12/27/82

Economic Theory and Political Reality

For most of the period since World War II the non-communist world experienced unprecedented economic growth. The historical business cycle of boom and bust seemed to be overcome. Recessions were relatively shallow and mercifully short. In the advanced industrial societies cheap energy, growing markets, adequate savings and modest inflation combined to bring about a prosperity seemingly without upper limit; the scourge of unemployment seemed so remote that many countries encouraged the immigration of foreign labor generally for tasks their own workers preferred to avoid. Consumption rose year by year. The developing countries lagged, of course, far behind. But the more advanced nations among them Brazil, Mexico and South Korea seemed to be on the verge of sharing in the general prosperity.

This idyll ended by the middle Seventies.

Institutional and regulatory

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rigidities slowed growth. Social welfare payments increased much faster than the Gross National Product. Rising governmental expenditures and the failure to finance the Vietnam War accelerated inflation. Thirty years of improving living standards reduced economic incentives.

The nearly twenty-fold increase in oil prices after 1973 culminated the process. By the beginning of the 80's recession was global. The advanced industrial countries were more or less grudgingly resorting to policies of austerity and some were accepting real declines in their standard of living. The developing nations heavily burdened by debt saw hopes for progress disappear. The global inflation in the 1970's gave way to global recession. Nearly thirty million workers are without jobs in the industrial democracies and their number continues to increase. Trade has slowed, economic activity is weak and investment sluggish. These events have shaken the foundations of the post-war political and economic order.

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Nor are there purely technical solutions to reverse
what is turning more and more into a structural crisis.
Simply put: without political leadership of high order
within the industrial democracies and cooperation among
them, the governability of all democratic societies is
likely to erode ability to conduct an effective and long-
term foreign policy or to assure that their national security
will not be jeopardized.

An augury is the fact that no democratic government-
except Canada-which was in office in 1979 when the Iranian
revolution ushered in a new surge in oil prices has survived
the intervening period. Socialist or liberal governments
in Germany, Britain and the United States have been
replaced by conservative ones; conservative governments in
France, Greece, Spain and Sweden have been succeeded by
socialist ones. The common feature is less the program of
the parties than the conditions of societies; restlessness
with a recession which seems to have no end; fear of a
future that has no signposts. If the public no longer

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believes that governments can control economic destinies,
political disorientation can only grow. Demagogues of the
radical right or left will increasingly dominate the political
landscape.

## Economic Theory and Political Reality

No more urgent challenge confronts the industrial
democracies than to put a decisive end to the global recession.

Economic theory after a generation of expansion encouraged
by inflation seems to have left a legacy of few tools and
institutions to cope with severe contraction and deflation.

Above all, decisive remedial action is inhibited by a growing
inconsistency between economic theory and political reality.

To the extent that current recession is the result of
deliberate governmental policy it derives from the premise
that deflation will wring out inefficiency, restore confidence
and thereby stimulate long-term growth. I agree with the
general proposition that governments have lived for too long
beyond their means and that more scope should be given to private

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initiative. But like all theories it can be pushed too
far. Two political facts must discipline its application.

The first is that the timescale for economic recovery
by governmentally induced recession may be longer than is
compatible with political stability, especially in the
developing countries. Political upheavals may therefore
convulse the patient before the medicine can take effect.

Secondly, a remedy that may work for the economic
ills of one nation may backfire if applied without adequate
regard for their impact on others. Thus the historically
unprecedented high interest rates-an effective tool for
fighting our domestic inflation-attract capital to the United
States, discourage investment abroad and thus deepend
the recession of the other industrial democracies. Even
policies that cause no special disadvantage if carried out
by one nation may prove politically untenable if several
seek to carry them out simultaneously. Orthodoxy prescribes--
almost surely rightly--that the cure for living beyond a
nation's means is to reduce consumption. Patently this

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cure cannot work if it is carried out on a global scale.

If everybody reduces consumption simultaneously and reduces imports, no country can expand its exports. The inevitable consequence will be to stifle trade, institutionalize recession and compound the risks of political instability.

Somewhere in the downward cycle governments must step into arrest this process. Deflation at some point must give way to a deliberate stimulation of growth. No industrial democracy is in a position to carry out such a policy by itself. To be effective, it requires the cooperation of the most significant industrial democracies. That point, I believe, has now been reached.

In 1977, the common view was that the Federal Republic of German and Japan should act as the "locomotives" of the world economy. That did not work. Today, most of the other industrial democracies wait--more or less passively--for an American economic recovery. That will not work either. A joint effort is needed not only

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for economic reasons but for psychological and political
reasons as well. Most of our foreign policy problems with
our Allies would be eased if we were perceived as leading
a global recovery. Nothing is more essential to restore
the political health of the individual democracies than a
sense that the West is in control of its destiny. No
American policy would reverse the tensions in the Alliance
more effectively than a clarion call to economic expansion
and a program to achieve it. Nothing is more likely to
encourage a healthy political evolution in the developing
world than the sense that they have a share in a world of
growth. Nor could anything more strengthen our hand in
East-West negotiations.

