2

In 1973, the United States entered a period of economic recovery known as the Vietnam War era. Social welfare payments increased substantially across National Product. Rising governmental expenditures and the failure to finance the Vietnam War accelerated inflation. Thirty years of improving living standards reduced economic incentives. The nearly twenty-fold increase in oil prices after 1973 culminated the process. By the beginning of the 80's recession was global. The advanced industrial countries were more or less grudgingly restoring to policies of austerity and some were accepting real declines in their standard of living. The developing nations heavily burdened by debt saw hopes for progress disappear. The global inflation in the 1970's gave way to global recession. Nearly thirty million workers are without jobs in the industrial democracies and their number continues to increase. Trade has slowed, economic activity is weak and investment sluggish. These events have shaken the economic political foundations of the post-war political and economic order.

2

ri
ch. Social welfare payments increased
much... across National Product. Rising

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

2

rigidities slowed growth. Social welfare payments increased
much faster than the Gross National Product. Rising
governmental expenditures and the failure to
finance the Vietnam War accelerated inflation. Thirty
years of improving living standards reduced economic
incentives. The nearly twenty-fold increase in oil prices
after 1973 culminated the process. By the beginning of
the 80's recession was global. The advanced industrial
countries were more or less grudgingly restoring to policies
of austerity and some were accepting real declines in
their standard of living. The developing nations heavily
burdened by debt saw hopes for progress disappear. The
global inflation in the 1970's gave way to global recession
Nearly thirty million workers are without jobs in the
industrial democracies and their number continues to increase.
Trade has slowed, economic activity is weak and investment
sluggish. These events have shaken the economic political
foundations of the post-war political and economic order.

3

Nor are there purely technical solutions to reverse
what is turning more and more into a structural crisis.

Simply put: without political

leadership of a high order within the industrial democracies
and cooperation among them, the governability of all
democratic societies is likely to erode
ability to conduct an effective and long-term foreign
policy or to assure the national security will be jeopardized.

An augury is the fact that no democratic government -
except Canada - which was in office in 1979 when the Iranian
revolution ushered in a new surge in oil prices has
survived the intervening period. Socialist or liberal
governments in Germany, Britain and the United States
have been replaced by conservative ones;

conservative governments in France, Greece, Spain
and Sweden have been succeeded by socialist ones. The
common feature is less the program of the parties than
the conditions of societies; restlessness with a recession
which seems to have no end; fear of a future that has no

4

signposts. If the public no longer believes that governments
can control economic destinies, political disorientation
can only grow. Demagogues of the radical right or left
will increasing dominate the political landscape.

Economic Theory and Political Realty. No more urgent
challenge confronts the industrial democracies than to
put a decisive end to the global recession, ~~and not one~~
of them can solve it alone. Economic theory after a
generation of expansion encouraged by inflation seems
to have left a legacy of few tools and insitutions to cope
with severe contraction and deflation. Above all,
decisive remedial action is inhibited by a growing
inconsistency between economic theory and political
reality. To the extent that current recession is the result
of deliberate governmental policy it derives from the
premise that deflation will wring out inefficiency,
restore confidence and thereby I agree with the genreal
proposition that governments have lived for too long beyond

5

their means and that more scope must be given to private
initiative. But like all theories it can be pushed too
far. Two political facts must discipline its application.

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

Secondly, a remedy that may ~~indeed~~ surely will work for the economic ills of one nation may backfire if applied without adequate regard for their impact on others.

Thus the historically unprecedented high interest rates - an effective tool for fighting domestic inflation, attract capital to the United States, discourage investment abroad and thus deepen the recession of the other industrial democracies. Even policies that cause no special disadvantage if carried out by one nation may prove politically untenable if several seek to carry them out simultaneously. Orthodoxy

7

not work either. A joint effort is needed not only
for economic reasons but for psychological and political
reasons as well. Most of our foreign policy problems
allies would be eased if we were perceived as leading a
global recovery. Nothing is more essential to restore the
political health of the individual democracies than a
sense that the West is in control of its desting. No
American policy would reverse the tensions in the Alliance
more effectively than a clarion call to economic expansion
and a program to achieve it. Nothing is more likely to
encourage a healthy political evolution in the developing
world than the sense that they have a share in a world
of growth. Nor could anything more strengthen our
land in East-West negotiations.

Team,FACT and Reality Political Reality, Trade Policy,

A policy of economic expansion will be imposed in the
regard for
industrial democracies, as well, if they are serious about
preserving the international trading system to which all
pay lip service in the theory which most ~~of~~ and violate
in practice. But if the gap between theory and practice

8

grows too wide, a collapse of the existing international
economic order will be inevitable. Recession will then
spurn trade wars, protectionism and mercantillism with
all that implies for the political relationships among
the industrial democracies.

