capital account consists entirely of endogenous capital movements. Under fixed exchange rates (or dirty floating), there will be an exogenous item: changes in the total of official reserves, resulting from intervention by the authorities in the currency markets.
n In the popular view (the do-it-yourself model ), the pound is weaker and the balance of payments more likely to be in deficit when national income is high and interest rates low.
n The post-war history of the international monetary system consists of two phases, the first being the fixed rate era, known as the Bretton Woods regime, which broke down in 1971, and the floating rate period since then. For reasons that are not yet clear, floating rates have proved extremely volatile, with violent short-term fluctuations and longer run swings to apparent over- and undervaluation charac- terizing all the major currencies, including the dollar. Among the notable features of the international financial scene in recent years have been: the US ‘twin deficit’ problem, two OPEC oil shocks in the 1970s and a steeply falling price in the 1980s, a gathering crisis in international and US domestic debt, the rapidly increasing importance of Japan and concomitant decline in the relative weight of the USA in world markets – all accompanied by an unprecedented degree of volatility and rapid innovation, both in the technology of executing transactions and in the range of financial instruments actually traded.
Reading guide
The subject matter of Sections 1.2 and 1.3 is amply covered in most textbooks about economic principles, all of which also provide more than enough microeconomic background material, for example, Begg, Dornbusch and Fischer (1987). For more detail, see specialized texts such as Kindleberger and Lindert (1978) or Grubel (1977). Section 1.1.3 is a little different in orientation. A fuller coverage is given in most international financial management texts, which typically also explain more of the jargon of the currency markets.
The trouble with books on the institutional background is that they date very quickly, as a result of the speed with which trading patterns in currency markets evolve nowadays. They are also frequently rather personalized in their approach – as may be the treatment here, too. Good examples are McKinnon (1979) and Williamson (1983), both of which contain excellent accounts of the Bretton Woods years. Perhaps the most useful guide to the intricacies of foreign exchange market operation is Grabbe (1986), which also starts with a fuller history than is given in Section 1.6, and will be of particular interest to any reader wanting more detail on the mechanics of the EMS.
For a summary of the facts of floating exchange rate life that need explaining, see Mussa (1979). Running commentaries are available in a number of different places, for example, the Bank of England Quarterly Bulletin.
The references to the debate on the relative merits of fixed versus floating rates in Section 1.6.3 may be difficult for the reader to understand at this stage. It might be worth looking back at these passages after reading Chapters 2 and 5. At any rate, the classic statement of the case for floating exchange rates is Friedman (1953). Dunn (1983) argues against floating. On the economics of the EMS, see the readings in Artis (1984).
Notes
1 To further complicate matters, it is common to refer to quotations against the dollar as either in European terms (that is, non-US currency per dollar) or American terms (dollar per cur- rency). The reader, having been warned of the complications awaiting in the market, would be best avoiding them for the moment, by sticking with the conventions set out in this chapter. 2 In general, a weighted average of three numbers: X, Y and Z is calculated as:
w1X+ w2Y+ w3Z
where the weights w1, w2and w3are proportions so that we have:
w1+ w2+ w3= 1
The reader may easily verify that what is known as ‘the average’ in everyday usage – the arith- metic mean, to give it its correct name – is simply a special case of a weighted average: one where the weights are all equal and so can safely be ignored.
3 This may not seem very much, until it is realized that we are talking about a variation of nearly 2% in one single day. As an annual rate (that is, if repeated day after day for a whole year) it amounts to an astronomic range. As it happens, according to the FT’s commentary on the cur- rency markets for the day in question, the pound fell in early trading after a bad night’s trading in the Far East and subsequently recovered to close the day at or near its high.
4 In fact, this would tend to be quoted in the market (where brevity is at a premium) in the form $1.4525–35 or even just as 25–35.
5 Of course, even for major currencies, spreads are far from negligible for small trades, as can be verified by consulting the table of tourist exchange rates published in the newspaper or displayed in the window of any bank or travel agent with a bureau de change. However, the impact of tourists’ purchases and sales on the exchange rate is very small, so we concentrate on the activities of the large traders here.
6 It would be a worthwhile exercise for the reader to redraw Figures 1.1(a) and (b) in terms of the market for pounds rather than dollars.
7 A trivial answer would be: foreign exchange traders, since the vast majority of currency trans- actions are carried out between professionals in the specialized currency markets in London, New York, Tokyo, Zurich, Frankfurt and so on. However, traders either act on behalf of other economic agents, in which case we prefer to deal with the actual decision makers rather than their representatives, or behave as principals in their own right, in which case they count as speculators or arbitrageurs themselves.
8 A more precise definition of speculation will be given later in the book. For the moment, note that there is emphatically no intention whatsoever to make moral distinctions between specula- tors and non-speculators or indeed to pass moral judgements on any type of activity carried on in the currency markets. It so happens that, in the author’s opinion, there are no moral grounds for passing judgement, and even if there were, the fact would be irrelevant to the analysis.