## Economic and Political Reality; Trade Policy

A policy of economic expansion will be required for
the industrail democracies, as well, if they are serious
about preserving the international trading system to which
all pay lip service in the theory and most violate in practice.

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We must begin with the recognition that to operate
a free market system in the current world would be a
formidable task in the best of circumstances. Here is
another case where economic theory and political reality
do not always mesh. And if the gap between theory and
practice grows too wide, the existing international economic
order will face growing strain. Recession will then spur
trade wars, protectionism and mercantilism with all
that implies for the political relationships among the
industrial democracies.

It is a rarely questioned cliche that free trade benefits
everybody. No country, so the argument goes, can possibly
be strong in every conceivable area of economic activity.
Therefore, specialization and comparative advantage are
the key to efficiency; competition insures that rewards
go to the most productive. Tariffs and other trade barriers
reward inefficiency, restrict commerce and lower the general
standard of living. The experience of industrialization

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of the late 19th and early 20th century seems to confirm
these premises. The current international trading system
is based on them.

Nevertheless, it is open to question whether these premises
are reflected in current practice. The free trade of the
19th century was based on a very few nations--no more than
four or five--from homogenous cultures with comparable living
standards operating by the discipline of the gold standard.
The current world economy contains at least twenty significant
industrial societies of widely different cultural backgrounds
with great variations in labor costs and standards of living,
each claiming sovereign control over their economic decisions.

In these circumstances, a free trading system encourages
grave obstacles. On the classical theory of free trade
everybody gains from an unrestricted flow of goods and services.
In practice, however, this is not true. As more and more
countries industrialize, specific industries and sometimes
whole sectors of them are bound to shrink or disappear in
existing industrialized countries. The problems of our steel

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and automobile industries require no elaboration; very few
television sets are still made in the United States.

Some thoughtful observers have indeed made the point that
America's future lies in the service industries. Even
more complicated is the problem of developing countries
with comparatively high labor costs. Countries like
Spain, Greece and Yugoslavia find it difficult to continue
the process of industrialization against the competition
of countries of Southeast Asia with low labor costs. And
in many European countries high expenditures for social
welfare and the near impossibility of disciplining labor
accentuate the comparative disadvantage.

In the 19th century countries might have accepted
these penalties in deference to prevalent theory-though
it had never to be tested in view of the limited number of
competitors. But the pressures and incentives of the
modern democratic state work against the unconditional
application of free trade theory.

The survival of democratic governments depends on

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high levels of employment; hence the losses of jobs
caused by foreign competition sets up fierce pressures
for protectionism. All industrial democracies-with the
possible exception of the United States-seek at least
to nudge the market in a direction that give a country a
special edge. Hidden or open subsidies of exports; hidden
or open non-tariff barriers impede trade. Exchange rates
fail to reflect values accurately-either by design or inertia.

Protectionism or mercantilism are on the march even while
lip service is being paid to free trade.

Domestic politics are thus bound to tempt democratic
goverments to intervene in the free flow of trade.

The Mediterranean countries of Europe will not permanently
accept second-class economic status in the name of an
abstract theory of free trade. Nor would it be possible
for the United States even to maintain permanence in services
over a historical period if the center of manufacturing
activity and hence technological innovation moved elsewhere.

t/3

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A permanent decline of the manufacturing sector would bring about social and political changes that would painfully and fundamentally alter the character of American society and politics. In addition, some basic industries must be preserved at all costs if we are able to assure our national security.

Considerations such as these have produced a trading system whose free aspects are under severe and growing pressure. There is a ratcheting up of competitive trade barriers such as subsidies. There is a slowness in the domestic adjustments process to changes in the competitive balances of international markets. Unstable and inappropriate exchange rates compound the uncertainties of international trade and become, by design or neglect, devices to improve competitive positions. Differential interest rates play their role in distorting capital flows.

Thus the industrial democracies can no longer avoid a fundamental decision which is at bottom political. They must either agree to apply strictly the rules of GATT embodying

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the principles of free trade--and develop rules to address trade problems not now adequately covered by GATT--or they will in a measurable time live in a mercantilistic world of unilateral actions and bilateral deals. Free trade--or even the aspiration to it-- cannot thrive in a world in prolonged recession. And even in a growing world economy it will be threatened by beggarthy-neighbor policies if there are major imbalances in domestic policies. The objective of maintaining an open-world trading system, therefore, requires a coordination of monetary and fiscal policies unprecedented in the post-war period. Only this can avoid major disparities in the rate of inflation and growth, and misalignment of exchange rates. A major political decision and an explicit act of leadership at the highest levels is imperative.

