GLOBAL ECONOMIC PAPER

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP83M00914R001000010006-8
• Release Decision: RIPPUB
• Original Classification: S
• Document Page Count: 35
• Document Creation Date: December 20, 2016
• Sequence Number: 6
• Content Type: MEMO

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THE DIRECTOR OF CENTRAL INTELLIGENCE
MEMORANDUM FOR: Director of Central Intelligence
National Intelligence Officer for Economics
DDI #555-82
22 January 1982
SUBJECT: Global Economic Paper
1. As per your request, attached is an expanded draft version of the
Global Economic paper. I have written three wholly new sections:
o The analysis of long-term industrial trends to which I referred
during our talk;
o A brief section on the Soviet Bloc; and
o One on implications for national power, lever{ and influence.
2. The section on short-term trends has been greatly shortened. The
one on vulnerabilities and risks is largely taken from the earlier draft
but the part on oil markets has been substantially revised.
3. The Key Judgments remain to be drafted, and we are still working
on supporting statistical charts and tables. None of the material has been
coordinated or reviewed.
Attachment,
As stated
r 'HS Pe vip_'A CI: I::'letedi
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DDI #555-82
22 January 1982
SUBJECT: Global Economic Paper
DCI/NIC/NIOI
122 Jan 82 )
0
Distribution:
Orig - Addressee
1 - DDCI
1 - 0/DCI/ExDir
1 - ER
1 - DD
I Registry
2 - NI
0/Econ
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GLOBAL ECONOMIC FORCES
Table of Contents
Preface ...............................................................1
Key Judgments .........................................................
1. The World Economy in 1982 ........................................3
2. Long-Term Industrial Trends .......................................5
3. Major Risks and Vulnerabilities ................................... 14
o Supply Interruptions ...........................................16
o Financial Collapse .............................................20
o Protectionism ..................................................23
4. The Soviet Bloc ...................................................24
5. Implications for National Power, Leverage and Influence ........... 25
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GLOBAL ECONOMIC FORCES
Preface:
The US is more and more open to global economic forces. Indeed, it is
scarcely an exaggeration to say that many of our present economic
difficulties stem from a general national failure to appreciate how
profoundly our country is affected by commercial, industrial, and
agricultural events and trends beyond our own borders.
This failure of insight no longer obtains. We now recognize that in
coming years and decades our ability to chart a successful national course
will depend, at least in part, on our grasp of key global economic forces--
on our grasp of their status, their direction, and of their impact on the
US and also on our chief adversary, the Soviet Union.
This paper will outline the key global economic forces at work today,
project their respective directions through the near-term future, and
articulate the opportunities these trends will offer--along with the
vulnerabilities they will create--for both the US and the Soviet Union.
We are concerned not with predictions or projections of economic
events or with a comprehensive survey of economic trends, but rather with
identifying particular forces and conditions which may generate new or more
intense economic problems for policymakers.
Following a brief evaluation of the world economy in 1982, we examine
the main external trends which will affect the structure of industrial
production and trade in the 1980s. Then we consider the vulnerability of
the world economy to various shocks: interruptions in the supply of oil
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and other commodities; systemic financial crises; and a surge in beggar-
thy-neighbor trade policies. Communist economies, and their linkages with
the world economy are treated briefly. Finally, we assess the implications
of those economic trends and vulnerabilities for the power, leverage and
influence of the US, the USSR, and other major countries.
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1. The World Economy in 1982
1982 is a pivotal year for the global economy. By midyear, the pace
of Free World economic activity should begin to move out of the doldrums
that characterized 1980 and 1981 but the vitality and durability of the
upturn remains a major uncertainty. US economic performance is unusually
important to the world economy this year as most other countries can do
little to expand their purchases. West European governments are very much
in need of a rapid pickup just to prevent furether increases in unemploy-
ment and large budget deficits are thwarting any major use of fiscal
stimulation. Most LDC and Communist countries face weak commodity markets
for their primary exports and a rising debt service burden. Many oil
exporting countries may be forced to slow the growth of their imports
because of the decline in demand for oil and falling real oil prices. Only
Japan is likely to be less dependent on a pickup in US economic performance
as it further increases its trade surplus.
The range of plausible recovery patterns for the United States and
Western Europe foreseen by economic forecasters for 1982 is rather broad--
ranging from a rapid, sustained upturn to continued economic stagnation
into 1983. The bulk of forecasters anticipate a "saucer-shaped" recovery
pattern with an initially vigorous recovery being checked by rising inter-
est rates.
This consensus view is based mainly on the belief that financial
markets will remain very sensitive to the long-term risk of renewed
inflationary pressures and could trigger another upturn in interest rates
in the US which would dampen the recovery. This, they argue, would be the
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case even though US inflation rates will probably continue to ease by late
1982, with less pronounced declines in Western Europe. With a "saucer-
shaped" recovery, unemployment in both areas would remain near their
cyclical high.
