Bulletin – March 2013 What needs to be done to get the UK economy back on track

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March 1, 2013 by johnmillsjml

Exchange Rate Reform Group

BULLETIN   –     March 2013


What needs to be done to get the

UK economy  back on track


The UK economy is in dire shape. If current trends continue, we are going to have a decade while it dips in and out of recession, accompanied by stagnant living standards, more and more overstrained public services, unacceptably high unemployment, mounting inequality and relative if not absolute economic decline. None of these disastrous outcomes is necessary. All could be avoided – but none of them will be without a major shift in economic policies away from the current ineffective consensus towards a much more realistic approach to our current difficulties. This Bulletin explains once more why our economy is doing so badly and what we need to do to get it to perform very much better.


The root problem is that the British economy is grossly uncompetitive. As a result we cannot pay our way in the world. We have a huge balance of payments deficit, estimated in the 2012 Autumn Statement to be about 4% of our GDP, or over £60bn a year. Between 2000 and 2011 the UK economy ran up a deficit every year, cumulating during this period up to £315bn. In 1950, the UK’s share of world trade was 25%. It is now well under 3%. Our visible trade deficit is now running at over £100bn per year. The evidence for our lack of competitiveness is overwhelming.


Because a foreign payments deficit means that the UK is paying out much more money than we are receiving in, it sucks demand out of the economy. To stop demand collapsing, this lack of purchasing power has to be replaced somehow. During the relatively prosperous years up to 2008, this was achieved by consumers and businesses borrowing and spending more than their incomes. Now the corporate sector is hoarding cash instead of investing while consumers are pulling in their horns. This leaves a big government deficit as the only way to hold up demand. Cutting the deficit by reducing government expenditure and increasing taxation, as currently advocated by almost everyone, is therefore no solution – which is why it is not happening. In present conditions, as long as there is a big foreign payments deficit, reducing the government deficit would simply force the economy to spiral down. Welfare payments would go up and tax receipts fall – and the deficit would stay about the same. This is why the Coalition economic strategy – without tackling the foreign payments deficit – is doomed to failure.


Both the UK’s £60bn foreign payments deficit and the projected £120bn underlying government deficit projected for both 2012/13 and 2013/14 can only be financed by either borrowing or capital receipts. During the 2000s, the foreign payment deficit was financed by massive net sales of UK portfolio assets. Most of our power generating companies, our airports and ports, our water companies, many of our rail franchises and our chemical, engineering and electronic companies, our merchant banks, an iconic chocolate company, our heavily subsidised wind farms, a vast amount of expensive housing  and many, many other assets all disappeared into foreign ownership. Now that so much has been sold both the country and the government have to rely on borrowing. This is why both the country’s and the government’s debt liabilities are spiralling upwards to unsustainable levels, and why we recently lost our AAA credit rating.


The main reason why the UK economy is so uncompetitive lies in our inability to export enough manufactured goods. Two thirds of our exports and three quarters of our imports are goods rather than services. The only cure for our trade deficit, therefore, is for us to sell the rest of the world more manufactures. Services will never fill the gap.


Why are our exports so uncompetitive? They are too expensive because we charge out our cost base at far too high a rate. Typically, most manufacturing operations spend about 20% on raw materials and 10% on plant and machinery, for all of which there are, broadly speaking, world prices. Including a provision for a profit of perhaps 10%, this leaves about 70% of all costs which are incurred in sterling – on everything from wages and salaries to interest charges, from bought in goods and services to rent for premises. How much the cost base is charged out to the rest of the world depends entirely on the exchange rate. Because ours is far too high we cannot compete with countries such as China whose undervalued renminbi allows their cost base to be charged out to the rest of the world at about half the effective exchange rate used for ours.


Look at where we would be – by way of a simplified illustration – if we had an exchange rate half what it is now. Measured in sterling 30% of our manufactured costs would double while 70% would stay the same. Our export costs – measured in sterling – would therefore rise by 30%. Measured in international currencies, however, 30% of our costs would stay the same and 70% would fall by half. Our exports would therefore become 35% cheaper to foreign buyers. This shows how critically important the exchange rate is to international competitiveness.


How did we ever get into a situation where our cost base is charged out at a rate about twice as high as countries in the Pacific Rim? There are good reasons for believing that the UK has been dogged with an over-valued exchange rate almost all the time since the early nineteenth century but the real damage was done when monetarist policies became fashionable. Between 1977 and 1982, high interest rates and a tight money supply drove up the UK’s exchange rate by over 60%. The policies used to keep inflation down – which are almost identical to those needed to keep sterling far too strong – have then kept the pound far too high almost all the time for the last four decades. No wonder we have far too little to export that the rest of the world wants to buy.


