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    "ocrText": "The original documents are located in Box B2, folder \"Balance of Payments (3)\" of the\nArthur F. Burns Papers at the Gerald R. Ford Presidential Library.\nCopyright Notice\nThe copyright law of the United States (Title 17, United States Code) governs the making of\nphotocopies or other reproductions of copyrighted material. Gerald R. Ford donated to the United\nStates of America his copyrights in all of his unpublished writings in National Archives collections.\nWorks prepared by U.S. Government employees as part of their official duties are in the public\ndomain. The copyrights to materials written by other individuals or organizations are presumed to\nremain with them. If you think any of the information displayed in the PDF is subject to a valid\ncopyright claim, please contact the Gerald R. Ford Presidential Library.\nBOARD OF GOVERNORS\nOF THE\nFEDERAL RESERVE SYSTEM\nOffice Correspondence\nDate March 25, 1971\nTo\nChairman Burns and Governor Brimmer\nSubject: Paper on the Balance-of-Payments\nFrom Ralph C. Bryant RCB\nImpacts of the U.S. Capital Controls\nI am attaching with this note a draft of the paper on capital\ncontrols which we have been preparing. Before leaving for Paris, Mr. Solomon\nand I agreed we would try to get a draft to you this week. We are planning\nto make final revisions in the paper on Monday, March 29th after Mr. Solomon\nreturns. If you feel it would be appropriate, you might then want to send\nthe paper on to Mr. Peterson at the White House for circulation to the\nmembers of the Council on International Economic Policy. In Mr. Peterson's\nmemorandum to the Council, a copy of which you have, comments on the OMB paper\non this subject were requested by March 30th.\nFORD & LIBRARY GERALD\nCONFIDENTIAL (FR)\nDO THE RESTRAINTS ON U.S. CAPITAL\nOUTFLOWS IMPROVE THE\nBALANCE OF PAYMENTS?\nDraft\nMarch 25, 1971\nSpecial Studies Section\nDivision of International Finance\nBoard of Governors of the Federal Reserve System\nFORD & LIBRARY GFRALD\nTable of Contents\nPage\nIntroduction and Summary\n1\nI. International Economic Interrelationships\n5\nII. How Much Do We Know About International Capital Flows?\n9\nIII. Judgmental Estimates of the Effects of the U.S. Capital\nControl Programs\n16\nA. Gross Savings on Capital Outflows Covered by the\nPrograms\n16\nInterest Equalization Tax\n16\nVoluntary Foreign Credit Restraint\n18\nForeign Direct Investment Program\n21\nB. Leakages Offsetting the Gross Savings\n25\nForeign Purchases of U.S. Securities\n25\nErrors and Omissions\n26\nForeign Holdings of Liquid Assets in the United States\n28\nExport Performance\n30\nOther Leakages\n31\nIV. A Brief Comment on the OMB Paper: \"Capital Controls:\nQuestionable Results and Undoubted Costs\"\n32\nAppendices:\nA. Potential Leakages via Reduced Foreign Purchases of U.S.\nCorporate Securities\n35\nB. A Comment on the CPR Report: \"Federal Control of Foreign\nDirect Investments\"\n39\nC. A Comment on Research by Arthur B. Laffer on Short-term\nBank-Reported Capital Movements\n42\nD. Annotated List of References\n43\n-\nFORD & LIBRARY GERALD\nCONFIDENTIAL (FR)\nINTRODUCTION AND SUMMARY\nThere are good grounds for believing that the restraints\non certain types of capital outflows from the United States -- the\ninterest equalization tax (IET), the voluntary controls on banks\nand other financial institutions (VFCR), and the controls over\ndirect foreign investment of U.S. companies -- have held such flows\nsubstantially below the levels they would have reached in the absence\nof the restraints.\nThe restraints have been effective in limiting the specific\ncapital outflows at which they are aimed in good part because they\nreinforce one another. Moreover, they undoubtedly have had a greater\nimpact in limiting these capital outflows during periods of monetary\nease in this country than during periods of tight monetary conditions.\nThe effect of the capital controls on the overall balance\nof payments, however, is not so clear. The gross balance-of-payments\n\"savings\" in outflows of U.S. capital affect monetary conditions\nand economic activity here and abroad. Those effects, in turn,\ninfluence the flow of foreign capital into the United States and may\nalso lead to changes in trade and other elements of the current\naccount. Specifically, the limitation on outflows of U.S. capital\ntends to tighten monetary conditions abroad relative to conditions\nthat would otherwise prevail, thereby reducing some foreign capital\nflows into the United States. Moreover, the restriction on U.S.\nFORD is LIBRARY GERALD\n- 2 -\ncapital outflows could limit the availability of trade credit and\nthereby result in some loss of U.S. export business. Still more\nindirectly, the restraint on capital outflows may cause GNP (nominal\nif not real) in other countries to be less than otherwise and thus\nreduce the demand for U.S. exports.\nStatements about the degree to which gross balance-of-payments\nsavings resulting from reductions in controlled U.S. capital outflows\nare counteracted by \"leakages\" -- by outflows of uncontrolled U.S.\ncapital, by the reductions in inflows of foreign capital, and by\nthe loss of export business -- involve very large elements of judg-\nment. The systematic exploration of structural relationships in the\ninternational economy lags far behind the investigations of behavioral\nrelationships underlying domestic economic activity, and the effort\nsuffers from severe data deficiencies. There are therefore firm\ngrounds for humility in expressing judgments. Our belief is that\noffsets to the gross savings in the form of leakages, while signifi-\ncant, are not complete. We do believe that the programs yield a\nbalance-of-payments gain.\nThe data do not give clear support to an argument that un-\ncontrolled forms of U.S. capital outflow have been larger than they\nwould have been in the absence of controls; these flows (nonbank\noutflows not covered by the programs, and also net errors and omis-\nsions) are dominated by shifts in relative monetary conditions between\nhere and abroad and by other influences unrelated to the controls.\nwith\nFORD i LIBRARY GERALD\n- 3 -\nThe evidence is relatively strong, moreover, that U.S. exports were\nnot hampered directly by limitations on capital outflows. With\nrespect to inflows of foreign capital, it is particularly difficult\nto make a judgment about the gap between what actually occurred and\nwhat might have occurred in the absence of the capital restraints.\nThere is no strong evidence suggesting either that the gap was large\nor that it was small. Concerning the still more indirect leakages\narising through the general effects of the U.S. controls on economic\ndevelopments abroad, there is no empirical basis for a judgment.\nOur judgment concerning these most indirect consequences rests on a\ntheoretical view of the functioning of the international system in\nthe contemporary environment.\nIn the next section of the paper, we summarize that view of\ninternational economic relationships and their implications for the\nbalance-of-payments consequences of the restraints on capital outflows.\nSection II is a brief appraisal of the current state of knowledge\nconcerning the structural relationships between national economies.\nWe review in Section III some of the empirical evidence that can be\nbrought to bear on the issue. Several appendices deal in more detail\nwith various subtopics. Finally, in Section IV, we include a brief\ncritical comment on a recent paper on this subject prepared in the\nOffice of Management and Budget.\nThis paper does not attempt to deal with the broader and\nstill more difficult question of whether the various costs associated\nGERALD FORD LIBRARY\n- 4 -\nwith the U.S. capital controls exceed any benefits. We do not\nexpress judgments about this broader question, and would not wish\nreaders to infer such judgments. We have deliberately restricted\nourselves here to the narrower question of whether the programs\nhave a net positive effect in improving the balance of payments.\nFORD is LIBRARY GERALD\n- 5 -\nI. International Economic Interrelationships\nThe extent to which the gross savings in outflows of U.S.-\nowned capital owing to the restraints result in a net gain in the\noverall balance of payments depends on the effects that outflows\nhave on monetary conditions abroad and on the responses of private\ndecision-makers and government policy-makers. The policy responses\nabroad, in turn, depend upon national economic developments and\nprospects, especially rates of resource use and degrees of price\npressures. The net effects of capital outflows on the U.S. balance\nof payments, in other words, depend a great deal on whether other\nindustrial countries wish to have policies of expansion or policies\nof restraint and the extent to which they are able to implement\ntheir policy goals. Responses in the private sector initially are\ninfluenced by portfolio preferences. The belief that assets denom-\ninated in different currencies are not perfect substitutes and that\nportfolio preferences abroad differ from those in this country\nunderlies the analysis below.\nOne way to view the process is to contemplate what would\nhave developed had the recent shift toward ease in monetary conditions\nin the United States occurred in the absence of any capital controls.\nTo begin with direct investment, a larger proportion of U.S. business\noutlays abroad in recent quarters would have been financed from U.S.\nsources. This difference in the source of financing would appear in\nthe balance of payments as an increase in direct investment. With\nGERALD FORD LIBRARY\n- 6 -\nthe passage of time, there also would be a stock adjustment as matur-\ning issues of U.S. corporations held abroad were replaced with issues\nin the United States. In the same way, the sale of foreign securi-\nties to U.S. investors would have been greater in the absence of\ncontrols in the environment of easy monetary conditions in the United\nStates.\nGiven the large shift in the locus of demands for long-term\ncapital that would have occurred without controls, the stimulus for\nlower interest rates in foreign capital markets would have been\ngreater than it has been; at the same time, the decline in long-term\nrates in the United States would have been somewhat retarded. Never-\ntheless, interest rates in the United States would have declined\nrelative to those abroad -- given that foreign monetary authorities\nwere not also implementing policies of active ease. The re-alignment\nin interest rates in the absence of controls would have induced\nboth American and foreign investors to alter their portfolios of\ndebt securities in favor of foreign instruments, thereby augmenting\nthe outflows of capital from the United States.\nIn the absence of the VFCR, the easing in monetary conditions\nin the United States would have induced the same sort of consequences\nthrough an expansion in bank credit to foreigners. In the short-term\narea, however, the stock adjustment in response to the changed interest-\nrate relationships between here and abroad can be accomplished much\nmore quickly, producing a substantial outflow promptly.\nGERALD R. FORD LIBRARY\n- 7 -\nThe additional capital outflows in the absence of the\ncapital controls would have tended to increase directly the money\nsupply in other industrial countries still more than the actual out-\nflows have done, and they also would have tended to increase bank\nliquidity still more and provided the basis for a larger secondary\nexpansion in credit and money. If this had been allowed to occur --\nif the foreign authorities had made no effort to neutralize the\ninflows of funds -- interest rates abroad would have been under still\ngreater downward pressure. The differential in interest rates be-\ntween the United States and foreign countries would have been smaller,\nbut this would have been the result of larger net outflows of funds\nfrom the United States than actually occurred.\nOver time, the process would have produced some balance-of-\npayments offsets to the augmented capital outflows. The easier\nmonetary conditions induced in other industrial countries would have\nexpanded their demands for U.S. goods and services. Also, working\ncapital requirements abroad would have been greater, and some portion\nof foreign working capital is held in dollars. To the extent that\nthe additional capital outflows from the United States would have\nbeen accompanied by expansion in private foreign demands for short-\nterm dollar assets, the rise in the U.S. official-settlements deficit\nwould have been tempered. The induced expansion in foreign demand\nfor goods and services occurs with some lag, however, and in the\ninterim the absence of capital controls during the process of easing\nM\nFORD is LIBRARY GERALD\n- 8 -\nmonetary conditions in the United States would have augmented the\ndeficit in the U.S. balance of payments.\nHow the process would have worked in fact would have been\nstrongly influenced by the policy responses abroad. To the extent\nthat the authorities would have been successful in neutralizing the\nadditional inflows of funds -- in retarding the monetary expansion\nand declines in interest rates -- the balance-of-payments offsets to\nthe additional outflows of U.S. capital would have been prevented\nfrom developing.\nThe augmented outflows of funds in the absence of the con-\ntrols would have been in addition to the large repayments of U.S.\nbank borrowings from the Euro-dollar market that have occurred and\nhave been reflected in the extraordinary U.S. official settlements\ndeficits. Moreover, the augmented outflows from the United States\nwould have occurred when other industrial countries already were\nexperiencing boom conditions and inflationary pressures. The ad-\nditional expansive effects on their economies would have been totally\nunwanted. Indeed, even the effects of the repayment of the Euro-\ndollar borrowings were unwanted and interfered with the policies that\nthe foreign authorities wished to follow. In the circumstances,\nadditional outflows of U.S. capital would have generated offsets in\nthe current account chiefly by raising nominal rather than real GNP\nin other industrial countries. It would have done so, in other words,\nby accelerating the rates of inflation abroad.\nFORD & LIBRARY GERALD\n- 9 -\nII. How Much Do We Know About International Capital Flows?\nWe have emphasized that reductions in the outflow of U.S.-\nowned capital brought about by the programs will have induced some\noffsetting flows in other balance-of-payments accounts. We have\nalso noted that since financial instruments are not perfect substi-\ntutes and international capital and goods markets are not fully\nintegrated, it seems likely that offsetting flows, while probably\nimportant, would be only partial. What would we need in order\nadequately to judge what part of gross balance-of-payments savings\nowing to the controls are lost in \"leakages?\"\nIn principle, it would be necessary to specify and estimate\na full model of the international economy. We would require demand\nand supply equations for each financial instrument which would re-\nflect the extent of the international interdependencies between\nnational money and capital markets. Thus, the model would even re-\nquire a complete elaboration of the markets for those financial\ninstruments issued and held entirely domestically since conditions\nin these \"domestic\" markets would impinge on the decisions of those\nindividual transactors who hold and those who issue \"international\ninstruments.\" Moreover, the model would have to embody the relation-\nships between international capital flows, economic activity levels\nin the important industrial countries, and merchandise trade flows.\nIn sum, we would need a set of highly elaborated macroecon-\nomic models for the major industrialized countries, with fully\nFORD i LIBRARY GERALD\n- 11 -\ndeveloped linkages between the real and financial sectors, and a\nwell articulated international sector linking the national models\ntogether. Clearly, such a project is not feasible in the foreseeable\nfuture.\nWhen evaluating such evidence as does exist on the effects\nof U.S. capital controls, it is important to realize just how far we\nare from having such a model of the world economy. In the first place,\nwe do not even have the necessary econometric models for the major\nindustrial countries. Many of the models which do exist do not even\nhave a link between domestic financial variables and the domestic real\neconomy. Virtually none attempts to explain international transactions\nother than the current account items.\nGiven this state of affairs, we obviously cannot produce\ndirect empirical evidence as to whether or not controls on capital\noutflows are partially offset through changes in the level of economic\nactivity abroad that reduce the United States' trade balance. But as\nwe have noted in Section I, this depends essentially on the ability\nand desire of foreign authorities to pursue independent monetary\npolicies. It might be possible to draw some inferences from investi-\ngations of the institutional factors affecting the ability of foreign\nauthorities to pursue independent policies. While some work along\n1/ Producing just such a model is the long-run objective of Project\nLINK, a study financed through the Social Science Research Council\nand under the direction of Lawrence Klein, Aaron Gordon, Bert Hickman,\nand Rudolph Rhomberg. Project LINK is at the present time only in its\ninitial stage. Not even its most enthusiastic proponents would claim\nthat its long-run objective could be attained for many years.\nFORD i LIBRARY GERALD\n- 12 -\nthese lines has been attempted, it is fair to say that the question\nof the degree to which independent policies can be pursued abroad\nmust be considered open.\nThe main reason why international capital flow equations do\nnot appear in any of the existing econometric models is simply that\nrelatively little work has been done in estimating such equations.\nIt is a common complaint of all empirical researchers that they are\nhandicapped by a lack of appropriate data. In this area, the con-\nstraint is especially severe. Data are often collected by national\nagencies on non-comparable bases and much of the data are held con-\nfidentially. Moreover, there are important unobservable variables\nwhich play a crucial role in determining capital flows, especially\nexpectations about interest rates and exchange rates.\nThere is also a clear need for fundamental improvements in\nthe theory of international capital flows. It is only recently that\nthe basic elements of domestic monetary and capital markets theory\nhave been applied to international flows.\nA very serious problem that remains to be solved is the\nappropriate treatment of non-price credit rationing, particularly\ncapital controls imposed by national authorities. Capital controls\nintroduce a \"wedge\" between desired flows and actual flows. A\nfrequently employed technique in studies that have tried to estimate\nthe quantitative effects of capital flow restraints is the introduc-\ntion of an additional (\"dummy\") variable which differentiates the\npre-control and post-control periods. However, this technique assumes\nGERALD FORD LIBRARY\n- 13 -\nthat the effects of the programs are uniform throughout the period\nof their imposition, allowing no scope for gradual adjustment by\ntransactors to the controls or to modifications of the controls by\nthe authorities. When the effective impact of the programs varies\nover the sample period, the \"dummy variable\" approach can be seriously\nmisleading.