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 in the world. Ever since they lost the Second World War, the Japanese have consumed less than they produced. For the first three decades, this surplus was used to build up Japanese industry to a point where it enjoys a comparative advantage over other nations in producing many products, and the world economy has difficulty in absorbing Japanese exports. Japanese industry has acquired a vast stock of modernized capital equipment, but Japan continues to run a savings surplus that is available for accumulating assets abroad. That is a winning formula for building economic power, and Japan is fast becoming the leading economic power in the world. Whether it has already overtaken the United States depends on the measure we use. If we look at the size of the domestic market, Japan has a long way to go; but if we look at the volume of exports or, even more to the point, the volume of overseas investment, Japan is clearly in the lead. Japan’s net external assets rose by $50 billion during 1986 and reached $180 billion by the end of the year, breaking the previous world record of $150 billion set by the United States at the end of 1982.1

There have been other occasions when leadership has passed from one nation to another; the fact that Japan is so much smaller than the United States is not an insuperable obstacle. After all, England is even smaller than Japan and it was the undisputed leader of the world economy in the nineteenth century.

The transfer of leadership is usually a troubling and dislocating process. The most recent occurrence was during the interwar period, when England lost its preeminent position, causing turmoil first in currencies and eventually in international trade. But there has been no previous example of a transfer of economic power as rapid as the one now taking place. As a consequence, both the international financial system and international trade are under great strain. Having become overvalued during the heady days of Reagan’s first term, the dollar has been declining since 1985, and its decline has been increasingly difficult to arrest.


The trade deficit shows only small signs of improvement, and protectionist pressures are strong. The willingness of foreign investors to buy our debt has been eroding and, as a result, interest rates have started to rise, posing the prospect of a recession and the specter of wholesale default by less-developed countries. Brazil has already declared a moratorium on debt repayment. Although it has recently embarked on an austerity program, Brazil will not be able to resume payments if export markets shrink and interest rates rise. The morning after, President Reagan’s borrowing binge looks very bleak indeed.

What is to be done? Protectionism through tariffs, quotas, and other barriers to the entry of foreign products is the counsel of despair. We have seen the consequences of the Hawley-Smoot Tariff Act of 1930, which provoked retaliatory tariffs in foreign countries and caused US trade to suffer a sharp decline. The proponents of protectionism can argue that the current imbalance is too great to allow our trading partners to retaliate effectively against US exports, and they have a point. But retaliation would take the form of a refusal to lend, and we have become far too dependent on foreign capital to allow that to happen. The imposition by the US of countervailing duties on $300 million worth of Japanese electronic goods on April 17, 1987, precipitated an eighty-point drop in the Dow Jones averages the next morning. This is a foretaste of what would be in store if serious protectionist measures were imposed by the US.

Protectionism is the counsel of despair in another sense as well. A reduction in international trade would result in a reduction in living standards throughout the world. It would also acknowledge our failure as the leading economic power in the world. Britain introduced the principle of “Imperial preference,” conferring trade advantage on imports from its overseas territories, in 1904. That was the precise moment when Britain lost its hegemony; ironically, it was also the beginning of the end of the British Empire. We ought to be able to do better. Unfortunately, protectionism appeals to certain elemental instincts, whereas a constructive policy is bound to be hard to grasp because the problems confronting us are complex.

To put matters in the simplest possible terms, the United States consumes more than it produces and Japan produces more than it consumes. Hence the imbalance in both trade and payments. To be sure, the imbalances need not be eliminated. The international economic system is flexible enough to accommodate capital flows and the transfer of economic power. What creates problems is the vehemence of the change and the rapidity of the transition. The question we must raise is why we are allowing our economic position to deteriorate at an unprecedented rate. The answer is painfully clear: we have been abandoning our economic superiority in order to achieve military superiority. We have been borrowing abroad to finance rearmament. The current account of the US, which reflects the balance of trade, declined by $155 billion between 1980 and 1986, while the defense budget rose by $138 billion between the same years.

This policy is very shortsighted. Many empires have maintained their military superiority by exacting tributes; but no great power has managed to maintain its position by borrowing from its allies. As our economic position deteriorates, we shall have to reduce our military expenditures, whether we like it or not. As Japan becomes stronger, it will have to increase its military expenditures, whether we like it or not. The sooner we confront that issue, the better. One way or another, we must eliminate or drastically reduce the budget deficit now, not at some distant date. And we must consider carefully what part the military budget ought to play in that reduction.

