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August 9, 1971

MEMORANDUM FOR THE PRESIDENT
International monetary and financial developments
have now become urgent and immediate policy problems.
While the attached statement is long, I have attempted
here to lay out the general nature of th^ problem, the
objectives, and the considerations involved with each..




Paul W. McCracken

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I

For several reasons major changes are needed in this
nation's international economic policies. In the short
run we are seeing sustained leakages of dollars to other
major centers which are giving us quite large deficits
in our external payments. These holdings of dollars
abroad are growing at an unsustainable rate, and they
court the risk of a disorderly interlude of adjustment
if we do not take the initiative.
Of more fundamental significance we have seen an
erosion in our basic international economic position.
After an improvement in merchandise trade payments in
1969 and a further improvement in the first half of
1970 , we have seen a disappointing deterioration leatfThg
U.S. Merchandise Trade
(Seasonally adjusted annual rate in billions)
Period

Exports

Imports

1964
1965
1966
1967
1968
1969

25 .8
26.8
29 .5
31.0
34.1
37 .3

18.7
21.4
25.6
26.9
33.2
36 .0

7.1
5.3
3.9
4.1
.8
1.3

1970-lst half
1970-2nd half

42 .3
43.2

39.2
40 .7

3.1
2.5

1971-lst half

44.5

45.2

- .7

Export Surplus

to three months (April, May and June) during which our
merchandise trade exports have been less than imports.
There are here, as is often the case, some extenuating
circumstances. There is a dock strike on the West Coast,
and such a strike often produces capriciousness in trade
figures. Canada, Japan, and the United Kingdom have been
in recessions of varying degrees of severity. Their slack
economic demand has probably resulted in some shortfall of
purchases from the United States, and these three economies
are important international customers for this country.
Indeed, these three nations normally account for approximately
40 percent of our total exports. At the same time the
weakness in our trade position, even after the stern
disinflationary policies here, must be taken seriously.




- 2 -

Moreover, there are disturbing indications for the future.
Investment plans of American corporations more and more are
taking the form of concentrating capital expenditures on
facilities abroad. In 1970 14.2 percent of capital
outlays by American companies will be spent on their
foreign facilities, compared with 12.4 percent three years
earlier. This increasing tendency to rely upon foreign
facilities not only to service third markets but also to
supply the American market is not an augury of growing
strength for the United States in the world market.
We, therefore, face some underlying basic problems which
could come to a head, as often happens, with specific and
more immediate financial and currency.problems. These
current flows of funds to other centers, however, are
more nearly the thermometer registering the problem
rather than the furnace producing it. The basic problem
has to do with these underlying evidences about our basic
competitive position.
What we now face, therefore, is the importance of
devising a coordinated economic policy that will accomplish
some basic objectives. First, it must substantially improve
the competitive position of the American economy in world
markets. Second, it should put the United States in a
position to reassert its leadership of international economic
and trade policy. No nation with a weak currency and a
weak competitive position can exercise strong international
economic leadership. Indeed, history is quite clear that
a country with a weak currency and a weak international
economic position will find its capability for international
political leadership also impeded. Third, it is essential to
find some means for reversing the trend toward protectionism
and restriction both here and abroad.
We can choose between two basic strategies. One
is an assault on restrictions abroad based on the
proposition that we confront unfair restrictions
against us in other important markets. We support, for
example, the political objectives of enlarging the European
Community, but we do have to recognize that its external
barriers may well become more inimical to our economic
interests. We confront important barriers in Japan. The
United States also bears a disproportionate share of the
common free world burden for security, and this imbalance
ought to be redressed. A posture based on the complaint
that we are being treated unfairly is, however, defensive,
it is apt to have limited practical results, and it is not
the foundation for strong international leadership.




