Chapter VI
THE INTERNATIONAL MECHANISM UNDER
A SIMPLE SPECIE CURRENCY

Besides that the speculation is curious, it may frequently be of use in the conduct of public affairs. At least, it must be owned that nothing can be of more use than to improve by practice the method of reasoning on these subjects, which of all others are the most important, though they are commonly treated in the loosest and most careless manner.

—David Hume, "Of interest," Political discourses, 1752.

I. INTRODUCTORY

In this chapter an account will be presented of the history and the present status of the theory of the mechanism of adjustment of international balances, in terms throughout of the simplifying assumption of an international simple specie currency, i.e., with the circulating medium consisting solely of standard metallic money. It was in terms of this assumption that the theory was first presented, and it has served ever since as a convenient device whereby to segregate for separate treatment different problems connected with the mechanism. It should be noted that in this chapter, as throughout the book, the term "balance of payments" is used in its original sense of an excess of immediate claims on abroad over obligations to abroad, or vice versa, which must be liquidated by specie. It should be noted also that by a "disturbance" to international equilibrium will be meant a change in one of the elements in a preexisting equilibrium such as to require a new equilibrium, and that this change, whether it takes the form of a series of crop failures, of international tributes or loans, of new import duties, or of a relative change in the demands of the two countries for each other's products, is presumed to continue indefinitely, and its cessation is treated as a new change in the reverse direction. A wide variety of disturbances can be used to illustrate the theory of the mechanism of international trade, and each has its own sequence of stages and to some extent its own set of special problems. A selection must be made, therefore, and the reader is asked not to attribute to me or to the writers cited generalization of the conclusions reached from the analysis of cases specifically dealt with beyond what the context clearly shows to be intended.

The "classical" theory of the mechanism of international trade, as developed from Hume to J. S. Mill, is still, in its general lines, the predominant theory. No strikingly different mechanism, moreover, has yet been convincingly suggested, although there has been gain in precision of analysis, and some correction of undoubted error. In recent years, it is true, a number of writers have pointed out what they regard as major errors in the classical theory, and have claimed that to eliminate these errors would require major reconstruction of the classical doctrines. But the current notions as to what the classical doctrines actually were are, with respect to this as to other matters, largely traditional rather than the product of examination of the original sources, and even when, as sometimes happens, the critics do use classical texts as the basis for the interpretation of the classical doctrines, they confine their references almost wholly to Ricardo and to J. S. Mill, and to the compressed, elliptical, and simplified expositions of their doctrines which are to be found in short chapters, labeled as on international trade, in their Principles. But if an adequate notion of the classical doctrines as to the mechanism of international trade is to be had, it is necessary to examine the writings of other classical economists, and for Ricardo and J. S. Mill to read in their Principles beyond the chapters distinctly labeled as dealing with international trade and also to explore what they had to say on this subject elsewhere. It is also necessary to bear in mind that there were important differences of doctrine within the ranks of the classical economists themselves, so that on some important points it is impossible to find any one doctrine which can properly be labeled as the classical doctrine. The following account will, I trust, demonstrate that some at least of the much-emphasized discoveries and "corrections" of recent years either are to be rejected as erroneous or were current doctrine in the classical period.

II. THE MECHANISM ACCORDING TO HUME

In so far as the classical theory of the mechanism of international trade had one definite originator, it was David Hume.^*1 His main objective in presenting his theory of the mechanism was to show that the national supply of money would take care of itself, without need of, or possibility of benefit from, governmental intervention of the mercantilist type. He started out with the hypothesis that four-fifths of all the money in Great Britain was annihilated overnight, and proceeded to trace the consequences. Prices of British commodities and British wages would sink in proportion; British commodities would consequently overwhelm foreign competition in foreign markets, and the increase in exports would be paid for in money until the "level of money" in Great Britain was again equal to that in neighboring countries. Assuming next that the money in Great Britain were multiplied fivefold overnight, he held that prices and wages would rise so high in England that no foreign countries could buy British commodities, while foreign commodities, on the other hand, would become comparatively so cheap that they would be imported in great quantities. Money would consequently flow out of England until it was again at a level with that of other countries. The same causes which would bring about this approach to a common international level when disturbed "miraculously" would prevent any great inequality in level from occurring "in the common course of nature." The same forces also would preserve an approximately equal level as between different provinces of the same country. An additional, though minor, factor, operating to correct "a wrong balance of trade," was the fluctuations in the foreign exchanges within the limits of the specie points. If the trade balance was unfavorable, the exchanges would move against England, and this would become a new encouragement to export. The entire mechanism was kept in operation by the profit motive of individuals, "a moral attraction, arising from the interests and passions of men," acting under the stimulus of differences in prices.