We must begin with the recognition that to operate
a free market system in the current world would be a
formidable task in the best of circumstances. Here is
another case where economic theory and political reality
do not always mesh.

It is a rarely questioned cliche that free trade benefits
everybody. No country, so the argument goes, can possibly
be strong in every conceivable area of economic activity.
Therefore, specialization and comparative advantage are
the key to efficiency; competition insures that rewards
go to the most productive. Tariffs and other trade barriers
reward inefficiency, restrict commerce and lower the general
standard of living. The experience of industrialization
of the late 19th and early 20th century seems to confirm

9

these premises. The current international trading system
is based on them.

Nevertheless, it is open to question whether these premises all reflect in current practice. The free trade of the 19th century was based on a very few nations--no more than four or five, from homogenous cultures with comparable living standards operating by the discipline of the gold standard.

The current world economy contains at least twenty significant industrial societies of widely different cultural backgrounds with great variations in labor costs and standards of living, each gains by free trade not through somebody claiming sovereign control over their economic decisions.

In these circumstances a free trading system grave obstacles. On the classical theory of free trade everybody gains from an unrestricted flow of goods and services.

[y]

10

NOT In practice, however this not true. As more and more
countries industrialize, uniting specific industries
and sometimes whole sectors of their industrialized areas may
in existing industrialized countries shrink or disappear.
The problem of our steel and
automobile industries require no elaboration; very few
television sets are still made in the United States.
Some thoughtful observers have indeed made the point that
America's future lies in the service industries. Even more
complicated is the problem of developing countries with
comparatively high labor costs. Countries like Spain, Greece
and Yugoslavia find it difficult to continue the process
of industrialization against the competition of countries
of Southeast Asia with low labor costs. And in many European
and the near east high expenditures for social welfare accentuate
the comparative disadvantage.

In the 19th century countries might have accepted these
penalties in deference to a prevalent theory-though it had
never to be tested in view of the limited number of

12

status in the name of an abstract theory of free trade.

Nor would it be possible for the United States even to maintain permanence in services of a historical period if the center of manufacturing activity and hence technological innovation moved elsewhere. A permanent decline of the manufacturing sector would bring about social and political changes that would painfully and fundamentally alter the character of American society and politics. In addition, some basic industries must be preserved at all costs if we are able to assure our national security.

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

13

Thus the industrial democracies can no longer avoid fundamental decisions. They must either agree to apply strictly the rules of GATT embodying the principles--and develop rules to address trade problems not now adequately covered by GATT-- or they will in a measurable time live in a mercantilistic world of unilateral actions and bilateral deals. Free trade--or even the aspiration to it--cannot thrive in a world in prolonged recession. And even in a growing world economy it will be threatened by beggar-thy-neighbor policies if there are major imbalances in the domestic price of countries. The objective of maintaining an open-world trading system, therefore, cannot be divorced from that of avoiding major disparities in the rate with inflation and growth, and misalignment of exchange rates, which will require a degree of coordination unprecedented in the post-war period.

## Theory & Reality in Exchange Rates

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

14

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

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

by agreement could be undone by unilateral decision; devaluation
designed to spur exports and to limit imports, turned
potentially into an act of policy, it was no longer a
consequence of automatic adjustments. Governments were tempted
to beggar their neighbors by exporting domestic difficulties
to other countries which in turn sought the same objective.
But the new system contained some considerable restraints:
the need for a formal decision and the knowledge that other
countries could negate these decision by refusing to go along,
maintained a measure of discipline.

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

aspect of trading; especially in times of crisis it compounds
uncertainty and thus inhibits recovery.

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

18

Such an approach could succeed only if the governments of the industrial democracies were prepared not only to intervene in exchange markets, but also to coordinate their domestic economic policies in order to reduce discrepancies which give rise to exchange rate misalignment.

## The Need for Industrial Strategy

We have thus arrived at a point where together with moving towards a world of peace the preeminent goal of American foreign policy must be to restore the vitality and spontaneity of the international economic order. The peoples of the democracies expect it, indeed, the survival of their institutions depends upon it. Our national security requires it. The developing world will lose all hope without it. And as I have said we have no realistic choice except free trade or some form of mercantilism.