-3-

It would be better if we could go on the offensive and
call upon the industrial world generally to eliminate
all external barriers to trade. The rest of the world would
then be on the defensive if they demurred about moving
toward a fundamentally more liberal economic order.
This affirmative economic strategy requires as a basic
condition that the United States dollar and the United
States position in the world economy be stronger. Without that
improved strength such a call would be an empty gesture
because our own present external payments position would
seem to point toward the need for more barriers here, not less.
II
There are fundamentally two broad approaches for
achieving that greater strength. First, we could impose
on the United States a severe disinflation.
If we could
moderate sharply the price cost inflation here, we could
expect a gradual further improvement in our international
competitive position since inflationary trends remain
strong abroad. Indeed, our price level performance during
the last year has been slightly better than that in the
industrial world generally. Moreover, if this better
performance began to look like a persisting thing, we could
expect a diminishing reluctance abroad about holding dollars
even if the U.S. balance of payments had not completed its
correction.
For several reasons it is doubtful if this is a
viable alternative. We would need to improve rapidly and by a
substantial amount our international competitive position.
Annual Percent Change in Export Price and Consumer
Price Indexes During the Past Year
Country
U.S.
Canada
Japan
Germany
France
U.K.
Italy

Export Prices—^
5.0%
-2.5
5.7
2.9
6.5
7.8
7.5

Consumer
4.5%
2.4
6.6
4.9
5.0
9.9
5.2

1/ Based on export prices expressed in U.S. dollars
Note. - This percent change is from early 1970 to early
1971, though the exact terminal month will vary slightly
from country to country.




-4The severity of a disinflationary program required to
achieve such a result would court the risk of further economic
stagnation at home and higher unemployment. A stagnant domestic
economy with sluggish markets and low investment is not
apt to make substantial progress in improving its basic
technological and competitive position.
This leads to a second fundamental approach which is
an adjustment in the exchange rate of the dollar. If the
dollar were cheaper in terms of other currencies, American
merchandise in other markets would be correspondingly
cheaper and foreign merchandise in the United States
markets would tend to be correspondingly more expensive.
It is probably only in this way that, we can achieve the
kind of prompt redress of imbalances between our costs and
those abroad that are needed.
Within this second alternative there is a progression
from the least to the greatest departure from the existing
system. The smallest departure would involve a border
tax on all imports with a corresponding credit for exports.
If, for example, we imposed a border tax of 10 percent
on imports we would be achieving a change in the exchange
rate for the trade dollar — leaving, however, the exchange
rate in the formal sense unchanged. Such an action would
have substantial political appeal, we would be strengthening
our relative merchandise trade position, and we could
maintain the same definition of the dollar as 1/35 of
an ounce of gold.
The border-tax approach, however, has certain
disadvantages. It leaves the "tourist dollar" exchange
rate unchanged, and this is an important net drain on
our balance of payments. It also leaves the "investment
dollar" exchange rate unchanged, and this is exactly the
opposite of what foreign nations would be most inclined to
accept. In many of these nations there is growing
concern about the rising American ownership of local
companies. We might, therefore, find resentment abroad
expressing itself in retaliatory measures against imports
from the United States or our own foreign investment.
Second, we could go for an outright devaluation of the
dollar, against other currencies generally, to a new and
lower fixed rate. This would be the most clean cut.
It would make foreign assets more expensive as well as




