The Day After Russia Attacks
What War in Ukraine Would Look Like—and How America Should Respond
For about a quarter of a century after the end of the Second World War, the market economies of the non-communist world enjoyed an unprecedented rate of growth, an exceptionally low level of unemployment, and comparatively low inflation. The average growth of the gross national product (GNP) in the advanced industrial nations of the Organization for Economic Cooperation and Development (OECD) from 1951 to 1973 was 4.8 percent a year in real terms. It was not until 1975 that output actually fell in the noncommunist world as a whole-and then by only one percent-whereas before the war there were periods when it fell very dramatically by from five to seven percent. Since 1975, growth has been averaging less than it did from 1951 to 1973-about 3.8 as against 4.8 percent-but there are ominous signs that it may settle down over the next decade to an average significantly lower than the current rate. Moreover, all the evidence is that, in the foreseeable future, the average growth of output in the free world is not going to recover to the level we experienced during those golden years from 1951 to 1973.
Why did we enjoy this uniquely high rate of growth and employment during those postwar years? First of all, the governments concerned accepted the principle of free trade. There has been a very close correlation over the years between the growth of gross domestic product (GDP) in individual countries and the growth of world trade. Free trade was exceptionally helpful to those of the developing countries which operated market economies, until the recent increase in import restrictions in the industrial world following the 1973-74 oil crisis. The second reason was that countries used the techniques of demand management, as taught by Keynes, and that in the immediate postwar period the United States used its big current account surpluses to finance, through the Marshall Plan, the deficits of those countries which had been damaged by the war and also helped to finance developing country deficits, initially through President Truman's Point Four program by increasing the flow of private investment capital to poor nations.
I think that a third factor-although economists will argue about this-may have been that the postwar Bretton Woods agreement, by maintaining a regime of fixed parities, reduced the uncertainties that inhibit the making of economic decisions and imposed a degree of financial discipline that probably helped keep inflation rates down. But the Bretton Woods system depended on discrimination against the United States, the only country in the system which could never change its exchange rate; America was liable to run a permanent deficit and had to keep her rate of inflation low.
A final factor which contributed to this period of unusual economic prosperity is that the world used cheap energy and exceptionally cheap oil. In fact, the real price of oil fell by half between 1950 and 1970. In recent years it has been easy to forget that it is only 20 years since the United States imposed quotas on imports of oil in order to keep up the price of its domestic oil.
All these factors, which contributed to the very high rate of growth in the postwar period, have now changed or disappeared. There has latterly been a slow accumulation of restrictions on trade, which has been contained only with very great difficulty. The United States soon became unable to carry the burden of financing other countries' deficits, and in 1971 refused any longer to accept the discrimination against it which was imposed by the Bretton Woods system. Finally, the oil-producing countries of the Middle East began to exploit their new political independence of the West just as the West's economic dependence on their oil became absolute; they followed the precedent set by the oil companies and began to manage the world market for oil in their own interest. Thus, the energy problem has now become a dominant factor in the international economy. Let us first try to draw some lessons from its impact over the last six years and then consider its consequences for the world's monetary arrangements.
When I became Chancellor of the Exchequer in 1974, I found myself in the middle of a bad-tempered argument between the Organization of Petroleum Exporting Countries (OPEC) and the West about whether the crisis the world then faced was due to the profligacy of the oil consumers or the rapacity of the oil producers. In fact, actions by the OECD countries and by OPEC both made their contributions.
The world inflation of the early 1970s had nothing whatever to do with oil. It was due to the failure of successive American administrations to finance the war in Vietnam out of current revenue; to the exceptional increase in raw material prices because a large number of countries achieved unusually high growth rates at the same time; and to a series of bad harvests. These factors helped lead to the breakdown of the Bretton Woods currency system under an American policy for which Treasury Secretary John Connally adopted the euphemism "benign neglect." The resulting currency instability itself added to inflation. So inflation was already high and rising by the middle of 1973, before the increase in oil prices took place.
The OPEC countries increased the price of oil partly in response to recent inflation in the industrial world, partly to make good the fall in the real price of oil in the previous two decades, and partly to influence Western policy toward Israel. The result was a massive fall in world demand, reflected in the 65-billion-dollar OPEC surplus in the first year, and a massive boost to prices. Nevertheless, some Keynesian and monetarist economists are now disputing fiercely from opposite positions whether wiser policies in the consuming countries might have avoided the deflation of demand and the inflation of prices; the latest annual reports of the International Monetary Fund (IMF), the General Agreement on Tariffs and Trade, and the OECD illustrate the range of disagreement on this issue.
