Foreign Relations of the United States, 1952–1954, Western Europe and Canada, Volume VI, Part 1

DMS files, lot W–1444, “FY 1955 Program Estimates”

No. 269
Memorandum by the Consultant to the Director for Mutual Security (Bissell) to the Assistant Director for Programs, Office of the Director for Mutual Security (Ohly)

Washington, October 29, 1952.

Subject:

• Long-run Policy on Aid to European Countries

In the course of recent discussions of the Fiscal Year 1954 Mutual Security Program for Europe, two fundamental questions have arisen which were rather sharply crystallized in the Budget Bureau Hearings on Wednesday, October 15. First, on what basis should the amount of aid to the NATO countries for FY 1954 be determined; specifically, should it be on a budgetary or balance of payments basis? Second, in what form should aid be given in that and subsequent years; should defense support and OSP be continued as well as the transfer of end items? I feel moved to set down my tentative views on these matters, which I shall do in rather theoretical form for the sake of brevity. I will begin by repeating several familiar points by way of background.

First, I assume it is now generally understood that a judgment as to the amount of aid in all forms which it is in the interest of the U.S. to furnish to any European ally in support of that ally’s military efforts depends upon an estimate of military requirements and other burdens on its economy on the one hand and an appraisal of its political and economic capabilities on the other. It is impossible to form such a judgment on the basis of any narrower “technical” appraisal. In particular, it must be emphasized that a calculation of the deficiencies in equipment that would have to be made good in order to meet an ally’s military requirements (after allowing for the ally’s programmed expenditures and for assets already in existence or already financed from previous US aid) does not by itself constitute a rational justification for any given amount of aid, whether in the form of end items or in any other form. Such a calculation has to take as given the ally’s own programs and to assume that they cannot be enlarged, and therefore fails to explain why the country cannot cover its deficiencies out of its own physical and financial resources. Yet the ally’s programs, in fact, reflect a balancing of all kinds of claims on resources against the volume of resources estimated to be available. Hence, the calculation of military needs and deficiencies proves nothing about the aid required unless it is supplemented with an appraisal of competing demands for resources and of economic and political capabilities.

A second fact which I take to be generally understood is that OSP, like defense support, is a device for furnishing aid in the form of foreign exchange. The fact that in an OSP transaction military end items are purchased by the US Department of Defense for transfer to an ally should not obscure the economics of the operation. Typically, in such a transaction US dollars are used to mobilize, say French productive resources, French capital and labor, to produce in France end items destined to be used by the French military establishment. What is transferred from the U.S. to France is a sum of hard money, which may later be used to pay for wheat or tobacco or which may end up in the French gold reserve. A gift of free dollars to the French Government to finance military procurement in France would be the exact economic equivalent of such a OSP transaction. To be sure OSP is a superior method of financing French military procurement because it permits the U.S. Government to set in motion the production in France of the right items in the right places with a minimum of delay and a minimum of apparent interference in the internal affairs of the country. But it is fundamentally different from the transfer of resources in the form of U.S. produced end items.

With due apologies for repeating these familiar but occasionally forgotten propositions, I will now attempt to define the main choice that seems to me to be called for in mapping the strategy of our aid to our NATO allies for the next few years. If the size and character of the forces we wish them to raise, and the phasing of the build-up of those forces may be taken as given for the purposes of this discussion, the amount of aid required will be determined by what the Europeans can do and will be largely independent of the form in which it is given. Broadly speaking, it can be given in the form either of US produced end items to supplement European production or of foreign exchange to enable the Europeans to produce more munitions than they otherwise could. The form will significantly affect the amount if, but only if, it affects the degree to which European political and economic capabilities can be exploited, a point which will be touched on further below.

The choice of form, in turn, clearly should rest upon a judgment as to the optimum location of the production of military hardware. If the Europeans should be encouraged to build up a war production base capable of turning out more military equipment than they can pay for, and if military production ought to be maintained in Europe at such a level, even after the build-up is completed, then a part of the aid furnished in any future program must be in the form of foreign exchange. Alternatively, if it is not necessary to contemplate in the long run a level of military production in Europe in excess of European financial capabilities, then aid could in the future take the form of end items exclusively. There is, of course, no such clear choice for FY 1954. It will probably be conceded without argument that, in view of the weight of the burden during the period of military build-up and the recent history of foreign exchange difficulties, some aid must be provided for at least another year in the form of foreign exchange in order to enable the Europeans fully to utilize their own productive resources. Nevertheless, the fundamental decision as to the level of military production in Europe after the military build-up is completed, as outlays on the European military establishment approach a maintenance basis, should largely determine the size and character of the war production base that should be built in Europe in the next year or two years. Accordingly, it is urgent that this decision be made now, at least on a planning basis.

