wherereaanomicsworks

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Where Reaganomics WorksAuthor(s): Henry R. NauSource: Foreign Policy, No. 57 (Winter, 1984-1985), pp. 14-37Published by: Washingtonpost.Newsweek Interactive, LLCStable URL: http://www.jstor.org/stable/1148325

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WHEREREAGANOMICSWORKSby Henry R. Nau

Throughout the Reagan administration'sfirst term, critics have charged that it has nointernational economic policy save for carry-ing out its domestic program.The administra-tion, it is argued, has "relegated internationaleconomics to a lower priority than any admin-istration in the postwar period" and hasformulated its domestic economic policies "inalmost total disregard for the outside world."'This charge betrays elements of a mindsetthat dominated discussion of internationaleconomic policy during the 1970s. From aperspective more appropriate to the 1980s,Reagan administration international economicpolicies reflect a coherent analysis and attackon the major economic ills of the previousdecade. Understanding this alternative per-spective is essential to balance the policydebate as well as to hold the administration,whose policies do not always conform to thisalternative perspective, accountable to its ownstandards.The alternative outlook rests on the simpleproposition that the world economy is only asgood as the national economies that composeit. If national economic policies promote sus-tained, noninflationary growth, economic re-lations among states are unlikely to be per-'SeeBenjaminJ. Cohen,"AnExplosion n theKitchen?Economic Relations with OtherAdvanced IndustrialStates," and RichardE. Feinberg,"Reaganomics ndthe Third World," in Eagle Defiant: United StatesForeign Policy in the 1980s, ed. KennethA. Oye,RobertJ.Lieber,and DonaldRothchild Boston:Little,Brown and Co., 1983); and C. Fred Bergsten, "TheCostsof Reaganomics, FOREIGNPOLICY 44 (Fall1981).HENRY R. NAU is professor of political science andinternationalaffairs at TheGeorgeWashingtonUni-versity and served rom 1981 to 1983 as senior staffmemberof the National Security Council responsiblefor internationaleconomicaffairs. A longerversionofthis essay appearssimultaneouslyin the SignificantIssuesSeriesof the Center or Strategicand Interna-tional Studiesof GeorgetownUniversity.14.


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verse. But deficient national policies, regard-less of international arrangements, will proba-bly produce little but international economicmalaise and instability.This self-evident proposition was neverthe-less forgotten during the 1970s. Then, globaleconomic problems were traced largely to themalfunctioning of the international economicsystem itself. Trade and capital flows hadbecome so sensitive and complex, it wasargued, that national policies, suffering fromdivisive special interests at home, could notcope with the new realities. Neither couldlimited international institutions. Interdepen-dence required more centralized and compre-hensive mechanisms and institutions to man-age the world economy and to make nationalpolicymaking effective once again.2This globalist view has been so dominantthat reasserting national authority and tiltingtoward converging national, rather thanglobal-institutional, solutions under the Reag-an administration have been branded disdain-fully as economic nationalism or, even worse,economic isolationism. Yet events in the early1980s and the initial results of Reagan admin-istration policies are making the case for analternative approach.The alternative approach reverses theglobalist logic and places national policymak-ing at the foundation of world economy. Itemphasizes the need for domestic economicperformance among major countries to con-verge around a few, fundamental indicators-low inflation, flexibility of markets, and openinternational economic boundaries. If theseconditions exist, trade and capital flows flour-ish and reinforce domestic growth and stabi-lity, as well as the effectiveness of nationalpolicymaking.Such a domesticist approach differs fromthe globalist approach in three importantrespects. First, it rejects the notion that na-tional policymaking is increasingly ineffective2See,for example, the two reports of the BrandtCommission,orth-South:A Programfor Surviv-al, and Common Crisis North-South (bothCam-bridge,Mass.:MIT Press,1983); and especiallyAlbertBressand, "Mastering the Worldeconomy, ForeignAffairs (Spring1983).

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FOREIGN POLICYand seeks to revive consensus and the capacityto act at the national level first, before interna-tional action. The domesticist views this tackas more realistic because however diversenational economies may be, international di-versity is still greater. Second, while domesti-cists agree that the world economy has becomemore sensitive and complex, they recall thatnational policies of price stability and flexible,open markets created this interdependence inthe first place. Thus, whether national policiesare inflationary or noninflationary, closed oropen, is far more important than the existenceof international cooperation. If national poli-cies are deficient, as they were in the 1930s,international cooperation can actually worsenmatters, as the ill-fated 1933 World Monetaryand Economic Conference in London showed.If national policies promote domestic price sta-bility and international comparative advan-tage, then extensive international cooperation,beyond a basic consensus on these points, maybe less necessary.Therefore, as a third point of differencewith globalists, domesticists play down direct,international political bargaining and institu-tions and advocate instead the use of vigorousnational action, working indirectly throughthe international marketplace, to induce mu-tual adjustment of national policies towardlow inflation, strong market incentives, andopen borders. In a world where economicpower is more diffuse and competitive, directinternational bargaining may be both moredifficult and less necessary: more difficultbecause the larger number of participantsimpedes agreement at the bargaining table,and less necessary because the move from ahierarchical to a more competitive worldmarket increases the odds that acting ondomestic or self-interest grounds also servesthe common interest. Thus, national actionthat commands sufficient economic power inthe marketplace and uses it efficiently canimprove prospects for international consensusin today's complex world.The differences between domesticists andglobalists are relative, not absolute. Both careintensely about the world and not just aboutthe U.S. economy, and both rely on national

