Bulletin October 2012 – Is it possible to tell whether Sterling is over-valued?

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October 15, 2012 by johnmillsjml

There is a general consensus in the UK that the current sterling exchange rate, primarily against the dollar and the euro, must be about right because it has been established by market forces. This is the rate which apparently balances supply and demand for sterling against other currencies. If those involved with currency trading were to judge the rate to be wrong, on this view, market forces would change it. In the meantime, there is also a general consensus that there is not much the government could or should do to alter the position since it is a fact of life that market pressures rather than government policy very largely determine what the exchange rate is day by day. Furthermore, it is generally thought that any weakening of the pound will raise inflation, reduce living standards and invite retaliation.

This Bulletin argues that all these opinions are almost entirely wrong. The rate thrown up by the markets is by no means necessarily the right one for the British economy. The government is perfectly capable of changing the exchange rate, if it determined to do so. And devaluations do not usually either increase inflation or reduce the national income or suffer from retaliation. It is the vicious combination of over-reliance on the wisdom of markets, apathy about the ability of the authorities to influence the exchange rate, combined with numerous unfounded beliefs about the negative impact of devaluations, which have been the bane of British economic policy for far too long. In particular, it is this combination of erroneous beliefs which has landed the UK with a grossly over-valued currency certainly for the last 40 years and arguably for nearly all the time since the middle of the nineteenth century, at huge cost to our economy and our relative position in the world.


What is the evidence that sterling has been much too strong for a very long time? Consider the following:

Share of World Trade It is the exchange rate which translates the costs incurred internally in any country as it produces goods and services for export to those charged to the buyers in international markets. The stronger the exchange rate is in relation to the domestic cost base the higher the prices charged to international markets will tend to be – and vice versa. A crucial test as to whether average export prices are too high or too low is therefore provided by whether any economy is gaining or losing share of world trade. In the British case, the evidence is damning. These are the figures:

In 1950 our share of world trade was 25%. By 1970 it had dropped to 6.5%. By 2000, it had fallen to 4.4% and by 2010 it was 2.7%. It is now 2.3%. These figures show beyond any reasonable doubt that at least for the last 60 years our export costs have been far above the world average.

When the exchange rate is too high, importing becomes much more profitable than manufacturing and exporting. This has been the position in the UK for many decades as one manufacturing plant after another has closed down. With all the economic incentives involved in foreign trade stacked in favour of buying from abroad rather than selling abroad – as is evidently the case in the UK – it is hardly surprising that our exports have grown more slowly than those of almost any other developed country in the world.

Balance of Payments Another clearly relevant measure of whether or not the exchange rate is correctly position is provided by the balance of payments on current account. If it is in deficit year after year, especially if at the same time the economy is growing very slowly, if at all, this is a strong indicator that the currency is over-valued.

The UK’s balance of payments on current account has been in chronic deficit for decades. Although there has been a surplus on services and net income from abroad this has been more than offset by a huge and increasing deficit on merchandise trade. This is very strong evidence that the UK cost base – all the costs which go into making anything which are rooted in the domestic economy – are being charged out to the rest of the world at much too a high a price. This is entirely an exchange rate issue.

During the whole of the period from 2000 to 2010, for example, the UK had an overall balance of payments deficit on current account of just over $520bn. The balance of trade on goods (excluding services, transfers and income) was much worse, at more than $1.3trn – an average of about £30bn a year for the whole period. The latest figures from the Office of National Statistics show no improvement, despite the depressed state of the economy. The current account payments deficit during the second quarter of 2012 came in at a further £20bn.

Deflation Another crucial test is the growth rate achieved by the economy. If the exchange rate is too high, the economy tends to suffer from balance of payments deficits which inhibit running the economy at anything like full throttle. It then becomes impossible for demand to be expanded because the result would be an unmanageably large current account foreign payments gap between revenue and payments.