What considerations should guide it? Clearly, they are (a) a strategic consideration, the vulnerability of European industry on the one hand and of trans-Atlantic supply lines on the other, (b) relative cost of production, with due regard to the possibilities of encouraging the production of European types of weapons and vehicles, (c) the effect on the US mobilization base, (d) political consideration, the desire on the part of the French and others to produce as large a proportion as possible of the weapons they will have to have in the event of war, and (e) the economic effects on the European countries, including the effect on the amount of aid required, and on the general pattern of trade and production.

My purpose here is to concentrate on the last of these five items; accordingly, I shall make certain assumptions about the others or dismiss them entirely. As to strategic consideration, it is pretty clear that certain items, of which ammo is the stock example, should be produced in Europe in quantities at least sufficient for European forces and that others, unconventional weapons for instance, should be produced only in the U.S. And there are probably other items which are not at either end of the spectrum but where there is clearly a preferred source. For instance, it might be decidedly cheaper for Europeans to produce their own trucks, while aircraft may be especially suited to US production because the delivery problem is simpler than with other types of equipment. Without going further, however, it will be assumed that strategic considerations alone leave a large range of indeterminacy, that is, a long list of items with respect to which these considerations give no clear indication. As the Europeans themselves are financing and will continue to finance a sizeable minimum volume of military production in Europe, it will probably be true that strategic considerations alone leave undetermined the optimum location of most production financed with US aid.

As to relative costs, I understand that the evidence is not clear that US costs are lower on all items, when transportation is taken into account, and there must be still unexplored possibilities for reducing production costs over the next two or three years in Europe. Accordingly, it will be assumed that the application of this consideration, too, will leave a sizeable area of indeterminacy. Nothing will be said here about the importance of maintaining a US mobilization base. Political considerations can best be weighed in connection with the final item, the economic impact of the choice between a higher or a lower rate of military production in Europe and the concomitant choice of giving some aid in the form of OSP or giving it all in the form of end items.

In considering the economic consequences of military production in Europe, it is useful to refer to the familiar distinction between the limit on a country’s economic and financial capabilities that is set by its resources of foreign exchange and that which is set by the size of the national government’s budget. Theoretically, there should be no foreign exchange limit. Any expenditure that a government can find room for in its budget and finance out of either tax revenue or “noninflationary” borrowing should have no adverse impact on the country’s balance of payments. The net effect of withdrawing an increment of funds from the income stream by taxation or borrowing and simultaneously permitting an equal increase in military expenditure should be to curtail the civilian demand for goods and services and expand the military demand by equal amounts and thus to engineer a shift of resources from civilian to military uses.

But in practice, of course, an increase in military expenditures is likely to have different consequences. For one thing, when a national government’s budget is large to begin with, an increment of military expenditures is most unlikely to be financed entirely out of current revenue, and it is not clear that there is any such thing as non-inflationary borrowing. For another thing, even if an increment of military expenditures is wholly covered by an increment of tax revenue, civilian demand is unlikely to be reduced as much as military demand is expanded so the net impact is apt to be inflationary (because higher taxes are paid in part out of lowered savings and only in part out of lowered private spending and because military expenditures are apt to stimulate private investment). Finally, an increase in the military demand for the products of the engineering industries that is offset by a decline in the civilian demand for, say, textiles, is most likely to have an adverse effect on the balance of payments, even if it has no net inflationary effect within the country.

In the real world, therefore, it is only realistic to assume that an increment of military expenditure, even if funds for financing it are somehow found within the budget, will absorb more productive resources than are released by any corresponding curtailment of civilian demand, and that it will, therefore, both draw unemployed resources into employment and attract additional resources in the form of larger imports or at the expense of smaller exports. The resulting deterioration in the balance of payments will be larger (a) the larger the increase in combined military and civilian demand and (b) the smaller is the scope for expanding output through the reemployment of previously unemployed resources or through the more intensive use of resources already employed. Accordingly, a nation’s foreign exchange position, the degree to which it can afford to place an additional strain on its balance of payments, sets a limit at some point on its economic capabilities which may well be different from that set by the government budget.

