Letter #3: George Soros (1984)

1984 Essay: The Danger of Reagan's "Imperial Circle"

Hi there! I go by KG, and I love studying the history of business and investing. I’ll be sharing some notes from one Investor/Shareholder letter per weekday (mostly from my compilations) here.

Today’s notes are on George Soros’ 1984 essay: The Danger of Reagan’s “Imperial Circle.” I’m still playing around with the format here, but today’s format is an essay annotation (Bold = my highlights, bullet points = some of my thoughts).

You can find this essay in my George Soros Compilation. This particular essay starts on page 14.

I’m still figuring out formatting, so I’d appreciate if you let me know how you like this one compared to my previous two on Teledyne (tweetstorm) and Apple (annotated tweetstorm).

If you have any thoughts on what you’d like to see, let me know!

The Danger of Reagan’s “Imperial Circle”

[[Financial Times]], May 23, [[1984]]

[[by George Soros]]

Without intending it, or even being aware of it, the Reagan administration has developed a few form of economic imperialism which allows it to finance a high budget deficit at the expense of the debtor nations. The policy is likely to appeal to the voters but it is bound to have disastrous consequences.

The budget deficit is not deliberate. It is the unintended consequence of irreconcilable policy objectives: a desire to it public spending while maintaining a strong military posture and reducing taxation. When government spending could not be cut sufficiently the deficit soared. Fortunately for Reagan, the budget deficit set in motion a self-reinforcing process which is beneficial for the U.S. Unfortunately for the debtor countries, what is a benign circle for the U.S. is a vicious circle for them.

  • [[loops]]

  • [[1980s]] was the thick of the [[Cold War]], of course the government was spending like crazy and unwilling to compromise on military spending

The budget deficit keeps interest rates higher than they would be otherwise. High interest rates coupled with financial deregulations suck in funds from all over the world, political considerations also play part: a strong defense posture in a world fraught with conflicts tends to attract foreign capital.

The budget deficit stimulates the economy. Without it, the recovery could not have been as fast and vigorous as it turned out to be. The recovery, combined with high interest rates and the influx of foreign capital, tends to keep the dollar strong. The recovery, combined with a high exchange rate, tends to suck in imports and create a trade deficit. The trade deficit combined with a high exchange rate tends to moderate inflation, as a consequence, the U.S. enjoys the best of all possible worlds: strong economic growth combined with low inflation and budget deficit financed by the influx of foreign goods and foreign capital. I shall call this benign circle the “[[Imperial Circle]].”

  • budget deficit -> stimulates economy (faster growth/recovery)

  • recovery + high interest rates + influx of foreign capital = dollar stays strong

  • recovery + high exchange rate (sucks in imports)-> trade deficit

  • trade deficit + high exchange rate -> moderate inflation

  • Imperial Circle = [[loops]]

The strength of the U.S. economy helps debtor countries build up their trade surplus. For the rest, the “Imperial Circle” acts as a vice which squeezes them dry. Both interest rates and the dollar are much higher than they were when the debts were incurred. Like other self-reinforcing, self-validating connections, the Imperial Circle is liable to be broken. Countries like Brazil enjoyed a period of unprecedented prosperity while they were amassing debt, but when the music stopped the piper had to be paid. It is only a question of time before the same thing happens to the U.S. budget deficit. When capital inflows cease to exceed the new rising trade deficit, the dollar will decline and the Imperial Circle will be turned upside down. With foreign capital seeking refuge elsewhere even a shrinking budget deficit will be more difficult to finance. With the dollar weakening, interest rates and the rate of inflation may rise when it ought to be falling.

  • No [[loops]] is perfect; it's only a matter of time until one is

  • See [[Wriston's Law]] -- capital (and talent) goes where it is well-treated; if foreign capital goes elsewhere, expect things to get hard

  • Foreign capital = [[liquidity]]; as [[Druckenmiller]] says, liquidity moves the markets; in for great times when it's up, in for a nightmare when it contracts

President Reagan seems to understand the workings of the Imperial Circle better than his economic advisers. That is why he has been so adamantly opposed to raising taxes. Political and economic pressures will oblige him to do so after the elections. Nineteen-eighty-five may therefore turn out to be a year of [[economic crisis]]. #prediction

  • Did Reagan actually understand the Imperial Circle? I'd guess that it was simply because he's a conservative and conservatives don't raise taxes

