[y]

March 29, 1984

MEMO FOR DR. KISSINGER

FROM: Rosemary

SUBJECT: Wharton Speech Edits - Last Call

Per your instructions to Suzanne, we have passed along the modest edits you have seen from me to Wharton. The final version of what Wharton now has is attached.

The issue is whether you want to make any other changes or let this go as is. The problem is that Wharton has been saying this is the last call.

The Managing Editor, Mrs. Ingall Hjelm, has been putting tremendous pressure on us to finalize your chapter. Wharton has all the other chapters in final page proof form and wants to begin printing almost immediately, with the book to come out in May. She would like to have your final answer by Monday, April 2. They may even go ahead on their own.

____ Tell Wharton to go ahead as is (attached)

____ Give Wharton additional edits as shown (mark them on the attached)

18.
FOREIGN POLICY AND
ECONOMICS

Henry A. Kissinger

In my last years in office and in the years since I left government, I have become more concerned than I was earlier about the intersection between economics and politics. The fact of the matter is that all the key issues before us have their major difficulty at precisely that interconnection. The purely intellectual analysis of the political issues and of the economic issues is double, but the decision-making process of how to relate them over a period of time to a set of goals has proved illusive. I shall not go into second-guessing any of the economic analyses presented here. But I want to present some observations or reflections on the various topics that are discussed.

I think all contributors to this volume agree that we are in a period of unprecedented change—in technology, in economic relationships, in problems of productivity, human relationships, fiscal management, monetary management. And, in fact, most agree on the components of various solutions, that deficits should be reduced, and even on the components by which the approach to a reduction of deficits should be made. What does not exist in our country and does not really exist here is a definition, a conception of the future toward which we want to be heading.

There are arguments presented here about industrial policy: whether to rely on competitiveness or the invisible hand, or whether to rely on industrial policy. I agree that to turn industrial policy over to government as it is now constituted is to turn it over to that which is a major element of the problem. However, I also believe that to rely entirely on the market in a rapidly changing environment cannot work either.

It seems to me that the nineteenth-century type of laissez-faire approach operated in a world that cannot be duplicated today. Then the perceptions of the key players were more or less similar. They all

a (sp: doable)

elements of an approach for
doing this.

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1984 JAN 28

agreed on the kind of economic theory and policy they should pursue. Technology was relatively stable. The rules of the game were fixed by the gold standard. There were only a relatively few players. None of these conditions exists the same way today. It would be rare if even one economic unit perceived either the environment or the future correctly. The chance that all of them will spontaneously come to the same conclusions about it would be nearly miraculous. This helps to account for the fact that most countries are trying to manipulate the rules of the game to their own advantage.

In addition, there are areas like our airways, for example, which the market does not reach. There are others in which the market incentives may actually be the opposite of what is needed, as in the field of energy today. There are still others in which the time scale for creative action is so long that any problems will suffer neglect.

For all of these reasons I think some industrial policy is needed. To be candid, however, I do not know who should do it or how it should be done. In our political system, as it now exists, stagnation is more likely to be the outcome of industrial policy than is creativity. How to prevent planning from becoming merely a projection of the familiar into the future, how to get a view of the future that is relevant to what will really occur, remains our overwhelming national problem. I would like to illustrate this with some of the topics that are discussed here, and then I want to conclude with a few observations on the future and on the role of bureaucracies.

First, everybody seems to agree on the fact that the Federal deficit is too high. Second, everyone seems to agree that the deficits must be brought under control by 1985 or something undefined will happen to our economy. No one says exactly what will happen after 1985 if the deficits are not brought under control, but there is a sense that it will not be healthy for our country.

The argument that deficits must be brought under control has three components. Entitlements have to be cut, defense has to be cut, and taxes have to be raised. And yet, we all know that none of these things is going to happen by 1985, except perhaps for a small cut in defense. The political process will not permit even raising the issue of entitlements before the presidential election, so that the earliest it can be brought before the Congress is in 1985, and the earliest it can take effect is in 1986.

I suggest that somebody take a look at what happens to our economy now that we know that the budget deficits for 1985 and 1986 will be at the higher range of the projections. Nobody, it seems to me, provides figures of what the deficit would be even at 5 percent growth. I do not know what Murray Weidenbaum and others think, but 5

many

reduced

any
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The Political and International Setting

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percent growth from now until 1985 would be a stunning perfor-
mance. Thus, at a minimum, it suggests to me that our recovery will
not be all that spectacular. Surely it will not be strong enough to be a
locomotive for all the developed and developing nations of the world
who are looking to us to pull them out of their own economic crises.
This is a problem that requires some serious analysis.

In this connection, I would like to comment on the defense bud-
gen. There is some discussion throughout the papers in this volume
that the defense budget ought to be cut to reduce the deficit, and no
doubt anyone who has ever seen a defense budget being prepared
knows that it can be cut. But, if the argument is that it was put
together mindlessly, cutting it mindlessly is equally dangerous. Ev-
erbody says one should cut the fat, and yet the fact is, bureaucracies
never cut the fat if you just tell them to cut. They will cut something
painful in order to create a political issue.

More fundamentally, however, I would like to say that defense
ought to be analyzed in terms of our national security requirements.
Certainly, one part of our national security is a strong economy, but it
should not be part of a tradeoff in which you say, "I will give you X
on defense in return for Y on entitlements." Those are two different
phenomena. If we cut defense below what is needed for our security,
we jeopardize our national existence. What is lacking is a definition of
what is essential for our national security. When the defense budget
was increased in 1981 (and I agreed with increasing it), something
was clearly wrong when we found that each service received exactly
33.33 percent of the increase. That is just not probable.

As a result of the absence of a consensus on what is needed, our
debate gets polarized between those who fight any weapon and those
who think any additional weapon must help our security. Weapon
system by weapon system, it is impossible for the average citizen to
participate in the debate. It is even impossible for the expert to form a
rational opinion. I do not believe, incidentally, that arms control will
save us a lot of money.

When you look at the figures that are mentioned by Peter Peterson,
for example, $25 billion is really not decisive in terms of the problem.
The danger is that if the defense budget is tackled as part of a fiscal
approach, there is no stopping point. I think the best thing that could
be done now is to create a bipartisan group to review defense policy
in terms of doctrine before the next budgetary cycle gets started. It is
not that the group would come up with anything new, because most
of the fundamental issues are known. However, it should be able to
crystallize the debate and establish some criteria that permit us to have
a debate, even in an election year.

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develop a

A consensus is especially important, because we have to get at least a defense policy, and preferably foreign policy as well, out of a kind of partisan country where every president who comes in not only claims that he is going to change the world but also insists that he created the world. This produces in other nations, who have to gear their actions to ours, an enormous sense of insecurity. So, it seems to me that a bipartisan review would be the best way to handle the defense issue rather than to have a civil war over every individual weapon system or to set abstract targets of what should be cut out.

partisan political
process in which

it as
well.

I shall turn to another question. One of the striking things in the papers here is that every contributor is passionately opposed to protectionism and everyone gives very good, often statistical, arguments why restraint benefits everybody. Because of my relative ignorance of economics, I find it striking that arguments that are so self-evident are so hard to transfer into political reality.

remarkable

If one looks at the politics of most countries, the fact of the matter is that obstacles to free trade are increasing. The papers here, after giving the arguments for free trade, list all the things we and other nations are doing that, to put it mildly, are contrary to the pure principles of free trade. I did not hear anyone saying that these barriers are diminishing, and indeed I have a sense that these barriers are increasing. Incidentally, I am not attaching a value judgment. Theoretically, I am also for free trade, but I am trying to relate political reality to economic theory as it emerges out of these discussions.