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Nauand international policy. Domesticists preferto act at the national level but seek interna-tional consensus on key aspects of nationalperformance, which ultimately limits nationalchoice. Globalists prefer to act at the interna-tional level, in part to secure more, not less,autonomy and effectiveness for nationalpolicymaking.The domesticist view is rooted in an evalu-ation of the performance of the postwarinternational economic system. The domesti-cists contend that, for all its faults, this systemhas achieved higher sustained rates of growthand development than any previous systemover a comparable period in history, and fordeveloping countries as well. From 1950 to1980 world output tripled and per capitaincome doubled. Average annual gross nation-al product (GNP) and per capita GNP in-creased by the same rate in some 60 middle-income developing countries as in the indus-trial countries. Taking comparative purchas-ing power into account, real per capita incomein the middle-income developing countriesactually grew twice as fast as in the industrialcountries. In the remaining 90 or so low-income countries, real per capita income roseby less than one-fifth of these increases. Yetfrom 1950to 1979,literacy rates in low-incomecountries increased from 20 to 51 per cent, lifeexpectancy went up from 41 to 57 years, andchild mortality declined from 28 to 12 deathsper thousand.

Domesticists play down direct, in-ternational political bargaining... and advocate instead the useof vigorous national action ...through the [world] marketplace.The domesticist attributes these results not

simply to historical inevitability or postwarreconstruction, but rather to deliberate policychoices in three basic directions.First, the postwar system gave pride ofplace to noninflationary domestic policies asthe source of world economic growth andstability. This priority was reflected in the

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FOREIGN POLICYcommitment by all other countries besides theUnited States to a fixed exchange rate inrelation to the dollar and a commitment by theUnited States to maintain the value of thedollar in terms of gold. Underlying the goldlink was an even more fundamental U.S.commitment to domestic price stability, whichbecame increasingly important during the1950s and 1960s as the dollar became theprincipal international reserve currency. Un-til about 1960, U.S. gold reserves could coveroutstanding liabilities against the dollar. Dur-ing the 1960s, however, these liabilities grewto many times the value of U.S. gold reserves,and the willingness to hold dollars abroaddepended more and more on the price compet-itiveness of U.S. goods and capital assets.Domesticists argue that foreign perceptions ofdeclining U.S. competitiveness, because of theU.S. government's inflationary guns-and-but-ter policies during the late 1960s, eventuallydestroyed confidence in the U.S. dollar andthe fixed exchange-ratesystem.Second, the postwar system sought to liber-alize trade, at least in manufactured goods.The decision to allow comparative advantageto work at the margins as governments movedtoward lower barriers-totally free trade wasnever the objective-was decisive for postwarprosperity, particularly when compared withthe prewar system. The latter system avoidedprice inflation, too, but sacrificed prosperityto protectionism. The commitments to freertrade and to price stability, fixed exchangerates, and domestic policy discipline wereinseparable.The idea was to prevent countriesfaced with balance-of-payments deficits orsurpluses from altering their exchange rates-except in circumstances of fundamental dis-equilibrium-or to impose new trade barriers,except for a limited-safeguards clause provid-ed by the General Agreement on Tariffs andTrade (GATT).Consequently, countries eitherwould have to finance deficits or absorbsurpluses through reserve losses or accumula-tions, or eventually would have to disciplinethe domestic policies that were contributing totheir economic troubles.

The commitments to price stability andliberalized trade also implied a third commit-18.


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Naument. That was to preserve a relatively flex-ible domestic economy, tilting at the marginstoward market forces and market pricing topromote efficiency. Since the internationalmeans of adjustment permitted by the systemwere relatively constrained, balance-of-pay-ments adjustments would have to be madelargely through domestic changes. Govern-ments were obliged to facilitate this adjust-ment and to ensure that economies retainedenough flexibility to move resources readilyfrom declining to growing sectors. The com-mitment was not to avoid direct governmentinvolvement in the economy but rather tokeep economies flexible to fascilitate adjust-ment. This goal was often best achieved bytilting toward market forces, whether re-sources were publicly or privately owned.ThePolicy Culprit

What went wrong in the 1970s? The mostcommon explanation is offered by the global-ists. In this view the unique postwar economicdominance of the United States inevitablydisappeared, as postwar allies and erstwhileenemies prospered and increasingly differedwith the United States on fundamental eco-nomic policy objectives. These differences,which could not be resolved at the bargainingtable-despite historic U.S. attempts to stabi-lize exchange-rate relationships--would haveto be accommodated by greater flexibility inthe marketplace. Domestic flexibility, whichensured adjustment under the old system,gave way to greater international flexibility.Floating rates absorbed some of the require-ments for domestic adjustmentand relaxed theneed for consensus on economic fundamen-tals. As a 1977 Trilateral Commission reportstated, "An important feature of a renovated[world monetary] system is precisely its scopefor accommodation of nations with widelydifferent circumstances and even with some-what different basic preferences regarding theobjectives of economic policy." What is more,floating rates came just in time, as the oilshocks further widened national economicpolicy differences.The domesticists agree with this analysis, asfar as it goes. But they believe that this