## Theory and Reality in Exchange Rates

The degree to which the international trading and financial systems are intertwined has been made abundantly

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clear in recent months. Throughout the 19th century currencies
were stable. Prices in 1914 were essentially unchanged from
1815. So long as currencies had to be backed by gold
there was an almost automatic regulatory mechanism. Countries
were technically unable to live beyond their means. When
gold started flowing out adjustments were imposed to all
interests and purposes automatically. Government-executives
and legislatures-had, so to speak, an alibi for self-discipline.
The gold standard was self-enforcing.

After World War I this rigid discipline grew politically
intolerable. More and more countries sought to gain greater
control over their economic future. They abandoned the gold
standard and fixed their exchange rates by governmental
agreement. After World War II, a new financial system
was created at the Bretton Woods Conference of 1944 that
combined fixed exchange rates which institutions like the
World Bank and the International Monetary Fund (IMF) to
provide assistance in emergencies. Still, what was fixed

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by agreement could be undone by unilateral decision

Devalutaion designed to spur exports and to limit imports

was no longer a consequence of automatic adjustment; it

turned potentially into an act of policy. Governments were
tempted to beggar their neighbors by exporting domestic
difficulties to other countries which in turn sought the
same objective. But the new system contained some considerable
restraints; the need for a formal decision and the knowledge
that other countries could negate these decisions by refusing
to go along.

At this ended when fixed exchange rates was abandoned
in 1973 for a system of floating rates. According to the
new rules, countries no longer tried to fix the value
of their currencies by agreement; they would let the
market determine it. In theory, this was supposed to restore
automaticity; in practice it eroded restraints on domestic
economic policy. While no country wants an excessively
overvalued currency because it reduces competitiveness,
or an excessively undervalued one because it creates inflationary

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Pressures, some governments have let their currencies weaken to gain an advantage for their exports by offsetting whatever gains in competetiveness its trading partners might be achieving. Others have encouraged appreciation of their currencies by maintaining high interest rates in order to fight inflation and to attract foreign capital. And, even where central banks play a minimal role, foreign exchange markets have a tendency to overshoot. All this disrupts trade and creates imbalances; it stimulates pressures for protection and subsidies, and creates uncertainties which depress investment. The modern form of economic warfare is all the more bitter for never having to be made explicit; the floating system encourages the myth that governments make no decision at all. A deterioration of structural economic conditions can thereby be obscured until a nearly unmanageable crisis erupts. In turn, unpredictability turns speculation in currency an increasingly important aspect of trading; especially in times of crisis it

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compounds uncertainty and thus inhibits recovery.

The encouragement of international trade in short
requires the restoration of some discipline and predictability
and a measure of automaticity to the international financial
sytsem. A new international financial system is needed.
Secretary of Treasury Regan's hints about a new Bretton
Woods must be translated into specific U.S. initiatives.
If we seek to avoid the rigidity of Bretton Woods, the central
banks could agree among themselves on a realistic range for
key exchange rate fluctuations and consult and take action
when relationships among major currencies move outside
this range. This is not to say that exchange rate considerations
should dominate domestic economic policy. But the harm which
comes from major misalignments (e.g. the recent dollar/yen
relationship) indicates that a misalignment should signal
the need for decisive remedial action.

We thus return to our original point: Such an approach
can succeed only if the governments of the industrial democracies
are prepared not only to intervene in exchange markets and

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above all if they coordinate their domestic economic policies in order to reduce discrepancies which give rise to exchange rate misalignment.

## The Need for Industrial Strategy

We have thus arrived at a point where together with moving towards a world of peace the preeminent goal of American foreign policy must be to restore the vitality and spontaneity of the international economic order. The peoples of the democracies expect it. The survival of their institutions depends upon it. Our national security requires it. The developing world will lose all hope without it.

And as I have said we have realistic choice except free trade or some form of mercantilism.

But free trade requires the following major steps:

A progressive elimination of existing trade barriers and other practices that impede trade; a coordination of monetary and fiscal policies; a new regimen on exchange rates; and a deliberate policy of economic expansion. This is a task

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that cannot be left to finance ministers. It is unachievable
without a political, indeed moral impetus; it requires a
dedication to a long-term strategy and that engages the heads
of state and their foreign ministers. It will be the test
whether the economic system as we have known it will hold
together and the political relationship with it.

For one should have no illusions. If we cannot bring
about the degree of coordination of economic policies described
here the free world economic system as we have known it
will gradually disintegrate.

