BANKING AND MONETARY POLICY

Financial intermediaries

The main function of the financial institutions which make up the British banking system is to collect deposits from those with surplus cash resources and to lend the funds to those with an immediate need for them. This is the func­tion of a financial intermediary. There are many advantages of the funds being channelled through a financial institution rather than being loaned directly by savers to borrowers.

1. Many savers want to save relatively small sums. They
will also want liquidity — the ability to withdraw their
money when they want it. Most borrowers want to borrow
for definite periods of time-often for quite long periods.
Financial intermediaries can aggregate many small sums of
savings and make relatively large loans. They can offer
savers liquidity by borrowing for short periods of time and
lending for long periods. Depositors can be allowed to with­
draw funds because such withdrawals are likely to be
matched by new deposits. If such an institution retains the
confidence of its depositors there is no reason why the funds
available for lending should fall significantly.

2. Savers will tend to look for security — they want to
feel that their money is 'safe'. By spreading its loans over
many different types of borrower, a financial intermediary
greatly reduces the risk of losses. It can take account of like­
ly losses in the rate of interest it charges to borrowers.

3. Financial intermediaries can use their size and exper­
tise to offer savers a wide range of savings schemes and to
offer borrowers several different types of loan.

Some of these financial intermediaries have been dis­cussed earlier for example, insurance companies, pension funds, building societies and finance houses. In this chapter we are concerned mainly with the most important of these institutions — namely, those in the banking sector.

The operations of the main banking institutions are explained later in this chapter. The various services provid­ed by banks are summarised below

(a) The provision of safe deposit faculties for money
and valuables.

(b) The lending of money; this is the most profitable
activity of the banks and the one which provides most of
their income.

(c) The issuing of banknotes: in England and Wales this
right is restricted to the Bank of England, but some banks in
Scotland and Northern Ireland retain the right to issue their
own banknotes.

(d) The provision of efficient money transmission ser­
vices (e.g. cheques, credit cards, standing orders, direct
debits, giro systems and the provision of cash).

In addition to these basic functions, modern banks pro­vide a wide range of other financial services, several of which are described later in this chapter.

The British banking system

1. The Bankers' Clearing House

The transmission of payments by means of cheques cre­ates problems when the person making the payment has an account in a different bank from the person receiving the pay­ment. The final settlement obviously requires a movement of 'money from one bank to another. In any one day there will be millions of cheques which require such inter-bank transac­tions to be carried out. Fortunately, many of these transfers of money will offset each other. There will be a large number of cheques drawn on accounts in Bank A that are payable to accounts in Bank B, but there will also be a large number of cheques requiring a transfer of funds in the opposite direction.

Each bank in a multi-bank system will find itself in this kind of situation at the end of each day. An obvious solution

is for each bank to pay (or receive) the net amount owing after the banks have totalled their claims against each other. This is the function of the Bankers' Clearing House. Cheques which are drawn on one bank but payable to anoth­er are sent to the clearing house where mutual claims are off­set against one another, and the banks merely settle the out­standing amounts. These payments from one bank to anoth­er are carried out by means of cheques drawn on accounts which the clearing banks keep at the Bank of England. On an average day in 1986, some 6—7 million cheques, with a total value of f27000 million, were exchanged and cleared.

The operational members of the London Clearing House are Barclays, the Midland, Lloyds, the National festminster, Coutts and Co., Williams and Glyn's, the Cooperative Bank, the Trustee Savings Bank, the National Giro Bank and the Bank of England. Non-clearing banks have agency arrangements with the clearing banks, although there are proposals to extend membership of the Bankers' Clearing House. There are three Scottish clearing banks, with their own clearing system: the Bank of Scotland, the Clydesdale and the Royal Bank of Scotland.

2. The Bank of England

Most countries have a central bank, which is responsi­ble for the operation of the banking system. The central bank in the UK is the Bank of England, which was taken into public ownership in 1946. It has many responsibilities, which are summarised below and discussed in more detail later in this chapter.

(a) It is the government's bank. It handles the income
and expenditure of the Exchequer and other government
departments.

