Britain's dysfunctional economy cannot last - but we can fix it

Because sterling is much too strong, manufacturing as a percentage of GDP in the UK has shrunk from 32% as late as 1970 to the unviable level of barely 10% now.

John Mills
2 March 2015


Most manufacturing operations, as is confirmed by the Office for National Statistics, (ONS) have a cost structure which clusters round about one third of charges being those for which there are world prices while two thirds are determined by local cost conditions. Typically there are world prices for raw materials and plant and machinery and locally determined prices for more or less everything else. The cost base comprises all of the charges which are incurred in the local currency. In our case, of course, this is sterling.

The cost base is made up of a very wide variety of charges – including everything from travel expenses to audit costs, from fuel bills to cleaning charges, from repair bills to postage costs, from insurance premiums to printing and stationery. It includes direct labour costs but also interest charges, rent and the need for a level of profitability. Rather more than half these charges are essentially labour costs because compensation for employment represents about 55% of our Gross Domestic Product (GDP). The remaining 45% is made up of what is received as unearned income in the form of payments for inputs such as rent, interest and dividends.

There is a stark contrast between those costs which are determined by world markets and those incurred domestically. Measured in an international currency such as dollars, everyone all over the world has to pay more or less the same amount for inputs, particularly raw materials and plant and equipment, for which there are world markets. The charges for domestically incurred costs, however, can and do vary enormously, measured in international terms, such as in US dollars. The rate at which all these domestic costs are charged out to the rest of the world depends almost entirely on the exchange rate. If the currency is strong, measured in international currencies these costs will be high and the price for goods to be exported will seem to foreign buyers to be expensive and, conversely, if the domestic currency is undervalued they will seem cheap.

Some simple maths shows how powerful influence of the exchange rate is on export costs. Between 1977 and 1981, the UK’s exchange rate rose by about 60%. Measured in world prices, the costs of raw materials and new machinery stayed the same but all the cost base costs rose by 60%. This meant, as a first approximation, that UK export costs, measured in international currencies, rose by two thirds of 60% - about 40%. This did not affect some export industries very much because they were in non-price sensitive markets such as aerospace, arms, pharmaceuticals and perhaps vehicles. All these industries are protected by long and complicated supply chains, high levels of expertise and experience which take a long time to accumulate, patents and other forms of intellectual protection, strong brands and sometimes competitors in other countries, such as the USA, where exchange rates also strengthened enormously. It did, however, have a devastating impact on manufacturing which was not protected in these ways and where therefore sales were much more price sensitive.

The situation was then made much worse by what happened in the East. Whereas most countries in the West, heavily influenced at the time by monetarist doctrines, adopted policies which greatly increased their exchange rates, very different policies were adopted round most of the Pacific Rim. In China, there was a huge devaluation of the renmimbi, by about 75% between the 1980s and the 1990s, as the graph shows.

Big exchange reductions were also implemented by many other Asian countries, following the 1997 Asian financial crisis. The Korean won, for example, fell by about 50% and the Malaysian ringgit by 35%. Because, as the graph shows, countries such  as the UK, far from taking action to ensure that their economies remained reasonably competitive, allowed – or even encouraged – their exchange rates to become  ever higher; their industries exposed to price competition were completely unable to compete.  As a result, most countries in the West rapidly de-industrialised.

This matters hugely for three reasons. The first is that productivity in much easier to increase in manufacturing than it is in most service industries. If you replace a machine which makes one unit with one which produces two, you double productivity whereas changing organisations to make them even five or ten per cent more efficient is extremely difficult. Second, manufacturing produces a far better spread of high quality and well paid jobs both regionally and in socio-economic terms than is the case in services. Third – and perhaps most crucially – most international trade is in manufactured goods, even for a country such as the UK with a very weak manufacturing base, and if we do not have enough to sell to the rest of the world, we cannot pay for our imports. This is exactly what has happened to us.  We have not had a visible trade surplus since 1982 or avoided an overall balance of payments deficit since 1985 – now 30 years ago. The resulting deficits have sucked demand out of the economy causing slow growth, rising unemployment, increasing inequality and ever rising debt.