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FOREIGN POLICYanalysis overlooks and perhaps excuses thecentral reason for the loss of U.S. competi-tiveness and the collapse of worldwide com-mitments to price stability, marketforces, andfreer trade. The culprit, as they see it, wasU.S. domestic policy, specifically, the growingbudget deficits and accelerating moneygrowth that began in the late 1960s and thatrepresented such a sharp break with the past.The federal deficit swelled from an annualaverage of $4.4 billion between 1961and 1966to $8.7 billion in 1967 to $25 billion in 1968.After a small surplus in 1969, the budget sankdeep into the red during the following decade,with deficits reaching $60 billion in both 1976and 1980. Similarly, money growth explodedfrom an average of 3.4 per cent annually from1961 to 1966 to 6.6 per cent and 7.7 per centannually in 1967 and 1968. Between 1969 and1979,money growth averaged6.3 per cent peryear. Largely as a result, U.S. average annualinflation rates increased from 1.8 per centbetween 1960and 1967to 4.5 per cent between1967and 1973 and to 7.9 per cent from 1973 to1980. During the same period, average annualU.S. unemployment rates rose from 4.4 percent to 6.1 per cent.According to the domesticists, this declinein U.S. policy discipline and performance didnot result from, but actually contributed to,the decline in U.S. power relative to itscompetitors, and imposed inflation and insta-bility on them through the international mar-ketplace. Contrary to those who stress declin-ing U.S. hegemony, the domesticists believethat the American role in the world economywas not significantly different in 1970 than itwas from the mid- to late 1950s. In 1955,U.S.GNP represented 36.2 per cent of total worldoutput; in 1970, 30.2 per cent. From 1960 to1970,U.S. exports declined only from 14.9percent to 12.8 per cent of the world total. Andthe dollar's share of total world reservesactually increased from 1955 to 1970. It isdifficult, therefore, to attribute the U.S. de-cline before 1970 primarily to external forcesoutside U.S. control. More likely, domesticistsargue, U.S. domestic policies after the late1960ssquanderedU.S. economic power and inthe process damaged the world economy.

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NauInflation was exported and then compoundedby the two oil price shocks. Compared to the1960s, average annual inflation in the 1970stripled in both the developed and developingworlds and unemployment in the industrialcountries more than doubled.

The breakdown of price stability made itharder to resist protectionism. As it becameclear that floating exchange rates did not pro-vide the expected insulation from policy dif-ferences, and as daily capital movementsexploded in volume, many countries, includingthe United States, found ready excuses to erectnew barriersto trade.Tariff barrierscontinuedto decline under the agreements of the TokyoRound, but nontariff measures, including quo-tas and subsidies both for declining and for newhigh-technology industries, began to spread.New doctrines emerged, declaring free tradean anachronism and calling for various kindsof comprehensive government economic plan-ning and industrial policy. Schemes were alsohatched to switch to static principles of man-aged international trade. Little wonder, do-mesticists concluded, that at the margins tradepatterns no longer contributed to the efficientallocation of world resources.The collapse of price stability and theerosion of free-trade commitments both facili-tated and reflected the loss of commitment tomarket forces and flexibility. Through the1970sthe role of government grew inexorably,as citizens demanded more and more fromtheir public authorities. For the seven majorindustrial countries combined-Canada,France, Italy, Japan, the United Kingdom, theUnited States, and West Germany-that haveparticipatedin the Western economic summits,the ratio of total public expenditures to grossdomestic product (GDP)rose from 29 per centin 1967to around 37per cent by the early 1980s.In Canada, Italy, Japan, Spain, the UnitedKingdom, and West Germany, this figure roseeven faster. In the middle-income developingcountries, central government expendituresalone grew from 18 per cent of GDP in 1970to26 per cent in 1980.State-owned enterprises inthese countries, often required to pursue non-market as well as market objectives, mush-

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FOREIGN POLICYroomed-in Brazil from fewer than 150 toalmost 500; in Mexico from fewer than 200 tomore than 500; in Tanzania from fewer than100 to 400. Domesticists believe that thesedevelopments weakened market forces andmarket pricing and further reduced nationaland international economic efficiency.

This administration has been par-ticularly remiss in presentingbroad intellectual explanations formany of its policies.Twice during the 1970s the United Statestried unsuccessfully to achieve internationalconsensus on economic issues through diplo-

matic bargaining. First, at a conference at theSmithsonian Institution, President RichardNixon sought to restore monetary order afterhe cut the dollar loose from gold. And at the1978 Bonn summit President Jimmy Cartertried to convince West Germany and Japan toloosen their fiscal policies and serve as locomo-tives for worldwide economic growth. Butboth times America squandered its diplomaticbargaining power by pursuing inflationarydomestic economic policies that weakened itspower in the marketplace. In the 1980s, do-mesticists urged a reversalof this approach:anassertive use of U.S. economic power in themarketplacebased on noninflationary policiesand a relatively passive U.S. economic diplo-macy, for example, at the annual economicsummits. Domesticists believed that this com-bination could work because U.S. power inthe international marketplace, exploited effec-tively and enhanced through noninflationarypolicies, remains much greater than its powerat the bargaining table-a fact that frequentlyirritates U.S. allies. If the U.S. economy,therefore, could be revitalized and steeredback to price stability, market incentives, andfreer trade, the world economy might beinduced to follow. At some point, domesticistsargue, changes in the world economy mighthelp the United States apply its reducedpolitical influence at the bargaining table tore-establishconsensus and, if necessary, secure