The free trade theory, in its pure form, developed when Britain had both a monopoly on energy and a monopoly on industrialization. It was very easy then to run the world based on that concept. Later on, in the nineteenth century, other nations, industrialized nations, developed, almost invariably, behind tariff walls. They entered the free trade system only after their protected industries were assumed to be competitive.

(sp: developed)

At that time there were only four or, at most, five players in the world, all of the same cultural background. They had more or less comparable labor costs and standards of living. They also had a system of exchange rates that was automatic and thus could not be manipulated.

Now, we have 20 to 25 major players, major differences in labor costs—at least between some countries—substantial cultural differences, and floating exchange rates. As a result, all the short-term pressures are to manipulate the system to a particular country's advantage. There are many examples of this.

I do not know how we are going to get out of this situation in which we all preach free trade and practice mercantilism. If you viewed

450

ASS

BB

this as a historian and you said, "What is the world likely to look like?"—never mind what you would like, but what is it likely to be in 10 to 15 years? Is it more likely to be free trade or more likely to be mercantilistic?—I would have to tell you it is more likely to be mercantilistic. In fact, we ought to give some thought to how we would live in such a world, whether we like it or not. Some of the caricatures of it are not really accurate, because you could have a mercantilistic world in which the protected areas would be rather large and not just small national units.

I do not want to give the wrong impression that I am advocating mercantilism. What I am saying is that we have to do one of two things. Either we have to move toward a genuine free trade system as an act of major national policy, which would then have to imply some coordination of monetary and fiscal policies, or we have to get intellectually ready for the other kind of world that will inevitably arise.

Which of these we will choose is a political decision, but to keep it at the middle level of the government means that we are at the mercy of our weakest industries and not of our most farsighted ones, and of a political process that cannot possibly look toward the future.

The same is true in other countries as well. A free-trade system of 25 players is very difficult to run. Somebody is going to go against the wall and you have to be willing to live with that. You have to insulate the political process against these pressures. If you do not mean it, then it is better to look explicitly at how to get the best advantage of some other system.

It is in this connection that I want to say a word or so about exchange rates. In 1969 I attended a meeting in the office of the then secretary of the Treasury, David Kennedy. There was some international monetary crisis, and I said, "Why don't we devalue." Well, if I had told an off-color joke in church, I could not have been treated with more outrage and contempt. It was explained to me very painfully by the few who would deign to speak to me at all that a reserve currency could not be devalued or revalued because everyone would move to offset our move. It was also immoral and impolitic. At any rate, I figured they knew something that I did not know, and I made up my mind I was not going to let them speak at any political meetings I chaired. My confidence began to be shaken somewhat when almost the same group went from no devaluation to permanent devaluation in the space of two years.

I am not questioning the political decisions or the economic decisions for the floating system that was established in 1973, and indeed it is quite possible that we could never have gotten through the oil shocks without it. It seems to me, however, that as it now operates, it

λ (sp: that)

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creates an additional element of uncertainty and therefore instability to international economic policies. The argument that the currencies will straighten themselves out, because if the dollar is overvalued it will reduce exports and if it is undervalued it will increase exports, just has not worked. It has not worked out that way either for governments or for businesses. There are businesses that make as much money from currency translations as from selling their products, or if not as much, a substantial amount. So it encourages a speculative element in businesses that is not necessarily related to productivity. We have also seen that governments, for reasons not having anything to do with international economics, can overvalue their currencies or undervalue their currencies, either for domestic reasons or for international reasons. If the two come together, as in the Japanese-American case, you have a situation in which no amount of productivity gains can make up for the currency fluctuations.

At one point, Treasury Secretary Donald Regan said something about reconstituting the Bretton Woods system in a new framework, and I must say I thought that was a very constructive remark. Since then, we seem to insist on our opposition to intervention. I do not understand the reason for it, but that may be because I do not understand the problem adequately.

It seems to me to be in our interest to make currency changes of a significant nature a political decision that cannot creep up unnoticed on a country. Certainly, if a country conducts irresponsible domestic policies, then fixed rates will not prevent an eventual devaluation. As we have seen with France, however, the fact that it requires a painful political decision can add an element of predictability. Since devaluation is not cost-free, it adds a restraint up to a certain point. I believe that, whatever we now say, we are going to be driven toward this approach, not only because the Europeans more or less hold this view, but also because it is not in our interest to permit the Japanese to maneuver their currency.

Another problem that also emerges in these discussions and requires a long-range political solution is the problem of energy. This is an area where I believe market projections can be particularly misleading. Projections have been almost congenitally wrong. Two years ago, people were talking of $50 plus per barrel of oil. The same people are telling us now that there will be an oil glut until the year 2000.

Projections have been wrong for at least two reasons. One, the oil market seems peculiarly sensitive to psychological factors. If one looks back at the situation in 1973, for example, I think it is probably true that there was no oil shortage in that year. What occurred in 1973 was that the OPEC (Organization of Petroleum Exporting Countries) na-

could

452

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and impose an oil embargo on the U.S. (which actually had
limited practical effect).

tions announced that they were going to cut production by 5 percent a month but never did it. On the basis of that statement, everybody started buying and hoarding oil. There was no purely economic reason for the oil price to go up in 1973 as sharply as it did. It is conceivable that the present oil glut may have some of the same characteristics precisely because everybody expects the price to go down and thus they are not hoarding oil. That process, however, is bound to come to an end as well.

these moves

psychological

The second factor is that the oil market seems to be extremely sensitive to political circumstances. For example, the internal OPEC controversies are usually analyzed in our financial pages in terms of supply and demand. The OPEC debate, however, really has as its principal purpose an assault on the political stability of the moderate oil producers, particularly the Gulf States. An attempt is being made by Iran and other radical producers—an attempt that has for all practical purposes succeeded—to make the Gulf States the residual producers and thereby create a situation in which they must bear the principal burden of the economic cost of sustaining any price or attempting to sustain any price. This, in turn, magnifies the possibilities of dissension within these countries where, after all, the allocation of resources is partly a personal and partly a bureaucratic issue. It also reduces the surplus available that these countries have for foreign aid and, above all, for aid to Iraq, which is in a conflict with Iran. If Iraq should collapse through a process of attrition, I assure you we would see a very rapid change in the oil market. This would occur not because of lost production, but because we would live in a new political environment.

When you add to the above the fact that in the eighties, North Sea oil will be running out, I think that here is a case where the market pressures can actually be misleading and where some kind of national policy is absolutely imperative. That policy should contain at least two features. First, we should continue to develop alternative sources even if they do not look very profitable at the moment. We should use this period of oil glut as a godsend to enable us to get ready for the next oil shock. It would be absolutely reckless to try to live on what must be a temporary condition. Second, we should continue to force conservation both in industries and as a governmental policy.

I think energy policy is an area where a conscious Western Hemisphere policy of cooperation can enable us to create generally useful political and economic structures. Those structures can be used to deal with what I consider to be, perhaps, one of our more grave economic-political threats—the debt problem. I shall discuss that first and then come back to the energy issue.

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When I was in office, there was a demand by the developing countries for what they called a new economic order. That was to be achieved by the transfer of resources from the developed to the developing nations. That demand was always rejected as being exorbitant and unjustified.

Within the last five years, more resources have been transferred by the private banking system than the wildest radical would ever have dared to propose as a transfer of government resources. Moreover, it happened in a manner that was practically unnoticed. There was no policy decision. There was no industrial policy that produced it. It happened, in fact, as a result of competition, because no bank really wanted to tell its competitor what it was doing. No lender, as the papers represented here so excellently point out, or borrower had any incentive or was asked to indicate the scope of this borrowing.

The result today is a debt of something like $600 billion. Given the present high interest rates, which, if the deficit projections are correct, are not going to come down very much before 1986, servicing the debt is going to be more and more difficult. All of this is familiar.

