Dateline Wall Street: Faustian Finance

The current solution to the international debt problem is disturbingly similar to the policies and processes that created the crisis in the first place.

On Friday, Aug. 13, 1982, as one U.S. Treasury Department official describes it, Mexico's Finance Minister Jesus Silva Her­zog "showed up on our doorstep and turned his pockets inside out." His arrival marked the beginning of an international debt crisis that by Christmas had swept through more than a dozen debtor countries and a thou­sand creditor banks and placed more than $300 billion in international loans in jeop­ardy.

Poland's and Argentina's debt-servicing difficulties had preceded Mexico's, to be sure, but did not have the same systemic impact. Mexico's liquidity crisis has in a few short months altered the way in which banks and governments now deal with international debt problems, and more im­portant, how they deal with each other.

For the first time, the International Mon­etary Fund (IMF) is applying conditionality to lending banks as well as to borrowing countries. IMF Director Jacques de Larosi­ere announced in November 1982 that the Fund package for Mexico could not prog­ress until the banks had agreed to provide $5 billion. Indeed, he refused to take the program to his board of trustees until the banks committed themselves on paper. The United States and other member gov­ernments supported him, and the banks agreed. This pattern was repeated in assem­bling rescue packages for Argentina, Brazil, and Yugoslavia.

Such IMF activism contrasted sharply with the Reagan administration's vision of the Fund's role. President Ronald Reagan came into office pledging to reduce U.S. financial support and participation in the IMF, the World Bank (International Bank for Reconstruction and Development), and related financial organizations, which he regarded as insufficiently responsive to U.S. foreign-policy directives. But as the magni­tude of the Mexican debt problem became apparent and as other countries of strategic concern to the United States approached the financial abyss, the administration turned to these same organizations for help in containing the debt crisis.

The debt crisis has also changed the attitudes and practices of the commercial banks, which historically have resisted at­tempts to intervene in their international operations by their governments and by international agencies. Now hailing a new era of cooperation with officialdom, the banking community is actively lobbying Congress to support the IMF quota increase and funds for the international develop­ment banks.

How did this dramatic transformation come about? What does this change portend for the future management of the interna­tional monetary system? The agreement governments and international agencies reached with the banks resembles nothing so much as a Faustian bargain, in which the governments may pay too high a price to secure the cooperation of the banks.

The Bounty of Petrodollars

Many have hailed the recycling of petro­dollars-the lending of hundreds of billions of dollars from the wealthier oil-exporting countries to Eastern Europe and to the less developed countries (LDCS) that are not part of the Organization of Petroleum Exporting Countries (OPEC) by U.S. and other private commercial banks-as the economic success story of the 1970s. The ease with which countries were thus able to finance chronic and growing balance-of-payments deficits, rather than having to reduce imports and slow growth, created the illusion that no lasting economic costs attended the quintu­pling of oil prices in 1973 and their more than doubling in 1979.

The larger U.S. and British banks led the way, but other banks quickly realized that they would have to join in the recycling effort or become uncompetitive. In the mid­-1970s the return on foreign loans was sub­stantially higher than on domestic loans. In 1976, for example, Chase Manhattan Bank classified 48 percent of its assets as interna­tional and attributed 78 percent of its earnings to those assets. Loans to Latin America produced 20 percent of Citicorp's earnings though they represented only 6 percent of its assets. Later, when regional banks joined the fray, and West European, Japanese, and eventually Arab banks began fighting for a share of the market, the competitive scramble pushed profit margins on foreign loans sharply lower--with no­table exceptions, such as loans to Brazil. But in this era of aggressive bank expansion, growth of assets was more important than return on assets.

Floating rather than fixed interest rates­, that is, interest rates adjusted about every six months to reflect changes in market rates -- protected the banks against the risk that the cost of funds would rise more rapidly than income from the loans. But the banks all but discounted the possibility that sovereign borrowers would default. As Wal­ter Wriston, chairman of Citicorp, argued, countries never go bankrupt. And the nar­row spreads between what the banks had to pay for funds and what they charged for these loans provided little insurance against this eventuality. For sound credit risks like Mexico, this spread could be as little as 0.5 percent over the London interbank offered rate (LIBOR).

The governments of the industrial coun­tries applauded the banks' recycling suc­cesses. Unwilling or unable to confront OPEC over the oil prices, these governments were only too happy to be relieved of responsibility for managing the resulting international financial dislocations.

Some bankers now claim that their gov­ernments pushed them into this lending. This charge has some validity with regard to loans by West European banks to East European countries. But more generally, it is fair to say the central banks, finance ministries, and bank regulators in the United States and other major creditor countries at each stage of the emerging crisis did nothing to moderate the pace of international lending by the banks. Indeed, each time a problem arose that might dis­courage this activity, governments rushed to restore confidence in the markets and to make the world safe for more lending.

In the early 1970s, for example, the IMF tried desperately but in vain to keep foreign banks from supplying unlimited credit to Pertamina, the Indonesian state oil com­pany, in clear violation of that country's standby agreement with the IMF. When Pertamina eventually found itself unable to service the $8 billion in foreign bank loans it had accumulated, the U.S. State Depart­ment and U.S. bank regulators nevertheless intervened to keep a Dallas, Texas, bank from calling a formal default. They then pressured the Indonesian central bank into taking over Pertamina's bank debts to save the banks involved from any losses.

Early 1977 saw a forerunner of the later crisis. Peru, Turkey, and Zaire were experi­encing debt-servicing difficulties. On March 15, David Rockefeller of Chase Man­hattan Bank warned in a speech: "Bank debt to a number of these countries has been expanding at a rate that should not -- and cannot -- be sustained."

Briefly, there was talk of governments' having to assume more of the burden of recycling. Instead, IMF members, including the United States, established a $10-billion Supplementary Finance Facility, arguing that it would restore confidence in the marketplace and encourage the banks to continue lending.

From late 1977 to mid-1982, loans to non-OPEC LDCs tripled, from $94 billion to $270 billion. Yet the Carter administration continued to consider debt problems man­ageable. Anthony Solomon, then under­secretary of the Treasury, confidently as­serted that "there is absolutely no prospect of a debt rescheduling in regard to Mexico and Brazil."

