JAN 17 1986

TIME
THE WEEKLY NEWSMAGAZINE

TIME & LIFE BUILDING
ROCKEFELLER CENTER
NEW YORK 10020
212 JUDSON 6-1212

January 16, 1986

Dr. Henry Kissinger
Kissinger Associates
26th Floor
350 Park Avenue
New York, New York 10022

Dear Dr. Kissinger:

TIME Magazine is planning a joint meeting of its three Boards of Economists on or about July 14 and would like to invite you to participate as one of the featured speakers.

TIME has three Boards of Economists, one for the U.S., one for Europe and one for Asia. These groups are made up of some of the leading economists in their regions. The U.S. board, for example, consists of Alan Greenspan, Walter Heller, Charles Schultze and Martin Feldstein among others. The European one includes Guido Carli, the former Governor of the Bank of Italy, and the Asian one has Bunroku Yoshino, president of the Institute for International Economic Studies in Tokyo, and Huan Xiang, the director general of Peking's Center for International Studies, as members.

The three boards normally hold separate meetings, but we are bringing them together in New York in July to discuss the current international business and economic situation. The interrelationship of world economic issues has greatly increased in the past few years, and we think that these groups could give us a unique perspective on the world economy.

I have noted in your recent writings and speeches that you have been talking about the issue of economic and foreign affairs, and I think that this topic would be a valuable contribution to our meeting.

The conference will last a day and a half and include discussions of issues like the debt question, monetary reform and protectionism in addition to a look at the current status of world growth.

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The nineteenth century was a period of unprecedented economic growth which produced what we now call the "developed" world. The principal causes were a combination of technological breakthroughs and the compatibility between political and economic philosophies in the countries that shaped world affairs. Governments acted on the premise that the economic sphere was beyond its power or even competence. The accumulation of capital was left to the operation of the market. The mechanism of adjustment between economies was provided by the gold standard to which all major trading nations subscribed. All this had the advantage of automaticity. The market gave the signal when economic adjustment was needed; no additional political decision was required to trigger adjustment policies. Politicians could either accept the gold standard or reject it. But once that decision was made, they were forced to conform spending, taxing, and monetary policies to its discipline.

There were of course costs, sometimes heavy human costs. Severe unemployment and periodic deflation were considered "natural"; the business cycle was believed to follow laws beyond the capacity of governments to repeal or amend. International trade was dominated by a very few countries whose competition was more often governed by strategic than by economic criteria. Colonial empires provided the safety valve of assured markets and sources of raw material.

But this combination of gold, colonialism and laissez-faire is not the current condition. In the 19th century the economic world order was established by a very few

dominant countries which set the rules of the game, that is of the market. Industrialization had been invented in Great Britain which for a while had a near monopoly on the relevant technology; free trade is easy to manage for the monopolist. The circle of industrialized countries gradually expanded (initially always behind tariff walls) but the economic system remained under the control of a small group of European countries with similar political systems and economies.

Even then the dominant countries did not adjust gracefully to the emergence of rivals. At the turn of the century Britain had trouble accomodating Germany. In the 1920's and 30's when rising Italy and Japan wanted "a piece" of the action, the failure of the economic system to accommodate them contributed importantly to rampant economic nationalism. In the fifties and sixties the United States became the balance wheel of the world economic order. Backed by the industrial democracies it was strong enough to make and enforce international rules. This arrangement collapsed in the seventies under the twin blows of resurgent economic nationalism (including American) and the oil crisis.

The economic world order of the past cannot be resurrected and a new one cannot be created by the old players. Too many newcomers insist on participation. China, Brazil, India, Korea, in time Mexico and Indonesia to name just a few will insist on helping to reshape the rules which affect their economic and hence their political destiny.

The task of constructing a new international economic order is made more challenging because the most important economic powers are governed by a kind of popular democracy unknown in the 19th century. Suffrage is universal; the public insists that governments assume responsibility to alleviate suffering and to improve the quality of life, if necessary even at the cost of slowing economic growth. Few, if any, excuses are tolerated; the political landscape of the last ten years in Europe and in the United States is littered with the wreckage of governments that failed to produce economic results acceptable to the electorate-- regardless of who was at fault. After the fall of the Shah triggered a new inflationary spiral, no national leader in office in a major democracy survived the next election.

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For this reason alone the present international political environment is hostile to automatic mechanisms. Unlike their 19th century counterparts office holders today are not willing to limit themselves to "on or off" decisions; they insist on controlling the economic policy levers directly in order to achieve immediate political goals.

This process puts a premium on short-term approaches; it encourages leaders to wait for crises to mature until action is unavoidable; simultaneously it tempts them to shift their economic problems to other countries for as long as possible.

The growing political nationalism runs counter to the dominant economic trends of this century. For the first time in history the world economy has become truly international. No geographic region is excluded from international commerce; each, with the possible exception of Africa, contains some major actor. But none is strong enough to impose its design. They compete through national decisions while being simultaneously linked by global markets. Not even the sharp political differences between the Soviet bloc and the West have proved an obstacle to these dominant trends. A conservative American administration has avidly encouraged Soviet grain purchases. Many European industrialists pursue in the less developed economies of the Soviet bloc the opportunity or the mirage--depending on one's point of view--of a market sheltered from Japanese and U.S. competition.

The incongruity between the internationalization of the world economy and the dogged strengthening of national autonomy in economic decision-making is the deepest cause of the gyrations of markets and exchange rates. Tax, spending, social employment, industrial and trade policies are insulated behind national borders despite the fact that such decisions have global consequences in direct proportion to the economic importance of the country involved. A case in point is the unilateral decision by the United States in 1971 to suspend the convertibility of the dollar and to impose a 10 percent surcharge. The effect was to overthrow the Bretton Woods arrangement affecting all countries--without prior consultation or notice to anyone. Comparable unilateralism has marked the Japanese restrictions on foreign investment and Europe's management of agricultural policy.

We live with the paradox of a global economy which lacks a system for setting agreed long-range goals. Automatic mechanisms to force coordinated decisions have proved politically unacceptable. But the industrial democracies have recoiled as well from the alternative

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of political coordination of fiscal and monetary policies. Forums where national economic policy makers meet exist, of course: the Bank for International Settlements, the International Monetary Fund and most dramatically the economic summits. But these occasions provide little more than an opportunity for an exchange of national views; they have not succeeded in shifting the framework of thinking and acting to a global perspective.

In recent years those charged with international monetary arrangements have tried to establish the International Monetary Fund as the global disciplinary force. The 1976 amendment of the Fund's Articles of Agreements give the IMF the authority to "promote stability by fostering orderly underlying economic and financial conditions" as well as "to seek orderly economic growth with reasonable price stability." In theory at least this implies the right to review national economic policies for their international compatibility.

