https://cpes.org.uk/om/files/original/addde8ab3dedf17929055c41d227e2cb.pdf aaa0557275395542f3870ebd176ec481 Dublin Core The Dublin Core metadata element set is common to all Omeka records, including items, files, and collections. For more information see, http://dublincore.org/documents/dces/. Title A name given to the resource Cambridge Economic Policy Review Volume 6 No 3 Text A resource consisting primarily of words for reading. Examples include books, letters, dissertations, poems, newspapers, articles, archives of mailing lists. Note that facsimiles or images of texts are still of the genre Text. Text Any textual data included in the document Chapter 2 The effects of financial institutions We have seen in the previous chapter how a pattern ofaccelerated spending, defined ex ante, would tend to generate rising trade imbalances in the early 1980s. But these projected imbalances are unlikely to occur in practice because growth of spending will be limited by financial constraints. The purpose of this chapter is to consider prospects for spending and trade balances on an ex post basis, taking account ofconstraints implied by financial institutions. The first section sets out an analytic framework for the simultaneous determination of spending, income and trade. This is followed by a discussion of some general properties of financial adjustment processes within a world trading system. The third section examines the effects of financial institutions on adjustment processes in different parts of the world. The fourth section presents projections of spending, income and trade taking account of financial constraints, and the final section examines how far the outcome would be altered by changes in objectives and constraints. 2.1 Financial adjustment processes In all parts ofthe world public and private institutions seek to maintain or expand their spending in pursuit of a variety of social and individual objectives. In so doing they are constrained by their income, their own financial objectives and by the credit limits placed on them by financial institutions. In particular, financial institutions limit divergence between spending and income if it results in a rapidly cumulating indebtedness. Changes in trade have a direct effect on income earned within a country. Thus so long as financial objectives and constraints have any influence on spending decisions, changes in trade will indirectly affect the level of internal spending. Such induced changes in spending generally feed back into external trade flows, especially demand for imports. The effect is normally to diminish the magnitude of ex post changes in the country's trade balance, compared with what would have happened if internal spending had remained unchanged. For example, an increase in exports will usually generate additional income and internal spending, causing a rise in imports which goes at least some way towards off- setting the improvement in the trade balance resulting from the initial increase in exports. In an extreme case, the ex post trade balance might not change at all; the rise in imports induced by additional spending might be equal to the increase in exports. However, the adjustment process will never be instantaneous so there is always likely to be at least a temporary rise orfall in the expost trade balance in response to a rise or fall in ex ante trade flows. There is one case in which internal spending may remain unaffected by changes in export earnings. Consider the example of an oil-exporting country with large foreign exchange reserves where all oil revenue accrues directly to the government. In this case it is quite possible that fluctuations in the value of oil exports will have no influence whatever either on internal spending or on imports, their only consequence being to alter the rate at which the government accumulates external assets. It is also possible that ex ante changes in external trade may be compensated by structural adjustments which reduce or eliminate the need for changes in the level of internal spending. For example, in a country whose government regulates imports, changes in export earnings may be compensated by tightening or relaxing the system of import control or, in a country with a liberal trade regime, an ex ante deterioration in trade might be compensated by a fall in the exchange rate, sufficient to stimulate exports and discourage imports. But in practice compensating structural changes are usually slow and incomplete. In this chapter we shall confine our attention to changes in spending which would have to occur in the absence ofstructural adjustments. Possible gains or losses resulting from 'restructuring' in the fields of energy and manufactures will be dealt with in the next chapter. A formal representation Let us now consider how processes of financial adjustment can be represented formally. The first step is to establish accounting relationships between trade, income, spending and financial deficits for each country or bloc. the accounting system used in our model (see p11 ) has three relevant concepts: B the balance on commodity trade 23 Y real income H domestic spending (plus net exports of services). We must now distinguish S net exports of services and D domestic spending(excluding net exports of services) where D = H-S The measure of real income in our accounts is income derived from domestic output (GDP). This does not include net receipts of profits, remittances, aid and other transfers from other countries. Nor does it include direct investment flows from other countries which may finance internal spending without giving rise to a financial deficit. Here we shall denote net receipts of income and direct investment from other countries by T. Given these accounting adjustments, the overall financial surplus (+) or deficit (-) of a country or bloc may be defined as F = (Y + T) - D = Y + T + S- H This represents the combined financial balance ofall internal institutions, banks, governments, companies and private individuals, after netting out their lending to one another. It is equal to the balance of payments surplus or deficit of the country or bloc on trade, services, income transfers and direct investment. Since income from domestic output, Y, is equal to domestic spending plus net exports of services and goods- Y=H+B it follows by substitution that F=Y+T+S-H =B+S+T This identity, linking the combined