A more rapid pickup of economic activity in the US and Western Europe
after midyear given the cut in US taxes and pent-up demand in the US and
Western Europe could occur. During such an upturn, inflationary pressures
should be held down by the large productivity gains that normally occur in
the early phase of an economic upturn. Unemployment, however, even in this
most optimistic case would remain high well into the recovery cycle.
The possibility also exists that the 1982 upturn could be choked off
by high interest rates and self-reinforcing stagnation tendencies would
evolve that could last well into 1983. In this case, inflation probably
would fall dramatically but unemployment rates in both the United States
and Western Europe could rise to politically disturbing proportions.
Japan's economic growth pace is likely to remain in the 4-5 percent a
year range, but the expansion is expected to depend much more on domestic
demand than on increases in exports. Japan is certain to run a massive
trade and hard currency surplus in 1982. This will be so even though
export growth slows substantially and domestic economic expansion continues
at a fairly high rate based on rising domestic demand. The Japanese
surplus will create severe political reactions in the US and especially
Western Eqrope. Neither the politically feasible measures Japan may take
in response to these pressures, nor the likely appreciation of the yen,
will have much effect on the trade surplus for 1982, although they could in
1983.
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Non-oil LDC growth can be expected to remain below the average pace
achieved since the early 1970s. It takes six months or more before the
upturn in industrial country activity begins to significantly boost the LDC
growth pace. Moreover, many important LDCs have already or soon will
accept domestic austerity to relieve foreign payments problems. In Central
America the disruptive impact of insurgencies and the depressive effect of
weak commodity markets will continue or will worsen in 1982. In much of
Africa, declines in earnings from primary exports, due partly to low
prices, have uncovered a legacy of decades of economic mismanagement. A
growing number of countries in both areas will have to reschedule their
foreign debt obligations, but most countries will meet their obligations by
cutting the imports which have supported the small but politically crucial
urban populations. Among the large, newly industrializing LDCs, Brazil
will have to keep the brakes on the economy to handle its enormous debt
service burden, Mexico will have to greatly slow its economic growth to
adapt to lower real oil prices and pay for past policy errors, and South
Korea will have difficulty sustaining its renewed dynamism in the face of
weak foreign markets and protectionism.
Most oil-exporting countries will increasingly have to deal with
problems caused by oil revenues falling behind development spending. Only
in the case of rapid growth would there be some chance of a modest oil
price rise near the end of 1982 that could help relieve this financial and
political bind.
2. Long Term Industrial Trends
Growing Competitive Pressures
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The mature industrial economies--the United States and Western Europe-
-are being subjected to three-pronged external competitive pressures from:
o LDCs with low-wage costs in traditional labor-intensive
industries, such as textiles.
o Newly industrializing countries (NICs) and some oil-rich LDCs,
in basic industries, such as steel, non-ferrous metals, and petrochemi-
cals, and in the simpler types of machinery and equipment.
o Japan in very high technology industries, such as robotics and
microelectronics.
Basically, international competition is a healthy reflection of the
economic development process and the growing integration of the world econ-
omy. But competitive pressures are far more severe than ever before
because they'are appearing on so many fronts at the same time, and the
industrial economies are far more open to foreign trade. In the US, for
example, the ratio of imports to domestic consumption of goods has doubled
in the past ten years.
Foreign competition is by no means the sole, nor even the dominant
pressure for change. The adjustment to high energy costs, for example,
will have a major impact on the demand for and the mix of products such as
steel, chemicals, and machinery regardless of foreign competition.
Environmental concerns also will impose heavy costs, particularly on basic
industries, as well as generate demand for new products. Domestic poli-
cies, not-foreign competition, will have the dominant effect on savings,
investment, consumer behavior and entrepreneurship. Nevertheless,
international forces are playing a far greater role in the pressures for
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change, at a time when the mature industrial economies have placed
increasing barriers in the way of dynamic enterprise and efficient
adjustment.
A Worsening Economic Environment
These enhanced competitive pressures are being felt during a period
when economic growth has been slow, with deeper and more frequent reces-
sions. Slower growth has been due in part to demand management policies
designed to bring down inflation, which had been ratcheted upward by the
jumps in oil prices, as well as by excessive monetary growth over many
years. Slower economic growth is also due to a slowdown in investment in
plant and equipment; to the allocation of a substantial part of investment
to energy conservation and substitution and to environmental control rather
than to the 'creation of new productive capacity; and to government tax and
regulatory policies which have discouraged risk-taking and hard work.
Under circumstances of slow growth, changes in the structure of demand and
costs have been more difficult to cope with. With overall demand growing
rapidly as in the 1950s and -60s, there were few industries in which pro-
duction was actually falling; shifts of labor and capital from these to
more dynamic industries could occur without major trauma. But during the
1970s, demand for the products of a number of industries has fallen,
sometimes sharply, for at least several years. This has meant large-scale
structural unemployment and major social and political problems in various
localities. A similar process can be expected in the 1980s.
Underlying Causes
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The intensification and broadening of international competitive
pressures reflects complex technological, institutional and economic
factors. Since World War II, the world economy has become more and more
integrated thanks to reduced restrictions on movements of goods, capital,
labor, and knowledge. At the same time, more and more countries have
climbed the development ladder, but major differences in traditions and
institutions have made their integration in the world economy difficult.
