CHAPTER 2

Years of Illusion and Reckoning

BY THE SUMMER OF 1976, the rapid rise in Eastern debts and Western doubts led Edward Gierek to alter his plans for Poland. Although the Socialist Bloc as a whole remained credible in the eyes of Western bankers, Poland was setting a torrid pace for debt accumulation that appeared to be unsustainable. From 1971 to 1975, the nation’s debt to the West had exploded from $764 million to $7.4 billion, and it showed no sign of slowing down unless the country’s economy underwent dramatic changes to lower imports and increase exports.¹ To that end, on June 24 the Polish government announced a plan to increase food prices across the country by an average of 60 percent.

Two glaring problems stood in the way: the increases would make Polish citizens poorer, and they would undercut late socialism’s foundational promise to always increase living standards. Recognizing that the proposal would be unpopular, the government committed to holding “public consultations” to discuss the plan with the population. The fact that the consultations were scheduled to take place in the course of a single day signaled the propagandistic intent underlying them, but Polish workers nevertheless took the invitation to express their opinion of the decision seriously. On June 25, strikes and street demonstrations broke out in industrial centers, and countless smaller work disruptions rippled through the rest of the country. Shaken and unwilling to risk a full reprise of the events of 1970, the authorities claimed by nightfall to have held productive consultations with the working class and rescinded the price increases indefinitely.²

In what context should these events be placed? Normally, the events of June 1976 are placed at the midpoint of a narrative about the rise of the labor union Solidarity that begins with the food price strikes of 1970 and ends with the formation of the union in the summer of 1980. Seen in this light, the attempted price increases signal the ineptitude and injustice of the Gierek regime and mark an important moment in the construction of a unified Polish opposition that would unleash the full power of its resistance under the banner of Solidarność in August 1980.³

But there is another way to describe the events of that June. Removed from their particular Polish context, they were emblematic of phenomena occurring across the industrial world as nations adapted to the economic crises of the 1970s. First, they exemplified the power of financial markets to force changes in domestic policies. Second, they reflected how torturous it was for governments to attempt to legitimize changes in domestic policy that would harm the interests of their populations. And finally, they spoke to the potential power of the working class to thwart governmental plans for domestic austerity. Described in this way, the Polish attempt to increase prices represents just one of many instances of the basic riddle at work in both Eastern and Western politics in the late 1970s: how could governments extract economic sacrifice from their people?

It was a challenge few governments mastered and most tried to avoid until they had no other choice. Throughout the 1970s, the power of the working class was, if anything, stronger in the West than in the East, and most governments on both sides of the Iron Curtain waited as long as financial markets would allow before asking their citizens to sacrifice. Because Western currencies were internationally convertible and Eastern currencies were not, crises in the West appeared under a different name than in the East. Currency crises bedeviled Western societies, while debt crises came to haunt Eastern ones. But Western currency crises and Eastern debt crises were different manifestations of the same thing: international capital’s loss of confidence in the viability of a nation’s economy. As such, they required the same response which can broadly be defined as austerity—government policies that intentionally lower the living standards of the domestic population to restore financial markets’ confidence in the national economy. Calling this austerity economic or structural “adjustment,” as financial officials did in the 1970s and 1980s, disguised the policy’s fraught social and political consequences. In both East and West, economic “adjustment” was nothing short of a direct challenge to the legitimacy and governing ideology of any government that tried to implement it.

This chapter chronicles the fraught moments of economic crisis that rolled across the Western and Eastern world over the course of the late 1970s. Governments of the Eastern Bloc continued to rely on their access to cheap Soviet raw materials and Western credit markets to avoid the disruptive adjustments austerity brought to Western societies beginning in 1976. But both of these economic lifelines ran out in the late 1970s, and austerity became unavoidable. In 1977, the Kremlin announced that the Soviet Union would no longer be able to increase energy deliveries to the rest of the bloc after 1980. This weakened one of the crutches Eastern European governments had used to defer the effects of the oil crisis since 1973 and left them overwhelmingly reliant on the continued flow of Western capital, and particularly US dollars, from the Euromarkets to defer the encroaching demands of the world market.

Because the US dollar was controlled by the US Federal Reserve, Western capital would continue to flow easily only as long as US monetary policy remained loose, as it had been throughout the 1970s. The United States, like the communists of the Eastern Bloc, deferred adjustment as long as possible. But by the late 1970s, its time, too, had run out. Severe runs on the US dollar in 1978 and 1979 forced the Federal Reserve to implement domestic austerity at the decade’s end to restore global-capital holders’ confidence in the currency. US Federal Reserve chairman Paul Volcker’s resolution of the 1979 dollar crisis through the imposition of domestic austerity brought an end not only to the United States’ years of deferring the effects of the oil crisis but also to the days of easy money on the Euromarkets. The centrality of the US dollar to the entire world economy meant that when the United States finally decided to face its reckoning with broken promises, the rest of the world, including the communist states of the Eastern Bloc, had no choice but to reckon with broken promises too.

Her Majesty’s Government in London was the first government to fall into austerity’s grip. Like its counterpart in Warsaw, the British Labour government of Harold Wilson had borrowed heavily on international credit markets after the oil crisis to defer adjustment. But by March 1976, international capital holders had begun to doubt the long-term viability of the British economy, and they started moving their wealth out of the British pound. This precipitated a run on the currency, and the Bank of England was drawn into supporting the pound on international currency markets. With its resources soon exhausted, the government was forced to approach other Western central banks for a loan. The US Treasury and the Bundesbank granted the British a $5.3 billion loan, but they attached the condition that the Wilson government reach a “high-conditionality stand-by agreement” with the International Monetary Fund (IMF). A package of measures was agreed to in July, but it failed to stem the flow of capital out of the country.

