8

[1c]

the screws on the economy with sharp investment cuts and tight controls on imports. Yet real wages were slated to grow 1.5-2.0% in the plan, reflecting the government's reluctance to put any of the adjustment burden on workers.

As the years wore on and as few signs of progress were evident, the Polish authorities approached the French and German governments with a request to refinance maturing export credits. Breaking long-standing agreements with other western governments, the French agreed to a bilateral rescheduling of FF1,250 million or about $300 million. The German government refused a rescheduling but offered modest amounts of new credit. These funds enabled Poland to meet its financing requirement into early 1980, but time was running out. By mid-1980 the economy had plunged into deep crisis.

## Conclusions

Future U.S. policy toward Poland must be based on a consideration of both political and economic factors. Since other members of the panel will address political issues, I will restrict my comments to economic matters.

The record of the past ten years suggests two major conclusions. One is that Gierek's populist policies led to a weakening of internal economic disciplines and an erosion of the government's ability to manage economic activity. The restoration of these disciplines is not a matter of finding a new mix of economic policies; it is, rather, a fundamental issue of economic structure. The structure of an economy defines the framework in which economic activity is carried out, the way in which factories, managers, workers, farmers, etc. interact and it provides a stability necessary for steering the economy.

Poland's economy today is without such a structure. The role of

9

money in the economy, for example, has been seriously undermined by
excessive monetary creation and fixed prices in state retail stores.
Such a situation has fueled a flight from money, a rampant black
market and a regression into barter. Economic management is described
by a continuing series of *ad hoc* directives; an annual plan for 1982
was not even drawn up. The government is preparing a new package of
economic laws in an effort to improve the functioning of the economy.
It remains to be seen how effective these laws will be in providing
the needed definition of a workable economic system of planning
and management.

A second conclusion is that Poland's access to external credit
has never been subject to conditions that would ensure a rational and
efficient use of these funds. Any agreement by the U.S. government
to reschedule Polish debts or to extend new credits should be based
on explicit conditionality regarding Polish economic policies.

The record shows that western governments, in particular those
in western Europe, bear a major share of the responsibility for
the uncontrolled expansion of Polish indebtedness in the period
after 1975. Loans were offered in the name of Ostpolitik or export
promotion with little or no consideration of Poland's ability to
use these funds. When problems became serious in the late seventies,
some of the governments made special deals or bent the rules governing
export credits. The Carter administration bears a portion of this
blame for its decisions made purely on political grounds to authorize
substantial increases in CCC credits to Poland. There are still
many unanswered questions regarding lending policies of western
governments during this period which deserve further study.

The differing policies of U.S. and European banks during this
period has already been covered in detail above. What remains is to

10

explain why banks cannot enforce that kind of conditionality that
governments avoided insisting upon. The basic reason is that banks
find it very difficult to work together as a group. Over 500 banks,
both large and small from many countries, hold claims on Poland. It
is unlikely that all of these banks agree on economic policy issues
or for that matter have the necessary background to make recommendations
on macroeconomic policy. Banks can have a strong indirect influence
on policy via restrictions on new loans. But in situations such as
this one, they must look to governments or the IMF to enforce
conditionality.

Western governments are still avoiding the issue of condition-
ality. The rescheduling of government credits signed in April 1981
contained no effective economic conditions. To be sure, the govern-
ments were uneasy about making such recommendations given their
concern about Soviet policies. The issue, however, remains and can-
not be avoided even now, given the prospect of IMF membership for Poland
later this year. In any case, the IMF will not be eager to accept
the responsibility that its member governments may wish to thrust upon
it.

My recommendation is that any future decision by the United
States to reschedule Polish debt or to provide new credits be based
on explicit and detailed economic conditionality. The U.S. govern-
ment has the necessary resources to define and articulate which con-
ditions are appropriate in Poland's case. Hopefully, the IMF will
also be able, in time, to assist in this task.

G. P. Shultz

March 17, 1982

# THE USE OF TRADE IN DIPLOMACY: US → USSR

1. From an economic standpoint, trade takes place _only_ when it is to the _mutual_ advantage of both parties: trade is a _plus_ not a _zero_ sum game.

