For some time now we Americans have had a double image of ourselves, as being both powerful and inadequate. Yet the characterization is more than an image; it is also true. We are powerful beyond the measure of any other nation in history and, as time passes, we are becoming more ordinary, more like the others, subject to unaccustomed constraints. How can we reconcile these two truths with each other and with what Walter Lippmann, over a generation ago, laid down as a fundamental principle of a wise foreign policy: that it be solvent? By this he meant that a nation must bring into balance, with a comfortable surplus of power in reserve, its commitments—economic, political, military—and its power. For well over a decade we have not done so. As a consequence, the central question for American foreign policy is how to manage our domestic and foreign affairs in order to bring about a solvent foreign policy, if indeed we can.

In the two great crises of the last twenty years—the Vietnam war and the dramatic rises in oil prices accompanied by periodic oil shortages—America has pursued a policy of profligacy, unable to reconcile the excessive demands of a consumer society with the limitations of our economic power. Once again we find ourselves in a position to make critical choices. Faced with an expanding Soviet Union which appears to have a global reach it did not possess even during the height of the cold war in the 1950s, the defense strategists associated with the Reagan administration claim that to maintain parity, or gain superiority, over the Russians in strategic forces, and to have equal conventional forces as well, we must have large increases in the US military establishment.

The Soviet Union, however, runs a command economy, able to increase military spending at the expense of the consumer without evident political costs. Must the United States seek to match, and outmatch, the USSR on such a grand military scale? Grave doubts can be raised whether the military buildup now being proposed is necessary for the defense of our national interests. If the US government does engage in such a competition, it faces a grim choice. Either it must persuade its citizens to accept increasing taxation and lower public and/or private spending, while increasing industrial productivity. Or the government will have to print money to provide both the military and the consumer goods we are accustomed to, with all the social dangers that such inflation entails. As has happened at several major turning points during the last twenty years, we once again risk weakening our society by failing to face the real costs of overambitious policies.

Of all the consequences of the Vietnam war—to take the first of these failures—one of the least noticed at the time, and yet one of the most permanent, was the damage done to the American economy. The United States spent over $100 billion on the destruction of Southeast Asia in a war which clearly hindered the building of a sound industrial base at home. Nor did Lyndon Johnson have the political courage to tax American citizens to pay for the war. The Johnson administration expanded the social programs of the Great Society and the Federal Reserve provided the dollars to finance these commitments, setting off the devastating inflation that now plagues us. We allowed ourselves to run up deficits abroad while foreigners had to go on accepting the increasingly worthless dollars with which we bought their goods because the dollar, as the main reserve currency, was used by all nations to settle their accounts among themselves.

The dollar was, in a sense, world money, and thus the United States could finance its external deficit by simply issuing more dollars. In large part, America fought the Indochina war on credit, borrowing on other people’s productivity, just as New York City financed itself by borrowing from local banks. The time would come when America’s credit rating would suffer, just as New York’s did, as foreigners found themselves submerged in a glut of debased dollars.

When the Indochina war began against the French in 1946, the United States was still committed to an open world economy, to a belief, for example, that Britain should dismantle its closed imperial markets, which represented discriminatory treatment in international commerce. Free convertibility of currencies and free movement of capital—these were the goals of liberal America. After all, what could be better than a liberal world order where money was easily convertible from one currency to another, and countries were pleased to welcome one another’s trade and investment?1 Especially was this the received wisdom after the experience of the interwar period when economic blocs warred against one another, when protectionism flourished and competitive devaluation was the rule—a world of beggar-thy-neighbor states that weakened those who would soon face Nazi aggression. But such a liberal world was not immediately attainable.


At the end of World War II Western Europe was too poor to compete in the open marketplace. Though, ideologically, Washington never gave up on the idea of a liberal world economy, it became evident that the idea had to be shoved aside during the cruel winter of 1947 when free convertibility of British sterling ignited the collapse of the British pound, as holders of sterling rushed to convert their pounds into dollars. Because British reserves and investments had been wiped out during the war, America had already granted a loan to help the British economy. With the collapse of sterling in 1947, however, the dollars Britain had obtained rapidly drained away.