Among all the forces for change, the following appear to be of
particular relevance for the 1980s:
o Technological changes permitting automatic control of production
processes and efficient, relatively small-scale production rates. Both
of these technological trends make it possible for LDCs to develop
certain basic industries rapidly and often to produce at low cost. The
greatest disadvantage of newly industrializing compared with estab-
lished industrial countries is in the shortage of skilled, experienced
workers. For example, it takes experience and skill to know exactly
when the iron is ready to pour or the mix of chemicals is right, and
this needed experience is available only in established industrial
countries. But in the past decade or so, automated computerized
controls have been developed which permit a few highly trained experts
to operate the entire production process. This is the case, for
example, with the continuous casting process used in many modern steel
mills. The need for skilled labor is greatly reduced, so that new
industries can be run mainly with relatively unskilled labor and a few,
largely imported, engineers and technicians.
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Technologies which permit low cost production on a relatively
small scale also favor the LDCs. Economies of scale gave major advan-
tages to established industrial economies in the past because the LDC
markets were generally too small to support large-scale production.
Now many mills using electric furnaces can produce crude steel and some
steel products far more cheaply than most large-scale integrated
mills. In the US mini-mills now account for about 20% of the domestic
steel market and can undersell the Japanese for many steel products.
But similar technologies are being used in LDCs such as Egypt, Mexico
and Saudi Arabia.
o More and more businesses have developed integrated international
operations, including specialization of production components on a
global scale in order to take advantage of least cost opportunities.
In the global industries, for example, Ford has major assembly plants
in 15 foreign countries and significant production facilities in 34
countries including a large number of LDCs. Obviously, this global
approach to production by multinational corporations has been an
important instrument for bringing not only capital and technology, but
also modern management to newly industrializing countries.
o Japan has reached a new stage of development, expanding R&D in
its already advanced production technology and beginning a major R&D
effort to develop new products in leading edge industries, such as
microelectronics and robotics. The Japanese are capitalizing on a
labor force with the highest educational attainment in the world,
coupled with a high degree of discipline and social cohesiveness. This
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means that the kinds of training and skills needed for R&D are cheap in
Japan compared with the US or Western Europe, and that Japanese firms
are able to pursue R&D objectives with consistency and purpose.
The Adjustment Process
The adjustment by the mature economies to growing international
competition has taken various forms, with varying degrees of success. On
the whole, adjustment has been smoother in the US than in Western Europe,
because it began earlier and was less constrained by government controls
and other institutional factors. The basic evolution in the mature
industrial economies has been from labor-intensive and basic industries to
knowledge-intensive industries and services. Recent US experience has
shown that competitiveness can be maintained or regained in some components
of most industrial branches, including such traditionally labor-intensive
branches as textiles. Various combinations of modern equipment, better
organization of production, product specialization, and marketing skills,
can assure healthy US industries in some types of textiles, shoes, etc.
Unfortunately there are many barriers to the adjustment process, and
some of these are of recent vintage. In the US, high marginal income tax
rates and taxation of capital gains have discouraged new, risky invest-
ments, of the type that would often be required for quick adjustment to
growing foreign competition. Moreover, high inflation and uncertainty
about future inflation have raised the target rates of return on new
investment to levels that-were bound to exclude new ventures with rela-
tively long payoff periods.
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In Western Europe the constraints to adjustment are greater than in
the US. Extremely high tax rates (which are now near 50% of GNP, compared
to about one-third ten years ago), very high levels of social security
payments and unemployment compensation, coupled with wage indexing and
labor union pressure, have greatly discouraged the hiring of labor by pri-
vate business and hindered labor mobility. High agricultural price sup-
ports and various forms of protection of small, traditional retail business
also have tended to raise the cost of labor. Investment has been focused
on saving labor, not on adding to capacity. A host of tax laws and licens-
ing regulations discourage the development of small-scale, modern enter-
prise, as in microelectronics and in modern service industries.
Future Industrial Problems
In the future the main adjustment problems will occur not so much in
traditional labor-intensive industries as in basic industries, including
traditional machinery and equipment, and in very high technology indus-
tries.
Increased competition from low wage LDCs in such areas as textiles and
shoes began on a large scale in the 1960s in the US market and continued in
the 1970s in both the US and Western Europe. The adjustment process has
involved production specialization and various degrees of protection, as
through the International Textile Agreement. Japan, too, is being sub-
jected to this kind of competition. Although competitive pressures will
continue, the adjustment process is already far along and should not
involve any major shocks. Inevitably, employment in these industries will
decline in the US, Western Europe and Japan.
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The crisis in basic industries will continue and probably worsen in
the 1980s. The US steel industry is on the way to being reconstituted,
based on mini-mills and a reduced number of large-scale plants. The
European steel industry is undergoing a traumatic adjustment, with many
plants being closed down. With high energy costs, less steel, a highly
energy intensive product, will be used per dollar of final output. Thus
the demand for steel will continue to be weak and will shift in favor of
thin sheets and special steels. New capacity will be built exclusively in
the LDCs, and these new industries will be highly competitive in producing
steel bars, sections and other relatively simple shapes.
