Foreign Relations of the United States, 1961–1963, Volume IX, Foreign Economic Policy

32. Memorandum From John Kenneth Galbraith to President Kennedy⁰

Washington, August 28, 1963.

THE BALANCE OF PAYMENTS

I have now reviewed the papers on the balance of payments¹ and have talked at some length with those principally concerned. The following assessment is divided into three parts: the problem; the past and present efforts to deal with it which I feel to be seriously defective; and the action we should now take. We are, I fear, faced with the need for serious and difficult steps more than a little occasioned by the reluctance and postponement of the past. Those who now urge further postponement may wish to recall that the steps we now face could have been avoided by lesser but more timely action in the past. Further delay will mean yet more severe measures.

Delay will mean continued accumulation in foreign hands of dollar assets convertible into gold or the conversion of these assets into gold. Gold withdrawals at any time during the next 14 months could occur with damaging political effect on the Administration. It might be promoted for political purposes. We are taking unacceptable risks as long as the imbalance continues. There are more deep-seated costs. You have heard sufficiently of the restraints that the payments weakness imposes on domestic employment policy. It is also notably undermining our foreign policy. Bargaining strength is far more intimately related to the balance of payments than to any other factor. Our troubles this past year with our European allies, France in particular, are not because we are militarily weaker or have less eloquent negotiators than in the past. It is because we are financially weak and our allies have become strong and more than a trifle arrogant as a result. If the weakness continues we will be able to keep our military and economic aid commitments only by borrowing. In consequence we will have the economic and political weakness of a debtor nation. It will soon be noticed that our foreign policy lacks the power, certainty and confidence of the past. This will also have domestic political overtones, for the weakness will be attributed one way or another to the Administration.

There is a feeling among some in the Administration that if the worst came to the ultimate worst these various consequences could be eliminated by devaluation. (Dr. Tobin has influentially taken this position.) So, though it cannot be mentioned, we have an ace in the hole. We have not. Prior to any decision to devalue in our system of checks, news leaks and balances there would be vast press disturbance, huge gold outflows, and deep suspicion of the competence of those concerned, all with the most disastrous political effects. And economists, even the men of reputation, persist in thinking of devaluation (or floating exchange rates) in terms of a small country vis-a-vis the United States. In fact, the devaluation by the United States would bring prompt and immediate devaluation by every other country, including currencies as hard as the Swiss Franc. All this would promptly restore the previous exchange and trading relationships, the previous imbalance, and the previous dependence on external credits.

In turning to measures, we must see first (a) why past action has not worked and (b) what prospective action is needed. For purposes not of criticism but of analysis, it is especially important that we see the defects of past action.

Shortcomings of Past Action

Much useful work has been done on the balance of payments problem. Both the underlying problem and the possible course of action have been considerably clarified in the last two and one-half years. However, our attitude toward the problem has been seriously defective for the following reasons:

1. We have naturally sought to maintain confidence in the dollar. Accordingly, we have been perpetually optimistic about the prospects for turning the balance in our favor. In the course of persuading others, we have repeatedly persuaded ourselves that all would soon be well. Each remedial step—to tie aid, reduce dollar outlays for defense, stimulate trade and tourist travel, and (more recently) to control access to the domestic capital market—has been presented as a total remedy. This optimism has then become the basis of policy until it was evident that something more was needed. There have been so many optimistic forecasts that none would now be taken seriously. This is not good public procedure.

2. We have attached great hopes to policies that were never capable of supplying a solution. And we have seized with inordinate enthusiasm on any available trend in the right direction. There was no chance whatever that increased foreign travel in the United States would have an important effect on the travel account or that Government-sponsored trade promotion activities abroad would importantly affect sales within the lifetime of this Administration. These steps may be useful but the changes they work can only be exceedingly gradual. Recently it has become the cliche, supported by the Brookings study,² that European prices are rising more rapidly than our own. This will be the fundamental corrective. This is unduly optimistic. One of the prime accomplishments of this Administration has been to obtain a measure of control over wages and prices. But there is no real indication that our control is better than that of our European competitors. At any time our prices could go up. And it seems certain that the Common Market governments can bring theirs under greater control if they must. At this moment, in fact, there are indications of adverse movements on our side. Accordingly, it is silly and dangerous to pin our policy, as we are now doing, to so slight a prospect.