By November, the Labour government, now under the leadership of James Callaghan, was back at the IMF with a request for further assistance. The conditions of the deal that emerged were stiff: 3.5 billion pounds in government spending cuts over the next two years, a reduction in the state borrowing requirement, limits on domestic credit creation, and the adoption of an “incomes policy” under which British workers’ wage increases would barely match inflation. Callaghan lobbied the US and West German governments to get the IMF to ease its terms. But both US president Gerald Ford and West German chancellor Helmut Schmidt demanded Callaghan accept the IMF’s dictates. Out of international lifelines, Callaghan had no choice but to move ahead with the IMF plan, which was adopted in December 1976.⁴

The country’s arrival at the precipice of insolvency led to further diagnoses of democracy’s ultimate propensity to promise more than it could deliver. “The greatest sacred cow of all—unfettered representative democracy—will have to be questioned,” the British financial writer Samuel Brittan concluded in his 1977 book The Economic Consequences of Democracy. “The basic trouble is the lack of a budget constraint among voters,” he wrote. “Is it possible,” he went on to doubtingly ask, “to create or evolve a consensus, so far missing, on a legitimate social order which would appeal to people’s sense of justice and persuade them to moderate their pursuit of private interest, both in the ballot box and in their other collective activities?”⁵ The prospects appeared bleak.

At the highest levels of the British government, the resolution of the crisis began to fundamentally alter the Labour Party’s views on the role of government. IMF austerity made budget constraints the order of the day and led to a rejection of Keynesianism in the economist’s home country. As Callahan famously declared in a speech to the Labour Party conference in September 1976, “We used to think that you could just spend your way out of a recession . . . I tell you in all candor, that that option no longer exists and that in so far as it ever did exist, it only worked . . . by injecting bigger doses of inflation into the economy, followed by higher levels of unemployment.” Coming as they did from the political standard-bearer of the British working class, Callaghan’s words stood as a profound rejection of the Keynesian economics that had dominated British politics since the Second World War.⁶

As global financial markets battered the postwar social contract in Great Britain, they also mounted a sustained assault on Italy. Since the oil crisis, Italian unions had brought their workers significant gains in real wages under the automatic wage indexation mechanism of the scala mobile and protected their members from the threat of labor “redundancy” as firms moved to become more efficient through layoffs. By 1976, Italian workers were expensive and difficult to fire, and the ruling coalition, led by the Christian Democrats, was at a loss for how to slow labor’s momentum. To cover the yawning gap between national production and consumption, the government had borrowed heavily on the Euromarkets and from the IMF in 1974 and 1975, but financial lifelines had run out by the start of 1976. Negotiations with both the IMF and the European Community early in the year produced demands that the government slow the growth of real wages, domestic monetary creation, and government spending. Lacking enough credibility with labor to get unions to agree to voluntary wage restraints and facing a tough election in June against the Italian Communist Party, the Christian Democrats balked at international capital’s demands.

In the context of the Cold War, the possibility of a communist victory in the elections appeared to signal that the Italian Left was dangerously ascendant. But in the crucible of financial crisis, it became clear that, like their counterparts on the British Left, the Italian communists would also accommodate international pressures for austerity. After narrowly winning the June election, the Christian Democratic leader, Giulio Andreotti, formed a government of “national solidarity” that relied on the communists to make the internationally demanded austerity policy “socially acceptable.”⁷ The Communist Party leader, Emilio Berlinguer, embraced what he described as the “ideology of austerity” in the hope of leading the nation out of its financial crisis. After the passage of deflationary measures in the fall of 1976 that were estimated to reduce domestic demand by 3 percent of GDP, the leading Italian industry and labor groups signed a “social compact” in January 1977 that began to restrict the use of the scala mobile and marginally boost labor mobility within firms. The social compact marked a turning point in Italian politics. From then on, labor was on the defensive. With the support of the communists and over the objections of many Italian unions, the government reached an agreement in 1977 with the IMF on cutbacks in public spending and domestic consumption.⁸

The disruptive legacy of austerity in Western democracies reinforced socialist governments’ reluctance to implement restrictive policies. For Erich Honecker and János Kádár, it also pointed the way to how their regimes could lay claim to superiority over their Western rivals. Austerity, they believed, was for capitalists whose system was evidently failing. Socialist countries, by contrast, had to appear as lands of economic serenity. “Many people admire the GDR,” Honecker told a meeting of East German officials in November 1976 as the crises in London and Rome were unfolding. “Under capitalism there is the path of deflation or inflation. We don’t use either one. We go the way of methodical, proportional development of the economy to ever higher levels.” Any economic reform must be sure not to “break the backs of the workers,” he told his comrades.⁹ In a Hungarian Politburo meeting the same month, financial officials warned the country’s rapid debt buildup from 1974 to 1976 might not be sustainable without revisions to the national plan. Kádár, however, remained committed to the necessity of raising workers’ standard of living. After a pause in the increase in real wages in 1976, Kádár returned the country to a 3.5–4 percent increase in 1977. The debt, in turn, increased apace.¹⁰

After the price increase debacle of 1976 in Poland, Edward Gierek undertook what he termed an “economic maneuver,” which would supposedly lower the nation’s debt to the West without lowering domestic standards of living by cutting back investment instead. Polish rates of investment were extremely high, so there was room for restriction, but unless the remaining investment was used more effectively, the new policy would only worsen the long-term debt picture by lowering future economic growth. Polish officials were well aware of this, but like their counterparts in both East and West, they chose the policy that guaranteed present social stability, no matter the long-term consequences.¹¹ In March 1977, financial officials within the Polish Central Committee warned, “The level of Poland’s indebtedness to capitalist countries at the turn of 1976/1977 should be seen as the maximum. Its further growth threatens to negatively impact Poland’s socio-economic development throughout the current five year plan.”¹² But the political mandates of the moment prevailed over the economic concerns of future years. As long as the nation could borrow money and import subsidized Soviet resources, political expediency would be the order of the day.

