Sacrificing His Core Supporters in a Race Against Defeat
The financial position is almost irretrievable: the country has lost its way. In the worst of the war I could always see how to do it. Today's problems are elusive and intangible, and it would be a bold man who could look forward to certain success.
--Winston Churchill, on returning as Prime Minister in 1951.1
Substitute "the Western world" or even "the whole world" for "the country" that "has lost its way" and Mr. Churchill's words would be equally applicable to the events of 1982. The strains which developed were neither foreseen nor particularly illuminated by any school of economic thought. Above all there was a lack of both the political and the economic leadership to find a constructive compromise-which would not have been just splitting the difference-between sheer immobilism and a return to the inflationary finance of the 1960s and early 1970s.
None of the world's economic problems began in 1982. The golden age of Western economic growth came to an end with the first oil price explosion in 1973. It was from then onward that growth rates slowed down, and unemployment and inflation both rose; and in many countries political instability increased as well. In some countries there seemed to be a swing to the Left; in others to the Right. The only common feature was a swing against the government which had the misfortune to be in power. The defeat in Britain of James Callaghan's Labour government in 1979 after a strike-ridden winter, of President Giscard d'Estaing's moderate conservative government in 1981, and of Chancellor Helmut Schmidt's Social Democrat-led coalition in 1982 were all clearly attributable to economic discontent. The economic situation was also important in the defeat in 1980 of President Jimmy Carter-the first President since World War I to be defeated after his party had had only one term in office.
These trends revealed themselves in the course of two economic cycles. The first consisted of a sharp downswing from 1973 to 1975 and an upswing from 1975 to 1979. The second cycle began with another recession which was triggered off by the second oil price explosion in 1979, following the deposition of the Shah of Iran. At the beginning the second oil-induced recession looked very similar to the first. It seemed, if anything, that the world might get off more lightly. The recession seemed to be shallower. Inflation rose less and subsided more quickly and most oil-importing developed countries adjusted their balance of payments more quickly.
The peculiar frustration of 1982 was that it showed these better tidings to be wrong or at least premature. The first oil-induced recession was V-shaped: a steep plunge followed by a quick recovery-admittedly to a lower growth path than before. The second turned out to be at best W-shaped. A hardly perceptible recovery in 1981 soon petered out and was followed by a second unexpected phase of recession in 1982. One could not rule out the possibility of further dips and false starts before a sustained recovery path emerged.
The recession that dominated 1982 had the following specific features: First, inflation subsided much more quickly than expected.
THE INFLATION SHAKEOUT
Annual Increase in Consumer Prices (Percent)
Country 1960-67 1967-73 1973-80 1980 1981 19821
United States 1.8 4.5 7.9 13.5 10.4 4.6
Main seven OECD 2.5 4.9 9.2 12.2 10.0 5.9
1 12 months to November.
2 United States, Japan, Germany, France, United Kingdom, Italy, Canada. SOURCE: OECD.
Second, nominal interest rates (i.e., interest rates as normally published) were slow to adjust. As a result real interest rates (i.e., the excess of the interest rate over the rate of inflation) rose to record heights. This was in sharp contrast to their behavior in the first oil-induced recession, when they were negative. Short-term real interest rates averaged about six percent for much of 1982 for the United States, and about four to five percent for the other main developed countries, according to estimates by the Organization for Economic Cooperation and Development (OECD).2
Third, the world's main currencies were far out of line with anything that could be expected on the basis of costs, prices or previous historical trends. On any such basis, the dollar and sterling seemed extraordinarily high, the D mark and yen excessively weak. The dollar described a great seesaw against the mark, falling from a value of DM 2.6 in 1976 to a low of near DM 1.7 in 1979, only to rise to a peak of nearly DM 2.6 in early November 1982. Despite a world-beating Japanese success in fighting inflation (which was down to three percent in 1982) and a strongly competitive trade performance, the yen weakened against the dollar from Y203 at the end of 1980 to Y220 at the end of 1981 and to a low point of Y270 by mid-November 1982, before starting to rise again.
Even more eloquent evidence of disharmonies was provided by the Morgan Guaranty index of "real" exchange rates (i.e., exchange rates adjusted for international differences in inflation rates).3 These showed a 25 to 30 percent real appreciation of the dollar and sterling in the four years to autumn 1982, and a scarcely credible real depreciation of the yen in excess of 30 percent. The German real exchange rate had in contrast remained quite stable, its gyrations against the dollar being cancelled out by those against other currencies; but German policymakers remained sensitive to the mark's rate against the dollar in view of dollar invoicing of oil and raw material imports.
The combination of prolonged recession and high real interest rates in the United States was in large part responsible for the currency distortions and the squeeze they exerted on real economic activity. The 1982 overvaluation of the dollar will have proved self-correcting if forecasts such as the OECD's are right and the U.S. current balance of payments deteriorates from a surplus of $6 billion per annum in the first half of 1981 to a deficit of $45 billion by early 1984.4 In the last two months of 1982, these currency distortions seemed to be unwinding. The dollar had fallen to just above Y230 and just below DM 2.4 by year end. But the turnaround came too late, and it had not gone far enough to affect the atmosphere at the Ministerial Meeting of the GATT in late November.
Fourth, although it is normal for non-oil commodity prices to fall in a recession, they fell particularly severely in 1981-82. Relative to the price of manufactures and fuel, the prices of non-oil primary products reached their lowest level since the mid-1960s.5
In the case of oil the impact of lower demand was felt more in terms of lower production than in depressed prices. Among the members of the Organization of Petroleum Exporting Countries, production fell from a peak of over 30 million barrels per day in 1979 to an estimated 19 million in 1982. To the surprise of many observers the Saudi reference price of $34 per barrel was maintained, although there was considerable fraying at the edges in the form of unpublished discount and special deals, and it looked as if the Saudis might have to concede a cut in the New Year. There were also many complaints that OPEC countries had exceeded agreed production quotas.
To the extent that effective oil prices have weakened, it is unequivocally a benefit for the non-OPEC world, including the great majority of developing countries. Just as rocketing oil prices in 1973 and 1979 triggered off two bad bouts of world "stagflation," any weakness in the oil price should speed economic recovery (even if not so quickly or to the same extent as the reverse impact of the earlier rise). The grumbles of bankers about the effect of weaker oil prices on one or two oil-producing countries, such as Mexico or Nigeria, should not blind us to the benefits they bring to far more countries with a far greater tendency than the average oil producer to spend marginal income (and thus help the world climb out of recession).
Fifth, needless to say, protectionist pressures continued to grow in 1982. Each government tended to think that other governments were taking unfair advantage; and, because of high and rising unemployment, sensitivity to Japanese and low-cost Third World competition became intense. Indeed, the world was fortunate that protectionism remained backdoor and selective.