3. The balance of payments has fallen afoul of the interests and concerns of individual Departments. The Council of Economic Advisers, in my view quite properly, have considered the balance of payments subordinate to the performance of the domestic economy. The State Department has considered it subordinate to troop strength, trade, and aid. The Treasury Department has until recently considered it subordinate to the maintenance of free capital markets. If all of these interests are protected (I exclude Defense, which has made a serious effort to cut down on its overseas outlays), there is precious little that can be done about the payments balance. Someone’s ox must be gored.

4. The liquidity problem has been used as an escape hatch by the economists. International reserves are unquestionably inadequate. As we make our balance of payments better, that of others will become worse. But more international reserves are not a basic remedy; they only extend the time we have to correct our imbalance. Moreover, as responsibility is now assumed in the world, the negotiation of improved reserve mechanism is only possible when the United States is acting out of generosity and not out of need. The European countries do not see their responsibilities as do we; they will not respond if we are the supplicants. They will, however, be more cooperative when they must.

5. Finally, in dealing with this problem we have had an erroneous view of the national interest. It has been said that trade, aid, and military outlays must not be touched because this would jeopardize the fundamental security of the United States. We have yet to realize how much the payments balance is already jeopardizing our position. A weak balance of payments is undermining our role as the leader of the Western Alliance, making it safe for difficult politicians to thumb their nose at us, weakening our hand on trade negotiation, and making us petitioners on currency matters. This is what is fragmenting the Alliance; by not needing to stick with us each can go off in his own direction. The Alliance would be in far better shape with fewer American troops and a strong American payments balance than a large American soldiery in Europe for which we have to beg from the French or the Germans.

I turn now to action. Three considerations should control our further steps in this field, as follows:

1. The time for purely cosmetic action is past. Hereafter, action must be considered and real. Anything that now smacks of toying with the problem will be damaging to confidence. Nor can we afford to waste more time.

2. It can no longer be held against a measure that it hurts—or that it is inconsistent with existing policy. Everything henceforth will hurt. All untaken action will interfere with some existing policy. Otherwise the action would have been taken.

3. We should bear in mind that determined action in this field may bring far quicker response than we imagine. Germany, France and Italy got out of a seemingly hopeless balance of payments position with amazing speed. Britain has been in trouble at least five times since World War II; each time when she has cranked herself up to determined action (which as with us was what required the effort), the situation was quickly remedied. The Canadians were in bad shape a year ago; a strong move brought quick results. It should be the same, given serious action, with us. This point is important because strong surgical action may do less damage to military, trade, aid, and other important things, including our domestic political situation, than the continuing erosion of half-hearted measures that are not really corrective.

There are five steps in decreasing order of importance which should be a part of the program of what might be called decisive reversal. These are:

1. A moratorium on long-term capital outflow;

2. Appropriate tariff action;

3. Modernized military deployment;

4. Restraint on tourist travel; and

5. Deep tying of aid.

I comment on each in turn.

Long-Term Capital Movements

Control of long-term capital outflows is the first essential in a balance of payments strategy.

It is the least damaging attack on the balance of payments. It means that savings which hitherto have been flowing into foreign investment will now seek domestic use. This will keep our long-term interest rates low, with supporting effect on domestic economy and employment. It has some differential effect on our productivity. Since other countries, including Switzerland, maintain full convertibility while keeping formal or informal restraint on long-term capital movements, there should be no serious loss of international confidence from this moratorium.

The way has now been paved for control by the interest equalization tax and the attendant uncertainty which has brought long-term capital outflow to a temporary halt. However, it is not at all certain that at present rates the levy will be an effective deterrent. Either passage or non-passage of the legislation could bring a renewed outflow. Nor does the levy touch direct investment. We should have a six-months’ moratorium on both. Long-term capital movements are a withdrawal of available surplus; this surplus by definition we do not have. Accordingly, I would urge that even after the passage of the tax (or its rejection) the market be kept closed for at least nine months. The portfolio and issues market could be closed to specifically foreign borrowers under Section 5 (b) of the Trading with the Enemy Act of 1917. Steps should also be taken to see that there is no evasion by way of long-term bank loans. By (say) next July we might have another look to see what relaxation we could afford, subject to the restraining effect of the tax.

