BALANCE-OF-PA YMENTS THEORY AND THE UNITED KINGDOM EXPERIENCE

BALANCE-OF-PA YMENTS THEORY AND THE UNITED KINGDOM EXPERIENCE

Also by A. P. Thirlwall * GROWTH AND DEVELOPMENT: with Special Reference to Developing Economies * INFLATION, SA VING AND GROWTH IN DEVELOPING ECONOMIES * FINANCING ECONOMIC DEVELOPMENT * REGIONAL GROWTH AND UNEMPLOYMENT IN THE UNITED KINGDOM (with R. Dixon) * KEYNES AND INTERNATIONAL MONETARY RELATIONS (editor) * KEYNES AND LAISSEZ-FAIRE (editor) * KEYNES AND THE BLOOMSBURY GROUP (editor with D. Crabtree) * KEYNES AS A POLICY ADVISER (editor) * KEYNES AND ECONOMIC DEVELOPMENT (editor) NICHOLAS KALDOR THE ESSENTIAL KALDOR (editor with F. Targetti) FURTHER ESSAYS ON ECONOMIC THEORY AND POLICY: Vol. 9 COLLECTED ECONOMIC ESSAYS OF NICHOLAS KALDOR (editor with F. Targetti) * EUROPEAN FACTOR MOBILITY: TRENDS AND CONSEQUENCES (editor with fan Gordon) DEINDUSTRIALISATION (with S. Bazen) * ECONOMIC GROWTH AND THE BALANCE OF PA YMENTS CONSTRAINT (with J. McCombie) Also by Heather D. Gibson * THE EUROCURRENCY MARKETS, DOMESTIC FINANCIAL POLICY AND INTERNATIONAL INSTABILITY * ECONOMIC INTEGRATION AND FINANCIAL LIBERALIZATION: PROSPECTS FOR SOUTHERN EUROPE (editor with E. Tsakalotos) * Also published by Palgrave Macmillan

Balance-of-Payments Theory and the United Kingdom Experience FOURTH EDmON A. P. Thirlwall Professor of Applied Economics University of Kent at Canterbury and Heather D. Gibson Lecturer in Economics University of Kent at Canterbury M

A. P. Thirlwall 1980, 1982, 1986 A. P. Thirlwall and Heather D. Gibson 1992 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1P 9HE. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. First published 1980 by THE MACMILLAN PRESS LTD Houndmills, Basingstoke, Hampshire RG21 2XS and London Companies and representatives throughout the world ISBN 978-0-333-56648-0 ISBN 978-1-349-21806-6 (ebook) DOI 10.1007/978-1-349-21806-6 A catalogue record for this book is available from the British Library. Second edition 1982 Third edition 1986 Reprinted 1988 Fourth edition 1992 Reprinted 1993

Contents Preface to the Fourth Edition Acknowledgements x xiii 1 Balance-of-Payments Accounting and the Foreign- Exchange Market 1 Concepts of the balance of payments 1 The accounting balance of payments 2 Balance-of-payments equilibrium 5 More on the concept of equilibrium 13 The foreign-exchange market 22 Tbe demand for dollars 23 The supply of dollars 25 Capital movements and speculation 30 Tbe forward rate of exchange ~2 2 The Capital Account of the Balance of Payments 37 Tbe components of the capital account 38 Official Reserves 41 Special Drawing Rights (SDRs) 46 Tbe Balancing Item 49 Tbe capital account and the net external wealth of the UK 51 3 Exchange Rate Determination S9 Tbeories of exchange rate determination 60 Purchasing Power Parity 60 Current Balance Model 65 Tbe importance of theories of expectations forrnadon 66 v

vi Contents The Mundell-Fleming Model 69 Exchange Rate Overshooting Models 77 The Portfolio Model of exchange rate determination 85 Speculative Bubble Models of exchange rate determination 91 Exchange rate determination: what have we learnt 94 Exchange rate systems and policies 96 Fixed versus flexible exchange rates 97 Types of exchange rate regime 102 Controls on capital movements 121 Exchange rate policies in the 1990s 127 4 The Balance of Payments and the National Economy 129 The integration of the balance of payments into the national accounts 129 The conflict between balance-of-payments equilibrium and other objectives of economic policy 131 Income equilibrium in an open economy and the open economy multiplier 136 The open economy multiplier relating imports to expenditure 139 The 'new' open economy multiplier with foreign repercussions 145 Balance-of-payments adjustment 148 The classical price-specie flow mechanism 150 The elasticity approach 150 The absorption approach 152 The monetary approach 153 5 The Elasticity Approach to the Balance of Payments 155 The Marshall-Lerner condition derived 155 Devaluation and the response of firms 162 Lags and the J-curve effect 166 Devaluation and inflation 168 Devaluation and the terms of trade 177 The difficulties of measuring price elasticities 178 6 The Absorption Approach to the Balance of Payments 183 The direct effect of devaluation on income 185

