Foreign Relations of the United States, 1981–1988, Volume XXXVIII, International Economic Development; International Debt; Foreign Assistance

126. Memorandum From Norman Bailey of the National Security Council Staff to the President’s Assistant for National Security Affairs (Clark)¹

Washington, August 12, 1982

SUBJECT

• The Impending International Financial Crisis

This memo is in response to a comment by Bud McFarlane on the last item of my August 6, 1982 Weekly Report (Tab I).² Instead of writing a memo to the President, I decided to lay out the matter in a memo to you so that you can digest it and then decide whether you want to show it to the President.

Since I joined the Administration, I have had direct responsibility on the NSC staff for international monetary and financial matters. I immediately went to work trying to set wheels in motion so that the government would begin to take the measures necessary to face up to the possibility of an international financial crisis due to the following factors:

— The buildup of a huge pyramid of international debt, much of it unproductive and unsecured.

— Gradual withdrawal of Western commercial banks from traditional balance of payments Eurodollar lending to the semi-developed non-oil producing countries due to having reached exposed ceilings and the assessment of inordinate risk.

— A decline in OPEC surpluses available for recycling.

— Historically high bunching of debt maturities (46% in 1982).

— A long period of historically high real interest rates.

— A worldwide recession.

— A substantial decline in commodity prices.

— Possibility of a domestic financial panic spilling out into the international arena.

Recently, the signs of crisis have multiplied, including:

— Sovereign risk reschedulings and de facto defaults at a level not seen since the depression. At the moment, the countries of greatest concern are Poland, Romania, Mexico, Sudan, Zaire and Argentina, totalling some $156 billion in private and public debt. Several other important debtors are on the brink.

— Domestic financial crises due to the liquidity crunch being added to severely impaired industrial and banking solvency, including the Alfa Group in Mexico; Dome Petroleum and Massey-Ferguson in Canada; AEG Telefunken in Germany; Banco Ambrosiano in Italy, and Drysdale, Braniff, International Harvester, Penn Square and Abilene banks, etc. here. Some of our largest and most prestigious banks, such as Continental Illinois, Chase and First Seattle have been damaged. The situation of the savings banks and the S&L’s is well known.

There is one international banking system now. No country can any longer isolate its banks from a systemic crisis. The bulk of the Eurocurrency market, now perhaps one trillion dollars, consists of interbank deposits based on which international lending takes place. Most of these deposits are short-term (from overnight to one year). Much of the lending is medium- or long-term. If a bank or a banking system gets into serious trouble, its first move will be to withdraw its interbank deposits in other banks as they mature. They will then do the same to try to protect their liquidity and the whole structure will literally implode, with quantities of unsecured credit simply disappearing from the system, but leaving the legal debt obligations of the borrowers intact with no way to fund them.

Government awareness of the dangers has increased somewhat. The Interdepartmental Working Group on LDC and Eastern European Debt has produced some useful papers (it reports to the CCEA).³ The International Monetary Group is finally taking up a Federal Reserve paper dating from April suggesting enhanced borrowing power for the IMF to confront such situations (curiously, the Fed, which a year ago was most airily unconcerned, is now the most concerned agency). I have recommended that the matter be taken up by the SIG–IEP. I was unable to get consideration of the issue at Versailles.⁴

The sense of urgency in all of this is, in my opinion, completely inadequate. The bureaucracy is grinding along with agonizing slowness, and with the exception of the Fed paper mentioned above (taken up four months after submitted), there aren’t even any concrete suggestions being made. I know from personal experience that the Europeans and the Japanese would welcome an initiative on our part along the lines of increased swap lines among central banks, Ministries of Finance and the Bank for International Settlements, and strengthening of the IMF in this area. Unfortunately, not only Versailles but the IMF/IBRD September meetings will be wasted from this standpoint.

However, although absolutely essential, all this is insufficient in the longer run because it addresses the symptom (illiquidity) and not the disease (insolvency). For the latter to be addressed, there must be a fundamental change in Federal Reserve policy and preferably also in Federal Reserve structure. This, however, is out of my area of direct responsibility.

I attach a table indicating the magnitude of the problem (Tab II).⁵

RECOMMENDATION:

That you show this memo to the President, if you feel it to be appropriate.⁶

1. Source: Reagan Library, Executive Secretariat, NSC Subject Files, International Debt Situation (5/82–9/82). Confidential. Sent for action. Copies were sent to Nau, Weiss, and Robinson. Wheeler initialed the top right-hand corner of the memorandum.
2. The last item of Bailey’s August 6 Weekly Report and McFarlane’s comment on it, Tab I, is attached but not printed. Bailey reported on the August 6 CCEA meeting: “The most important aspect of the meeting was Secretary Regan’s announcement that the Mexican government has closed its markets and declared a financial crisis. I despair at getting the government to realize and react to the magnitude and imminence of the impending international financial and monetary crisis.” McFarlane wrote in response: “Why don’t you lay this out in a memo to the President? RCM.” Minutes of the August 6 CCEA meeting are in the Reagan Library, Office of Cabinet Affairs, Southwest Border Initiative, OA 09972, Cabinet Council Minutes 1981–1982 [Binder] [Cabinet Council on Economic Affairs].
3. “Useful papers” are not further identified.
4. Presumably a reference to the Versailles Economic Summit, which took place June 4–6.
5. Tab II, the “LDC and EE Debt Burden Table,” is attached but not printed.
6. Clark checked the “No” option and wrote “President has been briefed” under it.