Case Study – British IMF loan 1976 – Part 6

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.

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Case Study – The British IMF loan in 1976

The November 1967 Devaluation


The 14.3 per cent devaluation in November 1967 saw the sterling shift from $US2.80 to $US2.40 and the Government thought it would result in a major shift in the composition of aggregate demand – away from imports in favour import-competing products and provide a stimulus to exports.

At the time, the economy was growing strongly and had little excess capacity and consumer spending robust as the wage restraint imposed earlier in 1967 was relaxed.

The external deficit was also rising sharply and speculators considered the sterling would have to be further devalued, and the resulting selling down of the pound led to a further drain on Britain’s reserves.

The Government had to fund the external deficits to ensure the new parity could be sustained. They tapped large support from foreign central banks (including the Bank of International Settlements), which allowed Britain to repay prior IMF drawings and defend the new sterling parity.

Further, on November 29, 1967, Britain signed a stand-by arrangement with the IMF worth $US1.4 billion. The 1967 arrangement was unique in several ways.

Through the 1960s, the IMF increasingly imposed quantitative conditions on nations seeking stand-by arrangements These conditionalities were controversial because nations them to be bordering on political interference on the rights of a nation to determine its fiscal policy settings. The IMF was not an elected body nor was it accountable to the voters in countries that the stand-by arrangement were extended to.

However, after vigorous debate, the UK government secured the large 1967 stand-by arrangement without any qualitative conditions being imposed. This was considered a slight on developing nations, which typically had to succumb to such restrictions. Further, the UK government requested a single payment rather than receiving the funds in instalments, which was the typical arrangement imposed on poorer nations.

After the devaluation, imports continued to rise and despite the sharp increase in exports, the overall balance of payments deficit continued to place pressure on the currency.

To limit the increase in aggregate demand while still enjoying the improvement in its external position, the Government introduced contractionary fiscal and monetary policy changes to accompany the devaluation. The fear was that the change in parity would increase inflation and undermine the competitive gains flowing from the devaluation.

The literature shows that the relationship between the IMF and Britain in this period could not be reasonably characterised as the former imposing its will on the latter. Even though the British government was often in disagreement with the IMF in terms of negotiating the stand-by arrangements, it is clear that the austerity that followed stand-by arrangements being agreed to were a reflection of the political will within the Government rather than the IMF using its financial clout to pursue ideological motives.

In it Budget in May 1968, the British government further tightened its policy settings in an attempt to restrict income growth and restrain import spending.

On June 19, 1968, Britain drew on the November 1967 stand-by arrangement with the IMF.

The domestic policy restraint imposed in 1968 saw some improvement in the external position by year’s end and domestic policy was further tightened in late 1968 and again in early 1969. Credit was restricted and taxes were raised.

To shore up the loss of reserves, the UK government secured a further stand-by arrangement with the IMF on June 20, 1969 of $US1 billion. There were two quantitative conditions imposed as part of this stand-by arrangement. First, that the Government would achieve a balance of payments surplus by early 1970. Second, that domestic credit growth would be required to stay within agreed upper limits.

By late 1969, an external surplus was achieved, mostly because external conditions were favourable to a substantial growth in exports. The devaluation also had improved Britain’s competitiveness, which enhanced the economy’s capacity to exploit the buoyant world trade situation.

The domestic restraint saw a significant slowdown in domestic spending and there was a substantial inflow of reserves as confidence in the sterling increased in 1969. The improved external position allowed Britain to repay significant amounts of its external debt liabilities.

However, inflation was still persisting at 5 per cent and this created mounting wage pressures as workers sought to defend their real standard of living.

The Government’s position was clear. It wanted the nominal devaluation in 1967 to “stick” in real terms, which meant that wages could not be compensated for the higher import prices. The trade unions opposed this and in 1968 and 1969 were able to gain nominal wage increases consistent with the underlying inflation rate.

The incomes policy guidelines imposed by Government were not capable of restricting the nominal wages growth and industrial unrest was relatively high as workers sought to improve their real living standards.

This tension would feature throughout the 1970s, which became more complicated with the collapse of the Bretton Woods system in 1971.

The demise of the Bretton Woods system

The Bretton Woods system finally collapsed in August 15, 1971, when the US government curtailed convertibility in the wake of an on-going external deficits which precipitated unsustainable gold losses.

The Group of Ten nations responded by agreeing to a new system of pegged exchange rates. The initial decision was to devalue the US dollar and increasing the band around which exchange rates could fluctuate. There was no taste at that time for a freely floating system of currencies.

Interestingly, the die was cast with the large devaluations in 1949 of the sterling and other European currencies against the US dollar. Prior to that the US economy had run large external surpluses, not the least because its productive system was undamaged by the Second World War.

After 1949, occasional US external surpluses were accompanied by more regular external deficits mainly due to net outflows of capital. The US became a major source of private direct investment, mostly to Canada and Latin America.

The US was faced with rising current account surpluses being offset by greater capital account deficits.

The result was that the US progressively lost reserves. The rest of the world looked on this favourably as the net outflow of US funds provided nations with US dollar reserves.

The trade surplus started to shrink in the latter part of the 1960s, largely due to a rise in import spending, which compounded the situation.

