The world economy has turned on the United States.

After an unprecedented seven years of peacetime growth, aided by declining real energy costs, cheap capital and, in recent years, expanding export markets, the free lunch ended. In 1990 U.S. economic expansion ground to a halt. Rising oil prices, a spreading capital shortage, tightening credit markets and the deadening burden of massive accumulated public and private debt took their toll. Moreover, frictions in the world trading system threatened to make the current recession one of unexpected length and depth.

Throughout the postwar period, the United States was accustomed to being master of its own economic fate. As the world's predominant economic power, America had the authority to mobilize other industrialized economies in time of crisis and to act unilaterally if necessary to protect its interests. But Washington and New York, once the world's preeminent political and financial capitals, must now share the spotlight with Tokyo, Bonn, Frankfurt and London. In this new multi-polar economic world, the United States is still the first among equals. But it no longer has the moral authority or the economic leverage to dictate the course of events. Leadership has of necessity become a collaborative effort. European and Japanese economic and political concerns now place real limits on U.S. action. The U.S. economy and American economic decision-making must now be adapted to an emerging global economy that no longer revolves around the United States.

The waning of the Cold War has changed the environment for U.S. policymaking. The internationalism of the Bush administration is frequently at odds with domestic isolationist elements on both the right and the left. In the past, foreign economic objectives were often subordinated to security concerns in a desire not to alienate allies. But without the constraint of the Cold War, America will not be as reluctant to aggressively pursue its economic goals. At the same time, it will have less leverage because Europe and Japan are less reliant on U.S. military protection. As a result, a more assertive America will confront a more assertive world, a prescription for confrontation.

II

The American economy emerged from the 1980s basically strong, but with some profound weaknesses. The dramatic rebound from the depths of the 1981-82 recession and the economy's prolonged period of recovery raised hopes that the tyranny of the business cycle had finally been broken. The structural reformation of the economy-downsizing of whole industries, creation of new jobs-surpassed all expectations. Expanding exports cut 40 percent off the 1987 peak of the current account deficit, the broadest measure of America's international financial health.

But recovery had a price. To fund its twin deficits, in trade and the federal budget, America went on a borrowing binge in the 1980s that left it the world's largest debtor nation, owing nearly three quarters of a trillion dollars. While the economy was more than capable of financing its obligations, the debt nevertheless constrained U.S. economic policy options. The federal budget deficit limited Washington's ability to use fiscal policy to pull the country out of an economic downturn, and the need to continue to attract foreign capital to balance international accounts hobbled the use of monetary policy to stimulate the economy.1

Previously autonomous decisions on domestic economic policy thus became hostage to international developments. It was no coincidence that President Bush's decision in the summer of 1990 to reverse his "no new taxes" pledge came only days before completion of the Structural Impediments Initiative talks with Japan, in which the United States was obligated to demonstrate a willingness to reduce its budget deficit. The Federal Reserve's reluctance to lower U.S. interest rates, put off until mid-December despite mounting signs of recession, reflected worries that high interest rates in Europe due to the cost of German unification would further slow the flow of capital to the United States.

The internationalization of the U.S. economy in the 1980s brought great benefits, but it also carried a cost. The bill has now come due.

III

The end of America's free ride on energy was one of several shocks to the U.S. economy in 1990. Iraq's invasion of Kuwait shattered the peace that prevailed in world energy markets since the mid-1980s. After declining 27 percent from January to June 1990, energy prices soared in August and fluctuated wildly in subsequent months.

The immediate impact of the price hike was devastating, because by 1990 the United States was importing virtually half of all the oil it consumed. Higher oil prices, like higher taxes, reduce aggregate demand in importing countries like the United States, Germany and Japan. They also increase inflation. A $10 rise in the price of a barrel of oil drains up to $80 billion from the American economy and, after the initial price shock reverberates through the economy, it translates into a two percent rise in prices. This, in turn, causes interest rates to rise and exports, recently the driving force of the American economy, to decline.

