ECON 100 Tutorial: Week 24

1. ECON 100 Tutorial: Week 24 www.lancaster.ac.uk/postgrad/murphys4/ s.murphy5@lancaster.ac.uk office hours: 3:00PM to 4:00PM Mondays LUMS C85

2. Question 1 From the national income identity, what association might exist between a fiscal deficit and a trade deficit? First, we know the national income identity is: Y = C + I + G + X – M A fiscal deficit occurs when government spending is greater than tax revenues. Using the same notation as in the national income identity, we could show a fiscal deficit as: G – T > 0 or G > T A trade deficit occurs when exports are less than imports; net exports is negative. Using the same notation as in the national income identity, we could show a trade deficit by writing: X – M < 0 or X < M

3. Question 1 From the national income identity, what association might exist between a fiscal deficit and a trade deficit? Let’s substitute (Yp + T) for Y, where Yp is permanent income and T is taxes: (Yp+ T) = C + I + G + X - M We can re-arrange: (Yp– C) = I + G – T + X – M Note: Yp – C = S Therefore: S = I + G – T + X – M (S – I) = (G - T) + (X – M) We’ve seen this equation before. If, for simplicity, S = I, then S – I = 0 and then we can re-write our equation as: 0 = (G – T) + (X – M) This equation tells us that: If savings equals investment (S = I) and we have a fiscal deficit (G – T > 0), then we will have a precisely equal trade deficit (X – M < 0). In other words: If S = I, then (G – T) = (X – M).

4. Question 2 Merchants (not countries) trade; so why is the state (in recent history) so concerned with thebalance of international trade and its associated capital movements? When the UK has a trade balance, the value of foreign currency the UK holds is equal to the value of domestic currency held by other states abroad. If the value of £’s held by other states > the value of foreign currency the UK holds, that means that there is a trade deficit, X > M, and vice versa. If other states hold a lot of £’s then the demand for our £’s will be lower. This will push down the value of the £ in exchange markets. This makes deficit spending more expensive for the UK and reduces the effectiveness of anti-recessionary policies. So, in short, governments care about the balance of international trade because it has an effect on the effectiveness of government policies. Here is an example: https://www.youtube.com/watch?v=Njp8bKpi-vg Prof. Steele’s solution is on the next slide – please review it.

5. Question 3 Of what relevance to international trade are the data below: Prof. Steele’s solution: Chronic US trade deficits increase debt held overseas. Without willingness to hold US debt, the value of the US$ would fall (and holders of US debt would take a haircut as real as that received recently by holders of Greek government bonds). Note: this is the same scenario as in Question 2.

6. Question 3 Relative to the previous slide, it is relevant to note that most holders of US debt are actually not foreign investors. Why does that matter: In a crisis, domestic debt-holders might be more willing to live with a reduction in interest rate and less likely to require austerity measures. The key concern however, is the amount debt.

7. Question 4 Is the balance of international payments an accountancy principle or an economic concept? Or is it both? Prof. Steele’s solution: It is an accountancy principle whereby categories of international financial flows are defined such that international payments are necessarily ‘balanced’. The structure of that balance is a matter for interpretation. The economic issue is whether payments flows are sustainable; e.g., for how long will China accumulate US Bonds? (China held $1.1 trillion in Dec 2011.)

8. Question 5 Without trade statistics, how might an international payments problem be noticed? Prof. Steele’s solution: By falling international values of the domestic currency. More domestic currency is being used to pay for foreign goods, than foreigners are acquiring in order to purchase domestic goods. As is generally the case, when supply exceeds demand, the value of the item tends to fall

9. Question 6 Which words fit the gaps in the following passage: The means by which the state manipulates interest rates derives from the sheer volume of its indebtedness. The implication is that variations in yields on _______________have special relevance to interest rates generally. The relevance is that, if the state wishes to raise interest rates, debt instruments must be offered to the market at ______ prices, so raising _______ to new creditors. In competing for savings, other institutions are then forced to match those ________ rates. In reverse, where the state initiates the repurchase of existing debt, bond prices _____ and yields ______. Other institutions are then able to arrange their own borrowing requirements at _______ rates. By such actions - which alter the composition of the ____________ in terms of __________ and ___________________ - the state manipulates interest rates. Typically, this technique is applied at the short end of the market. Less frequently, it is applied at the long end, with dealing in gilts, when it has become known as ‘______________’. government debt reduced yields higher rise fall lower national debt interest-bearing securities currency quantitative easing

10. Question 7 What are ‘exchange risk’ and ‘default risk’ and what is their respective relevance for state borrowing within the European Union? Exchange risk is the risk of the foreign currency value of a debt instrument falling, as the domestic exchange rate appreciates in relation to that foreign currency. For example, if you are a resident of the UK and you invest in some EU stock in euros, even if the value of your investment appreciates, you could still lose money if the euro depreciates in relation to GBP. Exchange risk is possible for all investments made in foreign currency. Default risk: if the state debt is denominated in (say) euros, but the state has no euros to redeem maturing debt and no capacity to borrow from the ECB. In other words, we could say that: Default Risk is when the state is unable to make the required payments on their debt obligations. Default Risk is possible for all investments. Both Exchange Risk and Default Risk exist for investment in foreign bonds. The higher these risks are, the higher individual’s discount rates will be.

