Although the weight of the United States in the world economy is less overwhelming than in earlier years, economic events, economic policies, and economic ideology in this country continue to have a substantial impact on the rest of the world, as was demonstrated again in the year just ended.

The most important event, from the viewpoint of other countries, was the steep and sustained climb in American interest rates, which contributed to but was not the sole cause of a dramatic appreciation of the dollar in foreign exchange markets. The corresponding depreciation of other currencies posed serious policy problems for a number of countries and gave rise to numerous complaints in the spring and summer of 1981.

The economic policy mainly responsible was the monetary policy of the Federal Reserve, carried out with the general, if occasionally backsliding, support of the Reagan Administration. With the Federal Reserve's growth targets for the money supply much below the growth of GNP (gross national product) in current dollars, the immediate reconciliation between money growth and GNP growth came through an escalation of interest rates to levels not seen in living memory. Later, GNP growth slowed as the economy slid into recession. The Federal Reserve's objective, about which there is virtually no dispute here or abroad, is to reduce the rate of inflation, with the impact on the rest of the world a by-product of the pursuit of this domestic objective. But coming as it did when the economies of most other industrial countries were already in a sluggish condition, still reeling from the effects of the oil shock of 1979-80, the U.S. impact was far from welcome.

Among the non-oil developing countries, those few that are heavy borrowers from the world's commercial banks experienced a significant increase in the burden of servicing debt, as interest rates skyrocketed. Some of these found it necessary to cut back their rates of economic growth, which had been remarkably rapid in recent years, in order to contain their balance-of-payments deficits. The large number of developing countries that are producers mainly of raw materials and food were not affected so directly by high interest rates in major financial markets, but both the volume and prices of their exports were depressed by stagnation in the industrial countries. And all developing countries were thrown into uncertainty by the apparent ideological approach of the Reagan Administration to development assistance and the role of the multilateral financial institutions, especially the World Bank and International Monetary Fund (IMF).

II

What happened to U.S. interest rates in 1981 has often been characterized as the result of a "collision" between fiscal and monetary policies, which were said to be pushing the economy in opposite directions and thus aggravating the interest-rate consequences of monetary policy. Such a policy conflict may well occur in late 1982 and beyond, as the Reagan tax cuts interact with increasing defense outlays and hard-to-compress non-defense government programs. The result could be an excessively stimulative fiscal policy and, assuming the Federal Reserve continues on its course of restraining the supply of money and credit, increased upward pressure on interest rates.

During 1981, however, fiscal policy actually became more restrictive. With cuts in non-defense spending counterbalanced by defense increases and the impact of the Reagan tax cuts not yet fully felt, total federal spending in real terms (that is, adjusted for inflation) was unchanged from the previous year, while tax revenues increased. (Although the actual budget deficit changed little, the budget adjusted for the effects of recession-technically known as the high employment budget-shifted significantly toward surplus.) It was thus a combination of tighter fiscal and monetary policies that helped to create the recession that began in the latter half of 1981. (The widespread misconception about the direction of fiscal policy in 1981 itself is understandable in view of the lengthy debate over the budgets for future years.)

In any event, before the recession took hold, U.S. interest rates rose to very high levels, with the prime rate at 20.5 percent and three-month Treasury bills at almost 16 percent. Since inflation was running at 10 to 11 percent in the summer of 1981, the inflation-adjusted or real rate of interest was probably higher than at any time since the late eighteenth century.

High interest rates were a principal cause of the rapid upward movement of the dollar in relation to the currencies of many other countries. The average value of the dollar in terms of the currencies of the ten major industrial countries (as measured by the Federal Reserve Board) rose 30 percent from August 1980 to August 1981. This was by far the largest swing in the dollar, up or down, since exchange rates began to float in March 1973. But it was not uniform among foreign currencies. In terms of the German mark and other currencies in the European Monetary System (EMS), the dollar rose 40 percent or more, while in terms of the pound sterling and Swiss franc the appreciation was about 30 percent. In Japanese yen, however, the dollar went up only four percent over this period, as the yen first rose against the tide until early 1981 and then declined more gradually than other currencies. Because the effect of U.S. interest rates on the yen was counterbalanced by Japan's rapidly strengthening current-account position, Japan's average exchange rate changed little in 1981. For this reason we focus on the European currencies in what follows.

From the viewpoint of most foreign countries, escalating interest rates in the United States attracted funds from money and capital markets at home into dollar-denominated deposits and securities abroad. Such shifts of funds into dollars, either in the Eurodollar market or in the United States, drove down the dollar value of foreign currencies.

Rising U.S. interest rates, however, were not the only reason for the depreciation of other currencies and the appreciation of the dollar. Two other forces, one economic and the other political, were at work.