I strongly prefer a free trading system. But statesmen
have the duty to deal with realities. If we cannot bring
about the prerequisites of a free trading system we must
prepare coldly and unemotionally for the protectionist and
mercantilist world which is sure to follow. We must not
move into that direction in a fit of pique nor through an
accumulation of tactical maneuvers. We must make a major,
indeed a heroic effort to revitalize a multilateral free

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trading system. Should that fail we will have no choice
but to look after our interests in an increasingly bilateral
economic world. We should do so reluctantly but also
confidently because we are in a strong position to maintain
that competition.

Whatever course finally emerges, its foundation must
be a deliberate national industrial strategy. Indeed-
ironically-a free system cannot flourish without it either
domestically or internationally. Domestically the quest
for job security has created conditions where employers have
increasing incentives toward automation. And it is no longer
clear whether the conventional wisdom still holds that ultimately
automation creates more jobs than it abolishes. Gains in
productivity raise doubts whether economic recovery will
bring about a corresponding increase in employment. We may
soon face the problem of unemployment becoming continuous.
At a minimum it emphasizes the need of a conscious strategy
of easing the adjustment process for labor.

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A strategy of growth will involve a process of easing
the pains of domestic adjustment, redirecting labor and
resources to the sectors with the most potential for growth,
and promoting an expansion that will reduce unemployment
and lead the world out of recession. We thus have two
seemingly contradictory tasks: to reduce the amount
of national resources claimed by government and yet to
contribute incentives to a policy of growth. The role
of government in spurring the economic process must
transcend its historic regulatory function; its relationship
to business cannot remain adversarial. Government, industry
and labor must act as partners if we wish to master the
issues threatening to engulf us. Only Japan among the
industrial democracies has so far met this requirement and
this is the key to its competitive edge. It is not for
the government to increase its share of the economy's resources;
Indeed, this should be reduced. But through tax incentives,
adjustment policies, and other devices, it can give guidance

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and support to private enterprise to channel investment to the most potentially promising sectors of our economy or can help ease inevitable shifts of labor. It should find some way of assuring that the more traditional industries benefit from new technology to avoid decline. Such a growth strategy could be of enormous international importance. No American action would do more to cure the current political malaise among the democracies than a demonstration that we are dedicated to economic expansion. No greater challenge exists to our political leadership than to bring about a coordination of similar policies among the industrial democracies.

## Theory and Practice: The Debt Problem

Restoring growth, trade, and the financial system among the industrial democracies cannot by itself achieve global economic recovery. The problem of the developing nations can no longer be avoided. The so-called North-South problem has finally imposed itself, not in terms of moralistic platitudes about whether the rich nations can thrive in a world of poverty, but in the form of a

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massive problem of indebtedness which threatens the advanced
industrial societies with financial catastrophe.

The debt problem is best described by some basic
statistics. The total external debt of the developing
countries is in excess of $700 billion of which approximately
$550 billion is long-term. At least $300 billion of this
amount is owed to commercial banks worldwide.

These figures spell a potential disaster. In 1982
interest payments alone ranged up to 45 percent of total
exports of goods and services of the developing countries.
An attempt to repay principal would increase that percentage
substantially. There is no way these countries can earn
enough to meet their present obligations so long as the
recession continues and probably even afterwards.

The current account deficits for the less developed
countries was approximately $100 billion in 1982. It will
be the same in 1983. Of this amount, some $45-50 billion
must be made up by loans from private sources primarily

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from commercial banks which are already understandably
gun-shy in view of the difficulty borrowers are having
with the existing debt. Substantial transitional support
from the International Monetary Fund is also essential.

But these requirements set up a vicious circle. The
debtors need additional lending to meet their oblications;
yet unless they first meet the existing obligations commercial
lending will dry up. On the other hand, debtors have little
incentive to increase their debt simply to pay interest;
this will appear to them primarily a device to protect
the balance sheets of Western banks. The makings of a deadlock
and financial crisis are clearly discernible.

This state of affairs takes on a special irony
in the light of the controversy that has been raging
between advanced and developing nations. For the better
part of a decade the developing countries have been insisting
On what they called a New International Economic Order based
on a massive transfer of resources. The industrial democracies

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have either rejected or evaded the proposal. Now it transpires
that a transfer of resources has taken place almost without
anyone noticing and on a scale not even the most radical proponents
of governmental economic aid would have dared to put forward.
To give added proficiency to this process it was the much
maligned capitalist system operating through the banks
which made this cornucopia possible.

Any reflection of the debt problem must begin with the
realization that this enormous transfer of resources is
already an accomplished fact; the funds have moved to the
developing world. What we are dealing with is how to contain
the consequences to the international system of the inability
of the recipients even to pretend to repay it.

What has turned into a historic joke or a parable
on the fallibility of human forsight has its origin as so
much else in the energy crisis which began in the early
seventies. The oil producers suddenly awash in dollars-
placed their surpluses into Western commercial banks usually
in the form of short-term deposits. The banks flush with

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resources, unimaginable even a few years earlier, competed fiercely for long-term loans to developing countries--especially the more advanced countries of Latin America.