\nThe \"learning by doing\" phenomenon is especially important\nfor estimating the net impact of the capital control programs. Leak-\nages will likely become increasingly important with the passage of\ntime. In the present context, this points up the necessity for\nestimating the lags in behavioral responses. The time path of ad-\njustments by transactors in other markets in response to the imposi-\ntion of controls in one market is virgin territory for both the\ntheoretician and the empiricist.\nThe preceding discussion has pointed out a few of the more\nimportant difficulties in estimating elements of the \"ideal model.\"\nWe wish to re-emphasize the central point that a thorough understand-\ning of the impact of the capital control programs is contingent upon\nthe availability of a complete model. The interrelationships between\nvarious capital markets and between capital markets and real economic\nactivity must be explicitly dealt with.\nThis point is well illustrated by considering one of the\nempirical studies cited in a recent paper of the Office of Management\nAM\nFORD : LIBRARY GERALD\n- 14 -\nand Budget. / The cited paper, written by Richard N. Cooper, was\nspecifically addressed to the time period when only the IET was in\neffect. There is general agreement that the leakages were extremely\nlarge at that point. This was clearly recognized and led to a more\ncomprehensive set of controls. In a more recent unpublished paper\nCooper summarized his judgment on the gross savings and on the\nprobable magnitude of offsetting leakages. He concluded that the\npresent elements of the comprehensive set of restrictions are rein-\nforcing and they have had a significant net impact on the balance-of-\npayments.\nCooper's paper, and all others of which we are aware, have\nattempted to estimate the impact (gross or net) of the control pro-\ngrams on the actually observed, historical data. Needless to say,\nthis historical analysis by itself is insufficient for our purposes.\nSince, as the analysis of the preceding Section suggests, the effective\nimpact of the restraints will vary with our cyclical position, we\nalso want to know (a) what the impact of the programs would have been\nif we had been more successful in having the economy grow along a\nnon-inflationary, high-employment growth path, and (b) what the impact\nof the programs would be in the future, given a wide variety of alter-\nnative assumptions about domestic and foreign economic activity.\n1/ OMB paper entitled \"Capital Controls: Questionable Results and\nUndoubted Costs,\" March 2, 1971 (Mimeo). We discuss the other two\nstudies cited by the OMB paper in appendices.\n2/ Richard N. Cooper, \"The Voluntary Credit Restraint Program: An\nAssessment,\" January 1969, theunpublished paper prepared for/meeting of\nAcademic Consultants at/Federal Reserve Board.\nFORD & GERALD LIBRARY\n- 15 -\nHow much do we know about international capital flows?\nThe profession has barely begun to tackle the job. The evidence\nthat does exist is sparse. Even tentative conclusions on what the\neffects of the United States capital control programs have been\nare no more than informed guesses.\nFORD i LIBRARY GERALD\n- 16 -\nIII. Judgmental Estimates of the Effects of the\nU.S. Capital Control Program\nWe try in this section to bring together some information\nrelevant to an analysis of the capital controls and to make some\njudgmental estimates of how large the gross balance-of-payments savings\nand the offsetting leakages may have been. We put forward these\njudgments with genuine hesitation. Although we believe our judgments\nare as reasonable as can be made given the present state of knowledge,\nwe are mainly impressed -- as emphasized in the last section -- with\nthe inability of anyone to make judgments that are clearly valid.\nA. Gross Savings on Capital Flows Covered by the Programs\nInterest Equalization Tax. The IET has been imposed on U.S.\npurchases of foreign securities since mid-1963 and on long-term bank\nlending since February 1965.\nThe IET induced a sharp reduction in U.S. purchases of\nforeign new issues, as suggested by Table 1. The annual average of\nthese purchases fell by $177 million between 1962-63 and 1964-65, and\nan additional $58 million between the latter period and 1966-69. The\nseverity of the reduction in 1964, shown in Table 1, is probably\nattributable to the availability in that year of untaxed bank loans\nas substitutes for security issues. With the extension of the IET\nto long-term bank loans in 1965, and also the inception of the VFCR,\nnew security issues rose. The reduction of new issues in 1966 and\nFORD i GERALD LIBRARY\n- 17 -\nsubsequent years from the 1964-65 average appears to be attributable\nto the relative tightness in the U.S. market for long-term capital.\nThus for new issues alone, the gross savings that can be attributed\nto the capital controls seems likely to be well under $200 million\nper year on average.\nTable 1\nU.S. Purchases of Foreign Securities Newly Issued in the United States\nby European Countries, Australia, New Zealand and South Africa.\n1960\n1961\n1962\n1963\n1964\n1965\n1966\n1967\n1968\n1969\n24\n57\n195\n289\n35\n95\n15\n-\n-\n14\n/ Japan is excluded because Japanese new issues were partially\nexempted from the IET. The 1965 exemption of $100 million was con-\ntinued for several years, but was not fully utilized because of rising\nU.S. interest rates.\nIn the face of the IET, American net purchases of outstanding\nforeign equities reached a cumulative total of only $1/4 billion\nduring the 1963-70 period. Suppose that in the absence of the IET,\nAmericans would have wanted to allocate a roughly constant proportion\nof their equity portfolios to foreign equities. This assumption\nimplies that substantial net purchases of foreign equities, possibly\n1/ Net purchases of outstanding bonds were negligible. Net U.S.\npurchases of Japanese equities in 1969 were very large and more than\noffset net U.S. sales of foreign equities during most of the 1963-70\nperiod. At the end of 1969, Japanese long-term assets were brought\nunder the VFCR program for nonbank financial institutions. This\naction has virtually eliminated the flow of funds by U.S. institu-\ntional investors into Japanese equities.\nGERALD FORD LIBRARY\n- 18 -\nas much as $3-4 billion, would have occurred. A number such as\n$3-4 billion probably represents an upper bound for the cumulative\ngross savings for 1963-70. With or without the IET, of course, net\npurchases would undoubtedly have fluctuated considerably.\nWe have not tried to make estimates of the gross savings\nattributable specifically to the 1965 extension of the IET to long-\nterm bank loans. Total foreign lending of banks is considered under\nthe VFCR program.\nVoluntary Foreign Credit Restraint. The introduction of\nthe VFCR early in 1965, in combination with the imposition of the\nlong-\nIET on banks'/term loans, was associated with a sharp cutback in new\nforeign lending by U.S. banks. The balance-of-payments accounts\nshow that the combined outflow of long-term and short-term bank funds\nfell from an annual average of $1.4 billion in 1960-64 to an annual\naverage of less than $100 million in 1965-69.\nThat the program played a large role in limiting the out-\nflow of bank credit is not contradicted by the continuous existence\nof an apparent leeway for additional lending, as shown in Table 2.\nThe apparent leeway under the ceiling reflects mostly cyclical\nfactors, differences among banks, and bank uncertainty about draw-\n/\ndowns by foreign borrowers.\n1/ Inspection of stock price trends in various countries suggests\nthat U.S. prices rose at roughly the average of foreign price rises,\nbut with less fluctuation.\n2/ See Bernard Norwood, \"Restraining Foreign Credit: Six Year Test,\"\nWharton Quarterly, Winter 1970, pp. 32-37.\nFORD & LIBRARY 9ERALD\n- 19 -\nTable 2\nBanks' Ceilings and Leeway Under the VFCR\n(Millions of dollars, end of year)\n1965\n1966\n1967\n1968\n1969\n1970\nGeneral Ceiling\nAggregate ceilinga/\n9,973\n10,407\n11,069\n9,729\n10,092\n9,956\nApparent leeway\n321\n911\n1,204\n476\n694\n606\nTotal General and Export Term-Loan Ceilings b/\n/\nAggregate ceilings\n9,973\n10,407\n11,069\n9,729\n11,356\n11,379\nApparent leeway\n321\n911\n1,204\n476\n1,939\n1,842\n/ Ceilings are calculated on the basis of the regulations in effect\nduring the given year. There was some liberalization of the guidelines,\neffective January 1, 1967, and January 1, 1968.\nb/ Export Term-Loan Ceiling added in 1968.\nEconometric research on bank lending to foreigners has been\nfraught with problems, many of which have not been satisfactorily\n/\nresolved.\nWith the exception of the studies by Bryant and Hendershott,\nthis research has allowed for the effects of the VFCR only in a crude,\ninadequate fashion. Even Bryant and Hendershott, despite strenuous efforts\nto adapt their equations so as explicitly to reflect the varying impacts\n1/ Appendix D lists some of the references. The studies most\nrelevant here are those by Branson, Bryant and Hendershott, Laffer,\nMiller and Whitman, and Patrick.\nFORD i LIBRARY GERALD\n- 20 -\nof the VFCR regulations, failed to come up with clear-cut\n/\nevidence.\nIf the proportion of foreign loans in the portfolios of\nU.S. banks had been the same at the end of 1970 as it was at the\nend of 1962, foreign loans would have been $16.6 billion instead of\nthe observed figure of $13.8 billion. 2/ This calculation may give\na crude indication of the possible magnitude of the effect of the\nVFCR on the distribution of U.S. bank portfolios. The precise\nimpact of the VFCR at any given time, of course, depends critically\non monetary conditions in the United States relative to those abroad.\nIn recent months, the restraining effect of the VFCR on bank lending\nhas increased considerably compared with its effect during the most\nintense periods of monetary tightness in 1969.\nThe effect of the VFCR on nonbank financial institutions\nis even harder to judge, because of the diversity of such institutions\nand because of potential switches between assets not covered (over $13\nbillion) to covered assets (under $2 billion). One indication of the\n1/ See Bryant and Hendershott, Financial Capital Flows in the\nBalance of Payments of the United States: An Exploratory Empirical\nStudy, Princeton Studies in International Finance No. 25, pp. 31-32,\n48-50, 60-61; also \"Empirical Analysis of Capital Flows: Some\nConsequences of Alternative Specifications,' Forthcoming in Universi-\nties-NBER Volume on The International Mobility and Movement of Capital.\n2/ Foreign loans here include Canadian, which are exempt from the\nVFCR. The year 1962 is taken as a base, because of the surge in\nborrowing in 1963-64 after the IET restricted security issues.\nFORD i LIBRARY GERALD\n- 21 -\neffectiveness of the non-bank program is the virtual cessation of\nU.S. purchases of Japanese equities after such assets were brought\nunder the program.\nForeign Direct Investment Program. This program was\ndesigned to limit outflows of U.S.-owned funds (as they are reflected\nin the balance of payments) to finance U.S. business investment in\nforeign affiliates; it was not the intention to limit the investment\noutlays of those affiliates. The program, it was hoped, would shift\nthe source of financing away from the United States, and it appears\nto have been successful in doing that. One possible indication of\nthe size of gross program savings is given by the amount of funds\nobtained abroad by U.S. parent firms; such financing was virtually\nzero until the advent of the voluntary program in 1965; in 1968 and\n1969 it was more than $2 billion per year. (See Table 3, line 4.2/)\nGross savings are indicated also by the decline in the ratio\nof U.S. -controlled funds to plant and equipment expenditures / that\n/ For example, Guy Stevens found that \"virtually no impact of\nthe various balance of payments program is evident on plant and\nequipment expenditures in manufacturing. \" See his \"Capital Mobility\nand the International Firm,\" Universities-National Bureau Conference\non International Mobility and Movement of Capital, forthcoming.\n2/ These data, from OFDI, are more inclusive than that from OBE,\nsince they include foreign borrowings which are used abroad without\nfirst being remitted to the United States.\n3/ U.S.-controlled funds are defined to include depreciation\nallowances since the latter allows direct investors to make some\nplant and equipment expenditures without recourse either to foreign\nborrowings or U.S. funds. In other words, reinvestment of deprecia-\ntion allowances leaves the book value of foreign affiliates unchanged;\nthus plant and equipment expenditures should be attributed to depre-\nciation allowances as well as to U.S.-source funds and foreign\nborrowing by parent firms.\nGERALD FORD LIBRARY\n- 22 -\nTable 3\nSelected Data on Direct Foreign Investment\n(millions of current dollars)\nFinancial\n1965\n1966\n1967\n1968\n1969\n1. Net capital transfers\n3926\n4386\n4178\n2671\n3720\n2. + Reinvested earnings\n1492\n1692\n1390\n1950\n2325\n3. = Direct investment\n5418\n6078\n5568\n4621\n6045\n4. - Long-term foreign borrowing\nby parent firms b/ and program\nadjustments /\n104\n638\n542\n2161\n2346\n5. = Net use of U.S.-source funds 5314\n5440\n5026\n2460\n3699\n/\n6. + Depreciation\n3686\n4074\n4632\n5265\n5800\n7. + Long-term foreign borrowing\nby parent firms and program\nadjustments\n104\n638\n542\n2161\n2346\n8. = Gross use of U.S.-controlled\nfunds\n9104\n10152\n10200\n9886\n11845\nReal\n9.\nPlant & equipment expenditures 7440\n8640\n9267\n9387\n10787\n/ Program adjustments are offsets to foreign borrowing, such as\nrepayments and indirect capital transfers.\nb/ Excluding Canada, since no data are available. In contrast, other\ndata in this table are worldwide, i.e., all three OFDI schedules plus\nCanada.\nC / Estimated\nSource: Depreciation and plant and equipment expenditures from Office\nof Business Economics; other data from Office of Foreign Direct\nInvestments.\nFORD & LIBRARY GERALD\n- 23 -\nhas occurred as foreign affiliates have relied to a greater extent\non local borrowing (i.e., borrowing by affiliates, in addition to\nforeign borrowing by parent firms). For 1965, this ratio was 1.225;\nfor the 1966-67 period, when the voluntary program specified firm-\nlevel targets, it fell to 1.135. In contrast, the ratio under the\nMandatory Program in 1968-69 was 1.075. If the 1965 ratio had\nprevailed in 1968-69, gross use of U.S.-controlled funds would have\nbeen some $1-1/2 billion greater on average per year.\nThe trend toward greater reliance on local financing is\nconsistent with another set of OFDI data, available for 1967-68\n(See Table 4) For all direct investment outside Canada these\ndata show greater use of local funds during 1968, in relation to\ncurrent assets, than was the case at the beginning of 1968. However,\ncomparable data for Canada (Table 4) showed a similar movement,\nreminding us that other factors probably accounted for much of the\nincreased use of local funds on the part of affiliates.\n1/ U.S. Department of Commerce, Office of Foreign Direct Invest-\nments, Foreign Affiliate Financial Survey 1967-1968 (Washington,\nJuly 2, 1970). Comparable data for 1966 and 1969 are not yet avail-\nable, either from OFDI or OBE.\nFORD is LIBRARY GERALD\n- 24 -\nTable 4\nMajority-owned Foreign Affiliates\nCurrent Assets and Foreign-Source Funds, 1967-68\n(millions of dollars)\nAll Schedules\n1967\n1968\nCurrent assets, end of year\n25,805\n30,406\nForeign debt\n21,909\n26,100\nRatio, foreign debt to current\nassets\n.849\n.858\nCanada\n1967\n1968\nCurrent assets, end of year\n7,649\n8,481\nForeign debt\n5,549\n6,273\nRatio, foreign debt to current\nassets\n.726\n.740\nFORD & LIBRARY 9ERALD\n- 25 -\nThe prima facie evidence is that the Voluntary and\nMandatory Programs had successively larger influences on both\nparent-firm and affiliate financing. / But, of course, part of this\nincreased foreign financing might have occurred even in the absence\nof controls as a result of tighter money in the United States toward\nthe end of the period. 2/\nB. \"Leakages\" Offsetting the Gross Savings\nWhile it is difficult to estimate a possible range of gross\nbalance-of-payments savings generated by the capital controls, it is\neven more difficult to guess at the size of leakages. The difficul-\nties are severe both because of the limited state of our knowledge\n(see Section II) and because offsets can conceivably occur in any\nbalance-of-payments category. In the following subsections we attempt\nto review the evidence available for four categories of transactions\nwhere leakages seem particularly likely to have occurred.\nForeign Purchases of U.S. Securities. An obvious source of\npotential leakages is in foreign purchases of U.S. corporate securities.\nMost directly, the convertible Eurobonds issued by U.S. corporations\n1/ The initial Voluntary Program for 1965 did not involve firm-\nlevel targets, and resulted mainly in the repatriation of head-office\nbalances formerly held in Europe.\n/ A further, albeit indirect, effect of the Mandatory Program on\naffiliate financing may have resulted from a program-induced change\nin the mix of capital expenditures towards LDC's, which in turn\ncaused firms to make a closer match between local-currency assets and\nliabilities.\nFORD & LIBRARY GERALD\n- 26 -\nas a response to the capital controls are undoubtedly a close sub-\nstitute for stocks and bonds purchased by foreigners in New York.\nThere is no convincing evidence that such substitution did or did\nnot take place. (See Appendix A for a more detailed discussion of\nthis potential leakage.)\nDuring the period in which the capital controls were in\nforce, foreign purchases of U.S. securities increased to unprecedented\nrates. They might, it is true, have increased still more in the\nabsence of the controls. The only unambiguously correct statement\nthat can be made about the magnitude of this leakage is that it could\nhave been of any size. We find it implausible to imagine that it\ncould have been in excess of a few hundred million dollars per year\non average.\nErrors and Omissions. Another possible offset to the\nsavings in controlled outflows of capital could have occurred in the\nerrors-and-omissions account in the balance of payments. When that\naccount is unusually large and negative, it is often inferred that\nflows of unrecorded capital are the cause. There is some evidence,\nhowever, that many of the major movements of the errors-and-omissions\naccount can be attributed to forces other than the capital controls. /\nIf unrecorded net outflows of U.S. capital were greater or if\n1/ R. Rickover, \"Interest Rates, Capital Flows, and Errors and\nOmissions in the U.S. Balance of Payments,\" Research Memorandum of\nthe Federal Reserve Bank of New York, March 8, 1971.\nFORD & LIBRARY 938870\n- 27 -\nunrecorded net inflows of foreign capital were smaller than they\notherwise would have been in the absence of the capital controls,\nthis has not been obvious in the actual data for net errors and\nomissions.