Economic Nonsense: 37. Government must act to redress trade deficits
No, not really. People used to think so. To some extent this is a hangover from mercantilist attitudes when people thought you needed a surplus of exports over imports so you could accumulate wealth. In its primitive form of bullionism, people thought you had to sell more than you bought in order to build up piles of precious metals.
When the UK had fixed exchange rates the balance of trade was regarded as vitally important. Each month when the Department of Trade (as was) published the figures, people would fret about rising imports or reduced exports. The "trade gap" would sometimes feature as the lead item on the evening news bulletins. The significance was that if the imbalance were sustained over a period of time, the pressures on the currency would rise to the point where the pound might have to be devalued to a new fixed rate. This was regarded as a humiliation, and made imports more expensive, increasing the cost of living.
Once the pound was allowed to float against other currencies, however, the issue lost significance. If imports exceed exports over a period, the pound drifts down in value, making exports cheaper to sell and imports cheaper to buy, thus closing the gap. Trade deficits are only a problem for countries with fixed rates of exchange. And even here, while devaluation can redress them, other countries might also devalue, leading to "currency wars" as each tries to give itself a trade advantage.
Floating currencies solve the problem. If a country is uncompetitive, buying more than it sells, its currency will go down, enabling it to sell more and buy less. One of the problems with countries such as Greece has been that within the eurozone, they were not able to devalue or to drift down. The value of the euro was not within Greece's control. Had they left the single currency and restored the drachma, a steep devaluation would have addressed their debts and their competitiveness.
If only Britain had joined the Euro?
Will Hutton tells us, in last Thursday's Guardian, that widespread consensus on the UK's staying out of the EU is wrong-headed—joining would have kept our exchange rate low, which in turn would have meant no financial boom and an economy based (more) around producing manufactures. To add to this, our entry would have meant a more activist European Central Bank, which would have been willing to intervene when necessary. There is more wrong with his article than I could possibly tackle in one post, so I will focus on the key elements I've summarised above. None of what I say implies it necessarily would have been bad to have been in the Euro over the past ten years—such an alternative history is almost impossible to conclusively support—just that the arguments Hutton uses are extremely weak.
Pretty much all of his argument is bizarre, utopian and uneconomic. Devaluations work not because they make a country's products cheaper to foreigners, adding to net exports and driving GDP growth. Devaluations work because they boost inflation, which gets around nominal wage stickiness, allowing markets (particularly labour markets) to clear and giving relative prices the space to adjust. They make no difference to the price of a country's goods to foreigners, and in practice often boost imports as much as or more than exports, due to improved conditions. This is even true if we devalue by decree, as Hutton's desired artificially low €-£ exchange rate would be—it's just that the inflation could take slightly longer to come as firms and households bid up prices.
What's more, this is a Good Thing. We don't want to spend energy, time, labour and capital hours, as well as space, producing valuable things only to sell them in exchange for artificially few foreign goods. If countries are happy to send us desirable stuff in exchange for less of our stuff then that's great, and in any case it sows the seeds of its own balance, as consistent deficits (ceteris paribus) will drive down the exchange rate. This may eventually force the UK to run surpluses, but this would not be a Good Thing. Running surpluses means lower social welfare because we are consuming less leisure or goods or services than we would otherwise be able to enjoy. And we may never even have to run one if we keep creating loads of property or financial wealth to pay for our imports.
But let's imagine that Hutton could have subverted economic rules as basic as gravity and magically have kept the exchange rate at his desired low rate without any of the obvious expected balancing effects from wages and prices. And let's imagine that we want to send more goods abroad to get less in return. Would this have supported the manufacturing industries he wants? It's difficult to see how. If the City was providing the best financial services options for the world at £1 = €1.25 then it's not obvious that a cheaper pound, and cheaper financial services, would make them less attractive. The UK's economy contains a relatively large contribution from financial services because the UK is relatively good at financial services—as well as hi-tech manufacturing, advertising, and many service sector areas. These are the UK's comparative and in some cases absolute advantages.
And would the UK be better under the ECB (albeit with some British influence) rather than its own Bank of England? It's hard to see why Hutton thinks this. The BoE let inflation rise to hit 5.2% on the CPI measure, and has consistently allowed inflation to stay above target—the ECB has inflation below its 2% target, despite the obscene jobs crises in Spain, Greece and other crisis-hit countries. It is basically refusing to do any monetary stimulus. There is essentially no debate in Europe over whether the ECB should actually meet its inflation target, or indeed consider other economic variables, or go yet more radical and drop inflation targeting altogether. Would the UK's input really outweigh the massive consensus there, especially when the UK is divided on the issue itself? Again, I am sceptical. Strangely, Hutton seems to think that pointing to the UK's own situation and reminding us we're not living in "a land of milk and honey" is sufficient to gloss over the fact that most of the Eurozone is doing so much worse!