In November 1979 the Carter administra­tion froze Iranian bank deposits and then conveniently allowed major American banks, which feared repudiation of the Shah Mohammad Reza Pahlavi's debts by the revolutionary Islamic regime, to use the frozen deposits to offset -- that is, to pay of -- the loans.

In each case, the governments clearly had broader policy objectives in mind than just helping the banks. The U.S. government hoped to prevent destabilization of the Indonesian government or deterioration of relations with this important oil producer; the Iranian asset freeze was also retaliation for the seizing of American hostages in Tehran. But the cumulative effect of these actions was to reinforce the banks' percep­tion that lending to sovereign states meant no-risk lending: Whenever a serious prob­lem arose, the banks' own governments would rush to the rescue. But the system could not absorb the multiple shocks of the 1979 oil price increase. Governments were unprepared for the unthinkable -- a simulta­neous debt crisis in the two biggest sover­eign borrowers, Mexico and Brazil.

Managing Mexico

Mexico's financial collapse has badly shaken both the international credit struc­ture and confidence in the recycling proc­ess. Federal Reserve Board Chairman Paul Volcker appears to have been the key actor in the latest debt drama. A White House official says Volcker "thought the banking system was about to collapse" when the Mexican crisis broke.

The Federal Reserve system (Fed) knew that the Mexicans were in trouble as early as winter 1981 to 1982, during the final months of Jose Lopez Portillo's presidency. That February the Mexican central bank drew on its swap line with the Fed, which allowed it to get dollars for pesos without buying them in the market. The drawing was quickly repaid, but the Fed interpreted the Mexican action as an indication that Mexico's dollar reserves were running low and that the country was experiencing a significant cash-flow problem. A February devaluation apparently did not solve the problem. The Bank of Mexico continued the pattern: It drew $600 million on April 30 and repaid; drew $200 million on June 30 and repaid; drew $700 million on July 31 and repaid; and drew $700 million on August 4. U.S. and foreign commercial banks con­tinued to lend to Mexico through most of this period, although a huge loan syndicated in May and June met with some market re­sistance. Yet the Fed did not discourage the banks, fearing that a halt in bank lending would only aggravate the situation. Like the banks, the Fed thought the problem could be managed until a new administration took charge in Mexico City in December.

Unfortunately, while foreign bankers re­tained confidence in Mexico, the Mexican people had lost theirs. They were shipping dollars out of the country faster than the government could borrow them back. It was this outflow of foreign exchange, far more severe than either the commercial banks or the U.S. government realized at the time, that precipitated the crisis in August and forced Silva Herzog to make his humiliating pilgrimage to Washington.

The Treasury moved with uncharacteris­tic speed in putting together a $2 billion U.S. emergency financing package for Mex­ico during that first critical weekend. At the Fed's urging, Mexico decided to declare a 90-day moratorium on the repayment of the principal of its foreign debts and threw itself at the mercy of the IMF. On the other side of the equation, by emphasizing the peril to the international economy, Volcker managed to reverse the Reagan administra­tion's strong ideological bent against official intervention either to help the banks or to pump more money into the international lending agencies.

While Volcker worked with Treasury in Washington to construct the U.S. aid pack­age for Mexico, the New York Federal Reserve Bank joined major creditor banks, Citicorp and Morgan Guaranty Trust, in gathering more than 100 of Mexico's com­mercial creditors for a meeting in New York the following Monday. Ostensibly, the Mexicans called the meeting. Nevertheless, Anthony Solomon, the president of the New York Federal Reserve Board, opened the gathering to explain the short-term aid that the U.S. government had extended over the weekend and to express strong U.S. government support for Mexico. Silva Her­zog then took the floor to justify Mexico's 90-day moratorium and to ask for time to work out a restructuring package. The selection of a 12-bank advisory committee to conduct negotiations with Mexico on behalf of the hundreds of creditor banks was announced. No one from the IMF was present.

From the banks' perspective, the Fed has been the chief U.S. government policy-mak­ing agency throughout the debt crisis. Sec­retary of the Treasury Donald Regan and Secretary of State George Shultz have both been active in the cabinet-level Senior Inter­agency Group, which Regan chairs and which has been meeting weekly on the debt situation. And Undersecretary of State Lawrence Eagleburger has carried a mes­sage to the banks that cutting off credit to Yugoslavia and Mexico, in particular, would be contrary to national security interests. But the Regan Treasury is held in low regard by the banking community. One banker, expressing what seems to be a widely shared sentiment, comments that "in this Administration, there really is no one at Treasury to talk to." And many bankers say they are not swayed by foreign-policy arguments. "State Department appeals to patriotism affect us very little. These are appeals to values on which management doesn't get graded or rewarded by the Board," explained Charles F. Turner, senior vice president of Comerica Bank of Detroit, Michigan.

The United States also pushed the IMF into a more assertive role in managing the international debt crisis. Says one IMF insider, there was "big pressure from the United States to get a big package for Mexico." Pressure was necessary because at first the West Europeans held back, appar­ently to remind the United States that it should have been more forthcoming in dealing with Poland's debts. Both Volcker and Solomon, says this source, strongly urged the Fund to take the lead in rallying the banks to come to Mexico's aid. This new activism seems compatible with de Larosi­ere's own instincts.

De Larosiere personally took charge of the next large bank meetings on Mexico and Brazil and laid down the terms for a joint solution. By December, Brazil had also run out of cash and was unable to service its $87 billion foreign debt. The IMF director told the banks flatly that the IMF would not support the restructuring proposed by the Brazilians unless the banks agreed to put up $4.4 billion in new money.

The banking community's reaction to this official intrusion in their affairs can best be described as one of relief. Leeds Hackett, senior vice president at Marine Midland Bank in New York, said: "At first we said, 'Hey, wait a minute, you're [de Larosiere] telling us we have no choice.' Now we realize we must all be in this together." Another New York banker, re­calling the many months of bitter wran­gling over Poland's 1981 debt rescheduling, says: "Left to themselves the banks will squabble. Someone has to say, 'You do X.' " Says Turner of Comerica: "The IMF'S ag­gressive role signals a new era and a wel­come one. A private sector entity can't command the necessary steps to get Mexico to put its house in order."