financial surpluses or deficits of institutions in each bloc to the overall balance of payments surplus or deficit of the bloc on current account and direct investment flows, is an ex post identity which says nothing about how balances are adjusted. To consider this we must now make assumptions about the objectives of relevant institutions and about the adaptations which occur if their objectives are mutually incompatible. For this purpose we define two fundamental targets - a normal or desired level of domestic spending, D*, and a desired financial surplus or deficit, F*, (both measured in real terms). Given these two targets for spending and financial balances, we may define the level ofdomestic income at which both could be achieved as Y*=D* + F*- T In other words, for spending objectives and financial objectives to be fulfilled simultaneously it is necessary that income generated by domestic output be sufficient to cover desired spending and net financial accumulation, less net transfers ofincome and direct investment from other countries. There is a corresponding implication for the trade balance. The trade surplus or deficit must be sufficient, after allowing for net exports of services and net receipts of income and direct investment from 24 abroad, to match the combined target financial surplus or deficit of all domestic institutions. Thus we may define a target trade balance, B*, such that B*+ S + T= F* If the actual trading position allows spending and financial targets to be met simultaneously, then we assume that actual levels of spending, income and financial accumulation will conform to the targets. In practice such an equilibrium is not often achieved. Given world prices, the state of export markets, and the supply position within the country orbloc, let us denote the trade balance to be expected ex ante, if internal spending objectives were fulfilled, by B ∑ In a 0 world recession the problem for many or most countries is that the ex ante trade balance, B , falls below the target, B*. An alternative way of p~tting this is that external trade does not generate sufficient income for spending objectives to be achieved in full except at the cost of some or all institutions falling short of their financial targets. In general, part of the necessary adjustment is likely to be made by reducing spending, and part by shortfalls in financial balances. Such an adjustment may be denoted by D - D* = a (Y- Y*) where a is a parameter between 0 and 1 indicating the severity of expenditure adjustment. The actual financial surplus or deficit will then be F - F* = ( 1 - a) (Y - Y*) For simplicity we shall treat net service exports and transfers and direct investment receipts from abroad as being fixed. We may then write H- H*= D- D* =a(Y- Y*) and B - B* = F - F* = ( 1 - a ) (Y - Y*) The adjustment of spending will cause an adjustment of the trade balance, mainly through induced changes in imports. We may write B -B = - J..1. (H - H*) 0 where J..1. measures the sensitivity of changes in the trade balance to changes in domestic spending, for the moment assuming unchanged world prices and spending in other blocs. The combination of trade and spending adjustment processes determines the eventual outcome. The expost trade balance is given by B- B o = l__+_)"'__f_ (B* - B) o where "'= ' .l..s-!Je:!:x__ Put in words, a discrepancy between the target trade balance B* and the ex ante trade balance Bois partially corrected by adjustment of spending, the adjustment being the more complete the more severe is the adjustment of spending to income (a) and the greater the sensitivity ( J..1.) of the trade balance to spending. In our projections of the world system as a whole the adjustment process becomes more complex because offeedbacks into world prices and spending in other blocs. The reaction of trade to changes in spending is governed by the 'real' side of our model, Table 2.1 Adjustment profdes for a constant tendency to shortfall in the trade balancea (percentage of shortfall eliminated) Normal adjustmentb Strong adjustmentb Very strong adjustmentb Low sensitivity of trade balance to spending (J.I. = 0.2) First year 38 54 64 Second year 70 80 86 Fifth year 96 98 99 High sensitivity of trade balance to spending (tJ. = 0.4) First year 55 71 78 Second year 77 87 91 Fifth year 97 99 99 a The tendency to shortfall in the trade balance is measured by B* - Bo b Alternative adjustment processes assumed in projections of the model. The adjustment proftles shown illustrate the effects of adjustment of spending within a single bloc, assuming fixed world prices and unchanged spending in other blocs. The coefficients of adjustment are as follows: ex {3 Normal 0.75 0.50 Strong 0.86 0.57 Very strong 0.90 0.60 discussed in the previous chapter. Implied values of the partial adjustment parameter, J.l. , for the trade balance are in the range 20-40%. Our projections in this chapter will assume that if the outcome persistently falls short of financial targets, the rising cumulative deficit exerts increasing pressure for adjustment of spending. Thus, defining the cumulative discrepancy, R, by R= R_1 + (F- F*) the adjustment process in the model takes the form H- H*=a (Y- Y*) + ~R_1 where {3 is a parameter measuring the strength of pressure for correction of cumulated past deficits. For a given and constant discrepancy between the ex ante trade balance Bo and the target B*, this formulation implies a progressive, and eventually complete, adjustment of the ex post trade balance. Depending on the strength of the adjustment process and on the sensitivity ofthe trade balance to internal spending, a constant discrepancy would be corrected, in the model, by 40-80% in the first year, by 70-90% by the second year, and by 96-99% by the fifth year. The assumption that excess financial deficits cannot be allowed to accumulate without limit evidently implies that persistent tendencies to a shortfall must ultimately be eliminated. In the long run the expost trade balance is then governed entirely by financial constraints: spending has to adjust fully to fmancial objectives. The strength ofthe adjustment process and the degree to which the country or bloc is open to external trade influence the speed of adjust- ment and the extentofcumulative financial shortfalls during the adjustment process (see Table 2.1). 