The Adjustment Problem

The Adjustment Problem

The essence of the adjustment problem is that every policy of adjustment generates economic costs.

Insofar as the efficiency objective is concerned, the challenge to the monetary order is to minimize these economic costs .

As the consistency objective is concerned, the principal challenge is to minimize conflict over the burden or privilege of taking action to initiate the adjustment process.

If the former challenge is a tough one, these latter two are even tougher.

These latter two challenges are not identical.

Taking action to initiate the adjustment process is not the same as bearing the costs of adjustment. The 'responsibility' for taking action may or may not be freely chose; it may be imposed by circumstances--- say, if a deficit country is running out of reserves.

But whether freely chosen or not, it need not always impose real economic costs on a country.

Initiating the adjustment process is clearly a burden in dilemma situations if only expenditure-changing policies are available.

Then, if the deficit country acts first to eliminate the payments disequilibrium by tightening monetary and fiscal policy, it will necessarily suffer an even greater rate of unemployment.

If it is the surplus country that acts first by loosening monetary and fiscal policy, it will an even greater rate of inflation.

But if expenditure-switching policies are available in such situations, the responsibility for taking action may actually turn out to be a privilege.

Say, if states the option of exchange rate change, which is by definition a substitute for a more direct realignment of domestic incomes and prices.

Currency devaluation, or revaluation can actually serve to transfer much of the economic costs of adjustment to other countries.

An upward movement of the change rate by the surplus country, for instance could enable it to avoid much additional inflation at home by contributing to price (cost) inflation in the deficit country.

A downward movement of the exchange rate could enable it to avoid much additional unemployment at home by contributing to resource unemployment in the surplus country.

And the same point applies equally to other disequilibrium situations. There is no direct correlation between the distribution of adjustment responsibilities and the allocation of adjustment costs.

Hence the embody the weaknesses as well as the strengths of the economists' traditional analytical approach.

As guideposts to the maximization of global welfare, they are particularly useful, especially insofar as their authors are careful to take explicit account of the various subjective elements inherent in codes of this kind.

But as organizing principles for real-world monetary relations, the usefulness of these codes is considerably diminished, since they ignore the equally fundamental problem of the distribution of economic welfare and decision making authority.

They fail to address the issue of how to minimize controversy over allocation of the collective costs of adjustment and the responsibility for taking action.