By the spring of 1977, the gap in East Germany between the political priorities of the party and the economic capacities of the state had grown so large that the chairman of the State Planning Commission, Gerhard Schürer, and the party’s economic leader, Günter Mittag, wrote a secret letter to Honecker pleading for an adjustment. “For the first time we are experiencing acute payment difficulties,” they wrote in March 1977. “The hard currency income from our exports . . . is already insufficient to finance new imports.” The recurrent fear since the first moments of the oil crisis that credit would suddenly become unavailable was once again at the forefront of their minds. To ward off the threat of looming insolvency, the two men urged their boss to undertake an immediate export offensive and restriction of imports.¹³

Honecker took their warning as a personal affront. Referring to his cherished Unity of Economic and Social Policy, he scolded his two deputies in a face-to-face meeting.¹⁴ Social and price stability were the hallmark advantages of socialism over capitalism, and Honecker was not about to give them up. In describing the Schürer/Mittag proposal later that year, he told the Central Committee the two men had “submitted a plan which would not allow for the continuation of the social policy program. But the path of restriction is not possible.” Under such “capitalist conditions,” he said, “we would have great complications.”¹⁵ Chastened by the browbeating, the two men beat a hasty retreat, and the challenge of asking the nation to sacrifice was delayed another day.¹⁶ In its place, the nation’s bankers returned to the Euromarkets to continue financing real existing socialism on credit. They could only hope the days of easy money would not soon run out.

Lucky for them, 1976 was a “vintage year” for the socialist states on the Euromarkets, as Euromoney termed it, and all indications were that 1977 would be the same.¹⁷ So long as Western capital and Soviet oil kept flowing freely, the day of reckoning could continue to be deferred. For the moment, state socialism had defied the laws of economic gravity that dragged the rest of the industrialized world down. But in 1977, cracks in the foundation of Soviet oil production signaled that the reckoning would not be long in coming.

“The Soviet oil industry is in trouble.” So began a bombshell March 1977 report from the Central Intelligence Agency titled “The Impending Soviet Oil Crisis.” The CIA kept close tabs on the industry that formed the economic base of Soviet power, and they now projected that Soviet oil production would “soon peak, possibly as early as next year and certainly no later than the early 1980s.” Soon after that, they augured, the decline in production would be “sharp.” The giant Samotlor oil field in western Siberia, which had accounted for most of the growth in Soviet oil production since the late 1960s, was projected to reach peak production by 1978 and maintain that level for only four years. The country had large amounts of coal and natural gas that could compensate for the drop-off in oil, but, the agency noted, these were “east of the Urals,” so “distance, climate, and terrain will make exploitation and transport difficult and expensive.”¹⁸

Taken together, the picture was bleak and the repercussions “profound.” With plateauing oil production, the Soviet Union would “find it extremely difficult,” the agency concluded, “to continue to simultaneously meet its own requirements and those of Eastern Europe while exporting to non-Communist countries on the present scale.” These were “important considerations” for the leadership in Moscow because the Kremlin currently supplied three-quarters of Eastern Europe’s oil, and “it undoubtedly wishes to retain the political and economic leverage that goes with being their principal supplier.” At the same time, however, oil exports to noncommunist countries were “the USSR’s largest single source of hard currency.”¹⁹ Thus, as the Soviet Union’s era of exceptional oil growth came to end, fundamental political choices awaited Leonid Brezhnev in Moscow.

The CIA’s timing was impeccable. At the very moment the report was published, the Soviet government was itself grappling with the knowledge that its oil production might soon begin to decline. As early as 1973, Soviet oil specialists had been warning the political leadership that the western Siberian oil boom was temporary and would not provide a basis for growth after 1980. General Secretary Brezhnev had rebuffed the warning signs even as Prime Minister Alexei Kosygin began to call for greater oil and gas conservation in the mid-1970s. By the end of 1977, the signs of impending crisis forced action, and Brezhnev decided on emergency changes to the five-year plan to redirect investment to the oil industry to ensure the output targets through 1980 were met. This bought the country some time and prevented the CIA’s prediction of plateau and decline from coming to fruition, but it did so at significant costs to the efficiency of the oil industry and the productivity of the rest of the economy, which lost out on precious investment resources.

Even with the emergency investment plan, the challenge of energy stagnation after 1980 remained unsolved. A fierce debate broke out within the Soviet leadership around how to rectify it, but all sides agreed on two things: the future would not be like the past, and the time of energy abundance had come to an end.²⁰ As a Soviet official told his East German counterpart in early 1978, “The question of raw materials is very difficult. . . . As of today . . . one cannot expect an increase in oil resources. There are also comrades in our country who cannot believe it. We had grown accustomed to having an increase of around 100 million tons of oil in each five-year-plan and not 0% growth, as it will be for the five-year-plan from 1981–1985.”²¹

As the CIA anticipated, the crisis had immediate effects on Moscow’s relations with its allies. At a meeting of Comecon ministers in June 1977, Premier Kosygin told a room full of officials hoping for increases in Soviet energy supplies that the growth of Soviet oil production after 1980 would be “considerably lower” than in the 1970s. The problems in the Soviet energy industry were numerous, Kosygin told the group, and under such conditions, the only answer for the bloc was to increase its energy efficiency. He framed the challenge as global in nature, one equally shared by East and West: “The fuel and energy problem is one of the sharpest problems of economic development in the world. All countries are looking for their solution by increasing the effectiveness of energy consumption through substantial savings of energy resources.” To adapt to the new environment, the Soviet Union had made increasing its energy efficiency a priority as well.

The same could not be said, Kosygin believed, for the rest of the bloc. Satellite governments had put forth woefully inadequate plans to increase their energy efficiency. Given the wastefulness of the Soviet economy, this had more than a tinge of the pot calling the kettle black. Nevertheless, Kosygin had come to the meeting to scold his allies into action. In preparation for the gathering, each nation had submitted projections of their energy needs out to 1990 to the leadership in Moscow. The resulting picture of the bloc’s energy situation over the next decade was sorry indeed. “It is clear from these materials,” Kosygin said, that “most countries are planning to increase the rate of growth in energy consumption over the period up to 1990.” Though the allies collectively planned to increase their energy demand by 47 percent through 1990, they only planned to increase their energy production by 23 percent. To the Soviet leader, it was clear they planned to make up the difference “mainly by an increase in petroleum and gas supplies from the USSR.” This, Kosygin firmly told them, was not possible. The numbers simply did not add up. When considered together, the Eastern Europeans were counting on a 74 percent increase in Soviet oil deliveries, a 130 percent increase in Soviet natural gas, and a 135 percent increase in Soviet electricity from 1980 to 1990. “We have made thorough calculations,” Kosygin told his audience, and those calculations made clear that “energy supplies from the Soviet Union at such levels are not possible.”

