John Mills

Competitive Exchange Rate Strategy

Few commentators believe that the UK economy is going to grow faster than about 1.5% per annum – maybe 2% at maximum – over the coming years. Experience over the last decade tells us that this will not be sufficient to lift real incomes for the majority of the population.

This is because our population has been growing at about 0.6% per annum, because about £40bn every year is siphoned out of the total available for UK incomes, our huge balance of payments income deficit, because there is a steady drift to wages and salaries declining as a percentage of GDP, and because those with sharp elbows tend to collar most of what increases in output there are.

To get real incomes rising for most people we need economic growth running at 3% to 4% per annum. Could this be achieved? Yes, but only with radical changes in the UK’s economic policies.

Contents
Investment

The UK's record on investment is appalling, and is the main reason why productivity is almost static and our economic growth so low.

We only invest about 16% of our GDP every year compared to a world average of 26% – and around 45% in China. Of the investment expenditure we do undertake, only 12.6% as a percentage of GDP is on physical assets, but depreciation running at almost the same rate means that virtually nothing additional is left.

Worse still, of the money which we do spend on investment, only 2.7% – down from 3.6% as recently as 2008 – is in the most productive ONS category of "Other machinery and equipment" – compared with 15% in China.

A key feature of investment is that some types are far better at increasing economic growth than others. By far the most productive forms of investment in terms of promoting economic growth cluster round mechanisation, technology and power, the most important drivers of standards there have been since the Industrial Revolution started.

Think of a bulldozer replacing a shovel, a 44-ton truck instead of a wheelbarrow, a combine harvester replacing a sickle or a new machine which produces a multiple per hour of the products compared to the one it replaces. The benefits derived from investment of this high-powered type are then diffused through the economy as higher output, increased wages, better and cheaper products, greater profits and a larger tax base, all building up to produce a social – as opposed to just a private – total rate of return.

Quantitatively, the social rate of return of nearly all public-sector investment, in roads, rail, schools, hospitals, public buildings and housing – however desirable it is socially – is very low in economic terms, barely above the rate of interest.

The same is true of much private sector investment, in office blocks, shopping malls, new restaurants and IT projects. Investment in machines, technology and power, however, can easily produce social rates of return of 50% per annum or more. The table below shows examples of the results achieved with a mixture of social and high-powered investment, showing how high the latter must have been to bring up the average to what was achieved.

Most investment in mechanisation, technology and power tends to be undertaken in the private rather than the public sector, predominantly in light idustry. It needs, therefore, to have a reasonable chance of being profitable.

The problem in the UK is that the exchange rate has for a long time been too high for this condition to be fulfilled. This, in a nutshell, is why we do so badly. Instead we need to provide incentives to switch about 4% of our GDP out of consumption and into investment, with a social rate of return, at the margin, of 50%. 4% times 50% equals 2% – the increase in the growth rate needed to lift ours from 1.5% to 3.5%.

Deindustrialisation

The next table shows why we have been unable to compete in world markets for manufactured goods and why, as a result, we have deindustrialised to a greater extent than any comparable country.

As late as 1970 almost a third of our GDP came from manufacturing. Now it is less than 10% and still drifting down. In the 1980s our exchange rate was far too high because priority was given to supressing inflation with sky-high interest rates dragging up the exchange rate while ignoring what this did to our competitiveness.

In the 2000s it was because we liberalised capital movements more than anywhere else, causing huge capital inflows as we sold off swathes of UK assets, pushing up the exchange rate to £1.00 = $2.00.

Deindustrialisation has had four disastrous results. It has impoverished large areas of the UK which had previously depended on manufacturing. It deprived the workforce of good, high-quality job opportunities. Since light industry is where most of the high-powered investment described above is to be found, steep manufacturing decline has pulled down both the volume and the returns on investment, generating our current acute productivity problem.

And since most of our exports are still goods rather than services, we have had too little to sell to the rest of the world to enable us to pay our way, causing us to drift into worse and worse balance of trade and payments problems. The next table illustrates how strong the correlation is between a reasonably strong manufacturing base and a sustainable substantial rate of economic growth.

Balance of Payments

The next table shows that not only do we have a substantial trade deficit but that other components of our foreign payments are serious weaknesses for the UK economy. We used to have a substantial net income from abroad every year but recently this has deteriorated, so that we now have a significant deficit on this score.