While never abandoning the notion that free trade would be good for the world in general and for America in particular—whose goods were desired by one and all—Washington decided that a new system was needed to allow the Europeans temporarily to set up high tariffs and other barriers to free trade. Only in this way could the Europeans—acting as a bloc—grow strong enough to buy American products. Then, in the course of time, the tariff walls would crumble and worldwide free trade would be revived. (By the 1960s this is what generally happened but with far stronger competition from Europe and Japan than most of us had ever imagined.) The Marshall Plan was to supply the money that would allow Europe to strengthen its economy, and, in so doing, to buy American imports.

The dollar shortage was to be overcome by American aid, and, to this end, the United States in the 1950s was willing to run—and the Europeans were eager to accept—overall American balance-of-payments deficits, largely as a result of US military expenditures abroad. The need for a strong Europe to resist a communist threat—perceived as coming from the Soviet Union and from internal subversion—meant not only a North Atlantic Treaty Organization but American dollars to finance it. In any case, a growing American economy would, everyone assumed, make good these short-term deficits.

Most European countries gladly accepted—indeed, clamored for—American military protection in exchange for the prospect of rapid economic recovery,2 especially since the United States had most of the world’s gold reserves at the end of the war—$22.8 billion worth in 1950—more than enough for the United States to back up its expanding currency.3 Thus, though the European central banks were able to buy gold at $35 an ounce, there seemed little need to do so, and when the European currencies became convertible into dollars in 1958, most Europeans were happy to hold their reserves in dollars rather than cash them in for gold. After all, dollars could be invested at decent interest rates, as gold could not, and an expanding world economy—the economy of the 1950s—meant that dollars were the currency needed for world trade and investment.

Slowly the so-called dollar gap closed, as the Europeans earned more dollars from their exports and from US military expenditures and investments abroad. The cost of providing a Pax Americana, first in Europe and then in the Far East, needed a strong American economy to do the job, with wise investments in new industries to keep up our competitive edge, and a population willing to moderate its consumption for the sake of investing in its own future. Above all, we had to make sure our military expenditures overseas did not impair the growth and productivity of new industry necessary to keep up our favorable trade balance and to maintain our ability to compete in world markets.

Throughout the Eisenhower and Kennedy administrations, the management of the American economy seemed sound, with a low inflation rate and a favorable balance of trade. Our overall payments deficits were justified in the light of the obligations we eagerly assumed by extending our military protection over others. But in fact, as Professor David Calleo has pointed out, during the 1950s a lower American rate of capital investment was beginning to mean “the relative decline of productivity—a decline thought both to reflect and to encourage the growing propensity of American companies to invest abroad.”4 Investment abroad, after all, seemed a sensible way for business to take advantage of cheaper foreign labor and to leap over the tariff walls the Europeans had erected in order to restore their economies.

However, the Kennedy administration saw these trends as linked to a now too protracted balance-of-payments problem. “While,” as Calleo notes, “the US payments deficits until the late fifties could be blamed on aid programs and trade and currency discrimination to help European and Japanese recovery, by 1960 the US payments deficit was persisting despite a general return to convertibility and a sharp improvement in the American trade surplus.”5 Much of this deficit was the price we were paying to maintain our role as the world’s policeman.