(b) It is the bankers' bank. The clearing banks maintain
accounts at the Bank of England. The final cash settlements
within the banking system and between the banking system
and the Bank of England take place through these accounts.

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The Bank is also a banker for about 100 overseas central banks and international monetary institutions.

(c) It is the central note-issuing authority for the UK and
the sole note issuing authority for England and Wales. Some
banks in Scotland and Northern Ireland still issue their own
notes but these are largely backed by Bank of England notes.

(d) It manages the national debt. This is a major
responsibility which involves making repayments on govern­
ment securities when they mature, undertaking new issues
of long-term securities, making regular payments of interest
to holders of existing government securities, and handling
the weekly issues of Treasury bills. The management of the
national debt, as we shall see later, has important effects on
the supply of money and the rate of interest.

(e) It is the lender of last resort. The Bank of England
stands ready to come to the assistance of the banking system
in times when it is threatened by a shortage of cash.

(f) It acts as the government's agent in the foreign
exchange market, in which it can intervene to influence the
value of sterling against other currencies.

(g) It has the responsibility for carrying out the govern­
ment's monetary policy.

(h) It has legal powers to supervise the operations of other banks. All banks are expected to supply the Bank of England with information about their business, and they have to respond to directives given to them by the Bank.

Although the Governor of the Bank of England has a certain amount of independence and his advice is sought and heeded, the Bank is subordinate to the Treasury which may give instructions to the Governor at any time.

Nationalisation and Privatisation Arguments far nationalisation

1. Monopolies. The technical conditions of production in some industries are such that competition would lead to a

wasteful use of resources. Competition in the distribution of gas, electricity, water and telephone services would lead to a costly duplication of the networks of mains, pipes, cables, etc. which are required to supply these goods and services. It is also argued that the full potential economies of scale can only be obtained by one undertaking operating on a nation­al basis. There are arguments for monopoly rather than for public ownership. The arguments for nationalisation are that

(a) these basic industries should be operated in the
national interest and not with a view to private profit, and

(b) only public ownership can ensure that a powerful
monopoly position will not be used to exploit consumers.

 

2. Adjustment to changing conditions. One of the main
arguments used in presenting the case for public ownership
when basic industries such as steel, coal and the railways
were nationalised was that only the state could and would
provide the very large injections of capital which were need­
ed to restructure and modernise these capital-intensive
industries, which had become badly run down during the
Second World War.

3. To help manage the economy. A further argument for
having a large sector of the economy directly under govern­
ment control is that it can be used as a powerful lever to con­
trol the economy. During a recession, for example, the
investment programmes of the nationalised industries can
be increased and, via multiplier effects, will help to stimu­
late an increase in income and employment. In the past,
governments have used their powers to restrict price increas­
es by nationalised industries as a means of reducing the rate
of inflation. This use of government power, however, makes
it very difficult for the nationalised industries to carry out
long-term planning.

4. Social costs and benefits. Social costs and benefits may
be quite different from private costs and benefits, owing to

externalities. Generally speaking, privately-owned firms will only undertake production if private benefits (revenues) are greater than private costs; they will not take account of externalities. Nationalised industries, charged with operat­ing in the public interest, will be under strong political and social pressures to give much more attention to externalities. They may be obliged to operate some loss making activities where social benefits are clearly greater than social costs — for example, rural, postal and transport services. The gov­ernment has recognised these social obligations and, in some cases, provides subsidies for such non-commercial operations.

5. Political arguments. The motives for nationalisation are political as well as economic. It is a central theme of socialist policy that the means of production should be owned by the state. Socialists believe that public ownership enables people to exercise full democratic control over the means whereby they earn their living and provides an effective means of redis­tributing wealth and income more equitably.

Ownership or control

It is possible that the purely economic objectives of state control may be achieved without resorting to complete pub­lic ownership (i.e. nationalisation). There are various ways in which a government can control the policy and perfor­mance of privately owned enterprise.

1. it may control the industry's prices, profits, and div­
idends.

2. It may take up shares in public companies and place
its representatives on the board of directors.

3. It may exercise constant supervision of the costs and
marketing policies of the firms in the industry.

4. It may take over the wholesale stage and hence con­
trol the prices received by the producers and those charged
to distributors.

