Economic Policy in the Open Economy - Essay Example

?ECONOMIC POLICY IN THE OPEN ECONOMY The primary purpose behind composing this article is to underline the current scenario of the UK economy, to suggest how its balance of payments can be improved, and lastly to review the feasibility of adoption of euro as currency by the UK economy. Let us revisit the concept behind balance of payments first. In principle, the balance of payments is a collective record that entails values of all transactions between domestic and foreign residents over a certain period of time, which is usually of a year. The balance of payments is based on the principle of double entry bookkeeping and the monetary value of every transaction is recorded as both a credit and a debit. Debits and credits in the balance of payments are collected into groups on the basis of what is exported or imported. The partitioning of these groups varies between countries however. We generally divide the balance of payments into four traditional subdivisions: current account, unilateral account, capital account, and gold account, these in return contain the value of goods and services either exported or imported plus dividend and interest income and payment, second entry for gift received, imports and exports of assets like bonds and common stocks and, the import and export of gold for commercial purposes, respectively. The import of a bond or any asset similar in context is recorded as a debit in the capital account. Since its purchase results in the country’s residents paying out money or capital, the import of a bond, like any other debit entry in the capital account, is called a capital outflow. On the other hand, the export of a bond means the residents actually receive money or capital; and thus, the export of a bond, like other credit entries made in the capital account, is called a capital inflow. The collective value of these four accounts is generally used to compute the balance of payments, which if contains a positive value is a surplus and a deficit is recorded if the total value comes out to be negative. With the increasing Eurozone’s recessionary fears, and industrial production slumping on an incessant basis, it is evident that UK’s balance of payments is only getting more negative. (Wall street Journal, April 2012) According to the Statistical Bulletin, The UK’s current account deficit was recorded to be ?15.2 billion in the third quarter of 2011, the highest value recorded as yet. Its trade deficit extended to ?9.9 billion in the third quarter of 2011, an increase of ?2.7 billion since the previous quarter. The income surplus was ?0.3 billion which is actually the smallest surplus ever since the fourth quarter of 2000. Moreover, the international investment position recorded UK net liabilities of ?245.5 billion at the end of the third quarter 2011 which outweigh the inward investment of ?22 billion by at least ten times. In the recent picture, the increasing balance of payments deficit is only adding to the mound of problems. The repercussions produced by slowdown in exports followed by increasing faster growth in imports of goods and services caused by a rise in the value of sterling against other currencies has indeed led to a worsening balance of payments’ position. Due to the increasing deficit, the government has responded by the introduction of tough austerity measures aimed at narrowing the budgetary deficit; however this has only led to soaring unemployment and rising business bankruptcies. There is a loss of employment because UK businesses are losing market share and output to cheaper imports from overseas. A fall in business confidence and a decline in capital investment spending by UK exporting firms have been witnessed primarily because of the continually declining aggregate demand. Balance of payments deficits are nearly always bad for the economy, except if a country is importing a high volume of goods and services to make available diverse resources to its citizens. However, in the long term if the trade deficit is a symptom of a weak economy and a lack of competitiveness then it can provoke deterioration of the standards of living. Years of slow growth at the very same, would further pressurize the government's budget as well as weaken the economy's taxable capacity. Large and persistent budget deficits can usually be financed without difficulty by tapping high private sector savings. But the financial markets can also prove to be less accommodating. The loss of confidence as aforementioned increases market fears of default. In case, this happens, we will see a further weakening of the economy and its institutions and stressed taxpayers will become keen to evade the cost of servicing ever-rising levels of government debt. In such a crisis, the debt will not be financeable at any price. The balance of payments deficit can be effectively reduced if the trade deficit can be managed. This can be done if more UK businesses endeavor to seek and exploit opportunities in export markets existing overseas. At the very same, the country should increase focus on industries where it enjoys an apparent competitive advantage for instance tourism, which can bring abundant foreign exchange home. However, this does not imply that the sectors that are facing tough external competition can be sidelined; efforts would have to be made to improve efficiency and productivity to cater to those export sectors. Research and development should be increased to develop new products for the high growth markets, especially those which are highly income elastic in the other exporting countries. As we have discussed the contribution that can be made by the industrial sector, it is pertinent to make recommendations for the government to act upon. The government can introduce transitory export subsidies after talks with WTO and its approval. Sound macroeconomic policies should be introduced to boost business confidence, and the very same, tax exemption should be executed for industries which are investing in their business for an expansion in exports. Many economists have predicted that in a certain years’ time, the UK would have no alternative but to adopt euro as its currency as an attempt to escort its failing economy to recovery. In this article, the pros and cons of this measure will be considered to determine if the option stands to be overall