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Objections to a lower exchange rate – and the answers

Roger Bootle and John Mills, September 2016

Real Sterling Crisis front cover1. Currency devaluation (or depreciation) inevitably leads to higher inflation.

There are many examples of countries experiencing currency depreciation and rapid inflation interacting with each other, indeed, feeding off each other. These examples, usually involving developing countries, often burdened by weak and ineffectual governments, have been widely assumed to reveal a general truth about the linkages between the currency and the price level. They do not. In fact, for developed countries they can be extremely misleading.

It is true that even for developed countries, following currency depreciation, the price of imports is bound to rise. Indeed, this is a necessary part of switching demand from international to domestic suppliers. It does not follow, however, that the overall price level generally will rise more quickly than it would have done without a devaluation. A wealth of evidence from the dozens of devaluations and depreciations which have occurred among relatively rich and diversified economies such as ours in recent decades shows that in fact, although lower exchange rates usually lead to a rise in the price level, sometimes they produce a bit of a reduction, and sometimes little if any change compared to what would have occurred anyway.

Moreover, even when the price level does increase, so that the measured rate of inflation rises, at least for a time, generally the increase in inflation is short-lived. After the once-and-for-all price shock has passed through the system, the inflation rate may readily fall back to roughly where it was to begin with.

One of the clearest examples is when the UK left the Exchange Rate Mechanism in 1992. Sterling fell by a trade-weighted 17%, but inflation fell from 3.2% in August 1992 to 1.5% in September 1994.

The reason why inflation may not pick up much, if at all, is that, while higher import prices push up the price level, many factors to do with a lower exchange rate tend to bring it down. Interest rates tend to be lower and production runs become longer, bringing down average costs. Investment, especially in the most productive parts of the economy may rise, increasing output per head, reducing costs and producing a wage climate more conducive to keeping income increases in line with productivity growth.

2. In today’s economy it is impossible to change the exchange rate.

It is frequently contended that the parity of sterling is determined by market forces over which the authorities have little control, so that any policy to change the exchange rate in any direction is bound to fail. Again, historical experience indicates that this proposition cannot be correct. The Japanese, to provide a recent example, brought the parity of the yen down by 10% between April 2013 and October 2014 as a result of deliberate policy (although the yen has since rebounded, partly because of safe haven demand). Further back, the Plaza Accord, negotiated in 1985, produced a massive change in parities among the major trading nations of the world at the time, causing the dollar to fall against the yen by 40% in the two years following the agreement.

Of course, market forces determine exchange rates but the authorities can influence the factors which determine what market forces are. If the UK pursues policies which make it very easy for overseas interests to buy British assets, for example, this will exert upward pressure on sterling’s exchange rate. If the markets think that the Bank of England is going to raise interest rates, this will also push sterling higher.

Nor is it true that it is impossible to change the real exchange rate by altering the nominal rate. This is the perspective that whatever gain is achieved by a lower exchange rate is soon offset by a higher domestic price level. Accordingly, it is addressed by the remarks under 1 above.

3. Any benefit from depreciation would be lost through retaliation.

There is no doubt that this is a significant issue. Yet the eurozone has been able to benefit from a huge depreciation of the euro without suffering retaliation. And the UK, of course, is much less important in world trade than the eurozone.

Moreover, the case for retaliation depends, in part, on the position from which the devaluing country starts. The problem of overseas payments imbalances starts, not with countries like the UK, with massive deficits, but with economies such as Germany and Switzerland with huge surpluses – in 2014 running at about 8% of GDP in Germany’s case and 7% for Switzerland. These surpluses have to be matched by deficits somewhere else in the world economy.

Unfortunately, surplus countries are never under any immediate pressure to reduce the beggar-thy-neighbour impact of their surpluses by revaluing their currencies and this leaves economies such as ours, carrying big deficits, with no alternative but devaluation to get the situation under control. There is thus a very strong principled case for countries such as the UK to make.

