Current discussion of British economy policy is divided between those who argue the Keynesian case for fiscal expansion in order to secure recovery from the slump, and those who claim that fiscal expansion is impossible in present circumstances, or undesirable anyway, and that we need policies that lead to sustainable (ie.,long run) economic growth. John Mills’ ‘A Price that Matters’, which concentrates on exchange rate policy, usefully straddles this divide. A lower value for the pound can produce both a temporary boost to exports and improve Britain’s long-run competitiveness. However his paper suffers from concentrating on only one aspect of a complex problem.
Mills’ argument is that, whatever fiscal policy we adopt, the only way that the British economy will be brought back to growth is by devaluing the pound – not by a little, but by up to 25%. For decades, he argues, obsessive focus on keeping down inflation has resulted in an exchange rate which erodes any chance of a competitive domestic manufacturing industry.
The overvalued pound is not only responsible for the loss of industries and the rise in unemployment but also the subsequent inability of the British economy to pay its way internationally. We run a huge trade deficit which has to be financed by borrowing. In other words, by winning the battle on inflation we have lost the battles on competitiveness. Now is our last chance to arrange an ordered devaluation to break the spiral of anaemic growth, de-industrialisation and indebtedness. If we wait, loss of creditor confidence will see the pound diving uncontrollably.
It is a powerful argument with all the ingredients of a good action movie: a villain, a solution, and a tight deadline. The international price of the pound clearly does matter a good deal, and a debate on exchange rate policy is long overdue. But Mills’s argument – despite impressive theoretical and empirical density – runs the risk run by every action movie: to keep the audience enthralled the story has to be kept very simple. Too simple, in fact.
Devaluation is unlikely to be the panacea that Mills makes it out to be. The clearest illustration of this is events since 2007. The average annual effective exchange rate has gone down by some 23% over the last four and a half years – approximately the devaluation that Mills urges us to undertake – yet we have seen neither neither economic recovery nor industrial renaissance. In fact, as Mills himself point out, the trade deficit grew during the 2007/8 devaluation.
To be effective, an aggressive exchange-rate policy requires an aggressive industrial policy that ensures that there are British firms able to enjoy the benefits of a cheaper pound: you can’t sell what you don’t make. Unless British workers are willing to accept wage cuts of 90%, British companies will never be able to compete with Asia on a cost basis alone. Asian manufacturing did not rise because of the rise in the pound and it will not go away in the wake of devaluation. Rather, the Asian manufacturing miracle was made possible by governments putting in place a framework for furthering long-term industrial investment and then sticking to it for decades.
Central to a British industrial policy should be the establishment of a mechanism for translating the growing piles of dormant private savings into active investment, and for signalling a stable policy environment. This is particularly urgent today when the Coalition Government is cutting public investment by £50bn over the next few years. As I have argued elsewhere, a government-owned British Investment Bank might fill that role. It would leverage a small pot of public capital in the private capital markets to lend to infrastructure projects, cutting-edge technology and to SMEs. Through its ownership stake in the Bank, it would be in the government’s interest, regardless of what party is in power, to maintain a policy environment conducive to sustained investment. Without an active industrial policy, devaluation is unlikely to create anything new. It will improve the conditions for existing exporters but it will not be enough to close the trade deficit or to breed the next generation of exporting firms.
However, even when combined with industrial policy, devaluation is not unproblematic. Mills claims that as long as Britain refrains from running a balance of payments surplus, a unilateral British devaluation is likely to be accepted internationally. This seems to me to downplay the risks of setting in motion competitive devaluations. (This is of course a serious risk which would arise from the break down of the euro). Already Brazil has threatened the USA and Europe with a ‘currency war’ if Western exchange rates continue to fall and there are long-standing tensions between the US and China over the value of the renminbi. A unilateral British devaluation may well start a race to the bottom where an initial devaluation is followed by further rounds as Britain’s trading partners follow suit. The 1930s show what can happen if every country pursues only its own interest.
It was his experience of the currency and tariff wars of the 1930s that prompted John Maynard Keynes to suggest an international Clearing Union in the 1941. Under the so-called Keynes Plan, international trade was to be funded by an international currency, ‘Bancor’, in an intricate system of transfers between member states’ accounts in the Union. At the time the Keynes Plan was defeated by resistance from America who feared for its trade surpluses. However, it is time to review the Clearing Union again. In the long run, the only way to avoid currency wars is to agree on a new international exchange-rate regime.
What is the right price of the pound? This is a question that needs much more attention. Mills’ rich historical narrative is an informative point of departure for this debate. But it is important that we avoid a situation in which important economic debates take place in silos. Just like fiscal and monetary policy, exchange rate policy needs to be considered as a component of a general reordering of the economic life of an increasingly interdependent planet.