September 15, 2012 by johnmillsjml
If the key to getting the UK economy to perform much better than it is at the moment is to get the exchange rate down to a level which will enable us to compete in the world, is this something which could be achieved by a change in government policy? Or, alternatively, is the exchange rate almost exclusively dictated by the markets, leaving the government on the sidelines as an impotent spectator as the balance between supply and demand determines what the pound is worth on the foreign exchanges?
The conventional view is that, with a floating rate for sterling, it is very difficult for the government to do much to influence the exchange rate. On this view, the rate day by day is the result of the interplay of huge movements each way across the exchanges over which it is impossible for the government to have much influence in the absence of capital controls. The exchange rate is therefore a given around which all other aspects of economic policy have to operate, without the government having any significant influence on what the rate actually is at any time.
This view is, however, this Bulletin argues, fundamentally mistaken. There is plenty which the government could do to change the exchange rate if it was determined to do so and this Bulletin sets out the actions which it could take if it was minded to get this done.
Government Policy Perhaps the most important single requirement is that the government should make up its mind that it wanted a much lower exchange rate and then announce that it was determined to achieve it. This would be a huge change from the present position which is that the authorities are generally perceived by almost everyone always to welcome the pound strengthening and to be concerned when it weakens. The markets are well aware of this propensity. They therefore expect any significant falls in the value of the pound to be resisted by the authorities by raising interest rates, tightening the money supply and restricting expenditure. This market leadership then frames expectations in a way which tends to mean that the perceived official view becomes a self-fulfilling prophecy.
Of course, there is a limit to the extent to which government can resist market pressures, so that the rate for sterling is not entirely under the control of the authorities. There is, however, normally quite a wide band, even within normal stable conditions, within which it is feasible for government policy to influence the rate. If it is perceived that the authorities always feel more comfortable with a higher rather than a lower rate, it is hardly surprising if the rate tends to stay on the high side. It is this perception which needs to be reversed not just by nudging the rate down but by making it clear that an entirely new strategy, aiming at a much lower rate, is going to be adopted.
Expanding Demand The most obvious way to get the exchange rate down is to expand demand on the economy by a combination of fiscal and monetary policy. Taxes could be lowered and expenditure increased. Monetary conditions could be made easier by flooding the economy with liquidity. The reason why this is not done is because of fears that such changes in policy would cause the markets to lose confidence in the government’s ability to control the economy along current lines. The result would be downgrades in the UK’s creditworthiness, and a flight from sterling. If these are regarded as disastrous outcomes, the pressures not to pursue policies of this sort are very strong. If, however, the government wants to get the exchange rate down, the position is reversed. The government can then simply ignore – even encourage – downgrade postings on the country’s creditworthiness and sterling being sold off.
It cannot be true that it is both impossible to get the value of sterling down while, at the same time, we cannot have tax cuts, increases in expenditure and monetary expansion, because such policies would cause sterling to depreciate. Expansionary policies are bound to widen the current account deficit, causing sterling to fall in value. They cannot be pursued à l’outrance without this having any effect on the foreign exchanges. This is why it is always possible to get the exchange rate down, if the government is determined to do so, by deliberately adopting short term expansionary policies to make it happen.
Monetary Policy Leaving aside the impact of monetary policy on expanding the economy, widening the deficit and triggering a devaluation, it also has a direct impact on the exchange rate. There is ample evidence that high interest rates attract hot money seeking a maximum short term return. This is especially the case if the government concerned has a policy of keeping its exchange rate as high as possible, thus reducing the risk that the relatively high interest rates to be paid will be offset by capital losses as a result of the exchange rate falling. Raising interest rates also tends to depress the economy, thus reducing imports and at least temporarily improving the foreign payment balance, all of which tends to push the exchange rate up. The key interest rates here are not the rates charged by central banks, although even these are actually not that low in real terms if inflation is also very low. They are those charged to borrowers outside the banking sector, which tend to be much higher. Flooding the market with money and making sure that lending rates come down for non-bank borrowers will help get the exchange rate down.
Portfolio Investment One of the major causes of the very high exchange rate during the 2000’s was the huge excess of inward portfolio investment from abroad over UK portfolio investment overseas during this period. Between 2000 and 2010, the UK sold a staggering $700bn more assets on a portfolio basis to foreign companies and individuals than were bought by British companies and individuals from foreign owners. The massive inflow of funds that this entailed was much more than the $500bn cumulative current account deficit over the same period. This largely explains why it was possible for the UK to have such a high exchange rate over this period even though the trading performance of the economy was so relatively poor.
