The troubles of the dollar, intermittently rising close to the crisis point during the year, once again dominated the international economic system. It became evident by the summer that the November 1978 measures of massive international support for the dollar had not worked as planned. Part of the trouble was that the post-1975 U.S. economic expansion proved to be more robust than had been supposed; moreover, the Federal Reserve's deflationary stance seemed to the rest of the world unconvincing. So in the end the American boom had to be publicly and unmistakably decapitated. This was done on October 6, with all the appropriate gestures, by Mr. Paul Volcker, who had taken over the chairmanship of the Federal Reserve System a few weeks earlier.

By then, the rate of increase of U.S. consumer prices had risen to double figures and the only way to convince the international community that the United States was this time in deadly earnest about reestablishing the capacity of its currency to act as a reliable store of real value was to provide demonstrable evidence that the U.S. economy's apparently irresistible propensity to grow had not only been stopped but had been effectively reversed. The dollar's recovery in foreign exchange markets thus became dependent on the belief that the series of measures taken by the U.S. authorities, culminating in the Volcker package, could be relied upon to push the United States into a recession. To this extent, whatever good domestic economic reasons there may have been for curbing the pace of an already flagging economy-and for doing so in a way which decisively lowered the inflationary expectations of native Americans-the form of the final deflationary squeeze and the degree of its severity were imposed by external forces.

It is true that American self-suspicion not only reflected but also reinforced the international pressures. There was probably enough of this suspicion to counter the possibility of a hostile popular reaction that here was a healthy home-grown piece of American prosperity killed off by foreigners. It was visibly not healthy-though that may still not in the end save the foreigners from being blamed for their part in the 1979-80 economic reversal, once the full consequences in terms of unemployment and business bankruptcies become apparent later on.

The monetary relationship between the United States and "foreigners" was, predictably, a great deal more complex than this simplified version of events suggests. The foreign central banks were indeed exceedingly active in buying up dollars as part of a collective effort to ward off a succession of speculative attacks on the U.S. currency in foreign exchange markets. Britain and Italy, which against most expectations proved to have the two strongest currencies in the European system during the first half of 1979, were especially heavy buyers of dollars which they added to their reserves. It was the German central bank, however, which played the crucial role during the early months of the year and again later on. It began the year with heavy support operations. Then during the spring, when the U.S. exchange rate strengthened markedly, the Bundesbank sold dollars in large amounts, chiefly in order to prevent a sharp fall in the D-mark rate, which would in turn have affected German domestic prices of imported commodities whose level is fixed in dollar terms.

To that extent Germany, with its overwhelming wish to avoid any appearance of even a small increase in the rate of inflation at home, was responsible for holding back an upsurge in the dollar exchange rate that would have imposed a severe cost on those who had earlier speculated against it. As some observers argued, the occasional demonstration that speculating on the expectation of a weak dollar was not always an absolutely safe one-way bet might have had a salutary effect on the subsequent mood of international currency markets. But the German central bank's answer to such criticisms, namely that over time it fulfilled its function to moderate the violent movements, both upward and downward, in the market value of the dollar, had some force. Over the period as a whole, including the subsequent movement of exchange markets against the U.S. currency, the Germans ended up with a large net acquisition of dollars.

It should be noted that although there is a tendency to talk of "foreigners" and "international speculation," those concerned frequently included quite a lot of Americans, taking what they regarded as rational precautionary measures in converting a part of their portfolios of assets into foreign currencies. The individual who is branded as a "speculator" sees himself as a sober-minded "diversifier" of his investments.

The trouble was that in 1979 there were altogether too many people and businesses determined to diversify out of the dollar at the same time; its current weakness combined with long-term investment reasons to push them in this direction. This tended to put a ceiling on the dollar exchange rate, which bore little relation to the purchasing power of the currency in comparison with others. The point was simply that whenever its exchange parity went up beyond a certain point, the temptation to spread future risks by buying alternative currencies at a more favorable rate became irresistible for a significant number of market operators. What this implies is that the dollar now requires a larger and more sustained improvement in the underlying forces determining the long-term value of the currency-the balance of payments on current account and the rate of domestic inflation-to establish an improvement in the rate of exchange.

Thus the confidence expressed by authoritative American spokesmen early in 1979 that the tide of adverse forces was already being decisively reversed turned out to be premature. Whether it was Henry Wallich, a governor of the Federal Reserve, explaining that the substantial part of the American trade deficit was simply due to the fact that the U.S. business cycle in its upswing had got out of phase with that of the rest of the world, and would shortly be in phase again, or Richard Cooper, Under Secretary of State for Economic Affairs, pointing out that the flow of European and Japanese investment into the United States was growing on a sufficient scale to reverse the earlier adverse balance in the U.S. capital account, the predicted effect seemed to get systematically swamped by other factors.1 These factors were, it is arguable, in the last resort psychological-in the sense that market expectations in the face of any event which might cause difficulty for the United States were almost invariably reinforced. Similarly, developments which were apparently favorable tended to be discounted.

A clear example of the latter was the reaction to the sharp change in the world market for cereals following the poor harvests in some of the main producing countries. The United States had excellent harvests; it was evident that world trade in wheat and coarse grains would increase significantly, that prices would be higher, and that over half of the total of world exports of these products would be supplied from the United States. However, one consequence of this favorable turn was that domestic prices of food in the United States would rise and thus add something to the inflationary trend. In the balance of commentary on a development which was clearly going to be highly beneficial to the international position of the United States, it was the latter point which appeared to attract particular attention.

It was indeed very hard to see how the United States could obtain some offset to the sharp deterioration in its terms of trade caused by the rise in the price of imported oil without an increase in the prices of internationally traded products of American origin, which also happened to be sold in the home market. This is only another way of saying that the Americans were fortunate enough to be able to meet the increased oil bill by transferring relatively fewer additional real resources than other nations to the oil producers. However, the confused thinking behind the slogan that had now been generally adopted about giving absolute priority to the fight against inflation meant that this American prize was promptly put into the disaster category.