The industrial world was not the only casualty of the oil shock. Eastern Europe and much of the Third World were harder hit. Oil at $25 a barrel quadruples eastern Europe's oil import bill, making the region's economic prospects even more problematic. Higher oil prices may benefit oil-producing countries like Mexico and Venezuela by raising their export revenues, but the vast majority of indebted Third World states suffers. Higher interest rates increase debt-servicing costs for most Third World states, and slower worldwide economic growth reduces their markets for exports. With oil at $25 a barrel, heavily indebted nations lose about ten percent of their export earnings.

The political and diplomatic implications of these developments have only begun to be played out. The need for a steady flow of cheap oil from the Middle East has led to unprecedented U.S. military intervention in the region. The prospect of prolonged regional instability, even after the crisis is resolved, portends a permanent U.S. presence. The United States failed in the late 1980s to take advantage of economic growth and low oil prices in order to diversify its energy sources. This failure may dictate future U.S. military and diplomatic initiatives that were nearly unthinkable not long ago.

The Persian Gulf crisis and higher energy prices also threaten to undermine Washington's key strategic relationships. Already threadbare relations with Japan could further deteriorate. Although far more dependent on Middle East oil than the United States, Japan has been a reluctant supporter of U.S. policy in the region. Washington's pressure on Tokyo to send troops to Saudi Arabia has created a reservoir of ill will. That animosity could easily spill over to other issues between the two nations, even forcing a major Japanese reassessment of the security relationship. Higher energy prices could also indirectly strain relations with the European Community. As the energy crisis adds new stress for the already fragile democracies of eastern Europe, they are likely to place a new premium on closer ties with the EC. If those new relationships effectively discriminate against U.S. trade and investment, friction will inevitably ensue between Washington and Brussels.

Such dire prospects naturally depend on future trends in oil prices. Prices came down in December 1990 as the world oil market reestablished its equilibrium. Increased production by the Organization of Petroleum Exporting Countries (OPEC) offset the oil lost due to the U.N. boycott of Iraq and Kuwait. Moreover, higher prices and slower economic growth sapped the world's oil demand, and a million-barrel-a-day surplus was expected in the first quarter of 1991. Oil's supply-and-demand problem, in the short term, appeared to be solved. But this balance was fragile and extremely vulnerable: the aftermath of the war in the Persian Gulf or increased demand due to cold winter weather could send prices spiraling again.

IV

A global capital shortage, accompanied by a tightening of bank credit, was the second great shock to the American and world economies in 1990. Viewed from a macroeconomic perspective, much of this shock was a simple rebalancing of the global financial system. After running up a huge current account deficit in the 1980s, while Germany and Japan amassed surpluses, the United States was finally forced to try to balance its books. But a simple accountant's view belies the pain of that adjustment and the new economic and political relationships it engenders.

As their current account surpluses shrank, Asia and Europe emerged in 1990 as America's major competitors for world capital. Thus whereas trade was the primary source of friction among nations in the 1980s, in the 1990s it is likely to be capital. The competition for capital will increasingly sow international discord between the United States and its bankers: Japan, Germany and OPEC.

The U.S. economy, long a magnet for capital, lost its attraction. America's capital needs and economic policies no longer determined global capital flows. In the first half of 1990, for the first time in seven years, private investors took more money out of the United States than they put into it. Japanese investors led the way out the door. Notwithstanding some highly publicized takeovers, such as Matsushita Electric Industrial Company's $6.3 billion buyout of communications giant MCA Inc., Japanese investors withdrew almost $19 billion from the U.S. economy in the first nine months of 1990. Japan itself was simply a better investment opportunity. The Japanese economy was growing twice as fast as America's and had every prospect for relatively strong expansion in the years ahead. Moreover the Bank of Japan's effort to try to control inflation brought Japanese interest rates within one percent of our own, a difference hardly worth the exchange rate risk to potential investors.

Europe also became a capital sponge.2 EC investors poured almost $35 billion in new investment into the United States in the first nine months of 1989; in the first three quarters of 1990 they invested less than $11 billion. The impending creation of a single market in western Europe kept private European money at home and caused foreign capital to flow in. As a result, fixed business investment in Europe is expected to more than triple between 1985 and 1995. Additionally, German public demand for capital mushroomed to pay for the costs of unification: rebuilding eastern Germany's public infrastructure, raising its worker productivity, holding down unemployment by subsidizing jobs, and absorbing debts of former state-run firms. The German public sector deficit thus rose to 110 billion Deutsche marks in 1990, from 26 billion in 1989, increasing competition for credit and raising the cost of money.

