Any discussion of the economy today has to begin with the most favorable economic event of the last twenty years, the collapse in oil prices. The runaway increase in oil prices in the 1970s was an enormous tax imposed on the industrial world by the oil producers. It created the inflation and the economic crisis that caused political turmoil in the West, and laid the groundwork for the third-world debt crisis with which we are still struggling. The current collapse of oil prices has just the opposite effect. It is the equivalent of having a multi-billion-dollar tax cut without increasing our deficit. It keeps inflation rates down, thus allowing interest rates to come down, along with the dollar, despite large domestic deficits and borrowing requirements.
Just when the economy was beginning to slow down, the fall in oil prices set off a stock market boom which has created, at least on paper, hundreds of billions of new wealth capable of sustaining the economy for some time in the future. Oil prices may not stay down forever. But the fall in oil prices, along with the fall in the price of the dollar and the fall in interest rates, presents an opportunity that should be seized to set the economy on a strong footing for the long run. Important initiatives will be required both domestically and internationally.
On the domestic front, it is obvious that the strong economic stimulus provided by falling oil prices and interest rates, coupled with a stock market boom, allows considerable freedom to cut the budget deficit without an economic slowdown. Despite recent optimistic statements about the deficit, it will not disappear magically; and raising revenues through higher income taxes will be resisted by both parties. We now have, however, an opportunity to combine a gasoline tax of fifty cents a gallon, phased in over two years, with a one-year freeze on all spending, including both on military appropriations and on social security and other entitlements.
This combination would cut the deficit to below $100 billion, allow for serious reexamination of long-term spending priorities, and encourage further reductions in short-term interest rates. The tax would still leave US gasoline prices at half the price Europeans have to pay. A trust fund could be set up to collect the tax and to release the funds solely to purchase government debt, thereby reducing the temptation to use tax money to increase government spending. Some politicians and economists will be tempted to impose an oil import fee, arguing that this will bring relief to the distressed domestic oil industry and to the banks that have lent money to that industry, while such debt-burdened countries as Mexico could benefit by being exempted from an import tax. Such a temptation should be resisted; there are better ways to help the banks and Mexico. The right tax, in a time of falling gasoline prices, is a simple gasoline tax.
The other major domestic issues to be dealt with are our trade deficit and international competitiveness. In 1985 the gap between what the US buys and what it sells abroad amounted to $148.5 billion, a new record. The falling dollar will help, but it will not cure so large a deficit. To do so will require greater competitiveness on our part, strong economic recovery in the third world to absorb our exports, and fairer trade practices all around.
The need for some temporary protective measures for key American industries will still remain, particularly for such industries as steel, autos, and machine tools, all of which have been seriously threatened by foreign competition. Protection, however, whether by tariffs or quotas, or by relaxation of the antitrust laws or other special regulatory or tax relief, should be conditioned on commitments on the part of both management and labor to improve the productivity of their industries. If mergers in the steel industry are encouraged, under the protection of restrictive tariffs and antitrust exemptions, the management of the merging companies should be required to commit new capital to fully modernized steel facilities and should agree to tie price increases to inflation. Labor should make long-term concessions in wages and work rules. Funds should be set aside for retraining and relocating workers displaced by new technology. It is wasteful to provide international protection and other forms of relief for American industries unless they are willing to increase their competitiveness within a specified period.
As I have argued before,* some national entity reflecting the interests of industry, labor, and government should be available to help frame and carry out such a coordinated policy. The advantages of such national mechanisms have been amply demonstrated in Japan and Western Europe. By ignoring them, the US hobbles itself in foreign competition. Our industrial problEMS are not going to be limited to the auto, steel, and machine-tool industries. They will include computers, telecommunications, and other high-technology industries. They will ultimately include service sectors such as banking and insurance. Our willingness to carry out such policies will enable us to have a stronger negotiating position toward our foreign trading partners when we negotiate over reciprocal conditions of trade.
On the international front, the question of the dollar, the trade deficit, and the third-world debt are closely interconnected. Recent initiatives by the administration have been very constructive. After several years of a hands-off policy, reflecting a pure market attitude, strong interventions by Treasury Secretary Baker and Federal Reserve Chairman Volcker with respect to the dollar and the third-world debt have had considerable impact. The dollar has fallen by 25 to 30 percent against the main trading currencies since the Plaza meeting of the so-called G-5 countries (the United States, United Kingdom, Japan, Germany, and France) in November 1985. The US has demonstrated a new willingness both to intervene in the foreign exchange markets and to coordinate its actions with Europe and Japan, as when the recent successive reductions in lending rates by the Japanese and German central banks were immediately followed by a reduction in the Federal Reserve’s discount rate.