2.2 General implications of financial adjustment There are some properties of financial adjustment processes within a world system which are quite well known. For example, if trade targets are mutually inconsistent in the sense that most or all blocs aim for a surplus, the process of expenditure adjustment becomes cumulatively deflationary for the world as a whole. Each bloc cuts its spending, trying to improve its trade balance, but in so doing it worsens the position ofotherblocs which respond by cutting their spending further, causing a recessionary spiral. Another familiar proposition is that the expenditure adjustment process may tend to depress the level of spending and trade in the world as a whole if it is asymmetric. Blocs with excessive deficits may be compelled to cut their spending severely while 'surplus' blocs make little orno adjustment in the opposite direction. The implicit counterpart to these results is the proposition that if trade targets were mutually consistent and if the process of adjustment were uniform and symmetrical, then the financial adjustment process would have no effect on total world spending but would merely redistribute spending between blocs. Under such conditions total world income would be the sum of the ex ante spending 25 levels ofindividual blocs. Provided spending targets were genuinely given ex ante, changes in the pattern of world trade and prices would have no impact on aggregate world production and income. Tendencies to trade imbalance would cause a redistribution of production and income between blocs but would not affect world totals. It is abundantly clear that the processes of financial adjustment which exist in the modern world do not conform with the postulates of consistency and symmetry required for the above result to hold good in reality. Thus even ifthe targets for accelerated growth ofspending discussed in Chapter 1 genuinely represented the combined objectives of institutions within every bloc, there is no reason to expect that total world spending would in fact rise in the early 1980s at the rate assumed in our ex ante projection. The problem is not that the combined trade targets of different blocs are inconsistent in the sense of being too ambitious but rather that adjustment processes are asymmetrical and non-uniform. It seems likely that few countries want to achieve large balance of payments surpluses; on the other hand many countries evidently incur deficits willingly and are capable, within bounds, of financing them. The main surplus countries, those in OPEC, are embarrassed by the size ofsurpluses forced on them by high demand for oil in the rest of the world. Other potentially surplus countries such as Japan and Germany have appeared anxious to avoid any chronic surplus position for fear that this would force up their exchange rates to a point which seriously damaged the profitability of their industries. Indeed Japan now faces the problem of avoiding not only overvaluation of its currency but also discriminatory import controls aimed against its manufactured exports. Asymmetry and non-uniformity are most evident in the policies of international financial institutions such as the IMF and commercial banks. They frequently seek to negotiate reductions in spending in heavily indebted countries but have neither the motive nor the means to place corresponding pressure for higher spending on creditor countries. A similar asymmetrical pressure is exerted by domestic banking institutions in most countries, although this is compensated in some cases by government deficits and by incentives to encourage companies to borrow. If there were no ex ante trade imbalances, or if those imbalances diverged only marginally from the pattern required to meet financial objectives, the asymmetry of financial adjustment would matter little from the point of view of world spending and trade. But in the 1970s, and prospectively in the 1980s, pronounced tendencies to imbalance have combined with financial constraints to depress world growth and to limit very severely the possibilities of expansion for many individual blocs and countries. In these circumstances the processes of financial adjustment become very important. The next section therefore examines in more detail how the spending and deficits of different blocs are restrained in practice. 26 2.3 Financial adjustment in practice The specific mechanisms regulating spending vary considerably in different parts of the world. Here we consider countries in four groups - oil exporters, non-oil developing countries, developed market economies and centrally planned economies. Adjustment processes in the first and last of these groups can be described quite simply. The cases which need more thorough consideration are those of non-oil developing countries and Western industrial countries. It has already been mentioned that the level of spending in the main oil-exporting countries is determined almost entirely by governments and is scarcely influenced by fluctuations in trade or by external financial pressures. For our purposes the growth ofspending in such countries will be regarded as being determined ex ante by internal objectives. As for the centrally planned economies, their imports from other blocs have always been carefully regulated to maintain a close balance on trade overall. Imports from hard currency countries have mainly been financed by sales of gold, raw materials and energy. Although centrally planned countries also borrowed from the West in the 1970s, the rate of borrowing has been small relative to their internal income and is now inhibited by the political climate. The bloc as a whole is therefore likely to continue to maintain a near balance in its external trade, implying that, as in the past, the limit on its economic expansion will be set mainly by the internal supply position with regard to food, raw materials and energy. Non-oil developing countries The non-oil developing countries constitute the group whose imports and spending are most obviously constrained by export earnings and external sources offinance. Since the mid-1970s these countries have had large trade deficits, expected in total to exceed $50 billion at current prices in 1980(see Table 2.2). Their large debt requires them to make substantial interest payments, making their external deficits on current account (excluding official aid) larger still. Since aid and direct investment inflows cover only about one-third of