World Economy Under Stress

The year 1985 saw progress on several important fronts. The American recovery entered its fourth year; inflation continued its impressive decline and interest rates fell significantly. Washington took a more constructive approach toward the resolution of international economic problems. In much of Europe, wage and price increases were further slowed, business profitability was improved, budget deficits were cut and cumbersome regulations were loosened. Japan took new steps to liberalize trade and finance. The United States joined with Britain, France, Japan and West Germany to reduce exchange rate misalignments and bring greater order to the international monetary system. Growth picked up in some Latin American countries, and the world’s two most populous nations, China and India, substantially increased market incentives.

But there were ominous trouble spots. The large U.S. budget deficit endangered future prosperity. A still very strong dollar penalized American industry and agriculture, and the U.S. trade deficit reached another historic peak. The United States became a net debtor to the rest of the world for the first time since World War I; by the end of 1986, U.S. foreign debt will likely exceed the foreign debts of Mexico and Brazil combined. Europe’s efforts to cut joblessness also proved disappointing, and structural rigidities there slowed investment. The international trade picture grew more dangerous, as nations imposed import restrictions and increased subsidies, U.S.-Japanese frictions sharply intensified, and only limited progress was made toward beginning new multilateral trade negotiations. Latin America’s debt remained a barrier to its development, a threat to its political stability, and a serious impediment to world growth. Much of Africa suffered from tragic food and nutritional problems and experienced continued economic deterioration.

Underlying many of the successes and problems of the year was the continuing decline in inflation that began early in this decade and represented a sharp reversal of the corrosive price increases of the 1970s. In the recent past, much of the borrowing, and large additions to productive capacity, by sovereign governments, manufacturers, farmers and other producers of primary commodities were based on the expectation that future sales would rise more rapidly than interest payments. Lenders provided financing based on similar assumptions. As determined anti-inflation policies in industrialized nations led to high real interest rates and slower growth, many economic sectors in the United States and abroad found themselves with excess capacity. This led to a further reduction in inflationary pressures, but also to declining revenues and a burdensome debt, the twin causes of the intense problems shared today by U.S. agriculture (now in a precarious financial situation), by the Organization of Petroleum Exporting Countries (which in 1985 abandoned its effort to fix prices in favor of an attempt to regain market share), and by many developing countries (whose commodity earnings have dropped abruptly).

But low inflation has also substantially improved the overall economic outlook: creating a healthier investment climate in most other sectors; enabling savers to receive high real rates of return, in contrast to negative real rates during part of the 1970s; and inducing many industries to become more competitive as they found it difficult to raise prices and thus pass on the cost of inefficient practices to consumers.

At the close of 1985 there are encouraging opportunities for further progress. Slow rates of inflation will provide many countries with a sound base for reinvigorating growth and investment. Lower oil prices will place additional spending power in the hands of consumers and further diminish price pressures. The U.S. world debt initiative, announced in the fall by Treasury Secretary James Baker, and the beginning of efforts to improve the international monetary and trading systems, should encourage a more purposeful focus on these subjects in the future. Remarkable advances in technology, science, medicine and modern management methods—coupled with a surge of energetic entrepreneurship—have injected a new vitality in the United States and other nations.

But optimism must be tempered by recognition that the world also faces major dangers:

—a combination of historically unprecedented budgetary, trade and financial imbalances, along with enormous domestic and world debt, that will weaken the international economy and increase the chances of a major crisis if left uncorrected;

—a tendency to address symptoms rather than fundamentals, and thus to postpone difficult choices;

—a frequent underestimation by leaders of the degree to which their nations’ prosperity depends on a viable world economic system and on effective international institutions that foster the orderly expansion of trade and financial flows; and

—an inability to appreciate fully the profound foreign policy and security consequences of a prolongation of pressing monetary, trade, and development problems.

The United States and other countries will need to come to grips with these problems in 1986.

II

More than at any time in this century, U.S. economic well-being depends on conditions abroad. At the same time, American economic leadership and prosperity in the United States are the sine qua non of a properly functioning world economy. And the enormous global impact of the United States’ policies and currency produce a large-scale feedback that significantly affects—for good or ill—the U.S. economy.

America’s strong recovery, and the surge in its imports in 1983 and 1984, helped prevent a far worse recession in Europe and a financial collapse in Latin America. Imports and capital inflows also held down U.S. inflation and eased financing of the American budget deficit. But their enormous magnitudes eventually led to a large trade imbalance and an overvalued dollar which, in turn, slowed U.S. growth.

Early in 1985, concerns arose about the weakness of the recovery. The Reagan Administration sought to achieve three major goals: to revive growth, to cut the budget deficit and to improve the trade balance. These efforts were directly related. The trade deficit was the single greatest cause of the economy’s weakness. And the budget deficit, because of its impact on the dollar, was a key reason for this trade deficit.

Upon assuming office in 1981, the Reagan Administration had moved to stimulate economic activity through substantial tax cuts. A large budget deficit was helpful then because private spending and investment were weak. By 1984, however, robust economic growth had made a large deficit inappropriate; that was the optimum time for major debt reduction. But the President held out hope that further growth would generate revenues sufficient to reduce the deficit, and that spending reductions would do the rest. Democratic candidate Walter Mondale’s assertion that a sharply lower deficit could not be achieved without a tax increase generated little popular enthusiasm during the presidential campaign.

