January 1, 2014 by johnmillsjml
BULLETIN – January 2014
Why it is possible for the UK economy to do so much better
than it is at the moment
At the end of the 1930s, something extraordinary happened to the US economy. Having languished for much of the previous decade with the same sort of downturn and recovery accompanied by high unemployment as we have seen in the UK over the last few years, the US economy suddenly started growing at extraordinary speed. Between 1939 and 1944, it expanded by an astonishing 84%, a compound rate of 13% – much faster than has ever been achieved by China, and not just during one year but for five in a row. Over the same period, industrial output increased by almost 140%, while the number of people employed in manufacturing rose from 10.3m to 17.3m, an increase of just under 70%.
Of course, it was the stimulus that came from rearmament which provided this huge boost to US output. Something rather similar had happened, however, a few years earlier in the UK – well before military expenditure started to increase as World War II approached. Between 1932 and 1937, the UK economy grew faster than it had ever done before or has done since – cumulatively by 3.8% per annum. Manufacturing output rose by 48%. Unemployment fell sharply as the number of those in work rose from 18.8m to 21.4m as 2.6m new jobs were created, nearly half of them in manufacturing. It was this vastly improved economic performance that provided the industrial capacity without which – apart from anything else – the UK might not have been able successfully to fight the Second World War.
What caused these phenomenally successful periods of economic advance to materialise? Even more importantly, would it be possible to replicate them again in the UK, starting from where we are now? What would we need to do to reproduce the key conditions and triggers which caused not only the massive expansion of the US economy during World War II but which also made the UK economy work as well as it did during the mid-1930s? Would it be possible to get this done?
The first key requirement is to make it possible for a large increase in demand to take place on a sustainable basis without this either causing excessive inflation or provoking a balance of payments crisis. This is the first vital component to the favourable conditions achieved in both the US and UK economies as they did so well during the periods described above. The trick is to find a way of creating conditions in the UK which will make this happen again. In the US case, it was the demand for arms that caused the huge increase in demand. In the UK during the mid-1930s, however, rearmament had hardly started. The trigger was the big devaluation in 1931 when the UK came off the Gold Exchange Standard. This suddenly made industry much more profitable than it had been before, triggering a major rise investment – with a 47% increase between 1932 and 1937 – and a big drop in unemployment, which almost halved over the same period.
To get this done, the first step needs to be to rebalance the UK economy away from excessive reliance on the service sector and consumer expenditure, based in turn too much on house price inflation, and towards manufacturing, investment, exporting and import substitution. This has to be done by making all these activities far more profitable than they are now – exactly as happened in the UK in the 1930s. There is only one way to do this, as there was then. It is to provide the UK with a much more competitive exchange rate. We devalued by 28% against the US dollar in 1931 and we need to do the same again now, to provide the key profit incentives which will make the economy respond as we need. The high productivity gains obtainable from manufacturing will then help keep inflation down. More exports and relatively fewer imports will keep foreign deficits at bay. The boom in manufacturing and investment will provide a big stimulus to the rest of the economy.
These conditions then provide the platform for getting to grips with our chronic problems of under-investment, balance of payments deficits, excessive government borrowing and far too high levels of unemployment. In the UK, we now spend less than 14% of our national income in investment for the future compared to a world average of 23%. The figure for China is 46%. Unless we can get our investment ratio up to 20% or more, we have no hope of getting our economy to grow at any speed on a sustainable basis. As to our balance of payments, we have not had a surplus since 1983, while the gap between the government’s income and expenditure is still about 6% of GDP. The real level of unemployment is not the 2.4m headline figure. It is about twice this number if everyone of working age is included who would be able and willing to work if employment was available at a wage which made working worthwhile.
Because our economy is in such bad shape it might make it look as though it would be very difficult to get the economy to grow much faster, but actually the reverse is true. Just as happened in the USA and the UK in the examples quoted above, it is the fact that we have such vast unused resources of labour which makes it possible to combine increased employment with much higher levels of investment to produce far higher growth rates. To make this policy work there are essentially two requirements to be fulfilled. One is that the volume of export sales and import substitution has to be sufficiently sensitive to the prices charged to make enough difference to the country’s trade balance for the economy to expand fast without precipitating a foreign exchange crisis. The other is that the total returns on investment – the overall increase in output achieved as a result of using both much more efficient plant and machinery and previously unused resources of labour – has to be large enough to make it possible to provide for all the increasing demands on the economy at the same time. There is ample evidence that both these conditions can be fulfilled, especially if the right supporting policies are put in place. A major study by the International Monetary Fund published in 2010 showed that the responsiveness of UK export and import volumes to relative price changes was comfortably sufficient for a more competitive pound to improve the balance of payments. As to the overall returns on investment, while it is difficult to get them up to the required level from public sector investment in roads, rail, schools and hospitals, it is much easier to do this in light industry and related activities. A key element of the strategy to be pursued, therefore, has to be to bias investment as far as possible into these high productivity sectors. It is the very high returns from this kind of manufacturing which explains the impressively strong Chinese growth rate, and the economic success of high income countries such as Singapore.