These considerations suggest that, in making the choice for planning purposes of an optimum level of military production in Europe, three possible economic situations need to be examined. First, there is what used to be considered the general case, in which the significant limit on the nation’s economic capability is that set by its foreign exchange resources or, in other words, where the level of military expenditure in the country is limited by the unwillingness or inability of the government to incur the larger balance of payments deficit which would result from a larger budget. In such a situation, it is reasonable to assume that the expenditure of, say, an additional $2 million a year for military purposes within the country would worsen its balance of payments by, say, $1 million a year. Under these circumstances, $1 million a year of OSP would furnish enough foreign exchange to cover the balance of payments effect of the OSP itself and of another $1 million a year of military expenditure by the government of its own money. If the bargain could be struck, $1 million of US aid in this form would buy $2 million worth of military production in Europe.

The second case is that in which the financial limitation is set by the supply of foreign exchange and in which there is no narrow budgetary limit, but in which there is full employment of resources and direct competition between the production of military equipment and that of exports. Under these circumstances, $1 million a year of OSP which is additional to the country’s own program will worsen its foreign exchange position by about the full million dollars and will not support additional spending by the government of the country. This is very close to the present condition of the UK. In such a situation, one dollar of OSP buys only that same one dollar’s worth of additional production in the country.

The third case is that in which the financial limitation is budgetary in character, that is, where foreign exchange resources would permit a larger total expenditure by the government of the country than it is prepared to make. In such a situation, as in the first type, $1 million of OSP a year might be assumed to worsen the foreign exchange position by only half that amount. But since it would make possible no increase in expenditure out of the government’s own funds, the other $½ million a year of foreign exchange would, other things being equal, find its way into the country’s reserves. This is admittedly the present situation in France.

How is the choice between OSP and end item aid, that is, the choice of appropriate form of aid and level of military production in Europe, to be made in these three theoretically distinguishable situations? The first case suggests one obvious standard that might be applied in order to minimize the amount of aid that is required to achieve given results. Where the provision of one dollar’s worth of foreign exchange will enable the receiving country to spend a second dollar of its own money, that is, to make more effective use for defense purposes of its own productive resources, then only half as much aid would be required in the form of OSP as in that of end items to achieve a given result. It is probably a safe rule of policy, therefore, that where OSP has a multiplied effect on total defense expenditures within a country, this form of aid is preferable.

But to what extent, realistically speaking, does this situation obtain? Admittedly it does not at the present time in any of the major European countries. In France, aid is being provided in the current year, and is proposed for next year, for the purpose of supplementing the budget in amounts expected to lead to an increase in reserves. The MSA estimates that in FY 1954 there will be increases in monetary reserves in Germany and Italy as a result of OSP and small amounts of economic aid. No direct aid to Belgium, The Netherlands, or Norway is proposed and their foreign exchange positions are expected to be satisfactory without it. All of these countries would appear currently to come under the third case. The UK seems to fall under the second. The British have themselves said that additional or off-shore procurement undertaken in Britain, unless it provided for long-delayed deliveries, would compete directly with exports.

Admittedly, however, the present relatively strong dollar position of most of the continental countries reflects the current and anticipated high level of extraordinary dollar earnings from both US military outlays and OSP. There is a considerable likelihood that, if OSP were discontinued, Italy and France at least, among the major continental countries, and probably the UK as well, would again experience foreign exchange difficulties after the build-up was completed as payments on old OSP contracts tapered off. Nevertheless, I will venture the opinion that these difficulties will not be in fact, and will not be thought to be, the necessary consequence of domestic military expenditures, that foreign exchange difficulties, unless they became dangerously acute, will not have much effect on military expenditures, that only under unusual circumstances would the furnishing of foreign exchange through OSP clearly have a multiplied effect in minimizing the curtailment of military expenditures, and that the budgetary limit will come more and more to be the truly significant limit on European defense efforts.