The mechanism, therefore, was according to Hume automatically self-equilibrating, was intranational as well as international, was bilateral, involving adjustments both at home and abroad, and consisted of such changes in the volume of exports and imports, resulting chiefly from changes in relative prices but also in minor degree from fluctuations in exchange rates, as would bring about or maintain an even balance of trade, so that no further specie need move to liquidate a balance.

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,^*2 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.^*3

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,^*4 and to a change in the English demand for foreign commodities as compared to the foreign demand for English commodities.^*5 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.^*6 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?^*7

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.^*8 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.^*9

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.^*10 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.^*11

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.^*12 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.^*13

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.^*14 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."^*15 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.^*16

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,^*17 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,^*18 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.^*19

Cairnes, in his better known expositions of the mechanism of international trade,^*20 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....^*21

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.^*22

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.^*23

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.^*24 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.^*25 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.^*26

Taussig, 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."^*27 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.^*28

"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,^*29 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.^*30 As will appear later, this last proposition was an error, resulting from my failure, at this point,^*31 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.^*32 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.^*33 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.^*34

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.^*35 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.^*36 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.^*37 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."^*38 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.^*39

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!"^*41 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.

IV. PRICES IN THE MECHANISM: THE CONCEPT OF "PRICE LEVELS"

An adequate exposition of the role of price changes in the mechanism of international trade as it affects a particular country would explain both what would be the necessary relationship under equilibrium between prices in that country and prices abroad, and in what manner if any fluctuations of prices would contribute to, or would be associated with, the restoration of equilibrium when it had been disturbed. In tracing the development of doctrine on these questions, it is once more convenient to begin with Hume. For our present purposes it is convenient to accept as the predominant criterion of equilibrium in international trade under an international metallic standard a situation in which there is an even balance of payments, i.e., no flow, and no tendency to flow, of bullion or specie from country to country.^*42

Hume held that when the balance of payments of England with the outside world was even, the "level of money" in England and in neighboring countries would also be equal, subject to minor qualifications. The mechanism of international trade operated to bring money to a common level in all countries, just as "all water, wherever it communicates, remains always at a level." Hume meant by "level of money" the proportion between money and commodities:

It must carefully be remarked, that throughout this discourse, whenever I speak of the level of money, I mean always its proportional level to the commodities, labor, industry, and skill, which is in the several states. And I assert that where these advantages are double, triple, quadruple, to what they are in the neighboring states, the money infallibly will also be double, triple, quadruple.^*43

Modern usage makes it tempting to translate "level of money" by average value or purchasing power of money as against commodities in general, with some statistical average of prices as its reciprocal. But this would be an anachronism as far as Hume, or even as the classical school as a whole, was concerned. Hume wrote before the first attempt in England, that of Evelyn in 1798, to measure changes in price levels by means of statistical averages.^*44 Even after 1798, the leading economists until the time of Jevons either revealed no acquaintance with the notion of representing, by means of statistical averages, either a level of prices, or changes in such level, or found it inacceptable for various reasons, good and bad.^*45 While a number of crude index numbers were constructed during the first half of the nineteenth century, none of the classical economists, with the single exception of Wheatley, would have anything to do with them.^*46

Hume's use of the term "level" troubled some of the classical economists. Wheatley claimed that Hume was inconsistent in arguing both that money everywhere maintained its level and that one country might retain a greater relative quantity than another, "which is incompatible with the nature of a level."^*47 Ricardo, in his published writings, seems to have avoided the use of the term "level" for the general state of prices, although he used it in this sense freely in his private correspondence.^*48 He refused to acknowledge that there was any satisfactory way of comparing the value of money, or of bullion, in different countries:

When we speak of the high or low value of gold, silver, or any other commodity in different countries, we should always mention some medium in which we are estimating them, or no idea can be attached to the proposition. Thus, when gold is said to be dearer in England than in Spain, if no commodity is mentioned, what notion does the assertion convey? If corn, olives, oil, wine, and wool, be at a cheaper price in Spain than in England, estimated in those commodities, gold is dearer in Spain. If, again, hardware, sugar, cloth, &c., be at a lower price in England than in Spain, then, estimated in those commodities, gold is dearer in England. Thus gold appears dearer or cheaper in Spain, as the fancy of the observer may fix on the medium by which he estimates its value.^*49