The new US initiative with respect to third-world debt, set forth at the IMF meetings in Seoul last October, is equally significant, but it has been less successful. It is significant because it recognizes that constant reschedulings of debt and relying on the workings of the marketplace will not resolve the debt problems in the third world—and that if they are not resolved, the vast sums owed to US banks could render its entire economy vulnerable. The US government, for the first time, is now openly committed to play an important part in resolving this situation. It has been less successful than in its initiative on the dollar because collapsing oil prices have aggravated the situation of oil-producing borrowers like Mexico to the point where stronger measures will have to be considered.
Finally, in his State of the Union address President Reagan said he was directing the secretary of the treasury to study the possibility of an international monetary conference, a new Bretton Woods, aimed at the creation of a more stable system.
All these initiatives show a new attitude—a willingness by the US government to intervene in markets and to take the lead in cooperating with our Western trading partners. Such initiatives may be the limit of what is politically possible for the moment, but more will have to be done, especially when it comes to the third-world debt.
The notion of a new Bretton Woods conference to try to evolve a more stable international monetary system is long overdue. This should be the main item for consideration on the next economic summit in Tokyo in May 1986. Such a conference should take up the subjects of exchange rates and debt. They cannot be separated. Concerning currencies, the conference should deal with both near-term and long-term objectives. For the near term, the conference should aim to establish “target zones” for the dollar, the deutsche mark, sterling, and yen—ranges in which exchange rates would be permitted to fluctuate under an agreement to keep the rates from breaking through either end of the range. At the same time, large-scale interventions in the markets to defeat speculative runs on the main currencies must be backed by a sizable and credible intervention fund. The main central banks should as soon as possible establish a $20 to $30 billion exchange stabilization fund for this purpose.
For the long term, an expansion of the European Monetary System to include sterling, dollars, and yen should be considered. The EMS, on the whole, has been successful in maintaining a level of cooperation and coordination among members. Devaluations and reevaluations have occurred, but as part of an orderly, gradual process. It is time to study how it can be expanded. In order to do so, however, the obvious fact to be faced is that the dollar now accounts for some 80 percent of the world’s currency reserves—the currency that governments and international agencies hold to finance international trade; this disproportion must be counterbalanced by larger volumes of other currencies than are available today. The European Currency Unit (ECU)—which is based on a “basket” of European currencies—and the yen offer the best possibilities.
The ECU is already actively traded. Its greater use as a reserve currency, however, would depend on much greater integration of the European economies, and would really imply the creation of a European currency with a considerable volume. Bringing about such a development would represent a difficult political challenge, one that would take years to meet. What Jean Monnet tried to do in creating the European Coal and Steel Authority, namely to unite Europe politically in response to industrial needs, might be more feasible during the 1990s in response to financial needs. No matter how difficult, this remains a highly desirable objective. On the other side of the world, Japan will also have to allow its financial markets and currency to be used in stabilizing the world monetary system, and to do so it would have to increase their size considerably.
In the long run, currencies cannot be stabilized without considerably closer coordination between nations and, in some cases, integration of their economic policies. Central to both goals will be the creation of currencies or baskets of currencies in sufficient volume to counter-balance the dollar.
In February, Mr. Héctor Hernández, Mexico’s minister of commerce, said his country would not be able to make full interest payments on its $93 billion in foreign debt. The current crisis in Mexico, only partly caused by falling oil prices, concentrates attention once again on the problem of international debt, which only recently had been considered as a thing of the past. It is not a thing of the past; it will be with us for a long time to come. How we handle it may determine whether we use the present opportunity to set the world economy on the path of long-term growth. Without growth there is no hope for political stability in developing countries and no hope that the growth of exports from the US and Europe, critically important to both, will take place.