All of which will probably not stop some readers from wanting to divide the currency mar- kets into ‘goodies’ and ‘baddies’, the former consisting of the meek in spirit (‘genuine’ traders, that is, exporters and importers, long-term investors and so on – for the most part, multi- national corporations), while the latter correspond to what were once called ‘the gnomes of Zurich’ – traders only interested in short-term gain; wealthy, cynical and, worst of all, foreign! 9 This is not to say, of course, that the exchange rate will be anything like the only or even the major factor affecting the volume of trade in the two directions – hence the qualification in italics, which will be familiar to readers who have had even the briefest encounter with ele- mentary microeconomics. The subject is, in any case, one about which a lot more will be said later in the book, especially in Chapter 2.
10 Although in the long run, they may well switch sides. This is particularly true of multinational corporations (for whom a change from exporting to importing may simply involve diverting production from a subsidiary in the home country to one overseas) or indeed, of the inter- national trading companies peculiar to the Far East.
Notes 37
11 Far from matching the freewheeling ‘cowboy’ image of popular imagination, the speculator is most likely to be operating on behalf of an international bank that has reached the conclusion – with more or less help from the economic model on its computer – that the exchange rate is ‘out of line’.
12 Notice the potential asymmetry: volatility in the pound/dollar rate creates difficulties for many UK decision makers, but is in most cases of peripheral importance to their opposite numbers in the USA.
13 A short step, although not necessarily a sensible one – after all, cold weather is often damaging, but we only expect the government to help people live with the consequences, not to stabilize the temperature!
14 Apart, that is, from distorting the real sector of the economy, fostering the creation of ‘parallel’ (that is, black) markets, with a consequent growth in criminal activity of one kind or another and an erosion of respect for the law, as well as abridging the freedom of the citizen in the countries in question – marginally, perhaps, by the restrictions themselves, although much more seriously by the measures taken to enforce the restrictions.
15 The task of actually operating in the currency markets so as to fix a country’s exchange rate is usually assigned to another institution (often its central bank), which is not always strictly an arm of government. For example, while the Bank of England is an agency of Her Majesty’s government, the US Federal Reserve Bank is independent of the federal government in Washington DC.
For our purposes, these subtleties are ignored and at no point in the book will any attempt be made to distinguish between the policies and responsibilities of the government and the central bank.
16 In fact, traders may not even be aware that the central bank has been operating in the market. Very often they may only observe ‘business as usual’, with brisk two-way trading and no tend- ency for positions to accumulate on either side of the market. Where the markets do get wind of intervention, it is often because the authorities intend the news to emerge.
Of course, in the end, it all ‘comes out in the wash’ – in the UK and USA, at any rate – with the publication of the monthly figures for the change in the reserves. But by then the informa- tion is of more or less historical interest only.
17 Except, that is, where the authorities are able and willing to impose a price by decree, as happened in the Communist bloc for example. In such cases what is needed is not a buffer stock, but either a docile populace willing to accept queuing as a way of life or a secret police capable of preventing the market from reasserting itself – preferably both.
Notice that this scenario is simply the equivalent in the egg market of inconvertibility in the currency market – with about the same moral authority.
18 Since originally writing this chapter, reality has caught up with this particular example in the form of the UK salmonella scandal at the end of 1988, when the British government was actu- ally forced to buy up a sudden excess supply of eggs in order to prevent the price falling. 19 And often long afterwards too. For example, it is still unclear, even now, whether the rise in
the dollar in the mid-1980s was, in fact, an equilibrium or disequilibrium phenomenon. What is clear, of course, is that it could never have been prevented by intervention in the currency markets alone.
20 In practice, fixed exchange rate mechanisms tend to be highly complex arrangements, specify- ing in such detail the obligations and entitlements of the countries involved it would take a whole book to describe them fully. The objective here is, as always, simply to allow the reader to understand the general principles underlying the institutional arrangement.
21 Obviously, this non-system has the dubious attraction that it maximizes the discretionary power of the monetary authority.
22 More generally, the relationship of balance of payments accounting to the analysis of exchange rate determination is the same as that between national income accounting and (closed eco- nomy) macroeconomics or, for that matter, financial accounting and corporate finance theory.
23 It must be emphasized that balance of payments accounts are subject to a margin of error that is wide even by the standards of economic data. It is highly likely that the 1992 accounts will be
subject to revision for some years to come and when they are eventually allowed to settle down the final figures may well bear little resemblance to those given here, particularly as far as the capital account is concerned.
24 As someone once described them: items that hurt when you drop them on your toe!
25 There is an uneasy compromise here between what is feasible and what is ideally desirable. Strictly speaking, if the distinction between transactions on current and capital accounts is to be preserved, imports of durable goods (for example, motor vehicles, aircraft, computers) ought to be treated as the purchase of assets rather than imports of (consumer) goods and similarly for exports of durables. However, as is often the case with data on domestic aggregate consump- tion, separating the two is impractical.
