27

could only come from government no single financial
institution was in a position to gain an overall
view of the dimensions of the process much less of its
long-term implications.

The result was to convert the huge energy bill
owed by the developing world to the oil producers into an equally huge
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, economic growth in the industrial democracies
and fairly stable interest rates. None of these conditions
had been
continued to be met. Oil prices stabilized and indeed
began to decline. Austerity bred recession which reduced

exports from developing countries and led to falling
commodity prices. Tight money policies drove up
interest rates. As the cost of debt service rose,

28

and as real income delined many developing
countries found themselves running out of foreign
exchange and facing the inability to service their debts.

As for the industrial democracies they have
wound up paying 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
for the compounding of the recession and the threat
to the Western financial system caused by the debt
problem of the developing nations.

Two contradictory considerations are frequently invoked to play down the seriousness of this state of affairs. The first argument is that in the end the creditors can require the debtors to face the

29

consequences for their own financial irresponsibility by,
in effect, letting them stew in their own juice. This
is nonsense. A financial collapse of one major developing
country such as Mexico or Brazil or Argentina would have
calamitous consequences for all the industrial democracies.

It would place an enormous strain--to put it mildly--

that is, it is unlikely that the West will allow
the happen. For

on the international banking system. More importantly,

the developing countries absorb more than one third of
US exports (and more than 40% of the exports of the
industrial democracies). For the United States
this is more than we export to the European Community
and Japan combined. If developing countries are unable
to borrow and further contract their imports, global
recession will deepen and unemployment will mount. 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.

30

The second argument often made is that the debtor
countries would not dare default, since such a step
would forever jeopardize their creditworthiness. This
comforting proposition has never been analyzed. Which
side, debtor or lender, is in the strongest bargaining

position in the case of a debtor's threat to default?
It is hard to judge in the abstract

For there are many intermediate steps short of default
which lend themselves quite well to purposes of
blackmail. Whether a threat of default will ever
be made depends on at least two factors: First, how
much funding can be made available to debtor nations
beyond the amount needed to ensure repayment of interest.

Second, what is the likely impact on the political structure
of the debtor country of the conditions demanded for
"rescheduling", or, stretching out, their debt payment?

new loans * although are already sufficient
If the assistance to the debtors goes no farther than

new loans to pay interest, a blow-up is certain sooner
it is not self-evident that developing debtors
or later. Countries will not accept austerity

31

indefinitely simply to protect the balance sheets of
distant banks. They must be given the sense that they

will have a stake in an expanding world economy. Even then
it is to the debt problem depends on their perception of the
much depends on the stability of their political system.

their reaction

the second question: yes, but

yes, but

This is the last point to explain why the debt problem though
it is caused by economic factors does not lend
itself to purely economic solutions. At stake
by now is the internal political evolution of several
key developing countries. If the debt crisis winds up
spawning radical governments the financial issues will be
overwhelmed by the political consequences.

Most industrial democracies were nations before
they became states; most developing countries were
states before they were nations. Occasionally, Western
governments in economic trouble have used conditions
imposed by the International Monetary Fund as an excuse
to practice an austerity that domestic politics might
otherwise have prevented--Britain in late 1976 is a good
example. In most developing countries, by contrast,

33

Director, Jacques de Larosiere, or of its
dedicated staff, to point out that it was never
conceived for a crisis of this magnitude. The IMF's
original purpose was to lend to _individual_ countries
that found themselves in _temporary_ difficulty on
condition that they adopted measures of fiscal
and monetary discipline. The IMF has performed this
function admirably. The fact remains that the IMF was
not designed to deal with a crisis of the system affecting
most debtor nations simultaneously.

What the IMF does best is to provide _temporary_ support to gain time until there is improvement in a country's economy or in the world economy. But global recovery is precisely what the IMF cannot bring about, — and may even retard by its practices.