Our military plans were designed to protect the free world from the everlooming and worldwide threat of communism. This policy is wholly outdated; communism no longer presents a worldwide threat. Communism as an international ideology has lost much of its appeal. It survives largely in the virulent anticommunism it has spawned in our own country, and in a few aberrant strains such as the Sandinistas in Nicaragua and the Sendero Luminoso in Peru. China today is more friendly with the United States than with the Soviet Union. Both Vietnam and Cuba face the prospect of a cutback in Soviet aid. The Soviet Union itself is in an acute economic crisis caused by the rigidity of its political system and exacerbated by the priority it places on military spending. In some respects, the two military superpowers suffer from the same economic disease, namely military overspending, although in the case of the Soviet Union the disease is incomparably more debilitating because its economy is so much weaker.


The United States and the Soviet Union are able to destroy each other. Consequently, arms reduction must also be mutual and the military balance must be maintained. Fortunately, Gorbachev seems to want to move in this direction. If both countries could reduce their military spending simultaneously and proportionately, both countries would be better off and the world would become a much safer place to live in.

What would happen to the world economy, and to our own, if we managed to sharply reduce our military budget? Other sources of demand would have to take its place. Where are they to be found? In the United States higher exports and lower imports would go part of the way to compensate for reduced military spending; and industrial investment may eventually revive, encouraged by the combination of lower interest rates and greater demand for domestic products. But the US could no longer serve as the locomotive for the world economy as it has since 1982.

As for Europe, if the missile treaties currently under consideration are successfully concluded, the European nations would have to increase their expenditures for conventional armaments. Alternatively, Gorbachev may offer to reduce the military strength of the Warsaw pact countries in exchange for increased trade and credit. Either way, the European economy would be stimulated.

The outlook for Japan is much more clouded. The government has announced a variety of supplemental spending measures for stimulating domestic demand, but they do not seem to have much effect. The key question is housing. Living conditions in Japan are extremely poor and wholly inappropriate to the wealth that the country has amassed. The reason is to be found in the price of land, which is rising much faster than earnings. A Japanese family must therefore save an increasing proportion of its income in order to put a down payment on a house or apartment. That is why the savings rate is so high.

The first task of Japanese economic policy ought therefore to be to create additional living space. This could be done, first, by reducing or abandoning the subsidies and tariffs that protect Japanese agriculture and converting some of the agricultural land to other uses; and, second, by removing the sunshine laws and other restrictions that prevent the construction of high-rise buildings in urban areas.

The protection of farmers is as deeply ingrained in the Japanese political system as it is in our own. To abandon that protection would mean sacrificing Japan’s self-sufficiency and allowing Japan to become dependent for agricultural commodities on the vagaries of the world economy. The choice is a difficult one for the Japanese. If Japan wants to become the leading economic power in the world, it must abandon agricultural protection just as, in 1846, England repealed the Corn Laws, prohibiting imports of grain. If it is unwilling to do so, what right has it to expect the rest of the world to keep its markets open to Japanese imports?

If Japan made more living space available to its citizens, consumption would greatly increase. Not only would there be a construction boom, but purchases of other consumer goods would pick up as well. Both Japan’s savings surplus and its trade surplus would decline. In the US, a reduction in the budget deficit would move both the savings rate and the trade balance in the opposite direction. As a consequence, the imbalance between the two countries in both trade and capital flows would be greatly reduced.

We are in a strong position to press such a case on the Japanese. We are still the largest market for Japanese exports, and we provide Japan with military protection. Moreover, the policies I have outlined would, I believe, hold considerable appeal for the Japanese voters (apart from Japanese farmers), if their leaders were willing to present them. Such a shift in policy would not preclude Japan from becoming the leading economic power in the world; it would only slow down the process to a more tolerable pace.

The rise of Japan need not be accompanied by the decline of the United States. We could have an international economic system based on not one but three economic superpowers: the United States, Japan, and Europe (especially if the United Kingdom were to join the European Monetary System). For such a new system to function, however, the US would have to negotiate far-reaching reforms. Our present system has been based on the dollar as the international currency. This is quite inappropriate to changing circumstances. We need to develop a genuine multicurrency system; and to make it work, we need a genuine international central bank.

