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Would a competitive exchange rate policy be effective? If it would be, is it possible?

By John Mills

Would it be effective?

The case for the UK moving to a much more competitive exchange rate - roughly parity between the pound sterling and the dollar - is as follows:

1.A    Investment By far the most important reason why productivity in the UK is stagnant is our ultra-low levels of investment. The world average expenditure on investment as a percentage of Gross Domestic Product (GDP) is about 26%.  In China it is nearly 50%.  In the UK, it has dropped to 15.6%, including expenditure on intellectual property. Worse than this, on the latest Office for National Statistics (ONS) figures, of the 12.6% of GDP the UK spends on physical investment, only 2.7% (compared to 15% in China) goes on "Other Machinery and Equipment", which is the best available ONS proxy for the types of investment which really produces substantial increased output per hour. These are mechanisation, technology and power - and very little else. By the time depreciation is deducted from this 2.7%, virtually nothing is left. This has to change if we are going to get the economy to grow at any reasonable speed, allowing real wages to increase. This will only happen if this type of investment, which typically takes place in the private sector, is profitable. With the exchange rate anywhere near where it is at the moment, this condition for most manufacturing investment is a very long way from being fulfilled. The cost of producing almost anything in the UK is much too high.

1.B    Deindustrialisation  As late as 1980, about 30% of our GDP came from manufacturing.  Now it is less than 10%. The main reason for this huge fall is that a combination of the monetarist/neo-liberal fight against inflation in the 1980s (mainly with sky-high interest rates), followed by a deliberate policy in the late 1990s and 2000s of encouraging capital inflows -(mainly to buy up existing shares, bonds and property rather than investing in new industrial capacity), both pushed up the exchange rate to astronomical heights, making manufacturing in the UK hopelessly uneconomical. As a result, millions of good quality jobs disappeared, productivity increases stalled, and our trade deficit in manufacturing got wider and wider.

1.C    Balance of Payments  Our weakening and increasingly uncompetitive manufacturing base generated an ever-widening trade imbalance, despite our much better performance on services. In addition, the cumulative effect of borrowing or selling off assets every year to finance our foreign payments, deficit plus rising net transfers abroad on payments to the EU, remittances and aid programmes caused our balance of payments deficit to get worse and worse. In 2016, the total deficit was £115bn, not far short of a completely unsustainable 6% of our GDP.



1.D    Debt  Balance of payments deficits suck demand out of the economy and, to replace it and thus to avoid the economy collapsing, the gap has to be filled with expenditure from borrowed money.  This is why both as a nation - through our government - and as individuals, the amount of debt created in the UK has reached its current staggering levels; about fourteen times as high as the total in 2000. As the government deficit is driven very largely by the balance of payments deficit, and by the then inevitable excess of expenditure over income, austerity policies to get government borrowing down are almost entirely misplaced. 

1.E    Slow Growth The consequence of stagnant productivity is that the UK economy has been growing only very slowly - by an average of just under 2% per annum since 2010. It has not been driven on a sustainable base by investment and net trade, but unsustainably by ultra-low interest rates, equity realisation and consumer demand. Regional disparities have widened alarmingly, as has the gap between the old and the young. In 2016 average Gross Value Added per employee in London was £44,000 while in Wales it was £18,000 - well under half the London figure. 30 year olds are reported to be earning now 30% less than those who were 30 ten years ago.

1.F    Stagnant Wages  Real wages - i.e. money wages adjusted for inflation - are still less than they were in 2007 for a majority of the population. This has happened despite the meagre growth that has been achieved as a result of several factors. One is that such growth as we have seen has been diluted down per head by our population rising at some 0.7% per annum. Another is that more and more of what income has been generated in the UK has been paid abroad to finance our foreign payments deficit.  A third is that as long as the return on capital is higher than the growth rate, the share of GDP paid out as wages and salaries rather than in interest, dividends and profits is bound to go down. A fourth is that there is also a renewed trend for increasing  inequality in wages and salary distribution. Without a major change in policy, this state of affairs is likely to continue, with no real wage increases in prospect for most of the population for the foreseeable future.

