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There Is a Simple Way to Get the UK Economy to Perform Significantly Better

28/01/2015 17:55 | Updated 30 March 2015

In government, the civil service, the media and elsewhere, there is collective view that it's impossible for economies such as ours to grow faster than 2% to 3% per annum at best. This view has no foundation in reality and is holding us back from making the simple changes we need to ensure our economy performs significantly better in the long term.

The pessimistic view of the potential of the UK economy is founded on two wholly false assumptions. First, that it doesn't make much difference what we charge the rest of the world for the goods and services we sell to them. They will always sell in roughly the same quantities whatever we charge export customers, so the exchange rate makes little difference to our competitiveness, our trade balance or to our growth prospects. Anyway, the exchange rate is fixed by market forces over which governments have little or no control, right?

Secondly, all types of investment produce roughly the same returns to whoever finances them, so it doesn't make much difference where within the economy investments are made. The returns for the economy as a whole tend to be more or less the same for all sorts of investment projects, so there is no great benefit in prioritising some forms of investment over others.

Competitiveness matters

At the moment the UK is just not competitive. The hard fact of the matter is that we have been trying for far too long to sell our output, especially of manufactured goods, at far too high prices on world markets and we have priced ourselves out of the market. In particular, we have tried to sell our labour inputs, allowing for productivity which is combined factor of education, training, and the capital equipment we have available for it, at far above world prices. This is why we have so much of our labour force which is either employed at very low wages or out of work altogether. Many with sufficient skills and connections can still compete but millions of people who could be gainfully employed are consigned - completely unnecessarily - to life without high quality work.

The reality is that most international trade is hugely price sensitive. Some manufactured products are not very price sensitive - including most of those the UK now exports, such as arms, aerospace, pharmaceuticals and vehicles. This is because they are protected by a combination of complex supply chains, accumulated development and production expertise, first mover niche protection, extensive intellectual property rights and politically determined procurement policies - and sometimes by exceptionally good management. That's why they still exist in the UK. Industries without these advantages have nearly all been driven out of business. Most manufacturing in our globalised world is not, however, protected in any significant way. The production techniques employed are widely known and available. The key expertise involved then lies in developing and distributing the products which are manufactured. Where they are made depends very largely on where they can be produced at the cheapest price, allowing for quality and reliability.

Typically for most manufacturing operations, about one third of costs are raw materials and depreciation. For these inputs there are world prices. The remaining two thirds of total costs - the cost base - are incurred in the domestic currency, in our case, sterling. These cover everything from labour costs to charges for premises; bought-in services to transport and energy costs; interest charges to the profit needed to keep businesses viable. The price we charge the rest of the world for all these costs is almost entirely determined by the exchange rate. If we want to keep up with the rest of the world and to avoid our economy stagnating, we therefore must ensure that we have an exchange rate which allows us to charge out our cost base at a competitive rate.

The upshot of our lack of competitiveness is that our share of world trade, which was 10.7% in 1950 had fallen to barely half this figure by 1980 and has now halved again, as uncompetitive export pricing has dragged down our growth rate. Direct measurement of the costs of a wide range of manufactured goods suggests that they cost at least 20% more to produce in the UK than on world markets, if we can still produce them at all. As a share of our economy manufacturing - over 30% as late as 1970 - is now down to barely 10% - and of this percentage well over half is taken up by output of goods whose markets are in one way or another protected. What has gone from the UK is nearly all the production which does not fall in this category.

Not all returns on investment are the same

Not all investments produce the same return to the economy. There are huge variations. Most public sector investment - housing, schools, hospitals, roads and public buildings - produces barely sufficient returns to cover the interest charges involved in financing it. Investment in the service sector is more variable but the total returns to most of it is still very modest. Nowadays, a high proportion of business investment is being deployed on projects such as building office blocks and opening new restaurants, none of which produce huge returns to the economy as a whole. The difference between investments of this sort and those in light industry - and some parts of the service sector such as those producing innovative IT applications - is that they largely depend on doing what was done before more efficiently, which is possible but incremental in scale. Improvements in output of this sort are, however, quantitatively different from what happens when technology, usually embodied in machinery, is employed to produce perhaps twice as much as was produced before with the same inputs.

The key to getting the economy to grow faster, therefore, is to get as much investment as possible concentrated in sectors of the economy where the application of technology can produce the highest returns to the economy as a whole. This tends to be in light manufacturing where big productivity increases are spread out not only in returns to those who provided the necessary financial resources, but also in higher wages, larger profits, more taxable capacity and better products.

How to get this done

If we are going to improve our competitiveness, start to be able to pay our way in the world, avoid the endless balance of payments problems we have - which constrain the rate at which our economy can grow - we have to increase the proportion of our GDP which comes from manufacturing from around 10% to 15%. About 60% of all our exports and 75% of all our imports are goods rather than services and for both exports and imports about 80% of all these visible goods are manufactured rather than fuels or raw materials. The only practical way to get our foreign payments back into balance is for us to sell more manufactured goods overseas and produce more in the UK of those we need for our own consumption.

To do this, investment in manufacturing, particularly light industry, which would be capable of increasing both exports and import substitution to the extent we need, has to be made much more financially attractive - and by far the simplest and most effective way to achieve this is to have a much lower exchange rate.

Adjust the exchange rate

How much adjustment to our exchange rate would be required to bring about the changes in profitability incentives we so badly need? Because sterling is still so over-valued, to make major investments in manufacturing capacity viable financially, sterling would have to come down to about $1.10 or about €0.85. Is this possible? It certainly would be if the government realised what needed to be done and was sufficiently determined to make sure that it happened.

A lower exchange rate benefits for all

Some fairly simple calculations show what could be achieved between, say, 2015 and 2020 with a more competitive exchange rate. Economic growth would be 4% to 5% per annum instead of 1% - a cumulative increase of over 25% compared to 5%, allowing us to keep up with the rest of the world. Gross investment as a percentage of GDP would rise by about 10% of our national output. Unemployment would fall towards 3% and living standards would increase by about 3% per annum instead of stagnating as they are now. The government deficit would fall from close to 6% of GDP to an easily manageable 3%, so that total government debt would fall over the next decade to about 60% of GDP instead of rising to more than twice this percentage as will happen under current policies. Government expenditure as a percentage of GDP would fall from its current 45% to about 40% but there would be much more to spend on providing services instead of paying interest charges. Inflation would probably be slightly higher - averaging around 3% rather than 2% - while the Gini coefficient, the most widely used measure of inequality, would drop from its current 36 to about 30 as both regional and socio- economic inequality fell towards the sort of level seen in the 1950s and 1960s.

All of this is possible and changes are urgently needed. What are we waiting for? Why don't we make sure that it happens?