Download Zyla on the Pound, 1978-84

Steven J. Zyla
Problem 15.5 The British Pound’s Real Effective Exchange Rate
(1978-1984)
The rise and fall of the Pound’s real effective exchange rate between the years of
1978 and 1984 can be attributed to many factors; however, it is my opinion that there
were two factors that played the largest roles in influencing the value of the currency
between these years. The first of these factors, the second world oil shock, occurred in
1979, and placed inflationary pressure upon all industrialized countries. The second
factor, which contributed to the volatility of the Pound’s real effective exchange rate, was
the tight monetary policy of the Thatcher administration that came into power in the
United Kingdom in May 1979.
To fully understand the movement in the Pound’s effective exchange rate from
1978 to 1984, I think it is important to provide insight into the political and economical
struggles that plagued the United Kingdom earlier in the decade of the 1970’s. The graph
below illustrates the sharp depreciation of the Pound’s value throughout the first six years
of the decade. One of the largest problems facing the United Kingdom during this time
Effective Exchange Rate
Pound's Effective Exchange Rate, 1971-1980 (1971=100)
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was the large amount of foreign currency borrowing done by the Labour Government to
finance the enormous balance of payments deficit facing the United Kingdom. Upon
coming into power in 1974, the Labour government inherited a Balance of Payment
deficit in excess of 3 billion Pounds. Inflation was accelerating during this time and
laborers were demanding higher and higher wages to keep up with the inflationary
pressure. As a result of the demand for higher wages, unemployment rates were also
rising (mostly in the manufacturing sector). Foreign currency borrowing reached its peak
in 1976, at more than 3.5 billion Pounds. The borrowing of foreign currencies to meet
the deficit demands being experienced within the British economy caused a heavy fall in
the value of the Pound, and it reached its lowest value in 1976, at more than a 30%
decrease from its 1971 value. The British government, fearing the disaster that would
result in further depreciation of the Pound, turned to the IMF for help in 1976.
Throughout this massive decline in the value of the Pound, the British
Government took steps to help ease the downward pressure being placed upon it.
Between 1974 and 1977, the government cut public expenditures by 1 billion Pounds per
year to ease this pressure. To fight domestic inflation the British government and the
leading labor union in the United Kingdom agreed on wage increase restraints, which
would help to control the increasing price levels. To further reduce the downward
pressure on the value of the Pound, the government increased interest rates late in 1975,
as a measure to tighten monetary policy. The increases in the interest rate reached a high
point in October of 1975, when interest rates were in excess of 15%. This drastic
increase in interest rates stopped the outflow of short-term funds and started an inflow of
capital into the United Kingdom. The fiscal and monetary policies used to stop the
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decline in the value of the pound accomplished the mission they were put forth to do by
1976. From 1976 to 1979, the Pound rebounded and began to increase in value. During
this same time period British GDP also rebounded and increased steadily. Throughout
1976 and 1977, the government eased the monetary policy that was put in place to stop
the decline of the pound, and interest rates fell to 5% by late 1977.
The Pound’s value continued to rise throughout 1978, as a result of the tight
monetary policies set forth in the two prior years, but in 1979 the world experienced a
Real Effective Exchange
Rate
Real Effective Exchange Rate of the Pound Sterling, 19761984 (1980=100)
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second major shock to oil prices. This shock put extreme upward pressure on the pound
as seen in the graph above. The fall of the Shah of Iran in 1979, disrupted oil exports
from Iran and sent the price of oil skyrocketing. In 1978, the price of oil was roughly $13
per barrel, but by 1980, oil prices had reached nearly $32 per barrel. This dramatic
increase in the price of oil helped to increase the value of the Pound, as the United
Kingdom possesses the North Sea Oil Company, which is a huge producer of oil. The
rise in the price of oil put upward pressure on the value of the Pound, as countries looked
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for other sources of oil production outside of OPEC. This huge oil price increase also
produced problems within almost all industrialized countries as well. The increase in oil
prices put upward pressure on the overall price level, and inflationary concerns began to
surface in many of these countries, including the United Kingdom. Not wanting to fall
into the inflationary trap they found themselves in during the early ‘70’s, the newly
appointed British Government took actions to combat inflation.
Margaret Thatcher was named Prime Minister of the United Kingdom in May
1979. Thatcher, a member of the Conservative Party in Great Britain, brought with her
an administration whose chief economic policy was that of combating inflation. The
Thatcher wing of the Conservative Party believed that intervention by the government in
the markets hurt the economy, and that the main job of the government should be to
allow the markets to function on their own free of inflationary pressure created by
government monetary policy. In combating inflationary pressure, created by the increase
in oil prices, Thatcher’s administration raised interest rates to as high as 17% in
November 1979. The main problem with this policy was that the inflationary pressures
facing the British (and World) economy during this time were not the result of excessive
growth. In fact, during the second oil shock, and the subsequent years following, the
economies of most industrialized nations were facing stagflation. Total output within the
United Kingdom between 1979 and 1983 only increased 3.8%, whereas prices increased
at a rate in excess of four times that amount. The tight monetary policy put forth by the
Thatcher administration worked to combat these inflationary pressures. By 1980, the
inflation rates began to decline, and by 1983 they had fallen to a respectable 4.5%. The
problem with such policies is the strain they put on the domestic economy. During this
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time of tight monetary policy in the United Kingdom and in the United States, the global
economy fell into recession, as the output of the entire world grew at very low rates.
Production was not the only area of the economy to suffer from such monetary
tightening, as the British Stock Market fell nearly 8 billion Pounds in value between
1980-1982.
Many experts argue that it was the tight monetary policy put in place by the
Thatcher administration during the late ‘70’s and early 80’s, that led to the further
appreciation of the Pound during this time. They argue that the effects of the second oil
shock played a part in producing the tight monetary policy, but that it was these policies
and not the increase demand for oil from Britain that forced the value of the Pound
upward. In trying to explain this belief many have cited the fact that by 1986, the price
per barrel of oil had nearly been cut in half from its high value during 1979-80, but the
fall in the value of the Pound by 1986, was not nearly as severe. Others point to the fact
that the United States and Great Britain were the only two OECD countries to experience
a fall in GDP in 1980, and that both were pursuing tight monetary policies during that
year. As a result the following recession in 1981 was far more severe in both of these
countries, reducing imports and putting upward pressure on both the Pound and the U.S.
dollar.
By 1982, the Thatcher administration began to focus on other issues regarding the
economy. They began to fear that the pound had appreciated to a point where British
goods were becoming too expensive on the world market. They feared this would lead to
a substantial decrease in the international market shares enjoyed by British producers.
The focus of their budget conversations centered on coming up with a way to devalue the
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Pound. News of this soon became available to the public and the expectation of future
depreciation of the Pound by the public led to actions that created this effect. A
noticeable depreciation of the Pound began in November 1982, and lasted throughout
1984. The Pounds overall depreciation throughout this period was noticeably more
dramatic when looking at the Pound relative to the U.S. Dollar. The overall depreciation
of the Pound relative to the currencies of the world was roughly 10%, while the Pound
lost nearly half of its value against the Dollar during this same time, as seen in the graph
below. One of the main reasons for the Pounds loss in value in terms of the U.S.
Dollar, was that the United States Government continued their tight monetary policies
(Volcker Disinflation) further into the decade than their British counterparts had.
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