Bulletin – February 2013 How to get the economy to grow at 4% per annum and to reduce unemployment to 3%

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February 1, 2013 by johnmillsjml

Exchange Rate Reform Group

BULLETIN  –   February 2013



How to get the economy to grow

at 4% per annum and to reduce

unemployment to 3%


At the moment, the UK economy is barely growing at all. It is dipping in and out of recession. Total output, having fallen 5.4% between 2007 and 2009, had only risen 3.2% from its 2009 low point by the third quarter of 2012. The headline rate of unemployment at the beginning of 2013 stood at 7.7% although the total number of people who would be able to work if jobs were available at reasonable rates of pay is much higher than this. If all those who are on long term sickness benefit but still capable of working are included, plus everyone forced into early retirement or caught in benefit traps or who has given up hope and dropped out of the labour force, a report by the TUC in January 2012 suggests that total unemployment may be as high as 6.3m.


With four years of no net growth behind us and little prospect of much in the future, if present policies are maintained, is it really possible to get the UK economy to grow at 4% per annum and to bring unemployment down to 3% over the next few years? It is – and this Bulletin explains how this could be done.


What is the UK’s fundamental problem? The key problem faced by the UK economy is that we cannot pay our way in the world. We have therefore had a balance of payments deficit, sucking demand out of the economy, every year since 1983. The 2012 Autumn Statement estimates that this deficit is now running at 4% of GDP, which comes to about £65bn per annum.


The size of this deficit makes it impossible for the government to run the economy at anything like full throttle, because doing so would widen the deficit to unmanageable proportions. The result is that the level of demand for all the goods and services which the economy could produce is insufficient to keep all the country’s labour force employed or to use all the productive assets available to the full. In these circumstances, unemployment is bound to rise and investment to fall, which in turn makes the economy increasingly uncompetitive. Debt is also bound to increase as every pound of the deficit has to be matched by capital receipts or borrowing.


There is only one viable solution to this problem which is to get the UK’s manufactured exports up. More than half our exports are still manufactured goods. Our net income from abroad from services and investment – although both are still in surplus – even when taken together are much too small to close the gap. The only way to avoid future balance of payments deficits therefore is for us to sell far more goods abroad. By far the biggest single reason why this is not happening at the moment is that our export production costs are, on average, much too high to be internationally competitive.


The reason this is the case is that we are charging out to the rest of the world all the domestically incurred costs of our manufacturing industries at far too high a rate. This is entirely an exchange rate issue. Typically for manufacturing, about 20% of costs are raw materials, 10% is depreciation and all the rest – excluding profits at, say, 10% – consists of labour, rent, interest, bought in services, etc., almost all of which are supplied within the UK and priced in sterling. While broadly speaking raw materials and depreciation depend on world prices, all the components which make up the remaining cost base are sterling based and the exchange rate determines what we charge the rest of the world for them. As these typically make up 60% of total costs if, for example, the exchange rate was halved, our export costs would fall by half of 60%, reducing their cost to the rest of the world by 30%. As the cost base in countries such as China is about half what it is here, this is one of the key reasons why their exports are so competitive.


How responsive are our exports to the prices charged for them?  The crucial question for the UK, then, is by how much would we have to reduce what we charge the rest of the world for our manufactured goods to close the balance of payments gap and to reduce unemployment to a target of 3%. This depends entirely on how sensitive on average demand for our exports and imports is to changes in what is charged for them. Plenty of studies have been done to determine the elasticity of demand for both exports and imports. These were summarised most recently in a report published in 2010 by the International Monetary Fund which showed the UK having an elasticity of demand over a two to three year period of 1.37 for exports and 1.68 for imports (Table 1 page 15 in IMF Working Paper WP/10/180). The condition which needs to be fulfilled for a devaluation to improve the foreign trade balance (the Marshall-Lerner Condition, many descriptions of which can readily be found on the internet) is that the sum of these two elasticities needs to be more than 1. Clearly, this condition is easily met.


Armed with this information, it is then a fairly simple matter to calculate how much devaluation the UK would need to get both the country’s external payments back into balance and to get unemployment down to 3%. The factors which need to be taken into account are inevitably rather more complex than those shown below but the essential elements of the calculations which need to be done are as follows:


1.A     To allow for the fact that the elasticities may be overstated it may be safer to assume, as is done below, that each of them is no more than 1 rather than being 1.37 and 1.68, to provide a substantial margin of safety.