Valuable time was lost. Much could have been accomplished if the President, consistent with his support for a balanced budget amendment to the Constitution, had submitted a more balanced budget to the Congress. Instead, his budget contained another massive deficit. Ultimately neither the President nor the Congress was willing to support tax increases or major program cuts in the election year. The deficit for Fiscal Year 1985 reached a record $185 billion: 5.5 percent of U.S. gross national product.

The President’s landslide victory underscored the public’s distaste for a tax increase to reduce this deficit. The 1985 budget debate instead focused primarily on how to limit expenditures. An impasse continued into the summer, largely because of a confusing series of political stalemates, with the President blocking some of the bolder deficit-cutting initiatives by Congress.

For a time, pressures to cut the deficit were muted, as the large inflow of foreign capital helped to avoid higher interest rates and prevent a "crowding out" of private investment. But by early August, public opinion had become critical of inaction in Washington. These pressures ultimately induced Congress and the President to agree on a plan to cut expenditures by $55.5 billion in Fiscal Year 1986, still leaving a budget gap of over $171 billion. Official projections of the deficit for 1987 and 1988 were $154 billion and $112 billion respectively. Doubts were expressed that individual appropriations bills would conform to this legislative blueprint. Moreover, these projections appeared to overestimate U.S. growth—and thus government revenues—and to underestimate interest expenses.

Congress again addressed the deficit in the fall of 1985, this time taking the bolder and decidedly more controversial step of setting annual deficit ceilings intended to decline until a balanced budget was realized in 1991. While the intent of the Gramm-Rudman legislation is constructive, it amounts to an attempt to avoid difficult choices by substituting an automatic procedure for a conscious and more politically exposed effort to set priorities among individual programs. It threatens some important U.S. security and social objectives while placing others in a permanently "untouchable" category. The most desirable outcome of this experiment would be to force the American public and its leaders to face up to the fiscal facts of life, previously obscured by wishful thinking that economic growth would make the deficit go away. When it becomes apparent that vital programs are being undermined, there will need to be a responsible debate over priorities: where to cut expenditures, and whether, after maximum cutting consistent with U.S. military and domestic objectives, the national interest in a smaller budget deficit would not also be served by a tax increase. The recent fall in the price of oil provides a remarkable opportunity to enact at least a temporary tax on oil with no inflationary impact.

In the meantime, the government continues to provide more services to the American people than it is willing to ask them to pay for. It diverts private savings away from productive investment, and thereby jeopardizes long-term growth prospects. Future interest payments will limit the potential for tax reductions and preempt government funds that could be used for defense or domestic needs. Political leaders will be reluctant, or unable, to apply fiscal stimulus to get out of the next recession, and coming generations will be forced to pay more taxes, accept fewer government services and risk higher inflation.

Because the large budget deficit prevented the use of additional tax cuts or new spending to revive flagging growth in 1985, the major responsibility for nurturing the recovery fell to the Federal Reserve System. Arguably, the Federal Reserve itself had previously underestimated the economy’s weakness and the drag caused by a growing trade deficit. Beginning in the spring, however, it permitted a surge in the money supply (M1) to help reinvigorate growth. In July it widened the range for monetary growth and raised the base on which it is calculated. More confident than in the recent past about the non-inflationary course of the economy—and more concerned about the economy’s weakness and the sapping effect of the trade deficit—the Federal Reserve calculated that faster monetary expansion was in order, with the implied commitment to hold down interest rates and the dollar’s foreign exchange rate.

The Federal Reserve paid considerable attention during this period to the negative impact of the high dollar. As Chairman Paul Volcker put it in July congressional testimony: "The potential effects of interest rates and decisions with respect to monetary policy on exchange rates and the external sector of the economy have necessarily been a significant ingredient in FOMC [Federal Open Market Committee] deliberations." Specifically, Volcker added, the Federal Reserve’s "decisions with respect to providing reserves and reducing the discount rate have been influenced to some extent by a desire to curb excessive and ultimately unsustainable strength in the foreign exchange value of the dollar."

The Federal Reserve’s flexibility in taking steps to boost growth contrasted sharply with the political gridlock that prevented the combined makers of fiscal policy—the President and the Congress—from moving expeditiously to cut the budget deficit. But there is a danger in expecting too much of the Federal Reserve. In the past, political leaders have tended to believe that budget deficits can continue for a lengthy period. Rather than taking the political heat of cutting expenditures or raising taxes, they have turned to the Federal Reserve to ensure a money-supply increase sufficient to avoid high interest rates, at least in the short term. Over the longer term this has proved to be an unstable solution; it ultimately creates enormous inflationary pressures. It is to avoid being put in this uncomfortable position that the Federal Reserve, with its long institutional memory, has so strongly warned about the need to curtail the budget deficit.

III

A major aspect of Washington’s effort to strengthen the U.S. economic recovery was its attempt to reduce the nation’s trade deficit by encouraging accelerated investment, growth and imports abroad, notably in Europe and Japan. In a speech at Princeton University prior to the Bonn economic summit in May, Secretary of State George Shultz urged Europeans to "adopt policies that reduce the obstacles to change and innovation, that attract capital, and that stimulate domestic investment," and urged Japan "to stimulate investment, otherwise make greater use of its large pool of savings," and reduce trade restrictions.