11. Question 9 Today the pound was devalued, we withdrew from the Exchange Rate Mechanism, the pound fell, interest rates were raised first of all by 2 per cent then by another 3 per cent and they took the 3 per cent off and the speculators have made about £10 billion at the expense of the British tax payers.’(Tony Benn, 2002) Examine the view that the profit made by currency speculators on ‘Black’ Wednesday, Sept 16, 1992 was ‘at the expense of the British tax payers.’ The following slides and the first 10 minutes of this BBC documentary outline what occurred on Black Wednesday: https://www.youtube.com/watch?v=K_oET45GzMI

12. Q9 Background Info about Sept. 16, 1992 • In 1990, in an effort to control inflation and maintain a stable economy, the Chancellor of the Exchequer (and later in the year Prime Minister) John Major convinced Prime Minister Margaret Thatcher to join the European Exchange Rate Mechanism (ERM). • This meant that the pound would be pegged to the Deutsch Mark. • This required the UK match interest rates with the Germans in order to maintain the fixed exchange rate between the pound and the mark.

13. Q9 Background Info ctd. • Over the following 2 years, a slow economy in the UK meant that monetary policy makers wanted to lower interest rates. • But in 1992, inflationary concerns in Germany led to the German central bank raising interest rates in Germany. • Housing trouble in the UK made raising interest rates in the UK a bad political move (because doing so would cause mortgage payments to rise and individuals who couldn’t pay their mortgages ended up selling their homes for less than they had initially bought them.) • So, the UK gov’t initially did not match interest rates, but had to instead find another way to maintain the fixed exchange rate between the pound and the mark.

14. Q9 Background Info ctd. What would happen if the UK didn’t match the German interest rate? • Having different interest rates and a fixed exchange rate meant that it was profitable to convert pounds into marks and then buy German bonds, which decreased demand for the pound relative to the mark. • Decreasing demand for the pound should have lowered the relative value of the pound, breaking the fixed exchange between the currencies. So how did the UK keep the fixed exchange rate without matching interest rates? • To avoid a lowering of the value of the pound, the UK central bank started buying pounds on the foreign exchange market. • To do this, it used its foreign currency reserves and gold reserves. • Political effort was put into reconciling German and UK interest rates.

15. Q9 Background Info ctd. Early on 16 September 1992, it became clear that Germany and the UK were not coming to an agreement on interest rates, and currency speculators began short-selling pounds • This put heavy downward pressure on the value of the pound. Short Selling: In this scenario, the short seller borrows pounds and immediately sells them on the exchange market for another currency. The short seller then waits, hoping for the value of the pound to decrease; if it does, then the short seller can profit by purchasing the pounds to return to the lender.

16. Question 9 So, Question 4 is asking about what is essentially the British Central Banks’ response to the short-selling of the pound: Today the pound was devalued, we withdrew from the Exchange Rate Mechanism, the pound fell, interest rates were raised first of all by 2 per cent then by another 3 per cent and they took the 3 per cent off and the speculators have made about £10 billion at the expense of the British tax payers.’(Tony Benn, 2002) Examine the view that the profit made by currency speculators on ‘Black’ Wednesday, Sept 16, 1992 was ‘at the expense of the British tax payers.’

17. Question 9 What happened on Sept. 16, 1992? • The UK government sold about £27 billion of reserves in an effort to prop up the value of the pound. • Because the value of the £ at the end of the day dropped by a little over 10%, the total drop in value of their currency portfolio was about £3.3 billion. This means that the value of the reserves was lower, but that does not necessarily represent a £3.3 billion cost to the taxpayers. Why not? • 1) 1/3 of the 10 billion that speculators have made, came from the UK central bank (about 3.3 billion). The other 2/3 of this came from other foreign currency speculators. • 2) Of the 3.3 billion, some was not replenished; Of that which was replenished, some of it came from the fluctuation of the pound against other currencies and some was replenished by the sale of central bank assets and some was replenished via inflation and seignorage. • 3) The central bank doesn’t have the ability to tax citizens or to procure tax revenues.

18. Question 9 This is Prof. Steele’s answer for Question 9: Benn is not comparing like with like. (1) Taxation redistributes income from individuals to the state. (2) Currency speculation involves buying/selling currencies in anticipation of changes in their relative values: for every £1 gained there is £1 lost. No one is compelled to speculate. If the international value of a sovereign currency shows a chronic tendency to fall, it is because too much of is placed into circulation as the state spends without raising revenue from taxation. Every new currency note that enters circulation (thereby earning seigniorage) is an alternative to raising taxes. Once in circulation, a currency note has ‘done its job’ in providing an alternative means (to taxation) of raising revenue for the state in a given fiscal year. Thereafter, it is possible for a sovereign state to speculate upon the relative values of its currency and foreign currencies, without this having any relevance to taxation. NB: sterling is part of the UK state’s national debt all holders of sterling make a capital loss when sterling is devalued all holders of sterling assets might reasonably see the capital loss (as a consequence of currency depreciation) as a ‘haircut’; i.e., a result of the UK state reneging on a debt obligation! NB: May 1999: Brown sold 415 tonnes of UK gold reserves (1 tonne = 35,274 ounces) at an average price of US$275 per ounce. Sale value: US$4.025 million. 2012 March: gold $1650 per ounce. 2012 gold price: $US1780 per ounce (x 6.5 higher) Tony Benn is not alone. John Sergeant makes a similar point in Maggie. Her Fatal Legacy (Basingstoke: Macmillan) ‘The net loss to government funds as a result of the frantic trading on that day was officially estimated to have been £3.3 billion, which could have far more usefully spent on hospitals and schools.’ (Sergeant, 2005, p. 258) One nation’s foreign exchange reserves are other nations’ foreign exchange liabilities. This means that, aggregated across all trading nations, the value of foreign exchange reserves is necessarily zero. In total, foreign exchange provides no resources with which to build hospitals and schools. Foreign exchange (that is, currency) is simply an ‘IOU’.

19. Exam 4 on Friday Don’t forget to bring to the exam: - Student ID number - Pencil & Eraser - Calculator Good luck! Note: Next week’s tutorial will be some sort of review of past exams in preparation for the final.