In expressing these views, I am assuming that after the build-up is completed (which is the situation to which these views apply), the total outlay on European military establishments will be appreciably lower than the peak rate in FY 54 or even than the present rate, counting outlays by both the US and the European governments. I am also assuming that the US will be prepared to continue end item aid on a generous scale, say, $3 billion to $3½ billion per year. Since some further increase in expenditure is expected in Germany and since there should be little if any decrease in Italy or Belgium, there is room for considerable relief for France and the UK. Moreover, there should have been some growth in GNP in all these countries. And, finally, any required expansion of military production capacity should have been completed and the output of military equipment should have passed its peak.

The principal judgment underlying the above expressed views is that, if these assumptions are correct, the economic burden on the European countries should be well within their capacity to carry and should not be so large as inevitably to generate inflationary pressures, require an abnormally large volume of imports, or compete too seriously with exports. This judgment (if it is accepted) implies that the Europeans should be able, by something short of impossibly good management of their affairs, to prevent their military expenditures from having the kind of adverse impact on the balance of payments that is almost inevitable in a period when the absolute strain is severe and when the rate of expenditure is rising. It can fairly be said, therefore, that the foreign exchange shortage they may encounter will not be a consequence of large military outlays but merely the re-emergence of the same difficulties they experienced before mid-1950. More specifically, it must be expected that the circumstances which limit the ability of the Europeans to close the gap in their international accounts will not be the absorption of productive resources by the defense effort or the inevitably inflationary impact of rapidly growing defense expenditures but rather the difficulty of finding markets for European exports and the domestic inflationary pressures that are generated by civilian programs.

Under these circumstances the connection between defense expenditures and the balance of payments in these countries is apt to be attenuated both in fact and in opinion. To be sure, the European Governments might be tempted to deflate as a means of coping with the foreign exchange shortage, and the least painful way to deflate might seem to be to cut defense expenditures further. But direct controls over imports and, under extreme pressure, exchange rate changes are apt to be the first and second lines of defense against gold losses. Deflation will be resisted as a cure because of its possible impact on employment, even if there is sentiment for reducing military costs. And in any case, few European Governments will be able to develop deflationary budget surpluses in the face of the pressure for lowered taxes and expanded social programs. So long as budgets are at least close to balance and serious inflationary pressure is not apparent, the foreign exchange problem is apt to be regarded as (and in practice to be) unrelated to the budget and the effective limit on military expenditures is apt to be set by the competition for budgetary resources.

This does not mean that the foreign exchange problem can be ignored, and I will return to it below. The lack of connection between the foreign balance and the government budget should not be overstated. But the connection is most unlikely to be so close as to justify the assumption that a dollars worth of aid in the form of foreign exchange will induce the expenditure by the Europeans of a dollar’s worth of their own funds that would not otherwise be spent.

We are dealing, then, typically with the third case, complicated by the possibility of a chronic foreign exchange problem. The choice is not between the provisioning of a smaller amount of aid in the form of OSP and that of a larger amount in the form of end items to support a given level of military expenditure. Rather it is between, on the one hand, the maintenance of a relatively high level of military production, part of which would bring in a flow of extraordinary dollar earnings, and on the other hand, a lower level of military production coupled with increasingly heavy reliance on the earning of foreign exchange in other ways. The question is whether productive resources should be used to produce military end items for sale to the U.S. Government or, alternatively, to reduce commercial imports and expand commercial exports.

When the question is put in this form, it seems very clear to me that the answer should favor the latter course of action. I am convinced that to hold out the hope that the Europeans will be able to earn a substantial part of the dollars they need indefinitely by producing military end items would divert attention and energy away from the most difficult and very nearly the most urgent task that confronts them, that of making themselves competitive in world markets, finding and developing trading partners, and thus restoring their solvency. This objective should not interfere with the military buildup itself or with the creation of a strategically adequate war production base. But insofar as the choice is between producing military hardware in Europe and producing it here, surely it would be better to minimize the productive resources that are absorbed by military production in Europe and come to grips as soon as possible with the underlying economic problems.

If a major objective of the Kremlin for the next several years will be to break down the cohesion of the non-communist world, a strong case can be made up for giving enough help so that the burden upon the Europeans does not become impossibly heavy. But to induce them to place their reliance on the artificial, unstable, and highly political export market that is created by OSP would make things easier for the Europeans in precisely the wrong way. It would not reduce the volume of resources that would have to be used to earn foreign exchange, and thereby make more available for investment and consumption. All it would do would be to open up to them the prospect of earning foreign exchange in a protected market in the Pentagon without the necessity of having to become competitive in price, design, and salesmanship.