My point is that I do not believe that the remedial measures that were taken last year have ended the crisis. I think a political crisis that is caused by the debt problem is at least a possibility. None of the major borrowers can service its debt in a normal way. That is, if you look at the major countries, they pay interest and amortization that as a percentage of exports would be 117 percent for Brazil, 126 percent for Mexico, 154 percent for Argentina, 101 percent for Venezuela, and so on.

This situation is not durable, and therefore the result is a constant rescheduling of the debts and new International Monetary Fund (IMF) agreements. These IMF agreements have two components. They impose austerity as a condition for the agreement, and they then allow the original lenders to continue to increase their lending from the IMF. My argument is that it is highly improbable that most of these conditions will be sustained over an adequate period of time.

I do not believe that the smaller banks, as some of the papers in this volume suggest, are willing to continue this process. Also, I believe that austerity in the smaller countries is a major political challenge that will be very difficult to sustain. It will shake the domestic stability of many countries. Furthermore, if what is said about our deficit problem is correct, our recovery will not be rapid enough to raise commodity prices fast enough to rescue these economies. The net result is that countries, many of which have leaders who avow socialist or semi-socialist views, will be asked to sustain austerity programs that represent a rigid application of a kind of free enterprise philosophy.

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I know that is always said that countries will not default because the penalties are too great. It is also said that countries never go broke, although their creditors may. A sophisticated alternative analysis would go something like this: In some country a radical government could come into office that relates its debt service to its export earnings. It could set aside only a certain percentage of its export earnings for debt service, maybe less than is needed to *some* its interest. Would our banks then throw a country like this into default? But if that country gets away with it, it will encourage radicalism and other countries will inevitably follow suit. Consequently, if we want to avoid a radical political solution, at least two measures are necessary. First, among the industrial democracies, some kind of safety net for catastrophes is needed so that the effects of such a major change would not become generalized. Second, a coordinated response to the debtor country is needed. Over the longer term, a system is needed so that the level of lending becomes generally known early in the process.

It is also important politically for the United States to change the question from the payment of interest to the creation of the economic conditions in which that payment grows out of development rather than out of purely financial considerations. Austerity is a political liability for the countries concerned, and it is not even desirable for us, because it limits our export. Also, if the end result of this process is an increase of debt in order to pay interest, I fear that it is politically not sustainable. On the other hand, if we can change the question to a development question, there is at least a chance that we can create incentives in the country.

I believe that for some of the debtor countries in the Western Hemisphere, debt repayment can be linked to our energy policy. If we bought more oil to build up our strategic reserve, perhaps even at a price higher than the market would dictate, it would certainly help Mexico and Venezuela. This would make it easier for them to pay their way or at least make it less likely that the issue becomes one of foreign banks imposing impossible political conditions. Even if my particular solution has its flaws, there are better economic minds than I who could think up other solutions in the context of development, rather than in the context of debt service. The chance that every debtor will play the game by the current rules indefinitely seems to me at least one that we should not take for granted.

Before I conclude, I would like to get back to my original point. I have raised a number of analytical issues to which I do not have the answers. I raised another question to which I may have an answer, or at least the beginning of an answer, but the fundamental problem with which I began remains, in my view, the key problem of our society: How do you go from a world that is familiar to a world in

service

S
^

(exports)

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1981 DC AFIANT

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which you have never been? Where do you find leaders, either in the corporate field or, even more, in the government, who can handle this process?

The relationship of men to events is one of our unsolved problems. All of us who have worked in government in whatever administration know the obsession of our political leaders with the comments of evening news commentators whom they would never ask for advice before they made a decision. The obsession with the short term at the expense of the long term is one of the reasons why our leaders in their quests for popularity are using up their reserves of public capital. Strangely enough, the public does not forgive its leaders of catastrophes, even if the catastrophes were produced by carrying out the public's wishes. They expect the leaders to know better and to tell them the truth. Chamberlain was widely popular in 1938 at the time of Munich but destroyed eighteen months later nevertheless.

In our educational, economic and political systems, one tends to get to the top by doing the familiar as well as possible. But one lacks knowledge of the future. This is compounded by the destruction of an international consensus with respect to both deficits and defense—which could be illustrated easily in the field of foreign policy. The problems are made more difficult by a cumbersome bureaucracy, certainly in the government, perhaps even in the corporate world in which the management of the bureaucracy absorbs more and more of its own energies. The result is that the questions about where we are trying to go and what we are trying to achieve are very difficult to answer.

I want to end on a relatively hopeful note. If you look at the papers included here and at the arguments that they present, there is an amazing consensus that our system, as a system, could deal with many, if not most, of the economic problems. Everybody agrees that competitiveness gives us an enormous advantage over planned systems, for example. Everybody agrees, even in the field of human motivation, that things can be done to deal with the problem of structural unemployment. So, the real issue before us is that in many ways, we know bits and pieces of what we should do. The question now is whether we can organize ourselves to do it.

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[LC]

WHARTON/RELIANCE SEMINAR

May, 1983

HENRY A. KISSINGER

Ladies and Gentlemen, I appreciate this opportunity to address the final session of the Wharton/Reliance Symposium. I thought that Dan was just beginning to hit his stride when he ended the introduction. My father would have considered these adjectives another case of Anglo-Saxon understatements, but I must say that it's better than what Ed Williams said about me at the Alfalfa Dinner. He said, "Henry Kissinger has become a legend in his own mind". He said a few other things about me too which I will save for another occasion.

I understand that the invitation to me to address this Board and the Reliance Symposium really went through two phases. When I was asked at first I was requested to make an address, then I understand there was a Steinberg family caucus and it was decided that if I were left free I would probably start reading from my memoirs and there was no way I would get through that by this evening, even if I dropped the word I, which cuts it in half. So I was asked to summarize these economic discussions and I was gaining some confidence when I saw

2

Charlie Walker and some others who worked in the administrations with which I was associated where it was an absolute axiom that I had to be kept out, for the sake of the country, of any economic discussions altogether. The only thing that gave me a little more confidence in those days was that Bill Simon who used to be one of my less admiring critics used to say I have no economic judgment, at the height of the oil crisis he called the Shah of Iran a "nut" so I called him and said, "look, you can't do this, we have a close relationship with the Shah" and he said, "you political people you always get too excited, I'll straighten it out by this afternoon". So that afternoon he issued a statement saying that he had been quoted out of context. The poor Shah went to his grave trying to figure out the context in which you could call him a nut, and was it offensive?

So, I suppose one of the problems of our national policy is to find some meeting ground where the ignorances of economics and politics cancel each other out or maybe we can create some creative synthesis. But speaking more seriously, while I've been in office and in the years since I've left office, I have become more concerned than I was in my earlier years about the

3

intersection between economics and politics, because
the fact of the matter is that all the key issues
before us have their major difficulties at precisely
this vast interconnection. The purely intellectual
analysis of the political issues and of the economic
issues is stewable, but the decision-making process
of how to relate them over a period of time to set a
goal has proved elusive. Now I will not in these
remarks go into second guessing any of the economic
analyses that I have heard. What I want to do is to
present some observations or reflections that have
occurred to me as various topics have been discussed
from the perspective with which I began.

I think all participants agree that we are in a period
of unprecedented change; of change in technology, of
change in economic relationships, of problems of
productivity, human relationships, fiscal management,
monetary management. And in fact, many of them agree,
most of them agree, on the components of various
solutions that the deficits should be reduced and even
the components by which the approach to a reduction of
deficits should be made. Therefore it seems to me
that it does not exist in our country and it did not
really exist here, is a definition, a conception of the
future towards which we want to be heading.