\nThere appears to be a substantial normal error --\napproaching an annual rate of $1 billion -- reflecting systematic\nerrors in data collection. (See Table 5.) The actual figures vary\nfrom that base because of changes in interest-rate differentials\nbetween here and abroad, quarter-to-quarter changes in imports (the\nrecording of which appears to lag behind payments), and speculative\nmovements of funds from time to time.\nTable 5\nErrors and Omissions\n(Billions of dollars)\n1960\n1961\n1962\n1963\n1964\n1965\n1966\n1967\n1968\n1969\n-1.2\n-1.1\n-1.2\n-0.5\n-1.1\n-0.6\n-0.5\n-1.1\n-0.5\n-2.9\nThe large rise in errors and omissions in 1969, for example,\nwas associated with the sharp increases in interest rates in the\nEurodollar market, which attracted funds of U.S. residents out of\ntime deposits in U.S. commercial banks. There was a substantial circu-\nlar flow of funds, however, as the U.S. banks borrowed back these funds.\nIn fact, the banks' borrowings far exceeded these outflows, with the\nFORD i LIBRARY GERALD\n- 28 -\nresult that the official-settlements balance of payments was heavily\nin surplus. An additional factor contributing to the large figure\nfor errors and omissions in early 1969 was the dock strike.\nForeign Holdings of Liquid Assets in the United States. The\nU.S. capital controls no doubt had some effect on foreigners' demand\nfor liquid dollar assets held in the United States. The growth in\nforeigners' awareness of investment opportunities in the Eurodollar\nmarket in the 1964-70 period, together with the relatively higher\nyields offered on Eurodollar deposits compared with assets of compar-\nable liquidity and maturity in New York, would have constituted\nsubstantial incentives for substituting Eurodollar assets for dollar\nassets held in the United States. Imposition of the capital controls,\nwhich in turn led U.S. banks to multiply the number of their foreign\nbranches and to carry out lending through their branches which might\notherwise have been done at head offices, gave an added fillip to the\nbidding for funds in the Eurodollar market. With Eurodollar rates\nhigher relative to U.S. rates than they otherwise might have been, it\nseems likely that a larger proportion of the growth in foreigners'\ntotal holdings of liquid dollar assets took place in the Eurodollar\nmarket rather than in the United States.\nIn Appendix C, we review some research of Arthur Laffer\nwhich purports to show that this leakage has been so large as to off-\nset completely the gross savings due to the VFCR. In that appendix\nwe give some reasons for believing that the method which Laffer used\nFORD is LIBRARY GERALD\n- 29 -\nto reach his conclusion is not analytically sound. Indeed, using\nexactly the same technique that Laffer employed for 1965 and the\nfirst half of 1966, we have updated his analysis to include data for\nthe last half of 1966 and for 1967-70. When this is done, the results\nsuperficially point to a conclusion that the VFCR has led foreigners\nto increase their liquid assets in the United States compared with\nwhat they otherwise would have done. This latter conclusion is of\ncourse nonsense. The fact that Laffer's analytical method leads to\na clearly incorrect conclusion with 1967-70 data, however, should\nalso make one highly suspicious of the conclusion that Laffer drew\nfrom his analysis using only data for 1965 and the first half of 1966.\nThroughout the last fifteen years, U.S. liquid liabilities\nto nonofficial foreigners have grown more rapidly than the trade of\nthe rest of the world. The growth of foreign liquid assets in the\nUnited States relative to foreign trade and GNP has been quite high\neven if one excludes the atypical cases of liquid liabilities to\nbanks in the United Kingdom, Canada, Japan, and Switzerland. If\nanything, these trends may have accelerated during the latter half of\n/\nthe 1960'\nIf leakages from the gross savings have occurred on a\nsignificant scale through this channel, therefore, they have been\nmuch more than offset by other unexplained factors leading to faster\ngrowth of foreign liquid assets in the United States.\n1/ These generalizations are based on some recent empirical research\nby Ralph Bryant on the international demand for liquid dollar assets.\nFORD & LIBRARY 076835\n- 30 -\nAs in the other cases of potential leakages, one cannot\nreach clear-cut conclusions. But there is certainly no analytically\nacceptable evidence which demonstrates that leakages via this\nparticular channel have been large. Our best judgment is that the\nleakages here might be on the order of a few hundred million dollars\nper year, but not so large as to be measured in billions of dollars.\nExport Performance. We are reasonably confident that the\nVFCR program has had little \"direct\" adverse impact on U.S. export\nperformance. None of the export equations of which we are aware\nemploy the volume of trade credit as an explanatory variable. Yet\nthe predictive ability of these equations has not been materially\nimpaired since the imposition of capital controls. Thus, we infer\neither that United States exports have not been crucially dependent\non the availability of United States trade credit, or, more likely,\nthat the programs have succeeded in maintaining the level of these\ncredits while controlling other flows. Indeed, a recent survey of\nbanks, conducted by the Federal Reserve Board, \"turned up very few\nexamples of requests for financing the export of U.S. goods that\nwere denied in 1970 because of [the VFCR] program. 1/1/\n1/ Board of Governors of the Federal Reserve System, \"Report on\nInquiry into Possible Effects of Voluntary Foreign Credit Restraining\nProgram in 1970 on Export Financing and on Exports,\" January 7, 1971.\nFORD & LIBRARY GERALD\n- 31 -\nOf course, there may have been \"indirect\" effects on United\nStates exports resulting from a level of economic activity abroad\nless than what would have occurred in the absence of U.S. capital\ncontrols. Reduced capital flows to the industrialized countries may\nhave affected their monetary conditions and thus their levels of\neconomic activity. Reduced capital flows to the less developed\ncountries (LDCs) may have reduced LDC demand for U.S. exports direct-\nly, and indirectly reduced U.S. exports as a consequence of reduced\nLDC imports from the other industrialized countries. The extent to\nwhich these effects were operative depend in large part upon the\ndemand management policies pursued abroad and on their effectiveness.\nIn 1969-1970, economic activity levels in Japan and Western Europe\nwere quite high; capacity was being strained in these countries and\ninflationary pressures were strong. In those circumstances, greater\ncapital outflows might have enlarged U.S. exports as a result of even\nmore intense inflation abroad.\nOther Leakages. Offsets to the gross balance-of-payments\nsavings generated by the control programs could in principle have\noccurred in every uncontrolled category of transactions in the U.S.\nbalance of payments. While we believe the four categories discussed\nabove are likely to have been the most important in quantitative terms,\nwe recognize that non-negligible offsets could have taken place in\nstill other parts of the current or capital accounts. We have no way\nof making an informed judgment about the magnitude of these other\nleakages.\nFORD & LIBRARY GERALD\n- 32 -\nIV. A Brief Comment on the OMB Paper: \"Capital Controls:\nQuestionable Results and Undoubted Costs. II\nIn light of the discussion in the previous sections, how\nshould we interpret the recent paper from the Office of Management\n/\nand Budget?\nIn our view, the OMB paper fails altogether to do\njustice to the analytical complexity of the questions raised by the\ncapital control programs.\nThe OMB paper begins, quite correctly, by emphasizing that\nany reductions in the outflow of U.S. owned capital brought about by\nthe programs will have induced some offsetting flows in other balance-\nof-payments accounts. Unfortunately, this reasonable a priori\npresumption is then used to support the non sequitur (page 2) that\n\"there is no reason to expect that capital controls would, in any\nsignificant sense, actually reduce the net outflow of reserves.\"\nFinancial instruments are not perfect substitutes and international\ncapital and goods markets are not fully integrated.\nAlthough leakages surely exist, we strongly doubt that they\nhave completely negated the effects of the controls -- particularly\nin periods of monetary tightness in the United States. In any case,\nfar too little is known about this subject to justify the sweeping\n/ \"Capital Control Programs: Questionable Results and Undoubted\nCosts,\" transmitted on March 2, 1971, with accompanying memorandum\nby the Director of the Office of Management and Budget to the mem-\nbers of the Council on International Economic Policy via the\nHonorable Peter G. Peterson.\nFORD & LIBRARY GERALD\n- 33 -\nassertions in the OMB paper.\nThe empirical studies cited in the OMB paper fall very\nshort of being convincing evidence. We have already noted (page 14)\nthat the Cooper paper which is cited is not relevant to the present\nset of reinforcing controls.\nThe OMB paper does accurately convey the tenor of a study,\ndated May 11, 1970, by the Center for Political Research, the conclu-\nsions of which are in opposition to the OFDI program. But in our\nview these CPR conclusions are not warranted by the information and\neconomic analysis in the study (see Appendix B).\nThe third empirical study cited as evidence in the OMB\npaper is by Arthur Laffer and deals with short-term bank-reported\nclaims and liabilities. We have already noted (pages 28-29) that\nLaffer's analytical methods could not adequately justify his conclu-\nsion about the effects of the VFCR even in 1967 (when he first wrote\nhis paper), much less justify the position in the March 1971 OMB\npaper (see Appendix C).\nThe \"overall assessment\" in the OMB paper states:\nDetailed studies of the capital control programs\nhave uncovered absolutely no evidence of any effect\non the balance of payments.\nThe common and primary purpose of the capital con-\ntrol programs is to stem the net outflow of U.S.\nofficial reserve assets by obstructing American\ninvestments and loans to foreigners. All available\nevidence suggests that these programs cannot and\nhave not accomplished or even worked towards this\npurpose.\nFORD is LIBRARY 07V830\n- 34 -\nThese statements are simply false. It would be equally\nmisleading, but no more incorrect, to say that \"detailed studies of\nthe capital control programs have uncovered absolutely no evidence\nthat the gross balance-of-payments savings from reductions in U.S.\ncapital outflows have been undermined by leakages elsewhere in the\nbalance-of-payments accounts\" and that \"there is no available evidence\nsuggesting that these programs cannot and have not accomplished their\npurpose.\"\nThere is a trenchant line from the second scene of Act II\nof Hamlet, in which Gertrude reprimands Polonius for his rhetoric:\n\"More matter, with less art.\" This would be a useful guideline for\nimproving the OMB paper.\nThis paper was prepared by\nMurray Altmann, Ralph Bryant,\nGeorge Henry, and Alan Severn\nFORD & LIBRARY GERALD\n- 35 -\nAppendix A\nPotential Leakages via Reduced Foreign Purchases of\nU.S. Corporate Securities\nA frequently mentioned balance-of-payments account in which\ngross reductions in capital outflows might have been offset is that\nof foreign purchases of U.S. corporate securities. While foreign\npurchases of such securities rose markedly after controls were strength-\nened in 1965, it is of course possible that the rise would have been\ngreater in the absence of direct investment, or other, controls.\nOne obvious possibility is that the convertible Eurobonds\nissued by American direct investors were a substitute for ordinary\nAmerican equities. These Eurobonds were sold only to non-residents of\nthe United States. They were favorably priced, relative to comparable\nsecurities within the United States. Therefore, the standard argument\ngoes, investors outside the United States may have been induced to hold\nconvertible Eurobonds instead of ordinary American equities, since they\nreceived no price concessions on the latter category.\nObserved transactions, however, show a close quarter-by-\nquarter association between foreign purchases of U.S. equities and of\nconvertible Eurobonds issued by U.S. corporations (see attached chart).\nThus, if there was substitution in the short run, it was apparently\ndominated by causation common to the two types of security. In addi-\ntion, there may be a significant lag in foreigners' adjustment to the\nsurge of Eurobond issues. Therefore, further evidence is needed to\nestablish the degree of substitution between the two types of security\nover a longer period.\nFORD & GERALD LIBRARY\n- 36 -\nPreliminary results from an ongoing study of foreign pur-\nchases of U.S. equities being carried out by Alan Severn, however,\nfail to indicate any significant degree of substitution. The rela-\ntive importance over time of American stocks in foreign equity\nportfolios was compared to relative risks and returns and to the\ngrowth of mutual funds abroad / for the period 1962-70. Through\n1969 and the first three quarters of 1970, foreign investors con-\ntinued to hold as much of U.S. stocks as might be expected in light\nof relative risks, returns, and size of portfolios.\nDirect investment controls may also have affected foreign\npurchases of U.S. equities in ways other than through substitution\nof Eurobonds. In particular, any reduction of American cash purchases\nof existing foreign firms may have limited the equities purchases of\nforeign individuals, i.e., the former owners of the foreign firms.\nBut since a typical foreign investor is likely to invest only a small\nfraction of his equities portfolio in American stocks, this offset is\nlikely to be small. A similar, and similarly small, offset could be\na restriction of loans available to foreign equity investors as U.S.\ncorporations pre-empted part of available European capital.\nThere are also reasons for believing that the U.S. corporate\nsecurities account may contain some offsets to the IET or VFCR programs.\n1/ Including closed-end funds, to the extent that data are available.\n2/ Holdings during the 1968 Eurobond surge were nearly identical to\nthose \"predicted,\" while they were higher than \"predicted\" for 1969\n(by $.4 billion), though lower for the first three quarters of 1970\n(by $.3 billion).\nFORD is LIBRARY GERALD\n- 37 -\nFor example, one could imagine that the virtual cessation of American\npurchases of foreign stocks, induced by the IET, caused foreign stock\nprices to rise less rapidly, thereby lowering the value of foreigners'\nportfolios compared with what they otherwise would have been and,\nover time, inducing European investors to reduce their purchases of\n/\nAmerican equities.\nAltogether, it appears that the U.S. capital controls had\nrelatively little impact on foreign holdings of U.S. equities. Even\nif offsets were present, but hidden by other factors relevant to\nforeign investment in U.S. equities, the offsets were apparently small\nin relation to the gross savings generated by the control programs.\n1/ The rise in the nominal value of foreign equity portfolios\nexceeded $150 billion during the 1963-70 period. While an infusion\nof additional purchases from the U.S. could have raised the value of\nforeign equities even further, any reasonable amount of U.S. pur-\nchases would have played only a secondary role in foreign stock\nmarkets.\nFORD & LIBRARY\n14. DI\n- 38 - 38\nNET FOREIGN PURCHASES OF M.S. SECURITIES, 1965-1970\nU.S. Common Stocks\n/\nCONVERTIBLE EUROBONDS Sold AbRoAd By UIS-INCORPORATED COMPANIES\n$\nmillion\n800\n700\n600\n500\nFORD is LIBRARY GERALD\n400\n300\n/\n200\n100\n0\n- 100\n1965 4 1966 / 2 3 4 1967 / 2 3 4 1968 / 2 3 4 1969 1 2. 3 4 1970 2 \" 3 3 111 4\n- 39 -\nAppendix B\nA Comment on the CPR Report\n\"Federal Control of Foreign Direct Investments\"\nThis report by the Center for Political Research, dated\nMay 11, 1970, was apparently done for an unnamed corporate client;\nthe emphasis is on the locus of decision-making power with respect\nto control of foreign direct investment.\nSeveral flaws may be noted in this report:\n1. It implies that earnings on direct investment depend on U.S. equity\nin such investment, rather than on the aggregate size of the activity\n(as measured, for example, by total assets). On page 14 the following\nstatement appears:\n\"Just how long OFDI's short-term balance of payments\nbenefits will last is open to debate\nWhat is not\nopen to debate is that restrictions on direct U.S.\nforeign investment will eventually lead to a decline\n(or slower growth) in the dollar amount earned abroad\neach year by U.S. firms. In addition, heavy borrowing\nabroad by U.S. firms necessarily leads to sharp in-\ncreases in U.S. interest payments to foreigners. Such\npayments have more than doubled since 1966; they are now\nrunning at an annual rate of about 3.3 billion dollars.\"\n2. The above quotation implies that interest payments on corporate\nborrowing abroad are an addition to total interest payments by the\nUnited States as a whole. But if the corporations were to borrow in\nthe United States and send the proceeds abroad, the outflow would be\nreflected in combined private and official foreign holdings of dollars.\nSince the holders of these additional dollars could be expected to\nhold them in interest-bearing form, the interest payments on these\ni\nFORD\nGERALD\n717\n- 40 -\nholdings would partially offset the reduced payments by U.S.\ncorporations. Thus, only the difference between interest rates is\nrelevant here.\n3. Several New York bankers are quoted as stating that as of 1970,\nonly half-a-dozen firms (mainly in petroleum and computers) have been\naffected by the program; about 200 others have been partially\naffected, but can still carry out their investment programs. But\nthis statement apparently means that plant and equipment expenditures,\nrather than the financing of such expenditures, has been largely un-\naffected. Yet it is primarily the financing which directly affects\nthe U.S. balance of payments and which is aimed at by the program.\nThe debate about the balance-of-payments effects of direct\ninvestment activity (to which the report refers) is not relevant\nhere, because the scale of such activity has been largely unchanged.\nTherefore fees and royalties, parts and components, exports back to\nthe United States, etc., are not affected.\n4. The report states that in the aggregate, firms were below their\n\"allowables,\" in both 1968 and 1969. While this is true, it does not\nnecessarily reflect on the effectiveness of the program. The\nregulations are the most restrictive for the continental Western\nEuropean countries, and least restrictive for less developed countries.\nIt appears that most of the leeway below allowables was concentrated\nin the LDC's. The CPR report does not mention this possibility as a\nFORD in LIBRARY GERALD\n- 41 -\npartial explanation for the fact that allowables were not fully\nutilized.\nIn summary, the CPR report is analytically weak. Its\nworst fault is that it fails clearly to distinguish between financial\nand real consequences of the control of direct investment.\nFORD & LIBRARY GERALD\n- 42 -\nAppendix C\n(To be inserted in final version)\nFORD & LIBRARY GERALD\n- 43 -\nAppendix D\nAnnotated List of References\nThis is not intended as an exhaustive survey of the\nliterature. It does bring together much of the literature which\nbears on the subject matter of this paper.