The Kennedy administration’s answer to these problems was to try to strengthen the economy by encouraging domestic growth through stimulating our appetite for greater consumption, Growth, in turn, would lead to new investments at home and these new investments would then result in still further growth and so halt the decline in American productivity. Wage and price guidelines would prevent inflation and retain American competitiveness in world markets. Moreover, stimulating growth at home would lead to reduced investment abroad, since American capital would be given incentives to stay at home to fuel the expanding economy. In case anyone missed the point, outflows of US capital were restricted—a break from the liberal world economic order the administration espoused. In consequence, our currency was supposed to grow stronger, since the dollar outflow for corporate investment abroad had been a key factor in America’s balance-of-payments deficit. In short, as Calleo points out, “American capital would be thus strengthening productivity at home rather than bolstering competition abroad.”6

Finally, there was to be a new emphasis on reducing tariffs on goods at home and abroad to restore the traditional American commitment to free trade. The active promotion of free trade was designed to keep the world market open for American exports, particularly agricultural exports, and so improve the falling US trade balance and America’s balance-of-payments position. In the long run, agricultural exports did contribute to helping a faltering foreign trade; but they were not enough, for by 1971 the United States suffered its first trade deficit in the twentieth century. Our imports that year exceeded exports by $2 billion, and this, two years before the drastic hike in OPEC oil prices.

The Kennedy administration’s foreign aspirations, however, were such that the US balance-of-payments deficits were not overcome. Like its predecessor, the Kennedy administration saw the deficits as a result of America’s global commitments to maintain the peace. For in the overall balance there were two political items that helped drain a potential surplus. One was the overseas military cost and the other was foreign aid. And while agreements with our allies to buy our military hardware, and a policy of often tying foreign aid to agreements to buy US goods, helped to mitigate the consequences of our military and political commitments, the Kennedy administration had no intention of reducing such commitments. On the contrary, these problems were the foreign political counterpart of an American order that had created a monetary system dependent on the dollar as the predominant currency for world prosperity.7 At the same time, the need to keep the American domestic economy moving required relatively low interest rates at home; thus, still more American dollars flowed abroad where interest rates were higher.

While our foreign economic problems were worrisome to the Kennedy administration, those years were, nonetheless, a time of low inflation and high growth. By and large, the European countries continued to have confidence in the management of the dollar, though the French were most critical of America’s role as the centerpiece of the international monetary system in which dollars were literally supposed to be as good as gold. On the one hand, dollars were still needed as a form of international money because an expanding world economy required the enormous liquidity provided by the dollar to finance it; confidence in the management of the great US economy was still such that foreigners were willing to hold dollars rather than exchange them for gold, while the United States was only too ready to supply them. On the other hand, the very willingness of foreigners to hold dollars far in excess of the gold reserves the United States was compelled to hold in exchange for them set the stage for global inflation—as dollars continued to flow abroad—which threatened the breakdown of the international monetary system.

The United States was creating its own credit. At some point or other in the 1960s, there was not enough American gold (still pegged at $35 an ounce as it had been since 1934) to redeem all the dollars held by foreigners. But most foreigners continued to hold their overseas dollars because they still believed that the United States could redeem them because of its huge industrial potential. Even so, some of these so-called Eurodollars were being cashed in for gold, which resulted in a further depletion of the US gold reserves. What we were doing was printing dollars to borrow against the promise of an expanding future, a future that by 1980 had not in fact materialized. 8

Nonetheless, until the dramatic escalation of the Vietnam war in 1965, it seemed likely that the United States would be able to improve its trade position and its productivity, and to contain inflation, while maintaining low unemployment and high growth. Instead, the Johnson administration found that it was not possible, as it had been during the Korean War, for an expanding economy to pay for the cost of combat. LBJ’s decision to fight a war without inflicting economic pain was thus part of the same promise of a consumer society we had believed in when we preferred to invest abroad in order to provide ourselves with goods produced by cheap labor, rather than invest at home to keep our industrial plant modern. Even in 1966 when the Defense Department informed the president that the war would cost between $5 and $10 billion more than had been estimated, Johnson still refused to cut domestic spending or ask Congress for a tax increase, for this could have meant the end of his social welfare programs.