Environmental problems will continue to push non-ferrous refining
upstream, from the industrial countries to the LDCs. This shift should
accelerate. In the case of petrochemicals, large new capacity is being
built in Persian Gulf countries and a few other LDCs, using highly auto-
mated plants which require little skilled labor. Many of these plants
should be competitive on world markets, with resulting pressure on the
Western industries. The European and Japanese industries will be more
vulnerable to this commpetition than the US industry, which has access to
cheaper energy.
The 1980s will see a vast increase in the competitiveness of newly
industrializing countries in medium technology machinery and equipment.
Although Japan will continue to be a major factor in automobile markets,
the main new long-term corpetitive threat in this area is from such
countries as South Korea and Brazil which can easily master the modern
technology, have access to a relatively well trained labor force, but pay
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only a fraction of US, or even Japanese wages. The NICs are already major
producers of standard machine tools; in the future they will certainly
enter a great many areas of machine building, as they climb the economic
development ladder.
Japanese competition in very high technology industries presents a
special challenge. Japan is unique in that, although its per capita GNP
and average productivity is still well below the US and many countries in
Western Europe, it has the best educated labor force in the world. Apart
from lower wages, Japan's competitiveness in many industrial areas has been
based heavily on an ability to develop much improved production proces-
ses. In recent years the Japanese have rapidly increased their R&D expen-
ditures, in such areas as microelectronics and computers. Although they
have not developed many really new products, they have found cheaper
methods for producing products first developed in the US and elsewhere.
Over the next few yeas, the bulk of the Japanese competitive thrust in
the US market will remain in the traditional industries--steel, autos and
certain brands of consumer electonics. The Japanese will continue to apply
robotics and other new technologies to reduce labor costs as they have
already done at Nissam's Zama auto plant--the world's most automated. US
firms also will start to feel the impact of Japanese efforts to expand
sales in the computer and telecommunications industries in third-country
markets. Japanese companies have already won orders for computers in
Australia-.-a market long dominated by the United States--and will most
certainly go after growing markets in the LDCs.
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In the longer term, Japanese firms can be expected to attack directly
the US market for computers and telecommunications equipment once they have
built the necessary production volume. Moreover, recently initiated
massive R&D programs at the frontier of microelectronics, biotechnics and
robotics may start to have a significant impact. The Japanese believe that
the country's economic future depends on increasing the technology content
of its exports. Most recently, the Japanese have demonstrated their
ability to move in this direction in the semiconductor market. They now
hold 70 percent of the market for 64K RAM computer chip and may be ahead of
US manufactures in the development of a 256K RAM chip. Although the
outcome is still in doubt, their resources, excellent organization, and
singlemindedness enhance the chances of success.
3. Major Risks and Vulnerabilities
The economic troubles of this past decade have made the public and
policymakers much more aware of the vulnerabilities of the global economy
-- large scale commodity supply interruptions--oil, other raw
materials, and grain.
-- collapse of the international financial system.
-- rampant protectionism.
Although the nature of the three risks are much different, they have
some important characteristics in common.
-- The chances that they will occur are low. Since World War II, only
three situations can be considered to have had widespread and
highly adverse political-economic consequences. In each case, the
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problem was inadequate supplies causing rapid price runups: (1)
1950, when demand soared at the beginning of the Korean conflict;
(2) 1973-74, when a confluence of events sparked speculative fever
for most commodities, and cuts in Arab oil production spurred
energy prices; (3) 1979-80, when the collapse of the Shah's regime
sharply reduced Iranian oil production.
-- Their timing cannot be predicted, even though the risks are ever
present and widely recognized. Events (political turmoil, strikes,
bank failures, poor weather etc.) that could trigger these serious
situations almost always turn out to be local disturbances and/or
frictions that are a normal part of a dynamic global economy.The
few crises that do occur most often evolve from a highly unusual
coincidence of events and timing.
-- The global economy is most prone to these risks at the top of the
business cycle when speculative pressures are greater and at the
bottom of the recession when business financial problems are most
acute. The global economy is now at the bottom of the cycle, and
the next peak may take place in the mid-1980s.
-- Preventive measures do exist to reduce the risks. In the case of
supply interruptions, stocks and/or set-aside production capacity
are important; for the other two vulnerabilities, international
institutions and informal linkages and codes of conducts among
nations play a major role in risk reduction. These links have been
helpful in building an awareness of potential problems and imbuing
an understanding of the self-interest involved in supporting the
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international system and in avoiding actions that can hurt other
countries or impair the international order.