Actually, the boot should be on the other foot. It is not that the UK would encounter retaliation if she took action to reduce her exchange rate but rather that she is the sufferer from other countries’ competitive depreciations, principally the eurozone’s. It is the UK that needs to respond in order to preserve her own position. After the Brexit-inspired fall of the pound, the necessary response may simply amount to maintaining the new, competitive value for the pound.

4. Devaluation must make us all poorer.

Since import prices rise, depreciations tend to reduce the real incomes and living standards of many people. But this is not the end of the story. If a depreciation produces higher GDP then GDP per head will rise. Many people who did not have jobs will now have them and thus average incomes will rise. It is true that, for the depreciation to benefit the trade balance, there has to be an increase in net exports. While this will generate increased income it will not, directly, generate increased consumption. That is, after all, the point. Net exports represent consumption foregone.

Nevertheless, average living standards could rise if the increase in GDP, brought about by the depreciation, exceeds the increase in net exports plus any deterioration in the terms of trade (the ratio of export prices to import prices) and any redistribution of real income from workers to employers.

Many people assume that the terms of trade must deteriorate after a depreciation. They think this way because they reason that the depreciation ‘raises the price of imports but reduces the price of exports’. Indeed, this change in relative prices, they reason, is the channel through which the depreciation is supposed to improve the trade balance.

But when they reason this way they are thinking in different currencies for imports and exports. This is misleading. If you think in the same currency for both exports and imports then you can readily see that a deterioration in the terms of trade is not inevitable.

Let us assume that we are dealing with a small country that cannot influence the world price of its imports and exports. Then a deprecation will have no effect on the foreign currency price of its imports and exports and the domestic price of both will rise by the full percentage of the depreciation, leaving the ratio of export to import prices unchanged. Whether a depreciation improves or worsens the terms of trade depends upon the relative monopoly/monopsony power of the country in the various markets in which it trades.

When Britain devalued the pound in 1967, the then Prime Minister, Harold Wilson, told the British public that ‘the pound in your pocket has not been devalued’. The idea was that their purchasing power would not be reduced by the devaluation, or at least, not to the full extent. This statement was partly true – and partly highly misleading. At the very least, as import prices rose, other things equal, people’s real incomes would fall. In the extreme, if there were no excess capacity then prices would rise beyond the increase in import prices.

In the end, the major determinants of whether people on average will be better or worse off in regard to their level of consumption as a result of devaluation will be: the extent of excess capacity; the extent of the need to cut back consumption in order to boost exports; and the size of any deterioration in the terms of trade; and the size of any swing against real wages and towards real profits.

5. Past devaluations have not worked.

This is not true. Some devaluations that have taken place in the past have been too little and too late and have not worked. They might have made the situation better than it otherwise would have been but they have not transformed matters. The UK’s devaluation of 1967 falls into this category. But some drops of the exchange rate have had a powerful effect – notably in 1931 and 1992.

Moreover, there are plenty of examples from other countries of depreciations having a major beneficial effect. Furthermore, umpteen countries around the world carefully manage their exchange rates precisely because they know that their exchange rates have a major bearing on their trade performance, and hence on their GDP.

6. The UK has no bent for manufacturing.

While it is true that a wide swathe of low- and medium-tech manufacturing is uneconomic in the UK at present, because the exchange rate and the cost base for them are much too high, there is no evidence whatever that if more favourable conditions prevailed, UK entrepreneurs would not be just as good as those anywhere else in the world at taking advantage of the new opportunities which would then open up. There is no evidence that the UK lacks entrepreneurial people who would be willing to try their hands at making money out of making and selling if the right opportunities were there. The problem with the UK as a manufacturing environment is that these conditions simply do not exist at the moment, because the cost base is too high, and entrepreneurs rightly shun investing in ventures which they can see from the beginning have poor prospects of being profitable and successful.

It is true that it is normal for rich and successful countries like the UK to experience a fall in the share of GDP accounted for by manufacturing. But this is not the be-all and end-all. Germany is at roughly the same level of development as the UK but its share of manufacturing is roughly twice the UK’s. In part this reflects the different experience of the exchange rate of the two countries. Although Germany’s nominal exchange rate, under the deutschmark, tended to rise over time, it hardly ever experienced the sharp rises of the real exchange rate that UK manufacturers have suffered several times. And after the advent of the euro, Germany’s real exchange rate has been kept low.