As the interest payments on the third-world debt have come due in recent years, they have been “rescheduled,” i.e., added to the total debt owed. This device is a bridge to nowhere, as some simple figures show: Between 1983 and 1985 the external debt of Argentina grew from $43 to $46 billion; Brazil’s debt from $92 to $100 billion; and Mexico’s debt from $90 to $93 billion. This is the arithmetical result of turning interest payments into additional debt, despite enormous efforts by all three countries to promote exports and reduce imports during this period. The Mexican situation is now made desperate by falling oil prices following last summer’s earthquake. Continued reduction in the standard of living of the Mexican people as a result of its payments on debt to foreign banks is creating a political time bomb. Fear of radical political reactions will further increase the flight of capital from Mexico; this is already a serious problem and increases the likelihood that Mexico may unilaterally act to cut back its debt payments.
Several realities must be confronted:
1) Latin America is our most vital sphere of influence, both from a security and an economic point of view;
2) There is no way to repay on schedule, or to service, i.e., pay interest, on normal commercial terms, on the $350 billion of Latin American bank debt, without serious political risks to Latin American democracies. These risks are much greater than those posed by insurgency in El Salvador or Sandinistas in Nicaragua, as leaders throughout Latin America have been pointing out;
3) The US government will not allow one of our major banks to fail. At the time of the government rescue of Continental Illinois, the then secretary of the treasury, Donald Regan, stated that the top twelve US banks would, if the need arose, come under a protective umbrella;
4) Of the $350 billion of Latin American bank debt, approximately $100 billion, or about one third, is owed to US banks. As of December 31, 1984, the total equity capital of the largest twenty US banks was $46 billion.
There is obviously no quick way of resolving this situation. What is required is a process by which a) our banking system can be protected and b) significant relief from debt payments, together with new capital, can be provided to enable these countries to grow and to reduce the political pressures that are rising within them. These objectives, at first glance, are contradictory; providing for debt service relief, together with new capital to be provided to the borrowers, is not consistent with protecting the banking system. It would mean that banks must both accept damaging losses and make new loans. Some new elements must therefore be added to the equation.
The Baker plan, announced in Seoul last October, has some of the elements needed, but not all. It suggests that about $20 billion of new capital be provided by commercial banks over the next three years as well as $9 billion from multi-national institutions such as the World Bank. In view of the current crisis in Mexico much more drastic measures will be needed. It must also be remembered that whatever relief is provided for Mexico will not only have to be extended to Venezuela and other oil producers but probably to Argentina and Brazil as well. Even though Brazil’s financial situation has improved considerably, it seems unlikely that any political leader in the region will be able to agree to less lenient terms than those accorded Mexico without serious political consequences.
One way or another a package including the following measures will have to be agreed upon soon:
a) Significant interest rate relief. Simply increasing debt by borrowing interest costs cannot be continued much longer. A different approach is needed that will inevitably require reduction in current interest rates. A reduction of four percentage points on current interest rates would provide Mexico with $4 billion annually in new capital and Latin America with $14 billion annually.
It would also mean, in the aggregate, a reduction of $4.5 billion per year in the profit and loss account of US banks. That would be a crippling blow to our banks if they are not given some relief.
b) Some form of total or partial government guarantees must be given to US banks in exchange for reducing interest rates and stretching out the maturities of existing loans to third-world countries. In order to avoid a huge write-off of bad debt that would impair their capital, the banks will require some form of government guarantee to continue carrying these loans at their face value on their books, while interest rates are reduced and maturities are significantly stretched out. The loans to third-world countries would become long-term, low-interest loans, guaranteed in whole or in part by the US government or, alternatively, by an international organization such as the World Bank. In effect, the banks would exchange current profits for long-term financial security.
c) Regulatory relief to reduce the impact on bank profit-and-loss accounts. At present, we are permitting an accounting myth: namely, that money lent to Brazil, to be used to pay interest on its existing debt, can, when it comes back to the lending banks, be treated as real earnings.
Under the type of restructuring I have suggested, we will have to invent different accounting approaches. For instance, existing reserves already set up by the banks to provide for future losses on certain of these loans could be released and credited to future earnings over a period of years. Other possibilities will surely be suggested; we do not lack for creative accounting.
d) New capital from outside our banking system. The objective must be to reduce, not increase, the outstanding obligations owed to US banks. No real restructuring of existing loans can take place without significant sacrifice of the banks’ earning power. That sacrifice will make sense for banks only in return for government guarantees that the loans will be secure. But the banks cannot be asked, in addition, to supply large amounts of new capital.
