In the summer of 1971, President Nixon and Secretary Connally revolutionized U.S. foreign economic policy. In so doing, they promoted a protectionist trend which raises questions about the future of the U.S. economy at least as fundamental as those raised by the abrupt adoption of wage-price controls. In so doing, they have also encouraged a disastrous isolationist trend which raises questions about the future of U.S. foreign policy at least as fundamental as those raised by the President's essentially positive and decidedly non-isolationist China initiative, Vietnam policy and negotiations with the Soviet Union. Both the U.S. economy and U.S. foreign policy for the relevant future hang in the balance.

The President decided to seek a massive improvement in the U.S. balance of payments-substituting aggressive concern for our largely "benign neglect" posture toward the deficits of the last decade. He terminated the convertibility of the dollar, shattering the linchpin of the entire international monetary system-on whose smooth functioning the world economy depends. He imposed an import surcharge, proposed both the most sweeping U.S. export subsidy in history and discrimination against foreign machinery by making it ineligible for the Job Development Credit, bludgeoned East Asia into a "voluntary" restraint agreement on textiles, and sought to extend and tighten the existing "voluntary" agreement on steel-completely reversing the traditional position of U.S. administrations in resisting protectionism and leading the world toward ever freer trade. He abandoned the essential Executive role as protector of foreign aid and joined the competition to gain domestic political credit for cutting it, contributing directly to the near-scuttling of the entire aid program in the Senate just two months later. He violated the letter and the spirit of the reigning international law in both the monetary and trade fields, reversing the traditional American role of leading the effort to strengthen the rules governing global conduct

Most Americans, and many foreigners, can support the broad objectives enunciated by the Administration. The world economic roles of America must be reconciled with the growth to power of Europe and Japan. There must be fundamental reform of the international monetary system. There must be renewed efforts to reduce world trade barriers. The underlying U.S. balance of payments has deteriorated. The yen had to be sharply revalued.

But the new foreign economic policy went much too far. It set impossible objectives, both quantitatively and qualitatively. It has been alternately pursued with violent hyperbole and supreme indifference. It appears based on some totally erroneous, and exceedingly dangerous, theory that the United States has played Santa Claus to the world for the last 25 years. It is wrong for the American economy, for it risks immediate losses of jobs and investments, as well as long-term insulation from the indispensable impulses of global competition. It courts disaster for U.S. global interests, as spelled out below. It has suffered from the American tradition of waiting too long to act, then lunging unpredictably from one extreme to the other, instead of proceeding deliberately to a new equilibrium. Its dangers increase exponentially as time passes with no resolution of at least the issues of immediate urgency which it has raised. Quick action is needed, by the United States and major foreign countries, to avoid the most serious breach in the world economy and international politics since World War II. The signs of progress in early December toward resolving some of the immediate issues are thus highly welcome.


The international component of the New Economic Policy was wholly unnecessary.

To be sure, America was running a large balance-of-payments deficit. The deficit was due primarily, however, to the huge international movements of liquid capital which are so prevalent in today's world economy. Such capital had moved massively out of the United States since early 1970, when U.S. interest rates declined at record speed and Europe persevered in its effort to fight inflation by maintaining tight money. It could be expected to move back to the United States just as massively when the interest rate differentials narrowed again. Indeed, precisely such inflows to the United States occurred in both 1966 and 1968-69, causing large U.S. payments surpluses and forcing Germany to sell us gold to help meet the resulting dollar shortage. Deficits caused by such transitory events hardly call for the counter-measures of last August.

In addition, private speculation entered the picture twice: in favor of the German mark in May, and against the dollar in late July. The floating of the mark ended the first episode. The second was due primarily to the hugely inflationary wage settlements of the summer in steel and several other key U.S. industries, and resultant fears that the United States had not only lost the battle against inflation but given up trying to fight it. This reminded us that a stable and dynamic U.S. domestic economy is the key to a sound American external financial position and world confidence in the dollar. The freeze, its successor stabilization program, and proper monetary and fiscal policies were thus the proper antidote for "the international money speculators" as well as for domestic inflation per se.

It is highly significant that there are as yet no reports that foreign holders of dollars had lost their cool before August 15th, and demanded sizable amounts of U.S. gold. There is little evidence that they would have done so at any later time which might have proved more politically embarrassing to the present Administration. Even the existence of such a risk, however, would have justified at most the suspension of gold convertibility-not the panoply of protectionist trade and isolationist aid measures which accompanied it.

Inflation, past and present, had of course eroded the international competitive position of the United States. However, structural changes in both the U.S. economy and external position have sharply reduced the size of the trade surplus needed for overall U.S. payments equilibrium since the trade surplus high of $6.8 billion in 1964. Annual income on our foreign investments has risen by over $6 billion, foreign long-term investment in the United States has risen by several billion dollars per year, and foreign capital markets are able to take a large part of the load borne almost solely by the United States at that time. All these trends continue to move in our favor. Overseas military expenditures and U.S. interest payments to foreigners have risen significantly since 1964, but both are coming down as we withdraw from Vietnam, dollars flow back to the United States, and our interest rates decline. Tourist spending and outflows of U.S. private capital have continued to rise, but not nearly enough to require a return to the 1964 level of trade surplus to achieve overall payments equilibrium.