Supply Interruptions
Oil The painful transition toward a global economy less profligate in
the use of oil is clearly underway. Driven by two oil price shocks, a
conservation momentum has taken hold, and the shift away from conventional
oil to other sources is well along. The chances now seem low that some oil
shortfall will trigger a devastating price runup this year and possibly
through the mid-1980s. Although oil stocks have fallen from their record
high levels of mid-1981, excess production capacity this year will likely
remain rather large, even if the Iran-Iraq war continues. Even though
demand for OPEC oil may slowly increase in subsequent years, the probable
return of substantially larger Iranian and Iraqi exports, once the war
ends, makes it likely that there will be sufficient OPEC oil to meet demand
for several years. It would take a major and prolonged political upheaval
in Saudi Arabia or a closure of the Strait of Hormuz to create an OPEC
III. It is even possible, though unlikely, that the nominal price of oil
will fall.
By the mid-1980s, however, the oil market may become more vulnerable
to supply interruptions, even those of a moderate size. As demand for OPEC
oil rises with global economic activity, and as the additional impact of
past oil price increases on energy production and conservation diminishes,
the margin-of available excess capacity may be squeezed. As a result, a
much smaller supply interruption than a Saudi production disruption could
threaten to set off big price increases. -Unlike past price spurts,
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however, it is highly unlikely that any large future oil price increase
could be sustained for long. The conservation reaction after the 1979-80
price rise was far greater than had been the case after 1973, because oil
prices have become a much larger component of consumer and business
expenditures and have reached or surpassed the cost of many alternative
energy sources. The forces for adjustment would be far stronger in the
future, although there would still be massive economic costs.
In deciding how much should now be spent on reducing the risk of an
oil price explosion in the mid-1980s and beyond, policymakers face tough
decisions. The problem is that experts differ widely on oil market
trends. Although many analysts, including ourselves, expect the oil market
to tighten in the mid-to late 1980's, leading eventually to a rising real
price trend,, and, in any case to a greater vulnerability to shocks, others
hold different views--that demand for OPEC oil will continue to decline and
unused oil production capacity will remain large. If the first view is
correct, it is easy to justify building strategic reserves and keeping
domestic oil prices high to stimulate energy production and conservation.
On the other hand, if a long period of low prices and low risk is
expected, the advantages of these policies become less clear, and their
costs become more burdensome. These costs include not only a direct impact
of added expenditures or taxes, but also the loss in cost competitiveness
which would occur if the United States tries to support high prices for
domestic energy while some of its competitors import energy from the
cheapest source.
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Other Raw Materials. The potential problems associated with
dependence on imported raw materials are far less severe than in the case
of oil. As can be seen in table , no other commodity even comes close to
matching the value of oil trade. It would take a widespread commodity
shortages, as in 1950-51 and 1973-74, to seriously disrupt global economic
activity. And even in those cases, the surge in prices was soon reversed.
It is highly unlikely that LDCs exporters or Communist countries,
individually or in groups, will create shortages by withholding production
for political ends.
-- For most key commodities, the sources of supply are well
diversified with such developed countries as Canada, Australia, and
South Africa providing the bulk of Western imports.
-- Non-bil exporting LDCs lack the economic and financial wherewithal
to withstand a prolonged denial of mineral products.
-- LDC producers of commodities rarely have common political coals
powerful enough to initiate large cuts in exports.
One remote possibility is an embargo by Black African nations against
industrial countries for supporting South Africa. In this case, the United
States would be deprived of the bulk of its cobalt supplies and about 40
percent of its manganese needs. In addition to these two metals, the
Europeans and Japanese would be affected by more limited supplies of
copper, bauxite, and iron ore.
A morp- serious and enduring potential danger is a prolonged period of
racial strife in South Africa, which would disrupt supplies of platinum,
chromium, some minor strategic metals, and gold. To have a serious global
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impact, such a supply interruption would have to exceed a few months and/or
would have to coincide with a sharp increase in demand. This risk could be
significantly lessened through strategic reserves or private inventories.
Platinum is the only strategic metal for which industrial countries
depend heavily on the Soviets. Nearly half of Free World platinum
consumption is supplied by the USSR, while similar percentages for other
metals are 8 percent or less. Even in the case of platinum, users could
obtain sufficient amounts to meet crucial needs (mainly in petroleum
refining and chemical processing) for at least several years through
increased output of other major producers (mainly South Africa), available
stocks (both government and private), and the ability to substitute or to
do without. The inflationary impact would be small because platinum adds
little to the final selling price of most products in which it is used.
Grain. In the case of grain, the international market has become
increasingly prone to price fluctuations stemming from unpredictable
weather patterns. The US Government no longer holds huge grain stocks
which can be used to smooth out prices. International grain sales have
risen sharply in recent years, because oil-exporting countries and the USSR
have greatly expanded their purchases, and many countries have increased
their demand for livestock protein. The market, nonetheless, has remained
remarkably resilient to substantial and prolonged jumps in prices. In
recent years, for example, such a price run was averted despite three
consecutive poor Soviet harvests, a major US corn belt drought (1980), and
relatively low stocks. A major reason is that the significant increase in
grain-fed herds worldwide has provided a new means of grain storage.
