Economic and social good sense requires the UK to target a lower exchange rate

The exchange rate is the most important single price in the economy: it determines the price of goods for export and the real value of foreign-owned debt. The UK needs a more competitive external sector and can achieve it by much greater quantitative easing

John Mills
23 November 2011

When inflation took off in the 1970s and monetarism became fashionable, almost everyone agreed that getting inflation down was the top economic policy priority. As a result, all the available weapons were brought into play. Interest rates were raised. The money supply was tightened. Credit was restricted. Unemployment rose – and inflation fell back. Unfortunately, almost no-one was concerned with what all these policies did to the exchange rates both in the UK and elsewhere in the West compared to the Pacific Rim countries. China, which was just moving into the trading world, was barely at the time on any western economic policy maker’s radar screen.

Forty years later, keeping inflation down is still the top economic priority. The Bank of England’s target is 2%. The European Central’s Bank’s is even lower. The US Fed’s is about the same. The theory is that low inflation keeps interest rates down and will lead to economic growth. But this is not what has happened. Growth rates in the West are far below those in the East. By far the biggest reason why this has happened is that the exchange rates between West and East which were established in the 1970s have never changed significantly. Concentrating on inflation and ignoring the exchange rate has been a catastrophic policy error for the UK and for the West.

This is because it is the exchange rate which determines, more than anything else, what any economy charges the rest of the world for the output it sells to it. Any country with a low exchange rate – like China – will have four massive advantages over any country - like the UK - with a high one. These are:

  • A The competitive economy’s manufacturing base will grow more rapidly than the world average and it share of world trade will rise.
  • B It is much easier to achieve productivity gains in manufacturing than in most of the service sector, so that any economy with exceptionally competitive exports will grow more rapidly than the world average.
  • C Highly competitive economies benefit from a better spread of employment opportunities both geographically and in socio-economic terms than if they depend very heavily on services.
  • D Countries with highly competitive exports are very unlikely to find the economic policies constrained by balance of payments problems.

World trade consists partly of commodities, partly services, but far the largest component - about 60% for most modern diversified economies - is manufactured goods. If any country – like the UK – has a weak manufacturing base, it will therefore tend to have problems paying its way in the world – and indeed we do. In 2010, for example, the deficit on the UK’s current account payment balance was about £40bn. This sum has to be raised either by selling assets or by borrowing. It is an accounting identity that any current account deficit has to be matched pound for pound by an exactly equivalent amount of capital receipts.

There is also another crucial problem about a foreign payments deficit. If what we sell to the world is less than we buy, purchasing power gets sucked out of the economy - £40bn worth of it in the UK in 2010. There are three ways in which this can be counteracted, to avoid this gap depressing the economy. Either consumers have to spend more than their incomes or the government has to spend more than its revenues or businesses have to invest more than they save. At the moment corporate investment is low and their savings are high, so all the gap and more has to be filled by consumer and government borrowing. There is thus a direct causal link between the exchange rate and borrowing. If the exchange rate it too high it leads to a current account foreign payments deficit. The only way then to maintain demand in the economy is by consumer and government debt increasing.

Does this matter? Yes, indeed it does, especially if, to keep plugging the deficits in the country’s, the consumers’ and the government’s expenditure, more and more debt has to be created in relation to the borrowers’ capacity to repay. Provided lenders are satisfied that, in the last analysis, the debts owing to them will be honoured and in the meantime interest on them will be paid, borrowing can go on going up and up – as it does, for example, to growing and profitable companies. Unfortunately, however, neither countries with weak payment balances nor their consumers and nor their governments generate the sorts of income flows which are produced by profitable investments. Very significant constraints on borrowing then come into play.

When the sums owed both by consumers and the government begin to look uncomfortably large, lenders get increasingly unsure about lending to them. They also start to worry about the country’s capacity to meet its obligations. To stop the country’s current account payments deficit getting too substantial, the economy therefore cannot be run at full stretch because this would widen the payments gap to an unsustainable extent. A weak balance of payments position thus makes it impossible to run the economy at full throttle. The cumulative effect of this constraint explains why unemployment, running at about 2.6m in the UK during the autumn of 2011, is so high. Actually, however, the headline unemployment figure grossly underestimates the real total number of people who would be willing to work if there were sufficient jobs available that paid a reasonable wage. Surveys show that the total number of missing jobs is nearer 4m than 2.6m.

As deflationary polices bite harder and growth stalls, constraints tighten still further. If any economy has a borrowing requirement which is rising more slowly than the economy is growing – like India does at the moment – lenders can remain reasonably confident that their debts will be repaid. If the debts are rising faster than the growth rate – which is now the position in the UK and much of the rest of the West – as soon as it becomes apparent that this is the case lenders start getting much more nervous. Their reaction then is to try to cut down the amount of borrowing needed, but this can very easily turn into a self-defeating policy. The less borrowing there is to make up the demand deficiency, the more slowly the economy will grow and the less debt servicing capacity the economy will have. Meanwhile the need for borrowing may not go down. If consumers’ incomes drop more rapidly than their spending and claims on government expenditure rise faster than before as unemployment goes up, the need for more debt may go up rather than down.