favorable or unfavorable for UK. The theory of optimum currency areas stands to be very useful while evaluation of the alternative of adoption of Euro. The Euro can be judged against the criteria within this theory to tell if it fulfills them, either partially or totally or in other words, these criteria determine how optimum Euro is. First, let us consider what an optimum currency area (OCA) is. It can be described as ‘an economic unit composed of regions affected symmetrically by disturbances between which labour and other factors of production flow freely’. (ECB working paper, 2006) The purpose of Euro as integrated currency was to maximize economic efficiency for all the grouping nations. The theory of OCAs is divided into six parts, three economic and three political criteria respectively. The three economic criteria are mobility of labour, product diversification’ as well as openness. The three political criteria involve Fiscal Transfers, Homogenous Preferences and the conflict between Solidarity and Nationalism. Labour Mobility is based on the idea that if capital and labour are completely moveable across borders, then the cost of sharing the same currency is eliminated. Euro of course does not meet this criterion. The means that incase Britain join the Euro, and lose competitiveness in key industries, migration would not occur as needed and unemployment will occur as a result. ‘Openness’ implies that ‘countries in an optimum currency area should be very open to trade with each because, the higher the degree of openness, the more the domestic price level will reproduce changes in the international prices of tradable goods. Therefore, countries that are integrated through trade find it beneficial to adopt a common currency as their respective currencies will probably display similar movements on the international level. A consideration of the Euro-zone economies over this matter depicts how easily this criterion is met. Britain at the very same, has acutely integrated with the other European markets, the local price level is similar across the region as a whole. Production diversification, describes how ‘the likeliness between more diversified partner countries to endure small costs by forsaking nominal exchange rate changes and finding a single currency beneficial. Each trading partner however should be diversified in terms of both production as well as consumption in order to absorb the shocks that occur. A well-diversified portfolio of employment ensures that if any one sector is hit hard, the economy is not as reliant on a change in the exchange rate for minimizing the adverse effect. When considering if Euro meets this criterion, the current situation indicates that this criterion is indeed fulfilled for the different economies of the European Community are generally characterized by a diversified industrial structure. Therefore, Britain would stand to gain from entry into the Euro, on the grounds that the economy matches its partners in the region and hence a degree of protection is provided against shocks. The fiscal transfer criterion measures the ability to enable minimizing the risk by getting it shared with other countries. This means that funds should be transferable from one location to other in case a detrimental situation arises. This is preferable also because it substitutes the need for the nominal exchange rate to adjust in order to compensate for the shock. However, the Euro is proceeding without a public risk sharing facility. There is no entity in existence with a budget to transfer funds to a region hit by a shock, and hence appease adversity. As this criterion is not met, a second reason against Britain joining the Euro emerges. For optimization, the preferences of the trade partners must be homogenous. The partners of an OCA need to be agreed a unique economic policy, such as whether to target inflation or unemployment, or whether to favor exporters or importers. If the currency area members do not share the same preferences over trade-offs, a conflict will arise. Presently, the Euro partly fulfills this criterion. The conflicts amongst the countries are resolved amicably and without much disagreement. The conflict of solidarity and nationalism comes in to play when countries have to forego their own interests to pursue common interests. This criterion is difficult to determine as there is no sure way of measuring how far citizens of one nation are prepared to the interests of another over their own in the name of common interest. The current state of implementation of policies which usually involves talks between partners illustrates that ability to sacrifice self-interest for interest of all is existent. On the basis of these standards, we can judge whether Euro meets OCA criteria altogether. It does not fulfill Labour Mobility and Fiscal Transfers. Moreover, there is also uncertainty surrounding Homogenous Preferences and the conflict of Solidarity and Nationalism. This collectively leads to the conclusion that UK’s joining the Euro will not be a very favorable idea after all. However, if effective measures are taken encircling the first two problems, then joining the Euro can be considered. For now, we only have the unmet conditions to deliberate, including the time and money that would be taken for conversion to euro, loss of identity, imposition of fixed interest rates for the bloc, and lastly, the loss of FDI because of increased investment outside the Euro Zone. Conclusively, the primary focus of UK at present should be directed towards introduction of macroeconomic reforms for improvement of its budgetary and trade deficit, it can attend to other issues after its economy begins showing signs of recovery. References: Baldwin, R. and Wyplosz, C. 2006. The Economics of European Integration. New York: McGraw Hill. Euro-zone recession fears grow. Wall Street Journal, [online] Available at: Mongelli, F. 2006. New views on the Optimum Currency Area Theory: What is EMU telling us? ECB Working Paper 138 [online] Available at: [Accessed 20/12/06] Pippenger, J. 1973. Balance-of-Payments Deficits: Measurement and Interpretation. Federal Reserve Bank of St. Louis. December, 2011. Balance of payments third quarter. Statistical Bulletin. http://www.telegraph.co.uk/news/worldnews/europe/eu/8902450/Britain-will-have-to-join-the-euro-says-Tory-grandee-Lord-Heseltine.html Read More