This "technicians' automaticity" works better in theory than in practice. The Fund, though it may police a few troublesome cases, is far from being the governor of the general system. The U.S. and other major industrial democracies have been unwilling to modify their policies in response to IMF criticism. In fact the U.S. has been tacitly conceded a dominant role for the dollar and a disproportionate autonomy for its decisions. IMF discipline has in practice been applied primarily to those countries in economic trouble; most recently to developing countries facing a mounting burden of international debt.

In theory, of course, no mechanism such as the Fund or a commodity such as gold should be necessary. The market should be an incorruptible judge of the appropriateness of economic policies. In practice, however, the dominance of the United States in economic affairs, the imperfections of financial markets and the ability of countries to delay remedial adjustment through borrowing has meant that the market can be ignored at least for a while. To be sure the ultimate reckoning is all the more severe. But the temptation of governments to delay the bitter medicine of reform of economic policies--usually involving some contraction of non-affordable expenditures--beyond their electoral period tends to be irresistible.

In these circumstances the economic system operates--if at all--as crisis management. The risk is, of course, that some day crisis management may be inadequate. The

world will then face a disaster its lack of foresight
has made inevitable.

The biggest politico-economic challenge to statesmen
is to integrate national policies into a global perspective,
to resolve the discordance between the international
economy and the political system based on the nation state.
The goal can be stated as simply as it is difficult
to achieve: a dynamic and free global economy which will
be sustained by key developed and developing countries
because they have a stake in it.

In what follows I will discuss this challenge in
relation to three issues: trade, exchange rates and
international debt.

Trade Policy and International Politics

According to the maxims of the prevalent trade theory,
the free exchange of goods and services potentially benefits
everybody; tariffs and other trade barriers reward ineffi-
ciency, restrict commerce and lower the overall standard
of living. The professed objective of all trading nations
is to remove political obstacles to trade and to rely on
comparative advantage. But the gap between theory and
practice is wide. Many nations, while paying lip service
to free trade, systematically impede it in practice.
Clearly important political realities are at work.

For one thing, Adam Smith and David Ricardo developed
their theories when Britain had an effective monopoly
on industrialization and a large advantage in the generation
of energy based on coal. There is no doubt that free
trade benefits a country which enjoys such a comparative
advantage. Inefficient industries are replaced by more
efficient ones within the same national borders; labor
can move, at least theoretically, from one sector to
another. Productivity, income, growth and employment
are certain to benefit--though the adjustment process
in the 19th century was never as free of friction as the
theory maintained. This state of affairs continued for
a while after other European states industrialized. Cultural
homogeneity prevented any country from achieving a unilateral
advantage and colonial empires cushioned the shock of
competition. Even with these safety valves the German-
British trade rivalry contributed to the tensions that
ultimately produced the first World War.

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In our period, the number of actors has multiplied dramatically. There are over twenty major trading nations including the traditional industrial democracies and such significant exporters as Brazil, Korea, Singapore, and Hong Kong. The wage scales and cultural background of the major trading nations and exporters are dissimilar. With the best efforts to improve productivity, some nations-- especially in Europe--will be unable to compete with substantially lower standards of living, at least in industries that are labor intensive. Thus whole sectors of industry move from one country to another, indeed from one continent to another. This compounds the congenital unemployment produced by automation and rigid management-labor practices and generates pressures for protectionism.

The maxims by which the debt crisis is being combatted also tend to inhibit free trade. A key provision of every IMF adjustment program is to limit imports and to encourage exports. But by definition it is impossible for every nation to pursue such a strategy which is in effect mercantilistic. The limitation of imports must be at somebody's expense, especially if coupled with the systematic promotion of exports. And if the strategy works developing nations are transferring real resources to the industrialized ones, the precise opposite of what is needed for global development.

Two results are probable: Either the quasi-mercantilistic structure will collapse because there is simply not enough demand to sustain the exports required by the developing world. Or these export surpluses will be sustained on a temporary basis by extremely unfavorable trade balances in a very few countries, especially by the United States. The U.S. trade deficit is officially forecast to exceed $120 billion this year--a level unimaginable until very recently. Such a situation cannot possible be maintained without causing our government to take some remedial, probably protectionist, steps which could collapse the whole fragile edifice of current international trade practices.

In short, free trade is being stifled by the same political factors which prevent automaticity as the adjustment mechanism of the economic system. The growing influence of domestic political considerations in all democratic countries threatens the open trading system as we have known it. Protectionism, trade restraint and unfair trade policies are on the march.

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by political attempts to maximize national advantage--
in short a mercantilistic world.

Japan seems to have come to this conclusion. It
makes little pretense that its foreign economic policy
is guided by a commitment to the free play of market
forces. It is instead more or less explicitly geared
to manipulate the trade system as it really operates
to the national advantage. Japan is widely criticized
for acting counter to existing economic theory. In fact,
it is possible to argue that it is simply playing the
de facto game more systematically and with greater
coherence than anyone else.

But if we are driven to it we can play the same game,
however reluctantly, and thereby enhance our competitive
position in a world of unilateral trade practices and
bilateral agreements. We need not fear such a world;
its chief peril is if we fail to recognize its emergence.
At some point the sheer weight of the United States
managing-in cooperation with like-minded countries--
its foreign trade interests with determination and vision,
will probably convince the rest of the world-to put
it politely-of the need for more coordinated trade and
economic policies. We would then have achieved a more
coherent world trading system by the back door.

Exchange Rates and International Cooperation

Ever since the United States unilaterally abandoned
the Bretton Woods agreement in 1971 there has been a
debate about the relative merit of a floating system as
against fixed parities and at the margin even of the advantages
of a return to the gold standard. I will not enter into
the debate over the economic merit of the various schools
of thought. The original argument that the floating system
would automatically produce stability was falsified by
the oil shocks. No exchange system could have produced
stability when the price of oil quintupled with a two-year
period. But even after the oil price leveled off the floating
system has not worked as smoothly as its proponents had
predicted. Countries, it was held, would not accept an
overvalued currency because it would reduce the competitiveness
of exports or an undervalued one for fear of generating
inflationary pressures. Hence, almost like the gold standard,
the floating system was expected to force an adjustment
of irresponsible or extravagant policies nearly automatically.

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This has not happened because the impact of the market
has been partially obscured by political decisions. In
order to escape--at least for a while--the need to toughen
internal economic policies, governments often ignored
the market's warning signals and borrowed to finance current
account deficits. And countries promoting their exports
have avoided strenuous efforts to correct undervalued
exchange rates.

In a sense, of course, exchange rates tend to reflect,
not cause, domestic economic conditions. Incompatible
national economic policies inevitably lead to uneven
development and crises which will be reflected in the
constant need for exchange rate adjustments. The United
States is therefore surely right in arguing that correct
economic policies are the irreducible precondition to
exchange rate stability. Confusion and growing resentment
result however when the U.S. insists that it is the sole
judge of what is the right mix of its own economic policies
without regard to their impact on the rest of the world.

