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The pound must fall further if Britain is to have a lasting recovery
Recovery is in the air. Thank goodness. The question that is nagging me is whether it will be a healthy recovery or whether it will be more of the same old pattern of growth which, experience has taught us, flatters only to deceive.
There are plenty of examples of countries devaluing the nominal rate only to find domestic inflation taking off so that, within a short time, the real exchange rate is back to where it was, thereby giving no advantage but leaving the country with a higher rate of inflation. Photo: PA
By Roger Bootle
6:30PM BST 16 Jun 2013
12 Comments
There has been a widespread consensus that the UK needs a more balanced economy. In the short-term that requires a recovery unbalanced towards net exports and corporate investment, so that their relative size rises in relation to government spending and consumption, whose share needs to fall.
Is there any sign of this happening? Not a lot. Last year the economy grew by 0.3pc. Net trade actually made a negative contribution, that is to say, import growth outpaced export growth. Investment contributed 0.2pc but the big contributors to aggregate demand were government spending at 0.5pc and consumer spending at 0.7pc. Not much sign of rebalancing there. What's more, it seems unlikely that further recovery will show any rebalancing.
Net exports are unlikely to contribute much while the eurozone remains depressed.
True, corporate investment could be strong. After all, companies are sitting on extensive piles of cash. Yet companies typically wait to see if there is going to be adequate demand for their products before investing in expensive new equipment.
So what will lead the recovery? The answer is consumer spending. This sounds both surprising and concerning. How can consumers increase spending when their real incomes are still falling? One way is if employment is increasing, which has been happening. Over the past year, for instance, total real disposable income has risen by 2pc despite a fall in real average earnings of 1.5pc.
Another way is through a decline in the savings ratio, that is to say, the percentage of income that people devote to saving rather than spending. If consumers start to save a bit less they will be able to increase their spending by more than the increase in real income would justify. An increase in house prices would reinforce this trend.
As prices rose, so housing equity would pick up and housing transactions might rise too. Of course, if consumer spending does pick up, we can expect a fair proportion to fall on imports. Accordingly, unless exports are rising nicely too, the trade deficit is likely to widen.
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This sounds like a pretty unattractive sort of recovery – in fact just like the traditional British recovery that ends in tears: rising house prices, rising consumer spending and a widening trade deficit. Indeed, precisely because of that, companies may not invest heavily as the recovery gathers steam because they are not convinced of its longevity.
It could be argued that in today's circumstances, unsustainable growth is better than no growth. Indeed, as far as the fiscal deficit is concerned, a consumer-led recovery is apparently a good thing because, pound for pound, it means more tax revenue than one driven by exports (which don't carry any VAT or excise duties).
Moreover, what starts off as unbalanced may become more balanced when corporate investment and net trade pick up later on. Bearing in mind our history, though, you would be ill-advised to bank on it.
What, if anything, could economic policy do to make the recovery more sustainable? The most important issue concerns the exchange rate. The UK has had a deficit on trade in goods and services for years. Last year it stood at 2.3pc of GDP.
Traditionally this was largely made up for by a surplus on net investment income. Over the past several years, however, that has been nowhere near sufficient, so we have run a large overall (current account) deficit.
If domestic demand picks up now, the current account would go further into deficit. The economist and entrepreneur John Mills (and the American economist Robert Aliber) argue that the UK needs a lower exchange rate to price its domestic production into markets at home and abroad. For Mills the overriding requirement is to get the exchange rate to a level that can ensure sustainable growth at full employment. But a generation of UK policy-makers and commentators have swallowed a very different doctrine. For them the overriding requirement is to meet the inflation target.
Although they embraced sterling depreciation in 2007-8, the British policy establishment has never quite gone the full monty. The conflict with the inflation target is one of the reasons. Another is the fear that a policy of deliberately encouraging much weaker sterling simply wouldn't work. What counts for competitiveness, and hence for trade performance and GDP growth, is the so-called real exchange rate, that is to say, the nominal rate adjusted for inflation.
There are plenty of examples of countries devaluing the nominal rate only to find domestic inflation taking off so that, within a short time, the real exchange rate is back to where it was, thereby giving no advantage but leaving the country with a higher rate of inflation.
Yet there are counter-examples. In 1931, when the UK came off the Gold Standard, it was able to reduce the real exchange rate significantly. This happened again when we exited the ERM in 1992. On the last occasion, when the pound fell by 25pc in 2007-8, most of the gain was initially retained, although about half has now been lost.
