What are the likely impacts on the UK economy from the weaker pound? A recent report from the British Chambers of Commerce (BCC) has warned of sluggish growth in the UK during 2017 and beyond. It blames uncertainty over Brexit, along with higher imported inflation and weaker consumer spending due to the sharp fall in the value of the pound since the June referendum on EU membership.
The BCC focuses on a squeeze on consumer spending in the months ahead. This is one effect of a weaker currency: higher prices of imported goods and services will tend to push up overall inflation, meaning consumers will be worse off in real terms if real wages do not rise. Put simply, the pound in our pockets will not go as far. Of course, the measurement of economy-wide inflation is based on a basket of goods and services which are taken to be representative of an average person’s consumption. Imported goods and services which are directly consumed or which enter into UK companies’ production processes as inputs are likely to rise in price.
This imported inflation contrasts with inflation of goods and services produced domestically and which do not rely on imported inputs. The prices of these will be less affected by the weaker pound so that, if the latter is sustained, consumers will substitute some of their spending away from more expensive imports towards less expensive domestically produced output. If particular goods are weak substitutes then this may not be possible. Over the longer term however, the substitution effect will be stronger and domestic production will be stimulated relative to foreign production imported into the UK.
Recent media reports on UK economic performance and the weaker pound have paid very little attention to the possible effects on exports. After all, devaluation makes imports more expensive, but it also makes exports to our trading partners cheaper. Some firms may raise prices to take advantage of this and increase short-term profits, rather than attempting to gain greater market share via the lower export prices. But the opportunities are there for UK exports to perform much better. I find it surprising that the UK media seems almost to have ignored this issue. They have latched onto concerns about higher inflation and weaker consumption. This may be a product of our consumption-obsessed culture, but this in turn must be partly a consequence of an economy out of balance, with growth persistently biased towards debt-fueled consumption and away from domestic production and investment.
Larry Elliott, economics editor for the Guardian newspaper, has run against the tide with this nice piece on the weaker pound and its potential to rebalance the UK economy. He is right: the economy has been running a large current account deficit in recent years, of 7% of GDP at its peak. This means that the UK is accumulating debt with the rest of the world, which must be repaid at some point. This year’s devaluation should help to achieve this.
More expensive imports and cheaper exports should, all else being equal, reduce the UK’s trade deficit (exports minus imports). Yes, it will slow the growth of imports and overall consumption, but as Elliott argues, that is the point. If exports grow faster, this will mean that production is growing faster. A rebalancing of the economy requires that production grow faster than consumption for a time in order to reduce the current account deficit.
The difference between production and consumption is saving, which is currently too low. The UK needs a much higher savings rate, both absolutely and relative to investment, if its enormous accumulation of private and public sector debt is to be repaid, or at least shrink as a share of GDP as output grows faster than debt.
The current account deficit of an economy is equal to the excess of domestic investment over savings. To improve the UK’s performance, to raise productivity and wages for the majority, and to reduce the burden of debt, overall investment must rise and savings must rise even more. To this end, a weaker pound will help by reducing the trade deficit as well as increasing the value of net income from overseas investment, which will benefit from the weaker pound. In fact, the deterioration in investment income was more dramatic prior to the vote for Brexit than that of the trade deficit. An improvement in both will reduce the UK’s current account deficit and by implication the rate of accumulation of debt owed abroad.
The economic effects of the weaker pound have not yet become clear, but I would argue that sustaining it is a necessary condition for a rebalancing of the UK economy and improved performance over the medium and longer term. The UK needs to overcome its poor record in improving productivity, which will allow average wages to rise after years of stagnation. It also needs to reduce its debt burden, in both the public and private sectors, which make it vulnerable to rising interest rates. Such improvements will be especially helpful as the country prepares to leave the EU, with the potentially lengthy period of uncertainty for business and consumers that entails. I find it surprising that much of the media have ignored the likely gains from a weaker pound and focused only on the costs.