No Stepping Back: America’s International Economic Agenda for 2003-05

Lael Brainard and
Lael Brainard National Economic Advisor - National Economic Council

Robert E. Litan

December 1, 2003

September 11 was a defining event for America’s international economic posture. International engagement, we now know, is not a matter up for debate but a fact of our times. Securing the U.S. homeland will require extensive cooperation from nations around the world and a sustained effort to strengthen the perceived legitimacy of America’s preeminence in the international economic order. Now more than ever, it is important to demonstrate that combating international poverty and promoting vibrant international trade and capital flows are in the mutual self-interest of America and its foreign partners.

Fighting International Poverty

U.S. spending to fight world poverty plummeted during the 1990s. With the Cold War’s end, policymakers lost interest in using foreign aid to fight communism. And disillusionment about aid’s effectiveness was widespread. Aid critics contrasted the stunning economic success of East Asia, where aid has amounted to less than 2 percent of GDP, with the poor performance of the aid-dependent states of sub-Saharan Africa, where aid flows have exceeded 10 percent of GNP for several decades. This seeming contradiction may help explain why U.S. development aid, which had been more than 3 percent of total budget outlays in 1962, had fallen to roughly one-half of 1 percent by 2001.

Now the pendulum may be swinging the other way. Aid activists have learned to mobilize public support by using celebrities to back a simple, compelling goal—as when the global rock star, Bono of U2, made common cause with the pope in 1998 to persuade leaders of the richest nations to forgive the debt of the poorest nations. And the campaign against terrorism has provided a potentially powerful political rationale for foreign assistance—namely, that by strengthening foreign economies, aid may help weaken incentives for their residents to turn to terrorism.

The shift in the politics of aid and its heightened public salience present a tantalizing opportunity to make real progress in fighting global poverty. But it is critical to invest aid funds effectively and to be realistic about what aid can accomplish. The post-September 11 security rationale for development aid, for example, is far from airtight. The masterminds and key actors in the attacks were largely from middle-class backgrounds in the relatively more affluent societies of the Middle East. Their dissatisfaction is more likely rooted in frustration with the political and economic paralysis in their societies than in poverty per se. Yet poverty surely is a critical ingredient in failed states such as Afghanistan and Somalia that host terrorist training camps, and poor education coupled with despair helps explain the resonance of terrorist ideology in the Islamic world.

In the future, aid allocations should be driven primarily by an economic rationale—whether aid is likely to generate economic growth. Experience suggests that aid is most likely to spur growth when national leaders are committed to reform, governance is transparent and accountable, macroeconomic policies are sound, and the aid is more likely to add to national investment than merely to substitute for local investment.

Moreover, aid works best when it respects the power of the market. Previous “silver bullet” approaches that sought to supplant market mechanisms—forced industrialization, investing in industrial infrastructure—proved disappointing. Effective aid policies address market failures and align market returns with social returns.

In recent years, the share of total world aid devoted to investments in health, education, and sanitation has risen to nearly one-third (and nearly one-half for U.S. bilateral aid)—an emphasis consistent with both good economics and development experience. Aid is effective in these arenas because the market underprovides these socially valuable “public goods” whose benefits are spread so broadly that individuals do not have the incentive to pay the costs. Thus, the strong humanitarian case for development aid in providing public goods in the poorest nations is joined by a compelling economic case for action.

A strong public goods case can also be made for aid that advances scientific knowledge in areas such as agriculture and medicine, where weak demand for innovations in the poorest nations leads to large gaps between their potential social value and their apparent market value. In wealthy nations, governments combine public funding for basic research and development with targeted protection for resulting intellectual property to encourage the development of scientific knowledge commensurate with its social value. But poor nations have few public resources to subsidize research, and intellectual property investments offer little promise of private returns. Thus, a key challenge for international development is to establish incentives for the global production of scientific knowledge tailored to the needs of poor nations.