There are three problems. First, as country after
country admits its

34

inability to pay even interest--and therefore renounces
any immediate prospect of repaying capital--the IMF will
quickly discover that it does not have the resources
to rescue the entire developing world. Second,
the problem is not merely one of resources--indeed,
the United States is not the only important
in recent weeks there have been efforts to beef up
the IMF's available funds. The deeper difficulty
is a contradiction in the IMF's strategy. The IMF, as
a condition for its assistance, inevitably insists on
measures which have the effect of contracting the economy,
increasing unemployment and reducing consumption, in order to slow
imports and dedicate more resources to exports. The
problem is that IMF conditions cannot work if applied
at the same time in many countries, especially at a time
of global recession. If everybody practices austerity
simultaneously, recession becomes global, endemic and
institutionalized. Thirdly, a
a

35

nation is politically bearable only if rapid
progress can be shown toward an escape from the vicious
circle in which debt service consumes export earnings.

Austerity cannot bring this about by itself.

of the global trend It requires a combination of reduction of high interest rates in the democracies, coupled with a reversal of the global recession, declining trade, contraction in Western commercial lending and tragic reduction in official development assistance-all elements beyond the IMF's scope. Thus increasing the funds is not the core of the problem.

Of course it would be absurd for the IMF to launch a rescue operation without seeking to correct the economic practices that brought debtor nations to the edge of the precipice. But it is important to make sure that the conditions are realistic.

They must not be so weak or irrelevant

38

future if they are to sustain the immediate and inevitable
austerity without convulsions.

We thus return to our original problem: the urgent need for America to lead the world out of its economic crisis.

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 a comparable 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 to lead. We cannot afford to wait passively for some automatic process to end the present crisis. There is

JAN. 02 '83 12:27 KISSINGER ASSOCIATES, WASHINGTON, DC

P. 19

[y]

not This cannot be accomplished, in my view, without a
-But whichever course emerges our country needs a

for the United States. We may not be able
long-term economic strategy, -Indeed-perhaps ironically-

to the modern world economy
we cannot flourish in a free trading system without it.

for all my dedication to the free market as the only
for a dedication to a free trading system should not

From p. 22

historically successful mechanism of prosperity and of
ensure the reality that the market by itself cannot

freedom, I believe there is an inescapable responsibility for
sustain either competitiveness or all national purposes.

the national government in the present economic crisis.
This is the case in at least three fields:

First, there is general agreement, for example,

our lines of
infrastructure, the roads, bridges and basic communication

is in urgent need of renovation, which must become a national
(system) requires help from the government.

priority. This need is being addressed

This has been expressed in the gasoline

and enacted by the

tax proposed by the Reagan Administration for precisely

Congress.

this purpose.

(If Energy is another example of a)

Second, some national needs which can be forbidden some

may be adequately
years ahead and yet not be reflected in competitive

There are powerful national security reasons for reducing our dependence on markets. (The field of energy is a good example. Its foreign oil, let our foreign policy be subject to pressures and blackmarl.)

Today's energy market is marked
Current condition is dominated by a surplus of oil

production over demand, the so-called oil glut.

I would put
this at the
end.

Cover to
international
aspects first--
trade, monetary
system, debt
problem--

Then go to
"America's
Challenge"
(p. 38)

beginning
with this.

Move
pp.19-22,
as edited,
to p.38
46

Your
opposition is
foreign
policy
argument

JAN.02 '83 12:30 KISSINGER ASSOCIATES, WASH. DC

in America jobs even as it creates others. (And-domesticity) It is no longer self-evident that automation can be counted as theists used to assure us. on to create more jobs than it abolishes, Moreover, labor unions' quest for job security has had the perverse consequence of spurring employers' incentives toward automation.] Gains in productivity induced by the recession may mean that, when recovery comes, not everyone laid off will be rehired. High unemployment and as automation reduces the labor force of the middle class and increases unemployment, this spreads asymmetrically to the middle class and increases unemployment. It may become chronic. At a minimum, a conscious governmental strategy will be needed to ease the transition fromUMP to UTP. Programs adjustment process including policies of job retraining, emergency assistance, and placement, tax incentives, and other measures to (It would include as well programs to) encourage the flow of resources to the sectors with the most potential for growth, and be the only way to promote a rapid economic recovery—an expansion that will lead the world out of recession.

