The Crisis of the Sterling

In an international sense, the 'Golden Years' weren't quite so great. Sterling had major problems. Although as a whole the world is booming, external problems in the British  economy were starting to show. The fastest area of trade growth between major economies was in manufactured goods, yet Britain's share of manufactured trade fell from 25% in 1950 to 11% in 1970. The balance of payments was also perceived as weak because of its volatility. Visible trade was constantly in deficit and invisible trade in surplus, but the magnitude of these fluctuated a lot meaning there was never a consistent surplus. It was weakened further by the Sterling balances.

Sterling balances is the term given to debts accumulated during the Second World War. This figure stood at roughly £3.5 billion by 1950. The gold and foreign exchange reserves covered roughly 1/5th of this, although this figure was increasing. In 1957 exchange controls were removed and there was a danger than holders of the pound would sell up. The government needed to strengthen their reserves in order to stop this run on the sterling from occurring. It needed to run a persistent balance of payments surplus.

The government needed to resolve Britain's balance of payments problems. It had three routes to go down: protectionism, devaluation or deflation and 'Stop-Go'. Protection would've been opposed by the US and other members of GATT and EFTA, therefore that option was ruled out. Devaluation took place in 1949 to $2.80 as a war adjustment, but any further devaluation was difficult because of being part of the fixed exchange rate system of Bretton Woods. It would also conflict with the Sterling Area. The Sterling Area was what laid behind and held together the Commonwealth. It also supported the City of London's position as a global financial centre. Devaluation of the sterling would cause a collapse of the Sterling Area and would be unfavoured electorally. The final choice was the route taken. Bouts of deflation would be implemented to cut imports to improve the balance of payments position. However, the way the government went about it ultimately failed. They were too timid with their squeezing of the economy because they wanted to protect their full employment objectives and therefore foreign currency reserves stayed low and the sterling crisis continued.

One of the main issues Britain had was that state spending abroad was offsetting all private sector surpluses in the 1960s. The state was spending nearly £200 million a year in aid to the Commonwealth and £313 million in overseas military spending. Without this being cut any attempt to improve the balance of payments would be in vain.

Eventually, the Sterling had to be devalued. The Balance of payments crisis just prior to 1967 was the last straw and the Sterling was devalued to $2.40. Military spending was also cut back. There was some short term success from this, the balance of payments was in surplus by 1969 but it didn't last long as inflation and wage rises meant any gains were soon wiped out. The Sterling Area gradually faded away after this. It just could no longer be maintained with the decline of Sterling as a global currency. The empire was also in the process of breaking up as Commonwealth countries were beginning to gain independence and demand their own currency to complete this process. The demise of Britain was in full swing.

To conclude, we can say that during the 60s and 70s it was realised that the British economy was no longer in a position to support a global currency. The balance of payments was a persistent problem for the economy because of a wrongly held belief that Sterling was still a major currency. The problems did not end with the 1967 devaluation. 

The Challenges of the 'Golden Age'

If you read my previous post you'll see that the 'Golden Age' is a very positive time if viewed in certain lights. It wasn't all plain sailing for Britain, though, as this post will explain. If we look at the growth rate from the 1950s to mid 70s, we see it averages around 2.8% per year. Pretty good, higher than during the industrial revolution. But, compare it to the growth rate of other advanced economies and it looks feeble.  In the 1950s we expected these other economies to grow quicker with their scope for 'catch up' growth, but in the 60s many of these economies had actually caught up with and overtaken Britain and were still growing faster.

This suggests there's a fundamental problem somewhere in the British economy. Could it be a problem of investment? We said investment was one of the reasons for Britain's low unemployment in this period, but it could also be part of the reason Britain was lagging behind. Our investment rates had grown since the 1930s, but they were still a way behind other advanced economies. Some blamed this on the policy of 'Stop-Go'. The poorly planned contractions and expansions of demand were too frequent, which left a level of instability that hindered investment. In reality, during the 'Go' phase the demand was pumped into the economy too fast. Prices rise quickly and the government has to quickly backtrack with a deflationary policy that chokes off investment. In the 'Stop' phase firms just help back on their investment, waiting for the next 'Go' phase. The uncertainty of the whole system meant lower investment.