It is not difficult to determine why the banks are pleased with the new crisis-man­agement process. Their principal concern is to protect their balance sheets and their earnings. The quick extension of bridging loans from various central banks and subse­quent IMF drawings have prevented any significant disruption of the flow of interest payments from the debtor governments to the banks. Indeed, the Fund is acting as enforcer of the banks' loan contracts be­cause continued access to IMF funds is contingent on the debtor's regular pay­ments on its commercial interest. Moreover, the IMF's austerity programs are designed to free foreign exchange in order to service debts.

Although the banks are not happy about being asked to commit new money to troubled borrowers, they realize that unless they supplement what the Fund and the governments provide, some countries will be unable to keep up the crucial interest payments. Mexico, for example, owes the banks about $8 billion in interest in 1983 but will get only $1.3 billion from the Fund this year.

Moreover, the Fed and the IMF have given the banks a free hand in setting the terms for new bank loans and rescheduling. The banks have seized this opportunity to triple the spread charged on new money for Mexico and to tack on further substantial fees. They have also sharply increased the interest margin charged on rescheduled loans and extracted additional fees. Spreads and fees added to the base interest rate ­either LIBOR or the U.S. prime rate will cost Mexico about $800 million in 1983. Consequently, loans to troubled borrowers like Mexico and Brazil are for the moment among the most lucrative assets the banks have on their books. Bank earnings in the last two quarters have swelled. As one banker crowed in an unguarded moment about one recent reschedulee: "That coun­try is a cash cow for us. We hope they never repay!"

Not everyone is so enthusiastic. Martin Feldstein, chairman of the president's Council of Economic Advisers, has ac­knowledged these high rates make economic recovery and continued debt servicing by the debtor even more difficult. Volcker agrees but argues that "we can't force terms on the banks without creating another crisis of confidence."

The Fed and the IMF have also been quite helpful in insuring that the large U.S. banks that have the most at stake in Latin America are not abandoned by regional banks or by West European banks that believe they have enough on their hands with Poland. Ac­cording to West European banking sources, Volcker, for example, made a midnight call to Fritz Leutwiler, chairman of the Bank for International Settlements in Basel, Swit­zerland, and president of the Swiss Nation­al Bank, to insist that he pressure recalci­trant Swiss banks to contribute their fair share of new money to Brazil. De Larosiere has reportedly also intervened with West European and Japanese banks.

Volcker admits: "We're all being induced to close our eyes to loose banking practices."

It was not the IMF but the bank advisory groups that decided to allocate contribu­tions to the new package the IMF had ordered the banks to lend to Mexico on a pro rata basis among all banks with expo­sure in Mexico. The advisory groups were set up to formulate policy for each of the major debtor countries and are dominated by the biggest banks. The Fed and the IMF, however, have officially endorsed the loan packages designed by the bank advisory groups.

Some smaller American banks are com­plaining that the big banks are giving orders and that the Fed and the other regulators are supporting them. Richard Cummings is vice chairman of the board of National Bank of Detroit, which has a $200 million Mexican exposure. The bank has refused to increase its exposure by the mandatory 7 percent, despite "low key" calls from the Chicago Federal Reserve Bank, from Fed­eral Reserve Board staff members, and from the comptroller of the currency. Says Cum­mings: "The role of the Fed and the comp­troller of the currency is to protect the soundness of U.S. banking. I'm not sure that requires leaning on me to roll over my Mexican exposure and extend maturities. When they tell me to lend more, I ask, 'Is it guaranteed by you?' "

Of course, the large banks are not without leverage themselves. Each U.S. bank be­longing to one of the new country advisory committees is put in charge of a group of regional American banks, to keep them informed on negotiations with the debtor ­and to keep them in line. The big banks call it "baby sitting."

Dennis Weatherstone, chairman of the executive committee of the board at Mor­gan, who has been in charge of raising new money for Brazil, says there have been no threats against smaller banks. Nevertheless, banks that refuse to cooperate without a good reason, banks that are "seen as being bloody minded, will be remembered."

Under this pressure only six banks of more than 500 took no part in the new loan for Mexico, although there is some resistance to maintaining short-term credit lines. Wil­liam Lamoureux, vice president of Rainier National Bank of Seattle, Washington, says his bank has no choice but to participate in the rescue effort. "No one is going to buy us out and Mexico can't pay. The bank adviso­ry group rep who called us said: 'It's like Butch Cassidy and Sundance Kid, let's all hold hands and jump.' "

Finally, although both banks and gov­ernment officials vigorously deny it, there is an implied, if not an explicit, government guarantee for the new loans to Mexico, Brazil, and other presently uncreditworthy borrowers. The loans are, after all, part of a comprehensive rescue package assembled under the auspices of the IMF and individ­ual governments.

Bank supervisors have already granted the new loans privileged status. Volcker admits: "We're all being induced to close our eyes to loose banking practices." Private Mexican borrowers, for example, fell badly behind on their interest payments to U.S. banks in 1982 because of a lack of foreign exchange. But U.S. regulators allowed the U.S. banks to treat pesos deposited by Mexican companies in escrow with the Mexican central bank as current income for 1982 even though there was no assurance when, if ever, dollars would be available to complete the payments. The central bank committed itself to nothing more than making "best efforts" to find the dollars. One New York banker says his own ac­countants were quite reluctant to treat the peso payments as income to the bank even though the Fed had given its approval. Normally, 90-days' arrears on interest pay­ments means a bank must put a loan on a non-accruing basis and treat subsequent interest payments as a reserve against losses rather than as income.

