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Would a Competitive Exchange Rate Strategy really work?

By John Mills

The Pound Campaign has long maintained that the biggest single reason for the lack-lustre performance of the UK economy over a long period – but particularly more recently – is that the exchange rate has been – and still is – far too high.

Our strong pound has not been a major disadvantage for services, where we have substantial special natural advantages – our geographical position, our language, our legal system and universities, and the pools of talent supporting them. UK services can therefore live with £1.00 equals as much as $1.50 as testified by our consistent services net trade surpluses – £112bn in 2017.

Unfortunately, the same cannot be said for manufacturing, where price as well as quality competition is much fiercer, where we have no natural advantages, and where we therefore have a large deficit every year. This was £137bn on goods as a whole in 2017 and £93bn on manufactures alone. In the same year we had negative net income from abroad of £32bn and net transfers overseas of £21bn, leading to a total – and unsustainable – balance of payments deficit of £83bn – 4.1% of our GDP.

If we are ever going to rebalance our economy, so that we can pay our way in the world, we therefore need to sell more abroad and to import less (at least relatively) than we do now. Since services are not very price sensitive but much more difficult to sell abroad in proportion to our GDP than goods, the only real solution to our foreign payments imbalance is to improve our trade balance in manufactures. The problem is how to get this done.

The conventional wisdom in the UK is that there is no solution to this problem other than to apply ever more rigorously the many supply-side remedies which have been canvassed for year after year. On the left of centre, these tend to consist of industrial strategies, embracing objectives such as more education and training, increased research and development, changes to company governance to achieve less “short-termism” and more patient shareholding, more readily available sources of finance for industry, and improved infrastructure. On the right of centre, the emphasis is much less on activist government intervention and much more on lower taxation, increased deregulation, more privatization, a larger role for the private sector and a smaller range of functions generally for the state.

The Competitive Exchange Rate Strategy contention is that none of these supply-side policies will ever work successfully on their own. However, desirable they may be in the right circumstances, in the absence of demand-side policies to complement them they will not achieve any significant improvement in the UK economy’s performance. To rebalance the UK economy and to get the economy and get it to grow more quickly we have to make our international position much more competitive and the only effective way we will do this is by having a much lower exchange rate – with the pound sterling roughly on par with the US dollar, about 25% lower than it is at the moment.

Would such a policy work? Some elements of such a switch in policy may cause difficulties but are clearly achievable. Significant innovative steps would need to be taken to get the pound down and to keep it there. We would have to persuade our trade partners not to retaliate. We would have to shift a significant proportion of our GDP out of consumption and into investment, with tricky implications for living standards. We would have to find the entrepreneurial talent to take advantage of new economic opportunities. None of this would be easy but would clearly be possible.

Whether a Competitive Exchange Rate Strategy would then work, however, depends on three key metrics, all partly although not entirely under government control, having roughly the right values, without which a Competitive Exchange Rate Strategy will not be successful. First, exports and imports would have to be sufficiently price responsive to keep the balance of payments under control. Second, the return on investment would have to be high enough to support the transition to a much higher growth rate. Third, the impact of move to a much lower exchange rate would have to entail a manageable impact on inflation. Would these conditions be fulfilled?

The Price Elasticity of Demand for Exports and Imports  

The condition to be met to ensure that the economy can be expanded without running into unmanageable adverse foreign payment balances is that the responsiveness to price changes of both exports and imports has to be sufficiently large for the trade balance to improve. More specifically, the price elasticity of demand for exports and imports has to sum to well above unity. There is plenty of evidence that, in the past, this condition was met by the UK economy. More recently, however, the position seems to have deteriorated, because so much price sensitive low- and medium-tech manufacturing has gone from the UK economy as we have deindustrialized. This leaves largely only relatively price-insensitive services and high-tech manufacturing available to sell abroad, the consequence being that there is less of our economy available to respond in price sensitive ways to increased export demand and import saving opportunities

The way to see how this problem can be solved is to recognise that export and import price elasticities divide into two categories. With a lower pound the initial reaction among exporters is to squeeze more production out of existing capacity. This is, however, inevitably a limited approach. What is really needed to sustain increased production is to get new plant and equipment installed, so that there is no effective limit to the increased output which can be achieved. This will only happen, however, when overall production costs for low- and medium-tech manufacturing are sufficiently competitive to tip the location balance in favour of the devaluing economy. This is the way, however, to ensure that price elasticities for both exports and imports are sufficiently high for the foreign payments balance not to be a constraint on getting the economy to grow faster.   