Governments encouraged the process in order to maintain the incentive of the oil producers to pump oil and to maintain the economic growth of the developing world.

Indeed, but, for the "recycling" efforts of the commercial banks the immediately economic impact of the energy crisis would have been much more severe.

As is often the case the abdication of government and competitiveness of the banks solved an immediate problem by mortgaging the future. In the absence of coherent policy no single financial institution was in a position to gain an overall view of the dimensions of the process.

The result was to convert the energy bill owed by the developing world to the oil producers into debt owed to Western banks. The short-term deposits of the oil producers were translated into the long-term lending of the banks creating an obvious and massive vulnerability of the banking system. The growing debt could be financed only on the assumption

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of rising oil prices and fairly stable interest rates. Neither condition continued to be met. Oil prices stabilized and indeed began to decline. For example, Mexican earnings from energy exports would have been greater by $6 billion in 1982 but for the oil glut. And the industrialized countries began to fight inflation by tight money policies which drive up interest rates. Thus the cost of debt service rose, as real income declined and the global recession sharply reduced the exports of the less developed nations.

In this way the industrial democracies paid for the energy crisis three times: first in the inflationary pressures of higher oil prices; then in the inflationary pressures arising from the massive extension of credit to developing nations; and finally in the compounding of the recession and the threat to the Western financial system caused by the debt problem of the developing nations.

There are two contradictory arguments that play down the seriousness of the state of affairs. The first is that

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in the end the creditors can oblige the debtors to face the
consequences for their own financial irresponsibility by
letting them stew in their own juice. The second is that
the debtors in the end will not be able to default as that
would undermine their creditworthiness. Neither proposition
holds water. A financial collapse of one major developing
country such as Mexico or Brazil or Argentina would have
calamatous consequences for all the industrial democracies.
It would put an enormous strain --to put it mildly--on the
banking system. More importantly, the developing countries
absorb more than one third of US exports (and more than 40%
of the exports of the industrial democracies). For the United
States this is more than we export to the European Community
and Japan combined.

Thus the inability of developing countries to borrow
and a further reduction of their imports will deepen global
recession and add to unemployment. Indeed, if the industrial

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democracies lend out no more than the interest due them.

American exports will decline by 4 percent and our Gross National Product by 1 percent.

As for default by the debtors, conventional wisdom rejects the possibility. They are supposed to recoil from measures that would jeopardize their creditworthiness. But the bargaining position of two sides confronting different kinds of disaster is not simple to calculate especially as there are many intermediate steps between meeting objectives and outright default, each of which lends itself to some kind of blackmail. Whether a threat of default will ever be made depends on at least two factors: First, how much funding can be made available to debtor nations beyond the amount needed to ensure repayment of interest. Second the impact on the political structure of the debtor country of the conditions demanded for stretching out-or "rescheduling" in technical terms their debt payment. If the assistance

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to the debtors goes no farther than new loans to pay interest, a blow-up is certain sooner or later. Countries will not accept austerity indefinitely simply to protect the balance sheets of distant banks. They must be given the sense that they have a stake in an expanding world economy. Even then much depends on the stability of their political system. All must be taken not to overstrain political structures in order to prevent an immediate economic crisis.

The handling of the debt issues is therefore of vital importance and not simply for the international health of the world economy. It may usually affect, perhaps determine, the nature of internal politics with key countries. For if the crisis spawns radical governments in advanced developing countries, the debt issues will be overwhelmed by a process of political disintegration. It cannot be said that existing international institutions are well-designed to recognize much less to deal with this danger.

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The principal institution for overcoming the liquidity and repayment crisis of the debtor nations is the International Monetary Fund (IMF). It is no criticism of its extremely talented Managing Director, Jacques de Larosiere and its dedicated staff, to point out that it was never conceived for a crisis of this magnitude. The IMF's original purpose was to lend to individual countries that found themselves in temporary difficulty on condition that they adopted measures of fiscal and monetary discipline. The premise was that, as an international institution, the IMF was in a position to impose conditions that would be politically unacceptable if put forward by a single creditor nation.

Until now the IMF has performed its functions admirably.

The fact remains that it was designed to deal with discrete problems of individual countries not with a crisis of the system.

Indeed a key hope in the IMF's financial support is to gain time for a dramatic improvement in the world

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economy. That--more than the specific conditions imposed--
is the major hope to avoid a disaster.

That is precisely what cannot happen if austerity is
imposed not on one country but on a group of them. As country
after country admits its inability to pay even interest--
and therefore renounces any immediate prospect of repaying
capital--the IMF is discovering that it has neither the
resources nor the operating philosophy to recuse the entire
developing world. And while the problem of resources
is soluble--indeed major progress has been made--that of
operating philosophy is much less amenable to change.