New and rescheduled loans to troubled debtors are exempt from loan loss reserve requirements. While differing accounting practices and domestic loan portfolios make a precise comparison difficult, so far U.S. authorities do appear to have been less rigorous than their West European counter­parts in requiring banks to build reserves against foreign loan losses. The eight largest British banks doubled their reserves in 1982, and some West German banks have tripled reserves. By comparison, the four largest banks increased loan loss reserves by 56 percent or less compared with the levels they maintained in 1981, regulators have also apparently stretched the legal lending limit-no more than 15 percent of capital to anyone borrower -- to accommodate banks that might exceed the limit if they were to extend new loans to troubled debtors. In at least one case, a responsible bank official admits that regulators "looked the other way" when his institution, which had reached the limit on Mexico, engaged in a little creative accounting by putting the new loan on the books of the bank holding company rather than of the bank itself.

Volcker defends this regulatory flexibil­ity on the grounds that the first priority is to keep the situation from unraveling, and that goal means inducing the banks to lend to Mexico and the other large debtors. The Fed and other more reluctant regulators are willing to let the banks engage in what Federal Reserve Board Governor Henry Wallich several years ago condemned as Ponzi finance-schemes in which banks lend the debtor the money it needs to pay interest on existing loans.

Long-term Lessons

But does this approach really solve the problem? Who assumes the risk if the loans that the banks have extended in response to specific entreaties from their governments have to be written off? How easy will it be to reverse the loose banking practices now condoned?

A breakdown of the international finan­cial mechanism, in which both lending and debt servicing come to a halt, has been averted. But there are reasons to worry about the longer-term -- and even the near­ term -- implications of the process by which this was accomplished and the policies that were adopted to achieve it.

The banking system may be more vulner­able to shock than it was before the salvage effort. First, most banks have increased their exposure in the biggest debtor coun­tries -- by 7 percent in Mexico and Brazil, by 10 percent in Yugoslavia. Second, the risk is now more concentrated because loans to the private sector are being replaced by loans directly to central governments or guaranteed by governments.

Further, by giving free rein to the banks' most rapacious instincts in pricing resched­ulings and new loans to troubled borrowers, the IMF and the creditor governments have increased the likelihood that these addi­tional sums will not be enough to carry Mexico and Brazil or others through 1983. As Feldstein told a recent gathering of specialists on Latin America: "The risk premium [being charged by the banks] increases the risk of the loan. Lenders have to realize that at some point the risk premi­um becomes self-defeating."

But whose risk is it? Government officials interviewed say the risk belongs entirely to the banks. "We haven't twisted arms or told the banks to stay in," says Wallich. "We have merely pointed out that it is a matter of 'enlightened self-interest.'" Many bank­ers profess agreement. "Our decisions to lend or not to lend have nothing to do with what the Fed says," according to Frank Stankard, senior vice president in charge of international lending at Chase. Hackett of Marine Midland agrees: "We feel there is absolutely no government guarantee for new loans to Mexico."

But the banks are not well-equipped to carry the additional risk. Regulators have allowed U.S. banks to understate the risk­iness of restructured foreign loans by not requiring banks to build reserves against them. And they have allowed banks to overstate the profitability of these loans by taking rescheduling fees and interest down to the bottom line as income rather than applying them against principal to reduce loan exposure in these countries.

Either the government has created a very dangerous situation, or it does not mean what it says and is, in the end, prepared to put up more money to keep the banks' foreign loans from ever going sour. In that event, today's decision to persuade the banks to continue lending means a far costlier bail-out in the future.

What of the longer-term lessons from this crisis? "If they [the banks] learn not to lend to Mexico, that is wrong. If they learn that 'what we did was O.K., someone will al­ways help out,' that is wrong, too," says Wallich. For the moment the banks are acting cautiously. Lending to Latin Amer­ica outside IMF restructuring plans virtual­ly came to a halt in the last half of 1982. The banks also rejected embryonic Turkish and Filipino plans to raise substantial syndications in the eurodollar market in early spring 1983.

But banks do not appear to have lost their appetite for international lending. When the Latin American loan market collapsed, banks began "scrambling to lend to Malay­sia and Indonesia," says Hackett. Marine Midland expects its international lending to grow by 10 to 12 percent in 1983. "Events have demonstrated that the world is much more volatile than it used to be," says Weatherstone. But Morgan has no plans to alter its international lending strategy sig­nificantly. Gerard Alifano, senior vice pres­ident of Pittsburgh National Bank, of Pitts­burgh, Pennsylvania, says in the short run his bank expects modest growth in foreign loans. But he notes that "opportunities appear in times of crises too. It gives banks an opportunity to solidify relations" with potential customers.

There appears to be no interest whatso­ever among U.S. banks for a government buy-out of their international loan portfo­lios along the lines proposed by some economists. Stankard says, "The buy-out will never happen. There is no need for it." Chase plans to maintain its international lending levels, he notes, and argues that so long as the IMF, the governments, and the banks continue to cooperate, the situation is manageable.

Bankers see no need to alter their lending practices radically because they do not think they have overlent or acted impru­dently. They contend they were caught by unforeseeable changes in the world econ­omy -- deep recession, a weak oil price, and the Federal Reserve Board's tight money policy, which pushed interest rates higher in the eurodollar market as well as at home.

Volcker disputes this argument: "It was obvious two years ago that Mexico was going to be in trouble, but the banks were all over Mexico, pushing loans." Neverthe­less, Volcker's own institution, which is one of three principal bank supervisory agencies in the United States, did little to discour­age the banks from lending. Says Volcker: "We got into a lot of trouble classifying countries in the mid-1970s, so we left it to the banks to diversify their lending." Even­tually, "when all this is over" the only solution is much tighter regulation of inter­national banking, according to Volcker.

The problem is that by the time the crisis ends, the regulatory authorities may be so deeply compromised by the concessions they have made to the banks that there is no return. This dilemma is manifest in the feeble regulatory reform proposals the Fed, the comptroller, and the Federal Deposit Insurance Corporation (FDIC) jointly sub­mitted as draft legislation in April 1983 in response to pressure from Congress. A flat lending limit per country was ruled out, for example. How can the regulators set a meaningful country limit when the claims of the nine largest U.S. banks on Mexico. Brazil, and Argentina already equaled 112 percent of their capital in June 1982, and when the government has since told them to lend more? And the Fed clearly feels it has to live up to Volcker's promise not to subject new loans to these countries to su­pervisory criticism.