In 1979-80, there was a strong improvement in the U.S. trade balance, and more broadly in the balance on current account (which measures the surplus or deficit in transactions involving merchandise trade, services, dividends and interest, and remittances to foreign residents and governments). This improvement was partially masked by the substantial increase in the price of imported oil that took place in 1979-80 and affected the balance-of-payments positions of all oil-importing countries. Although the dollar value of U.S. oil imports rose by more than $35 billion, or 85 percent, between 1978 and 1980 (while the quantity of oil imports fell nearly one-fifth), the U.S. balance on current account shifted from a deficit of more than $14 billion to a surplus of more than $3 billion. Over the same period the other industrial countries as a group experienced a shift from a current-account surplus of $27 billion to a deficit of $71 billion. In particular, West Germany and Japan moved from large surplus in 1978 to large deficit in 1980.

The strong balance-of-payments position of the United States and the corresponding deficits abroad, which persisted into the early part of 1981, affected exchange rates both directly via the financing of the payments imbalances and indirectly via the expectation that the imbalances would have to be corrected by exchange-rate adjustments. In foreign exchange markets widely held expectations tend to be quickly self-fulfilling. Hence the dollar appreciated while the currencies of countries in substantial current-account deficit depreciated.

Moreover, some currencies in Europe were influenced by political factors in 1981. At times, when the situation in Poland appeared particularly unstable, the German mark tended to weaken, as investors moved out of that currency on the basis of fear of the unknown. In France, the election of President Mitterrand and of a Socialist majority in the National Assembly led to downward pressure on the franc as both French citizens and foreigners felt motivated to get their funds out of France while they could. Thus the mark and the franc depreciated more than the currencies of other European countries-for example, Sweden and Switzerland-which were more immune to political events.

Another influence on exchange rates, and one that has traditionally been regarded as the major influence, is differing rates of inflation. This factor played no discernible role, as far as the dollar was concerned, in 1981: the mark and the yen, for example, both depreciated against the dollar though Germany and Japan had lower inflation rates than the United States. (In contrast, the realignment of exchange rates in the European Monetary System in October, when the mark and the Dutch guilder were raised by 5.5 percent and the French franc and Italian lira were lowered by three percent, was more reflective of differences in inflation rates.)

The average exchange rate of the dollar reached its peak and turned down in August, shortly after U.S. short-term interest rates began to fall. By late December about one-fourth of the dollar's appreciation in the year to August 1981 had been reversed.

Once again, not only interest rates were at work. Germany's current-account deficit was contracting rapidly and Japan was in substantial surplus. As we shall discuss in greater detail below, this was, from the viewpoint of other countries, the silver lining in the depreciation of their currencies against the dollar in 1980-81. Their competitive positions improved, with positive effects on their current-account balances.

III

The sharp rise in U.S. interest rates in 1981 compounded a policy dilemma in which most industrial countries already found themselves in trying to cope with the dual effects of the near-tripling of the price of oil in 1979-80. As had become evident after the first oil shock in late 1973, a large advance in the OPEC oil price acts on oil-importing countries like a huge sales tax. On the one hand, it drives up the price of the taxed product and through it the overall price level; on the other, it drains off purchasing power that might have been spent on other goods and services, thereby depressing the economy.

The average rate of inflation in the industrial countries had accelerated from seven percent in 1978 to 12 percent in 1980. But industrial production peaked in the first quarter of 1980 and then fell off, while unemployment rose rapidly to record post-World War II levels. In the circumstances, interest rates began to decline in the second half of 1980 in a number of European countries and in Japan.

Meanwhile, inflation decelerated somewhat but was sustained by the momentum of advancing wages, which were in turn reacting to rising prices. The desire to bring inflation down further kept central banks from easing monetary policy despite the sluggishness of output and employment. This was the dilemma in the minds of policymakers in a number of countries even before the sharp run-up of interest rates in the United States.

The dilemma became more acute as the dollar appreciated, first gradually in the autumn of 1980 and then more rapidly in the first eight months of 1981. To countries in Europe especially, currency depreciation-the mirror image of the dollar's appreciation-threatened to worsen inflation again at a time when industrial output was stagnating at a level five percent below the early 1980 peak. Depreciation against the dollar meant rising costs of imports not only from the United States but from all countries whose exports are denominated in dollars, including OPEC members and other oil-exporting nations. Rising import costs, it was feared, would affect all prices in industrial countries and provoke demands for more rapid wage increases.