Simplify sentence

Clearly this requires a role for government beyond

The industrial democracies should constitute a small group of individuals having the confidence of their heads of government to prepare urgent recommendations on these issues--perhaps in Wittenburg in 1547, for the next economic summit, perhaps for an earlier smaller and less public 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 a panicky stampede. If we seize the initiative, we can draw from uncertainty and incipient despair an act of creation. And this is, after all, how almost all great creations have come about.

12/20/82

For most of the period since World War II the non-communist world experienced unprecedented economic growth. The historical business cycle of boom and bust seemed to be overcome. Recessions were relatively shallow and mercifully short. In the advanced industrial societies cheap energy, growing markets, adequate savings and modest inflation combined to bring about a prosperity seemingly without upper limit; the scourge of unemployment appeared to be ended, indeed many of them imported foreign labor for the more menial and less stimulating tasks. The developing countries lagged, of course, far behind. But the more advanced nations like Brazil, Mexico, Indonesia seemed to be on the verge of take-off, heading for self-sustaining growth.

This idyll ended by the middle Seventies under the impact of many causes: institutional and regulatory rigidities, social welfare payments beyond the growth of labor productivity; accelerated inflation induced by the failure to finance

2

the Vietnam war; a decline in the work ethic resulting from
thirty years of comfort; and, above all, a nearly twenty-fold
increase in oil prices since 1973. By the end of the Seventies,
recession was global; advanced industrial countries were
grudgingly adopting an austerity for which nothing in their
politics had prepared their peoples; the developing nations
heavily burdened by debt saw hopes for progress disappear.
Unemployment, thought to be banished forever returned cruelly;
nearly thirty million workers are without jobs in the
industrial democracies and their number continues to increase.
These events have shaken the economic and political foundations
of the post-war political and economic order.

My experience is not in the field of economics; but
I have a sense of the political ramifications of what is
happening. Simply put: without leadership of a high order
within the industrial democracies and cooperation among
them, the cohesion of all democratic societies may well

3

be undermined and with it the ability to conduct an effective,
coherent and above all long-term foreign policy or to assure
the national security.

An augury is the fact that no democratic government
which was in office when the fall of the Shah ushered in
a doubling of oil prices has survived the intervening period.
Left wing, socialist or liberal governments in Germany,
Britain and the United States have been replaced by conservative
ones; conservative governments in France, Greece, Spain
or Sweden have been succeeded by socialist ones. The common
feature is less the program of the parties than the condition
of the society; restlessness with a recession which seems
to find no solution; fear of a future that has no signposts.
If the condition is not mastered soon, political disorientation
can only grow. Democratic governments lose legitimacy
if the public no longer believes that they can control
their economic destinies; demagogues of the radical right

4

or left--the orientation will be almost an accident of personality--will increasingly dominate the political landscape.

The question is how governments can establish confidence in their ability to dominate events. A generation of expansion encouraged by inflation seems to have left a legacy of few tools and institutions to overcome contraction and deflation. And there seems to exist as well an inconsistency between economic theory and political reality. To the extent that current austerity is the result of deliberate governmental policy it derives from the premise that deflation will wring out inefficiency, restore confidence and thereby stimulate long-term growth. But two political facts may override this theory. The first is that the timescale for economic recovery by the automatic processes of the market may be longer than is compatible with political stability, especially in the developing countries. Political upheavals may therefore convulse the patient before the