It was, however, also creeping. For instance the United States signed in March a voluntary agreement with Japan restricting auto imports to 1.68 million units. The rate of creep was quite high, and 1982 was dominated by trade squabbles. The headline instance was the U.S. dispute with the European Economic Community (EEC) over the export of subsidized steel to the American market. This was eventually patched over, not by any reduction of European subsidies, but by voluntary export quotas announced by the EEC in August offering a ten percent reduction in shipments to the United States over the next three years-thus superimposing one market distortion on another.
Another dispute, which took up much time at the White House and State Department, was with European countries over the sale of equipment for the Soviet gas pipeline, which the Versailles Summit of June 1982 failed to resolve. Although the dispute was partly based on different political perceptions of the Soviet threat, its intensity reflected the desperation of European governments to obtain export orders at all costs; and the dispute was eventually settled in November 1982 by a retreat on the part of the United States, which ended sanctions against European companies involved in the pipeline in return for vague words about the study of the strategic implications of East-West trade. Neither the continued clampdown in Poland nor talk of putting economic pressure on the Soviet bloc prevented the Reagan Administration from extending for another year its grain sales agreement with the Soviet Union.6
Fortunately, some policymakers and their advisers were at least dimly aware that the U.S. Smoot-Hawley tariffs of May 1930, which raised U.S. duties to a record high, were followed within a few months by retaliatory tariffs elsewhere, quantitative restrictions in 26 countries by the end of 1931, and the U.K. switch to Imperial Preference early in 1932. Although the precise interconnections remain a matter of academic debate, this trade war, together with the banking crises, was among the events which turned the world recession of 1929-30 into the Great Depression of 1931-34.
It was the desire to avoid open trade war which averted a breakdown at the Ministerial Meeting of the General Agreement on Trade and Tariffs (GATT) in Geneva on November 24-29. This was the first Ministerial Meeting since the 1973 meeting at Tokyo, which had launched the last round of multilateral cuts in tariffs and trade restrictions. This time the atmosphere was much less favorable thanks to "a mixture of French pettiness, American aggressiveness and Japanese passivity," as The Economist felicitously put it.7 Proposals for a standstill on further trade barriers were shelved in favor of a much weaker undertaking "to resist" protectionist pressures. The two issues on which the meeting came closest to breakdown were the U.S. demands (a) to restrict agricultural protection (particularly subsidized EEC food exports), and (b) to bring trade in services into GATT. The 40 senators and congressmen who accompanied U.S. Trade Representative William Brock added to the heat by their threats of an agricultural trade war.
After a two-day extension of the meeting, ministers emerged with face-saving agreements to "study" all measures affecting agricultural trade, including subsidies, and trading in services (such as banking, insurance and shipping). There are also to be studies on safeguard measures taken to protect industries suffering from import surges. The object is to make the degree of protection more transparent and therefore more easily subject to international negotiations. The parties also agreed in principle to ban sanctions for non-economic reasons and not to block GATT rulings going against them. But there was considerable skepticism about the effectiveness of either of these last two undertakings.
The main consolation was that trade relations did not deteriorate further. One estimate suggests that the proportion of "managed" world trade-i.e., the proportion subject to non-tariff control, such as quotas, OPEC production ceilings, etc.-has risen from 40 percent in 1974 to 48 percent in 1980. Nevertheless, GATT's chief economist, Jan Tumlir, stated after the meeting that he did not expect a trade war, particularly between the United States and the EEC, if only because of the fear of the carnage which would ensue.8
Steps to defuse U.S.-EEC relations were taken by Secretary of State George Shultz (rapidly emerging as a main force in financial and trade, as well as foreign, policy) on a visit to Brussels on December 10 when he withdrew the threat of an agricultural trade war. No similar relief occurred in the field of trade with Japan-an issue not fully aired at the GATT meeting. EEC foreign ministers agreed in December to make a complaint against alleged Japanese non-tariff barriers under Article 23(2) of GATT. Taking the dispute to GATT was a step in the right direction. Unfortunately, irrespective of the GATT findings, European governments were expected to maintain pressure on the Japanese for "voluntary" export restraints on a very great number of products, ranging from fork-lift trucks to video recorders, on an EEC "surveillance list."
Sixth, there emerged during 1982 an international banking crisis, as a product or symptom of the other problems mentioned. Many of the projects which bankers had queued up to finance in the 1973-81 period were inherently questionable-as such projects always will be when easy money is available and few questions are asked. But slump, high interest rates and low commodity prices, plus protectionism in Western markets, caused many Third World and Soviet bloc nations (above all, but not only, Poland) to have the greatest difficulty in servicing their debts, quite apart from any errors of overborrowing on their part.
Seventh and finally, during 1982 the impact, actual and perceived, of high American interest rates, especially their repercussions on exchange rates, increased the feeling of dependence on the United States in the rest of the non-communist world. It was felt that only the United States could lead the world to lower interest rates, either by reducing its prospective budget deficits or by monetary relaxation on the part of the Federal Reserve. After two decades of talk of the relative decline in U.S. influence on the world economy, commentators in one country after another vied with each other in emphasizing the dependence of world recovery on U.S. fiscal and monetary policy. In the words of a distinguished former president of the Bundesbank, Dr. Otmar Emminger, "It was a return to the Pax Americana, at least in the monetary field."
Thus the rest of the non-communist world was looking to the United States for a lead out of the second severe recession to have hit the world since the 1973 oil price shock-and one marked by high real interest rates, currency distortions, trade tensions and an international banking crisis which received more and more attention as 1982 unfolded. Indeed fears about the financial system almost certainly depressed business sentiment in 1982 and aggravated the world recession, which in turn aggravated Third World payments problems in a mutually reinforcing way.
The seriousness of the banking crisis was brought home to nonspecialists by four major shocks. On May 17, 1982, the small New York firm of Drysdale Government Securities became insolvent and Chase Manhattan, to whom it owed money, showed a loss in the second quarter of the year. Then, the Italian Banco Ambrosiano went down, with its affairs in an impenetrable tangle and unpaid debts owed by its foreign subsidiaries. On July 5, a very small Oklahoma City bank, Penn Square, was closed by the U.S. Comptroller of the Currency. It had raised considerable sums for oil and gas projects from larger banks and this time a main victim was Chicago's Continental Illinois Bank.
The fourth and biggest shock came on Friday, August 13, when Mexico announced that it was no longer able to service $80 billion of foreign debts. In the next few weeks a rescheduling agreement was patched up with central and commercial banks, and a Letter of Intent was agreed to with the International Monetary Fund by the end of the year. The rescheduling of Mexican undertakings was still queried by some of the banks, but Mexico's trump card was that a failure to settle would be as painful for the United States as for itself. If Mexico defaulted, 70 percent of the common equity of two of the largest U.S. banks would have vanished overnight.