The majority of European governments have pursued conservative economic policies for much of this decade. In order to avoid a repetition of the high inflation of the 1970s, Britain, Germany and several other European nations brought down budget deficits and restrained money-supply growth. In France, significant stimulus early in the presidency of François Mitterrand created severe balance-of-payments difficulties; these in turn led to a policy of greater stringency to which the French government has continued to adhere. Italy has emphasized the reduction of inflation, although government deficits continue to exert upward pressures on prices. In Scandinavia, the Netherlands, Spain and Portugal, leaders have stressed greater fiscal prudence, in some cases departing sharply from earlier zealous expansion of social programs.

But Europe still has problems. A Financial Times editorial emphasized: "Europe needs a more invigorating climate which will stimulate existing industries to deploy their resources more productively and enable new ones to flourish." Europe’s weakness in world high-technology markets is a particular concern. Its inability to create a true common market free of barriers to internal trade impedes efficiency and economies of scale. Its governments continue to discriminate against foreign (including other European) suppliers, particularly in the telecommunications sector. Agricultural subsidies, costly to consumers and taxpayers, divert resources from more productive uses.

Promising steps were taken in December when the leaders of the European Community, at their Luxembourg summit, set the end of 1992 as the deadline for achieving the reduction in internal barriers, harmonization of standards, and elimination of nuisance regulations necessary to make the Community live up to its name as a region in which goods, services, workers and competitive forces can move about freely. Europeans increasingly appear to be aware that denying their industries the economies of scale offered by their large continental market puts them at a disadvantage vis-à-vis the United States and Japan. It is the resulting improvements in efficiency and growth, combined with an attendant increase in the attractiveness of investment, rather than tinkering with the labor market by such illusory devices as cutting the workweek, that will provide the most promising way to reduce Europe’s 11.5 percent rate of unemployment.

Such changes are necessary to improve the medium-term outlook; they cannot be counted on to generate increased economic activity right away. However, Europe has been cautious about attempting to boost growth by applying too much fiscal stimulus. In the Netherlands, Italy and France, budget deficits are already large, and thus big increases in government spending or big tax cuts are inappropriate. Many European leaders feel that recent progress in slowing price increases and reducing inflationary expectations would be reversed by new stimulus. The success of West Germany, which has maintained steady budgetary discipline, in restoring noninflationary growth has surely strengthened this line of thinking.

But progress in stabilizing prices, coupled with the windfall of lower oil costs and the lower dollar, now offers European countries greater scope for tax reductions with less inflationary risk. West Germany plans modest tax cuts in 1986 and 1988; other countries with low budget deficits and high unemployment, such as Britain, are considering a similar approach. Prudent, well-structured tax cuts could provide an additional incentive to new investment and growth. It is probably politically counterproductive, however, for the United States, with its string of record budget deficits, to push the Europeans to go faster in this direction than they feel comfortable in going.

The fall in the dollar, in U.S. interest rates and in oil prices provide an opportunity for still further relaxation of monetary policy. The Deutsche Bundesbank, the Nederlandsche Bank and the Banque de France, among other central banks, eased monetary constraints in 1985 relative to 1984. These recent economic developments provide additional possibilities for doing so without jeopardizing the price stability that Europe correctly regards as important.

Issues on the U.S. agenda with Japan differ considerably from those with Europe. Japan’s economy has performed impressively over the years; alarmed by a large public debt, it has substantially reduced its government deficit. Its net personal savings rate is several times that of the United States. It has a history of low unemployment, low inflation and flexibility in reallocating resources to foster their efficient use, and recently has undertaken important financial liberalization. But Japan’s substantial excess of savings over investment has resulted in an outflow of capital that has contributed to the dollar’s strength and the yen’s weakness. Access to its market has proved difficult for many foreign companies. And Japan has been overly dependent on demand abroad for its growth.

In July Prime Minister Yasuhiro Nakasone announced an initiative to improve access to his country’s market, including lower tariffs, relaxation of inspection procedures, easier licensing rules, and broader opportunities for foreigners to compete for government contracts. He also recognized the strong Japanese consumer loyalty to domestic products, and the complexity of supplier relationships when he stressed the need "to change . . . the public’s attitude toward domestic and foreign goods." He noted that "efforts to expand domestic demand are required together with market liberalization." The prime minister followed up by appointing a high-level commission to recommend ways in which Japan can contribute to a better international equilibrium.

Washington’s reaction to this package was less than enthusiastic. Business and political leaders expressed concern that U.S. exporters would not see quick results even if the measures were promptly effected. Nor, many felt, would the quantitative impact be significant unless domestic demand in Japan grew more rapidly. Such concerns reflect deep frustrations. This initiative should help; but the problem, as the prime minister’s statement suggests, is structural.

Japan has a savings-intensive economy and is a major exporter of capital. The United States, on the other hand, has a credit-intensive economy. It has a low personal savings rate and requires enormous capital imports to finance private and government borrowing. As long as a large savings-investment imbalance continues, the dollar will be relatively strong vis-à-vis the yen, and the United States will have a sizable trade deficit with Japan. An increase in tax incentives to encourage new investment, particularly in elements of social infrastructure such as housing, could enable Japan to use more of its capital at home and thus help relieve exchange rate and trade pressures. And both the United States and Japan will need to reexamine their tax systems: the United States should reduce artificial incentives to borrow and disincentives to save, and Japan should reduce artificial incentives to save and disincentives to invest.

Continued investment by Japanese companies in production in the United States—which has already become a significant source of jobs in a number of states—is also a constructive use of Japanese savings and a contribution to reducing the trade imbalance. Another structural concern, the historically close ties between Japanese suppliers and purchasers, can be partially redressed by permitting a number of foreign firms to participate in government-sponsored research. For their part, American companies will need to make investments in time, language training and follow-up service—and the modifications in product design—required to take better advantage of new opportunities in Japan.