This is the bind in which the UK government now finds itself. Labour advocates reflation, but clearly with a substantial risk that such a policy will cause the creditworthiness of the country to be downgraded. Interest charges would then rise as the lending risks increased, and expansion of the economy would be unsustainable. The Conservative/Lib Dem Coalition is trying to cut expenditure to satisfy lenders that borrowing can be kept under control, but with the heavy risk that growth will disappear completely while more borrowing is still needed. Neither policy looks viable. If we carry on the way we are at the moment, at best we will suffer from years of slow or quite possibly negative growth, rising unemployment, stagnant or falling real incomes, and cut backs in government expenditure. At worst, our capacity to go on borrowing the money we need to plug the unending deficits with which we will be confronted will lead to lenders losing patience with us. Our ability to borrow more money on any viable terms will then disappear, and a really major crisis will be precipitated.

Is there a solution to these problems? There is but only if our economic policy priorities are radically changed. We need to cease trying to fight inflation as our major objective. Instead, we need to get the exchange rate right. If we can do this, we can get rid of our weak balance of payments position which, in turn, is the only long term way to stop the country, its consumers and its government needing to borrow more and more money with less and less chance of being able to pay it back. It will also enable us to have a much more prosperous future. In addition, it will avoid our position in the world sliding downhill as a result of our inability to run our economy effectively. It will also strengthen our capacity to help solve some of the world’s longer term problems from a position of strength and confidence rather than weakness and decline.

What would we have to do with the exchange rate to get our economy functioning much better? Some fairly easy calculations provide the order of magnitude of the devaluations which would need to be made to deal with various different objectives, starting from where we are now. The results are as follows:

  • A To eliminate the payments deficit, leaving the economy capable of growing at about 2% per annum but with still large levels of unemployment, a devaluation of between 10% and 15% would be needed.
  • B To eliminate the payments deficit and to provide enough leeway to allow the economy to be run with a much higher level of demand, producing a cumulative growth rate of about 4% per annum – the world average – a devaluation of between 20% to 25% would be required.
  • C To enable the UK economy to move over a transitional period to the growth rates experienced by countries such as Germany and Japan after World War II, or China now – i.e. with a growth rate of about 8% per annum – the pound would need to fall in value on the exchanges by 40% to 50%.

It is important to realise that these parity changes need to be on a trade weighted basis to be effective. If other countries were to devalue at the same time as the UK then even larger devaluations against the non-devaluing countries would be required. The magnitude of the changes need is, however, an important testament to the enormous lack of competitiveness particularly with many of the Pacific Rim countries, to which Britain is currently exposed.

What would need to be done to get the exchange rate down? There would have to be a major reversal of the policy objectives which policy makers in the UK have long strived to attain. The authorities would need to make it clear that a much lower pound was not only what they wanted to see but what they were determined to achieve. The Bank of England could be instructed to sell sterling and buy foreign currencies. More quantitative easing could be introduced. The government could deliberately increase its deficit to widen the payments deficit unless the parity of the currency fell. The nationalised banks could be instructed to lend more money to businesses, accepting the risk that there might be more bad loans. Portfolio inward investment could be discouraged instead of being welcomed, as it has been. If the credit rating agencies threaten downgrades, they should be ignored because these would help to bring the pound down. All of this is technically feasible but there would be two major obstacles in the way. One would be the attitude of the countries against whom we were devaluing and the other would be the entrenched views on economic policy within the UK and most other western countries too.

Countries like China may well object to losing some of their competitiveness but on mature reflection they may realise that they have little to lose and much to gain from countries such as the UK being in better shape. It is not in China’s interest for there to be a massive debt crisis in the West, undermining the prosperity of the world economy generally and the prospects for Chinese exports in particular. Nor is it in China’s long term interest to run its present large balance of payments surplus, especially if the foreign exchange thus generated is lent to countries which are never likely to be able to pay it back. China’s very rapid growth rate would only be impacted if the UK and other western countries adopted very deep devaluations, which would be much more difficult to achieve than smaller ones. For depreciations of anything up to about 25% against the Chinese renmembi, there would not be much erosion, if any, to China’s huge manufacturing capacity. Furthermore, if no international consensus was forthcoming there would still be nothing to stop the UK taking the unilateral actions described earlier. It may be better to achieve some measure of agreement, if this can be done, but in the last analysis, it is not essential.

Much larger objections’ however, are likely to come from everyone in the UK who is inured to different policy objectives. Politicians and civil servants, who have fought for low inflation and ignored the significance of the exchange rate for decades, supported by the media and academia, are unlikely to change their minds quickly. Importers are bound to oppose devaluation and so will all those who regard cheap foreign holidays as a prize not to be foregone. The City has always tended to favour a strong pound, as have pensioners and others who fear that the accommodating monetary policy and low interest rates which go with low exchange rates may adversely affect them. There is also the fear that a big devaluation will lower everyone’s living standards, although there is no evidence that in practice this would be likely to happen.

So if there is no change of economic policy priorities away from inflation and towards achieving a competitive exchange rate, we can expect the response to further worsening of our debt position to be exactly the reverse of what is really needed. There will be more cuts, more unemployment and no growth. Unfortunately, however, the need for borrowing will not go down. On the contrary it is likely to increase as neither the country, nor consumers nor the government can make ends meet. This is not a sustainable position. It cannot go on for ever, and it won’t. Sooner or later there will be no lenders.

When this happens, the exchange rate will fall uncontrollably. The choice before us, therefore, is not whether we are going to have a much lower exchange rate at some stage. We will. The choice is whether we engineer this in time for the transition to be done in reasonably good order or whether, by fighting a losing battle to the bitter end, we waste huge additional amounts of time and money before the inevitable outcome overtakes us.

John Mills is a donor to openDemocracy.

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