5

medicine can take effect. Secondly, a remedy that may work for the economic ills of one nation may backfire if applied to the difficulties of several. Orthodoxy prescribes-- almost surely rightly--that the cure for living beyond a nation's means is to reduce imports and to expand exports, to reduce consumption in other words. Patently this cure can work only if not too widely applied. Once a recession has become global it must backfire. Everybody cannot practice austerity simultaneously. If every country seeks to cut consumption, reduce imports and expand exports the inevitable consequence will be to institutionalize recession and probably to trigger trade wars. Somewhere in the downward cycle governments must step in to arrest this process. Deflation must give way to inflation; to be effective this requires the cooperation of the most significant industrial democracies. That point has now been reached. And it requires coming to grips with some of the structural problems of the current economic crisis.

6

The Market and Government

I sympathize with the proposition that a principal
cause for the state of affairs is that increasing governmental
intervention stifles initiative; that almost all democratic
societies have lived for too long beyond their means. The
problem is, however, more complicated than simply reducing
the proposition of the Gross National Product absorbed
by the government. For side by side with reducing excessive
national expenditures there is a need for devising an industrial
strategy to overcome those structural problems with which
even an invigorated market cannot cope.

For example, we now face in earnest the problem that
technological advance is likely of itself to compound lowered
employment. The conventional wisdom in the postwar period
has been that automation created new jobs faster than it
did away with old jobs; a combination of factors seems
to have rendered this rule at least temporarily inoperative.

7

Automation may well have a tendency to make a growing
percentage of the labor force redundant. Social welfare
legislation making it difficult or costly to replace workers
has often an effect opposite to what is intended. It creates
incentives for labor saving machinery, disincentives to
employment. The mobility of labor that used to characterize
this country seems to have decreased. Unemployment therefore
threatens to become congenital, labor-management relations
threaten to become increasingly bitter as workers seek
to hold onto jobs made obsolescent by new technology and
management struggles to keep weakened industries competitive.

An industrial strategy to generate a growth conducive
to employment is comprised as well by the nature of the
international trading system. There too economic theory
and political reality are not always compatible. It is
a rarely questioned cliche that free trade benefits everybody.
No country, so the argument goes, can possibly be strong

8

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 19th century was based on a very few nations
from homogeneous cultures with comparable living standards
operating the gold standard. Competition then indeed was
relatively free; and the gold standard saw to it that there
were nearly automatic rewards for the efficient. But the
current world economy contains at least twenty significant
industrial societies of widely different cultural backgrounds

9

with great variations in labor costs and standards of living.

In these circumstances it becomes increasingly difficult for countries with high labor costs--for example Western Europe--to compete with countries whose wage rates may be less than half. It becomes nearly impossible for developing European countries like Spain or Greece or Yugoslavia to industrialize when faced with the competition of for example the countries of Southeast Asia. Even in the most advanced countries like the United States, entire sectors of manufacturing have disappeared. Very few television sets, for example, are made in the United States. Some thoughtful observers indeed have argued that America should bow to the inevitable and shift towards service industries.

It is clear however that the modern democratic state, as well as the requirements of national security prevent the pure application of this theory. Precisely because the survival of democratic governments depends on high

[y]

10

employment, the fewest of them will be content to permit
the international market to operate without seeking at
least to nudge it in a direction that gives a country a
spiral edge. Hidden or open subsidies of exports; hidden
or open non-tariff trade barriers impede free trade.
Protectionism or mercantilism are on the march even while
lip service is being paid to free trade.

In addition to economic rivalry, there are strong national
security reasons that will tempt governments to intervene
in the free flow of trade. The Mediterranean countries
of Europe will not permanently accept second-class economic
status in the name of an abstract theory of free trade.
Nor will it be tolerable for the United States to emphasize
service industries while the center of manufacturing activity
moves elsewhere. There are some basic industries we must
preserve at all costs if we want to be able to assure our
own national security. Even beyond that the decline

[y]

11

of the manufacturing sector would bring about social and
political changes that would painfully and fundamentally
alter the character of American society and politics. The
result will be that, in every country similarly threatened,
the pressures for protectionism will grow over time to
unmanageable proportions.