the total deficits, the remainder has to be financed by borrowing, creating a debt which has risen from $75 billion in 1973 to an anticipated $280 billion by the end of 1980. The fundamental reason for the deficits and debts of non-oil developing countries is that their internal growth objectives have a high priority on account of their low income levels and persistent growth of population. The need for rapid internal expansion is incompatible with balance in external Jrade while their export earnings remain low, especially when they depend on imports ofenergy and manufactured producer goods. In the 1950s and 1960s the ability of developing countries to incur trade deficits depended mainly on the sponsorship ofWestern governments and official institutions which alone were in a position to provide them with aid or foreign currency loans. But the growth of international commercial banking since ∑ Table 2.2 Financing trade deficits: Non-oil developing countries3 1973 Trade balance Net services and private transfers -10.8 - 0.5 1975 -40.2 - 5.6 1978 -30.3 - 5.2 ($billion) 1980b -53.6 -14.4 Balance on current accountc Official aid Net direct investment Net long-term borrowing from official sources Net long-term borrowing from commercial sources Residuald -11.3 4.5 4.3 5.5 6.4 9.4 -45.8 6.9 5.3 11.4 14.9 7.3 -36.2 7.6 6.5 16.3 21.0 -15.2 -68.0 10.8 8.4 19.1 26.9 2.8 a Includes Greece, Portugal, Yugoslavia, Israel and South Africa as well as some countries with significant oil productionnotably Mexico and Egypt. b Projected figures. c Excluding official transfers. d Principally, changes in reserves and short-term borrowing. Source: IMF May 1980, World Economic Outlook,pp. 97 & 101. the late 1960s has very much diversified the potential sources of finance. Thus in the 1970s some developing countries borrowed heavily from commercial banks, most ofthe counterpart deposits being placed with those banks by the official institutions of oilsurplus countries. The combination of borrowing by non-oil developing countries and accumulation ofdeposits by oil exporting countries has brought about an expansion of deficits and surpluses, debts and reserves, far larger than that sponsored by the Central Banks and official international institutions of Western countries. A large part of the debt is owed by a few countries (in 1978 the debts of Brazil and Mexico alone amounted to one quarter of the total). Other developing countries remain at leastpotential clients of the international commercial banks, so long as the bankers regard them as acceptable borrowers and their governments regard the banks as acceptable creditors. The evident risk of borrowing by low income countries is that they may become heavily dependent on trade deficits, resulting in a fast-growing external debt with rising interest charges. Both sides are then placed in great difficulty. It is not easy for the banks to force low-income deficit countries to restore external financial viability, nor for their governments to cut internal spending and imports to meet the banks' requirements. The IMF has several times been brought in by creditors to negotiate restrictions with debtor governments, placing it in the unfortunate role ofbailiff, enforcing the paymentofother people's debts (see Table 2.3). Official institutions such as the IMF and World Bank have been responsible, ifconservative, lenders on their own account, seeking to prevent accumulation of debt on terms or to an extent which might force borrowing countries towards bankruptcy. But financing of deficits on 'responsible' terms has been inadequate to meet the circumstances of the 1970s when OPEC surpluses, created mainly by the energy demands of developed countries, were not matched by deficits in the major oil-importing blocs. The USA, Western Europe and Japan 'passed on' their deficits to non-oil developing countries without institutions being created to finance such deficits in a secure way. Large-scale commercial lending to non-oil developing countries is no more sensible in the long run than lending to low-income individuals with chronic tendencies to overspend. It is evident that multilateral trade cannot be fmanced indefinitely on this basis. The alternative would have been for high income oilimporting countries to incur deficits on the appropriate scale themselves, providing non-oil developing countries with better opportunities for increasing exports instead of increasing their debt. T6- see why ∑ this has not happened, we now consider mechanisms ofadjustment in the developed countries themselves. Developed countries In the first twenty years after World War II the countries ofWesternEurope were subjectto financial constraints not very different in nature, though much less stringentin degree, from those now faced by nonoil developing countries. With fixed exchange rates and limited mobility ofprivate financial capital,their governments were obliged to take primary responsibility for the finance of any deficits on trade, invisibles and direct investment, through depletion of exchange reserves or through official external borrowing. Trade deficits tended to force governments to undertake deflationary fiscal and monetary policies in order to protect official exchange reserves. In practice European countries other than the UK rarely had to make any prolonged adjustment, since 27 ,,.._ Table 2.3 External debtsa of non-oil developing countriesb Creditor institutions Governments International institutions Commercial banks Other private 1973 36.9 12.2 13.1 13.8 1975 50.8 18.6 30.9 14.5 1978 76.2 35.4 76.7 23.1 ($billion) 97.6 49.0 106.2 26.8 Total 75.9 114.9 211.6 279.5 Debtor areas Latin America Asia Africa Middle East Europe 25.7 42.2 82.9 104.2 23.6 32.3 53.9 72.3 10.5 16.7 33.1 43.3 7.7 12.2 22.9 30.9 8.4 11.5 18.8 28.8 Ratio of total debt to annual exports of goods and services annual GDP (per cent) 69.8 76.2 86.3 74.0 13.7 15.0 19.2 19.3 a Public and publicly guaranteed. b See Table 2.2 Source: IMF, op. cit., pp. 102-3 their balances ofpayments usually remained manageable despite high growth rates of internal spending. The option of deliberate exchange rate devaluation to correct tendencies to trade deficit was used quite successfully (although not without accompanying short-term financial restriction) by France on several occasions. The USA enjoyed the privilege ofbeing the single genuine reserve currency country: it did not need to worry about balance of payments deficits since these were financed automatically as other countries accumulated dollar reserves. Consequently, its financial and monetary policies were dictated almost entirely by internal considerations.