The rapid increase in domestic spending as a result of the military spending associated with the Vietnam War, saw the excess capacity, which had persisted throughout the earlier part of 1960s, quickly absorbed. The unemployment rate fell to record lows in the second-half of the 1960s.

Rising inflation also resulted from the strong domestic economic conditions and this eroded the external competitiveness of the US (particularly against Japan) and the trade surplus narrowed as imports boomed and export growth moderated.

The competitive position of the US had been deteriorating throughout the 1960s as a result of the combination of devaluations among its trading partners and the rising domestic inflation made matters worse.

The US government responded with rising interest rates in 1969 and by 1970, the US was in recession.

It is worth noting that through the 1960s, the US shifted from being a net exporter to a net importer of consumer goods. At the same time, it funded this shift by being a net exporter of capital goods. Its position as a net exporter of capital goods deteriorated in the late 1960s, which also accounts for its worsening balance of payments situation.

This was in the face of growing productivity in other advanced nations, which enjoyed strong income growth with significantly lower wages growth.

However, the on-going loss of reserves and the associated gold losses (as nations sought to convert their US dollar holdings into gold under convertibility) were unsustainable.

The US government was under the same sort of political pressures that all external deficit nations faced. To reduce imports it would have to adopt deflationary fiscal and monetary policies, which drove up unemployment and undermined the popularity of the government in question.

Further, given the fact that the US dollar was at the heart of the Bretton Woods system, the US government was under massive pressure to maintain the official exchange parity of the dollar as a sign that the international monetary system was stable.

This meant that the US government had limited policy room in which to move to reduce the persistent external deficits. The main target became controls on private capital outflow, mostly of a voluntary nature.

It became increasingly clear that the US dollar was overvalued through the 1960s. The persistent external deficits and the rapid build up of reserves by Japan as a result of its strong surpluses was indicative. The rather large decline in the US trade surplus in 1968 provided a clue to this assessment.

By 1971, the persistent US external deficits and other problems in the international monetary system reached the crisis point.

In fact, the Bretton Wood system had been under strain through the 1960s. With the growth in World trade throughout the 1960s, the system required a commensurate growth in reserves to defend the agreed fixed parities and a growth in IMF resources, given its support role to nations with temporary external imbalances.

Further, the growth in reserves had to be proportionality split between gold and US dollars, given the convertibility arrangements. Participating nations had to have certainty that they could always convert their US dollar holdings into gold on demand.

With growing US deficits, the rapid growth in US dollars in the world reserves and a shortage of new gold started to stretch the system as early as 1960. Throughout the 1960s, the US was losing gold as it maintained convertibility in the face of a slower growth in overall World gold production.




Saturday Quiz

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That is enough for today!

(c) Copyright 2013 Bill Mitchell. All Rights Reserved.

This Post Has 2 Comments

  1. I’d find it helpful if you expanded on WHY it was so widely accepted that currency exchange rates should not float. Soddy ‘s work expounding on why he thought they should float was well known but rejected I guess -but why? I suppose Wynn Godley must have been at the heart of this as he was a key figure in the Treasury at that time and yet much of MMT builds on his work doesn’t it? Explaining this difference in view point seems crucial to me.
    I’m also struck but how Wynn Godley was anti-euro because the euro zone lacks fiscal union and yet having pegged exchange rates between US , UK, Japan etc as was the case in the 1960s when Godley was one of those at the helm seems fairly similar to a eurozone type arrangement in that it amounts to (partial) monetary union without fiscal union. Did he have a U-turn in his view point between 1970 and 1990 on this?

    PS. I just googled this and found one of Ramanan’s posts where he quotes Nicolas Kaldor. It would be very helpful to get your angle on this too. I’ve pasted from Ramanan’s post below:

    “Nicky Kaldor also had a paper The Relative Merits Of Fixed Exchange And Floating Rates – a memorandum as an economic adviser to the Chancellor in 1965 in which he was arguing for the merits of floating the exchange rates. In page xiii from introduction to Further Essays On Applied Economics he confesses:

    The strategy advocated in my 1965 paper “The Relative Merits of Fixed and Floating Exchange Rates” thus proved in practice futile …

    … So the policy which I advocated in the 1960s and developed at greater length in my 1970 Presidential Address to the British Association, of reconciling full employment growth with equilibrium in the balance of payments through adjusting the relationship between import and export propensities by a policy of continuous manipulation of the exchange rate, proved in the event a chimera. The main reason for this was that (along with most economists) I greatly overestimated the effectiveness of the price mechanism in changing the relationship of exports to imports at any given level of income. The doctrine that exports and imports are kept in balance through induced changes in their relative prices is as old and deeply ingrained as almost any proposition in economics.

    So there you have it – realising his mistake earlier than anyone else.

    He goes on further to drive this point:

    … In other words, what the Harrod theory asserts is that trade is kept in balance by variations of production and incomes rather than by price variations: a proposition which implies that the income elasticity of demand of a country’s inhabitants for imports and those of foreigners for its exports are far more important explanatory variables than price elasticities.

    which is essentially saying that it is non-price competitiveness which is far more important than price competiveness.”

  2. To what extent has use of currency exchange rate hedging financial derivatives, by importers and exporters, eroded the capacity of floating exchange rates to moderate trade imbalances?

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