Bulletin December 2012 – The Chancellor of the Exchequer’s Autumn Statement and the Exchange Rate

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December 15, 2012 by johnmillsjml

The Treasury has published on its website a 97 page document providing a huge amount of background detail to the Chancellor of the Exchequer’s Autumn Statement, delivered to the House of Commons on Wednesday, 5th December 2012. A careful search shows only one mention of the exchange rate in the entire document. This is buried in a table on page 87 which tells us nothing more than that the Office of Budget Responsibility projects that there will be no change in the value of sterling vis à vis the euro during the next five years. As to the House of Commons itself, neither in the Chancellor’s speech nor during whole of the subsequent debate on the Autumn Statement was there any reference at any point to the exchange rate. Not a single one.

Incredibly, one of the most significant influences on the performance – or lack of it – of the UK economy, which is the impact of the exchange rate on our international competitiveness, was completely ignored. It is this total lack of interest in perhaps the most important economic policy tool of all available to the government which goes a very long way towards explaining both why the economy is in such dire shape and why we are promised nothing better than many more years of austerity, low or negative growth, high unemployment, cuts in expenditure and relative if not absolute national decline. None of this is necessary. All of it could be avoided – but none of it will be if we continue as we are. On the contrary, if growth does not pick up soon – which seems unlikely – by the first half of 2013 we may well be in a triple dip recession.

We are committing ourselves to a future of economic misery and failure not because this has to happen but because of bad economics, intellectual failure and a relentless determination to chase the wrong economic policy targets.

Why is the Exchange Rate so crucial? The fundamental problem with the British economy is that we cannot pay our way in the world. Every year we have a huge balance of payments deficit – estimated in the Treasury Autumn Statement document at 4.0% of GDP in 2012, or about £65bn. The main reason for this very large difference between the total income we receive and the total expenditure we pay out is the massive deficit we have on manufactured goods – now running at well over £100bn a year. Manufactured goods are far the largest component of our foreign payment balance – still about 50%, and much greater than services, income or transfers – so unless we can sell enough manufactures to the rest of the world, we will never get rid of our current account deficit.

Nor will we ever manage to get government borrowing under control as long as this foreign payment deficit exists. This is because our current account deficit sucks demand out of the economy while every pound of the deficit has to be financed by borrowing, getting the UK economy deeper and deeper into debt. There are then three ways in which the demand deficit could be offset. Businesses could invest more than they save – but this is not happening because confidence is so low. Consumers could spend more than their incomes – but they are pulling in their horns at the moment. The only other way to plug the gap is for the government to make up the difference by spending more than it raises in taxes and charges – and to continue racking up more debt year after year. This, of course, is what is happening. The reason that this is such a serious problem is that government borrowing is now increasing fast while the economy is not growing, so the ratio between total government debt and the national income is rapidly deteriorating. No wonder that the UK’s Triple A credit rating is now under threat, as the markets wake up to the implications of this unsustainable trend.

Why can’t we export enough to pay our way in the world? There is a simple reason why year after year we have a big foreign payments deficit. Measured in international terms, it costs more to produce almost anything in the UK than it does in other parts of the world, particularly in the Far East. As a result we do not have enough to sell to the rest of the world to pay for all our imports. This is not because wages are lower in other parts of the world than they are here. It is evidently possible to have highly competitive export sectors in high wage economies, as countries such as Germany, Norway and Switzerland clearly show. Our problem is that the amount we charge the rest of the world for all the domestically incurred costs involved in production is far too high in relation to UK productivity. This is entirely an exchange rate issue. If we want to charge the world competitive prices, we need a much lower exchange rate.

Why is the exchange rate much too high? It is because for a long time now we have been chasing the wrong economic goals. Much of the problem goes back to the 1970s and 1980s, when inflation was a huge concern. The solution adopted was to squeeze unacceptably large price rises out of the system with very high interest rates and ultra-tight money. Inflation did come down but very few people at the time paid any attention to what monetarist policies did to other economic policy variables, particularly the exchange rate. In fact sterling rose in real terms against all other currencies by over 60% between 1977 and 1982 – and, with some fluctuations, it has stayed at this far too high level ever since. The main reason this has happened has been the continuing obsession which policy makers have with keeping inflation as low as 2% per annum. Unfortunately, the policies needed to try to hit the 2% inflation target are almost exactly the same as those required to keep the exchange rate far too high.

