Questioning the weak sterling policy
Today’s Economist has an article noting that so far in 2013 the pound has been the weakest of the major currencies but, so far, the large devaluation has not brought about a boom in exports. Interestingly enough a similar point is made today on Socialist Economic Bulletin.*
It is fairly clear to most observers that the Bank of England is relatively pleased with sterling’s weakness. At this week’s Treasury Select Committee hearing Bank officials were keen to note that they are not actively ‘talking down the pound’ before then moving on to discuss negative interest rates. Make of that what you will…
In reality it would be fair to characterise the current macroeconomic approach of UK policy makers (at both the Bank and the Treasury) as one of loose monetary policy, tight fiscal policy and weak sterling.
A couple of weeks ago Larry Elliot set out the logic between this policy mix:
The theory is simple. When the economy gets completely out of whack – as it did in the late 1940s, mid-60s and early 90s – the warning signs are either an overheated domestic economy or a poor export performance, and normally both. The excesses are killed off by higher interest rates, with slower growth pushing up unemployment and reducing cost pressures.
Once the economy has been hosed down, policy is loosened. This takes the form of an easing of monetary policy – lower interest rates and cheaper sterling – to stimulate business investment and exports. Faced with the risk that any pickup in activity will lead to higher consumer spending and a bigger imports bill, chancellors keep fiscal policy – tax and public spending – tight. Hey presto: the economy rebalances.
Whilst the theory may be simple, the results in the past two years have been disastrous. Overall growth has been terrible, living standards have been squeezed, the deficit refuses to come down as planned and, as Sarah O’Connor set out in this week’s FT, the economy has failed to ‘rebalance’. As she noted:
Wednesday’s data show net trade actually subtracted almost 1 percentage point from growth in 2012, while business investment contributed just 0.4 percentage points.
I’ve long argued that fiscal and monetary policy are not exact substitutes for each other and without a change in fiscal policy the long slump of recent years is unlikely to end. Whilst a change in fiscal policy remains the most straight forward (and much needed) step that could boost the British economy in the short run, it may be time to start questioning the unstated policy of weak sterling.
Four years ago, in one my very first blog posts, I wrote that I was extremely relaxed about sterling weakness. Now though it may be time to think again. Back in early 2009 I welcomed the fall in sterling both as a guard against the then very real threat of deflation and as a way to boost exports. Fast forward to 2013 and the squeeze on living standards is a more pressing threat to the economy than outright deflation, whilst the depreciation has not provided the hoped for boost to exports (obviously the counterfactual here is – how bad would the current account deficit be with a stronger currency?).
Chris Dillow has persuasively argued that economists should think not in terms of models, but in terms of mechanisms. Rather than assuming that X will lead to Y, a better way of thinking about this is to ask, “by what mechanism X will lead to Y?”
Conventional thinking is that a cheaper pound will make imports more expensive whilst making our exports cheaper; this should therefore lead to an improvement in the trade position. But it is worth asking, why is this straight forward relationship is not occurring?
I can think of a few plausible reasons why weaker sterling may not be helping our net trade position.
First, it may be that much of what we import (energy/food) is simply not produced locally and has a relatively low price elasticity of demand (i.e. demand for these goods is not especially responsive to changes in prices – food might get dearer but we still need it), in which case a weaker currency will increase the costs of imports without lowering their volume very much.
Or it could be that, as a recent article on Vox argued, as much of international trade is dominated by large firms and their internal supply chains, many pricing effects are actually insulated from exchange rate moves. As the authors concluded:
The prices of the largest firms, accounting for their disproportionate share of trade, are insulated from exchange rate movements both through the hedging effect of imported inputs and through active offsetting mark-up adjustment in response to cost shocks. Both forces limit the expenditure-switching effect of a given exchange rate movement, but have very different implications for the allocative efficiency of global production.
Another explanation is that the demand for many of the services that the UK traditional exports (i.e. high value financial services) has diminished globally. It may now be cheaper for a global firm to hire UK based lawyers and accountants to work on a major deal, but there is simply less demand for M&A activity for example.
More relevant for the debate is the relative performance of Germany and the UK. The UK’s trading partners grew more rapidly, but Germany’s trading partners bought more of its stuff.
The explanation seems to be that Britain makes stuff people don’t much want – much of it, of course, banking and other financial services. German luxury cars and capital goods, on the other hand, are much in demand, even if the sum of its trading partners are not growing quite as quickly.
Or it could be the case that much of what Britain does export (services, pharmaceuticals, aerospace products and other advanced manufacturing, creative industry output, etc) is simply not very price sensitive.
Whatever the explanation, the mechanism through which a cheap currency boosts exports does not appear to be working.
On the other side of the ledger though, weak sterling has pushed up energy and food costs adding to inflation and prolonging the squeeze in incomes. This has had major implications for consumer spending and added to the UK’s current stagnation.
It is certainly frustrating that the lack of an adequate industrial policy and tight bank credit have meant that UK firms have failed to take as much advantage of a weak currency has many hoped (including myself) they would.
In the final analysis there is an important point here. If Britain is going to compete in the world economy, it cannot do so on price. Just as this means a policy of lowering wages will not work, so it means a policy of cheap sterling is a not a long term solution. Sterling’s major post-war devaluations in 1947, 1967, 1976 and 1992 all fundamentally provided fleeting gains. What is required is higher productivity (and much more inclusive growth) to underpin rising living standards, not a cheaper currency. Whilst increased productivity provides long term benefits, the gains from a weaker currency can prove temporary.
It may be that a stronger currency would have made for an even worse trade performance (even if it meant less of a squeeze on household incomes), but this is a question that can never truly be answered. What is clear is that the current policy mix of easy money, fiscal contraction and a weak currency is not working.
*I am quite pleased to be in the overlap of the Venn diagram of people who regularly read both the Economist and Socialist Economic Bulletin.