The Global Economy: The U.K - Essay Example

Nations have incurred deficits to fund government programs for decades. Governments can decide to seek funds directly from capital markets, they can borrow from existing public trust funds such as the Social Security Trust Fund in the United States or they can choose to sell government backed instruments such as bonds and treasury bills on the open market. In the U.K. government securities are sold through National Savings and Investment. Historically, the debt that governments accrued to help fund public programs was never really of much concern to ordinary citizens. In the last few years, however, this has changed dramatically. Rising government debt, and indeed, the economic health of several nations, is now at the center of the public policy debate. The results of the recent national election in Britain, was in part, a reflection of public dissatisfaction with the state of the economy and the growth in the level of debt under the Labour Party’s administration. As long as deficits are kept at manageable levels and as long as the economy experiences growth, there is no need for concern. The question, of course, is what constitutes “manageable” and what level of economic growth is sufficient to honour the repayment of the debt? Economists prefer to compute a measure of debt as a percentage of Gross Domestic Product (GDP) because it is a reliable indicator that controls for the size of the economy. For example, if the U.K.’s debt is five percent of GDP in a given year and Denmark’s debt ratio is nine percent of GDP, we have a reasonably accurate means of examining the comparative debt level even though the economic output of each country is different. The International Monetary Fund data shows that during most of the 1990s, the annual debt to GDP ratios for Britain and the United States averaged between three and five percent [http://www.imfstatistics.org]. This was considered acceptable because the economies of the two countries were growing at between four and six percent per year. In 2010, the Congressional Budget Office estimates the debt to GDP ratio for the US at 9.9% of GDP while economic growth is estimated at 3.2 percent [http://www.cbo.gov]. The Statistics Office estimates that the debt to GDP ratio for the U.K. in 2010 at 10.6% of GDP with economic growth forecast at 3 percent [http://www.statsitics.gov.uk]. The current debt to GDP ratios for both countries are clearly unsustainable. Warnings have recently been issued to the U.K. that the country’s credit rating may be lowered over fear of the growing debt. The situation in Greece, where the European Union was forced to bail out that country over its possible bankruptcy, has sent shock waves around the world. The euro has depreciated in value, global stock markets have dropped dramatically and other countries such as Spain, Portugal and Ireland are being scrutinized because of their alarming levels of debt [LONDON TIMES, April 28, 2010]. Governments have two fiscal policy tools at their disposal to manage levels of debt, assuming of course, that they choose not to follow the same path as Greece. One is expenditure management; the other is to increase revenues. Typically, governments utilize some combination of the two. On the revenue side, the primary means of generating funds is through taxation, although there are several secondary sources such as the sale of government owned assets like railroads or airlines and fees collected for the use of publicly owned lands such as parks. Taxes, however, generate the bulk of government revenues. Taxes on individual and corporate income represent the major source of funding for national levels of government. Besides the fact that few individuals want to pay taxes, setting income tax rates is an important and complex policy matter. When income tax rates are low, corporations have more capital to invest in expanding business, creating jobs and helping to create economic growth for the nation as a whole. If more people are employed, they are paying taxes and government revenues could actually increase. When individuals pay less taxes, they have more disposable income that they can spend to purchase products manufactured locally, thereby stimulating economic growth. Conversely, when tax rates are too high companies cut back on production or leave the country all together and set up shop in a more tax friendly environment. High individual income tax rates negatively affect productivity by forcing individuals to seek leisure activity instead of working. Although this sounds simple in theory, the application is tricky and the outcome is never what analysts predicted when the tax policy was initially enacted. Both the Thatcher and Reagan governments in the 1980s, for example, instituted massive tax cuts convinced that this would lead to a long period of economic growth. The opposite happened. Deficits ballooned prompting some analysts to label the Reagan-Thatcher strategy as “voodoo economics.” The optimum strategy, therefore, is to try and set the marginal tax rates on individual and corporate income at levels that ensure a steady and adequate supply of revenue to government, without placing too much burden on corporations and individuals. The problem for most governments is that the revenue from income tax falls far short of the total resources that government requires to fund it programs and to service is existing debt. Two additional tax strategies are often employed to try and fill the void; one is a value added tax (VAT) and the other is payroll taxes. Payroll