4

We had a debate, or we heard last month and we had
a little discussion this morning about the industrial
policies and the arguments whether you can rely on
competitiveness or the invisible hand or whether you
should rely on industrial policy. Thus, and I must
say I found myself in the position of Mr. Kahn's
rabbi except I used to tell that same joke about Jimmy
Carter, that I thought everybody was right. I agree
that to turn over industrial policy to government as
it is now constitute, turning it over to a major
element of the problem, but I also believe that to rely
entirely on the market in a rapidly changing environment
also cannot work, for these reasons: It seems to me
that the 19th Century type of laissez faire operated
in a world in which the perceptions of the key players
were more or less similar. They all agreed on the kind
of economic theory and policy they should pursue and
secondly, the rules of the game were fixed by the gold
standards and third, technology was relatively stable,
relatively stable and then there were only relatively few
players. None of these conditions exist in the same way
today. It would be rare that even one economic unit
perceives either the environment or the future correctly.
The chance that all of this will spontaneously come to
the same conclusions about it would be nearly miraculous
and this accounts for the fact that most countries are

[LJ]

5

trying to manipulate the rules of the game to their
own advantage as we have heard in many of the
presentations.

And then there are areas which were mentioned this
morning which the market does not reach. There are
others in which the market incentives may actually
be the opposite of what is needed as in the field of
energy today, and there are still others in which the
time scale is so long for creative action that it
will suffer neglect. For all of these reasons I
think some industrial policy is needed, but I must
tell you honestly I don't know who should do it. I
think if our political system as it now exists is going
to try to generate it, stagnation is more likely to be
the outcome than creativity. And how to prevent
planning from becoming a projection of the familiar
into the future, how to get a view of the future that
is relevant to what will really occur, that seems to me
our overwhelming national problem and I would like to
illustrate this with a number of topics which have been
discussed here, on some of which I have ideas and on some
of which I don't. And then I want to conclude with a
few observations on the beaucratics and of looking into
the future.

6

First, everybody seems to me to agree on the fact
that our deficits are too high and are growing.
Secondly, everyone seems to agree that the deficit
must be brought under control by 1985, or something
undefined would happen that would not be healthy for
our economy. It was interesting, I didn't hear,
maybe I didn't attend the right panel, but I did not
hear exactly what would happen after 1985 if they
were not brought under control, but there was a sense
that it was not healthy for our country and it had
three components. Entitlements had to be cut, defense
had to be cut, and taxes had to be raised. And yet,
all of us in this room know that none of these things
are going to happen by 1985 unless maybe a defense cut.
The political process will not permit even raising the
issue of entitlement before the Presidential election.
The earliest it can be brought before the Congress is
in 1985 and the earliest it can take effect is in 1986
and I would suggest if somebody get to work on the
problem of what happens to our economy when we know now
that the budget deficits for 1985 and 1986 will be at
the higher range of the projection. And nobody it
seems to me, even Pete Peterson gave us figures of what
the deficit would be even at 5% growth, and I don't
know what Mr. Weidenbaum and others think, but 5%
growth between now and 1985 would be a stunning performance.

7

Thus at a minimum, it seems to me that our recovery
will not be all that spectacular and surely not a
locomotive for all the developed and developing
nations of the world who, if you now travel around
the world, are looking to us to pull them out of their
own economic crises into which they fall very often
by following policies comparable to our own or by
their own mistakes. But at any rate, that seems to
me to be a factor that requires some analysis.

Now let me say a word about the defense budget in
this connection. There was some talk throughout that
the defense budget ought to be cut as part of this
process. And, no doubt anyone who has ever seen a
defense budget being prepared knows that it can be
cut. But, if the argument is that it was put together
mindlessly, cutting it mindlessly is equally dangerous.
Everybody states that one should cut the fat and yet
the fact is, bureaucracies never cut the fat if you
just tell them to cut it. They'll cut something
painful because this will create a political issue.
I would like to say that defense ought to be analyzed
in terms of our national security requirements.

Certainly, one part of our national security is a strong
economy, but it should not be part of a trade-off in
which you say I will give you x of defense in return for
y and z on entitlement. Those are two different

8

phenomenon. If we cut defense below what is needed
for our security, we jeopardize our national
existence. So what is lacking is a definition of
what is essential for our national security. When
the defense budget was increased in 1981, and I agreed
with increasing it, something was bound to be wrong
when we found that each service received exactly
33 and 1/3 percent of the increase. That is just not
probable. So, I would say one result of the absence
of a consensus on what is needed is that our debate
gets polarized between those who fight any weapon and
those who think any additional weapons must help our
security. Weapon-system after weapon-system, it is
impossible for the average citizen to participate in
the debate. It is impossible for the experts really
to form a rational opinion. I do not believe,
incidentally, that arms control will save us a lot of
money. And when you look at the figures that are
being mentioned by the Peterson Group, twenty-five
billion dollars are really not decisive in terms of the
problem. The danger is, if the defense budget is
tackled as part of a fiscal approach, there is no
stopping point. So, I would think that the best thing
that could be done now is to create a bipartisan group
to review defense policy in terms of sanction before the
next budgetary cycle gets started. It is not that
they would come up with anything new because most of the

[L]

9

fundamental issues are known, but it is that they
should be able to crystalize a debate and establish
some criteria so that at least the next budget cycle
permits us to have the debate, especially when it is
in an election year. And it's especially important
because we have to get at least defense policy, but
preferably foreign policy as well, out of a kind of
partisan country where every President who comes in
claims not only that he is going to change the world,
but insists that he created the world. And it
produces in foreigners who have to gear their action
to ours an enormous sense of insecurity. It seems to
me that this is the only way we can, or the best way
to handle the defense issue rather than have a civil
war over every individual weapon system that is now
before us or to set abstract targets of what should be
cut out of our defense.

Now let me turn to another topic. One of the striking
things in the discussions here to me was that every
speaker was passionately opposed to protectionism and
every speaker gave very good, often statistical,
arguments for restraining benefits. Due to my relative
ignorance of economics, I find it striking that arguments
that are so self-evident are so hard to translate into
political reality. If you look at the politics of most

[L]

10

countries, the fact of the matter is that obstacles
to free trade are increasing and speaker after speaker,
after giving us the arguments for free trade, listed
all the things we were doing that were contrary to the
pure principles of free trade, to put it mildly.
Well, that's all the things other nations are doing,
and I did not hear anyone say that these barriers are
diminishing. I have to sense that these barriers are
increasing and it seems to me that there are a number
of reasons for this. Incidentally, theoretically I
am also for free trade. I don't want you to misunderstand
this. I'm trying to relate political reality to economic
theory as it emerged out of these discussions. I'm not
attaching a value. It seems to me that a number of
problems abound. The free trade theory in its pure
form was when Britain had both a monopoly on energy and
a monopoly on industrialization and then it was very
easy to run the world based on that topic. Later on
in the 19th Century, other industrialized nations
developed -- incidentally, almost invariably, in fact
I would say, invariably behind tariff walls, who then
entered the free trade system after their protected
industry was assumed to be competitive. But there were
only three or four or at most five players in the world
of the same cultural background with more or less
comparable labor costs and standard of living and world
markets and a system of exchange rates that was automatic

11

so that those could not be manipulated. Now we
have twenty to twenty-five major players, big
differences in labor costs, at least between some
countries, substantial cultural differences, so
all the short term pressures are hence floating
exchange rates, so all the pressures are to manipulate
the system in favor of a particular country's advantage.
And, we all heard, over the last few days of the many
examples of this.