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Nauformal commitments to a revitalized interna-tional economic system.The domesticist approach underlies muchof the Reagan international economic pro-gram. This is not to say that domesticism'spremises are shared consciously or fully byindividual administration officials or even bythe president himself. This administration hasbeen particularly remiss in presenting broadintellectual explanations for many of its poli-cies.Yet it is also a mistake to argue that theReagan administration has had only a domes-tic economic strategy. This charge reveals thecritics' tendency to view domestic reactions toworld economy as essentially counterproduc-tive-as nationalistic, neomercantilistic, uni-lateral, or simply "ideological." Globalistargue that such reactions, by definition, can-not be helpful in dealing with the worldeconomy because the problems lie outside thenation-state. Also, the fragmentation of do-mestic authority ensures either that there willbe no response or that the most reactionarydomestic forces will determine internationalpolicies. Thus globalists conclude that anemphasis on domestic policies must inevitablyreflect a repudiation of international policies,if not of the world economy itself.In fact, the administration's policy has con-sistently emphasized the primary importanceand role of domestic economic policies as thekey to stable and prosperous internationaleconomic relations, not as an end in them-selves. Re-establishing sound U.S. domesticpolicies was the fulcrum for restoring theproper emphasis on price stability and marketincentives in the world economy as a whole.Rather than ignoring the effects of U.S. policychanges on the world economy, domesticismstressed their global importance. Almost im-mediately, at the Ottawa, Canada, summit inJuly 1981, the administration made clear thatits domestic focus reflected not an "AmericaFirst" strategy but a reminder that the worldeconomy could only be as good as its mem-bers' economies.

Restoring the domestic economic founda-tion would help stabilize exchange rates andthen rejuvenate international trade. From the23.


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FOREIGN POLICYoutset, and through the depths of the ensuingrecession, the administration championedfreer trade. Far from pure rhetoric or cyni-cism, this view reflected the domesticist con-viction that freer trade is the chief economicrationale for having a world economy. With-out freer trade, no new growth through com-parative advantage is possible. And traderelations pursued for noneconomic purposesdo little more than divide up existing wealthand exacerbatepolitical tensions.The emphasis on domestic policy reformand on "the magic of the marketplace"becamethe leading themes of administration policiestoward international development and fi-nance. These themes were first laid out com-prehensively in September and October of1981 in the president's address to the WorldBank, in his pre-Canciin speech in Philadel-phia, and in statements at the North-Southsummit in Cancuin,Mexico. Progress towarddomestic stability and freer trade, the adminis-tration contended, would rejuvenate interna-tional financial flows that ultimately dependon real transfers of goods and services to beredeemed. Direct investment and commercialbank lending would increase as countriesacquired more predictable access to foreignmarkets.Financial transfers through the inter-national development institutions could thensupplement these commercial flows ratherthan substitute for them, as was feared in thecase of the then-proposed World Bank energyaffiliate. Further, concessional developmentassistance could be reserved for the poorestcountries, which was the objective of theadministration's controversial policy towardthe World Bank's International DevelopmentAssociation.True to its domesticist precepts, the admin-istration played down international institu-tional solutions, maneuvering to deflate enthu-siasm for global negotiations on North-Southissues. Above all, the administration felt thatthe dialogue and policies of internationalinstitutions should not weaken the incentivesfor domestic policy reform. Initial administra-tion attitudes toward the International Mone-tary Fund (IMF) were thus understandablyskeptical. This institution was perceived as

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drifting away from its primary role as lenderof last resort and thereby weakening its lever-age for economic adjustment by making moregenerous, longer-term loans earlier in theadjustment process. Administration officialsdoubted that economic pressures at this earlystage of the adjustment process would besufficient to produce decisive domestic policychange. In the world of high debt and infla-tion inherited from the 1970s, the administra-tion valued the IMF more for its policy thanfor its financing role. The administrationconcluded that until IMF policies shifted-again, at the margins-caution on new fund-ing made sense.ExportingDisinflation

From these policy premises, the administra-tion has achieved remarkable success in revi-talizing U.S. and, to a lesser extent, worldeconomic recovery and growth. Yet in anumber of ways, its policies fall short of itsown standards and certainly those of a domes-ticist.

In its first year the administration concen-trated on its domestic economic program ofrestoring price stability and renewing growthincentives. The expectation prevailed thatboth lower inflation and renewed growthcould be achieved simultaneously, and that theimpact both at home and abroad would bebeneficial. Under these circumstances, eventhough the United States was now operatingin a much more flexible international environ-ment with floating exchange rates, it seemedreasonable and appropriate to discontinuedaily and sustained exchange-marketinterven-tion. Such intervention only weakened theimpact of U.S. policies in the internationalmarketplace through which, in domesticistfashion, the United States sought lower infla-tion and improved market incentives aroundthe world.