taxes are additional taxes levied on the employer and employee to help cover costs associated with health and unemployment benefits. In the United States, the payroll taxes have been increasing each year. In 2010, the combined maximum payroll tax rate for Social Security, Medicare and Unemployment Insurance is 15.3 percent [http://www.irs.gov]. European Union member states agreed to establish a minimum 15 percent Value Added Tax on all goods and services, although many EU nations exceed the minimum. On January 1, 2010 the VAT rate in the U.K. increased from 15 percent to 17.5 percent and further increases are likely given the current fiscal challenges facing the new government. A Value Added Tax is defined as a tax imposed on each stage of the production of a given product [BIRNBAUM 2007]. Proponents of VAT argue that those who consume the product should pay the tax. On the surface, it sounds like a reasonable argument. If I purchase a new car, it seems only fair that I should pay the taxes on each segment of the production process where value was added to my car. The problem is that the value added tax is a proportional tax. The same rate applies to every individual who purchases goods and services regardless of their income level or total wealth. The 17.5 percent VAT levied against the single parent who purchases clothing for her three children has a much larger impact on her than it does on the executive from British Airways who makes the same clothing purchase and therefore pays the identical tax as the single mother. In its application, the VAT can be a regressive tax that has a disproportionate negative impact on low income individuals. The major issues around government sources of revenue and the complexities surrounding tax policy is only one factor in determining the amount of public debt that is prudent . The second fiscal policy tool that governments use to manage deficits is called expenditure management. Our elected officials must make difficult choices over which programs receive public funding support and which do not. They ultimately decide if a program that provides services to veterans receives an increase in funding next fiscal year or a reduction from the current year budget. These are difficult choices because they are political and they affect the lives of our citizens. But when deficits are large, cutting program funding is an important part of the solution. The new coalition government in the U.K will have to make choices that will be unpopular with constituents because a deficit of 10.6 percent of GDP for 2010 is not sustainable. Some who do not understand the realities of the budget process argue that all we need to do is to cut the national budget by twelve percent across the board this year and ten percent next year and use the savings to pay down Britain’s debt. Problem solved. Unfortunately, it is not that simple. Look at what is happening in Greece. There are riots in the streets, people are being killed and the rule of law is rapidly being eroded. Besides the public outcry associated with large reductions in government expenditures, there are legal and constitutional complexities that constrain government’s ability to wield the budget axe. Budget analysts refer to two types of macro-level expenditures; discretionary and non-discretionary. Large portions of government budgets in the U.K. and U.S. are non-discretionary. This means that legislators do not have the discretionary authority to cut program funding in certain areas. These programs have come to be known as “entitlements.” Residents of the country (in some cases you do not have to be a citizen) are entitled to receive the program benefit and the courts have affirmed this right as a constitutional right. Take the United States, for example. Analysts in the Office of Management and Budget (OMB) estimate that seventy percent of the $3.5 trillion 2010 federal budget is non-discretionary. Of the thirty percent that is discretionary (in other words, Congress can cut these funds), the largest amount is located in Defense. If one looks at the discretionary non-defense part of the overall U.S. federal budget that can actually be reduced next fiscal year, the amount is so small that cutting the entire discretionary portion of the budget would have an insignificant impact on reducing the deficit [http://www.whitehouse.gov/omb]. In the U.K. we see a similar pattern. In examining the 2010 budget on the H.M. Treasury website, the data indicate that Health, Education, Welfare, Pensions, Interest and Defense consume sixty-five percent of the total budget of $488.5 billion pounds. [http://www.hm-treasury.gov.uk]. Both of these examples demonstrate clearly the reason why our elected representatives struggle to find solutions to the ever growing deficits. The fact is that there are no easy answers. Deficits matter because they affect the choices that government makes over the types of public programs that we are able to afford and the level of taxes that we must pay to support these programs. These decisions affect all of us. The level of debt that countries like the United Kingdom, the United States, and European Union member states incur not only dictate fiscal policy choices today, they shape the level of prosperity that our children and grandchildren will enjoy for generations to come. Bibliography BIRNBAUM JEFFREY H. 2007 Value added: A new take on the tax that Liberals used to hate. Washington Monthly Jan-Feb. MORTISHED, CARL WIGHTON, David 2010 ‘Greece infection’ spreads as stricken nation’s debt is rated junk London Times April 