Soviet energy could no longer be the bloc’s economic elixir. “The CMEA [Comecon] countries’ fuel supply problem cannot be solved only through an increase in supplies from the Soviet Union,” Kosygin said. Instead, each country would have to look inward, to their own economies, and figure out how to use resources more efficiently. “We must say,” he concluded, “that so far this work is insufficiently accomplished in all Comecon countries, including the Soviet Union.”²²

The news that Soviet energy deliveries were likely to peak in 1980 sent shock waves through the bloc. For states whose economic growth depended on ever-increasing inputs of energy rather than the more efficient use of energy, Kosygin’s message was nothing short of an existential threat. The GDR’s reaction illustrates the broader bloc’s dynamics. Throughout the 1970s, East German policy makers had closely linked the fate of their nation to the supply of Soviet raw materials. The changes in Comecon prices announced in 1974 had altered the price of these raw materials, but they had left their year-over-year growth rate untouched. Even at higher prices, it was clear to the leadership that the continued growth of Soviet resource deliveries was essential to their survival. “It was and is an invaluable advantage for our national economy,” the State Planning Commission wrote in 1975, “that we import the majority of our raw materials from the socialist economic area, especially from the USSR, at long term contract rates that are below the capitalist world market price.”²³ A year and a half later, as planners began to work on the 1980–1985 plan period, they returned to the fundamental importance of increasing Soviet deliveries. “The questions of covering [our] demand for raw materials and energy,” planners wrote at the end of 1976, occupied “a central place” in the Soviet–East German relationship. The GDR would “continue to depend on growing imports for many energy sources and raw materials.” Even under the country’s plan to make “the most efficient use of fuels and energy,” the planning commission stressed that “we need further increases in oil and natural gas supplies from the USSR.” To that end, the policy makers asked that annual oil deliveries be raised from their 1980 level of 19 million tons to a level of 22 million tons by 1985 and 25 million tons by 1990. Similarly, they requested that annual natural gas deliveries be raised from the 1980 level of 6.5 billion cubic meters to 9 billion cubic meters in 1985 and 11 billion cubic meters in 1990.²⁴

Kosygin’s announcement in the summer of 1977 clearly threw a significant wrench in these plans. Without the increases in energy after 1980, the GDR would have two options: it could either figure out a way to use energy resources more efficiently or make up for the lost Soviet deliveries by taking out more debt from the West in order to purchase the raw materials on the world market. With regard to the first option, East German officials who studied the problem knew that despite the leadership’s commitment to undertaking “great efforts” to save energy, their planned economy stood little chance of using energy more efficiently.²⁵ Even after domestic energy prices were raised in 1980, the basic structure of the planned economy led firms to hoard input materials, rather than try to save them.

At a loss over how to increase energy efficiency, officials quickly recognized they would have to make up for the shortfall in Soviet deliveries with imports from the West. This would, in turn, worsen their already serious sovereign debt problem. Indeed, this connection was so strong that East German officials began to quantify the link between a decline in Soviet energy and raw materials and increasing hard currency imports from the West. First, they tallied the gains they had already received in the 1970s from the Soviet Union’s patronage. In 1977, planners concluded (and underlined for emphasis), “If the GDR had been forced to buy the amount of oil it received from the Soviet Union from 1974–1976 on the world market, it would have been forced to pay about 4.5 billion VM more than it paid the Soviet Union.” Even that figure, the planners recognized, understated the benefit because rather than paying for the oil with hard currency, East Germany had been allowed to pay for the Soviet oil “with goods from the GDR, which as experience shows, would have been difficult to sell on the capitalist market.”²⁶ In countless other areas like grain, natural gas, and steel, the planners well understood that Soviet price patronage had directly lowered the country’s debt to the West. As high as the debt was, it was clear it would only have been higher without Soviet raw materials.

This was a point East German officials tried to make over and over to their Soviet counterparts in the late 1970s. After numerous conversations in 1977 in which the Soviet side emphasized that there could be no increase in deliveries after 1980, East German officials opened 1978 by stressing that Soviet shortfalls would only drive them further into the arms of the West. After being told, yet again, in a February 1978 meeting that increases were not possible, a member of the State Planning Commission told his Soviet counterpart that if “the supplies of the USSR cannot be increased,” the GDR “would have to buy the raw materials in the West.”²⁷

This back and forth continued between the two sides until October 1978, when Kosygin informed his East German comrades that rather than level off their deliveries after 1980, the Soviet Union would, in fact, have to cut them back. The East Germans were furious. They immediately told him such a decision would either “call into question” the economic development of the GDR or force the country to carry out “a politically and economically unacceptable increase in hard currency imports.” In response, Kosygin told them that Soviet deliveries had given the GDR the luxury of being “largely independent from raw material imports from capitalist countries.” Because the development of raw materials in the Soviet Union had become “increasingly difficult and expensive,” it was a luxury the bloc could no longer afford.²⁸

Back in East Berlin, planners quickly calculated that the Soviet decision to cut back deliveries would lead to VM 10.7 billion more in imports (and debt) from the West.²⁹ Such an alarming number meant the time had come to take their case to the highest court. In late 1978, Honecker made a direct appeal to Brezhnev to hold energy and raw materials at their 1980 level during the next five-year plan. By the time East German premier Willi Stoph returned to Moscow in December to meet with his old friend and comrade Kosygin, Honecker’s appeal had worked. Kosygin announced that the 1980 levels would be maintained because “Comrade Brezhnev has decided to find possibilities to help the GDR in this matter.”³⁰