Thus, governments will soon have to make fundamental
decisions. The industrial democracies must either agree
to apply strictly the rules of GATT embodying the principles
of free trade or we will in a measurable time live in a
mercantilistic world. Free trade--or even the aspiration
to it--cannot thrive in a world in recession. And even
in a growing world economy it will be threatened by protectionist
beggar-thy-neighbor policies unless there is a coordination
of fiscal and monetary policies between the industrial democracies
for which there is no precedent in the postwar period,
if ever. Such a code must leave room for special exceptions

12

for protecting national security.

## The International Financial System

Another obstacle to freer international trade is the
existing 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 automatic regulatory
mechanism. Countries were physically unable to live beyond
their means. When gold started flowing out adjustments
were imposed nearly automatically. Governments did not
have to make deliberate decisions of economic discipline;
they had, so to speak, an alibi for self-discipline

13

After World War I this rigid discipline grew politically intolerable. More and more countries sought to gain greater control over their economies. They abandoned the gold standard and fixed their exchange rates by governmental agreement. After World War II, a new financial system was created at Bretton Woods that combined fixed exchange rates with institutions like the World Bank and the International Monetary Fund 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 became an act of policy not the consequence of automatic adjustments. Governments were tempted to export domestic difficulties to other countries which in turn sought the same objective. Still the need for a formal decision and the knowledge that other countries could negate these decisions by following suit maintained a measure of discipline.

14

All this ended when the system of fixed exchange rates was abandoned in 1973 for a system of floating rates. According to the new rules countries no longer tried to fix the value of their currencies by agreement; they would let the market determine it. Theoretically this was supposed to restore automaticity; in practice it eroded restraints on the temptation to solve a country's problems at the expense of others. Governments could let their currencies weaken to gain an advantage for their exports; or they could encourage strengthening them to attract foreign capital. If sufficiently disciplined, their central banks could even strive for this result by purchasing or selling foreign currencies thus bringing about lower export prices and negating whatever gains in productivity its trading partners might be achieving.

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

15

exchange rates devaluation or revaluation was a political
decision which had to be negotiated. The floating system
encourages the myth that governments make no decision at
all; this form of economic warfare is all the more bitter
for never having been made explicit. It masks a
deterioration of structural economic conditions until they
erupt into nearly unmanageable crises. The resulting
unpredictability makes speculation in currency an increasingly
important aspect of trading; it thus accentuates economic
swings exaggerating both the upper and the lower ends of
the economic cycles. Especially in times of crisis it
compounds uncertainty and thus inhibits recovery.

World recovery in short requires the restoration of
some discipline and predictability and automaticity to
the international financial systems. A new international
financial system is needed. Secretary of Treasury Regan
hints in this direction must be translated into specific

16

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

## The Need for Industrial Strategy

Whether such coordination proves feasible or not, however, an explicit industrial strategy for our country is imperative. The market cannot possibly react rapidly enough to handle the substantial redirection of labor and resources that free trade will surely impose on the industrialized countries, especially of Europe and North America. But if it should not, we will not be able to be the only industrial democracy which is unprepared for the mercantilism

[y]

17

which is sure to follow. In that case, we must coldly and
realistically prepare ourselves to withstand the supplication
of such a world and put them into the service of our national
prosperity.

I am not implying a governmentally directed economy.
On the contrary, I believe in reducing to the greatest extent
possible the resources the government exacts from the economy.
The strategy that is required involves an end to the historic
conception in which government saw itself as the watchdog
or regulator of the economic process. It must now become
a partner by generating incentives and goals together with
industry and labor. Only Japan among the industrial democracies
has so far mastered this requirement and it is the key
to its competitive edge. And we will not be able to avoid
a further dramatic decline without it. If we want to lead
what we call the free world we need a strategy of growth:
some method of arranging resources into industries which

18

are the hope for the future, some way of easing inevitable
shifts of labor. No American policy would reverse the
current political malaise in the industrial democracies
more effectively than a clarion call to economic expansion
and a program to achieve it. Nor could anything more strengthen
our hand in East-West negotiations.