The bulk of the deterioration in the U.S. trade surplus in early 1971 was in fact due to purely temporary factors, and our long-term shift was fully mirrored in the improved positions of just three countries: Japan, Germany and Canada. Remedial action was called for-and was already taking place. The mark was revalued by 9 percent in late 1969, and had moved upward another 8 percent since being floated in May 1971. The Canadian dollar had floated up by 8 percent since May 1970. In addition, the Netherlands, Switzerland and Austria had appreciated their currencies by smaller amounts. The full payments effects of exchange-rate changes take at least two years to appear, but the process of adjustment was underway well before August.

There did remain one big exchange-rate problem: Japan. Much of the blame for the present turmoil must be laid on its doorstep, although the standard U.S. perception of Japan today over-estimates by far both its competitive invincibility and the real trade effects of its remaining controls. In addition, the greatest tragedy of the U.S. textile effort is that it absorbed virtually all of the attention of the two governments in their economic relations from early 1969 through mid-1971. The exchange rate and overall trade policy issues, with their much wider effects, were permitted to fester unattended. The U.S. government apparently made no serious effort before August to get Japan to meet its international economic responsibilities, though the United States demonstrated shortly thereafter- on textiles-that it was willing to apply great leverage to achieve objectives deemed of truly great importance.

Finally, political pressure was certainly mounting for protectionist trade legislation.[i] The New Economic Policy would help preëmpt a quota bill if it brings a prosperous domestic economy, reduced inflation, a significant exchange-rate realignment and greater flexibility of exchange rates, and a new credibility for administration toughness in negotiating U.S. foreign economic policy. However, except for Japan, the major exchange rates had already moved. There had been no major effort to negotiate a yen revaluation, or the needed changes in the monetary system. Negotiating credibility in trade matters could have been achieved at any time by the adoption of specific retaliatory measures against any foreign barriers which were illegally restricting U.S. exports. The Administration has announced no progress whatsoever in developing a new adjustment assistance program to cushion the domestic effects of freer trade, one crucial element in restoring a progressive trade policy. No effort to build the needed new coalition of political constituencies, to combat the concentrated push of organized labor, can be observed. The import surcharge, the other trade moves, and the rhetoric accompanying the whole effort actually foster domestic and foreign protectionism. So the new international policy is hard to justify on these grounds as well, except as an admission of total neglect in seeking similar ends through far less risky means.

There are only two plausible interpretations of the real rationale behind the international component of August 15th, aside from simple error or misjudgment. The first is that it represents a straightforward effort to export U.S. unemployment to other countries. Unemployment is our cardinal domestic problem at the moment, but exporting it to others is unacceptable in principle and cannot possibly work anyway. Indeed, precisely such an effort contributed mightily to throwing the world into its deepest depression in modern history. It is fully legitimate, of course, to seek adequate trade improvement to achieve the needed payments position. Seeking sufficient trade improvement to achieve a huge payments surplus is illegitimate, however, and the Administration target of a $13 billion swing would do just that Seeking sufficient trade improvement to permit sharply increased U.S. capital outflows, in effect changing the structure of our balance of payments, is also unacceptable to such unlikely allies as the AFL-CIO and the Common Market. So the excesses of the present approach connote pure mercantilism at its worst, and belie the reasonableness of its broad objectives.

The second interpretation is that the Administration concluded that the United States needs a large trade surplus to maintain its international political power. This view is true only to the extent that a surplus is needed to support a liberal trade policy, which does carry considerable political weight though making little economic sense. Such a conclusion ignores all of the empirical evidence, however: Britain was in trade surplus in only four years of the century of the Pax Brittanica, and the U.S. world role well survived the sharp decline in our trade balance in the late 1950s. In fact, a "weak" payments position has on balance promoted U.S. international objectives heretofore; at most, an equilibrium payments position is needed to underpin a continued active world role for the United States.


The New Economic Policy could produce dramatic improvements in the international monetary and trading systems, and deserves unstinting support toward those ends. But it is an extremely high-risk strategy, and could lead instead to extremely damaging effects on national economies around the globe.

The policy could easily lead to the first real international trade war since the 19308. The surcharge and discrimination of the Job Development Credit are already having an addictive effect domestically, and will be increasingly difficult to lift as individual industries become accustomed to their protection. The arithmetic is simple: an industry now protected by the ten percent surcharge plus a ten percent appreciation of the yen will not want to swap the combination for a 12 to 18 percent yen revaluation, especially if it is now helped by the "Buy America" rule as well. And the textile and steel deals, while they may reduce the zeal with which these industries seek quotas themselves, legitimize protection for others on "equity" grounds.

The difficulty is compounded by the domestic politics of U.S. trade policy. The AFL-CIO has already begun to rally support behind the incredibly protectionist legislation which it will seek in 1972. Since organized labor has made trade and foreign investment one of its top priority issues, both parties will be sorely tempted to support such legislation at least partially in the coming election campaign-as they woo the huge labor vote, which is less committed now to either of the two major parties than in any presidential election since World War II. If the surcharge is still in effect when labor begins to push, then its permanent retention will look to many like a moderate compromise. The President himself presaged such a comparison last August, when he asserted that the surcharge was superior to import quotas-a true statement about a false choice, since no one was even thinking of trying to pass a quota bill in 1971. The only possible reconciliation is that he foresaw the surcharge as much more permanent than was implied at that time, a reading which was reinforced by his own press conference statement of September 15th. The continued retention of the surcharge, when the floats have already produced most of the needed revaluations-despite the fact that the surcharge itself brakes them-adds to the fear that it is being turned from a temporary negotiating lever arid payments adjustment measure into a permanent protectionist device.