In the context of the balance of payments, the result is that if a British firm purchases a piece of equipment in the USA and brings it into the UK, it is deemed to have imported on current account. On the other hand, if for any reason the equipment remains abroad – leased back to its original owners or used by the British company for its operations in the USA or elsewhere outside the UK – then the purchase, if it is picked up at all by the statistics, will be included in the capital account. From our standpoint, all that matters is that in both cases, the result of the transaction is (a) an addition to the UK’s productive capacity and (b) an increase in the net demand for foreign currency by sterling holders.
26 For some countries this item is far from negligible, relative to the balance of payments as a whole. For example, most of the countries of southern Europe have substantial foreign currency income in the form of remittances from emigrants working abroad to their families at home. Some developing countries have considerable receipts of aid that come under this heading. Likewise, reparations paid by Germany after the world wars appeared as transfer payments in the German balance of payments and as credits in those of the recipient countries.
27 The difference between the two figures is well within the margin of error. In fact, it is quite likely that the statistics on trade in invisibles are underestimates, something which cannot be said to the same extent of the figures for exports and imports of goods.
The scale of the trade in services is, on reflection, not surprising, given that nearly two-thirds of the UK’s GNP originates in the services sector of the economy.
28 See the chapter on the circular flow of income or national income accounting in any economic principles textbook or Section 5.1.1 of this book.
29 About £800bn for the UK’s GDP at market prices (average estimate). 30 Or, indeed, from a relatively tiny error in the statistics themselves.
31 For example, suppose that (US company) A buys 10% of the equity of (UK company) B in a ‘dawn raid’ on the London Stock Market. Does that count as portfolio or direct investment in the UK? Presumably, if it increased A’s holding in B to 51% (in other words, if A previously owned 41%) then the answer would be unambiguous, since for all practical purposes (that is, in terms of control of the target company), it would be as good as 100% ownership. But what if A’s move had only raised its stake in B to 30%?
In fact, international conventions for balance of payments presentation fix an arbitrary cut-off point at 30%. But this is clearly unsatisfactory, especially when one takes account of the fact that shares and even real estate are often purchased via nominee holdings, which make it almost impossible to sort out true ownership patterns.
It is worth pointing out that capital account presentation used to focus much more on the distinction between ‘short-’ and ‘long-term’ investment than it does today. The case for this distinction rested on the assumption that long-term investment was inherently less sensitive to market sentiment with respect to the currency than short-term investment, which in the limit was nothing more than so-called ‘hot money’. This distinction was probably never clear enough to warrant separating the two types of investment in this way even in theory, let alone in prac- tical statistical terms.
32 For comparison, imagine trying to work out how far someone had travelled during the year, simply by comparing his location on 31 December with his position on 1 January!
Note that, while monthly current account statistics are compiled for the UK and USA, in neither country is capital account data published more often than quarterly.
33 The official reserves figure given here includes a small additional item: transactions in other (that is, non-reserve) assets and liabilities of central government.
Notes 39
34 It is usually assumed that the main source of inaccuracies lies in the capital account. However, other evidence suggests there may well be enormous errors in the current account data too.
For example, as long as there is no trade with Mars, the sum total of all the world’s current account balances must obviously equal zero – one country’s surplus must be another’s deficit. Unfortunately, instead of adding up to zero, the world’s current account has in recent years been in apparent deficit by as much as $60bn – a staggering figure greater, for example, than West Germany’s surplus during the 1980s. If this under-recording were shared out in propor- tion to each country’s proportion of world trade, the UK’s current account position would have been transformed throughout the 1980s into one of embarrassing robustness.
35 The BBC’s 1985 Reith Lectures, published in The Listener, from 7 November 1985 onward. 36 It owes most to the orthodox Keynesian models current at that time, which is ironic in the light
of Keynes’ own famous and prophetic comment at the end of his General Theory that: ‘Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.’
37 Broadly speaking, from about 1958 onward, the major European currencies offered current account convertibility – that is, were freely usable for financing trade – but were either com- pletely unavailable or subject to serious restrictions where the purchase or sale of foreign assets was concerned.
38 Although, strictly speaking, this amounted to less than full convertibility, since only banks were allowed access to the Gold Window. Neither in America nor Europe were private citizens allowed to hold gold. It is interesting to speculate how much sooner the system would have broken down had private holdings of gold been permitted.
39 Recent years have seen the growth of a literature analysing mathematically the process whereby fixed exchange rate regimes collapse. Its starting point is the insight that the market will not look passively on as a country’s reserves run out. Instead, it will anticipate the point at which the reserves are exhausted and in the process hasten the collapse.
40 Something that is often forgotten by people discussing the merits of fixed exchange rates is that even a relatively small probability of a devaluation (or revaluation) may be enough to attract a