It’s Wednesday and I just finished a ‘Conversation’ with the Economics Society of Australia, where I talked about Modern Monetary Theory (MMT) and its application to current policy issues. Some of the questions were excellent and challenging to answer, which is the best way. You can view an edited version of the discussion below and…
I am now using Friday’s blog space to provide draft versions of the Modern Monetary Theory textbook that I am writing with my colleague and friend Randy Wray. We expect to complete the text during 2013 (to be ready in draft form for second semester teaching). Comments are always welcome. Remember this is a textbook aimed at undergraduate students and so the writing will be different from my usual blog free-for-all. Note also that the text I post is just the work I am doing by way of the first draft so the material posted will not represent the complete text. Further it will change once the two of us have edited it.
- Case Study – British IMF loan 1976 – Part 1
- Case Study – British IMF loan 1976 – Part 2
- Case Study – British IMF loan 1976 – Part 3
- Case Study – British IMF loan 1976 – Part 4
Case Study – The British IMF loan in 1976
[THIS BLOG TAKES US UP TO THE 1967 DEVALUATION – AND ESTABLISHES THE THEME THAT PERSISTED INTO THE 1970s – I WILL TRY TO GET UP TO 1976 NEXT WEEK AND THEN EXAMINE THE ACTUAL EPISODE THE WEEK AFTER. THIS WILL NOT BE ALL REPRODUCED IN THE TEXT BOOK BUT WILL FORM PART OF OUR ON-LINE SITE WHICH IS IN THE PROCESS OF CONSTRUCTION. A SHORTER VERSION WILL APPEAR IN THE TEXT BOOK]
Post War Period to the 1967 Devaluation
Soon after the Bretton Woods system was introduced there were major failures in agricultural harvests in Europe (and hence exports) as a result of adverse weather.
Many European nations were particularly vulnerable to these fluctuations, not the least because their external reserve position (holdings of gold and currency reserves) was fragile in the face of Balance of Payments deficits.
The Marshall aid plan began in 1948 partially helped European nations to fund their balance of payments deficits while still engaging in the reconstruction effort.
But the reserve losses were still substantial during this period. The Bank of England, for example, started 1946 with 2,696 million dollars worth of gold and dollar reserves and by 1949 this had dropped to 1,668 million dollars. The United Kingdom endured large reserve losses in 1947 but drew on the “Anglo-American loan”.
As recognition for the losses Britain endured prosecuting the war effort and the late entry of the North American nations into that conflict, Keynes had negotiated the Anglo-American loan whereby the US and Canadian governments provided a low cost loan to Britain (from 1946), which allowed the British government to maintain its financial commitments to the sterling-area nations (principally the Commonwealth countries) without having to cut back infrastructure renewal in Britain.
The loan arrangement also required the British government to provide sterling convertibility into dollars and many nations that held sterling as reserves sought to exchange them for US dollars thereby worsening the loss of reserves arising from the external deficits.
Britain also received aid under the Marshall Plan which helped offset the assistance that Britain was providing to the Commonwealth nations and had the effect of allowing these nations to increase government spending on infrastructure development “beyond what would otherwise have been possible” (BIS, 1950, page 29).
[Reference: Bank of International Settlements (1950) Twentieith Annual Report, Basle]
Convertibility under the Anglo-American loan was abandoned in 1947 as the reserve crisis increased. Britain responded by introducing contractionary domestic policy.
The crisis came to a head in early 1949 as a result of a US recession, which significantly reduced the demand for US imports from Europe (particularly food and raw materials).
As a result of the deteriorating trade balance (less exports), British gold and dollar reserves fell to $570 million between April and June 1949.
To avoid a complete loss of reserves, the pound was devalued on September 18, 1949 by 30.5 per cent, which led to similar devaluations in the non-dollar currencies in Europe and the sterling-area.
The 1949 devaluation was in response to the shortage of reserves and to some extent reflected the teething problems – that is, getting the parties right – in the newly created Bretton Woods system.
Soon after the US recession ended and British reserves recovered somewhat due to the dual impacts of increased competitiveness arising from the devaluation and the short-lived nature of the US economic downturn.
Throughout this period, Britain was running large sterling surpluses within the sterling-area but large dollar deficits overall.
