Battling Against Inflation, 1970-79

The 70s were a bad decade for the British economy. 'Failure' is probably the most fitting word for the period. From 1974 to 1979 unemployment had crept up to pushing on 5%, growth had fallen to 2% but the real issue was inflation at 16%. Part of the rise in prices can be attributed to the collapse of the Bretton Woods system, this led to a global commodity price rise which saw oil rise four fold in a 2 year period. Domestically, though, the supply side issues discussed in a previous post weren't helping and a lot of errors were made in macroeconomic policy cause partly by confusion over the actual cause of inflation.

The confusion was theorists thinking they understood the tradeoffs between economic objectives, such as inflation and unemployment. Stagflation occurred in the early 70s which shocked theorists - inflation and unemployment was rife at the same time, the government were struggling to achieve any of their objectives.

The government needed to re-think. They put the priority on targeting unemployment in the early 70s. During this period the Barber Boom took place. The chancellor at the time (Barber) injected a large monetary and fiscal stimulus to raise output but not inflation because of the spare capacity in the economy. Sterling was also allowed to float freely to stop a balance of payments crisis choking the growth. Did it work? In the short term - yes. Growth peaks at 7% in 1973. But, over the longer term, the balance of payments deficit soars, inflation starts to runaway and smaller financial institutions collapsed - the three things that really weren't wanted.

Because of the soaring inflation the government makes controlling this the main priority as the 1970s progress. Unemployment falls down the pecking order. Revised Keynesian theory defined the inflation as cost-push. Wages were rising faster than productivity forcing up the prices. Pay rises needed to be checked - were income policies the solution to this? Income policies worked like so: pay rises would be limited by setting a norm that everyone should follow. Some would be voluntary, some would be forced, others would be more complex. It worked for small periods of time, but it always failed eventually as people became dissatisfied and it defied the point of trade unions.

The monetarists attacked the income policies claiming they didn't curb inflation at all they just distorted the labour market. Tighter financial policy was required. This was true, public spending was high and still increasing. It rose faster than national income from 1970-75 and reached 9% of GDP during 1975. This high spending was crowding out private sector investment by pushing up interest rates. In 1976, Labour realise the problem and agree to a deflationary package. Their new budget regime centred around cash limits. 60% of their spending would now be subject to 'cash limits'  and different programmes received a fixed cash sum year on year regardless of inflation. In real terms, this change meant public spending fell and brought inflation down to some extent.

What can we conclude from this then? Was this the end of the Keynesian era? The government were still trying their hardest to adapt Keynesian demand management policies rather than find a new, improved framework. This just resulted in what seemed like aimless policies that didn't solve any problems. Real living standards on the whole were hit, especially the middle income people, which led to a lot of resentment. 

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. 

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. 

Britain and the International Economy, 1870 - 1914

During the period from 1870 up to the start of the First World War in 1914 the British economy changed a lot. As well as this, the international economy as a whole had a spectacular change around so that conditions in 1870 in no way matched those in 1914. Firstly, world trade was growing. The rate at which it was growing was outstripping world output which shows the industrialisation, falling transport costs and mass emigration that was happening across the globe. In Britain, trade grew 35 fold over the 19th century.

Let's focus more on Britain now. Foreign Trade stayed fairly constant in the time period given, in terms of the fact it was at 30% of GNP in 1870s and also at this level in 1913. As a bit of background, it was at 10% in the 1830s and 17% in the 1850s. During 1870 and 1913 foreign trade as a percentage of GNP did fall, but it recovered just before the First World War. The majority of this foreign trade was in the form of manufactured goods, although it was declining. For example, 56% of exports in 1870 were textiles but textiles only made up 37% in 1910. As far as imports go, we imported a lot of food and raw materials because we weren't self sufficient in these, apart from coal.