28. Data reported by the United States Congressional Budget Office are available at: http://www.cbo.gov. Retrieved on May 8, 2010. Data on the European Union member countries are available at: http://ec.europa.eu. Retrieved on May 8, 2010. The fiscal 2011 budget of the United Kingdom is located at: http://www.hm-treasury.gov.uk. Retrieved on May 8, 2010. Comparative data by country on a number of economic factors can be found at the International Monetary Fund website: http://www.imfstatistics.org. Retrieved on May 8, 2010. Information on U.S. payroll taxes is available at the Internal Revenue website: http://www.irs.gov. Retrieved on May 8, 2010. For an independent assessment of the budget deficit in the U.K. see reports from the National Institute of Economic and Social Research at: http://www.niser.com. Retrieved on May 8, 2010. The executive budget of the President of the United States is located at the Office of Management and Budget website: http://www.whitehouse.gov/omb. Retrieved on May 8, 2010. A nation’s exchange rate is a barometer of its economic health. Exchange rates are important within the context of international trade and can affect domestic investment as well. The foreign exchange market (forex) represents the single largest market in the world trading currencies valued at more than $3.2 trillion each day [http://www.goforex.net] Trade between nations has been at the foundation of the free market system for centuries. The exchange rate is simply the value of one country’s currency compared to another country’s currency. The unit most often used to value currencies is the U.S. dollar. As of this date, one pound sterling is worth $1.51 U.S. dollars while one euro is equivalent to $1.27 U.S. As the exchange rate fluctuates, so to does the cost of imported goods. When the value of the euro declines as it has done recently, then the cost of imported goods from Australia, the Middle East and Mexico are higher. Conversely, the lower valued euro means that cheese from France, chocolate from Belgium and olive oil from Italy are less expensive for consumers around the world who import them. There are many factors that influence the currency exchange rate. Some of these are domestic while others relate to events in the global economy. Several of the more important factors are discussed below. It is valuable to remember, however, that understanding changes in foreign exchange rates always involves more than one of these factors. There are often several interrelated factors at play which makes the foreign exchange markets dynamic and difficult to predict. The basic economic principle of supply and demand helps shape the foreign exchange markets just like it affects the market for automobiles. Because the rate of exchange is subject to market forces, it is sometimes referred to as the “floating exchange rate.” If demand for pound sterling exceeds supply, the currency rises in value. Conversely, if the supply of currency exceeds demand, the value of the pound declines. If only life was that simple. What happens, in fact, is because a country’s exchange rate directly affects demand for its exports, the central bank often intervenes. In this case, the Bank of England either creates an “artificial” demand by purchasing pound sterling on the open market or, if it wants to hold down the exchange rate, it sells pound sterling on the open market [http://www.bankofengland.co.uk]. In both instances, the value of the pound in relation to the benchmark U.S. dollar is affected by the central bank’s actions. This type of monetary policy operation is used by all central banks in managing foreign exchange rates. An intangible factor that is almost impossible to understand until it happens is the impact that consumer confidence can have on the value of a nation’s currency. A perfect example concerns the decline in the euro. A recent article in Business Week [2010], notes that on May 6, 2010 the euro recorded its lowest level in fourteen months over widespread fear that the debt crisis in Greece and Portugal will spread throughout the globe. This is a classic example of how lack of consumer confidence can cause a significant decline in one of the world’s major currencies. This is particularly intriguing given that the economic fundamentals for many of the developed economies are strong. Nonetheless, people become uneasy and begin to lose confidence in the entire system. Inflation can affect the foreign exchange rate as well. Specifically, there appears to be a negative correlation between the rate of inflation in a particular country and that country’s foreign exchange rate. In other words, the lower the inflation rate the stronger the value of the currency. This makes sense intuitively. Japan, for example has historically had a low rate of inflation which, in turn, gives the yen more purchasing power relative to other currencies. The balance of payments represents the difference in the value of total trade in goods and services between two countries. Trade between Germany and France serves as an illustration. Assume that France purchases a total of 100 million euros worth of products (Porche cars, for example) from Germany. The 100 million euros is listed as a credit for Germany in the current account. Germans prefer French wine and so Germany purchases a total of 40 million euros of wine from France. The 40 million is credited to France in the current account. The difference of 60 million euros is the current account deficit against France. If the current account deficit is large, the foreign exchange rate can be