It funded the deficits in several ways: drawing on its gold and dollar reserves; drawing on the Anglo-American loan; drawing on the Canadian loan, and in 1947, 1948 and 1949 the sterling-area countries borrowed from the IMF. A once-off gold loan from South Africa and the ERP aid also helped.
The drawings mentioned actually allowed Britain to increase its gold and dollar holdings in 1947, 1948 and 1949.
At this stage, the IMF had not yet introduced conditionality into the drawing arrangements. By the mid-1950s, conditionality was increasingly used to steer nations who were relying on IMF funding support to pursue domestic economic policy that the IMF felt would reduce the nation’s reliance on future support from the Fund. The principal emphasis was on so-called Domestic Credit Expansion (DCE) targets.
The imposition of conditionality was extended in the 1960s to most advanced nations who sought stand-by arrangements with the IMF.
The British economy grew relatively strongly in the early 1950s and produced external surpluses on the back of robust export growth. The growth in tax revenue also pushed the budget into surplus.
However, import growth was trending upwards and the Bank of England tightened monetary policy in 1955 in order to moderate domestic demand.
The Suez Crisis in 1956, whereby British and French troops intervened militarily in a tripartite agreement with Israel, after Egypt sought to nationalise the Suez Canal, provided some challenges for Britain, beyond the military considerations.
While it did not interrupt trade as much as might have been expected given the strategic importance of the canal – Britain’s current account surplus continued in 1956 and 1957, the crisis created a lack of confidence in the value of sterling and a speculative outflow of sterling.
The growing lack of confidence in the sterling (with rising domestic inflation) depleted Britain’s US dollar reserves and forced Britain to draw $US561 million from the IMF in 1956 with an additional stand-by negotiated worth up to $US739 million. This represented 100 per cent of Britain’s IMF quota and was four times larger than any previous IMF drawing by any nation.
These stand-by arrangements have an historic importance because they represented a change in direction for the IMF, whose main role up until that point had been to provide financial assistance from temporary balance of payments imbalances arising from international trade in goods and services.
Boughton (2000: 4) argued that prior to the Suez conflict, drawings under stand-by arrangements was small and largely limited to either “gold-tranche drawing” or drawings on the “first credit tranche (i.e., countries were borrowing no more than 25 per cent of their quota)”. He also noted that at the time, the IMF was not constituted to lend to fund shortages arising from speculative outflows of capital.
[Reference: Boughton, J.M. (2000) ‘Northwest of Suez: The 1956 Crisis and the IMF’, IMF Working Paper No. 00/192, Washington, International Monetary Fund.
But the 1956 financial assistance to Britain was the first time that the IMF had extended standby arrangements to help a nation quell a speculative attack on its currency.
The British government was adamant that it didn’t want to devalue because it wanted to avoid adding to the domestic inflationary pressures and it wanted to preserve the position of the sterling as the second reserve currency and the dominant currency in the sterling area.
While it was running a surplus on the current account, this was offset by its external investments and debt repayments on the capital account. As a result, the speculative withdrawals of sterling meant Britain quickly lost reserves.
Boughton noted (2000: 13) that with only a “small cushion of liquid dollar-denominated claims” held by the Bank of England, the markets started to dump sterling holdings, which put the $US2.80 sterling parity at risk. It was in this context, that the Bank of England and the British Treasury determined to fund the defense of the parity via an IMF stand-by arrangement.
Of importance, and this has bearing on what happened in 1976, Boughton (2000: 18) concluded that the request for assistance was “political rather than economic” given that the current account was in surplus, domestic economic policies were appropriate, and the currency was basically stable. Britain could have devalued to head of the financial crisis but did not want the political stigma they perceived would come with that option.
However, Britain did increasingly tighten domestic policy as a way of increasing the external surplus and reducing domestic inflation
Under US pressure to resolve the Suez crisis, the only condition the IMF imposed with respect to the stand-by arrangement was a British withdrawal from the Suez conflict.
The IMF overcome its apparent problem of not being able to lend to help defend a currency against speculative attacks by arguing that the assistance was to support Britain’s move to full convertibility (see later) as part of the policy of making international trade and payments freer.
The desire by the IMF for full convertibility was strong in the context of the development of the international trade and payments system after World War 2.
Article VIII, Section 2(a) of the IMF Articles of Agreement states that “no member shall, without the approval of the Fund, impose restrictions on the making of payments and transfers for current international transactions”. In other words, any resident should be able to purchase other currencies at the official parity in order to purchase foreign goods and services, which are recorded in the Current Account of the Balance of Payments.