Now I don't know how we're going to get out of this
situation in which we all preach free trade and practice
mercantilism. And, in fact, if you looked at this as
a historian and you said, "what is the world most likely
to look like," never mind what we would look like "what
do you think it is going to, what is it likely to be in
ten to fifteen years?". I would have to tell you it
is more likely to be mercantalistic and, in fact, we
ought to give some thought to how we would live in such
a world, whether we like it or not. And some of the
charicatures of it are not really accurate because you
could have a mercantilistic world within which the
protected areas would be rather large and not just small
national units. But I don't want to give the wrong
impression, I'm advocating this. What I'm saying is
that we have to do one of two things. We either have

12

to move towards a genuine free trade system as a
lack of major national policy and not just of
rhetoric and periodic summons which would then have
to imply some coordination of monetary focus and
fiscal policy or we have to get in the arena for the
other kind of theory that will inevitably arise.
Which of these two we will choose, that's up to our
political leaders, but to keep it at the middle level
of the government and to have an occasional cat meeting
and to start picking at this restriction or that
restriction and to take this count or the count of
ailing method means that they are at the mercy, first
of all, of our weakest industries and not of our most
farsighted ones, and of a political profit that cannot
possibly look at the ten year future. And the same is
true in other countries as well. When you have a free
trade system with twenty-five players it is very
difficult to run. Somebody is going to go against the
wall and you have to be willing to live with that and you
have to insulate the political process against these
pressures if you really mean it. If you don't mean it,
then it is better to look explicitly at how to get the
best advantage of some other system, not next year, but
over a ten year period.

It is in this connection that I want to say a word or more

[Lc]

13

about exchange rates. In 1969 I attended a meeting
in the office of Exo Officio. They couldn't keep
me out of it or they would have Ex Officio in the
office of the Defense Secretary of the Treasury,
Kennedy. There was some financial crisis, some
international monetary crisis and I said, "why don't
we devalue?" Well, if I had told a dirty joke in
church it would not have been treated with more outrage
and contempt. It was explained to me very patiently
by the few who would dain to speak to me at all that
a reserve currency couldn't be devalued or revalued
because everyone would move with them, that it was
also immoral and impolitical. I forget, but at any
rate, I figured they knew something I didn't know and
I made up my mind I wasn't going to let them speak at
any political meetings I fared. And it subsided.
Well, my confidence began to be shaken somewhat when
almost the same group went from no devaluation to
permanent devaluation in the space of two years. Now
I'm not pressuring political decisions or the economic
decisions for the floating system which was established
in 1973 and indeed, it's quite possible that we could never
have gotten through the oil shock without it. It seems
to me, however, that as it now operates, it has an
additional element of uncertainty and therefore instability
to international economic policies. The argument that
the currencies will straighten themselves out because
overvalue, if it is overvalued, will reduce exports, if it

14

is undervalued it will create inflationary pressures and
so that therefore it would work almost like the gold
standards, just has not worked out. It has not worked
out that way, either for government or for businesses.
We know businesses which make as much money from
currency translations as from selling their products,
or if not as much, a substantial amount. So, it
encourages a speculative element in businesses and
forces a kind of consideration that is not related
necessarily to productivity. And we have seen that
government for reasons not having anything to do with
international economics, can overvalue their currencies
or undervalue their currencies for, in one case, for
domestic reasons, in other cases for international reasons
and if the two come together like in the Japanese-American
case, you have a situation in which I first pointed our
no amount of productivity today can make up for the
currency fluctuations. Now, I must say at one point
Secretary Regan said something about reconstituting the
Bretton Woods system in a new framework and I must say
I thought this was a very constructive remark. Since
then, we seem to insist upon our opposition through
intervention. I don't understand the reason for it
but that may be because I don't understand the problem
adequately. But it seems to me to be in our interest
to make currency changes of a significant nature a

15

a political decision that cannot creep up on you in
an unseemingly unnoticed way. Certainly if a country
conducts irresponsible domestic policies fixed rates
or rates in white bags which is all we're talking about,
will not prevent an eventual devaluation. But as we
have seen in the case of France, the fact that it
required a political decision is painful and is not
cost-free. And it is therefore a restraint up to
a certain point and adds an element of predictability.
And it either means we're going to be driven towards
this in some manner whatever we now say, because if
the Europeans more or less hold this view; I don't
know why it is in our interests to permit the Japanese
to maneuver their currency.

So now let me turn to another problem that also
emerged in these discussions and it seems to me to
require a long-range political solution - the problem
of energy. This is an area where I beleive market
projections can be particularly misleading. Projections
have been almost congenitally wrong. Two years ago
people were talking of fifty dollars plus oil. The
same people are telling us now that there will be an
oil glut until the year two thousand. And projections
have been wrong for at least two reasons; One. the
oil market seems to be peculiarly sensitive to
psychological factors. If one looks back at the situation

16

in 1973 for example, I think it is probably remarkable
that there was no oil shortage in 1973. What occurred
in 1973 was that the OPEC nations announced that they
were going to cut production by five percent a month.
They never did. On the basis of that statement, everybody
started buying oil and hoarding oil. There was not, in
fact, an excess of demand over supply. There was no
purely economic reason for the oil price to go up in
1973 as sharply as it did. And, it is conceivable to
me that the present oil glut may have some of the same
characteristics precisely because everybody expects
the prices to go down, but that process is bound to
come to an end as well.

The second factor is that the oil market seems to be
extremely sensitive to political circumstances. It
seems to me for example, that the debate, that the
internal OPEC controversies which are usually analyzed
in our financial pages in terms of supply and demand, and
overall supply/demand situation, really have as their
principal purpose an assault on the political stability
of the moderate oil producers, particularly the Gulf
States. The attempt is being made by Iran and other
radical producers, an attempt to all practical purposes
has succeeded to make the Gulf States the residual
producers and thereby produce a situation in which

17

they must pay us the principal burden of the economic
cost of sustaining any price or attempting to sustain
any price. This, in turn, magnifies the possibility of
dissensions these countries; where after all, the allocation
of resources is partly a personal and partly a bureaucratic
issue and it also reduces the surplus available that
these countries have for foreign aid and above all for
aid to Iraq, which is in a conflict with Iran. And, if
Iraq should collapse through a process of attrition,
I assure you we would see a very rapid change in the
oil markets, not because Iraq is producing so much but
because we would live in a new political environment.

Now when you add to that the fact that in the
1980's North Sea oil will be running out, I think it
seems to me that here is a case where the market pressures
can actually be misleading and where some kind of national
policy is absolutely imperative. And where we need
at least two aspects. One, I think we should continue
to develop alternative sources even if they do not
look very profitable at the moment. We should use this
period of oil glut as a Godsend to enable us to get
ready for the next oil shock in which it would be absolutely
wreckless to try to live on what must be a temporary
condition. Secondly, of course, we should continue to
force the conservation both in industries and as a governmental

[Lc]

18

policy. Third, I think energy policy is an area where a conscious Western Hemisphere policy of cooperation can enable us to create political and economic structures to deal with what I consider to be, perhaps, one of our graver economic political threats, which is the debt problem. Let me talk about that and then come back. Let me come back to the energy issue.