But free trade requires the following major steps:

A progressive elimination of existing trade barriers and other practices that impede trade; a coordination of monetary and fiscal policies; a new regimen on exchange rates; and

19

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

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

splitting up

collapse

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

22

the more traditional industry benefit from technology to avoid decline. Such a growth strategy would be of enormous international importance. No American action would do more to cure the current political malaise among the democracies than a clarion call to economic expansion. No greater challenge meets our political leadership than and a corrected program to achieve it. Living about a coordination of similar policies among the industrial democracies, Theory and Practice:

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

The Debt Problem:

The debt problem is best described by some basic statistics.

23

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

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

The current account deficits for the less developed countries was approximately $100 billion in 1982. It will be the same in 1983. Of this amount, some $45-50 billion must be made up by loans from private sources primarily from commercial banks which are already understandably gun-shy in view of the difficulty borrowers are having concerning the existing debt service. Substantial transitional support

25

Any reflection in the debe problem must begin with the
realization that this transfer of resources is already an
accomplished fact; the funds have moved to the developing
world. What we are dealing with is how to contain the
consequences of the international system of instability and
economic ruin and scarcity of payment.

What has turned into a historic joke or a parable
on the fallibility of human foresight has its origin as
much less in the energy crisis which began in the early
seventies. The oil producers suddenly awash in dollars-
placed thier surpluses into Western commercial banks usually
in the form of short-term deposits. The banks flush with
reources, unimaginable even a few years earlier, competed
fierecely for long term loans to developing countries--
especially the more advanced countries of Latin America.
Governments encouraged the process in order to maintain
the incentive of the oil producers to pump oil and to
maintain the economic growth of the developing world. Indeed
it is for the "recycling" efforts of the commercial banks
the immediately economic impact of the energy crisis would

26

have been much more severe.

In the absence of a coherent government policy no single
financial institution was in a position to gain an overall
view of the dimensions of the process.

As is often the case the abduction of government and
the competitiveness of the banks solved an immediate problem
by mortgaging to the future.

For the end result was to convert the energy bill owed
by the developing world to the oil producers into debt
owed to Western banks. The short-term deposits of the
oil producers were translated into the long-term lending
of the banks creating an obvious and massive vulnerability
of the banking system. The growing debt could be financed
only on the assumption of rising oil prices and fairly
stable interest rate. Neither condition continued to
be met. Oil prices stabilized and indeed began to decline.

For example, Mexican earning from energy exports would have
been greater by $6 billion in 1982 but for the oil glut.
And the industrialized countries began to fight inflation

27

by tight money policies driving interest rates. Thus the cost of debt service rose, as real income declined and the global recession sharply reduced the exports of the less developed nations, making the debt problem more intractable.

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

Contradictory arguments that play down the serious nature of this state of affairs. The first is that in the end the creditors can oblige the debtors to face the consequences for their own financial irresponsibility. The second is that the debtors in the end will not be able to default as that should undermine their creditworthiness. Neither proposition holds water.

28

Thus the inability of developing countries to borrow and
a further reduction of their imports will deepen global
recession and add to unemployment. Indeed, if the
industrial democracies lend out no more than the interest
due them, American exports will decline by 4 percent and
our Gross National Product by 1 percent.

As for the degree of default by the debtors, conventional
wisdom rejects the possibility. They are supposed to recoil
from measures that would jeopardize their creditworthiness.
But, the bargaining position of two sides confronting different
kinds of disaster is not simple to calculate especially as
there are many intermediate steps between meeting objectives

and
> straight
> default.

Whether a threat of default will
ever be made depends on at least two factors: First,
how much funding can be made available to debtor nations
beyond the amount needed to ensure repayment of interest.
Second the impact on the political structure of the debtor
country of the conditions demanded for stretching out-or

30

The principal institution for dealing with the
liquidity and repayment crisis of the debtor nations is
the International Monetary Fund (IMF). It is no
of its extremely talented Managing Director, Jacques de Larousiere
and its dedicated staff, to point out that it was never
conceived designed for a crisis of such magnitudes. The IMF's
original purpose was to lend to help out individual countries by
lending them funds on condition that they adopt measures
of fiscal and monetary discipline. The premise was
that as an international institution, the IMF was in a
position to impose conditions that would be politically
unacceptable if put forward by a single creditor nation.

Until now the IMF has performed its functions admirably.
The fact remains that it was designed to deal with discrete
problems of individual countries not with a crisis of
the system. As country after country admits its inability
to pay even interest--and therefore renounces any immediate
discovering prospect of repaying capital--the IMF is discussing that
it has neither the resources nor the operating philosophy
to rescue the entire developing world. And while the

32

the objective of escaping the v Löwais

circle in which debt service consumes export earning.

