The Blog

Lowering the UK Exchange Rate to Improve Our Balance of Payments

Our balance of payments deficit is far too high. In fact we have not had a surplus on our trade in goods since 1982 and we have not had an overall surplus in any year since 1983 - 30 years ago. As a result, we are unable to run our economy at full throttle.

Our balance of payments deficit is far too high. In fact we have not had a surplus on our trade in goods since 1982 and we have not had an overall surplus in any year since 1983 - 30 years ago. As a result, we are unable to run our economy at full throttle. This has resulted in a chronic lack of adequate demand which explains why we have such high unemployment, low growth, rising inequality, overstrained public services, stagnant living standards and declining international significance and why government debt is mounting to unmanageable proportions. Unless we can make the UK economy competitive enough for us to be able to pay our way in the world, none of these problems will be soluble.

But what can we do to change this position? There are two separate ways in which the UK balance of payments can be brought down at the same time as expanding the economy. One is increased exports and the other is import substitution.

The key to making our export performance better is to make exporting more profitable while at the same time making our exports more competitive. The lower our exchange rate, the easier it is to achieve both these objectives at once. This is because the effect of a much lower pound is to enable our exporters to charge out all domestically incurred costs to the rest of the world much more cheaply than before while still increasing profit margins.

Although about 60% of all our exports are goods rather than services, services have nearly all their costs incurred in their local currency. Therefore, they are likely to benefit even more than manufactured goods from a more competitive currency. This is because for manufacturers, typically about 20% of their costs are raw materials and other inputs and 10% depreciation of plant and machinery for all of which there are world prices, whereas almost 100% of the costs of service industries are domestically incurred.

Perhaps even more important than increased exports resulting from a lower exchange rate would be a corresponding drop in imports. Higher prices for imports, especially as a result of a much lower pound, would strongly encourage the production of goods within the UK which had previously been imported. The same would apply to services. Holidays abroad for UK residents - which count as imports - would become more expensive, thus encouraging people not to have holidays overseas - and I, amongst many others, believe that this is a price which has to be paid for making the economy more competitive. Correspondingly, however, foreign tourism in the UK is likely to increase substantially.

It is sometimes claimed that the UK economy, in its weakened state and with its reliance on housing and services is incapable of responding to price and profitability signals. This is extremely unlikely to be true for all of the following reasons:

Despite the fact that we still have a large visible trade deficit, UK exports have grown substantially since the exchange rate was lowered in 2007/2009. Between 2009 and 2012 UK exports of goods rose 31% by value and 17% by volume. This certainly shows that expansion of sales abroad is possible. Unfortunately, imports of goods also rose over the same period by 31% and 15% by volume but from a higher base, so the visible deficit grew larger rather than becoming smaller.

At £1.00 equals a little over $1.00, however, the picture would change dramatically. The problem is that at £1.00 equals $1.70, import substitution on any sufficient scale is not worthwhile. With the exchange rate a third lower than it is now, much of the light manufacturing which relocated along the Pacific Rim as we de-industrialised would become more economical to locate again within the UK. Most light industrial production - such as injection moulding, metal pressing, fabrication and assembly - involves processes which are relatively easy to establish, and machinery, equipment and raw materials which are readily available on world markets. This is why re-establishing the UK as a manufacturing base would enable the economy to grow at 4% to 5% per annum as unemployment fell towards perhaps no more than 3%.

The path back to sustainable prosperity for the UK therefore lies both in increased exports and import substitution, covering both goods and services. In 2013 our foreign payments deficit was £67bn - running at 5.5% of GDP by the second half of the year. £27bn of this sum was our trade deficit, another £27bn by transfers abroad and a further £17bn was net income from aboard, which has now turned negative. If the economy is expanded strongly, imports are bound to rise. This is why a very substantial increase in exports and a strong move towards import substitution will be needed - all made possible by a lower exchange rate - to cater for the needs engendered by much more rapid growth.

Is all this possible? Emphatically, it is. None of the standard objections to managing our exchange rate down stand up to close scrutiny. The reason we stick to a grossly over-valued pound has nothing to do with the impossibility of changing its external value and everything to do with the fact that our politicians, civil servants, commentators and academia are wedded to views on economics which are wholly out of kilter with what really needs to be done.

Targeting inflation at 2% is not by a very long chalk the primary economic objective. Making sure that the exchange rate is at a competitive level is far, far more important. Until opinion changes, we will be condemned to little economic growth, stagnant living standards, overstrained public resources, an unfundable Welfare State, a pensions crisis, rising inequality both regionally and between socio-economic groups, mounting unemployment and declining international significance.

Of course, a competitive pound is not a solution on its own. Many supply side policies will be needed to complement what needs to be done by making the UK economy more competitive internationally. The crucial point about the exchange rate, however, is that without getting this at the right level, no other mix of policies will work. This is the crucial perception which our policy makers need to take on board.