In order to dampen these effects, many countries attempted to cushion the decline of their exchange rates by raising interest rates and by intervening in foreign exchange markets to support their own currencies by selling dollars. Germany's central bank took strong steps in February, which lifted the three-month money market rate from 9.5 to 13.5 percent. Similar, if less drastic, measures were adopted elsewhere.

There is no way to estimate the effect of these actions on exchange rates. It is hard to believe that they did not slow down the rate of depreciation of European currencies. Yet that depreciation was very rapid in the spring and summer of 1981. From March to August the dollar value of the mark fell almost 16 percent.

It is a fair question whether the European countries would not have been better off in 1981 to have kept their interest rates lower-in order to improve the performance of their lackluster domestic economies-and let their dollar exchange rates go. The rate of depreciation might have been faster, but this in itself might have brought an earlier reversal of exchange rates, as expectations developed that the trough had been reached. This approach never had a chance, however, since it would have required the participation, if not the leadership, of the West German Bundesbank. Through most of the year, while officials of the German government-from Chancellor Helmut Schmidt on down-were expressing unhappiness about U.S. interest rates, the Bundesbank was concerned about Germany's current-account deficit. It justified its stringent policy by the need to reduce this deficit as well as to counteract the price-increasing effects of depreciation and to sustain foreign confidence in the D-mark.

Another alternative would have been for European governments to have borrowed more heavily abroad and used the proceeds to support their exchange rates in the markets. The German authorities, for example, did borrow DM 20.6 billion (more than $9 billion) in the first ten months of 1981, but there is no doubt about Germany's creditworthiness and ability to borrow more.

In any event, European policymakers chose to combat the depreciation of their currencies with rising interest rates as well as sales of dollars. As they did so, a swelling chorus of complaints was directed westward across the Atlantic, and the term "benign neglect" was revived to characterize the posture of the U.S. authorities. Since no one wished to oppose American efforts to reduce inflation, criticism focused on excessive reliance on monetary policy in the United States and the Reagan Administration's announced policy of refraining from intervention in foreign exchange markets except in dire emergencies. (The ill-chosen illustration of such an emergency was the attempt in March on the life of the President, when in fact a small amount of market support was given to the dollar.)

The annual report of the Bank for International Settlements, published in June, strongly recommended that governments should reinforce anti-inflationary monetary policy with greater restraint in fiscal policy and also suggested that incomes policy-that is, direct action, by regulation or tax incentives, to influence wage and price behavior-should not be ruled out. Although these proposals were directed at industrial countries in general, press reports interpreted them as being aimed especially at the United States. More pointedly, France's new Minister of Economy and Finance, Jacques Delors, characterized high American interest rates and the appreciation of the dollar as comparable to a "third oil shock."

As the Ottawa summit meeting approached in July, the press featured reports about the coming confrontation between President Reagan and the other leaders over U.S. economic policies. By the time the meeting convened, however, it was evident that the Americans had no intention of yielding, and the communiqué papered over any differences that may have been expressed. But, on his return to Bonn, Chancellor Schmidt announced that he would propose a reduction in planned defense expenditures, in view of the high interest rates prevailing in the United States. The economic logic was not apparent. If Germany's economy was being depressed by the necessity to maintain high interest rates, wouldn't the decline in government expenditures depress it even more? Not for the first time, an economic rationale was used to support a politically convenient decision.

Meanwhile, central bankers were either silent or openly supportive of the Federal Reserve. It is not surprising that the president of the German central bank, Karl Otto Poehl, denied that "in present circumstances Germany could have very low interest rates if only rates in the United States were lower." The fact that few if any central bankers joined their government colleagues in public disapproval of U.S. policies is probably explained in part by esprit de corps in the central banking fraternity, but also by a strong belief, right or wrong, that they could not rid their own countries of inflation unless the United States led the way.

Those who expressed dissatisfaction with U.S. policies claimed that stagnation, if not recession, was being forced on Europe through the high real interest rates it had to maintain in order to combat currency depreciation. This complaint had a familiar ring. In 1977-78, when the dollar was going down rather than up, stagnation in other industrial countries was often blamed on the falling dollar, on the grounds that appreciating currencies were hurting exports. In 1981, stagnation was blamed on the rising dollar. While there may have been some merit in both views-paradoxical though it seems-it is also true that politicians abroad have for many years found it convenient to blame the United States when their own economies were not performing satisfactorily.

This unsatisfactory performance was aggravated by a tendency in some countries of Europe to use fiscal policy in a perverse way. As is normal in a modern economy, budget deficits increased as output, incomes and employment sagged. This familiar process, involving lower tax receipts and higher unemployment benefits, has long been referred to as a built-in stabilizer. But governments in some countries, most notably the United Kingdom, had become so preoccupied with public sector deficits that they adopted measures to offset the automatic enlargement of deficits. British Chancellor of the Exchequer Sir Geoffrey Howe, in his March budget, raised tax rates in an economy in its worst recession since the 1930s.