* When the fixed exchange rate system broke down at the beginning of the 1970s, the processes of financial adjustment in developed countries were already starting to change. One underlying development was the increasing tendency to trade imbalance between developed countries as tariffs were reduced or removed and trade in manufactures expanded rapidly. Another related change was the build-up of *The one external financial problem faced by the USA was attempts to convert external dollar holdings into gold. The consequent drain on US gold reserves was limited by pressure on foreign monetary institutions not to buy gold and, eventually, by ending convertibility of the dollar into gold. Only once, in 1960, was internal policy appreciably influenced by the gold drain. inflation, which varied considerably between countries. These two changes together made fixed exchange rates inconsistent with balanced trade at full-employment levels of spending. At the same time liberalisation of private international financial transactions gave rise to the possibility, indeed the necessity of speculative anticipation of exchange rate changes. Private international banking expanded rapidly to serve commercial customers and soon also provided a medium for deposits and borrowing by governments of developing countries. Increasingly large and unstable flows of commercial funds could no longer be offset by drawing down official exchange reserves. Thus in the early 1970s the Central Banks ofwestern countries abandoned the attempt to enforce fixed exchange rates and allowed exchange rates to be determined in a global foreign exchange market. They have continued to intervene directly in"':hat market by buying and selling currencies, although not with any great long-term success. The situation has therefore arisen that if governments wish to influence exchange rates they must do so by influencing demand for currencies in the market. This they achieve in some degree by raising or lowering domestic rates ofinterest, butprincipally by securing confidence in their overall monetary and economic policies. 28 Table 2.4 Exchange rate crises: Italy, 1974 GDP Consumer prices (change over six months at annual rate %) Prime lending rate (%) Official support for exchange rate ($million) Exchange rate (1973 Q1 = 100) 1973 Q1 Q2 Q3 Q4 + 6.1 + 6.0 +13.4 + 9.0 11.3 13.0 12.1 10.3 7.0 7.0 10.3 9.5 1195 1432 616 1154 100 93 90 91 1974 Q1 Q2 Q3 Q4 1975 Q1 Q2 + 5.9 + 2.7 2.6 7.7 6.2 3.8 16.9 22.8 24.4 26.6 20.9 13.2 12.8 18.0 18.5 19.5 18.0 14.0 2651 2489 513 1281 108 60 87 85 84 82 81 82 Key events January 1973: establishment of dual exchange rate regime. February 1973: commercial lira allowed to float, free of EEC arrangements. January 1974: Bank of Italy penalties on excess borrowing increased. March 1974: IMF agreement on letter of intent (limited budget deficit, ceiling on credit expansion);$ 1.9 billion EEC assistance. Summer 1974: $1.8 billion drawn from IMF; $2 billion loan from Germany. August 1974: budget tightened with higher indirect taxes, charges for public services and taxes on high incomes. November 1974: peak prime lending rate. Floating exchange rates have not freed financial policies from external constraints as had been hoped at the beginning of the 1970s, especially in weaker trading countries. The threat ofan inflationary spiral set off by depreciation of the exchange rate (which raises world prices in terms of domestic currency) has simply replaced the former threat of exhaustion of reserves. The discipline of market confidence Table 2.5 Exchange rate crises: UK, 1966 GDP Retail prices (Change over six months at annual rate,%) Minimum Lending Rate (%) 1975 Q3 -0.6 30.6 Q4 +0.2 16.5 11.0 11.25 1976 Q1 +4.3 14.9 Q2 +4.8 15.3 Q3 +3.4 12.5 Q4 +2.3 14.6 9.0 11.5 13.0 14.25 1977 Q1 +0.8 20.7 Q2 +1.2 20.3 9.5 8.0 Official support for exchange rate ($million) 453 723 1356 3535 1523 220 -3278 -1561 Exchange rate (1975 Q3 = 100) 100 97 96 88 85 79 82 82 Key events November 1975: application to IMF for $2 billion (oil facility and non-conditional tranche). February 1976: Public Expenditure White Paper announces cuts. March 1976: £ falls below $2.00: exchange rate crisis more-or-less continuous until November. June 1976: $5.3 billion standby arranged with leading Central Banks. September 1976: Announcement of government intention to borrow $3.9 billion from IMF; strict conditions anticipated. October 1976: MLR raised to record 15%; £falls below $1.60. December 1976: agreement with IMF (budget cuts to reduce public borrowing by £2 billion, ceiling on credit expansion). 29 ∑ Table 2.6 Exchange rate crises: USA, 1978 GDP Consumer prices (Change over six months at annual rate,%) 1977 Q3 Q4 +5.9 +4.5 7.4 6.2 1978 Q1 +2.0 5.7 Q2 +5.0 8.9 Q3 +6.0 10.3 Q4 +4.6 8.9 1979 Q1 Q2 Q3 Q4 +3.3 -0.6 +0.4 +2.4 9.3 12.5 14.2 13.1 1980 Q1 Q2 +1.5 -4.0 14.3 15.9 Federal funds rate (%) 5.82 6.51 6.76 7.28 8.10 9.58 10.07 10.18 10.95 13.58 15.05 12.69 Official support for exchange ratea ($million) 800 15060 15080 - 4780 - 4640 18390 8500 9870 8340 180 8630 n.a. Exchange rate (1977 Q3 = 100) 100 98 94 93 88 87 88 90 88 90 90 90 Key events January 1978: expansionary budget proposed for 1979. Summer 1978: acceleration of inflation, real growth stronger than expected, high trade deficit. November 1978: crisis package - increased discount and Federal funds rates, mobilization of foreign currency for exchange intervention, announcement of intention to issue "Carter bonds" in Germany and Switzerland. Summer 1979: acceleration of monetary growth and price inflation. October 1979: second crisis package- discount rate and reserve requirements raised, shift of monetary policy to focus on monetary base rather than interest rates. aofficial support for the dollar was mainly through intervention by non-US monetary authorities. necessary to maintain exchange stability has proved as strict as the former discipline ofprotecting a fixed exchange rate. Indeed the discipline has become stricter on balance because it now embraces the United States. There is no longer any individual monetary authority in the developed countries which could unilaterally stimulate a