Speech on the Economy: Currency Fluctuations
| Thursday, November 17, 2016
My Lords, I, too, thank the noble Baroness, Lady McIntosh, for making this debate possible. The most dramatic economic effect of the United Kingdom’s Brexit vote has been the collapse of sterling. Since June, the pound has fallen by about 16% against a basket of currencies. Mervyn King, the former Governor of the Bank of England, has hailed the lower exchange rate as “a welcome change”. Indeed, with Britain’s current account deficit in the order of 7% of GDP—by far the largest since records started—depreciation could be regarded as a boon. But is it? That is the subject of our debate today.
There are two things to consider. The first and most urgent is the effect of sterling depreciation on our payments to, and receipts from, the European Union’s budget. The second is its effects on our economy. I do not want to say much about the first, but I think the headline answer is fairly straightforward. As Britain’s contribution is fixed in euros, Britain will have to pay about £700 million more to meet its EU budget obligation next year, but devaluation will also make the British economy smaller in terms of euros, so its required euro contribution based on GDP will go down. The two effects should cancel each other out. On the other side, it will receive fewer pounds from the EU budget, so farming support subsidies, for instance, will go down, as the noble Baroness, Lady McIntosh, pointed out.
All this will complicate Mr Hammond’s budget arithmetic, but the budgetary problem is a secondary matter compared to the effects of sterling movements on the economy. Larry Elliott, economics editor of the Guardian, argued on 16 October:
“The current account deficit will shrink as a result of stronger exports from the manufacturing and service sectors, the boost provided to the tourism industry, and because cheaper domestic goods and services will be substituted for more expensive imports. To say that dearer imports will make life more difficult for consumers is to miss the point. That's how rebalancing works”.
However, one could say that, in some ways, Mr Elliott has missed the point, because the argument assumes that sterling depreciation will cause an increase in the demand for British exports and holidays that foreigners want to take in Britain. Quite simply, foreigners will have to pay less of their own currency to buy British goods or enjoy holidays in this country. Certainly, consumers and many businesses will take a hit, but this will be offset, it is said in the Elliott argument, by increased export demand, which will increase employment, profits and wages. So the effect on our living standards, on this argument, will be very small.
However, if all that depreciation of sterling does is make imports more expensive, the rebalancing of the accounts works simply by making us poorer. If domestic demand falls sufficiently that we will no longer be able to afford the same amount of imports, that is the way a rebalancing through imports works. There may be some uptake in tourism but we have to recognise that the price effect is partially offset by the weather effect. However cheap we make holidays in Britain, holidays in the Mediterranean will continue to be more attractive. The essential point is that you can always get back to a balanced position by making a country too poor to import on the old scale. That is roughly what has happened in much of the single currency area, with countries such as Greece and others. They have rebalanced their accounts, admittedly under a different exchange range regime, just by reducing their standards of living.
What does the evidence tell us about the effect of exchange rate changes on the economy? It tells us that the effect of sterling depreciation on the demand for our exports is small. On the one hand, demand for our exports and our own demand for imports are price inelastic, as the economists like to say—a fall in sterling means that we spend more money on imports but without increasing our exports; on the other hand, even if the demand for our exports is increased, we do not have enough exporting capacity to take advantage of it.
In 2008-09, when the rest of the world was on the verge of deflation, the UK was experiencing an inflationary recession, with GDP contracting at a top rate of 6.1% annually, while inflation reached 5.1%. This occurred because sterling fell more than 21%—peak to trough—from 2007 to 2008. Moreover, although the current account deficit subsequently narrowed, the improvement was only temporary. After 2011, the current account deficit started to widen again, even though the pound never clawed back its losses.
In fact, this has been a problem ever since the late 1950s. Whenever we get close to full employment, imports start to rise faster than exports. When sterling was fixed to the dollar, Governments reacted to the widening trade imbalance by slowing down the economy for a year or so, causing imports and the trade deficit to fall. Then we took off again and the deficit widened again. That was the pattern of the 1950s and 1960s. Since the pound started floating in the 1970s, a widening of the deficit has been met by currency depreciation, but this has not basically altered the pattern. With short intermissions, the pound has just continued sinking, without the vaunted recovery of competitiveness. Who now recalls that £1 was worth $4.03 in 1967?
It is hard to avoid the conclusion that the basic reason for this pattern of events has been the continued decline in our manufacturing industry. This has accelerated in the past 40 years from around 28% of gross value added in 1978 to less than 10% today. As the economist Nicholas Kaldor pointed out quite frequently in this House, because manufacturing has higher returns to scale than services, manufacturers benefit more from devaluation than services. We have restricted the advantage of devaluation by restricting our manufacturing sector.
In addition, as has been pointed out, structural reforms since the mid-1990s have ensured that British exporters are deeply integrated within global supply chains, As a result, many of Britain’s exports require imported inputs so that when sterling depreciates and import prices rise, the knock-on effect on export prices renders them less competitive. The most recent OECD data show that the import content of UK exports is around 23%, compared with around 15% for the United States and Japan.
For the moment, the UK is relying on capital inflows into the City of London to limit sterling’s fall. But, as the exchange rate collapse of 2008 showed, this source of foreign demand for sterling is highly unstable. When the worm inevitably turns and the flows reverse, both sterling and exports will take another hit. The bottom line is reasonably clear: we cannot rely for continued prosperity on exporting financial services—valuable though these are—the amenities of London and selling attractive old properties to foreigners. A very small country might live off services of this kind, but we cannot.
What is to be done? Here I might step out of line with what other noble Lords think. I think the only rapid government action that will work is to substitute goods currently imported with domestically produced goods. The classic way of doing this is through import controls but other measures less damaging to trade rules and international amity are available. The national investment bank that the Labour Party is advocating could be given a mandate to invest in industries with a high import substitution potential. That is one way. An alternative would be to subsidise such industries directly from the Exchequer, with subsidies tied to the quality-adjusted price of the import being substituted. As the domestically produced goods become competitive with the foreign goods, the subsidies would be reduced and the industry allowed to stand on its own two feet.
There are problems with both solutions, which I would be the last person to want to minimise, but something has to be done. If nothing is done, we risk permanent impairment of prosperity. A depressed economy can be reflated and an inflationary economy can be depressed, but losing access to crucial foreign markets through uncontrollable movements in the exchange rate is largely irreversible.
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