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The historical background to the gap in the UK’s current account and how it could be closed

Roger Bootle and John Mills, September 2016

Real Sterling Crisis front coverDuring the 19th century, Britain had a huge current account surplus, balanced by equally large capital exports. Our surplus was not achieved by Britain enjoying a positive visible trade balance over most of this period. Despite Britain’s pre-eminence, at least during the first half of the century, as ‘the workshop of the world’, the available statistics show Britain generally running a visible trade deficit only partially offset by a surplus in services. The reason why Britain had a major overall current account surplus during the 19th century was that the country enjoyed the benefit of a huge accumulation of net assets abroad, which generated a massive net income.

The beginning of competitiveness problems

The pre-eminence of Britain at least in terms of living standards, up to the outbreak of World War I, therefore relied only to a limited extent on the competiveness of our manufactures. Certainly, for the early decades of the 19th century, Britain enjoyed a major benefit in that there was little international competition for the goods which British industry was making at the time, but this was always a fragile advantage.

Some loss of market share for Britain was inevitable as other countries caught up with the prime mover. Nevertheless, it is difficult to argue that the level of the pound did not contribute to the relatively slow growth in British manufacturing compared to what happened in other countries in the run-up to the First World War.

If Britain was dogged by the strength of sterling up to 1914, worse was to follow when the war was over. Following the precedent set at the end of the Napoleonic Wars, the Cunliffe Committee recommended that the parity between the pound and the dollar should be re-established at the pre-War rate – $4.86 to the pound – even though inflation in Britain had been much higher during the war than in the USA – about 80% in Britain compared to 50% in the USA. This objective was eventually attained in 1925, but at the expense of stagnation during nearly all of the 1920s. By 1931, GDP was still slightly lower than it had been in 1919.

The 1930s, however, told a very different story. In 1931, sterling was allowed to be driven off its previous parity and to fall in value by 31% against the dollar, and by 24% against all other major currencies. The result was a dramatic improvement in the country’s economic performance. By 1938 GDP had grown by 24% and manufacturing output by 45%. By the end of the decade, however, after the USA had devalued the dollar by 41% in 1934 and the gold bloc countries had followed suit in 1936, Britain’s competitive edge had disappeared and the economy was moving back towards depression, only to be rescued by rearmament as World War II approached. In 1948, the Economic Commission for Europe estimated that sterling was as overvalued in 1938 as it had been in 1929.

Post-war problems

The UK was on the winning side during World War II, but emerged from the conflict heavily over-extended and with its currency yet again substantially over-valued – initially against the US dollar but subsequently against a basket of currencies, including those of many countries recovering strongly from the war. The result was devaluation in 1949 and 1967. Nevertheless, the UK’s share of world trade continued to decline remorselessly, from 10.7% in 1950, to 5.7% in 1980, and then to 2.7% by 2010. Again, to some extent this was inevitable as many countries around the world developed rapidly. But the UK also lost market share to countries that were similar to it, particularly Germany.

The China issue

Thanks to a series of reforms begun in 1979, China greatly increased its productive capacity and its role in world trade. Not only did its nominal exchange rate fall but, because of rapid increases in productivity (not offset by rises in the nominal exchange rate), China’s real exchange rate fell by some 75% over the next decade, producing an enormous disparity between the costs of manufacturing almost anything in the UK – and indeed in most of the West – compared to China and other countries along the Pacific Rim, most of which also devalued heavily following the 1997 Asian crisis.

Two extremely important consequences have flowed from these developments. The first is that, as a result of the cost base being so much lower in the East than it has been in the West, there has been a huge transfer of manufacturing capacity from the western world to the Pacific Rim.

The cost base is made up of all production costs incurred in the domestic currency. Typically for manufacturing operations, about one third of total costs are for raw materials and plant and machinery, for which there are world prices. The other two thirds is made up of costs incurred in sterling in the UK and renminbi in China – mostly wages, but also including everything from audit charges to taxi fares, from cleaning costs to interest charges, from getting stationery printed to getting vehicles repaired. These costs are all charged out to the rest of the world in the domestic currency and the higher its valuation, via the exchange rate, the more expensive domestic output will appear to be to the rest of the world. It is because the cost base became so much lower in the East than the West that, on a massive scale, manufacturing capacity migrated eastwards.