With so much focus on Japan and Europe, America’s largest single trading partner has received remarkably little attention. The U.S. current account deficit with Canada was second only to that with Japan. Ottawa’s large budget deficit, however, stimulated Canadian growth in 1985, which increased imports from the United States. The government of Prime Minister Brian Mulroney also took a more open approach to foreign investment and adopted a less nationalistic energy policy. Both steps helped to dampen frictions with the United States that in past years had surrounded those controversial issues. While there were disputes over lumber, steel, potatoes and publishing, Americans lodged far fewer complaints against Canada than against Europe or Japan. U.S.-Canadian moves to negotiate a bilateral trade liberalization agreement, which began under former Prime Minister Pierre Elliott Trudeau and continued under the current government, could help to expand two-way trade. Negotiations also present an excellent opportunity to address lingering differences over the treatment of investment. These concerns are especially important to American interests, just as secure access to the U.S. market is important for many Canadians.

IV

The persistence of exchange rate and trade imbalances in 1985 led to unprecedented international frictions over trade policies. Demand for import curbs reached a post-World War II high in the United States. Over 300 bills were proposed in Congress to restrict imports and deter a variety of trade distortions abroad.

Several major factors contributed to these intense trade pressures. As tariffs were cut in the 1960s and 1970s, subsidies, safety and other standards, large research grants, and "buy national" preferences became growing impediments to world trade. Unlike tariffs, which are highly visible and act at the border, these were built into economies and were difficult to quantify. Many were harmful to U.S. interests. Underlying changes in the world economy, such as the growing food output of large traditional importers like China and India, and the rapid international diffusion of technology and modern production capacity, also cut into the growth of U.S. exports. The deterioration in the U.S. trade balance after 1981, a loss of market share in important areas, and alarm about a weakening of the U.S. industrial base sharply heightened American concerns.

The Reagan Administration added to the frustrations felt in Congress and the private sector. It had tried to cut funding for the Export-Import Bank, eliminated trade adjustment assistance to firms and workers, and until late September adopted a cavalier attitude toward the consequences of the greatly overvalued dollar. While resolutely and correctly resisting new restrictive trade legislation, the Administration also rejected as "protectionist" other requests for redress under existing legislation that could have been justified according to the rules of the General Agreement on Tariffs and Trade.

The GATT, it may be recalled, recognizes that open trade can be preserved only if governments can, from time to time, temporarily moderate injurious surges in imports, and counteract dumping and subsidies. Existing U.S. law contains tools sanctioned by the GATT to deal with the vast majority of the trade problems that Americans face. The Administration’s frequent unwillingness to use these tools, however, has increased congressional support for precisely the type of legislation the President dislikes.

Many influential political and business leaders who had historically opposed protectionist measures pressed for tougher legislation to compel the executive branch to be more assertive, bring about changes in trading practices abroad, "shock" other nations into negotiations as the Nixon surcharge had done in 1971, and build up bargaining "chips" to strengthen the U.S. negotiating position.

The thrust of administration policy was to try to reach an international agreement to begin a new round of multilateral trade negotiations. This, it reasoned, would reduce congressional pressures for new restrictions and provide an opportunity to confront the glaring failures in the world trading system. Although it deserves great credit for its leadership in pressing for these much-needed negotiations, the Administration miscalculated the difficulty of obtaining international and domestic support.

The U.S. initiative, although essential to generating international momentum toward trade negotiations, led other nations to see the United States as a demandeur. Several sought to extract a "price" from Washington before agreeing to negotiations, even though reversing the deterioration in the world trading system is at least as important to the United States’ trading partners as it is to the United States. A few European countries wanted prior U.S. endorsement of international monetary talks. At the July economic summit in Bonn, this issue blocked agreement to begin a new round of negotiations in 1986. Throughout most of 1985 key developing countries insisted that, as a precondition, the subject of trade in services either be eliminated or considered separately from manufactured goods, because they felt that they were less competitive in services than in other products. At home, the U.S. business community, labor and Congress were concerned that too much emphasis had been placed on multilateral negotiations, which promised only distant remedies at best, and too little on addressing the more urgent problems of the dollar and foreign trade restrictions.

Recognizing the weakening of domestic support for its position and the growing threat of tough congressional legislation, the Administration in September filed cases under Section 301 of the U.S. Trade Act of 1974 (which addresses unfair trading practices) against the European Community, Japan, Korea and Brazil, proposed a $300 million fund to enable the United States to match foreign subsidies, and pledged greater efforts to eliminate foreign trade distortions. These steps, along with a successful effort to reduce the dollar’s exchange rate, took some steam out of pressures for protective legislation. Notwithstanding these efforts, however, Congress passed a bill (which the President vetoed) to limit textile and other imports. And there is a high probability that early in 1986, especially after the unprecedentedly high trade deficit figures for 1985 are announced, new attempts will be made to enact stronger legislation. Trade is likely to be one of the top domestic political issues in 1986. Several "omnibus bills" have already been introduced that link a congressional mandate for a new round of trade negotiations to requirements that the President act more assertively to secure the dismantling of foreign barriers to U.S. exports; these bills also force the President to provide import relief in certain cases where he now has discretionary authority to deny it.