For example, the United States may need to fine-tune intellectual property protection for pharmaceuticals. Intellectual property laws are designed to strike a balance between two competing needs—encouraging innovation and making valuable knowledge widely accessible. In recent years, efforts by the United States to extend these protections to the international level have come under attack for denying lifesaving medicines to the poorest nations. Indeed, there is some tension between boosting research on diseases disproportionately afflicting the poor and making medicines more accessible to poor nations. Extending the time a given producer enjoys an intellectual property monopoly on a particular drug encourages greater research effort. But making the drug broadly accessible requires pricing it at cost, which undercuts the value of the monopoly. For a limited class of internationally agreed health emergencies, where medicines are already in production in response to demand in rich nations, these goals can be reconciled by segmenting markets in rich and poor nations. Pharmaceutical producers could maintain their profit margins in wealthier markets if their governments prohibit “parallel” imports of their drugs from poor countries. And poor countries could get medicines at close to cost directly from the pharmaceutical company or from local or third-country generic producers.

Emerging International Consensus on Aid

Aid programs historically have been driven by the diverse agendas of donor countries. In a break with tradition, broad international agreement has recently emerged that aid is most effective when beneficiary countries are heavily involved in shaping development programs and priorities. It may now be possible to reorient the aid process around comprehensive national strategies designed by beneficiary governments in an open process involving key stakeholders. The World Bank’s new Poverty Reduction and Growth Framework, established to direct resources freed up by debt forgiveness toward nationally determined social investments, reflects this new orientation. In the new framework, beneficiary nations present spending plans and assistance needs as part of an overall strategy to reduce poverty, thus ensuring that domestic budget resources reinforce the same priorities as aid.

Recent years have also seen an emerging consensus on the highest-priority programmatic areas for development aid. The consensus is broadly reflected in the eight development goals adopted in September 2000 at the United Nations Millennium Summit, for achievement by 2015. The goals—to eradicate extreme poverty and hunger; promote gender equality; achieve universal primary education; reduce child mortality; improve maternal health; combat HIV/AIDS, malaria, and other diseases; ensure environmental sustainability; and develop a global partnership for development—were specified in terms of 18 targets linked in turn to measurable results. One target, for example, was to halve the share of people whose income is less than one dollar a day.

Achieving these goals will be expensive. A group chaired by former Mexican President Ernesto Zedillo has put the price tag at an additional $50 billion a year—roughly double the current annual aid contributions of $53 billion, $30 billion of which goes to the world’s poorest nations. Of the added resources, $12 billion would go for education, $10 billion for health, and $20 billion to fighting poverty. The U.S. share would range somewhere between $8.5 billion and $20.7 billion a year—the low end based on the U.S. share of IMF and World Bank capital, the high end reflecting the 41.3 percent U.S. share of the total GDP of industrialized donor countries.

The Bush administration has pledged to increase bilateral development aid by $5 billion a year by 2006 and to provide the new funding through a Millennium Challenge Account. Recipients would have to meet eligibility criteria in the areas of good governance, economic freedom, and investment in health and education. Continued access to funds would be contingent on measurable results. The administration’s announcement of the new aid was greeted by applause from aid advocates and officials from poor nations—but also by an undercurrent of skepticism along the lines of “Show me the money.” Some advocates have suggested a fiscal year 2003 down payment. Aid requests from the administration, however, have essentially held steady at historically low shares of the budget in the past two fiscal years. And the few areas that have seen increased funding—such as combating international HIV/AIDS—have come partly at the expense of spending on malaria and tuberculosis, rather than as net increases. Even on HIV/AIDS, the administration has resisted funding increases proposed by Congress.

Strengthening the Trading System

After growing a record 12.5 percent in 2000, world trade grew less than 2 percent in 2001. Foreign direct investment flows, which reached a record $1.3 trillion in 2000, are estimated to have fallen by half in 2001, the sharpest drop in three decades. Most experts see little or no link between these sharp declines and the events of September 11 and attribute them instead to economic slowdowns in the United States, European Union, and Japan, as well as the information technology collapse.

