Fritz Machlup, The Alignment of Foreign Exchange Rates (1973)

Machlup’s Horowitz Lectures argue that persistent balance-of-payments disequilibrium should normally be met by exchange-rate realignment rather than by controls, reserve losses, foreign borrowing, inflation, or deflation. The book’s central claim is comparative, not utopian: all adjustment imposes costs, but some methods waste fewer resources and distort fewer decisions. Its preface states the thesis directly:

“the best option available, under conditions usually prevailing in most countries, is a realignment of foreign-exchange rates.”

The first lecture is deliberately analytical. Machlup resists the language of an “equilibrium exchange rate,” because the relevant conditions—money, wages, productivity, capital flows, tastes, tariffs, taxes, and import propensities—are continually changing. He therefore prefers “alignment” and “disalignment,” terms that treat exchange rates as institutional prices that may become inconsistent with the wider structure of costs, demands, and payments. The practical question is not how to discover a timeless true rate, but how to respond when the official rate has ceased to coordinate international transactions.

Against this background, Machlup distinguishes real adjustment from evasive substitutes. Governments often prefer import restrictions, exchange controls, surcharges, quotas, or multiple-rate arrangements because they conceal the political embarrassment of devaluation or revaluation. Yet these devices protect particular interests, invite administrative discretion, and redirect trade without removing the underlying imbalance. Stripped to essentials, the policy choice is stark:

“either to adjust supply and demand to the exchange rate or to adjust the exchange rate to supply and demand.”

The first option relies on domestic demand management. A deficit country may deflate until imports fall and exports rise; a surplus country may inflate until imports rise and exports fall. Machlup grants the formal symmetry but emphasizes the real asymmetry of costs. Deflation in deficit countries means unemployment, idle capacity, and lost output. Inflation in surplus countries redistributes wealth and distorts relative prices. Fiscal and monetary policy can shift the burden, but they cannot make a wrong parity harmless. The second option changes the relative price at issue: devaluation raises the domestic price of foreign exchange and encourages substitution toward home goods, while revaluation cheapens imports and moderates export demand.

Machlup does not claim that devaluation mechanically succeeds. If credit expands enough to offset the loss of purchasing power caused by dearer imports, the corrective effect may disappear into inflation. But this objection supports discipline after realignment, not the defense of an overvalued currency through recession or controls. His welfare argument is that exchange-rate adjustment works through the price that is out of line, while selective restrictions create wider deadweight losses. Hence the book’s concise conclusion:

“Adjustment of real flows by means of adjustment of exchange rates is the least-cost option.”

The second lecture asks why governments delay if the case is so strong. Machlup’s answer is political economy. Exporters in surplus countries, import consumers in deficit countries, protected firms, officials administering controls, and politicians attached to national prestige all resist realignment. Governments also fear that devaluation will signal failure, worsen debts, stimulate speculation, or accelerate inflation. Some fears are legitimate, but postponement usually enlarges them. A small early adjustment may prevent the larger jump required after reserves are depleted and expectations harden.

Machlup’s institutional remedy is greater flexibility: wider margins, crawling or gliding parities, and temporary floating when authorities cannot know the new sustainable rate. He rejects the charge that flexibility necessarily licenses fiscal irresponsibility, ruins trade, or produces competitive devaluation. Speculation, he argues, is most dangerous when officials defend a visibly false rate and markets anticipate a sudden change:

“Currency speculation is a function of disaligned exchange rates that are expected to undergo adjustment by large jumps.”