Whether the more activist administration policy would succeed in securing more open markets for U.S. products remained unclear at year’s end. Also unclear was whether the United States would take the domestic measures necessary to improve its underlying international competitiveness. The tax reform debate of 1985, which should have been seen as an opportunity for doing so, inadequately addressed questions of productivity, investment incentives and the U.S. personal savings rate. (The low savings rate, which during 1985 reached a postwar nadir of less than three percent, contributed to the need to import funds from abroad, and thus to the strong dollar.) The Administration’s tax proposal and the bill that was approved in the House of Representatives—in their commendable effort to cut marginal taxes—would also harm a number of industries already under heavy international competitive pressures, provide less favorable tax treatment for depreciation, and place a heavier burden on much of the productive sector. The lower marginal tax rate and limits on the deductibility of interest payments, unfortunately too watered down, will mean a welcome reduction in the public’s incentive to borrow. But other measures, for example stricter tax treatment of payments to pension funds, will discourage savings.

While the tax bill has many strengths, the government’s commitment to improving the U.S. trade position will come into serious question if the final package weakens the foreign competitiveness of U.S. business. A thorough assessment of the trade implications of proposed legislation should be an early priority in 1986, lest the United States exert a major international effort to improve access to foreign markets only to find that a new tax law makes it less able to take advantage of that access.

Internationally, the persistence of U.S. Trade Representative William Brock and his successor, Clayton Yeutter, was rewarded in December by agreement among GATT members to begin preparations for a new round of trade negotiations and to set September 1986 as the date for a meeting of trade ministers to formally launch those negotiations. This was a major step forward. But it remains uncertain whether negotiations will seriously address U.S. priorities such as services, agriculture, intellectual property and government subsidies—or, for that matter, the priorities of any other country. Little consideration seems to have been devoted, in the United States or elsewhere, to the question of precisely what should be offered in return for the concessions sought from others.

In order to put these negotiations on a sound footing, and improve confidence that they will produce results, governments must do a far better job of explaining to a skeptical public the vital role that expanded trade has played in postwar prosperity, and of emphasizing the declines in growth and employment that would result from the deterioration of world trade.

Deeply ingrained attitudes will need to change: many U.S. trading partners appear to believe that the relatively small size of their economies permits them to protect their markets without hurting the worldwide trading system, while the United States, because of the enormous international impact of its economy, is urged to exercise a unique self-restraint. Large numbers of Americans may have convinced themselves that the United States is virtually free of trade barriers and can obtain vastly increased access to markets abroad with few concessions on its part. And many developing countries feel that they can obtain major concessions from industrialized nations while making only minimal efforts to liberalize imports. For negotiations to succeed, misconceptions such as these will have to be dispelled. The President of the United States and other heads of state must be willing to personally support the process as well as bring their influence to bear on one another—much as they do on strategic issues—to ensure maximum progress in the negotiating process.

To achieve needed liberalization of international trade, negotiators will need to adopt improved "safety valves" to enable governments temporarily to limit imports that cause injury to domestic industries and workers. To prevent abuse, negotiations will also need to provide tighter rules for international monitoring of adjustment measures by the protected industries, so that the duration of any such restraints is limited. Dispute-settlement procedures, the slowness, ambiguity and evasions of which undermine the credibility of the trading system, will need to be improved. Unless grievances—that is, charges of rule violations—can be expeditiously resolved, the negotiating process will be undercut by concerns over the difficulty of obtaining redress when others fail to fulfill commitments. And the major developing countries will need to participate actively in the negotiations. They are among the world’s fastest-growing markets and most active competitors. Failure to agree on an appropriate balance of benefits and responsibilities with them would condemn the trading system to frequent disputes and disruptions.

So far, progress toward negotiations has resulted more from a desire to prevent a collapse of the trading system than from a common vision of how to improve it. Yet unless genuine improvements are made in the near future, there is a great risk that the trading system will erode further. If they are not, the United States, and perhaps other nations, might increase import barriers and negotiate a series of restrictive bilateral agreements. Such steps could provide the necessary shock to induce nations to negotiate more purposefully to improve trading rules and reduce barriers. Alternatively, they might set the world on a downturn reminiscent of the post-Smoot-Hawley period of the 1930s.

V

The exchange rate of the dollar was one of the salient domestic and international issues of 1985. It had a profound and pervasive impact on jobs, production, inflation and interest rates in the United States and virtually every other country. No sector was immune from its costs or benefits, or from the deep uncertainties surrounding its future course.

Until only recently, President Reagan had extolled the strong dollar as demonstrating the strength of the U.S. economy. The Administration had appeared virtually oblivious to the burden it imposed on American business and labor. In late September, however, Treasury Secretary Baker and Federal Reserve Chairman Volcker, and their counterparts from France, Germany, Japan and the United Kingdom (the Group of Five), agreed in a meeting at the Plaza Hotel in New York that "further orderly appreciation of the main non-dollar currencies against the dollar is desirable," and that they would "cooperate more closely to encourage this." The United States thus departed from its previous position of intervening only to counter extremely disorderly markets; it now agreed to do so where currencies did not reflect fundamental conditions.

This agreement was largely a political decision: a constructive effort by the United States and its partners to forestall restrictive trade legislation in the United States. It also served to bring greater order to the international monetary system. Because it was reached at a time when the markets were already pushing the dollar down, because the U.S. commitment was seen to be genuine, and because easier monetary policy by the Federal Reserve was, in any case, anticipated to revive a sluggish American economy, the "Plaza pact" triggered a dramatic drop in the dollar. Subsequently, central-bank intervention and an increase in Japanese interest rates sustained the correction of currencies. The dollar fell to 200 yen, compared to its early 1985 level of 260 yen, and to 2.5 deutschmarks from 3.4 deutschmarks in early 1985.