The problem becomes more acute because we have the
strength to impose our views--at least for awhile. The
dominance of the American economy explains why no matter
what the value of the dollar we are criticized for its
allegedly harmful impact on the world economy. Five years
ago at the IMF meeting in Yugoslavia the weakness of the
dollar was the dominant theme. Today the strength of our
currency is blamed for our presumed policy to use the capital
of the rest of the world to finance the deficits which stim-
ulate our economy. In the seventies the "market" belatedly
corrected the imbalance but not until the Federal Reserve
Bank pushed up interest rates. Today these same high
interest rates, coupled with the possibility of attractive
capital appreciation and political stability contribute to
exorbitant exchange rates. The strength of the American
economy is such that whatever the value of the dollar the
United States can take away with one hand what it gives with
the other. Today the growth in imports which is the con-
sequence of a high dollar is balanced by higher debt ser-
vice costs and lower commodity prices for developing countries.
Tomorrow a sharp and sustained drop in the value of the dollar
could produce--as it did in the seventies--major disruptive
effects on international trade and finance. The policy
question--unanswerable in the abstract--is whether a desirable
one-time drop in the dollar is conceivable. Or whether once
the dollar starts weakening it will be difficult to reestablish
confidence. In economics as in other fields the gods sometimes
punish humanity by fulfilling its wishes too completely.

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Three political consequences seem to me to flow
necessarily from existing arrangements:

-- One of the principal virtues of floating exchange rates--economic policy flexibility--too often has been turned into a vice. Countries have been able to support overvalued exchange rates by borrowing, or to encourage undervalued rates to foster exports. In practice, the system has allowed too much flexibility.

-- Exchange rate arrangements have been a profound source of political controversy among the industrial democracies for over a decade. The political impact of unilateral economic decisions mortgages other relationships.

-- Disagreement over exchange rates is the way underlying disagreements over broad economic policy goals and methods are made explicit. The exchange rate regime now in place tends to magnify these differences but it does not cause them.

The fundamental issue is that the international financial system cannot be sustained indefinitely by unilateral American decisions, however advantageous these might be to us in the short run. Leaders concerned with cooperative international foreign and economic policies must undertake a systematic review in order to find the basis for new, more equitable and less volatile exchange arrangements. Its test will be whether the industrial democracies are able to agree on coordinated economic policies. No international system can meet everybody's maximum demands; but it must respond to enough common aspirations so that maintaining the system seems more important to its members than insisting on any specific dissatisfaction. A system that does not meet this test--and the present system does not--is congenitally volatile.

## The Politics of International Debt

I have expressed myself on other occasions on the international debt problem--not always to the entire satisfaction of banking audiences. Let me begin by stating two propositions:

-- In the seventies neither governments nor the IMF intervened seriously in the process for recycling the huge accumulated earnings of the oil producers. The commercial banks thus played an indispensable role in cushioning the financial consequences of the sudden and dramatic rise in oil prices. Had they not done so a financial crisis would have occurred much earlier and under much worse circumstances.

(markets for our exporters) and political (allies in the global
competition with the Soviet union) terms. Moreover, the post war
role of economic leadership granted to the United States a unique
degree of economic policy flexibility since the U.S. alone we
could finance its deficits by simply issuing more dollars to the
rest of the world. Within limits, such flexibility is clearly
valuable; if abused -- as some would argue it has been in recent
years -- then it is a danger.

But the benefits of the leading international economic role
extend beyond the mixed blessing of policy flexibility. There is
clear advantage to exporters when most of their trade is
denominated in their own currency. There is advantage to setting
the ground rules by which the economic system operates and under
which the international financial organizations conduct their
business. And there is an inextricable linkage between our
global political presence and our economic leadership; the latter
provides part of the justification for the former as well as a
principal means through which it is exercised.

However, in the mid 1980s much of the underlying political
consensus on which the leading economic role of the U.S. was
based seems to have eroded. Certainly on trade issues, the
political consensus now favors rolling back import penetration
and protecting American industry from foreign competition. With
regard to developing countries, there is almost no support for
the idea that the U.S. should play a lead role in financing

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renewed development. And there is little sympathy for the notion
that the U.S. should accept higher unemployment in return for the
benefits of the dollar's role as the reserve currency. In
general, the American public, and even key elites, appear
increasingly less willing to bear the short run costs which
international leadership implies.

This change was presaged by the collapse of the fixed
exchange rate arrangements during 1971-73 when the U.S. declared
its unwillingness to live with the discipline of either gold or
fixed parities. The global economic system, however, has not
changed in a more fundamental way: it is still essentially based
on the assumption of a dominant, internationalist United States.
As this assumption becomes less valid the institutions and,
indeed, the system are likely to function less effectively, to
become crisis prone, and, possibly, to collapse. This may
already be happening, as evidenced by Third World debt problems,
violent swings in exchange rates and growing impediments to free
trade.

Gradual deterioration or ultimate collapse of the
international economic system as the U.S. withdraws from its
leadership role cannot be in this country's best interests since,
for better or worse, the U.S. economy has become integrated into
the world economy in significant ways.

Thus, we need to explore alternatives: Can the U.S.

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are innovative, flexible producers of complex goods and services (e.g., Japan) and penalizes countries which are dependent on the production of raw materials (e.g., Philippines or Algeria) or excessively bound by traditional ways of organizing labor relations, production processes or, more fundamentally, society itself (e.g., Britain or the Soviet Union).

One measure of the degree of change in the world economy is that the simple categorization of countries according to degrees of development has lost much of its meaning. Bangladesh is clearly undeveloped and the United States is developed, but what is Brazil -- whose economy is larger than all but seven of the so-called "industrial market economies" -- or Korea -- whose increasingly high tech exports are competitive with those produced by the United States? Indeed parts of Brazil and Korea are arguably more developed than some areas of the U.S.

There has been another change during the past four decades. As Europe and Japan rebuilt their industrial plants from the devastation of the war, the dominant weight of the U.S. economy declined, at least in a relative sense. At the same time the U.S. was becoming more integrated into the world economy; exports and imports together accounted for 8.3% of Gross National Product in 1950, but 23.2% 1985. However, because of the recovery of other industrial countries, the emergence of new trading nations, and declining U.S. competitiveness, the United States has become less influential in world trade even as trade has become

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more important to the American economy.

For the U.S., some of this has been made up by the spectacular growth and internationalization of capital markets and the continued dominance of the dollar as the most important international reserve and transactions currency. The rapid expansion of the capital markets reflected a number of factors: countries, for competitive as well as ideological reasons, have reduced or eliminated capital and exchange controls; financial market technology has improved; bankers and traders have become more innovative. Coupled with the oil shock related emergence in the 1970s of huge financial imbalances between countries -- which have continued in the 1980s, but for different reasons -- both the volume and velocity of capital flows have increased exponentially. The President of the New York Federal Reserve Bank recently said that the value of dollar payments processed by his bank and the New York Clearing House exceed $1 trillion per day. This huge turnover creates the risk that if there is a panic in the U.S. financial markets -- over a troubled bank or a major corporate bankruptcy -- then the consequences could spread quickly around the world.