Contents vii The direct effect of devaluation on absorption 186 The interaction between changes in income and changes in absorption 188 Strengths and dangers of the absorption approach 190 The monetary aspects of balance-of-payments deficits 192 Domestic credit expansion 193 7 The Monetary Approach to the Balance of Payments 195 8 Simultaneous Internal and External Balance 203 Internal and external balance under flexible exchange rates with no capital movements 205 Internal and external balance under fixed exchange rates with capital movements 209 Internal and external balance in an IS-LM curve framework 214 The use of monetary and fiscal policy under alternative exchange-rate regimes 216 The assignment of policies in the United Kingdom 217 9 A History of the UK Balance of Payments 219 1854 to 1939 219 1940 to 1950 225 1951 to 1959 228 1960 to 1969 231 Devaluation, 1967 239 1970 to 1979 243 Since 1980 251 Appendix: a polemic on floating the pound, 1972 258 10 Import Functions 272 The determinants of imports 272 Imports and capacity 274 Imports and labour-market bottlenecks 278 Imports and income (estimates of income elasticities) 281 Imports and relative prices (estimates of price elasticities) 285 Import penetration 286

viii Contents 11 Export Functions 291 The determinants of exports 291 Exports and capacity 292 Exports and world income (estimates of income elasticities) 298 Exports and relative prices (estimates of price elasticities) 299 Export performance in manufacturing 304 The United Kingdom's declining share ofworld exports 306 North Sea oil and the balance of payments 315 Appendix: Commodity and geographie composition of UK exports and imports 319 12 The Balance-of-Payments Equilibrium Growth Rate 323 The determination of the balance-of-payments equilibrium growth rate 324 A fundamental law of growth The model with capital ftows 328 332 Use of the model for forecasting and simulation 333 Conclusion 336 13 Export-Led Growth 337 The importance of export-ied growth 337 Models of export-ied growth 341 An export-ied growth model with a balance-ofpayments constraint 347 14 The Balance of Payments as a Structural Problem 351 Non-price factors determining exports and imports 354 The 'new' trade theories 359 Studies of non-price competition 361 Research and development effort 363

Contents IS Deindustrialisation and the Balance of Payments Does deindustrialisation matter? The causes of deindustrialisation A trade strategy for the United Kingdom The future Notes References Index ix 366 366 372 378 384 389 401 423

Preface to the Fourth Edition This book has three main purposes: first, to provide an elementary exposition of the balance of payments and of balance-of-payments adjustment theory; secondly, to describe the historical evolution and contemporary position of the United Kingdom's balance of payments, and thirdly, to critically appraise conventional balanceof-payments adjustment mechanisms, particularly in the light of the poor record of changes in nominal (and real) rates of exchange in rectifying balance-of-payments disequilibria in the world economy in the last decades. We emphasise the importance of non-price factors as determinants of export and import performance, which are reflected in the income elasticities of demand for exports and imports. As far as the United Kingdom is concerned, it is argued strongly in the book, particularly in Chapters 12, 13 and 14, that the balance of payments should be viewed in a growth context, and that at the heart of the UK's poor post-war growth performance relative to other. industrialised count ries is its relative neglect of the tradeable goods sector which is reflected in a low propensity of other countries to buy UK exports and a high propensity in the UK to import foreign goods (particularly manufactures). This problem cannot be tackled by exchange rate depreciation or monetary manipulation. It requires real economic policies of a structural nature related to the wider characteristics of goods, such as their quality, design, reliability, marketing and delivery. Exchange rate depreciation simply ossifies the industrial structure and makes producers temporarily more competitive in the export of goods with given characteristics which were the source of payments weakness in the first place. In our view, the UK's inferior economic record in relation to other countries is largely a function of its balance-of-payments strait jacket caused by the slow x