The announcement removed a contentious issue from the agenda but left a simmering tension between the two sides that boiled over in the remainder of the meeting. Socialist solidarity could no longer mask the widely divergent economic interests of the allies. Kosygin launched into an extended tirade about how easy the GDR had it in the grand scheme of the global economy. “I would like to . . . say that the entire economy of the GDR is in a rather privileged position,” the Soviet premier said. “You will not think about that sometimes, but I would like to remind you of it.” Posing what he termed “a foundational question for the entire economy,” Kosygin asked: “Where can you find, Comrade Stoph, such a situation in the world, where oil and also natural gas come by pipelines practically to your front door?” Pushing the thought further, he said, “The economy of [your] country is in paradise. The GDR [is] in a much better and more privileged position than the economy of Italy, France, or the Federal Republic.” Stoph shot back angrily, “What do you mean Italy, France, and the Federal Republic? We’re not them at all. We are the GDR!” Kosygin responded, “I understand that you are not Italy or France. But very often you hear—‘We have different conditions.’” On the question of energy, this was not so. Every country, whether capitalist or communist, now had to use energy more efficiently.³¹

As Stoph left Moscow, the worst-case scenario had been averted. The Soviet leadership had committed to maintaining deliveries at the 1980 level for the 1981–1985 period. But there were few reasons for optimism. The basic dilemma remained the same—either the GDR could achieve radical advances in energy efficiency or it would have to increase its Western imports and debt. In 1979, the State Planning Commission tried to formulate a realistic estimate of how the burden of stagnating Soviet supplies would be split between these two elements. The results were a lopsided reflection of the problems with the planned economy. Frozen at their 1980 levels, Soviet oil deliveries to the GDR from 1981 to 1985 would be 19.5 million tons below what the GDR had planned. Of these 19.5 million tons, planners believed only 3.8 million could be saved through increased efficiency. That meant 15.7 million tons of oil, worth about $3.2 billion, would have to be imported from the West for hard currency.³² More borrowing clearly would be required.

But just as Soviet stagnation was increasing the GDR’s demand for Western loans, warning signs were appearing in the West that financial markets’ confidence in the Socialist Bloc was wearing thin. While officials from the State Planning Commission were busy shuttling back and forth to Moscow to try and secure more Soviet oil, officials from the East German Foreign Trade Bank were making the rounds in the nerve centers of global capitalism to secure more Western loans. In May 1978, the president of the bank, Werner Polze, made a two-week trip around North America to drum up support for a new round of credits. Upon his return, Polze filed an ominous report. Many bankers had told him that there was “now no absolute confidence in the future repayment capacity of the socialist countries.” Western bankers could see that the situation was starting to become untenable. “The question was continuously raised,” Polze reported, of how the GDR planned to “balance its trade and payments accounts” in the face of “considerably higher import prices, poor export opportunities to capitalist markets . . . and the stable domestic price level, which leads to constantly increasing domestic demand.” The same questions could have been (and surely were) asked of all bloc countries.³³

In the eyes of Western banks, the most pressing problem was Poland. Since the aborted 1976 price hikes, the country’s debt had continued to rise at a torrid pace. Polish officials, led by Jan Wołoszyn, had returned to the Euromarkets over and over again. By the fall of 1978, this search for Western capital led them to announce that they would seek to organize a $500 million loan on the Euromarkets, an unprecedented and shocking amount for a socialist country. Polish officials tried to minimize the growing financial difficulties in public, but in private, the truth was plain enough to see.³⁴ Just as Poland was getting set to announce its new loan, Polze returned to the West to once more test the waters for East German credit. In meetings in London, “the question of socialist countries’ debt again played a clear role in the negotiations,” he reported. “Almost all banks emphasized that Poland’s frequent appearance in the market had led to a certain distrust of granting further credit to the Poles.” In the shadow of Warsaw’s spiraling financial needs, the banks “warned [against] a country or a bank entering the market for finance loans too often.”³⁵

Thus, with Soviet raw material deliveries about to level off and Western financial confidence hanging by a thread, the task confronting all Eastern Bloc countries at the dawn of 1979 was daunting. Perhaps best summed up by the East German State Planning Commission that summer, “the basic problem” for their economies was that “despite the fraught task of increasing performance under extremely limited commodity supplies” and despite efforts to raise exports and lower imports from the world market, “a significant unresolved financial deficit . . . remains.”³⁶ The “unresolved financial deficits” in different bloc countries varied in magnitude, but the basic problem was the same. Try as they might to cut their dependence on Western capital, policy makers in East Berlin, Budapest, and Warsaw remained more dependent than ever on the financial markets of the West to finance their societies. Moscow could no longer be relied on to shield the bloc from the world economy. The times were changing, as Brezhnev demonstratively told Honecker in the fall of 1979. Pounding his fist on the table during a meeting with the entire East German Politburo in East Berlin, the Soviet general secretary declared, “Those who say that you can only consume what you produce are correct.” In a thinly veiled warning, he continued, “None of us wants to live at the expense of others or declare ourselves bankrupt.”³⁷

Only the US Federal Reserve could tip the scales and turn this array of warning signs into a full-blown crisis. As Fed chairman Paul Volcker would one day say of the US dollar, “Our money is the world’s money.”³⁸ So long as the Fed, the engine of global monetary creation, kept real interest rates low and US dollars flowing easily around the world, socialist governments would be able to retain their veneer of tranquility amid the choppy waters of the world market. A shining example of this fact came in the spring of 1979, when, despite their profound misgivings about the Polish economy, Western bankers pooled their capital together and granted the Polish request for the $500 million loan anyway.³⁹

But if events ever conspired to force the Fed to change its policy and restrict the easy flow of capital around the world, the bloc would be exposed to the crisis it had fought to avoid since 1973. It was a frightening prospect, but as late as 1979, it also remained an unlikely one. A significant increase in the Federal Reserve’s interest rates would surely bring austerity to the United States, and just like the communist states of Eastern Europe, the American government had shown little inclination and no ability to impose austerity on its own people in the 1970s. By the end of the decade, most American officials had come to question whether their democracy would ever be able to solve the country’s riddle of austerity. Inflation, the telltale sign of too many promises chasing too few goods, was running at 13 percent in 1979 and showing no sign of slowing down. “Can a democracy discipline itself?” Alfred Kahn, a prominent American economist and advisor to US president Jimmy Carter, weightily asked in the late 1970s.⁴⁰ The answer would have implications on both sides of the Iron Curtain.