In a more general way, there was a tendency to understate the causes of the acceleration of the inflationary trend in 1979 which derived from events over which the U.S. policymakers had little or no possible control. Food, energy and the rise in prices resulting from the big and sustained depreciation of the dollar during the earlier period up to 1979 were together responsible for a sizable portion of the additional inflation experienced in the year. The extent of the "J-curve" effect of currency devaluation-i.e., that the adverse effects of higher import costs come first, worsening the country's international performance, before the benefits of greater competitiveness come through-had been underestimated in the United States. This is not to say that domestically induced inflation was not also a major problem. But the latter was too readily and too often treated as if it were the whole problem.

It is instructive to contrast this mood with the contemporaneous international response to economic developments in a country like Germany. The German economic policymakers had been highly successful during the late 1970s, and this led to a market reflex based on the expectation that they would continue to be so. It was only necessary to observe how the market responded in the first half of 1979, when the German central bank once again, for the third year running, was failing to achieve the targets set for the control of the country's money supply. There were, as we shall see, good excuses that could be made for this failure. The essential point was that Germany had accepted some of the consequences for the domestic economy of the emergence of the D-mark as an international currency, accepting it as its proper task to provide support for, rather than to replace, the dollar. But what was noteworthy was that the excuses never had to be made; the market generally gave Germany the benefit of the doubt. Meanwhile the President of the Bundesbank, Dr. Emminger, explained with engaging frankness that after all a country with an appreciating currency had certain domestic price advantages which meant that it could afford to be a bit lax in pursuing its objective of controlling the money supply.2 One cannot help wondering how a comparable explanation about an apparent failure of monetary policy would have gone down in some other financial center, London for instance.


This provides the background for what was perhaps the outstanding development in the economic relations of the Western world in 1979: Germany moved firmly and visibly into the center of the international stage. This was not immediately obvious to all observers, though many of them sensed that something had changed. In 1978 there was a tendency to group Germany and Japan together as problem countries, especially for the United States, which was trying to lead the world out of economic recession with little help-and occasional hindrance-from the other two most powerful economies. In the following year the U.S.-Japanese economic relationship improved in a dramatic fashion. The clearest evidence that the Japanese had become for the time being a non-problem was the fall in the yen-dollar rate from its 1978 peak by one-third. The center of the dollar's troubles moved elsewhere. Germany emerged as the main alternative pole of attraction in the international financial system.

It had all the appearance of a reluctant emergence-rather like a minor actor who unwittingly stumbles backward into the limelight. There had been, it is true, the prelude to the drama when the Germans had appeared in the lead part during 1978 in the creation of the European Monetary System (of which more later). But this earlier event was seen by the Germans as an effort to share a key currency role with others, rather than to capture such a role for themselves. There were admittedly certain ambiguities here about the kind of sharing which the Germans had in mind: although the authority over European monetary arrangements was certainly intended to be collective, it was not absolutely clear whose national policy was to be adapted to whom.

The gradual shift in German thinking on the subject of a possible reverse role for the D-mark was reflected in a carefully written statement by the Bundesbank toward the end of the year. Characteristically for that institution, it was tucked away as one of a series of articles in a modest position in the bank's monthly report.3 The report tells the story of the increasing use of the mark as an "international currency asset" and of the problems that this brings for German monetary management. There is a long list of the various devices employed by the German monetary authorities from 1970 onward to fend off the inflow of foreign funds. However, foreign holdings of German currency continued to grow very rapidly, especially in the second half of the 1970s; by the middle of 1979 the total was twice what it has been in 1975. It became evident, as the international wave of speculation mounted, that there was no practical way of preventing D-marks from accumulating in foreign ownership and being used in transactions between third countries. The bank accordingly decided to confine its interventions, which had earlier been exceedingly active, to the task of influencing the form in which these internationalized D-marks were held, specifically to reduce their potential mobility so that being less volatile they had a lower nuisance value for the controllers of the national monetary system.

One interesting aspect of the development of the new role of the D-mark in the 1970s was its coincidence with the decline of the pound sterling as an international reserve currency. Sterling had accounted for some ten percent of international reserves at the start of the 1970s and declined to almost insignificant proportions by the end of the decade; meanwhile the D-mark's share of international reserves rose to 11 percent. The comparison between the past role of sterling and the new role of the D-mark is significant because of the Bundesbank's insistence on its own role as the guardian of a second reserve currency-a kind of surrogate for sterling-with no ambitions to replace the dollar.

It is evident that the German authorities were, and are, extremely sensitive on this point. That sensitivity was no doubt enhanced by the tenor of some American comment on the European Monetary System which saw in it a device that would, at the very least, make life more awkward for the dollar as an international currency, even if it did not successfully challenge its predominance.4 And the D-mark was after all the monetary cement which was intended to hold the EMS together.

Was the European Monetary System in fact a kind of preliminary dress rehearsal for the D-mark as the international key currency of the future? There was a view held by some European monetary experts that this was indeed the unstated, and probably largely unconscious, purpose of German policy in the establishment of the new system. If that was so, it would explain why the EMS avoided having a clear policy toward the dollar-a fact which particularly concerned the British, and also the Italians, both before and after the system started functioning in March.5 The question of the D-mark/dollar relationship caused trouble for the EMS almost from the beginning. As was observed above, the Germans were anxious, for their own reasons, to prevent the dollar exchange rate in D-marks from rising by more than a moderate amount. For the other members of the European system, notably the Belgians, this rate, which clearly understated the relative purchasing power of the dollar, threatened to make them uncompetitive in foreign trade.

The history of the EMS during the first few months of its functioning in 1979 illustrates both some of the unresolved conflicts of national policy inherent in it and the skill which the Germans, having now overcome some of their inhibitions about the acceptance of an international currency role, applied to the management of the system. The Europeans belonging to the new monetary bloc appeared to have established an island of currency stability, while those outside-Japanese, Americans, Canadians, British-were tossed about by a series of violent storms. It is known that the Germans in fact used very substantial amounts of D-marks in day-to-day intervention in the foreign exchange markets with the aim of preventing the escalation of any small movement into a speculative assault on the currency of any one of the member countries.6 This intervention took place well within the limits for permissible changes in currency parities set forth by the EMS agreement, and applied especially to the French franc.