Would it work?

There are six standard arguments against a competitive exchange rate strategy, none of which has any real substance. These are:

2.A    Inflation  Devaluation is often alleged to cause inflation, potentially on a scale which wipes out any initial potential competitive advantage. This is simply not a correct assessment as inspection of any numbers of devaluations shows.  Sometime inflation goes up a little, sometimes it goes down in relation to what otherwise might have been the case, but always the impact is small enough to ensure that better competitiveness is maintained.

2.B    Retaliation  With the UK starting from a position where our balance of payments deficit is nearly 6% of GDP but our share of world trade is now down to below 3%, the likelihood of retaliation is very low. There was none when the UK exchange rate went down from $2.00 in 2007 to $1.50 in 2009.

2.C    Open Markets  It is sometimes claimed that any kind of exchange rate policy is incompatible with open markets. The fact that many other countries -including Switzerland, Singapore, and South Korea and China, all with large trade surpluses - maintain their currencies at competitive levels, shows that this cannot be correct. Our exchange rate has been much too high because of high interest rates, because it is very easy for foreign interests to buy UK assets, and because the general thrust of Bank of England and government policy has been to keep the exchange rate as strong as possible.     

2.D    Makes us Poorer  There is an entirely unjustified fear that a lower parity of itself really makes us all poorer. Measured in international currency, such as the US dollar, this is of course true, but UK residents do not shop in dollars but in pounds. This is why international statistics almost invariably show GDP rising more rapidly than would otherwise have been the case after a devaluation. It can't be true that GDP per head goes down if GDP goes up and the population stays the same. It is true that faster growth means more investment and less consumption and that a smaller balance of payments deficit both constrain disposable incomes, but this would be true of any policy to get the economy to perform better.

2.E    Tried Before  The fact that sterling has weakened against other currencies such as the US dollar and the Swiss franc is often used as an argument for saying that devaluations don't work. This state of affairs, however, is only a reflection of the fact that inflation has been much higher than in many other countries over the years, making exchange rate adjustment inevitable. For example, between 1970 and 2010 prices in Switzerland rose by 74% while in the UK they increased by 614%. The trouble with the UK's policies on the exchange rate is that they have always led to too little devaluation too late, with devastating consequences on the UK's capacity to compete in the world. 

2. F    No Response  Finally, it is often claimed that the UK is no good at manufacturing and that our future therefore lies with services at which we evidently perform much better. The reason for the UK's poor manufacturing performance, however, has nothing to do with lack of ability among UK entrepreneurs but because too high an exchange rate makes manufacturing unprofitable. Hardly surprisingly, then, that investment in it has been much too low and able people are repelled from making a career in an under-valued and under-appreciated - but nevertheless critically important - sector of our economy.

While none of these standard objections to a competitive exchange rate strategy carries much weight, there are two critical tests which such a policy would have to pass for it to be successful.  One is how high the return on investment in mechanisation, technology and power would be, given the most favourable conditions. This would determine how quickly new resources could be created to enable investment to increase and real wages to rise. The other is how responsive the balance of payments would be to a much lower parity, thus enabling the economy to be rebalanced towards a much lower foreign payments deficit, lower government borrowing and increased demand coming from net trade and investment instead of consumption.  

Both these conditions can be met - and have been by many other countries which have transformed their economic prospects by building their economies on export-led growth rather than import-led stagnation. If they can do it so can we. Generally in the past, it has been underdeveloped countries or defeated and devastated nations which have shown the way. The UK now needs to show the world that a relatively advanced country with relatively high living standards such as ours can follow the same path. The dynamics in both cases will be the same. There is no reason why this could not be done by a determined and clear-sighted UK government. 

Labour Leave shares a number of viewpoints from external commentators, both Leave and Remain, without necessarily endorsing any of the viewpoints therein.

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