The surcharge, even on its avowedly temporary basis, has already begun to produce emulation and reaction abroad. It could not help but do so, since it directly affects jobs throughout the world. Canada, which reacts first to U.S. economic moves but often accurately forecasts countermeasures elsewhere, moved quickly to provide domestic subsidies to its exporters hurt by the move. Denmark cited President Nixon by name in justifying its own adoption of an import surcharge. Japan will probably slow its trade liberalization. The DISC export subsidy,[ii] if authorized by law, will certainly be emulated. And retaliation does not require overt import restrictions abroad: quiet pressures by European governments could seriously disrupt the activities and profits of the European subsidiaries of U.S. corporations, and Japan's quasi-public purchasing agencies could sharply reduce their purchases of U.S. farm goods. If the U.S. surcharge came to be seen as a permanent feature of the international landscape, retaliation and emulation would be swift and certain, if not always open and obvious.

Beside such specific effects, the whole debate has been shifted by the Administration's moves and rhetoric. Exporting unemployment has been sanctioned. The President himself has made protectionism respectable, whereas he had previously deviated from the principles of liberal trade only for textiles, for well-understood if deplorable reasons. The broad message to Congress and the public is that the Executive, by far the most powerful-and sometimes the only-bastion against protectionism in the United States, has also switched sides.

The potential effects of this switch are magnified enormously by the vast expansion of presidential legal power to act in the trade field implied by the recent acts. Was the surcharge legal? Most lawyers had always thought it would require congressional action. Was it legal, not to mention judicious, to invoke the Trading With the Enemy Act as authority to apply textile quotas against Japan unilaterally and thus force it to "voluntary restraint"? Was it not ludicrous to call the balance-of-payments situation a "national emergency" sufficient to justify invoking that Act, when the deficit at its peak amounted to less than one percent of our gross national product and when the textile effort began more than two years earlier when our payments were in large surplus? Such an expansion of executive power will obviously create domestic political pressures to use it again and foreigners will fear that it will be precisely so used.

Continuation of the status quo threatens the world economy through monetary as well as trade effects. Truly floating exchange rates would help solve international economic problems, but the present array of "dirty floats" could seriously exacerbate them. Individual countries will be increasingly subjected to domestic pressures to reduce the appreciation of their rates or even to depreciate them against the dollar, to regain competitive advantage, and most have already acted in precisely this direction. The wholesale destruction of the international rules governing exchange-rate changes, completed by the suspension of dollar convertibility, makes this one of the easiest means to "retaliate" against the U.S. protectionist devices. We, of course, triggered the "dirty floats" ourselves, by coupling the surcharge with our suspension of convertibility. Trade wars could become full economic wars, precisely as they did under similar international conditions in the 1930s.

These reactions to such a U.S. policy could have been expected at any time. But they come at a particularly dangerous moment because of the poor economic outlook in numerous key countries: unemployment is higher in Canada than in the United States and higher relative to historical norms in Britain; much of Europe is in or headed toward recession, and Japan has experienced a sharp slowdown. The danger is particularly acute because of the uncertain economic outlook in our country, and the consequent tremendous pressure on the Administration to show results, especially in reducing unemployment, in time for the 1972 election-results whose popularity would hardly be diminished, in this period of rising isolationism, if they were achieved partially at the expense of foreigners. Aside from the principles involved, this is the worst time in the postwar period to risk such an effort-and it is hard to believe that the weekenders of Camp David would have tried it had they considered the world, rather than just the American, economy.

The uncertain outlook for the world economy heightens the need for precisely the opposite approach to foreign economic policy, both here and abroad. Mercantilist efforts to achieve full employment at the expense of others are doomed to fail, because domestic politics in all countries assure that all will play the same game. In fact, such efforts are counterproductive in meeting today's economic dilemma, because they foster inefficiency and monopoly and hence exacerbate inflation. The only effective economic policy approach is to use domestic fiscal and monetary policies to restore and maintain full employment; institute an effective balance-of-payments adjustment mechanism so that such policies will not produce intolerable external financial difficulties; and develop effective incomes policies and other selective measures, including maximum liberalization of world trade, to restrain inflation. A throwback to trade restrictions and competitive depreciations would lead just where they did once before-toward a world depression. And it would make it impossible to agree on new exchange rates, the only way to really improve the U.S. balance of payments and increase U.S. jobs.


These economic effects would have a disastrous impact on U.S. foreign policy, and on our own national security.

Continuation of our military commitments to NATO have already been undermined by xenophobic rhetoric, and a tough European reaction to our moves would add dramatically to existing congressional disenchantment with present force levels. Incredibly, the Administration has contributed directly to such sentiment by again demanding better "burden-sharing," after having apparently cooled the issue less than a year earlier, and after rallying the entire foreign policy community to help defeat the Mansfield Amendment only a few months ago.