There are also benefits to the globalization of capital markets. Morgan Guaranty estimates that, at the end of 1985, the gross size of the Euromarkets exceeded $3 trillion; these markets barely existed fifteen years ago. (1) U.S. corporate treasurers routinely raise billions of dollars in foreign markets for use

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both abroad and at home. For example, in the first quarter of
1986 American companies reportedly raised the equivalent of $5.5
billion in the Japanese capital market, which until recently was
effectively closed to foreigners. And, of course, a significant
portion of the huge U.S. balance of payments and budget deficits
have been financed by Japanese purchases of U.S. Treasury
securities.

The continuing attraction of the dollar rests in large part
on the size, creativity and appetite of the U.S. capital markets,
reinforced by several years of high real interest rates -- which
pulled capital from developing as well as developed countries --
and a period of rapid economic growth. The result is that the
U.S. influence on the global economy is increasingly expressed
through the capital rather than the trade account.

With size and integration have come volatility. Economies
and markets seem to fluctuate more violently and disturbances in
one part of the world economy can be easily transmitted to
others. Examples abound, but none are more readily obvious than
the ongoing international debt crisis. As a result of the drying
up of new credits and half hearted stabilization efforts by many
debtor countries, Latin American imports from the U.S. fell by
$12.4 billion between 1981 and 1985.

Just as the international economy has changed, there has
been a profound political change in the United States. The

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American public and their political leaders seem increasingly disinclined to play a central role in the world economy since such leadership necessarily implies costs and risks. Indeed, the concept of the U.S. as the reserve currency country -- which since the Second World War has meant the United States is the residual importer, financier, and guarantor of the world economy -- implies the willingness to accept domestic unemployment to keep the international system stable. This willingness has been sorely tested in recent years as imports exploded, exports slumped and employment in import competing and exporting industries fell. To the extent that this is viewed as a permanent and not a cyclical change -- which it seems to be by many businessmen, union leaders, and government officials -- it erodes the willingness of many political constituencies within the United States to continue playing the key currency role.

In the mid 1980s the U.S. no longer instinctively searches for international solutions to economic problems or for solutions rooted in the Bretton Woods institutional framework. For example, the U.S. increasingly tends to manage important trade issues outside the context of the General Agreement on Trade and Tariffs (GATT), the recognized multilateral trade organization, as evidenced by "voluntary" import quotas on Japanese cars and, more recently, the President's proposals to restrict machine tool imports. The United States has promoted the establishment of an ad hoc "Summit Group" as the forum for co-ordinating economic policies among major industrial countries, rather than the IMF

8

or the OECD. Traditional free trade lobbies like farmers have become protectionist, and businessmen debate "level playing fields" rather than poor productivity growth as the source of U.S. trade problems.

This change, which reflects the increasing exposure of the U.S. economy to international pressures, the lack of internationally oriented leaders, and the unwillingness of other countries to bear part of the costs of maintaining the system, has significant implications for the global economy. It means that the central assumption of the dollar based post war economic system is being invalidated. It means that the institutions (the International Monetary Fund, the World Bank, the GATT, the Organization of Economic Cooperation and Development) around which the system is constructed, and which still presume the existence and support of a strongly committed, internationalist America, are likely to be increasingly ineffective. And it means the system -- as well as the businesses and banks which operate in it -- will be more and more vulnerable to shocks and dislocations, especially during periods of poor U.S. economic performance.

### III

It is not accidental that the economic change -- growing U.S. integration into the world economy -- and the political

9

change -- growing disenchantment with the costs of maintaining a
more or less open trade and payments system -- have happened
simultaneously. The luxury of aggressively advocating free trade
is easier to sustain if only a small segment of the economy is
affected by import competition or cyclical fluctuations in world
markets. However, as more workers and more businesses find
themselves out competed in third markets or, even more
importantly, in the U.S. market itself, a theoretical commitment
to free trade becomes difficult to sustain.

From one perspective, it is somewhat surprising that the
U.S. commitments to free trade and to underwriting the
international system have not deteriorated even faster.
According to data published by Morgan Guaranty, the imported
share of the U.S. domestic market for manufactured goods has
risen from 8% in 1970 to just under 19% in 1985. (2) (By
contrast, in the European Community import penetration rose from
11% to 17% and in Japan from 6% to 9%.) Perhaps more
importantly, almost one-half of this change occurred in the past
five years. Both the level of import penetration and the rate of
change were guaranteed to produce economic dislocations and
political friction.

Moreover, export performance in recent years has been poor.
U.S. merchandise exports have fallen in three of the last five
years and in 1985 were almost 10% below the peak 1981 level.
This reflected the cumulative effects of the high dollar, the

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jobs. (3) Less conservative estimates of the displacement effects of job loss suggest that the 1984 surge in imports -- imports increased from $65 billion to $334 billion on a balance of payments basis -- cost 1.5 to 2 million jobs. (4) Whatever the number, the conventional wisdom is that these are permanent losses which would have important economic and political consequences even if, on net, U.S. employment keeps growing because of new jobs in the service sector.

A more detailed study of the employment and output effects of trade on the U.S. economy has recently been published under the auspices of the Department of Commerce. (5) It estimates that almost 10% of U.S. manufacturing output in 1984 was lost due to international competition; twenty industries had output losses and only ten had gains attributable to trade. Similarly, this study estimates that the manufacturing sector lost 2.2 million jobs in 1984 due to the direct and indirect effects of trade (i.e., imported cars include imported steel so there are job effects in both industries).

If the economic effects of the deterioration in the U.S. trade position are difficult to specify with precision, the political effects are considerably clearer. Public opinion polls show overwhelming support for import restrictions whether in general, aimed at Japan, or targeted at specific industries like automobiles or television sets. For example, a Harris poll in September, 1985, found that 56% of those surveyed felt import

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competition from Japan does more harm than good to the United
States, while 79% indicated their support for a special tariff on
Japanese goods sold in the U.S. Fifty percent of the respondents
to a *Business Week/Harris poll* in April, 1985, said they thought
the U.S. should discourage Japanese investment in the United
States, compared to only 15% that would encourage it. In a June,
1985, *New York Times/CBS poll*, respondents split evenly (47%-47%)
in answering the question, "Has competition from foreign
countries hurt the economy in your community?". In the same
poll, those interviewed overwhelmingly (70%) supported the
proposition that the U.S. should limit imports, even if the
consequence was to reduce the range of products they could
purchase.