The logical source of such new capital is Japan. Japan’s commercial trade surplus is currently running at about $50 billion per year; it could increase to about $70 billion as a result of falling oil prices, even though the falling dollar will undoubtedly offset this somewhat.
The US has been waging a constant rear-guard action to open Japanese commercial markets to our goods. This effort has been the subject of much rhetoric but we can’t realistically expect that increased US exports will reduce Japan’s trade surplus by more than $10 to $15 billion per year. What is more important is that Japan be encouraged to provide the growth capital for Latin America. This should be done through major long-term commitments to the capital of multilateral institutions such as the World Bank, the Inter-American Development Bank, etc. A five-year commitment by Japan of $20 billion per year, together with interest-rate reductions of about $15 billion per year, as I have suggested above, would provide $175 billion of new capital to Latin America over the next five years.
Properly invested, that should provide for real growth, fewer internal political pressures, reduced immigration pressures on our southern borders, and increased exports from Western industrial countries.
e) Conditions must be imposed on the recipient countries to adopt economic policies designed to repatriate the domestic capital that they have sent abroad. The flight of capital from the debt-burdened countries to the US, Switzerland, and other European countries has been one of the most damaging developments of recent years. Instead of being used for productive investment at home, this money, derived in some cases from US loans, has been used to build fortunes overseas. Loans of new capital should be conditioned on the repatriation of such flight capital, in some reasonable proportion to the new money, under the supervision of the IMF.
The real question we are facing is whether our government will take the lead in proposing to negotiate some version of such a plan with Latin America, Europe, and Japan, in view of all the political benefits we could derive from such an initiative. Or will we wait for a desperate Mexico or another country to unilaterally default on its payments, denounce its debts, and set off a crisis? Obviously any such plan would require congressional approval. However, Congress knows, or should know, that after the rescue of Continental Illinois Bank, the US government is, in reality, a guarantor of the US banking system. If defaults abroad send tremors through the banking system here, then the government would have to intervene on a vast scale.
A collateral question concerns the broader issue of commercial bank lending to sovereign countries. We now have the worst of all possible worlds. Our banks have become prisoners of their big borrowers and, at the same time, in order to protect their financial structure, the banks have become a major factor in the internal economic and social policies of borrowing countries. Throughout Latin America, political leaders complain that unacceptable austerity measures are being imposed on their populations in order to sustain their credit with foreign banks. This has major effects on our foreign policy which, in turn, has become a prisoner of the banks’ dilemma.
As a result we are prevented from rationally and effectively using one of our most potent foreign policy strategic weapons, namely the granting or the withholding of credit. When martial law was imposed on Poland in 1981, we were unable and unwilling to threaten to withdraw the large credits that had been extended to Poland: we feared the effects on US banks. During the recent crisis in the Philippines, we were paralyzed when it came to making strategic use of the credit accorded under Marcos’s rule. In South Africa the bank debt is being rolled over instead of frozen, as it might be, to put real pressure on the Botha government. The case of South Africa is typical. To withhold loan rescheduling would be a powerful weapon in urging real reform of apartheid. Mindful of the effects on Western banks, we cannot make use of this weapon and instead try to make do with “disinvestment,” an ineffective policy which does more damage to American interests than to the South African economy.
At the same time, we cannot help our friends. It might be wholly appropriate, as part of an overall plan, to permit Mexico to defer both interest payments for two to three years and principal repayments for fifteen to twenty years. If the Mexican debt were in the hands of the Federal Reserve or the Treasury, this could be done with the stroke of a pen. If the South African or Philippine debts were so held, their management would also become part of our foreign policy. For the banks to take similar action would immediately impair their capital.
As we get more deeply into the question of restructuring the third-world debt as well as related questions of bank deregulation and oversight, we might well ponder whether loans to foreign governments should not be the sole province of our government or of multilateral institutions controlled by governments. I believe a powerful case can be made for this.
One of the major economic challenges facing us today (if not the principal one) is maintaining the soundness of our banking system while, simultaneously, bringing about a realistic rescheduling of third-world debt. No doubt this will be a complex process, requiring cooperation of other Western governments as well as case-by-case negotiations with debtor nations. I believe our Western allies would follow our lead if we were to provide one and that an initial test case such as Mexico’s would rapidly set a pattern for similar settlements with other countries.
