Foreign Relations of the United States, 1964–1968, Volume XII, Western Europe

262. Memorandum From Secretary of the Treasury Fowler to President Johnson¹

Washington, July 18, 1966.

SUBJECT

• The Sterling Crisis and the U.S. Bargaining Position vis-á-vis the U.K.

The Situation

—Last week’s severe losses—$200 million on Friday alone—followed a month of weakness. If they do not take severe measures, they very likely will face an avalanche by the end of next week. (The U.K. reserve position is set forth at Tab A.)²

—As you know, on the telephone on Friday, Callaghan promised a powerful package of demand-compression and wage restraint, to be announced Wednesday.³ He was confident that Wilson would be backed by a united Cabinet. According to Callaghan, the only seriously divisive issue involved cuts in overseas spending, i.e., defense and aid. De-valuation, he said, is out. (A record of my telephone conversation with the Chancellor is at Tab B.)

—Even if the Wednesday measures scare away the bears—and certainly if they do not—we will face some critical choices. This memorandum is to report the views of your advisors about these choices. It is based on extended discussion on Saturday morning between myself, Secretaries Rusk and McNamara, and Messrs. Ackley, Rostow, Barr, Deming, Bator, Solomon, and Okun.

There are basically two possibilities:

I. The U.K. actions on Wednesday are successful in keeping the bears at bay and bringing U.K. payments into balance during the next few months.

(1) This outcome is quite possible. Callaghan sounded both determined and appropriately scared. The New York Fed’s foreign exchange expert, Charlie Coombs, is convinced that a strong package would lead to substantial reflow of money into London—much like last September. In any case, we will know, one way or the other, fairly quickly.

(2) But no matter how successful the program is in stopping the speculators, and eliminating the deficit, it cannot be a permanent cure. It will “solve” the U.K. payments problem, but at the cost of recession now, and, over the longer pull, unacceptable unemployment and little or no growth. Wilson will still be up against the basic problem faced by every British government since the post-war recovery—how to keep his international payments in order and, at the same time, keep unemployment at a tolerable level and maintain a good rate of growth.

(3) In the face of that prospect—and in the face of the mounting political pressures on him to back away from a policy of deflation (and perhaps wage freeze), Wilson may decide that, in order to resolve his long-term dilemma, he must:

(i) Save several hundred million dollars of foreign exchange by cutting back on defense East of Suez and in Germany. (At Tab C is a table giving the foreign exchange costs to the U.K. of its present defense positions in Malaysia, the Persian Gulf, Germany, etc. The balance of payments cost in the Far East is about $200 million per year.)

(ii) Reduce domestic spending for defense, in order to make more domestic resources available for export and investment—they will have a tough time meeting their defense commitments without running way over their 1970 target for defense spending (5-percent of GNP. The present budgetary costs of overseas defense, by area, are also set out at Tab C. The Far East costs about $750 million per year, about 13 percent of the U.K. defense budget and about 0.8 percent of GNP.).

(4) Quite apart from the economics, there will be great political pressure on him to reduce defense spending—especially East of Suez. Absent such action, he will be accused of making his unemployed pay for a neo-colonial policy, under pressure from Washington.

(5) This is where we come in. So far, the U.S. position has been that:

• —The U.K. must remain in full force in the Far East ($200 million in foreign exchange; $750 million in budget costs);
• —They must keep the full British Army on the Rhine ($238 million in foreign exchange, about 50 percent offset; $504 million in budget cost);
• —They must get their balance of payments in order without devaluation, or exchange controls, or permanent restrictions on trade;
• —There is no more U.S. money to bail them out in case they run into trouble.

(6) It is more than likely that Wilson will say that he cannot do all that without more help from the U.S.—that it would involve his keeping his economy in a permanent state of recession. Specifically, he might face us with an implicit “more money” or “cut East of Suez” choice. His tactic would be to propose a cut-back in Malaysia during ′67-′68, on the ground that “confrontation” has ended. If so, our options will be as follows:

(i) We can, after some preliminary bargaining, offer him an extra $200 million per year through arms sales and U.S. redeployment from the Continent to the U.K. This would cover his Far East foreign exchange costs. Bob McNamara believes we can do this without any significant balance of payments cost to the U.S., simply by shifting to the U.K. defense dollars now going to France and Germany (on top of what the Germans offset). All your advisors agree that this would be a worthwhile bargain. Defense and State are working on a possible package.

(ii) This may not turn the trick. Wilson may feel that he has got to cut back in the Far East even if his direct foreign exchange costs are covered. He may feel that the domestic, defense-budget cost of his present Far East position ($750 million, 13 percent of defense budget, .8 percent of GNP) is unacceptable—that he needs to free up the resources involved for investment and exports. Further, he may feel that, even apart from economics, the political cost is too great.