Yet such a goal cannot be achieved even by the coordinated
policy of the industrial democracies acting in isolation.

The problem of the developing nations--the so-called North-
South issue--can no longer be avoided. It has obtruded
itself ironically not in terms of moralistic platitudes
of whether the rich can thrive in a world of poverty; rather
it has come home to roost by way of the problem of
indebtedness which threatens the advanced industrial societies
with financial catastrophe.

## The Debt Problem

The debt problem is best explained by some basic statistics.

The total external debt of the less developed countries

19

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 the total bill for principal and interest of the less developed countries exceeds the value of their *entire* export of goods and services. Interest payments alone ranged from 30 to 45 percent of total exports of goods and services. In other words, there is no way these countries can meet their current obligations.

In 1982, the current account deficits for the less developed countries was approximately $100 billion. It will be the same in 1983. Of this amount, some $45-50 billion must come from private sources. Specifically, the gap must be closed by commercial banks understandably gun-shy in view of the difficulty they encounter in having the existing debt serviced. But this sets up a vicious circle. Unless

20

there is more lending the debtors cannot possibly meet
their obligations; yet unless they do so commercial lending
will dry up. The makings of a financial crisis are clearly
discernible.

Nor can we afford the argument that the less developed
country face the consequences of their own financial
irresponsibility. For a financial collapse of the less
developed countries--especially the middle income group
such as Mexico or Brazil or Argentina--would have disastrous
consequences for all industrial democracies. For one thing,
nearly $100 billion dollars is owed to American banks;
a financial collapse of the less developed countries would
put an enormous strain--to put it mildly--on our banking
system. More importantly, the less developed countries
absorb thirty percent of US exports (and 40% of the exports
of the industrial democracies). For the United States
this is more than we export to the European Community and

21

Japan combined. A continuation of the global recession
will reduce imports in the less developed countries. This
in turn will spell increased unemployment and pressures
for protectionism in the industrial democracies. Indeed,
if the industrial democracies lend no more than the interest
due them the exports of the United States will decline
by 4 percent and our Gross National Product by 1 percent.

This sorry state of affairs had its origin, as so
much else, in the energy crisis which began in the early
seventies. The oil producers suddenly awash in dollars--
since that was the currency in which the oil price was
denominated--placed their surpluses into Western banks
in the form of short-term deposits. The banks flush with
resources, unimaginable even a few years earlier, competed
fiercely for long term loans to developing countries--
especially the more advanced countries of Latin America.
Competition encouraged secrecy to make it difficult for

22

any single financial institution to gain an overall view
of the dimensions of the process. Governments were reluctant
to intervene partly because of a commitment to market economies;
largely in order not to reduce the incentive of the oil
producers to pump oil and to maintain the economic growth
of the developing world.

All of this transformed the energy bill owed by the
developing world to the oil producers into debt owed to
Western banks. It created an extraordinary vulnerability
of the international financial system. The most obvious
symptom of the instability is the disparity between the
short-term deposit of the oil producers and the long-term
lending of the banks.

When the income of the oil producers was high the
banks had an incentive to increase their lending, encouraging
consumption and spurring inflation. When the income of
the oil producers declined the banks were forced to retrench.

23

This drove up interest rates and the costs of debt service
at the precise moment that the international recession
sharply reduced the exports of the less developed nations.
This in turn forced the debtor nations to curtail their
imports which deepened the recession in the industrial
democracies and made the debt problem even more intractable.

