The Blog

The Exchange Rate Is Falling and It's Good News

If you were to believe the commentariat, the recent falls in the pound are a complete disaster. According to many, we are on the edge of an economic abyss. Our country is about to be plunged into financial turmoil. And, worst of all it would seem, our summer holidays abroad have become a bit more expensive...

If you were to believe the commentariat, the recent falls in the pound are a complete disaster. According to many, we are on the edge of an economic abyss. Our country is about to be plunged into financial turmoil. And, worst of all it would seem, our summer holidays abroad have become a bit more expensive.

Hardly anyone is telling the public the good news. And there is plenty of it. For decades Britain's economy has suffered, people have lost their jobs, manufacturing has declined, factories have closed and exports have been crippled - all because the pound is much too strong. The basic fact of the matter is that we probably have the most consistently overvalued currency in the world.

What will happen if the pound continues to fall?

A competitive exchange rate will make a much wider swathe of manufacturing more profitable than it is at the moment, leaving us less dependent on high-tech which itself is vulnerable to low-cost competition even if it takes longer to attack successfully than low-tech.

A much lower exchange rate will make all investment, especially in machinery and technology in the tradeable sector, viable and attractive which most of it is not at the moment.

Because a lower exchange rate will improve the trade balance, albeit after a time lag, the balance of payments deficit will be reduced. The government deficit is close to being a mirror image of the UK's foreign trade deficit. If the foreign payments deficit can be brought down, the government deficit will come down as well, thus stabilising the government's finances. If the balance of payments deficit remains as high as it is at the moment, however, there is no prospect of the government deficit being brought under control.

Instead of growth being driven by consumer demand, as it has been for the last few years, a lower exchange rate will enable growth to be driven by investment and net trade - exports minus imports - which is what the economy urgently needs.

Our exchange rate works for services but not for manufacturing

The exchange rate we have had for some time - with sterling at around $1.50 and €1.30 on the foreign exchanges - has worked reasonably well for businesses in the service sector. But it is much too high for manufacturing. This is why the percentage of GDP coming from manufacturing is still falling while the service economy is doing reasonably well.

This state of affairs would not necessarily matter if services were as good at increasing productivity as industry is, and if we could sell enough services abroad to enable the economy as a whole to pay its way in the world. Unfortunately, neither of these conditions is fulfilled. Increases in output per head are far more difficult to secure in services than in manufacturing and - despite the huge extent to which the UK economy has deindustrialised - we still sell far more goods abroad every year than we do services.

In 2015, we had a foreign trade surplus of £90bn on services and a deficit of £122bn on goods.. This came about because the UK has significant competitive advantages in services which we lack in manufacturing. The demand for services on international markets is not nearly as sensitive to price as it is for manufactured goods. The English language, our geographical location, the reliability and probity of the UK legal system, the accumulation of successful experience and the concentration of talent, particularly in financial services, provides the UK service sector with a series of substantial competitive edges.

The problem, however, is that services are just not as valuable to the economy as manufacturing in a number of key areas. Services comprise a considerably smaller proportion of our total export earnings than goods - 44% in 2015 compared to 52% - with the balance being made up of commodities such as oil. At the same time, services do not generate the same amount of productivity increases or good quality blue collar jobs. As a result, too much dependence on services for export earnings has led the UK economy to exhibit a woeful combination of slow growth, productivity stagnation, rising inequality and severe balance of payments deficits.

A low exchange rate would give manufacturing a chance

If services are not particularly price sensitive on export markets but manufactured goods are; and we are much more dependent on the volume of manufacturing exports sales than those for services, this provides a very strong argument for pitching the exchange rate to suit manufacturing rather than services, whose sensitivity to the value of the pound on international exchanges is much less.

Because of our large balance of payments surplus on services, however, to achieve a manageable foreign trade balance, we do not need to have as large a proportion of GDP coming from manufacturing as countries such as Germany and Japan, with about 19% each. This is because we have a much stronger and more export-orientated service sector than they do. But we do need to get the ratio up from about 10% to 15%.

If we are going to get our economy rebalanced, therefore, so that it can grow on a sustainable basis, we have to have an exchange rate which is sufficiently competitive to enable at least a fair proportion of low- and medium-tech industries to flourish - as well as those which are high tech, which are generally less price sensitive.

To achieve this objective, we need an exchange rate about 25% to 30% lower than it is at the moment to enable heavy investment in a wide range of UK manufacturing industries to be viable.

We can get our economy moving again - if we manage our exchange rate

Only when the Industrial Revolution got under way did a combination of mechanisation, the application of technology and the use of new sources of energy - coal initially - begin to drive up average living standards. The key to sustainable long-term growth therefore lies in investment in these limited areas of the economy.

Expenditure on most capital assets including housing, roads, rail, most commercial buildings, schools and hospitals - however desirable on other grounds - does not usually produce large increases in output per head. Only manufacturing and technology have the capacity for doing this on any substantial scale. This is why these sectors of the economy are so crucial.

We have to use a radically lower exchange rate to engineer the rebalancing of the UK economy required to get us back onto a sustainable growth path. This is the only way to make investment in machinery and technology profitable enough to make it happen on a major scale.

We need to increase the proportion of GDP devoted to physical investment to at least 20% from its current base of just under 13%. The world average is about 26%; in China it is 50%.

The UK's balance of payments deficit needs to be brought down at least to a level which enables the rate at which foreign debt is being accumulated to be less than the economy's growth rate.

Finally, the rate at which both government debt and that of the UK economy as a whole are accumulating also needs to be less than the rate of economic growth, otherwise the debt burden will eventually become unmanageable. The constraints here are not so much the solvency of the UK but the pressure which ever-increasing interest charges will put on other headings of expenditure.

The best long-term solution lies with the exchange rate

Our long-standing relatively slow growth problems can be addressed by a combination of policies:

We can rely on our competitive advantage in services to provide our foreign payments balance with a substantial proportion of the support it needs. But we must ensure that we have a sufficiently competitive exchange rate to enable us to secure a positive trade balance in manufactured goods, enabling the balance of payments as a whole to be in manageable condition.

We need to enable the economy to grow on a sustainable basis by making it profitable to invest in the comparatively narrow areas of the economy - manufacturing and technology - which actually provide almost all of the increases in output per head and thus rising productivity which the economy is capable of producing.

We then need to introduce all the supply side policies which need to be implemented to complement what needs to be done to increase demand on a sustainable basis.

This is how the UK economy needs to be rebalanced. And at the same time we must all learn to celebrate when our overvalued currency falls to a level which enables manufacturing to compete on the world stage.