sustained increase in spending regardless of attitudes in the foreign exchange market. The typical pattern of adjustment forced on major governments by exchange rate crises in the 1970s is illustrated by episodes in Italy, the UK and the USA (see Tables 2.4-2.6). The most dramatic ofall was the moment in 1978 when the government of the USA, the country which had for years dominated international trade and finance, was forced to change its internal monetary policy in response to loss of confidence. Neither the IMF nor foreign governments had ever succeeded in bringing influence to bear on the US government's internal policies, but the foreign exchange market did. In 1978 the continuing fall in the market value of the dollar, despite massive intervention in its support by the Central Banks ofEurope and Japan, forced a continuous rise in US interest rates. Eventually, it was necessary for the USA to adopt a crisis package of restrictive measures, ending internal economic growth and forcing its economy into recession. 30 The original optimism about floating exchange rates rested on the belief that depreciation of a currency would quite quickly improve a country's competitive position in trade. The threat of appreciation of the currencies of surplus countries would force their governments to choose between accelerated spending or a loss ofcompetitiveness. Thus any government which wished to stimulate spending in its country could do so, while allowing its currency to depreciate. Governments have at times been tempted to ignore depreciation ofthe exchange rate or even encourage it, hoping that the above mechanisms would soon come into operation. However, in practice the destabilising consequences of loss of confidence in the foreign exchange market always made themselves felt and. exchange rates fell uncomfortably fast This for_ced restrictive policies on offending governments before beneficial changes in competitiveness or in the policies of other governments had time to materialise. The financial policies favoured by the foreign exchange market are at present extremely conservative. Holders ofa foreign currency rarely have any interest in the expansion of spending in that country. On the other hand they are concerned about the preservation of the currency's value and they gain a better return the higher the country's interest rate. I ∑ The situation is aggravated by the widespread view that conservative financial policies are the best way to restrain inflation. Thus a secure currency has come to be that of a country whose government refrains as far as possible from deficit spending and curtails private borrowing through high interest rates in pursuit of a low target for growth of the money supply. Such policies quickly eliminate tendencies to deficit (although they do not always succeed in meeting money supply targets). The by-product, which is oflittle interest to external currency holders but of great interest to those concerned with growth of income and trade, is that countries with liberal exchange regimes have a strong tendency to eliminate trade deficits. While low-income countries with tight exchange controls and chronic shortages of export earnings can and do finance large trade deficits, developed countries with high export earnings and free exchange regimes are in effect rendered incapable ofmaintaining large trade deficits by the foreign exchange market's insistence on conservative internal financial policies. Evidently the preference for restrictive policies is not confined to the foreign exchange market. Many governments in developed countries believe in them and some go further than would be necessary to maintain a reasonable exchange rate for their country's currency. What the experience of the 1970s has shown is that governments which stimulate spending and accept a trade deficit are sooner or later forced to change their policies by external loss of confidence in their currencies. Thus in the end the foreign exchange market imposes a decisive constraint. 2.4 Projections embodying financial constraints Having discussed the principles and practice of financial adjustment, we now examine the pros- pective impact of financial constraints in the early 1980s, comparing the ex ante projection of trade imbalance presented in Chapter 1 with revised projections which embody adjustments of expenditure to financial targets. The first step is to consider the purely redistributive implications ofuniform and symmetrical adjustment towards a set of mutually consistent targets for all blocs, without any modification of the ambitious spending objectives assumed in ourex ante projection. We then examine the deflationary effects of asymmetrical or non-uniform financial adjustment. The final section of the chapter will consider the implications of changes in assumed spending objectives and in the magnitude of financial targets. Purely redistributive adjustment To define a uniform adjustment process, assume that every bloc alters its spending, whether up or down, according to∑the same 'normal' profile illustrated in Section 2.1 above (Table 2.1 on p.25). This implies correction of38-54% ofany external disequilibrium in the first year, depending on the openness of the bloc to external trade, rising to 70-77% in the second year and 96-97% in the fifth year. To complete the specification we must also define a set of mutually consistent financial objectives for each bloc, expressed in the form of implied target trade balances. The developed blocs, with increasingly conservative financial policies, may be assumed to aim at a combined trade balance of zero Western Europe accepting a small target deficit on account of its net service exports, matched by a corresponding target trade surplus for Japan on account ofits negative balance on services, transfers and direct investment. The centrally planned bloc, like the USA and the' other developed' bloc, may be assumed to aim at a zero trade balance. For developing blocs other ih.an the Middle East we assume target trade deficits slightly larger than Table 2.7 Target trade balances ($1975, billion) USA Western Europe Japan Other developed Latin America Africa Asia Middle East Centrally planned Average trade balances 1964-72 1973-79 +6.3 -8.0 +6.3 -0.8 -2.4 -0.4 -8.0 +5.2 +1.6 - 7.7 -19.5 + 9.0 2.6 8.8 3.0 5.9 +39.3 - 0.9 See p. 11 for accounting delmitions. Assumed target balances 1980-85 0 5 +5 0 -10 -5 -10 +25 0 31 Table 2.8 Uniform financial adjustment: a hypothetical projection3 1985 trade balances Growth of per capita spending 1979-85 Ex anteb Projected ($1975 billion) Targetc Projected (%per year) Excess (+) or shortfall (-) USA 44 8 2.5 1.8 -0.7 Western Europe 70 -9 3.0 2.3 -0.7 Japan 1 +4 4.0 4.2 +0.2 Other developed 8 3 3.0 2.5 -0.5 Latin America 0 9 4.5 5.0 +0.5 Africa + 33 + 2 6.0 10.1 +4.1 Asia - 44 -17 6.5 4.9 -1.6 Middle East +157 +47 4.5 13.8 +9.3 Centrally plannedd 23 8 5.0 4.7 -0.3 World totald 0 0 2.7 2.7 0.0. a See text and Appendix Afor assumptions. b Assumes spending targets achieved exactly. c Targets consistent with gradual convergence of blocs (see Table 1.3). d Spending data exclude China (see Table 1.1) The figure for growth in world GDP per capita or spending per capita is always some 1•2% below the average across blocs; this happens because population growth is concentrated in low-income blocs. those which materialised on average in the period 1973-78, to be financed not only by aid and direct investment but also, and in most cases principally, by additional net borrowing. Finally, to preserve the overall consistency ofthe targets, we impute a hypothetical target trade surplus to the Middle East equal to the sum of the other developing blocs. The effect of the uniform adjustment process would be to reduce ex ante trade imbalances very considerably ex post (see Table 2.8). The projected deficit of Western Europe in 1985 is cut from $70 billion (at 1975 prices) to $9 billion. Correspondingly, the projected surplus of the Middle East in 1985 is reduced from $157 billion to under $50 billion. As noted earlier, uniform and consistent financial adjustment has no effect on total world spending and GDP. But the distribution of growth between blocs is considerably modified. The developed blocs other than Japan are required to cut growth in their spending by over~% per year and the developing Asia bloc has to cut back by more than 1~% per year below the evidently over-ambitious target which we assumed in Chapter 1. Two blocs, Africa and the Middle East, are required to make almost all of the counterpart upward adjustment in spending since ex ante they are the blocs which would significantly exceed their financial targets. The implied ex post growth rates of per capita spending, 10% per year for Africa and nearly 14% per year for the Middle East, are wildly unrealistic (especially when it is remembered that these averages include non-oil countries in the two blocs). The implied growth rates of imports ofmanufactures into these blocs are even more absurd(14% per year and 23% per year, respectively). This projection is in fact an illustration of why symmetrical and uniform financial adjustment does not, and could not, rectify large and persistent ex ante tendencies to trade imbalance. A deflationary non-uniform adjustment Now consider a non-uniform pattern of adjustment, while retaining the same spending and trade targets. We shall assume stronger, more rapid adjustment towards financial targets on the part of the centrally planned bloc, the USA and Western Europe, but no financial adjustment at all on the part of the Middle East. The outcome is still a major reduction in projected trade imbalances, though less than before since the adjustment process is rendered more difficult due to a greater conflict of objectives in deficit blocs. The growth rate of total world spending is reduced by 1~% per year, the cutback being greatest in developing Asia, but also above average in the USA, Western Europe, the 'other developed' bloc and the centrally planned economies. Japan loses least as it has most to gain from lower world prices for oil and raw materials. Given the reduced pressure of world demand, the projected prices ofoil and other primary commodities are, respectively, 23% and 12% lower, relative to prices ofmanufactures, than in ourex ante projection. As a whole the projection begins to acquire a somewhat dismal realism. The low growth rates for the USA and Western Europe imply either continued low productivity growth or chronic, rising unemploy- 32 - Table 2.9 Non-uniform financial adjustmenta 1985 trade balances Exanteb Projected Growth of per capita spending 1979-85 Targetc Projected Excess (+) or shortfall (-) ($1975 billion) USA Western Europe Japan Other developed Latin America Africa Asia Middle East Centrally plannedd 44 70 1 8 0 + 33 44 +157 23 -12 -15 +2 7 -16 -6 -22 +84 6 World totald 0 0 a Pattern of adjustment: Very strong: centrally planned Strong: USA and Western Europe Normal: other blocs None: Middle East (for profiles of adjustment see Table 2.1) b,c,d, See Table 2.8. (%per year) 2.5 0.6 -1.9 3.0 1.1 -1.9 4.0 3.8 -0.2 3.0 1.3 -1.7 4.5 3.6 -0.9 6.0 7.3 +1.3 6.5 3.3 -3.2 4.5 4.5 0.0 5.0 3.4 -1.6 2.7 1.2 -1.5 Table 2.10 Composition of 1985 trade balances: ex ante and ex posta projections (% ofGDP) Primary commoditiesb Manufactures Ex ante projectionc Ex post projection Ex ante projectionc Ex post projection USA Western Europe Japan Other developed Latin America Africa Asia Middle East Centrally plannede 2.2 8.0 -12.7 + 1.3 + 7.1 +28.5 - 4.8 +56.7 - 0.7 1.1 6.2 -10.8 + 1.3 + 4.8 +18.7 - 2.9 +47.9 - 0.2 + 0.3 + 5.1 +12.5 3.0 7.2 -18.0 - 4.3 -20.1 - 0.1 + 0.4 + 5.5 +11.1 3.0 7.4 -20.6 - 2.5 -24.2d - 0.1 a Projection with non-uniform financial adjustment (See Table 2.9) b Food, raw materials and energy. c Projection assuming spending targets are achieved fully in all blocs (see Chapter 1). d The Middle East's imports of manufactures are the same in both projections but its national income is lower in the ex post projection. e See Table 1.1. Note: 1985 world prices for primary commodities relative to manufactures are projected as follows: (1975 = 100) Ex ante Ex post projection projection Food and raw materials Energy 109 294 96 226 33 ∑ ment. The average growth rates for developing blocs apart from Africa and the Middle East are too low for any major catching-up of living standards and probably imply little progress at all in many non-oil developing countries. Japan emerges as the only bloc likely to achieve a reasonable growth target with a reasonable trade balance. All other blocs are way off their targets, mostly on the down side. The implied adjustments of trade flows include lower demand and prices, reducing imbalances in energy and raw material trade, and lower imports of manufactures by developed blocs tending, ifanything, to increase imbalances in trade in manufactures (see Table 2.10). The prospect delineated by this projection still rests on assumptions which may in certain respects be too optimistic. The spending targets remain the ambitious ones chosen in Chapter 1 to be consistent with sustained growth and eventual convergence of living standards. The ex post trade imbalances still imply financial recycling between blocs on a considerably larger scale than was achieved in the late 1970s. We must therefore consider, finally, the possible effects oflower growth objectives and tighter financial targets. 