When the president finally requested a tax increase in August 1967, Congress, its members also concerned for their political futures, delayed it for almost a year while the deficit rose to $25 billion.9 Thus, throughout this period, even though there was real growth—as the president was committed to a full employment budget—there were ominous shadows. Inflation grew, with the consumer price index increasing by 2.9 percent in 1967 and by 5.9 percent in 1969. Wages rose correspondingly—5.7 percent in 1967, 7 percent in 1969.10 Most serious of all, the money created when the Federal Reserve Bank financed a large part of the growing deficit was being invested not in the domestic economy but in the wasteful war in Southeast Asia.

Observing these policies the Europeans reacted by increasing their reserves of gold as they lost confidence in America’s ability to manage its economy, just as banks began charging New York City higher interest when the city’s faltering economy began to weaken its tax base. In so doing, the Europeans deprived themselves of the world money they were trying to protect. Ironically, it was not so much the balance-of-payments deficits—at least the still modest ones that occurred during the first few years of the Vietnam escalation—that bothered the Europeans, but the relative size of the domestic budget deficit, which revealed the unwillingness of the participants in the economy to pay for the public services they demanded.

Running a deficit by spending more than a society earns tends to create inflation and erode the value of the currency—including of course, in this case, the billions of dollars the Europeans were holding. The switch to gold, whose price was eventually to exceed $800 per ounce by the end of the 1970s, was one consequence.

As the domestic economy was swept forward on a wave of inflation, we also sold less abroad, and so our trade balance declined further. While 1964 had seen the highest trade surplus since 1947, by 1966 the surplus had fallen to half that level, and by 1971 we saw the first US trade deficit since 1893.11 Moreover, beyond the military costs, imports not including military expenditures increased by 70 percent between 1965 and 1979, a rise in those four years equal to that of the preceding nine years, that is, from 1956 to 1965.12 As it continued to fight a war in Southeast Asia while maintaining a powerful military presence in North Asia and Europe—and all this in the face of declining productivity, continuing inflation, high labor costs, and the expectation of a higher standard of living—could the United States also preserve a strong dollar backed by gold? The answer was: It could not.

In 1971, Nixon announced that the United States was no longer willing to convert dollars into gold. The indebtedness of the United States was such that we no longer possessed enough gold to back the dollars we had printed and sent abroad. Foreigners were now expected to go on using dollars as world money—even though there was no gold behind them; but as their confidence in the management of the American economy declined, their willingness to hold dollars declined as well. They sought “harder” currencies, such as the West German mark or the yen, testifying to German and Japanese productivity and low inflation rates. The depreciation of the dollar on the foreign exchanges further fed domestic inflation as the cost in dollars of imported goods rose during the Ford and Carter administrations. Domestic manufacturers, far from underselling imports, took advantage of higher prices for competing exports to raise their own prices. With billions of dollars still held abroad, foreigners lived in fear that these would some day prove almost worthless.

By 1978, for the first time in memory, the United States faced a situation where the weakness of its currency on the world’s exchanges affected the domestic life of its citizens. The Federal Reserve, in order to defend the value of the dollar abroad, raised interest rates at home, at the expense of American borrowers and business investment. But a year later, the US rate of inflation, far from diminishing, grew worse. The dollar fell further and the Fed again raised interest rates, this time to unprecedented levels. These measures, and others designed to curb the expansion of domestic credit, managed to shore up the dollar temporarily, but when interest rates fell, as they did a few months later when the economy slid into a rapid recession, the dollar fell again on the world’s exchanges. For the problems that have plagued the American economy since the Vietnam war have not gone away. The deterioration of our productivity and hence our competitiveness on the world market remains one of the gravest legacies of the Johnson era, a legacy that would lead within a few years to an insolvent America.

In the next issue we will consider how America’s failure to conserve oil in the 1970s and its projected defense spending in the 1980s may be equally dangerous for our economic well-being, unless we decide to live within our diminished means—a choice that so far appears to be unthinkable.

(This is the first part of a two-part essay on “Insolvent America.”)

This Issue

March 19, 1981