225. Memorandum From the Under Secretary of State for Economic Affairs (Cooper) to Secretary of State Vance 1
World Economic Outlook
Economic events threaten a repetition of the high inflation rates and declines in output the industrial countries experienced in 1974–75. Largely because of higher-than-expected oil price rises this year (so far nearly 60 percent from the end of 1978), forecasts both by the USG and international organizations have been considerably revised in the last month. They indicate substantially greater inflation and unemployment, lower growth rates in real output, and a significant worsening in the balance-of-payments positions of both developed and less-developed countries. Faced with this bleaker picture of the world economy over the next eighteen months, we and other major industrial countries should adopt policies that attenuate, rather than exacerbate, our economic difficulties. While current projections do not indicate a world-wide recession next year, strong defensive policies in each major country could generate such an outcome. We can expect both increased protectionist pressures and increased calls by developing countries for financial help.
The Outlook in Figures
In the past week the Administration has revised the economic forecast it issued only July 12.2 Real GNP in 1979 is now expected to decline by 1.4 percent, rather than by 0.5 percent previously estimated, and will increase by only 1.1 percent, rather than 2 percent, in 1980 (fourth quarter over fourth quarter). (Growth in 1978 was 4.4 percent.) Inflation (GNP deflator) over the same periods is now expected to be about one percentage point higher than originally forecast: 11 percent in 1979 and 9 percent in 1980. By comparison, the inflation rate was 8.3 percent in 1978. The unemployment rate, currently 5.6 percent, is expected to rise to 8.2 percent by the end of 1980.[Page 657]
Except for the United Kingdom, other developed countries are not currently expected to be in recession next year. (The projected decline in U.K. GNP, roughly 1–2 percent over the next 12 months, is due primarily to the Thatcher administration’s policy of cutting government spending.) Nevertheless, the OECD now forecasts that its members will grow by only 2 percent in the next 12 months, down from 2¾ percent previously projected. Over the same period, consumer prices in OECD countries are expected to rise by 10 percent, 1 percentage point more than anticipated. The IMF paints a similar picture; it now forecasts a growth rate of 2 percent for industrial countries in 1980 (unpublished figure and confidential, not for attribution), which is one percentage point below their previous estimate. Private forecasts for Europe are considerably more pessimistic even than these figures imply.
The prospects for LDCs are more difficult to quantify, but the sketchy evidence we have suggests that the growth rate of non-oil exporting LDCs may be cut from roughly 5 percent in 1978 to perhaps 4 percent this year, most of the reduction being attributable to the oil price rise. The growth rate will be even lower next year if as a result of the slowdown in the OECD countries both the volumes and the prices of their raw materials exports fall.
The current account impact of the oil price rise, both directly and indirectly through its domestic contractionary and inflationary effects, will also be severe. Assuming no further rise in oil prices beyond July 1, the Treasury estimates that the combined current account of OECD members will shift from a surplus of $8 billion in 1978 to a deficit of roughly $20 billion this year, with a reduction in the deficit to $13 billion in 1980 as OPEC countries spend more of their oil revenues. Non-OPEC LDCs are also hard hit, with their current account deficit rising from $21 billion in 1978 to $29 billion this year. Treasury projects a further increase in their deficit to $36 billion in 1980. On the other side, the OPEC surplus, which was close to zero last year, is forecast to balloon to $42 billion this year and a slightly smaller figure, $38 billion, in 1980. Further oil price increases will raise these surpluses.
This deterioration in the global economic outlook will create a number of policy problems:
First, the “re-cycling” problem, i.e., the question of financing the enlarged payments deficits of OECD and less-developed countries. In the aggregate, the outlook is fairly bright. Although private banks have increased the proportion of their loans going to countries with payments deficits, their capital has increased and they have gained considerable experience since 1974 in how to re-cycle funds from OPEC countries to those in need of balance-of-payments financing. Moreover, [Page 658]official financing facilities have also been enlarged; the Witteveen Facility, for example, has increased the IMF’s ability to cope with the additional financing needs of its members, and the recently agreed liberalization of the Compensatory Financing Facility will make such financing more readily available. In addition, the foreign exchange reserves of less-developed countries have risen to such an extent that many of them can dip into these assets to finance larger deficits.
Nevertheless, while the aggregate financing problem appears manageable, there are bound to be specific cases of countries with severe balance-of-payments and financing problems. We can expect many more appeals for debt rescheduling and emergency financial support in the next 18 months than we have had in the last year and a half.
Second, the higher unemployment in both the U.S. and other major countries is likely to lead to increased calls for protection. In 1980 various groups will also undoubtedly introduce electoral considerations in pressing for protectionist actions. It will of course be vitally important that such pressures be resisted, not only in terms of our own well being, but also in terms of the severely adverse international repercussions. It will be necessary to watch carefully the evolution of the trade reorganization and the implementation of the MTN with a view to restraining these protectionist pressures.
Third, while it appears that the distribution of payments imbalances among the main industrial countries will be improved next year, there is the distinct possibility that increased uncertainty about economic prospects and policies may generate renewed exchange market instability. The Treasury is forecasting a small U.S. surplus next year, and Germany and Japan are likely to have drastically reduced surpluses, possibly even deficits. Such a situation should be favorable for the dollar. Nevertheless, the uncertain outlook and uncertainty as to what policies governments may adopt can well lead to increased exchange rate volatility.
The President will soon be considering action to deal with this deteriorating economic situation. To mitigate the adverse effects of this situation, both for the U.S. and for the world economy, it would be helpful if our economic policy could be directed toward moderating the decline in output. A moderately expansionist policy would attenuate our unemployment-protectionist problems, and would help maintain growth rates in other countries. Perhaps even more important is the need for increased oil conservation. Oil conservation is necessary to permit a desirable rate of growth of output without putting upward pressure on the price of oil.
These policy recommendations also apply to other major countries. It is especially important that Germany and Japan should be [Page 659]urged not to overreact to the inflationary impact of the oil price increase. They have already significantly increased their interest rates this year, forcing other countries (including us) to do likewise. Further restrictive policies in both countries could severely curb their growth rates. If this should occur, we could well end up in the situation we all want to avoid, a repeat of 1974–75.
- Source: National Archives, RG 59, Office of the Secretariat Staff, Records of the Under Secretary of State for Economic Affairs, Richard N. Cooper, 1977–1980, Lot 81D134, Box 4, Macroeconomic Policy Coordination E–1 (Econ), 79. Confidential. Drafted by Cooper and Peter Clark.↩
- On July 12, the White House announced that the economy was on the brink of recession. (Edward Cowan, “Recession Starting, White House Says, Revising Forecasts,” The New York Times, July 13, 1979, p. A1) The New York Times reported on August 2 that administration officials had amended this forecast and were now predicting a more severe economic downturn. (Edward Cowan, “Economic Forecast Made Bleaker In a Confidential Revision by U.S.,” The New York Times, August 2, 1979, p. A1)↩