Malthus denied that money necessarily maintained a uniform level in different countries, if by uniformity of level was to be understood necessary equality of the prices of some specified commodity or of the "mass of commodities."^*50

What then were the views of the classical writers with respect to the relationship of prices and of the value of gold in different countries? The following seems to be a correct interpretation of their general position: (1) When they speak of the value of money or of the level of prices without explicit qualification, they mean the array of prices, of both commodities and services, in all its particularity and without conscious implication of any kind of statistical average; (2) when they postulate a tendency for the uniformity of the value of money, or of prices, in different countries, they have reference only to particular identical commodities taken one at a time, and only to transportable commodities, and they claim such a tendency for uniformity only subject to allowance for transportation costs both for the commodities and for the specie; (3) where the monetary units are not the same, or where different standards are in use, they postulate uniformity in the prices of identical commodities only after conversion into a common currency unit at the prevailing rate of exchange, and they postulate uniform ratios between the prices of different transportable commodities in the currencies of the respective countries.^*51

Most of these propositions are implied in the following passage from Hume:

The only circumstance that can obstruct the exactness of these proportions, is the expense of transporting the commodities from one place to another; and this expense is sometimes unequal. Thus the corn, cattle, cheese, butter, of Derbyshire, cannot draw the money of London, so much as the manufactures of London draw the money of Derbyshire. But this objection is only a seeming one; for so far as the transport of commodities is expensive, so far is the communication between the places obstructed and imperfect.^*52

In spite of the obscurity of his exposition, it seems clear that Ricardo would have subscribed to these propositions, and that where occasional statements in his writings appear to conflict with them the inconsistency is only apparent. Thus Ricardo says at one point that "the value of money is never the same in any two countries" and that "the prices of the commodities which are common to most countries are also subject to considerable difference"^*53 but the context shows that he had in mind the differences in different countries in the purchasing power of gold over particular commodities which were due to the cost of transporting gold, to bounties and tariffs, to the cost of transporting goods, and to the existence of non-transportable "home commodities" which, according to him, would be higher in price in countries where the effectiveness of labor in export industries and therefore also the wages of labor were comparatively high, and he included as an element in the value of money its purchasing power in terms of labor, which he assumed to be a non-transportable commodity.^*54 In a letter to Malthus, Ricardo conceded that the situation suggested by Blake, where gold moved from France to England although the value of gold in terms of commodities was constant in France and rising in England, was possible though improbable, and explained the possibility of such divergent trends of the value of gold by reference to the transportation costs of commodities and the existence of non-transportable commodities.^*55

Wheatley held that in the absence of tariff barriers "corn and manufactures...would always be brought, or have a constant tendency to be brought to the same proportion and price in all countries, with the exception of the charge of transit between them. A difference to the extent of this charge might always exist; but if trade were open, the difference in the price of corn and manufactures, in any two countries, could never exceed the expense of bringing in the one and taking out the other."^*56

The classical school and its important followers all held the same views on this point: after allowance for transportation costs, the market prices of identical transportable commodities must everywhere be equal or tend to be equal when expressed in or converted to a common currency.^*57 When, therefore, critics of the classical theory have taken it to task on the ground that it explained the adjustment of international balances by the influence on the course of trade of divergent market prices in different markets of identical transportable commodities,^*58 or when followers of the classical theory have attempted to defend it although themselves giving it such an interpretation,^*59 they have misinterpreted the classical doctrine.

When costs connected with transportation, including tariff duties as such, are taken into account, prices in two markets for identical commodities can vary independently of each other within the limits of the transportation costs in either direction between these markets, except as a connection of both markets with a third market may impose narrower limits. Assuming only two markets, A and B, a cost of transportation from A to B of m, and from B to A of n, and a technological possibility of the production of the commodity in either A or B, and it is possible, (1) when P_a is the price in A, for the price in B to be anywhere from P_a+m to P_a-n, and (2) when P_b is the price in B, for the price in A to be anywhere from P_b+n to P_b-m. If the commodity is regularly moving from one market to the other, the price in the buying market must obviously be higher than the price in the selling market by exactly the cost of transportation, but the possibility of reversal of direction of movement, or of cessation or initiation of movement because of substitution in one country of domestic production for import or of import for domestic production, makes the double-transportation-cost range of possible relative variation in price potentially of practical significance.^*60