The IMF--as a condition for its assistance--inevitably
insists on measures which have the effect of contracting
the economy, increasing unemployment and reducing consumption--
in short austerity.

As an emergency measure this may be unavoidable, perhaps
even desirable, but there should be no illusion that it can
possibly cure the long-term problem of a global recession.

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Indeed it is possible that IMF conditions cannot work at all if applied simultaneously in too many countries. If everybody practices austerity simultaneously, recession becomes global and congenital. All nations cannot at one and the same time expand exports and contract imports without wrecking the international trading system.

[y]

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For austerity in developing nations is politically possible
only if rapid progress can be shown toward the objective
of escaping the vicious circle in which debt service
consumes export earnings. This requires a reversal
of the global trend of high interest rates, spreading
recession, excessive caution of the Western financial
system, and tragic reduction in government-developed
assistances. IMF conditions can work only in conjunction
with a deliberate policy which will insure a resumption
of sustained economic expansion in the industrial democracies.

Thus increasing funds to the IMF is not enough
nor even the case of the problem. What is needed as well
is a program of economic growth which is beyond the IMF's
scope and a reconsideration of its operating philosophy.
Of course it would be absurd for the IMF to launch a rescue
operation for debtor nations without seeking to correct economic
practices that brought them to the edge of the precipice.
But it is important to make sure that the conditions are
realistic. They must not be so irrelevant as to serve

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primarily as an alibi for banks to continue lending in
essentially unchanged economic circumstances and thus to
increase the fragility of the system. Nor must they be
so stringent that they mortgage the political futures of
debtor nations.

Each commitment sought should be assessed not only
in technical terms but in relation to its political credibility.
How firm, for example, is the assurance of an Argentine military
government daily losing legitimacy and in the process of
turnning over its authority to civilians of a quite different
political orientation? With the best of intentions can these
targets be met? And what is in say two years the economic
conditions have not improved? Is another rescue mission
then concievable? And if the IMF option is no longer available
is there any other ressources then available except some kind
of default? Two contradictory dangers inhere in current
IMF procedures. The first is that the IMF conditions are
not met. But the opposite danger may be more insidious still:

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That a government makes a major effort to fulfill the conditions
and, in the process, undermines its political viability.

For the most searing problem in almost every developing
country is not economic; it is political. Most industrial
democracies were nations before they became states, most
developing countries were states before they were really
nations. Occasionally, Western governments in economic trouble
have used IMF conditions as a convenient excuse to impose
and austerity that domestic politics mights otherwise have
prevented--Britain in late 1976 is a good example. In most
developing countries, prolonged austerity is bound to shake,
perhaps to shatter, the legitimacy of political structures
which are the only hope for national cohesion. Few have
unemployment insurance or other resources which in the
West cushion the impact of economic downturns. Forcing a
developing country to cut consumption drastically over a
long period weakens moderate government; it tempts a
radicalism that rallies public opinion (and perhaps other

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debtors) to defy foreign creditors. All of this must be
the opposite of the West's intent.

Several conclusions follow: the first is that the debt
problem cannot be resolved either by exclusively economic
criteria or on a country-by-country basis. Second, political
criteria-especially governmental stability-must be seriously
considered. Third, the IMF must be supplemented by an early
warning system so that crises can be anticipated and prevented.
Above all it must be magnified that the debt problem is the
symptom, not the cause, of the current crisis which will
not be overcome except by an expanding world economy. The
Mexico's of this world must be given hope for a better future
if they are to sustain the immediate and inevitable austerity
without convulsions. We thus return to our original problem:
the urgent need for America to lead the world out of its
economic crisis.

America's Challenge

In the immediate postwar period the Marshall plan
restored Europe's morale and saved the democracies by evoking

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the vision of a better world. Sacrifice was sustained
by hope. The United States faces the same challenge today
both toward its allies among the industrial democracies and
toward at least the moderate, pro-Western countries of the
developing world. For the current crisis should teach us,
if nothing else, the interdependence of all peoples.

As a matter of fact we have no choice. We cannot afford
to wait passively for some automatic process to end the
present cirris. There is a major risk that, if we seek to
wait out the downturn, some accident or default or bank
failure may collapse the whole deck of cards. We need
strategy. This cannot be accomplished by any industrial
democracy alone; not even by one as powerful as the United
States.

Our foreign policy therefore has two urgent
talks which have been increasingly recognized in recent
statements by Secretaries Shultz and Regan: First is
recovery in the industrial democracies butressed by
a stabilization of exchange rates and coordination of economic
policies. Second, expansion of economic activity in the

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advanced developing countries leading to a less ominous
international debt structure. Neither of these problems
is soluble in isolation. Interdependence has been transformed
from a slogan to a necessity. Whether we devote an economic
summit or a special conference to this challenge it must
not only be dealt with but be seen to be dealt with.

