We have now managed to marshal practically all the data which we need to acquire understanding of the individual parts of the economic process. By making a number of simplifying assumptions, in particular, that the social division of labor and the price system are the dominant features of the economic system and that we are concerned with a “closed economy” (one, i.e., without foreign trade), we may picture the operation of the economy in global terms as follows. There is, first, production in the broad sense of that activity which makes available the largest quantities and most numerous kinds of goods possible. Following our previous assumption, this total output is then exchanged on the several markets and its value determined by means of price formation (circulation of goods). The formation of prices, in turn, determines by way of the formation of income that share of the total output which accrues to each individual (distribution). Finally, these shares are used or consumed by the individual economic units. What we have done thus far is to list the several parts of the economic process in their logical order, a procedure which does not imply their successive occurrence in time. We do not suggest, for example, that during a given period of time goods are produced, are later apportioned to the recipients by circulation and distribution, and are finally consumed. In reality, all of these operations take place simultaneously. The economic process is thus a simultaneous process and one in which all the parts are intimately connected to each other and conditioned by each other. This network—which represents a major difficulty in the understanding of theoretical economics—will become even more apparent in the course of the subsequent analysis.
To simplify our inquiry, we have thus far admitted a number of hypotheses, the first of these being that the total output (gross national product) of the economy equals the total supply of the economy in a given time period. This follows naturally from our admission that the whole of production enters the market. But since the producers buy each other’s products, the gross national product (i.e., total supply) must, in a state of equilibrium, also equal total demand. If in any considerable degree this is not the case, we are then faced with that total disturbance of the economy known as a crisis. It is a truism, moreover, that the gross national product is always equal to the gross income of the economy during the period in question. The latter we may define, initially, as the sum of the various money incomes, incomes which are converted into real goods only by the exchange of “vouchers” acceptable in the “general store” of the national economy; in other words, incomes are converted into goods by market demand. We must, therefore, distinguish between the formation of income and the use of income. But here again we must reckon with the possibility of a twofold disturbance. In the first place, the expenditure (use) of income may be retarded because income earners may hesitate a long time before spending their money (deceleration of the speed of circulation of money, hoarding, deflation) . Secondly, the expenditure of income may not correspond to the actual composition of output. In such case, the producers have produced at cross purposes. In this connection, it is necessary to direct attention to the three ways in which income may be used: (1) to obtain goods for immediate use (consumption); (2) to obtain producer goods for the maintenance of the productive apparatus (replacement); (3) to obtain producer goods for the purpose of expanding the productive apparatus (accumulation of capital). This division of the different kinds of income use must correspond, in a state of equilibrium, to the composition of the national output. Otherwise, we shall again have to reckon with the emergence of a state of disequilibrium (crisis). But this is a discussion we have reserved for a special chapter.
One of the most fruitful results of the above analysis will have been to put us on our guard against regarding any one part of the economic process as autonomous and given. All the components of this process are joined together, all are interdependent: supply and demand, producers and consumers, production and purchasing power, the formation and the use of income. For the beginner, nothing is more difficult than to visualize this total process in concrete terms; nothing is more difficult than the job of making it clear to him and, by the same token, nothing is more important than the understanding of this process.4
The analysis of the total economic process by manipulation of the gross magnitudes of the economy—macroeconomics as it is now termed in contrast to microeconomic theory which will concern us in the following chapter on “Markets and Prices”—is as old as economics itself. Heavy emphasis on macroeconomics is a characteristic mark of the economic thought of recent decades, a result primarily of the experience of the Great Depression (1929-1933). The ever greater refinement of macroeconomic concepts and the rise of a self-contained national income theory has been accompanied, as well, by an increasingly successful use of statistics to measure the actual global movements of the economy in the course of a year. The usefulness of such calculations is undeniable. But there are also unmistakable dangers connected with the use of the new techniques. They can be avoided only where there is awareness of the limitations of this kind of analysis.5
In our analysis of the economic process thus far, we have assumed a “closed economy”; that is to say we have deliberately ignored the actual connection of the domestic economy with the rest of the world. If we now relax this assumption, we find that the domestic economy is joined to the world economy by a multitude of transactions and activities involving the exchange of goods and services, and of a corresponding number of payments made to foreign countries and received from them. This connection may be clearly seen and statistically measured by grouping the various foreign transactions and payments of a nation under several principal headings, somewhat in the manner of a firm’s balance sheet. The balance of payments of a country is so constructed as to show payments (in domestic currency) received from abroad on the plus or credit side of the balance, and payments to foreign countries on the debit or minus side of the balance. The principal categories of such a balance of payments are: (1) the savings account which shows the net total yield (+ or—) of (1) the merchandise account (the “balance of [visible] trade”), (2) the services account (tourism, transportation, insurance, banking services, copyright payments, etc.), (3) the investment income account (dividends and interest received from abroad or paid to abroad), (4) unilateral transfers (receipts or payments); (II) the investment account which shows the total of capital investments by foreigners in the domestic economy and total investments by domestic residents in other countries; (III) the cash account which shows the increase or decrease in a country’s holdings of foreign exchange and/or gold. This yields the following scheme in which the plus or minus sign in each case indicates whether the transaction in question is to be assigned to the credit or debit (active or passive) side of the balance of payments.