Perhaps more significant were responses to *New York Times/CBS polls* taken in 1986. In January, 46% of those surveyed said they thought that trade with other countries hurt the U.S. economy (up from 38% in June, 1985), while 47% said it helped the United States. In April, 52% disagreed with the opinion that the U.S. should maintain its leading position in the world economy, even if it imposes some economic burdens; only 33% of the respondents endorsed the view that the U.S. leading role should continue. Although comparable data for earlier periods are not available, it is difficult to believe that the same questions would have elicited such inward looking responses twenty or even ten years ago.

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in some key sectors as a way to dampen protectionist fervor.

But the President's commitment to free trade, consistent with his general ideological commitment to free markets and incentive economics, has not translated into a push for broader U.S. involvement in the international economy or, for that matter, assertion of U.S. international economic leadership. In recent years the U.S. has on a number of occasions favored bilateral over multilateral approaches to key trade and economic problems and has been reluctant to support the international financial institutions, especially the multilateral development banks. Several examples come to mind:

* the establishment of a free trade agreement with Israel, which some U.S. officials have suggested could be replicated with other countries, especially Canada (representing a significant departure from the long standing U.S. commitment to non-discrimination in the granting of trade preferences, although one sanctioned by the GATT rules);

* a marked antipathy toward the World Bank and regional development banks, only recently softened as an element of the apparently stillborn debt initiative of Treasury Secretary Baker;

* a reluctance to use the IMF or OECD as vehicles to coordinate economic policies among the major industrial

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countries, instead favoring the creation of an ad hoc
"Summit group";

* the focus on bilateral trade imbalances which has
increasingly cropped up in official statements, especially
with regard to Japan, contrary to a long standing analytic
tradition within the U.S. government of concentrating on and
managing the overall trade balance;

* efforts within the Congress and occasionally the bureaucracy
to separate U.S. economic aid from IMF or World Bank policy
conditionality, substituting U.S. government defined
conditionality when possible (e.g., such provisions have been
incorporated into so-called Kemp-Kasten amendments which in
recent years have been attached to several appropriations
bills);

* resistance to multilateralizing economic assistance efforts
in Central America, favoring instead strong bilateral
programs;

* Congressional reluctance to increase U.S. financial support for the IMF in 1983 and continued reluctance to increase funding for the multilateral development banks.

Even U.S. advocacy for a new multilateral trade round raises

16

[L.C.]

Perhaps the most important has been that the United States would
be the lynchpin of the system, exercising a leadership role and
bearing the costs of maintaining the system, because such a role
was in long run American interests.

Certainly many contrary examples can still be found in both
the speeches and actions of the Reagan Administration but the
weight of evidence seems to be that all of these principles are,
in effect, being reconsidered not only by the government but by
the country as a whole.

Indeed, this reconsideration seems to be broad based and not
attributed to one party or one Administration; nor is it a
reaction to passing phenomena, but to secular political and
economic changes in the United States. In the face of these
pressures, the Carter Administration tried to multilateralize the
responsibility for managing the system to include Germany and
Japan. Both countries resisted -- with the exception of the Bonn
summit in 1978 when both countries, to their subsequent dismay,
accommodated to the U.S. request to stimulate their economies to pick
up the international economic slack from a slowing American
economy. At a time of U.S. economic and political weakness, the
system became increasingly rudderless.

The Reagan Administration entered office with a goal of re-
asserting American pre-eminence. In economics this meant
reducing inflation, slowing the growth of government spending and

18

[L.C.]

reducing tax rates to stimulate investment, and resuming economic growth. In international economic relations it has variously meant initiatives that were *unilateral* (e.g., the often repeated argument that the principal U.S. role in the world economy was to get its own house in order), *bilateral* (e.g., the trade negotiations with Israel and Canada), or *multilateral* (e.g., the Baker Plan for international debt). Not only has this sent confusing signals to other countries, but to the multinational companies, banks and other institutions which comprise the fabric of the international economy.

If the international economy was rudderless at the end of the 1970s, it now suffers from a helmsman who steers in contradictory directions.

## IV

What are the alternatives? There seem to be four possible options, each with different consequences for U.S. national interests:

* accept continued erosion of the system, relying on *ad hoc* arrangements to manage crises as they arise;

* reivigorate U.S. willingness to play the leadership role in the international economy;

19

* multilateralize both the leadership and reserve currency roles; or

* reorganize the United States' international economic relations to emphasize bilateral or regional relationships over multilateral commitments.

The least desirable of these is the first: continued erosion of the system runs the risk of not being able to cope adequately with the next crisis or the one after that. The growth in the volume and velocity of international capital flows, the trend toward closer integration of national capital markets, and the increasing volatility of markets means that crises are more difficult to contain; the lack of clear systemic rules means that it is difficult to predict how problems will be managed when they arise, or even who will manage them. In combination, these imply a world which is increasingly risky and, hence, one unlikely to be conducive to long term investment and growth. Ultimately, this must be unfavorable for U.S. national security in its broadest definition.

The international debt problem is an example of both the strengths and weaknesses of current arrangements. When the debt crisis began with Mexico's near default in 1982 there was widespread fear about the possibility of a collapse of the international banking system. Not only was collapse avoided, but

20

[L]

in many ways the U.S. and international banking systems seem stronger today than several years ago, reflecting how the crisis was managed. The debt issue was essentially addressed -- and to some extent solved -- as a financial problem. Debts were rescheduled; banks were required to increase their capital and allowed to slow their lending, resulting in a considerable improvement in their relative exposure to troubled debtors; interest payments were sustained, financed partly by trade surpluses and partly by some new lending from the banks and the international financial institutions; central bankers clarified, to some extent, the very informal arrangements under which they would cooperate to rescue an endangered bank; and, most importantly, U.S. regulatory authorities demonstrated they could (and would) rescue a major commercial bank -- the Continental Illinois -- on the verge of failing.

None of these considerable accomplishments -- which add up to a much stronger international banking structure than existed several years ago or even remotely seemed possible in light of the pressures which existed in 1982 -- address the fundamental problem from the debtor countries' perspective: how to grow again. The accumulation of debt in the 1970s was intended to finance more rapid economic growth than would otherwise have been possible; indeed, despite the disruptions caused by the oil price shocks, developing country growth rates remained high. However, the debt crisis has put an end to high growth, at least in most of Latin America and parts of the rest of the developing world.

21

The IMF estimates that countries which have had serious debt service problems in recent years grew at an average annual rate of 5.3% between 1968 and 1980; since 1980 they have grown less than 1% per year, well below the increase in their populations. Unfortunately, despite efforts by the IMF, only Brazil among the large debtor countries and almost none of the smaller ones seem to have used these years of austerity to restructure their economies in ways which make them less vulnerable to external shocks or more likely to resume growth without renewed access to net inflows of capital. As a result, many of these countries face bleak economic futures, for which they increasingly blame the United States, the IMF, and other international institutions. Eventually this could affect American political as well as economic interests in many parts of the world.