The second crucial result of this change is that the West – unable to compete with the East over a very wide range of manufacturing output – began to run huge balance of payments deficits with countries such as China. By the 2000s, China was running a current account surplus which averaged about 5% of its GDP for the whole of the decade, peaking at a staggering 10% in 2007, while the USA ran a deficit of 4.5%. During the same decade, the trade deficit between the UK and China averaged about £10bn per annum, but in recent years the overall UK current account position, including the UK’s trade balance with China, has deteriorated very sharply.

The overall result has been that the West has become more and more deeply indebted to the East at the same time as the enormous benefit of increased productivity that well-run manufacturing operations always bring in train has generated massive growth rates along the Pacific Rim. Since 2007, the aggregate growth for the last eight years in the West has been not much above zero while in the East it has been close to 77%. In the UK, the economy during these eight years has grown by 7.3%, but the population has increased by 6.5%, so that GDP per head, a good proxy for living standards, has hardly increased at all. In China, by contrast, over the same eight years, GDP has risen by about 93% and GDP per head by almost 85%.

What this brief history of the make-up of UK exports and imports shows is that our performance has always been price sensitive and that the exchange rate has always been a crucial factor in determining what our trading position will be. With occasional exceptions such as in the 1930s, there has been a pronounced tendency for sterling to be too strong, with the consequence that our manufactured exports have tended to be uncompetitive and importing too attractive.

The result has been to make manufacturing in the UK generally unprofitable; to discourage able people from taking up a career making and selling things in the UK; to ensure that we have kept losing our share of world trade; to make us suffer from chronic balance of payments problems; and to discourage investment. Moreover, the overall result has been to make our economy grow more slowly than it should have done as a result of a combination of both deflationary policies to protect the balance of payments and foregoing much of the growth in productivity which a higher contribution from manufacturing would have allowed us to achieve.

There are many reasons why a high value for sterling has been popular in the UK – from holiday makers getting a good rate of exchange for their trips abroad to the City liking a strong exchange rate because it provides those working there with more international leverage. And there are further reasons – discussed later – why policy makers have favoured a strong pound. But the overall impact of our over-valued currency has been to leave our economy much weaker and more unbalanced than it needed to be.

How could the current account gap be closed?

If the exchange rate were appreciably lower than it has been in recent years and the UK’s trade balance improved substantially, what would be the nature of the exports that now appeared?

A pound is a pound is a pound. In principle, we could close the gap between overseas income and expenditure in several different ways. However, a number of factors, outlined below, suggest that increased manufacturing output, and indeed an increased share of manufacturing in GDP, will have to play an important part.

Productivity and costs

It is important to realise that countries are not competitive simply as a result of wages being low. It is wage costs per unit of output, not wage levels considered in isolation, that are crucial. In economies such as Germany, Japan and Switzerland, hourly wage rates in manufacturing industry are high but because these economies have very large accumulations of capital and skills, output per head is also very high and wages as a component of costs are correspondingly low. This is why it is possible for countries such as Singapore, which also has a well-paid labour force, to remain highly competitive and to continue to grow rapidly – by almost 3% in 2014 and by an average of 6.4% per annum for the last 10 years.

It is true that, as economies get richer, they tend to concentrate production on more complicated products and their industries tend to become more high-tech. This is the result of their growth success, however, and not the cause. That is why it is an illusion for UK policy-makers to believe that moving the UK economy to higher-tech manufacturing will make us more competitive. This will tend to happen as we succeed but we cannot jump several stages of development in one go.

While we await our ‘high-tech transformation’, the UK simply cannot produce enough high-tech exports to enable it to pay its way in the world. Moreover, although high-tech is more difficult than low- or medium-tech to attack from low cost base economies, it is not impossible. In the long-term, high-tech is likely to be almost as vulnerable as less sophisticated industries as the Chinese learn to build aircraft and their engines, the Indians to produce world class drugs and the Koreans to produce better cars.

