Is the Pound Overvalued? – and why it matters

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August 22, 2012 by johnmillsjml

There was a time not so very long ago – during the quarter of a century after World War II – when Britain had constant balance of payment crises. These focused policy makers’ attention on to whether the value of the pound was getting unmanageably high. It did not stop there being the same marked policy preference for keeping the value of the pound as high as possible that there has been at least since the nineteenth century. There was, however, a recognition – particularly in 1949 when the value of the pound dropped from $4.03 to $2.80 and then again in 1967 when I fell to $2.40 – that the exchange rate mattered.

Since the break up of the Bretton Woods fixed exchange rate system in 1971, the pound has floated. With a floating rate, there is not the same crisis atmosphere as there is when a fixed rate comes under pressure. Instead, the rate just falls. Mainly as a result of this, policy makers have taken their eye off the exchange rate as being a major factor to be concerned about when shaping economic policy. If there is no crisis likely to be in the offing, and the exchange rate can apparently be left to find its own level as a result of market forces, why worry about it?

Furthermore, if there are powerful interests in the City who almost invariably favour a high exchange rate, there are millions of people taking holidays abroad who like getting plenty of foreign currency for their pounds, and almost everyone is worried that a weakening pound will add to inflation, why not keep the pound as strong as possible? Who, in any event, wants a devalued currency? Who wants to see a national symbol such as the pound going down rather than up? Who indeed wants to defy the strongly ingrained attitudes, reflected vividly in the language used, which takes it as axiomatic that a currency which is “strong” must be better than one which is “weak”. The answer is almost nobody. Unfortunately, however, this has a huge amount to do with why our economy is in the condition it is in.

Here’s why. The exchange rate is like a prism. All the costs incurred in producing goods and services sold to the rest of the world are refracted through the exchange rate to produce export prices. If the currency is kept as strong as possible on the foreign exchanges, these prices tend to be high compared to those of other exporting countries. If it is weak, the reverse applies. The effect of keeping the exchange rate high, therefore, is to make it much more difficult for manufacturers to export and much easier for the domestic market to be filled with imports rather home produced goods. Long periods with an exchange rate which is too high to give manufacturers a reasonable chance to compete in world markets thus tends to lead to progressive deindustrialisation.

This matters a lot because diverse developed countries such as Britain depend hugely on exports of manufactures to pay their way in the world. Despite the fact that only 8.5% of the UK’s workforce now works in manufacturing – producing 12% our national output – well over half our export earnings are still goods rather than services. Unfortunately, this generates nothing like sufficient revenue to keep our current account with the rest of the world in balance. We have a deficit of about £100bn a year on manufactured goods, which nets down to an overall current account deficit which has averaged about £30bn a year over the last decade when net revenues from services, transfers and income from abroad are all taken into account.

The weakness of our manufacturing base is all to easy to highlight by reviewing what has happened to our export performance compared to other countries in recent decades. In 1950 Britain produced a quarter of all the world’s exports. By 1970, this ratio was down to 6.5%. By 2000 it had fallen to 4.4% and by 2010 it was 2.7% – and still trending downwards. To seek the reasons for this decline, one only has to look at the experience with domestic inflation in the UK, unrequited by any corresponding adjustments in the exchanger rate, compared to other countries. In Switzerland, to take an extreme example, which has a huge balance of payments surplus, average domestic inflation per annum between 1970 and 2010 was 1.6% whereas in the UK it was 5.6%. Over this period, the price level rose by 88% in Switzerland and 780% in the UK. Meanwhile the pound sterling moved from being worth about 12 Swiss Francs to 1.5 today. Faced with these sorts of figures, who can possibly claim that the UK is at no risk of having a grossly over-valued exchange rate?

The weakness of our manufacturing base not only leaves us very vulnerable to deficits as a trading nation, it also has a number of other key negative impacts. Because productivity increases are so much easier to achieve in manufacturing than they are in services industries, countries with weak manufacturing bases tend to have much slower economic growth rates. They also tend to generate many fewer high quality blue collar jobs, while the collapse of manufacturing operations and the closing of factories in areas previously heavily dependent on industry produces enormous regional disparities in living standards. This is why, in the UK, the South East now has average living standard which are 20% higher and the North West 20% lower than the national average.