There is, however, a major difficulty to be overcome. You cannot use the output of the economy for investment, for improving our foreign payment balance and for maintaining living standards at the same time. To get our rate of investment up to the world average we would need to switch about 9% of our national income – raising it from 14% to 23% – away from consumption to building for the future. Closing the foreign payments gap involves at least another 4% of GDP. How are we going to do this without a massive reduction in living standards?
The solution to this problem comes in two parts. One is that, if the economy grows much faster, there is much more output to spread everywhere. We need to use a fair proportion of it to make sure that living standards go up. The second is that, if we can get the economy to expand much more quickly, we can then safely afford to go on borrowing from the rest of the world by running a balance of payments deficit during the transitional period while the economy is rebalanced, knowing that the resources will be available for us to pay back our foreign creditors later. Closing the foreign payments gap too early will put too much stress on living standards during the critical transition period.
The reason why this is a safe and realistic policy is that there is no big problem about borrowing, as long as you have the resources to meet the interest payments and to be able to pay back the principle in due course. The problem comes when debt is rising but there is no growth in repayment capacity. This is the bind we are in at the moment on both the government deficit and our negative foreign trade balance. If they are both going up as percentages of our national income much faster than our economy is expanding, sooner or later insolvency must result. If, on the other hand, the economy is growing at, say, 5% but the debts are accumulating at, say, 3%, the position will be sustainable as far ahead as anyone can see.
Put all this together and what could we achieve? Over a five year period, the UK growth rate could be raised to as much as 4% to 5% per annum on a sustainable basis. Unemployment would fall towards 3%. The proportion of the UK GDP devoted to gross investment would rise from its present barely 14% to well over 20% as the economy was rebalanced. Manufacturing output would rise by about 50% over the five year period. Consumer expenditure could increase every year. Inflation would probably be no more than about 4% but might be less. The rate of growth of both the government’s and the country’s total debts would fall well below the growth rate and would thus become sustainable. Inequality both between the regions and socio-economic groups should fall. Government revenues and expenditure should stabilise at about 40% of GDP each. The government would then no longer need to borrow and total government debt – likely to be as high as 100% of GDP by the time of the next general election – would steadily fall as a percentage of our national income as the economy continued to grow.
So why don’t we do it? It is not because any of the key requirements on price sensitivity or returns on investment are not in the right place. Nor is it because it would be particularly difficult to get the exchange rate down to the truly competitive level we need, if there was a government determined to achieve this objective. Japan, for example, has brought down the value of the yen on international markets by about one third over the past year by taking exactly the sort of steps which we need to copy. The reason why we are stuck with the catastrophically ineffective economic policies we currently pursue is that our politicians, commentators, civil servants and the academic world have all reinforced each other in pursuing economic doctrines which are the opposite of what we really need. Chasing inflation at 2% is not the Holy Grail, not least because it is impossible to combine reasonable growth rates with inflation as low as this. Indeed, strategies based on the idea that low inflation leads to low interest rates which in turn lead to more investment and higher economic growth manifestly do not work. Instead we need to make the most important things the economy needs to do the most profitable. Until more money can be made in manufacturing than in accountancy and banking, we will never be able pay our way in the world and to keep up with other countries.
We need to realise that there are not two but three main ways in which the government can control the way the economy operates. Fiscal policy – changing government tax and expenditure – is one. Monetary policy – controlling the amount of money in the economy and the interest rates at which it is borrowed and lent – is the second. Equally important as both of these – and at least as important as either of the others – is the third, which is exchange rate policy. The solution to our economic problems is to use all three of them together. This is what was done by the USA during World War II, what drove the UK so successfully in the 1930s, what is going to make China overtake the USA as the largest economy in the world before long, and what keeps Singapore expanding at 6% per annum even though the living standards there are already higher than ours in the UK. There certainly is an alternative to our current economic policies, and we ought to adopt it.
Published by the Exchange Rate Reform Group
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