In the fall of 1978, the future of the US dollar hung in the balance. After menacing Great Britain and Italy with currency crises in 1976, international capital holders had turned their attention to the United States and forced the dollar to severely depreciate against the Japanese yen and the deutsch mark from September 1977 to October 1978. As with the more acute crises in London and Rome, capital holders’ departure from the dollar signaled their doubts about the long-term viability of the US economy. After declining to 4.9 percent at the end of 1976, inflation had risen back to 9 percent by 1978, which led capital holders to worry that the future value of their US dollar holdings would be frittered away over time.⁴¹ Their departure from the currency sent policy makers across the West scrambling to support the dollar in foreign exchange markets. Over the course of 1978, the Federal Reserve gradually raised interest rates from 6.5 percent to 9.5 percent, but these moves barely brought interest rates in line with inflation. It was clear more aid would be needed, so on November 1, Western central banks unveiled a dollar “rescue package” aimed at saving the currency. For a time, the coordinated efforts worked, and the dollar stabilized at the end of the year. But for everyone involved, the crisis was a wake-up call and a harbinger of the far-reaching crisis that would come if American domestic policy did not soon change.⁴²

The dawn of 1979 brought renewed challenges, as the crescendo of revolution in Iran led to the ouster of the shah, Mohammed Reza Pahlavi, in January and a wave of uncertainty on world oil markets. Iran, the world’s second-largest oil producer, had stopped exporting oil in December 1978, and the social instability that followed the shah’s departure provided reason to think those exports would not return anytime soon. Panic ensued, and OPEC members took the opportunity to engineer another massive increase in oil prices. From December 1978 to December 1979, crude oil prices rose 150 percent, this time from thirteen dollars a barrel to more than thirty. Gas prices within the US climbed 55 percent in the first half of 1979, and inflation quickly followed suit, rising to 13.4 percent. If it was allowed to continue to rise, there was no telling when international capital holders might again lose confidence in the United States and precipitate another run on the currency.⁴³

Thus, like the pressure they had applied to many smaller governments since 1973, oil and capital markets conspired in the spring of 1979 to put pressure on Washington, DC to implement austerity. The question, as always, was how to make this policy socially acceptable to the domestic population. The administration of Jimmy Carter thought about the challenge in precisely these terms. “How best to sell publicly a policy of long-term economic austerity” read the cover sheet of a memo sent from Treasury Secretary Michael Blumenthal to President Carter in the spring of 1979. Blumenthal considered the “continuation of tough and austere macroeconomic policies requiring sacrifices by many” to be “the only viable course” for the nation going forward. However, this path would create “political dissatisfaction among a broad array of interest groups.” Therefore, the administration would have to find a way to make austerity domestically palatable. “I freely concede,” Blumenthal wrote, “that this is no easy task.” To be successful, Blumenthal believed, a program of austerity needed “an overarching theme that engages the imagination and deep convictions of the people.” Carter would have to tell the nation that “as individuals, a national economy, and as a government, we have been borrowing and consuming—living off deficits in our personal, governmental and trade accounts.” The message had to be, “We can no longer afford this.” In order to return the United States to its former economic preeminence, Carter would have to tell the country, “We must now sacrifice and rebuild.”⁴⁴

For Carter, the question of how to regain control of the country’s economic fortunes quite literally produced a period of deep soul-searching. For ten days in the summer of 1979, he withdrew to Camp David, the presidential retreat in the foothills of Maryland. There he discussed the nation’s dilemmas with a wide array of experts and considered his own journey to that point. He was a Democrat who had risen to the presidency in 1976 on promises of enacting full-employment legislation, fiscal stimulus, and labor law reform to strengthen the bargaining power of unions. And yet circumstances now appeared to dictate that he transgress the interests of the constituents who had elected him. There were three options for controlling inflation—cutting government spending, inducing wage restraint through negotiations with the nation’s labor unions, and tightening monetary policy. At various points during his first two and a half years in office, he had half-heartedly tried all three. But the challenge remained undiminished. Indeed, with Americans now waiting in lines at gas stations across the country, inflation running at 13 percent, and GDP contracting at a rate of 3 percent in the second quarter of 1979, the task of steadying the American economy amid the volatility of the world market appeared more intractable than ever before.

The crisis, Carter decided, was spiritual. When he descended from the mountains of Maryland, he took to the nation’s airwaves to tell Americans they were collectively experiencing “a crisis of confidence” in a nationally televised address. Amid a wide-ranging diagnosis of the nation’s ills, the president told the nation that “too many of us now tend to worship self-indulgence and consumption.”⁴⁵ Although he did not directly say it, the undertone of Carter’s speech was a call for the nation to live within its means. Little did he know, it would be the exact message Brezhnev would deliver more bluntly to his East German comrades a few months later in East Berlin. A healthy nation could only consume what it produced—everybody could agree on that. Both sides in the Cold War believed they had consumed too much, both were distinctly aware of their dependence on global capital and foreign energy to fund their way of life, and both believed their time was running out. The question now was how to remedy these conditions.

Like Western European governments before him, Carter had come to believe that managing the relationship between business and labor held primacy of place. If unions could be made to moderate their wage demands, Carter and his advisors believed, the long road back to low inflation could slowly begin. To that end, in the summer of 1979, the president launched an initiative to bring business and labor together around a program to moderate wage growth. At the end of September, he signed a “national accord” with representatives of the American labor movement that aimed to ensure that “the austerity arising from battling inflation is fairly shared.” Modeled on the social contracts that had been used in Western Europe to try and restrain real wage growth in the 1970s, the national accord was seen in its immediate aftermath as a decisive step in shifting the country to a more austere footing. As Jefferson Cowie has written of the accord, “It stood as an inverted homage to the triumphs of the thirties and forties. Rather than FDR’s compact for working-class plenty, the accord looked to shared austerity to overcome political hostility.”⁴⁶

Rather less consequential in Carter’s mind was the nation’s monetary policy. In the days following the “crisis of confidence” speech, he shook up his cabinet and asked a number of people, including Treasury Secretary Blumenthal, to resign. He replaced Blumenthal with the current Fed chairman, William Miller, which left a vacancy at the helm of the central bank. Many names from the world of private business and banking were floated for the job, but Carter eventually settled on Paul Volcker, the head of the Federal Reserve Bank of New York. By all accounts, the president chose Volcker with little sense of his vision for monetary policy beyond a vague knowledge that he was “very tough on inflation.”⁴⁷