Toward the end of 1982 an IMF Letter of Intent was also agreed with Argentina, and negotiations were in train to reschedule Brazil's debts (which amount to nearly $90 billion). The mere fact that Brazil, which had been one of the most successful of the developing countries, should have this rescheduling problem and should be cutting back on its planned 1983 borrowing was symptomatic of the world financial squeeze.
The problems extended well beyond country (or "sovereign") lending. Many bank loans were to corporate borrowers who themselves were having difficulty staying in business; and the quality of the loans was therefore in doubt. Like many symptoms of the bank debt problem, this one was liable, if neglected or mishandled, to aggravate the disease and turn recession into depression.
The chairman of the (British) Lloyds Bank, Sir Jeremy Morse, remarked in the autumn of 1982 that there was a five percent probability of a financial collapse; the percentage risk should probably have been doubled. Unfortunately there was a much higher chance of difficulties and fears, short of collapse, depressing world output and trade.
When it comes to diagnosis of the 1982 financial crisis and prescription for the future, a distinction should be drawn between (a) the threat to the world's banking system and (b) the threat to world economic activity and the flow of world trade. They interact, but need to be analyzed separately.
The direct banking danger comes from the external loans made by the world's chief banks. Outstanding medium-term bank credit to the non-OPEC developing countries rose from $43 billion at the end of 1975 to an estimated $182 billion at the end of 1982. There are no comprehensive figures for short-term credit, but OECD estimates put the end-1982 total at $121 billion (mostly, but not entirely, emanating from banks), giving a grand total of around $300 billion. Four countries-Mexico, Brazil, Argentina and South Korea-accounted, on OECD estimates, for 50 percent of all short-term debts.
TOTAL DISBURSED DEBT OF NON-OPEC DEVELOPING COUNTRIES
(One year and over)
Bank Loans 182
Export Credit 105
Banks and other Private Lending 46
Official Development Assistance 55
Multilateral Organizations 70
Total Medium Term 520
Short Term 121
(Less than one year, OECD estimate)
Total Debt 641
SOURCE: External Debt of Developing Countries, OECD, Paris, December 1982, Tables 3 and 7.
At the same time as bank assets became more risky, the equity-to-assets ratio (that is, the portion of assets not corresponding to deposit or fixed-interest liabilities and therefore available to shareholders) of the U.S. banks in the main American financial centers fell.
There are particular reasons why, in sovereign or country lending, there is a divergence between the self-interest of an individual bank and that of the banking system as a whole. In much domestic lending one bank-or at most a very few banks-is dealing with one establishment. But with internationally syndicated country loans, each individual bank provides only a small proportion of the country's total borrowing.
Each additional loan to a vulnerable country increases the degree of risk not merely to the particular lending bank, but to all bank lending to that country; however, it is only the former that will be taken into account. The costs imposed on others are what economists term an "externality." A good analogy is with the congestion costs imposed by each additional vehicle in an urban center, not merely on itself but on other vehicles. In each case there is an adverse externality, i.e., the imposition of costs which the responsible agent does not bear himself.
There is a second source of divergence between the individual and collective interest. This is the information problem. Information about a debtor's position is a public good. Each bank has an interest in being a "free rider" on the investigations of others.
The externality and public good aspects together provide a case for some umbrella organization, whether the IMF or the institute established by 35 international banks belonging to the Ditchley Group formed in 1982, to provide information and concert strategy toward particular countries.
But precautionary action was left until very late. The banking danger arose from the possible effect on the banking system of the default of one or more major borrowers, combined with domestic bankruptcies during a bad phase of the economic cycle.
One urgent question was whether "lender of last resort facilities," which were supposed to exist for domestic banking, existed and were adequate in the international field. In particular, were there plans to meet not merely a liquidity crisis, but a solvency crisis when the amount of bad debt would exceed the equity capital of a bank?
The last statement on "the problem of the lender of last resort in the Euro-markets" was made by the Bank for International Settlements in September 1974 when the assembled governors pronounced that "it would not be practical to lay down in advance detailed rules and procedures." But they were satisfied that means were available for the purpose "and will be used if and when necessary."
It is on grounds of moral hazard-the fear that they might encourage imprudent bank lending-that central banks have justified vagueness about their lender of last resort obligations on an international scale. But this is not credible. The imprudent lending has already taken place. Moreover, the same arguments could be used against domestic "lender of last resort" facilities.
A more convincing reason for reticence was that central banks had been slow to make adequate contingency plans for stemming or offsetting any major failure in international banking. Until well into 1982 the main publicly disclosed efforts had gone into only partially successful efforts to bring regulatory practice in different countries together.
According to the Basle Concordat of 1975, each central bank was responsible for regulating the activities, home and overseas, of banks with headquarters in its own country. By extension, it was also supposed to be morally responsible for lender of last resort operations, although this was never formally stated. But the problem of consortium banks or partially owned subsidiaries was left unresolved. So, too, was the question of what was to count as a bank.
Both these problems were exemplified on a small scale by the crash of the Italian Banco Ambrosiano, whose affairs were revealed to the world when its chairman, Roberto Calvi, was found hanging from scaffolding under Blackfriars Bridge in London on June 18, 1982. The Bank of Italy set up a pool of seven banks to provide liquidity to meet the demands of creditors and depositors of the Banco Ambrosiano, which was declared insolvent by a Milan court on August 26. But the Italian central bank did not accept responsibility for debts worth over $400 million of the 69 percent-owned subsidiary Banco Ambrosiano Holdings of Luxembourg. The Bank of Italy argued that it had no legal responsibility, whatever might have been said on the moral side. It must be added that the Bank of Italy's morale had been severely weakened, when in 1979 its own directors were charged with a series of offenses-subsequently withdrawn and generally believed to have no substance. These charges were widely regarded as a "punishment" for an earlier and highly critical report that it had made on Ambrosiano.
But although these events humanized the problems of bank supervision and brought in an altogether new class of reader about them, the biggest problem facing lender of last resort operations was of a different kind. This was that a central bank may run out of foreign exchange reserves if there is a run on deposits of banks for which it is responsible and which are denominated in an external currency. It could still act as a lender of last resort, but only by activating a swap network with the central banks whose currencies were being demanded by depositors. Here was a further reason for clarifying lender of last resort arrangements-even if it were better not to reveal the size of swap lines lest they be thought insufficient in a really big crisis, when larger sums could probably be arranged on the telephone.9
The threat to world trade and activity can occur without any banking collapse. Indeed it can be precipitated by the attempts of bankers to maintain solvency by cutting down on new lending to the Third World, either because they are worried about exposure or because they want to rebuild their own equity. Similarly, contractionary forces can come from Third World and other debtors either if they lose their borrowing power or if they try to satisfy the IMF and other lenders by adopting policies of domestic retrenchment.