By 1982 Reaganomics had achieved majortax reductions, less significant spending cuts,gains in deregulation, and, through support ofthe Federal Reserve, an extremely tight mon-ey-supply policy. The outcome, by whatevercausal sequence, was large current and pro-jected budget deficits, high nominal and real25.


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interest rates, a strong dollar, a decline inexports and general economic activity, andlower inflation at the cost of sharply increasedunemployment. In this situation, the issue forthe administration was whether disinflation-now that it would clearly hurt-should bestretched out or discontinued. If the presidentwas prepared to accept pain and political riskat home, he had little reason to alleviate thesecosts abroad,where inflation for the most partremained at double-digit levels. Admittedly,the unbuffered export of U.S. disinflationthrough high interest rates and recessionwould test the fabric of open internationaleconomic relationships, as well as the domes-tic political processes in some countries. Butthe administration ultimately concluded thatdisinflation without growth must be accom-plished quickly or not at all.The lack of early success in revitalizing theU.S. and world economies led to an accelera-tion of administration diplomacy, albeit of adomesticist rather than a globalist variety. Atthe Versailles, France, summit in June 1982,the administration elaborated its concept thatsound domestic economic policies in the ma-jor-currency countries should convergearound common indicators of low inflationand greater market flexibility over a medium-term, 2- to 3-yearperiod. It recommended as acoordination vehicle the new multilateral sur-veillance process that brings together semian-nually at the highest political level the fivemajor-currencycountries (France, Great Brit-ain, Japan, the United States, and West Ger-many) and, on an informal basis, the managingdirector of the IMF. This new mechanismsupplements the IMF's bilateral surveillanceauthority over exchange-rate policies of mem-ber countries and focuses on discipliningdomestic economic and financial policiesamong the major-currency countries as thefundamental and lasting route to exchange-rate stability, whether the formal exchange-rate regime is fixed or floating.The multilateral surveillance concept dif-fered from earlier globalist prescriptions foreconomic policy coordination in at least threeimportant respects. It focused on domesticpolicy consequences, not policy instruments

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Nauor direct negotiated policy adjustments; itemphasized a medium- rather than a short-term perspective; and it minimized formal,institutional arrangements.Administration initiatives at Versailleswere not intended to induce immediate policychanges. For that the administration, like thedomesticist, looked to the international mar-ketplace. From summer 1982to summer 1983,international market pressures began to forcepolicy adjustments both in the United Statesand abroad, reflecting the limits imposed ondomestic policy choices if an open internation-al market were maintained.

Beginning in the summer of 1982, the debtcrisis in Mexico and other developing coun-tries threatened, along with bad domesticloans, to overwhelm both the American andthe world banking systems. U.S. policy adjust-ed, but in a way that seemed to contradictadministration priorities. The Federal ReserveBoard sharply accelerated the growth of themoney supply. U.S. interest rates declined andthe immediate crisis was weathered. But thefundamental fiscal imbalance in the UnitedStates remained, threatening the ability tosustain an easier monetary policy withoutreigniting inflation.Similarly, international market pressuresbrought change in French economic policy.After the expansionary policies of PresidentFranqois Mitterrand's Socialist governmentcreated repeated pressures on the Frenchfranc, and after the United States made clearat Versailles that it would not intervene tohalt the franc's slide, Mitterrand turned fullcircle. In March 1983 he imposed severeausterity measures in an attempt to end thelong French love affair with inflation. Inaddition, during the winter of 1982-1983,more conservative governments came to pow-er in West Germany and Japan and firmed upnational commitments to achieve new growththrough low inflation and market incentives.This shift toward common performanceobjectives of low inflation and market incen-tives took place during the depths of the worstrecession in postwar history. It attests both tothe international market power of the Ameri-can economy, despite all the talk of U.S.

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FOREIGN POLICYdecline, and to the spreading conviction underthe domesticist precepts of the Reagan admin-istration that growth based on nonmarketinterventions and increasing prices was notviable in the 1980s. Although internationalcontroversies swirled during this period overU.S. interest rates, exchange-market interven-tion, trade, and the Soviet gas pipeline, themajor industrial countries narrowed gaps intheir domestic economic performance and setthe stage at the 1983 Williamsburg, Virginia,summit for a consensus on economic objec-tives and, to the surprise of many, specificpolicies (such as the need to reduce gov-ernment expenditures).

The current U.S. recovery has notbeen solely or even primarily aconventional Keynesian phenome-non.The strong U.S. recovery in 1983-1984

vindicated these policy shifts and, throughunprecedented U.S. trade deficits, has sparkedinitial worldwide economic recovery. For cal-endar-year 1984,U.S. growth is projected at 6per cent and, for the industrialized world as awhole, at 4.25 per cent. Meanwhile, inflationin the industrial countries dropped from anaverage of 13 per cent in mid-1980 to 4.5 percent in mid-1983, and remained steady there-after. Disinflation and renewed growth havelagged in the developing world, but the IMFprojects averagegrowth of 3.7 per cent in 1984and 4.3 per cent in 1985.Moreover, data from the Council of Eco-nomic Advisers suggest that the current U.S.recovery has not been solely or even primarilya conventional Keynesian phenomenon. RealGNP has grown at a rate of 7.1 per centannually during the first six quarters of thecurrent recovery, compared with 5.9 per centannually for the typical postwar recovery.While personal consumption expenditureshave contributed about the same percentageshare to the current recovery as to previousrecoveries- 55per cent- nonresidential fixedinvestment, mostly producers' durable equip-

