Exchange Rate Alignments, John Mills, Palgrave Macmillan, £60.27
“Exchange Rate Alignments” is not a title that is likely to set many heart-beats pumping in anticipation of broad-based, synthetic excitement. But that’s a problem with the title, not the book, as it ranges from Sumeria to 2011, from climate change to immigration, from monetarism to endogenous growth theory.
John Mills looks at the major Western economies since 1971 or so and notes the particular disgrace of the era for all of them barring Germany, Switzerl;and and Japan: large-scale unemployment and under-utilisation of productive resources. He looks at the Asian Tigers and finds the opposite. While not straightforwardly a model for the laggards in the West, he envies their growth rates, manufacturing and export sectors and the virtuous cycle they have sustained of competitiveness and investment.
Mills is not just an economist. He is a successful businessman, but that success has been hard won. His first business manufactured low-tech consumer goods in the UK. When Thatcher implemented “really existing monetarism” in 1980, inflation was reduced through a policy of high interest rates, strong sterling, high unemployment and recession. How exactly this policy’s transmission mechanism functioned - even in the narrow sense of how it reduced inflation rates - is still contested. But one thing’s for sure: it took huge amounts of demand out of the economy and the high exchange rate led to a substitution of domestic manufacturing for imported. Mills’ business was hit hard by cheap imports and folded. His next business served the customers he knew well - households buying low-tech consumer goods - but it imported its products, mostly from the Far East. It has been stunningly successful.
So Mills understands domestic and foreign demand from a much more than theoretical point of view. “Export substitution” may be a phrase in any textbook chapter on exchange rates, but for Mills, it meant a traumatic bankruptcy. “Exchange Rate Alignments” can be read as Mills’ story of what might have been and why it wasn’t: why was he so successful in the business that created jobs and growth in the Far East, but not in the one that based its manufacturing and created blue-collar jobs in the UK? He believes that alternative policies - and especially exchange rate policies - could have had the combined effects of sustaining high growth in the UK, eliminating persistent unemployment and enriching the whole nation. There was an alternative – he argues – and it was a much better one. Not only that, but the same alternative remains open today: a rebalancing of the economy towards export-generating, import-substituting, low-tech manufacturing is the only option that will save the sick Western economies from decline. In the UK’s case, a devaluation of sterling of about 25% against its trading partners is the way to achieve this.
Mills spends the first part of the book offering some theory on how this works. The basic point is that devaluation can make manufacturing competitive on world markets once again by lowering the cost of domestically sourced inputs - mainly labour. Once manufacturing is competitive, it will start to attract the kind of managerial and entrepreneurial talent that can make it grow fast. And with that growth - much of it financed by the profit margins that investment in light industry generates - will come sounder public finances as well as a relief from the bane of most attempts to increase demand in the UK economy for the past 40 years - the deficit on the balance of payments. Imports will be less attractive and exports more attractive. The productive capacity of the economy will be permanently improved and persistently high unemployment will finally come down. The diagnosis is demand deficiency in the presence of persistent balance of payments deficits – the medicine is to rebalance the economy away from imports and towards exports – and as the patient recovers, a virtuous cycle takes hold that makes the patient stronger and stronger.
It all sounds simple. Why would anyone disagree?
An economist like myself, trained in the 80s, needs a great deal of dead-wood clearing out before accepting the argument, and a great virtue of Mills’ book is that he tackles that work. A first objection which used to be presented as fact was that the effects of devaluation would not last - they would soon translate into imported inflation, so that any competitive advantage would be whittled away through wage rises. The basic idea of the myth is that in an economy open to world trade, there is really just a single world price for productive inputs and that the price level in domestic currency will adjust to reflect that one price. There is even a “theorem” (ahem...) to back it all up - “factor price equalisation”. But Mills presents the facts. It’s just not true that inflation has ever whittled away all of the competitiveness gains from a devaluation. Inflation has typically risen a bit within a couple of years after devaluation. But not to the extent of cancelling out the competitiveness gains. And inflation has then typically stabilised. A plausible explanation is the existence of the kind of virtuous cycle that Mills describes - the devaluation increases the productive capacity of the economy, it influences the supply-side of the economy, and if inflation is to wipe out all the gains of devaluation, the economy must be capacity constrained. Lift that constraint and you get a free-ish lunch.
The reason inflation is meant to rise to cancel out the demand-creating effects of devaluation is precisely because, in the orthodox view, the economy is constrained by its output capacity. In the extreme theoretical case of “rational expectations”, behaviour won’t change in the face of a policy of devaluation as all economic agents anticipate the re-adjustment of prices. But if the productive capacity of the economy is not a given, it can be quite rational to anticipate a devaluation having real effects.
Another orthodoxy from the ‘80s was the financial flows approach to the balance of payments. The view was that international portfolio capital flows were so large and swift that they dominated the balance of payments in the determination of exchange rates, and indeed were so huge that governments had no hope of changing their own exchange rates. Exchange rate movements were to be explained either by fundamental changes in the supply side of the economy - for example the discovery of North Sea oil increased the value of our exports relative to our imports - or by anticipated changes in the relative inflation rate of a country: fleet-footed investors had to be compensated for holding a currency whose value was anticipated to be falling faster than others, and so would only buy it at a lower price. The alternative to devaluation was compensation through higher interest rates which would both attract hot money and reduce anticipated inflation. The interest rate was the king of policy instruments under this view. Giving an independent central bank an inflation target and manipulation of interest rates as its mechanism perfectly reflected this orthodoxy.