It is now necessary to translate general principals
into policies. The industrial democracies should constitute
a small group having the confidence of their heads of
government to prepare urgent recommendations on these
issues--perhaps for the next economic summit, perhaps for
an earlier smaller forum.

Nearly two centuries ago the German philosopher
Immanuel Kant predicted that eventually world order would
come about either through intellectual and moral insight
or through the experience of chaos. We are still in a
position to make that choice. If the United States does
not lead we will sooner rather than later be confronting

40

[y]

a panicky stampede. If we do, we can draw an act of creation
from uncertainty and incipient despair. And this is, after
all, how almost all great creations have come about. As
we turn to these labors we can draw courage from the
fact that many of the problems of the industrial democracies
arise from an excess of productive capacity. It is a problem
the rest of the world must envy. It reminds us that the
ultimate challenge is not economic weakness or ignorance
but the need for political will.

## QUOTE FROM BILL BROYLES

....the ideas of economist and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.

FROM: John Maynard Keynes

THE COLLECTED WRITINGS OF JOHN MAYNARD KEYNES - Volume 7

THE GENERAL THEORY OF EMPLOYMENT, INTEREST AND MONEY - page 383

EAGLE-A
Trojan Bond

25% COTTON FIBER

Economic Theory + Political Reality

12/20/82

For most of the period since World War II the non-communist world experienced unprecedented economic growth. The historical business cycle of boom and bust seemed to be overcome. Recessions were relatively shallow and mercifully short. In the advanced industrial societies cheap energy, growing markets, adequate savings and modest inflation combined to bring about a prosperity seemingly without upper limit; the scourge of unemployment seemed to vanish as those countries encouraged the flow of appeared to be ended, indeed many of them imported foreign labor for the more menial and less stimulating tasks. The task of their workers performed to a high degree was not developing countries lagged, of course, far behind. But even among many less advanced countries like Brazil, Mexico, Indonesia, the more advanced nations like Japan in the general prosperity seemed to be on the verge of take-off, heading for self-sustaining growth.

This idyll ended by the middle Seventies under the impact of many causes, institutional and regulatory rigidities, increased rate of faster than the gross national social welfare payments beyond the growth of labor productivity. Progress, thiscompounded the unevening governmental expenditure in general, accelerated inflation induced by the failure to finance

14

All this ended when the system of fixed exchange rates was abandoned in 1973 for a system of floating rates.

According to the new rules, countries no longer tried to fix the value of their currencies by agreement; they would let the market determine it. Theoretically this was supposed

domestic economic policy, and while no country wants an excessi-
on the temptation to solve a country's problems at the
overvalued currency, because it reduces competitiveness, or an excessi-
undervalued one, because it creates inflationary pressures, government
can be expensive to others. Governments could let their currencies

weaken to gain an advantage for their exports, or they

are at a disadvantage in maintaining their export prices, and

could encourage strengthening them to attract foreign capital.

an advantage in fighting inflation and attracting foreign capital.

If sufficiently disciplined, their central banks could even

strive for this result by purchasing or selling foreign

currencies thus bringing about lower import prices, and

a decrease in export prices, and offsetting a decrease in

currencies thus bringing about lower export prices, and
negating whatever gains in productivity its trading partners

might be achieving.

and, even when central banks play a minuet role, foreign exchange markets have a tendency to

all this can be done nearly imperceptibly and ascribed to impersonal market forces. Under the system of fixed

overshoot, which disrupt trade and create imbalances, which
stimulate pressures for protection and subsidies, and create
uncertainties which depress investment.

Have I not
supposed
deliberate
the effect
produced - it
influences, and
I believe that
where no power
your point.

DEC.21 '82 15:26 KISSINGER ASSOCIATES, WASH. DC

16

American initiatives. If we seek to avoid the formality of Bretton Woods, the central banks could agree among themselves on the fluctuations of exchange-rates, before they intervene. But this will only return us to our starting point. Such an approach could succeed only if the governments of the industrial democracies were prepared to coordinate their monetary policies, which they must do in any event if they want economic recovery and freer trade.

Whether such coordination proves feasible or not, it is clear that in the United States, a strategy of growth means however, an explicit industrial strategy for our country - a process of easing the pains of domestic adjustment, is imperative. The market cannot possibly react rapidly redirecting labor and resources to the sectors with the -enough to handle the substantial redirection of labor and most potential for growth, and promoting an expansion of resources that free trade will surely impose on the industrialized that will reduce unemployment and lead the world countries, especially of Europe and North America. But out of recession. If it should not, we will not be able to be the only industrial democracy which is unprepared for the mercantilism.