Such a reduction in the credibility of U.S. military support for Europe would threaten Chancellor Branch's Ostpolitik in the short run, and push Germany toward either accommodation with Moscow or extreme nationalism over the long run. It would push all Europe toward neutralism by strengthening neo-Gaullists within all major countries there and by creating an anti- American attitude which would render pragmatic problem-solving across the Atlantic increasingly difficult. The evolution of the Common Market could easily take on a distinctly anti-American flavor, self-fulfilling the prophecies of those who have always viewed it as counter to U.S. interests and thus pitting the United States against one of the dominant political drives in Europe-now including Britain, perhaps our closest ally. It would become almost impossible for us to do business constructively with Europe in such an atmosphere, on the whole range of issues where we interact daily, from trade and investment themselves to nuclear coöperation and allied defense.

Japan, the key influence in Asia for at least decades to come, has been badly shaken internally and has already begun to reconsider whether her whole national policy should continue to be based overridingly on close ties to the United States. Canada is making the same reappraisal, though it has little alternative. The less-developed countries, which were given favored treatment under all major balance-of-payments measures previously taken by the United States, were singled out for adverse treatment-the aid cut, the new trade barriers to their most dynamic export industries, demolition of any possibility of U.S. trade preferences in the foreseeable future, new uncertainties to cloud their development efforts. Even worse politically, they have no control at all over the unfolding events; they will continue to face the surcharge until the industrialized countries reach a negotiated settlement. It is no surprise that these countries see August 15th, and the subsequent events which it triggered, as further confirmation that the United States has copped out of helping them with the problems which they deem most important to their national futures. No area of the non-communist world is left unscathed by the new approach, which ignores domestic politics abroad as fully as it now caters to domestic politics at home.

Indeed, America is now pursuing two separate and contradictory foreign policies. This comes as no surprise to students of bureaucratic politics, since different people are obviously running each. But the new economic approach, coupled with the coming presidential visits to Peking and Moscow, produce the most bizarre U.S. foreign policy imaginable: war on our friends, concessions to our traditional adversaries. Even within the economic area itself, the Administration has achieved the desirable objective of moving the communist countries toward most-favored-nation treatment by the highly undesirable method of raising our duties toward everyone else. This dual policy is doubly dangerous at this time, as the new overtures have already made our friends extremely nervous-witness Japan regarding Peking, and Europe regarding the Strategic Arms Limitation Talks (SALT)-and thus heightened, not relieved, the need to take their sensitivities fully into account.

It is ludicrous for the United States to call for a new sharing of responsibility among allies, and then unilaterally unleash a bombshell which both upsets such coöperation directly and makes it more difficult, economically and thus politically, for others to contribute. Or to call for an era of greater equality among allies, and then to seek to dictate terms of settlement on the central internal political issues of others. Or to call for a liberal trading and payments system, and then break all the rules and seek to export unemployment. Or to mount a massive campaign to defeat the Mansfield Amendment and cool the burden-sharing issue, and then to provide new ammunition for the next Mansfield attempt by stridently accusing Europe of not pulling its weight. Or to call for an era of consultation, and then use public rhetoric to impugn both the motives and policies of others. Or to refer to aid as a central component of the Nixon Doctrine, and then pull the rug from under it. Or to deplore abrupt shifts in policy as unsettling, and then reverse course overnight on every fundamental aspect of foreign economic policy.

Even those who argue that the United States "would win a trade war" admit that this means only that we would lose less in economic terms than would others. Some say this is enough to deter others from lashing back, especially when they consider their reliance on the United States in security terms as well. But such restraint is almost inconceivable in major countries with self-respect in today's global mood of virulent nationalism, particularly given the pressure on their leaders to respond with at least verbal toughness and thus constrain their future actions just as the tough U.S. rhetoric constrains ours.

In the short run, it is unclear which foreign policy will prevail. Protectionist economics mean isolationist politics, and vice-versa, and it is extremely doubtful that an outward-looking military and political policy can coexist for long with an inward-looking foreign economic policy. Short- term U.S. politics appear to pull in the protectionist direction at this point, but it is hard to imagine that losses of farm exports, curtailment of the overseas activities of U.S. firms, a stock market depressed in part by fears of a trade war, and deep rifts with our closest allies would produce a very impressive score even on this narrow criterion.

Even if the existing pattern of relations survives these immediate dangers, the New Economic Policy has raised fundamental questions for U.S. foreign policy over the longer term. Has the United States turned basically isolationist? Or will we be able to accommodate ourselves constructively to our reduced power position in the world economy? Has the executive branch finally given up the battle to keep isolationism at bay? Will we begin to use the leverage of our military and political position to achieve economic objectives, reversing the mode of the past when economic programs were used as much to promote our security objectives as to improve American economic welfare? Would other countries succumb to such U.S. pressure, or simply jettison our political support and hence permit wreckage of the postwar alliance system? Will we abandon the effort to preserve an open political system outside the communist world, or support the economic trends toward bloc creation and move consciously toward geographic spheres of political influence?