In fact, the IMF advised the consumer countries at the beginning of 1974 to meet the reduction in world demand not by removing their deficits through deflation but by financing their deficits through borrowing, so as to recycle the OPEC surplus. But most governments rejected this advice and tried to eliminate their deficits or to run surpluses instead. The result was that countries like Britain and Italy-and later the United States-which took the IMF's advice, had to accept exceptionally high deficits on current account, which led to the depreciation of their currencies and so bred still higher inflation. They finally escaped from this situation only through very painful readjustments. Meanwhile, the world entered a period of great currency turbulence which still persists.
By 1978, the combined surpluses of West Germany, Japan and Switzerland were many times greater than the OPEC surplus. If there was any deflation of world demand, it was by then due to their behavior, and not to OPEC's. However, the major industrial countries had by then accepted the need for concerted action to reduce the divergence in their economic performances. Following decisions taken at the Bonn Summit of July 1978, Germany and Japan increased domestic demand. As a result, their economies have been growing faster and their surpluses have fallen dramatically-indeed Japan is now running a very substantial overall deficit. Meanwhile, Britain, France and Italy have moved into balance on current account. In fact, by the beginning of 1979 the industrial world was moving steadily toward adjustment, although, because Congress failed to legislate President Carter's energy program, the United States was still lagging well behind the rest in the process.
Before discussing the implications of the second oil shock, which started last December, let us look at some of the unexpected lessons which we should have learned from the first oil shock.
First of all, the private banking system has been more flexible and ingenious in recycling the OPEC surplus than anybody thought possible five years ago. Official financing has played only a minor role in financing the deficits-indeed the facilities available in the IMF have not been fully used. The main reason for this has been the mushroom growth of the Euromarkets. It is ironic to reflect that when the IMF met in Nairobi in the fall of 1973, it was widely believed that the Eurocurrencies would soon disappear because they would be absorbed in paying the higher price of oil. In fact, they have increased at least four times since then. For the industrial countries, the Euromarkets offered a means of avoiding domestic monetary controls, a point which Paul Volcker, the new Chairman of the Federal Reserve Board, is deeply conscious of. For the Third World they offered a way of getting loans on fine terms without political conditions. The result has been the accumulation in the Euromarkets of an enormous mountain of debt, which is now growing automatically as countries borrow to finance the servicing of their existing loans. Aggregate borrowing by the Third World from the multinational banks now amounts to some $190 billion, 70 percent of which must be refinanced or repaid by 1982. In addition, about $125 billion is owed to governments and multinational organizations like the World Bank.
The second surprise was that the OPEC countries proved capable of increasing their imports so as to absorb their new earnings very much faster than expected. Their overall annual surpluses dwindled from $65 billion in the first year to $5.5 billion four years later. Indeed, few of the individual OPEC countries are still in surplus. The biggest exception is Saudi Arabia, although Saudi Arabia has been absorbing faster than any other country; with three percent of the OPEC population, it now takes 21 percent of OPEC imports. In 1974, many bank economists estimated that by 1980 OPEC's cumulative reserves would have risen to $500 billion. In fact, they are only $50 billion bigger now than they were in 1973.
The third surprise-and I must confess it was a great surprise to me-is that many of the non-oil developing countries suffered less than expected. As a group they continue to grow faster than the OECD countries, partly because they are less dependent on oil and partly because they have been able to finance their deficits by borrowing from private banks without the restrictive conditions the IMF would have imposed. In some cases they have had help from OPEC itself. But within the Third World there have been big differences in economic performance between the supercompetitive countries like Korea, Taiwan and Singapore at one extreme and sub-Saharan Africa at the other, with India, well above average, in the middle. A lot of the borrowing carried out by some of the non-oil developing countries has been solely for the purpose of increasing their reserves-thus, despite the oil shocks the total reserves of these countries have risen from $27 billion to $62 billion in the last five years. Primitive monetarists have learned a further lesson-I hope-namely that market forces are not strong enough to break the oil cartel.1
There has been one other unforeseen development over the last five years, although it is unclear how much the oil price increase by itself is responsible. A long period of high inflation with low growth has produced big changes in economic behavior throughout the industrial world. Confidence has weakened dramatically; investment has been unusually low; and the reaction to changes in economic policy has been exceptionally sluggish. In fact, all the instruments of economic policy-fiscal, monetary and exchange-rate policy-have been less effective than was expected. There is also some reason to believe that the sudden increase in the price of energy may be partly responsible for structural changes in our economies, which are resulting in bottlenecks and inflationary pressures at a lower level of economic activity than in the past. But there is still great uncertainty about the nature and causes of these changes, so the economic schoolmen are having a field day in claiming miracles for their own proprietary medicines.