Why does aiming to keep inflation at 2% do so much damage? The theory behind aiming for price rises of no more than 2% per annum is that a low rate of inflation such as this will enable interest rates to be kept down, thus encouraging investment and growth. Unfortunately, there is no indication that this is actually what happens. On the contrary, there is overwhelming evidence that policies of this sort are entirely counter-productive. It is not difficult to explain why this should be the case.

Keeping inflation at no more than 2% entails constantly depressing demand in the economy, to suppress price and wage increases. The relatively high real interest rates involved – nominal rates minus inflation – attract in foreign currency, pushing up the exchange rate. Any benefit from low nominal interest rates is then far more than offset by deteriorating prospects for manufacturing industry and the economy generally, so investment levels are low, steadily making the economy less and less competitive. The consequent deterioration in the trade balance then acts as a more and more powerful constraint on expanding demand, so the economy gets increasingly more depressed. This is why we now have no growth and such very high unemployment – currently nearly five million people out of work altogether, including everyone able and willing to work if enough jobs at reasonable wages were available. The headline unemployment figure tells barely half the story. In addition to the 2.5m people counted officially as out of work, nearly the same number have been forced into early retirement or are caught in benefit traps or are on long term sickness benefit while still being capable of working or have given up hope of trying to get a job. This is both an economic disaster and a social and personal tragedy for all those involved which makes absolutely no sense, especially as the population ages and the ratio between those of working age and those outside it constantly falls.

Are we really all in this together? While the measures announced in the 2012 Autumn Statement involved some more austerity for almost everyone, the fact is that the highly depressed state of the UK economy has a far more devastating effect on those on already relatively low incomes than on those who are better off. This is because the current cut backs are being implemented against the background of one of the most pernicious effects of our long-standing over-valued exchange rate, which is its role in generating more and more inequality.

It is no coincidence that inequality has become so much more conspicuous in the UK since the huge increase in the exchange rate in the late 1970s and early 1980s. There are three main inter-locking reasons why this has happened. The first is the decline of manufacturing industry, with all the high productivity blue collar jobs which disappeared as we de-industrialised. This has had a major impact not only on income disparities but also between the fortunes of different areas of the country. The North East – once the shipbuilding capital of the world – now has average incomes per head which are 20% below the national average compared to London where they are 20% higher. The second huge driver of increased inequality has been the weakening bargaining power of labour as the economy has stagnated, driving up unemployment. This is exemplified most tellingly by the proportion of the national income which goes to wages and salaries. In 1976 this was 64%. It is now 55%. The third major reason for increased inequality is the ever increasing proportion of the potential labour force which is out of work and therefore living on benefits. Inevitably, income from these sources is well below the national average – and now being targeted for uprating by less than inflation – with the increasing number of people needing to be supported in this way putting ever heavier burdens on those still working. These three factors go a very long way to explain why there is now such a huge disparity in life chances between those at the top and bottom of the income spectrum not just in terms of income and wealth but also in life expectancy, health outcomes, susceptibility to crime and many other relevant measures of welfare.

What could be done instead? What would the prospects for the British economy be if we had a competitive exchange rate – perhaps 25% lower than it is at the moment? It is actually surprisingly easy to work out what they would be. There are plenty of statistics showing how sensitive demand for manufactured exports is to the prices charged for them on world markets. With an exchange rate of about $1.20 or €0.85 to the pound it would be possible within two or three years both to close the foreign payments gap and to start getting unemployment down towards about 3%. Economic growth would then be sustainable at 3% or 4% per annum. With rising prosperity and falling numbers of people depending on welfare, the condition of the government’s finances would vastly improve. Removing the foreign payments deficit would mean that the economy no longer depended on government borrowing to sustain demand. Without the need for more debt and with a growing economy, the government would find it easy to reduce the ratio between its total debt and the size of the national income, just as happened during the relatively prosperous decades experienced by the UK after World War II. Both geographically and in socio-economic terms, the UK would edge back to becoming a more equal and less divided society as prospects for those currently particularly vulnerable to unmanageable competition for jobs found demand for their services greatly increasing. Instead of stagnation there would be rising incomes for almost everyone as belt tightening and the prospect of endless austerity melted into the past.

Why don’t we do it? The biggest obstacle to doing what needs to be done is nothing technical or practical. It is changing ingrained attitudes. Keeping inflation as close as we can to 2% is not the main economic target at which we ought to be aiming. Instead, it ought to be to make sure that we have an exchange rate which allows us to export enough to pay for our all our imports, to have our economy growing, to reduce unemployment to much lower levels and to enable us to afford to provide high quality public services. We could do all of these things if only we had the will and clarity of purpose to do so.

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