In the City
The Thirteenth District
To Rudd
The reality of the present situation in London's markets is that practically everything is determined by what is happening in America. In particular the level of interest rates, on which the whole structure of Market values ultimately depend, is keyed into the level of rates set by the policy of the monetarists in Washington operating through their chosen instrument of the Federal Reserve system. One way of recognising the reality of the situation would be to make the United Kingdom the Thirteenth District of the Federal Reserve System. A consequence of that would of course be to transform the Bank of England into the Federal Reserve Bank of London.
Its relationship with the board of governors in Washington would be approximately the same as that between the board and its quasi-independent operating arm in New York, the Federal Reserve Bank of that City. Such a plan might receive less than total support from those who work in and purport to run the Bank of England, but they might well appeal to Mrs Thatcher, Whose economic philosophy would at one stroke receive the benefit of the influence and support of her natural allies in the Present Reagan administration in Washington. The only fact which prevents this sort of thing coming to pass is basically that the two currencies, the pound and the dollar, are separate entities. The fact that the influence of the one over the other has become for the time being almost total doesn't eliminate the fundamental distinctness of the two.
In looking ahead to divine what these forces might be the clue may be found in the Ultimate impact on markets of President Reagan's taxcutting programme. He has had a remarkable success in getting this through Congress. Certainly he has surprised most of the more sophisticated financial observers on Wall Street, whose reports have been read during the past few months in London. The general expectation was that the administration would be stopped from achieving its budgetary targets by the Democrats. Considerable comfort was drawn on both sides of the Atlantic from this prospect. Now that it has been proved wrong and Mr Tip O'Neill, the House Democrat leader, has been defeated in detail, we face a very different and somewhat worrying picture. The President has got away with everything that he wanted on the tax-cutting front. This means that, if any semblance of fiscal balance is to be retained next year and in 1983, swingeing cuts will have to be made in expenditure.
Everybody knows that these cuts will not be coming from defence, which is sacrosanct, and because of the way that modern technology costs double the number you first thought of every time the budgets are looked at, it is an escalating factor at all times. So the knives will have to fall on social expenditure of all kinds. This is where the policy of Mrs Thatcher's government went astray. When it comes to it, cutting social expenditure is extremely difficult. Even where there is a will to achieve a lower level of expenditure, the actual live victim keeps slipping out of the clutch of the man with the knife. In other words, it's all very well for the Democrats in Congress to have voted tax cuts; it's going to be a very different matter when they asked to vote for expenditure cuts which affect their consn tuents. The likelihood must be that the cuts will not be made in the size and by the timetable which have been made necessary by the enthusiasm shown by all concerned for the first leg of the exercise. This is an extremely important point to get right.For if there is serious slippage in maintaining a budgetary balance, the the outlook, affecting us all and particularly in the City, is going to be much affected.
The first and most important impact of such a development would be that the weight of achieving overall balance in the economy would once again be thrown on to the Federal Reserve system. In other words, with too little revenue coming in to support budgetary expenditure which overall is not being trimmed back (when allowing for the increase in defence) there will be a natural trend towards an increase, once again, in inflation — too much government-produced money chasing too few goods. At that point the natural monetarists in the administration, who are still riding very high, will assume the burden of making up the difference. This they will do in the time-honoured way of cutting back in the private sector by using the interest rates weapon once again.
So the prospect may well be a switchback in interest rates in both London and America over the next twelve months. There will be a fall in interest rates this autumn and winter as the inflationary pressures in the US economy abate and this economy itself goes into recession. That will provide welcome relief all over the world. But just round the corner there will be this renewed hike in interest rates to come, probably in mid-summer 1982 and certainly by the autumn. Not an agreeable prospect but at least forwarned is forearmed.
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