(iii) If Wilson turns down a U.S. offer which would cover his Far East foreign exchange costs, our choices will be more painful, and your advisors are of two minds:

• —Bob McNamara still believes that it is absolutely essential that the U.K. remain in the Far East. For the next year or two, he thinks anything which will smell of a British pull out will fatally undermine our domestic base on Viet Nam. Further, he believes that confrontation in Malaysia will, in fact, continue indefinitely and is determined that it remain a British responsibility.

• —I, myself, believe that, if we adopt Bob’s position—and Wilson goes along—it will either cost us a weak Britain and a great deal of balance of payments money or, even more likely, a weak Britain and an eventual devaluation of sterling. Either would have disastrous consequences for the dollar—and for our international political position. I do not believe that this, or any other U.K. government, will be willing to sacrifice its domestic goals to maintain an overseas position in which it does not believe, for the sake of a friend—unless that friend is willing to pay for the favor. And I do not think we can afford the price, either in terms of money now or in terms of an implied open-ended call on U.S. money in case of trouble later.

  My own position is that our first priority should be to move the United Kingdom to save its long-term economic and financial position and thereby to prevent potentially disastrous consequences for the United States, our over-all foreign policy, and the stability of the Free World financial system. A weak ally is of no use to us East of Suez, in Europe, in the international financial set-up, or anywhere else. This priority suggests that we must leave it to the U.K. government to decide what it must do, short of devaluation, to save its national position. It would be contrary to this priority for us to lean on the Prime Minister to do something he would not otherwise do. If we do, we will pay a large price many times over, and damage both the pound and the dollar. In other words, I would not go beyond the terms of the $200 million package suggested in the first paragraph, (i), above.

• —Secretary Rusk agrees with Bob that it is important to us that Britain hold up its end in the Far East. However, following his conversations with Michael Stewart in Canberra, he is skeptical whether we can keep the U.K. in a meaningful Far East role at any price. He doubts whether they have it in them to stick it out. You will, of course, want to hear his views—as those of Bob—in person.

(7) I have assumed that the implicit choice will be:

(i) pull out from East of Suez, or

(ii) more money now, or

(iii) a progressive deterioration of sterling during 1967-68 (with devaluation or more bail-out money at the end of the road).

It is possible that, as an alternative, Wilson will say that they must cut either East of Suez or in Germany. A sharp cut in the British Army on the Rhine will appear particularly attractive to London if the Germans do not improve the U.K. offset. (They are currently bargaining, with a report due to the two governments in September.)

(8) On a Far East versus Germany choice, you will wish to have a separate memorandum spelling out the arguments. Bob McNamara would clearly prefer a substantial British cut-back in Europe over any reduction in the Far East. I don’t know Secretary Rusk’s views on this. I suspect that a number of your foreign policy advisors would vote the other way. They would be worried about the strain imposed on German politics, the consequences for Britain’s prospects for going into Europe, and an unhealthy, excessive German dependence on the United States.

II. The second possibility is that the Wednesday package will not do the trick.

This could happen because the package is inadequate in terms of the basic deficit. I told Callaghan it would be better to be safe than sorry, but his (perfectly honest) notions of strong action may be different from mine. Or, although adequate in terms of the basic payments position, it might not convince the world, especially the speculators. In either case, sterling would remain teetering on the edge. The marginally more likely prospect would be for continued erosion over several weeks, with a series of bad Fridays culminating in a disastrous run during the late summer or autumn. The alternative would be a really massive run within the next week or two.

In either case, we would face the same choices we faced last summer:

(i) We could put up more bail money. I do not believe we could count on getting help from the Europeans, and I would vote, as I did last summer, against putting up a nickel on our own.

(ii) A large devaluation of sterling (e.g., 25 percent), which would be followed down by everyone else.

(iii) A controlled or small devaluation, followed by only a few sterling area countries and no one else. (This is the outcome we would work for, but it would not be easy to convince the U.K. A small devaluation tends to be unconvincing and may make the speculation worse.)

I believe our contingency plans, worked out last summer and kept updated (under Fred Deming’s chairmanship, by Messrs. Bator, Okun, Solomon, and Dewey Daane) are in good shape. I will be prepared to discuss them with you on a separate occasion at your convenience.

We will need a full-dress meeting with you and your other advisors during the early part of this week.⁴

Henry H. Fowler ⁵

1. Source: Johnson Library, Bator Papers, UK Problem. Secret; Very Sensitive. A handwritten notation on the memorandum reads: “Talked of this with Deming’s help over weekend.”
2. None of the tabs is printed.
3. On July 21 the Wilson government presented 500 million pounds in budgetary cuts to Parliament.
4. The meeting was held July 22. According to Bruce: “I made my spiel, suggesting we have not only a short range but a long range policy toward the British. Ball proposed, among other things, we push them into the Common Market…. Rusk supported him. Joe Fowler thinks they are over-extended in their commitments. The President listened but was cryptic in his comments.” (Department of State, Bruce Diaries: Lot 64 D 327)
5. Printed from a copy that bears this typed signature.