Immediately, the 500 largest American corporations plus any others indicated as operating abroad should be circularized by the Treasury with the request that they (a) defer any new direct investment abroad and (b) notify the Treasury of present commitments. If this does not work, stronger steps should be taken under existing law as above. Direct investment is a large item in the Western European countries and if savings are to be appreciable it must be included. Without hurting Canada or the Underdeveloped Countries, for which there would be exceptions, a half to three quarters of a billion (net) of last year’s $2.2 billion deficit could have been covered by suspension of long-term outflow. For this year there would have been a proportionately rather larger saving out of the larger deficit.

Trade

While it is official doctrine in Washington that the trade balance is moving in our favor, in fact the prospect is unfavorable. We have had no gains in the last three years; the merchandise balance has in fact fallen from $5.4 billion in 1961 to $4.1 billion in the first quarter of this year. This is a surplus, as the papers on the subject stress ad nauseum. But our past position has only been strong because this balance on commerical account was relatively much more favorable than now. As noted, this is no reliable assurance that our wage-price situation will continue more to our advantage than that of our European competitors. There is the absolute certainty as things now stand of adverse movements in our tariff position.

Specifically, under the Treaty of Rome it is the unweighted average of tariffs that is being lowered around the Community. This means that we will get tariff reductions in those markets to which we do not now ship goods; we will get tariff increases in our established markets. Since it takes time to develop imports, the damage will considerably exceed the benefit. Meanwhile, the elimination of internal tariffs means that American machinery and equipment and other manufactured products will be subject to the increased competition of tariff-free products from other countries within the Common Market. This adds up in the years ahead to an adverse movement of some magnitude.

Reaction to this matter so far has combined hope with incantation. The papers say the adverse movement must be offset by muscular and masculine bargaining during the Kennedy round. This is self-delusion. Tariffs are in fact being raised against us. We can get them back down only by equal concessions on our side. Our payments balance weakens our hand on tariff bargaining as elsewhere. So present trends will leave us at a real disadvantage. But it is worse than that. We shall be reducing tariffs primarily on European consumers goods which are responsive both to lower prices and high incomes in this market. We shall be offering concessions at least in considerable part on machinery and equipment which, in the view of qualified observers, are procured in the United States less because of their price advantage than because of their technological superiority. In any case, we do know that consumers goods are generally more responsive to tariffs and price reductions than capital goods.

The hard truth is that traditional trade policy is now at odds with the balance of payments problem and no semantic obfuscation can cancel the fact. We should not be surprised. The existing policy was born in reaction to the incongruity of high tariffs in a creditor which had no unilateral transfers abroad. It accommodated the need of foreign countries to make large payments to the United States. The policy remains; the situation has been reversed. If we are going ahead with the Kennedy round we must expect it to worsen the payments balance.

We have come very far down a very dubious path. The historic method of correcting a payments balance has been to raise tariffs and raise domestic prices. It is probably the best method of accomplishing the result—and one that is most consistent with a free price system and minimum controls. Present policy is to go in exactly the opposite direction. We are planning action that makes our balance of payments action more perilous. There are also interesting questions of priority. Are we to expand our imports of luxury automobiles, fine woolens, and other expensive European products at the same time as we limit travel freedom or redeploy troops?

The issue is eased by the time-consuming character of the negotiations. It will be some months before they begin and a considerable period thereafter before there are any cuts. This quiet but calculated delay can hold off adverse effects for some time. This I recommend as a minimum. It would limit the damage by unveiling a tariff round that must weaken us beyond what is inherent in the forming of the Common Market.

There is a strong case for suggesting that we should go in the opposite direction. Tariffs are being raised against us in Europe. We need to cut back on imports of consumer products. The logic of this situation is an offsetting surcharge on manufactured products from the Common Market Countries as the best way of getting our balance of payments turned around. Even from the viewpoint of the proponent of liberal trade, this might be the best way of righting our position promptly and with minimum damage. The long erosion of lesser measures could be worse. There would, presumably, be some retaliation by the Common Market Countries. But our farm exports to the Common Market Countries, grain especially, are on a residual basis and retribution would hurt the exporter. Machinery and equipment exports are related to the technological situation and retribution here would also hurt the buyer. However, a step of this kind is probably beyond the range of present attitudes. The psychological turn-around would be very great.

Defense Outlays Abroad

I am impressed by the efforts that the Defense Department has made to cut its expenditures abroad. I am persuaded that no further efforts should be made in this direction which seem to discriminate against military personnel. Limitation on travel by dependents and limitation on personal expenditures by the military abroad, particularly so long as nothing is done about expenditures of tourists and wealthy American residents abroad, is palpably discriminatory.