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Naument, has contributed twice its usual share tothe current recovery-25 per cent comparedwith 12per cent.Meanwhile, the administration's domesti-cist diplomacy in the international arena hasfocused attention on the right issues. Indeed,now that sustaining the recovery is the keyissue, the multilateral surveillance process isprecisely where Reagan's policies should betested against their premises. Massive U.S.budget deficits cannot continue much longerwithout deleterious domestic and worldwideresults, including devastating consequencesfor the developing countries. Unless the do-mesticist is totally wrong about the ills of the1970s, the Reagan deficits inevitably portendthe same domestic and worldwide stagflationas the earlier and much smaller deficits of the1970sthat the president sharply criticized.One can agree with the administration'sview that it matters not only when but alsohow the deficit is reduced. A return to indis-criminate or automatic tax increases, coupledonce again with special-interest-oriented, log-rolling spending policies, could bring back theera of stagflation as surely as deficits. But theultimate test of the Reagan approach is itsability to achieve politically its preferred solu-tions to the deficit issue. And that meanstaking the results on November 6 of thepresident's domesticist-motivated attempt torevive national consensus on the budget issueand making the best deal possible next year inCongress to reduce spending and, failing that,to raise taxes.The administration should also continue topress other aspects of its domesticist interna-tional policy initiatives. Procedurally, themultilateral surveillance process should bestrengthened to include more frequent meet-ings, the participation of the GATT directorgeneral, evaluations of convergence not onlyby the IMF director but also by membercountries-which frequently lack a good un-derstanding of how other economies work-and more detailed briefings on these meetingsfor nonparticipating countries and nonfinanceagencies within participating countries. Inaddition, parallel multilateral surveillanceseminars among nongovernmental groups

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FOREIGN POLICYfrom the five largest free-market industrialcountries would deepen each society's aware-ness of international economic relationshipsand greatly aid the official surveillanceprocess.Substantively, the summit countries shouldcontinue discussions on exchange-market be-havior initiated at Versailles. The Versailles-ordered study of exchange-market interven-tion correctly concluded that interventioncould have significant long-term effects onexchange rates only if underlying monetarypolicy changed as a consequence of interven-tion. It thereby reinforced the importance ofthe multilateral surveillance exercise. Never-theless, differences remain over whether inter-vention may still be useful in the short run tosmooth out exchange-rate fluctuation, giventhe bandwagon tendency of international cur-rency markets. The Reagan administration,like the domesticist, tends to view these dis-torting international capital flows more as theconsequence of national policies-specificallypolicies that restrict access to national capitalmarkets-than as the result of unpredictablespeculation. Thus the administration advo-cates removing restrictions on capital markets,as it has done in negotiations with Japan.Liberalizing financial markets, of course, mayexaggerate short-term exchange-rate misalign-ments, as long as markets for investmentremain restricted. For the domesticist, there-fore, progressively liberalizing markets for allassets--financial as well as goods and services,and investment as well as portfolio assets-isthe indispensable condition for lasting ex-change-ratestabilization.ThreeTrade-PolicyPhases

Reagan administration trade policy hasgone through two phases and is now enteringa crucial third phase. In the first phase, true toits domesticist outlook, the administrationgave priority to its domestic economic pro-gram. While this program was being put inplace, Reagan's trade record was mixed. Re-strictions were imposed on Japanese automo-bile imports but lifted on South Korean andTaiwanese footwear imports. Once the admin-istration's domestic program was adopted in

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NauJuly 1981,its preferences for multilateral freertrade became clearer. In February 1982, theUnited States launched the Caribbean BasinInitiative and prepared an overly ambitiousagenda for multilateral free trade for theGATT ministerial meeting held in November1982. Simultaneously, however, recessionweakened the administration, leading to addi-tional individual cases of protectionism athome-the multifiber agreement, steel, andmotorcycles, for example-and lack of successat the GATTministerial abroad.

In 1983the Reagan policy entered a secondphase, pressing for international consensus ona multilateral trade round at the annual eco-nomic summits while using U.S. market pow-er to initiate bilateral and regional free-tradediscussions-with Canada, Israel, and theAssociation of Southeast Asian Nations,among others-as a way to catalyze a consen-sus for multilateral talks. Aided by recovery,this strategy registered some success. TheWilliamsburg summit placed a new traderound on the agenda of the industrializedcountries and the 1984London summit partic-ipants agreed to hold such a round "at an earlydate."Now the administration's domesticist tradepolicy is entering a crucial third phase, wherethe bilateral and regional free-trade agree-ments, if they proliferate, as in the case of therecent U.S.-Israel free-trade area, may under-cut multilateral, nondiscriminatory negotia-tions. Much depends on how new worldwideattitudes toward the multilateral trading sys-tem, bred in the economic travails of the 1970s,sort themselves out and how U.S. actionsinfluence these attitudes.These attitudes embrace three schools ofthought. The first, entertained by many devel-oping countries, sees the postwar tradingsystem as unjust and inequitable. Not havingparticipated in the system's creation, the de-veloping countries insist on new rules, such aspreferences and nonreciprocity rather thanmost-favored-nation status and reciprocity,and on new institutions-for example, theU.N. Conference on Trade and Develop-ment instead of GATT. Having pursued de-velopment policies of import substitution,

