161. Memorandum From the Assistant Director of the Office of Management and Budget (Schlesinger) to the President’s Assistant for International Economic Affairs (Peterson)1

Hidden in the minds of economists are certain presuppositions from the theory of international trade—inclusive of obsolescent elements—which many of us carry about as relics of our graduate student days. The basic premise is the existence of self-equilibrating mechanisms bringing appropriate adjustments of trade and payments—and operating without fail on all nations. (There should be no exception, at least among nations that adhere to the rules of the game.) Flowing from this premise are entrancing visions of adjustments achieved through smoothly-functioning monetary and price mechanisms. The vision is commendable; the departure from reality is substantial; so that the overall impression approaches “the dreamland of equilibrium” as Arthur Burns phrased it in another connection.2

The processes of adjustment, whether price-level or exchange rate, are based on the presumed willingness of all major trading nations to adhere to the rules of the game. Earlier theorists did not envision the range of measures available to put off the required day of adjustment. No nation, guilty of deviant behavior, would have a major share of trade or of capital flows. If necessary, enlightened self interest would elicit the appropriate degree of game-plan behavior. A situation such as the present in which one nation, the United States, serves as international banker and upholds a system of relatively fixed exchange rates on which it has virtually no direct influence was not envisaged.

In one sense, the older attitude was enshrined in the Bretton Woods agreement. The notion of “fundamental disequilibrium” was more than a technical concept; it was a moral concept in that it distinguished between proper and improper behavior and pointed directly to those nations which were failing to adhere to the rules of the game. In the Bretton Woods concept no nation was to be permitted [Page 447]to follow beggar-my-neighbor policies. In this concept, use of an undervalued exchange rate to enhance domestic employment and production at the expense of others was clearly proscribed.3

How different is our world today in which undervalued exchange rates are employed by major states engrossing a considerable share of international trade. These are clearly beggar-my-neighbor policies in the older conception and (you should try to make it so) in the new. Undervaluing the yen, for example, by a full 20 percent is a beggar-my-neighbor policy. There is no reason that the United States should be willing graciously to tolerate such a condition. While the methods of adjustment today, self-equilibrating or otherwise, are much weaker than hitherto, the case for moral and political force grows so much stronger. I would take it to be primarily your job to harness such moral and political forces.

The impact of undervalued currencies, perennially in a state of “fundamental disequilibrium” without adequate adjustment, underlies many of our trading problems. The undervaluing of foreign currencies works a particular hardship on producers of goods as opposed to producers of services. The existence of palliatives and patch-up mechanisms means that such producers of goods are subject year after year to these hardships, which might as well be described as an unfair degree of competition.

The fundamental point, however, is the following: these hardships ought not to be dealt with and cannot be cured by patch-up adjustments on the trade side. This would lead only to a jerry-built structure of controls and to inefficiencies. One must go to the heart of the matter—i.e., the monetary machinery and adjustments of the structure of exchange rate. This is the kernel of truth in the observation of your economist critics, that too much stress is being given to the decline of American competitiveness and that monetary adjustments should substantially alleviate the problem. By and large this is true. But such adjustments do not come about automatically; there are no self-equilibrating mechanisms. That is what is wrong with their arguments. What is required is a code of behavior or a new set of rules to which the major nations will adhere either voluntarily or per force. To develop such a code and provide vitality for it is your principal task.

[Page 448]

It is a truism that comparative advantage varies with and depends upon the exchange rate. An adequate set of exchange rates would eliminate many of the problems of the producer groups—in autos certainly and in steel to a lesser degree. It would also lead us very close to a balance of payments equilibrium that would be maintainable in the long run.

Under such conditions many problems associated with the so-called “U.S. loss of competitiveness” would disappear. Of course, the standard of living in the United States would grow in ratio to increased efficiency in production, but the pace of efficiency in the U.S. vis-à-vis the other countries would no longer be the type of problem that it is today. From the standpoint of self-esteem and perhaps national power, the problem would remain, but it would not spill over into crippling of the performance of the economic machinery.

This also bears immediately and directly on the structure of U.S. trade. The undervaluing of foreign currencies has fostered an undue dependence upon high-technology products. Rather than cure the disease, we seem ready to embrace the effects of the disease. Since we have steadily in the years after World War II, in effect, subsidized high technology products, it should come as no surprise that these products make a major contribution in the sale of U.S. goods abroad.

However, a goal of achieving balance by the subsidization of high technology products to compensate for the discrimination practiced against our products in general seems less than ideal. Once again, the moral seems clear: elimination of the discrimination practiced through undervalued currencies or quantitative restrictions against U.S. products is the way to proceed. This is economically more efficient and politically more reasonable than reliance upon and subsidy of high-technology products. High-technology products, which others cannot produce and are inclined to accept, are a desirable part of our trade pattern; they should not be viewed as a means of deliverance from undesirable conditions created by persistent exploitation of the U.S. international position as banker and world leader.

What should be done about these matters? It is inefficient and unjust to use tariffs, or general trade barriers, or general adjustments of the exchange rate to deal with the problems created by the violation of the rules of the game by a few of the major trading states who in the present era are consciously exploiting the absence of self-equilibrating mechanisms. To deal with beggar-my-neighbor policies and the maintenance of fundamental disequilibria for exploitational purposes requires a sense of discrimination in the better meaning of that word. Given the structure of the international economy at the present time, the most favored nation clause provides unintended protection for the very [Page 449]nations which are indulging in exploitative practices. We should recognize the problem and deal with it on that basis. A Tariff Commission finding, for example, which hurts all nations is not the most desirable way to proceed—when the fault lies with a single nation which has a drastically undervalued currency. To proceed in that manner is inefficient and unfair. We should deal with the real problem without hurting bystanders. If this requires reexamination of the traditional bromides, so be it. This will require careful examination of the arsenal of tools which can deal specifically with the offenders. And these tools should be employed in such a manner that they deal with the fundamental problems—of monetary and price maladjustments—so that they contribute directly or indirectly to a closer achievement of equilibrium. The importance of avoiding further expanding of a jerry-built structure of trade and capital restraints should be kept in mind.

  1. Source: Washington National Records Center, Department of the Treasury, Files of Under Secretary Volcker: FRC 56 79 15, CIEP. No classification marking.
  2. Not further identified.
  3. Although he did not use these terms, Bank of Italy Governor Carli seemed to agree with this approach during a meeting in Rome with an Embassy officer on October 16, 1971: “According to Carli, basic cause of current monetary and other economic problems is mercantilist approach adopted by most countries over past decade or more. Other countries have allowed exports lead their economic growth and have enjoyed U.S. deficit while complaining about it. President Nixon’s program has exposed this contradiction and has engendered process of adjustment in thinking and policies which not yet completed.” (Telegram 6622 from Rome, October 18; National Archives, RG 59, S/S Files: Lot 73 D 153, Box 124, Morning Summaries)