Therefore, although the FDIC argued for earlier and larger reserves against loans to troubled debtors, the joint proposal will make reserve rules uniform, but not neces­sarily tougher. Reserves 10 percent of the loan would be required only when a country has paid no interest for six months and has no immediate prospect of doing so. By that definition, no reserves would be required against loans to most Latin Ameri­can governments. Only Zaire, which most banks have already written off completely, Sudan, and perhaps Poland meet that de­scription. The proposed public disclosure re­quirement is something the banks have al­ready conceded and that clarifies rules already adopted by the Securities and Exchange Commission. The provision re­quiring that lending fees be amortized over the life of a loan is a rule the bank accounting profession was about to adopt anyway.

With a doubling of IMF lendable re­sources in the offing, the government safety net under the banks seems more tightly strung than ever. But regulation of banks' foreign lending will, if anything, be more lax than before. The current solution to the international debt problem is disturbingly similar to the policies and processes that created the crisis in the first place.

Georges Bendrihem/AFP/Getty Images


Ten Years of Foreign Policy

The diffusion of power today, both inter­nationally and domestically, makes it impera­tive that the United States develop a more democratic foreign policy.

On April 30, 1970, President Nixon took to the nation's television sets to announce the invasion of Cambodia by American troops and to rail against those at home who would allow the United States to become "a pitiful, helpless giant." Just five days short of a decade later, another president came before the cameras to reveal that eight charred bodies and some wrecked aircraft in the Iranian des­ert were all that remained of his administration's attempt to rescue 53 American hos­tages held for six months in Tehran. To many observers, in the United States and abroad, the failed rescue attempt was a grisly suggestion that perhaps Nixon's night­mare had come true.

Those two events-the invasion of Cam­bodia that ultimately could not prevent the fall of Indochina to the communists, and the aborted raid in Iran that did not end the perception of a United States in decline ­exactly bracket the first decade of Foreign Policy's existence. Founded in 1970 amid great uncertainty about the ends and the means of U.S. foreign policy, the magazine, has sought to provide a forum for re-examin­ing those purposes and techniques. Although successive editors have reiterated Foreign Policy's commitment-stated in its first is­sue-to publish writers at all points on the political spectrum, it is symptomatic of a larger national insecurity that the magazine has at times been under attack for allowing certain views into print.

This insecurity, both cultural and intel­lectual, reflects significant shifts in the global distribution of power, shifts that did not benefit the United States. During the decade just past, the Soviet Union achieved a broad parity with the United States along many of the dimensions of military power, particularly in the strategic realm. Some critics would argue that in a few crucial areas Mos­cow now has a commanding superiority.

Meanwhile, several Third World states have amassed so much sophisticated weapon­ry that, whether they themselves would ever be America's adversaries, the net result has been to curb significantly U.S. power in var­ious regions of the world. Although this weaponry also places limits on Soviet ef­forts to exert influence, that is a factor for the future. For the time being, the world's attention is on reduced U.S. influence.

While these adverse military trends were proceeding, the United States also lost its pre-eminence in the world economy. Al­though an economic giant, it was outstripped during the 1970s by the combined economies of its partners in Western Europe and Japan. And when the pulse rate of Western econ­omies slowed dramatically in 1973 to 1974 and in 1979 as the Arab oil-exporting states raised by many times the price they charged for the life's blood of much of the rest of the world, successive American administrations seemed unable to confront that challenge either at home or abroad.

Suddenly, at the end of the decade, with the nation in economic crisis and with So­viet troops in Afghanistan, popular' demands for simple and decisive solutions to the na­tion's problems mounted. At home, many citizens were attracted to Republican -- and now Democratic -- proposals for a massive tax cut that would break the economic im­passe, release productive energies, and miracu­lously solve, with little pain to anyone, the nation's economic problems.

To cope with crises abroad, Americans were inclined increasingly to favor the use of force. A growing body of intellectual opinion encouraged this shift. And it seemed that, to many of these advocates, the actual location of any demonstration of U.S. power was less important than a successful assault on the psychological barriers to the use of force that, it was argued, comprised the "Vietnam syndrome." The presidential candidates, with only a few exceptions, seemed to commit themselves to military action before they examined U.S. capabilities or interests.

The American Locomotive

It is scarcely surprising that campaign politics has reduced discussion of the American position in the world to bean counting regarding the military balance between the United States and the Soviet Union-how many missiles, ships, tanks, and aircraft each superpower has at its disposal. But the larger discussion within the society as a whole has been startling in its lack of historical per­spective. The prevailing focus on the military balance betrays a crippling ignorance of the sources of American postwar power.

Those sources were economic and political as well as military. In the 1970s all three of them eroded. During the first two decades following World War II, the United States could simultaneously play the roles of world policeman, world banker, and world man­ager. These roles were most evident in the immediate aftermath of the war-as late as 1950, for instance, the United States ac­counted for 50 percent of the world's mili­tary spending and disposed of 50 percent of its financial reserves. Yet the decline of this position of relative advantage was so gradual that, until the nation's will cracked against the rock of Vietnam during the late 1960s, most Americans did not comprehend just how unnatural and temporary, as one con­sequence of a devastating world war. U.S. preponderance had been.

During the period when that preponderance was largely unquestioned, the United States exerted a powerful locomotive force in the international system. The advantages to other societies of hooking onto U.S. policy were considerable. The United States car­ried most of the military burden; the eco­nomic benefits were without precedent; and the political control exerted by Washington was benign by any historical standard.

By the end of the 1970s, however, the American locomotive no longer pulled with sufficient force, and there were alternatives to which dependent states could turn. The United States now held less than 7 percent of the world's monetary reserves; its industrial might, which accounted for two-thirds of the world's production in 1950, accounted for less than one third in 1975. And by that year, its share of the world's military spend­ing had dropped to 25 percent.