Although other cases were less flagrant, the OECD (Organization for Economic Cooperation and Development) has shown that fiscal policy became more restrictive in 1981 in Japan, France and Germany as well as in Britain and the United States. Thus, the major countries were raising their interest rates in response to the U.S. impact at a time when their own fiscal policies were tending to depress their already-sluggish economies. But it was American policies they complained about.

Moreover, what seemed to be ignored in all the complaints was that the exchange-rate changes in 1980-81 were setting the stage for a substantial improvement in the balance of payments of Europe at the expense of the strong surplus of the United States. Germany's current-account deficit fell from $19 billion at an annual rate in the first quarter of 1981 to $10 billion in the third quarter. In October and November, the current account was in surplus. For the ten countries of the European Community, the current-account deficit is estimated by the OECD to have declined from $40 billion in 1980 to about $21 billion in 1981.

More broadly, stagnating economies, in which both monetary and fiscal policies had become more restrictive, were getting a lift from their export sectors, which had become more competitive thanks to exchange-rate depreciation. How much further this process could go was an open question in early 1981. With the United States in recession and the non-oil developing countries under balance-of-payments pressure, as is discussed below, the only buoyant markets appeared to be in some of the OPEC countries.

IV

In the economic conditions prevailing in 1981, trade policies in the industrial countries tended to become more protectionist.

The Reagan Administration's free-market philosophy was a force working against trade barriers. Early on, it acted to abolish quotas on shoe imports. But with its political constituency in economic trouble and members of Congress in a position to bargain over the domestic economic program, convenience as well as tradition called for the ills of the automobile, steel and textile industries to be blamed on imports. Tradition has also called for Americans to rant against Japan whenever that country is in large surplus in its bilateral trade with the United States, even at times, as in 1981, when the United States has a bilateral surplus with Europe.

Thus the Administration surmounted its free-market ideology in the spring and persuaded Japan to limit automobile exports to the United States. Also disturbing was American acquiescence to European protectionism in the late-1981 negotiations over renewal of the multifiber arrangement, under which the industrial countries had agreed, in 1973 and again in 1977, to accept "orderly" increases in their imports of textiles and apparel from developing countries. Under the renewed arrangement, signed in Geneva in December, industrial countries are permitted, in bilateral agreements implementing the general arrangement, to reduce imports. This was an ironic sequel to President Reagan's lectures to developing-country officials, in Washington in September and at Cancún in October, about the virtues of relying on free markets to generate economic development.

At the same time, Administration officials were following the time-honored practice of threatening Japan with congressional action against its exports if it did not reduce its trade surplus with the United States. Japan's imports of manufactured goods are very low indeed, as compared with the import composition of other industrial countries. The explanation is not very clear, but there is every reason to keep the pressure on Japan to see to it that obstacles to imports, whatever their nature, are removed. Such pressure would come with more grace and perhaps would yield more results if the United States and Europe were moving away from, rather than toward, protectionism.

V

Up to now, this article has focused on the economic performance and policies of the industrial countries. The past year was not a stellar one for the developing countries either.

Since the time of the 1973 jump in oil prices, a small group of so-called non-oil developing countries have become major borrowers from commercial banks in the industrial world. Eight countries in this category (Argentina, Brazil, Chile, Mexico, Peru, the Philippines, South Korea and Thailand) account for 70 percent of the external bank debt and half of the total debt of all non-oil developing countries. This small group also accounts for nearly half of the GNP of all non-oil developing countries. Its membership is not identical with the group that has been dubbed "newly industrialized" countries; the overlap is substantial but it is not complete because some of the latter countries, such as Hong Kong and Taiwan, are not-or are no longer-heavy borrowers, and a couple of the heavy borrowers are not far along on the road to industrialization.

These facts confirm that what is so often characterized as "the Third World" or "the South" consists, as Roger Hansen has put it, of "states of enormous diversity by all economic measures." Furthermore, "the economic 'gaps' growing most dramatically in the past decade have not been between the North and the South, but rather within the South itself-between the oil-rich and the industrially developed countries and the vast majority of their predominantly poor and significantly less industrialized diplomatic partners."1

The eight countries that were such large borrowers used the borrowed resources mainly to help finance current-account deficits. Such deficits supplement domestic savings and thereby permit a high rate of capital formation. This in turn has facilitated rapid export expansion and rates of economic growth considerably above the average for all developing countries. Even in 1979-80, when the second oil shock was having its effects, these eight countries had an average rate of growth of 5.5 percent per year compared with 1.5 percent for the industrial countries.