It is on the balance of payments, however, that the effect of deindustrialisation is in many ways most acute. Because we cannot afford to let our foreign payments deficit get too large, we cannot afford to run our economy at full throttle, because of the risk that this would suck in an unmanageably large volume of imports. The cumulative effect of running the economy with too little pressure of demand, however, is to have unemployment creeping up and up. The claimant count in the UK is now about 2.6m – including over one million people aged between 16 and 15 – but the real number of people not working but able and willing to do so if reasonable wages and conditions were available is closer to 5.0m. This is a staggering waste of resources and a huge tragedy for millions of people whose talents are wasted as they are denied any opportunity to make a contribution to the national income.

Deindustrialisation also has a major impact on both the government’s and consumers’ finances. Every year in which there is a big balance of payments deficit is another period when payments abroad exceed the income we earn from overseas. The result is a highly deflationary shortage of demand for the output which the economy is capable of producing. To fill this gap, the government then comes under enormous political pressure to spend more than it generates in revenue from taxation and charges while consumers are encouraged to spend more than they earn. The result in both cases is more and more borrowing.

Now there is nothing intrinsically wrong with running up debts if there is every chance that they will eventually be repaid and if, in the mean time, interest costs can be serviced. This is not, however, the condition into which the UK is drifting. Because of all the constraints there are on expanding the economy as a result of our inability to pay our way in the world, our growth rate has ground to a halt. At the same time, the government in particular is continuing to borrow more and more, not least because the more its expenditure is cut back the worse the economy tends to perform and the lower the tax take and the higher welfare claims become. Rising debt at the same time as static or falling capacity to service or repay is, however, a lethal combination. It is unsustainable and can’t – and won’t – last.

What can be done about this situation? Current economic policy in the UK has two main strands. Unfortunately, neither of them has an realistic chance of overcoming our present problems. One is to keep inflation low – as close as possible to 2% – and to hope that this, with the low interest rates which should accompany low inflation, will stimulate the economy into growth. The biggest problem with this strategy is that the policies needed to keep inflation very low are almost exactly the same as those required to keep sterling much too strong. This is why this strategy will never work. It provides all the wrong economic incentives – making manufacturing unprofitable and importing much too attractive. The other policy strand is to try to make the economy more competitive by concentrating on supply side initiatives such as training schemes, subsidies for favoured economic activities and policies to encourage high tech new industries. The problem with these sorts of policies is that none of them does much, if anything, to make the economy significantly more competitive, while again doing nothing to improve economic incentives where it really matters, which is to make manufacturing and exporting more profitable and importing less so.

The only answer to our current malaise is to get the exchange rate down to the level which would be needed at least to enable us to reduce unemployment to a much lower percentage and to get the economy growing again. How much devaluation would be needed? Probably around 25% from where we are now – i.e. with the pound worth about $1.20 or €0.85. Because it would take time for manufacturing on the scale required to get re-established it would take a period of two or three years for a policy change along these lines to become fully effective but all the international trade statistics show that this could be done.

Why don’t we do it? Conventional wisdom says that this would produce more inflation, that UK living standards would fall, that we now have nothing to sell the rest of the world, that other countries would probably retaliate and that no-one is going to be happy with more expensive holidays abroad. The first three of these arguments are easily refuted. The statistics simply do not bear out any of these contentions. As regards retaliation, our share of world trade is now so small that what we does not make that much difference. Yes, holidays abroad would be more expensive but this is a small price to pay for getting the economy back to 3% to 4% growth and getting unemployment down to perhaps 3%.

Actually, the biggest problem is not any of the conventional objections to a much more competitive pound. It is that for many decades now our policy makers have become inured to fighting the wrong battle. Keeping inflation at around 2% is not the most important economic policy goal. Getting the exchange rate to a level which allows us to compete in the world – and keeping it there – is a much more important economic objective. Until our economic policy makers realise this is the case, we have no hope of avoiding years of austerity, very high unemployment, mounting inequality and national decline. A competitive pound, on the other hand, will not on its own solve all our problems, but without it no other mix of policies will work.

John Mills

1,896 words

22nd August 2012

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