Such an institution could play a central role in resolving the debt problem of the developing world. Latin America, in particular, is badly in need of an imaginative scheme like the Marshall Plan; but the United States on its own can no longer afford a scheme of this kind. Relief has to be international and Japan has to have a prominent part in it. It should be handled by an international agency; otherwise Japan would gain a degree of influence in Latin America that the US and the European nations would not accept.

The details of a debt-relief scheme are highly complex and technical. Here I can only sketch the broad outlines. The outstanding debt would be converted to obligations issued and guaranteed by the international central bank. This would let the commercial banks off the hook and they would be required to pay for such relief by accepting an interest rate below the one prevailing in the market; or even better, they would accept a reduction in the face value of their loans. The discount in value would vary according to the creditworthiness of the debtor country in question—there is a fledgling market in third-world debt that could serve as a guide. For instance, Mexican debt can now be acquired at a discount of about 43 percent and Brazilian debt at a discount of 41 percent. Banks have begun to set up reserves against potential losses on third-world debt. At present, they amount to about 25 percent of the outstanding debt. A doubling of these reserves ought to be more than sufficient to convert the currently outstanding bank debt into obligations of the international central bank. Commercial banks would no longer be required to provide loans to less-developed countries. That task would be taken over by the newly formed institution. Commercial banks may hold the obligations of that institution just as they hold government obligations—and both kinds of obligations would rank equally in calculating the banks’ reserves.

The international central bank would provide credit to sovereign countries on a continuing basis. That is to say, it would refinance the debt rather than insist on repayment, just as the national debt of the industrial countries is continually refinanced. At the same time, the present anomaly, that developing countries cannot refinance their debt, would be eliminated and Latin America would open up again as an export market. With the debt problem on the way to being resolved, private investment could also be expected to pick up again, but it would take the form of buying the shares and bonds of selected foreign enterprises rather than providing bank loans. As the main source of credit, the international central bank would be in a position to ensure that the developing coutries do not once again acquire excessive debts. If foreign profit investment rose, or domestic budget deficits got out of hand, the central bank could cut back its lending.

The capital of the international central bank would be underwritten by the major industrial nations. The size of their financial commitments would be determined partly by the respective voting rights they would negotiate when they set up a central bank and partly by their trade balances. Thus, so long as the trade imbalance between the US and Japan persists, Japan would contribute more and the US less than their respective voting rights. The present allocation of voting rights in the World Bank could serve as a starting point for negotiations; but the United States can no longer expect to retain the blocking minority rights that it currently holds in the World Bank.

The institutions of the Bretton Woods system—the World Bank and the International Monetary Fund—fell short of a genuine international central bank. Strange as it may seem in retrospect, the Bretton Woods system did not envisage large-scale international capital movements and it broke down when they occurred. The free movement of vast sums among the world’s capital markets is now a fact of life and a return to fixed exchange rates has become desirable because currency fluctuations are disrupting the world economy. Speculative transactions far outweigh in importance the balance of trade in determining exchange rates; and trends in exchange rates tend to become exacerbated by speculation. As a consequence, fluctuations in exchange rates are carried to extremes, investment in fixed assets is discouraged, and “hot money” accumulates.2

An international central bank that engages in continuous large-scale borrowing operations would make a system of fixed exchange rates possible. The bank’s obligations would be issued in a new international unit of account—similar to the European ECU—which would link the major currencies of the world together and allow them to fluctuate only within a narrow band. Moreover, the new institution would be able to control the worldwide money supply through its borrowing operations, much as national central banks do at present.

With the Plaza Agreement of September 22, 1985, the monetary authorities of the leading nations abandoned the system of freely floating currencies, but they have not been able to develop a better system in its place. Clearly the creation of an international central bank would infringe on the sovereignty of every nation. In all probability, only a financial crisis would induce the nations of the world to sacrifice part of their sovereign rights. History shows that every step in the development of central banking as an institution has been preceded by a crisis.

It would require an act of strong leadership to short-circuit the process. Fortunately, the United States is still in a position to provide such leadership. The US has been the linchpin of the financial system ever since the end of the Second World War. By sponsoring an international central bank it could consolidate its position at a time when it seems destined to lose it.

This Issue

August 13, 1987

  1. 1

    From Comments on Credit, a weekly commentary issued by Salomon Brothers, May 29, 1987. 

  2. 2

    See George Soros, The Alchemy of Finance, Chapter 3 (Simon and Schuster, 1987).