Chastened, I hope, by the surprises we had following the first oil price increase, let us now look at the second oil shock this past year.
Slower growth and higher inflation in the consumer countries reduced the real price of oil after 1974. But once recovery was underway, it took only a small cut in output due to the troubles in Iran to send spot prices through the roof. The OPEC price increase last summer inevitably followed. The OPEC countries were, in fact, following the market, a market largely created by Western consumers. And, in fact, up to last summer they were simply restoring the real price of oil to what it had been in 1974. But now we are off on the rollercoaster again.
This time, however, there are some important differences from the first oil shock. First of all, the immediate percentage reduction in world demand is so far much less than it was six years ago. The OPEC surplus looks like being about $50 billion in the year to July 1980 as against $65 billion in 1973-74. But that figure is misleading because the dollar is worth less than it was then, and the GDP of the consumer countries is higher. So the impact of the OPEC surplus on demand will be a good deal smaller in relation to current activity than it was five years ago.
On the other hand, governments everywhere are now very much more worried about inflation than about unemployment. Many governments have adopted more restrictive policies in reaction to the current oil price increase than they did in 1974-75. This will mean fiercer competition for less trade. Many governments are also trying to raise their exchange rates through higher interest rates so as to reduce imported inflation, even if that means less activity and more unemployment.
The 1980s look like they will be a decade of competitive exchange-rate appreciations, in contrast to the competitive depreciations of the 1950s and 1960s. In the next few years we may find out whether the new emphasis on monetarist theory produces a greater or lesser shock to business confidence than what happened after the first oil price increase. Partly because of their governments' indifference to the effects of their policy on unemployment, there are already signs that the trade unions in many countries are this time less ready to take the oil price increases on the chin and that we may have more industrial trouble and higher wage increases than was the case last time.
The third area where the situation differs from the one which prevailed when the first oil shock hit us lies in the relative economic performance of the major consuming countries. On the one hand, the difference in balance-of-payments performance is very much smaller. Britain, France and Italy are all now close to balance, whereas they had a combined deficit of $20 billion last time. On the other hand, the divergence in inflation rates is much more dramatic now than it was then. In 1973, America and Japan stood at the extremes of inflation performance with a gap of 5.3 percent between them. In 1978, Germany and Italy were the extremes with ten percent between them. By mid-1979 the gap was significantly higher.
There is also a puzzling divergence in savings behavior. In the United States the savings ratio has fallen to about 4.5 percent. In Europe the ratio is still well into the teens-in most cases between 12 and 16 percent.
These differences in performance make the risks of turbulence on the foreign exchanges greater, particularly because the effect of the oil price increase will vary dramatically between countries. It already looks as though America's oil import bill this year will be between $50 billion and $70 billion, an increase of between $8 billion and $28 billion over 1978. So there are already signs of a flight from money, of which the stupendous increase in the price of gold is only one example. People have been moving not only into other metals but into almost any commodity they can buy. It would be interesting to know how much of Japan's deficit this year is due to the stockpiling of commodities rather than to trade in manufactured goods. Moreover, such speculation in commodity futures is reminiscent of the excesses of 1929.
Another probable difference from the situation after the first oil shock is that the absorptive capacity of the OPEC countries may diminish. Some of the OPEC countries are already in deficit. Others are worried about the consequences for their economic and social stability if they continue their current rates of absorption.