We will rarely see a more favorable climate for undertaking such an initiative: downward trends in interest rates, a strong economy, a booming equity market. We must not forget, however, that there is much speculative fragility in the economy and that a stock market that can go up one hundred points in a week could also come down one hundred points in a day. There are still many trouble spots that should be of sharp concern. The energy industry, farming, and certain manufacturing and retail sectors are still weak; many regions of the country are in difficulty. Productivity of US industry remains relatively low. A fortuitous inflow of foreign investment has cushioned the consequences of the growing gap between what we buy abroad and what we can sell; notwithstanding the past effects of the strong dollar, that gap reveals deficiencies in our ability to compete. There is more to our economy than the stock market.
These, however, are only several pieces of a very large puzzle. We are mesmerized by domestic issues, such as tax reform or the Gramm-Rudman bill. What we need is a long-term, global economic strategy to fit with our international security strategy. That economic strategy should in my view include the following elements:
1) The Soviet economy is weak. In order to improve it, the Soviets will have to face exceedingly difficult political choices. The advanced telecommunications and data-processing technology required of an advanced industrial society is to a large degree incompatible with a closed, rigid, bureaucratic system. To provide the Soviet people with a higher standard of living and the benefits available in Western and even in parts of Eastern Europe, the Soviet government will have to make major investments and changes in its domestic economy. We should encourage such a process since it will have to lead to reduced military spending and could lead to political change. Putting pressure on the Soviet Union to take part in an escalating arms race, which they will maintain by rigid social discipline, is counter to our own interests and requires us, as well, to divert to military production enormous resources that can far more usefully be invested in the needs of our own people.
2) We should not provide major amounts of credit to Eastern Europe by ourselves. Since the beginning of the Polish political crisis in 1981, the Polish external debt has increased from $26 billion to over $30 billion as a result of rollovers of loans by Western banks. We should propose to the Soviets that, if we are to continue our own credit arrangements, we share the financing requirements of Eastern Europe on a fifty-fifty basis. We could increase the availability of credit if arms control agreements are reached. Among our objectives should be to encourage closer relations between Western and Eastern Europe and to encourage larger exports from Western Europe to Eastern Europe and the Soviet Union. This could also lead to pressures for political change in Eastern Europe and, ultimately, in the Soviet Union.
3) We should make the North-South axis on the American continent our first economic priority. Canada, Mexico, Brazil, Argentina, Venezuela should be our biggest markets and most important investment partners. We should be seriously considering the possibility of establishing a common market with Canada that might one day include Mexico. Restructuring the debt should only be the first step toward recognizing that both from an economic as well as from a geopolitical and security point of view, Latin America and Canada come first. The economic health of Latin America is vital not only to our export industries but to those of the Western European countries and therefore, ultimately, to their political strength.
4) We should encourage the creation of a European currency followed by much greater economic and political integration of Western Europe. This will make Europe a much stronger partner militarily and enable us to reduce our defense commitments there. It would also enable Europe to undertake the kinds of economic support for the sub-Sahara nations in Africa that we should be working out in Latin America.
5) Japan will soon embark on a huge foreign direct-investment program both to offset potential protectionist moves in the United States and to take advantage of the stronger yen. That program should be the subject of careful negotiations since its implications are farreaching. After decimating many of our industries by its exports to the US, with the help of a higher dollar, Japan could acquire control of many of those industries with the help of a cheap dollar. We should find ways to insist that Japan’s foreign direct-investment program be a balanced one and that it include major efforts, through multilateral institutions, to finance third-world growth and, in turn, help our own and European economies.
Successful American business leaders learned decades ago that they had to plan internationally if they were to survive. Our political leaders must now do the same, not only in the security sphere, but in the economic sphere as well. It is obviously impossible to speak of a world economic order; we must, however, have some carefully formulated goals that will serve as a general basis for American policy during the next ten to twenty years.
These goals do not have to be predatory or imperial; indeed I believe they are doomed to fail if they do not respond to the grim conditions in the poorer countries in this hemisphere and elsewhere. They must, however, deal with this country’s long-term interests in a world that grows smaller, more interconnected, and more complicated every day. The Japanese have a motto: “Win first and profit later.” Useful advice for planning our own economic objectives in the years to come.
April 24, 1986