Nonetheless, September 11 was a wake-up call for many trade supporters worldwide. It reinforced the direct interest of the wealthier nations in strengthening the trading system by rectifying the perceived inequities that prevent millions of the world’s poor from reaping the potential benefits of globalization.

A key question now is whether the new security environment will signal a sustained shift in the terms of the U.S. debate to a broader definition of America’s national interest. Sensing the opportunity, U.S. Trade Representative Robert Zoellick lost no time in proclaiming trade to be central to America’s campaign against terror. President Bush used even stronger terms: “The terrorists attacked the World Trade Center, and we will defeat them by expanding and encouraging world trade.”

But together the terrorist attacks and the deepening of recession in the United States and around the world upped the ante on both sides of the trade debate. With the United States experiencing the first surge of unemployment in years and with the manufacturing sector hit particularly hard, domestic concerns moved front and center.

The post-September 11 emphasis on international coalition building created enormous momentum for the successful launch of global trade talks at the World Trade Organization meeting in Doha, Qatar, in November 2001. Success became a political imperative. Although the decision to hold the talks in Qatar, one of a handful of WTO member-states from the Middle East, had been long since made, the determination to follow through was courageous and symbolically important. Moreover, as evidenced by the term used to describe the outcome, “the Doha Development Agenda,” the tenor of discussions at Doha tipped the balance on the margins toward the developing world. Both the European Union and the United States made important concessions to the developing countries to assure a successful launch. But the advanced nations will be hard pressed to deliver on their promises, given the high domestic sensitivities of the sectors likely to be affected by most controversial subject areas—the farm sector, textiles, and environmental and labor standards.

In 2002, following eight years of stalemate, Congress granted the president trade promotion authority—whereby Congress agrees to streamline its approval process for future trade agreements in return for enhanced oversight of negotiations. But the vote by the House of Representatives was highly partisan and won by a razor-thin margin of three votes, purchased at the expense of concrete up-front concessions in the form of trade-restrictive measures. The process left a deep divide at home and left foreign trading partners questioning the value of the U.S. promise to negotiate future trade opening in the face of immediate trade rollbacks.

Still, both the Doha agreement and TPA are important commitments to proceed with trade negotiations—which will inevitably require concessions in specific sectors where identifiable jobs and livelihoods are directly on the line. And so far, whenever concrete sectoral trade-offs have arisen—whether on farm subsidies, steel safeguards, Canadian lumber, or textiles access—the Bush administration has decided in favor of domestic sectoral interests.

The United States is by no means unique in this gap between its broader geostrategic aims and its willingness to accept painful sectoral dislocation when the economy is under stress. Both the European Union and Japan have been under tremendous pressure from their farm sectors to oppose opening agriculture to international competition.

Sustaining a focus on smoothing the rough edges of the global trading system, addressing inequities in global governance, and helping to give the world’s poorest citizens a stake in the international system is as difficult as it is important. Even the compelling national security rationale of vanquishing terrorism may not be enough to overcome the intense domestic pressures. Trade policy presents knotty trade-offs between the losses faced by those whose jobs and companies are vulnerable to international competition and the greater but more diffuse national interest in a more competitive and productive economy—and in promoting a more peaceful, prosperous, and equitable world.

The potential worldwide gains from trade are quite impressive. The IMF puts the gains from eliminating all barriers to merchandise trade in a range from $250 billion to $680 billion a year. Developing countries would stand to gain the most in relation to GDP, with one-third of the total gains accruing to the poorest countries. The World Bank values comprehensive trade reform at $350 billion overall, with half accruing to developing nations. The value of total agricultural support by governments in industrialized countries is more than $300 billion a year, more than five times higher than spending on foreign development aid and more than the entire GNP of sub-Saharan Africa. Cuts in these subsidies could materially improve the livelihoods of the three-quarters of the world’s poor who live in rural areas. Cutting barriers to services trade would produce a further annual global gain of $250 billion, most of it accruing to the developing world. The World Bank’s chief economist estimates that trade protection in the rich nations costs the developing nations more than $100 billion a year—twice the value of the international aid they receive.