Moreover, it looks as if the deficit of the non-oil developing countries will be very much greater this time. Egypt, Mexico and Malaysia are now oil producers. The former head of the IMF, Johannes Witteveen, has recently stated that the deficit of the developing countries which are still without oil could be as high as $65 billion next year.2 Because parts of the private banking system are already overstrained by earlier lending, these new deficits may be more difficult to finance, particularly if other countries follow or extend the precedent set by Mr. Volcker and adopt measures to reduce the avoidance of domestic monetary controls through the Euromarkets. It also seems likely that a prolonged period of low growth in the industrial countries will not only automatically reduce their trade with the developing countries but may also strengthen protectionism, particularly against imports of manufactures from supercompetitive countries like Korea and Taiwan.
The picture I have painted so far assumes that the supply and price of oil will respond to the demand for oil. But there are already signs that the oil producers may reduce the supply, partly to conserve the finite supplies of their most precious resource, partly to maximize its price, and perhaps also to exert political pressure. Many of them, which were quite unprepared to deal with some of the consequences of the first oil shock, have been learning fast in the last five years. For example, Britain's exchange rate stayed firm in 1974 and 1975 mainly because some of the Middle East governments did not know where to put their money except in London. They are now as sophisticated as any government in the world in judging exchange rate risks and balancing their portfolios.
Kuwait is typical of the development in OPEC thinking. It has already made a further increase in the price of its oil, and it is now talking of cutting output from 2.2 billion barrels a day to 1.6 billion next year. Mr. 'Ali al-Khalifa, its Minister for Oil, told a seminar at Oxford in September 1979 that Kuwait might progressively reduce the ratio of production to reserves from the current 1 to 25 or 30, to 1 to 100, so that the output of its oil would fall by half over the next five years.
There is a dangerous tendency in some consuming countries to try to cope with such developments by putting excessive pressure on their friends in the OPEC countries. The fate of former Premier Nuri Said in Iraq should be a warning. He was lying dead in the gutter within a short time after being pushed against his better judgment into the 1955 Baghdad Pact. The only certain way by which the consumer countries can discourage the tendency to cut output in the producing countries is to press on faster with conservation and the development of alternative energy supplies so as to present OPEC with the prospect of a fall in the real price of oil in the longer term, which would make it irrational for them to restrict output now.
It is always possible that political changes in an oil-producing country could lead to a sudden cut in output as it did in Iran last year. Armed conflict between two or more cannot be ruled out. The Kurdish problem involves three Middle East countries. Sectarian divisions between Sunni and Shi'ite Muslim sects are already imposing strains in Bahrain, and behind it all there is the possibility of another Arab-Israeli war.
A final danger is that if social and political strains increase in the consumer countries, or if OPEC goes too far in exploiting its monopoly position-particularly for political objectives-then some external intervention in the supplier countries may occur, an intervention which might bring Western countries into direct conflict with the Soviet Union. It is possible to overrate the rationality of governments and peoples, particularly in a democratic country, when they are under severe strain.
One of our greatest difficulties in developing policies for dealing with the energy problem is the great uncertainty about the ultimate size of the world's real oil reserves. This uncertainty will last as long as the oil companies are reluctant, whether for financial or other reasons, to explore for oil without guarantees of production. As a result, the experts differ widely in their estimates. Some of the oil-producing countries are becoming so impatient that they may short-cut the oil companies and develop their own exploration capability. We may then discover it is not so difficult, after all, to find oil, just as after 1976 we found it was not so difficult to pilot ships through the Suez Canal. Monopolies can inflate their expertise as well as their prices.
The way in which the producers have handled the supply and price of oil, and the way in which the consumers have reacted to this, have already reduced world growth and increased inflation. They threaten worse consequences still. There is no sign at the moment of an improvement in the situation. At Tokyo the heads of government made meaningless noises about it-forgotten as soon as uttered. The IMF seemed to ignore it altogether at its fall meeting in Belgrade.
Is it inevitable that we should sit and watch the situation drift, meeting occasionally at massive jamborees of producers and consumers for the ritual exchange of abrasive misunderstandings, or at ill-prepared weekend summits which produce ambiguous communiqués as a substitute for policies? Or do we attempt to create some areas of agreement with the producers based on accepted mutual interests, so as to establish some patches of relative certainty in this uncertain situation, by eliminating or at least reducing some of the more obvious risks?