2. The gains from trade are not necessarily evenly distributed, and the division of the total gain between the parties is subject to bargaining (including the use of non-economic trade-offs) but is also constrained (sometimes tightly) by the market prices of items traded.

3. With or without the use of loans in producer countries (themselves an indication of where bargaining power lies) both buyers and sellers can ultimately be severely squeezed by over-dependence on one buyer or seller. This factor has always led to efforts to diversify sources and markets.

a. The USSR sums all its buyers or sellers together as it approaches a western market; whereas, many participants are characteristic on the western side and collaboration is prohibited by U.S. participants by our anti-trust laws.

4. A special feature of East-West trade involves the ideas embodied in the transactions.

a. The principal items from the East of interest in the West are raw materials: oil, timber, minerals. They contain ideas at the stage of production (and western goods containing ideas are being purchased) but contain no ideas as articles for sale.

b. Western manufactured goods are in demand in the East and, by contrast, they are typically loaded with scientific and engineering ideas.

5. These background comments are intended to point up aspects of analyzing the relative gains from East-West trade and the relative losses from a diminution of such trade. Broadly speaking, the balance of relative advantage seems somehow to have been turned upside down.

G.P. Shultz

March 17, 1982

Page 2

a. The USSR has much more to gain from trade than do the western nations. Furthermore, a kind of dependency on advanced products, let alone grains, would seem, one would think, to have developed.

b. The situation now appears at least to be the reverse, with producer pressures and concern about rippling effects of a financial squeeze putting more apparent pressure on the West than the East.

c. Obviously, a key point is that the East is better co-ordinated in its approach than the West.

6. The fact that trade carries relatively great advantages to the East means that trade inevitably helps their capacity to develop military strength. A decision to trade at all concedes this point but presumably seeks to limit its force by making certain distinctions designed to use trade as an element in diplomacy. Some principles and a strategy are needed in making these distinctions.

7. The first distinction involves separating tradable from non-tradable goods and services. Relevant questions include:

a. Can they be obtained elsewhere?

b. Are there reasonable substitutes?

c. How long would it take for alternative production to be developed?

d. Are there special quality characteristics involved?

e. What about immediate usefulness in a military or semi-military (communications/transportation) way?

8. The second need for distinctions derives from the idea that the lines drawn as to tradability will be changed in response to USSR behavior.

a. By the time a trading relationship is developed, does change hurt us more than them?

b. Closely related, can a consortium of supplying countries be organized or must we go it alone?

c. What will be the impact of changes on the willingness of private firms to undertake market development in the first place or again?

G. P. Shultz

March 17, 1982

Page 3

9. A third set of distinctions stems from the apparent conviction that treatment should vary as between the USSR, its eastern European satellites, other Communist countries, its allies (Libya, Syria).

a. Are there dimensions of independence that can be observed?

b. Is it possible to change attachments through the use of trade policy?

c. Is it possible to change the way an internal economic system is arranged by a combination of exposure, incentives, sanctions?

10. A fourth set of distinctions necessarily involves our trading partners and allies.

a. To what degree should we seek to harmonize attitudes and behavior toward trade with the East, as in debt rescheduling?

b. Do we gain or lose from taking a unilateral line?

c. How much pressure and retaliation should we use in specific circumstances, such as the Japanese sale of pipelaying equipment denied by the U. S. government to Caterpillar Tractor?

March 15, 1982

MEMORANDUM

TO: Henry A. Kissinger

FROM: William D. Rogers

RE: Clark Special Group

I have been persuaded from the outset that the subject of the Group's attention is fundamental. My sense of the usefulness and significance of the work of the group was enhanced by the first meeting.

I will transcribe my notes of the meeting later.

This will represent something of a record of what was said for purposes of your recollection.

The important themes that emerged in my mind from the discussion -- important that is in terms of the future direction of the group -- were these:

— The financial and economic relationship between East and West will bulk large in the foreign policy concern of the U.S. in the years ahead. That relationship will have its political component but how the economic dimension is managed will be increasingly

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vital to the domestic and foreign policies of the Soviet
Union, the East European countries and the West.