However, as the international system now functions there is little willingness to address the issue in these terms. Admittedly, the rhetoric of debt management changed with the debt initiative of U.S. Treasury Secretary Baker in October 1985 who called for renewed economic growth in the developing world. In effect he argued that renewed growth would have to come from the application of supply side or incentive economics in the developing countries, supplemented by some lending from the commercial banks and development institutions. Many forecasts, including those of the Economic Commission on Latin America, indicate the loans envisioned under the Baker Plan would cover only part of scheduled interest payments, leaving nothing to

22

[L.C.]

finance growth. The growth envisioned by Secretary Baker would largely have to be financed with internally generated funds, which realistically seems possible in very few countries, or the reflow of flight capital while the debtor countries continue to be net exporters of goods (the trade surpluses) and capital (interest and some principal repayments). This seems an unlikely formula for renewed growth and an even less likely recipe for sustained economic development. It also seems unlikely to be supported by the internal political processes of the debtor countries.

In short, the crisis management capabilities of the system worked well enough over the past several years to sustain and even strengthen the international banking system; the lack of dynamic U.S. leadership, reluctance to commit financial resources, and the weakening of the international institutions have resulted in a failure even to address the more fundamental development problem in the debtor countries. The validity of these points is demonstrated by the renewed crisis in Mexico, caused in part by the collapse of oil prices. While there is considerable concern in the financial community about Mexico, there is little worry about the integrity of the system.

If the continued erosion of the system is the least desirable, reinvigoration of the traditional leading U.S. economic position is probably the most desirable, since it implies the least institutional changes and would reserve the

23

[L]

benefits that flow from leadership entirely to the U.S. Even though the relative size of the U.S. economy has declined, it is still by far the largest and the U.S. capital market is certainly the most sophisticated and dynamic. In addition -- and perhaps more importantly -- the United States is a global political power with world wide interests which would be difficult to realize without a parallel international economic presence.

The economic benefits of being the reserve currency country, of course, still exist. With the world on a dollar standard, the U.S. has the luxury to eschew fiscal and financial discipline to a considerably greater extent than any other country. In the late 1970s we apparently began to test the limits of tolerance for our lack of monetary discipline when the near free fall of the dollar indicated that international investors were becoming increasingly reluctant to hold dollar assets. Over the last several years the unusual combination of high interest rates and massive budget deficits renewed foreign interest in the U.S. economy and the dollar; even as critics complained about budget policies which produced deficits in excess of $200 billion, foreigners eagerly accumulated dollar investments at a pace which allowed the United States to talk a lot, but actually do little, about deficit reduction. It is fair to say that no other country could have done the same. This is a virtue if we use the extra time to adjust our economic policies; it is a vice if we simply delay the adjustment.

24

[L.C.]

Over time it is likely that the reserve currency benefits will fade if the U.S. leading economic role is allowed to atrophy -- and if the United States fails to control its fiscal policy or to increase its historically low savings rate. Foreign investors will eventually reach the limits of their willingness to hold dollar assets that are now depreciating in value and the dollar could become caught in a vicious downward spiral.

Other resource currency benefits -- the advantage for U.S. exporters and importers as well as bankers operating in a largely dollar dominated world; the ability to dominate the rule setting process in the international trade and finance arenas; the ability to accomplish important foreign policy goals using economic leverage which derives not y from our size but our dominance of key institutions and processes -- also contribute importantly to overall U.S. welfare.

Thus, it is in the U.S self interest to reinvigorate its leading role. The difficulty is that there is little apparent political appetite for the role, in Washington or in mythical Peoria. At the popular level and among elites there is a preoccupation with the costs of international involvement, economic or political, and almost a return to the isolationism and populism which dominated American thinking about the world before the mid twentieth century. On the economic side the focus -- as evidenced by politicians' speeches, Congressional actions, and survey after survey of public opinion -- is almost entirely

25

on the dislocations and costs of interaction with the world
economy. Overcoming this negative momentum would require
unusually strong and forceful Presidential leadership.

The alternative of multilateralizing the responsibilities of
international economic leadership has long been proposed as a
natural analog to the growing economic strength of Japan and
Germany. The United States today accounts for around 23% of
world gross national product, compared to almost one-third in
1950; the U.S., Germany and Japan together today count for some
37%. (6) What little diversification of countries' foreign exchange
reserves has occured -- the bulk is still held in dollars -- has
gone into marks and yen; according to the Bank for International
Settlements at the end of 1984, 61% of all official exchange
reserves were held in dollars while another 26% were held in
either marks or yen. And, these three countries, including their
trade with each other, account for almost one third of the value
of world trade.

It would not be technically difficult to construct a dollar-yen-mark based economic system to succeed the present dollar based one. The essential requirements -- in addition to underlying economic strength and size -- would be greater international access to both the Japanese and German capital markets and probably some kind of rule linking the three currencies. The key would be whether international investors would ratify such structural changes by further diversifying

26

[L.C.]

their currency holdings which are used for investments as well as for transactions, out of dollars and into marks and yen. Once such a system was established there would have to be a considerable degree of currency stability and well coordinated economic policies to avoid large, destabilizing shifts in assets among the three capital markets. In addition, the three countries would be expected to share the leading role in funding the international financial institutions, in setting international trading rules, and in facilitating global economic adjustments when the world economy comes under pressure.

For the United States the most important cost of sharing leadership would be accepting somewhat narrower limits on economic policy implied by such a system. The tremendous tolerance for U.S. monetary (in the 1970s) and fiscal (in the 1980s) excesses which has characterized the world system would be reduced; the United States would be forced to incorporate international considerations into the process of formulating economic policy -- which has been neither our habit, nor our inclination. In one sense, of course, the U.S. would benefit from a more disciplined policy process, but at any given moment such discipline could require policy changes, perhaps resulting in higher unemployment and other dislocations, which would not otherwise be produced by the U.S. political process.

The economic risks to Germany and Japan are clear: both countries, in accepting a greater degree of internationalization

27

[L]

of their currencies would have to accept greater responsibility
for running the system. In practice this would mean accepting
more imports or tolerating more unemployment or providing
increased financial support to the IMF and World Bank. There are
important benefits to the countries, the most significant being the
less binding constraints on economic policy which flow from
reserve currency status. There are also concrete political
and economic gains which would accrue from sharing the dominant
position in the international financial institutions and from
being able to conduct a larger proportion of international
transactions in national currencies.