7. We should leave the exchange rate to be determined by market forces.

Market forces do not exist in a vacuum. They respond, in part, to the policy settings, macro and micro, imposed by the authorities.

To the extent that the UK exchange rate is sustained by overseas wealth holders’ preferences for UK assets, it could be argued that this is just a particular manifestation of the ‘market forces’ to which the UK at present submits – and should do so. Yet the interests of foreign asset holders are not naturally congruent with the interests of UK citizens. The UK ‘provides’ some intangible things that overseas wealth holders value – political stability, the rule of law, liquidity. Other things equal, the UK should be able to charge a fee for providing these things. It is frequently argued that this is just what the United States does in that it is able to borrow more cheaply than it otherwise would without having the ‘exorbitant privilege’ of issuing the world’s money. To a lesser extent this should also be true of the UK.

But where is the comparable ‘fee’ secured by selling real assets to overseas wealth holders? And what if the attractions of UK (or US) assets to foreigners have the result of increasing the amount that needs to be financed? After all, if foreign capital inflows drive up the exchange rate and thereby induce an increased current account deficit then both the public sector (thanks to lower tax revenues) and the private sector (thanks to reduced incomes from net exports) will have to borrow more. In these circumstances it seems as though it is the host country that ends up paying a fee to attract overseas capital.

The key issue here is what the capital drawn into a country actually finances. If it is productive investment then that will bring a return that may offset – and more than offset – the cost. But if it merely finances consumption this will not be true. Worse than this, it will diminish total national income by pushing up the exchange rate. If we assume that other components of macroeconomic policy (interest rates, QE, tax policy) take up the slack so as to maintain full employment, then the overall loss of income will be avoided but it will remain the case that total national investment will have been reduced, and the overall national wealth diminished compared to what it would otherwise have been. This hardly seems to be to our national advantage.

Of course, it is not easy to tell the ultimate use to which a capital inflow is put. It is possible, for instance, that when an overseas company buys real assets – perhaps an existing UK company – from its current owners that the proceeds are invested in new productive ventures. It may be possible but it is unlikely, even by a circuitous route.

In some ways this discussion carries echoes of the events that led up to the Asian financial crisis of 1997. In the year before the crisis, International funds poured into the Asian emerging markets but in only a few countries did this extra portfolio investment lead to increased real investment in the domestic economy. On the contrary, it fed an upsurge in domestic credit and a burst of property speculation.

When the money washed out again this left many of the receiving countries in a hopeless mess. Some of them endured falls in output that rivalled what Germany and the United States had suffered during the 1930s. In the wake of the crisis, the stance taken by Malaysia to control capital inflows – which had previously been widely regarded as both antediluvian and deeply damaging – was now widely regarded as the appropriate way to deal with footloose international capital.

In view of this experience, and countless other episodes, why, should we leave our exchange rate – and hence our international competitiveness – at the mercy of international capital holders? Of course, if they should some day fall out of love with UK assets then this would, other things equal, bring about the very drop in sterling that we are advocating. But by the time that this happens huge damage may have been done to the UK’s manufacturing and exporting businesses. Moreover, as and when international capital holders pull out, the change may be sudden and unpredictable, thereby causing serious problems in both the real economy and the financial system. (Arguably, this has already happened with the sharp fall of the pound induced by the Brexit vote.) It would surely be far better to discourage such inflows in the first place and thereby keep the exchange rate at a competitive and sustainable level.

Why the need for an exchange rate policy can easily be disparaged

Most British experience of exchange rate policy has involved trying to stop the pound from falling. This has inevitably led to crises as either the limited stock of international reserves has run low and/or interest rates have had to be increased, which is both unpopular and damaging to the domestic economy. By contrast, we are advocating a policy that can be used to reduce the pound and keep it low. This requires being prepared to build up international reserves and keeping interest rates low. Such a policy is much more readily sustainable and much more popular. There is no limit to the amount of your own currency that you can print to build up foreign currency reserves.