The government needed some alternative methods to raise investment whilst still maintaining their very favourable employment conditions. They didn't want to devalue the sterling and they didn't want to deflate the economy for too long. The only option left was to return to a policy of state planning. A policy of 'Indicative planning' was working well in France so the governments of the early 60s tried to mimic it.

In steps the National Plan! Launched in 1964 by the Labour government with the aim of boosting long term growth up to 4%. A lot of effort was put in to the plan, production targets were set across the board which were needed to achieve the goal. It was all placed under the control of the new 'Department of Economics'. Sound good? It wasn't. It failed. There was no method given to meeting the targets and no penalties for those that didn't make them. It was a naive hope that workers would just cooperate. Well, they didn't. It potentially could have worked, but the whole plan stemmed from a misdiagnosis of the economy's problems. It all assumed that the 'Stop-Go' cycle caused the low investment which hindered growth. What if this wasn't the cause?

Was 'Stop-Go' really the problem? In a way, no. Large fluctuations in the economy that were persistent before 1939 and also occurred after 1973 didn't occur during the 'Golden Age' and a similar policy was used in other countries that were experiencing rapid growth. So was low investment the problem? Britain's investment rates were catching other countries by the 70s, but it was investment in private housing that was holding the rate back. It seemed that Britain was very unproductive compared to its competitors with the same equipment which could have been a deterrent for investment. Investment is seen more and more as a symptom of Britain's decline, rather than a cause of it.

The suggestion from this was that Britain was suffering from other supply side weaknesses. What could these have been? Bad industrial relations, restrictive practices, poor management, poorly aimed research and development and inadequate human capital formation.

Britain's bad industrial relations came partly in the form of strikes. Compared to Germany the strike rate was poor, but compared to the USA it was much better. Productivity was the real issue. Britain's steel productivity was a 1/3 of the EEC average. We were over-manning our factories with people putting in little effort. Top managers in large industry seemed to be completely oblivious to shop floor activities.

Research and development was one of the big problems too. Britain was spending more than all other Western economies bar the USA, with half of this coming from the private sector. The direction of this spending was an issue. It was being spent on defence, civil nuclear power and civil aerospace - three unprofitable and poor commercial areas. All of the most talented scientists and technical manpower were stuck in dead end projects not adding  much to the GDP of the country. Innovation was falling too.

Another one of the supply-side issues was education. We were a comparatively uneducated economy. Only half our factor directors had degrees, the figure was closer to 90% if you looked abroad. It was even worse at middle management level. Those managers that did have degrees tended to have them in arty subjects and not managerial subjects.

So, if these really are the problems causing low growth - why did they persist? You'd assume that market forces would create change and push the inefficient parts of the economy out. The explanation for this is put down to 'Institutional sclerosis'. Key power structures had been left undisturbed for such a period of time that they had become entrenched. Vested interests were created and these resisted change. A part of this can be put down to the little damage Britain took during war. If we compare it to Germany, who took a lot of damage, we see why. Germany's war damage forced them to rethink the whole economy, they kept their strengths and replaced their weaknesses. With Britain, this didn't happen and institutions were left entrenched. The world boom then further lessens Britain's incentive to change.

The government were also very reluctant to generate the required change. They didn't want to challenge the vested interests in competition policy and preferred to follow the path of 'Stop-Go' and not detailed economic intervention. Another reason the government didn't force change is perhaps the problems weren't as bad as first implied. This was the view of some historians. There were some positives: our research and development spending was similar to France and they were growing rapidly. We looked good in industries such as pharmaceuticals and food and drink. Globally, Britain's incomes were in line with the OECD average and the economy was still successful. The only real negative was the loss of global political influence.

To conclude, the 'Golden Age' is a period that can be argued to have been good and bad for Britain. The debate about the extent and causes of the failures I've detailed above will continue for many years to come. Britain does lose ground, but is still a successful economy.

The 'Golden Years'

Once World War 2 had come to an end, the government had a changed view on the economy. There was a unanimous agreement that the economy could not be returned to the conditions of the 1930s. A prime opportunity had presented itself for economic betterment to take place. The war experience could fuel this improvement along with breakthroughs in Keynesian economic theory.