These prompt intramarginal exchange market interventions certainly saved the monetary authorities of the European member countries a great deal of anxiety. As one participant in these operations remarked privately, "The appearance of stability was highly manipulated." Still, it worked. The net cost to Germany at the end of the period was not on a large scale, certainly by comparison with the cost which Germany incurred in supporting the dollar. The trouble, if there was one, with the EMS was that member states were almost too reluctant to devalue their currencies when the need became apparent, because of their anxiety about possible domestic inflationary consequences. And when the first agreed currency realignment took place on September 24, involving a small rise in the D-mark rate and a small devaluation of the Danish krone, the operation went off smoothly and did not give rise to a chain reaction of disturbances in other currency markets.

The unresolved conflicts were concerned first with the extent to which the dominant members of the bloc would be prepared to modify national financial objectives to accommodate the interests of other members of the EMS, when the going became more difficult. The second EMS currency realignment on November 29 was directly related to this question. It involved another devaluation of the Danish krone, which came under particular strain as the D-mark strengthened further with the tightening of German domestic financial policy, including a rise in interest rates. The Danes evidently feared, for some reason, that they would not be able to prevent their exchange rate from moving beyond the permitted 21/4 percent limit of divergence from the strongest currency, without very heavy intervention. And behind the problem of intra-EMS policy divergencies was the other major issue, that of the external policy of the European currency bloc toward the dollar. The two questions are closely interwoven.

What it is possible to say on the basis of the evidence of 1979 is that Germany's responses do not provide any support for the theory that the EMS is regarded as a stepping stone for the D-mark to a larger key currency role. As the Bundesbank made clear in the same statement cited above, it has been motivated to engage in extremely costly support operations for the dollar by a conviction that there is no available alternative to the latter as an international reserve and settlement currency at present. Certainly the ECU (the European Currency Unit), although it has begun to be used for certain settlements between European central banks, is not one. The D-mark, the bank shows convincingly, is very ill-equipped to perform the role. As the Bundesbank sees it, it has in fact played a role of international intermediation between those who wanted to reduce their dollar holdings on the one side, and the United States on the other. Its policy, it explains, has been to smooth the process by accepting, in a limited way, the movement of funds into D-marks while itself transferring more D-marks to the United States and accepting additional dollars in exchange.

The closing months of 1979 supplied a striking illustration of the political exposure that goes with the dollar's continued role as the key international currency. When the hostage crisis broke in November, Iran's threatened action against the United States, by the removal of its deposits and other liquid assets there, together with a refusal to accept future payments for oil in dollars, would have meant little if it had been applied to almost any other Western country. But the U.S. government, in anticipation of the event, felt impelled to embark on the risky course of freezing assets belonging to Iran which were under American jurisdiction-risky because of the possible effects on the nerves of other potentially unpopular governments in the Middle East and elsewhere holding their reserves in dollars-and to issue hurried official reassurances about the continued viability of the international role of the dollar. The U.S. Deputy Secretary of Energy explained authoritatively the reasons why the dollar was unique as an international settlement currency: no other currency could provide the necessary market and other facilities required to sustain an alternative medium of exchange for the immense volume of world oil transactions during the "next several months if not years."7 He was, as it happened, repeating almost exactly one of the arguments used by the German central bank in refusing for the D-mark the role of key international currency which circumstances appeared to be thrusting upon it.


Inside the European Community, conflicts on certain other aspects of economic policy became acute as the year progressed. The main battleground was the Community's budget. For somewhat different reasons two of the four larger member countries, Britain and Italy, felt keenly that they were receiving least-favored-nation treatment from their partners. The Conservative government in Britain which took office in May, for whom the EEC attachment was an integral element of party policy, carried its complaints about the unjust proportion of the budget which it was compelled to shoulder loudly and bitterly round the capitals of Europe-and finally to the European summit meeting in Dublin at the end of November. The issue became a major source of conflict, as dangerous and bitter as any the European Community had experienced in its 20-year history.

The Dublin meeting was deeply discordant in tone, and the British Prime Minister, Mrs. Thatcher, made it a point of honor to refuse the partial financial concessions offered to her. By the somewhat maladroit way in which she seemed to attack cherished Community principles, in particular to assert the right of a member country to treat its EEC budget contribution as if it were still, in some sense, national property, Britain managed to isolate itself from its European partners, including Italy, which had a comparable, though much smaller, grievance. In subsequent weeks the British government set about mending some of its fences. The gesture of intransigence having been made, it appeared that there might, after all, be a readiness graciously to accept some form of interim relief, so long as it was substantial.

Whatever the outcome of this particularly bitter dispute with one member country, the deeper budget problems of the EEC which surfaced in 1979 were, it was clear, likely to assert themselves with increasing force in the period ahead. The demands on future budgets, which were already apparent, would soon push the Community's expenditure beyond the capacity of the existing sources of Community revenue. Britain and to a lesser extent Italy were in effect signaling the arrival of a more fundamental crisis in the EEC.

The efforts made by these two nations which felt themselves to be especially disfavored by the EEC came up against the resistance of the Franco-German entente which had become the hard core of Community policymaking.8 It was not so much that the Germans were unsympathetic to the Italian or the British cases. The key factor was the hostility of the French government and the fact that West German Chancellor Helmut Schmidt realized that in order to make his initiatives in the European Community work he needed the active collaboration of France. Germany's activist policies in Europe, and elsewhere, were concerned with different and larger issues than making Britain and Italy happy and reasonably contented members of the European Community. Thus on the question of the overdue reform of the EEC's Common Agricultural Policy, while the Germans agreed about the need, they were not prepared to pay a price which involved even a small amount of French ill will. And if the Common Agricultural Policy was not to be quite radically changed, it would not be possible to meet Britain's and, to a lesser extent, Italy's grievances.