It is often argued that for the UK to adopt an exchange rate policy would be against our commitments to the G7. This is understandable. The obligations have been explicitly stated, as below:

Statement by G7 Finance Ministers and Central Bank Governors, February 12, 2013:

‘We, the G7 Ministers and Governors, reaffirm our longstanding commitment to market determined exchange rates and to consult closely in regard to actions in foreign exchange markets. We reaffirm that our fiscal and monetary policies have been and will remain oriented towards meeting our respective domestic objectives using domestic instruments, and that we will not target exchange rates. We are agreed that excessive volatility and disorderly movements in exchange rates can have adverse implications for economic and financial stability. We will continue to consult closely on exchange markets and cooperate as appropriate.’

G20 Communique, November 15-16, 2015:

‘We reaffirm our previous exchange rate commitments and will resist all forms of protectionism.’

Yet of the G7 grouping, three countries, namely Germany, France and Italy, are involved in a de facto policy of trying to depreciate the euro in an attempt to stimulate the eurozone economy. A fourth, Japan, is widely acknowledged to be doing the same through its policy of QE in pursuit of higher domestic inflation. Only the three Anglo-Saxon economies, the US, Canada and the UK, are left. Neither of the other two have significant current account problems in the way that the UK does.

Operating with a strong exchange rate is superficially very attractive for a government. In the short-term at least, it keeps inflation low, enriches consumers and seems to offer a vote of confidence from the markets in the government’s policies. The latter can seem particularly valuable, and is well appreciated, when governments have a history of being plagued by currency weakness and fixed exchange rate crises. This is surely true of New Labour. The Labour Party had previously endured the gold standard crisis of 1931, the devaluation of 1949, and the devaluation of 1967. It had also witnessed the Conservative Party tearing itself apart after the ERM crisis of 1992. So, to have the exchange markets apparently approving of your policy/country, as they did in the years after 1997, was a source of great joy.

The language used to describe exchange rate movements makes it sound as though a high exchange rate is better. Not only do discussions contrast ‘higher’ with ‘lower’ but currencies are often described as ‘strengthening’ or ‘weakening’. This language seems to suggest that a higher exchange rate is better.

The effects of exchange rate misalignments take time to come through. Companies do not withdraw from markets or dismantle plant – still less invest in new markets and new plant – at the drop of a hat. Accordingly, the sharp fluctuations in the UK’s real exchange rate have meant that the response to even the periods of low exchange rates has been much weaker than it might otherwise have been.

It is frequently argued by successful businesses that they can ‘cope’ with the current exchange rate. Such assertions are otiose. We know that they can cope. They are there. They are the survivors. But a suitable exchange rate policy has to cater also for the businesses that are no longer there – and even those that are as yet unborn. The objective of economic management should not be to ensure the highest average batting score but rather to ensure the highest score overall. This objective is not secured by deciding not to play your weakest six batsmen on the grounds that they are not as good as the others.

The case for action

We are far from being enemies of market forces. On the contrary, both of us are supporters of the capitalist system and believe that, in general, market forces encourage people and institutions to behave in a way that maximises output and hence living standards.

But, especially in the realm of finance, markets can sometimes go awry. Moreover, market forces do not emerge from a vacuum. They are themselves a response to the economic conditions of the time and to the constellation of government and central bank policies, both here and abroad.

Exchange markets are particularly prone to misalignment with the economic fundamentals. In the wake of the collapse of the Bretton Woods system in 1971, many economists argued that the system’s collapse created a brave new world in which market forces would push exchange rates to levels appropriate to the economic fundamentals.

These hopes were misplaced. The international monetary system is a mess and the misalignment of exchange rates and huge international payments imbalances have been a prime contributor (amongst others) to the world’s recently poor economic growth. We hope that political leaders will again come to develop an international monetary system that deals with these problems and enables the world to reach its full potential. But you shouldn’t hold your breath. In the meantime, the UK policy authorities have to fashion policy as best they can in the UK’s interests, taking the world’s monetary system as it is.