Much-too much-has been made in recent years of the supposed unwillingness of the United States to use military force to achieve its political objectives. A more startling and sweeping change, because it is relevant in more concrete situations, has been U.S. unwillingness to use economic power to influence the behavior of other nations. Between 1961 and 1977, U.S. official development aid declined by 38 percent in real value.

Military assistance program grants and foreign military sales credits for 1979 were 23 percent smaller, in constant dollars, than in 1960. What was happening to the com­position of these programs? In 1969 Israel and Egypt received 2.7 percent of total U.S. military assistance. In 1979 they received 82 percent. In the same 10 year period their share of economic assistance soared from 1 percent to 24 percent overall and 42 percent of bilateral assistance. Thus, through its concentration of increasingly limited resources on just two Middle Eastern countries, the United States lost valuable access and potential leverage elsewhere. Ironically, without anyone noticing, the United States was retreating into just the kind of regionalism of which former Secretary of State Henry Kissinger has accused the West Europeans.

This is not to argue that the United States can now, or ever could, buy compliant behavior on the part of other governments with economic or military assistance funds. In a few instances, such aid has obtained desired responses from particular governments. But those instances are rare. Indeed, one reason why Congress has been so reluctant to sup­port foreign aid in recent years has been the overselling of aid by successive administrations as a means of assuring desired behavior by client governments.

In fact, as aid officials have long known, their programs cannot be judged by such a criterion. Occasionally, but not often, aid from external sources so affects a particular government's calculus of incentives and dis­incentives as to cause sharp departure from previous policies. More usually, aid pro­grams make it easier for governments to do what they would have been inclined to do in any event, had they had the resources. In many instances, those actions will be con­sonant with U.S. interests.

But as long as aid programs are of more than token dimensions, such programs create a network of relations between donor and recipient in which frank, confidential com­munication is possible. They insure that Washington's views will have a serious hear­ing. They make the United States a constant, relevant actor in a regional setting. The recipient government may, in the end, decide to reject U.S. advice, as any sovereign state is entitled to do, but it will not reject it out of hand. There are Third World countries that, for geopolitical reasons, are important to the United States, but for which the United States -- because it is not present in any con­crete sense -- is relatively unimportant. Aid equalizes the balance.

Driven to Sticks

Except in the early, heroic, Marshall Plan years, American aid programs -- economic and military -- have always been modest by comparison with the resources of the Ameri­can economy. They seem especially inade­quate now when developing countries have alternative sources of support. Among them, of course, are some of the Arab oil-produc­ing nations, whose funds go mainly to help a target group of developing countries cope with escalating oil prices-and also to buy weapons for Palestinian guerrillas.

But Iraq has established relations with the Puerto Rican independence movement, per­haps recalling earlier U.S. support for the Kurdish separatists in their rebellion against Iraqi authority. Venezuela and Nigeria, also major oil producers, have become important aid donors; Nigeria has given the liberation movements in southern Africa a source of support that enables them to escape total de­pendence upon communist funds. Brazil and India -- neither one an oil exporter -- have also increased their regional influence through well-targeted aid programs.

Because of congressional whittling away at the aid budget and the insistence of suc­cessive administrations on concentrating re­maining funds so narrowly, the United States has shortsightedly deprived itself of its long suit-the magnetic attraction of the American economy. In recent years, largely lacking economic carrots, American policy makers have been increasingly driven to sticks-the economic sanctions imposed against Iran following the seizure of the U.S. embassy there, and against the Soviet Union following the invasion of Afghanis­tan. These measures take their places along­side some of the punitive economic actions of the past, such as the embargo against Cuba and restrictions on credits and tariff conces­sions for the Soviet Union.

None of the entire panoply of sanctions has been very effective at influencing political behavior. Few policy makers have faced up to the reason, namely, their unilateral applica­tion. And therein lies the difference between economic carrots and economic sticks. Car­rots are most effective precisely when they are unilateral; economic sticks, however, must be multilateral if targeted governments are not to evade them merely by finding al­ternative suppliers and markets. Only one kind of stick, however, can be applied uni­laterally: force. That may explain the sud­denly enhanced appeal military measures seem to hold for many Americans.

Among the outspoken domestic critics of recent U.S. foreign policy, only a few call for substantial increases in military and economic assistance. Instead, most call for greater evi­dence of U.S. willingness to use direct mili­tary power as a way to regain the nation's previously dominant position in world af­fairs. There may be particular circumstances for which military measures are appropriate. But as a panacea, such a prescription repre­sents a political hoax on the American people.

No matter how many additional dollars an administration is willing to devote to military forces, the United States cannot so overshadow its allies as to maneuver them back into the position of economic and po­litical subservience in which they found themselves in the decade following World War II. And the actual use of U.S. military forces in a Middle Eastern crisis, for exam­ple-would be at least as likely to inspire a neutralist posture on the part of most U.S. allies as to inspire greater willingness to ac­cept Washington's direction. Similarly, the states of the Third World are not likely to be induced by American military posturing to resume the condition of political or psycho­logical dependence from which most have now liberated themselves.

As for the communist states, they con­sistently give evidence of a healthy respect for U.S. military capabilities more, indeed, than many Americans display. This respect relates to their understanding of the dangers of direct military confrontation with the United States. The difficulty has always been how this respect comes into play.

It is difficult to imagine that more capable or ready U.S. forces would have led Moscow and Havana not to intervene in the Angolan civil war in 1975, or not to respond to a plea for help from a duly recognized Marxist government in Ethiopia two years later.

(Likewise, it is difficult to imagine better­-equipped Soviet forces persuading the United States not to send troops into the Dominican Republic -- or Vietnam -- in 1965.) Nor. would greater U.S. preparedness have kept Soviet forces out of Afghanistan, or to move beyond the communist world, Shah Mohammad Reza Pahlavi on his Peacock Throne. For it is difficult to imagine an American administration ordering, or Con­gress acquiescing in the use of U.S. military forces in combat in any of these situations.