This virtuous circle of investment, growth and export expansion based in part on external borrowing had been encouraged in the 1970s by very low and at times even negative real rates of interest (i.e., rates below the inflation rate).2 This favorable circumstance has changed markedly in the past two years. The excess of the interest rate on three-month Eurodollar loans over inflation (of consumer prices) in industrial countries rose from 1.5 percent in 1978 to 2.5 percent in 1980 to 8.7 percent in the third quarter of 1981. In late December, it was back to about four percent.

Even if real interest rates had not risen to abnormal levels, the advance of nominal interest rates in step with inflation would have added to the current debt burden of developing countries. To be sure, this kind of enlargement of the debt burden would have been matched by a reduction in the real value of the debt with inflation, making future debt repayments lighter in real terms. But the effect, if interest rates keep up with rising prices, is to accelerate debt repayment, so that the traditional benefits that debtors derive from inflation are removed.

As it happens, the interest rates that prevailed in 1981, until August, went well beyond compensating for the erosion of debt because of inflation. They imposed a substantial burden on debtors. And, it is safe to say, they were a threat to economic progress in industrial as well as developing countries.

Among the ways in which the restrictive effects of the high interest rates showed up was in an increase in the current-account deficits of developing countries. Since the reduction in debt owing to inflation is not reflected in the reported current-account deficits, the latter tend to exaggerate the plight of the debtor countries. Nevertheless, the interest burden was heavy. For the eight countries we have been looking at, interest payments in 1980 came to $16.5 billion, a sum greater than their total current-account deficit in 1978. The increase in interest payments abroad from 1978 to 1980 accounted for more than one-third of the increase in the current-account deficits of these countries.

Similar data are not available for 1981, but in view of the fact that a substantial portion of the bank debt carries floating interest rates, there can be no doubt that interest payments rose sharply as the average rate on Eurodollar loans advanced from 14.4 percent in 1980 to 17.4 percent in the first three quarters of 1981.

The result, as might have been expected, was a determined effort by a number of these countries to compress their balance-of-payments deficits to magnitudes that could be financed and would preserve their appearance of creditworthiness. In the process, economic growth was sacrificed. Brazil, the largest debtor among developing countries, adopted severely restrictive domestic policies and experienced a substantial decline in industrial production. Its real GNP, which expanded eight percent in 1980, is estimated to have grown little in 1981. Mexico, despite the advantage of oil resources, also cut its growth rate in 1981 because of concern over its balance of payments.

This is, of course, an unfavorable turn of events for the development and political stability of the countries involved. Moreover, the consequent slowdown in imports by these and other developing countries will affect the exports of industrial countries and thereby add to the downward pressures on their economic activity.

VI

The overwhelming majority of developing countries were not strongly affected, in a direct way, by what happened to interest rates and exchange rates in 1981. What they were vulnerable to was slack demand for imports by industrial countries. This showed up in both the volume and prices of their exports of raw materials. And they, too, were still feeling the effects of the increase in oil prices of 1979-80. For those developing countries classified in the "low income" category by the International Monetary Fund, import prices rose an estimated 53 percent from 1978 to 1981, while export prices went up less than 23 percent. In the circumstances, the latest annual report of the Fund, an institution whose publications do not feature colorful language, characterized the impact of these events on the low-income countries as "almost devastating."

Furthermore, these countries are for the most part dependent on official development assistance (ODA)-bilateral aid from donors among the industrial and oil-exporting countries and loans on a concessionary basis from the soft-loan windows of the World Bank and the regional development banks. The size of these aid flows determines the capacity of the low-income countries to incur current-account deficits. In contrast to most industrial countries, low-income developing countries cannot count on finding the means to finance any given external deficit that they might incur as the result of developments in their own economies and those abroad. In technical jargon, their current-account deficits cannot be treated as autonomous. Rather, the amount of external funds available has to be taken as given, and the current-account deficit has to be limited accordingly.

Between 1978 and 1980, ODA increased about $10 billion, or 40 percent, to somewhat more than $35 billion.3 Although this represented a welcome acceleration in such assistance, it was nearly matched by the rise in the cost of oil imported by the low-income developing countries. The OECD countries as a group are expected to increase ODA by perhaps four percent per year, in real terms, in the next several years. In the United States, however, the prospects for foreign aid and contributions to multilateral development banks are uncertain. Moreover, the slow growth likely to prevail in the industrial countries will hold down the export proceeds of developing countries, especially the poorer ones dependent on exports of primary products.