The dollar’s decline at the end of 1985, while still leaving it at a historically high level, has already led some foreign suppliers to raise prices in the United States in order to avoid a fall in profits after translation into their domestic currencies. Many American companies are well positioned to take advantage of a more favorable dollar exchange rate because they have improved their efficiency during the period of the strong dollar by cutting overhead, paring labor forces and improving inventory management. A lower dollar should permit such companies to be significantly more competitive with foreign producers. On the other hand, there is a danger that foreign companies that have become accustomed to the artificial support of their nations’ undervalued currencies will seek protection or subsidies to offset currency shifts.

Moreover, the dollar’s strength has been a factor in the closing of factories in the United States, the siting of new production abroad and substantial "outsourcing." The lingering effects of these developments will reduce the ability of the United States to respond to a better alignment of currencies. Foreign suppliers that have gained a firm foothold in the United States by developing strong distribution systems during this period will be in a good position to withstand an appreciation of their national currencies.

The longer the overvaluation of the dollar lasts, the greater will be the fall required. The growing foreign debt of the United States can only be serviced if it earns the necessary funds through a major improvement in its current account balance. The greater the debt, the more sizable the required dollar depreciation. A dollar decline that is too rapid or too great, however, would contain its own perils. It could trigger a dangerous surge in inflation and reduce the willingness of foreigners and Americans alike to hold dollar-denominated securities, leading in turn to higher interest rates and the chances of a severe economic slowdown. Concern that the buildup of foreign debt will trigger an erosion of confidence and a fall in the dollar, and thus increase inflation and interest rates, is a risk factor keeping interest rates high in the United States.

Furthermore, hope for a turnaround in the U.S. trade position should not be pinned too heavily on the dollar’s decline. Over 40 percent of the U.S. trade deficit is with developing countries. Their currencies have not appreciated very much against the dollar; many have in fact fallen. For most debt-ridden countries it is not their exchange rate but a lack of financing and a slow growth rate that limit their imports of American goods. In the final analysis, it is increased domestic demand abroad, more than exchange rate movements, that would give the greatest boost to U.S. exports.

Japan’s dilemma illustrates this. Japan raised its interest rates shortly after the Group of Five agreement in order to strengthen the yen vis-à-vis the dollar, but in so doing it chanced weakening its domestic consumer demand. This in turn risked slowing the increase in Japan’s imports and impeding the decline in its trade surplus that the stronger yen was intended to promote. Recognizing this danger, Japan eased monetary policy at the year’s end.

Were Japan’s economy to turn sluggish this year, its bilateral trade imbalance would remain a major source of friction. Overall, however, stronger growth in West Germany and other parts of Europe, coupled with modest improvements in Canadian and Latin American recovery, a lower U.S. oil import bill, and the benefit of the dollar’s decline, should lead to a strengthening of the U.S. trade position during the course of 1986.

The Group of Five agreement, followed in November by a conference sponsored by Congressman Jack Kemp (R.-N.Y.) and Senator Bill Bradley (D.-N.J.) to explore alternatives to floating exchange rates, focused attention on the long neglected subject of monetary reform. After the breakup of the Bretton Woods system in the early 1970s, negotiations were begun to find a replacement. The oil crisis brought with it a period of instability in which reestablishing parities, or any other system with firm exchange rate commitments, would have been difficult. The floating rate system was accepted by default. Now, recognizing that it is no better able than its predecessor to prevent serious misalignments, and in fact may have added to the risk of international transactions, governments are searching for ways to increase stability. In 1971 the large U.S. trade deficit and the overvaluation of the dollar had forced the United States to abandon the Bretton Woods system. Precisely the same factors have generated the current interest in the United States in finding a replacement for floating exchange rates.

There is an understandable yearning for a return to fixed exchange rates. In the past they provided a useful "anchor" for the world economy and a measure of discipline to domestic economic policy. And because trade has become increasingly important to the U.S. economy—11 percent of GNP today as compared to five percent two decades ago, with exports accounting for 40 percent of agricultural sales and most manufactured goods facing strong international competition—stable exchange rates are of greater importance to a greater number of Americans than in years past.

But fixed rates will be difficult to restore. First, they were most successful during periods when countries maintained capital controls; recent liberalization of capital markets and the introduction of new technologies have given capital enormous mobility. Second, while governments regard stable and properly aligned currency rates as important to their domestic economies, most are reluctant to subordinate other domestic policy goals to that of keeping currencies fixed in some previously established alignment. Third, the volume of international capital has grown dramatically since 1972, the last year in which governments tried to maintain fixed rates. In that year the volume of international syndicated lending was $7 billion, in 1985 it amounted to roughly $55 billion; in 1972 the Eurocurrency market was about $200 billion, now it is over $2.5 trillion.

While a move to fixed exchange rates appears unlikely in the near term, a number of reforms could substantially increase currency stability. The central elements of a more stable system may have been foreshadowed by recent events. The commitment of the Group of Five to "encourage further orderly appreciation of the main non-dollar currencies against the dollar" reflected its view that inflation and interest rates had converged downward but that currency alignments had not reflected these developments. Underlying this conclusion must have been some measure of agreement on what constituted more appropriate currency relationships, particularly for the dollar and yen. This in itself marked a first for the United States under this administration.