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During good harvest years when grain prices are comparably low, farmers
build up their herds and feed them more grain; when crops are poor and
prices soar, the livestock industry responds by cutting back herds and by
reducing the grain fed each animal, thus providing the market with grain-
fed meat while reducing the demand for grain. Such a phenomenon has been
particularly noticeable in the United States, with the major retrenchment
in hogs and grain-fed beef. Given this market adjustment potential and the
likely quick production response of farmers to higher grain prices, it
would take a highly unusual number of crop disasters throughout the world
over a number of years to create serious global food shortages or a
prolonged period of relatively high grain prices.
Financial Collapse
Although since the early 1970s the international financial system has
remained remarkably resilient to shocks that could cause a panic, it also
has become increasingly susceptible to such devastating events because:
-- The dramatic changes that have taken place in the size, scope, and
complexity of the system have created numerous new uncertainties.
- Differences between domestic and international systems have
been greatly clouded, thereby reducing the effectiveness of
each country's ability to regulate financial transactions and
creating many "grey" areas in regard to each government's
responsibility in a crisis.
The much longer chain of financial institutions linking the
ultimate saver and borrower has significantly enhanced the
potential for a weak link to set off an uncontrollable chain
reaction.
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- The switch from a fixed to a floating exchange rate regime
has vastly increased the potential for bank failures resulting
from losses on foreign exchange dealings.
- The rapid rise in Euro-dollar transactions has established a
financial market that lacks government controls and seems to
work in a mysterious fashion.
-- Market participants have become less prudent in handling
deposits and making loans. It is only natural that bankers
should act with less caution. The international system has
worked remarkably well despite two currency crises (1971 and
1973), several bank failures in 1974, and two bouts with
absorbing and dispensing huge amounts of new petrodollars. In
addition, for many banks international lending has produced
fewer bad debts than domestic operations and has been very
profitable. This sanguine mood, however, has meant that banks
have become more prone to borrow short-term funds and lend them
out on a long-term basis, and have taken less cognizance of the
risks inherent in the system and those arising from lending to
foreign governments where they have no legal recourse.
The probability of a full-fledged systemic crisis, nevertheless,
remains low. The same forces that have created greater dangers for the
system have also bolstered its survivability. The lack of government
regulation over internati'onal transactions has provided the flexibility
needed to cope with rapidly changing circumstances. The much greater
involvement in international business by many financial institutions has
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diversified the risks. The constant publicity as to potential problems has
made banks somewhat more cautious and has led to government and bank
actions aimed at preventing and at better diagnosing potential problems.
Probably most important, both lenders and borrowers have accepted informal
norms of behavior because they believe it is in their best interests to
ensure a continuing smooth operation of the system. Finally, a closely
knit and rather small fraternity of Western financial leaders (both in
government and in the private sector) has worked together effectively, even
during emergencies.
If there is a system crisis, it will most likely result from a suprise
event (or confluence of events) that leads to a loss of confidence in the
system. Such an undercutting of the basic beliefs in the system's
operation would occur if:
-- Central banks and/or the financial community are unable or
unwilling to act quickly and in unison to meet an emergency.
-- The leader of some major debtor nation decides to repudiate its
debt for whatever reason (political or economic), and this type of
action becomes commonly accepted.
-- The US government is incapable of controlling inflation and thus
unable to prevent a significant erosion in the value of the dollar.
During the next few months the international system should be watched
more carefully than usual. There is a high potential for widespread
bankruptcies, country defaults, and bank failures because of adjustments to
the sharp drop in economic activity. In addition, the political turmoil in
Poland raises a specter of that country defaulting on its massive foreign
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debt. In itself, the problems caused by a Polish default (mainly for West
German and Austrian banks) are unlikely to lead to a failure of the
international financial system, especially since the potential difficulties
are widely recognized. If other important borrowing countries default on
their debt or if there are a significant number of major domestic bank or
firm failures, then the risk of a crisis would be uncomfortably high.
Protectionism
The battle against protectionism in the industrial world has been
remarkably successful in the past decade despite the considerable jump in
unemployment, the severe strains caused by major shifts in industry, the
numerous times protectionist sentiment reached a feverish point, and the
imposition of some new import restrictions. By far the major reason for
this favorable outcome has been the high priority government leaders have
given to preventing a global trade war and the international institutional
arrangements that have allowed for a give-and-take on trade issues. This
process has provided enough pressure on the key countries to inhibit them
at least from taking actions that could seriously hurt other nations.
Attitudes could shift dramatically, however, if any one major country would
decide it is in its best interest to break with established international
norms. As such, protectionist tendencies must be constantly watched and
countered.
In the next few years, the following possibilities are the most likely
sources of-rampant protectionism:
-- Japan -- The frustrations against the Japanese trade practices are
growing once again in both the United States and Western Europe and
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will likely be exacerbated by the growing Japanese current account
deficit which is expected to reach a record $20 billion in 1982.
Although once again Tokyo might be able to approach the other
industrial countries with minor trade concessions, it is certainly
conceivable that this time the frustrations against Japanese trade
practices may be much greater than Tokyo realizes. The result
could be that some countries decide to restrict in a major way
Japanese exports. Other countries would have to follow suit to
prevent a massive diversion of Japanese goods to their markets.