2.5 Sensitivity of the results As shown earlier (Section 2.1) the strength of financial adjustment processes affects the speed of adjustment more than the medium-term outcome. The latter may, however, be sensitive to growth objectives and, especially in a constrained situation, to the pattern of financial targets towards which adjustment processes are directed. The assumed growth1objectives setout in Chapter 1 were probably more ambitious, particularly for the USA and Western Europe, than those likely to obtain in reality. But since these two blocs are expected to be heavily constrained by conservative financial policies, their ex ante growth objectives do not have much weight in determining expost results. To illustrate this we have calculated a revised projection in which targets for growth ofper capita spending in the USA and Western Europe are cut by 1% a year(from2.5% to 1.5% and3% to2%respectively). One consequence oflower spending objectives is that the USA and Western Europe would come nearer to their financial targets by 1985, with expost growth oftheir per capita spending reduced by 0.2% to 0.3% per year. The other main consequence would be that developing blocs lost export revenue and, except in the case of the Middle East, would be compelled to cut their own spending by as much as the USA and Western Europe. Japan would be least affected, gaining through lower oil prices much of " what it lost through depression of trade in manufactures. Although this example shows that the internal growth objectives of developed countries may influence the medium term growth ofworld trade and the prospects for developing blocs, that influence is weak. By the same reasoning it follows, equally, that Table 2.11 The effects of reduced growth objectives in the USA and Western Europea USA Western Europe Japan Other developed Latin America Africa Asia Middle East Centrally plannedc World totalc Base projectionb Reduced growth ($1975 billion) -12 7 -15 -10 +2 +2 -7 8 -16 -17 -6 -6 -22 -23 +84 +76 67 00 Base projectionb 0.6 1.1 3.8 1.3 3.6 7.3 3.3 4.5 3.4 1.2 Reduced growth (%per year) 0.3 0.9 3.8 1.1 3.3 6.8 3.1 4.5 3.2 1.0 Difference -0.3 -0.2 0.0' -0.2 -0.3 -0.5 0.2 0.0 -0.2 -0.2 a Reduction in target growth rates by 1% per year. b Non-uniform financial adjustment (see Table 2.9) c See Table 2.8, note d. 34 accelerated growth objectives would be insufficient in themselves to prevent slow growth or stagnation when financial constraints are tight. The other important determinant of projection results in this chapter is the assumed pattern of financial targets. The outcome is in fact very sensitive to changes in these targets. Ifthey are tightened up in such a way as to restrict expansion in any one bloc, the cutback in its imports reduces the earnings of other constrained blocs bringing a cumulative multiplier process into operation. ∑ Consider, for example, a $15 billion reduction in the target deficits ofdeveloping blocs (other than the Middle East). This is a small adjustment relative to world trade or income (it is equal to 1~%of world trade in manufactures andonly0.2% ofworld GDP). It is very small by comparison with the change in spending targets just considered (which implied a $260 billion cut in ex ante spending levels by 1985). Yet the impact of this small tightening of financial targets is projected to be slightly greater by 1985 than the effect of the cut in spending objectives. The consequence for Asia, Africa and Latin America would be reductions of between 0.8% and 1.4% in per capita growth rates. The developed blocs would find their trade deficits increased with ex post spending cut back by about '4% per year. The projected loss in terms ofworld GDP in 1985 amounts to $150 billion, ten times the size of the reduction in target trade deficits. How large would target trade deficits have to be in order to nullify the restrictive effects of trade imbalance on growth in spending in all blocs and in the world as a whole? The answer to this has already been given by the ex ante projection in Chapter 1 which assumed the full achievement of spending objectives. The necessary deficits, although in most cases not large as percentages of national income, are huge compared with those which can at present be financed in practice. The conclusion must be that world economic growth will be severely constrained so long as major tendencies to trade imbalance persist. Table 2.12 The effects of tighter financial targets for developing blocs3 1985 trade balances Growth of per capita spending 1979-85 Base projectionb Tighter financial targets Base projectionb Tighter fmancial targets Difference ($ 1975 billion) (%per year) USA -12 -13 0.6 0.4 -0.2 Western Europe -15 -16 1.1 0.9 -0.2 Japan + 2 + 1 3.8 3.7 -0.1 Other developed -7 -8 1.3 1.1 -0.2 Latin America -16 -13 3.6 2.8 -1.2 Africa - 6 - 2 7.3 5.9 -1.4 Asia -22 -18 3.3 2.5 -0.8 Middle East +84 +74 4.5 4.5 0.0 Centrally plannedc 6 -7 3.3 3.1 -0.2 World totalc 0 0 1.2 0.9 -0.3 a Target deficits of Latin America, Africa and Asia reduced by $ 5 billion for each bloc. b Non-uniform financial adjustment (See Table 2.9). c See Table 2.8, note d. 35 Dublin Core The Dublin Core metadata element set is common to all Omeka records, including items, files, and collections. For more information see, http://dublincore.org/documents/dces/. Title A name given to the resource Chapter 2 The effects of financial institutions Creator An entity primarily responsible for making the resource Paul Atkinson Iain Begg Francis Cripps Michael Anyadike-Danes Graham Gudgin Source A related resource from which the described resource is derived Cambridge Economic Policy Review Volume 6 No 3, pages 23 - 35 Date A point or period of time associated with an event in the lifecycle of the resource December 1980