The statements made by Western finance ministers and central bankers at the IMF meeting in Toronto in September 1982 in response to such fears might have been calculated to induce neurosis in a Pavlovian dog. Central bankers were lectured on prudence-and they were also told not to be too prudent for the sake of world activity. But in a speech on November 16, Paul Volcker, Chairman of the Federal Reserve, resolved the dilemma on the expansionist side by saying that where loans facilitated "the adjustment process," such "new credits should not be subject to supervisory criticism."
The moves to enlarge Fund quotas and set up a standby borrowing arrangement for the IMF (the latter proposed by the United States at the annual IMF meeting in Toronto in October) were a step forward. The broad lines of IMF enlargement were agreed at a meeting on December 9-10 at Kronberg, near Frankfurt, of finance ministers and central bankers of the Group of Five (the United States, Germany, Japan, France and the U.K.). The Kronberg meeting paved the way for an eventual increase of IMF quotas from the present $67 billion to around $100 billion,10 and an increase from the present $10 billion to around $20 billion in the existing General Arrangements to Borrow (GAB) which is to be expanded into an emergency fund on the lines first proposed by the United States at Toronto.
A third element, which would complete the package and do more than anything else to promote international confidence, would be for the IMF to announce that it intended to borrow from private capital markets at least until the quota increase could become effective, which would not be until mid-1984 at the earliest. Such borrowing was proposed by Dr. Emminger after a meeting in December of the "Group of 30" central and commercial bankers and economists, formed two years before to monitor the world scene on an informal but authoritative basis. So far however (up to January 1983) the suggestion has still to receive official endorsement.
A much more difficult task than IMF enlargement is to determine the criteria for the distress lending it undertakes. This is especially important as an agreement with the IMF has been regarded as a seal of good housekeeping and helps to restore the creditworthiness of the borrowing country in the international capital market. The normal IMF country-by-country approach is outmoded at a time when a particular country's problems may well reflect a world slump rather than its own imprudence.
Lending as such is neither good nor bad. Ideally the Fund should take a view of the rate of world savings which would prevail at a sustainable level of world activity, and of the appropriate investment across frontiers corresponding to it, before deciding on an appropriate total of official finance. But this is likely to turn out to be extremely difficult to practice. A simpler (but still difficult) approach would be to determine a global stance on lending on the basis of whether the total level of world expenditure on goods and services in money terms is rising so quickly as to pose inflationary dangers, or whether, on the contrary, the main danger is that it may fall (or rise inadequately), thus posing a recessionary threat. If world demand is deficient, the main remedy should most definitely not be to encourage unwise spending by, say, Mexico or Argentina, but to relax monetary and fiscal policy in the major world economies. If the IMF "seal of good housekeeping" is given too readily to help out panic-stricken Western creditors, it will become devalued and less capable of attracting private lenders into problem countries.
The emphasis in Western financial policy-such as it was-in 1982 was neither on lender of last resort operations nor on the global management of monetary demand, but on case-by-case patching-up operations to "reschedule" the debt of countries unable to pay. It would be a brave man who would condemn these operations in the fragile state of the world's financial markets. But the approach puts excessive economic power in the hands of potential defaulters.
A country which declared default would indeed risk cutting itself off not merely from world financial markets, as normally understood, but from export credits and a whole network of financial services such as banks and insurance on which modern commerce depends. (Even communications, shipping and telephones are often dependent on bank finance.) On the other hand, borrowing countries can go a long way in threatening default because they know that Western governments and banks are terrified of the potential consequences to the world financial system of the threats being carried out. Thus there is a large element of crying "chicken" on both sides. A more systematic approach to rescue operations, with clear-cut guidelines and publicized fallback plans to support the non-communist world banking system in the event of a major default, would give the West more bargaining power in dealing with threats made by fanatical regimes of all kinds.
It was not a very good advertisement for Western capitalism that the decision on whether to reschedule both banking and official debts to General Jaruzelski's Poland could not be made on broad foreign policy considerations, but was guided by fears of the consequences to the Western financial system of a Polish financial collapse. To take another instance: it was far from certain that a complete financial clampdown on Argentina would have persuaded the Buenos Aires government to negotiate a peaceful withdrawal from the Falklands. But the fact that this was never even put to the test, and a thousand people were killed in a conflict, is a shaming instance of what happens when Western countries cannot afford a financial showdown with petty dictators of the Right or Left.
The banking and international indebtedness problems were symptoms of underlying problems. The most obvious arose from the pains involved in expelling an inflationary psychology.
The costs of reducing inflation are in principle fairly straightforward. There is no reason to suppose that there is any long-term choice between inflation and unemployment. Output and employment will be no lower-they could easily be higher-at a low rather than at a high inflation rate. But the process of reducing inflation is an extremely painful one, nearly always involving a transitional recession.
Different kinds of prices react with very different speeds to demand restraint. Primary-product prices react most quickly and have to take much of the strain. Wages are slowest to react. Final products and services are somewhere in between. They are more sensitive than wages to recessionary pressures-and therefore profit margins are inevitably squeezed-but they are not as sensitive as primary products. Thus it is not surprising that Third World countries have had debt servicing difficulties.
Two severe price shocks, followed by two tight money periods intended to squeeze out inflationary expectations, were bound to take their toll. Unfortunately, transitional unemployment, if too severe or too prolonged, can have long-lasting effects. For instance it can lead to the scrapping of capital equipment and the atrophy of human skills and work attitudes. Thus high actual rates of unemployment breed high equilibrium rates. In other words, the economy will operate at a higher "normal" level of unemployment even when it is well into a recovery phase.11
What went wrong with monetarist remedies? There is nothing wrong with the contention that inflation and deflation are monetary phenomena. A student has to be very clever not to relate sixteenth-century European inflation to the influx of New World gold, or the German post-World War I hyperinflation to the multiplication of Reichsmarks. Similarly, he has to be very clever not to relate the depth of the 1930s depression to the destruction of the U.S. money supply. There may be more fundamental causes of these events, but the monetary changes were the proximate cause and were both necessary and sufficient for them to take place.
The mistake made by the technical monetarists has been in passing from the observation that inflation and deflation are monetary in nature to supposing that it is easy to measure the effective quantity of money or to control its growth in a non-inflationary way. During the two-and-a-half centuries of broad price stability England enjoyed, from the reign of Charles II to World War I, there was no conscious attempt to regulate the money supply; it was automatically checked by its link with gold. In none of the periods covered by Milton Friedman's Monetary History of the United States 1867-1960,12 was there a conscious money supply policy. The Federal Reserve, established in 1913, acted to maintain the gold value of the dollar by raising interest rates when there was threat of a gold drain.
Thus, the main finding of technical monetarism-the stability of the demand for money in relation to total income-applied to periods when no one was consciously controlling its amount. In such a situation it did not matter what the exact definition of money was. Different definitions simply yielded different long-term changes in velocity (the rapidity with which money changes hands during a given period of time); and thus, slightly different numbers came up for the long-term growth of money supply consistent with stable prices.