This requires a reversal of the global trend of high
interest rates, spreading recession, excessive caution
of the Western financial system, and tragic reduction in
government-developed assistances. The IMF conditions can
only in conjunction with

be work a deliberate policy which will insure a resumption
of sustained economic expansion in the industrial democracies
is essential.

No! In deed it is possible that IMF conditions cannot
work if applied simultaneously in too many countries. If

everybody practices austerity simultaneously, recession becomes global

and it is
congruent. All nations/ cannot at one and the same time

expand exports and contract imports withou wrecking the existing

Trading system. Thus the expansion of funds to the IMF is not enough for the care of the problem. What is

needed as well is a reconsideration of its operating philosophy.

A program of economic growth which is intended to end the 1940's scope and need of

operation for debtor nations, without seeking to correct
economic practices that brought them to the edge of the
precipice. But is important to make sure that the conditions

33

are realistic. They must not be so irrelevant as to serve
primarily as an alibi for banks to continue leaning in
essentially unchanged economic circumstances and thus
increase the risk they must take to immerse a fragility of the system in so stringent a condition that they force debtors to agree to formulate a mortgage that will pay the political futures of debtor nation.

The worst debt problems arise in countries with the most tenuous governmental processes (Brazil may be a notable exception). Each commitment sought should be assessed not only in technical terms but in relations to its political credibility. How firm, for example, is the assurance of an Argentine military government daily losing legitimacy and in the process of turning over its authority to civilians of a quite different political orientation? With the best of intentions can these targets be met? And what if in say two years the economic conditions have not improved? Is another rescue mission then credible? And if the IMF option is no longer available is there any other recourse then available except some kind of default?

34

Two contradictory dangers in current IMF procedures. The first is that the IMF conditions are not met. But the opposite danger may be more insidious still: That a government makes a major effort ~~is~~ made ~~for~~ to fulfill the conditions and, in the process, undermines its political viability.

For the most searing problem in almost every developing country is not economic; it is political. Most industrial democracies were nations before they became states, most developing countries were states before they were really nations. Occasionally, Western governments in economic trouble have used IMF conditions as a convenient excuse to impose an austerity that domestic politics might otherwise have prevented--Britain in the winter of 1976 is a good example. In most developing countries, prolonged austerity is bound to shake, perhaps to shatter, the legitimacy of political structures which are the only hope for national cohesion. Few have unemployment insurance or other resources which in the West cushion the impact of economic downturns.

36

America's Challenge

In the immediate postwar period the Marshall plan restored Europe's morale and saved the democracies by evoking the vision of a better world. Sacrifice was sustained by hope.

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

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

Our foreign policy therefore has two urgent tasks which have been increasingly recognized in recent statements by Secretaries Shultz and Regan: First is recovery in the industrial democracies butressed by a stabilization

37

of exhnage rates and coordination of economic policies.

Second, expansion of economic and sounder (less ominous)

debt structure. Neither of these problems is soluble in

isolation. Interdependence has moved from a slogan to a

necessity. Whether we devote an economic summit or a special
conference to this challenge it must not only be dealt with
but be seen to be dealt with.

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

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

be overcome simply by removing the debris of past mistakes
on a national basis or by the market alone. An act of economic
statesmanship is required for which deliberate decisions by
governments are necessary.

The structural problems of the international economic
order include the nature of the international financial system;
the *need* to redefine free trade under contemporary circumstances
and the relation of advanced to developing societies, especially
the "middle class" of developing countries like Brazil, Mexico,
Argentina, the countries of Southeast Asia, South Korea.

The nature of the international financial system. Throughout
the 19th century currencies were stable. The value of money
in 1914 was essentially unchanged from 1815. International
trade could therefore be conducted in predictable and--as far
as currencies were concerned--nonspeculative patterns. The
mechanism for achieving this stability was the gold standard.
So long as currencies had to be backed by gold there was an

10

industrial
could succeed only if the governments of the individual

democracies were prepared to coordinate their monetary

whil they must do in any event if they want economic
policies an imperative imposed in any event by the current

recovery + free trade.
crisis.

The Problem of Free Trade: It is a rarely questioned
cline
shibboleth that free trade benefits everybody. No country,

so the argument goes, can possibly be strong in every
conceivable area of economic activity. Specialization is the
key to competitiveness; competition weeds out the weak and
insures that rewards go to the most productive. Tariffs and
other trade barriers reward inefficiency, restrict commerce
and lower the general standard of living. The experience of
industrialization of the late 19th and early 20th century seems
to confirm these premises. The current international trading
system is based on them.

Nevertheless it is open to question whether these premises
reflect either practice or reality. The free trade of the