We'll move on to the balance of payments position for Britain now. Before 1914, imports exceeded exports. Exports of goods only made up two thirds of our imports between 1870 and 1900. However, it wasn't all bad because Britain had a very sophisticated 'invisible' sector for this time; this comprised of business services and overseas investment. With the exports of these included in the mix Britain actually ran a surplus which increased between 1851 and 1913. We have many reasons as to why a lot of funds were leaving the country in terms of these 'invisible' goods, they are split into two groups: 'pushing' funds out factors and 'pulling factors'.

'Pushing' funds out factors are basically the factors in Britain that meant it was in the best interests of investors to send their money abroad. They include:

•  The safe investments in Britain gave very poor returns compared to the equivalent abroad.
• High return investments in Britain were all very high risk.

The other factors are called 'pulling' factors. These are factors that come from the countries abroad that encourage investment. They include:

• Large infrastructure spending abroad because of industrialisation. 
• Overseas governments were issuing bonds with returns of 4-5% in comparison to the 2% return in Britain.

Britain played a vital role in the world balance of payments during this time period as well. We ran deficits with industrial countries and surpluses with the primary producers. So, we were in deficit to countries such as the USA but ran surpluses with countries in Asia and South America. 

Some contempories came to the conclusion that Britain was in a weak position at the time. They argued that Britain's share of world exports was falling and they were beginning to import more and more manufactured goods. The British exporters were falling behind in more advanced products. They had solutions, however. They felt British business needed to be more efficient in their production techniques to make them competitive on the world market again. They also felt that government policy was to blame, especially free trade. The idea behind free trade was that it would maximise the wealth of all nations by the theory of comparative advantage, and this in turn would maintain Britain's dominant position in the world economy. However, most major economies didn't adopt it and the protectionist countries actually grew faster than Britain after 1870. 

I'll round things off there. Basically, we can conclude that from 1870 to 1914 Britain was comparatively having a bit of a rough period. It kept a surplus on its balance of payments and was still very much a key player in the world economy. But, other countries were catching up. Britain had lost its place as the dominant exporter of manufactured goods and was adopting policies (free trade) that weren't effective. Next I'll move on to the interwar period of the British economy to see how that changed. Thanks for reading!

Sam. 

Monetary Policy (Macroeconomics)

Monetary policy, liked with fiscal policy is another tool the government can use to control the economy. Monetary policy involves the use of exchange rates, interest rates and the money supply to manage the economy.

Firstly, interest rates. These are set by the MPC and are mainly used in the U.K to try and achieve the inflation target of 2.0%. The theory is that a reduction in interest rates will give consumers more disposable income through lower loan repayments and this will boost the consumption factor of Aggregate Demand. Also, it should make businesses take out loans more willingly as borrowing money becomes cheaper and thus the investment factor of Aggregate Demand will rise also. Overall, a fall in in interest rates should create a rise in the real GDP of the country. It works the opposite way with a rise in interest rates, this should reduce the real GDP of the country as well as control inflation.

Interest rate changes also effect the Balance of Payments. Interest rates in the U.K. rising will cause a flow of 'hot money' into the economy as people will benefit from the higher returns of putting their money in the U.K. This flow will increase the demand for the pound, so the value will appreciate. The knock on effect of an appreciation in the value of the pound is that our exports become more expensive and it becomes cheaper for us to import goods. This will worsen the Balance of Payments. Obviously, the opposite will occur with a fall in interest rates.

Exchange rates was another tool under the title of 'Monetary Policy'. By managing the exchange rate, the Bank of England can buy and sell pounds to influence the exchange rate. This will control the competitiveness of U.K. exports and therefore help control the Balance of Payments. However, the government doesn't generally take this approach as they let the free market determine the value of the pound. One instance where this is sometimes done is in China.

The final tool under the 'Monetary Policy' heading was the money supply. This is where the government can increase or decrease the amount of money in the economy. The idea behind increasing the money supply is that it should stimulate Aggregate Demand as people have more money to spend and businesses have more money to invest. However, this method is very inflationary and is widely avoided. Decreasing the money supply will have the opposite effect to the above.

That's it, the three parts involved in the 'Monetary Policy' tool the government has at its disposal. Thanks for reading.