One problem, which I think it is reasonable to try to tackle, is the speed of change. Oil is so important in so many ways that sudden changes in its price or supply can inflict great damage on the whole world economy. When change is sudden, the industrial consuming countries cannot hope to meet it by conservation alone. Given the current economic fashion, they will meet it by deflation, and the ever-present risk of further sudden changes will have a damaging effect, both on their economic psychology and their political stability.
The OPEC countries stand to suffer no less from sudden change, which is likely to generate more inflation in their countries, an immense waste of human and material resources, and the accumulation of large stocks of depreciating currency. All of these can be socially and politically disruptive.
The non-oil developing countries from now on will have to bear a disproportionate share of the resulting deficits, will suffer very badly from deflation in the industrial countries, and will risk facing new barriers to their manufactured exports. Moreover, they may find it less easy than before to finance their deficits.
Finally, sudden changes may disrupt what order we still have in international currency arrangements. This is particularly likely if they produce a more rapid move out of the dollar, if the stronger countries refuse to allow their currencies to be used for reserve purposes, and if there is no other reserve system available.
Anybody can devise blueprints for dealing with this situation; the problem is to get governments to accept and act on them. International economic diplomacy is like rowing a boat through treacle. I think the most hopeful area of agreement to aim at would probably involve the consumers accepting regular small increases in price-at least indexed to inflation in the countries which provide OPEC with manufactured goods-in return for some guarantee of output from the producers.
For obvious reasons even this would be very difficult to achieve. The industrial countries are reluctant to forego the potential advantage which the market might provide, although the market for oil is liable to violent disruption. The oil producers are far from united in their attitudes and objectives-and in their ability to guarantee any particular level of output. Perhaps a small group of countries from each side could make a start-for example, the European Community and the Gulf producers. If we could create even one precedent for such cooperation between producers and consumers, wider agreements might flow from it. If we do not try the situation is certain to deteriorate.
Now let me turn briefly to the effect of all this on the international monetary scene.
Even if we make some progress in conservation and in negotiating agreements with members of OPEC, the 1980s are likely to be marked by recurrent shortages in the supply of oil and continued increases in its real price. However wisely the consuming countries adjust their policies to minimize the effect of this on their rates of inflation and economic growth, it is bound to produce major divergences in their balance-of-payments performances. Recent experience suggests that when exchange rates are floating they are affected most of all by the balance of payments on current account, prospective as well as present. That is why sterling rose so much against the dollar in the last twelve months. So the 1980s are likely to be a period of great currency turbulence unless some international action is taken to control the situation.
At present, the dollar is the only major reserve asset available in the world. It now represents 40 percent of the world's reserves (62 percent if Eurodollars are included) as against six percent in the late 1940s. Diversification from the dollar is bound to continue disturbing world currencies until the dollar represents a significantly smaller proportion of the world's reserves. As I said earlier, more and more individuals, and some countries, are moving out of currencies into gold and commodities. Meanwhile, speculation on futures is becoming an important contribution to currency turbulence. From time to time it has pushed the Swiss franc up against the Deutschmark when there was absolutely no underlying economic reason for this to happen. It has also pushed sterling up against other currencies. And it is now moving into commodities, not only gold and other precious metals but into almost anything which can be stockpiled.
This type of speculation in futures can also have striking effects on the internal distribution of wealth. A leading Italian banker recently said that two years ago he could have named at least nine out of the ten richest men in Italy without the slightest difficulty. Now he could not name one: the richest men in Italy today all owe their wealth to speculation in commodity futures with money borrowed from the Euromarkets. No one with any knowledge of financial history can contemplate this type of activity without foreboding. Governments would be wise to restrict it by collective as well as national action.
Calls for control of the Euromarkets have recently become very fashionable. There is an overwhelming case for parent banks establishing prudential control over lending by their subsidiaries abroad in Eurocurrencies, under supervision by the central banks of both parent and host countries. The banking systems of the world are probably too sophisticated to remain bound by controls which go much further than that. Moreover, some of the types of wider control which are now under discussion could work only by drying up the supply of loans to finance Third World deficits, since there is at present no adequate source of official finance as an alternative. There is urgent need for action by the IMF to create new sources of official finance for their deficits. Otherwise, we could see a series of defaults which would bring the whole international banking system crashing down. Too many banks are now in the situation of a cyclist who has to choose between falling off because he puts the brake on too suddenly, or pedaling slowly over the precipice.