affected. Whether the impact on the exchange rate is significant or not depends on the size and complexity of the economies of the countries involved. The U.S. for example, always runs a current account deficit in its trade with China but this has minimal impact on the value of the dollar because of the size and diversity of the U.S. economy [COHEN 1998]. The final major factor that can affect the market value of a nation’s currency is the rate of interest that a country is willing to pay on its government issued securities such as bonds and treasury notes. Assuming that a nation’s economic fundamentals are strong, a positive differential in interest rates will attract foreign investment. The increase in foreign investment, in turn, makes the currency more valuable. Many of the indictors described above appear to point to a weaker currency as the preferred alternative for a country wanting to expand its export base and create jobs in the local economy. An examination of the strengths and limitations of the “weak currency” concept will assist in determining whether this is an appropriate course of action to take for a country like the United Kingdom. One of the major advantages to a weaker currency is that in theory it becomes cheaper for U.K. firms to sell products produced in Britain in foreign markets. In the long term, more jobs are created in the U.K. because of this increase in exports. The increased levels of employment, translates into more net disposal income for individuals to spend in the domestic economy. Because more British people are employed and spending their money on products made in the U.K., government income tax revenues as well as revenues from the Value Added Tax increase [FINANCIAL NEWS July 30, 2009]. Another advantage is that a weaker currency tends to positively affect tourism and of course, global tourism is a multi-billion dollar industry. The lower value of the pound makes it less expensive for tourists to visit the U.K. As a result, airline profits increase and businesses in the food, beverage and hotel industries prosper. A major factor that analysts examine within the foreign exchange markets is the effect that a weaker currency has on foreign direct investment. Assume that a multi-national firm is looking to expand its operations somewhere in Western Europe. The company has allocated two hundred million U.S. dollars for capital investment. The firm has narrowed its choice to either Germany or the U.K. The current exchange rate for the euro is 1.95 euros to 1 U.S. dollar. The pound sterling is currently trading at 1.38 to the U.S dollar. Strictly from an investment perspective holding other factors constant, the company would decide to expand its operations in the U.K. The lower value of the pound gives the U.K a comparative advantage of almost forty-three million pounds over Germany. The reason is that the initial two hundred million dollar investment will buy forty-three million pounds more in the U.K. than the same investment made in Germany. The solution seems clear. A weak dollar policy will solve the economic woes facing the new British coalition government. Unfortunately for the new government, it is easier said than done. Consider the long term problems that a weak dollar causes for the British economy. As noted earlier, when the dollar falls in value relative to other currencies in the foreign exchange market, the price of imported goods such as oil, food produced outside the U.K., clothing, and so forth increase. These increases in prices which can often be quite dramatic, lead to a higher cost of living in Britain. As the consumer price index increases, demands for increases in wages begin to come from unions. As wage demands are met, companies need to pass on those increases in costs to consumers. The cycle continues and the long term result is inflation. Probably the single most significant factor that constrains our ability to accurately predict the impact that changes in the value of our currency will have on the economy, is the reality that many political, social and economic issues combine to shape our policy choices at any given point in time. The current situation in the United Kingdom serves to highlight this point. The pound sterling has been in decline since it reached an all time low in January 2009 of $1.35 U.S. Today, it trades around $1.50 which is considerably lower than the $2.16 that the pound traded at in 2007. That said, the U.K. manufacturing sector should be booming because a weaker currency is supposed to fuel exports. The reality, however, is that even with a weaker pound, manufacturing output has steadily declined for over a year. Howard, Archer, U.K. chief economist at HIS Global Insight explains that other factors such as depressed demand within the U.K. and the European Union, tight credit markets and very low volumes of global export activity combine to devastate the U.K. manufacturing sector [WEARDEN 2009]. Bibliography The Advantages of a Weaker Pound.(2009) Financial News July 30. Retrieved from http://www.financial-news.org.uk on May 9, 2010. COHEN, BENJAMEN H 1998 The Geography of Money Cornell Press Ithaca New York. POOLE, JAMES KUHOYAMA, NORIE 2010 Stocks, Euro Drop, Bond Risk Climbs on European Debt Concern Business Week May 6. WEARDEN, GRAHAM 2009 Weak pound fails to lift fortunes of U.K. manufacturers The Guardian March 10. Refer to the Bank of England’s monetary policies at [http://www.bankofengland.co.uk] retrieved on May 9, 2010. Refer to Forex publications at [http://www.goforex.net] retrieved on May 9, 2010. Read More