The Value of the Pound Sterling
The British Economy and the Bretton Woods Agreement
Britain's Balance of Payments Problems
The Value of the Pound Sterling
Why is the value of the pound important?
If the pound loses value, people will not hold pounds. They will want to exchange their pounds for something else (like dollars, or marks, or gold) that they believe will not lose its value.
Why do people have pounds in the first place?
1. People have pounds because they want to invest in Britain (e.g., in stocks or bonds) and think they will get a good return on their investment, or because they want to do business in Britain. If people don't want to hold pounds, London would lose its role as one of the world's major financial centers.
2. During the Second World War, Britain's trading partners -- mostly within the Empire (e.g., Australia, India), but also other countries (e.g., in South America) -- accepted payments for exports to Britain in pounds, since Britain had no goods to export to these countries in return. They would only hold their pounds, however, if they were getting a reasonable return on them, and there would be no reason for them to continue to hold pounds after the war unless the value of their investments was maintained.
What makes the pound lose value?
1. Inflation -- any holder of pounds can buy less with the same return on his/her investment if prices in Britain go up.
2. If the supply exceeds the demand, it drives down the price of pounds. Supply will exceed demand if people who have pounds want to get rid of them, and not enough people want to buy them. Thus, if all those people who held pounds after the Second World War wanted to get rid of them, then unless the Bank of England could keep buying the pounds with something these people wanted (dollars or gold), the value of the pound would be forced down (relative to the dollar or gold).
Why did all these "sterling balances" leave Britain with a potential problem after the Second World War?
1. All of these holders of pounds would want to get rid of them after the war in order to buy goods. Britain was unable to produce enough goods that anyone would want because of war damage, and because its industry was entirely tooled for war production and would require time to convert. No country but the United States had an economy after the war that could produce any consumer goods. So everyone wanted dollars. And if all these people cashed in their pounds, the pound would lose value once the Bank of England ran out of dollars and gold to buy back the pounds, which means the pound would have had to be devalued, which means even more people would have tried to unload their pounds.
2. For this reason, the Bretton Woods Agreement of 1944 established the pound as well as the dollar as reserve currencies.
The British Economy and the Bretton Woods Agreement
What was the Bretton Woods Agreement?
1. It was an attempt on the part of the free nations to define their financial relations after the war, so as to assure stable exchange rates for their currencies in a way that was more flexible than the gold standard of the 19th century had allowed.
2. Under the gold standard, countries had defined the value of their currencies in terms of gold. Any debts between countries would be settled with gold. The outflow and inflow of gold in settling debts between two countries would keep the exchange rates between their currencies stable. During the Great Depression, however, all countries went off the gold standard because it forced them to deflate their economies. Economists came to believe that, because of this deflationary effect, the gold standard had made the Depression worse.
3. The Bretton Woods Agreement defined the dollar and the pound as reserve currencies. That meant that countries must accept dollars or pounds in settling debts. Each country (including Britain) would define the value of its currency in dollars, and the U.S. would tie the value of the dollar to gold, so in theory there was still a link to gold that would impose a discipline on the system.
How did the Bretton Woods Agreement affect Britain?
1. By defining the pound as a reserve currency, with which countries other than Britain could settle their debts, the nations at Bretton Woods were trying to eliminate the incentive for the holders of sterling balances to cash them in. The holders of sterling balances, however, would still want to cash in their pounds if they feared that the pound would lose value.
2. All countries were obliged to try to maintain the fixed exchange rates defined under the Bretton Woods Agreement. If a national economy was weak or strong relative to others, this would put pressure on the exchange rate as people tried to sell (for the weak economy) or buy (for the strong economy) its currency.
3. Thus, if the British economy were weak, that would lead people to try to sell pounds because they did not want to buy goods with them (e.g., because British prices were too high, or British goods were not as good as other countries' goods). The Bank of England would buy up the pounds in order to maintain the value of the pound, but eventually, unless Britain could make the economy strong, Britain would have to devalue the pound so that its value reflected the strength of the economy. If people thought the pound was going to be devalued (relative to the dollar), however, then they would try to unload their pounds before the value went down, which in itself would increase supply relative to demand and so put pressure on the value of the pound. One of the signs of strength or weakness in the economy was the balance of payments.
Britain's Balance of Payments Problem: The Impact of the Second World War
What is the balance of payments?
It is the net balance of all flows of money into and out of a country as it buys and sells goods and services. There are two basic components to the balance of payments:
1. The "balance of trade": that is the balance of imports and exports of all goods. Historically, since 1800 Britain has had a negative balance of trade because of the need to import food.