VII

The doubts about U.S. development assistance stem in part from general budgetary stringency as the Reagan Administration attempts to restrain non-defense outlays. And, despite the passage of a foreign aid bill in December, members of the Congress are unlikely to be generous to foreigners when they are being asked to cut back assistance programs to their own constituents.

Apart from the budgetary constraint, the economic ideology of the Reagan Administration raises questions about the future of the international institutions that provide funds to developing countries. The ideology was deftly summarized by the President, in his welcoming address to the annual meeting of the International Monetary Fund and the World Bank in September, as reliance on "the magic of the marketplace."

Although the Administration's policy stance is still in process of formulation, the broad outline is clear.4 With respect to the World Bank and the regional banks, it is being suggested that too much lending has gone to finance public sector projects and not enough to private enterprises. The obvious answer to this charge is that much of the development lending is designed to provide the infrastructure necessary for economic development: roads, railways, harbors, dams and other projects for this purpose are inherently in the public sector. But in recent years the World Bank in particular has shifted its lending toward programs designed to develop energy sources and to improve the productivity of the rural and urban poor, and this is likely to mean the provision of funds for both public and private projects.

In the same vein, the Administration's new approach would emphasize the role of the development banks as catalysts for private investment flows rather than as sources of capital. The unwillingness to go along with the proposed energy affiliate of the World Bank, in the face of widespread support for it by industrial and developing countries, was an early concrete expression of this principle.

Beyond the nature of lending by the development banks, the American Administration's objective appears to be to reduce and ultimately eliminate government financing and guaranties of their capital increases. In particular, U.S. budgetary contributions to the International Development Association (IDA)-the World Bank's affiliate that lends three to four billion dollars per year to low-income countries at minimal interest rates and with long maturities-as well as to the "soft loan windows" of the regional development banks would be reduced in real terms. It is noteworthy that A. W. Clausen, the new president of the World Bank (and former head of the Bank of America), made a special plea for IDA in his address at the annual meeting:

What is it worth to the wealthy nations to be able to count on a reasonable degree of political and social stability, based on prospects for economic progress, in the poorest countries of the world? Does that touch on the affluent nations' self-interest, on their trading patterns; on the assured supply of this or that commodity; on their relations with other countries in the region? Should affluent countries worry that hunger and hopelessness in an urban slum of a poor society can drive jobless young people to irrational violence? Or can the rich countries afford, in the security of their wealth, not to care?

While IDA depends entirely on governmental contributions, the effect of the new approach, if it is implemented, on the World Bank itself and on the regional banks, is less clear. In particular, any removal of government guaranties of the banks' capital increases would raise serious questions. In the past, the ability of the banks to issue securities successfully in major capital markets has depended at least in part on the investors' assurance that the capital of the banks-callable from governments-stood behind the banks' liabilities.

Thus, if the Reagan Administration were to carry out to the full its rhetoric that the multilateral banks should henceforth depend on their success in the "marketplace" of private financing, the effect could indeed be drastic. How far the existing capital could be stretched could then become a serious problem.

American ideology was also focused on the International Monetary Fund, though in a rather awkward way. In a press interview before the annual meeting, Secretary of the Treasury Donald Regan stated that the United States wants the IMF to impose tougher policy conditions on borrowing countries. Apparently the Secretary was speaking from an out-of-date brief, and at the meeting itself all was sweetness and light and the Fund's "conditionally," as it is called, was not criticized. Nevertheless, a while later, the U.S. Executive Director abstained when the IMF was passing on a loan of more than five billion dollars to India and again when it was approving a further installment of a loan to Pakistan. The strength of U.S. support for the Fund is in doubt.

The highlight, at least as measured by theatrics, in what are called North-South relations, came at a summit meeting of 22 nations at Cancún, Mexico in October. This meeting had been recommended by the Brandt Commission, and President López Portillo persuaded President Reagan to attend. In two days at the plush resort of Cancún, the leaders failed even to identify specific issues on which concrete progress could eventually be made. Instead the representatives of the industrial countries accepted the proposed "global negotiations" in the United Nations. What this means or where it will lead is not at all clear. How can 150 nations negotiate? Whatever was agreed procedurally at Cancún, there is no chance that issues pertaining to the IMF and World Bank, where weighted voting prevails, will be permitted by the industrial countries to be decided at the United Nations.

Here was an instance of ideology in the developing world-where demands for a "New International Economic Order" and "global negotiations" are exceeded in their vagueness only by their lack of realism-prevailing over the ideology that the Reagan Administration has been expressing. But little is likely to come from this procedural victory. As The Economist put it, "words will speak louder than actions."