\n1. Board of Governors of the Federal Reserve System, \"Report on\nInquiry into Possible Effects of Voluntary Foreign Credit\nRestraining Program in 1970 on Export Financing and on Exports,\nJanuary 7, 1971.\nThe survey of banks summarized in the report, \"turned up very\nfew examples of requests for financing the export of U.S. goods\nthat were denied in 1970 because of [the VFCR] program\"\n2. William H. Branson, Financial Capital Flows in the U.S. Balance\nof Payments, (North-Holland Publishing Company, Amsterdam, 1968).\nBranson's Ph.D. dissertation applies a stock-adjustment model\nto capital flows, with particular emphasis on estimation of lags\nvia the Almon technique. The capital control programs are taken\ninto account only by means of on-off dummy variables.\n3. William H. Branson and Raymond D. Hill, Jr., \"A New Model of\nFinancial Capital Flows in the U.S. Balance of Payments,\"\nDecember 9, 1970 (Mimeo).\nThis paper updates and revises the empirical results in the\npreceding reference.\n4. Ralph C. Bryant and Patric H. Hendershott, \"Financial Capital\nFlows in the Balance of Payments of the United States: an Ex-\nploratory Empirical Study,\" Princeton Studies in International\nFinance No. 25 (June 1970).\nBryant and Hendershott attempt to elaborate an appropriate\ntheoretical framework for investigating international capital\nflows. The model is applied to data for U.S. short-term outflows\nto Japan with particular attention placed on trying to capture\nthe influence of the VFCR program.\nBERALD FORD LIBRARY\n- 44 -\n5. Ralph C. Bryant and Patric H. Hendershott, \"Empirical Analysis\nof Capital Flows: Some Consequences of Alternative Specifica-\ntions,\" a paper presented at a Universities - NBER Conference\non International Mobility and Movement of Capital, January 30-\nFebruary 1, 1970, Washington, D. C.\nThis paper, which expands the analysis in the previous reference,\ndiscusses the substantial difficulties in determining an appro-\npriate specification for capital flow equations. Alternative\nspecifications are shown to imply very different conclusions\nabout the effect of capital control programs.\n6. Center for Political Research, \"Federal Control of Foreign Direct\nInvestments, May 11, 1970.\nThe report discussed the program and concludes that \"the avail-\nable statistics regarding the OFDI program\ncast doubt on the\nextent to which the program actually restricts direct foreign\ninvestment today.\"\n7. Richard N. Cooper, \"The Interest Equalization Tax: An Experiment\nin the Separation of Capital Markets,\" Finanz Archiv, 24 (Decem-\nber 1965), 447-471.\nCooper investigates the period when only the IET was in effect\nand concludes that, for all intents and purposes, offsetting\nflows in other accounts entirely negated the impact of the IET.\n8. Richard N. Cooper, \"The Voluntary Credit Restraint Program:\nAn Assessment,\" January 1969 (Mimeo). Unpublished paper prepared\nfor FRB Academic Consultants.\nCooper summarizes his judgment on the gross savings and on the\nprobable magnitude of offsetting leakages. He concludes that the\npresent elements of the comprehensive set of restrictions are\nreinforcing and that they have had a significant net impact on\nthe balance-of-payments.\n9. Arthur B. Laffer, \"Short-term Capital Movements and the Voluntary\nForeign Credit Restraining Program\" 1969 (Mimeo).\nLaffer presents regression equations for the changes in \"U.S.\nprivate short-term claims on foreigners\" and for the changes in\n\"U.S. short-term liabilities to private foreigners.\" The relation-\nship between actual flows and what his equations predict lead him\nto conclude that there has been no net balance-of-payments saving\nfrom the VFCR program.\nFORD & LIGRARY GERALD\n- 45 -\n10. Walther Lederer, \"Notes on the Structure of the U.S. Balance of\nPayments,\" not dated, (Mimeo).\nLederer argues that \"major fluctuations in the balance on goods\nand services are to a large extent offset by fluctuations in\nunilateral and nonliquid capital transactions.\" However, some\nregressions of the capital flow balance on the goods and services\nbalance and various dummy variables lead him to conclude that the\ncapital constraint programs have had a net effect on the balance\nof payments.\n11. C. H. Lee, \"A Stock-Adjustment Analysis of Capital Movements:\nThe United States-Canadian Case,\" Journal of Political Economy,\nVol. 77 (July/August, 1969), 512-523.\nThis is another econometric application of the stock-adjustment\nmodel, in this case to U.S.-Canadian capital flows. On-off\ndummy variables are used to allow for the effects of the capital\ncontrol programs.\n12. Fritz Machlup, \"The Transfer Gap of the United States,\" Banca\nNazionale del Lavoro Quarterly Review, No. 86 (September 1968),\n195-238.\nMachlup rearranges the standard balance-of-payments accounts to\narrive at what he calls the \"net real transfers\" and the \"net\nfinancial transfers\" of the United States. His work leads him\nto conclude that in most circumstances changes in net financial\ntransfers will be offset by changes in net real transfers. He\nconcludes that \"the balance-of-payments program pursued by the\nUnited States Government\n...\nis useless for the purpose for\nwhich it was designed.\"\n13. N. C. Miller and M. V. N. Whitman, \"A Mean-Variance Analysis of\nUnited States Long-Term Portfolio Foreign Investment,\" The\nQuarterly Journal of Economics, LXXXIV (May 1970), 175-196.\nIn this and several subsequent papers, Miller and Whitman apply\nthe portfolio selection approach to various categories of capital\nflows in the U.S. balance-of-payments. On-off dummy variables\nare used to allow for the effects of the capital control programs.\n14. John Patrick, \"Bank Lending to Foreigners under the FCRP and the\nIET,\" NYFRB Research Memorandum, June 20, 1969.\nQERALD FORD LIBRARY\n- 46 -\nPatrick reviews recent data on capital flows and then presents\nregression results for equations explaining (quarterly changes\nin) short-term bank-reported claims on foreigners and in total\nbank-reported claims on foreigners. His results lead him to\nconclude that the two programs do reduce (and quite substantial)\nthe flows at which they are directed.\n15. Samuel Pizer, Statement to the Commission on International Trade\nand Investment Policy on the \"Capital Restraint Programs,\"\nOctober 15, 1970.\nPizer argues that there has been a large impact of the programs\nin reducing gross outflows in the categories controlled. He con-\ncludes moreover that despite the possibility of some leakages,\nthere has been a substantial net effect.\n16. Martin F. J. Prachowny, A Structural Model of the U.S. Balance\nof Payments (North-Holland Publishing Company, Amsterdam, 1969).\nThis is another econometric study that uses on-off dummy vari-\nables in some capital flow equations to allow for the effects of\nthe U.S. capital control programs.\n17. R. Rickover, \"Export Finance Before and After the Voluntary\nForeign Credit Restraint Program,\" NYFRB Research Memorandum,\nOctober 14, 1969.\nRickover attempts to estimate the effect of the VFCR program on\nexport financing with a simple regression relating changes in\ntrade credit to (current and lagged) changes in the value of U.S.\nexports. He believes that the volume of export trade financing\nhas been affected by the VFCR program.\n18. R. Rickover, \"Interest Rates, Capital Flows, and Errors and\nOmissions in the U.S. Balance of Payments,\" NYFRB Memorandum,\nMarch 8, 1971.\nRickover concludes that the \"normal\" unrecorded outflow (errors\nand omissions) attributable to systematic errors in data collec-\ntion is sizable. Interest rates (in the United States, Canada,\nand the Euro-dollar market) and U.S. banks' liabilities to their\nforeign branches exert a strong influence on unrecorded outflows.\nDelays between payments for U.S. imports and their recorded\narrival in the United States also influence errors and omissions\nwhen significant changes occur in the volume of imports.\n&\nFORD\nGERALD\nLIBRARY\n- 47 -\n19. Guy Stevens, \"Capital Mobility and the International Firms,\"\na paper presented at a Universities-NBER Conference on Interna-\ntional Mobility and Movement of Capital, January 30-February 1,\n1970, Washington, D. C.\nStevens estimates an econometric model of firm behavior. He con-\ncludes that \"virtually no impact of the various balance-of-\npayments programs is evident on plant and equipment expenditures\nin manufacturing.\"\nnot\nFORD & LIBRARY GERALD\nBOARD OF GOVERNORS\nOF THE\nFEDERAL RESERVE SYSTEM\nOffice Correspondence\nDate April 12, 1971\nTo\nBoard of Governors\nSubject: Effects of Balance of Payments\nFrom\nRobert Solomon\nRestraint Programs.\nCONFIDENTIAL (FR)\nThe attached paper, prepared in the International Division's\nSpecial Studies Section, under the guidance of Ralph Bryant, examines\nthe impact of the capital outflow restraint programs and tries to\nevaluate the various leakages that could offset their direct impact.\nAfter studying the evidence, the authors of the paper state\ntheir belief that \"the programs yield a significant balance of pay-\nments gain.\"\nRS\n9)\nAttachment.\nlifend and\nFN. blance\nFORD & GERALD LIBRARY\nCONFIDENTIAL (FR)\nDO THE RESTRAINTS ON U.S. CAPITAL\nOUTFLOWS IMPROVE THE\nBALANCE OF PAYMENTS?\nApril 7, 1971\nSpecial Studies Section\nDivision of International Finance\nBoard of Governors of the Federal Reserve System\nFORD & LIBRARY GERALD\nTable of Contents\nPage\nIntroduction and Summary\n1\nI. Analytical Frame of Reference\n5\nII. How Much Do We Know About International Economic\nRelationships?\n12\nIII. Judgmental Estimates of the Effects of the U.S. Capital\nControl Programs\n14\nA. Gross Savings on Capital Outflows Covered by the\nPrograms\n14\nInterest Equalization Tax\n14\nVoluntary Foreign Credit Restraint\n16\nForeign Direct Investment Program\n19\nB. Leakages Offsetting the Gross Savings\n22\nForeign Purchases of U.S. Securities\n24\nErrors and Omissions\n24\nForeign Holdings of Liquid Assets in the United States\n26\nExport Performance\n28\nOther Leakages\n29\nIV. A Brief Comment on the OMB Paper: \"Capital Controls:\nQuestionable Results and Undoubted Costs\"\n31\nAppendices:\nA. An Appraisal of the State of Current Knowledge\n34\nB. Potential Leakages via Reduced Foreign Purchases of U.S.\nCorporate Securities\n40\nC. A Comment on the CPR Report: \"Federal Control of Foreign\nDirect Investments\"\n43\nD. A Comment on Research by Arthur B. Laffer on Short-term\nBank-Reported Capital Movements\n46\nE. Annotated List of References\n57\nFORD & LIBRARY GERALD\nConfidential (FR)\nINTRODUCTION AND SUMMARY\nThere are good grounds for believing that the restraints\non certain types of capital outflows from the United States -- the\ninterest equalization tax (IET), the voluntary controls on banks\nand other financial institutions (VFCR), and the controls over\ndirect foreign investment of U.S. companies -- have held such flows\nsubstantially below the levels they would have reached in the absence\nof the restraints.\nThe restraints have been effective in limiting the specific\ncapital outflows at which they are aimed in good part because they\nreinforce one another. Moreover, they undoubtedly have had a greater\nimpact in limiting these capital outflows during periods of monetary\nease in this country than during periods of tight monetary conditions.\nThe effect of the capital controls on the overall balance\nof payments, however, is less clear. The gross balance-of-payments\n\"savings\" in outflows of U.S. capital affect monetary conditions\nand economic activity here and abroad. Those effects, in turn,\ninfluence the flow of foreign capital into the United States and may\nalso lead to changes in trade and other elements of the current\naccount. Specifically, the limitation on outflows of U.S. capital\ntends to tighten monetary conditions abroad relative to conditions\nthat would otherwise prevail, thereby reducing some foreign capital\nflows into the United States. Moreover, the restriction on U.S.\nFORD is LIBRARY GERALD\n- 2 -\ncapital outflows could limit the availability of trade credit and\nthereby result in some loss of U.S. export business. Still more\nindirectly, the restraint on capital outflows may cause GNP (nominal\nif not real) in other countries to be less than otherwise and thus\nreduce the demand for U.S. exports.\nStatements about the degree to which gross balance-of-payments\nsavings resulting from reductions in controlled U.S. capital outflows\nare counteracted by \"leakages\" -- by outflows of uncontrolled U.S.\ncapital, by reductions in inflows of foreign capital, and by loss of\nexport business -- involve very large elements of judgment. The\nsystematic exploration of structural relationships in the international\neconomy lags far behind the investigations of behavioral relationships\nunderlying domestic economic activity, and the effort suffers from\nsevere data deficiencies. There are therefore firm grounds for humility\nin expressing judgments. Our belief is that offsets to the gross\nsavings in the form of leakages, while far from negligible, are also\nfar from complete. We do believe that the programs yield a significant\nbalance-of-payments gain.\nThe data do not seem to give much support to an argument\nthat uncontrolled forms of U.S. capital outflow have been substantially\nlarger than they would have been in the absence of controls; these\nflows (nonbank and bank outflows not covered by the programs, and also\nnet errors and omissions) are dominated by shifts in monetary policies\nFORD is LIBRARY GERALD\n- 3 -\nhere and abroad and by other influences unrelated to the controls.\nThe evidence is relatively strong, moreover, that U.S. exports were\nnot hampered directly by limitations on capital outflows. With\nrespect to inflows of foreign capital, it is particularly difficult\nto make a judgment about the gap between what actually occurred and\nwhat might have occurred in the absence of the capital restraints.\nThere is no reliable evidence showing either that the gap was large\nor that it was small. Concerning the still more indirect leakages\narising through the general effects of the U.S. controls on economic\ndevelopments abroad, there is no empirical basis for a judgment.\nJudgments concerning these most indirect consequences necessarily\nrest on a theoretical view of the functioning of the international\nsystem in the contemporary environment.\nIn the next section of the paper, we briefly summarize the\nanalytical perspective appropriate for studying the balance-of-\npayments consequences of the restraints on capital outflows. Section\nII and Appendix A give our appraisal of the current state of knowledge\nconcerning the structural relationships between national economies.\nWe review in Section III some of the empirical evidence that can be\nbrought to bear on the issue. Several appendices deal in more detail\nwith various subtopics. Finally, in Section IV, we include a brief\ncritical comment on a recent paper on this subject prepared in the\nOffice of Management and Budget.\nFORD i LIBRARY GERALD\n- 4 -\nOur paper does not attempt to deal with the broader and\nstill more difficult question of whether the various costs associated\nwith the U.S. capital controls exceed any benefits. We do not ex-\npress judgments about this broader question, and would not wish readers\nto infer such judgments. We have deliberately restricted ourselves\nhere to the narrower question of whether the programs have a net\npositive effect in improving the balance of payments.\nFORD & LIBRARY 0ERALD\n- 5 -\nI. ANALYTICAL FRAME OF REFERENCE\nAn analysis of the balance-of-payments effects of imposing\ncontrols on U.S. capital outflows should in principle take into\naccount all the behavioral relationships which link national economies\ntogether into an interdependent world economy. It is clearly insuffi-\ncient to look just at the reductions in outflows of the specific types\nof capital at which the controls are directed, large though these gross\nsavings may be.\nOne way to establish the appropriate analytical perspective\nis to pose the following three questions: 1) Do U.S. residents\ndirectly substitute other types of capital outflow for the flows of\ncontrolled capital that otherwise would have occurred? 2) How are\nmonetary conditions and economic activity in the United States affected,\nand how do such effects feed back onto the balance of payments? 3) How\nare monetary conditions and economic activity in foreign countries\naffected, with consequent feedback effects on the U.S. balance of\npayments?\nThe various control programs -- the IET, the VFCR, and the\nOFDI regulations -- cover the principal types of U.S. capital outflows\nthat may substitute for one another and therefore are mutually re-\ninforcing. The remaining flows of U.S. capital not subject to controls\nare the claims of nonbanks on foreigners - both those claims reported\nand those that are not reported but reflected in errors and omissions\nGERALD FORD LIBRARY\n- 6 -\n-- and also some exempted claims of banks. The extent to which these\nother outflows can and do substitute for the controlled outflows has\nto be ascertained before one can answer the question posed in this\npaper.\nThe way that a reduction in capital outflows from the United\nStates affects monetary conditions and economic activity in the United\nStates is conditioned by the reserve-currency role of the dollar. If\nthe reduction in the outflow of capital and the initial improvement in\nthe U.S. balance of payments has no effect on U.S. holdings of gold and\nother reserve assets, there is no automatic effect on the money supply\nand on the reserves of U.S. commercial banks. Since U.S. official\nsettlements deficits or surpluses are often financed solely by changes\nin reserve liabilities, the U.S. monetary authorities are frequently\nnot confronted, as other countries in such circumstances always are,\nby the issue of whether to offset the effects of the balance of pay-\nments on money supply and bank liquidity. Demand management policies\nin the United States, therefore, have probably been little if any\ndifferent from what they would have been without the controls -- unless\nprior to introduction of the controls, the concern for external balance\nwas leading U.S. policy-makers to pursue more restrictive policies than\n/\nthey wanted to pursue for domestic reasons alone.\nOn the other hand, the controls and their immediate balance-of-\npayments effects did induce shifts in both the demand for and supply\nof funds in particular sectors of the U.S. money and capital markets,\nwhich had some consequences for the size and composition of. banks'\nassets and liabilities and also for the term structure of interest rates.\nThrough causal sequences of this type, the imposition of the controls\ncould have produced second-order feedback effects on a number of cate-\ngories of balance-of-payments transactions.\nFORD & LIBRARY GERALD\n- 7 -\nWhat type of feedback effects can result from the impacts\nof the controls on monetary conditions and economic activity in\nforeign countries? The way an analyst answers this third question is\nlikely to be a critical factor in determining his estimates of the\nimportance of leakages, and hence his judgment about the ultimate net\neffects of the controls on the U.S. balance of payments.