One specific issue will be our international monetary policy. From World War II to August 15, 1971, the United States was largely passive with respect to any deficits in its balance of payments. These deficits were of great importance in supporting postwar reconstruction in Europe and Japan, economic development everywhere, a steady trend toward trade and payments liberalization, and the avoidance of major political frictions deriving from economic conflict Our payments deficits were an economic umbrella for the rest of the world, similar to the defense umbrella provided by our nuclear deterrent-except that the economic umbrella modestly improved the economic welfare of the American people, by permitting us to consume real resources from abroad and accumulate foreign assets, while the nuclear umbrella cost us substantial sums of money. To be sure, U.S. deficits are no longer needed for some of these purposes; for example, the invention of Special Drawing Rights (SDKs) means that the world need no longer rely on U.S. deficits to create new dollar reserves and thus avoid a new cross of gold on which economic growth might founder. But the continuing growth of private demand for dollars around the world, and demand from monetary authorities to build at least their dollar working balances, means that equilibrium in the U.S. balance of payments will equate with a moderate deficit on any of the standard accounting definitions.

It is even dubious that a "strong" U.S. balance of payments would provide a sounder basis for a proper U.S. foreign policy than the "weak" balance of payments of the past, as the Administration asserts. An active, even if not aggressive, U.S. balance-of-payments policy would completely change the basic foundations on which the world economy rests. The essentially mercantilist external financial objectives of most of the other major countries are already incompatible with each other, and have been met even partially only through U.S. acquiescence. Such acquiescence makes sense from both the U.S. and global standpoints, since we are at once the biggest single factor in the world economy and the least dependent of any nation on trade. Adoption of similar mercantilist objectives by America could make the global economic system unworkable, since no other country can or will take our place as the balancer. Other countries will have to adjust their economic thinking and behavior no less radically than those small countries in East Asia which must adjust their security thinking to U.S. withdrawals and the Nixon Doctrine. For the future, only an effectively internationalized monetary and trading system could provide the basis for a viable world economy without U.S. stewardship. We turn now to what that world might look like, and how to get there.


The first requirement is for America and the other major countries to assess their priorities among the wide range of issues which have been raised. For reasons already stated, early elimination of the U.S. surcharge and the related "Buy America" credit are the most important immediate targets. The United States must thus clarify what it wants in return and present its proposals to others, and the foreign response must be adequate.

Our more fundamental objective, however, must be basic reform of the international monetary system to avoid in the future the errors of the crisis-prone past and to provide the foundation for a second generation of postwar prosperity. The system needs more effective means of adjusting national payments imbalances through greater flexibility of exchange rates in order to avoid the build-up of large disequilibria including our own. It needs ways of regulating the growth of international money without excessive reliance on the dollar, and hence excessive economic and political risks for the United States, which means new reliance on Special Drawing Rights. These issues are extremely complex, and will take time to work out A two-stage approach is called for, with the surcharge removed in the first stage and basic reform achieved in the second.

Fortunately, both the short-term and long-term needs point to a single major ingredient for the first stage: an adequate realignment of national exchange rates. On August 15th, the President made such a realignment the sole condition for removal of the surcharge, and we should abandon the new "Buy America" discrimination and the DISC export subsidy as well if we could get larger revaluations in return. Indeed, this is the only way the United States can achieve a sizable sustained improvement in the U.S. balance of payments and an increase in U.S. jobs from rebuilding our trade surplus. Realignment is also a necessary prerequisite for more basic monetary reform, since no country will agree to new rules unless it knows the starting points for all countries and since a régime of greater flexibility of exchange rates can begin smoothly only if rates are near equilibrium at the outset. Fortunately, most countries have already floated their exchange rates close to the new levels which they need to find. Widening the margins within which rates would fluctuate around the new parities, to at least three percent on either side compared with the 0.75 percent which prevailed in most countries prior to August 15th, would provide for the inevitable margin of error in setting new rates.

The second U.S. and foreign priority should be new steps to liberalize world trade, building on the recent proposals of the President's Commission on International Trade and Investment Policy and using the Organization for Economic Coöperation and Development (OECD) High Level Group already created for this purpose. Such an effort is necessary to reverse the present momentum toward protectionism, and a commitment to move should be a part of Stage One. The President has no authority to make any U.S. trade concessions at present, however, so new legislation is needed to pave the way for negotiations, as well as to demonstrate that the Administration's commitment to liberal trade encompasses substance as well as rhetoric.

It would probably be possible for the United States to get some minor nonreciprocal trade concessions in Stage One. However, they would provide little help for the desired payments swing, appear purely cosmetic, and actually undermine the credibility of the tough new U.S. approach. More important, they could cost us something on the amount of the foreign revaluations, and thus actually represent a net loss for the United States if they simply represented an acceleration of steps to be taken subsequently anyway. Because different people handle trade and monetary policy in all countries, because different institutions are involved in Europe, and because the political effects of trade changes are much more obvious and thus more difficult than monetary changes, insistence on a sizable trade package could seriously delay Stage One. Actual negotiations on trade matters-and on defense burden-sharing, for precisely the same reasons-should be left to Stage Two.

Other countries have already raised two obstacles to this two-stage approach, even if it were adopted by the United States. They insist that the United States raise the official price of gold as part of the exchange- rate realignment, and that the United States resume some form of dollar convertibility at that time as well. Both points are understandable politically: the United States should "share" in the realignment by devaluing the dollar overtly, instead of solely via the revaluations of others, and others should not be forced to remain on the dollar standard imposed explicitly by August 15th after they have accommodated to a sizable improvement in the U.S. balance of payments.

