adjustment mechanism

adjustment mechanism

a means of correcting balance of payments disequilibriums between countries. There are three main ways of removing payments deficits or surpluses:
  1. external price adjustments;
  2. internal price and income adjustments;
  3. trade and foreign-exchange restrictions.

See BALANCE-OF PAYMENTS EQUILIBRIUM for further elaboration.

While conventional balance of payments theory emphasizes the role of monetary adjustments (e.g. EXCHANGE RATE devaluations/depreciations) in the removal of payments imbalances, a crucial requirement in this process is for there to be a real adjustment in terms of industrial efficiency and competitiveness. An example will reinforce this point. Let us assume that, because UK goods are more expensive, the UK imports more manufactured goods from Japan than it exports manufactures to Japan. Since each country has its own separate domestic currency, this deficit manifests itself as a monetary phenomenon - the UK runs a balance of payments deficit with Japan, and vice-versa. Superficially, this situation can be remedied by, for example, an external price adjustment: currency devaluation/ depreciation of the pound and currency revaluation/appreciation of the yen.

But price differences in the domestic prices of manufactured goods themselves reflect differences between countries in terms of their real economic strengths and weaknesses, that is, causality can be presumed to run from the real aggregates to the monetary aggregates and not the other way round: a country has a strong, appreciating currency because it has an efficient and innovative real economy; a weak currency reflects a weak economy. Simply devaluing the currency does not mean that there will be an improvement in real efficiency and competitiveness overnight. Focusing attention on the monetary aggregates tends to mask this fundamental truth. Thus, if the UK and Japan were to establish an economic union in which, as provided for by the European Union's Economic and Monetary Union (EMU) arrangements, their individual domestic currencies would be replaced by a single currency, then, in conventional balance of payments terms, the UK's deficit would disappear.

Or does it? It does so in monetary terms but not in real terms, that is, the disequilibrium manifests itself not in terms of cross-border (external) foreign currency flows but as an internal problem of regional imbalance. The leopard has changed its spots’ - a balance of payments problem has become a regional problem, with the UK region of the customs union experiencing lower industrial activity rates, lower levels of real income and higher rates of unemployment compared with the French region. To redress this imbalance in real terms requires an improvement in the competitiveness of the UK region's existing industries and the establishment of new industries by inward investment. For example, within the UK itself the decline of iron and steel production in Wales has been partly offset by the establishment of consumer appliance and electronics industries by American and Japanese multinational companies. See EURO, REGIONAL POLICY.