\nReduced outflows of capital from the United States tend to\nhold down the growth in money supply, bank liquidity, and credit flows\nin the rest of the world, compared with what would occur in the absence\nof the U.S. controls. The extent to which these effects are important\nin individual countries depends critically on government policy-makers.\nAt one extreme, a country's policy-makers may have such a variety of\npolicy instruments and be so skillful at offsetting external influences\nthat they succeed in creating virtually the same domestic monetary\nconditions and economic activity that would have prevailed in the\nabsence of the U.S. controls. If all foreign policy-makers were so\nfortunate and skillful, the initial gross savings in the U.S. balance\nof payments attributable to the capital controls would not be badly\neroded by unfavorable feedback effects. At the other extreme, a country's\npolicy-makers may be unable to prevent the reduced outflows of capital\nfrom the United States from having a full impact on domestic monetary\nconditions and economic activity. If all foreign policy-makers were\nlimited in that way, a very large proportion of the initial gross savings\nFORD & GERALD LIBRARY\n- 8 -\nin the U.S. balance of payments might ultimately be eroded and there\nmight be little net effect of the controls on the overall balance of\npayments. Most countries, of course, fall somewhere in between these\ntwo extremes.\nThe feedback effects on the U.S. balance of payments can in\nprinciple occur in virtually all categories of balance-of-payments\ntransactions. Tighter monetary conditions and higher interest rates\nabroad (compared with what they would be in the absence of the U.S.\ncontrols) could reduce all types of foreign capital flows in the United\nStates. Slower real growth and/or a less rapid rate of inflation\nthan would otherwise occur may reduce foreign imports from the United\nStates.\nThe qualitative effects of the controls on capital outflows\nand on the balance of payments can be illustrated more specifically\nby describing the hypothetical situation that might have developed had\nthe recent shift toward ease in monetary conditions in the United\nStates occurred in the absence of any capital controls. Our purpose\nin including this hypothetical description here is still the limited\none of outlining an appropriate analytical frame of reference. We are\nnot attempting to predict what might happen if the existing control\nprograms were to be dismantled.\nTo begin with direct investment, a larger proportion of U.S.\nbusiness outlays abroad in recent quarters would have been financed\nfrom U.S. sources. This difference in the source of financing would\nGERALD FORD LIBRARY\n- 9 -\nappear in the balance of payments as an increase in direct investment.\nThere also would be a stock adjustment as maturing debt of U.S. cor-\nporations held abroad -- much of which is short-term -- was replaced\nwith issues in the United States. The sale of foreign securities to\nU.S. investors would have been greater in the absence of controls in\nthe environment of easy monetary conditions in the United States.\nGiven the large shift in the locus of demands for long-term\ncapital that would have occurred without controls, the stimulus for\nlower interest rates in foreign capital markets would have been greater\nthan it has been; at the same time, the decline in long-term rates in\nthe United States would have been somewhat retarded. Nevertheless,\ninterest rates in the United States would have declined relative to\nthose abroad -- given that foreign monetary authorities were not also\nimplementing policies of active ease. The re-alignment in interest\nrates in the absence of controls would have induced both American and\nforeign investors to alter their portfolios of debt securities in favor\nof foreign instruments, thereby augmenting the outflows of capital from\nthe United States.\nIn the absence of the VFCR, the easing in monetary conditions\nin the United States would have induced the same sort of consequences\nthrough an expansion in bank credit to foreigners. In the short-term\narea, the stock adjustment in response to the changed interest-rate\nrelationships between here and abroad can be accomplished quickly,\nproducing a substantial outflow promptly.\nFORD & LIBRARY GERALD\n- 10 -\nThe additional capital outflows in the absence of the capital\ncontrols would have tended to increase directly the money supply in\nother industrial countries still more than the actual outflows have\ndone, and they also would have tended to increase bank liquidity still\nmore and provided the basis for a larger secondary expansion in credit\nand money. If this had been allowed to occur -- if the foreign author-\nities had made no effort to neutralize the inflows of funds -- interest\nrates abroad would have been under still greater downward pressure.\nThe differential in interest rates between the United States and\nforeign countries would have been smaller, but this would have been the\nresult of larger net outflows of funds from the United States than\nactually occurred.\nOver time, the process would have produced some balance-of-\npayments offsets to the augmented capital outflows. The easier mone-\ntary conditions induced in other industrial countries would have ex-\npanded their demands for U.S. goods and services. Also, working capital\nrequirements abroad would have been greater, and some portion of foreign\nworking capital is held in dollars. To the extent that the additional\ncapital outflows from the United States would have been accompanied by\nexpansion in private foreign demands for short-term dollar assets, the\nrise in the U.S. official settlements deficit would have been tempered.\nThe induced expansion in foreign demand for goods and services occurs\nwith some lag, however, and in the interim the absence of capital\nGERALD R. FORD LIBRARY\n- 11 -\ncontrols during the process of easing monetary conditions in the\nUnited States would have augmented the deficit in the U.S. balance\nof payments.\nHow the process would have worked in fact would have been\nstrongly influenced by the policy responses abroad. To the extent that\nthe authorities would have been successful in neutralizing the addi-\ntional inflows of funds -- in retarding the monetary expansion and\ndeclines in interest rates -- the balance-of-payments offsets to the\nadditional outflows of U.S. capital would have been prevented from\ndeveloping.\nThe augmented outflows of funds in the absence of the controls\nwould have been in addition to the large repayments of U.S. bank borrow-\nings from the Eurodollar market that have occurred and have been re-\nflected in the extraordinary U.S. official settlements deficits. More-\nover, the augmented outflows from the United States would have occurred\nwhen other industrial countries already were experiencing boom conditions\nand inflationary pressures. The additional expansive effects on their\neconomies would have been totally unwanted. Indeed, even the effects\nof the repayment of the Eurodollar borrowings were unwanted and inter-\nfered with the policies that foreign monetary authorities wished to\nfollow. In the circumstances, additional outflows of U.S. capital would\nhave generated offsets in the current account chiefly by raising nominal\nrather than real GNP in other industrial countries. It would have done\nso, in other words, by accelerating the rates of inflation abroad.\nFORD & LIBRARY GERALD\n- 12 -\nII. HOW MUCH DO WE KNOW ABOUT INTERNATIONAL ECONOMIC RELATIONSHIPS?\nHow would it be possible adequately to appraise the magnitude\nof gross balance-of-payments savings due to the U.S. capital controls\nand the proportion of these gross savings that are lost through leakages?\nAs the preceding section suggests, it would be necessary to\nspecify and estimate a highly elaborated model of the international\neconomy. Such a model would need to include demand and supply equations\nfor each important financial instrument (international and domestic).\nThese equations would in turn have to be specified so as adequately to\nreflect the complex interrelationships between all financial markets.\nMoreover, the model would have to embody the behavioral relationships\nlinking international capital flows, merchandise trade flows, and\neconomic activity levels for all major countries or regions. Finally,\nthe analysis would have to take explicit account of the likely reactions\nof foreign policy makers to various types of U.S. policy actions.\nThe economics profession is very far from having such a\nmodel of the international economy. The partial evidence about behav-\nioral relationships that does exist is grossly inadequate. In these\ncircumstances, even tentative conclusions about the effects of the\nUnited States capital control programs can be no more than informed\nguesses. A fuller treatment of this important point has been deferred\nto Appendix A.\nWe try in the next section to bring together some empirical\ninformation relevant to an analysis of the capital controls and to\nFORD & LIBRARY GERALD\n- 13 -\nmake some judgmental estimates of how large the gross balance-of-\npayments savings and the offsetting leakages may have been. We put\nforward these judgments with genuine hesitation. Although we believe\nour judgments are as reasonable as can be made given the present state\nof knowledge, we are mainly impressed -- as emphasized in Appendix A --\nwith the inability of anyone to make judgments that are clearly valid.\nFORD & LIBRARY GERALD\n- 14 -\nIII. JUDGMENTAL ESTIMATES OF THE EFFECTS OF THE\nU.S. CAPITAL CONTROL PROGRAM\nA. Gross Savings on Capital Flows Covered by the Programs\nInterest Equalization Tax. The IET has been imposed on U.S.\npurchases of foreign securities since mid-1963 and on long-term bank\nlending since February 1965.\nThe IET induced a sharp reduction in U.S. purchases of\nforeign new issues, as suggested by Table 1. The annual average of\nthese purchases, which had been building up sharply in 1962 and early\n1963, fell by $177 million between 1962-63 and 1964-65, and an addi-\ntional $58 million between the latter period and 1966-69. The severity\nof the reduction in 1964, shown in Table 1, is probably attributable\nto the substitution of untaxed bank loans for security issues in that\nyear. With the extension of the IET to long-term bank loans in 1965,\nand also the inception of the VFCR, new security issues rose moderately.\nThe reduction of new issues in the 1966-69 period from the 1964-65\naverage appears to be attributable in large part to the relative tight-\nness in the U.S. market for long-term capital. With the advent of\neasier money in the United States after 1969, the IET undoubtedly had\nmore of a restraining effect on foreign new issues.\nFORD i LIBRARY GERALD\nFORD & GERALD LIBRARY\n- 15 -\nTable 1\nU.S. Purchases of Foreign Securities Newly Issued in the United States a/\nby European Countries, Australia, New Zealand and South Africa.\n(millions of dollars)\n1960\n1961\n1962\n1963\n1964\n1965\n1966\n1967\n1968\n1969\n1970\nb/\n24\n57\n195\n289\n35\n95\n15\n-\n-\n14\n/ Japan is excluded because Japanese new issues were partially exempted\nfrom the IET. The 1965 exemption of $100 million was continued for several\nyears, but was not fully utilized because of rising U.S. interest rates.\nb/ Excluding an exchange of stock issued to finance a foreign direct\ninvestment in the United States. This transaction had a neutral effect on\nthe balance of payments.\nThe IET has at least two types of effects on new issues. Most immediately,\npotential foreign borrowers are deterred by the existence of the tax itself.\nLess directly, the cumulative effects of the tax over time probably have\ngiven an added fillip to the development of European capital markets,\ninducing Europeans to raise more capital in their own markets as opposed\nto the U.S. market. In the face of growing foreign demand for long-term\ncapital, the full impact of the IET on new issues in 1970 could well have\nbeen substantially in excess of the average volume of new issues observed\nin 1962-63.\nIn the face of the IET, American net purchases of outstanding\nforeign equities reached a cumulative total of only $1/4 billion during the\n/\n1963-70 period.\nSuppose that in the absence of the IET, Americans would\n1/ Net purchases of outstanding bonds were negligible. Net U.S. purchases\nof Japanese equities in 1969 were very large (approximately $300 million) and\nmore than offset net U.S. sales of foreign equities during most of the 1963-\n70 period. At the end of 1969, Japanese long-term assets were brought under\nthe VFCR program for nonbank financial institutions. This action has virtu-\nally eliminated the flow of funds by U.S. institutional investors into\nJapanese equities.\n- 16 -\nhave wanted to allocate a roughly constant proportion of their equity\nportfolios to foreign equities. This assumption implies that sub-\nstantial net purchases of foreign equities, possibly as much as $3-4\nbillion, would have occurred. A number such as $3-4 billion probably\nrepresents an upper bound for the cumulative gross savings for 1963-70.\nWithout the IET, of course, net purchases would undoubtedly have\nfluctuated considerably.\nWe have not tried to make estimates of the gross savings\nattributable specifically to the 1965 extension of the IET to long-term\nbank loans. Total foreign lending of banks is considered under the\nVFCR program.\nVoluntary Foreign Credit Restraint. The introduction of the\nVFCR early in 1965, in combination with the imposition of the IET on\nbanks' long-term loans, was associated with a sharp cutback in new\nforeign lending by U.S. banks. The balance-of-payments accounts show\nthat the combined outflow of long-term and short-term bank funds fell\nfrom an annual average of $1.4 billion in 1960-64 to an annual average\nof less than $100 million in 1965-69.\nThat the program played a large role in limiting the outflow\nof bank credit is not contradicted by the continuous existence of an\napparent leeway for additional lending, as shown in Table 2. The\n1/ Inspection of stock price trends in various countries suggests\nthat U.S. prices rose at roughly the average of foreign price rises,\nbut with less fluctuation.\nFORD & LIBRARY GERALD\n- 17 -\napparent leeway under the ceiling reflects mostly cyclical factors,\ndifferences among banks, and bank uncertainty about draw-downs by\n/\nforeign borrowers.\nTable 2\nBanks' Ceilings and Leeway Under the VFCR\n(Millions of dollars, end of year)\n1965\n1966\n1967\n1968\n1969\n1970\nGeneral Ceiling\n/\nAggregate ceiling\n9,973\n10,407\n11,069\n9,729\n10,092\n9,956\nApparent leeway\n321\n911\n1,204\n476\n694\n606\nb/\nTotal General and Export Term-Loan Ceilings\n/\nAggregate ceilings\n9,973\n10,407\n11,069\n9,729\n11,356\n11,379\nApparent leeway\n321\n911\n1,204\n476\n1,939\n1,842\na / Ceilings are calculated on the basis of the guidelines in effect\nduring the given year. There were both liberalizations and intensifica-\ntions of the guidelines from 1965 to mid-1968 and several relaxations\nsince late 1968.\nb/ Export Term-Loan Ceiling added at the end of 1969.\nEconometric research on bank lending to foreigners has been\nfraught with problems, few if any of which have been satisfactorily\n2/\nresolved.\nWith the exception of the studies by Bryant and Hendershott,\n1/ See Bernard Norwood, \"Restraining Foreign Credit: Six Year Test,\"\nWharton Quarterly, Winter 1970, pp. 32-37.\n2/ Appendix E lists some of the references. The studies most\nrelevant here are those by Branson, Bryant and Hendershott, Laffer,\nMiller and Whitman, and Patrick.\n-\nFORD & LIBRARY GERALD\n- 18 -\nthis research has allowed for the effects of the VFCR only in a crude,\ninadequate fashion. Even Bryant and Hendershott, despite strenuous\nefforts to adapt their equations so as explicitly to reflect the\nvarying impacts of the VFCR guidelines, failed to come up with clear-\ncut evidence. /\nIf the proportion of foreign loans in the portfolios of U.S.\nbanks had been the same at the end of 1970 as it was at the end of\n1962, foreign loans would have been $16.6 billion instead of the\nobserved figure of $13.8 billion. This calculation may give a crude\nindication of the possible magnitude of the effect of the VFCR on the\ndistribution of U.S. bank portfolios. The precise impact of the VFCR\nat any given time, of course, depends critically on monetary conditions\nin the United States relative to those abroad. In the past year, the\nrestraining effect of the VFCR on bank lending has increased considerably,\ncompared with its effect during the most intense periods of monetary\ntightness in 1969. It is estimated that German companies borrowed\nnearly $1.8 billion in Eurodollars during 1970. In the absence of the\nVFCR, a significant portion of this loan demand might have been met by\nU.S. banks.\nSee Bryant and Hendershott, Financial Capital Flows in the Balance\nof Payments of the United States: An Exploratory Empirical Study,\nPrinceton Studies in International Finance No. 25, pp. 31-32, 48-50,\n60-61; also \"Empirical Analysis of Capital Flows: Some Consequences of\nAlternative Specifications,\" Forthcoming in Universities-NBER Volume on\nThe International Mobility and Movement of Capital.\n2/ Foreign loans here include Canadian, which are exempt from the\nVFCR. The year 1962 is taken as a base because of the surge in borrowing\nin 1963-64 after the IET restricted security issues.\nBERALD FORD LIBRARY\n- 19 -\nThe effect of the VFCR on nonbank financial institutions is\neven harder to judge, because of the diversity of such institutions\nand because of potential switches between assets not covered (over $13\nbillion) and covered assets (under $2 billion). One indication of the\neffectiveness of the non-bank program is the virtual cessation of U.S.\npurchases of Japanese equities after such assets were brought under\nthe program, in contrast to net U.S. purchases of $300 million in 1969.\nForeign Direct Investment Program. This program was designed\nto limit outflows of U.S.-owned funds (as they are reflected in the\nbalance of payments) to finance U.S. business investment in foreign\naffiliates; it was not the intention to limit the investment outlays\nof those affiliates. The program, it was hoped, would shift the source\nof financing away from the United States, and it appears to have been\nsuccessful in doing that. One possible indication of the size of\ngross program savings is given by the amount of funds obtained abroad\nby U.S. parent firms; such financing was virtually zero until the\nadvent of the voluntary program in 1965; in 1968, 1969, and 1970 it\nwas more than $2 billion per year. (See Table 3, line 4.2/)\n1/ For example, Guy Stevens found that \"virtually no impact of the\nvarious balance of payments program is evident on plant and equipment\nexpenditures in manufacturing.\" See his \"Capital Mobility and the\nInternational Firm,\" Universities-National Bureau Conference on\nInternational Mobility and Movement of Capital, forthcoming.\n2/ These data, from OFDI, are more inclusive than those from OBE,\nsince they include foreign borrowings which are used abroad without\nfirst being remitted to the United States.\nGERALD FORD VIBRARY\nR.\nFORD\n- 20 -\nGERALD\nTable 3\nLIBRARY\nSelected Data on Direct Foreign Investment\n(millions of current dollars)\nFinancial\n1965\n1966\n1967\n/\n1968\n1969\n1970\n1. Net capital transfers\n3926\n4386\n4178\n2671\n3720\n4250\n2. + Reinvested earnings\n1492\n1692\n1390\n1950\n2325\n3150\n3. = Direct investment\n5418\n6078\n5568\n4621\n6045\n7400\n4. - Long-term foreign borrowing\nby parent firms and program\nadjustments\nb/\n104\n638\n542\n2161\n2346\n2500\n5. If Net use of U.S.