Britains Balance of Payments Problem - Essay Example

BUSINESS ECONOMICS 2 (a) How useful is the circular flow diagram in explaining Britain’s balance of payments problem (75 The circularflow of income diagram is a graphical representation of the income flows into and out of the national system. As for international trade, imports and exports represent the country’s international flows. Source: www.tutor2u.com These flows consist of three pairs of injections and withdrawals: (a) Injections are investment, government expenditure and Exports (I + G + X). (b). Withdrawals are Savings, Taxation and Imports (S + T + M) It’s simplistic to assume that when imports are equal to exports in money terms there will be a balance of payments equilibrium (Nellis, 2004, p.331).The step by step development of a circular flow of income model for an economy requires a series of theoretical assumptions to be made. Initially, we assume that the economy is a basic model consisting of just two groups of economic agents – households and firms. In other words it is a closed private economy. Households supply labor to firms which in turn pay wages to the former. They buy goods and services produced by the firms. Next we introduce the government. The government is both a producer and a consumer at the same time. It is not only actively involved in production and consumption but also in charging taxes from and giving subsidies to the first two groups. In the next stage we introduce financial institutions such as banks. They enable the flows to be made smoother through their services such as cheques, credit cards and so on. However, still this is a domestic economy, though there are financial institutions in the rest of the world as well. So we finally introduce international trade, i.e. imports and exports. This is where the problem of balance of payments comes up. Balance of payments is the sum total of all imports and exports between a particular country (e.g. Britain) and the rest of the world in monetary terms. Therefore global financial institutions also come into the system. The circular flow diagram, indeed, adequately represents the fact that what is paid by a member of a given sector, say, firms to a member of another sector, say, households, is income for the latter while it’s expenditure for the former. However, in itself it’s a static model of a dynamic series of national and international flows. This is where its inadequacy as a representative model of income flows shows up. The balance of payments problem of Britain or for that matter of any other country is a dynamic one which necessitates a dynamic modeling structure to adequately capture the hidden forces of change. For instance in 2006, Britain’s total exports were equal to £ 369,691 million while imports were equal to £ 424,128 million. Thus the current account balance recorded a deficit of £ 54,437 million in 2006 (Annual Blue Book of Statistics, 2007, p.206). In fact, ever since 1998 up to now there has not been a surplus in the current account of Britain’s balance of payments. Circular flow of incomes and expenditures can be connected with the current account deficit, in the first instance, to show how effective the former is in explaining the most formidable economic problem of Britain in the current decade. The above figures simply sum up payments made to British exporters of goods and services by foreigners and payments made by British importers to foreigners. Foreigners mean governments, corporations, private firms, citizens and so on. The most pertinent question to ask here is “How many such transactions wouldn’t have been recorded in the books?” In other words there are so many instances of failure in recording statistics. Most of them are deliberate attempts by individuals who for whatever the reason might not disclose correct figures or would altogether hide them from authorities. The most glaring example is the smuggling activities. Further, there is the problem of importers exaggerating figures in order to claim concessions from the government by way of rebates on export processing activities. For example raw materials are imported by domestic producers to manufacture final products for the export markets. Multinational companies have a practice of over-invoicing imports and under-invoicing exports to claim tax concessions. There is no guarantee that the final figure in the current account balance always represents the true picture because there is always the possibility of a flow or two being unrecorded or swept under the carpet. Any effort at matching receipts and payments is to prove that what the circular flow diagram depicts is exactly what happens in the real world. Empirical evidence of such flows does not support this theoretical construct. According to the economic theory a constant deficit in the current account balance indicates a structural problem in the country’s economy. For example when Britain accumulated deficits year after year with Malaysia, the argument was that it could be solved by producing more consumer electronics domestically. What has happened over the years is just transferring those deficits from Malaysia to China. The structural problem persists even today. Circular flow diagram does not help Britain to find out where it has gone wrong either. Next we add net property