1.B     Not all the increased cost of imports will be passed on to the consumer and exporters will take some of the benefit of a lower exchange rate in raising prices. A reasonable estimate is that that these pricing effects will reduce the balance of payments impact on the trade balance by one third.


1.C    Elasticities of 1 for both exports and imports implies that a devaluation of 1% will then increase our exports over a two to three year period, allowing for the pricing effect described in the previous para by two thirds of 1% while the rise in import costs will be fully offset by an equivalent fall in import volume.


1.D    With a deficit of, say, 4% of GDP and about 30% of the economy involved in exports, the devaluation required to close this gap is 4% divided by 30% times two thirds, which is 20%. This is a higher percentage than that given in some previous calculations circulated by the Exchange Rate Reform Group, because the foreign trade balance has significantly deteriorated recently.


1.E     To get unemployment down from its current headline level of about 8% to 3%, demand on the economy might look as though it needs to be increased by about 5%. Actually, experience shows that for every two people who are currently counted as unemployed, at least one more person will be drawn back into the labour force, so the extra demand needed is not 5% but more like  12% – 3%, which is 9%, to get the headline rate down to 3%. To enable the economy to run at the considerably higher level of demand needed to get unemployment down to 3% while also taking account of the pricing dilution impact detailed in para 1.B above, an additional devaluation of 9% x 3 / 2, or about 13% would be needed.


1.F     Taking the two requirements together – getting our current account in balance and reducing unemployment to 3% – would therefore require in current circumstances a devaluation of around 20% plus 13% – i.e. about one third. It is no coincidence that it was a depreciation of about this size in 1931 which stimulated the UK economy to its fastest growth of any four year period in its history between 1932 and 1937, when GDP rose cumulatively at over 4% per annum for the whole of this period. Employment rose from 18.7m to 21.4m as 2.4m new jobs were created, half of them in manufacturing.


Are there dynamic as well as static benefits from having a competitive currency? While charging out the UK cost base at a much more competitive rate would substantially improve the UK’s competitive position, this is by no means a one off benefit. There are a number of crucial ways in which this would make the UK economy much more able to compete in the world on a long term basis. The key reasons why this is the case are as follows:


2.A     Exporting would become much more profitable than it is at the moment and exporting companies would therefore be in a much stronger position than they are now to pay sufficiently high wages and salaries to attract talented people at every level, but especially in key management positions. One of the main reasons why many UK companies are so uncompetitive is that so few talented people with enough ability to have a wide range of career choices in front of them opt for manufacturing.  


2.B     Because of both increased profitability and the prospects of much larger foreign sales than existed before, investment in export orientated plant and equipment would become a much more attractive proposition. New machinery, embodying the latest technical developments, is hugely much more productive than equipment which is a decade or two old, as technology, especially based on more and more powerful computer control, continues to   advance very rapidly.


2.C    A successful manufacturing economy depends on there being a wide spread of manufacturing companies and suppliers to them, so that supply chains can be established locally. Relying on foreign suppliers for raw materials and components is never as convenient and productive as having them based reasonably close by. Quality control is then easier. Deliveries are faster and interchange of information needing to productivity improvements is much more likely to take place.


2.D    Perhaps as critical as anything else, manufacturing would be much more powerful politically than it is at the moment. Instead of having all the running made by financial interests, which are by no means that closely aligned to those in manufacturing, those running successful and profitable exporting companies would be much more likely to have the ear of government – as they do, for example, in Germany – than is the case at the moment in the UK, where manufacturing is too weak and poorly regarded to have much clout.


If we want to avoid all the austerity, economic stagnation, high unemployment, rising debt, increasing inequality and relative if not absolute economic decline which currently appears to be in front of us for the foreseeable future, the only way we will do it is by exporting more manufactures. To do this, we have to make them more competitive both in price and quality. Of course a much lower exchange rate is not a silver bullet which will cure all our ills. Many other complementary supply side policies will be required. Unless, however, we focus on making sure that our exchange rate is reduced to a competitive level and kept there, no other mix of policies will work. 





Published by the Exchange Rate Reform Group

JML House, Regis Road, London, NW5 3ER

Tel: 020 7691 3833 * Fax: 020 7691 3834

E-mail: john.mills@jmlgroup.co.uk  *  Website: http://www.johnmillsblog.co.uk

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