Change the Exchange Rate

"Because no one is talking about the exchange rate, we are in danger of locking ourselves into entirely pointless and unnecessary austerity"

John Mills

All our major political parties say that reducing the public sector deficit is a major priority. Despite all the current government’s efforts it is still running at about £100 billion a year, or close to 6 per cent of our Gross Domestic Product (GDP). Total government debt, which is already approaching 100 per cent of GDP, is rising at about 3 per cent of GDP per annum. On present trends, therefore, within a decade it is going to be about 125 per cent of GDP and rising towards still more unsustainable levels. Clearly, it needs to be brought under control. But how?

Common sense appears to tell us that the way to do it has to be some combination of cutting government expenditure and raising taxation. This is clearly the approach which any individual person would have to adopt with expenditure running well ahead of his or her income. It is, however, a major fallacy to think that what would work for a single person would also work for the economy as a whole. This is because everyone’s income is someone else’s expenditure and, while any individual’s spending decisions make a negligible difference to the whole economy, this is not true of government receipts and spending.

The simplest way of seeing this is to consider what is likely to happen if government expenditure is cut and taxation raised. Other things being equal, demand will fall and the economy will contract. This will produce lower tax receipts and higher claims on the social security budget as unemployment rises. As a result, the deficit may not get any smaller. Indeed, it may increase.

There is also a more sophisticated way of approaching what to do about the deficit, which provides a more compelling way of seeing what the deficit problem is and how to overcome it. As an accounting identity, all borrowing in the economy has exactly to be matched by all lending and there are four major sectors involved. They are the government, business corporations, household consumers and the foreign balance of payments.

The key to reducing the government deficit is not to cut government expenditure or raise taxation because policies like these will not shift any of the other borrowing/lending sectors in the right direction. They are likely to discourage rather than increase business investment, thus leaving the corporate sector with even larger cash balances which have to be lent to the rest of the economy. Similarly, government cuts are unlikely to get the household/consumer sector to borrow more. Nor are they likely to do anything significant to contain our soaring balance of payments deficit, which can only be financed by borrowing from overseas. The government deficit, which is the balancing factor, is therefore almost certain to stay as high as it was before.

It is now easy to see what would happen if, nevertheless, attempts are still made to reduce government expenditure and to raise taxation to cut the government deficit. Because all borrowing would still have to equal all lending, the impact of government cuts would be not to reduce the deficit but to reduce GDP. A new borrowing/lending equilibrium would be established but with lower tax receipts and higher social security payments. The deficit would be as large as it was before but the economy would be smaller.

The only way, therefore, to cut back the need for government borrowing is to reduce the balance of payments deficit, and this can only be done by improving our net trade position. There is only one way to get this done, which is to get the UK to operate with a much lower and more competitive exchange rate. Moves in this direction may be critically important and eventually unavoidable, but they are barely on the agenda anywhere in the UK at the moment.

Because no one is talking about the exchange rate, we are in grave danger of locking ourselves into entirely pointless and unnecessary austerity, which will not cure the deficit but which will reduce GDP, causing living standards to stagnate and unemployment and inequality to rise. This is nevertheless the policy currently endorsed by all our major political parties.

Until now, calls for the UK to have an exchange rate strategy as well as fiscal and monetary policies, rather than just ignoring the strength of sterling or leaving its level entirely to market forces, have not had much traction. If it is true, however — as evidently it is — that the only way of tackling the deficit is through the exchange rate and the balance of payments, and that cutting government expenditure or raising taxes to try to do this involves unnecessary self-inflicted injury on a major scale, perceptions may change.

Here, once more, are the bald facts. If we continue as we are, gross government debt will go on rising at about 3 per cent of GDP per annum. In ten years’ time, interest charges will be crowding out an increasingly large proportion of government expenditure on goods and services. Our creditworthiness will be under ever-rising strain, threatening interest rate increases initially and then a sterling crisis. If, on the other hand, we move now to having a fully competitive exchange rate in a controlled and deliberate way, careful calculations show that government debt could fall by about 4 per cent of GDP per annum and in ten years’ time it would be no more than about 60 per cent of GDP.

This is the real choice in front of us. How soon will any of our political parties realise that this is the case?

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