The competition for capital was compounded by a global tightening of credit as banks hunkered down. Japanese banks, which provided 16 percent of U.S. commercial loans in the late 1980s, were buffeted by the collapse of the Tokyo stock market. Consequently, in the first half of the year they repatriated assets and held off new loans. The money problems of U.S. banks further complicated the situation. Loan portfolios were suffering from "adverse selection": Latin American loans left over from the late 1970s and overextended real estate loans from the late 1980s. There were also fewer top-flight corporate borrowers because most blue-chip corporations began to issue their own obligations. And in order to meet new international capital adequacy requirements set by the Bank for International Settlements, U.S. banks failed to relend much of the capital that did come in from abroad.

The rise in oil prices raised the prospect that OPEC, flush with a windfall of tens of billions of dollars this year, might again become America's banker, as it had after the first two oil crises. But this time, the reason for the increase-the Persian Gulf crisis-is likely to keep much of OPEC's new revenue in the Middle East, for military equipment, regional foreign aid and subsidies to the Pentagon. Much of the remainder will go to Europe or East Asia, where investment opportunities did not exist in the 1970s.

With foreign capital in short supply and little prospect of new injections of cash from abroad, the Bush administration and Congress were forced in 1990 to make a historic deficit reduction agreement. The accord promised to cut $492 billion from the deficit over the next five years. Such savings, in turn, could trim the U.S. current account deficit to a more sustainable $60 billion in 1995. But these cuts could also prove ephemeral. The savings projections do not take into account a costly war in the Persian Gulf. They are also premised on decidedly optimistic expectations: economic growth in excess of three percent a year and at least a two percent drop in interest rates. Judging from Congress' reaction, the budget agreement did cause some pain. It was nonetheless probably more significant as a political than as an economic event. More cutting needs to be done.

With limited new capital available from domestic savings, the widening global scramble for capital ultimately means that the U.S. economy is increasingly at the mercy of decisions made in Bonn and Tokyo. As a result, Washington will be inexorably drawn into the domestic economic policy debates of other countries; the outcomes of such debates are now vital to American well-being. For example, when the Bundesbank raised German interest rates in the spring of 1990 to stanch the anticipated demand for Deutsche marks to pay for unification, the move was quickly mimicked by the Bank of Japan. Increased interest rates then helped to precipitate a dramatic falloff on the Tokyo stock market, as Japanese investors adjusted their portfolios from low-return equities to higher-yielding bonds. That, in turn, accelerated the withdrawal of even more Japanese funds from the United States.

In an era of capital shortage, the United States clearly has a vital stake in the level of interest rates around the world. But Washington's ability to influence those rates is constrained. Both Japan and Europe are preoccupied with domestic events, less willing to follow the U.S. economic lead, and no longer convinced that their own prosperity depends solely on America's economic success. For example, disregarding domestic pressures, the Bank of Japan eased its monetary policy in 1987 and mobilized Japanese institutional investors to buy U.S. securities to support the dollar, averting a hard landing for the American economy. Today the Bank of Japan would not be so accommodating. Japanese monetary officials are now focused on controlling domestic inflation. Easy money is blamed for the run up in Japanese land prices in the late 1980s, which helped to destabilize the Japanese banking system. Moreover, a slowdown in Japanese export growth has placed a new premium on domestic economic expansion, which requires investment at home induced by high real rates of return.

When U.S. and Japanese domestic economic needs were at cross purposes in the past, Washington had different kinds of leverage over Tokyo: the threat of closing U.S. markets or of removing the U.S. security umbrella. Such threats ring increasingly hollow today. The only leverage the United States has left is to allow the dollar to sink to such a low level that Japanese exporters will force the Bank of Japan to ease monetary policy. And Washington can only play that card at the cost of the American standard of living.

Washington is also on the outside looking in as Bonn makes its domestic economic policy choices. It is clearly in the U.S. interest that the Bundesbank maintain low interest rates and that the Kohl government cut spending and raise revenues to forestall its mushrooming deficit. But American suggestions that Bonn alter its policies fall on deaf ears. Germany cut interest rates under U.S. pressure in 1978, and severe inflation ensued. While economists agree that there was no causal connection, politicians in Bonn have never forgiven Washington. The United States must now rely on Germany's European partners to try to force a change in Bonn's monetary and fiscal policies.