Having taken this step, the next logical one would be for the Group of Five to agree on a set of implicit targets for the major currencies. Such targets would serve primarily as a point of focus for achieving greater compatibility among the economic policies of these countries, and secondarily as a point of reference for currency intervention if exchange rates were to diverge too far from fundamentals. The European Monetary System has helped to restrain currency volatility in Europe, not so much by forcing exchange rate intervention as by averting serious policy divergencies and, in particular, by encouraging efforts to restrain inflation. A similar procedure among the members of the Group of Five should chiefly aim at avoiding unsound or incompatible monetary and fiscal policies. It should also seek to reduce radical divergencies in tax and regulatory policies that lead to vast differences in incentives (or disincentives) to save, borrow, invest, or create credit. Because most other currencies are directly or closely linked to those of the Group of Five, this process would have a stabilizing effect on a wide range of exchange rate relationships.

VI

A persistent danger facing the world economy during 1985 was the high debt of many Third World nations and its disruptive impact on their development. Earlier emergency rescue packages, debt reschedulings, policy improvements in several highly indebted nations, and the strong U.S. recovery had prevented a major collapse. But in 1985 growth slowed in the United States (which has absorbed most of the recent export growth of developing countries), and demands for new import restrictions intensified in industrialized nations. Commodity prices fell (by 8.6 percent against a basket of currencies, according to The Economist’s Commodity Price Index), the oil price collapse dealt a major setback to Mexico (already disrupted by a major earthquake) and other oil exporters, and concerns about social stability grew as the result of unemployment levels of over 20 percent and inflation rates of over 100 percent in many Latin American countries. Finally, there were fears that other countries would follow the example of Peru’s recently elected president, Alan García Pérez, who announced his intention unilaterally to limit his country’s debt service to a fixed percentage of export earnings.

U.S. world debt policy underwent an important change in October. Its previous emphasis had been to encourage debtors to take tough austerity measures and to support the central role of the International Monetary Fund in promoting and assisting countries to attain these goals. But, notwithstanding the pivotal role the IMF played in averting a major crisis after 1982, attitudes toward it had soured in some indebted countries because of the difficult adjustments with which its programs were associated. In addition, voluntary lending by commercial banks had not picked up as the indebted nations expected; in fact, it had shrunk for some indebted countries. And while many had improved their trade balances by constraining growth and devaluing their currencies, they had made too little progress in reducing subsidies and budget deficits, sustaining market-related exchange rates, or improving the investment environment. External adjustment had proved easier than internal adjustment.

Secretary Baker, at the annual meeting of the World Bank and the IMF, presented an initiative to reverse what he correctly considered a deteriorating situation. His "Program for Sustained Growth" urged debtor countries not only to implement sound fiscal and monetary policies, but also to strengthen their private sectors, mobilize more domestic savings, facilitate investment, liberalize trade and pursue market-oriented approaches to currencies, interest rates and prices. The World Bank was encouraged to provide more funds, and to disburse them more quickly, to support these structural policy improvements and supplement continued balance-of-payments lending by the IMF. Commercial banks were asked to lend $20 billion over three years in support of the sought-after improvements in the performance of 15 of the major indebted nations.

The Baker plan finally put the United States on the correct side of the issue. By recognizing that the debt crisis had become a development crisis, and by stressing the importance of reviving growth and pressing for increased lending, it improved U.S. credibility with debtor nations. By underscoring the need for policy improvements in these nations it addressed a major economic imperative and a legitimate concern of creditors. And by underlining the need for indebted countries to establish confidence in the private sector sufficient to reverse capital flight—which in past years was extremely large in Venezuela, Mexico and Argentina—it addressed a particular concern of the Congress, which finds it difficult to justify programs to support countries whose own citizens are sending capital abroad. Indeed, new lending without the policy improvements and private-sector confidence necessary to ensure that these funds were well utilized would simply worsen the debt problem.

Implementation of the Baker plan will be difficult. Most highly indebted countries have little appetite for further politically sensitive policy corrections. Cuts in government payrolls and subsidies to state enterprises, which are necessary to reduce budget deficits and improve competitiveness, have run into stiff political opposition. And the private sector in many parts of Latin America is often forced to take a back seat to state enterprise when it comes to access to new financing.

In this environment commercial banks, while basically supportive, demonstrated caution about making new loans without evidence of genuine policy improvements. Having lowered exposures in Latin America as a percentage of their capital, and under fire from regulators, stockholders and boards of directors, many are reluctant once again to increase what they see as risky loans. U.S. money-center banks are concerned that regional and foreign banks will not participate, leaving them even more exposed.

Though Mexico had seemed an obvious first beneficiary of the Baker program, the Administration moved Argentina to the head of the queue. Argentina had already made a number of tough fiscal and currency reforms, and the United States saw it as the most viable prototype to convince other nations that they could gain by participating in the process. Mexico, the third-largest U.S. trading partner and a country whose economic, social and political stability is of enormous domestic importance in the United States, must still be considered a priority candidate. A Mexican financial collapse would pose a foreign policy problem for the United States that would dwarf all others.

The United States also began a major effort to bolster the role of the World Bank in dealing with the debt problem. The World Bank’s direct lending, cofinancing, and guarantees will be of central importance to the success of this initiative; Bank programs can provide a vital catalyst by making commercial banks feel more comfortable about new lending.