All this was bound to change once central banks established monetary targets, as the Fed began to do in the 1970s. "Goodhart's Law" states that any monetary target becomes distorted once it is selected for policy purposes.13 In the United States the proliferation of interest-bearing "NOW" checking and money market accounts has been a running saga for several years. The development of a more competitive financial system is highly desirable, but it inevitably weakens mechanistic relationships based on experience in earlier, more regimented periods.
The earlier fear about the monetary approach to inflation was that it would fail due to the growth of such money substitutes, the greater ability to economize on cash balances as a result of computer developments, and so on: in other words, that the velocity of circulation of money would rise and monetary policy would fail to restrain spending as sharply as intended. But the problem in the last couple of years, especially in the United States and Britain, has been the opposite: velocity has fallen and the whole stance of demand management-despite large fiscal deficits in the United States-has (at least until the autumn of 1982) been a good deal tighter than intended. Thus the characteristic criticism of technical monetarism turned out to be precisely the reverse of the strictures which were justified by events.
The greatest mistake may have been in the international dimension. Monetarist models tend to assume that the demand to hold a country's currency comes mainly from its own citizens and is fairly stable. The removal of exchange controls and the development of world capital markets have made nonsense of this assumption-especially after the two oil price explosions which led to the accumulation by OPEC of hundreds of billions of dollars worth of foreign exchange reserves, often footloose and ready to go wherever the prospects seemed best.
Low-inflation countries are still likely to have rising exchange rates relative to high-inflation ones, other things being equal. But political hopes and fears, stemming for instance from the effects of the Polish crisis on West Germany or the vulnerability or safety of energy supplies, are also important, and the evaluation even of economic policies can change overnight.
Neglect of the international dimension and of institutional change caused the pace of disinflation to be much faster than intended. As a result of human action but not human intention we did not have Friedman's well-known policy of gradualism, but something more like the less well publicized policy of a sharp shock advocated by Friedrich Hayek.14 Because labor markets take a long time to react to exchange rates, the dollar and sterling became overvalued, thus aggravating the recession. But the effects have not been symmetrical. The Central European countries and Japan have had to keep a tight rein on money and credit, because they were worried about the inflationary impact of further depreciation. So they were not able to reap the full benefit of the trade stimulus which normally comes from undervaluation.
Official exchange-rate intervention, which many people have called for, would not help as it would fail to tackle the underlying forces affecting the demand for particular currencies. The insistence of France (partially backed by her EEC partners) on the issue at the Versailles Summit in June, in place of more important issues, contributed to the failure of that gathering.
A great deal of time and effort was devoted at Versailles to a face-saving agreement which accepted the case for intervention "in disorderly market conditions" (a phrase which the United States used to minimize its commitment) and to a study of the effectiveness of intervention, the results of which will almost certainly be inconclusive. Because of these preconceptions, the Summit leaders did not adequately diagnose or prescribe for either the deterioration taking place in the world economic conjuncture or the international debt position.
On East-West trade the Summit actually aggravated tensions. A compromise wording on the need for a "prudent and diversified approach" failed to prevent the bitter row over the Soviet gas pipeline from surfacing a few days after the summiteers had dispersed. The Versailles meeting was widely judged to have been the least successful of the whole Summit series. The lesson many leaders have drawn was that the next Summit (in Virginia in mid-1983) should pay less attention to the communiqué (which some would like to see dispensed with altogether) and that there should be much less structured and more informal conversation. As Lord Asquith might have said, we will "have to wait and see."
More important than these summit bickerings was the fact that, from the beginning, many in the Fed understood the weaknesses, in changing conditions, of technical monetarism based on a target for one or more monetary aggregates. The main factor preventing an earlier relaxation in the Fed's monetary policy terms was fear of the U.S. budget deficit. Indeed, calls for a higher U.S. tax level or lower government spending became a feature of international meetings, and were expressed by governments, such as the French, which were committed to expansionist fiscal policies in their own countries (at least until their own currencies weakened dangerously on the foreign exchanges).
What exactly was the U.S. fiscal problem? The 1981-82 and prospective 1982-83 U.S. budget deficits were still low by international standards and largely the outcome of recession. The rational cause for inflationary worry was not the existing U.S. budget deficit but fear for the future. Projections had shown it rising on unchanged policies to over $200 billion by 1984-85 and beyond, even on the assumption of economic recovery and normal growth. The financial markets obviously feared that this might be financed from the banking system. But even if it were not, borrowing on such a scale would drive up real interest rates.
The budgetary resolution passed by Congress before the 1982 mid-term election did not remove the longer-term threats. What was new was that both the President and Congress at least agreed on the need-if not on the actual measures-to shift the U.S. budget deficit onto a downward track as a proportion of national income. The earlier, so-called "supply side" belief that budget deficits either did not matter if the Fed held to its monetary targets, or would be automatically reduced as a result of the stimulating effects of tax cuts, was abandoned decisively when Professor Martin Feldstein took over as chairman of the Council of Economic Advisers in the summer of 1982.
By October 1982, the U.S. Fed felt able to relax, and Chairman Paul Volcker announced at Hot Springs, Virginia, the suspension of U.S. monetary targets. A similar message had been given in the same month by the other supposedly "monetarist" government, that of Great Britain. Sir Geoffrey Howe, the British Chancellor, in a speech at the Mansion House, London, loosened the link between his medium-term financial strategy and the observance of any particular targets for any particular monetary aggregates, coining the slogan, "Flexibility without laxity."
In the United States, the Fed's action had been foreshadowed by Paul Volcker's earlier important, but much misunderstood, half-yearly report to the Senate Banking Committee on July 20, which marked the death knell of monetarism as a specific and technical doctrine. (It by no means marked the end of the wider and more important doctrines which have come back into favor as a result of the monetarist episode.)15 In his July report the Fed Chairman wondered aloud whether the rising trend of velocity of the past ten years (which were mostly periods of rising inflation and interest rates) was not being reversed. He very reasonably did not pretend to know; but this very agnosticism was bound to increase the discretion of the Fed both in determining monetary targets and deciding how far they should be observed. The July and October statements were followed by a moderate reduction in interest rates. But it was not at all clear what the Fed's new longer-term yardsticks were to be, whether they were to be newer and higher monetary targets, interest rates, output and employment, or the gross domestic product measured in current (as opposed to constant) dollars. Nor was it clear how these variables were to be weighed against each other. The Fed was feeling its way.
The combination of the new fiscal seriousness of the Congress and the Administration, the depth of the recession and the evidence of a very sharp fall in inflation, created a climate in which the Fed could safely shift from the letter of technical monetarism. But unfortunately neither the Fed nor other national monetary authorities seemed to have a very clear idea of how to find a middle way between technical dogmatism and the earlier inflationary follies committed in the name of full employment policies, which ultimately collapsed.