Changing the gold price is the lesser evil of the two. The maximum change envisaged is five to ten percent, which would leave the official price well below the free market price and so provide no windfall profits for speculators, Russians, or South Africans. By clearly ruling out a large increase in the price, it could even discourage gold speculation The need for congressional action could perhaps be delayed by adopting the proposal of Senator Javits that the Treasury simply declare a new selling price temporarily, without changing the official gold parity, and that Congress tidy up the legal situation as part of the fundamental reforms of Stage Two. And a willingness to change the gold price could result in a larger revaluation package since France would probably accept a five percent appreciation against the dollar via the gold price, Germany is reluctant to move more than five percent above France, Japan wants to move no more than five percent above Germany, and Italy, Britain, and some smaller Europeans will not move at all unless France does.

The negative effects of the gold price change on the monetary system could be countered by some corollary conditions. As will be explained shortly, the United States should not resume any form of convertibility, including gold convertibility, for the dollar until the satisfactory reform of the system in Stage Two. There would thus be no U.S. gold transactions at the new price until later, when new roles for the SDRs should mitigate any psychological boost which such transactions might give to gold. The change would not be meaningless, however, since other countries could trade gold among themselves or with the International Monetary Fund (IMF) at the new price.

The unfavorable psychological effects could also be met by simultaneous agreements in principle to move SDRs to the center of the monetary system. SDRs should be the future numeraire, in which all currencies are defined, replacing gold and the dollar in that role; we could denominate the new dollar parity in SDRs to highlight the shift, and further reduce the risk of boosting gold psychologically through the dollar devaluation. A special issue of SDRs should be authorized into which countries could convert any reserve assets now in their portfolios which they wish to get rid of, mainly dollars and sterling, but also gold itself. There should be sufficient creation of new SDRs (at least $4-5 billion annually) in the multi-year allocation period beginning in 1973, to assure adequate reserve growth without relying on dollars or gold. The details of these steps, or of steps to reduce the role of gold directly, will clearly take time to elaborate. Agreement on the governing principles should be possible in Stage One, however, if it is necessary to take the risks associated with an increase in the official dollar price of gold.

Convertibility of the dollar into U.S. reserve assets is much more critical than the gold price for the United States, and for the system as a whole. From the U.S. standpoint the external effects of the exchange-rate changes and the domestic disinflation program will take at least two years to be felt. The anticipated reversal of capital flows could get us to an official settlements balance much faster, but premature resumption of convertibility could produce losses of a sizable portion of the remaining U.S. reserves, for purely transitional reasons, when the whole objective is to strengthen the U.S, payments position. Other countries would lose, too, given their stake in having a strong dollar in the system and their interest in avoiding hair-trigger U.S. moves in the future, which smaller U.S. reserves would promote. And it is they who want the U.S. adjustment to be spread over time to cushion their own accommodations.

On the other hand, other countries want to minimize the duration of the dollar standard onto which they were formally thrust on August 15th. Before that date, foreign monetary authorities could convert any dollar accruals into U.S. reserve assets or at least justify holding dollars to their domestic critics by pointing out their right to do so. In the face of our suspension of convertibility, they now have only two choices when the United States is in deficit: to acquire dollars, or to eliminate their own surpluses by inflating, imposing controls on capital inflows or accomplishing the same end through multiple exchange rates, or appreciating the value of their currencies. Avoidance of this dilemma is precisely why these countries should be willing to move quickly to reform the international monetary system. Since the surcharge and probably the gold price will have to go in Stage One, the resumption of dollar convertibility will be the only U.S. lever to prod any such reform. Without it, we could easily see a repetition of 1967-69, when the British-French-German exchange- rate realignment led to much talk of reform but removed all pressure for it, and the likelihood of an August 15th was sharply accelerated.

To be sure, other countries fear that the United States wants them to revalue and then be stuck with a dollar standard forever. Such a fear is, of course, whetted by the inward-looking economic tendencies which do clearly exist, so the United States would have to display consistent sincerity in pushing toward constructive reform. Our insisting on agreements "in principle" about Special Drawing Rights in Stage One should be reassuring. It should be snapped up by the others precisely in order to maintain momentum away from a new dollar standard-especially by the Europeans, who can veto all significant decisions on Special Drawing Rights under International Monetary Fund voting rules, and hence maximize their international monetary power by promoting an SDR standard to replace it.


Stage Two should comprise negotiations aimed at producing fundamental improvements in both the international monetary system and international trade arrangements. Both must be included because money affects primarily the macroeconomic problems of nations, and trade affects the microeconomic problems of particular industries within nations. The underlying political objective is to adapt world economic relations to the new underlying economic and political balance, reducing the relative role of the United States and enhancing the relative roles of Europe and Japan. The reforms must preserve the benefits of growing world economic interdependence while meeting the insistence of national authorities that they retain adequate means of control over their individual societies.

The most important monetary need is a better process through which national balance-of-payments positions can adjust. Financing is generally available only for temporary periods and limited amounts, especially for deficit countries; it is essential in avoiding excessive adjustment costs, but if used too freely will simply permit disequilibria to cumulate and thus make the inevitable adjustment all the more painful. Adjustment via domestic deflation or inflation is exceedingly costly in terms of domestic economic objectives, especially if domestic needs call for moves in the opposite direction; thus such adjustment is frequently unacceptable for internal political reasons. Controls adopted for payments reasons carry significant economic and political costs and at best suppress imbalances, delaying the need for more fundamental measures and perhaps increasing their magnitude.