I would urge, however, that continuing and forceful attention be given to a more modern deployment of troops. It is much more important to our position to have a strong balance of payments than to have any given number of divisions in Europe. Modern airlift capacity gives us a choice which we did not have 10 years ago as to whether troops are stationed in forward positions in Europe or in the zone of the interior of the United States. We should increasingly exercise the option in behalf of stateside locations. This is not withdrawal or redeployment; rather it is an accommodation to the mobility of the modern force. Long-range combat aircraft are providing much the same opportunities for the Air Force. Our terminology should reflect this fact. The semantics are important. We should speak not of redeployment but of (say) multiple-base operations. Gains from this source will take time to realize but are obviously important.

Tourist Travel

Much attention has been paid in recent discussion to the increasing outlays for travel from $1.0 billion in 1954 to twice that amount this year, with another $400 million on foreign flag carriers. There is no chance of appreciable offset from foreign travel in the United States—American expenditure increases $100,000,000 a year, while foreign expenditure goes up $35,000,000. Nor is there relief from the Travel America program. Both are useful but have their principal quantitative effect on the volume of wishful thinking.

To control tourist travel means to control the movement of people, with attendant political and administrative difficulty and annoyance. A tax on passports would be highly regressive. A per diem tax on days spent abroad would have a particularly adverse effect on students, artists and writers, who have the best of reasons for foreign residence. However, it would be possible to have people declare expenditures abroad on their income tax and subject outlays so declared to a surtax. This latter would be little more subject to abuse than the deductions presently allowed under the income tax. Control could be exercised in various ways, including certified and attested exchanges of money. It would exempt the low-income traveler—the person who spent less than say $750 abroad. It would reach the higher-spending traveler and would also be a device for guiding traffic to American flag carriers were purchases of tickets on such carriers excluded from the tax.

This would require new legislation. We should start work on the tax, but defer a final decision until the beginning of the next legislative year. The amounts involved are difficult to estimate. Perhaps we would do well if we checked the present increase.

Deep Tying of Aid

As a last step, and one with longer run implications, we must begin to extend aid-tying to include dollars which, in the absence of such assist-ance, would have to be spent in the United States. There is always danger of using aid for purchases that must come from the United States market and free dollars earned in American trade somewhere else. In the past, I have urged, unsuccessfully, that countries like India agree as a quid pro quo to direct an increasing proportion of their free dollar purchases to the United States. This proposal has run afoul of the liberal trade-at-any-price policy. I am now inclined to think it insufficient. Instead, we should move toward a policy of partial financing. Both project and non-project assistance abroad would be covered not 100% of dollar requirements but some specified percentage of the total. The aid, though of an equal total, would be spread over a large number of projects and purchases. Countries thus would have an inducement to direct purchases now going to other countries to the United Sates and to use dollars for this purpose. Our aid would thus become a direct inducement to dollar trade; our aid, if you will, becomes a massive but quite legitimate subsidy to our dollar trade. Other developed countries that object have the option of effecting similar arrangements. This would not bring any short-run change. It would take the balance of payments problem out of the aid program in the longer run. My judgment on this particular recommendation is not final, pending a study now being undertaken by David Bell.³

Conclusion

The foregoing program is not agreeable. But I would not judge there is any part which I now propose that is insuperably difficult.

I would urge that we take a decision on four matters—the moratorium on capital exports, the administrative delay on the Kennedy round, the further military program, and the deep tying of aid—at this time. The tourist expenditure tax should be ready if the prospect still seems grim when Congress assembles. We have time on this before the next travel season. The temporary surcharge on imported consumers’ goods is a drastic turn-around in policy. I have an uneasy feeling that it will still be necessary in the end, the consequences notwithstanding. Those who are troubled by it should not go too far out on the limb for, by historical standards, it is the most commonplace as well as the most certain of all the remedies available.

0. Source: Kennedy Library, President’s Office Files, Treasury, 8/63-11/63. No classification marking.
1. Not further identified.
2. Not further identified.
3. A draft memorandum from Bell to the President, October 29, prepared by Francis Bator (AID/AA/PC), comments on Galbraith’s supertying proposals, but on an attached note from Frederick Simmons (AID/EXSEC) to Bell, October 30, appears the handwritten notation, “Not sent. Can now be filed. DB 2/7”. (Washington National Records Center, RG 286, AID Administrator Files, FRC 67 A 1530, Balance of Payments, FY 1964)