132. Memorandum From Secretary of the Treasury Simon to the Economic Policy Board 1
- The International Monetary Situation
The problems which have surfaced in recent months in the form of disruptions in the exchange markets have their origins in the domestic economies of several important countries. Deep divisions on the distribution of income have in Italy and the United Kingdom, for example, been obscured by efforts to manufacture solutions through policies which would assure rapid economic expansion. Internally, highly expansionary fiscal and monetary policies have triggered strong and sustained inflationary pressures. These pressures have been augmented by "external shocks", the most important of which was the quadrupling in the prices of oil. The external manifestation of these underlying factors has been disequilibrium in balance of payments positions. The choice has been whether this disequilibrium should be financed or be permitted to reflect almost directly the exchange rate of the countries involved.
On the premise that the underlying disequilibrium was of a transitory nature and that countries would over time effectively adjust, countries such as Italy opted to finance the imbalance in their external accounts. Unfortunately the basic premise has not been borne out by events. Adjustment has been almost nil and in fact heavy external borrowings (loans on international markets) have provided reserves which have been used to finance the status quo, both in terms of basic domestic economic policy and in terms of the level of the countries’ exchange rates.
The practice of financing the status quo is coming to an end. Italy no longer has access to private funds in the international money market and can no longer use this technique to avoid adjustment. The United Kingdom, while not in the same specific situation, is in an overall sense in the same category.
The principal danger in this situation involves the types of adjustment efforts that could be taken. Import controls can produce, initially, the form but not the substance of adjustment. Competitive depreciation of an "adjusting" country’s exchange rate can produce the [Page 471]form of adjustment and lack the substance. Both types of maneuver will elicit responses from other countries and in the end be counter productive to the interests of the initiators and to the world as a whole. It would represent a turning back to a world of economic and financial relations guided by the law of the jungle.
Our objectives have been on the following lines:
- Discourage the use of import controls as a substitute for internal adjustment.
- Create a climate both in terms of the legal content of the Jamaica Agreements and in terms of world public opinion which makes competitive depreciation policies unacceptable.
- Facilitate the provision of financing—through the IMF and the Financial Support Fund—that would truly be conditional on tangible progress in the direction of domestic stabilization.
- Keep the U.S. from becoming involved either in a political sense or in a financial sense in the congestion produced by the Italian, British, and to a degree the French situations. The method followed has been heavy involvement in trying to facilitate solutions both in terms of those countries’ underlying problems and the incidents produced by them. At the same time we have taken care to protect the dollar and our other direct interests. What follows is a description of recent events and an account of our activities including a review of what additional action might be considered at this time.
During the past few weeks the pound sterling and the French franc each declined about 5% in value in relation to the dollar; the Italian lira declined about 19%; and there has been upward pressure on the German mark. Most of the turmoil which surrounded these changes could have been avoided had governments either pursued more effective fiscal and monetary policies to achieve improved economic stability, or been willing to allow their exchange rates to move naturally in response to the pressures of underlying economic and financial conditions. Both of these policies are in accordance with our understandings at Rambouillet and Jamaica. Underlying conditions have, of course, been highly unstable and inflation rates among major countries continue to vary widely. The exchange rate movements have tended to compensate for diverging domestic prices and thus avoided the distortion of competitive positions and the accompanying disruption of world trade patterns.
For varying reasons, however, the Italians, the French and the Germans attempted to resist the market-directed changes in their exchange rates while the British took steps which some observers suspected of being a deliberate effort to push their rate down.
In an effort to stimulate domestic growth last summer Italy adopted expansionary fiscal and monetary policies. The Italian authorities [Page 472]have now spent most of their foreign exchange reserves and utilized most of their borrowing capacity in an effort to prevent the lira from falling in the wake of those expansionary measures. The pressures on their position intensified with the fall of the Moro government in January2 and a growing lack of confidence in the ability of the centrist parties to restore economic stability.
The French and the German currencies had been locked together in the European Common Market arrangement, popularly known as the "snake," which called for fixed exchange rate relationships among the currencies of the participants although allowing the rates to move against the U.S. dollar. Strains on the snake became quite acute in January following the withdrawal from the market of the Bank of Italy3 and the depreciation of the lira, as the continued divergence in inflation rates and other underlying conditions among members of the snake—particularly Germany and France—made it increasingly apparent to traders that these relationships were unsustainable. The Germans were, however, unwilling to appreciate at a time when economic recovery was still tenuous and unemployment high because it would be politically unacceptable; the French were unwilling to devalue unilaterally, fearing damage to President Giscard d’Estaing’s prestige. By inducing an increase in short-term interest rates, issuing strong public statements, and spending some $2.8 billion in defense of the rate, the French prevailed and a temporary calm returned. In this effort they had cooperation from us as well as from the Germans.
When market operations by the Bank of England on March 3 and a lowering of British interest rates on March 4 triggered a massive selling of sterling which caused a drop of about 5% in a matter of days after a lengthy period of stability, many suspected that the decline had been deliberately engineered. The British government has staked its future on the expansion of exports as a means of restoring domestic growth, curbing unemployment and reducing external borrowing.
The British action rekindled the fires of speculation on the Continent. The French used another $1.8 billion of their reserves and made another attempt to negotiate a multilateral change in the snake rates. When this failed, they withdrew from the snake and let the franc find its own level in the market.4 Subsequently, the French may also have decided to reduce somewhat the emphasis on the control of domestic inflation and give greater attention to employment and growth, perhaps [Page 473]in the expectation that international competitiveness can be maintained through a declining exchange rate.