When I was in office, there was a demand by the developing countries for what they called the new economic order to be achieved by the transfer of resources from the developed to the developing nations. It was always rejected as being exorbitant and unjustified. Within the last five years, more resources have been transferred by the private banking system than the wildest radicals would ever have dared to propose as a transfer of governmental resources. And it happened in a manner that was practically unnoticed. There was no policy decision. There was no industrial policy decision. It just, it happened, in fact, as a result of competition, because no bank really wanted to tell its competition what it was doing. No lender as the papers represented here so excellently pointed out, no borrower had any incentive or was asked to indicate this scope of borrowing in contrast to private borrowing and we now have a debt burden, something like six hundred billion dollars and present high interest rates before which, if the deficit projections are correct are not going to come down

19

very much before 1986 and high interest rates that make servicing the debt more and more difficult. Most of this is fairly familiar. Now what I would like to put before this group is that I do not believe that the remedial methods that were taken last year have ended the crisis. I think a political crisis that is caused by the debt problem is at least a possibility. I'm not saying a certainty. Let me explain why I think this is. None of the major borrowers can service his debts in a normal way. I mean, if you look at the major countries, they pay interest and amortization normally as a percentage of exports; it would be 117% for Brazil, 126% for Mexico, 154% for Argentina, 101% for Venezuela and so on and so forth. It is not durable, and therefore, you get a constant rescheduling of the debt and you have these IMF agreements. These IMF agreements have two components. They impose austerity as a condition for the method and they require the original lenders to continue, in a need to increase their lending over the period of the IMF loan. My argument would be that it is highly improbable that both of these conditions will be sustained over an adequate period of time. I do not think that the smaller banks according to the papers that were presented to this group pointed out in much more competent terms, that the smaller banks are going to continue this process indefinitely; and I believe

20

that austerity in developing countries is a political
challenge of huge mangitude that will be very difficult
to sustain, shaking as it does the domestic stability
of many countries. And if what we said about debt
service and other problems is correct, our recovery
will not be rapid enough to raise commodity prices
fast enough to overcome the fundamental problem, so
that the net result will be that in countries, many
of which avow Socialist or semi-Socialist views, countries
of which leaders have been asked to sustain austerity
programs that are the very rigid application of a kind
of free enterprise philosophy that in Mexico, for example,
is not helped by the political system; or in Argentina
or in other countries you could mention.

Now I know it is always said that countries will not
default because the penalties to them are too great.
And it is also said that countries never go broke to
which one of our panelists said yesteray, "the countries
may not go broke, but their creditors may". But a
sophisticated analysis will go something like this:
It is not inconceivable that in some countries a radical
government will come into office that relates to debt
service to its exporters and sets aside only a certain
percentage of its exporters for debt service, maybe
less than is needed to serve its interests. Would we

[L]

21

then throw, would our banks then throw these countries into default? And, if they get away with it, it will have encouraged radicalism and other countries will inevitably follow suit. So, if we want to avoid a radical political solution, at least two measures are necessary. One is an internal measure among the industrial democracies, some kind of safety

net for the catastrophies so that the effects of such a major change would not become generalized and a response could be coordinated, some improvement of the system by which at least a level of lending is generally known. And, I must say, I was impressed by some of the specific technical proposals made in the paper by Professors Guttentag and Herring, but I don't want to get into those.

I want to get to another point, I want to say it is also important politically for the United States to change the question from the payment of interest to the creation of the economic conditions in which that payment grows out of development, rather than out of purely financial considerations. Austerity is a political liability for the countries concerned, if it is the only measure, and it is not even desireable for us, because it limits our export. And, if the end result of this process is an increase of debt in order to pay interest, I fear that

22

Now I believe that in the Western Hemisphere, at least,
where also the heaviest debtors are, something like this
can be done as part of an energy policy. If we bought
more oil than the market would dictate to build up our
strategic reserve and maybe, even at a price that we are
not pressing very hard, it would certainly help Mexico and
Venezuela and even Canada. If we made this part of a
treadmill trading relationship and economic relationship
of some kind of preferences for the Western Hemisphere, there
is at least a chance that they can pay their way or at
least a chance that the issue does not become one of
foreign banks imposing impossible political conditions.
This it seems to me, is, and even if my particular solution
has its flaws, there are better economic minds than I in
this room who could think up other solutions in the context
of development, rather than in the context of debt service,
which I believe is a hopeless wicket in the political --
from the political point of view over an extended period
of time, the chance that every debtor will play that game
indefinitely seems to me at least one that we should not
take for granted.

23

Now, I would like to conclude. I've already spoken
longer than my assignment, and I am so intimidated by
Miss Friedman that I do not dare to violate her injunction.
I'd like to get back to my original point. I have made
a number of analytical--I've raised a number of analytical
issues to which I don't have the answers. I raised
another question to which I may have an answer or at least
the beginning of an answer, but the fundamental problem
with which I began remains, in my view, the key problem
of our society which is how do you go from a world which
is familiar to a world in which you've never been. Where
do you find leaders either in the corporate field or
even more in the government that can handle this process.
The relationship of men to events is one of our unsolved
problems. All of us who have worked in government in
whatever administration know the obsession of our political
leaders with the comments of evening news commentators
whom they would never ask for advice before they made
a decision. The obsession with the short-term at the
expense of the long-term is one of the reasons why our
leaders in their quests for popularity and many Democratic
leaders are using up their reserves of public capital,
because strangely enough, the public does not forgive
its leaders for catastrophies, even if the catastrophies
were produced by carrying out the public's wishes. They
expect the leaders to know better and to tell them the
truth. Chamberlain was widely popular in 1938 at the
time of Munich and destroyed eighteen months later,

[L]

24

nevertheless. Both in our educational system and in
our political experience, and I suspect in some respects,
in our economic experience, one tends to get to the top
by doing the familiar as well as possible and one lacks
experience about the future. This is compounded by the
destruction of international consensus both with respect
to deficits with respect to defense and which could be
illustrated easily in the field of foreign policy in which
I wasn't permitted to speak. And, finally by cumbersome
bureaucracy, certainly in government, maybe even in the
corporate world in which the management of the bureaucracy
absorbs more and more energies so that the questions
about where we are trying to go and what we are trying
to achieve is very difficult to answer.

Now I've just added one other item to our agenda, but
I want to end on a relatively hopeful note. If you look
at the papers that have been presented here and at the
arguments that have been made here, there is an amazing
consensus that our system, as a system could deal with
many, if not most of these problems. Everybody
agrees that competitiveness gives us an enormous advantage
over planned systems, for example. Everybody agrees,
even in the field of human motivation that things can
be done to deal with the so-called structural unemployment.
So, the real issue before us is that in many ways, we

3

[Lc]

that Dan was just beginning to hit his stride when he ended the introduction. (Laughter.) My father would have considered these adjectives a classic case of Anglo-Saxon understatement. But, I must say, it's better than what Ed Williams said about me at the alfafa dinner. He said, "Henry Kissinger has become a legend in his own mind." (Laughter.) He said a few other things about me, too, which I will save for another day, for another occasion.

I understand that the invitation to me to address this board and Reliance Symposium really went through two phases. When I was asked at first, I was just requested to make an address and then. I understand there was a Steinberg family caucus and it was decided that if I were let free, I would probably start reading from my memoirs, and there was no way I would get through that by this evening, even if I dropped the word "I", which cuts it in half. So, I was asked to summarize these economic discussions and I was gaining some confidence when I saw Charlie Walker and some others who worked in the administration with which I was associated where it was an absolute axiom that I had to be kept out, for the sake of the country, of any economic discussion altogether. The only thing that gave me a little more confidence in those days was that

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LQ

1 Bill Simon, who used to be one of my less admiring critics, always used to say that I had no economic judgment, at the height of the oil crisis, call the Shah of Iran a nut. So, I called him up and said.
2
3
4
5 "Listen, you can't do this. We have close relationships with the Shah." He said, "You political people.
6
7 you always get too excited. I'll straighten it out by
8 this afternoon." So, that afternoon, he issued a statement saying he had been quoted out of context. Poor
9
10 Shah went to his grave trying to figure out the context
11 in which you could call him a nut. (Laughter.)