The Social Rate of Return on Investment  

Why do economies grow? What changed when the Industrial Revolution began, and living standards started to rise exponentially? It was the systematic application of three new sorts of investment – in power, mechanization and technology – which fuelled the huge increase in living standards we have seen over the last 250 years. It is still largely only these three types of investment which are responsible for all economic growth. The problem in the UK – as the table below shows – is that we both invest far too little of our national income every year and we get an exceptionally poor return on the money we do spend. This is why our productivity growth is so low and why our rate of economic growth and our ability to increase most people’s real incomes is so poor.

 


 

GROSS INVESTMENT, SOCIAL RATES OF RETURN AND GROWTH RATES

FOR SELECTED COUNTRIES AND PERIODS

 


Country


Period

Gross Investment

as a % of GDP

Average Social Rate of Return

Average Growth Rate

UK

1934-1941

14%

37%

5.6%

USA

1939-1944

7%

144%

10.1%

Japan

1953-1970

29%

35%

10.1%

China

2002-2012

37%

25%

9.1%

Korea

2005-2016

30%

12%

3.5%

Singapore

2005-2016

26%

20%

5.3%

UK

2005-2016

17%

8%

1.4%

World

2005-2016

26%

14%

3.5%

NB the Gross Investment figure for the USA for the period 1939 to 1944 covers private investment only, so the average Social Rate of Return for the US economy as a whole must have been lower than 164%.

 

Our problem is not only that total investment is much too low but also that we invest almost nothing – and probably an overall negative figure after deprecation – in machinery, power and technology. The major reason for this state of affairs is that this type of investment tends to be found in the private sector where profitability is key – and with the pound as strong as it is, very little has any prospect of producing a positive return. Our overvalued pound makes it unprofitable to invest in the sorts of investment with the highest return because the overhead costs, which have to be charged out to the rest of the world, involved in siting them in the UK, are too high for them to be competitive. It is then more cost-effective to site new facilities in countries – such as China, Germany and Holland – with have much more competitive exchange rates than we do.

Devaluation and Inflation  Devaluations will always make imported goods more expensive but they also tend to lead to lower interest and tax rates, longer production runs, diversion from foreign to now newly cheaper local suppliers, higher productivity  and a better wages climate. For all these reasons, the amount of extra inflation caused by devaluations ends to be much lower than is conventionally expected – as the figures in the table below show.  

 


Year of

Devaluation

Overall

Devaluation  percentage

Inflation previous year

Inflation devaluation year

Inflation devaluation year + 1

Inflation

devaluation

year + 2

Inflation devaluation  year +3

1931

25%

-1.7%

-10.1%

-9.9%

-6.6%

+5.5%

1949

31%

5.1%

2.4%

2.7%

9.9%

6.3%

1967

16%

3.9%

2.7%

4.8%

5.4%

6.3%

1992

15%

5.9%

3.7%

1.6%

2.5%

3.4%

2008

22%

2.3%

3.6%

2.2%

3.3%

4.5%

2016

9%

0.1%

1.3%

2.6%

2.4%

 

 

Even if there is some extra inflation, however, as a result of a much more competitive pound, most people would surely judge that this was a price worth paying for a much faster rate of economic growth. In the end, it is not the cost but the standard of living which counts – and the only way to get the growth rate up is to get productivity to increase, not to be obsessed by holding inflation as close as possible to 2% per cent per annum.

Of course, there are always risks with any policy mix, but the downsides from the Competitive Exchange Rate Strategy look very low compared with having another decade during which most of the population sees no increase – and probably a decline – in their living standards. This is the huge risk we run by maintaining the status quo.   


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Labour Future’s purpose is to steer the Labour party towards two key aims: reconnecting with the working class base, and reshaping the British economy towards a more manufacturing based, high wage, high job security, and resilient economy. Only by addressing these core issues can Labour win the support of the country.

Secondly, we must reshape the British economy towards a more manufacturing based, high wage, high job security, and resilient economy. We need a competitive exchange rate, and an environment that encourages long term investment over short term profiteering and asset sales.

Only by addressing these core issues can Labour win the support of the country.