-source funds\nand Reinvested Earnings\n5314\n5440\n5026\n2460\n3699\n4900\n/\n6. + Depreciation\n3686\n4074\n4632\n5265\n5800\n6400\n7. + Long-term foreign borrowing\nby parent firms and program\nadjustments\n104\n638\n542\n2161\n2346\n2500\n8. = Gross use of U.S.-controlled\nfunds\n9104\n10152\n10200\n9886\n11845\n13800\nReal\n9.\nPlant & equipment expenditures\n7440\n8640\n9267\n9387\n10787\n13200\n/ Excluding Canada, since no data are available. In contrast, other\ndata in this table are worldwide, i.e., all three OFDI schedules plus\nCanada.\n/ Program adjustments are offsets to foreign borrowing, such as repay-\nments and indirect capital transfers.\n/ Estimated\nSource: Depreciation and plant and equipment expenditures from Office of\nBusiness Economics; other data from Office of Foreign Direct Investments.\n- 21 -\nThe decline in the ratio of U.S.-controlled funds to plant\nand equipment expenditures that has occurred as foreign affiliates\nhave relied to a greater extent on local borrowing (i.e., by affiliates,\nin addition to foreign borrowing by parent firms) is a possible indica-\ntion of additional gross savings. For 1965, this ratio was 1.225; for\nthe 1966-67 period, when the voluntary program specified firm-level\ntargets, it fell to 1.135. In contrast, the ratio under the Mandatory\nProgram in 1968-70 was 1.065. If the 1965 ratio had prevailed in\n1968-70, gross use of U.S.-controlled funds would have been some $1-3/4\nbillion greater on average per year.\nThe trend toward greater reliance on local financing is con-\nsistent with another set of OFDI data, available for 1967-68 (See\n2/\nTable 4).\nFor all direct investment outside Canada, these data show\nthat each dollar of new current assets was matched in 1968 by 91 cents\nin affiliate borrowing, as opposed to 85 cents in outstanding affiliate\nU.S.-controlled funds are defined to include depreciation allow-\nances since the latter allow direct investors to make some plant\nand equipment expenditures without recourse either to foreign borrowings\nor U.S. funds. In other words, reinvestment of depreciation allowances\nleaves the book value of foreign affiliates unchanged; thus plant and\nequipment expenditures should be attributed to depreciation allowances\nas well as to U.S.-source funds and foreign borrowing by parent firms.\n2/ U.S. Department of Commerce, Office of Foreign Direct Investments,\nForeign Affiliate Financial Survey 1967-1968 (Washington, July 2, 1970).\nComparable data for 1966 and 1969 are not yet available, either from\nOFDI or OBE.\nMA\nFORD & LIBRARY GERALD\n- 22 -\nborrowing per dollar of current assets at the beginning of 1968. /\nHowever, comparable data for Canada (Table 4) showed a similar move-\nment, reminding us that other factors probably accounted for much of\nthe increased use of local funds on the part of affiliates.\nThe prima facie evidence is that the Voluntary and Mandatory\nPrograms had successively larger influences on both parent-firm and\naffiliate financing. But, of course, part of this increased foreign\nfinancing might have occurred in 1968 and 1969 even in the absence of\ncontrols as a result of tighter money in the United States. In 1970,\nhowever, the Mandatory Program was undoubtedly effective in preventing\ncorporations from shifting new financing back to U.S. sources, as well\nas refinancing outstanding foreign debt in the United States.\nB. \"Leakages\" Offsetting the Gross Savings\nWhile it is difficult to estimate a possible range of gross\nbalance-of-payments savings generated by the capital controls, it is\neven more difficult to guess at the size of leakages. The difficul-\nties are severe both because of the limited state of our knowledge\n(see Appendix A) and because offsets can conceivably occur in any\n1/ Affiliate financing is functionally related to current assets\nbecause of seller financing of locally obtained inputs and because firms\nattempt to match local-currency assets and liabilities. See S. Robbins\nand R. Stobaugh, Comment on Stevens' \"Capital Mobility and the Interna-\ntional Firm,\" Universities-National Bureau Conference on International\nMobility and Movement of Capital, forthcoming.\n2/ The initial Voluntary Program for 1965 did not involve firm-\nlevel targets, and resulted mainly in the repatriation of head-office\nbalances formerly held in Europe.\nFORD & LIBRARY GERALD\n- 23 -\nTable 4\nMajority-owned Foreign Affiliates\nCurrent Assets and Foreign-Source Funds, 1967-68\n(millions of dollars)\nOutstanding\nOutstanding\nChange during\nend-1967\nend- 1968\n1968\nAll Schedules\nCurrent assets\n25,805\n30,406\n4,601\nForeign debt\n21,909\n26,100\n4,191\nRatio, foreign debt to\ncurrent assets\n.849\n.858\n.911\nCanada\nCurrent assets\n7,649\n8,481\n831\nForeign debt\n5,549\n6,273\n724\nRatio, foreign debt to\ncurrent assets\n.726\n.740\n.871\nFORD & LIBRARY GERALD\n- 24 -\nbalance-of-payments category. In the following subsections we attempt\nto review the evidence available for four categories of transactions\nwhere leakages seem particularly likely to have occurred.\nForeign Purchases of U.S. Securities. An obvious source of\npotential leakages is in foreign purchases of U.S. corporate securities.\nMost directly, the convertible Eurobonds issued by U.S. corporations\nas a response to the capital controls are undoubtedly a close sub-\nstitute for securities which foreigners would otherwise purchase in\nNew York.\nDuring the period in which the capital controls were in force,\nforeign purchases of U.S. securities increased to unprecedented rates.\nThey might, it is true, have increased still more in the absence of the\ncontrols. Indeed, there is no convincing evidence on what the magnitude\nof this leakage may have been. We find it implausible, however, to\nimagine that it could have been in excess of a few hundred million\ndollars per year on average. (See Appendix B for a more detailed\ndiscussion of this potential leakage.)\nErrors and Omissions. Another possible offset to the savings\nin controlled outflows of capital could have occurred in the errors-\nand-omissions account in the balance of payments. When that account is\nunusually large and negative, it is often inferred that flows of un-\nrecorded capital are the cause. There is some evidence, however, that\nGERALD FORD LIBRARY\n- 25 -\nmany of the major movements of the errors-and-omissions account\ncan be attributed to forces other than the capital controls.\nThere appears to be a substantial normal error -- approaching\nan annual rate of $1 billion -- reflecting systematic errors in data\ncollection. (See Table 5.) The actual figures vary from that base\nbecause of changes in interest-rate differentials between here and\nabroad, quarter-to-quarter changes in imports (the recording of which\nappears to lag behind payments), and speculative movements of funds\nfrom time to time.\nTable 5\nErrors and Omissions\n(Billions of dollars)\n1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970\n-1.2 -1.1 -1.2 -0.5 -1.1 -0.6 -0.5 -1.1 -0.5 -2.9 -1.3\nThe large rise in errors and omissions in 1969, for example,\nwas associated with the sharp increases in interest rates in the Euro-\ndollar market, which attracted funds of U.S. residents out of time\ndeposits in U.S. commercial banks. There was a substantial circular\n1/ See, for example, R. Rickover, \"Interest Rates, Capital Flows,\nand Errors and Omissions in the U.S. Balance of Payments,\" Research\nMemorandum of the Federal Reserve Bank of New York, March 8, 1971.\nFORD & GERALD LIBRARY\n- 26 -\nflow of funds, however, as the U.S. banks borrowed back these funds.\nIn fact, the banks' borrowings far exceeded these outflows, with the\nresult that the official-settlements balance of payments was heavily\nin surplus. An additional factor contributing to the large figure\nfor errors and omissions in early 1969 was the dock strike.\nIf unrecorded net outflows of U.S. capital have been greater\nor if unrecorded net inflows of foreign capital have been smaller than\nthey otherwise would have been in the absence of the U.S. capital con-\ntrols, this has been far from obvious in the actual data for net errors\nand omission.\nForeign Holdings of Liquid Assets in the United States. The\nU.S. capital controls no doubt had some effect on foreigners' demand\nfor liquid dollar assets held in the United States. The growth in\nforeigners' awareness of investment opportunities in the Eurodollar\nmarket in the 1964-70 period, together with the relatively higher\nyields offered on Eurodollar deposits compared with assets of compar-\nable liquidity and maturity in New York, would have constituted\nsubstantial incentives for substituting Eurodollar assets for dollar\nassets held in the United States. Imposition of the capital controls,\nwhich in turn led U.S. banks to multiply the number of their foreign\nbranches and to carry out lending through their branches which might\notherwise have been done at head offices, gave an added fillip to the\nbidding for funds in the Eurodollar market. With Eurodollar rates\nhigher relative to U.S. rates than they otherwise might have been, it\nGERALD FORD CIBRARY\n- 27 -\nseems likely that a larger proportion of the growth in foreigners'\ntotal holdings of liquid dollar assets took place in the Eurodollar\nmarket rather than in the United States.\nIn Appendix D, we review some research of Arthur Laffer\nwhich purports to show that this leakage has been so large as to off-\nset completely the gross savings due to the VFCR. In that appendix\nwe give some reasons for believing that the method which Laffer used\nto reach his conclusion is not analytically sound. Indeed, using\nexactly the same technique that Laffer employed for 1965 and the\nfirst half of 1966, we have updated his analysis to include data for\nthe last half of 1966 and for 1967-70. When this is done, the results\nsuperficially point to a conclusion that the VFCR has led foreigners\nto increase their liquid assets in the United States compared with\nwhat they otherwise would have done. This latter conclusion is of\ncourse nonsense. The fact that Laffer's analytical method leads to\na clearly incorrect conclusion with 1967-70 data, however, should\nalso make one highly suspicious of the conclusion that Laffer drew\nfrom his analysis using only data for 1965 and the first half of 1966.\nOver the last fifteen years, U.S. liquid liabilities\nto nonofficial foreigners have grown more rapidly than the trade of\nthe rest of the world. The growth of foreign liquid assets in the\nUnited States relative to foreign trade and GNP has been quite high\neven if one excludes the atypical cases of liquid liabilities to banks\nin the United Kingdom, Canada, Japan, and Switzerland. If anything,\nFORD & LIBRARY GERALD\n- 28 -\nthese secular trends may have accelerated during the latter half of\nthe 1960'\nIf leakages from the gross savings have occurred on a\nsignificant scale through this channel, therefore, they have been much\nmore than offset by other unexplained factors leading to faster growth\nof foreign liquid assets in the United States.\nAs in the other cases of potential leakages, one cannot\nreach clear-cut conclusions. But there is certainly no analytically\nacceptable evidence which demonstrates that leakages via this\nparticular channel have been large. Our best seat-of-the-pants judg-\nment is that the leakages here might be on the order of a few hundred\nmillion dollars per year, but not so large as to be measured in\nbillions of dollars.\nExport Performance. We are reasonably confident that the\nVFCR program has had little \"direct\" adverse impact on U.S. export\nperformance. 2/ None of the export equations of which we are aware\nemploy the volume of trade credit as an explanatory variable. And\nthe predictive ability of these equations has not been materially\n/ These generalizations are based on some recent empirical research\nby Ralph Bryant on the international demand for liquid dollar assets.\n2/ A recent survey of banks, conducted by the Federal Reserve Board,\n\"turned up very few examples of requests for financing the export of\nU.S. goods that were denied in 1970 because of [the VFCR] program.\"\nBoard of Governors of the Federal Reserve System, \"Report on Inquiry\ninto Possible Effects of Voluntary Foreign Credit Restraining Program\nin 1970 on Export Financing and on Exports,\" January 7, 1971.\nFORD & GERALD LIBRARVA\n- 29 -\nimpaired since the imposition of capital controls. Thus, we infer\neither that United States exports have not been crucially dependent\non the availability of trade credit, that the programs have succeeded\nin maintaining the level of U.S. trade credits while controlling\nother U.S. flows, or, most likely, that other sources of credit\n(including lending by the foreign branches of U.S. banks) have been\nsubstituted for U.S. credit.\nOf course, there may have been \"indirect\" effects on United\nStates exports resulting from a level of economic activity abroad less\nthan what would have occurred in the absence of U.S. capital controls.\nReduced capital flows to the industrialized countries may have affected\ntheir monetary conditions and thus their levels of economic activity.\nReduced capital flows to the less developed countries (LDCs) may have\nreduced LDC demand for U.S. exports directly, and indirectly reduced\nU.S. exports as a consequence of reduced LDC imports from the other\nindustrialized countries. The extent to which these effects were\noperative depends in large part upon the demand management policies\npursued abroad and on their effectiveness. In 1969-1970, economic\nactivity levels in Japan and Western Europe were quite high; capacity\nwas being strained in these countries and inflationary pressures were\nstrong. In those circumstances, greater capital outflows might have\nenlarged U.S. exports as a result of even more intense inflation abroad.\nOther Leakages. Offsets to the gross balance-of-payments\nsavings generated by the control programs could in principle have\nFORD is LIBRARY GERALD\n- 30 -\noccurred in every uncontrolled category of transactions in the U.S.\nbalance of payments. While we believe the four categories discussed\nabove are likely to have been the most important in quantitative\nterms, we recognize that non-negligible offsets could have taken\nplace in still other parts of the current or capital accounts. We\nhave no way of making an informed judgment about the magnitude of\nthese other leakages.\nFORD & LIBRARY GERALD\n- 31 -\nIV. A BRIEF COMMENT ON THE OMB PAPER: \"CAPITAL CONTROLS:\nQUESTIONABLE RESULTS AND UNDOUBTED COSTS.\"\nIn light of the discussion in the previous sections, how\nshould we interpret the recent paper from the Office of Management\nand Budget? / In our view, the OMB paper fails altogether to do\njustice to the analytical complexity of the questions raised by the\ncapital control programs.\nThe OMB paper begins, quite correctly, by emphasizing that\nany reductions in the outflow of U.S.-owned capital brought about by\nthe programs will have induced some offsetting flows in other balance-\nof-payments accounts. Unfortunately, this reasonable a priori pre-\nsumption is then used to support the non sequitur (page 2) that\n\"there is no reason to expect that capital controls would, in any\nsignificant sense, actually reduce the net outflow of reserves.\" It\nis a big step from the plausible statement that leakages exist to the\nstatement that they completely offset the effects of the controls.\nFinancial instruments are not perfect substitutes and international\ncapital and goods markets are not fully integrated.\n1/ \"Capital Controls: Questionable Results and Undoubted Costs,\"\ntransmitted on March 2, 1971, with accompanying memorandum by the\nDirector of the Office of Management and Budget to the members of the\nCouncil on International Economic Policy via the Honorable Peter G.\nPeterson.\nFORD is LIBRARY QERALD\n- 32 -\nAlthough leakages surely exist, we strongly doubt that they\nhave completely negated the effects of the controls -- particularly\nin periods of monetary tightness in the United States. In any case,\nfar too little is known about this subject to justify the sweeping\nassertions in the OMB paper.\nThe empirical studies cited in the OMB paper fall very short\nof being convincing evidence. We note in Appendix A (page 34) that the\nCooper paper which is cited is not relevant to the present set of\nreinforcing controls.\nThe OMB paper does accurately convey the tenor of a study,\ndated May 11, 1970, by the Center for Political Research, the conclu-\nsions of which are in opposition to the OFDI program. But in our\nview these CPR conclusions are not warranted by the information and\neconomic analysis in the study (see Appendix C).\nThe third empirical study cited as evidence in the OMB paper\nis by Arthur Laffer and deals with short-term bank-reported claims\nand liabilities. We have already noted (pages 27-28) that Laffer's\nanalytical methods could not adequately justify his conclusion about\nthe effects of the VFCR even in 1967 (when he first wrote his paper),\nmuch less justify the position in the March 1971 OMB paper (see\nAppendix D).\nThe \"overall assessment\" in the OMB paper states:\nDetailed studies of the capital control programs\nhave uncovered absolutely no evidence of any effect\non the balance of payments.\nFORD & LIBRARY GERALD\n- 33 -\nThe common and primary purpose of the capital con-\ntrol programs is to stem the net outflow of U.S.\nofficial reserve assets by obstructing American\ninvestments and loans to foreigners. All available\nevidence suggests that these programs cannot and\nhave not accomplished or even worked towards this\npurpose.\nThese statements are simply false. It would be equally mis-\nleading, but no more incorrect, to say that \"detailed studies of the\ncapital control programs have uncovered absolutely no evidence that\nthe gross balance-of-payments savings from reductions in U.S. capital\noutflows have been undermined by leakages elsewhere in the balance-of-\npayments accounts\" and that \"there is no available evidence suggesting\nthat these programs cannot and have not accomplished their purpose.\"\nThere is a trenchant line from the second scene of Act II\nof Hamlet, in which Gertrude reprimands Polonius for his rhetoric:\n\"More matter, with less art.\" This would be a useful guideline for\nimproving the OMB paper.\nThis paper was prepared by\nMurray Altmann, Ralph Bryant,\nGeorge Henry, and Alan Severn\nFORD & LIBRARY GERALD\n- 34 -\nAppendix A\nAN APPRAISAL OF THE STATE OF CURRENT KNOWLEDGE\nReductions in the outflow of U.S. owned capital brought\nabout by the programs will have induced some offsetting flows in other\nbalance-of-payments accounts. However, since financial instruments\nare not perfect substitutes and international capital and goods markets\nare not fully integrated, it seems likely that offsetting flows, while\nprobably important, would be only partial.\nIn order adequately to measure the size of gross balance-of-\npayments savings owing to the controls and to determine what part of\nthe gross savings are lost in \"leakages,\" it would be necessary to\nspecify and estimate a full model of the international economy. We\nwould require demand and supply equations for each financial instrument\nwhich would reflect the extent of the international interdependencies\nbetween national money and capital markets. Thus, the model would even\nrequire a complete elaboration of the markets for those financial in-\nstruments issued and held entirely domestically since conditions in\nthese \"domestic\" markets would impinge on the decisions of those\nindividual transactors who hold and those who issue \"international\ninstruments.