Changes in the exchange rate are thus the only economically effective means of adjustment which is likely to be politically acceptable in most countries at most times. This is particularly true for the United States, where adjustment via changes in domestic policy would be extremely costly, because foreign transactions represent such a small part of our total economy. Exchange-rate changes raise political problems, too, since they produce sharp changes in income distribution within a society, but the main barrier to their use in the postwar period has been the inadequate international rules by which they are governed. As it evolved, the Bretton Woods system discouraged changes except when "fundamental disequilibria" had clearly developed. This meant that the problem was obvious for all to see. Speculators could make easy money by betting on a change with virtually no risk of even modest loss; and governments dug in defensively to avoid the admission of previous errors, "national failures," or, in the case of surplus countries, "solving the other country's problem." Particularly in the case of surplus countries, no effective pressures existed to force exchange-rate changes when needed. With regard to deficit countries, there was no sure protection against unnecessary or excessive changes. The result was a devaluation bias against the dollar, the pivot currency of the entire system.[iii]

A new régime thus needs to be established, essentially to depolicitize exchange-rate movements as much as possible and to equalize the incentives to adjust for surplus and deficit countries. To do so, exchange-rate changes need to be fostered on a smaller scale, and hence occur more frequently. New attitudes on the part of national monetary authorities are essential to such a new régime, and should be readily accepted by them as providing a new policy instrument to help cope with the complex array of responsibilities which they face.

It is doubtful that such changes in attitude will suffice, however, especially to induce surplus countries to take timely action. International agreement is thus needed on four changes in the rules. The margins around exchange-rate parities need to be widened permanently, to at least three percent and preferably five percent on either side, to permit greater fluctuations and hence encourage small parity changes. The International Monetary Fund Articles need amendment to clearly permit parity changes when disequilibria are pending, not accomplished facts. The international community needs to agree on guidelines which will indicate when parity changes are needed-essentially in those "dilemma" cases when the external balance calls for a domestic economic policy which clashes with the needs of the internal economy-with a presumption that changes will take place in such cases. And sanctions should be available to the international community to apply against a country which does not do so.

Such an approach would provide effective international surveillance of balance-of-payments adjustment via the exchange rate, the policy instrument through which national economies interact. As such, it would clearly represent a new "invasion" of national sovereignty. At the same time, however, it would provide national authorities with a new policy instrument to help meet their needs. In addition, through the stepped-up process of international consultation which would be triggered by the guidelines, countries could justify their failure to change their exchange rates by pointing to other policy actions they had taken, or attempt to persuade others that their payments imbalance required no action at the time. The tension between effective international control and maintenance of national sovereignty will always exist, but such a process would provide ample scope for both as it evolved toward improving the payments adjustment process.

The second key monetary need is to reform the means by which international reserves are created and held. The dominant role of the dollar in the reserve system has raised major international political problems and created major difficulties for the United States by circumscribing its ability to change its own exchange rate. (Under any reform, the dollar will doubtlessly maintain its predominant role in financing private international transactions, and for exchange market intervention use by monetary authorities.) A return to gold would reverse the evolution of money through all history, and subject the world economy to the uncertainties of South African production and private demand. If only because of the shortcomings of the alternatives, future reliance must be placed on Special Drawing Rights.

Fortunately, there are persuasive positive reasons for doing so as well. Only via Special Drawing Rights can the international community truly manage the growth of world liquidity through a rational decision-making process. Special Drawing Rights can be used to replace reserve assets presently in the system, including dollars, which other countries may no longer wish to hold and which the United States wishes to remove as a threat to its reserves. They combine the attractiveness of a gold-value guarantee and interest earnings, And they are managed by the International Monetary Fund, providing a base for enhancing the role of the institution; this is critical for successful reform of the adjustment process. Some countries will want to continue holding reserve currencies in their portfolios, and new rules could be adopted to permit them to do so while avoiding the risk of adverse international consequences from switches among assets as has been possible in the past

At the same time, one may fairly ask: What are Special Drawing Rights? Where does their value come from? Will they always have value? The answer is simple: their value comes from agreement among virtually all non- communist countries to accept them in settlement of payments imbalances. Countries agree to provide their currencies, or other reserve assets, in exchange for Special Drawing Rights.

The value of the Special Drawing Rights rests on international coöperation. It is thus true that they might not survive a major war, or a total breakdown of international economic coöperation. The risk of either is remote, even under the pessimistic outlook described earlier. In addition, most countries will continue to hold a "war chest" of gold-whose official price and acceptability also depends on international coöperation-against such a contingency; gold converted into the special issue of Special Drawing Rights could even be retained physically in the territory of the converter as such a hedge. So the overwhelming superiority of Special Drawing Rights to either alternative, in any situation short of international disaster, renders it by far the best choice as the monetary base of the world economy of the future.