I. The Savings Account
1. The balance of trade (visible)
(a) merchandise exports (+)
(b) merchandise imports (–)
2. The services account
(a) services of residents to foreigners, also called “invisible exports” (+)
(b) services of foreigners to residents, also called “invisible imports” (–)
3. The investment income account
(a) dividends and interest received from abroad (+)
(b) dividends and interest paid abroad (–)
4. Unilateral transfers (aid and gifts)
II. The Investment Account
1. Capital imports (+)
2. Capital exports (–)
III. The Cash Account
1. Increase of monetary reserves (–)
2. Decrease of monetary reserves (+)
It is clear that a net surplus yielded by the algebraic sum of the items in any of the above categories may be offset by a net deficit in another category (or categories). Thus in the balance of payments of Switzerland for the year 1959, the large net deficit in the (visible) trade balance was offset by a still larger net surplus yielded by the other items in the Savings Account so that this account as a whole showed a substantial surplus (+ 758 million Swiss francs). This surplus in turn was offset partly by a net debit in the investment account (excess of capital exports over capital imports) and partly in an increase of Swiss monetary reserves. Different was the situation yielded by the West German balance of payments for 1960 in which both the Savings Account and the Investment Account closed with large net credits. The Savings Account was “active” because of the extremely large (favorable) balance of (visible) trade which more than offset the large deficit on services account. The Investment Account yielded a net surplus because of the substantial excess of capital imports over capital exports. The net surplus resulting from the sum of the Savings Account and the Investment Account was offset in turn by a debit on cash account, that is, by a correspondingly large increase in Germany’s monetary reserves (of almost DM 8 billion [about $2 billion]). In this growth of German monetary reserves was reflected the aforementioned (p. 106) “imported inflation.”
It is evident that in the evaluation of the balance of payments position, the greatest caution is indicated. The “activity” or “passivity” of the individual items in the several accounts signify relatively little, as we have seen; what is significant is the net position yielded by the sum of all the accounts. But here too circumspection in passing judgment is required.6 Even to speak of an “active (favorable) or passive (unfavorable or adverse) balance of payments makes for difficulty since such a balance, like a firm’s balance sheet, always balances in the sense that the algebraic sum of the credits and debits necessarily equals zero (for every credit there must be an offsetting debit, and vice versa).
To qualify the balance of payments as active or passive has meaning only to the extent that we abstract from the balance of payments as an accounting device and omit certain accounts (the offsetting ones) in order to focus attention on the disposition of others. Customarily, the cash account is neglected in determining whether the balance of payments is active or passive; it is said to be active (or in surplus) when the algebraic sum of all the accounts except the cash account yields a net surplus, and passive (or in deficit) in the converse case in which the sum of all the accounts except the cash account yields a net deficit. Alternately, one may focus attention solely on the cash account, qualifying the balance of payments as active when monetary reserves increase and passive when they decline. But even here it is not necessarily true that an active balance of payments is something good and a passive balance something bad. Indeed, an active balance of payments can represent a danger for the economy as shown in the example of the imported inflation in West Germany and in other European countries at the present writing (1962). Conversely, a passive balance of payments of a certain duration and amount can serve to restore a disturbed equilibrium of international payments.
It is under no circumstances permissible, however, to see in an active balance of payments the proof of the riches and capital wealth of a country nor in a passive or deficitary balance of payments proof of the poverty and capital insufficiency of an economy. The activity or passivity of the balance of payments involves merely the external equilibrium of an economy (which is, in turn, primarily dependent on monetary factors), not the quantity of commodities and real capital of which it disposes. For years West Germany achieved balance of payments surpluses because it was a comparatively cheap country, but West Germany was made not one penny richer on that account. The United States has suffered for years from a balance of payments deficit, thanks chiefly to the wage policies of American labor unions, and has become a comparatively expensive country. But the United States is today far richer than it was when the world still suffered from a “dollar shortage.” France, too, was not poor and insolvent because it suffered from a passive balance of payments thanks to the financial mis-economy of the Fourth Republic. And France did not become rich and solvent overnight merely because the De Gaulle government changed the international value of the franc, put an end to inflation, and thereby converted the balance of payments deficit into a surplus.