International Finance

The first half of the 1990s saw remarkable progress in integrating the so-called emerging markets and transition economies into the international financial system. Private capital flows to emerging markets rose from $46 billion in 1990 to $235 billion in 1996. But as a series of damaging financial crises—Mexico in 1995; Southeast Asia, Russia, and Brazil in 1997-99; and Argentina, Turkey, and Brazil among others in 2002—make clear, sustaining that progress will not be easy. Important challenges are yet to be resolved.

The issues arising out of these crises are of direct interest to U.S. policymakers and citizens for several reasons. First, with world financial markets tightly linked and shifts in investor sentiment sudden and sharp, the U.S. economy can be adversely affected by instability far from our shores. Second, the United States has a strong national security interest in avoiding financial and often political crises in key allies, such as South Korea and Thailand in 1998 and Turkey and Argentina in 2001. Third, the United States is the principal financial supporter of the two international financial institutions—the International Monetary Fund and the World Bank—whose resources have been mobilized to prevent these crises from spinning out of control.

The typical policy reaction to financial crises—hard currency loans from the IMF and other sources coupled with broad conditions on how recipient governments must operate their economies—has become increasingly controversial. In 2000, a congressional commission, headed by Alan Meltzer of Carnegie Mellon University, concluded that the “bailout with conditionality” policy was making things worse rather than better by encouraging lenders and borrowers to believe that an international rescue effort always would be mounted to prevent lenders from suffering any loss. The commission recommended radically scaling back IMF lending and cutting back on the conditions accompanying loans.

Policy has, in fits and starts, moved in this direction—though driven more by the complex realities of the financial markets than by the commission’s recommendations. The IMF has adopted policy reforms to reduce the likelihood and severity of crises and their potential worldwide impact. Perhaps most important, countries that have undergone crisis have abandoned fixed exchange rates and now allow the market (more or less) to determine the rate of exchange. Flexible rates require both borrowers and lenders to take account of the risk of future currency movements as well as the risk of nonrepayment.

The financial crises also led to institutional reforms. The IMF is better funded and somewhat more transparent. The governance of the international financial system has been strengthened by the creation of a new steering group that includes important emerging markets and the largest advanced economies. Several key creditor governments are pressing the IMF to narrow its focus to crisis prevention and response and to scale back the medium-term balance-of-payments financing that has made too many countries virtual dependents of the Fund.

Policymakers have continued to debate whether financial crises should be resolved by bailing out borrowing countries or by “bailing in” private investors by suspending debt payments. During the second half of the 1990s, policymakers tried many approaches to private-sector involvement, mostly out of desperation rather than by design and only after substantial sums had been spent. The bail-ins ranged from purely “voluntary” exchanges (which failed) to “concerted” rollovers blessed and orchestrated by the international financial authorities to unilateral exchanges dictated by debtor governments without an international seal of approval. Increasingly, private-sector involvement is being acknowledged as a vital lever in crisis resolution—a recognition that official resources are more and more outgunned by private capital.

Institutionalizing this new presumption is proving thorny. The absence of a world bankruptcy regime makes it difficult to develop rules that would encourage investors to make better risk assessments but not exacerbate creditor panic at moments of financial precariousness. Since 1999, private-sector involvement has been a prominent feature of most sizable stabilization programs, with the particulars being worked out on a case-by-case basis.

Meanwhile, investor expectations have shifted to incorporate a higher probability that their claims will be restructured in the event of losses. Indeed, the dominant concern by 2002 was no longer that too much money is sloshing around the emerging markets, but that capital flows have been drastically, perhaps excessively reduced.

Adjustment among the Advanced Economies

Today risks are also being posed by the industrial countries—a problem that no amount of IMF reform is likely to fix, for the Fund has no leverage over countries that are not borrowers.