5, It may lay down technical specifications governing the quality and performance of the industry's products, or, through a system of licensing, control the nature of the ser­vices provided by the industry.

As for some of the other objectives, a redistribution of income may be achieved by subsidies on the prices of certain goods, or by a straight transfer of income to the poor, and social costs may be dealt with by taxing those who create the social burdens (e.g. 'taxing the polluters'). These alterna­tives would, of course, be unacceptable to those who are politically committed to public ownership.

Efficiency of public enterprise

Serious problems arise in trying to judge the efficiency of public enterprise. Efficiency is a measure of success in achieving a given objective, but if the objective includes such non-measurable elements as 'operating in the best interest of the public', then any single measure of efficiency is mis­leading.

The fact that a nationalised industry makes a profit can­not be taken as an indication of efficient operation because the industry may have used its monopoly powers to raise prices. Likewise a substantial loss does not necessarily imply inefficiency because a nationalised industry may be obliged, for social reasons, to operate unremunerative services, or its prices may be held down as part of the government's defla­tionary policy.

Movements in labour productivity are often used as a guide to changes in efficiency, but these too can be mislead­ing. In fact, labour productivity in several of the British nationalised industries has risen faster than the rates for industry as a whole. This measurement however does not take account of the degree of capital investment which has taken place and increases in output per unit of capital have often been relatively low.

It is also difficult to use performance elsewhere as a guide to efficiency since industries in the private sector do not offer any true basis for comparison. The performance of the industry relative to the performances of the same indus­tries in other countries may be a better guide, but here again there are many special factors to take into account. For example, in comparing productivities in coalmining the geological conditions may be very different in the countries being compared.

We must remember, too, that the performances of Britain's nationalised industries have been affected by the way in which they have sometimes been used as an instru­ment of economic policy. Although most of them are monopolies, they cannot be too complacent because they operate in a competitive framework to the extent that there are substitutes for their goods or services (e.g. coal v. oil, gas v. electricity, road v. rail).

Pricing policy

The Acts which established the nationalised industries merely said that prices should be related to costs but did not specify the nature of the relationship. The simplest method of ensuring that total revenue covers total cost is to make price equal to average cost. For many of these industries, however, the costs of supplying one group of consumers can be very different from those of supplying another group. For example, in the case of the railways, the cost per passenger mile on the busy inter-City routes is much less than that on suburban branch lines where trains are normally running with a lot of excess capacity. If fares on all lines were based on average costs for the whole network, passengers on busy lines would be subsidising those on other lines.

There has been much discussion on the subject of mar­ginal cost pricing as a basis for fixing the prices of the com­modities supplied by the nationalised industries. In theory,

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when price is equated with marginal cost we have the optimum allocation of resources. If we assume that price is a good indi­cator of marginal utility and that marginal cost measures the opportunity cost of the resources used to supply the marginal unit, then output should be expanded up to the point where Price = MC and no further. Additional units of output would yield satisfactions which were less than the value (in alternative uses) of the resources used to produce them, because the prices of these units would be less than their marginal costs. Unfortunately, it is very difficult to obtain any precise measure of marginal cost. Another problem with this scheme is that when the industry is operating under conditions of increasing returns, marginal cost will be less than average cost so that, if Price = MC, the industry will be making losses. If it is operat­ing under diminishing returns, marginal cost will be above average cost so that, if Price = MC, the industry will be mak­ing abnormal profits. Nevertheless there has been some move­ment towards marginal cost pricing for particular products and services (e.g. the two-part tariff for electricity).

In practice, the nationalised industries in the UK have not been given complete freedom in determining their pric­ing policies. For considerable periods they have been subject to restraint, either because the government wished to reduce inflationary pressures, or because the public has come to expect low prices in the public sector. This policy can lead to a misallocation of resources. If the private sector charges prices which yield profits while the public sector just breaks even or makes a loss, then public sector goods are under-priced, in terms of the resources used, compared with private sector goods. These 'artificially' lower prices will lead to larg­er quantities of public sector goods being demanded than would be the case if prices fully reflected costs in both sec­tors. More resources will be drawn into public sector pro­duction than consumers would 'vote' into that sector if the prices they paid were truly indicating the costs of production.