Europe's internal relationships mattered more because, as already indicated, the world economic balance of power had changed. A curious aspect of the matter is that the highly successful development of the German economy in 1979-the combination of accelerated growth induced by a major budget stimulus with a strong currency-occurred in large part as a result of international persuasion exercised on German policymakers, which Chancellor Schmidt went on denouncing to the end. In an interview in the autumn of 1979 he referred to the pressures that had been put on the Germans during the period of the weak rebound from the 1975 slump to move ahead and expand their economy faster than that of other Western countries, as part of the effort to re-create a collective economic momentum. His verdict, delivered with characteristic contempt for those against whom he had argued rather fiercely on this subject, was: "I think that this ridiculous little 'locomotive theory' has withered away now. And correctly so."9

In fact the "locomotive theory" of the Western economy-later renamed the "convoy principle" in a (not very successful) attempt to placate its opponents, since it implied that the strong countries would simply lead the weaker ones rather than be responsible for dragging the latter behind them-was precisely the policy that was adopted in 1978 and given the full sanction of the Germans and the Bonn summit of the heads of governments in July of that year. The German government reduced taxes and embarked on a large increase in public investment; 1978 was a bumper year for the latter and the rise continued, though at a slower pace, in 1979. Further reductions in taxes raised the budget deficit and so imparted a continuing fiscal stimulus to the economy, which then induced a growing response from the private sector and brought on the high prosperity and the expansionist mood of the middle of 1979. As the OECD remarked in its mid-year survey, "the concerted action programme" (another, more respectable name for the "convoy" principle) had worked and "the geographical pattern of the demand expansion has changed markedly." Domestic economic expansion was going ahead "much faster" in Japan and Germany than in the United States.10 The convoy therefore did arrive; but it came rather too late. It was too tardy to provide the hoped-for contribution to the American balance of payments in time to dispense with the further drastic measures of deflation which were imposed on the U.S. economy in the course of the year. By the second half of 1979, the dollar was suffering from the protracted crisis of confidence and had become distinctly accident-prone. The Iranian crisis in the autumn merely rounded off its troubles.

Already by the end of June, when the leaders of the seven major Western countries held their summit meeting in Tokyo, the United States was in no mood to persist in its earlier views about the appropriate international response when faced with an externally induced disruption of the economy of the Western world. It had led the way in the second half of the 1970s by accepting a massive balance-of-payments deficit, in large part oil-induced, while calling on other nations to adopt more expansionist policies. But in June no one demurred from the argument that a rise in the cost of imported energy, which was not promptly and fully offset by an equal rise in exports to the oil-producing countries, required a corresponding fall in domestic demand and economic activity in the importing countries. The Carter Administration had conceded defeat.


The difference in the international mood following the first oil shock in 1974 and the second in 1979 was in this respect striking. The second time around, the Western countries made no serious effort to concert their policies with the aim of averting the threat of recession as domestic demand was squeezed by higher energy prices. Perhaps the most important factor was that in the five years' interval they had had the novel experience of sustained high rates of inflation associated with relatively low economic activity, which made them nervous about policies which deliberately aimed to give a boost, however temporary, to domestic demand. This sentiment was reinforced by the clear evidence of an acceleration of the rate of inflation in the major Western countries during the first half of the year.

That was in turn connected with the effect on business sentiment of the recovery of demand outside the United States, led by Germany and Japan, combined with the hard-to-break U.S. boom and secondary economic stimulus promptly communicated to the regional groups in Western Europe and the Western Pacific, directly dependent on Germany and Japan for much of their foreign trade. The coincidence of the sturdy tail end of the American prosperity and the strong upswing elsewhere induced a feeling of business buoyancy which was especially in evidence in the middle of the year. Even the Americans, despite the evidence before their eyes, of a sharply declining rate of growth, appeared to be ready at this stage to be comforted by arguments, officially as well as unofficially sponsored, that the recession that was bringing the current business cycle to an end would be short and shallow.

Outside North America there were long-awaited signs that the revival of economic activity might at last be taking off into self-sustaining growth. The clearest indication was the revival of private investment, first in Japan and then in Germany. In Europe optimism was sustained by the movement of traditional indicators of investment demand, including the flow of orders to the steel industry, which after a long period of decline-cushioned by the efforts of an officially sanctioned steel cartel of the EEC countries-began to revive around the middle of the year. World trade in industrial products continued to move forward at the higher rate that it had reached in 1978, but its distribution had become more balanced and it looked more sustainable.

Above all, the disequilibrium caused by the discrepancy between the exceptionally rapid growth of Japan's industrial exports and the slow increase in its imports was, at least for the present, eliminated. In fact, so effective were the measures taken to cut Japan's surplus that its balance of payments moved into substantial deficit on current account as the year progressed, bringing a drastic fall in the value of the yen. Its decline against the dollar amounted to as much as one-third from the high point in the fall of 1978. The secondary effects in terms of increasing the competitiveness of Japanese exports in foreign markets did not immediately make themselves felt. Meanwhile, however, higher import costs were working through into domestic inflation, and toward the end of the year the Bank of Japan embarked on a series of drastic measures aimed at raising the international value of the currency. It looked as if this was another boom that was going to be hard to break. In terms of its international repercussions, its favorable, and highly unusual, feature was that it was home-grown in Japan and not export-generated.

It is arguable that the governments of the leading countries of the West were already prepared to apply a touch of the brake to the growth of their economies even before the succession of new oil price increases-in June especially-made their effects felt. It seemed safe, as well as prudent, to do so in view of what they saw as the underlying strength of world economic activity. But other views, and anxieties, on this subject were not wanting, although the doubts about the prospect ahead seemed to obtain wide currency only toward the end of the year. Anxieties centered first on the possibility that the American recession might go deeper; second, that it would coincide with a drop in economic activity elsewhere (for example in Britain, where it was an expected consequence of the Thatcher Government's deliberate policy); and third, on the probability that the Organization of Petroleum Exporting Countries (OPEC) would not behave as they had done after the first oil shock in the early 1970s, when they had facilitated the adjustment of the advanced industrial countries to the effects of the big, adverse movement in their terms of trade. There was little likelihood this time that they would go on the unrestrained buying spree in which they had engaged as their vastly increased foreign exchange revenue came in from 1974 onward. This was true especially for Saudi Arabia and the other Gulf States. The prospect was therefore that a much larger unspent surplus of oil export earnings would remain over for investment.