The potential for disorderly adjustment in America’s growing external imbalance cannot be lightly dismissed. During the late 1990s, the United States was a magnet for foreign capital, attracting much of the world’s international capital flows. With strong productivity growth and a booming stock market, America seemed like a great investment. Against a backdrop of stagnation in Japan, slower growth in Europe, and diminishing appetite for exposure to emerging markets, the dollar strengthened by 30 percent against the yen between late 1999 and early 2002 and by 36 percent against the euro between its introduction in early 1999 and early 2002. The flip side of this equation is a growing current account deficit, which has remained at or above 3.9 percent of GDP since 2000, reaching 5 percent in the second quarter of 2002.

When the current account deficit last exceeded 3.4 percent of GDP (in 1987), it precipitated a sharp drop in the dollar and a delayed fall in the current account, which returned below 2 percent in 1989. The current circumstances could likewise presage volatility and a sharp adjustment at a time when weakness in the U.S. stock market threatens recovery and causes foreign investors to flee. At the same time, projected financing needs of the federal government have increased sharply, with a $236 billion surplus turning to a $106 billion deficit in just two years and continued deficits projected through 2004. Meanwhile the dollar tumbled roughly 12 percent against the yen and the euro between February and July of 2002. The share of foreign capital coming into the U.S. market as direct investment or committed capital fell from 39 percent in 1998 to 17 percent in 2001, suggesting that a much larger share of external borrowing is being financed by short-term capital or “hot money” that can reverse direction rapidly.

In late 2001 and throughout 2002 the United States found itself at the center of one of the worst crises in corporate governance and transparency since the Great Depression. The crisis—reflected most graphically in a steep fall in stock prices during much of 2002—was triggered by the failure of Enron and followed shortly thereafter by disclosures of accounting errors at Worldcom, Xerox, Merck, Bristol-Myers-Squibb, and other companies. With each new disclosure, investors, commentators, and the public seemed to lose ever more confidence in the system of corporate disclosure and governance that only a few years back had seemed to be the best in the world. After serving as a safe haven for foreign investors throughout the 1980s and 1990s, U.S. markets suddenly lost their appeal. Portfolio and direct investment from abroad plummeted by nearly half, from annual rates of $686 billion in 2000 to $361 billion in the first quarter of 2002.

By last summer, Congress had enacted and the president had signed sweeping reform legislation that created a new quasi-government agency to oversee the auditing profession; restricted auditors from engaging in nonaudit businesses; toughened criminal and other penalties for corporate fraud and misrepresentations; speeded up disclosure of insider trading of securities; and prohibited corporate loans to executives. Earlier the Securities and Exchange Commission had implemented new disclosure requirements, and the New York Stock Exchange had proposed sweeping corporate governance reforms for companies listed on the exchange that required a majority of board directors to be independent; shareholders to approve executive compensation packages; and audit committees of boards of directors to hire and fire outside auditors.

One key unresolved issue was whether the United States will continue to require all publicly held companies whose shares are traded here to report their financial condition according to Generally Accepted Accounting Principles (GAAP) or permit foreign (and domestic) companies to use the International Accounting Standards (IAS) that are being accepted elsewhere around the world. The Enron affair gave impetus to advocates of IAS, who claimed that Enron would not have been able to expand so rapidly—and take on so much debt—had it been required by IAS to consolidate its many off-balance sheet entities. The growing globalization of capital markets also seems to strengthen the case for a single set of reporting standards worldwide, which is what IAS is well on the way to becoming.

There are two views on what should be done. The dominant one is that the two standards should continue to coexist but more closely approach one another. A minority view (to which one of us subscribes) is that competition between the two is healthy and if allowed to proceed—for example, by governments or exchanges allowing companies to use either standard without restriction—then demand by investors for useful disclosure would keep both standard-setting bodies on their toes. Perhaps most important, competition between the standards could reduce the role of political influence, which has been apparent in the setting of U.S. GAAP for some time.

An Urgent Question

September 11 brought a new urgency and heightened focus to the debate over America’s international engagement—its roles in development assistance, world trade, and the international financial system. Today the question is not whether the United States should remain engaged, politically and economically, with the rest of the world in all these areas. The question—which urgently needs answering—is how.