Britain's Autonomy Centers on Sterling and the Essay

  • Length: 6 pages
  • Subject: Economics
  • Type: Essay
  • Paper: #47349878

Excerpt from Essay :

Britain's autonomy centers on Sterling and the Bank of England. The United Kingdom was the most prominent country to have abstained from Europe's effort to create a common currency, which caused such prominent and popular political figures as Lady Margaret Thatcher to be ousted. Once a mere cog in the economic hegemony of the United States following the Bretton Woods conference, England is a currency trading powerhouse, with nearly 700 billion pounds sterling trading hands every day in London's interbank market. In that many believe or once believed the currency issue to have the ability to economically castrate Britain, the nature of the Bank of England, monetary policy, and the recent history of the Pound deserve our redress.

The determinants of the value of the Pound differ markedly from times past. Forward rates on foreign currencies are calculated on the basis of interest rates, the balance of trade, and monetary policy. Interest rates affect bond prices in that one may borrow one currency, exchange it for another, invest in a foreign country's bonds and buy a forward contract so that he may re-exchange the principal amount for the original currency. If markets are liquid and sovereign debt is similarly risky, one currency will lose ground against another as a new equilibrium is established. Rates of interest are determined by central banks but are said to also reflect what is known as The Fisher Effect: a rise in the rate of interest, which results from a long-term rise in the rate of inflation. Inflation also results from the effect of purchasing power parity on the balance of trade.

When one country buys products from another, the availability of the foreign currency is determined by the balance of trade and to some extent, the level of foreign direct investment. The Bank of England, which maintains vast reserves of foreign currencies, actively practices what it calls monetary policy. For instance, if it wishes the value of the British Pound to increase vs. The Euro, it may exchange its Euros for Pounds so that Euros are more plentiful and Pounds more scarce. In the years preceding European Monetary Union, the central banks of countries that wished to become members co-ordinated interest rates through monetary policy in order to keep currencies at a fixed exchange rate. This was known as the Exchange Rate Mechanism. (Bank of England, 2003)

According to the Economist, "In March 1979, all member countries except Britain joined the system's exchange-rate mechanism (ERM), which limited [the central bank's interest rate] fluctuations to 2 1/4% either side of a central rate (6% for those with wide bands)." (Economist, 9 April 1998.) This replaced a short-lived scheme whereby Britain and other countries tied their currencies to the Deutschmark in 1972; Britain allowed rates to fluctuate six weeks later. By 1979, Britain's Conservative Party was unwilling to tie their currency to those of continental socialists.

While Britain was to only briefly implement the ERM twice, the Bank of England became enamored with Monetary Policy, which is often associated with economist Milton Friedman and the University of Chicago or, conventionally, "Chicago School of Economics." Monetary policy advocates, unlike their Keynesian counterparts, advocated a stable pound and thought of inflation as something to be avoided. In the system that preceded monetary policy, there were strict controls on the transfer of capital. As the Economist put it, "A British investor, for instance, could not easily buy American stocks or bonds. Mainstream economic opinion felt that capital mobility was unnecessary, and often undesirable." (Economist, 23 October, 1997.) Monetary policy opted instead that the Bank of England maintain vast reserves of currencies and of gold that it would exchange one currency for another so as to stabilize rates.

Throughout the 1970's and early 80's, the United Kingdom experienced crippling interest rate fluctuations. These had resulted from rampant government spending and the use of the United States dollar as a reserve currency. In 1971, the United States had allowed the price of gold to float freely against the dollar for the first time since the Roosevelt administration. Unfortunately, the value of gold set by the United States failed to reflect the amount of gold that the United States maintained in its reserves. As the Bank of England abandoned fixed exchange rates and the international system established at Bretton Woods following the Second World War evaporated, the need for the adoption of monetary policy became clear. The Bank of England soon began actively buying and selling currency so as to maintain the day-to-day stability of the pound and keep inflation at reasonable rates. The Pound, which had been nearing parity with the dollar, re-surged in the mid-1980's and has since stood at between 1.50 and 1.70 dollars. The Federal Reserve, a semi-independent bank that sets the United States' lending rate by controlling the interest rate on U.S. Treasury Bills, Bonds, and notes, dictates American monetary policy.

EU Member countries faced repeated trouble throughout the early years of this system. France and Italy repeatedly devalued their currencies, and French Socialist president Francois Mitterand was tempted to leave in 1982 and 1983 during the interest rate crisis. His finance minister, Jacques Delors, convinced him of the mechanism's usefulness, and France elected not to abandon it. Delors later became the European Commission's president and re-introduced a plan for European currency union that had originally introduced in 1969.

Delors commissioned a report in June of 1988 which advocated a multi-staged move towards European Monetary Union. Many of Britain's leaders were amenable to this idea, although Thatcher steadfastly refused. She was eventually ousted from power in 1990 and Britain joined the Exchange Rate Mechanism. However, Germany's higher-than average interest rates put a strain on the other member countries as Germany attempted to borrow capital to re-build areas that had been united with the federal republic after the fall of communism. Danish voters rejected the Maastricht treaty, which called for currency union, and the United Kingdom followed suit. To prevent a complete dissolution of the Union, the commission widened the exchange rate bands to 15% of the central rate. However, it was too late for Britain.

Britain was rocked by another recession in the early 1990's, which contrasted woefully with Germany's post-unification boom. As money rushed to high-yield German debt, Britain scrambled to raise interest rates in order that the Deutschmark would not skyrocket against sterling. Foreign Direct Investment, which finds the highest returns globally, bypassed Britain for the Asian Tiger economies. The relative robustness of Sterling incited domestic manufactures, who argued that a weaker pound would allow Britain to market its products overseas.

By 1997, the Maastricht treaty was set to expire and the United Kingdom again had the chance to become part of the union. However, the new Labour Prime Minister, Tony Blair, was one who notoriously relied on public referendums in order to push new legislation ahead. Britons were against integration. Britain wished to enlarge the union but Britons did not want to tie their economy to those of Portugal and Greece, let alone the poor countries of Eastern Europe. At this time, the value of the Pound increased significantly vs. other currencies, and did not return to reasonable levels vs. The semi-fictional European "ECU" (European Currency Unit) until Autumn 1998. Another factor in the strength of Sterling was the Asian crisis, which caused capital flight from countries such as Malaysia and Thailand to the stable economies of Europe and the United States. The debate between having a closer integration between countries and one that accepted more members became a common one. Ultimately, Britain opted for a 'wider' union rather than a 'deeper' one.

According an Economist article published in 1997,

Britain has more non-EU trade, and more home loans made at variable interest rates than its partners, and that it is the only oil exporter. These factors make it hard for Britain's economic cycle to match Europe's, and hard for its interest rates to be the same. Given these difficulties, EMU supporters will be disappointed that the government did not announce more concrete measures to promote convergence. But EMU doubters may be alarmed that the government has not been more explicit about how it will tell whether convergence has been achieved. (Economist, 1 November 1997)

On May 1997, Chancellor Gordon Brown announced the government's intention to hand the operational responsibility for setting interest rates to the Bank of England. The Bank of England Act of 1998 formerly gave the Bank this responsibility on 1 June, 1998. According to the Bank's web site,

The Bank's monetary policy objective is to deliver price stability (as defined by the Government's inflation target) and, without prejudice to that objective, to support the Government's economic policy, including its objectives for growth and employment... The price stability objective is to achieve underlying inflation (measured by the RPI excluding mortgage interest rates) of 2.5%. (Bank of England, 2003)

The European currency was plagued with trepidation, and the Pound's value increased alongside the dollar during the 1990's boom. The free…

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