With such reforms, the United States could agree to finance completely any deficits in its basic payments position with reserve assets, Dollar convertibility would thus be resumed on a much more meaningful basis than before August 15th, into whatever assets we chose to use when necessary. We should be willing to undertake such an obligation in view of the assured creation of adequate liquidity via Special Drawing Rights; the improved prospect for prompt adjustment by other countries, reducing the pressures on our own balance of payments; and the new capability to move ourselves via changes in the exchange rate of the dollar, the only economically effective means of adjustment which is also politically feasible in the United States. It would be disastrous to U.S. foreign policy to keep the dollar inconvertible and try to maintain a world dollar standard, if most other currencies were fixed or most countries wished to return to such a régime. And such an effort would doubtlessly trigger foreign reactions which would seriously hurt wide segments of our economy as well.

On the trade side, negotiations are needed on a host of issues. The most pressing problem is agriculture, where we should be willing to swap some of our industrial protection and our dairy quotas for reductions in the stimulation afforded European production of feedgrains and other commodities by the Common Agricultural Policy. Tariffs on industrial trade remain important, particularly in those industries where they range much higher than the national averages of six to ten percent, and should be reduced reciprocally. Specific nontariff trade distortions, such as discriminatory government procurement rules and practices, need to be eliminated or moderated.

Meaningful action, however, might require a more imaginative leap than simply extending the current style of trade negotiations to more of the existing and well-recognized issues. Indeed, the development of a whole new range of relevant topics desperately requires new international rules, or at least new modes of coöperation. The multinational corporation and international transfers of technology are subject to no international understandings, despite their tremendous importance. International coöperation in devising and implementing adjustment assistance programs could prove a necessary part of any further trade liberalization. National policies adopted for purely domestic reasons, such as environmental control and regional development, will have significant trade effects. And a major breakthrough in reversing the protectionist tide may require a quantum leap toward liberal trade, perhaps a new treaty pointing to the phased removal of all remaining tariffs and most other barriers over the next 10 to 20 years, just as the Kennedy Round could be accomplished only through the adoption of new techniques which represented such a jump a decade ago.

One way to attack the subject would be to set out consciously to restructure the General Agreement on Tariffs and Trade (GATT). The IMF Articles would be basically restructured by the monetary reforms suggested above, which would substitute a presumption of exchange-rate changes for the pre-August 15th presumption of fixed rates, and reliance on SDRs for the previous reliance on gold and dollars. There is widespread agreement that many of the key GATT rules, while appropriate when devised in the late 1940s, simply cannot be expected to cope with trade problems a generation later. And an explicit effort to reconsider GATT would meet directly the perceptions of many Americans that the international trade rules are unfair, exposing them in most cases as unfounded but providing the best possible means to air the issues comprehensively.

Investment is not covered at all by GATT. Agriculture and nontariff distortions are covered inadequately. The basic most-favored-nation rule no longer governs a majority of world trade. The rules governing customs unions did not foresee the evolution of the Common Market. The trade controls permitted to meet balance-of-payments needs are outdated. The border tax rules were based on inadequate economic theory. New means of measuring reciprocity are needed to convince skeptical legislators of the fairness of future trade concessions. Indeed, it is legitimate to speculate about whether international economic responsibilities should continue to be bifurcated, with the IMF handling money and the GATT handling trade, now that the U.S. government has forced a widespread realization of how closely they are related. The absence of a single forum in which to consider both is a serious impediment to rapid resolution of the present problem.


In view of their new positions of power, their resulting claims for international economic responsibility, and the uncertainties of U.S. leadership, Europe and Japan should initiate efforts to solve both the short-run and long-term phases of the present impasse. Such a step at this time would mark without doubt their transition to true international equality in the post-postwar world, and accord them new dignity and respect which would profoundly affect world politics for the 1970s and beyond. It has now become especially urgent for Europeans to put aside their differences, some petty and personal, but even those economic and very real, and achieve sufficient monetary unity to provide the basis for a common front at least on international financial issues. Only in that way will they be able to at least respond as one to the United States and to Japan, and offer any hope of seizing leadership in order to move back from the abyss.

Unfortunately, it is doubtful that other countries can mobilize quickly enough to take the lead in meeting the ever-tightening time limit for achieving a constructive Stage One. In addition, it is the United States which has primarily plunged the world into the present perilous situation. It is thus extremely gratifying that the United States has finally begun to present proposals on which immediate action can be based. In so doing, the United States has started to clarify its own priorities among the broad agenda it has tabled for discussion, to moderate its demands, and to adopt a more reasonable-though still extremely tough-negotiating approach. Failure to do so would be one more piece of evidence that the Administration was prepared to sit indefinitely behind the surcharge and an inconvertible dollar, pandering to the most isolationist elements in American society. In view of the dangers which loom in the absence of definitive action, the change came none too soon-and must be carried through to a prompt settlement of Stage One.

[i] See the author's "Crisis in U.S. Trade Policy," Foreign Affairs, July 1971.

[ii] The measure would authorize creation of Domestic International Sales Corporations (DISC), domestic subsidiaries of U.S. firms which could defer, perhaps indefinitely, corporate tax payments on their export profits.

[iii] See the author's, "The United States and Greater Flexibility of Exchange Rates," in Bergsten, Halm, Machlup, Roosa, eds., "Approaches to Greater Flexibility of Exchange Rates: The Bürgenstock Papers," Princeton: Princeton University Press, 1970.

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