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FOREIGN POLICYthey generally doubt the value of unregu-lated international trade, and tend to treattrade largely as another form of foreign aid.A second school of thought, advocated bysome European governments and industrialpolicy proponents in the United States, arguesthat the basic nature of trade and comparativeadvantage has changed. Competitiveness is nolonger a consequence chiefly of comparativefactor endowments but of organizational andtechnological capabilities. These include acountry's ability to choose its comparativeadvantages and to integrate government, in-dustry, and research organizations to createthis advantage. The increasing governmentrole makes old rules of nonintervention andquasi-judicial settlement of disputes underGATT obsolete, say adherents of the secondschool. At the very least, governments have tonegotiate more directly to establish a levelplaying field and at times to be active playersin bargaining for market shares.The third school of thought reflects thegrowing influence of capital and exchangemarkets on trade flows. This school arguesthat prices of internationally traded goods andservices are increasingly influenced by mas-sive and often speculative capital flows thatoverwhelm currency exchange markets andbadly distort exchange rates and hence tradingpatterns based on comparative advantage. Un-til the exchange-rate system is revamped,liberal trade policies make no sense.Developing-country attitudes, especiallythose of the newly industrializing countries(NICs),are crucial to a new trade round. TheReagan administration recognized this by ad-vocating a North-South round at the GATTministerial meeting in 1982 and by initiatinginformal trade policy discussions in May andSeptember 1984 between the QuadrilateralGroup countries- Canada, the EuropeanCommunity members, Japan, and the UnitedStates-and key developing countries, includ-ing Brazil, India, Mexico, the Philippines, andSouth Korea. These discussions reflected somewillingness to move away from sterile institu-tional issues of the 1970s toward more prag-matic policy questions: trade problems leftover from the Tokyo Round and characteris-

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Nautics of a new trade round. The issue now iswhether these talks lead to partial negotiationswith individual countries or groups of severaldeveloping countries, producing discriminato-ry arrangements and possible confrontationwith nonparticipants, or whether they buildtoward nondiscriminatory, multilateral tradenegotiations. The Reagan administration can-not press its bilateral and regional approachtoo far without forcing countries like Braziland India back into confrontation. The marketpower approachto liberalization works only ifit yields multilateral consensus; otherwise theworld cracksapart into trading blocs.Industrial policy advocates are unlikely tosucceed in pressing their trade views unlessthe bottom drops out of world economicrecovery. Their call for more direct gov-ernment involvement in deciding comparativeadvantage and actively managing markets issimply impractical. This approach will politi-cize all aspects of commercial relations be-tween countries, severely straining good willand political ties. Moreover, the role of gov-ernment and, more important, the institution-al structures and political traditions in indi-vidual countries, are different enough to pre-vent common definitions of acceptable gov-ernment intervention in trade matters. Howdoes one compare U.S. tax policies that affectcredit allocation in U.S. venture capital mar-kets with the administrative procedures ofJapanese banks and government agencies thatfunnel credit to Japanese industry? Similarly,how can huge U.S. space and defense pro-grams, which undoubtedly had significantspin-off effects, be accounted for when U.S.trading partners have had no comparableprograms?Finally, those pushing monetary policy re-form in advance of trade liberalization mayeventually be won over to new trade talks asconvergence of domestic economic perform-ance helps stabilize exchange rates. As somehigh-level U.S. officials have stated privately,once greater exchange-rate stability throughlower inflation and more open and stablecapital markets is achieved, the choice ofexchange-rate regimes becomes a less weightyissue. Commitment to a specific exchange-rate

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FOREIGN POLICYregime-fixed, floating, or gold-is much lessimportant than the more fundamental under-lying commitment to price stability.In the field of finance, domesticists regardcapital flows, such as commercial lending anddirect investment, as the consequence, not thecause, of predictable prices and flexible, openmarkets. Without the latter, finance can post-pone but not avoid inevitable adjustment.Reagan administration policies toward in-ternational finance betrayed the domesticistpreference for adjustment over finance, evenif in the short-run adjustment meant lessfinance. Disinflation and the search for great-er market flexibility triggered worldwide ad-justment and inevitably interrupted financialflows and international debt accumulationthat the Bank for International Settlementsstated in 1983"would have been unsustainableeven if world demand ... had continued togrow at a fast pace and interest rates hadremained at low levels."Short-term administration efforts to speedthe process of worldwide adjustment reliedheavily on the policy role of the IMF, disap-pointing those who tend to measure supportfor the Fund primarily in terms of finance.The conclusion of IMF-led adjustment pack-ages attacking inflation and market inflexibili-ties, particularly due to excessive governmentintervention, subsequently facilitated both re-scheduling of commercial debt and restructur-ing of government loans. Throughout, theadministration sought flexibility on a case-by-case basis. Tailoring negotiations to the indi-vidual country's situation permitted grantingeasier terms-if politically required-with-out creating precedents that in a more com-prehensive approachwould have reduced con-ditionality to the lowest common denomina-tor. The administration consistently resistedappeals for generalized and institutional solu-tions through global negotiations or an inter-national monetary conference.The case-by-case approach also seems well-suited for the longer term, as recent Mexicanand Venezuelan rescheduling agreements sug-gest. The IMF is no longer formally involvedin these agreements, but banks have access toIMF and government reports and, say Mexi-

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Naucan officials, can suspend the new agreementsif they feel the country is heading again fordisaster. If this arrangement works informal-ly-and the parties have plenty of incentive tomake it work-there seems little need togeneralize or institutionalize the process.