2. What the British call the balance on "invisible exports". There are four main components of invisible exports:
a. Shipping -- the income from carrying foreign goods in British ships (or airplanes), vs. the costs of carrying British goods on foreign ships (or airplanes)b. Financial services -- income from insurance and banking provided to foreigners by the City of London, vs. the costs of Britons buying such services overseas (e.g., in New York)
c. Income from investments -- that is, the interest and dividends that the British get from their investments in foreign countries, vs. the interest and dividends that Britain pays to foreign investors in Britain
d. Tourism -- that is, the money that foreigners spend in Britain when there, vs. the money that Britons spend when they are in foreign countries
Historically, Britain had a surplus on its balance of invisible exports that more than outweighed the deficit in its balance of trade. The most important of the invisible exports to Britain's positive balance of payments was the income from overseas investments.
How did the Second World War hurt Britain's ability to maintain a surplus in its balance of payments?
1. As a condition of Lend-Lease, Britain was forced to sell a substantial portion of its overseas assets (i.e., those investments that yielded an income), including nearly all in the U.S. Thus, this key source of income was reduced, and in particular a source of dollars with which to buy American goods after the war was eliminated.
2. The destruction and running down (through lack of investment) of British industry during the war, and the redirecting of all remaining industry toward war production, meant that Britain could no longer export goods. In the short- term, the balance of trade was going to be worse than usual.
3. Under the post-war settlement, Britain was obliged to keep an army in Germany, while the U.S. would be keeping troops in Britain. This balance of "tourism" money was against Britain.
4. In the medium-term, Britain lost its advantage as a world shipper, as poorer countries with lower labor costs could under- sell British shippers.
5. All of this meant that, in the decades after the war, Britain had an enormous incentive to rebuild and maintain London's role as a major financial center, and to build up Britain's overseas investments again, so as to restore these two important positive net sources of income in the balance of payments.
What, then, were the sources of Britain's economic problems after the Second World War?
1. The role of sterling as a reserve currency: Britain wanted to maintain the value of the pound, both to secure sterling's role as a reserve currency and to revive London's position as a center for financial services. Other countries, however, wanted dollars with which to buy American goods, so they wanted to cash in some of their sterling balances.
2. A balance of payments deficit, which put pressure on the pound.
a. A balance of payments deficit meant that Britain was paying out more than it was taking in. Because sterling was a reserve currency, Britain could use pounds to pay for the foreign goods and services that it was unable to pay for with British goods and services. This "printing of pounds" to cover the deficit expanded the supply relative to the demand and so reduced the value of the pound. It was also inflationary. If the value of the pound was being reduced, people would sell.b. The balance of payments deficit in itself was taken as a sign of the weakness of Britain's economy, and so its inability to maintain the value of the pound. People who held pounds would try to sell before a devaluation reduced the value of their holdings.
3. The political imperative, after the Great Depression and the war, to maintain full employment, which became a primary objective of government policy until the 1980s.
Britain's Balance of Payments Problem and Stop-Go Economic Policies
How did these problems work themselves out after the war?
1. The Labour government pursued the following policies to try to reduce the pressures on the pound:
a. It tried to channel reconstruction (such as Marshall aid) toward export industries, to improve the balance of trade.b. It introduced exchange controls, which meant that people holding pounds could not exchange them on demand.
2. Exchange controls were contrary to the Bretton Woods Agreement, so the U.S. government wanted the British to end exchange controls. When the government did so in the summer of 1947, as a condition of an American loan, there was an immediate "run" on the pound, as people cashed them in. The exchange controls had to be reintroduced after a month.
3. A new balance of payments crisis in 1949 finally forced the government to devalue the pound from £1 = $4 to £1 = $2.80.
Why didn't the devaluation of 1949 end the pressures on the pound?
1. The need to maintain full employment meant that government economic policies tended to encourage the expansion of the economy.
2. With the advent of prosperity in the 1950s, expansion eventually led to a balance of payments problem, as Britons imported more goods than they could pay for with exports (visible and invisible).
3. The excess demand that came with expansive government policies and prosperity led to inflation.
4. A balance of payments deficit and inflation put pressure on the pound, as people started to sell rather than see their pounds lose value (with the risk of another devaluation).
5. So the government changed policies to stop the expansion, so as to limit inflation and bring the balance of payments back into surplus. This meant higher interest rates (which limited investment and borrowing), higher taxes (to discourage consumer demand), and/or reduced government spending.
6. These deflationary policies eventually led to unemployment, so the government reversed itself again and adopted expansionary policies, starting the cycle over again.
7. This was the policy known as "stop-go".
8. By the mid-1960s, Britain was having difficulty supporting the pound. That means, the Bank of England was in danger of running out of dollars and gold in buying all the pounds that people wanted to sell because they were losing confidence in Britain's ability to control inflation.
a. The Bank turned to the central banks of other developed countries (especially the U.S.) to arrange for emergency stand-by loans of dollars to increase Britain's reserves. The hope was that this united demonstration of determination to preserve the value of the pound would convince people to hold onto them and end speculation.b. When this policy and the government's deflationary measures failed to stop the pressure on the pound, the government devalued it in 1967 to £1 = $2.40.