Fritz Machlup, “Real Adjustment, Compensatory Corrections, and Foreign Financing of Imbalances in International Payments” (1965)

Machlup’s essay is a conceptual reconstruction of balance-of-payments analysis. Against the long classical tradition from Hume to Meade, he argues that modern discussion remains clouded by unstable terminology. “Adjustment,” “balance,” “equilibrium,” “financing,” and “correction” are used as if self-evident, but their ambiguity allows policy disagreements to masquerade as technical consensus.

Theoretical analysis may be seriously hampered where semantic inconsistencies reflect conceptual confusion.

The opening sections therefore separate different meanings of adjustment. It may name a process, an end-state, or a policy program. It may refer to observed payments balance or to theoretical equilibrium. Machlup insists especially on distinguishing the beginning of adjustment from its completion: one may demand prompt action while rejecting a forced and disruptive rush to final balance.

There is, of course, no contradiction between a demand to begin the process promptly and a warning against trying to rush it toward a prompt conclusion.

This semantic clarification leads to a critique of the standard definition of adjustment as the process by which payments surpluses and deficits are eliminated. Such a definition fits the classical specie-flow model, where reserve changes alter credit, income, costs, prices, imports, and exports. But it fails when exchange rates move freely, since market-clearing depreciation or appreciation may prevent an actual deficit or surplus from appearing. A theory that excludes exchange-rate changes from “adjustment” mistakes an institutional form for the underlying economic mechanism.

Machlup then surveys the wide range of policies commonly grouped under adjustment: monetary contraction or expansion, wage and price policies, fiscal changes, tariffs, subsidies, foreign aid, capital controls, interest-rate changes, exchange controls, devaluation, appreciation, and floating. His purpose is taxonomic rather than programmatic. These measures do not all work in the same way. Some alter relative prices, incomes, and resource allocation; others merely suppress or reroute payments. Direct exchange controls, for example, may eliminate a recorded deficit without eliminating the excess demand that caused it.

Rationing a scarce supply of foreign exchange under direct controls does not reduce the demand, but merely leaves part of it unsatisfied.

The central contribution of the essay is Machlup’s third category: “compensatory corrections.” He reserves “real adjustment” for mechanisms that change relative prices, incomes, exchange rates, and productive allocation so that the current account itself is brought into line. He reserves “foreign financing” for temporary accommodation of excess supply or demand in the exchange market, especially through reserves, official borrowing, or short-term capital flows. Between them are changes that reduce or remove the payments imbalance without constituting either real adjustment or mere financing.

adjustment is one thing and reduction or removal of the need for adjustment is another.

This distinction also revises the common suspicion that foreign financing necessarily delays adjustment. For Machlup, selling foreign exchange to domestic buyers can drain purchasing power and thereby initiate contractionary adjustment. What blocks the process is not external finance as such, but domestic monetary policy that offsets the contraction. Hence the analytical focus must be on the interaction between foreign financing and domestic credit creation.

The resulting taxonomy is precise. Real adjustment includes deflation in deficit countries, inflation in surplus countries, depreciation of deficit currencies, and appreciation of surplus currencies. Compensatory corrections include productivity changes, shifts in demand, trade restrictions or liberalization, altered foreign aid, and changes in long- or short-term capital movements when these reduce the need for real adjustment. Temporary financing includes reserve use, official borrowing, leads and lags, and stabilizing short-term funds.

Machlup’s policy conclusion is restrained but pointed. Governments prefer compensatory corrections because real adjustment is painful and financing is limited. Yet such corrections are often unreliable or distortionary: import restrictions can provoke retaliation, capital controls can alter import demand, aid cuts can reduce export markets, and induced capital movements can be offset by trade effects. The essay’s durable lesson is that payments policy must ask what mechanism is actually operating: financing an imbalance, adjusting the real economy, or merely compensating for imbalance by some separate and possibly inefficient correction.