Article for the Economic Research Council

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August 14, 2012 by johnmillsjml

We are facing a daunting prospect. It is years of austerity, high unemployment, cuts in public expenditure, nil or negative growth and mounting debts, combined with more and more inequality. Is this all impossible to avoid? Is the best we can do to resign ourselves to this dismal scenario, while accepting its inevitability? Or is there a way ahead which would break us out of current trends, leading to a far better outcome? Let me try to persuade you that there is, that all the austerity we are promised is unnecessary and that our present economic predicament is directly the result of entirely avoidable policy mistakes which we should never had made and which would not be that difficult to correct.

The starting point is to recognize that our fundamental problem, from which most of our other difficulties flow, is that we cannot pay our way in the world. We do not have enough exports to pay for our imports, so we have a payments deficit every year. This sucks money out of the economy, creating a highly depressing influence on economic output. The only available way of filling the gap, to avoid the economy getting more and more depressed,  is by more and more expenditure on borrowed money by the government and by private consumers. This is why our public and private debts are so high. It is directly the result of shortage of domestic demand caused by our huge balance of payments deficit. Our weak balance of payments position also makes it impossible to run our economy at full throttle, to avoid the deficit becoming even larger. This is why we have a massive unemployment problem., with not just 2.6m but nearer 5.0m people out of a job,  but who would be willing to work for reasonable wages, if the opportunities for doing so were available.

Why do we have a huge and persistent payments deficit? It is because most exports from all developed and diversified economies such as ours are still manufactured goods and we have allowed our country to deindustrialise to a point where we do not have enough manufactures to sell to the rest of the world to pay for everything we want to import from abroad. Income from services and investment income is nothing like large enough to fill the gap.

An            d why is our manufacturing base so weak? It is because it is far more expensive to produce almost everything here than it is elsewhere in the world, especially in the Far East. And why has this happened? It is because the cost base in the UK is much higher than it is in most of the rest of the world. The cost base is made up of all the domestic costs – in the end very largely wages and salaries – which make up what we charge the rest of the world for our exports. The amount we charge is determined by the exchange rate which, in the UK and indeed in many other western countries, is far too high compared to what it needs to be to make our exports competitive in world markets.

How did we – and most of the West – ever get into this predicament? Overvaluation of sterling is a longstanding UK problem going back to the nineteenth century, but it got much more acute in the 1970s and 1980s. When prices were then rising rapidly, economic policy makers fixated on inflation as economic enemy number one. As a result, to get inflation down, interest rates were raised, the money supply was tightened dramatically, unemployment went up – and price rises did come down. But  none of the policy makers involved seem to have bothered with what happened as a result to the exchange rate, which shot up as a result of high interest rates and tight money.

Unfortunately, this happened just as South Korea, Hong Kong, Taiwan and Singapore – the so called Tiger Economies – were getting into their stride and also just when China was entering   the trading world. The result was that the cost base for manufacturing from the 1980s onwards charged out to the rest of the world by Pacific Rim countries, particularly China, has been on average little more than half what it is in the West. Because of the continuing obsession among the West’s policy makers on maintaining and reinforcing all the policies needed to keep inflation down, it still is. The result is that we have de-industrialised while the East now has far more than it fair share of manufacturing and all the high growth rates, rising prosperity and economic power which go with it. Manufacturers in the UK and many other western countries have simply been unable to compete.

The evidence for this is overwhelming. Our share of world trade has tumbled from about 25% in 1950 to less than 3% today. Barely more than 10% of UK output is manufactured goods compared to 30% or more in some Pacific Rim countries. As manufacturing has declined, so has the supply it provided of good quality well paid blue collar jobs while areas of the country previously involved in industry have been left with very little to contribute to Britain paying its way in the world. – maybe a bit of tourism but not much else.

What can we do about this? The only solution is to get our cost base down, so that on average our exports of manufactured goods are competitive with those from the rest of the world, thus making us able to pay our way. To do this, we have to get the value of the pound down – right down – until we can get the UK cost base sufficiently low to enable us to compete in international markets. How much devaluation would be required? Probably about 25% from where we are now, to generate enough additional exports to eliminate our payments deficit, to allow the economy to grow at 3% or 4% per annum, to reduce unemployment to perhaps 3% and to provide the funding we need for public services.

Is it possible to get the exchange rate down? Yes. If the government was determined to get this done, they could do it relatively easily. Could other countries retaliate? They might try but there is very little they could do to stop us, although actually retaliation on any major scale is unlikely. The US dollar is a reserve currency, making it much more difficult for the USA to devalue than for us to do so. The Eurozone has plenty of other pre-occupations. As our share of world trade is now less than 3%, the Pacific Rim countries are likely to be no more concerned if the pound comes down from $1.50 to $1.20 as they were when it went from $2.00 to $1.50.

Will a 25% devaluation happen? Probably not – at least for now – because for decades practically every politician, civil servant, political commentator and academic has thought that keeping inflation at around 2% was a much more important economic objective than getting the exchange rate right. Unfortunately, policies to keep inflation right down also keep the pound far too high. It is these sorts of policies which are  the catastrophic mistake we have made.

Why, nevertheless, is almost everyone against ensuring that we have a competitive exchange rate if this is the key to our national economic revival? It is very largely because most people believe a whole range of things about devaluation which are not true. Here are the key ones. Most people believe that lowering the pound would increase inflation. They should look at the historical figures. This is not what happens. It is also widely believed that if we charge lower prices for our exports to the rest of the world, this must make us worse off. This is not true either, as again all the available statistics show. If the economy grows faster but the population stays the same as it would otherwise have been, on average everyone must be better off. Then we are told that, even if we wanted to get the pound down, we could not do it because the rate is determined by market forces and not by the government. This is also completely untrue. Government policy has a huge impact on the exchange rate. Apart from anything else, expanding the economy and deliberately making the balance of payments gap wider for a while would soon get the pound down,

If, on the other hand, the government continues to keep the value of sterling roughly where it is at the moment, this policy will eventually fail and the pound will come down whatever government policy may be. This is because with no growth and mounting debts, sooner or later we will become insolvent, a bit like Greece. When we reach this point, sterling will  crash, after wasted years while we persevere with the wrong policies. When this happens, however, our economy will recover, just as it did after the all too temporary devaluations of 31% in 1931 and 19%,  in  1992. In both cases inflation went down  – contrary to what almost all the pundits said would happen – and everyone’s standard of living went up.

Now is the time to do the same again and to make and keep sterling competitive  – not to waste years in a completely unnecessary and avoidable depression.

John Mills

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