243. Memorandum From the President’s Assistant for National Security Affairs (Scowcroft) to President Ford1
- Message from Prime Minister Callaghan
Prime Minister Callaghan, via the Cabinet line, has sent you a message (Tab A) expressing gratitude for your sympathetic response to his [Typeset Page 769] current difficulties and for your agreement that UK discussions with the IMF should be expedited.
Callaghan states that he is convinced that his general strategy is sound and that the pound’s decline earlier this week has been almost wholly because of speculative selling. He points out that the UK has cut its rate of inflation by half in the last year, is reducing its government deficit next year to 3%, has announced a tight guideline for the money supply, obtained agreement of the trade unions to a tighter realm of incomes policy. He indicates, however, that the UK could not afford to continue support for sterling in the face of such speculation even though it realizes that a stable exchange rate is in its interest and that of the West in general. Callaghan believes that if he can get a quick and sympathetic response from the IMF on the basis of its present policies and announced objectives, the pressure of the pound should be eased, at least in the short term.
Callaghan adds, however, that sound UK policies are subject to special and separate risks resulting from the possibility of major withdrawal of sterling balances which currently overhang the market. These constantly threaten to magnify small decreases in the rate of exchange, creating chaotic conditions such as those experienced earlier this week. [There are roughly $5.5 billion worth of sterling outstanding—held primarily by Nigeria ($1.5 billion), Saudi Arabia ($1.4 billion), and Kuwait and Abu Dhabi ($2.2 billion).] Callaghan indicates that this overhang problem must be solved if the British economy is to be held on a straight course and if its policies are to be given a chance to succeed. He hopes that a solution could be found to this problem, which would not require any significant lending by the UK’s partners over and above that being made available through the IMF and that the existence of a “contingent loan facility” linked to the sterling balances would suffice to exert a significant calming effect. Without such a solution the UK would be forced into action which would put at risk the UK’s contribution “as an ally and a partner in the Western Alliance and its value as a member of the International Trading Community”. He intends to do everything he can to fight against this, but it is not a problem the UK can “tackle by ourselves”.
Callaghan would like to discuss these matters further with you in due course, and Denis Healey is thinking of talking to Bill Simon soon after Manila.
Comments on Message
The two essential points of the Callaghan message are: one, that present UK policies and objectives are adequate to deal with the UK problem, thus implying that the IMF should set no new conditions on UK policy or performance. In fact, it is likely that the IMF will insist on [Typeset Page 770] greater restraint on public spending and slower growth in money supply. Callaghan doubtless fears that such measures would worsen Britain’s unemployment level, which is at a 30-year high. Without such measures, however, Britain is likely to continue to have to borrow heavily. The difficult task will be to figure out a balance between measures necessary to achieve domestic stability and thus reduce Britain’s dependence on external borrowing but which also avoids too sharp a cutback in public spending, too severe an increase in taxes, and too abrupt a drop in money creation, which would significantly worsen unemployment.
The second point is that the British are seeking a separate solution to the sterling overhang problem—the roughly $5.5 billion held abroad which Callaghan fears could be sold in a way which would create chaotic conditions in the currency market. For a number of years, this has been a problem for Britain. The obvious answer to the problem is success by Britain in stabilizing its domestic economy in order to increase confidence in those countries which hold sterling, coupled with enough potential borrowing power from the IMF to avoid minor disruptions in the currency market which would cause sterling holders to dump their currency. We will have to explore this issue further with the British to determine just what they have in mind.
Ed Yeo is going to the UK tonight, and should gain a clearer picture of what the British have in mind on both issues.
The British are clearly at a critical stage in their economic decision-making. Their belt-tightening efforts of the last several months are perceived as inadequate by the international financial community—which is today less confident than in the recent past in the ability of the British government to hold down its wage and government spending policies. The settlement of the threatened seamen’s strike last week was seen by a number of people as potentially inflationary; although the actual pay increase fell within the government’s guidelines, fringe benefits included in the package will be very costly. In addition, the increase in the money supply for the three-month period ending in mid-August was at a rate of 16%, well above the target rate of 12%. Furthermore, roughly £900 were sold in the second quarter.
This data combined with no further progress in reducing the inflation contributed to the recent weakening of confidence in the British economic outlook. These overshadowed the recent successes of the British economy, such as lower than expected government borrowing requirement and some improvement in the trade balance. On top of these developments, pronouncements of the Labor Party conference regarding nationalization of banks and insurance companies, dissatisfaction with the government’s restraint of the growth of public expenditures, and the strength of the left wing of the Labor Party in the election [Typeset Page 771] of the party executive, even though these have little influence on the policy of the UK government, would appear to have had an adverse influence on the foreign exchange markets.
Thus, while the drop in sterling has been in part due to a psychological reaction, or as Callaghan calls it “almost wholly speculative selling, bearing little relationship to an underlying economic position and prospect”, it is also a result of the market’s perception that the British economic performance still leaves something to be desired. The major question which will have to be addressed by Britain and the IMF is what actions Britain must take to make greater progress toward stability, and which of these actions Britain believes to be politically tolerable in light of its domestic unemployment situation and labor pressures. It is clearly undesirable for us to become involved in negotiations with the IMF. If, for instance, we press the IMF to be more lenient on the UK, the result may be insufficient progress in the UK toward equilibrium and thus a continued reliance on foreign borrowing. This would only postpone the inevitable crisis. On the other hand, we should be as helpful as possible to the British in encouraging them to find the most satisfactory ways of reducing their monetary supply and curbing government expenditure. If Callaghan and Healey desire it, this could mean strengthening their hand versus the Labor left by applying a combination of pressure and support.
Summary: Scowcroft discussed a message from Callaghan on the UK economic situation.
Source: Ford Library, National Security Adviser, NSC International Economic Affairs Staff Files, Box 3, Country File, United Kingdom (2). Secret. All brackets are in the original. Attached but not published is Tab A, a September 30 message from Callaghan to Ford. Scowcroft did not initial the memorandum. In an October 2 memorandum to Kissinger, Rogers reported that he, Scowcroft, Hormats, Greenspan, and Yeo, had concluded “that the U.S. Government must be exquisitely careful not to give a false signal to the British, publicly or privately, about our willingness to plead their case with the Fund” and “that this financial issue is becoming too important to be left exclusively to the Treasuries. We are therefore institutionalizing the interagency consultations.” (National Archives, RG 59, Records of Secretary of State Henry Kissinger, Entry 5403, Box 18, NODIS Memcons, September 1976 (Folder 6)) Yeo discussed the situation in London with UK officials. (Backchannel message 325 from London, October 3; Ford Library, National Security Adviser, NSC International Economic Affairs Staff Files, Box 3, Country File, United Kingdom (2))↩