All these trends were magnified when fighting inflation
became the primary economic objective of most industrial
democracies. It then became apparent that policymakers
had forged no tools for dealing with a deflationary world.
The process of financing the oil deficit had been sustained
by conditions of continuous inflation enabling the debtors
to repay in cheaper currency. Deflation however essential
for the industrial democracies, was bound to raise havoc
in the developing world and deepen the recession everywhere.

In this way the industrial democracies paid for the
energy crisis three times: first in the inflationary

24

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 caused by the debt problem of the developing
nations. The industrial victims of the rise in oil prices
have wound up as hostages to the less developed victims
of the same crisis.

The conventional wisdom requires the possibility of
a default by the debtor nations. They are supposed to
recoil from extreme measures that would jeopardize their
credit worthiness. But there are many steps of blackmail
possible between meeting obligations and outright default.
The bargaining position when two sides confront different
kinds of disaster is not simple to calculate. What would
be the reaction of Western banks to the threat of default
unless certain conditions are met? Whether such a threat
will ever be made depends on at least two factors: First,

25

how many funds beyond the interest payments can be made
available to debtor nations? Second the impact on the
political structure of the debtor country of the conditions
demanded for easing their debt burden ("rescheduling" is
the technical phrase). If the assistance to the debtors
goes no farther than new loans to pay interest, a blow-
up is certain sooner or later. Countries will not increase
their debt indefinitely to protect the balance sheets of
distant banks. And their willingness to be responsible
participants in an international order depends on the stability
of their political system.

This is why the handling of the debt issue is of the
greatest importance--not simply for international economic
order but also for international political order. The
principal institution for dealing with the crisis of debtor
nations is the International Monetary Fund. It is no discredit
to its extremely able director, de Larosiere and its

26

dedicated staff, to point out that it was never designed
for a crisis of such magnitude. The Fund is well adapted
to help out individual countries by lending them funds
in return for measures of fiscal and monetary discipline.
And as an international institution, the Fund can impose
conditions that would probably be unacceptable if they
were put forward by an individual creditor nation.

Still, the Fund was never designed to deal with a crisis
of the system. As country after country admits its inability
to pay even interest--and therefore renounces any immediate
prospect of repaying capital--the Fund is asked to step
in. In return for providing the resources to service the
debt it imposes financial discipline. This inevitably
takes the form of specific requirements to reduce consumption
and the public debt, in short austerity.

As an emergency measure this may be unavoidable above
all as there is no other choice. But there should be no

27

illusion that it can possibly cure the disease. Indeed
the major utility of the individual IMF grants is to gain
time for a radical reform of the system that produced the
crisis. That--and not the specific conditions imposed--is
the major hope to avoid a disaster.

For one thing debtors can have little incentive actually
to implement conditions that add to their debt burden for no
other purpose than to meet interest payments. Their principal
motive must be not austerity but economic growth sufficient
to escape the vicious circle in which debt service consumes
export earnings. But no amount of domestic austerity
can bring this about. It requires a reversal of the pattern
of high interest rates, global recession, falling oil
prices and the new-found caution of the Western banking system.
If IMF conditions are to work, a deliberate policy of economic
expansion in the industrial democracies is essential.

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Until this comes about--and even thereafter--a careful examination of the political implications of IMF conditions is imperative. Of course it would be absurd for the IMF to launch a rescue operation for debtor nations without seeking to correct some of the deficient economic practices that brought them to the edge of the precipice. But it is important to make sure that the conditions are realistic. They must not become an alibi for banks to continue lending in essentially unchanged economic circumstances nor for debtors to agree to formulae that mortgage their political future. The worst debt problems arise in countries with the most tenuous governmental processes (Brazil may be a notable exception). What is the significance of their commitments? 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

29

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 conceivable? And with
the IMF recourse exhausted what option is there except
some kind of default?

There are thus two contradictory dangers: the first
is that the IMF conditions are not met. But the opposite
danger may be more insidious still: that a major effort
is made to fulfill the conditions and, in the process,
undermines the political framework.