The market power approach toliberalization works only if ityields multilateral consensus;otherwise the world cracks apartinto trading blocs.For the longer-term phase, the Reagan ad-ministration has stressed the third leg of thedomesticist triad--trade-liberalizing negotia-

tions. The fundamental solution to the debtproblem, Special Trade Representative Wil-liam Brock argued in the Summer 1984 issueof ForeignAffairs, is more exports, not fewerimports. Significant, new access to foreignmarkets requires reciprocal trade agreements,since only this traditional technique energizesexporters to oppose protectionist pressuresfrom industries hurt by imports and ultimate-ly makes domestic politics work for tradeliberalization. Larger and more predictableaccess for Third World exports, as opposed tothe year-to-year uncertainties created by thecurrent preferences, will then not only helprestore these countries' creditworthiness butalso attract more foreign investment.The poorest countries, however, will stilllack the infrastructure to trade successfully orto attract private investment. They could beassisted by establishing a link between tradeliberalization efforts to help primarily ad-vanced developing countries and long-termconcessional finance for the poorest countries.The international financial institutions canfacilitate this link. By encouraging multilater-al trade liberalization, they can strengthentheir case for aid. For under these circum-stances, aid transfers not only are less disrup-tive of market incentives-that is, they nolonger support inefficient import-substitutionpolicies-but also are ultimately essential tohelp poor countries develop the infrastructure

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FOREIGN POLICYneeded to participate eventually in freer inter-national trade and investment. Aid wouldthen truly supplement private markets, and anew consensus to revitalize aid could befashioned to include conservative critics of aid.The World Bank has recognized this poten-tial and focused the last three sessions of thejoint World Bank-IMF development commit-tee on trade. If the Reagan administration istrue to its domesticist roots, it will supportthis trade-aidlink.U.S. international economic policies todaynot only reflect a coherent and cogent analysisof world economic problems in the 1970s butalso have worked remarkably well. What isneeded now is not a fundamental change ofdirection but some modifications in line withdomesticist standards. The budget issue re-mains central to U.S. hopes to restore pricestability, market incentives, and freer trade.Thus far, it can be argued, the large deficitsand high dollar, irrespective of their origins orconnection, have on balance been pluses. Theyhave revived both domestic and increasinglyworldwide consumption while providing cashbalances and net capital inflows in the UnitedStates that permitted corporate investment toplay a much larger role in this recovery thanin previous postwar recoveries. Moreover, asconsumption now slows in the United Stateswhile investment shifts to plant capacity rath-er than equipment, interest rates and netcapital flows into the United States maydecline somewhat, releasing resources to fuelthe embryonic investment phase of recoveryabroad.

Nevertheless, unless America is in an en-tirely new era-and thus understands nothingabout the economy, budget deficits of $200billion cannot be less frightening in terms oftheir long-term worldwide effects than defi-cits of $60 billion in 1976 and 1980. From apurely economic perspective, cutting spend-ing will do more to sustain the recovery thantax increases, since the level of governmentexpenditure, not the deficit, is the ultimatedrain on private resources. But the presidentwill be in his strongest position to cut spend-ing the sooner he addresses this issue. He willthen be able to focus on his next domesticist

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Nauobjective-new authority for multilateraltrade negotiations. For these negotiations toinclude items of interest to the United States,such as services and high technology, theymust also include politically touchy productsof interest to developing countries, such astextiles and steel.The stakes for this administration are high,both for its political place in history and forthe credibility of its outlook, which couldinfluence economic policy for decades. If itfails, rather than domestic price stability,market incentives, and freer trade underlyingthe world economy, the financial crisis willcome to dominate all else. Government aidwill be needed, either in the form of inflation-ary monetary policies in the industrial coun-tries or through legislative appropriations, tohold a faltering world economy together.No one could welcome this sequence ofevents. Higher U.S. interest rates will increas-ingly make debt management impossible andpolitically antagonize the developing coun-tries, which are already trying to force thegovernments of industrial countries into moredirect involvement in debt reschedulings andnew lending. This government-to-governmentapproach could revive the sterile North-Southconfrontation and highly structured globalnegotiations that marked the 1970s.The domesticist perspective offers betterprospects for the 1980s. The Reagan adminis-tration has rightfully reasserted U.S. power tolead the world back to the domesticist triad ofworld economic rearmament: low inflation,market incentives, and freer trade. But now itcannot escape the tenets of its own theology.The domesticist perspective offers a usefuland long-overdue intellectual template bothfor appreciating the fundamentally correctinternational economic policy course chartedby the Reagan administration and for appeal-ing to the administration to follow through onits own domesticist priorities.

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