It is very important that the flexibility which arrived with the fall of 1982 should not look like going back to traditional postwar demand management, which attempted to underwrite any level of wages and prices which happened to emerge in the marketplace. The reason for this is not puritanical anti-inflationary virtue, but severely practical. For if a return to inflationary finance is foreseen, interest rates will rise and not fall in response to monetary and fiscal stimuli, which will therefore "not work." There were indeed many signs that the Fed-like financial authorities in many other countries-was not at all sure how to implement "flexibility without laxity" in practice.
Unfortunately, leaving the size and scope of action completely to central banks' discretion is not likely to be adequate. Without guidelines they cannot be depended upon either to do enough to maintain monetary demand to offset a slump, or to restrict it enough to prevent a re-acceleration of inflation in the longer term.
One constructive response to the new instability in the "demand for money" is to have a combined international money supply objective.16 It need only involve the countries with the world's main currencies-say the United States, Japan, Germany and perhaps Britain. This would be a great step forward, as the demand for a central group of currencies is almost certain to be more stable than for any one currency alone. Echoes of such ideas must have reached Treasury Secretary Donald Regan when, in contrast to his earlier position, he called on countries on the eve of the Kronberg meeting to take into account the international repercussions of their domestic monetary policies. But neither the United States nor any of its partners had any clearly formulated ideas on how this might be done.
If it were politically possible to have a joint money supply objective for a few major countries, it would be an improvement on the experience of the last few years. Nevertheless, I question whether even the demand for a key group of currencies will be stable enough to provide a reliable target. There will be occasions when the central banks may have to inject liquidity into the world financial system without too obsessive and immediate a concern about the money supply numbers. But a series of piecemeal adjustments to the pressures of the moment is most unlikely to bring the stability of expectations which the world so badly needs.
It is for this reason that some economic commentators have suggested that the objective of financial policy should be shifted from means to ends, i.e., to monetary demand or "money times its velocity of circulation" (MV). This is the same as the gross domestic product (GDP) measured in current dollars (Money GDP) and it is in fact a good deal easier and less contentious to measure than the money supply itself. By making Money GDP the objective rather than Real GDP, policymakers are resisting the delusion that it is possible for them to spend their way into target levels of output and employment irrespective of the effects on prices and wages. They thus show they have learned the lesson from the collapse of earlier types of demand management, sometimes known as Keynesianism, but in the United States more often labelled the "New Economics," practiced during the Kennedy-Johnson period. On the other hand, a Money GDP objective should help to ensure that demand is kept on a gently rising path sufficient to produce real growth of output and employment, not unconditionally but if producer groups refrain from pricing their members out of work.
An objective for Money GDP for, say, the inner group of five summit countries-the United States, Japan, Germany, the U.K. and France-may sound a tall order; but it is doubtful if anything less will suffice. Long-run guidelines for the growth of Money GDP in the core countries of the industrial world are, of course, no substitute for intermediate objectives for monetary aggregates, public sector borrowing or official international lending or emergency operations to bolster countries or banks. A Money GDP objective would however prove the best guide to using these instruments so as to combine firm long-term guidelines with maximum short-term flexibility for central banks and finance ministers.
The fact that such an objective makes sense mainly over a period of years is a positive advantage. For it enables short-term discretion for central banks to be combined with coherent long-term guidelines. It is not a gimmick, but merely a way of expressing policy objectives which experience suggests have some, admittedly imperfect, chance of being achieved.
Although new guidelines for macroeconomic policy are urgently needed, the problems of the industrial economies go deeper. An explanation of the traumas of 1982 entirely in terms of the transitional costs of reducing inflation is at bottom too optimistic. If inflation and tight money policies were the only problem, it would be possible to move back toward earlier levels of performance once inflationary expectations were eliminated.
But, apart from being optimistic, such a view leaves many questions unasked. Why was it so much more difficult and costly to puncture inflationary expectations after the oil-price explosion than, say, after the post-Korean-War inflation in the early 1950s, let alone in many earlier periods? Why are wages and some prices quite so sticky in the face of reduced demand?
It seems pretty clear from the experience of recovery periods that the rates of employment and growth consistent with stable non-accelerating inflation have fallen in most Western countries. It is unconvincing to blame the 20 percent fall in British manufacturing output since 1979-which has been paralleled by similar if less spectacular difficulties in established industries throughout Europe and North America-either on the inevitable costs of disinflation or on the mistakes of President Reagan, Prime Minister Thatcher or former German Chancellor Helmut Schmidt (who was deposed in the fall of 1982 by a shift of coalition politics partly reflecting economic discontents). There are clearly "real" non-monetary forces at work.
There are a good many indications that the large amounts of unused capacity revealed by industrial surveys are deceptive. No doubt the physical plant and equipment are there-but much of it may be economically obsolete and not likely to come back into operation even in a period of normal growth. The most important single pointer is the prevalence of high real interest rates, which cannot be accounted for entirely by monetary policy mistakes. High interest rates are normally a sign of capital shortage.
Another remarkable phenomenon has been the clamor of complaints from so many Western countries that most of any increase in demand is sucked off into imports with little benefit to domestic industry. If this were so only in one or two countries, it might be just a sign of wrongly aligned exchange rates. But such reports come from many countries; and the beneficiaries from rising imports always seem to be Japan, Southeast Asia, the other newly industrializing countries and the low-cost plants of southern Europe.
One reason for the obsolescence of so much capital has been the shift in relative prices of different inputs into the production process.17 The golden-age growth period before 1973 was accompanied by fairly stable price relativities. Since then the most spectacular change has been in energy prices. Despite the recent shakeout, oil still sold at over $30 per barrel at the end of 1982, compared with $16 in 1978 and $2-$3 in 1972. Capital costs have, as already mentioned, risen recently. On the other hand, the market-clearing price of labor (the price at which demand and supply are brought into line) has clearly fallen, if not its actual price.
A major force behind all these changes and the economic obsolescence of so much capital equipment in the West has been the emergence of the developing countries as major manufacturing centers. They have been acquiring a comparative advantage in an increasing number of industries formerly the preserve of the West. This so-called transition thesis, which has been most fully developed by Professor Michael Beenstock of the City University of New York, does tie together a number of developments.18
The most obvious is the growing uncompetitiveness of many parts of traditional industries in the West, not just textiles but a large range of metal and engineering goods and even services, such as shipping. Manufacturing has, however, been the prime victim. As manufacturing is also the most capital-intensive sector, the downward pressure here has contributed to a general fall in the share of profits in the national income of most Western countries. The pressures on the rate of return in the old countries and competitive advantages of the new centers have directed investment toward the developing countries, where fixed investment grew in the 1970s at an average annual rate of 7.8 percent, compared with 1.6 percent in the developed world. Thus, Third World indebtedness is a natural development-but, like similar investment a century ago, it is prone both to fits of overexuberance and to setbacks whenever a global recession puts a check on the growth of markets.