Finally, the global capital shortage has placed the United States in an ambiguous position with OPEC. America's need for capital, as well as oil, may increasingly help to shape a new relationship with these oil-producing states. Washington assumes that its defense of Saudi Arabia will oblige that nation to invest most of its capital in the United States. The Saudis, however, have an ever widening circle of investment options and new regional demands on their wealth. They may still choose to take their money elsewhere. Moreover, it is open to question who will gain leverage in the wake of the Persian Gulf crisis, especially if the United States has to keep troops in the region into the future.

V

Increasing trade frictions in 1990 underscored the new tensions in the United States between internationalism and isolationism, multilateralism and unilateralism, and free trade and protectionism. The Bush administration groped to find its way on trade policy, mixing a variety of unilateral, bilateral and multilateral initiatives. These mixed signals jeopardized American credibility on trade issues. If the current Uruguay Round of the General Agreement on Tariffs and Trade (GATT) fails to satisfy U.S. domestic constituents and Congress, demands for new unilateral initiatives could become overwhelming.

Named after the country in which the talks were launched in 1986, the Uruguay Round was the cornerstone of the Bush administration's multifaceted approach to trade. It rapidly turned into the first big test of international economic cooperation in the post-Cold War period. As the talks evolved, it became clear that the United States would no longer subordinate its economic objectives to security concerns. It was also evident that America had less leverage to get what it wanted from trading partners with divergent interests. The EC and Japan, for their parts, had an opportunity to demonstrate their commitment to a truly global economy, but they remained preoccupied by parochial concerns.

The talks broke down in December 1990 because of a stalemate over agriculture between the EC and the United States. Farm trade had not been adequately covered by GATT since 1955, when the United States sought a waiver for its farm programs. The subsequent creation of the EC's Common Agriculture Policy, with its billions of dollars in subsidies, gave politicians on both sides of the Atlantic reason to steer clear of changing the status quo. But farm subsidies have such a distorting effect on world trade that they can no longer be ignored.

As the Uruguay Round unfolded, however, agriculture became the linchpin of the talks. Agricultural exporting nations, including Australia, Argentina, Brazil and Canada, formed a coalition-the Cairns Group-to push for reform of farm trade as a prerequisite for a final accord. The developing countries threatened to block progress on services and intellectual property unless farm subsidies were reduced. In Brussels the EC refused to budge and the negotiations were suspended when several Latin American nations, followed by the United States, announced that further progress was impossible at that time. The rest of the world would wait for the EC to make the next move.

Because international trade negotiations are fundamentally deliberations about domestic policy, the talks may still be put back on track. The EC's business sector, transfixed by the potential benefits of integration, is a natural constituency for multilateral trade liberalization. While it has been unwilling in the past to take on European farm interests to force agricultural reform, it may press for change if its own interests are now threatened. If the Uruguay Round is to be successfully concluded, however, the United States must also be more flexible. Washington should lower its expectations of a virtual elimination of all farm subsidies. In any case, Congress must be notified by March 1, 1991, that a negotiated package is ready, and time is short.

VI

A major risk of failed multilateral trade talks is the impetus it will provide toward regionalism and protectionism. The Bush administration signaled its willingness to go this route when it announced in June 1990 the Enterprise for the Americas Initiative. In October it also requested expedited congressional authority to negotiate a wide-ranging free-trade agreement with Mexico. The Americas initiative envisions debt relief and trade agreements for every nation in the hemisphere, but so far the content has not been spelled out. Negotiations with Mexico are much further along. Barring disapproval by Congress, talks will begin in earnest in mid-1991.

These proposals come after the 1989 free-trade agreement with Canada and a more modest 1985 bilateral deal with Israel. Both agreements were justified by special circumstances: Israel for political and security reasons, Canada because of geographic proximity and economic interdependence. Mexico presents a similar special case. But after an agreement with Mexico, a series of hemispheric bilateral agreements would present almost insurmountable problems.

