Foreign Relations of the United States, 1955–1957, Western Europe and Canada, Volume XXVII

247. Memorandum From the Officer in Charge of United Kingdom and Ireland Affairs (Dale) to the Director (Parsons) and Deputy Director (Lister) of the Office of British Commonwealth and Northern European Affairs¹

Washington, November 26, 1956.

SUBJECT

• U.S. Stake in Avoiding U.K. Financial Crisis

1. Extent of Financial Problem Facing the U.K.

During the last 18 months a serious strain on U.K. gold and dollar reserves has developed, and it was already apparent before the Suez crisis occurred that the British would face a tight financial squeeze towards the end of this year, in spite of a relatively favorable trade balance. The Middle East crisis is now placing additional financial burdens on the pound sterling, both in terms of direct and indirect costs related to the British military effort in Egypt, and more importantly, of increased speculation against the pound. This has been reflected in losses of gold and dollar reserves of $102 million last week alone, bringing the U.K.’s total reserves down to just over $2 billion. Still greater pressure will be exerted by the loss of Middle East oil, which at once deprives the British of a source of dollar and Western European (EPU) currency earnings, forces them to increase purchases of dollar oil (to the extent of $225 million for the next six months) and will eventually lead to reductions in industrial production with resulting adverse effects on exports. It is still too early to judge the quantitative impact of the oil shortage on the financial structure of the U.K. and the sterling area but it can be stated confidently that it will be both lingering and severe. With the domestic economy already running at full tilt, a reduction in oil supplies would tend to increase domestic production costs which, in turn, would raise the price of British goods competing in world markets, further darkening the U.K. outlook. Coupled with the problem of supporting sterling under the difficulties described above, with November losses in dollar and gold reserves likely to exceed $200 million, are persistent EPU deficits, which require 75% settlement in gold, and obligations to repay $190 million interest and principal in December on the U.S. and Canadian loans,² as well as smaller ECA loans (approximately $5 million). Thus, there is a strong probability that without external aid the British will soon enter a most serious financial crisis.

2. Possible Consequences of Financial Crisis in the U.K.

a. Claims on Sterling.

To a large extent, the British financial structure is built on the willingness of foreign countries to hold and use sterling. These foreign countries will be willing to do so only if they have confidence that such funds eventually can be used either to buy British goods or foreign goods elsewhere in the world, or can be converted into gold or dollars. Although it is not a likely contingency, the Bank of England would, of course, encounter the greatest difficulty in redeeming all its liabilities in cash at one time. Yet if confidence should be lost, perhaps as much as one half of the sterling balances held by foreign countries and Dependent Territories, now amounting to just under $10 billions at London, could become active claims on British goods, British gold, or other foreign currencies. The U.K. avoided this “run” on the bank in World War II partially by Government controls, and prevented “leaks” from the sterling pool as a whole by the extension of a network of exchange control throughout the Sterling Area. The U.K. was able to run up prodigious liabilities with a handful of assets. To weather the postwar period of adjustment Britain was forced severely to restrict imports, to ration real resources among competing uses, to support the pound through exchange equalization operations and to effect liquidation of overseas assets in the Sterling Area. These programs were conceived and ably administered by financial technicians whose abilities represented an additional asset. It is doubtful, however, that Britain would have succeeded, had it not been generally accepted that close financial cooperation between the United States and the United Kingdom existed; that in case of crisis, United States financial assistance could be called upon. U.S. financial aid to Britain during the war and postwar period was substantial, but its psychological value equaled its nominal value. If such aid were not forthcoming now and such countries as India, Pakistan, and Ceylon, losing confidence in the value of sterling, attempted to force redemption of their sterling claims, the British financial position would undoubtedly worsen. Resort to tight currency controls, including the blocking of foreign-held accounts in London, would be necessary. Sterling as an international currency would probably never recover,

b. Consequences for Sterling Area.

The U.K. has been called the “pre-1914 International Monetary Fund.” To some extent, Britain is still operating for some countries as it was envisaged the Fund would operate for the whole world.³ Her loans to countries having temporary difficulties with their balances of payments have saved the borrowers from gold export, exchange depreciation, or internal inflation. Also, as an international central bank, she held out valuable clearing services so that each member of the community could settle in sterling for its net debts to all other members. Each unit has been able to hold some or all of its monetary reserves in sterling and can earn income on them. Britain, by its central position in a galaxy of less-developed economies, has served, through skillful financial management, to expedite trade and the smooth running of much of the world’s business, as well as provide a certain amount of capital for development in underdeveloped regions.