It may be objected that some difference, slight though it may be, must exist between the market prices of identical commodities in different regions, even in the absence of transportation costs, if there is to be any inducement to move the commodities from one region to the other. This is not true, however, with respect either to intranational or to international trade. When there is no intermediary between buyer and seller, the selling price and the buying price, f.o.b., are the same price whether the buyer is here or abroad. The only difference in price necessary to induce export from A to B of a particular commodity, transportation costs being assumed to be zero, is an excess in the actual or potential supply price at which B can procure the commodity from any source other than A in the quantities required by B over the price at which it can be procured from A.

Such changes in relative sales prices of identical commodities in different markets as may occur within the limits of the transportation costs and may result in the complete cessation or initiation of movement, or in a reversal of the direction of movement, of the particular commodities affected, can ordinarily be a minor, but only a minor, factor in bringing about adjustments of the course of trade to disturbances of moderate duration such as international loans. It is relative changes in the supply prices of identical commodities as between different potential sources of supply, and, above all, relative changes in the actual sales prices of different commodities which, through their influence on the direction and extent of trade, exercise a significant role in the mechanism of adjustment of international balances.

V. THE "TERMS-OF-TRADE" CONCEPT

In the classical theory, the discussion of the role of variations in prices in the mechanism of adjustment of international balances relates not to relative variations in prices of identical commodities in different markets, but to relative variations in prices of different commodities in the same markets, and primarily to relative variations in prices as between export and import commodities. It concerns itself, therefore, with the effect of disturbances on what are now called the "terms of trade." Changes in the terms of trade were discussed, however, with reference to two essentially distinct though related problems; first, their role in the mechanism of adjustment and, second, their significance as measures of gain or loss from foreign trade. It is only the former of these problems that concerns us in this chapter.^*61

The most familiar concept of the terms of trade measures these terms by the ratio of export prices to import prices, what Taussig has called the "net barter terms of trade," and I prefer to designate as the "commodity terms of trade." The classical economists, however, had also another concept of terms of trade, for which they tacitly accepted the commodity terms of trade as an accurate measure, so that they used the two concepts as quantitatively identical although logically distinct. This second concept, which I would designate as the "double factoral terms of trade," is the ratio between the quantities of the productive factors in the two countries necessary to produce quantities of product of equal value in foreign trade.

From Hume on, there was general agreement that some or all types of disturbances in international balances would result in changes in the terms of trade, and that these changes would contribute to the restoration of equilibrium. As has been shown, Hume held that a relative change in the quantity of money in one country as compared to other countries would result in a rise in the prices of its products relative to the prices of foreign products, until, as the result of the influence of this relative change in prices on the course of trade and on the flow of specie, the "level of money" had again been equalized internationally. This was almost universally accepted doctrine during the next century. Thornton and Malthus claimed, with Wheatley and Ricardo dissenting, that a similar change in relative prices would occur and would operate to restore equilibrium in the balance of payments when it had been disturbed by a crop failure or the remittance of a subsidy, and this also came to receive wide acceptance, under the erroneous designation of the "Ricardian theory." Ricardo conceded, however, that there were some types of disturbance in an existing international equilibrium other than those originating in the currency which would affect the terms of trade, and he specified an original change in the relative demand of two countries for each other's products and a tariff change as disturbances of this sort.^*62 There is ground for distinguishing in this connection between different types of disturbances, and Ricardo's distinctions have some measure of validity. In the account which follows of later treatments of the question, only the historically most important controversies are referred to.

Irish Absenteeism.

The economic consequences for Ireland of the absenteeism of Irish landlords was a burning issue in the eighteenth and nineteenth centuries and gave rise to extensive discussion. The Irish complaints against absenteeism often rested on mercantilist arguments to the effect that the remittance of the rents abroad represented an equivalent loss of specie to Ireland. The English classical economists, notably McCulloch, tended to be satisfied that when they had demonstrated that the remittances were ultimately transferred in the form of goods rather than in specie they had also demonstrated that absenteeism was not economically injurious to Ireland. An early instance of this argument follows:

When it is considered that, if in the natural order of things, undisturbed by such a measure as the restriction on specie, the remittances to absentees, by causing a balance of pecuniary intercourse against Ireland, would force an export from thence wherewith to pay it, and restore the level, it may be fairly concluded that the absentees, by bringing over their money to England, force the manufacture or produce to follow them, which, but for their coming, they would necessarily have caused to be used at home, the only difference is, that the produce or manufactures which their incomes naturally promote, would come to be consumed or used in England, in the stead of being consumed or used in Ireland; and thus the encouragement to the productive industry of Ireland may be said to operate in both cases...^*63

Longfield^*64 introduced into the controversy the question of the effect of absenteeism on the Irish terms of trade, apparently for the first time in print.^*65 He insisted that it was important to examine whether the increase in Irish exports resulting from absenteeism took place "in consequence of a diminished demand [for Irish products] at home, or an increased demand abroad," and claimed that the former was the case, because Irish landlords living abroad would not have the same demand for Irish commodities and services as would the same landlords if living in Ireland. In order to induce acceptance of the rents in goods instead of money, therefore, the Irish tenants would have to offer more goods to liquidate their indebtedness to absentee landlords than would be necessary if the landlords lived in Ireland, i.e., there would have to be a fall in the prices of Irish export products relative to the prices of imports.^*66

Tariff Changes.

Torrens's discussion of the effect of a tariff on the terms of trade has already been referred to.^*67 In his basic illustration, Torrens assumed unit elasticities of demand for sugar and cloth in both countries, production of sugar only in Cuba and of cloth only in England, and production under conditions of constant costs for both countries, and he concluded that both the commodity and the factoral terms of trade would move in favor of Cuba, the tariff-levying country. His argument was on the whole received unsympathetically by most of the economists of his time, because it seemed to them to undermine the case for free trade.^*68 But their criticisms, in so far as they were deserving of consideration at all, bore only on the conformity of the assumptions to real conditions. Of these criticisms, the most important was the argument by Merivale that if sugar could be produced in England as well as in Cuba, or if a third country which could produce sugar were brought into the hypothesis, the English elasticity of demand for Cuban sugar would be greatly increased, and the shift in the terms of trade in favor of Cuba would in consequence be much lessened in degree.^*69 The only favorable comments on Torrens's argument were by an anonymous writer in the Dublin University magazine,^*70 who may perhaps have been Longfield, and by J. S. Mill, who made the publication of Torrens's The budget the occasion for the publication of his own Essays on some unsettled questions, which had been written some fifteen years before, and of which the first essay presented a similar argument as to the effect of import duties on the terms of trade.

VI. THE PRICES OF "DOMESTIC" COMMODITIES

While the distinction between "domestic" commodities and those entering into international trade dates at least from Ricardo,^*71 and subsequent writers made clear that international uniformity in the prices of identical commodities after allowance for transportation costs was a necessary condition under equilibrium only for "international" commodities,^*72 Taussig was the first to lay emphasis on the significance for the mechanism of adjustment of international balances to disturbances of changes in the level of domestic commodity prices as compared to the prices of international commodities. In 1917, Taussig argued that some of the proceeds of an international loan would ordinarily be directed in the first instance to the purchase of domestic commodities, instead of import commodities. But in order that the loan should be transferred wholly in the form of goods, it was necessary that there should develop an excess of imports over exports equal to the amount of the borrowings, and this could not occur if part of the proceeds of the borrowings continued to be directed to purchases of domestic goods. The increased purchases of domestic goods would raise their prices, however, relative to other commodities, and the rise in prices of domestic commodities as compared to international commodities, as well as the rise in export prices as compared to import prices, would operate to decrease exports, increase imports, sufficiently to effect a transfer of the loan in the form of goods.^*73

In my Canada's balance, I conceded that the increase in means of payment in the borrowing country would, even in the absence of price changes, result in both a decrease in exports and an increase in imports. I claimed, however, that in the absence of price changes and of special circumstances it was to be expected that the borrowings abroad would not disturb the proportions in which the total purchasing power in the borrowing country, including that derived from the loan, would be used in buying domestic and foreign commodities; and I claimed further that without a change in these proportions the direct effect of the transfer of means of payment would not suffice fully to adjust the balance. I held, therefore, that there would have to occur relative price changes of the type postulated by Taussig, namely, for the borrowing country, a rise of export prices relative to import prices and of domestic commodity prices relative to both export and import prices.^*74

