Why it is much easier than most people think to fix the UK economy

We need to move investment to those areas with the highest returns for society as a whole. The best way to do that is to fix our over-valued currency.

John Mills
10 February 2015

The reason why most people believe that it is impossible for economies such as ours to grow faster than 2% to 3% per annum at best - and why it is likely that we will not even do as well as this over the coming years - is that these beliefs are largely founded on two assumptions which are simply not correct. These are:

1.A     It does not make much difference what we charge the rest of the world for the goods and services we sell to them. They will always sell in roughly the same quantities whatever price we ask our export customers to pay for them, so the exchange rate makes little difference either to our competitiveness, our trade balance or to our growth prospects and its level does not therefore matter much if at all. Anyway, the exchange rate is fixed by market forces over which governments have little or no control.

1.B     All types of investment produce roughly the same returns to whoever finances them. It does not therefore make much difference where within the economy investments are made. The returns for the economy as a whole tend to be more or less the same for all sorts of investment projects, so there is no great benefit in prioritising some forms of investment over others.

It is because both these assumptions are wholly unfounded that there is so little understanding either among politicians, the civil service, commentators or the academic world as to why the UK economy has for a long time performed so relatively poorly and what needs to be done to make it achieve much better results.


The reality is that most international trade, although not all, is hugely price sensitive, particularly the majority of it which consists of relatively low-tech manufactured goods. Some manufactured products are not very price sensitive – including most of those the UK now exports, such as arms, aerospace, pharmaceuticals and vehicles. This is because they are protected by a combination of complex supply chains, large amounts of accumulated development and production expertise, first mover niche protection, extensive intellectual property rights, highly developed brands, politically determined procurement policies – and sometimes by exceptionally good management. It is for these reasons that they still exist in the UK. Industries without these advantages have nearly all been driven out of business. Most manufacturing in our globalised world is not, however, protected in any significant way. The production techniques employed are widely known and available. The key expertise involved then lies in developing and distributing the products which are manufactured. Where they are made depends very largely on where they can be produced at the cheapest price, allowing for quality and reliability.

Typically for most manufacturing operations, about one third of costs are raw materials and depreciation. For these inputs there are world prices. The remaining two thirds of total costs – the cost base - are incurred in the domestic currency, which of course in the UK’s case is sterling. These cover everything from labour costs to charges for premises, from bought in services such as cleaning and accountancy to transport and energy costs, from interest charges to the profit needed to keep businesses viable. The price we charge the rest of the world for all these costs is almost entirely determined by the exchange rate. If we want to keep up with the rest of the world and to avoid our economy stagnating, we therefore have to ensure that we have an exchange rate which allows us to charge out our cost base at a competitive rate – allowing for the productivity of our labour force compared to those in other countries.

There are at least three immediate ways of telling whether our economy has a competitive cost base or not. One is to observe the trends in our share of world trade. The second is to measure directly the cost of producing a wide variety of manufactured goods in the UK compared to the prices at which they are available on world markets. The third is to observe the proportion of the UK economy devoted to the types of manufacturing which do not have the forms of protection described above. 

Readily available statistics then tell the story. Our share of world trade, which was 10.7% in 1950 had fallen to barely half this figure by 1980 and has now halved again, as uncompetitive export pricing has dragged down our growth rate. Direct measurement of the costs of a wide range of manufactured goods suggests that they cost at least 20% more to produce in the UK than on world markets, if we can still produce them at all. As a share of our economy manufacturing – over 30% as late as 1970 – is now down to barely 10%, and of this percentage well over half is taken up by output of goods whose markets are in one way or another protected. What has gone from the UK is nearly all the production which does not fall in this category.

The reality is that we have been trying for far too long to sell our output, especially of manufactured goods, at far too high prices on world markets and we have priced ourselves out of the market by charging much too much. In particular, we have tried to sell our labour inputs, allowing for productivity which is a combined factor of education, training, and the capital equipment we have available for it, at far above world prices. This is why we have so much of our labour force which is either employed at very low wages or out of work altogether. Those lucky enough to be endowed with sufficient skills and connections can still compete but millions of people who could, given the right exchange rate, be gainfully employed are consigned – completely unnecessarily - to life without high quality work.