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. In
developing countries exactly the opposite is true. The
state often has to form the nation; its legitimacy is
the principal unifying bond. Occasionally, Western governments
in economic trouble have used IMF conditions as a convenient

30

excuse to impose an austerity that domestic politics
might otherwise have prevented--Britain in the winter of
1976 is a good example.

But in most developing countries prolonged austerity
is bound to shake, perhaps to shatter, the political
framework. The fewest of them have unemployment insurance
or other institutions which in the West cushion the
impact of economic downturns. Austerity in most developing
countries threatens legitimacy; it weakens moderate
government; it tempts a radicalism that rallies public
opinion and perhaps other debtors in defiance of foreign
creditors. All of this must be the opposite of the West's
intent.

Two conclusions follow: the first is that the debt
problem cannot be resolved either by economic criteria or on a
country-by-country basis. It must include a realistic
political assessment of what conditions are in fact fulfillable

[y]

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and what strains they impose on the political structure. More
important is to redefine the terms of the discourse. The
debt problem is the symptom, not the cause, of the
current crisis which will not be overcome except by
an expanding world economy. The Mexicos of this world
must be given hope for a better future if they are to
sustain the immediate and inevitable austerity without
convulsions.

## 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 at the end of a period of
adjustment. We have the same challenge today both toward
the peoples of the industrial democracies and toward at least
the key countries of the developing world. For the current
crisis should teach us, if nothing else, the interdependence
of all peoples.

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Indeed, we have no other choice. We cannot afford to wait at home or abroad for automatic market forces to bring about a major recovery. There is a major risk that, if we seek to wait out the downturns, some accident or default or bank failure may collapse the whole deck of cards.

We need a strategy that gives hope not by governmental intervention into daily market decisions but by setting priorities for a five to ten year period. This cannot be accomplished by any industrial democracy alone; not even by one as powerful as the United States. In 1977, the common view was that the Federal Republic of Germany and Japan should act as the "locomotives" of the world economy. That did not work. Today, most of the other industrial democracies wait--more or less passively--for an American economic recovery. That will not work either. A joint effort is needed not only for economic reasons but above all for psychological and political reasons. Most of our foreign

33

policy problems with our allies would be eased if we were
perceived as leading a global recovery. Nothing is more
essential to restore the political health of Western
democracies than a sense that the West is in control
of its destiny. 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.

Our foreign policy therefore has two urgent tasks which
have been increasingly recognized in recent statements by
Secretaries Shultz and Regan: Recovery in the industrial
democracies butressed by a stabilization of exchange rates and
coordination of economic policies Expansion of economic
activity in the more advanced developing countries leading to
a general refinancing of the debts. Neither of these
problems is soluble in isolation. Interdependence has moved
from a slogan to a necessity. We must abandon the myth
that all developing countries can be grouped into a single

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global effort. Countries like Brazil, Mexico, Spain,
Yugoslavia, the ASEAN countries, South Korea are halfway
between underdevelopment and advanced insutrialization. They
are on the verge of self sustaining growth. As they
develop, moreover, they will raise new problems of competition
for the existing industrial states imposing on them the
need for a long-range industrial policy, at home and a
farsighted and coordinated final, trade and monetary policy.

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

In truth we have no other choice. Nearly two centuries
ago the German philosopher Kant predicted that eventually world

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order would come about either through intellectual and
moral insight or through the experience of chaos. We are
now approaching that point. If we do not lead we will
sooner rather than later be confronting a panicky stampede.
If we do, we can draw an act of creation from uncertainty.
and incipient despair, which is how almost all great
creations have come about. And as we turn to these
labors we can draw courage from the fact that many of the
problems of the industrial democracies arise from an excess
of productive capacity. It is a problem the rest of the world
must envy. It reminds us that the ultimate challenge
is not economic weakness but the need for political will.