To some extent, the Declaration issued after the recent
Tokyo economic summit seems to anticipate this kind of multipolar
system. The Declaration established a process among the seven
summit countries -- the U.S., Japan, Germany, France, the UK,
Italy and Canada -- aimed at coordinating economic policies and
performance (including interest and exchange rates). According
to the Declaration, finance ministers and central bankers should
"make their best efforts to reach an understanding on appropriate
remedial measures whenever there are significant deviations from
an intended course...". While this agreement can be criticized
for involving too many countries (thereby increasing the
complexity and reducing the effectiveness of the coordinating
process) and on technical grounds (for example, there is a
confusion in the Declaration between policy variables like
interest rates and performance variables like growth rates or

28

[L.C.]

trade deficits and an implicit assumption that all these can be forecast with equal accuracy; there is also no recognition of the statutory independence of the U.S. and German central banks from direct government control), it nevertheless points the way towards significant new systemic arrangements.

However, the summit did not address the more basic political issue of whether Germany and Japan are prepared to accept leading roles in the world economy. The leaders of both countries tend to argue their economies are too small, their foreign policy ambitions too modest, and the burden of history too great to justify such an international role. More fundamentally, neither Japan nor Germany seem interested in changing economic policies to accomodate international needs. The export led, neo-mercantilist economic strategy which Japan has pursued with increasing success over the past forty years now seems more appropriate to a developing country than the non-communist world's second largest economy. Yet, apparently with widespread popular support at home, the Japanese government gives every indication of wanting to persist with its strategy, despite occasional public statements to the contrary designed largely for foreign consumption. Although Germany's economic strategy is somewhat more sensitive to international or at least European pressures (because of membership in the European Community and the European Monetary System), the German authorities in practice have generally been unwilling to modify their own economic policies to accomodate others. The accepted view in Bonn seems

29

[L.C]

to be that when Germany last acquiesced to U.S. entreaties to stimulate its economy for international benefit -- in 1978 -- the result was unacceptably high inflation and fiscal imbalance.

In short, it seems unlikely that either the Japanese or the Germans are yet prepared to accept the responsibilities of international economic leadership, however attractive the potential benefits. The option of the U.S. imposing a leadership role, either through forceful negotiation or through aggressive economic and commercial action (e.g., by forcing excessive appreciation of the yen or imposing quantitative restrictions on imports from Japan) seems unlikely to be effective, although both the Carter and Reagan Administrations have pursued it. Indeed, it is more likely that both countries will avoid such leading roles until they come to define at least shared leadership as being in their own national interest, through their own internal processes and on their own terms.

Reinvigoration of the free trade and payments economic system with U.S. or shared U.S.-Japanese-German leadership holds the greatest promise for the world economy and, indeed, probably for the U.S. economy. Trade liberalization, the increasingly free flow of capital and strong U.S. leadership during the first few years or so after the war contributed importantly to unprecedented global economic prosperity. The erosion of the system, growing protectionism, and much reduced U.S. interest in exercising its leading role have already affected the

30

international economic climate and eventually could threaten that
prosperity. Unfortunately, there is a historic parallel: the
explosion of protectionism and the absence of strong
international economic leadership in the 1920s and 1930s helped
provoke the Great Depression.

The critical question is whether the U.S., alone or with the
other two major industrial powers, is willing and politically
able to resuscitate the post-war system. If not, then the
further question is whether there is an alternative which is
better for the United States than gradual disintegration -- even
while recognizing that any alternative will be, perhaps
considerably, less than perfect.

One alternative would be for the United States to
deemphasize its multilateral commitments in favor of intensified
bilateral relationships with select countries, particularly in
the developing world. This would amount to a radical
reorganization of the international economic system as it has
existed for the past forty years, justified by the political need
to better match immediate costs and benefits and reflecting the
changes which have occured in the international economy.

To maximize U.S. interests these relationships would have
several characteristics:

* They would seek to gain special advantages for U.S. economic

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interests, e.g., investment rights or trading privileges or
banking licenses;

* they would encompass the range of trade, finance,
and investment issues both to overcome artificial
distinctions among different arenas of economic activity and
to create a broad menu of issues to facilitate tradeoffs;

* they would be structured to exchange preferential treatment
in one area (e.g., debt relief) for preferential treatment in
another (e.g., trade concessions or investment rights);

* the selection criteria -- since the process necessarily
implies favoring some countries while deemphasizing
relations with others -- would have to combine economic,
political and strategic factors;

* such relationships would take precedence over
multilateral commitments -- e.g., to the GATT or the IMF --
and would imply dramatic changes in how these organizations
function, but would not preclude a role for them in the
international system.

The costs of such systemic change -- if the U.S. began to
move aggressively towards more emphasis on bilateral than
multilateral relationships, Japan and the Europeans would surely
follow -- should not be contrasted with the benefits of textbook

32

free trade or even the international system as it has existed
during most of the post war years. Rather, the comparison should
be with the much weakened structure of international economic
relationships which exist today and even weaker system which may
be in prospect.

One objection is that it could tend to make the United
States a regional power, since many of the key relationships
would be in the Western Hemisphere (e.g., Canada, Mexico,
Brazil). However, countries like China, which could become an
important regional economic power and whose economy in many ways
compliments our own, or South Korea, with which the U.S. already
has strong trade and investment as well as political links, might
be prepared to enter into a broad based political and economic
relationship with which would be more beneficial to U.S. than
some others in South America. Thus, it is not a formula for
regionalism as much as it would be a proposal to better match the
costs and benefits of international commerce for the United
States.

A more telling objection may be that to negotiate and
maintain the kind of complex relationships envisioned would
require a great degree of political sophistication on the part of
the U.S. and its prospective partners. Countries have long
preferred to deal with the U.S. in a multilateral context to
avoid highly unequal bargaining positions, and the U.S. has long
felt more comfortable deflecting countries' requests or demands

33

[L]

to a multilateral setting where rejection can be more easily
justified. And bilateral relationships, like that of the U.S.
with Israel, take on a degree of permanence which might be
inappropriate in the rapidly paced global economy of the late
twentieth and early twenty-first century.

The economist's objection to bilateralism is that anything
short of free trade fails to maximize the benefits of
international commerce. Of course, the system as it exists today
is already considerably short of textbook free trade -- and may
deteriorate further.

Again, the essential argument in favor of exploring a
bilateral alternative is that it may be better than what is
otherwise in prospect. For example, at present, the most
important aspects of our economic relationship with Mexico are
largely handled through multilateral institutions -- the IMF,
World Bank, and, at least prospectively, the GATT. Yet, the
combination of low oil prices, poor economic management, heavy
debt burden and weak leadership have brought Mexico to the verge
of economic collapse and, perhaps eventually, social disorder.
U.S. national security requires a stable Mexico on its southern
border; indeed the possibility of an unstable Mexico is one of
the most worrisome national security issues which the United
States could face in the balance of this century. This alone
should be sufficient justification for the U.S. to take Mexico
out of the multilateral context -- which, arguably is not working

34

well in any event if the overriding U.S. interest is stability --
and to attempt to address a whole range of bilateral economic
(e.g., debt, growth, trade, investment) and political (e.g., drugs,
migration) issues in direct negotiations. There is a strong
argument not to burden such talks with too many extra issues
(e.g., Central America) both because they would be complex enough,
dealing with the key aspects of the direct bilateral
relationship, and because any partner, especially Mexico, would
insist on preserving freedom of foreign policy action. If the
negotiation succeeded in incorporating key economic issues in a
broad bilateral cooperation framework (which, for example,
granted U.S. companies special investment rights in Mexico,
established bilateral trade preferences, and allowed for
renegotiation of Mexican debt owed to U.S. institutions on
preferential terms) then the bilateral political relationship --
and U.S. national interests -- could be considerably enhanced.
To admit that neither Mexico nor the United States seem close to
undertaking such a negotiation or establishing such a
relationship of mutual benefit, does not argue against its
attractiveness. Rather it attests to the difficulties, which
admittedly exist.

