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Britain's Borrowed Time
John Bull dropped the other shoe
last week, when the Government
announced a £ 1.5-billion reduction
in planned public-sector borrowing
for next year, involving a combina­
tion of stiff spending cuts and high­
er social-security taxes. This dose of
fiscal restrictiveness, coupled with
tighter monetary and incomes poli­
cies, represented Britain's response
to last month's $5.3-billion interna­
tional aid package, which gave the
nation a welcome breathing spell
while it began to attack its underly­
ing economic problems. Britain's
problems became painfully evident
last spring, as the pound sterling
crashed through its $2.00 psycho­
logical floor in early March and
didn't stop until it reached $1.70 in
early June, rebounding only with
the announcement of the interna­
tional rescue effort.
PPP and all that

Up until recently, sterling deprecia­
tion could be explained by the fact
that inflation was far worse in Brit­
ain than among her major trading
partners. During 1975, the U.K.'s 20percent wholesale price inflation
compared with only 3 percent in
Germany, 5 percent in the United
States, 6 percent in the Nether­
lands, and 9 percent in France.
Relative to her competitors, Brit­
ain's domestic wholesale prices
rose about 15 percent on a tradeweighted basis during this period—
and this was matched by a 15percent effective depreciation in
exchange rates, in a neat demon­
stration of the theory of
"purchasing-power parity."
1




According to the theory, when
domestic prices rise higher in one
country than in others, the result is
a stimulation of import demand and
a dampening of export demand,
and a consequent weakening of
that country's exchange rate. Main­
tenance of a currency's purchasingpower parity vis-a-vis tradingpartner currencies requires that
inflation-rate differentials be offset
by exchange-rate changes.
However, this spring's severe 16percent depreciation of sterling far
exceeded the decline which would
be warranted by current inflationrate differentials. Indeed, the
pound at that point was underval­
ued by at least 4-6 percent in terms
of purchasing-power parity, with
1974 as a base year. Exchange rates,
of course, respond to many other
factors besides price changes—
short-run expectational factors and
interest-rate differentials being
especially important.
In the case at hand, uncertainties
over British economic prospects
apparently created a temporary
downward bias in market expecta­
tions and led to an exaggerated
selling bout against the pound on
the part of speculators and holders
of short-term sterling balances. The
obvious cure for this unstable situa­
tion was the $5.3-billion package of
standby credits, which was de­
signed to preserve "orderly condi­
tions" in foreign-exchange mar­
kets. Indeed, the announcement of
the credits accomplished its pur­
pose. The pound immediately in­
creased about 5 percent in value, to
(continued on page 2)

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Opinions expressed in this newsletter do not
necessarily reflect the views of the management of the
Federal Reserve Bank of San Francisco, nor of the Board
of Governors of the Federal Reserve System.

around $1.77, and thereafter re­
mained near that level, helped
along by the Chancellor of the
Exchequer's statement that govern­
ment policy was to maintain a stable
exchange rate rather than to try to
force it higher.
Policy gamble

In the light of this policy posture,
Britain’s borrowed bankroll may be
interpreted as a gamble which
hinges on whether or not the hold­
ers of sterling balances (including
speculators) are convinced of the
Bank of England’s ability to main­
tain a stable exchange rate. Should
the gamble succeed, several im­
portant consequences would be
likely to follow. The discount of
forward sterling (the cost of cover­
ing investments in sterling) would
come down. A decline in the for­
ward discount, coupled with higher
interest rates than abroad, would
attract short-term funds back into
London. Finally, the Bank of Eng­
land could rebuild its reserves and
repay any drawings on the standby
credits.
On the other hand, should the
gamble fail, a temporarily stable
exchange rate would afford the
holders of sterling balances an op­
portunity to get out of sterling
while the going was good, with the
Bank of England footing the bill.
Britain might then find it difficult to
repay heavy credit drawings from
her official drawings, and would be
forced to turn to the International




Monetary Fund for a medium-term
loan which could have tightly re­
strictive terms.
The Government thus was keenly
aware that its gamble would have to
succeed, and yet equally aware that
defending the value of the pound
would depend on its success in the
very difficult task of controlling
domestic inflation. During the last
several years, a growing budget
deficit has contributed to an infla­
tionary "demand pull,’’ while a
wage explosion, which peaked at a
30-percent annual rate in mid-1975,
provided a strong “ cost push’’ argu­
ment.
Restrictionism