The most serious effect of these changed circumstances was on the balance of payments of the developing countries outside OPEC. A question which assumed increasing urgency was how far the existing financial arrangements could be depended on to recycle the large capital funds accumulated by the oil producers to meet this deficit. These arrangements had progressively come under strain as a result of the highly successful efforts of the developing countries during the 1970s to finance a substantial proportion of their imports by borrowing in international private capital markets. The result, in the form of a loss of credit-worthiness by some of them, as their debts mounted much more rapidly than their earning power, was in evidence beforehand and grew more serious during the year.

The other aspect of the matter, which came into sharp prominence with the development of the dispute between the United States and Iran in the fall, was how far the owners of the oil surplus funds would be ready to entrust them to the same financial mechanisms as they had used in the years following the first oil increase. As already noted, the movement to diversify these assets by investing them in other currencies was putting a strain on the dollar. But the long-term problem created by the new accumulation of discretionary funds was not that the United States would be embarrassed in any significant way if the additional money were invested in other financial centers or in other currencies. It was rather whether the financial authorities responsible for some alternative national currency, or currencies, would be able or willing to act in the role of worldwide financial intermediary in a manner which satisfied both the owners' requirement for liquidity and the numerous potential borrowers' desire for ready access to a large and efficient capital market. There were no viable candidates in sight; but that would not necessarily avoid the travails attendant on trying to find one.


The oil price increase also posed a threat to one important and promising development in North-South relations of the late 1970s. During the five years following the end of the great business boom of 1973 imports of manufactured goods by the advanced industrial nations from the developing countries increased rapidly, at a notably higher rate than the exports of the advanced industrial countries to each other. The new exporters were out-competing the old not only in the traditional lines of textiles and clothing but also in certain engineering products. Their market share of imports of engineering goods in the advanced industrial countries, starting admittedly from a modest level, rose by about two-thirds in five years.11 A trend of equal importance for the long-term future of this improved trading relationship was that it was balanced by an increase in the share of the markets of developing countries in the exports of manufactures from the industrial countries. The latter of course includes exports to the oil producers in the developing world. Even so, it was a striking change in a period of five years for North America to increase the share of its exports of manufactures going to developing countries to almost one-third-that is, to a larger proportion of the total than that absorbed by Western Europe and Japan combined. A similar switch in the relative dependence on markets in developing as compared with developed countries occurred in Western Europe's exports of manufactures.

The international economic balance, measured in terms of market dependence, was thus in the process of changing. But how to interpret the change was more problematical. The aggregate figures reflected the outcome of a series of complicated cross currents. The advanced industrial countries greatly increased their exports to the markets of the developing world, with the main emphasis on the oil-producing countries, while at the same time a group of developing countries which were not oil producers managed to capture substantial new markets for their manufactured goods in the markets of Western countries.

The two movements are not in any evident way causally connected. The rise in the efficiency and the international comparative advantage of the newly industrializing countries (NICs) simply coincided with the export drive of the advanced industrial countries in certain parts of the Third World. But now the NICs, which consist of a comparatively small number of countries in the Far East (Korea, Taiwan, Singapore and Hong Kong) and in Latin America (Argentina, Brazil and Mexico) have become more vulnerable because of the protectionist impulse of Western countries suffering from high levels of unemployment, which are subject to-or subjecting themselves to-further deflationary pressures as a result of the events of 1979.

As the GATT remarked in its 1979 survey of the performance of the NICs: "Against the background of the numerous protectionist developments of recent years, the relatively high growth rate of industrial countries' imports of manufactures from developing countries may appear suprising. . . ."12 The explanation lies partly in the way in which these countries have succeeded in diversifying the export mix of their manufactured products. They remain, however, heavily dependent on their traditional exports of textiles and clothing; and the textile industries in the Western world which compete with them are in many countries the largest single employer of labor in the whole of the manufacturing sector. All the available evidence, including the special arrangements made for trade in textiles in the "Tokyo Round" of the GATT in 1979 (discussed below), indicates that this industry intends to conduct a vigorous battle to safeguard its home markets from the threat of further inroads from low-wage producers in the developing countries. If, as the responses to the events of 1979 suggest, a period of slower growth lies ahead in the Western economy, attitudes which have become widely ingrained in the textile industries will tend to spread to other sectors. In that case the Asian NICs which have been outstandingly successful in their efforts to capture a growing share of the Western market for engineering products-they account for over half of total sales of these products by Third World countries in Western markets-will be at risk.


In the broader context of economic relations between the advanced industrial countries and the developing world as a whole, policies were overshadowed by the domestic problems of the former. It was not only a matter of anxiety about the effects of a more liberal approach to trade on levels of industrial unemployment; the rich countries were also in no mood to increase the volume of development aid at a time when national budgets were under increasingly severe scrutiny. There was a widespread view that an important source of the inflationary pressures from which the West was finding it so difficult to escape was the reaction of taxpayers, typically in the form of higher wage demands, to what they regarded as excessive claims made on them by public authorities. It was not a time for international generosity.

Even when Western countries did agree to an increase in their aid contribution, as for example in the second Lomé Convention which was signed after protracted negotiation by the EEC with the 57 so-called ACP (African, Caribbean, Pacific) states at the end of October, the outcome was only achieved by the application of considerable and sustained pressure by the developing countries concerned. It was political rather than moral pressure that worked on the EEC.

Its original offer of aid for development, made in May, covering the period 1980-85, was only some 50 percent larger in money terms than the amount supplied under the first Lomé Convention in 1975. The EEC's desire was to arrive at a quick settlement with these nations with which it recognized a special relationship. But they balked at what appeared to be a net reduction of aid in real terms, to be spread among a larger number of countries than the 1975 allocation. The donors had to be induced, in the course of some months of further negotiation, to do better.