For most of the last 100 years the exchange rate has been at the centre of UK economic policy. For the last quarter century, however, it has been on the periphery. During this period, the UK’s overseas trading performance has been poor, with the country running persistent current account deficits. The result has been a huge deterioration in the UK’s international financial position. It has moved from being a substantial net creditor to being a substantial net debtor. This might not matter that much if the UK were also investing heavily at home. But it is not. Indeed, by international standards it is investing very little.

This situation has not developed as the result of a deliberate policy decision by UK governments. At no stage have the UK authorities deliberately set out to run down the UK’s international assets or build up the UK’s international liabilities. They have simply had no policy on this issue at all. Accordingly, what has happened to this important variable has simply been the passive response to other factors and policy decisions. The UK authorities have sleep-walked into a situation where the UK has sold many of its key assets to fund a short-term consumption binge and continues to grow more and more in hock to overseas asset holders. This situation has emerged as the incidental by-product of other policy decisions. The contribution of the UK authorities has simply been to ignore it.

The evidence is clear that the exchange rate for sterling has been too high. This has had major consequences for the whole UK economy and for its future. The strength of sterling has had three main sources:

  • The structure of UK macro policies which, unlike those in most of the rest of the world, takes no direct account of the exchange rate;
  • Policies adopted in our main trading partner, the eurozone, deliberately to depreciate its currency, the euro;
  • The attractions of UK assets to overseas wealth holders.

The UK cannot do anything directly to correct the second of these. But it can and should take action on the other two. We favour a two-pronged approach: a macro policy that accords a bigger role for the exchange rate; and a set of micro policies to diminish the attraction of UK assets to foreigners.

The point of having a more competitive currency would not be to take market share from rapidly developing countries, such as China or India, still less to seek to undermine their success. Admittedly, a lower pound would make UK exports more competitive against China and other emerging market countries, and thereby limit, deter, and even in some cases, reverse the leeching of manufacturing away from the UK. Nevertheless, the rise of the emerging markets has not been primarily due to the advantages of operating with an under-valued currency (although at times China has assuredly done so).

The really striking phenomenon, though, is the UK’s loss of market share relative to other advanced countries. Here an over-valued exchange rate has played a definite role – and a competitive exchange rate could reverse much of the loss.

There is a view that if a low exchange rate is needed for the UK economy, then the markets will deliver it of their own accord. Yet this cannot be taken for granted – even after the sharp drop of the pound after the Brexit vote. We believe that, in the majority of cases, market forces do work – in the end. But the end can be a very long time in coming. In the meantime, the damage done to the economy by a severely misaligned exchange rate can be very severe. Indeed, the forces that are established by a misaligned exchange rate can be so serious that it may be impossible to return to the original growth path for decades subsequently.

Moreover, an exchange rate that is eventually driven by market forces to roughly the right level will not necessarily stay there. This is our profound worry after the Brexit vote has reduced the pound to a much more competitive level. Moreover, businesspeople involved in exporting and importing will not have the confidence that it will stay there. Accordingly, even if the exchange rate is established at a competitive level this may not have the full beneficial effect that it would do if the rate were believed in.

A policy of deliberately encouraging a competitive value for the currency is frequently inhibited by the authorities’ fear that this may unleash a burst of inflation. In fact, in many cases those fears are unjustified. They would be unjustified now. The UK is in an era of ultra-low inflation and the Bank of England has evidently had difficulties in getting inflation up to its 2% target. It is hard to imagine a more propitious time for a successful depreciation of the currency. After the Brexit vote produced a much lower exchange rate, many members of the commentariat fretted about the effects of the drop and discussed what the authorities might need to do to reverse it and ‘stabilise the pound.’ The right answer is: ‘Nothing at all’. Indeed, the prime task now facing them is how to ensure that the pound stays at its new competitive level.

This is the latest – and most pressing – example that confirms our fundamental message: the UK authorities need to put the exchange rate back where it belongs – at the centre of economic policy–making.

This essay is an edited extract from the book The Real Sterling Crisis: Why the UK needs a policy to keep the exchange rate down, which is available here.



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