In weighing up what exactly the government could do to improve the economy from the 1930 levels, three main areas appear. Firstly, could they try a policy of nationalisation? The short answer to this was no. Many key industries were already under national control, such as steel, coal and the railways and most other important industries were so highly regulated already that nationalising them completely would have been ineffective. So, the policy of nationalisation was crossed off the list. Could they try and raise public spending? Well, in reality - not really. Public spending was already high at 37% of GDP in 1948, most of this going on social safety nets rather than boosting the economy. Any further public spending would be unsustainable. There goes public spending off the list. The option that was chosen was macroeconomic management.

The 1950s was a period of breakthrough for Keynesian theory. It saw the policy of demand management come to flourish - or better known: 'Stop-Go'. The idea behind this policy was constant tweaking of the economy to keep it heading in the right direction and to avoid overheating or recession. When unemployment began to rise, the government would loosen policy and when the economy looked like it was overheating the government would tighten policy again. Did it work? Eh... In some senses, yes, in most other senses, not really. If you place a high priority on unemployment then it could be passed as a success - unemployment reached historically low levels and fluctuated around the 1.5-2.5% mark. Living standards also rose. However, this was at the cost of frequent balance of payment crises, slower growth than the UK's major competitors and inflation (although not runaway inflation).

The policy had a famous critic in the form of the economist RCO Matthews. He had his doubts about Keynesian theory. The basic thrust of his argument was that the reason unemployment was so low wasn't to do with the policy the government had implemented - this policy only affected unemployment at the margin. He claimed that demand was higher than pre-war levels, but not because of financial policy. Tax was higher than spending, budgetary policy tended to be deflationary and interest rates were consistently higher in the 50s.

So what could the other reasons for the low unemployment be? Some have put it down to high investment rates. Investment was especially higher than in 1939 and most of it was coming from the private sector. Investment is a fickle economic variable that depends a lot on confidence. From 1950-1973 there was a world economic boom which is the reason for this high investment. In Europe and Asia, war had hit harder than in the US. This left a lot of scope for 'catch up' growth to repair the war damage using the best practice techniques. Many workers also moved into more productive sectors such as services instead of agriculture. As well as this, world trade barriers come down and the Bretton Woods system begins to function efficiently as the USA pump the system with overseas aid and defence spending. Overall, world demand increases which fuels investment and productivity growth. This growth in world trade in a way drags the British economy along with it.

Another contributory factor for the higher investment comes from Broadberry. Productivity rises were higher than wage rises which favours job creation. As well as this, wage restraints continued through the 1960s, essentially increasing firms profits allowing investment to take place. The wage restraints were supplemented by cheaper imports of food and raw materials to keep living standards rising.

We can conclude the 'Golden Age' by saying that, yes, full employment was pretty much achieved, but it wasn't all down to the wonders of government policy. They were helped a great deal by very favourable conditions around the world. With hindsight, we can also see that this is only a temporary purple patch for Britain as problems begin to crop up. 

Macro-Economic Issues

The macro-economy refers to the wider economy - it's looking at an economy as a whole as opposed to individual firms or operators within an economy that micro-economics refers to. We come across macroeconomics on a daily basis: inflation and unemployment for example. The topic gets a lot of media attention and is the main cause of a lot of the criticism that politicians receive. The importance placed on macroeconomics by politicians can never be understated - they fully understand that voters want a thriving economy and therefore they strive to achieve this.

The four major economic issues are ones we will all have heard of: Economic growth, unemployment, inflation and the Balance of Payments/Exchange rate. The government aims to keep all four of these in check as part of their policy objectives. They want economic growth to be at a high, stable level. They aim to reduce unemployment because not only is it a drain on their finances in the form of unemployment benefits but it is a waste of resources. Inflation needs to be kept low and stable to make decision making easier on individuals and firms. The balance of payments wants to be in surplus, or at least balanced, so that the exchange rate isn't pushed upwards (this can fuel inflation as import prices will rise). The problem the government faces is that these policy objectives can conflict. If there's one thing you learn from this post, make it be this: The government are in a difficult position - they will struggle to achieve all four of these objectives at the same time.