12 So, I suppose one of the problems of.
13 I imagine, public speaking, is to find some meeting
14 ground where the ignorances of the economics and politics cancel each other out or, maybe, create some
15 creative synthesis. But, speaking more seriously, in
16 my last years in office and in the years since I left
17 office, I have become more concerned than I was in my
18 earlier years about the intersection between economics
19 and politics, because the fact of the matter is that
20 all the key issues before us involve -- have their
21 major difficulty at precisely that interconnection.
22
23 The purely intellectual analysis of the political issues
24 and of the economic issues is stewable, but the decision-
25 making process of how you relate them over a period of

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[L]

time to a set of goals has proved illusive. Now, I
will not. in these remarks, go into second-guessing
any of the economic analyses that I have heard. What
I want to do is to present some observations or reflex-
ions that have occurred to me as various topics had
been discussed from the perspective with which I began.

I think all participants agreed that
we are in a period of unprecedented change, of change
in technology, of change in economic relationship. of
problems of productivity, human relationships, fiscal
management, monetary management. And, in fact, many of
them agree, most of them agreed on the components of
various solutions, that the deficits should be reduced.
and even the components by which the approach to a
reduction of deficits should be made. But, what it
seems to me does not exist in our country and did not
really exist here is a definition, a conception of the
future towards which we want to be heading.

We had a debate or we heard last
night and we had a little discussion this morning about
industrial policy and the argument whether you can rely
on competitiveness or the invisible hand, or whether you
should rely on industrial policy. And. I must say, I
found myself in the position of Mr. Kahn's rabbi, except
I used to tell that same joke about Jimmy Carter, that

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I thought everybody was right. I agree that to turn over industrial policy to government as it is now constituted is turning it over to a major element of the problem, but I also believe that to rely entirely on the market in a rapidly changing environment also cannot work for these reasons: It seems to me that the nineteenth century type of laissez faire operated in a world in which the perceptions of the key players were more or less similar. They all agreed on the kind of economic theory and policy they should pursue. And, secondly, the rules of the game were fixed by the gold standard, and third, technology was relatively stable, relatively stable, and then, there were only a relatively few players. None of these conditions exist the same way today. It would be rare that even one economic unit perceives either the environment or the future correctly. The chance that all of them will spontaneously come to the same conclusions about it would be nearly miraculous, and this accounts for the fact that most countries are trying to manipulate the rules of the game to their own advantage as we have heard in many of the presentations.

And, then, there are areas, like were mentioned this morning, for example, our airways, which the market does not reach. There are others in which

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1 the market incentives may actually be the opposite of
2 what is needed as in the field of energy today. and
3 there are still others in which the time scale is so
4 long for creative action that it will suffer neglect.
5 For all of these reasons. I think some industrial policy
6 is needed, but I must tell you candidly. I don't know
7 who should do it, because I think if our political sys-
8 tem, as it now exists, is going to try to generate it.
9 stagnation is more likely to be the outcome than crea-
10 tivity, and how to prevent planning from becoming a
11 projection of the familiar into the future, how to get
12 a view of the future that is relevant to what will
13 really occur, that seems. to me, our overwhelming
14 national problem. And, I'd like to illustrate this
15 with a number of topics that have been discussed here
16 on some of which I have ideas and on some of which I
17 don't. And. then, I want to conclude with a few obser-
18 vations on bureaucracies and of looking into the future.

19 First, everybody seemed. to me, to
20 agree on the fact that our deficits are too high and
21 are growing. Secondly, everyone seemed to agree that
22 the deficits must be brought under control by 1985 or,
23 well, something undefined would happen. but it would
24 not be healthy for our economy. It was interesting: I
25 didn't hear exactly what would happen after '85 if they

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weren't brought under control, but there was a sense
that it was not healthy for our country. And, it had
three components. Entitlements had to be cut. defense
had to be cut and taxes had to be raised. And, yet,
all of us in this room know that none of these things
are going to happen by 1985, unless, maybe, a defense
cut. The political process will not permit even raising
the issue of entitlement before the presidential elec-
tion, so that the earliest it can be brought before the
Congress is in 1985, and the earliest it can take
effect is in 1986. And, I would suggest that somebody
get to work on the problem of what happens to our econo-
my when we know now that the budget deficits for '85
and '86 will be at the higher range of the projections.
And, nobody, it seems to me, even Pete Peterson gave us
figures of what the deficit would be even at five percent
growth, and I don't know what Mr. Weidenbaum and others
think, but five percent growth from now until '85 would
be a stunning performance. Thus, at a minimum, it seems
to me to mean that our recovery will not be all that
spectacular and surely not a locomotive for all the
developed and developing nations of the world who. if
you now travel around the world, are looking to us to
pull them out of their own economic crises into which
they slip very often by following policies comparable to

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1 our own, or make their own mistakes. But, at any rate.
2 that seems to me to be a factor and that requires some
3 analysis.

4 . Now, let me say a word about the defense budget in this connection. There was some talk
5 throughout that the defense budget ought to be cut as
6 part of this process and no doubt, anyone who has ever
7 seen a defense budget being prepared knows that it can
8 be cut. But, if the argument is that it was put together
9 mindlessly, cutting it mindlessly is equally dangerous.
10 Everybody says one should cut the fat and yet
11 the fact is, bureaucracies never cut the fat if you just
12 tell them to cut. They'll cut something painful in
13 order to create a political issue. But, I would like
14 to make it more fundamental. I would like to say that
15 defense ought to be analyzed in terms of our national
16 security requirements. Certainly, one part of our
17 national security is a strong economy, but it should not
18 be part of a trade-off in which you say, "I will give
19 you "X" on defense in return for "Y" on entitlement."
20 Those are two different phenomena. If we cut defense
21 below what is needed for our security, we jeopardize
22 our national existence. So, what is lacking is a definition
23 of what is essential for our national security.
24 When the defense budget was increased in 1981, and I

LC
HARPER
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1 agreed with increasing it, something was bound to be
2 wrong when we found that each service received exactly
3 thirty-three and a third percent of the increase. That
4 is just not probable. So, I would -- and one result of
5 the absence of a consensus on what is needed is that our
debate gets polarized between those who fight any
7 weapon and those who think any additional weapon must
8 help our security. Weapon system by weapon system. it
9 is impossible for the average citizen to participate in
10 the debate. It is impossible for the expert, really.
11 to form a rational opinion. I do not believe, incident
12 ly, that arms control will save us a lot of money. and
13 when you look at the figures that are being mentioned
14 by the Peterson group, twenty-five billion dollars are
15 really not decisive in terms of the problem. The danger
16 is, if the defense budget is tackled as part of a fiscal
17 approach, there is no stopping point and so. I would
18 think that the best thing that could be done now is to
19 create a bipartisan group to review defense policy in
terms of doctrine before the next budgetary cycle gets
21 started. It's not that they will come up with anything
22 new, because most of the fundamental issues are known.
23 but it is -- they will be -- they should be able to
24 crystalize a debate and to establish some criteria so
25 that at least the next budget cycle permits us to have

K
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KAIPEES-COHEN ASSOCIATES

11

1 a debate, especially when it is in an election year.

2 And, it's especially important because we have to get

3 at least defense policy, preferably foreign policy as

4 well, out of a kind of a partisan country where every

5 president who comes in claims not only that he's going

6 to change the world, but insists that he created the

7 world. And, it produces in foreigners, who have to

8 gear their actions to ours, an enormous sense of insecurity.

9 So, it seems to me that this is the only way

10 we can -- or the best way to handle the defense issue.

11 rather than have a civil war of every individual weapon

12 system that is now before us or to set abstract targets

13 of what should be cut out.

14 Now, let me turn to another question.

15 One of the striking things in the discussions here to

16 me was that every speaker was passionately opposed to

17 protectionism and every speaker gave very good, often

18 statistical arguments why retraining benefits everybody.

19 Due to my relative ignorance of economics, I find it

20 striking that arguments that are so self-evident are so

21 hard to transfer into political reality.