Yet issues exist on which cooperation between industrialized and developing countries could yield concrete benefits to both groups. Rodrigo Botero, former Finance Minister of Colombia and a member of the Brandt Commission, has identified these topics: increased energy production in developing countries, improved mechanisms for financial recycling, promotion of food production in developing countries, encouragement of exports by developing countries, and alleviation of poverty in the least-developed countries.5

VIII

The outlook for the world economy in early 1982 is rather gloomy. One of the few rays of brightness is that the oil-importing countries have not had to endure still another hike in oil prices, as has happened so often after year-end meetings of OPEC. In fact, OPEC prices are edging down as the premiums other countries have been charging over the Saudi Arabian base price are trimmed. Of greater significance, 1981 saw a determined and successful Saudi effort to use its production potential to force down the prices of some of its OPEC partners; Sheikh Yamani pointedly announced that OPEC prices can go down as well as up. It seems more evident than ever that Saudi Arabia, with oil reserves that will last well into the next century, is concerned about the future value of those reserves, as conservation and alternative sources of oil and other energy are stimulated by present OPEC price levels. (President Reagan's early move to deregulate oil eliminated perverse incentives to import, and now keeps the U.S. oil price on a par with the world price. This is all to the good. What is questionable is the apparent tendency of the Administration to leave energy policy completely to the market by cutting tax inducements to undertake conservation measures and by de-emphasizing the synthetic fuels program. One would have thought that such efforts were part of the raison d'être of the Saudi policy on prices.)

There are few other rays of brightness. The inelegant term "stagflation," coined in the 1970s to capture the unhappy combination of sluggish output and employment combined with inflation, is still apposite as regards the industrial countries in the early 1980s. The United States is unlikely to meet the optimistic targets for growth, unemployment and inflation announced by the Reagan Administration in its early heady weeks. The other industrial countries, although affected by U.S. policies, cannot avoid looking to their own policy failures for an explanation of poor economic performance. And the diverse groups of developing countries cannot help being affected by what happens in the industrial countries.

In what follows, we shall put some analytical flesh on the bare bones of these concluding generalizations and offer a policy prescription.

The U.S. economy, whatever the precise timing of recovery from the recession into which it plunged in 1981, is unlikely to expand very far before once again running into monetary restraint. And now the federal budget and monetary policy are likely indeed to be on a "collision course," unless the prospective deficits are reduced drastically by tax hikes, smaller increases in defense outlays, larger cuts in non-defense spending, or some combination of these possibilities.

The three-year tax cut embraced by President Reagan relied heavily on the case put by supply-side economists, who claim that lower marginal tax rates increase incentives to work, to save and to invest. While these effects on economic behavior remain to be tested, it can be assumed with confidence that those whose taxes are lowered will increase their spending. Demand and supply are the bread and butter of economists, but the supply-siders would like us to ignore the demand effects of tax cuts. This would be myopic.

In an economy in recession, some degree of demand stimulus should be welcome. The problem is that a vigorously expanding economy will once again run into the ceiling imposed by monetary policy, whether the expansion is propelled by loose fiscal policy or by strong private spending.

The only way to reconcile sustained expansion of the real economy with the Federal Reserve's monetary targets is to bring about a significant reduction in the rate of inflation. The Federal Reserve's policies are consistent with a certain rate of growth of current-dollar GNP. The slower the rate of price advance, the more scope there is for that GNP growth to take the form of output expansion.

This is a message that Federal Reserve Chairman Paul Volcker proclaims almost every time he makes a speech or testifies before a congressional committee. Specifically, he pleads for moderation in wage settlements and price increases.

In a way, then, the Federal Reserve is operating an incomes policy-a policy that recognizes and tries to deal with the self-sustaining nature of the interaction of wages and prices. It cannot be claimed that the inflation still present in the United States-or, as discussed below, in Europe-is the result of excess demand, of too much money chasing too few goods. With unemployment above seven percent and capacity utilization in manufacturing below 80 percent even before the recession, more goods and services could have been produced. What explains the persistence of inflation is the inertia involved in the reaction of wages to prices and of prices to wages, both past and expected. Once a wage-price cycle starts, it tends to go on.

The classical remedy is a lengthy recession, in which workers accept lower wage increases out of fear of losing their jobs and producers trim price increases in consequence of the smaller wage advances as well as of the pressure of heavy inventories and idle capacity. Some of this is happening but it is a slow process, as Mrs. Thatcher's experiment demonstrates.

The alternative is an overt incomes policy, which acts directly on prices and wages. Incomes policy can take a variety of forms. One is governmental regulation of wage and price advances, as was done by the Nixon Administration in 1971-73. Another is provision of tax incentives or penalties to induce wage and price behavior in accordance with established norms.6 Any type of incomes policy would clash with the philosophy of the present Administration. Nevertheless, if one or another form of this approach were adopted, as a temporary complement to-not a substitute for-monetary policy, it would accelerate the process of disinflation and make possible a sustained period of economic expansion and a reduction in the level of unemployment.