While the market now appears to be returning to a more orderly situation, some difficulties remain because of the efforts of the remaining members of the snake to preserve its rules despite divergences in underlying conditions. The market continues to feel that an increase in the central rate of the German mark within the snake is likely to be announced in the near future. Periodic pressures among the snake countries must be expected to continue until underlying stability is achieved or the snake arrangements are abandoned.
Currently the Bank of Italy is attempting to prevent sharp exchange rate fluctuations without interfering with basic trends, although they have used a substantial portion of their new loans from the U.S. and Germany in this process. The extent of the decline in the exchange rate, 19%, has undoubtedly been a factor in persuading the new government to adopt more forceful internal measures. The Italians have increased interest rates sharply, reduced inflationary bank financing of the government deficit, and imposed new taxes designed to reduce the deficit about 10%.5 Very little progress has been made, however, in correcting the basic longer term problems of excessive government expenditures and wage rate increases which go beyond both probably productivity gains and cost of living increases. Neither political nor economic stability in Italy is likely to be assured until these excesses are corrected.
Role of the United States
The U.S. has played a very active role in moderating the impact of these events, largely behind the scenes. In my visit to Rome on March 8 and 9,6 I told the Government of Italy that unless they put their own house in order external financial assistance would be money down the drain. They now have taken quite significant steps. Whether these actions will prove adequate remains questionable. U.S. assistance, through drawings on the Federal Reserve System, has been used judiciously in applying this pressure. We have also encouraged other lenders—the European Common Market and the IMF—to attach firm conditions to their credits.[Page 474]
In close and continuing consultation with other major countries we have been pointing out that these exchange rate flurries have arisen essentially because of the failure to apply the principles agreed upon at Rambouillet and at Jamaica. You will recall that at Rambouillet it was agreed that orderly underlying economic and financial conditions were a prerequisite to the maintenance of exchange rate stability and that governments should focus on economic and financial policies to deal with underlying instability. In the foreign exchange markets action was to be taken to counter only disorderly market conditions destined to be described as "erratic fluctuations."
We have quietly pointed out to the French and the Germans that the snake concept is untenable—the inverse of Rambouillet. With the French departure, the snake now becomes little more than a group of small countries linking their currencies to that of Germany.
Significantly, we have also issued a clear warning to the British—with the French within hearing—that we will not tolerate deliberate competitive depreciations.
Policy Choices for the Future
In the case of Italy, one choice is to continue to link the limited financial support which we are in position to provide to the implementation of strong domestic restraint measures. The alternative would be to encourage restraint but not to make our financial support conditional on its adequacy. The former approach would be based on the view that in the absence of an adequate domestic restraint program, external financial support would be wasted and would simply use up what remains of Italy’s borrowing capacity. Failure to restore economic stability is likely to lead to Communist participation in the government eventually anyway. The latter course would be based on the conclusion that the Christian Democratic Party does not now have sufficient political strength to implement an adequate restraint program and that financial assistance would buy time during which the political situation might improve. I have been following the first course and believe we should continue to do so.
These disruptions in the foreign exchange markets arouse political and economic concern in the United States as well as in Europe. Our capability to solve the problem is, however, quite limited. It is clear that the philosophy agreed upon at Rambouillet is not yet being applied in Europe. Insufficient attention is being focused on the need for internal policies which can lead to stability. There is need for a broader and better understanding of the operating principles on which the Rambouillet and Jamaica agreements were based. The consultation mechanism needs to be refined and strengthened as envisaged at Rambouillet. We also need to develop safeguards against the possibility of manipulating the system for unfair competitive purposes.[Page 475]
We might consider the issuance of a Presidential statement. Such a statement would constitute the most powerful method of communicating our views. Unfortunately, however, the problems which have created these disturbances are not problems of the exchange rate system, which is in a period of transition. The roots of the difficulties lie in the domestic policies of the European governments and there are no quick, practical solutions to the high and divergent rates of inflation. Thus a Presidential statement at this time might have limited impact.
Another possibility would be to call for a second economic summit, a sequel to the Rambouillet conference. Such a conference would focus public attention on these problems but it would need to be both carefully prepared and properly timed. We should not call for such a conference in the absence of a reasonable prospect that the conference could bring visible progress. Since less than five months have elapsed since Rambouillet, a call for another conference at this time might be criticized as substituting motion for policy.
In the coming months, refining and improving the consultation mechanism, as envisaged at Rambouillet, may be the most viable option. I plan to devote major effort to this task.
- Source: Ford Library, L. William Seidman Papers, Box 77, Economic Policy Board Subject File, Monetary—International. No classification marking.↩
- Italian Prime Minister Moro and his Cabinet resigned on January 7, 1976; Moro resumed his post as Prime Minister at the head of a new government on February 10.↩
- The Italian foreign exchange market closed on January 21. It reopened on March 1.↩
- France left the snake on March 15.↩
- Italy announced its austerity program on March 18. (The New York Times, March 19, 1976, p. 1)↩
- A copy of Simon’s March 15 report to President Ford on his trip to Italy, as well as to the Middle East, Spain, and Germany, is in the Ford Library, National Security Adviser, Presidential Agency Files, Box 18, Treasury Department (1).↩