-- France -- If, as now seems likely, the newly introduced economic
policies of the Mitterrand government fail to materially reduce
unemployment, Paris might believe the only way to achieve this goal
is by further closing the French market to foreign manufactures.
Because France is a Common Market country, it would mean that the
other nine nations would be forced into applying their own
restrictions. Again, the potential for export diversion could
cause other industrial countries to take similar actions as the
French.
4. The Soviet Bloc
The Communist countries, especially the Soviet Bloc, will suffer not
from enhanced competition from outside industrial sources, but rather from
the lack of competition inside. A stultifying bureaucratic economic system
will continue to promote slow modernization, but with a massive waste of
resources, and an inability to make quick, effective adjustments to
changing circumstances.
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'
Economic growth in the Soviet Union and Eastern Europe will be slow--
probably 2% a year or less. Given the grossly inefficient use of
investment and the large defense burden, this will mean stagnation in
living standards which will be perceived by most as a decline in the
quality of life. The hope of most Russians and East Europeans that they
could achieve substantial improvements in living standards by working hard
through the system has largely disappeared and popular attitudes are likely
to be even more negative in the 1980s. These attitudes in turn will fur-
ther dampen productivity unless drastic reforms of the economic system are
introduced, and that is very unlikely.
Among the factors likely to cause slower economic growth are: a much
reduced growth of the population of working age; much slower growth of
energy production; greatly increased cost of extracting and transporting
raw materials and energy from Siberia; and apparently growing difficulties
with introducing and absorbing technological change. In addition, Soviet
and East European growth will be hindered by a likely stagnation or decline
in imports from the West. Stagnating exports coupled with a high hard
currency debt for some countries will greatly constrain hard currency
import capacity for the entire Eastern Bloc even if the West provides large
new credits.
5. Implications for National Power, Leverage, and Influence
These economic trends and vulnerabilities taken together are not un-
favorable to the position of the United States as a world power. Although
there is a potential for serious weakening of the US economy under some
circumstances, the US clearly has the potential dynamism, the resources and
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the institutional flexibility to prepare itself against some future
economic problems, and to adjust effectively to other problems. Many other
countries are not so fortunate.
The rapidly growing integration of the international economy is
clearly an important force enhancing economic growth, efficiency and
welfare throughout the world. At the same time closer international links
constrain the freedom to pursue purely national goals.
For the US, a healthy economy provides a strong foundation for
national defense and foreign policy, but may not meet all national security
needs. Growing foreign competition, especially in high technology
industries, may leave the Defense Department far more dependent than in the
past on purchases from abroad to obtain key elements of US weapons
systems. This dependence could grow to dangerous proportions. No
projection can now be made, but the problem must be closely analyzed and
watched.
Economic trends and vulnerabilities will affect the economic leverage
and influence the US can bring against other nations as well as the pres-
sures they can bring on the United States. The potential for leverage can
rarely be specified unambiguously, however, because of the complexity of
the linkages within the world economy and between economic and political
relations with foreign countries. The closer and more complex these links,
the greater the difficulty of defining and using economic leverage. For
example, the complexity of US relations with Canada, Mexico, and Western
Europe is such that use of leverage in one economic area tends to have
unintended undesirable effects on other areas very quickly. Potential for
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leverage is easier to define in relations with countries like the Soviet
Union, which are far less intricate and pervasive.
Western Europe
Western European countries are likely to be sufficiently preoccupied
with their economic problems to bring a further erosion of their ability to
take any strong new initiatives in defense and in foreign policy. The
tendency for dissatisfaction with high unemployment and other economic ills
to spawn strongly divergent political solutions both within and among
countries in the area will probably continue. Political divisions over
economic problems in turn will make it harder to achieve a national
consensus on such issues as: increased defense spending within NATO;
tighter controls over trade with and technology transfer to the Eastern
Bloc; and solution of the Arab-Israeli dispute. Given political divisions,
it is unlikely that a higher degree of regional policy coordination will be
achieved through the Economic Community. Indeed, there is a growing risk
that policy coordination among European countries will diminish, although
the underlying, widely shared interest in continuation of the degree of
economic union that has been achieved probably assures against major steps
backward.
Japan
Economic trends in the 80s clearly will enhance Japan's national
policy options. The rapid development of high technology industry will
greatly strengthen the bate for arms production. Even if military
expenditures are held down, Japan will be able, should it so decide, to
develop most modern military systems very rapidly. Major departures in
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Japan's foreign and military policies are unlikely, however, because of the
country's pacifist and nuclear hangups and deepseated fears of losing its
access to foreign sources of energy, raw material, and food.
US relations with Japan will continue to involve a strong US tactical
leverage which is limited by lonqer term strategic considerations. In the
short term--a few years--Japan has little choice but to negotiate the best
terms it can for access to US and West European markets. It has nowhere
else to go. This means that serious threats of imposing restrictions on
Japanese goods may, if sustained, be effective in slowly opening up the
Japanese market. But at some point of intensity, such pressures would
begin to stimulate a change in Japanese internal politics, greater
nationalism, and bilateralism, including broader dealings with Soviet Bloc
countries.
