You probably have to be old enough to have bought Sgt Pepper when it first came out to recall the angst, but there was a time when people cared about Britain’s trade deficit. There were screaming headlines. There were runs on the pound. There were policy changes to choke off imports and to boost exports. As far as the economy was concerned, the summer of love in 1967, which included a song by the Beatles called Fixing a Hole, ended with a 14% devaluation to balance the books.
So it was quite nostalgic last week when Roger Bootle and John Mills urged the government to take steps to prevent sterling’s recent depreciation from being reversed. Keeping the pound cheap, they said, was necessary to build up the UK’s manufacturing base, reverse the slide in investment as a share of national output and close a current account deficit that is now far higher than it ever was in the stop-start days of the 1960s.
A competitive exchange rate can help the balance of payments because it makes exports less expensive and imports dearer. In theory, it should help UK manufacturers to increase their market share, which in turn should encourage new investment in order to support rising production. When the deutschmark was weak in the years immediately after the second world war, West Germany took full advantage.
Bootle and Mills are quite right to point out that Britain has suffered from periods when the exchange rate has been absurdly over-valued, most egregiously during the early Thatcher years from 1979 to 1981, but also under Labour during the late 1990s and early 2000s. Both periods contributed to the hollowing out of industry and the steady deterioration in trade figures.
The current account deficit reflects Britain’s trade gap with the rest of the world, and the shortfall between money paid out by the UK and money coming in. Running permanently big deficits comes at a cost. They are financed either by Britons selling off their overseas assets or by investors from other countries buying up assets in the UK. There is always the risk that UK assets become less attractive, and if the investors suddenly pulled their money out there would be a run on the pound.
The financial markets have so far been relaxed about the UK running a current account deficit of 7% of GDP, but that doesn’t mean they will always be so. In the aftermath of the Brexit vote, it makes sense to take action to close it, which is one reason the Bank of England has been hinting at further interest rate cuts. Lower borrowing costs equate to downward pressure on the pound. To that extent, Mark Carney and the other eight members of Threadneedle Street’s monetary policy committee are doing exactly what Bootle and Mills suggest.
There is more, however, to solving Britain’s chronic current account problem than simply driving down sterling. For a start, there’s the little matter of how you keep the pound at its current depreciated levels. Official interest rates are already close to zero, so there is a limit to how much they can be cut. Money creation through quantitative easing could be deployed to keep the pound cheap, but the evidence since QE was first used in 2009 is that it boosts activity more through raising asset prices and consumer spending than it does through higher manufacturing output.
The reality is that keeping a currency stable at a low level when they are free to float on the foreign exchanges and in the absence of capital controls is quite a challenge.
A second and perhaps even more important issue is whether exporters will exploit sterling’s depreciation. There are two ways in which a company can do so. They can try to capture market share by reducing their prices, or they can keep output unchanged but cream off higher profits. Britain’s short-termist culture means there is forever a temptation to take the latter option, because that goes down better with shareholders. In Germany, where 80% of the mid-sized companies that make up the Mittelstand are not publicly quoted, there is much less pressure to make an instant killing.
Over the years, there have been times when governments have sought to tackle some of the UK’s supply side deficiencies, which include the way businesses are financed, a lack of investment in new plant and research, poor skills, inadequate management and poor industrial relations. Theresa May has made the right sort of noises since becoming prime minister, talking about the need to put workers on boards, tighten up the takeover code and look at boardroom remuneration practices. As Bob Bischof, the chairman of the Anglo-German forum noted, Britain is adopting the German business model as it is leaving the EU.
This is perhaps not quite as curious as it sounds, given that the German model predated the EU and has proved its enduring worth despite the disastrous obsession with ever-greater integration that led to the creation of the euro. The golden age for German workers was when the Beatles were knocking around the Hamburg clubs in the early 60s.
Nor has membership of the single market done much to boost UK exports to its EU partners. A study by Adam Slater of the Oxford Economics consultancy has shown that the value of Britain’s exports to the EU “grew considerably more slowly from 1993 to 2015 (4% per year) than in the pre-single market phase of the UK’s EU membership (16% per year) and also more slowly than in the 1950-1972 period before the UK joined the EU (8%)”.
Slater’s analysis highlights how the UK’s trade pattern has shifted away from the EU since the 1990s. More than 60% of UK goods exports went to the EU in the late 1990s, but this share has since fallen to 45%. Since 2007, UK exports to the rest of the EU have barely grown.
What’s more, Oxford Economics notes that a 1% rise in EU GDP leads to only around half the rise in UK exports to the bloc that a 1% rise in GDP in the rest of the world prompts in British exports to non-EU countries. Should the recent trend continue, the EU would account for 37% of UK goods exports by 2035 and 30% by 2050, which would be back to its 1960 level.
The projections make no allowances for any potential Brexit effects on the future pattern of UK trade, but it is easy to see how they might have some bearing on the negotiations that will take place once the government finally triggers article 50. The EU will clearly remain a key trading partner for the UK, but membership of the single market is less important than it was at the turn of the millennium. Trade relationships with emerging economies such as China will become increasingly significant. Hence, perhaps, the decision not to upset Beijing over Hinkley Point.
