249. Memorandum From the Under Secretary of State for Economic Affairs (Cooper) to Secretary of State Muskie1

International Factors Bearing on U.S. Tax and Budget Policy

In view of discussions within the administration of potential shifts in US macroeconomic policy2 and your up-coming lunch with Secretary Miller, I thought a brief outline of the foreign policy implications of US macroeconomic performance would be timely. While the US share of world GNP and world trade has declined over the years, what happens in our economy still has a tremendous impact on the world economy, and our economic recession will have a substantial depressive effect. This will reduce world inflationary pressures and world demand for oil, but it will increase protectionist pressures, aggravate the already serious financial problems of LDCs and smaller industrial countries, and generate political unrest in some countries.

[Page 745]

We face a situation in which “fiscal drag” next year from higher inflation and the January 1 social security tax increase3 will add $60 billion of deflationary pressure to the economy. Thus even a “neutral” fiscal policy would include a tax cut in that amount. I do not mean to argue, at this stage, for or against a cut of any specific magnitude. The timing and size of any potential tax cut will be based on a weighing of costs (in terms of relaxing or appearing to relax the fight against inflation) against benefits (in terms of higher growth and employment). My object is to add to the cost/benefit calculation the international implications of US macroeconomic policy.

You are aware of the steep decline in the first half of the year in the US economy. The mid-year forecast assumes the decline tapers off in the second half of the year and we return to modest positive growth in 1981. This pattern of decline, accompanied by an assumed recovery in 1981, is common to all the major industrial countries. In general, the decline elsewhere is forecast to lag that of the US; and the recovery is expected to be modest as in the US. In particular, from mid-1980 to mid-1981, the OECD is forecasting real growth of less than 1% for the six Summit countries other than the US and about one percent growth for all the OECD excluding the US. With the United States, OECD growth rates will be even lower. Thus the main engines of growth in the world economy will be virtually dead in the water during the next year.

The continuing weakness of growth abroad is at least partly attributable to the fact that the 1979–80 increase in oil prices has not yet worked fully through their economies. In addition, the other industrial countries, like the US, are generally following restrictive fiscal and monetary policies. Interest rates abroad rose with US rates early this year. The other industrial countries also have fiscal drag arising from the effects of inflation on tax revenues and will also have stagnant public expenditure (in real terms) through the rest of 1980.

There are three aspects of the overseas impact of our economic growth which I would like to emphasize. The first has to do with the impact on rates of growth abroad. In the early post-war period a slowdown in the US had very sharp effects on growth elsewhere in the world through our demand for imports from abroad. That effect is weaker today, but is still important. In the meantime, however, growth abroad and world demand for US exports have become more important to us. A fall in European economic activity or a slower recovery will noticeably affect the depth of our recession and the speed of our recovery. CEA’s mid-year forecast takes account of foreign demand for [Page 746] our exports and, indeed, the assumption of the forecast is relatively pessimistic. The OECD’s latest forecasts represent a shift down from previous projections of foreign growth. Even with these forecasts the OECD Secretariat and others in Europe (the EC Commission for example) see the major risks of error as being on the down-side.

The second aspect of these macroeconomic developments worth flagging is the pressure they will put on our trading relationships. Within the US Government we have tended to view the problems of automobiles and steel as special cases. It is true that each has a very particular set of circumstances, explanations, and solutions. However, industry-specific problems, while they may not be created by the overall economic slowdown, are strongly exacerbated by it. The number of problem industries both here and abroad will increase as slow growth persists. These industry-specific problems, in turn, will be characterized as “trade problems” and will create pressure for greater protection. If granted, that protection will increase prices and reduce efficiency, both compounding the cost of our economic slowdown. It will also create strains in the political relationships with our allies. Since similar pressures are operating abroad, the dangerous possibility of emulative “trade wars” arises.

The third important dimension of the slowdown has to do with our relationships with developing countries (LDCs). The IMF estimates that $68 billion of the $115 billion OPEC balance-of-payments surplus in 1980 will be borne as deficits by developing countries. Moreover, while the OPEC surplus is projected to decline to something less than $90 billion in 1981, the developing country deficit will actually rise by an additional $10 billion due to the economic slowdown in the OECD countries. Even within the industrial countries, virtually all of the projected fall in the combined deficit from 1980 to 1981 is concentrated in the largest economies. As a group, the smaller industrial countries are not expected to reduce their deficit at all.

Large LDC deficits—due partly to high oil bills, partly to recession-induced decline in prices of and demand for their exports—will mean they have to borrow more, and we will see many more calls for debt rescheduling. New credits will worsen their already serious debt problems and merely postpone some of their difficulties. Absence of new credits will reduce growth in the LDCs, generate political unrest, and worsen the economic slowdown here and in Europe and Japan.

Of course, the LDCs must begin to make adjustments in response to their expanded deficits and higher oil prices. But we should not be blind to the fact that these adjustments entail political strains within the developing countries and in our relationships with them. These costs increase as the size and speed of the required adjustment rise.

[Page 747]

We have set in train a number of actions which will assist LDCs in their adjustment process, including adaptations in the international financial institutions (IMF and World Bank). These measures are, however, only a partial response to the problem.

Historically, the economic growth of the industrial countries has been far more important as an engine of growth for the LDCs than the contributions of aid or lending by international financial institutions.

We should keep these international considerations in mind as we approach the possibility of a tax reduction and the President’s overall budget proposals for January.

  1. 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 7, E—Memoranda of Conversations, Jan. 1980–June 1980. No classification marking.
  2. On August 28, Carter announced a national “economic renewal program” based on increased investment, public-private sector cooperation, efforts to relieve the effects of economic dislocation, and tax relief. See Public Papers of the Presidents of the United States: Jimmy Carter, 1980–81, Book II, pp. 1585–1591.
  3. The salary base on which the social security tax was assessed increased on Janu-ary 1. (Deborah Rankin, “Taxes,” The New York Times, January 1, 1980, p. 32)