What was so depressing about the IMF meeting in Belgrade, as at the Tokyo Summit in June, was that these problems of international finance do not seem to have been seriously considered, apart from the useful decision to consider the creation of a substitution account. The substitution account is a proposal to replace some of the dollars held by central banks outside the United States with Special Drawing Rights. Great technical difficulties remain to be overcome if such an account is to be made attractive to the banks concerned, unless the United States is to carry the whole burden of guaranteeing its value-in which case America might just as well issue bonds on her own account. Moreover, unless a substitution account rapidly rose to a total of some $50 billion, and then beyond, it would have little impact on the real problem. Nevertheless, it is the one constructive idea currently in play, and deserves strong support, particularly by countries like Germany and Japan which do not wish their own currencies to assume a reserve role.
One reason for this failure to confront the financial problems appears to be an altogether excessive confidence in the ability of market forces to produce the best of all possible worlds when they are free from guidance or control. But, in fact, there is no free market in currencies, since all over the world currency is regarded as a prime function of government. At the present time, of the 135 world currencies, 95 are pegged in one way or another, and eight of the rest are in the European Monetary System (EMS).
The inadequacy of regional arrangements, however, is well illustrated by the history of the EMS. Though some see it as the first step toward monetary union, most of the member governments see it as a basis by which they can make the necessary adjustments in their exchange rates with minimum drama. There is no sign of the European Currency Unit (or ECU) developing into a reserve currency or asset. Moreover, such stability as the EMS has so far maintained depends on the stability of the dollar. Since the Deutschmark and sterling (which is part of the ECU basket though Britain does not participate in the exchange rate regime) are both currencies of refuge, the EMS can be disrupted by sharp changes in the value of the dollar in either direction unless its members are prepared to abandon control of their money supply for the sake of intervening to prevent this.
The choice is not between a free market in currencies and international regulation, but between uncoordinated national or regional controls, which may tend to increase turbulence, and some coordinated international control to reduce turbulence. As long as the industrial countries fail to produce the latter, the OPEC countries will use their monopoly power over the supply and price of oil to protect themselves as they think best, and they will be increasingly tempted to use it for political purposes. It was no accident that, because the IMF failed to address itself in Belgrade to the financial implications of the oil problem, OPEC's power was reflected only in attempts to get the Palestine Liberation Organization represented there.
This is not an encouraging picture of the energy and monetary prospects. But it is not an unrealistic one. Again, I do not offer a simple answer to the problem. Anybody can draw up blueprints for a solution, and many people have. The difficulty is to find some line of approach which has a chance of attracting enough interest among the leading governments to produce serious negotiation. Perhaps the most useful advice a spokesman from the Opposition party can give to governments on external financial policy is Kant's categorical imperative: "Act only on the maxim through which you can at the same time will that it should become a universal law." What is so bizarre at the moment is that a number of governments really believe it is the moral duty of every country to run a surplus on current account and to make its currency strong, although they know perfectly well that this is absolutely impossible both in logic and in practice.
To the extent that we cannot get more uniformity in our domestic economic performances, we must aim at a better balance between countries with differing performances. The surplus and deficit countries, and those where currencies are depreciating or appreciating, should adopt complementary policies to produce convergence. Only 16 months ago the major governments accepted the need for complementary policies of this nature. That was the whole basis of their approach to the Bonn Summit. It was successful. The Germans did inject an extra one percent of GDP into demand; as a result their economy is much healthier this year and business confidence greater. Japan followed similar policies with similar results. On the other hand, the deficit countries followed policies to reduce or eliminate their deficits. The industrial world was moving slowly toward convergence at the end of 1978.
This year, however, everybody seems to have relapsed into a moody or cynical fatalism, relieved only in a few cases by a theological faith in the more primitive versions of monetarist theory. One can only hope that governments will at least look at the facts of the situation as it develops and reconsider their policies-or lack of them-if they are visibly failing to improve the situation. The survivors of the Second World War did so, and in three years of confident inspiration constructed our international system which brought unprecedented benefits to the whole of the free world. We desperately need some glimmer of that inspiration today.
1 Professor Milton Friedman, for example, predicted in 1974 that OPEC would collapse long before oil reached $10 a barrel.
2 Speech at the opening of the AMRO Bank, Tokyo, September 7, 1979.