It is a paradox that the long-term success of the developing countries should have weakened economic growth in the West, which has in turn hit the market opportunities and borrowing power of the less-developed countries (LDCs) themselves; but, paradox or not, it seems to have occurred.
The strongest evidence for the Beenstock "transition thesis" is the simple fact that, taking the decade since 1973 as a whole, Third World countries have performed better than the advanced ones. Non-oil developing countries were only slightly affected by the 1973-75 recession and did better than the developed ones in the 1975-79 recovery. Third World countries have suffered a substantial check in the 1979-82 recession; but even so they have fared considerably better than the Western world. The Wharton projections to 1987 again show the Third World countries outstripping the First by a substantial margin.19
GROWTH OF REAL GDP
(Annual average compound growth rates)
Golden Age First Recovery Second Wharton
1960-1973 oil shock 1975-1979 oil shock Forecast
1973-1975 1979-1982 1982-1987
Developed countries 5.0 0.3 4.0 0.8 3.0
United States 4.1 -0.8 4.5 -0.1 3.3
Japan 9.9 0.6 5.2 3.2 3.4
Europe 4.8 0.8 3.4 0.8 2.4
West Germany 4.5 -0.7 4.0 0.6 1.7
Oil exporting 8.2 2.3 5.4 0.1 4.2
Other developing 5.5 4.8 5.4 2.0 4.2
Centrally planned economies 7.2 5.6 4.6 2.9 3.3
SOURCE: World Economic Outlook, Wharton Econometric Associates.
It may be said that Third World competition still accounts for too small a proportion of the imports of developed countries to be responsible for the stagnation of the last decade. This is not as decisive a rebuttal as it seems. In many ordinary domestic markets threats from low-cost marginal entrants can have a profound effect on profits and costs even when the sales involved are comparatively low; the Third World competition so far seen is only the tip of the iceberg.
But the "transition thesis" by itself does not account for the unemployment and stagnation of the Western world. It is impossible for one country to have a comparative advantage over another in every product; and there normally exist terms of trade at which a country can pay its way in the world and sustain a normal level of economic activity.
Beenstock's main explanation of why the development of LDC competition should have caused unemployment in the West is what he calls "mismatch." Redundant steel or garment workers cannot transform themselves into computer programmers overnight; and inflexibility of relative wages, and controls and subsidies in the European housing markets, hinder mobility. There still remains the awkward fact that redundancies in traditional industries do not seem to be matched by comparable excess demand for labor in the service sector or in the newer industries. Moreover, the rise in real wages in Europe relative to productivity, and the decline in the rate of return to capital and the share of profits, seem to be too great to be accounted for merely by a relative shift away from the older capital-intensive industries.
Third World competition and even energy price changes would not have led to such prolonged stagnation and inflation without institutional rigidities, which prevented relative prices from adjusting enough to secure full employment. These rigidities are particularly great in the labor market. At this point, some distinction must be made between Europe and North America.
During the period of postwar growth, a rapid rise in European real wages was possible with little disturbance. Some of the factors which made this possible were straightforward gains from catching up with the best U.S. methods; a demand for more and more of the same types of goods which encouraged economies of scale; cheap energy; and as yet little resistance to growth from any "green" environmental lobby. In addition, "money illusion"-i.e., the habit of treating tomorrow's dollar as equivalent to today's-enabled the finance ministers and central banks to keep real interest rates and unemployment below the levels at which they could be sustained in the long run.
There have always been strong social, political and institutional forces in Europe tending to resist either reductions in average real wages or changes in relative remuneration. But these did not matter so much when the above-mentioned forces, which made rapid real wage growth compatible with full employment and with minimum disturbance, were in operation. But when these unusually favorable factors ceased to operate, the structural rigidities began to cause far more harm.
In the United States these forces were less powerful; and despite the record postwar unemployment rates of 1982, the unemployment increase was much less than in Europe. (With such wide variations in national labor market characteristics, changes in unemployment rates are more comparable than absolute amounts.) In the United States the unemployment increase between the 1973-75 recession and late 1982 has been about three percent. In Europe it has been over six percent. Despite the cyclical unemployment peak of 1982, the U.S. labor market has been able to absorb over the last decade a rapid increase in new entrants, youths, and women, at the expense of lower real wages and lower productivity. Average real earnings per hour for U.S. private-sector workers were lower in 1981 than ten years earlier and have not shown any net growth since 1967. All the rise in American output in recent years has come from increases in the employment of labor, with hardly any net gain in productivity or per capita real earnings.
In Europe real wages have grown faster for those who have retained their jobs; and many people have been priced out of work. In Japan and still more in Southeast Asia, real wages have been even more flexible than in the United States, and they, rather than employment, have taken the strain.
Why then has institutional sclerosis crept up on the West, but at different speeds in different countries? The most plausible theory I know relates to the politics and economics of common interest groups and collusive associations. These cover a great variety of organizations and informal groupings-professional associations, trade unions, price rings, industrial lobbies that campaign for protection from foreign competition and for government subsidies. The list is endless.
Some of these associations may strengthen the cohesion of society by creating a network of local professional loyalties intermediate between the citizen and the state. But they reduce growth, efficiency and the capacity to adapt to outside events. The pernicious direct effect of "common interest organizations" is that they prevent or delay the changes in relative incomes and prices required when productivity changes or the system is subject to an external shock.
The effect of common interest groups resisting economic adaptation is greater than that arising from the pure influence of monopoly power efficiently wielded. For the power of the group is not even efficiently wielded. Some of the most important effects arise from the high cost of decisions within these groups. Major external changes will alter the optimum policy of such organizations and require difficult bargaining with other organizations and/or the government. Thus, cartelized organizations are cautious about innovations and change.
As important as the direct effects in the market place are the political by-products of interest group lobbying. The complexity of regulations and the scope of government are increased. Increased resources are devoted to lobbying, negotiations and political activity; and individuals with these abilities will be favored relative to those with technical or entrepreneurial abilities.
The most plausible theory which explains why collusive organizations and interest group politics are more important in some societies than others is that of the American economist, Mancur Olson.20 These organizations are costly to maintain and even more costly to start. Each individual member has an incentive to be a "free rider" on the actions of others. Participation is costly whether in the form of membership dues, strike action or lobbying. For interest groups to become effective, the leaders have to provide "selective incentives" such as professional information or social insurance benefits which make participation individually worthwhile. Alternatively, moral pressure or coercion may be applied. The relevant incentives, loyalties and pressures all take many years to evolve. But once they have become established, interest groups tend to maintain themselves almost indefinitely at much less cost. From this we derive Olson's Law:
Stable societies with unchanged boundaries tend to accumulate collusive organizations and interest groups over time, and thus tend to lag behind in their growth rates and capacity to adapt in comparison to newer and more dynamic societies.