A western hemisphere trading bloc that includes most of the world's major debtor nations could make it extremely difficult for all of these economies to work their way out of debt. This is a particular concern for the United States, which must generate significant trade surpluses to service its debt, in part by reestablishing export markets in Latin America. Those nations, in turn, need trade surpluses as well to repay their obligations to American banks, among others. It will be impossible for all countries to run surpluses in a system of closed bilateral trading arrangements.

Bilateralism also has diplomatic ramifications. The essence of bilateral pacts is favoritism, which inevitably creates foreign-policy problems with those who are discriminated against. Some countries must be left out. By what criteria will they be chosen and who will decide? In the United States, Congress will have a role to play. Domestic political interests, already apparent with organized labor's opposition to the Mexican agreement, will further complicate these policy decisions. Members of Congress will inexorably be drawn into the micromanagement of such bilateral deals in ways unthinkable in broad multilateral arrangements.

A series of bilateral free-trade agreements or a regional trading bloc in the Americas would also create thorny legal, institutional and political problems. In lieu of a common legal code and method of jurisprudence, an institutional apparatus would have to be adopted to establish rules and procedures for settling disputes. Some issues will inevitably defy easy solution. If Nicaragua were a member and the Sandinistas resumed power, could the United States expel them from the bloc? Such issues have not yet been thought through, but should be soon; the Americas initiative will gain more momentum once the GATT talks are concluded.

A breakdown in the GATT's Uruguay Round could also trigger more unilateral trade actions by the United States. The Bush administration discouraged the filing of unfair trade practice cases in 1990 to avoid antagonizing its negotiating partners just before the conclusion of the round. But many such cases, like the long-threatened action against Japanese barriers to imported rice, could be activated in the environment of frustration that will likely prevail if the Uruguay Round finally fails. If the White House begins to pursue unilateral actions more aggressively, Congress may be only too willing to lend its support. Last fall a presidential veto was all that prevented Congress from radically restricting textile imports. Congress has also tried to retract executive "fast track" negotiating authority-its agreement with the president to vote on trade pacts within 90 days of their submission to Congress with no amendments. While this effort failed, by the end of the year 37 senators had sponsored a resolution to revoke "fast track" provisions, thus raising doubts about congressional willingness to extend that authority if the Uruguay Round needs more time.

Congress has also threatened to reinstitute the "Super 301" provision included in the 1988 Trade Act, which requires the identification of unfair trading countries and sets a timetable for negotiating the dispute and for possible retaliatory actions. Super 301 was first applied in May 1989 against Japan, Brazil and India with significant effect. Japan agreed in the spring of 1990 to open its markets for lumber, satellites and supercomputers. And Brazil promised to improve protection of intellectual property. Only with India, which refused to negotiate under threat of sanctions, did the Bush administration fail to make progress. As a result, India was again named as an unfair trader in April 1990. While Super 301 authority has lapsed, some senators would like to give the administration new authority to tackle trade problems in this unilateral fashion if the multilateral approach breaks down. After all, President Bush has demonstrated that unilateral action can bear fruit.

These pressures toward regionalism and protectionism are not unfolding in a vacuum. There has been growing American frustration over a perceived lack of allied burden-sharing for the multilateral effort in the Persian Gulf. After the war, this resentment could spill over to trade issues as well.

At the same time, the emergence of European, East Asian and North American trading blocs may foster regional security perspectives. This will only reinforce the narrow security interests manifested by some Europeans and Japanese in the Persian Gulf crisis. It could also accelerate America's retrenchment from its role as guarantor of global security. A world with three roughly equal economic powers may have no country willing to take responsibility for collective security.

VII

Frictions over trade, capital and oil in the last year were aggravated by a breakdown in fiscal and monetary coordination by the Group of Seven (G-7) major industrialized countries. This was especially evident in the saga of the dollar. The dollar declined significantly in 1990 and most analysts felt it would have to fall even further if the U.S. external account was to come close to balance. The Treasury Department seemed satisfied to let the dollar slide in an effort to breathe new life into exports. But unlike previous retreats of the dollar, which were measured and appeared choreographed, there was little evidence this time that Treasury was anything more than a spectator. The perception that the dollar had no floor, and that Washington was unwilling or unable to build one, only exacerbated the U.S. economy's capital shortage. Rather than rushing in to buy American assets at fire-sale prices, foreign investors pulled even more money out of the economy in anticipation that existing asset values would continue to shrink.