It was not only the wrangle over the amount of aid which delayed agreement; there were a number of other matters on which the 57 countries declared themselves less than fully satisfied. They are mostly small countries, and a number of them are highly dependent on the market price of one or two key commodities for the difference between subsistence and prosperity. In the earlier convention the EEC had established a stabilization fund, applying chiefly to tropical products, called STABEX, which was intended to supply insurance cover against the effect on export earnings of a fall in these commodity prices. The new element in the second Lomé package was a scheme called MINEX which was to provide some of the same benefits to producers of mineral products. It was however cast on a less generous scale. The EEC countries in the end jibbed at the prospect that they might be called upon to make good the large losses caused by the extremely volatile market behavior of metals, like copper, which are in widespread use and are essentially sensitive to movements in the business cycle. So the conditions governing the use of the new fund, which is of modest size (under $400 million), allowing for the fact that it is intended to accommodate such major mineral producers as Zaïre and Zambia, are restrictive.

Probably the best that can be said about the continuing dialogue between rich and poor countries in 1979 is that, even though there was little evidence of movement toward the establishment of a satisfactory long-term relationship, the fierce tone which was characteristic of the formal encounters of the two sides during much of the 1970s was somewhat moderated. The fifth UNCTAD conference on the problems of developing countries, which took place in Manila during May and June, although hardly a friendly affair, was felt by many of those involved to have been less dominated by adversary tactics and by the spirit of confrontation than earlier meetings on the same theme.

It would be too much to say, however, that there was much evidence of consensus in the conclusions which attracted the support of a majority of the participants. Indeed, where these aimed to impose specific obligations on the developed countries, they generally failed to obtain the agreement of the latter. The essential matter of establishing a Common Fund to provide international assistance to the producers of a number of commodities of special interest to developing countries-a contentious issue left over from the previous UNCTAD meeting in Nairobi in 1976-had in fact been agreed in advance of the Manila conference. That may have helped the atmosphere. Although it was a much smaller fund than the Third World countries had asked for, the donor countries did show a willingness to take a more liberal view on the arrangements governing the way in which it was to be used.

Manila was also notable for providing the occasion for a statement by Mr. Robert McNamara, President of the World Bank, on a long-term program aimed at improving relations between developing and developed countries. The main emphasis was on trade. The speech gave a gloomy, though realistic, appraisal of the poor prospect, during a period of slow growth in the advanced countries, for dismantling the great number and variety of non-tariff barriers employed by these countries to impede the exports of the developing world. But he went on boldly to propose that, as soon as economic conditions in the West improved, additional development aid should be earmarked for the specific purpose of expanding exports from poor low-wage countries. While the logic of his proposal could not be faulted on the assumption that the West had returned to full employment and was seeking to realize the gains of comparative advantage in international trade, the political issues involved were, in the conditions of 1979, highly sensitive and even explosive. The choice of certain development projects by the World Bank was already the subject of complaint by some industries, notably textiles, which had been adversely affected by Third World exports.

Mr. McNamara's proposed remedy for the industries so affected was to offer them some form of international "adjustment assistance" and to provide it on a far more generous scale than had been hitherto contemplated by any organization, national or international. It should, he suggested, be supplied not only to the workers directly displaced, as well as to the local communities affected by competing imports from developing countries, but should also go to entrepreneurs who lost their shirts when they were no longer able to compete in a previously protected domestic market. This daring adaptation of the capitalist ethos in the service of international amity and the benefits of comparative advantage stood in stark contrast to the highly restrictive position maintained by Western industries that were affected by Third World competition, notably in the field of textiles, in the GATT Tokyo Round.


The long, drawn-out negotiations in the GATT on the reduction of tariff and non-tariff barriers were brought to a formal conclusion in Geneva, after five and a half years, in April. The end of the Tokyo Round naturally served to recall the concluding stages of the Kennedy Round of trade negotiations in 1967, in an atmosphere of elan and excitement, which was recognized at the time as an expression of the joint will of the nations of the Western world to advance by another large step toward the objective of open world markets in industrial products. The nations involved, individually and sometimes collectively, had been awkward at various stages in that negotiation too, and the outcome was in doubt almost up to the end. But there was no mistaking the underlying international mood in which the Kennedy Round took place: it was a mood which could accommodate bold bargains.

There was no sign of boldness in the bargains which emerged from Geneva in the spring and which still required several months of refinement and clarification before they secured the approval of the governments of the main trading countries. All the bets seemed to be heavily hedged. Even the program of tariff cuts, which did no more than lop some two to three percentage points off average rates of import duty on manufactured goods (around ten percent in the main industrial countries), and was going to take eight years over the process, required the backing of an insurance policy to calm unsteady nerves. It was agreed that the annual tariff reductions could be stopped dead after five years, if parties to the agreement found them too uncomfortable.

Sensitive items like textiles were, as already indicated, subject to a special let-out. The first tariff cuts were delayed for two years after the normal starting date (January 1980) and they can be halted at any time if the importing countries run into any trouble which they regard as serious. Moreover, behind the facade of the new tariff exercise there were the considerably toughened quantitative restrictions on textile imports from developing countries, negotiated earlier under the revised international Multi-Fibres Agreement. Textiles even came in for specially protective treatment when they were the subject of ordinary trade between advanced industrial countries. The outcome of the special terms negotiated by the U.S. Administration with the American textile industry left many of the Europeans, who had hoped for a freer run of a highly protected market, feeling that when any domestic interest group was strong enough to mount an effective lobby in Congress (as the textile lobby had shown once again it was preeminently capable of doing), the Administration was ready to give very little away to foreigners. The prize case which attracted attention in Europe was a cut in the U.S. tariff on certain woolen textiles which would still leave the level of protection in 1987, at the end of the eight years, at 33 percent.

One grand gesture which recalled something of the spirit of the 1960s negotiations was the agreement to abolish all tariffs and trade restrictions on aircraft for civilian purposes. The real issue which this raised was how far governments could be persuaded to stop intervening in the many ways open to them, other than trade restrictions, to induce national airlines to place their orders with suppliers whom they happened to favor. In this case there was an early test of the willingness of one notoriously interventionist government, the French, to change its traditional style of behavior in order to abide by the spirit of the new arrangement.13 The underlying question, which applies to a number of other countries besides France, about the ultimate willingness of officials armed with public power to exercise deliberate restraint in using it, could not of course be answered in 1979. But the matter was at least taken seriously enough for the GATT to proceed with plans to create a committee of surveillance to hear complaints about aircraft sales which appeared to infringe the new rules. The agreement, as well as its policing, was a distinct victory for the United States. International trade in aircraft is a large and growing business, and the United States has a dominant position in it.