I can readily conceive that the foreign exchange program may in a few cases turn out to be so intractable that we will be driven to resort to OSP, as we felt compelled to carry out the Marshall Plan, in order to avoid economic collapse in one or more vital countries. Certainly, we should try to leave the way open for such action if it is necessary. But the OSP already programmed for FY ’53 followed by one more year of OSP on a large scale in FY ’54 will assure the Europeans of a high rate of extraordinary earnings for another 2½ to 3 years. If 8 years after the beginning of the Marshall Plan the Europeans are again threatened with a foreign exchange crisis, presumably despite continued sizeable dollar outlays by the U.S. military establishment, this outcome must be accounted a major failure of U.S. policy. It seems to me neither necessary nor wise to begin now to plan for that failure. Instead, it seems to me we should make it clear to the Europeans that they must contemplate, after a further period of grace of about two years, a gradual tapering off of extraordinary dollar earnings, which will confront them with the absolute and unavoidable necessity of bringing their international accounts more nearly into balance. This is the only economic strategy that seems to me to hold promise for the long pull.

Persuasive as these economic arguments seem to me, however, it is the political ones that are decisive. I believe it essential that we move rapidly toward a state of affairs in which, although the US continues to provide aid to its allies on a generous scale and with, I would hope, greater certainty for longer periods than at present, the Europeans are compelled to accept the residual responsibility for their own economic affairs, that is, to become again the common stockholders in their own countries. It is intolerable that, for very much longer, every bad harvest, commodity price decline, or political crisis should give grounds for a request for additional U.S. aid. It was appropriate to tailor aid closely to “need” in the earlier years of the Marshall Plan. But to continue to do so indefinitely is to deprive the Europeans of control over their own fate and to foreclose any possibility of a revival of self-reliance.

If the United States is in this sense to put the final responsibility for their own affairs back on to the shoulders of its allies, it must, I believe, provide sufficient aid, determine the amount of aid in a fashion such that it is independent of day-by-day changes in political and economic “needs”, and provide it in a form that minimizes the sense of European dependence on the United States and that is clearly appropriate to the purposes of the alliance. The provision of aid mainly or wholly in the form of end items would, I suggest, go far to meet these requirements. End item programs are more likely than are the plans for other kinds of aid to be based on a long-run appraisal of requirements and capabilities. Once established, it is not immediately obvious why such programs should be affected by the threatened fall of a cabinet, a decline in the price of rubber, or a dry summer in France; they are much better insulated against such day-by-day circumstances. And it seems to me that end item aid creates less of a sense of dependence and is more obviously appropriate to the purposes of the alliance than gifts of foreign exchange to make up for an inadequate competitive position.

I will finish these rather rambling remarks with a summary of my conclusions, as they apply practically to the FY ’54 program.

1. There is good reason to continue with an OSP program in FY ’54 both because appropriate amounts of aid in the form of foreign exchange can have a multiplier effect on military expenditures in a number of countries for some time longer and because I gather that quite a lot remains to be done in building a suitable war production base.

2. What I would regard as an appropriate amount of OSP in each country, from the standpoint of short-term economic considerations alone, is that which would (in conjunction of course with other extraordinary receipts and any other aid) give rise to a modest increase in monetary reserves during the period when the main impact of the transactions is felt on the balance of payments. Taking longer-run considerations into account, there should be sufficient OSP to support the creation of a war production base suitable in the light of the desired scale of military production after the build-up is complete. (Presumably, an adequate war production base would provide for considerable excess capacity after the buildup.)

3. I would endeavor to avoid all direct budgetary aid. In the case of France, if such is given to support the war in Indo-China, I would take it into account in shaping the OSP program for France.

4. I would initiate planning discussions with the Europeans at the earliest possible date to consider appropriate policies for the period after the military build-up and, in the course of these discussions, would make clear that extraordinary dollar earnings would begin to taper off toward the end of FY ’55 and that the Europeans must not in any of their planning place major reliance on this source of foreign exchange after the next 2 or 3 years.