The LDCs
Economic trends in the 1980s will bring an increasingly sharp bifurca-
tion among the LDCs between the successful ones and those that remain unde-
veloped. Neither group of LDCs, however, will be able to exercise much
political power. As the successful countries--the NICs and some of the big
oil exporters--climb up the development ladder, they will have less and
less in common with the rest of the "South." Although they will want to
increase their international influence, they will try to do this by
increasingly participating in the institutions which govern the present
international trade and monetary system. As their economic links to the
industrial West expand, the practical possibilities to adopt narrow,
inward-looking, policies will shrink. There will be little scope, there-
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fore, for cooperation between these countries and those that remain poor
and undeveloped. The latter group will continue to agitate wherever it can
for more aid and higher prices, but will have little muscle behind their
demands.
The political power of OPEC producers and other oil exporters will
probably be smaller in the 1980s than it was in the 1970s. A soft oil
market at least for the next few years will reduce their purchasing
power. Growing domestic expenditures also will cut into any surpluses;
indeed, most OPEC countries may well be running a deficit within a year or
two and could continue to do so for some time. Those oil exporters who
will succeed in diversifying their economic base will thereby acquire new
economic linkages with the West and consequently additional reasons not to
want to rock-the boat. Finally, domestic economic development will divert
more and more of oil production to domestic consumption and reduce the
surplus for export. Consequently, although the West will remain highly
vulnerable to a prolonged oil supply interruption, the flexibility of the
oil exporters to use their oil assets for political purposes will be
reduced. This situation could change drastically, however, if only tempo-
rarily, if a major oil supply interruption or strong growth in oil demand
caused new shortages.
Among the oil exporters, however, Saudi Arabia will have considerable
economic power for years because of its enormous oil earnings and excess
productive capacity. The Saudis will continue to play a key role in OPEC,
will have a major influence on Middle Eastern politics, and will be courted
by the West. Their political links with other Arab countries, their
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growing economic links with Western countries, and their dependence on the
US to help protect their security all work against Saudi use of the oil
weapon in other than a subtle way. Iraq too may become a Middle East power
to be reckoned with if it can extricate itself from the war with Iran and
can avoid major political upheavals, which is by no means certain. Even
with a far larger population and economic base than the Saudis, the Iraqis
should be able to export enough oil to fund foreign aid programs and other
external initiatives.
Among the other countries, South Africa is probably the only one with
large implicit economic leverage by virtue of its vast mineral resources.
A desire not to disrupt supplies of South African minerals is likely to be
as much of an inhibition on Western willingness to impose severe sanctions
on South Africa in the 1980s as it was in the 1970s. Other African mineral
producers need money too badly to use their minerals for political pur-
poses. LDC based commodity cartels are likely to be no more successful
than in the past, and where there has been some success, as in the case of
tin, economic, not political, objectives are governing.
The Soviet Bloc
Economic problems in the '80s will make the further expansion of
Soviet military power and political influence increasingly difficult and
painful. Moscow will try to continue to increase its military expenditures
rapidly, sustain its empire, and finance influence in the Third World in
spite of slow economic growth, by forcing the long-suffering Soviet people
to accept a lower standard of living. But expenditures on foreign
adventures and to support Eastern Europe, always unpopular in the past,
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will obviously become even more so in the future and are likely to generate
substantial internal political opposition. And it is possible that popular
pressures for improved living standards and reform will build up to such a
point that the Soviet leadership would have to consider changing its
priorities.
Moscow will be in a weak bargaining position in its economic
dealings with the West during the 1980s. The Soviets badly need Western
grain, technology, and steel. Moreover, Moscow cannot increase, and may
have to curtail, its hard currency imports if it cannot obtain a great deal
of new Western credit and/or Western help in developing new energy and raw
material exports. To exploit this dependence, however, will take concerted
Western actions. Because Moscow can obtain almost everything it needs--
whether grain, industrial products, or credit--from other non-Communist
countries, the US has little unilateral leverage on the Soviet Union.
Coordinated Western policies regulating credits to the Soviet Union and
Eastern Europe could have a subtle influence on Soviet foreign policies.
The possibility of achieving a common position among major Western lenders
may be greater in this area than any other. It will be far more difficult
to achieve a common position on investments in Soviet energy and raw
materials development, but Japan and, to an increasing extent Western
Europe, should be able to extract favorable economic terms and possibly
some modest bilateral political concessions.
The Soviet Union's economic leverage on Western countries is small and
diminishing. Soviet Bloc markets will constitute a diminishing share of
Western country exports. Apart from Soviet natural gas, the availability
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of which can lower the price of gas in Western Europe, and platinum, there
are ample and cheap sources outside the Soviet Bloc for what this area
exports. Only an exceedingly unlikely set of circumstances could lead to
Soviet control of enough of world supply of any critical material to allow
Moscow to gouge the West or disrupt markets on a significant scale. In the
case of LDCs, Soviet economic aid is useful primarily to help maintain
governments that have already swung toward the Bloc; it is unlikely to be a
significant attraction.