What are the implications for our economic and political
relations with Europe and Japan? U.S. exports in 1985 to these
two regions accounted for 36% of total exports, while imports
from them accounted for some 42% of total U.S. imports. The
largest part of U.S. financial investments and assets abroad are

35

LC

in these regions; capital flows increasingly freely (and in
increasing volume) among them. The exchange rate relationships
among the dollar, yen and German mark are at the center of
international financial markets. Beyond these economic facts, by
almost any measure the relationships with Europe and Japan have
been the most strategically important which the U.S. has had in
the post war era.

But these relationships are changing, both quantitatively
(as trade with and investments in other countries increase) and
qualitatively. Trade frictions with Japan and with an enlarged
European Community are increasing. European businessmen seem
pessimistic about their ability to compete in a world market
dominated by new technologies (even though the shadow of
"Eurosclerosis" has recently faded somewhat in popular
perception) in part because of Europe's inability to create a
unified market of sufficient scale to support sustained
technological change. Europe appears to be trapped in a long
term pattern of low growth and high unemployment, which could
produce political pressures that are increasingly nationalistic,
and possibly anti-American.

With regard to the Japanese, there is a growing antagonism
of the kind which exists when a perennially second place
competitor begins closing the gap with the front runner. While
U.S. companies are learning to accomodate to, if not compete
with, Japanese pressures -- e.g., through the growing incidence

36

[L]

of joint ventures between American and Japanese competitors in
the industry -- resentment in the U.S. of the Japanese "miracle"
is deep rooted and widespread. This resentment shows up
consistently in opinion polls, newspaper editorials, and
politicians' speeches. The U.S.-Japanese relationship, rather
than benefitting from the much discussed historic reorientation
from Atlantic to Pacific, seems to be withering under the strain
of increased attention.

Nevertheless, the political and economic ties among the
U.S., Europe and Japan will inevitably remain central, although
in a world economic system increasingly dominated by bilateral
relationships, rather than multilateral commitments, they would
just as inevitably change. The U.S., Japan and Europe would
compete for special relationships with the more important third
countries. To some extent success would be at each other's
expense; to some extent success would divert existing trade or
financial flows among the industrial countries to different
channels. But the bulk of the economic and political
relationships among the major industrial countries would probably
remain intact, if they can be justified by mutual benefit.

This does necessarily imply that the U.S. should seek
bilateral trade balance with each trading partner. Rather it
means that in assessing the broad economic and political
relationship with a given country -- including the major
industrial countries -- the U.S. would seek to balance costs and

37

benefits.

Finally, it is important to stress that a more bilateral
world is likely to be preferable only to a more chaotic one where
the rules are increasingly unclear and where the distortions of
the underlying free trade model are haphazard. Moreover, any
shift toward bilateral arrangements would likely be incremental,
e.g., starting with negotiations between the U.S. and Mexico,
because of the economic and social impact of the debt crisis and
the implications for U.S. national security. The argument here
is that such discussions should be broadly inclusive of the
range of economic and commercial issues and that strengthening
some special relationships (in a world where almost every country
lays claim to a more or less special relationship with the U.S.)
eventually means weakening others.

What might the result look like? If the U.S. were to begin
such a process, explicitly seeking to maximize its own clearly
defined economic and political interests, then the consequence
could be a series of bilateral relationships with key emerging
countries that compliment the flow of goods and, more importantly,
capital among major industrial countries. Indeed, such a
process would probably further separate trade flows and capital
flows; trade would likely become more regulated (if not by
product, than by preferential market access) while capital
becomes even more mobile.

38

The competition among the industrial countries for key relationships is one in which the U.S. would have tremendous advantages because of its economic size, technological prowess, and political strengths. There is little doubt that the U.S. international position could be strengthened as a result. Whether the economic system which emerges is stable and conducive to global economic prosperity -- whether the sum is as great as the parts -- would depend largely on the willingness of major industrial countries to agree on reasonable limits to their competition.

V

What are the next steps? The United States is about to enter an important political period: Congressional elections this November, the presidential selection process beginning in earnest shortly thereafter, and the presidential election itself in 1988. Because the leadership of both political parties will be open, the political debate is likely to be unusually broad. Congressional consideration of a trade bill in the current legislative session, the start of the new multilateral trade round, growing protectionist sentiment, uncertainties over exchange rates and how exchange rates should be managed, the continuing international debt problem, and concerns over the economic outlook once the initial benefits of low oil prices and lower interest rates have passed mean that the role of the United

39

States in the world economy will be -- explicitly or implicitly
-- high on the agenda.

In the usual U.S. fashion, the debate will probably be fuzzy
and inexact, but it will have important consequences for the
world economy. If the political leaders of both parties can be
convinced to try, U.S. international economic leadership might be
reasserted, the international financial and economic institutions
reinvigorated and updated to cope with present day problems, and
an open trade and payments system reconstituted. There is little
doubt that this would be in the country's best long run interest,
even if the leading role had to be shared with others.

This will only happen if the U.S. economy is competitive
enough not only to survive, but to prosper in such an
environment. If it is not -- and recent experience in many
industrial and even some service sectors is not encouraging --
then no amount of intellectual commitment to free trade among an
apparently shrinking group of leaders will be able to resist
a shift towards new international economic arrangements. The
issue then would be whether these arrangements can be constructed
in a way that would serve U.S. national interests better than the
kind of "non-system" which gradual erosion and occasional crisis
might produce.

Put another way, the popular wisdom in the United States
increasingly seems to be that maintenance of the leading role in

40

the international economy represents more cost than benefit, that other countries are unfairly taking advantage of the system while the U.S. pays the bills, that our "generosity" is being abused. Admittedly, some of this is an excuse to cover poor U.S. productivity performance and some reflects the impact of the unusually strong dollar of the past several years, which has now to some extent been corrected. But it also reflects a marked lessening of commitment to the post war economic system which, in fairness, has only partly been reflected in government policy.

Policy, however, seems likely to catch up to political sentiment sooner or later and at that point both the American and world economies will be in danger. Thus, for reasons of our own self interest as much as responsibility to the rest of the world, now is the time to begin exploring alternatives.

41