In the absence of such direct action on prices and wages, the economy is all too likely to fluctuate in a narrow band, lurching between aborted recoveries and frequent recessions. In time, inflation could come down to a tolerable rate, since the progress toward lower inflation in recessions is unlikely to be fully lost in the short-lived and incomplete recoveries. Still, one must ask, are these hardships necessary?

Furthermore, is such an economy likely to be conducive to an adequate rate of investment? The need to embody technological progress and to restore a decent rate of productivity growth is widely recognized. But the required capital formation is unlikely to occur in an economic environment in which either recession or astronomical interest rates are always just around the corner.

Most other industrial countries face similar problems, though the severity varies. In Europe, unemployment has passed 8.5 percent of the labor force, and idle youth pose serious political difficulties. The poor outlook is exemplified by a recent report of Germany's council of economic advisers-the so-called wise men-who proposed a program to boost investment in 1982 so as to increase the economy's rate of growth from 0.5 percent without the program to one percent with it. Japan has the best record on inflation, but its huge trade surplus is a reflection, at least in part, of inadequate growth of domestic demand. And the budget proposed by Prime Minister Zenko Suzuki for the next fiscal year will, despite the increase in defense expenditures, weaken domestic demand further.

The prescription set forth above, adoption of an incomes policy, also applies to most countries in Europe. Even before they found it necessary to dampen depreciation of their currencies against the strengthening dollar, they were using monetary policy to combat inflation that was not the result of too much demand but, as in the United States, was of the cost-push variety. And when monetary policy created sluggish economies that generated fewer tax revenues and required higher unemployment benefits, they tried to reduce the enlarged budget deficits, thereby aggravating economic stagnation.

What is needed in the industrial world is a determined attack on persistent inflation based on its essential nature-and almost everywhere today that is a self-sustaining wage-price cycle. Monetary policy is a very blunt instrument for damping such a cycle in economies suffering from insufficient demand. If the political bias and political obstacles to incomes policies could be overcome, the industrial countries would be in a position to restore a better rate of real growth. This would bring tangible benefits to their own citizens, in the form of lower unemployment and faster growing real incomes. It would provide an environment in which the developing countries, in all their diversity, would be more able to achieve or, for the lucky few, continue to enjoy rapid economic progress. And it would discourage protectionism, which always gathers strength when unemployment is high and factories are idle.

The lower inflation rates brought about by successful incomes policies would take much of the burden off monetary policy in the industrial countries. This in turn would permit significantly lower rates of interest. While exchange rates would continue to fluctuate over time, the extreme movements of the recent past would be less likely to occur.

At the risk of repetition, I would like to conclude by anticipating my critics. I am not proposing the abandonment of anti-inflation policy in favor of "pump-priming" or "Keynesian expansionism." Nor am I suggesting permanent controls. What I am proposing are anti-inflation policies that are more suited to the nature of the inflation that the United States and most other industrial countries are now suffering from. Even with present fiscal and monetary policies, a deceleration of inflation would result in faster real growth almost everywhere. In those countries that have tightened monetary policy in order to resist currency depreciation, some monetary relaxation would be possible. And in those countries that have tightened fiscal policy to combat recession-induced increases in budget deficits, some fiscal relaxation would be possible.

The sorry state of the world economy and the unpromising outlook call for new approaches. What many will regard as naïve or unworkable is worth a try. He who sleeps on the floor cannot fall off the bed.

1 Roger D. Hansen, "North-South Policy-What's the Problem?" Foreign Affairs, Summer 1980, p. 1105.

2 See, for example, Robert Solomon, "The Debt of Developing Countries: Another Look," Brookings Papers on Economic Activity, 2: 1981.

3 World Bank, Annual Report, 1981. p. 26.

4 It is set forth in "Assessment of U.S. Participation in the Multilateral Development Banks in the 1980s," Consultation Draft, Department of the Treasury, September 21, 1981, especially the section entitled Conclusions and Recommendations.

5 Newsweek, October 26, 1981, p. 43.

6 The pros and cons of tax-based incomes policies are discussed in Brookings Papers on Economic Activity, 2: 1978.

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  • Robert Solomon is a Guest Scholar at The Brookings Institution and formerly was Adviser to the Board of Governors of the Federal Reserve System. He is the author of The International Monetary System, 1945-1976: An Insider's View. The quoted phrase in his title is based on a remark by Otmar Emminger, former President of the West German Bundesbank.
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