Since the Second World War, America has been the undisputed leader of the world economy. In military power, we had to share the first place with the Soviet Union because of our mutual ability to destroy each other; but in economic matters our hegemony was complete. The international trading and financial system reflected this fact. The dollar served as international currency and the economic policy of the United States set the course for the world economy. The United States did not fully live up to the obligations implicit in this arrangement because it did not restrict the supply of dollars sufficiently. In the 1960s US corporations and other investors amassed assets abroad, flooding the world with unwanted dollars. As a consequence the currency system established at Bretton Woods, which effectively tied both the value of gold and the value of other currencies to the dollar, broke down. The dollar was cut loose from the price of gold in 1971 and the fixed exchange rate system was abandoned in 1973.
After the first oil crisis, which also occurred in 1973, the commercial banks recycled the dollar surplus of OPEC countries by making loans to the oil-importing countries. Eventually, the process deteriorated into a binge of uncontrolled credit creation as the banks re-lent the deposits that their own borrowing had generated. The indebtedness of the less-developed countries reached unprecedented levels and the dollar declined in value.
After the second oil crisis, in 1979, inflationary pressures accelerated to such a degree that the Federal Reserve decided to call a halt by imposing a strict limit on the growth of the money supply. A sharp rise in interest rates precipitated a worldwide recession in 1980 and an international debt crisis in 1982.
Fortuitously President Reagan embarked on a huge rearmament program while cutting taxes at the same time. The resulting budget deficit saved the world economy from depression by providing a much-needed fiscal stimulus. In an ironic twist of fate the United States became, in effect, both the borrower and the spender of last resort.
The policy was highly successful in the short term. The domestic economy prospered and at the same time the US acquired a vast military arsenal. President Reagan could strike a strong military pose, which seemed to appeal to the electorate, especially since it provided a contrast to President Carter’s vacillation. But, as in the case of every policy based on borrowing, there was a heavy price to be paid in the long run, which in this case has not been very long. Even before the end of President Reagan’s second term, the painful aftereffects are beginning to make themselves felt. The federal government is running a large budget deficit and the economy is running a large trade deficit. Both deficits are covered by borrowing from abroad. The trade imbalance has played havoc with US manufacturing industry and the accumulating budget deficit has turned the US into a debtor nation.
Japan has emerged as the leading creditor nation…
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