Returns on investment

As to investment, far from all of it producing roughly the same return to the economy, the reality is that there are huge variations. Most public sector investment – housing, schools, hospitals, roads and public buildings – produces barely sufficient returns to cover the interest charges involved in financing it. Investment in the service sector is more variable but the total returns to most of it is still very modest. Nowadays, a high proportion of business investment is being deployed on projects such as building office blocks and opening new restaurants, none of which produce huge returns to the economy as a whole. The difference between investments of this sort and those in light industry – and some parts of the service sector such as those producing innovative IT applications – is that they largely depend on doing what was done before more efficiently, which is possible but incremental in scale. Improvements in output of this sort are, however, quantitatively different from what happens when technology, usually embodied in machinery, is employed to produce perhaps twice as much as was produced before with the same inputs.

The key to getting the economy to grow faster, therefore, is to get as much investment as possible concentrated in sectors of the economy where the application of technology can produce the highest returns to the economy as a whole. This tends very strongly to be in light manufacturing – and also in related parts of the service sector - where big productivity increases are spread out not only in returns to those who provided the necessary financial resources, but also in higher wages, larger profits, more taxable capacity and better products. The key to getting investment of this sort carried out – and on a sufficient scale – is to make it highly profitable: exactly opposite to the condition which prevails at the moment in the UK.

How to get this done

The problem is how to make the sort of investment we need most profitable enough to ensure that it is undertaken on a sufficient scale and – where there is competition for resources - in preference to other forms of investment with much lower rates of return. The answer is that investment in manufacturing, particularly light industry, which would then be capable of increasing both exports and import substitution to the extent we need, has to be made much more financially attractive – and by far the most effective way to do this is to have a much lower exchange rate. This automatically reduces all the costs in sterling – typically about two thirds of the total - which have to be charged out to the rest of the world in export prices, or which inhibit goods currently being bought from abroad being made in the UK because it is so much more expensive to produce them here than in other countries.

If we are going to be able to pay our way in the world, and to avoid the endless balance of payments problems we have, which suck demand out of our economy, encourage borrowing, and constrain the rate at which our economy can grow, we have to increase the proportion of our GDP which comes from manufacturing from around 10% to 15%. About 60% of all our exports and 75% of all our imports are goods rather than services and for both exports and imports about 80% of all these visible goods are manufactures rather than fuels or raw materials. Thus the only practical way to get our foreign payments back into balance is for us to sell more manufactures overseas and to produce more in the UK of those we need for our own consumption.

How much adjustment to our exchange rate would be required to bring about the changes in profitability incentives we so badly need? Because sterling is still so over-valued, to make major investments in manufacturing capacity viable financially, sterling would have to come down to about $1.10 or about €0.85. Is this possible? It certainly would be if the government realised what needed to be done and was sufficiently determined to make sure that it happened. Some fairly simple calculations then show what could be achieved between, say, 2015 and 2020 with a competitive exchange rate instead of what we have at the moment. Economic growth over this period would be 4% to 5% per annum instead of 1% - a cumulative increase of over 25% compared to 5%, allowing us to keep up with the rest of the world instead of constantly falling behind. Gross investment as a percentage of GDP would rise by about 10% of our national output. Unemployment would fall towards 3% and living standards would increase by about 3% per annum instead of stagnating as they are now. The government deficit would fall from close to 6% of GDP to an easily manageable 3%, so that total government debt would fall over the next decade to about 60% of GDP instead of rising to more than twice this percentage as will happen under current policies. Government expenditure as a percentage of GDP would fall from its current 45% to about 40% but there would be much more to spend on providing services instead of paying interest charges. Inflation would probably be slightly higher – averaging around 3% rather than 2% - while the Gini coefficient, the most widely used measure of inequality, would drop from its current 36 to about 30 as both regional and socio-economic inequality fell towards the sort of level seen in the 1950s and 1960s.

All of this is possible. Why don’t we make sure that it happens?

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 is a donor to openDemocracy.

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