The underlying reason for this happening is that our current account deficit has to be financed by borrowing and sale of assets, both of which build up large cumulative negative liabilities. Net transfers abroad – about half to the European Union and a quarter each in the form of net remittances abroad and our aid programmes – have also increased.

We cannot expect to be able to live in the UK with a standard of living which, year after year, is some 5% higher than we are actually earning. The only feasible way of stopping this happening is for us to sell more manufactured goods abroad.

Although the UK does well on export of services, with a large surplus, as the table below shows, this is not enough to offset the other components of our foreign payments position which are in deficit. Services are too difficult to sell abroad in sufficient volume to close the gap.

Debt

Since 2000, the UK has accumulated a total balance of payments deficit of over £1tr. This has siphoned a huge amount of demand out of the economy which, to stop the economy going into recession, has had to be replaced by expenditure financed on borrowed money.

In consequence, the monetary base in the UK has expanded enormously, to about 14 times its level in 2000. The table below shows the impact these developments have had on the UK economy. There has been a massive increase in government debt, while recently households have switched in aggregate from being lenders to the rest of the economy to being borrowers, as their savings ratio has collapsed.

All surpluses have to have equal but opposite deficits and total borrowing has to equal total lending. This means that it is never going to be possible to get government and consumer borrowing down to safe and sustainable levels unless the balance of payments deficit is much lower than it is at present.

Inequality

A major consequence of the economic policies pursued by successive governments in the UK is that inequality has increased markedly in at least three significant respects.

First, a huge gap has opened up in average gross value added (GVA) per employee between London and the least advantaged reasons. In 2016, Average GVA in London was £44k, while in Wales it was £18k and only £19k in the North East, although these discrepancies were less post-tax but only as a result of huge subsidies from London to the rest of the country.

Second, a large gap has opened up between the living standards and prospects of millennials compared to those born earlier, mainly brought about by a combination of shortage of both job opportunities and adequate housing.

Third, while the distribution of income especially post tax has recently become slightly more equal, the situation on wealth and life chances generally has become progressively less equal. All these problems are exacerbated by slow growth, to which we very urgently need to find solutions.

Solutions

The basic problem with the UK economy does not lie in the supply side deficiencies which tend to be pinpointed by the left – inadequate education and training, short-termism, poor infrastructure and lack of finance for industry – or by criticism from the right about over-taxation, too many regulations, lack of privatisation and too large a state.

Any such shortcomings are the consequences rather than the causes of our slow growth. The real problem is our lack of competitiveness, which is very largely an exchange rate issue. Unlike in services, we have no natural advantages in manufacturing and we charge out the sterling overhead costs involved at far too high a rate to enable us to compete in highly competitive world markets. This is the cause of our deindustrialisation and our low investment and growth.

To overcome these problems, we need a much lower exchange rate – probably about parity with the US dollar, or around 25% lower than it is at present at approximately £1.00–$1.30.

Essentially we need an exchange rate which makes it profitable to site new industrial plant in the UK rather than elsewhere. Could this be done? A determined government could certainly implement a competitive exchange rate strategy – as we can see from countries such as China, Singapore, Germany and Switzerland who do exactly this. The key question is: would it work?

In fact, for such a strategy to work, there are only three key metrics which have to have roughly the right values.

First, our foreign trade has to be sufficiently price sensitive for a much lower pound to ensure that expanding the UK economy will not cause unmanageable balance of payments problems.

Second, the overall returns on high-powered investment – and there needs to be enough of it – needs to be high enough to ensure that there are sufficient resources available to pay for the transition to a much higher rate of growth. In particular, there needs to be sufficient extra output to enable the proportion of our GDP devoted to investment to rise sharply from where it is now to closer to the world average without this transition hitting living standards. There is strong evidence that these two conditions can be met in the UK’s case, as indeed they already are in many other countries in the world, which are doing much better than we are.

The third issue is whether a deep devaluation might generate sufficient extra inflation to swamp any gain in competitiveness. There is no evidence from either our own history or from that of other countries that this would happen. The table below shows what has happened to inflation in the UK after various devaluations which have – nearly always too little and too late – reversed previous periods of gross over-valuation.

Conclusion

There is, therefore, a way ahead for the UK economy with a sustainable much higher rate of growth than seems to be in prospect at the moment. Of course, there are risks involved with any radical change in policy.

But there are also huge risks – economic, social and political – from maintaining the status quo, with no real wage increases for most people in prospect as far ahead as anyone can see. Some risks are worth taking – and adopting a competitive exchange rate strategy looks like one of them.