In the past America's needs with regard to the dollar dictated international action, as evidenced by the G-7's highly successful "Plaza accord," struck at its 1985 meeting in New York, and the ill-fated 1987 "Louvre accord." But the U.S. international monetary agenda no longer prevails. Other nations were willing in 1990 to let the dollar fall to serve their own domestic interests, not those of the United States. While a weak dollar and strong yen hurt Japanese exporters, Tokyo's monetary officials felt the sacrifice was more than offset by the benefits. A stronger yen negated the rising cost of imported oil (priced in dollars) and made it easier for Japanese banks to meet new asset requirements. Germany similarly gained: a strong mark attracted capital to pay for unification.

The coup de grace came in the first week of November, when French Finance Minister Pierre Bérégovy called for a meeting of the Group of Seven, ostensibly to halt the slide of the dollar. Paris' ulterior motive was to enlist Washington's help in staving off a further rise in German interest rates and in pressuring Bonn to raise taxes. Rather than being the leading actor in the drama, the United States was a foil for the actions of others.

The planned creation of a European Economic and Monetary Union (EMU) and eventually a single currency will further alter the power relationship between the United States and Europe on monetary and fiscal issues. The EC agreed in October 1990 to establish by January 1, 1994, a European central bank. An intergovernmental conference began in December to negotiate the details. In the past, even when the European Monetary System formally linked EC currencies, trans-Atlantic monetary relations were essentially bilateral. The depth and breadth of the market for the dollar gave the United States enormous leverage. Washington could talk down the value of the dollar and force Bonn and Tokyo, which saw their U.S. export markets evaporating, to begin expansionary domestic economic policies. The emerging self-sufficient single European market will be increasingly immune to the arm-twisting effects of threatened dollar depreciation.

The EMU is also likely to transform the international economic coordination process industrialized nations have fitfully pursued over the last decade and a half. The emergence of an industrialized world Big Three-Europe, Japan and the United States-will place a higher premium on coordination. At the technical level, creation of a European central bank, with one currency and one bureaucracy, will presumably make that coordination easier: transaction costs will be reduced. But in reality coordination could become more difficult. Greater symmetry could generate greater instability if it creates more of an incentive to manipulate exchange rates for domestic purposes.

A clearly stated mandate in its charter to maintain price stability, above all else, could hinder the European central bank's ability to ease monetary policy for international coordination. Much depends on the personal chemistry of the decision-makers. American officials have long found German Bundesbank personnel more difficult with which to deal than the leaders of the Bank of Japan. An emboldened Bundesbank, newly confident in its leadership, perhaps even dominance, of the European central bank may be even less likely to cooperate with Washington. And if the new European central bank is truly independent of the political process, like the Bundesbank and the Federal Reserve, then it may be harder for governments to put their international economic agreements into practice.

The United States and Japan could now find negotiating macroeconomic policy with the EC as difficult as negotiating trade policy, where the Community's position is almost immutable after it has been negotiated internally among 12 governments. Because Brussels lacks substantial power to tax and spend, fiscal outcomes in the member states will condition EC monetary policy. Conversely, central policy under EMU will put greater pressure on member states' fiscal policies to achieve domestic objectives. This could have adverse effects on interest and exchange rates and on the international economy in general. A situation like that which occurred in the United States in the early 1980s-tight monetary policy and loose fiscal policy-is all too possible. International coordination of fiscal policy becomes more important, but also more difficult. The head of the European central bank might be able to agree with his or her counterparts in the United States and Japan, but who among the 12 member states will serve as the EC's finance minister to negotiate on fiscal policy?

Finally, the new European currency will increasingly challenge the dollar's role as the world's key currency. The dollar has long been the medium of exchange all over the world. More and more, however, trade and assets are yen and Deutsche mark denominated. In a symbolic gesture, some of the assets of the new European Bank for Reconstruction and Development will be denominated in European Currency Units, the first multilateral institution to do this.

Thus, EMU fundamentally changes the power relationships among Europe, Japan and the United States on monetary issues. The EC may soon be able to trade off macroeconomic changes for other objectives on trade or security issues.