Carter was not alone in paying relatively little attention to monetary policy and the role of the Fed chairman. Most observers in the late 1970s believed there was little central banks could do to stem the tide of inflation in the face of the well-entrenched habits of postwar democratic governance. The politics of the welfare state simply would not allow it. None other than a former chairman of the Federal Reserve, Arthur Burns, proclaimed as much in a speech to global financial elites in the fall of 1979. Over the course of the postwar period, he said, “rising economic expectations, wider citizen participation in the political arena, and governmental commitment to full employment” had driven governments across the West to perpetually promise more than their economies could deliver. “Once it was established that the key function of government was to solve problems and relieve hardships . . . a great and growing body of problems and hardships became candidates for governmental solutions.” In such an environment, Burns concluded, central banks “will be able to cope only marginally with the inflation of our times.”⁴⁸

Volcker understood the purpose and power of his new office very differently. Inflation, he believed, was a product of people’s expectations about the economy. By 1979, rising prices had become such a standard part of life people had begun to factor them into their behavior. Workers asked for higher wages, consumers borrowed more money, the government ran a larger deficit, and speculators bet against the US dollar because they universally accepted it as fact that US dollars would be worth less tomorrow than they were today. These actions, in turn, produced a self-fulfilling prophecy; they created the very inflation they anticipated. Higher wages, higher borrowing, and higher government spending increased the demand for goods, and prices inevitably rose as a result. Therefore, if inflation was to be vanquished, Volcker believed that expectations would have to be altered.

To alter expectations, one first had to understand them. Where did they come from? What assumptions underlay the universal confidence that inflation would always continue? The answer was, in short, the politics of making promises. If inflation was an inherently political phenomenon, then inflationary expectations were, by definition, assumptions about politics. They signaled widely shared and unconsciously held beliefs about what society and government valued. By 1979, people had come to believe instinctively what intellectuals in the West had been writing since the mid-1970s: the government—and, by extension, its central bank—was incapable of breaking its promises and imposing economic discipline. For reasons of public morality and electoral expediency, governments were unable to turn a blind eye to the fates of their constituents. Given the choice between preventing unemployment and fighting inflation, postwar governments had always chosen to prevent unemployment, and there was no reason to think they would not continue to do so.

Volcker believed he had to change precisely this line of thinking. He and the Federal Reserve had to convince the country and the world that they were willing to let Americans suffer economic hardship. As he privately told his colleagues at the Federal Reserve in 1980, “When we take on this inflation fighting job . . . we should not look around for much of a constituency. If we . . . go to the brink or let some . . . things happen that we have not allowed to happen during the entire postwar period, people . . . are not going to be very happy.” But, he said, they could not “change inflationary expectations without it happening.” To illustrate the point, he recounted a recent conversation he had had with a banker in Chicago. The banker, when pressed on why his bank was aggressively expanding despite the poor economic conditions, responded, “If we get in trouble, the government will protect us.” If there was “a real problem in the economy,” Volcker concluded, people thought the Fed was always “going to give way.”⁴⁹

Thus, changing inflationary expectations entailed nothing short of changing citizens’ assumptions about what they could expect from their government. It was the most political of tasks. Inflation would end once people believed that the Federal Reserve cared more about price stability than it did about full employment or economic growth. The United States government’s commitment to breaking promises had to become credible.

If that was the end goal, what were the means by which it could possibly be achieved? As Volcker told his colleagues, it was a task that would invite intense political backlash. During any economic downturn, the popularity of political leadership suffers because people expect the government to do something to fix it. Austerity was different because the source of the economic pain was the government itself. In the Federal Reserve’s case, every time it voted to raise interest rates, it would look like (and it would indeed be) a conscious decision to inflict economic pain on the American people. With inflation running at 13 percent and inflationary expectations firmly entrenched, no one at the Federal Reserve knew how high they would have to raise rates or how long they would have to keep them elevated in order to get people to believe they really were comfortable inflicting pain on American society. All they knew was that every one of their decisions would create a political blowback.

It was best, then, to minimize the number of decisions they had to make. Monetarism, the school of economics promoted in the 1970s by University of Chicago economist Milton Friedman, posited that the sole responsibility of a central bank was to ensure a constant annual rate of growth in a nation’s money supply. Friedman held little faith in the powers of central bankers to accurately understand the economy, so he argued they should give up trying to influence it. The Federal Reserve should simply set a simple target for annual monetary growth—3 percent was Friedman’s ideal—and call it a day.

Volcker, and most of the other members of the Federal Reserve, found the economic fundamentals of monetarism to be woefully simplistic. The idea that monetary policy was as easy as setting an annual target offended both their self-regard and their life experience. But in the face of the horrendous politics of the anti-inflation fight, Volcker became attracted to monetarism because it offered an escape from political culpability. If, under monetarism, the Fed could simply commit to growing the monetary supply at a constant low rate, then the dramatic increases in interest rates that would inevitably result would appear to the public not as active and mean-spirited decisions of the Fed but rather as unfortunate by-products of market forces. President Carter’s chief economist, Charles Schultze, said of Volcker’s embrace of monetarism, “This whole move was, in the broadest sense, a political move, not an economic move. In theory, the Fed could have kept on raising the bejesus out of the interest rates, but that’s what it couldn’t do politically. The beautiful thing about this new policy was that as interest rates kept going up, the Fed could say . . . ‘We’re not raising rates, we’re only targeting the money supply.’ This way they could raise rates and nobody could blame them.”⁵⁰

For his first month on the job, however, Volcker found most of his colleagues at the Fed leery of both monetarism and higher interest rates. At a meeting on September 18, 1979, the Federal Reserve Board publicly split its vote 4–3 on whether to raise the discount interest rate it charged to US banks. The interest rate was raised, but because the board normally reached decisions by consensus, the public dissent appeared to signal to the market that the effort to implement a more restrictive monetary policy would eventually fail. Faced with a political system that appeared unable to implement austerity, speculators did what they always did: sold the currency in question. In the weeks following the September split decision, markets lost confidence in Volcker’s ability to control inflation, and a second run on the dollar began. The price of gold soared more than $25 in a day, and by early October, it reached $442 an ounce. “There was a genuine flight from the currency,” Fed vice chairman Fred Schultz recalled. At the Fed, the need for radical change now beckoned.⁵¹