Again, this is exactly what has happened to us and once more the evidence is overwhelming. The UK economy has grown more slowly than that of any other developed country since World War II except Italy, which suffers from the same problems as we do but in even more accentuated form. Listed below are the growth figures for some of the major economies in the world covering the 40 years between 1970 and 2010:

Average Yearly Total % Increase in

Country Growth Rate GDP over the Period

China 8.4% 2,601%

France 2.1% 133%

Germany 2.1% 132%

Holland 2.3% 155%

Italy 1.9% 113%

Japan 2.9% 220%

Singapore 7.1% 1,584%

South Korea 7.6% 1,909%

UK 2.0% 126%

USA 2.4% 1.66%

The very slow growth of the British economy over this long period, especially compared to the most successful Far Eastern countries, is the result of our chronic balance of payments weakness. The huge $520bn cumulative current account payments deficit racked up by the British economy between 2000 and 2010, financed very largely by net sales of portfolio assets on a scale unmatched by any other country, sucked a massive amount of demand out of the economy while, at the same time the deflation thus generated weakened the economy’s capacity to attract sufficient investment to rebalance itself.

De-industrialisation The section of the economy which is hit most heavily by an over-valued currency is manufacturing. This is because it is the production of goods which is most exposed to international competition and which is therefore most vulnerable to unmanageable competition resulting from an uncompetitive cost base.A further test as to whether any diversified economy such as that of the UK has an over-valued currency or not is therefore provided by the proportion of the economy devoted to manufacturing as opposed to services and other components of the national income.

Yet again, the evidence is damning. The proportion of British output arising from manufacturing has declined dramatically over recent decades. Even as late as 1980, 23% of UK GDP came from manufacturing. By 1995 this had fallen to 18% and by 2012 to 12%. While other countries, especially in the West, have seen comparable falls, Japan and Germany, each with strong balance of payments positions, still have over 20% of their GDP derived from manufacturing, while Korea has 25% and China over 30%. It is their export led growth which has undoubtedly been the main driver of their sustained growth rates – exactly the opposite to what has happened in the UK.

Unemployment Another key way of assessing whether the exchange rate is at the right or wrong level is provided by how much unemployment there is. If the exchange rate is at an appropriate level, it ought to be possible to achieve unemployment rates of 3% or less on average from year to year. This was indeed the position across almost the whole of Western Europe during the 1950s and 1960s. Low unemployment levels could be maintained because there was sufficient demand to keep almost everyone in work.

Nowadays, the situation is catastrophically different. In the UK, the headline unemployment figure is currently hovering around 8.0% – about 2.5m people – but these figures enormously underestimate the total number of people who would be prepared to work if jobs at a reasonable wage were available to them. A recent survey by the TUC indicated that the total, including all those both on long term sickness benefit and those caught in income trap problems but capable of working given the right incentives, was little short of five million. It is lack of demand, caused by our weak balance of payments and our consequent inability to expand the economy to provide everyone with work which has caused the huge economic and social problem which lack of adequate employment prospects brings in train.


Perhaps the most telling indication of all as to whether the pound is over-valued or not is provided by how many talented people with a wide choice of potential career paths choose to go into manufacturing. Some do, but far too few. The reason is simple. Wages and salaries tend to be far lower in industry than they are, for example, in the City, the media and many of the professions. The result is that for many decades, British manufacturing has been starved of talent at every level. This no doubt explains why so many of the manufacturing operations still left in Britain are now managed – and owned – by people from abroad.

No doubt weak management feeds on itself, producing progressively less competitive products, and poorer and poorer export performance. The truth is, however, that this situation will never be remedied until the remuneration and career prospects in manufacturing are as good or better as they are anywhere else in the economy.


If all the ways of assessing whether the UK has an over-valued currency or not

suggest that this is indeed a very large problem, together they provide overwhelming evidence that the excessive strength of sterling is indeed a major millstone round the neck of the British economy. It is the failure to recognise how damaging this is which is the single most important reason why, without taking remediable action on this front, it is so difficult to see any way of our avoiding years of austerity, high unemployment, low or negative growth, stagnant or falling living standards and declining influence in the world. Making sure that the exchange rate is at a level which enables our manufacturing companies to compete internationally is the only way of getting Britain to be able to pay its way in the world on a sustainable basis. Unless we get this done, there is no way of avoiding all the negative trends exemplified by the British economy in recent decades becoming steadily more depressingly acute. We very urgently need a major change in policy.

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