This freedom is referred to as current account convertibility. After World War II, the participating Bretton Woods nations, progressively relaxed restrictions on imports and currency transactions. However, the War had destroyed a large proportion of Europe’s productivity activity and most nations had few foreign currency reserves. In that context, trade and the related payments arrangements were predominantly bi-lateral.
That is, nations would try to run trade balances against each of their trading partners so as not to run down their foreign currency and gold reserves. In 1950, the European Payments Union (EPU) was formed to allow nations within Europe to trade more freely with each by coordinating the settlement in gold and US dollars for each of member nations. This provided a wider convertibility of currencies within Europe and made it easier for nations to engage in multilateral trade arrangements.
However, the foreign exchange transactions were still conducted in segmented markets. First, each European currency traded against the US and Canadian dollars in one market. Second, the European currencies traded against themselves in another market. There were arbitrage arrangements provided for by the EPU.
At the end of 1958, full convertibility was achieved, which meant that all currencies were to be freely traded against each other and against the North American currencies in a unified market. All nations agreed to buying and selling rates for the US dollar with limited variation permitted.
By the late 1950s, British growth had fluctuated but was still relatively robust (averaging 2.4 per cent). The problem was that growth became a stop-go affair as the balance of payments imposed a persistent constraint on the capacity of the economy to expand and maintain its exchange rate parity.
Britain saw its only solution was to expand exports and this led to its desire to join the Common Market, established by the Treaty of Rom in 1957. However, this introduced another challenge which would also be significant in 1976. Entering the Common Market would be beneficial from an exports perspective if the economy’s competitiveness improved and this required constraining the persistent wage-price spiral.
The other major development in trade was the signing of the 1960 General Agreement of Trade and Tariffs which required the signatories, including the United Kingdom, to reduce tariffs by around 20 per cent across a broad array of products.
Entrenched inflation was undermining Britain’s competitiveness and the weakening external position was continuing to deplete Britain’s external reserves. As a result, by the early 1960s, domestic economic policy was contractionary but only partially successful in reducing the current account deficit.
As a result, there was increasing speculative pressure on the sterling and the Bank of England tightened credit to further slow the economy down. In fact, the two reserve currency nations – the US and Britain – we encountering persistent external deficits which was leading to unsustainable net capital outflow in their respective currencies.
There was also recognition that most of Europe needed to reduce their trade surpluses and increase net capital outflow to resolve the imbalance in the international trade and payments system.
The role of the IMF expanded during this period and they negotiated an agreement among the ten large industrial nations to provide a massive boost to the supplementary resources held by the IMF, which was to provide the Fund with more capacity to assist national currencies who were under speculative attack.
By mid 1961, Britain had to taken urgent account to stop the drain on its foreign reserves, including increases in excise taxes, a credit squeeze (higher interest rates), fiscal austerity, a concerted policy of wage restraint, and a massive stand-by arrangement drawing from the IMF amounting to US1,046 million.
The restraint led to falling real GDP growth and rising unemployment and by the end of 1961 the fall in imports and rise in exports reduced the deficit significantly and Britain’s gold and dollar reserves rose substantially.
The wage restraint manifested in the form of an incomes policy (wage pause), which both unions and employers accepted. However, there was no fundamental change in the bargaining relationships and so the incomes policy was only a temporary solution.
The wages debate was another important issue which resonated into the 1970s. Through the 1950s, wage bargaining in the UK had increasingly been dominated by unions and peak industry bodies exerting their respective market power to defend (and expand) their respective shares in real national income.
The unions pushed for real wages growth that at times exceeded the growth in productivity and capital pushed for increases in real profit margins at the expense of the workers real wages. Each group used their individual price setting strength (unions to push for higher money wages and firms to raise prices) to react to a claim by the other for a higher real share.
The result was a creeping inflation problem and rising costs which undermined Britain’s trade position. By the end of the 1950s, Britain was finding its dominant trade strength had waned significantly.
While much of the focus was on the so-called abuses of trade union power there was also a noted lethargy on behalf of British industry to invest in latest technology and drive labour productivity higher.
The United Kingdom’s balance of payments situation was becoming more influenced by monetary movements than by its current account (trade position) which exacerbated the sensitive of the currency parity to economic growth and meant the stop-go nature of economic development was accentuated.
