Let The Pound Fall Further

"The UK has had an overvalued currency since monetarism became the fashion in the 1970s"

John Mills

In his critique in the November edition of Standpoint of The Real Sterling Crisis, a Civitas pamphlet I co-authored with Roger Bootle, Tim Congdon asks whether there is “any exchange rate they regard as too low?” Bearing in mind the damage that an over-valued pound does, surely the question which really needs to be asked is: “Is there any exchange rate which Tim Congdon thinks might be too high?”

Here is what an overvalued currency does. It makes investment in most sorts of manufacturing uneconomical, leading the way to the proportion of GDP going to investing in the future going down. In the UK the ratio of physical investment (excluding intellectual property) is now less than 13 per cent compared to a world average of around 26 per cent and nearly 50 per cent in China. With depreciation running at 11.5 per cent of GDP, no wonder we have a productivity problem. As a result of the consequent deindustrialisation, we have a huge visible trade deficit — currently running at about £130 billion a year — and for this and other reasons we have a £100 billion per annum balance of payments problem. This causes us to borrow or sell assets every year worth about 6 per cent of GDP to enable us to have a standard of living which is now at a level about 6 per cent more than we are earning.

Government borrowing is largely the mirror image of the balance of payments deficit, and because we cannot pay our way in the world, government indebtedness is rising much faster than our national income. What little growth we then have is driven by consumer demand, based on ultra-low interest rates and asset inflation instead of net trade and investment.

Because we have big natural advantages in services — our language, geography, skills base, legal system and experience — and because services generally are not that price sensitive, this sector of our economy can live quite happily with an exchange rate of around $1.40 or $1.50 to the pound. Unfortunately, for manufacturing we have far fewer comparative advantages and with close substitutes available to almost all products there are highly competitive world markets. Manufacturing as a proportion of UK GDP, having been almost one third as late as 1970, is now barely one tenth.

Does this matter? Yes, it does — for three reasons. The first is that it is much easier to achieve a productivity increase in manufacturing than it is in services, so the smaller the manufacturing percentage, the more slowly the economy is likely to grow. The second is that making goods rather than importing them produces far more high-quality blue-collar jobs than services. Globalisation only works if manufacturing is reasonably evenly spread round the world, not if all the good new jobs are in China. Third, even though we do well on service exports, most of our foreign earnings still come from goods. If we cannot produce enough of them to pay for our imports, deflation and slow growth follow as night follows day.

So how low does the pound have to be? The answer — because producing more goods for world markets is the only practical way to get the UK economy back into the kind of balance that will sustain a reasonable rate of economic growth in the future — is that it needs to be low enough to make investment in internationally tradeable light industrial manufacturing profitable. What would that rate be? Probably around $1.10 to the pound. Could we get there and hold the exchange rate where we need it to be? Of course we could. The world is replete with countries who do just this. Would any such policy be undermined, as Tim Congdon avers, because inflation would soon wash away any benefits from a more competitive exchange rate? No — exactly the reverse would occur.

Look at the figures. There have been plenty of devaluations in the developed world since the Second World War to use as examples. Although devaluations always push up the prices of imports, it simply isn’t true that they always produce more inflation across the board. On the contrary, the investment they produce in the tradeable sector produces cumulatively more competitive export prices — exactly as happened in Germany and Switzerland — and lower prices generally. These countries have appreciating currencies because their competitive exchange rates have kept inflation down both in their export industries and across their economies as a whole — not the other way round, as has been our bitter experience in the UK.

Indeed, the UK has had an overvalued currency at least since monetarism became the fashion in the 1970s. The 60 per cent hike in the exchange rate achieved between the late 1970s and early 1980s was when the rot set in, followed by the wholesale sale of UK assets from the late 1990s onwards, which made a bad situation even worse. There is a huge unwinding to be done. This is why we need a lower exchange rate.

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