At this point I am going to direct you to a previous post I've written about the circular flow of income as this will come in handy when looking at the next part. Click here to be linked to that post.

So, the macroeconomic goals of the government have a close relationship with the circular flow of income. If the withdrawals from the flow exceed the injections into the flow then we will see a case of aggregate demand falling. This subsequently will lead to a fall in economic growth, a rise in unemployment, lower inflation and a potential improvement of the balance of payments. With injections exceeding withdrawals we expect the opposite to happen. Here is a perfect example of the difficulties the government faces. A rise in aggregate demand has the potential to push the government closer to two of its goals (economic growth and a fall in unemployment) but at the same time it also pushes them further away from the other two goals (rise in inflation and a worsening balance of payments). The dilemmas of a politician. 

VampireStat: A Warning & Referrer Spam

This is completely off the topic of economics I'm afraid. It's a heads up to other bloggers - if you've been getting hits on your blog from a website called VampireStat then do not click on it. Please. I was always suspicious of it when I saw it was browsing my page and pumping up my hit counter so I never clicked on it to find out what it was - but from what I've heard its a potentially malicious site. There are other sites similar to it, trying to entice blog owners onto their page to spam them and potentially infect them.

So, this is a heads up to blog owners not to click on the link to VampireStat. I don't know anyway of blocking them from viewing your blog, but for now just resist the temptation to click. If you know the names of other similar sites please comment them and help out fellow bloggers.

A few other sites have come up that are essentially the same thing: 'Filmhill', 'current' and 'topblogstories'. Once again, DO NOT click on these links. I did some digging and these sites are known as referrer spam. There isn't actually someone viewing your blog, these sites are using bots to trawl through blogs to get you to click on their link. The only way to stop them is to not click on them. Clicking on them makes them do it more. So, to reiterate, ignore any hits from these sites and do not click the link. It's for the good of yourself as well as others!
Cheers guys!

Marketable Permits

Another market based instrument the government can use to try and internalise the externalities caused by the use of environmental goods and services is marketable permits. The authorities choose the amount of pollution they feel is acceptable for a particular pollutant. Then, they issue permits to firms, each one allowing the firm to emit one unit of pollution. The amount of permits they give out will be equal to the pollution limit they have set. A market has then been created - firms can buy or sell these permits when they need to, the price of the permits will depend on the demand and supply. These marketable permits leave the decision to the firm as to how many permits to buy and how much pollution to abate.

The firms marginal abatement cost and the cost of permits will influence the firms decision to cut their pollution. If the marginal abatement cost is greater than the permit price then the firm will keep its pollution as it is and buy permits to cover it. If the permit price is greater than the firms marginal abatement cost then the firm will cut its pollution because it will be cheaper than buying the permits to cover it all.

Marketable permits are a lower cost way of reducing pollution than command and control. Imagine we have two firms: Firm 1 and Firm 2. Firm 1's MAC is £100 and it is polluting 50 tonnes. Firm 2's MAC is £150 and it is also polluting 50 tonnes. Total emissions is 100 tonnes. If we wanted to cut pollution down to 80 tonnes using command and control methods we'd get each firm to cut pollution by 10 tonnes. This would have a cost of £1,000 to Firm 1 and £1,500 to Firm 2, a total cost of £2500 to cut the pollution.

Now, If the permit price was £130 and we were trying to get to 80 tonnes under marketable permits the cost would be different. 80 permits would be issued to firms, so Firm 1 and Firm 2 would both get 40. Firm 1 could cut pollution by 20 tonnes to reach a total of 30 tonnes emitted at a cost of £2000. They could then sell 10 spare permits netting them £1300, meaning the net cost was £700. Firm 2 could buy up 10 additional permits and keep its pollution at 50 tonnes - this would cost them £1300. So, pollution has now fallen to 80 tonnes (30 from Firm A and 50 from Firm B) but it has only cost a total of £2000 (£700 for Firm A and £1300 for Firm B). Therefore marketable permits is a more cost effective way of reducing pollution than command and control.

Marketable permits also have a benefit over the pollution tax system. Permits allow authorities to set the amount of pollution and then let the market choose the price. With taxes, the authorities choose the price and let the market choose the pollution level.