Preface to the Fourth Edition xi growth of exports and high propensity to import, and until this underlying weakness is rectified, the UK will be condemned to a low growth rate (and the spectre of rising unemployment) whatever other domestic policies are pursued. The idea that countries may be constrained in their growth performance by balance-of-payments weakness leads to the concept of balance-of-payments constrained growth. We formally derive a formula for a country's growth rate consistent with balance-of-payments equilibrium which turns out to be a remarkable predictor of growth rate differences between advanced industrial countries since the Second World War. Since the book was first published in 1980, it has been widely used as a preliminary text on balance-of-payments theory, and as a source of reference on the performance of the UK balance of payments. This fourth edition provides the opportunity to bring up to date all the tables relating to the balance of payments, imports and exports, the commodity and geographie composition of trade, the exchange rate, and so on, and also the text relating to the history of the UK balance of payments. The tables and text now extend to 1989/90. In addition, the analysis and exposition has been extended in several places. The most significant change. which has led to coauthorship of the book, has been the addition of two new chapters on the capital account of the balance of payments and on the determination of exchange rates. A detailed analysis of these two topics was a major omission from previous editions. Other changes include the following: the book continues to argue strongly that the focus of balance-of-payments policy ought to be on the current account, but in Chapter 1 there is a fuller account of why the current account of the balance of payments matters for the functioning of the real economy. It has become fashionable in some quarters to argue that current account deficits do not matter if they are not government induced and can be voluntarily financed. We argue that they do matter. Chapter 4 on the balance of payments and the national economy retains one of its distinctive features of presenting the foreign trade multiplier relating imports to expenditure rather than to income, which is obviously more realistic if the import coefficients of various components of domestic expenditure differ. In this chapter, the worsening trade-off between the balance of payments on current account and the level of unemployment in the UK is also highlighted. Chapter 9 extends the history of the UK balance of payments to 1990 with particular emphasis on exchange rate policy

xii Preface to the Fourth Edition and the worsening current account deficit in the latter years of the 1980s. Chapters 10 and 11 contain up to date information on import penetration and export performance in the UK. Chapter 12 on the balance-of-payments equilibrium growth rate reports recent work by other researchers of applying the model of balance-of-payments constrained growth to a range of countries for the most recent years. We also show how the model can be used for simulation and forecasting purposes. Chapter 14 on the balance of payments as a structural problem has an extended discussion of non-price factors as determinants of trade performance, and gives the results of some tests of the theories of non-price competition. The link between balanceof-payments weakness and deindustrialisation in the UK is further developed in a new Chapter 15. In the original writing of the book a debt was incurred to a number of organisations and individuals. The Economic and Social Research Council (formerly the Social Science Research Council) financed the initial research on the structural aspects of the UK balance of payments. The Treasury and Department of Trade and Industry provided statistics. Mr John Goy and Mrs Julia Stevens of the University of Kent Library obtained and checked references. The editors of Banca Nazionale dei Lavoro Quarterly Review, Applied Economics, the Oxford Bulletin of Economics and Statistics, the Journal of Common Market Studies and the National Westminster Bank Quarter Iy Review gave permission to reproduce certain material which first appeared in their journals. Finally, colleagues - Richard Disney, John Craven, Charles Kennedy, Bob Dixon and Thea Sinclair - read the first edüion and helped to improve the book with their constructive comments on various chapters. For this new edition we must also thank Euclid Tsakalotos for constructive criticism; Keith Povey and Steven Gerral'd for editorial assistance, and Celine Noronha for typing various drafts of the manuscript. A. P. THIRLWALL HEATHERD. GIBSON

Acknowledgements The authors and publishers wish to thank the following who have kindly given permission for the use of copyright material: Cambridge University Press, for tables from Abstracts of British Historical Statistics, by B. R. Mitchell and P. Deane; The Controller of Her Majesty's Stationery Office, for tables from U.K. Balance of Payments, Key Statistics, and Economic Progress Reports; Lloyds Bank Ltd, for a table from Lloyds Bank Review (January 1975), by M. Panic; Institute for International Economics, for a table from The Exchange Rate System, by J. Williamson; National Westminster Bank Ltd, for a table based on figures from National Westminster Bank Quarterly Review (May 1975); Organization for Economic Cooperation and Development, for a table derived from OECD Manpower and Labour Force Statistics; Martin Robertson & Company, for an extract from Modern Capitalism: Its Growth and Transformation, by J. Cornwall (1977); Financial Times for a diagram by T. 0' Shaughnessy in an article published 1 February 1989; Heinemann Publishers for the use of text from Deindustrialisation, by S. Bazen and A. P. Thirlwall. Every effort has been made to contact all the copyright-holders, but if any have been inadvertently omitted the publishers will be pleased to make the necessary arrangement at the earliest opportunity. xiii