21. Memorandum From Secretary of the Treasury Kennedy to President Nixon 1

SUBJECT

  • The First Quarter Balance of Payments Results and Announcement

Later this week (probably on Thursday),2 the regular announcement will be made of the balance of payments results for the first quarter. This will not be happy reading.

The measure most widely used by the press—the so-called “liquidity” balance—will be in deficit, seasonally adjusted, by $1.8 billion, or an annual rate of $7.2 billion. While the informed public and foreign officials are already aware that we had a sizeable deficit on this basis, the actual near-record figure will nonetheless be startling. It can only add to the already uncertain atmosphere in international financial markets.

Actually, the immediate situation is not nearly so bad as the “liquidity deficit” makes it look; moreover, the alternate measure of results (“official settlements”) shows a very substantial surplus of $1.1 billion for the first quarter. This surplus reflects the strong performance of the [Page 53]dollar in the exchange markets and the fact that official dollar holdings of many European central banks got uncomfortably low-even before the recent exchange crisis.

Nevertheless, the liquidity deficit will make the headlines. The heavy dependence of the official settlements surplus upon short-term capital inflows related to the tight money conditions in the United States renders this performance more suspect.

Only technicians will fully unravel the confusions inherent in the different measures of our balance of payments. However, all sophisticated observers will recognize that the structure of our balance of payments is in poor shape. The major culprit is the long period of domestic inflation and excess demand, which has dwindled away our historic large trade surplus-averaging $4 to $6 billion in the first half of the 1960’s—to a small deficit. Consequently, earnings on the trade account are simply not available to pay for the balance of payments costs of our aid and military commitments overseas, or for private foreign investment.

For the time being, the adverse impact of the shrinking trade balance has been largely offset by extraordinary capital inflows—long and short term. But we must recognize that certain capital inflows are quite subject to reflow. In looking ahead, we should be under no illusions about our ability to achieve and maintain a sustainable payments position without a sizeable positive trade balance.

Special Factors in the First Quarter

Two important factors contributed to the deterioration in the first quarter.

  • —U.S. corporations apparently placed an exceptionally large volume of funds abroad, either directly or through their foreign subsidiaries. This reversed the artificial pull-back of funds to the United States last December, when companies made sure they got under their direct investment quotas.
  • —In addition, the first quarter was almost free of so-called “special” official transactions, which also contributed heavily to the statistical liquidity surplus recorded in the fourth quarter of 1968. As a matter of policy, we have not pressed foreign countries to alter the form of their dollar holdings simply to “dress up” our statistics.

For these reasons, it is logical to average the last two quarters to arrive at a fairer estimate of the trend in the payments, as shown in the table attached.3 While the six-month average shows a sizeable deficit on the liquidity basis, it does not show a basic deterioration. Moreover, the official [Page 54]settlements basis shows an improving trend—a fact that deserves more emphasis, even though we cannot forget it is highly subject to variation.

Outlook

A new Government staff review of the balance of payments outlook for this year points to a near-record deficit of about $4 billion on the liquidity basis, before allowing for any “Special Transactions”. Estimates on the official settlements basis might show approximate balance for the year as a whole but it could also give way to a sizeable deficit. While these projections point up the structural weaknesses in our balance of payments, our position could well be sustainable for some time, provided:

(1)
Tight money in the United States retains the short-term capital inflow, and
(2)
Progress in curbing inflation offers a firm prospect of future improvement in our trade balance. But neither the financial community nor foreign officials are likely to maintain optimism for long, unless progress is visible on the “fundamentals.”

Meanwhile, we must live with the fact that the weakness in our balance of payments compromises our negotiating posture in the economic and the financial field generally. It does not provide a firm base for leadership in pushing for international monetary reform; in this sense, our payments performance is our own worst enemy.

Implications

The potentially unsettling consequences on the international exchange markets of our own balance of payments performance is further complicated by the release this week of poor trade figures by both the U.K. and France. The other side of the coin is the very strong performance by Germany, Japan, and Italy. (It is not entirely a coincidence that these countries carry relatively light defense burdens.) The refusal of the Germans to revalue in the face of the strongest kinds of market pressures—and the refusal of the Italians or Japanese to even consider revaluation—only points up the difficulty of redressing these basic imbalances in an orderly way.

Three implications seem to me perfectly clear:

(1)
Progress on the side of controlling inflation and eliminating excess demand is as essential to maintain the strength of the dollar abroad as it is domestically. We cannot expect dramatic or quick results in terms of the trade balance, but signs of progress are essential to maintain confidence that we have the will and the ability to achieve eventual equilibrium.
(2)
We must continue to work toward some revaluation of exchange rates by chronic surplus countries (at least by Germany). This would be [Page 55]a necessary prelude to more thoroughgoing monetary reform. It would also be “preventive therapy” against the possibility of one-way devaluation by the French and British that would simply leave us and the monetary system worse off.
(3)
At this stage, we are in no position to seek further important relaxation of our balance of payments measures, including defense offsets, investment controls, and aid tying.

Meanwhile, we will continue to work with other leading countries on “evolutionary” reforms—pushing the Special Drawing Rights in the IMF, actively exploring the feasibility of agreed changes toward more flexibility in exchange rates, and (subsequently and for the more distant future) considering the possibility of consolidating all reserve assets in the IMF.

However, we must also recognize that the events of recent weeks and our own balance of payments difficulties point out the political and economic roadblocks to orderly agreed change. We can anticipate the probability of further currency crises. Conceivably, such a crisis could be turned to a constructive purpose, and help accelerate the process of desired change. But a crisis atmosphere could also defeat the process of orderly change and cooperation by giving rise to uncoordinated, independent actions detrimental to our basic objectives in this area.

I am reviewing again our main alternatives in this difficult situation and will report to you shortly.

David M. Kennedy 4
  1. Source: Washington National Records Center, Department of the Treasury, Deputy to the Assistant Secretary for International Affairs: FRC 56 83 26, Contingency Planning 1969. Confidential. A May 14 cover note from Petty’s office to Willis indicates that distribution in the Treasury Department was limited to the Secretary, Under Secretaries Walker and Volcker, Petty, and Willis. There is no indication that this memorandum was forwarded to the President’s attention, but the President was subsequently informed of the balance-of-payments results by McCracken; see Document 129.
  2. May 15.
  3. Not printed. This short table gave balance-of-payments results for 6-month periods ending in March 1969, September 1969, March 1968, and September 1968.
  4. Printed from a copy that indicates Kennedy signed the original.