There are many technicalities to the system that I'll talk through now. The first of these is 'bubbles'. This is essentially a 'bubble' over a whole firms pollution - the aim is to make the aggregate level of pollution in the bubble stay the same. So, they can increase pollution from one of their outlets as long as they reduce pollution elsewhere in their firm by an equal amount. 'Banking' is an extension to this. It allows a firm to bank credits for later use if they reduce below the aggregate amount - it allows them to temporarily pollute more in the future by using these credits. 'Netting' is another concept. This allows firms to create a new source of emissions only if they generate equal reductions elsewhere in their firm - they cannot buy new permits from the outside to cover the new emissions they must internally trade the permits they already have.

In reality, marketable permits are a difficult concept to get going. An example of this is the EU CO2 Emissions Trading Scheme of 2005. It ultimately failed because too many permits were given out at the start and therefore nothing was achieved, but a lot of money was wasted. There are many other problems with the system. Firstly, the politics behind it make it difficult to impose and coupled with this the unethical-ness of actually permitting firms to pollute generates a lot of opposition. The system comes with massive administration costs that only get higher with more firms being included in the operation. The main problem is how to actually allocate the permits in the first place? One method used already is 'grandfathering'. Firms are given permits based on historical emissions data, the more the firm polluted in the past the more permits they get. This is, in essence, rewarding dirty firms. It also incentivises firms to increase production and therefore pollution when talk of a permit scheme being introduced starts so that the firm can gain more permits. 

In theory marketable permits are a great idea, currently in reality they don't work too well and there are many obstacles that need to be overcome. Maybe in the near future we will see these sort of schemes becoming more common and helping the pollution problem. What is your opinion? Cheers for reading.

Sam.

Government Failure

Sometimes we see governments intervening in markets in an attempt to make them more efficient. However, it is very often the case that they aren't any better at managing resources than the free market - this is known as government failure. We'll look at example involving land conversion and biodiversity loss.

Land conversion is the main reason for biodiversity loss around the word - both grassland and forest cover is declining rapidly in some parts of the planet. We use a diagram similar to the one used in the last post which looks at the interaction between a firm's marginal net private benefit and the marginal external cost of land conversion. The definitions in this case are as follows:

• Marginal net private benefit (MNPB) = the profit associated with a one unit increase in land conversion.
•  Marginal external cost (MEC) =  External cost of a one unit rise in land conversion.

The market for this looks as follows:

Let us describe the market. We have an initial over-conversion because of the market failure. Lp is converted when the socially optimal level would be L*. This is all explained in the last post I made. The government failure, however, comes in the form of the subsidy. The government may be subsidising farmers' incomes, or something of the sort, but this is encouraging more land to be converted. The subsidy increases the marginal net private benefit of land conversion for the firm and therefore the amount of land converted has moved further away from the socially optimal level. We have to remove the government failure before we can remedy the market failure.

We've assumed a constant upwards sloping marginal external cost curve here, but it may be a good time to mention other plausible curves. We could have a curve that increases at a constant rate and once a threshold point is reached it increases faster. Or, we could even have a downwards sloping MEC curve. How? Imagine a view being ruined by a factory. The first factory has a massive effect on the view but subsequent factories have a lesser effect because the damage has already been done by the previous factories.

Government failure occurs a lot in the real world. One example would be with the Common Agricultural Policy. It aimed to provide farmers with a steady income by offering a guarantee price for their goods. This meant overproduction was rife - farmers knew that the best technique was to farm as much as they possibly could to get the most revenue. Land was farmed more intensively and more land was converted to farming to expand production. This will/has caused degradation of the land and biodiversity loss.

Another example is subsidies in developing countries. Governments there tend to impose subsidies to keep prices below the market price so that food and the like is affordable. This encourages over use of the land once again and makes the economic activity look artificially appealing, attracting more firms in. It is also a waste of financial resources that are needed elsewhere.

As we can see government failure is something that is very real. It can occur fairly easily and it needs to be stopped before any market failure can be addressed. How do we stop it, though? I'll be going into this in later posts, stay tuned. Thanks for reading.

Sam.