October 15, 2012 by johnmillsjml
It is an extraordinary fact that one of the most potent economic policy levers is now barely ever mentioned. When we had a fixed exchange rate between the end of World War II and 1971, it was a constant pre-occupation. Since the pound began to float, however, using the exchange rate as an economic policy instrument has dropped almost completely out of sight.
Of course this is partly because if the pound came under attack with a fixed exchange rate, a crisis atmosphere was precipitated, to which policy makers had to respond. With a floating rate, sterling just drops. If demand for the pound goes up in relation to supply, the rate goes up. There is no drama.
Ignoring the exchange rate and just leaving it to market forces is, however, a huge mistake. The rate at which the UK cost base is charged out to the rest of the world makes a massive difference to the way our economy performs. If the rate is too high, manufacturing and exporting becomes unprofitable and declines. Manifestly, this has been what has happened to the UK.
The resulting balance of payments deficit – £100bn a year on goods nowadays – means we cannot expand the economy as we would like. Furthermore, the trading deficit sucks demand out of the economy, causing governments to make up the lost purchasing power with excessive borrowing. Because it is much easier to achieve productivity gains in manufacturing than in services, the UK growth rate is much lower than it needs to be, and has been elsewhere.
How did we ever get into this situation? Much of the blame goes back to the battle against inflation in the 1970s. Monetarism swept the board and squeezing price rises out of the system became the over-riding priority. Interest rates were raised. Money was tightened – and as a result sterling became about 60% stronger against all other currencies between 1977 and 1982. With some oscillations, this is where it has stayed every since.
The main reason why sterling has stayed so strong is that keeping inflation down has become the main economic policy objective, around which all others revolve. The problem is that keeping inflation at 2% – the British target – with about the same one in the USA, and with an even lower goal in the Eurozone, involves almost exactly the same economic policy responses as one designed to keep the pound much too strong.
The fact that we are chasing the wrong policy objective – keeping inflation at about 2% – rather than maintaining the exchange rate at a level which would enable us to compete in the world is by far the largest reason why the British economy is in the catastrophic state in which we now find it. Growth has ground to a halt. Unemployment – if all those who would be willing to work if there were enough jobs available – is about 5.0m – far higher than the headline figure. Living standards are stagnant. We are facing years of austerity, cuts in public services and national decline.
But actually, none of this is necessary. If we got the exchange rate right, so that we could pay our way in the world, this dismal outlook could all be avoided. What we need is the same medicine which worked so well in the 1930s – when after the 1931 devaluation, the economy grew faster than it ever has done before or since – or in the 1990s after we came out of the Exchange Rate Mechanism in 1992. Only we need a bigger dose to deal with a bigger problem.
Could the government get the exchange rate down if it was determined to do so? Of course it could. Just increasing government expenditure and cutting taxes would soon produce a much lower pound and there are many other steps which would achieve the same goal. So why does this not happen? For two main reasons.
One is that almost nobody thinks about the exchange rate any more as a policy instrument, so they do not see the lost opportunity that there is as a result of leaving it at far too high a rate for far too long. The other is that for decades everyone has been chasing low inflation, and it is very hard to get all the politicians, policy makers, academics and public opinion formers involved, who have all been aiming at the wrong target to recognise the huge mistake they have made, and to change their mindsets.
Until they do, however, we will have nothing but austerity and decline. Once we start aiming at the right target, however, all the evidence suggest that, with the right complementary policies, everything would move in the right direction, as it did in the 1930s and the 1990s. Why don’t we do it?
14th October 2012