Financial objectives

Since the nationalised industries are state owned, the government is responsible for meeting any debts incurred by these industries. The nationalised industries do not borrow from the domestic market other than for short-term bor­rowing. Instead they borrow from the National Loans Fund and the government, in turn, borrows from the market. This means that the provision of external funds to meet the cap­ital requirements of these industries has a direct effect on the borrowing of the public sector. In its attempt to control the growth of the money supply (and market rates of inter­est), the government is concerned to exercise strict control of public sector borrowing.

The government has, therefore, introduced a system of external financial limits (EFLs) which control the amount of finance (grants and borrowing) which a nationalised industry can raise in any financial year from external sources. Further features of the financial framework which the government has created for the nationalised industries concern,

(a) some target for the industries' profits, and

(b) the basis on which investment decisions are made.
A government White Paper published in 1978 declared

that an adequate level of profit was essential for the well-being of the nationalised industries; it would enable them to make contributions to their investment programmes and keep down their borrowing requirements on the economy. To this end the government established a financial target for each industry. This target takes the form of some given per­centage return on the net assets employed by the industry, each industry being given a different target.

The second feature of financial control uses the idea of the opportunity cost of capital. Investment plans of the nationalised industries should only proceed if they are expected to earn a rate of return of 5 per cent in real terms.

This figure was decided upon because it had been calculated that 5 per cent was the average real pre-tax return achieved by private investment. In other words it represented the opportunity cost of capital to the nationalised industries.

In setting financial targets as a measure of performance, the government has been obliged to allow the nationalised industries much greater freedom in setting their prices. In addition the government has agreed to compensate these, industries for activities which are classified as 'public service obligations'. For example, the railways receive a grant towards the cost of keeping open lines (for social reasons) which they would otherwise choose to close.

Arguments for privatisation

\. Raising revenue for the government. By 1987 privatisa­tion has generated f 25 billion in revenue for the govern­ment; it is estimated that it will raise a further f20 billion over the next four years. This revenue clearly makes it possi­ble for the government to reduce its borrowing and to make tax cuts without reducing its own spending. However, pri­vatisation has been likened to 'selling the family silver'. The most marketable of the nationalised industries are obvious­ly those which are the most profitable. Once they are priva­tised, the state loses the future net revenues from these industries. Much depends upon how the state uses the rev­enues from privatisation. If it is used to finance tax cuts, will taxes have to be raised again when the privatisation pro­gramme has run its course? If it is used to reduce the gov­ernment's debt, it will help to reduce the future tax burden,

2. Increased competition and efficiency. It is argued that the private sector has the spur of competition, since ineffi­ciency is punished with bankruptcy. State-owned enterpris­es cannot go bankrupt because the government guarantees their borrowings. This contrast persuades the supporters of privatisation that industries and firms transferred to the pri-

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vate sector will be more efficient organisations. They believe that managers of privatised firms will be freed from political control and interference — they will be able to charge the prices they regard as commercially sensible and to make the investments they think will pay.

But in cases such as British Telecom and British Gas, competition in their main activities is virtually impossible — they are natural monopolies. The state is left with the task of ensuring that these monopoly positions are not abused. It is also extremely doubtful whether, in many cases, the threat of bankruptcy is a realistic sanction — would the govern­ment allow a major basic industry to go bankrupt? Nevertheless, in 1987, it seemed that several of the priva­tised firms had benefited from the discipline of the market.

3. Wider share ownership. The broadening of share own­ership is another aim of privatisation. The idea is to shift ownership away from the state and large institutions towards individuals. Privatisation has been largely responsible for the increase in the number of private shareholders from 2.5 mil­lion in 1979 to more than 9 million in 1987. This has been accomplished because the sales of shares in privatised undertakings have been arranged so that small investors have been given preferential treatment. This has also been true of the workers in the industries being privatised. More than 90 per cent of British Telecom's employees bought the shares they were offered when the enterprise became a public lim­ited company.

PART 3