Frustrating Coils

The lasting legacy of Vietnam is not (al­though in most circumstances it should be) a greater national squeamishness about using force. Rather, it is a greater skepticism about the ability of outsiders, even those willing to employ a large-scale military intervention, to control the politics of Third World states over the long haul. This skepticism is com­bined with a view of U.S. interests that at­taches less importance to the political align­ment of individual Third World govern­ments and with a more realistic recognition of the high costs of using military force against even guerrilla troops that are armed with sophisticated modern weapons.

A century ago, tiny handfuls of troops from the metropolitan centers could main­tain colonial rule over large tracts of terri­tory with tens or even hundreds of millions of inhabitants. Today, while there is no question that the United States or the Soviet Union could prevail in battle against, say, Iraq or Saudi Arabia or Vietnam -- countries they themselves have armed -- the cost would be great. And the perceived inconvenience, at least for the American polity, if not for the Soviet, would be considerable.

For resistance to outside military inter­vention is now in fashion, worldwide. One reason why the colonial powers of the nine­teenth century could rule so effectively was that their victims could not talk to one an­other. The successful resistance of one tribe in one territory was often unknown else­where in the same territory, much less among other colonialized people in other lands. Nowadays -- and this is another trend that has been accentuated in the 1970s -- the po­tential victims swap war stories, and ex­change tactical manuals and instruction in the latest techniques for infiltrating terrorists or for destroying aircraft with hand-held, heat-seeking missiles. They also meet with the international media to publicize their cause.

And unlike their 19th-century predeces­sors, today's resisters find that there are plenty of sources, ranging from other revolu­tionary movements and regimes through the covert services of the great powers to overt support by Moscow or Washington, where they can acquire those missiles or the efficient Kalashnikov rifles that have become the to­tems of resistance for groups whose politics range across the entire spectrum.

The Soviet Union, the armorer if not al­ways the inspirer of so many insurgent move­ments over the past 30 years, now finds it­self enmeshed in the same frustrating coils in which the United States and other Western powers have too often labored. Moscow is not subject to the same domestic constraints that have hobbled one after another of the Western capitals. With its monopoly on all media and its refusal to countenance opposi­tion, the Kremlin makes sure of that.

It is true, also, that in the 1970s Moscow's armed forces had for the first time developed an ability to project military power beyond their East European glacis. But in Africa, two alleged Soviet "successes" -- Angola and Ethiopia -- are the sites of civil wars that after years of blood and treasure seem to remain unwinnable for Moscow's clients. Mean­while, Mozambique, another Soviet "suc­cess." is showing signs of turning more toward the West than ever before (as is An­gola itself). More serious for the Soviet leadership, because its direct investment of military force and therefore of prestige is higher, is the struggle in Afghanistan. Far from being able to call its troops home by May Day, the USSR finds them in a quagmire, whether of Vietnam dimensions remains to be seen.

Meanwhile. Vietnam itself -- another So­viet client with strong support from Mos­cow -- has been unable to complete its con­quest of Cambodia. The unexpectedly strong Khmer resistance, with aid from China, may last indefinitely. And even Cuba, Moscow's first important Third World "success," seems to be turning sour; despite the con­tinuing massive Soviet subsidy, the Cuban economy is woefully inefficient, and internal opposition to the Fidel Castro regime is in­creasing. There is a remarkable irony here: An American president with a record of sim­ilar "successes" might well face impeach­ment; yet this record of Soviet "success" is the standard by which this and future U.S. administrations are judged.

A Fundamental Weakness

Thus, the political base of the Soviet Union's new empire is extraordinarily frag­ile. At any moment, a reversal might take place that would severely damage Moscow's image of invincibility. This is a point foreign­ers understand better than Americans.

A fundamental weakness of the Soviet position in the world is that, owing to the nature of its economy and political system, military power is the Soviet Union's most es­sential tool, and this power is more difficult to use in Africa or Asia than it is in Eastern Europe. Yet rather than exploiting that weakness by making more effective use of U.S. political and economic strengths, the re­cent policies of the Carter administration­ and the policy prescriptions of Republican presidential candidate Ronald Reagan -- in­creasingly emphasize direct military measures.

The president's most recent State of the Union message in January 1980 did not even mention the more positive instruments the United States has to increase its influence. Moscow can thereby point to the build-up of U.S. military forces (and of American mili­tary rhetoric) and tell its clients that now they do have something to fear. The in­creasingly militarized approach to the prob­lems of the Third World threatens to impart to U.S. positions something of the same one­-dimensional focus that characterizes that of the USSR.

Why have U.S. policies emphasized so poorly America's comparative advantages?

One reason, surely, is the adversary nature of U.S. domestic politics: The easiest way for those out of office to score points against a sitting administration is to accuse it of be­ing insufficiently attentive to threats to the nation's security. This has been the case no matter which party holds the White House. Whatever the real state of the U.S. military, American foreign policy has been overly mili­tarized for most of the period since the late 1940s because no administration has been willing to risk a contrary posture.

A more fundamental explanation, how­ever, lies in the U.S. Constitution itself. More than other Western democratic govern­ments, and much more, of course, than au­thoritarian regimes like that of the USSR, U.S. administrations find it difficult to pur­sue consistent, coherent policies. In parlia­mentary systems, where governments serve only so long as they command a working legislative majority, they can knit together sets of policies that form a coherent whole. No British, French, or West German govern­ment could find itself in the intolerable posi­tion of holding out the prospect of economic or political support to another nation, only to find that its parliament either blocks its proffered package altogether or else so re­duces its magnitude or surrounds it with con­ditions that its final effect is largely vitiated. Yet that has happened so often to U.S. administrations that it is scarcely newsworthy.

Not only aid is thus affected. The U.S.­-Soviet trade agreement, a centerpiece of the Nixon-Kissinger notion of detente, was still­born because Congress made the trade con­cessions on which Moscow counted depend­ent upon Soviet removal of all restrictions limiting Jewish emigration. And one reason for the Carter administration's largely un­creative response to Third World appeals for international economic reform has been its knowledge that Congress would be unwill­ing to agree to the trade and investment tradeoffs an effective response would entail.

These institutional handicaps have af­fected Washington's ability to conduct a coherent military policy, too. The last stage of American military involvement in the In­dochina war, in which the Nixon administration launched bombing raids right up to the moment of a congressionally mandated halt, is grotesque in retrospect.