  • [[Reagan Policies]] [[Reaganomics]] (from Wikipedia): Reagan lifted remaining domestic petroleum price and allocation controls on January 28, 1981, and lowered the oil windfall profits tax in August 1981. He ended the oil windfall profits tax in 1988. During the first year of Reagan's presidency, federal income tax rates were lowered significantly with the signing of the Economic Recovery Tax Act of 1981, which lowered the top marginal tax bracket from 70% to 50% and the lowest bracket from 14% to 11%. This act slashed estate taxes and trimmed taxes paid by business corporations by $150 billion over a five-year period. In 1982 Reagan agreed to a rollback of corporate tax cuts and a smaller rollback of individual income tax cuts. The 1982 tax increase undid a third of the initial tax cut. In 1983 Reagan instituted a payroll tax increase on Social Security and Medicare hospital insurance. In 1984 another bill was introduced that closed tax loopholes. According to tax historian Joseph Thorndike, the bills of 1982 and 1984 "constituted the biggest tax increase ever enacted during peacetime"

The tension between the collective of commercial banks and the debtor countries is also likely to reach a climax around that time. Countries like [[Argentina]], [[Brazil]] and [[Mexico]] will have built up significant trade surpluses; yet they will be suffering from continued high unemployment and recession.

  • Trade Surplus != Good Economy

Debtor countries may choose to stimulate their domestic economy rather than service their foreign obligations. If they continue to abide by the IMF prescription, discontent may well find expression in direct action. It will be all too easy to interpret political developments in an East- West context and to combat Communism all over Latin America, not to mention the Philippines or Tunisia or Kenya. A slowdown in the U.S. economy would then coincide with a debt crisis and/or political turmoil in Latin America and other parts of the Third World.

  • As [[Charlie Munger]] says, "Show me the incentives and I will show you the outcomes" -- the best [[predictions]] are made by studying [[incentives]]

Is there no alternative to economic and political calamity in 1985? I believe there is, but it would require a thorough revision of U.S. economic and foreign policy.

  • When have National economic/foreign policies ever actually been thoroughly revised? Especially before anything bad happens.

To bring the budget into better balance it is essential to reduce military expenditures. But that is not enough. The U.S. budget deficit is the last remaining engine of inflation in the world; if it is reduced, deflationary forces will predominate and the world economy is going to crash. The heavily indebted countries will be unwilling and unable to pay their debt. That is a problem that needs to be resolved. It cannot be resolved between the banks and the debtor countries for the simple reason that the banks’ commitments far exceed their own resources. Any viable arrangement will require some additional commitments from the industrialized nations both to underwrite the banks and to ensure a flow of new lending.

  • Military spending is one of the biggest expenditures (on-balance-sheet, at least). However, reducing this is not nearly enough. See [[Druckenmiller]] talk on [[Generational Theft]]

  • If the US crashes, the whole world crashes -- it is imperative that the US does not (clearly seen in [[2008]] when the US crashed, the world fell into recession; [[IMF crisis]] mostly stayed within Asia)

  • Banks' commitments > than their own resources... [[leverage]] is bad!!

Military spending can be reduced only if there is a relaxation in political tensions. Anti- [[Communism]] as it is professed and practiced by the Reagan administration runs a great risk. If we interfere in the internal politics of countries within our orbit in order to prevent them from falling into the Communist orbit, we must deny them the privilege of choosing their own form of government.

  • Lol, I see why the right hates George. See him as pro-communist.

Since under the present arrangements we are also denying them economic prosperity, we are obliged to rely on increasingly oppressive regimes in order to maintain our dominion. That  is already happening in Central America, but if we continue on our present path, the rest of Latin America is likely to follow.

  • Is he suggesting that anti-communist = oppressive? I personally wouldn't exactly put them on the same scale…

If we did a better job in assuring the freedom and prosperity of the countries at the periphery of our economic empire, we would have less need to depend on our military might. The way to do it is not by regional handouts to repressive regimes but by tackling the international debt problem.

  • Not sure I agree that [[economy]] > [[military]]. Economy is [[soft power]], and Military is [[hard power]]. If you don't have hard power, soft power doesn't matter, especially dealing with [[Machiavelli]]an regimes

If you’ve got any thoughts, questions, or feedback, please drop me a line - I would love to chat! You can find me on twitter at @kgao1412 or my email at kevin@12mv2.com.

All compilations here.