There were other bits of veiled and complicated power play in the negotiations, which did not always go the American way. The Europeans were able to obtain the removal of the objectionable American law which compelled the Administration to impose countervailing duties on goods which the Americans held to be subsidized, regardless of whether they could be shown to cause damage to U.S. firms. The expected return for this concession was a tightly drawn code designed to control the use of subsidies by the Europeans and others. In the event the agreed rules, although they do indeed make it more difficult to impose direct subsidies on exports, leave the more important, and much more complicated, business of indirect subsidies resulting from various forms of government intervention for purposes other than the explicit encouragement of exports largely uncontrolled. It is in fact precisely this kind of subsidy which the European Community authorities themselves have had so much difficulty in controlling in their own member countries. However, in terms of the short-term politics of the negotiation, the 1979 agreement on subsidies gave the European Community more or less what it wanted, at the expense of the wishes of the United States.

The most interesting question about the significance of the Tokyo Round concerns not so much the detailed content as the practical handling of the various codes of conduct, mainly on non-tariff barriers, which were so exhaustively negotiated. An outstanding example is the code laying down rules for government procurement of goods that are of interest to exporters in other countries. It not only marks a beginning in an area of economic activity which is already very big and likely to continue to grow, but also points the way to a process of continuing negotiation which, if it is followed, will progressively increase the range of items subject to international surveillance.

Here again the European Commission has a coincident interest in opening up this category of transactions, which has in large measure been treated as a national preserve, to international inspection. It has indeed been struggling, not altogether successfully, with entrenched government habits in this field for some time past. Of course its aim is a more parochial one of giving the other Community countries an equal chance to tender for the government business of any one of them. But like the GATT, its first endeavor must be to achieve greater "transparency" in regard to the actions of national officials.

"Transparency" is the key concept in the new codes. They will only have a significant effect if they induce governments in dispute with one another to demand information-and be ready to give it-on matters which have hitherto been treated as if they were strictly within the sphere of national sovereignty. The point can be put another way. The effectiveness of the codes, and of the new procedures which are essential to them, depends essentially on whether the spirit of international litigation can be successfully promoted by the GATT. The governments of the advanced industrial countries will have to be willing to engage in formal disputes with one another, rather than continue to follow their instinct to rely on private deals privately arrived at, most especially when dealing with any question that both affects international economic relations and involves awkward private interests. But unless the habit changes it is hard to see how a body of case law backed by practical rules of a readily comprehensible kind could be established.

As one commentator on the agreement put it, "The new GATT has the mechanisms which would make the last twenty years of the century as civilized and expansive a period for world trade relations as those which followed the GATT's creation in 1947"14-but all this was conditional on a high degree of active cooperation between the governments of the United States, the European Community and Japan. It was, he added, a large condition. International cooperation of the kind that is being suggested in this article involves a willingness to handle differences in a new and more public way, relying on international institutions to do the job that has hitherto been regarded typically as the function of bilateral diplomacy.

The developing countries which participated in the Tokyo Round were little interested in these issues. They were dissatisfied with the outcome insofar as it affected their trade, and by the end of the year very few of them had signed the new agreement. What they had achieved in the negotiation, as they saw it, was to block the proposal to modify one of the articles of the GATT in such a way as to make it easier to impose trade restrictions on an individual basis against the exports of countries which were competing too successfully with domestic producers. Some of the advanced industrial countries had hoped to obtain permission to impose restrictions on imports from a particular source which was causing trouble without having to restrict imports of the product concerned from all sources.15 This was the most-favored-nation principle, the core of the GATT, in reverse. The developing countries were assisted in their effort to resist this innovation by others who were worried about a change which looked as if it might put in doubt in an explicit fashion a key principle of international commercial conduct.


At the year-end a renewed major upsurge of oil prices-taking effect in a market that had become disorganized and more than usually unpredictable as a result of differences among the main OPEC members-dominated the prospects for the world economy. Even before the final round of price hikes which culminated in mid-December with the OPEC meeting in Caracas, the outlook for world economic growth had become bleak. The OECD had revised its estimate for the combined performance of the Western industrial countries for the year ahead to one percent, a fall of two-thirds from the fairly modest rate attained in 1979.16 The earlier late-June forecast of an overall growth rate of two percent, it quickly became evident in the light of the new circumstances, had been too optimistic.

The OECD had pinned its hopes for a less damaging world economic response to the second oil shock of the 1970s-in contrast to the sequence following the first shock in 1973-largely on the fact that the leading countries of the West were not, on this occasion, going to move downward in unison from a highly synchronized business boom into a collective slump. The business cycle (as was observed above) had become de-synchronized in 1979, with the German and Japanese economies advancing strongly through the year, as the United States and Britain turned down. This gave rise to a reasonable hope that the U.S. current balance of payments, which had been gradually improving, would consolidate its gains to show a substantial surplus in 1980-the obverse of the anticipated deficits of Japan and Germany-imparting a new and welcome stability to world currency markets.

However, the reactions to Caracas suggested that whatever initial gains might derive from a de-synchronized business cycle were likely to be swamped fairly quickly by the unison of the Western policy response. (In 1974-75, it will be recalled, there were significant variations in economic policy and in consequence, at least temporarily, in national rates of growth and contraction.) Faced with a greatly increased balance-of-payments deficit and a further sharp rise in prices, as the higher energy costs worked through the system, all seemed determined on a prompt and complete deflationary adjustment to accommodate the change. Exhortations from the OECD that countries should respond to it with different degrees of severity, in the light of their individual economic circumstances, were not likely to find a receptive audience.