If informed opinion is given substantial reason to doubt that the U.S. stands ready to bolster the British financially in a new crisis, confidence in the Sterling Area financial structure could collapse. The result would be widespread chaos and hardship, both within and without the Sterling Area. The situation of some of the countries now acquiring political freedom from the British but lacking financial know-how and responsibility would be particularly difficult. In anticipation of a general run on sterling, some countries recently indicated an interest in spending sterling balances now held in London as currency reserves and in running down commercial working balances, especially should U.S. loans be available to provide reserves to the withdrawing country.

The existence of a large number of areas deprived of British financial guidance and services at this crucial stage of their development could create a new opportunity for Soviet economic penetration, unless both the U.S. Government and private agencies were willing to assume vastly expanded responsibilities overseas. While international agencies, such as the IMF and IRBD, have been created to handle problems of international finance and economic development, it is doubtful if such agencies could or would replace Britain in its financial relations with territories now approaching political independence and with the independent members of the Sterling Area.

c. Psychological Impact on U.K.

The results of the Anglo-French Suez adventure on British morale are bound in any case to be depressing. The spectacle of seeing their military success turned into defeat by diplomatic action of the “superpowers” will further encourage the British to consider themselves a second-rate power with a reduced role to play in the free world with correspondingly reduced responsibilities. This belief will be accentuated to the extent the British lose control over their oil supply in the Middle East and the essential means of transporting it. A financial crisis would tend to emphasize to the British their own limitations, would promote a diminishing conception of their own significance, and could hasten a shift in military planning to the point where they would no longer be willing or able to commit the present level of resources to defense.

d. Defense of Europe.

The British have been maneuvering for almost a year to reduce their ground and air forces in Germany. They have thus far not been able to plead a financial crisis (as provided for in the Paris Agreements)⁴ in support of their efforts. If such a crisis should develop in the absence of a significantly increased threat of Soviet aggression, however, they will have a compelling case for reducing their NATO commitments.

Stripped of its position as Sterling Area banker and perhaps, concomitantly of its Middle East oil interests, however, the U.K. would almost certainly sink to the status of a second-rate power in a material sense and would consequently be forced to reduce defense expenditure drastically. The consequences to NATO could be devastating.

e. American Trade.

Even if the British Government does not resort to devaluation to arrest the loss of gold and dollar reserves, in the absence of U.S. assistance, it will probably be forced to institute more stringent controls on dollar imports even if such action introduces an element of hardship in the U.K. This would inevitably lead to a reduction of imports from the United States (with the exception of oil) and possibly also an increase in pressure for more trade with Communist countries.

f. Anglo-American Relations.

The effect on Anglo-American relations of differences concerning the Middle East over the last year (both before and after the attack on Suez) has been the rupture of the fabric of mutual confidence upon which the alliance rests. If both parties do their utmost to repair the damage through consultation and actual decisions on matters affecting each other, the rupture could prove temporary. If, on the other hand, the U.S. does not show a sympathetic attitude, which it will demonstrate in specific actions, towards the British financial problem the element of mutual helpfulness which has made the alliance particularly useful to the British will appear vitiated. If this happens, the British are less likely to cooperate with us in affairs touching areas other than the Middle East and the substance of the alliance will tend to dissolve, weakening the Western front against Communist aggression.

3. Recommendation.

To the extent that the U.S. moves quickly to assist the British in meeting its severe financial problem, the adverse effects outlined above can be avoided. Therefore, it is recommended that, whenever possible, you warn other departmental officers of the dangers of inaction and of the necessity to prepare now to take action promptly when a British request is forthcoming.

1. Source: Department of State, Central Files, 841.10/11–2656. Confidential. Drafted by Dale, Elrod, and Charlotte M. McLaughlin.
2. The United Kingdom had also negotiated a loan from Canada in 1945; see footnote 3, Document 245.
3. The Sterling Area includes, in addition to the U.K. and colonies, Australia, New Zealand, Iceland, India, Pakistan, Ceylon, Federation of Rhodesia and Nyasaland, Burma, Iraq, Ireland, Jordan, and Libya. South Africa and the Persian Gulf territories are nominal members, but have special arrangements with respect to the gold and dollar pool at London. [Footnote in the source text.]
4. Reference is to clause III of the Final Act of the London Nine-Power Conference, October 3, 1954; for text, see American Foreign Policy, 1950–1955: Basic Documents, vol. I, pp. 1474–1483.