In the medium term, therefore, if the UK is ever to get its balance of payments problems under control, we will have both to nurture those industries we still retain and to re-establish more medium-tech activity. There is no knowing the industry structure that would best enable the UK to return to something like current account balance. But it seems likely that, bearing in mind the structure of UK exports, balance in our current account would require manufacturing as a proportion of UK GDP to get back to somewhere around 15% of GDP. To do this, we will have to have a much lower exchange rate than we have been used to.

The service sector to the rescue?

There are two well-worn counter-arguments to this approach. One is that, because we are better at producing services than manufactured goods, we should put our effort behind developing our service industries where we have a competitive advantage. The other is that we should move up market into high-skilled occupations and thus be able to keep sufficiently far ahead of world competition to keep paying our way. We consider these two arguments in turn.

The UK is good at producing services and selling them on world markets – and it always has been. Financial services, including insurance, banking, legal and accounting services and ship broking – as well as other invisible export earnings from tourism and intellectual property – are responsible for the UK having a large services export surplus every year – £89bn in 2015, but averaging £59bn per annum for the previous 10 years.

This has happened partly by luck – the pre-eminence of English as the world’s business language and our position geographically in the world half way between the USA and the Far East – and partly by good management. The UK has a reliable legal system, a long accumulated depth of expertise and an attractive environment all of which have stood its service industries in good stead. Services are also, in general, less price sensitive than manufactured goods because they are less easy to compare. There is, therefore, everything to be said for protecting and enhancing the UK’s services exports wherever we reasonably can.

The problem is that most exports – even for the UK – are not services but goods and it is extremely difficult – and indeed historical experience has shown it to be impossible – to close the gap between our export surplus on services and our deficit on goods solely by increasing services exports. Our visible deficit was £126bn in 2015 and an average of £96bn for the previous 10 years, with the corresponding figures for the overall trade deficit being £37bn and an average of £37bn for the previous decade.

Relatedly, does moving upmarket with a better educated and trained labour force look as though it might solve our trade deficit problem, through both helping to bolster still further our service sector and helping us to produce more high-end manufactured output? Despite the obvious intuitive appeal that it would, it is hard to see how it might happen in a way which would make more than a marginal difference in the relevant time-frame. And, in the long-run, better educational and training standards will only improve our competitive position if they are not accompanied by higher earnings expectations. The situation might be a bit better on services, some of which, at least, depend more than manufacturing on the intellectual capacity of the workforce, but it is difficult to see there being a quantum leap in net trade performance as a result.

Actually, what has happened is that for many decades, the lack of profitability and the poor prospects in manufacturing have led to low earnings and low prestige, with the result that this vital sector of our economy has been starved of talent. Faced with a poisonous mixture of poor management and unmanageable competition, UK industry, especially its low- and medium-tech varieties, has withered and declined. This is the price paid by economies whose exchange rate is too high for its manufacturing industries to bear. The trade deficits thus generated require deflationary policies to contain. Investment as a proportion of GDP declines. Economic growth is reduced.

A less dramatic answer

All that said, it shouldn’t be forgotten that with a lower exchange rate there are all sorts of ways that net exports might recover without a dramatic turnaround in the UK’s industrial structure. We could achieve the result, or at least part of it, simply by expanding the production and sales abroad of those things where we already have a significant presence.

Motor cars are a good example. There is no reason to suppose that the demand for particular brands/types of cars is not price sensitive to some degree. If sterling were maintained at an appreciably lower rate than it has been then British exports of cars would be higher – and, just as importantly, for the same reason, our imports of cars would be lower.

This leads on to a more general point. Improving the trade balance can be achieved just as effectively through reduced imports as it can through increased exports. Of course, we are not going to suddenly start producing bananas to substitute for the imported variety. But in many cases we both produce domestically and import broadly similar products. Cars are not the only example. Moving down the value-added chain, take bottled mineral water as an example. Or, with admittedly more product discrimination, cheese.

Nor does effective substitution of domestic for foreign have to involve the whole product. It may simply mean more of a production process being conducted domestically as opposed to abroad.

For example, it has recently been suggested that Rolls-Royce may relocate some of its production processes abroad, including to India because of lower costs. If the sterling exchange rate were substantially lower, such pressure would be appreciably reduced.