The Bank’s affiliate, the International Finance Corporation, was encouraged by Baker to play an active role in strengthening the private sector in developing nations. In 1985, for the first time, the IFC participated as lead manager of a Eurobond issue for a Latin American borrower. And it is utilizing imaginative techniques to increase equity investment in companies in developing nations. Both methods help the private sector in these countries to tap the increasingly international-minded, several-trillion-dollar pool of institutional capital. The World Bank will also establish a Multilateral Investment Guarantee Agency to protect foreign equity investors in Third World countries against noncommercial risk.

Support from Europe and Japan will also be of major importance. Their banks collectively have a bigger share of the overall exposure in Latin America than do U.S. banks. Although many have shown more prudence than U.S. banks by putting aside larger loan loss reserves against the possibility of default, they still have a large stake in the success of this initiative. Europe and Japan need to find ways to increase both official export financing and their share of imports from heavily indebted nations. Japan could make a particularly important contribution to this effort; the Tokyo economic summit in the spring of 1986 will provide it with an excellent opportunity to launch a program to provide untied, low-interest trade credit to finance imports for nations that pursue appropriate adjustment policies. That demonstration of leadership—a positive complement to the Baker plan—would ease world trade tensions.

Congressional support for new funds will not be easily forthcoming during a time of budget cutting—as the recent record clearly demonstrates. Yet a substantial increase in the capital of the World Bank and the Inter-American Development Bank, and later the World Bank’s soft-loan affiliate, the International Development Association, will be required if this initiative is to succeed. Likewise, more loans and guarantees by the U.S. Export-Import Bank will be needed to help indebted countries to overcome bottlenecks resulting from the inability to finance needed imports.

In many countries debt service payments are growing more rapidly than export earnings and greatly exceed new capital inflows. Large and prolonged net outflows of funds, absorbing in some cases 50 percent of export receipts, are incompatible with Secretary Baker’s objective of restoring growth in heavily indebted nations and with U.S. interests in ensuring stability there. The Administration will need to use at least as much political capital to obtain additional funds for these countries as it has in seeking aid for Central America. The political and economic stakes are considerably greater.

VII

Historic economic and technological developments have combined in this decade to bring about unprecedented change within and among nations. The intensity and pace of international economic integration, combined with rapid advances in technology, have outpaced the ability of governments and institutions to cope. Decisions of governments must be made in a national political context, while markets, trade, finance and technology are international. The distinction between domestic and international economic policy has all but disappeared. Unless the international economic system can be made to work more effectively, and interdependence can be better managed, a proliferation of nationalistic policies will threaten world growth.

These issues are closely linked to broader political and security considerations as well. Slow growth and high unemployment in Western Europe, and economic frictions with the United States, weaken NATO’s cohesion. That is particularly important to the United States at this time. It will need strong Western unity as it seeks to reach agreement on arms reductions with the Soviets. Progress in reducing U.S.-European economic tensions removes an important issue that Moscow could use to promote dissension within the alliance. Weak growth in Europe would limit funds available for defense, thus reigniting the debate over burden sharing and producing friction in transatlantic relations.

In East Asia, as the Soviets seek to develop the economic resources of eastern Siberia, improve relations with China and Japan, and build on their considerable naval presence at Vladivostok and Cam Ranh Bay, they may well seek to take advantage of trade frictions between the United States and its East Asian trading partners by holding out prospects of expanded investment and trade ties. And Latin American debt—which threatens the stability of Mexico and other large countries in this hemisphere—carries serious implications for U.S. security, immigration and political well-being.

International economic issues have moved to the top of the domestic and foreign policy agenda. After World War II, the United States assumed a leadership role as chief architect of the institutions that were to become the basis for future prosperity. The time is ripe for a similar demonstration of leadership to address the new problems of a dramatically changed world economic environment and ensure that our institutions are prepared to cope with future demands.

Each generation sows the seeds of the difficulties of the next. Heavy dependence on imported oil in the 1960s led to the oil price crisis of the 1970s. Inflation in the 1960s and 1970s led to the wrenching adjustments of the early 1980s. Rapid growth of Third World borrowing in the past led to the debt problems of today. The current buildup of U.S. government, corporate, consumer, agricultural and foreign debt portends slower growth in the future and raises concern that the United States will feel pressed to "inflate" its way out of these debts. This several-trillion-dollar mega-debt makes the U.S. economy highly vulnerable to increased interest rates and to serious financial disruptions. It could well be the Achilles’ heel of the present recovery. Exchange rate misalignments and large trade imbalances foreshadow painful adjustment problems. Continued deterioration of important Third World economies risks economic and political instability and would impede future world growth. Inadequate efforts to strengthen international institutions could deprive the United States of its vehicles for addressing international economic problems in coming years.

The United States took steps to address some of these issues in 1985. But there are dangers ahead should that momentum falter or key nations fail to come to grips with the fundamental problems before them. The noted historian Arnold Toynbee wrote that years from now the twentieth century will be remembered for "having been the first age, since the dawn of civilization . . . in which people dared to think it practicable to make the benefits of civilization available for the whole world." Sustained world growth, and a widening of access to its benefits, are prerequisites for achieving the expanded opportunities and improvements in the human condition that Toynbee envisaged. They must surely be fundamental moral and political objectives of all democratic societies—for their own people and for others. More and more, achievement of these goals depends on a healthy structure of international economic relationships. That will require vision, cooperation and leadership on a far grander and broader scale than we have seen in the past.

1986 will be a major challenge on all fronts. The prosperity and, ultimately, the security of the United States hang in the balance.