-- In an ideal world, the East-West economic relationship should be conditioned by political considerations in the West. It is in the East. However, the widening divisions in the western alliance in recent months suggests that it will be even more difficult in the future than it has been in the recent past to develop and coordinate positions among western governments on how the economic relationship should be adjusted.

-- That economic relationship includes both trade and financing:

As to trade, we have already run through most of the options on the sanctions list as to which the cost-benefit ratio is favorable to the West. It is time now to consider sanctions which are admittedly costly to the West, as well as to the Soviet Union, in order to demonstrate our will.

As to western credits, there are none now available to the East except those guaranteed by western financial authorities, according to Dr. Bailey.

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-- Coordination of official policy with respect to
such credits has been fitful at best; and more often non-
existent. An effort will be made by the Buckley mission
to arrive at a new agreement among the allies on guaran-
teed credit terms. This, however, will not address the
issue of the volume of guaranteed credit, nor will it
regulate non-guaranteed private financing.

-- The East European countries have come to depend
extravagantly on access to western financial credits in
recent years. Poland is only the most extreme and
least successful example of the eastern economic strategy
of massive use of western credit to finance growth. Hun-
gary, Yugoslavia and others are also in trouble.

-- The "umbrella" looks less and less water-
tight. The Soviet Union is known to be dumping commodi-
ties -- diamonds, gold and petroleum -- in a scramble for
hard currency. But whether it will be prepared to bail
out its bankrupt allies is increasingly questionable,
particularly in the eyes of western bankers.

-- Thus, whether western governments will or
not, the flow of financing to East Europe and the Soviet

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Union in the years to come will be increasingly a func-
tion of official government policy.

-- There is no mechanism at the present time to
harmonize that government policy. Events in Poland have
laid bare the inadequacy of the western institutional
mechanisms for response. The Ford Administration made
a concrete proposal to the Germans, British and French
in late 1976, openly and in general terms at the summit
in Puerto Rico, and later privately in Paris. That
proposal was to establish a device to monitor the flow
of East European credits from the West. The device
envisioned in that proposal could have laid the ground-
work for a consultative mechanism to develop common
policy -- or at least a practice of openly examining
the question whether there ought to be a common policy.
Six years later we are without such a device.

-- The first meeting of the special group gen-
erated a clear consensus that contemporary western
practices with respect to economic sanctions and reprisals
against the Communist countries was highly unsatisfactory.

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They are too episodic. Both trade and financial relations are built over the long term. They cannot be turned off and on quickly. An attempt to do so robs them of a greater part of their political effect. A strategy and long term planning are essential.

-- The quarrel over the nature of sanctions now bids fair to split the Alliance. It could even be suggested that the issue of what sanctions by whom has damaged western coherence more than it has disturbed the Soviet Union.

-- There is a growing body of opinion, led by the Pope, that sanctions against the Polish nation itself is a mistake.

-- All too often the sanction effect has been marked by robust proclamations of intent which are not followed by execution. Proclamations of truth, but no consequence, as George Schultz put it. This is disastrous to our reputation for firmness, reliability and commitment.

-- Finally, the absence of any rational and systematic consideration of western political interest,

- 6 -

particularly in the financial and natural gas areas, has made the West hostage to the East. The western banking system is exposed to Moscow's political determination whether to pay or default.

-- This is a preposterous position for the West to be in. The West has made itself vulnerable to the threat, but has failed to take advantage of the opportunity, presented by eastern dependence upon European, American and Japanese financial resources.

-- It is intolerable that the West should repeat in this decade, with the example of Poland before us, the practice of the 1970's -- that the Soviet Union should be free to conduct an ambitious global program to alter the geopolitical balance at the very time it and its allies fuel their own economics from the resources of the West.

-- It is therefore a matter of highest priority for the United States and its allies to develop a coherent, long-term policy with respect to the structure of future economic relations between the East and West.

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We do this in the interest of preserving what is left
of the alliance, to avoid further exposure of our own
financial and trading institutions to political mani-
pulation by the Soviets and in the long run to take
advantage of what may be the most significant lever
available to western authorities to modify Soviet
political behavior around the world. This, in fact,
must be the ultimate objective of all western foreign
policy.