Mills wants to dispute the orthodoxy from all sides. It is quite possible for a state in control of its money supply to permanently change its exchange rate. The central bank can effectively create pounds and buy foreign financial assets with them - the supply of pounds rises relative to other currencies and their value falls. Manufacturing and exports lift off; inflation is kept at bay despite the rise in the supply of sterling because the productive capacity of the economy has risen. The trade account of the balance of payments improves, which allows demand to be sustained at a high level without entering a permanent cycle of devaluations.
But there are still objections from the orthodoxy that niggle away at me.
The first is that devaluation provides at best only temporary respite from uncompetitiveness: far from kicking off a virtuous cycle, bad managers and over-demanding workers are let off the hook from their economically irresponsible decisions. This creates a vicious cycle in which processes that lead to bad decisions are allowed to persist. There is no reason for managers and unions to work together responsibly - devaluations take care of excessive settlements; there’s no need to worry about quality or marketing or R&D - you can always eventually make sales by devaluing. The proponents of this view would point to the Wilson devaluation of 1967, or the devaluations of sterling in the 1970s - they did not set off the kind of cycle that Mills describe, so why should we believe that it would be different now? This is the sort of position exemplified by Philip Stephens in the FT, who wrote (March 1st 2013):
"A weak pound has proved at best a palliative and, more often, a short-lived excuse to defer tougher policy choices. The economy does indeed need to "rebalance", but to do so it needs to address the deep structural weaknesses – from infrastructure to science; from education to industrial policy – that hold businesses back. Devaluation is addictive. It is also an admission of defeat."
Mills refuses this picture. He does not believe that the Wilson or 1970s devaluations came soon enough or were large enough - the de-industrialisation rot had been in the fabric of UK policy since at least Churchill’s return to the Gold Standard in 1924, and most probably a good deal before then too- Mills believes that Britain lost industrial dominance to Germany in the second half of the nineteenth century due to the strong pound policy that won the day after victory in the Napoleonic wars.
I am not sure that the exchange rate and the exchange rate alone should be blamed. Germany shows how successful a manufacturing economy can be with a strong exchange rate. Some of that might be because of the virtuous cycle Mills describes arising out of the immediate post-war ultra-low exchange rate that Germany enjoyed. But what makes a country go down the virtuous cycle rather than the vicious one suggested by Philip Stephens? Both are theoretical possibilities, and the UK has tended to enter the wrong one. The wider social contract, the aspirations of all economic agents and their ability to work towards common goals are essential. Mills spends almost no time thinking of social or political differences that might explain different growth rates; an analysis that combines his understanding of the short and medium run dynamics of exchange rate policy with social norms would be welcome.
Where Mills does offer socio-political analysis, is in answering the question his analysis naturally invites - what are the interests in favour of strong exchange rates in the UK? Ever since the 1810 “Report from the Select Committee on the High Price of Gold Bullion”, which pitted the “currency school” (proto-monetarists) against the “banking school” (who were relaxed about paper money creation), those with wealth and liquidity have, in Mills’ analysis, wanted to increase the value of what they have by making it more scarce. The 1810 report - with David Ricardo dissenting from the majority opinion - led to the re-establishment of sterling’s parity with gold after the Napoleonic wars - a precursor of Churchill’s post World War 1 position. This could be achieved only by a painful process of deflation - wages and prices fell between 1815 and 1821. The ensuing hardship caused the Peterloo riots and the outlawing of trade unions. Mills believes that the real interests of the class that is currently creating manufacturing wealth and those they employ should be united in wanting low exchange rates, low interest rates and loose money, while those making money in finance or with inherited wealth want tight money and high exchange rates.
Here is the political heart of Mills’ argument: if economic policy is made for producers, you get growth and employment; if it is made for financial investors, you get tight money, low demand and persistent unemployment. The 80’s and 90’s orthodoxy saw no such division in interests. Financiers were meant to be on the lookout for profitable projects in the real economy, so their interests were aligned with those of producers. Low inflation meant that savers and accumulators of wealth were not subject to a “stealth tax” of rising price levels - this was meant to add to the incentives for activity creation in the productive economy. But that’s not the behaviour that came out of monetarism. Mills’ account of it - of financialisation and de-industrialisation of the economy seems more accurate. It’s tempting to conclude with Mills that the “Currency School” had their go at policy for the last 30 years, and they failed to build an economy that works. If Mills had been clearer about the social conditions which allowed Germany to take advantage of low exchange rates in the immediate post-war, the case for trying that out now in the UK would have been much stronger.
Mills’ book is ambitious, and he wants his preferred outcome of low exchange rates to be a solution to all the important problems that we face. This will inevitably lead him to stretch some arguments too far. Perhaps the clearest case is in his treatment of the environmental crisis.
Mills wants the sluggish Western economies to be firing on all cylinders producing in order to eliminate the disgrace of mass unemployment. But what about the problem of resource constraint - especially the carbon constraint? Mills’ argument here is that the greatest threat to the climate is rising world population. The faster the poor countries get rich, the faster will their birth rates fall. And the known way to their enrichment is for the West to consume more. So his recipe for growth in the sluggish West is, counter-intuitively, a recipe for lower emissions eventually. I am not convinced by any of the steps in this argument - the emerging poor may one day be a CO2 problem, but the 1 billion who live on huge energy budgets - including all the energy embedded in the low-tech industrial goods that Mills is so keen on - and provide the aspirational standard for the 6 billion are the problem today. I don’t have an easy answer, but it stretches credibility to think that devaluation is the answer to the carbon problem. A carbon tax, yes. Carbon externalities - including transport ones - priced into our imports of goods through border price adjustments if necessary, yes. Some of these will go in Mills’ general direction of greater reliance of the country on its own productive potential. But the environment needs its own policies. Mills does not need the exchange rate to solve every problem we face in order to be convincing that it should be brought back into the policy toolkit.
*Both Tony Curzon-Price and John Mills are openDemocracy board members.
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