Thus it is not surprising that a country such as Britain, which pioneered the Industrial Revolution and has had the longest record of political freedom and settled institutions, should have been among the first to succumb to economic stagnation (whether it will be the first to emerge is another question), closely followed by the industrial Midwest of the United States. On the other hand, countries "where common interest organizations have been emasculated or abolished by foreign occupation, totalitarian governments or political instability" experience rapid rates of growth "after a free and stable legal order is established." The countries of continental Europe in the 1950s and 1960s are the obvious examples.
But as World War II and its aftermath receded, and settled democratic institutions moved into their second generation, it was only to be expected that producer-interest groups would gain ground in Western Europe as well. The countries now experiencing the most rapid growth are in the Pacific Basin, where industrial development is still a novelty and untrammeled by collective or political pressures.
Olson has now extended his theory to cover unemployment and prolonged recession as well as low growth. He starts from a state where there is involuntary unemployment, i.e., there are workers who would be willing to work for less than the going wage but still cannot find jobs. Mutually advantageous job contracts could in principle be made between employers and unemployed workers at a wage below the going rate, but above the value of the unemployed person's free time. Who, Olson asks, might have an interest in blocking such transactions? The answer, of course, is "workers with the same or competitive skills." Existing workers can only prevent such contracts if they are organized into a cartel or lobby or are informally able to exert collusive pressure. If we recall the earlier argument that collusive organizations find it particularly difficult to react to changed market conditions, for instance, those requiring lower real wages, it is not difficult to see how the impact of shocks such as oil price increases, or Third World competition, or counter-inflationary policies, can be felt in a prolonged and deep recession.
It seems clear that the collusive groups with the most power to price workers out of jobs, or stop them pricing themselves into jobs, are the labor unions, in Western Europe at least. In the United States it is probably the political lobbying of a great variety of producer groups ranging from the American Medical Association to corporations threatened by imports. The European variety is the more harmful.
The deep-seated structural problems of the older industrial nations are not easily amenable to summit diplomacy. For they are neither parochial problems nor international problems, but common problems, which have to be tackled on the spot by whoever has the opportunity to act.
International economic cooperation can help to minimize the financial and macroeconomic disturbances which make the real problems worse. It can also help to keep down the economic arms race in trade restrictions, subsidies and other costs and distortions. These are particularly pernicious, because, although they are imposed to protect employment in particular sectors, their ultimate effect is to delay adjustment and to worsen either employment or living standards or both.
Progress on the international economic front will require not only a more coherent response to default risks and to lender of last resort operations; it will also require a common demand management and monetary policy by at least the three or four major countries of the system. But the result of all these financial efforts will be extremely disappointing if there is not a great improvement in the ability of the developed countries of the world to respond to changes in demand, technology and costs-in what is known as the "supply side" of the economy, using this term for once in its correct sense.
Exhortations, committees and training schemes may have their place in such improvement. Far more important is to allow the price mechanism-in the labor as well as in the goods market-more scope, to provide incentives to produce the products of the future rather than the past, to price workers into jobs and to move resources from areas of surplus into areas of scarcity.
1 Cited in the Memoirs of Lord Chandos, London: The Bodley Head, 1962.
2 Long-term real interest rates were also estimated at similar levels; but the calculations here are suspect. To derive them one would need to know the views among the borrowers and lenders about the path of inflation rates for many years ahead. One piece of direct evidence widely ignored was the yield on U.K. government-indexed bonds which fluctuated around 2.2 to 3 percent. Unfortunately, these lower real long-term rates had little practical effect. For nearly all corporate and many country loans were either on a short-term or variable-rate basis.
3 The inflation differences which matter for international trade are not the difference in domestic consumer prices indices, but in the prices of products which enter into international trade. Morgan Guaranty uses the index of wholesale prices of non-food manufacturers as the best approximation for this purpose.
4 OECD Economic Outlook, Paris, December 1982. OECD forecasts are based on the technical assumption of unchanged exchange rates. The actual U.S. current deficit could turn out less if the dollar falls and trade flows respond reasonably quickly.
5 International Trade, 1981-82, Geneva: GATT, 1982.
6 The same governments that were so anxious to obtain export contracts from the Eastern bloc and to sell arms to Latin American dictatorships, such as that of the Argentine, hesitated to expand domestic demand for fear of inflationary consequences; but no one explained why an order which came from abroad or as a substitute for imports was any less inflationary than a home market equivalent. The combination of so-called "sound money" plus make-work policies which gripped European policymakers was every bit as half-baked as the earlier types of Keynesian demand stimulation.
7 The Economist, December 2, 1982.
8 Time, December 20, 1982.
9 A deeper thought came to mind during the alarms of 1982. Was it reasonable that cash balances for household transactions or domestic business should be put at risk because of problems that arose in lending surpluses to Third World industrializing countries? There was an old proposal that the provision of balances for monetary transactions should be strictly separated from borrowing and lending operators. Under this concept, known as "100 percent money," banks would be required to have liquid reserves sufficient to repay all their deposit liabilities at sight if requested; and they would be remunerated by service charges. The difficulty with this idea is that the interest-paying liabilities of other investment institutions might tend to circulate as money in preference to the interest-charging obligations of the reformed banks. But the possible recurrence of demands for "100 percent money" deserves at least a footnote.
10 The range under discussion for the revised quota total was $93 billion to $110 billion. See Secretary Regan's testimony before the House Banking Committee, December 22, 1982.
11 The impact of short-term or cyclical forces on the longer-term equilibrium is sometimes known as hysteresis, based on an analogy from the physics of electromagnetic fields.
12 Milton Friedman and Anna Jacobson Schwartz, Monetary History of the United States 1867-1960, Princeton: Princeton University Press, 1963.
13 Named after Charles Goodhart, a senior Bank of England economist who promulgated it informally in the later 1970s.
14 F.A. Hayek, 1980: Unemployment and the Unions, London: Institute of Economic Affairs, 1980.
15 Some account of these can be found in S. Brittan, How to End the Monetarist Controversy (revised edition), London: Institute of Economic Affairs, 1982.
16 As advocated by Professor Ronald McKinnon of Stanford in testimony before Congress.
17 See Herbert Giersch and Frank Waller, "On the Recent Slowdown in Productivity Growth in Advanced Economies," Economic Journal, forthcoming.
18 See Michael Beenstock, The World Economy in Transition, Winchester, MA, and London: Allen & Unwin, 1983.
19 The contrast is even more dramatic if the most rapidly industrializing Asian countries are examined. In the developed world, GDP growth in 1982 has been negative and is expected by Wharton to average three percent in the years to 1987. But for Korea it is put at five percent, rising to five to seven percent in the years ahead. For the Philippines it is three percent rising to six percent. For Hong Kong and Singapore current growth rates of five percent are regarded as "low."
20 See Mancur Olson, The Rise and Decline of Nations, New Haven: Yale University Press, 1982.