Consistence and Coherence

The proper course for a government so re­pudiated would have been to resign and to call for new elections. But the American sys­tem does not provide such an option. Dis­credited administrations continue in office.

The American response has been to pass the War Powers Act. Yet congressional be­havior in the wake of the abortive Iranian rescue operation suggests that provisions of the act will obtain to the letter only when the military action ordered is unpopular, as well as unsuccessful.

Otherwise, why did congressional leaders, at first contending that the conduct of the raid violated the War Powers Act, fall silent when it was evident that the country was fully behind the president? From the Iran­ian hostage rescue effort came an important lesson for future presidents: The ability of the president to resort to military action has not been as severely circumscribed by the events of the last decade as many thought.

Yet the 1970s also saw a new develop­ment that those conducting foreign policy have still not absorbed. As Arthur Schle­singer pointed out in The Imperial Presidency the Founding Fathers expected that com­mercial issues, not political or military issues, would dominate the foreign policy agenda for the United States, and they lodged the primary responsibility for international eco­nomic policy in Congress, not in the presi­dency. The Founding Fathers' tilt in the di­rection of Congress was deliberate, a careful expression of their 18th-century liberal dis­trust of centralized power, and of their awareness of the inherent difficulties of pre­serving a compact whereby separate states with quite distinct economic interests came together to form a federal union.

The 1970s saw a vast exacerbation of the nation's domestic economic problems because of skyrocketing energy costs, aging of the country's industrial plant, and a whole series of other factors that led to a sharp decline in the nation's ability to increase its pro­ductivity. These problems, in turn, made it more difficult to relate to other economies.

The scope and complexity of these prob­lems made it all the more desirable that there should be consistency and coherence in the management of the U.S. domestic economy. But they were not forthcoming, as Carter's repeated inability to secure congressional ap­proval for an effective energy policy was graphically to demonstrate. Individual sen­ators and congressmen feared for their own political futures if they were to vote for measures that would adversely affect living styles in their states or districts. And the dif­fuse nature of the U.S. political system -- the absence of meaningful parties -- prevented the administration from imposing the kind of discipline that is the prerequisite of co­herence. It is no wonder that European lead­ers, such as West German Chancellor Helmut Schmidt, sometimes speculated openly about whether the Carter administration could be even minimally effective as an interlocutor.

Schmidt and others undoubtedly have a point when they show particular scorn for the Carter administration, but they may mis­understand the real nature of the administration's failure. It may not be merely absence of coherence. Incoherence is built into the American system, which has become more unmanageable as each significant act of for­eign policy seems to require formal congres­sional support. Rather the failure may lie more in Carter's inability to understand that the growing power of Congress and the rise of economic issues to the top of the inter­national agenda have opened a new chapter in U.S. foreign policy.

Whoever occupies the White House must find better ways to develop joint manage­ment responsibility with Congress, or he must scale back American pretensions to sus­tained international leadership in foreign pol­icy. For unless economic issues recede in im­portance or the Congress undertakes unex­pected reforms, U.S. foreign policy will never again have even the minimum level of coher­ence it enjoyed in the postwar era.

A More Populist Foreign Policy

Contributing to the incoherence has been the rise of the U.S. press as a much more ac­tive participant in the policy process. In all political systems, power flows from knowl­edge and access. Because of the Freedom of Information Act and the proliferating cen­ters of foreign policy power in Washington, the press now has much more of each.

Passed in the aftermath of the Vietnam war and the Watergate scandal, the Free­dom of Information Act was a necessary corrective to the dangerous abuses created by these two events. There is no gainsaying that it also reduced drastically the ability of the executive branch to restrict information. The act not only provided a torrent of informa­tion -- foreign journalists express astonish­ment at the degree of official cooperation they receive -- but it has also fostered a more per­missive approach to the provision of in­formation throughout the government. Re­cent efforts by the Central Intelligence Agen­cy to muzzle its former employees or of the president to receive affidavits of loyalty from his cabinet are not so much symptoms of a new repressiveness as they are a rearguard ac­tion that points up how much the old ground rules have changed.

The hostage crisis in Iran threw the new role of the press into sharp relief. Journal­ists -- especially television journalists -- be­came central elements in the processes by which all parties to the complex conflict in­teracted. Journalists, not U.S. government officials, had access to Tehran's streets and to the groups, official and unofficial, that strug­gled for power there.

Thus, a new and undoubtedly permanent element of incoherence entered the process of conducting American foreign policy. An earlier harbinger was Egyptian President An­war el-Sadat's brilliant use of the U.S. media to orchestrate his peace initiative to Israel in 1977. Then, as in the Iranian crisis, the government was reduced to a role assumed historically by the press-that of passive commentator on events beyond its control. Now, for the first time in history, foreign leaders like Sadat or the Ayatollah Ruhollah Khomeini can speak to the American people instantaneously, over the head of the U.S. president and even around the desks of edi­tors. It is a foreign policy tool that they will use more frequently as they seek to exploit the diffusion of power in the United States.1

Because of the immediacy afforded by to­day's television coverage, Americans are probably more aware of dramatic interna­tional events, such as the hostage crisis and the Soviet invasion of Afghanistan, than ever before. Yet the effect of this issue im­mediacy and power diffusion has been to make U.S. foreign policy not more demo­cratic but more populist -- less confined to elitist prescriptions but more subject to pop­ular whims; less conscious of past mistakes but more open to new errors; less understanding of foreign cultures and more strident about America's own. The lines of responsibility and accountability running be­tween controlling institutions and the public that would be necessary for a more demo­cratic foreign policy are lacking, and little has been done to explain to the country why it is necessary to create them.

The diffusion of power today, both inter­nationally and domestically, makes it impera­tive that the United States develop a more democratic foreign policy. For unless those who hold power in Washington practice seri­ously the democratic arts of governance and consultation, neither domestic support nor the approval of other nations will be forthcom­ing. As America moves into the 1980s, coali­tion building at home and abroad may well be the priority issue in U.S. foreign policy.

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