VIII

Is the end of the longest peacetime economic recovery finally at hand? The Organization for Economic Cooperation and Development (OECD) expects that the U.S. economy will contract in the first half of 1991 and expand by no more that 0.9 percent for the full year, compared with 2.5 percent growth in 1989.

But even these forecasts may be optimistic. When the effects of rising oil prices are looked at, not in isolation, but as part of a dynamic process involving greater competition for capital, the global tightening of credit and blossoming trade conflicts, growth prospects look far worse and the recession promises to be deeper and longer than anticipated. Eventual economic recovery may be less robust than normal because U.S. financial institutions are saddled with such poor quality assets that they lack the capacity to expand credit. Moreover, prospects would dim even further should the war in the Middle East turn out to be costly and protracted.

Strong demand for capital has effectively placed a floor under the price of money. Higher interest rates are likely to have a stronger drag on the U.S. economy, as the weakest of the three major regional economies, than on those of Europe or Japan. At the same time, balance-wary banks are expected to keep their growth in lending at modest single-digit levels well into the 1990s. As a result, small- and medium-sized U.S. firms are likely to find it more difficult to obtain capital than at any time since the 1960s, further constraining the economy's growth prospects. Developments in the trade arena, moreover, suggest there is little chance the United States can use exports to breathe new life into the economy, as it did in the late 1980s. Exports had been the motive force behind U.S. economic growth, accounting for almost half the increase in gross national product from 1988 through the first six months of 1990. But they have finally begun to run out of steam. Exports of goods and services, which grew by 11 percent in 1989, may grow by less than half that in 1991.

Even the falling value of the dollar may not reverse this slowdown in exports, due to uncertainties in foreign markets. Great Britain and Canada, which buy more than a quarter of U.S. exports, are themselves headed into recessions. Japan, which was steadily increasing imports from the United States, anticipates sharply lower economic growth as well, and Japanese industrialists acknowledge that they will first cut back on purchases from foreign suppliers. OPEC will increase its imports of U.S. products in the near term, but the size of its markets do not allow it to be anyone's savior.

As exports slow, foreign trade barriers, ignored in times of expanding markets, suddenly invite confrontation. At the same time, domestic manufacturing interests are likely to be increasingly wary of trade liberalization and to fight for protection under trade remedy laws that almost entitle them to relief from import competition. All of this may portend ill for the GATT; a recession is not the best time to close a multilateral trade negotiation.

IX

In the precarious economic times ahead, the growing interdependence of economies will dictate new U.S. policy initiatives.

Until the United States becomes more energy self-reliant, dependence on imported oil will continue to exact a heavy economic and diplomatic toll. America now uses more than twice as much energy to produce a dollar of gross national product as France, Germany or Japan. Improving energy-use efficiency to European or Japanese levels would help to insulate the United States from the vicissitudes of world oil markets.

At the same time, Washington should initiate discussions with its allies about future responsibility for the defense of Middle East oil supplies. The Persian Gulf crisis exposed differing allied perceptions of how best to safeguard common interests. Germany and Japan are likely to continue to be reluctant to use force, except in immediate self-defense. American resentment about the lack of burden-sharing for the gulf operation could undermine U.S. willingness to take the lead in future such situations, jeopardizing the global nature of postwar security arrangements. Disagreement over how best to ensure future energy security is a time bomb in the alliance. It needs to be defused through the development of an allied consensus over what constitutes threats to global security in the post-Cold War world and how the burden of paying for that security should be shared.

The need for joint action in response to macroeconomic developments in Europe and Japan is equally clear. In the wake of German unification, west European integration, east European liberation and the emergence of Japan as an economic dynamo, the United States must contemplate international initiatives aimed at reorganizing the world economy. This should be done while the United States still has the clout to protect its interests, and before Europe and Japan go their separate ways. Indeed, as the EC grapples with EMU, petitions for membership and economic upheaval in the east, it is likely to be perennially preoccupied. Keeping the EC actively engaged in multilateral initiatives will be a challenge of the first order.