22 If you look at the politics of most

23 countries, the fact of the matter is that obstacles to

24 free trade are increasing and speaker after speaker,

25 after giving us the arguments for free trade, listed all

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the things we were doing that were contrary to the pure principles of free trade, to put it mildly. Well, that's all the things other nations were doing, and I did not hear anyone say that these barriers were diminishing. I have to sense that these barriers are increasing. It seems to me that there are a number of reasons for it. Incidentally, theoretically. I am also for free trade. I don't want you to misunderstand me. I am trying to relate political reality to economic theory as it emerged out of these discussions. I am not attaching a value judgment. It seems to me there are a number of problems. The free trade theory, in its pure form, developed when Britain was -- had both a monopoly on energy and a monopoly on industrialization. And, then, it was very easy to run the world based on that concept. Later on, in the nineteenth century, other nations, industrialized nations developed -- incidently, almost invariably, in fact I would say, invariably, behind tariff walls, who then entered the free trade system after their protected industries were assumed to be competitive. But, there were only three or four or at most, five players in the world of the same cultural background with more or less comparable labor costs and standard of living and world markets, and a system of exchange rates that was automatic so

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[Lc]

Now, we have twenty to twenty-five
major players, big differences in labor costs, at least
between some countries, substantial cultural differ-
ences, so all the short-term pressures are and floating
exchange rates, so all the pressures are to manipulate
the system in favor to a particular country's advantage.
And, we all heard, over the last few days, many examples
of this.

Now, I don't know how we're going to
get out of this situation in which we all preach free
trade and practice mercantilism. And, in fact, if you
looked at this as a historian and you said, what is the
world likely to look like, never mind what you would
like, but what is it likely to be in ten to fifteen
years. Is it more likely to be free trade or more likely
to be mercantilistic. I would have to tell you, it is
more likely to be mercantilistic, and in fact, we ought
to give some thought to how we would live in such a
world, whether we like it or not. And, some of the
characatures of it are not really accurate, because you
could have a mercantilistic world in which the protected
areas would be rather large and not just small national
units. But, I don't want to give the wrong impression
that I'm advocating this. What I'm saying is, we have

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HANIPES-COHEN ASSOCIATES

14

1 to do one of two things. We either have to move towards

2 a genuine free trade system as an act of major national

3 policy and not just of rhetoric and periodic summons.

4 which would then have to imply some coordination of

5 monetary offers and fiscal policies, or we have to get

6 intellectually ready for the other kind of world that

7 will inevitably arise. Which of these we will choose.

8 that's up to our political decision, but to keep it at

9 the middle level of the government and to have an occasional

10 cat meeting and to start picking at this restriction

11 or that restriction and to take this count

12 or that count of ailing measure means that we are at

13 the mercy, first of all, of our weakest industries and

14 not of our most farsighted ones, and of a political

15 process that cannot possibly look at the ten year future.

16 And, the same is true in other countries as well. When

17 you have a free trade system of twenty-five players,

18 it's very difficult to run. Somebody is going to go

19 against the wall and you have to be willing to live with

20 that, and you have to insulate the political process

21 against these pressures if you really mean it. If you

22 don't mean it, then, it is better to look explicitly at

23 how to get the best advantage of some other system not

24 next year, but over a ten-year period.

25 It's in this connection that I want to

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1 say a word or so about exchange rates. In 1969. I
2 attended a meeting in the office of the ex officio.
3 They couldn't keep me out of it or they would have, ex
4 officio in the office of the then Secretary of the
5 Treasury, Kennedy. There was some financial crisis.
6 some international monetary crisis, and I said, "Why
don't we devalue." Well, if I had told a dirty joke
7 in church, I could not have been treated with more out-
8 rage and contempt. It was explained to me very pain-
9 fully by the few who would ordain to speak to me at all
10 that a reserve currency couldn't be devalued or evalued
11 because everyone would move with them, with us, that it
12 was also immoral and impolitical. I forget. At any
13 rate, I figured they knew something that I didn't know
14 and I made up my mind I wasn't going to let them speak
15 at any political meetings I fared. Well, my confidence
16 began to be shaken somewhat when almost the same group
17 went from -- I only had in mind a single devaluation.
18 They went from no devaluation to permanent devaluation
19 in the space of two years. Now, I'm not questioning the
20 political decisions or the economic decisions for the
21 floating system that was established in 1973, and indeed
22 it's quite possible that we could never have gotten
23 through the oil shocks without it. It seems to me,
24 however, that as it now operates, it has an additional
25

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[Lc]

element of uncertainty and therefore, instability to
international economic policies. The argument that the
currencies would straighten themselves out because of
overvalue, if it is overvalued, it will reduce exports
and if it's undervalued, it would create inflationary
pressures and so that, therefore it would work almost
like the gold standard, just has not worked. It has not
worked out that way either for governments or for busi-
nesses. We know business which make as much money from
currency translations as from selling their products.
or if not as much, a substantial amount. So, it encour-
ages a speculative element in businesses and forces a
kind of consideration that is not related necessarily to
productivity. And, we have seen that governments, for
reasons not having anything to do with international
economics, can overvalue their currencies or undervalue
their currencies for, in one case, for domestic reasons.
in other cases, for international reasons, and if the
two come together, like in the Japanese-American case.
you have a situation in which, as was pointed out, no
amount of productivity gains can make up for the curren-
cy fluctuations.

Now, I must say, at one point. Secret
ary Reagan said something about reconstituting the
Brentwood system in a new framework, and I must say. I

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COHEN

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17

Lc

1 thought that was a very constructive remark. Since
2 then, we seem to insist on our opposition through inter-
3 vention. I don't understand the reason for it, but that
4 may be because I don't understand the problem adequately.
5 But, it seems to me to be in our interest to make cur-
6 rency changes of a significant nature a political deci-
7 sion that cannot creep up on you in an unseemingly un-
8 noticed way. Certainly, if a country conducts irrespon-
9 sible domestic policies, fixed rates or rates in white
10 bags, which is all one is talking about, will not pre-
11 vent an eventual devaluation. But, as we have seen in
12 the case of France, the fact that it requires a politi-
13 cal decision is painful and it's not cost-free, and it
14 is, therefore, a restraint up to a certain point, and
15 adds an element of predictability. And, I believe, we
16 are going to be driven towards this in some manner,
17 whatever we now say, because the Europeans more or less
18 hold this view, and I don't know why it is in our inter-
19 est to permit the Japanese to maneuver their currency.

20 So, now, let me turn to another prob-
21 lem that also emerged in these discussions, and it seems
to me to require a long-range political solution, the
22 problem of energy. This is an area where I believe
23 market projections can be particularly misleading. Pro-
24 jections have been almost congenitally wrong. Two years
25

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Lc

ago, people were talking of fifty dollar plus oil. The
same people are telling us now that there will be an
oil glut until the year two thousand. And, projections
have been wrong for at least two reasons. One, the oil
market seems, to me, peculiarly sensitive to psycholo-
gical factors. If one looks back at the situation in
1973, for example, I think it is probably true that
there was no oil shortage in 1973. What occurred in
1973 was that the OPEC nations announced that they were
going to cut production by five percent a month, but
never did it. On the basis of that statement, everybody
started buying oil and hording oil, but there was not,
in fact, an over -- there was not an excess of demand
over supply. There was no purely economic reason for
the oil price to go up in 1973 as sharply as it did.
And, it is conceivable to me that the present oil glut
may have some of the same characteristics precisely.
because everybody expects the price to go down and
they're not holding oil, but that process is bound to
come to an end as well.

The second factor is that the oil mar-
ket seems to me extremely sensitive to political circum-
stances. It seems to me, for example, that the debate.
that the internal OPEC controversies which are usually
analyzed in our financial pages in terms of supply and

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