While direct investment in plant, machinery and factories is clearly potentially beneficial to the recipient country, it is far less obvious that there is any long term benefit to be gained by selling off national assets – everything from water utilities to airports, from power companies to chocolate factories. Do we really want to have such a huge proportion of our national infrastructure and production facilities owned by companies which do not have the UK as their home market? Clearly the focus of the loyalties of foreign companies is inevitably to their own economies. The control which the UK can exercise over the key assets which they own is therefore correspondingly limited – quite apart from the damage that the consequent over-valuation of sterling has done to our remaining manufacturing capacity.
Historical Experience Perhaps the best guide to whether it is possible to change exchange rates in the future is to look at what has happened in the past. Clearly, very big exchange rate movements have been engineered by government policy. Between 1977 and 1982 sterling was driven up 64% against all other currencies by the monetarist policies adopted by the governments of the time, with catastrophic results for British manufacturing. The impact of the Plaza Account in 1985, on the other hand, was a huge and deliberate weakening of the US dollar – which at the time was recognised as being grossly over-valued – with its value falling against all other currencies by almost 45% between 1984 and 1987. Our own recent economic history is also instructive. The trade weighted value of sterling fell by almost 20% when we came out of the Exchange Rate Mechanism in 1992. More recently still, sterling fell from being worth about $2.00 to around $1.60 between 2007 and 2009 – tellingly as net inward portfolio investment dropped between these two years from $256bn to $38bn.
Retaliation If the pound came down from $1.60 to, say, $1.20, would there be any more likelihood of retaliation than there was when it dropped from $2.00 to $1.60? It seems unlikely. The US dollar’s role as the world’s reserve currency makes it much more difficult to devalue the dollar than sterling. The Eurozone currently has much more acute exchange rate pre-occupations than the value of the pound. If, however, the Single Currency were to collapse – which seems quite likely to happen over the coming period – this would be bound to lead to massive exchange rate changes which might well produce an environment were a big UK adjustment could be fitted in with many others. In particular, if the weaker economies in Southern Europe drop out of the Single Currency, leaving only a block of northern countries still in the euro, their currency is likely to appreciate very heavily. At least as regards our trade with the countries still in the euro, their currency appreciation would be the mirror image of an equivalent sterling depreciation. This may well cause other countries, not least France, and probably Holland, Austria and Finland as well, to decouple from the euro, causing a huge exchange rate upheaval. This would provide us with an opportunity for a major trade weighted devaluation, if a much lower exchange rate for sterling had not been accomplished already.
As regards the rest of the world, we are now so insignificant that it is very unlikely that other countries would be that concerned about sterling. In 1950 our share of world trade was about 25%. Now it is less than 3% – a sorry commentary in itself about the huge damage that having an over-valued currency for many years has done to our international status and our ever-diminishing role – at least relatively – as a trading nation.
There is, however, a compelling reason why other countries ought to be persuaded to put up with a sterling devaluation – and faced with unilateral action on our part if they are unwilling to do so. It is not remotely in their interest that Britain should drive itself into insolvency and default, which is what we are doing at the moment as a result of our over-valued currency. Because we cannot pay our way in the world, we are running up more and more debt every year. This might be sustainable if the economy was growing, but with growth having ground to a halt it is only a matter of time before the markets realise that we may never be able to honour all our debt obligations. Unless, therefore, we are successful in getting the pound down to a competitive level, all the countries to whom we owe money and with whom we trade are in danger of having to deal with a country which cannot meet its obligations.
Capital Controls There is another policy to which we could resort if all else failed. This would be to implement capital controls and to use them as a way of holding down the exchange rate – just as China has been doing for decades. There are major disadvantages to this policy and all the evidence suggests that it would not be necessary. If, however, a choice had to be made between capital controls and reviving prosperity on the one hand or lack of them and years of austerity and decline on the other, there would then be a strong case for restrictions on capital movements being imposed. Hopefully, this is not a choice which will have to be made, but the cost and consequences of the thrust of current policies is so enormously high that it would made no sense to rule out any reasonable way of avoiding them.
No doubt there would be enormous resistance from the financial interests in the UK to the adoption of capital controls but the City should not be our primary concern. There is nothing to be said for damaging the City unnecessarily but there is everything to be said in favour of taking account of the interests of the country as a whole rather than that of a narrow sectional interest whose policy objectives and assumptions can so easily and so heavily be in conflict with those needed by the rest of the country..