income form abroad, i.e. the difference between income earned by foreign citizens by way of dividends and interests in Britain and British citizens abroad. This brings us to the final current external balance. In the financial year 2006 it stood at -£ 47,781. Again there is no circular flow diagram based explanation to the problem. Chronic structural problems in the British economy such as persistently high and rising labour costs, structural unemployment, lack of labour mobility (e.g. occupational mobility of labour),the rising value of the sterling pound and so on are not reflected on the circular flow diagram. It’s a static model that represents two way flows and nothing else. The endogenous and exogenous variables that influence such flows are not represented by it. By extension the same argument can be applied to the other two components of the balance of payments - capital account and financial account. The capital account registers all transactions between a British citizen and a foreigner. For example an asset owned by a British citizen may be transferred to a foreigner or vice versa. Foreign Direct Investment (FDI), portfolio investment (e.g. shares of existing firms) and so on are included in this account. However, there is confusion between the two accounts, because by convention financial account should include all transactions with a finance background. Therefore only international capital movements such as machinery and equipment are recorded in the capital account while all financial transactions are recorded in the financial account. Yet again the circular flow diagram does not adequately explain the balance of payments problem of Britain. Both the accounts have been persistently registering surpluses over the years because many British citizens have invested so much abroad. Overall the balance of payments has a surplus. Even the invisible account, i.e. services, registers a smaller surplus. But nevertheless, what the circular flow diagram does at its best is to show positive and negative flows as they are and nothing more or less. (b). How does Britain’s consumer debt compare with German consumer debt (25%)? Consumer debt is the amount of current consumption which is not paid for now. According to Telegraph newspaper British household debt is highest in history. “Families in the UK now owe a record 173pc of their incomes in debts, official figures have shown” (Conway, June 6, 2008, http://www.telegraph.co.uk). Right now consumer debt in Britain is recorded at £ 1,345 billion. How does it compare with Germany’s consumer debt? The Organization for Economic Cooperation and Development (OECD), puts consumer debt in Germany at 107% of annual disposable income while it puts Britain’s figure at 164% (www.oecd.org). Consumer debt management policies in Germany as dictated by the Bundesbank are based on very strict consumer credit regimes that very rarely leave anything to be desired by the consumer. On the other hand Britain, right now with the highest consumer debt figure as percentage of the annual disposable income, has not adopted a consistent consumer debt management policy. Such disparities are reflected in these figures. Bank of England has been following an independent monetary policy/fiscal policy combination for a very long period since Britain is not a member country of the Euro-zone. This freedom from a common obligation to a monetary union, allows the country a degree of flexibility in policy formulation that Germany lacks as the policy setter in both the EU and the Euro-zone. Though Britain, as a matter of fiscal/monetary control, has adopted a target inflation rate of 2.5% or below to be achieved annually, this in itself does not help in controlling consumer debt. Inflation is well under control in Britain but not consumer borrowings. Consumers in Britain borrow more than they are able to pay back in order to finance their current purchases. A recent argument put forward by some maverick economists is “how much of UK’s consumer debt is problem debt?” According to TDX Group, a debt management solution provider, it is £25 billion (Sanders, June 1, 2008, www.allbusiness.com). Germany’s problem is altogether different. Its problem debt or unsecured debt is much less and its ability to leverage consumer credit is at the root of its success story. The British economy is right now being powered by consumer debt/credit and this might not be a good sign for the average British citizen is running up debt that he himself cannot sustain in the long run. REFERENCES 1. Annual Blue Book of Statistics, (2007), retrieved on August 17, 2008 from www.statistics.gov.uk 2. Conway, Edmund, (June, 28, 2008), British Household Debt Highest in History, Telegraph, retrieved on August 17, 2008, from www.telegraph.co.uk. 3. Fox, Justin, (Feb. 7, 2008), Americans aren’t the only people who have been running up debt, retrieved on August 17, 2008, from www.time-blog.com. 4. Nellis, Joseph, (2004), Principles of Macroeconomics, Essex, Pearson Education Ltd. 5. Consumer debt of leading industrialized countries as a percentage of disposable income, (2008), retrieved on August 17, 2008, from www.oecd.org. 6. Sanders, Mark (June 1, 2008), UK Problem Debt: Consumer Crisis or Efficient Markets? retrieved on August 17, 2008, from www.allbusiness.com. Read More