On Saturday, October 6, Volcker called a secret emergency meeting of the Federal Open Market Committee, the Fed’s main governing body, and gained its assent for the switch to monetarism. The recent wild speculation in the markets had convinced previous doubters that change was needed. The implications of their decision were clear to everyone who gathered around the table. “There wasn’t any question that the board knew that recession would follow” the vote, Federal Reserve governor Phillip Coldwell recalled.⁵²

At a press conference that evening, Volcker announced the change in policy. A reporter asked him if the new policy meant the federal funds rate would be “completely free to go as high as it might.” The Fed chairman responded, “I don’t know what you think is as high as it might. There will be substantial freedom in the market.”⁵³ The fate of the nation, Volcker now told Americans, rested in the hands of the marketplace. This was not actually true, of course. By controlling the money supply, Volcker was still controlling the total amount of liquidity in the system and thus controlling interest rates, growth, and employment. But the language of monetarism had now given him a way to shift responsibility for policy outcomes to the market.

The effects of Volcker’s actions were hardly limited by national borders or ideological boundaries. Across the Iron Curtain, bankers and policy makers in the communist world watched as their last lifeline of external support begin to slip away. On October 25, three weeks after Volcker’s decision, Horst Kaminsky, the president of the East German State Bank, wrote in a memo to Günter Mittag, “Recently a dramatic increase in interest rates has commenced on the capitalist financial and credit markets. The current interest rate on the Euromarket stands at about 16%. Further increases in the coming weeks cannot be ruled out.”⁵⁴

Two weeks after Kaminsky’s warning, an event halfway around the world that had nothing to do with the Cold War, socialism, or even finance caused the Eastern Bloc’s financial predicament to go from bad to worse. On November 4, 1979, Iranian students stormed the American embassy in Tehran and took fifty-two Americans hostage. Ten days later, the Carter administration responded by freezing all Iranian assets in US banks: roughly $11 billion at the time. As the diplomatic crisis between Tehran and Washington played out over the next year, the frozen Iranian assets caused significant uncertainty in the international financial community and further limited its willingness to lend to socialist states.⁵⁵

The Soviet Union itself then hammered the final nail into the coffin of the Eastern Bloc’s access to Western capital. At the end of December 1979, Soviet forces invaded Afghanistan, and President Carter responded by placing a grain embargo on the Soviet Union and asking all US banks to review their credit policies toward the Eastern Bloc. He also announced a new US defense posture in the Middle East, dubbed the Carter Doctrine, and requested corresponding increases in the US military budget. The renewal of superpower tensions over Afghanistan destroyed the last semblance of normalcy for socialist borrowing on the Euromarkets. In early February, Polze and Kaminsky produced a new confidential report, which began, “The situation on the international finance and credit markets . . . has significantly tightened in the last few weeks.” Because of “the uncertainty arising from the blockade of Iranian assets in the USA” and the US government’s “blackmail” (Erpressung) against the Soviet Union in response to Afghanistan, banks “temporarily could not grant any new loans” or were “demanding higher credit costs due to the increasing risk.” Leading capitalist banks believed, Polze and Kaminsky wrote, that “credit granted to socialist countries in the future would be considerably restricted.” The “arms buildup in the USA and other imperialist states” in response to the Soviet invasion of Afghanistan, they noted, would “lead to interest rate increases in the future” because it would force Western governments to borrow and spend more money. Thus, they concluded, “a decline in the high interest rates can hardly be expected in 1980.”⁵⁶

The arrival of spring brought no change. As always, the telltale sign of market sentiment was Poland. Since the June 1976 price increases, Gierek had avoided, at all costs, asking Polish citizens to sacrifice, but he could avoid it no longer. At the end of May 1980, the Polish State Planning Commission urgently warned the party leadership that the “conditions for implementing the national plan” had “deteriorated markedly.” They wrote, “Notably, the payment situation has worsened” because of “credit difficulties.” The “main problem” was “the issue of obtaining financial loans for the purchase of raw materials.” Even for the loans they did receive, the interest rate had “greatly increased, at times exceeding 20%.” These conditions led the commission to project a financing shortfall for the remainder of the year of $4.1 billion. In order to compensate for this difference, the ministers proposed to increase exports to the West by about $3 billion and to restrict hard currency imports by $1–$1.5 billion. If these corrections could be achieved, the planners wrote, they would compensate for the current “deterioration in credit possibilities.”⁵⁷ The challenge of breaking promises had now arrived in the Socialist Bloc.

Even in these first moments of the onrushing crisis, a decisive difference was already apparent between the neoliberal capitalism emerging in the West and the state socialism struggling to survive in the East. When contemplating the fate of democratic welfare states in the doldrums of the mid-1970s, Fred Hirsch had approvingly written of the capitalist system, “A great strength of liberal capitalism has been its ability to dispense with an explicit ethical standard for the distribution of awards. Justification is provided by the benign outcome of autonomous unregulated processes.”⁵⁸ Under the postwar ethos of the welfare state, this “great strength” had been submerged under explicit government promises to distribute economic gains fairly and broadly throughout society.

Those promises were now being broken, and appeals to “the market” to justify the distribution of economic outcomes were returning to prominence. Volcker’s fight against inflation had dispensed with Washington’s commitment to full employment, and his embrace of monetarism had allowed the Fed (and the broader national government of which it was a part) to claim it was no longer responsible for social outcomes. Once more, American officials could say that markets were producing social outcomes, even if, in reality, they remained in full control of policy. As a member of the Fed put it, “Everyone could say: ‘Look, no hands.’”⁵⁹

Under state socialism, by contrast, the party’s hands were in everything, and explicit ethical standards for the distribution of economic benefits formed the ideological foundation of the state. The communist parties of the Eastern Bloc had spent the entire postwar period purposefully creating states in which they were responsible for everyone’s fate, and this would make their promises immensely more difficult to break.