The consequence is that the UK economy is now almost incredibly unbalanced. As a result of slow growth feeding on itself the proportion of our national income which we invest in the future – at barely 14% excluding research and development – is now one of the lowest in the entire world, where the average is 24%. In China it is 46%. We now have too little manufacturing in the UK for us to be able to pay our way and as a result we have a massive balance of payments deficit - about £100bn in 2014 with a higher figure still expected in 2015. To make up for the national income which we enjoy spending but which we are not earning, we continue to sell off vast quantities of national assets and to borrow huge sums from abroad, which is why both the UK economy as a whole - and the government in particular - are getting deeper and deeper into debt. What growth we have is very largely driven by consumer demand, fuelled by asset inflation on a scale which is completely unsustainable and cannot last.

What can we do to remedy this situation? There are plenty of things which need to be done on the supply side of the economy – to improve our education and training, for example, and to upgrade our infrastructure, to install faster broadband, and to update our planning procedures. But we also need to act on the demand side. We need to provide the right economic incentives to get people to invest on a big scale where investment is really needed – and the place where the highest returns are to be found, given the right conditions, is in light relatively low tech industry. To make this occur, we need to ensure that investment of this type is highly profitable – and to do this we need to make sure that the cost base is low enough for UK pricing – both for exports and for import substitution – to be competitive.

How much lower would the exchange rate need to be to make this happen? It depends on what we want to try to achieve, and there is a simple trade-off. The lower the exchange rate, the more competitive the cost base will be, the more response there will be from both exports and imports, and the faster the economy will grow. Careful modelling of the economy shows that if the exchange rate stays at $1.50 to $1.60 to £1.00, the economy will barely grow at all for the foreseeable future. At $1.00  to $1.10 to £1.00, with an equivalent reduction in the exchange rate to other currencies such as the euro, within five years the economy could be growing at a sustainable rate of 4% to 5% per annum.

Is this possible? You have only to look round the world to see that it is. The common factor between all the economies which have grown fast since World War II has been that they have all had low exchange rates, competitively priced cost bases and successful exports. Outstanding examples include most of Western Europe during the 1950s and 1960s, Japan through until the 1980s, the Tiger economies (Singapore, Hong Kong, Taiwan and South Korea) right up to now, and of course China, which has grown by around 10% per annum for every decade since the 1980s. Why has the UK missed out? Because we have always tried to keep our exchange rate as high as possible rather than realising how crucial it is to keep it down to a competitive level.

It is not an exaggeration to say that it is perverse attitudes to the exchange rate – either ignoring it completely or favouring it being maintained at completely unrealistic and uncompetitive levels - which have very largely been responsible for generating the chronic weaknesses from which the UK economy suffers. If we deliberately – or by default – continue to charge out our cost base to the rest of the world at levels which are far above the world average, then the consequence will be continuation of our all too obvious decline in share of world trade, constant balance of payments problems, slow or non-existent growth, rising inequality, increasing debt, and relative if not absolute national decline. Relatively developed and well diversified economies like that of the UK need realistic exchange rate policies just as much as they need stable fiscal and monetary strategies. When all three economic policy components pull in the same direction, spectacularly successful economic outcomes become relatively easy to achieve. When the crucial cost link between our economy and all the rest of the world is either ignored or misjudged in the way we have seen in the UK, the inevitable consequence will continue to be the kind of desperately poor economic performance we have seen as our political institutions slowly fragment under the strain of completely unnecessary austerity, stagnant living standards and the inability of our political leadership to achieve tolerably successful economic outcomes.

This article is part of the There is an Alternative series. An economist and entrepreneur, John Mills is Chairman of JML. He recently established The Pound Campaign to raise awareness of the uncompetitive exchange rate and the effect it is having on UK manufacturing and the wider economy. John Mills sits on openDemocracy's board and is a supporter of OurKingdom.

John Mills is a donor to openDemocracy.

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