Naturally, where producers need to switch the sourcing for their output from abroad to here in the UK – and even more so if they are to decide to relocate whole areas of production here – they need more than a transitory move of the exchange rate to encourage them to do so. Accordingly, time lags are likely to be significant, and probably longer than in the past before a response is forthcoming. Moreover, the response will be greater the more the producers believe that the new exchange rate will be long-lived. They are more likely to take this view if a competitive exchange rate is an avowed policy objective. (More on this below.)

Another twist on services

Some of the adjustment can also come from services. It is widely believed that services exports are not very price-sensitive. That may be true of some services but not all. It is difficult to believe, for instance, that our net tourism balance would not improve as a result of a substantial drop in the exchange rate, thereby making UK holidays cheaper compared to foreign alternatives, for both UK and foreign holiday-makers alike.

But suppose it is true that the demand for UK service exports is not particularly price sensitive. Accordingly, after a devaluation of sterling the profit maximising option for UK service providers would be to keep the foreign currency price the same, thereby yielding a higher sterling price. Meanwhile, with regard to our imports of manufactured goods, which are price sensitive, the profit-maximising decision for importers might well be to keep the sterling price unchanged, implying a drop in the foreign currency price.   If this happened then, although UK trade volumes might not respond to the lower exchange rate, there would be an improvement in the terms of trade which, in regard to its effect on the trade balance, would be just as good.

Whether something like this will happen would depend on the competitive conditions in the UK’s service exporting businesses. To the extent that these industries are oligopolistic then something like the above result should stand. If these industries are fully competitive, however, then the foreign currency prices should be competed down, leaving the sterling prices (more or less) unaltered and thereby risking a terms of trade loss, which would serve to worsen the trade balance.

The exchange rate and the investment income balance

The UK has a huge balance sheet, with overseas assets and domestic liabilities to overseas asset holders each of the order of 500% of GDP. The assets, and the income on them, are predominantly denominated in foreign currencies, while the liabilities, and the payments made on them, are largely in sterling. In other words, the UK is ‘long’ on foreign currencies.

Accordingly, a depreciation raises the sterling value of income flows from abroad, while leaving the sterling value of payments to overseas asset holders unchanged. Alternatively, you could say that the depreciation leaves the foreign currency value of the income flows on our assets unchanged, while diminishing the foreign currency value of the payments we send overseas.

If the amounts of assets and liabilities are the same, and the returns earned on assets are the same as those paid on liabilities (it won’t be), then, supposing that the return is 2%, with assets and liabilities of 500% of GDP, a 20% fall of sterling would bring about a boost to our investment income balance of 2% of GDP (500% x 20% x 2%).

Trade, growth, productivity and inequality

To what extent is our weak trade performance responsible for our relatively low rate of productivity increase, economic growth and living standards, and the rises we have seen in both socio-economic and regional inequality? Why has our performance in these key respects been so much worse than in many other parts of the world? What does the differing performance of other countries have to tell us?

Evidence from across the planet shows that there is a pattern which we decline to follow at our peril. Economies, large and small, which have grown quickly – and which are still doing so – perform best when they have strong export-orientated manufacturing sectors. There are exceptions – countries in the Middle East, for instance, whose wealth comes from natural resources such as oil – but these countries tend to be relatively poorly diversified and to suffer from extremes of inequality.

The countries which offer all their populations the best outcomes and which appear to have the most secure future prosperity are those whose economies are based on a wide variety of manufacturing industries, supporting a thriving service sector, with increasing demand in the economy unconstrained by balance of payments problems. These are the conditions which led to the huge increase in prosperity in continental Europe between 1950 and 1970, which prevailed in Japan until the 1980s and which drove the rise in prosperity for many years in the Asian Tiger economies – South Korea, Hong Kong, Taiwan and Singapore. They are still very evident in China today and indeed in many of the other economies stretched out along the Pacific Rim.

With slow growth goes increasing inequality. It is no coincidence that relatively slow growing, heavily service-orientated economies, such as the USA and the UK, have some of the highest indices of inequality and that these have become more pronounced in recent years.

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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