Britain’s public-sector deficit (in­
cluding nationalized industries) es­
calated from £4.3 billion in fiscal
1974 to about £12.0 billion in the
current fiscal year, leading to fears
both of increased inflationary
pressures and of a crowding-out of
private borrowers from financial
markets. In an early effort to con­
trol the fiscal 1976 budget, the gov­
ernment placed cash ceilings on
two-thirds of budgeted expendi­
tures. However, real spending plans
were based on an assumed inflation
rate which is now likely to be too
low due to the inflationary effects
of sterling’s recent depreciation.
Thus, the maintenance of spending
ceilings would probably require
real reductions in some areas. In
addition, the £1.0 billion in fiscal
1977 spending cuts announced last
week—affecting regional develop-

ment grants, nationalized indus­
tries' capital spending, road build­
ing, food subsidies, defense spend­
ing, home building and social
services—obviously would mean
even deeper cuts in real terms.
Restrictive policies have slowly
evolved in other areas as well. Be­
tween fiscal 1975 and fiscal 1976
(ending March), the growth of the
broadly defined money supply (M 3)
decelerated from 14 percent to 9
percent. Some deceleration was
also evident in the growth of the
narrowly defined money supply
(M.,), although that measure contin­
ued to expand between the two full
fiscal years. Meanwhile, in the latest
version of the “ social contract"
between the Government and the
trade unions, a 4.5-percent ceiling
was placed on average wage in­
creases over the next twelve
months. On the other hand, the
wage agreement was coupled with
income-tax cuts which could aggra­
vate the budget deficit.
The objective of all these measures
is to reduce inflation to single-digit
figures by the end of this year—a
difficult task in view of the lingering
effects of earlier overstimulative
policies and the inflationary impact
of sterling depreciation. In particu­
lar, the unions are likely to be made
restless by the reduction in living
standards caused by depreciation
and now by cuts in social programs,
coming at a time when the jobless
rate (at more than 5.5 percent) has
reached the highest level of the

past generation. But the alternative,
unfortunately, is reduced living
standards through further inflation.
Road back?

Any success achieved in this anti­
inflation drive should bode well for
British exports, permitting the na­
tion to build on the price appeal of
British goods resulting from sterling
depreciation. This factor, plus the
worldwide business recovery, could
generate an export boom which
would help drag the U.K. out of its
economic slump and, by improving
her trade balance, help restore con­
fidence in the pound.
The $5.3-billion credit package, by
restoring short-term sterling stabili­
ty, has bought time for Britain's
domestic anti-inflation policies to
take hold. Over the long term,
confidence in the stability of the
pound, as well as prospects for
sustained recovery, will depend
upon the British Government's
continued ability to perform a diffi­
cult balancing act. At one end of
the balancing pole are the real
wage expectations of Britain's pow­
erful labor unions and the nation's
social objectives. At the other end
are the more general economic
goals of reduced inflation and bal­
anced economic growth. In view of
Britain's trading position in the
world and the role of sterling as an
international reserve-andtransactions currency, the rest of
the world also has a high stake in
Britain's balancing skill.
Michael Riordan

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BANKING DATA—TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Loans (gross, adjusted) and investments*
Loans (gross, adjusted)—total
Security loans
Commercial and industrial
Real estate
’
Consumer instalment
U.S. Treasury securities
O ther securities
Deposits (less cash items)—total*
Demand deposits (adjusted)
U.S. Government deposits
Time deposits—total*
States and political subdivisions
Savings deposits
O ther time deposits}:
Large negotiable C D ’s

88,841
66,892
1,459
22,178
20,166
11,218
9,648
12,301
90,004
25,797
260
62,545
6,115
26,354
27,405
12,413

Weekly Averages
of Daily Figures

W eek ended
7/14/76

Member Bank Reserve Position
Excess Reserves
Borrowings
Net free(+)/Net borrowed (-)
Federal Funds—Seven Large Banks
Interbank Federal fund transactions
Net purchases (+)/Net sales (-)
Transactions of U.S. security dealers
Net loans (+)/Net borrowings (-)

Change
from
7/07/76

Change from
year ago
Dollar
Percent

+
+
+
+
+
+
+
-

Amount
Outstanding
7/14/76

+
+
+
+
+
+
+
+
+
+
-

53
260
28
33
35
24
18
331
145
884
115
116
28
104
266
58

2,960
2,327
517
967
497
1,218
1,029
396
4,127
1,868
68
2,440
433
5,624
1,570
3,169

W eek ended
7/07/76

+
+
+
+
+
+
+
+
+
+
-

3.45
3.60
54.88
4.18
2.53
12.18
11.94
3.12
4.81
7.81
20.73
4.06
6.61
27.13
5.42
20.34

Comparable
year-ago period

+

49
3
46

28
8
20

+

+

845

-

431

+ 1,780

+

679

+

180

+

+

35
5
30

799

♦Includes items not shown separately. ^Individuals, partnerships and corporations.
Editorial comments may be addressed to the editor (William Burke) or to the author. . . .
Information on this and other publications can be obtained by calling or writing the Public
Information Section, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
Phone (415) 544-2184.