In 1964, the continuing themes of persistent domestic inflation, a current account deficit and loss of confidence in the currency were dominant policy issues and the Government responded in 1965 with some limited austerity measures but overall unemployment fell and the budget deficit widened.
Wages growth kept domestic demand strong and to formalise the government’s desire for wage restraint, they introduced the National Board for Prices and Incomes in 1966 to produce and enforce wage guidelines.
Throughout this period, the British economy was struggling with the seemingly incompatible goals of maintaining strong domestic growth with rising living standards and managing its external payments situation. Of-course, the reason for that incompatibility was the rigid view that the British authorities had with respect to maintaining the sterling parity.
But the current account was in deficit through 1964 and 1965 with a drain on reserves leading to another drawing from the IMF in May 1965 of $US1,400 million, the second largest to that date and the Fund’s sterling holdings were equal to 198 per cent of Britain’s quota.
The restoration of reserves combined with the tightening of domestic policy saw the trade position move into a small surplus by the end of 1965.
Both Britain and the US, introduced various constraints on international monetary movements in 1965 to reduce the net outflows of their currency, an increasing source of weakness.
The following graph is taken from Boughton (2000: Figure 2, Page 23) and shows the IMF financial assistance to member-states between 1948 and 1999. The two major UK drawings in 1961 and 1965 feature prominently.
The November 1967 Devaluation
1967 was a year of world economic crisis – the largest since 1949. Cost pressures were rising and translating into persistent inflation in many nations.
In 1966 and into 1967, Britain ran very large balance of payments deficits and there was a substantial associated loss of reserves and reduced confidence in the sterling.
Policy contraction including a wage and prices freeze in mid-1966 led to a decline in imports and an improving current account position. There was a slight slowdown overall and unemployment edged up.
The trade surplus renewed confidence in the sterling.
Further, sterling was strengthened because interest rates were eased in the US and Europe, encouraging net capital inflows into Britain in search of higher yields.
Britain used the windfall of funds to repay various international debts, including reducing its outstanding IMF liabilities under previous stand-by arrangements.
The calm was short-lived. The first disruption came on June 5, 1967, when the – Six-Day War – between the Arab States (United Arab Republic, Jordan and Syria) and Israel broke out after Israeli military aggression (air strikes into Egypt).
The War impeded British exports, increased the cost of oil and saw a sell-off of sterling.
Secondly, the US increased interested rates to quell a credit boom and this boosted the value of the dollar.
Third, Europe entered recession which further damaged UK exports and the current account went into deficit. The loss of export revenue also led to rising British unemployment and plunged Britain into a policy quandary.
The sterling was under pressure from the increasing external deficit and net capital outflow, which would normally have led to some domestic policy contraction. But with a recession looming the Government needed to bolster domestic demand. This is a situation that would repeat itself in 1975 and 1976.
The British government opted to avoid the politically costly rise in unemployment and there was a monetary easing combined with some fiscal policy expansion, which pushed the deficit up.
There was considerable debate as to whether the British government was committed to maintaining sterling stability given these expansionary domestic policy interventions.
Additionally, despite initial wage restraint in 1967 following the completion of the 1965-66 wage freeze, wages growth was rapid in the latter part of 1967 and outstripped productivity growth thereby undermining Britain’s international competitiveness.
Further industrial unrest on the wharves in the latter part of 1967 constrained Britain’s exports and the current account deficit rose.
The British government had to face the reality that to defend the mounting pressure on the sterling it would have to invoke a harsh recession and drive unemployment up significantly. The stop-go growth pattern had come firmly up against the political constraints.
It also knew that earlier efforts in the 1960s to deal with a weak balance of payments situation had resulted in lost national income but didn’t really solve the underlying problem.
The problem became rather obvious – the exchange rate was overvalued and try as they might to preserve that value for reasons of national prestige the reality was that it had to be devalued.
On November 18, 1967 the British government devalued the sterling by 14.3 per cent against the US dollar.
NEXT WEEK – THE CRUCIAL PERIOD UP TO 1976 WILL BE EXAMINED.
STAY TUNED ITS BUILDING UP TO THE CLIMAX.
The Saturday Quiz will be back again tomorrow. It will be of an appropriate order of difficulty (-:
That is enough for today!
(c) Copyright 2013 Bill Mitchell. All Rights Reserved.