This laughable logical leap is nothing compared to his claim that both sides of the political divide are "united only in their belief, against all the evidence including Britain's export performance, that floating exchange rates are a universal panacea." As might be expected, he doesn't give the tiniest shred of evidence that the consensus view holds that floating exchange rates are not only the best exchange rate policy, but a panacea for all types of economic ills. But really, that's not the point. Even if everyone did—ridiculously—think that floating exchange rates were actually a panacea for economic problems, that wouldn't go any way to implying that they weren't better than fixed exchange rates.
Will Hutton's argument is completely invalid, though perhaps he gets some points for making such an outlandish and unpopular case. If it would have been good for the UK to enter the Euro 10 years ago, then it is not because it would have allowed us to permanently rig all markets to send off more of our stuff for cheaper than it is worth. And it seems completely implausible that the UK could have influenced the ECB enough to see it ditch its destructive hard money policies during the crisis, instead it seems more likely the UK would be just another country suffering under its negligence.
Devaluing the pound won't do what its advocates want it to do
Civitas this week released a pamphlet, written by import-export businessman John Mills, arguing that the UK government should target an exchange rate a third lower than the current one, in order to boost demand and UK manufacturing by raising net exports. In turn, this would lessen the burden on the welfare state, allow the government to extricate itself from the economy, alleviate long-term unemployment, improve the self-help ethos and traditional work ethic, and even arrest the UK’s international relative decline, Mills argues.
While making this case Mills ties himself up in a few apparent contradictions (e.g. a strong pound is terrible because it is bad for purchasing power) and with no argument dismisses hundreds of years of economic consensus (with a very crude mercantilism) but I will try to distil the most coherent and convincing argument out of the monograph, in order to make the fairest possible critique.
While China has wound its exchange rate policy down, and Japan does not explicitly target the price of the Yen, Civitas founder David Green holds up Switzerland as a good example of how a country can target its exchange rate. Switzerland buys up foreign currency with newly-created money from the central bank in order to keep Swiss Francs at the desired target. While a Civitas blog post from a third author, Daniel Bentley, comes out against a similar money printing means of achieving a lower rate, it’s unclear what else Mills would propose, since he doesn’t suggest any mechanism at all.
In any case, the price of a pound is governed by demand and supply. Economic authorities could either cut demand or boost supply. Since the whole point of the scheme is to raise the demand for British goods by cutting their price a demand-cutting plan would have to be careful. Green thinks that investment into UK housing and gilts is “artificially” propping up sterling, so perhaps he’d like to ban or limit these. Presuming this outrageous interference with trading freedom was legal; it’s unclear if the pound could actually be cheapened by the desired third by cutting these demands.
Still, foreigners hold about 30 per cent of gilts and foreign buyers have recently been responsible for a majority of transactions in prime London property. If previous investments could be hit as well as new activity, sterling would surely come under serious pressure. This would slash home-owning Londoners’ wealth and hike the government’s borrowing costs, but it should also make UK manufactures (and services) cheaper.
However, even with this printing-free mechanism there should be inflation. Any import business will face higher prices on its imports. Presuming margins are already competitive, the entirety of the exchange rate driven cost hike should feed through into prices. Depending on demand elasticities – the responsiveness of consumer choices to price rises in all the different affected markets (the UK currently imports about £570bn of goods, services and oil per year) this might produce some substitution in demand for these goods, along with a secular fall in demand. But it seems highly likely that this demand dip will not be enough to bring prices back to where they were – and bear in mind if it did this would mean a big fall in consumption for the same prices.
The necessity to bluntly interfere in investment and housing decisions make the above method a very unpleasant one, and we have seen how Mills’ promise that there will be no inflation (based on the dip in the pace of price rises seen after the exit from the Exchange Rate Mechanism) appears very unlikely. Of course, as suggested, the above demand-based scheme is highly distortionary aside from its philosophical issues. So the supply-based method of cheapening the pound – money printing, and inflation – starts to look much more attractive.
But – aside from going against Bentley’s blog post, and Mills’ promise not to create inflation – printing has very clear problems as a means of boosting exports. If $1 buys £1 when the money supply is £100, and we print £100, we’d expect – all things being equal, for the dollar to now buy £2. But since all things are equal, UK factories are still only churning out 100 widgets. These originally went for £1 (and hence $1), but now they will go for £2, so despite the fact the pound is cheaper, the widgets still cost $1. We get all the costs (and benefits) of inflation and none of the supposed benefits (and costs) of cheaper sterling.
Here’s where it gets interesting. Printing extra money is futile if your goal is to boost UK net exports past the very shortest of short runs. But it is by no means futile if your goal is to boost UK inflation to overcome the nominal rigidities (cash prices that won’t fall) particularly wages. UK unemployment is still well above the natural rate, even though employment recently hit an all-time record. One of the key reasons it reached the 29.75m peak is that real wages have been falling throughout the crisis.
A further bout of inflation would give the space for relative real prices to adjust to clear markets and bring the UK much closer to full employment of all resources. So while the paper is muddled and wrongheaded, I would actually support an exchange rate target as a misguided way of getting the extra demand we need.