)

The MIT Press, Cambridge, MA, USA, 1989, ix + 221 pp., $32.50.

Quite a while ago, Professor Jagdish Bhagwati, one of the better-known examples of international brain-drain, started arguing that LDCs should be compensated in some form for what they lost by “brain-drain.” He organized a meeting of experts in New Delhi in 1981, supported by The Ford Foundation. This resulted in a number of interesting papers, which, together with some other contributions, make up a book, published, however, with regrettable delay. In addition to the editors, contributors include William J. Baumol, Koichi Hamada, Gary Clyde Hufbauer, James A. Mirrlees, and Richard Pomp.

Unfortunately, there is a fundamental problem with this book. The authors rightly describe the brain-drain as one in which the LDCs train people, who later use their potential to feed the tax-rolls of other, normally richer, countries. If these people could be forced to pay income tax in their home countries—although with a deduction or credit for the tax paid in their countries of employment—the authors argue that this would have a beneficial influence on the home countries’ tax base. What is more, it would widen the scope for income taxation, now unduly narrowed by the real or perceived risk of provoking a brain-drain. But the only practical instances of taxation based on citizenship that are cited serve to illuminate the unworkability of such a system. The US system functions incompletely; the Philippine system according to the authors is a total failure.

The book thus remains a theoretical exercise, dwelling on the possible outcome of a system that so far has proven to be unrealistic. For it to work, there would have to be extraterritorial exercise of tax authority; the United States has some practices that might be (malevolently) described that way, but no other country would even dare to try such a thing, let alone have the resources to do so. Alternatively, host countries could cooperate voluntarily. But here, again, there are sovereign considerations. Moreover, not all developing countries are under a regime fulfilling such standards as to make it palatable for host governments to collect taxes on their behalf, or acceptable to their expatriates to have to support them.

The book also suffers from a terminological flaw. The editors believe that global income taxation means taxation of citizens on their worldwide income, whereas all other income taxes are schedular. An expert reviewer could have told them that (1) schedular taxes are those imposed separately on different elements of a person’s income without using the total net income as a tax base; (2) “global” income taxation is sometimes used as the opposite of schedular income taxation to characterize a tax on total net income (better described as “synthetic”); (3) “world-wide” income taxation is often used in the sense of taxing all income derived by a resident taxpayer (or citizen) regardless of source; and (4) taxation according to citizenship seems to be the only acknowledged term for the odd system applied by the United States and the Philippines.

The book is an example of the best being the enemy of the good. The authors now discuss in terms of optimal taxation what would be the situation if a “citizens’ tax” worked, a situation rather far from reality. They could have made the book more useful, if, instead, they had tried to present a workable alternative.

Leif Mutén

The Foreign Exchange Market

Richard Baillie and Patrick McMahon

Theory and Econometric Evidence

Cambridge University Press, New York, NY, USA, 1989, xii + 259 pp., $44.50.

Since the breakdown of the Bretton Woods system, the foreign exchange market has held an irresistible appeal for many applied economists and econometricians. Simple monetary models of exchange rate determination have been tested and, given their frequent failure to explain the data, have been refined to incorporate exchange-rate expectations, wealth effects, imperfect asset substitutability, and sticky prices. A battery of econometric techniques has also been aimed at testing whether foreign exchange markets are efficient, in the sense that exchange rates embody all available information and that no riskless profits can be earned through arbitrage.

Baillie and McMahon survey the progress of research on the behavior of floating exchange rates. In the early chapters, they first discuss the principles and implications of market efficiency, and then go on to present the theoretical models that have had the greatest role in empirical research, namely the monetary and portfolio balance models and their variants. The models they present treat exchange-rate determination and market efficiency as largely separate topics, in contrast to some recent models, associated with Lucas and others, that integrate money and finance in a framework of individual intertemporal optimization.

In the later chapters of the book, the authors survey a range of empirical techniques and results, with particular emphasis on their own recent work; the exposition is aimed at readers with more than passing familiarity with, and interest in, econometric method. The authors review various tests of market efficiency, covered and uncovered interest arbitrage, the usefulness of forward exchange rates as predictors of future spot rates, and the way in which “news” is incorporated into exchange rates. Finally, they describe some efforts to identify and test simple models of exchange rate determination. They also give considerable emphasis to applications of time-series analysis.

Some disquieting results emerge from tests both of market efficiency and of models of exchange rate determination. There is a substantial body of evidence against foreign exchange market efficiency, in several of its aspects; although this does not preclude the possibility that the assumption of efficiency is still a good enough approximation for many purposes, it still implies that this assumption cannot be invoked without caution. There has also been a general failure to find a model of exchange rate determination that performs well for a range of sample countries and periods.

The negative character of many of the empirical results surveyed by the authors may be seen as challenging the view that the exchange rate is best left to be determined by market forces, by suggesting that, in the foreign exchange market, these market forces are still not well understood. It also challenges researchers to refine their models further, in search of a better reconciliation of theory with econometric evidence.

Timothy Lane

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