To my statement that, in the absence of price changes, it was theoretically to be expected that increase in the amounts available for expenditure by the borrowing country would not result in a change in the proportions in which these expenditures were distributed among the different classes of commodities, it has been objected that "there are ample grounds to dispute this view,"^*75 and that "there is every reason to believe, on the contrary, that borrowings abroad would disturb the proportions."^*76 But this statement was not intended to be a denial of the obvious fact that there were an infinite number of proportions in which the increased funds could conceivably be divided among the three classes of commodities, nor even as an assertion that in the absence of price changes the probability that the proportions in which the expenditures were divided among the three classes of commodities would not be disturbed was greater than the probability that these proportions would be disturbed, i.e., was greater than all the other probabilities combined. The probability that the proportions would be disturbed is obviously infinitely greater than the probability that they would not be. If an indifferent marks-man aims at a distant target, the probability that he will hit the bull's-eye is, on the basis of experience, small. But it is nevertheless much greater than the probability that he will hit any other single spot in the universe, and if a forecast of his shot must be made, the probable error will be minimized if, in the absence of a known bias in his marksmanship or in the conditions governing his shooting, it is forecast that he will hit the bull's-eye.^*77 The assumption that, in the absence of price changes and of known evidence to the contrary, the amounts available for expenditure in each country would after their increase or decrease be distributed among the different classes of commodities in the same proportions as before still seems to me more reasonable than any other specific assumption. It represents what Edgeworth in another connection described as "a neutral condition between two conditions of which neither is known to prevail."^*78 But this assumption was not sufficient to justify such definite conclusions as I drew from it, and in occupying themselves with the assumption instead of with the partly erroneous inferences I based upon it my critics have directed their ammunition at the wrong target.

The existence of domestic commodities affects the mechanism of adjustment only as it affects the manner in which the amounts available for expenditure are apportioned as between native^*79 and foreign products. The assumption of the existence of domestic commodities is not essential to any valid theory of the general mechanism of adjustment of international balances to disturbances; and certainly no quantitative proposition as to their importance relative to international commodities need be incorporated in an abstract explanation of the mechanism. But if "domestic" commodities do exist, certain important consequences ensue, and it becomes necessary to take specific account of them in the analysis. For a commodity to be a "domestic" commodity, be it noted, it is not necessary that its prices be wholly independent of the prices of similar commodities abroad, or of the prices of competitive or of complementary international commodities at home. If this were the case, there could obviously be no "domestic" commodities in a world in which all prices are parts of an interrelated system. It suffices to make a commodity a "domestic" commodity if it ordinarily does not cross national frontiers and if its price is not tied directly to the prices of similar commodities abroad in such manner that there is always a differential between them approximating closely to the cost of transportation between the two markets.^*80

That in the United States, for instance, there is an extensive and important range of commodities (including services) available for purchase whose prices are capable of varying within substantial limits while the prices of identical or similar products or services in other countries remain unaltered, seems to me so obvious that it would not require restatement had it not been disputed. One writer^*81 has claimed, however, not only that the existence of a substantial range of domestic commodities is a vital assumption of the ordinary theory of the mechanism but that such an assumption is contrary to the facts. But the evidence he offers in support of his argument consists only of an irrelevant demonstration that the prices in different markets of identical commodities actually moving in international trade in constant directions are bound together in a close relationship.

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.^*82

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.^*83He 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.^*84 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,^*85 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.

WILSON'S EXAMPLE I: NO PRICE CHANGES NECESSARY
Commodity	Paying country		Receiving country
	Purchases before payment	Purchases after payment if no price changes occurred	Purchases before payment	Purchases after payment if no price changes occurred
P...	60	54	30	36
Dp...	...	...	...	...
Dr...	...	...	...	...
R...	30	27	15	18
Total...	90	81	45	54

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."^*86 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."^*87

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.

WILSON'S EXAMPLE IV: TERMS OF TRADE MOVE AGAINST RECEIVING COUNTRY
Commodity	Paying country		Receiving country
	Purchases before payment	Purchases after payment if no price changes occur	Purchases before payment	Purchases after payment if no price changes occur
P...	20	18	30	31
Dp...	40	36	...	...
Dr...	...	...	210	217
R...	30	27	30	31
Total...	90	81	270	279

To an objection to his analysis made by some unspecified person^*88 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.^*89 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,^*90 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.^*91 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.^*92 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,^*93 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,^*94 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;^*95 (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."^*96 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."^*97