\" Moreover, the model would have to embody the relation-\nships between international capital flows, economic activity levels\nin the important industrial countries, and merchandise trade flows.\nFORD & LIBRARY GERALD\n- 35 -\nIn sum, we would need a set of highly elaborated macroecon-\nomic models for the major industrialized countries, with fully\ndeveloped linkages between the real and financial sectors, and a well\narticulated international sector linking the national models together.\n/\nClearly, such a project is not feasible in the foreseeable future.\nWhen evaluating such evidence as does exist on the effects\nof U.S. capital controls, it is important to realize just how far we\nare from having such a model of the world economy. In the first place,\nwe do not even have the necessary econometric models for the major\nindustrial countries. Many of the models which do exist do not even\nhave a link between domestic financial variables and the domestic real\neconomy. Virtually none attempts to explain international transactions\nother than the current account items.\nGiven this state of affairs, we obviously cannot produce\ndirect empirical evidence as to whether or not controls on capital\noutflows are partially offset through changes in the level of economic\nactivity abroad that reduce the United States' trade balance. This\ndepends essentially on the ability and desire of foreign authorities\nto pursue independent monetary policies. It might be possible to draw\n/ Producing just such a model is the long-run objective of Project\nLINK, a study financed through the Social Science Research Council\nand under the direction of Lawrence Klein, Aaron Gordon, Bert Hickman,\nand Rudolph Rhomberg. Project LINK is at the present time only in its\ninitial stage. Not even its most enthusiastic proponents would claim\nthat its long-run objective could be attained for many years.\nGERALD FORD LIBRARY\n- 36 -\nsome inferences from investigations of the institutional factors\naffecting the ability of foreign authorities to pursue independent\npolicies. While some work along these lines has been attempted, it\nis fair to say that the question of the degree to which independent\npolicies can be pursued abroad must be considered open.\nThe main reason why international capital flow equations\ndo not appear in any of the existing econometric models is simply\nthat relatively little work has been done in estimating such equations.\nIt is a common complaint of all empirical researchers that they are\nhandicapped by a lack of appropriate data. In this area, the con-\nstraint is especially severe. Data are often collected by national\nagencies on non-comparable bases and much of the data are held con-\nfidentially. Moreover, there are important unobservable variables\nwhich play a crucial role in determining capital flows, especially\nexpectations about interest rates and exchange rates.\nThere is also a clear need for fundamental improvements in\nthe theory of international capital flows. It is only recently that\nthe basic elements of domestic monetary and capital markets theory\nhave been applied to international flows.\nA very serious problem that remains to be solved is the\nappropriate treatment of non-price credit rationing, particularly\ncapital controls imposed by national authorities. Capital controls\nintroduce a \"wedge\" between desired flows and actual flows. A\nFORD LIBRARY\n- 37 -\nfrequently employed technique in studies that have tried to estimate\nthe quantitative effects of capital flow restraints is the introduc-\ntion of an additional (\"dummy\") variable which differentiates the\npre-control and post-control periods. However, this technique assumes\nthat the effects of the programs are uniform throughout the period\nof their imposition, allowing no scope for gradual adjustment by\ntransactors to the controls or to modifications of the controls by\nthe authorities. When the effective impact of the programs varies\nover the sample period, the \"dummy variable\" approach can be seriously\nmisleading.\nThe \"learning by doing\" phenomenon is especially important\nfor estimating the net impact of the capital control programs. Leak-\nages will likely become increasingly important with the passage of\ntime. In the present context, this points up the necessity for\nestimating the lags in behavioral responses. The time path of ad-\njustments by transactors in other markets in response to the imposi-\ntion of controls in one market is virgin territory for both the\ntheoretician and the empiricist.\nThe preceding discussion has pointed out a few of the more\nimportant difficulties in estimating elements of the \"ideal model.\"\nThe central point is that a thorough understanding of the impact of\nthe capital control programs is contingent upon the availability of a\ncomplete model. The interrelationships between various capital markets\nGERALD FORD LIBRARY\n- 38 -\nand between capital markets and real economic activity must be\nexplicitly dealt with.\nThis point is well illustrated by considering one of the\nempirical studies cited in a recent paper of the Office of Manage-\nment and Budget. The cited paper, written by Richard N. Cooper,\nwas specifically addressed to the time period when only the IET was\nin effect. There is general agreement that the leakages were es-\ntremely large at that point. This was clearly recognized and led to\na more comprehensive set of controls. In a more recent unpublished\npaper, 2/ Cooper summarized his judgment on the gross savings and on the\nprobable magnitude of offsetting leakages. He concluded that the\npresent elements of the comprehensive set of restrictions are rein-\nforcing and they have had a significant net impact on the balance-of-\npayments.\nCooper's paper, and all others of which we are aware, have\nattempted to estimate the impact (gross or net) of the control pro-\ngrams on the actually observed, historical data. Needless to say,\nthis historical analysis by itself is insufficient for our purposes.\nSince the effective impact of the restraints will vary with our cycli-\ncal position, we also want to know (a) what the impact of the programs\n1/ OMB paper entitled \"Capital Controls: Questionable Results and\nUndoubted Costs,\" March 2, 1971 (Mimeo). The other two studies cited\nby the OMB paper are discussed in Appendices C and D.\n2/ Richard N. Cooper, \"The Voluntary Credit Restraint Program: An\nAssessment,\" January 1969, unpublished paper prepared for a meeting of\nAcademic Consultants at the Federal Reserve Board.\nGERALD FORD VIBRARY\n- 39 -\nwould have been if we had been more successful in having the economy\ngrow along a non-inflationary, high-employment growth path, and (b)\nwhat the impact of the programs would be in the future, given a wide\nvariety of alternative assumptions about domestic and foreign economic\nactivity.\nHow much do we know about international capital flows?\nThe profession has barely begun to tackle the job. The evidence that\ndoes exist is sparse. Even tentative conclusions on what the effects\nof the United States capital control programs have been are no more\nthan informed guesses.\nFORD i LIBRARY GERALD\n- 40 -\nAppendix B\nPOTENTIAL LEAKAGES VIA REDUCED FOREIGN PURCHASES OF\nU.S. CORPORATE SECURITIES\nA frequently mentioned balance-of-payments account in which\ngross reductions in capital outflows might have been offset is that\nof foreign purchases of U.S. corporate securities. While foreign\npurchases of such securities rose markedly after controls were strength-\nened in 1965, it is of course possible that the rise would have been\ngreater in the absence of direct investment, or other, controls.\nOne obvious possibility is that the convertible Eurobonds\nissued by American direct investors were a substitute for ordinary\nAmerican equities. These Eurobonds were sold only to non-residents of\nthe United States. They were favorably priced, relative to comparable\nsecurities within the United States. Therefore, the standard argument\ngoes, investors outside the United States may have been induced to hold\nconvertible Eurobonds instead of 'ordinary American equities, since they\nreceived no price concessions on the latter category.\nObserved transactions, however, show a close quarter-by-\nquarter association between foreign purchases of U.S. equities and of\nconvertible Eurobonds issued by U.S. corporations (see attached chart).\nThus, if there was substitution in the short run, it was apparently\ndominated by causation common to the two types of security. In addi-\ntion, there may be a significant lag in foreigners' adjustment to the\nGERALD FORD LIBRARY\n- 41 -\nsurge of Eurobond issues. Therefore, further evidence is needed to\nestablish the degree of substitution between the two types of security\nover a longer period.\nPreliminary results from an ongoing study of foreign pur-\nchases of U.S. equities being carried out by Alan Severn, however,\nfail to indicate any significant degree of substitution. The relative\nimportance over time of American stocks in foreign equity protfolios\nwas compared to relative risks and returns and to the growth of mutual\nfunds abroad / for the period 1962-70. Through 1969 and the first\nthree quarters of 1970, foreign investors continued to hold as much\nof U.S. stocks as might be expected in light of relative risks, returns,\n2/\nand size of portfolios.\nDirect investment controls may also have affected foreign\npurchases of U.S. equities in ways other than through substitution\nof Eurobonds. In particular, any reduction of American cash purchases\nof existing foreign firms may have limited the equities purchases of\nforeign individuals, i.e., the former owners of the foreign firms.\nBut since a typical foreign investor is likely to invest only a small\nfraction of his equities portfolio in American stocks, this offset is\nIncluding closed-end funds, to the extent that data are available.\n2/ Holdings during the 1968 Eurobond surge were nearly identical to\nthose \"predicted,\" while they were higher than \"predicted\" for 1969\n(by $.4 billion), though lower for the first three quarters of 1970\n(by $.3 billion).\nVERALD FORD LIBRARY\n- 42 -\nlikely to be small. A similar, and similarly small, offset could be\na restriction of loans available to foreign equity investors as U.S.\ncorporations pre-empted part of available European capital.\nThere are also reasons for believing that the U.S. corporate\nsecurities account may contain some offsets to the IET or VFCR programs.\nFor example, one could imagine that the virtual cessation of American\npurchases of foreign stocks, induced by the IET, caused foreign stock\nprices to rise less rapidly, thereby lowering the value of foreigners'\nportfolios compared with what they otherwise would have been and, over\ntime, inducing European investors to reduce their purchases of American\n/\nequities.\nAltogether, it appears that the U.S. capital controls had\nrelatively little impact on foreign holdings of U.S. equities. Even\nif offsets were present, but hidden by other factors relevant to foreign\ninvestment in U.S. equities, the offsets were probably small in relation\nto the gross savings generated by the control programs.\n1/ The rise in the nominal value of foreign equity portfolios\nexceeded $150 billion during the 1963-70 period. While an infusion\nof additional purchases from the U.S. could have raised the value of\nforeign equities even further, any reasonable amount of U.S. pur-\nchases would have played only a secondary role in foreign stock\nmarkets.\nFORD & LIBRARY GERALD\nFORD & LIBRARY\n- 42a -\nNET FOREIGN PURCHASES OF U.S. SECURITIES, 1965-1970\nU. S. Stocks\nConvertible Eurobonds Sold Abroad by U.S. - Incorporated Companies\n$\nmillion\n800\n700\n600\n500\n400\n300\n200\n100\n0\n- 100\n1965\n1966\n1967\n1968\n1969\n1970\nIV I II III IV I II III IV I II III IV I II III IV I II III IV\n- 43 -\nAppendix C\nA COMMENT ON THE CPR REPORT\n\"FEDERAL CONTROL OF FOREIGN DIRECT INVESTMENTS\"\nThis report by the Center for Political Research, dated\nMay 11, 1970, was apparently done for an unnamed corporate client;\nthe emphasis is on the locus of decision-making power with respect\nto control of foreign direct investment.\nSeveral flaws may be noted in this report:\n1. It implies that earnings on direct investment depend on U.S. equity\nin such investment, rather than on the aggregate size of the activity\n(as measured, for example, by total assets). On page 14 the following\nstatement appears:\n\"Just how long OFDI's short-term balance of payments\nbenefits will last is open to debate\nWhat is not\nopen to debate is that restrictions on direct U.S.\nforeign investment will eventually lead to a decline\n(or slower growth) in the dollar amount earned abroad\neach year by U.S. firms. In addition, heavy borrowing\nabroad by U.S. firms necessarily leads to sharp in-\ncreases in U.S. interest payments to foreigners. Such\npayments have more than doubled since 1966; they are now\nrunning at an annual rate of about 3.3 billion dollars.\"\n2. The above quotation implies that interest payments on corporate\nborrowing abroad are an addition to total interest payments by the\nUnited States as a whole. But if the corporations were to borrow in\nthe United States and send the proceeds abroad, the outflow would be\nreflected in combined private and official foreign holdings of dollars.\nSince the holders of these additional dollars could be expected to\nGERALD R. FORD LIBRARY\n- 44 -\nhold them in interest-bearing form, the interest payments on these\nholdings would partially offset the reduced payments by U.S.\ncorporations. Thus, only the difference between interest rates is\nrelevant here.\n3. Several New York bankers are quoted as stating that as of 1970,\nonly half-a-dozen firms (mainly in petroleum and computers) have been\naffected by the program; about 200 others have been partially affected,\nbut can still carry out their investment programs. What this state-\nment apparently means is that plant and equipment expenditures, rather\nthan the financing of such expenditures, has been largely unaffected.\nBut the stated purpose of the control programs was and is to affect\nthe financing, which in turn is what directly affects the U.S. balance\nof payments.\nThe debate about the balance-of-payments effects of direct\ninvestment activity (to which the report refers) is not relevant here,\nbecause the scale of such activity has been largely unchanged. There-\nfore fees and royalties, parts and components, exports back to the\nUnited States, etc., are not affected.\n4. The report states that, in the aggregate, firms were below their\n\"allowables,\" in both 1968 and 1969. While this is true, it does not\nnecessarily reflect on the effectiveness of the program. The regula-\ntions are the most restrictive for the continental Western European\ncountries, and least restrictive for less developed countries. It\nappears that most of the leeway below allowables was concentrated in\nFORD is LIBRARY GERALD\n- 45 -\nthe LDC's. The CPR report does not mention this possibility as a\npartial explanation for the fact that allowables were not fully\nutilized.\nIn summary, the CPR report is analytically weak. Its\nworse fault is that it fails clearly to distinguish between finan-\ncial and real consequences of the control of direct investment.\nFORD : LIBRARY GERALD\n- 46 -\nAppendix D\nA COMMENT ON RESEARCH BY ARTHUR B. LAFFER ON\nSHORT-TERM BANK-REPORTED CAPITAL MOVEMENTS\nArthur Laffer carried out some econometric research during\n1966-67 from which he drew strong conclusions about the balance-of-\npayments impacts of the VFCR program. Laffer's conclusions have\nbeen recently cited in the March 1971 OMB paper entitled \"Capital\nControls: Questionable Results and Undoubted Costs,\" as follows:\nthe net effects of the VFCRP on the U.S.\nbalance of payments seem to be quite negligible.\nIn fact, for a long time, the VFCRP appears to\nhave cost the United States in terms of foreign\nexchange, and only after a year or more in\noperation were the net effects on the U.S.\nofficial settlements balance of payments non-\nnegative. Therefore, the ostensible success of\nthis program with respect to U.S. capital flows ap-\npears to have been negated by foreign capital flows.\nWe believe Laffer's research to be so inconclusive and the\nmethod by which he reached his judgment about the VFCR to be so\n/ The basic research done by Laffer is described in detail in his\nStanford Ph.D. dissertation entitled International Hot Money and the\nU.S. Balance of Payments. Part of this research, particularly that\npart concerned with the VFCR, is summarized in an unpublished paper\n\"Short-term Capital Movements and the U.S. Balance of Payments\"\n(December 1967). We believe that a slightly revised version of the\nDecember 1967 paper was circulated in 1969 at the University of Chicago\nunder the title \"Short-term Capital Movements and the Voluntary Foreign\nCredit Restraint Program.\" We were unable to obtain a copy of the 1969\nversion of the paper; as far as we are aware the equations and empirical\nresults are identical in the 1967 and 1969 versions.\n2/ OMB paper, p. 6. The same passage appears on page 20 of the\nDecember 1967 paper.\nFORD is GERALD LIBRARY\n- 47 -\nunreliable that little if any weight should be attached to his sup-\nposed evidence. The purpose of this appendix is to review Laffer's\nresearch briefly and to update it with data for 1967-70.\nAs we note in the text (p. 27 above), our replication and\nupdating of Laffer's results yield an opposite conclusion from the\none originally reached by Laffer. In our opinion, however, neither\nconclusion -- that the VFCR does or does not improve the balance of\npayments -- is warranted by Laffer's research and our updating of it.\nSynopsis of Laffer's Methods and Conclusion\nLaffer's study deals with only two types of capital flows:\n(a) changes in the short-term claims on foreigners reported by U.S.\nbanks, and (b) changes in the liabilities to private foreigners\nreported by U.S. banks. For each of these two flows, Laffer estimates\na regression equation, using monthly data for the period January 1959\nthrough December 1964. (The influence of the VFCR program is held to\nhave begun during January 1965; although the program was not announced\nuntil mid-February, Laffer argues that the market anticipated its\nimposition.) Using these estimated equations, Laffer then projects\nthe values of the two capital flows for the eighteen-month period\nJanuary 1965 through June 1966. He interprets the differences\nbetween the actual values and the predicted values of the capital\nflows (the \"residuals\") as measures of the impact of the VFCR program.\nIn other words, data for the explanatory variables for the\nJanuary 1965 to June 1966 period are plugged into the estimated equa-\ntion in order to obtain a \"predicted\" series for the two capital flows.