foreign merchandise. It would also make foreign tourist
travel in the United States cheaper and foreign travel
on the part of our tourists more expensive, thereby leading
to some closing of the tourist gap. A change of the same
percentage magnitude would thus have a greater therapeutic
effect on our overall balance of payments than the same
percentage change through a border tax (which would affect
merchandise trade only).
The problems here, however, are also formidable.
The magnitude of the change to which other nations would
ow agree might well be less than what is really needed
to correct the present disequilibrium. Moreover, the
magnitude of the change in the dollar's exchange rate
that would be desirable is not the same relative to all
currencies. We need a smaller adjustment against the
pound, for example, than against the yen. Finally, we
cannot change the exchange rate of the dollar without
legislation. If this took or seemed to be taking the form
of an increase in the price of gold, some members of the
Congress (e.g., Henry Ruess) could be expected to object
strenuously. Indeed, this might substantially delay a
congressional action where a prompt decision would be
urgently desirable.
(During the interlude exchange markets
might be in enough turmoil to have a serious effect on
trade, and U.S. tourists abroad might also be in trouble.)
At the same time the United States ultimately ought to
have domestic legislation that would enable it to adjust
its own exchange rate relative to the field, just as is
true for most other nations. Obviously, the United States,
by virtue of its size and the international role of the
dollar, is in a somewhat different position from other nations,
but we should still have this perogative available to
us.' This we do not now have without congressional action.
If a change to a new fixed rate seems difficult
operationally, there is a third strategy. This would allow
the exchange rate of the U.S. dollar to float. We now
maintain the fixed exchange rate by agreeing to buy or
sell gold at $35 an ounce. If we were to close the
gold window, the value of the dollar in the foreign
exchange market would simply depend on what someone would
pay for dollars in terms of another currency. The
evidence strongly suggests that the exchange rate for the
dollar in a free market would tend to decline but by how
much is impossible to estimate.
(Since for trade purposes
other nations would resist an enormous change, it is
reasonable to assume that no massive settling of the exchange
rate would be involved.)




-6Floating also has its disadvantages.
It would arouse a
certain amount of resentment internationally.
There would
be an overhang of uncertainty that would have its inimical
influence on world trade and on international financial
markets.
Probably these adverse effects would be less
than we might fear, but we cannot be sure.
Limited experience
with floating does suggest that floating rates are not
necessarily violently unstable exchange rates.
Indeed the
D-mark, the guilder and the Canadian dollar are now
floating and movements have been reasonably orderly.
At the same time we must recognize that this is an uncharted
sea when we are talking about floating the world's
most important currency.
t
This approach, however, does have certain advantages.
The fact of floating, and the probability that this would
not be warmly welcomed by other nations, would produce
leverage for achieving a change in the exchange rate of
the dollar somewhat larger than countries otherwise might
be inclined to accept.
After a period it might also be
possible to wrap up a package of legislation with less
paralysis in the foreign exchange market than if we started
out to move from one fixed rate to another.
If the free
market tended to indicate clearly a new equilibrium level,
this would be extremely useful information in selecting the
new fixed r a t e .
Ill

These various approaches are not, of course, mutually
exclusive.
It is possible, for example, that a border
tax would need to be considered in the near-term even
if we were to have also a change in the exchange rate
or a floating rate.
The therapeutic effects on a nation's
trade balance deriving from exchange rate adjustments
take a substantial amount of time to emerge (one or two
year s ) . Actions to produce some effect in the interim
might be in order.
Whatever the exchange rate strategy in the narrow sense,
a program that would give greater assurance about American
cost-price stability would be an urgently desirable
element of the program.
The cumulative evidence suggests
that strong actions will be needed if we are to break the




-7-

wage-price spiral, and this should be a part of any
i
package. This, of course, is also desirable for domestic
reasons in order that the expansion can take the form of
more employment and output rather than Eaigher prices and costs.
Without minimizing the flack that csould be expected
to occur from action here, in short, we should see this as
a means of avoiding being forced into iirrational domestic
policies. That is the basic objection -o the first broad
to
approach of trying to regain needed international, economic
strength through disinflation. The magnitude of disinflation
required and the adverse effects it would have on the
domestic economy would make it, if we,were to rely on this
alone, almost socially unacceptable and possibly even
perverse in its overall results. The results could be
perverse, to repeat, because a weakened and stagnant
domestic economy is not an economy whichi over the long run
can be a strong contender for international economic
leadership. Indeed, we should take thes;«e actions in
order to establish the foundation for burilding a strong
domestic economy at home, and the greater market strength
for the U.S. dollar which is the indispe;nsible condition
for international economic and political, leadership.





Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102