Any suggestion of delay or gradual adaptation tended to be discounted. Indeed it was precisely because the soft option had been chosen by many countries after the first oil shock of the 1970s that the West was so ill prepared for the second. This conclusion was by no means self-evident-it could also be argued that the general absence of drastic remedies, except in a few countries, had, through its effect in maintaining a continuing rise in the prices of Western-produced goods during a period of slow economic growth, substantially offset the initial deterioration of the terms of trade with the oil producers without a major social upheaval in the importing countries. In consequence, the real price of oil at the start of 1979, i.e., its cost in terms of other goods and services, was only modestly above the level of the early 1970s five years after the first oil shock.

However, the important point was that governments were now not willing to "buy time" for adjustment. They had decided, in fact, that further inflation, even if it produced incidental advantages in international trade, was not acceptable. In a more general sense the mood of policymakers had shifted: the dominant motif was financial caution, most clearly reflected in the OECD's estimate that the contribution of public expenditure on goods and services to the growth of demand in the whole group of member countries in 1979-80 would be the lowest two-year average of the decade.17

Demand restraint in the West promised no rewards for the developing countries; indeed it was already clear that the main deficit, matching the huge prospective surplus of the oil producers in 1980, would be in the Third World. The slowdown in international trade with the industrial countries would aggravate the problem, and it was hard to see how the existing international institutions, notably the International Monetary Fund (IMF) and the World Bank, could be adapted fast enough to meet what looked as if it might well become a crisis of Third World solvency. Developing countries would be making increased demands on international capital markets to finance their immediate import needs at a time when the major banks and credit institutions had come to share the mood of financial caution of Western governments. Moreover, the certain prospect that a number of advanced industrial nations would be turning to the international market for loans to cover their balance-of-payments deficits meant that the Third World would be up against greatly reinforced competition for private capital, as well as more exacting standards of creditworthiness.

All this, together with the new uncertainties about the future behavior of the major depositors of surplus funds in the international financial system, added up to a sense of enhanced vulnerability among those whose actions could well determine whether the recession of 1980 would be transformed into a worldwide slump. At the same time, American efforts to use nonmilitary means of pressure, especially financial pressure, in its dispute with Iran tended, ironically, to aggravate the underlying malaise. To many foreign observers it appeared that the U.S. threat to Iran's capacity to survive could only be made effective if the freezing of its dollar assets were accompanied by a full-scale economic blockade which effectively prevented the Iranians altogether from selling their oil-a difficult operation in conditions of world oil shortage. In default of this, the Americans might be tempted to use the monetary instrument with increasing vigor, and this could in turn reinforce the trend among others besides the Iranians to diversify their financial holdings out of dollars. Not for the first time, the key currency was found to be a highly uncertain weapon when used on its own, without other powerful means with which to back it up.

In fact the dominant trend in international financial opinion, including that of the United States, was moving strongly against the whole notion of national key currencies as the basis of the world monetary system. The experience of the dollar had demonstrated that even when supported by a continental economy of exceptional size and strength, the key currency suffered from a high rate of obsolescence. It was now proposed that as a first move away from the old system the IMF should proceed to a systematic funding of the excessively large dollar balances held outside the United States and issue its own internationally guaranteed paper in exchange.

This scheme which had earlier been viewed with suspicion was strongly supported by the United States and the IMF. It was regarded by many as an elementary form of insurance against the risks of a major speculative attack on the international key currency. But a "dollar substitution account" would almost certainly prove expensive and there was no agreement about who would meet the cost. It was of course to be expected that there would be argument on this and other matters connected with the movement away from the traditional key currency system. Yet it was hard to avoid the impression that the pace of required institutional change was lagging dangerously far behind the pace of changes occurring in the international marketplace.

2 Lloyd's Bank Review, July 1979.

3 Monthly Report of the German Bundesbank, November 1979, p. 26.

4 See, for example, Benjamin J. Cohen, "Europe's Money, America's Problem," Foreign Policy, Summer 1979.

5 The British managed to establish a "half-in half-out" position, which allowed them to participate in certain parts of the new arrangement but did not tie the sterling parity to any fixed relationship with the other European currencies. The Italians became members on special terms, which gave them a wider margin of maneuver for determining their exchange rate in relation to the rest of the European Community.

6 See the data in the paper by Prof. N. Kloten (provisional text mimeographed) for the Bologna Conference, Johns Hopkins University (Bologna Center) and the European University Institute, on "The Political Economy of the European Monetary System," November 1979.

7 The Financial Times (London), November 21, 1979, p. 1.

8 This had been reinforced further by the events leading up to the establishment of the European Monetary System. When the French delayed the start of the EMS for two-and-a-half months beyond the official opening date at the beginning of 1979 because of a purely domestic political issue requiring an international gesture from President Giscard d'Estaing to satisfy his agricultural lobby, the EEC, taking its cue from the German Chancellor, showed marked sympathy and patience for the French government's problem. The contrast between this and the tough treatment of the Italians a few months earlier in the context of the EMS negotiations, when they had asked for special consideration because of their own domestic political problems, was not lost on the latter.

9 The Economist, September 29, 1979.

10 OECD Economic Outlook, July 1979, p. 19.

11 See the GATT report, International Trade 1978/79 for data quoted here and in the following text.

12 Ibid.

13 See The Economist, October 13, 1979. The Americans complained that the French government was interfering in the choice by Air France between two competing aero-engines (both American) for a new plane, in contravention of the GATT rules; thus far there is no clear evidence that the eventual decision will be taken in a different manner than it would have been in the past.

14 Sidney Golt, "Beyond the Tokyo Round," The Banker, August 1979.

15 They can, and do, secure the same practical result by means of individually negotiated "voluntary export control agreements"; these are not subject to GATT rules.

16 OECD Economic Outlook, December 1979.

17 Ibid., p. 18.



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  • Sir Andrew Shonfield is Professor of Economics at the European University Institute, Florence. He was Director of the Royal Institute of International Affairs, London, from 1972 to 1977, and before that Chairman of the British Social Science Council. He is the author of The Attack on World Poverty (1960); Modern Capitalism (1965); Europe: Journey to an Unknown Destination (1974); and editor of the RIIA survey International Economic Relations in the Western World (1975).
  • More By Andrew Shonfield