The deindustrialisation which has happened as a result of the collapse of so much British manufacturing industry also has other very major costs. Productivity increases are much easier to achieve in manufacturing than in the service sector, so countries with weak manufacturing bases tend to grow much more slowly – if at all – compared to those with strong ones. Manufacturing also provides far more good quality blue collar jobs than services and industrial jobs tend to be much more widely distributed geographically, thus discouraging the enormous differences in living standards between different parts of the country. Recent figures show a staggering difference in the annual average gross value added per worker in Greater London (£35,638) compared with the poorest region, which is the North East, where the comparable figure was £15,842. Average gross weekly earnings may provide a better guide to actual living standards and in the second quarter of 2012 these were £719 in London and £462 in the North East. Of course London is a much more expensive place to live than Newcastle, so the differences in living standards are not as stark as these comparisons might suggest. Even so, they are still very wide and there is little doubt why these enormous gaps have opened up. It is the collapse of so much manufacturing industry in the regions combined with the dominance of financial services in London which is very largely responsible.


Balance of payments deficits year after year also entail a very heavy constraint on expanding the economy, thus making it possible for us to use all our resources to full effect. This is the main reason why we have such appalling unemployment problems. Not only do we have over a million young people out of work, but we now also have a total of nearly 5m people who are not working in the UK but who could do so if there were opportunities to do so at a reasonable rate of pay. This is an incredible and inexcusable waste, especially at a time when the population is aging.


The only policy which will remedy these problems is to get the UK cost base down to a level which will make it possible for us to re-establish enough manufacturing capacity to enable us to compete in the world. To do this, some fairly simple calculations – taking into account the recent worsening trade balance – show that we need to get the pound down from its present level of about £1.00 = $1.50 to somewhere fairly close to £1.00 = $1.00 or €0.80. This would not enable us to grow as fast as China does but it would make it possible for us to expand our economy at about 4% per annum and to get unemployment down to perhaps 3%. Of course getting the pound down on its own is not enough. Many complementary supply side policies will be required, but without getting the exchange rate in the right place no other mix of policies will work.


Why don’t we do this? Much of the reason is because of very widely held beliefs about economics which are simply not true. The most widely prevalent are:


  1. Devaluation always produces more inflation. This simply is not the case. People who believe this cannot have looked at all the historical statistics which are readily available. Inflation usually stays much the same as it was before a devaluation although in many cases – such as ours after the 1992 depreciation – it actually falls.


  1. Devaluation reduces living standards.  This cannot be correct if a much lower exchange rate makes the economy grow much faster than it did before. GDP per head – a close proxy for living standards – must rise on average if the population stays the same while GDP gets larger.


  1. Governments cannot change exchange rates, which are entirely fixed by market forces. This is patently not true. Governments can have a large influence if they want to use it – to get the exchange rate up, as happened to the UK between 1977 and 1982 or to get it down as Japan has done recently and the USA did as a result of the Plaza Accord Agreement in 1985.


  1. Other countries would retaliate. This did not happen as the pound fell from $2.00 to $1.50 over the last few years. Why should a further fall to around $1.00 be such a problem? Our share of world trade is now so small that what we do with sterling no longer matters very much to everyone else.


  1. We have tried devaluation before and it does not work. Our problem is that we have always devalued too little and too late, while our rate of inflation has been well above the international average. This has left sterling chronically over-valued for decade after decade.


It is, however, true that if the pound went down by 25% imports and foreign holidays would be more expensive. It is also true that all the politicians, civil servants, commentators and academics who have supported policies to keep inflation down as top priority would have to change their mind-set to understanding that getting the exchange rate right is a much more important goal. Changing accepted orthodoxy is likely to be much the biggest obstacle to getting economic policies for the UK back on track.


There are two other compelling reasons why the policies advocated above should be adopted. The first is that they are a necessary but not sufficient condition for any recovery to our economic prospects. While many complementary policies are going to be needed, unless we deal with the problem of our hugely uncompetitive cost base, no other mix of policies will work. The second is that if we continue as we are, this will not stop the pound eventually being devalued by market pressures. This will inevitably happen sooner or later as we get trapped into more and more borrowing with an economy which is not growing, a condition which is simply unsustainable. If we are going to have to devalue at some stage, we would be much better to do it earlier rather than later, thus avoiding a long and wholly unnecessary period of austerity, high unemployment and little or no growth, as our position in the world steadily declines.




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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