Larry Elliott’s economics opinion piece from today’s Guardian discusses the issue of the UK’s large current account deficit and how to reduce it. He refers to a paper by Roger Bootle and John Mills, two authors spanning the political divide (the paper is free to download here). Bootle is a free-market Keynesian economist who runs his own consultancy, Capital Economics, and generally favours light regulation and low taxes, but also attaches importance to the Keynesian emphasis on aggregate demand. Mills studied economics at Oxford, is a successful businessman and a major Labour party donor. On the issue of the UK’s exchange rate, they seem to agree.
The pound fell sharply following the result of the UK’s referendum on EU membership. Economic theory teaches that a lower exchange rate, by reducing the price of a country’s exports and increasing that of its imports, all else equal, should boost sales of the former and reduce those of the latter. In the UK’s case, this should reduce the current account deficit. At 7%, the latter is at the highest level since records began. The financial markets don’t seem to mind financing it for now, but there are a number of reasons why it makes sense to maintain the current lower level of the pound.
When a national economy runs a current account deficit, this is financed by borrowing from abroad. This is reflected in the flip side of the current account: the capital account. The UK finances its current account deficit by importing capital. National accounting identities show that a current account deficit is matched by an overall domestic excess of investment over saving. Thus the private sector (firms and households) and government sector must together be borrowing an amount equal to the capital account.
The government’s budget deficit is about 4% of GDP which, taking in to account the current account deficit of 7%, means that the private sector is borrowing about 3% of GDP (3+4=7). Both sectors are therefore accumulating debt at a rate faster than the current growth rate of GDP itself. The latter was 2.2% in the second quarter of 2016. Thus the share of GDP of both private debt, and public debt, is currently rising. A significant improvement in the nation’s current account deficit towards balance, brought about by maintaining a weaker exchange rate would, as a matter of accounting, necessarily reduce the private and public sector deficits. Reduction in the latter has been a matter of policy since 2010 and the aftermath of the Great Recession, but has been much slower than planned. Reduction in the former would also reduce the potential fragility of corporate and household balance sheets.
Simply put, a reduction in the current account deficit (foreign borrowing) would translate into a reduction in the rate of increase of domestic borrowing. National savings relative to investment would increase.
There are further substantial benefits to this rebalancing of the economy. If the current lower exchange rate is maintained, thus benefitting exporting firms, this will tend to favour manufacturers. Indeed periodic overvaluation of the pound in the early 1980s, early 1990s, from the mid-90s until 2007, and again for several years prior to the EU referendum, has made exporters, including manufacturers, less competitive internationally. While the firms that survived may be leaner and meaner, there are substantial numbers that suffered from the neglect of the exchange rate as a policy target. A weaker exchange rate would help boost manufacturing output, investment and maybe even employment to some degree.
Studies have shown that productivity growth in manufacturing tends to exceed that in services. A boost to manufacturing would therefore help productivity to grow faster in the economy overall. For this to happen, profits need to rise in manufacturing and these profits need to be reinvested in expanded capacity. To the extent that exporters use imported inputs in production, the lower pound will raise their costs, diminishing the benefits of the devaluation. If UK exporters respond to these higher costs by sourcing a larger proportion of their inputs from domestic suppliers then the impact will be more positive. These kinds of changes can take time to happen, which emphasises the importance of maintaining the pound at its new lower level, as well as a supportive industrial policy.
Faster productivity growth in manufacturing and the potential spillover effects across the economy would also create room for wages to rise faster, even as profits and investment increase. Wage stagnation has been a problem in the UK for a number of years, and this policy could help to provide a remedy.
Alongside lower borrowing, higher investment and productivity, there is the potential for income inequality, another perennial problem for the UK, to fall. Faster growth in manufacturing output may generate new jobs in the middle of the distribution. This is in contrast to growth in the dominant services sector, which tends to create both high paying jobs in finance and low-paying jobs in retail, hotels and catering. The overvalued exchange rate has meant that this pattern of employment creation has been a dominant trend in recent decades. Of course, the latter is not all down to a strong exchange rate, but it has surely been a factor.
A sustained recovery in manufacturing could also go some way to narrowing the UK’s regional divide by boosting mid-tech industry in the midlands and north, relative to the south-east, which contains much of the finance and related service sector jobs.
Lower household borrowing, a falling government deficit, higher wages and productivity, lower inequality, and a falling regional divide: these potential benefits of a persistently weaker currency may sound too good to be true. The UK economy has certainly suffered from an overvalued exchange rate, on and off, for several decades. A weaker currency was one immediate outcome of the Brexit vote, and there is now a danger that it will rise again if the anticipated economic weakness does not materialize and investors’ confidence in UK assets rises once again. Letting this happen would be a mistake.
As described above, a rebalancing of the UK economy is sorely needed and a new policy of targeting a weaker pound sterling has the potential to achieve a number of positive structural changes. A supportive industrial policy would also help, which could include changes to corporate governance, and an improved supply of finance to domestic producers. Firms also need to be encouraged to invest more for the long term when profits rise, rather than raising prices which will tend to undo the potential for increasing market share. Although a consistently weaker currency would help them to plan and operate based on long term prospects, such additional policies may be needed. The overall economic and social benefits discussed here would certainly be welcomed across the political divide.