For most of the period after World War II, the non-communist world experienced unprecedented economic growth. The historical business cycle of boom and bust seemed to be overcome. In the advanced industrial democratic societies, cheap energy, growing markets, adequate savings and modest inflation combined to nurture a prosperity, seemingly without upper limit. The scourge of unemployment appeared so remote that many countries encouraged the immigration of foreign labor for tasks their own workers preferred to avoid. Although the developing countries lagged far behind, the more advanced among them such as Brazil, Mexico and South Korea were beginning to share in the general prosperity.

This idyll ended by the middle Seventies. There were many causes: institutional and regulatory rigidities that限了 the pace of the Gross National Product; slowed growth. Social welfare payments increased much

11

in service industries. It would in fact be impossible
for the United States to maintain preeminence in services
over a historical period if a large portion of its
manufacturing activity and hence technological innovation
will move elsewhere. Such a change would bring about politically
unacceptable social and economic upheavals. A high capacity in some
basic industries must be preserved at all costs if we
are to assure our national security.

And yet, when all is said and done, there is no hope
for recovery unless the free trading system is preserved. Thus
the industrial democracies can no longer avoid some fundamental
political decisions. First they must either agree to apply
strictly the rules of GATT embodying the principles of
free trade--and develop rules to deal with trade problems
not now adequately covered, or else they will in a
measurable time live in a mercantilistic world of
unilateral actions and bilateral deals. Second, they
must recognize that free trade--or even the aspiration to

19

But whichever course emerges our country needs a long-term economic strategy. Indeed-perhaps ironically- we cannot flourish in a free trading system without it. For a dedication to a free trading system should not obscure the reality that the market by itself cannot sustain either competitiveness or all national purposes. This is the case in at least three fields:

First, there is general agreement that the national infrastructure-the roads, bridges and basic communications system- requires help from the government. This has been expressed in the gasoline tax proposed by the Reagan Administration for precisely this purpose.

Second, some national needs can be forseen some years ahead and yet not be reflected in competitive markets. The field of energy is a good example. Its current condition is dominated by a surplus of oil production over demand, the so-called oil glut.

20

With oil prices stable or declining there is little incentive for the large investments needed for a systematic effort to develop alternative sources of energy. Yet it is all but certain that within the decade the energy crisis will return. The end of the recession will increase demand; the Persian/Arabian Gulf has surely not seen its last political convulsion; some oil-producing countries will deplete their reserves. The oil glut is therefore not a cushion on which to sit, but an opportunity for a major effort to develop alternative sources to free our policy and economy to the greatest extent from potential blackmail. Since current market conditions are hostile to such a policy the government will have to step in with a systematic, long-range program of incentives.

Finally, as the free trading system flourishes the government is needed to cushion some of its consequences. International competition is bound to abolish some

21

jobs even as it creates others. And domestically it is
no longer self-evident that automation can be counted
on to create more jobs than it abolishes. Moreover,
labor unions' quest for job security has had the
perverse consequence of spurring employers' incentives
toward automation. Gains in productivity induced by
the recession may mean that, when recovery comes, not
everyone laid off will be rehired. High unemployment
may become chronic. At a minimum, a conscious
governmental strategy will be needed to ease the
adjustment process including policies of job
training, emergency assistance and placement.
It would include as well programs to
encourage the flow of resources to the
sectors with the most potential for growth, and
promote an expansion that will lead the world
out of recession.

Clearly this requires a role for government beyond

22

its historic regulatory function; it must stop thinking
of itself as in an adversarial position to business.
And business and labor must give greater recognition
to the fact that with respect to foreign competition,
at least, they are in the same boat. Government,
industry and labor must act as partners in setting
the broad outlines of a national strategy. Only
Japan among the industrial democracies has so far
achieved such a social compact, and this is one key
to its competitive edge.

I am not inferring that the government increase
its claim on the resources of the economy. A sound
economic policy would indeed reduce these claims. But
through tax incentives, adjustment policies, consultation
and other devices, it can facilitate investment to the
most promising sectors of our economy. It should find
some way of assuring that the more essential of our
traditional industries benefit from new technology to
avoid decline.

26

to pretend to repay it.

What has turned into a historic joke or a parable
on the fallibility of human foresight had its origin
as so much else in the energy crisis of the seventies.
The oil producers suddenly awash in dollars placed
their surpluses into Western commercial banks, usually
in the form of short-term deposits. The banks, flush
with resources unimaginable even a few years earlier,
competed fiercely for long-term loans to developing
countries--especially the more advanced countries of
Latin America. Governments encouraged the process of "recycling"
in order to maintain the oil producers' incentive to
pump oil and to maintain the economic growth of the
developing world.

The abdication of government and the competitiveness
of the banks solved an immediate problem by mortgaging
the future. In the absence of a coherent policy which