\nBERALD FORD VIBRARY\n- 48 -\nFor the eighteen-month period examined by Laffer, the\npredicted net outflows for bank lending substantially exceed the net\noutflows actually observed. This result leads Laffer to conclude\nthat the VFCR was successful in holding down the category of capital\noutflow at which it is directed. But for his other category of\ncapital flow, Laffer finds a result that seems consistent with large\n\"leakages\" having occurred. Actual inflows of foreign liquid funds\ninto U.S. banks are substantially less than the inflows predicted\nby the equation. Laffer attributes the entire amount of these\nresiduals to the effects of the VFCR as well. When the supposed\neffects of the VFCR on the two types of capital flows are netted\ntogether, it turns out -- for this eighteen-month period -- that the\nnet effect is quite close to zero.\nChart 1 (reproduced from the OMB paper) shows these alleged\nimpacts of the VFCR program. In that chart, the residuals calculated\nby Laffer (the difference between predicted and actual flows) are\naccumulated through time, so that the plotted curves give the supposed\ncumulative effects of the program.\nActual bank claims on foreigners changed little from the\nbeginning to the end of the period. Laffer's equation predicts a\nsignificant net increase.\nFORD is 9FRALD LIBRARY\n- 49- 49\nChart 1\nCUMULATIVE BALANCE-OF-PAYMENTS IMPACTS\nOF VFCR PROGRAM FOR SIXTEEN-MONTH PERIOD\nJANUARY 1965 TO APRIL 1966 AS CALCULATED\nBY ARTHUR LAFFER\n(chart reproduced from OMB Paper)\n1965\n1966\nXII\n=\nIII\nIV\nY\nvi\nwe\nviii\nIX\nX\nXI\nxii\nil III ir\n2.0\n(a)\n1.5\naccumulated U.S. private short-term\ncapital flows\n1.0\n.5\n0\nnet of (a) and (b)\n-5\n-1.0\n-1.5\n(b)\n-2.0\nassumulated foreign private shert-term\ncapital flas\nFORD & GERALD LIBRARY\n- 50 -\nUpdating Laffer's Conclusion\nEven if Laffer's method were analytically reliable, it\nwould seem undesirable from the vantage point of March 1971 to accept\na conclusion based only on an analysis of the eighteen-month period\nending in June 1966. We therefore thought it only prudent to bring\nLaffer's results up to date by considering the whole period January\n1965 to September 1970 (the last month for which we could easily ob-\ntain data for all the required variables). The results of updating\nhis analysis are displayed in Chart 2. As the reader can easily\nverify, the first eighteen months of Chart 2 are essentially a re-\n/\nproduction of Chart 1.\nIf we follow Laffer in attributing residuals from his equa-\ntions entirely to the VFCR program, Chart 2 tells us that the VFCR\nheld bank lending to foreigners some $1-2 billion below what it other-\nwise would have been throughout the five years ending in September\n1970. It also says that the VFCR had the effect, up until mid-1968,\nof reducing foreigners' holdings of liquid assets in U.S. banks com-\npared with what they otherwise would have been. After the summer of\n1968, however, the VFCR began to give an immense stimulus to\nforeigners to hold more liquid assets in U.S. banks than they otherwise\nwould have held. Still taking the results at face value, Chart 2 tells\n1/ The very minor differences between the paths plotted in Chart 1\nand those in Chart 2 (for the period January 1965 to April 1966) are\ndue to very minor differences between Laffer's equations and our replica-\ntions of Laffer's equations. These differences are explained further\nbelow.\nFORD & LIBRARY GERALD\n- 51 -\nGERALD FORD LIBRARY\nChart 2\n1965-70 CUMULATIVE BALANCE- OF PAYMENTS IMPACTS\nOF THE VFCR PROGRAM CALCULATED VIA METHOD\nADVOCATED BY ARTHUR LAFFER\n(billions of dollars)\n11.0\n11.0\n10.0\n10.0\n9.0\n9.0\n8.0\n8.0\n7.0\n7.0\nFavorable-Effect on Balance of Payments\n6.0\n6.0\nAlleged Cumulative Impacts\nof VFCR on U.S. Balance of\n5.0\n5.0\nPayments: Sum of (a) and (b)\n4.0\n4.0\n(a) Accumulated residuals for\nshort-term bank-reported\n3.0\nU.S. capital flows\n3.0\n2.0\n2.0\n1.0\n1.0\n0\n0\nUnfavorable Effect\n1.0\n1.0\n(b) Accumulated residuals for\nshort-term bank-reported\n2.0\nforeign private capital flows\n2.0\n3.0\n3.0\n1965\n1966\n1967\n1968\n1969\n1970\nM\nJ\nS\nD\nM\n3\nS\nD\nM\nJ\nS\nD\nM\nJ\nS\nD\nM\nJ\nS\nD\nM\nJ\nS\nD\n- 52 -\nus that the impact of the VFCR on the two capital flows combined\nwas either perverse or zero until mid-1966, became sharply favor-\nable in the last half of 1966, became perverse again in mid-1967,\nand thereafter became immensely favorable.\nThese inferences are of course completely unfounded. The\nequations which underpin the analysis are weak and the residuals\ncalculated from them, therefore, cannot be validly used to make such\nstrong inferences about the impacts of the VFCR. We have taken the\ntrouble to present the updated calculations only to emphasize that\nLaffer's evidence will not begin to support the conclusions that have\nbeen based on it.\nSome Weaknesses in Laffer's Econometric Analysis\nThis is not the place to present a detailed, technical\nreview of Laffer's research. Of necessity, therefore, we merely\nenumerate here what we believe to be some of its most serious weak-\nnesses.\nThe Achilles' heel in Laffer's methodology is his interpre-\ntation of the post-1964 residuals calculated from his equations as\nentirely due to the impacts of the VFCR program. This procedure would\nonly be acceptable if his estimated equations were highly successful\nin all other respects at explaining the two types of capital flow.\nBut in fact the explanatory power of his equations is quite poor (the\nadjusted R²¹s in his two equations are .49 and .35). What is worse,\nFORD is LIBRARY GERALD\n- 53 -\nthe economic rationale for the estimated equations is doubtful in\nseveral ways. In these circumstances, it can be extremely mis-\nleading to project the equations outside the sample period and to\nassign the calculated residuals to only one of many omitted influences.\nJust how misleading this procedure can be is amply illustrated by\nChart 2. The tremendous bulge in foreign holdings of liquid assets in\nU.S. banks in 1969 had little if anything to do with the VFCR. But\nthere is nothing in Laffer's methodology -- even for the 1965-66 period\n-- that guards against such a serious misinterpretation.\nThe basic weaknesses in Laffer's research stem from the in-\nadequate and incomplete specification of his equations. Although\nLaffer argues that interest rates ought to appear in the equations, he\ndrops them out of his analysis after a superficial effort suggests\nthey are statistically insignificant. The least unsatisfactory econo-\nmetric studies of capital flows to date have produced evidence that\ncapital flows are quite sensitive to interest rates. / The failure\nappropriately to take interest-rate effects into account is almost\ncertainly a major explanation for the poor performance of Laffer's\nequations.\nThe equation for changes in bank claims on foreigners in-\ncludes a variable representing the previous month's capital flow.\n1/ See, for example, the studies by Branson, Bryant and Hendershott,\nand Miller and Whitman cited in Appendix E.\nDERALD FORD VIBRARY\n- 54 -\nLaffer includes this variable on the grounds that \"we might easily\nexpect a repayment effect on capital flows of this month due to\ncapital flows of the previous month. 1/1/ We believe that this variable\nin fact introduces a complicated lag pattern into the equation that\ncannot be explained as a \"repayment effect\" and that is difficult to\nrationalize on theoretical grounds.\nThe equation for changes in bank liabilities to private\nforeigners makes no distinction between liabilities to overseas\nbranches of U.S. banks, liabilities of U.S. - located agencies of Cana-\ndian and Japanese banks to their head offices abroad, and liabilities\nto other private foreigners. An analysis that does not make these\ndistinctions may well fail from the outset. The greatly increased\nborrowing of U.S. banks from their own branches in the Eurodollar\nmarket, for example, is the primary reason why Laffer's equation pro-\nduces huge residuals in 1969 and 1970, which in turn underly the big\nhump in Chart 2.2/\nA major part of the statistical explanatory power of the\nliabilities equation, which in any case only captures 35 per cent of\nthe variation, is due to several \"institutional\" variables having\n/ Laffer paper of December 1967, p. 12.\n2/ In fairness to Laffer, it should be noted that no one has yet\nbeen very successful in econometrically analyzing the liabilities of\nU.S. banks to their overseas branches. But even in 1967 Laffer\nshould have been aware of the importance of making this distinction.\nFORD :- LIBRARY GERALD\n- 55 -\npurely transitory effects (e.g., year-end window-dressing, month-\nend so-called \"Thursday-Friday\" transactions). Well over half of\nthe variables that Laffer's theory suggests to him should have non-\ntransitory effects on the stock of foreign private liquid assets in\nthe United States (e.g., interest rates, U.S. imports, growth rates\nin the United States and foreign countries) turn out to be statis-\ntically insignificant.\nOf the two equations, the one for changes in bank claims\non foreigners is less unsatisfactory. As can be seen in Chart 2,\nit does much less badly in tracking the actual 1965-70 changes in bank\nclaims than the other equation does in tracking changes in bank\nliabilities.\nAll in all, Laffer's two econometric equations cannot be\naccepted as reliable. We were led to further skepticism, moreover,\nin the process of trying to duplicate the equations. We were able to\ncome close to Laffer's equations only by using the exact data which he\nhad used. When we collected revised data for the two capital flow\nvariables and for several of the explanatory variables, which are\npresumably more correct than the data used by Laffer, we found that\nthere were non-trivial changes in some of the coefficients in Laffer's\nequations and that the explanatory power of one of the equations\n1/ In replicating Laffer's equations, we drew on the data tables\ncontained in appendices to his Ph.D. dissertation. In a few very\nminor respects, we were unable to duplicate Laffer's data exactly.\nThese data discrepancies account for the very small differences be-\ntween Laffer's coefficients and the coefficients we obtained using\nhis data.\nGERALD FORD LIBRARY\n- 56 -\ndeclined appreciably. We also re-estimated Laffer's equations for\nsome other sample periods. In these cases, too, the equations\nwere altered to such a degree that we found ourselves becoming more and\nmore doubtful of the basic specifications.\nConcluding Comment\nWe have been quite critical of Laffer's research in this\nnote. We would like to end by trying to dispel a possible misinter-\npretation of our views. We are certainly not maintaining that we\nourselves have an unambiguously superior method of estimating the\nimpacts of the VFCR on short-term bank-reported capital flows. All\nresearchers in this difficult area have every reason to present\nresearch results with a large dose of humility. The only unpardonable\nsin is to pretend that blood can be squeezed out of a turnip.\nFORD is LIBRARY GERALD\n- 57-\nAppendix E\nAnnotated List of References\nThis is not intended as an exhaustive survey of the\nliterature. It does bring together much of the literature which\nbears on the subject matter of this paper.\n1. Board of Governors of the Federal Reserve System, \"Report on\nInquiry into Possible Effects of Voluntary Foreign Credit\nRestraining Program in 1970 on Export Financing and on Exports,\nJanuary 7, 1971.\nThe survey of banks summarized in the report, \"turned up very\nfew examples of requests for financing the export of U.S. goods\nthat were denied in 1970 because of [the VFCR] program\"\n2. William H. Branson, Financial Capital Flows in the U.S. Balance\nof Payments, (North-Holland Publishing Company, Amsterdam, 1968).\nBranson's Ph.D. dissertation applies a stock-adjustment model\nto capital flows, with particular emphasis on estimation of lags\nvia the Almon technique. The capital control programs are taken\ninto account only by means of on-off dummy variables.\n3. William H. Branson and Raymond D. Hill, Jr., \"A New Model of\nFinancial Capital Flows in the U.S. Balance of Payments,\"\nDecember 9, 1970 (Mimeo).\nThis paper updates and revises the empirical results in the\npreceding reference.\n4. Ralph C. Bryant and Patric H. Hendershott, Financial Capital\nFlows in the Balance of Payments of the United States: an Ex-\nploratory Empirical Study, Princeton Studies in International\nFinance No. 25 (June 1970).\nBryant and Hendershott attempt to elaborate an appropriate\ntheoretical framework for investigating international capital\nflows. The model is applied to data for U.S. short-term outflows\nto Japan with particular attention placed on trying to capture\nthe influence of the VFCR program.\nGERALD FORO LIBRARY\n- 58 -\n5. Ralph C. Bryant and Patric H. Hendershott, \"Empirical Analysis\nof Capital Flows: Some Consequences of Alternative Specifica-\ntions,\" a paper presented at a Universities - NBER Conference\non International Mobility and Movement of Capital, January 30-\nFebruary 1, 1970, Washington, D. C.\nThis paper, which expands the analysis in the previous reference,\ndiscusses the substantial difficulties in determining an appro-\npriate specification for capital flow equations. Alternative\nspecifications are shown to imply very different conclusions\nabout the effect of capital control programs.\n6. Center for Political Research, \"Federal Control of Foreign Direct\nInvestments, May 11, 1970.\nThe report discussed the program and concludes that \"the avail-\nable statistics regarding the OFDI program\n...\ncast doubt on the\nextent to which the program actually restricts direct foreign\ninvestment today.\"\n7. Richard N. Cooper, \"The Interest Equalization Tax: An Experiment\nin the Separation of Capital Markets,\" Finanz Archiv, 24 (Decem-\nber 1965), 447-471.\nCooper investigates the period when only the IET was in effect\nand concludes that, for all intents and purposes, offsetting\nflows in other accounts entirely negated the impact of the IET.\n8. Richard N. Cooper, \"The Voluntary Credit Restraint Program:\nAn Assessment,\" January 1969 (Mimeo). Unpublished paper prepared\nfor FRB Academic Consultants.\nCooper summarizes his judgment on the gross savings and on the\nprobable magnitude of offsetting leakages. He concludes that the\npresent elements of the comprehensive set of restrictions are\nreinforcing and that they have had a significant net impact on\nthe balance-of-payments.\n9. Arthur B. Laffer, \"Short-term Capital Movements and the Voluntary\nForeign Credit Restraining Program\" 1969 (Mimeo).\nLaffer presents regression equations for the changes in \"U.S.\nprivate short-term claims on foreigners\" and for the changes in\n\"U.S. short-term liabilities to private foreigners.\" The relation-\nship between actual flows and what his equations predict lead him\nto conclude that there has been no net balance-of-payments saving\nfrom the VFCR program.\nGERALOR FORD FIBRARY\n- 59 -\n10. Walther Lederer, \"Notes on the Structure of the U.S. Balance of\nPayments,\" not dated, (Mimeo).\nLederer argues that \"major fluctuations in the balance on goods\nand services are to a large extent offset by fluctuations in\nunilateral and nonliquid capital transactions.\" However, some\nregressions of the capital flow balance on the goods and services\nbalance and various dummy variables lead him to conclude that the\ncapital restraint programs have had a net effect on the balance\nof payments.\n11. C. H. Lee, \"A Stock-Adjustment Analysis of Capital Movements:\nThe United States-Canadian Case,\" Journal of Political Economy,\nVol. 77 (July/August, 1969), 512-523.\nThis is another econometric application of the stock-adjustment\nmodel, in this case to U.S.-Canadian capital flows. On-off\ndummy variables are used to allow for the effects of the capital\ncontrol programs.\n12. Fritz Machlup, \"The Transfer Gap of the United States,\" Banca\nNazionale del Lavoro Quarterly Review, No. 86 (September 1968),\n195-238.\nMachlup rearranges the standard balance-of-payments accounts to\narrive at what he calls the \"net real transfers\" and the \"net\nfinancial transfers\" of the United States. His work leads him\nto conclude that in most circumstances changes in net financial\ntransfers will be offset by changes in net real transfers. He\nconcludes that \"the balance-of-payments program pursued by the\nUnited States Government\nis useless for the purpose for\nwhich it was designed.\"\n13. N. C. Miller and M. V. N. Whitman, \"A Mean-Variance Analysis of\nUnited States Long-Term Portfolio Foreign Investment,\" The\nQuarterly Journal of Economics, LXXXIV (May 1970), 175-196.\nIn this and several subsequent papers, Miller and Whitman apply\nthe portfolio selection approach to various categories of capital\nflows in the U.S. balance of payments. On-off dummy variables\nare used to allow for the effects of the capital control programs.\n14. John Patrick, \"Bank Lending to Foreigners under the FCRP and the\nIET,\" NYFRB Research Memorandum, June 20, 1969.\nGERALD FORD VIBRARY\n- 60 -\nPatrick reviews recent data on capital flows and then presents\nregression results for equations explaining (quarterly changes\nin) short-term bank-reported claims on foreigners and in total\nbank-reported claims on foreigners. His results lead him to\nconclude that the two programs do reduce (and quite substantial)\nthe flows at which they are directed.\n15. Samuel Pizer, Statement to the Commission on International Trade\nand Investment Policy on the \"Capital Restraint Programs,\"\nOctober 15, 1970.\nPizer argues that there has been a large impact of the programs\nin reducing gross outflows in the categories controlled. He con-\ncludes moreover that despite the possibility of some leakages,\nthere has been a substantial net effect.\n16. Martin F. J. Prachowny, A Structural Model of the U.S. Balance\nof Payments (North-Holland Publishing Company, Amsterdam, 1969).\nThis is another econometric study that uses on-off dummy vari-\nables in some capital flow equations to allow for the effects of\nthe U.S. capital control programs.\n17. R. Rickover, \"Export Finance Before and After the Voluntary\nForeign Credit Restraint Program,\" NYFRB Research Memorandum,\nOctober 14, 1969.\nRickover attempts to estimate the effect of the VFCR program on\nexport financing with a simple regression relating changes in\ntrade credit to (current and lagged) changes in the value of U.S.\nexports. He believes that the volume of export trade financing\nhas been affected by the VFCR program.\n18. R. Rickover, \"Interest Rates, Capital Flows, and Errors and\nOmissions in the U.S. Balance of Payments,' NYFRB Memorandum,\nMarch 8, 1971.\nRickover concludes that the \"normal\" unrecorded outflow (errors\nand omissions) attributable to systematic errors in data collec-\ntion is sizable. Interest rates (in the United States, Canada,\nand the Euro-dollar market) and U.S. banks' liabilities to their\nforeign branches exert a strong influence on unrecorded outflows.\nDelays between payments for U.S. imports and their recorded\narrival in the United States also influence errors and omissions\nwhen significant changes occur in the volume of imports.\nBERALD FORD LIBRARY\n- 61 -\n19. Guy Stevens, \"Capital Mobility and the International Firms,\"\na paper presented at a Universities-NBER Conference on Interna-\ntional Mobility and Movement of Capital, January 30-February 1,\n1970, Washington, D. C.\nStevens estimates an econometric model of firm behavior. He con-\ncludes that \"virtually no impact of the various balance-of-\npayments programs is evident on plant and equipment expenditures\nin manufacturing.\"\nFORD is LIBRARY"
}