Greater symmetry among the major economies has strengthened the case for closer economic policy coordination. Common objective indicators of economic well-being have already been developed by the G-7 nations. These should now be used to guide and enforce economic coordination, so that interest rates, exchange rates and other key economic indicators do not dramatically diverge. New procedures to ensure follow-up and monitoring of economic summit agreements should also be considered. The time may even have come to establish a permanent secretariat, with officials seconded from the major industrialized countries, to scrutinize economic summit pledges. By institutionalizing coordination, the United States can derive some of the domestic benefits of externally imposed economic discipline, while ensuring that the economic policies of other countries are tempered by the needs of the American economy.

Regardless of the outcome of the Uruguay Round, Europe, Japan and the United States will continue to have trade frictions that will prove costly unless they are amicably resolved. Washington should now begin to focus on crafting a post-Uruguay Round multilateral trading environment, one that both constrains U.S. protectionist impulses and guarantees that the trade and industrial policies of Europe and Japan do not harm American interests. Creation of a new World Trade Organization could provide that new framework. Such an institution, as a successor to the GATT, could implement the results of the Uruguay Round and also provide a venue for ongoing international trade negotiations. This organization could also help to ensure that, as the trading blocs now emerging in Europe, North America and possibly East Asia expand and adopt new rules on trade and investment, they do not discriminate against outsiders.

Specific trade conflicts between the major industrialized powers may deserve special attention in order to avoid damaging diplomatic spillovers. U.S.-European and U.S.-Japanese dispute resolution panels should be established to handle such quarrels. These panels could be based on the successful approach created under the U.S.-Canadian free-trade pact. Also, because many trade conflicts can be traced to the clash of different competitive environments, an American-EC dialogue should be launched on harmonization or mutual recognition of regulations, industrial subsidies and other government actions that affect international commerce. This interchange could be patterned on the U.S.-Japanese Structural Impediments Initiative talks and lay the groundwork for broader negotiations involving all major industrialized nations, possibly under the auspices of the OECD.3

If the United States is to remain an economic leader in the world, it must adapt its leadership style to the increasingly interdependent nature of the global economy. At a time when virtually all domestic policies have international implications, economic leadership is best exercised first at home. For the United States, that means cutting the federal budget deficit even further. It also means increasing incentives for private savings. Only in this way can the United States reduce its dependence on foreign capital, easing the global capital shortage and minimizing the inevitable drag on the U.S. economy of high world interest rates.

As economics supplants defense as the foundation of national security, Washington must give new priority to international economic policymaking. The economic arm of the National Security Council needs to be strengthened. Responsibility for coordinating international economic policy, now scattered throughout the executive branch, should be centralized in the White House. The president may need new powers, such as fast-track authority to raise or lower taxes for limited periods of time, in order to have more flexibility in coordinating economic policies with other industrialized nations. Domestic political changes should also be considered, such as reform of campaign finance laws, to insulate politicians from protectionist pressures.

With Europe and Japan emerging as its economic coequals, the United States can no longer afford to play the role of Henry Kissinger's "Lone Ranger." A more appropriate leadership model may be found in Prince Metternich, the consummate nineteenth-century Austrian diplomat who crafted a stable European order through consensus building. Consensual leadership should not be confused with accepting the least common denominator. The United States must continue to shun the parochial perspectives held by many Europeans and Japanese. The liberal multilateral trading system was the product of America's global economic vision. While that ideal may be tarnished, and the United States may lack the leverage to ordain it, it is no less important a goal.

Reform of U.S. economic policies, a necessary adaptation to a changing world, will be no easy matter. If such changes can be effected, however, 1990 may yet be remembered not as the year the global economy turned on America, but as the year that inspired the United States to begin to fashion a new role for itself in the world economy of the 21st century.

1 For an analysis of the legacy of the 1980s, see C. Michael Aho and Marc Levinson, "The Economy After Reagan," Foreign Affairs, Winter 1988/89.

2 See Bruce Stokes, "Trans-Atlantic Shock," National Journal, April 21, 1990.

3 See Sylvia Ostry, Governments and Corporations in a Shrinking World: Trade and Innovation Policies in the United States, Europe and Japan, New York: Council on Foreign Relations, 1990.

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  • C. Michael Aho is director of economic studies and the International Trade Project at the Council on Foreign Relations. Bruce Stokes is the international economics correspondent for National Journal.
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