246. Memorandum From Secretary of the Treasury Simon to President Ford 1
Harold Lever is coming as a representative of Prime Minister Callaghan. His visit is delicately timed. After some days of essentially technical discussions, the IMF team (headed by Alan Whittome) is getting down to the key elements in its negotiations with HMG. The Lever visit is in the context of the meeting at Chequers between Prime Minister Callaghan and Chancellor Schmidt (October 10); the EC Finance Ministers’ meeting (November 8); the Basle central bankers’ meeting (November 8, 9), and Callaghan’s meeting with President Giscard (November 12), at Rambouillet.
At each of the above meetings the British consistently pushed the view that much of their problem is the sterling balances, and that if these balances were “funded” by large scale international credit, this would go a long way toward alleviating the UK’s problems. In a number of instances (Under Secretary Yeo’s talks with Chancellor Schmidt, our spokesmen at the Basle central bankers’ meeting) we have indicated that we felt the center of attention ought to be on the IMF negotiations, and that we shouldn’t be diverted by talk of funding sterling balances.
Funding sterling balances is an elusive concept, particularly when one asks the British exactly what they mean. In the narrowest sense this can mean the British guaranteeing holders of official sterling balances against any further depreciation of the pound, and as a complement, her allies providing short-term credit designed to demonstrate to the holders of official sterling balances (central banks and other official bodies) that the UK has the capacity to repay.
In its broadest sense “funding sterling balances” can involve something like the suggestion the British submitted to the Germans—that private as well as official holders of sterling balances be guaranteed, and that the UK be granted for this purpose a $10 billion line of credit, with amounts drawn down under this line to be repaid in ten years. [Typeset Page 776] (The balances total about $10 billion equivalent—half official, half private.)
On either the narrow or the broad basis, funding of sterling balances involves the extension of credit—perhaps $5 billion if the purpose is only to “fund” official balances, or $10 billion if the idea is to “fund” both official and private balances. This is separate and distinct from IMF loans, which if the $3.9 billion package is successfully negotiated, will total $5.9 billion. Britain borrowed $2.0 billion from the Fund in January of this year. Another dimension is the term of the credit. The 1968 sterling guarantee operation involved short-term swaps—six month maturity. The recent British proposal to the Germans called for 10 year maturity.
In addition to official borrowings such as from the IMF, Britain has been borrowing huge amounts in the private capital markets over the past eighteen months. We estimate $3.5 billion has been borrowed by British Government entities. This, plus a reduction of reserves of $2 billion, official borrowings on the June swap line to date of $1.5 billion, and an IMF drawing of $2 billion, has provided the $9 billion that has been used to support sterling which has fallen from $2.32 to $1.62 over the same time period.
The problem is not sterling balances. Focussing on that issue deflects scrutiny from UK economic policy and appeals to a limited component of UK public opinion that likes to ascribe its difficulties to an evil and insidious force like “sterling balances.” The real problems are:
1. The British have lost control over the budget. Since 1972 budget outlays have increased 129% to a point where they represent 59% of GDP at factor cost. The deficit has increased by 360% from 4.5% of GDP to 10.3%.
2. In the British system the linkage between the size of the deficit and monetary policy is more direct than in the U.S. It is extremely difficult to control monetary policy with a deficit equal to 10.3% of GDP. In the third quarter, money supply grew 27% despite repeated promises to us that monetary policy would be firm. This lack of monetary control was the principal reason for the sterling crisis this fall.
3. If the UK attempts to operate with a huge deficit, and at the same time conduct a firm monetary policy, the result is that there are not enough funds available to permit growth of the private sector—particularly in the vital investment area where the UK has lagged so badly. High interest rates are the symptom of this.
4. If the country operates with a huge budget deficit, and a monetary policy that does not squeeze out private investment, the result is likely to be a relatively high rate of inflation. As a result, sterling is likely to depreciate relative to other currencies. (The inflation rate in the UK is presently about 14% and rising.)
[Typeset Page 777]5. When the price of sterling falls, import prices rise and the general price level also rises. This in turn places even greater stress on HMG’s incomes policy, because while the unions are exercising restraint on pay settlements their members are suffering an erosion in real wages. At some point the policy of wage restraint collapses.
The broad strategy of this Government and the one that preceded it has been to finesse substantive solutions and to borrow large quantities of money to try to hold sterling.
The issue is whether we are going to continue to be a party to this unsatisfactory approach. An even broader issue is whether a country like the UK can be encouraged to adopt an alternative strategy—one that combines money and changes in policy—which is the essence of the IMF approach. It is essential that the answer to this broader question be in the affirmative. If it is seen that the UK has not changed its basic strategy, the result is likely to be no more satisfactory than the record of the past 18 months. In fact, the result could be even less satisfactory, since the UK cannot continue to borrow funds at anything like the recent and contemplated rate. In financial markets their credit will collapse. In a political sense they have been drawing heavily on the stock of good will in principal countries around the world, and this too can be exhausted.
Unhappily the success or failure of the effort to nudge the British in a new direction has an even broader impact. The international monetary system is under enormous strain. Private lenders, including many of our principal banks, have been large lenders to many countries. If it becomes clear that a politically clever country like the UK can, with the help of its friends, continue to avoid dealing with its problems, lenders will have to question whether the formulation that you fashioned in Puerto Rico—based on support for effective policy changes—actually works in practice. In addition, other countries—notably Italy, Mexico and Brazil—will be forced to question whether they should undertake difficult measures if the British can avoid policy changes and the distasteful, short-term political consequences.
The reaction of lenders would probably be to slow down the rate at which they are providing credit to countries in deficit (on an individual basis and faced with such a situation they should). The result of this would be incredible monetary strains.
One of the tragedies in the present situation has been the time and energy devoted to finding ways of borrowing more money. If that same time and energy had been devoted to creating the political basis for the policies that ultimately must come, the outlook would be different. The signs are many that there is a considerable base of support in Britain for policies that deal with the real problems. But this latent support has not been translated in concrete terms and Britain’s political crisis con[Typeset Page 778]tinues—indeed deepens. Harold Macmillan’s call for a coalition government is symptomatic of the crisis and the sense that the Government has not been dealing with the real problems.
In concrete terms this means supporting the IMF’s efforts to negotiate a sound stabilization program which will combine foreign financial support with UK policy changes, and avoid any commitment of even larger amounts of money. Whether further financial support is needed or desirable can only be gauged after the successful conclusion of the IMF–UK negotiations, and dependent on the emergence of strong political leadership directed at fostering support for policy changes which assures that a sincere and skillful effort is going to be made.
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Summary: Simon discussed Lever’s visit to Washington and the UK economic situation.
Source: Ford Library, National Security Adviser, Presidential Country Files for Europe and Canada, Box 15, United Kingdom (9). Secret. On November 3, Yeo briefed Kissinger on his recent trip to Germany, where he discussed the UK economic situation with FRG officials. (Memorandum of conversation, November 3; National Archives, RG 59, Records of Secretary of State Henry Kissinger, Entry 5403, Box 19, NODIS Memcons, November 1976)
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