Robert Skidelsky
Robert Skidelsky, Professor Emeritus
of Political Economy at Warwick University and a fellow of the British
Academy in history and economics, is a member of the British House of
Lords. The author of a three-volume biography of John Maynard Keynes, he
began his political career in the Labour party, b… read more
LONDON
– The most dramatic economic effect of the United Kingdom’s Brexit vote
has been the collapse of sterling. Since June, the pound has fallen by
16% against a basket of currencies. Mervyn King, the previous governor
of the Bank of England, hailed
the lower exchange rate as a “welcome change.” Indeed, with Britain’s
current-account deficit running at over 7% of GDP – by far the largest
since data started being collected in 1955 – depreciation could be
regarded as a boon. But is it?
Economists
would typically argue that the way to balance a country’s external
accounts is through a fall in its currency, which would make imports
more expensive and exports cheaper, causing the former to fall and the
latter to rise. Higher import prices – a net loss for the country –
would be offset by the higher employment and wages generated by the more
competitive position of the country’s exports.
But
in order for currency depreciation to work its magic, more demand for
exports must be forthcoming when the exchange rate falls (or, as
economists say, the price elasticity of demand for exports must be
high). But various studies have shown that the price elasticity of
demand for UK exports is low. For example, a recent paper
by Francesco Aiello, Graziella Bonanno, and Alessia Via of the European
Trade Study Group finds that “the long-run level of exports appears to
be unrelated to the real exchange rate for the UK.”
This
means that British consumers and producers will have to bear the entire
brunt of devaluation: their import consumption will be rationed through
a sharp rise in price inflation, with no offsetting gain for exports.
This is by no means merely a theoretical proposition. In 2008-09, when
the rest of the world was on the verge of deflation, the UK was enduring
an inflationary recession, with GDP contracting at a top rate of 6.1%
annually, while inflation reached some 5.1%. This occurred because
sterling fell more than 21%, peak to trough, from 2007 to 2008.
Moreover,
although the current-account deficit narrowed to around 1.7% of GDP in
2011, the improvement was only temporary. After 2011, the current
account deficit started to widen once more, even though the pound never
clawed back its losses. In economics jargon, the UK seems to be
suffering from an extreme variant of the Houthakker-Magee effect – named
after two economists who discovered in 1969 that price elasticities for
imports and exports could diverge substantially, giving rise to a
permanent tendency toward current-account imbalance.
The
reason appears to be the massive contraction of the UK manufacturing
sector – from around 28% of gross value added in 1978 to less than 10%
today. As the economist Nicholas Kaldor pointed out long ago, because
manufacturing has higher returns to scale than services, manufacturing
exporters tend to beat service exporters.
In
addition, structural reforms since the mid-1990s have ensured that
British exporters are deeply integrated within global supply chains. As a
result, many of Britain’s exports require imported inputs; so when
sterling depreciates and import prices rise, the knock-on effect on
export prices renders them less competitive. The most recent OECD data
show that the import content of UK exports is around 23%, compared to
around 15% for US and Japanese exports.
For
now, the UK is relying on capital inflows into the City of London to
limit sterling’s fall. But, as the exchange-rate collapse of 2008
showed, this source of foreign demand for sterling is highly unstable.
When the worm inevitably turns and these flows reverse, both sterling
and exports will take another hit.
The
worst-case scenario would involve a sharp fall in the value of
sterling, followed by sticky inflation that reinforced the rise in
British export prices, fueling further currency depreciation. This doom
loop would stop only when British consumers suffered a fall in real
income of a magnitude not typically seen outside developing countries.
The
more likely outcome is a sort of slow rotting effect, with periodic
depreciations gradually driving down living standards for all who earn
their living in sterling.
What
is to be done? Only rapid government action to substitute goods
currently imported with domestically produced goods will do the trick.
The classic solution is import controls. But other measures that are
less damaging to trade rules and international amity are available.
The
national investment bank which the Labour Party is now advocating could
be given a mandate to invest in industries with a high import
substitution potential. An alternative would be to subsidize such
industries directly from the Exchequer, with subsidies tied to the
quality-adjusted price of the import being substituted. As the
domestically produced goods became competitive with the foreign goods,
the subsidies would gradually be removed and the industry allowed stand
on its own two feet.
Ideally,
the British government should aim to bring down imports as a percentage
of GDP from the current high of around 30% to pre-1974 levels of around
20%. This may prove too ambitious, and the UK may have to settle for
somewhere around 25% of GDP. But if something is not done, Britain risks
permanent impairment of prosperity. A depressed economy can be
reflated, and an inflationary economy can be depressed. But losing
access to crucial foreign markets as a result of currency movements
outside the country’s control is largely irreversible.
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