Most significantly for the case against further sterling weakness, since that recent sterling drop, the performance of net trade has been disappointing and there is a danger that a further sharp fall could be counter-productive, because the sensitivity of exports to price could be very low, and delayed, whereas the sensitivity of consumers to squeezes on their real incomes could be great, and immediate.
So there would be risks in encouraging sterling lower.
But there are always risks in economic policy. The current approach of encouraging a housing market and consumer-led recovery is about the riskiest of the lot.
Our obligations to our G7 partners rule out an avowed policy of targeting the exchange rate but that still leaves much room for manoeuvre. Such obligations have not prevented Japan from "accepting" a 20pc fall in the yen last October and outside the G7 umpteen countries, including China and Switzerland, have adopted policies for the exchange rate.
With a new Governor soon to take office and with a policy of greater flexibility on the inflation target already in place it is time to take Mills' arguments seriously. Otherwise, we could soon be back to the traditional British pattern of a recovery which is already doomed from the start.
Roger Bootle is managing director of Capital Economics.
roger.bootle@capitaleconomics.com
Recovery is in the air. Thank goodness. The question that is nagging me is whether it will be a healthy recovery or whether it will be more of the same old pattern of growth which, experience has taught us, flatters only to deceive.
There are plenty of examples of countries devaluing the nominal rate only to find domestic inflation taking off so that, within a short time, the real exchange rate is back to where it was, thereby giving no advantage but leaving the country with a higher rate of inflation. Photo: PA By Roger Bootle
6:30PM BST 16 Jun 2013
12 Comments There has been a widespread consensus that the UK needs a more balanced economy. In the short-term that requires a recovery unbalanced towards net exports and corporate investment, so that their relative size rises in relation to government spending and consumption, whose share needs to fall.
Is there any sign of this happening? Not a lot. Last year the economy grew by 0.3pc. Net trade actually made a negative contribution, that is to say, import growth outpaced export growth. Investment contributed 0.2pc but the big contributors to aggregate demand were government spending at 0.5pc and consumer spending at 0.7pc. Not much sign of rebalancing there. What's more, it seems unlikely that further recovery will show any rebalancing.
Net exports are unlikely to contribute much while the eurozone remains depressed.
True, corporate investment could be strong. After all, companies are sitting on extensive piles of cash. Yet companies typically wait to see if there is going to be adequate demand for their products before investing in expensive new equipment.
So what will lead the recovery? The answer is consumer spending. This sounds both surprising and concerning. How can consumers increase spending when their real incomes are still falling? One way is if employment is increasing, which has been happening. Over the past year, for instance, total real disposable income has risen by 2pc despite a fall in real average earnings of 1.5pc.
Another way is through a decline in the savings ratio, that is to say, the percentage of income that people devote to saving rather than spending. If consumers start to save a bit less they will be able to increase their spending by more than the increase in real income would justify. An increase in house prices would reinforce this trend.
As prices rose, so housing equity would pick up and housing transactions might rise too. Of course, if consumer spending does pick up, we can expect a fair proportion to fall on imports. Accordingly, unless exports are rising nicely too, the trade deficit is likely to widen.
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12 May 2013
This sounds like a pretty unattractive sort of recovery – in fact just like the traditional British recovery that ends in tears: rising house prices, rising consumer spending and a widening trade deficit. Indeed, precisely because of that, companies may not invest heavily as the recovery gathers steam because they are not convinced of its longevity.
It could be argued that in today's circumstances, unsustainable growth is better than no growth. Indeed, as far as the fiscal deficit is concerned, a consumer-led recovery is apparently a good thing because, pound for pound, it means more tax revenue than one driven by exports (which don't carry any VAT or excise duties).
Moreover, what starts off as unbalanced may become more balanced when corporate investment and net trade pick up later on. Bearing in mind our history, though, you would be ill-advised to bank on it.
What, if anything, could economic policy do to make the recovery more sustainable? The most important issue concerns the exchange rate. The UK has had a deficit on trade in goods and services for years. Last year it stood at 2.3pc of GDP.
Traditionally this was largely made up for by a surplus on net investment income. Over the past several years, however, that has been nowhere near sufficient, so we have run a large overall (current account) deficit.
If domestic demand picks up now, the current account would go further into deficit. The economist and entrepreneur John Mills (and the American economist Robert Aliber) argue that the UK needs a lower exchange rate to price its domestic production into markets at home and abroad. For Mills the overriding requirement is to get the exchange rate to a level that can ensure sustainable growth at full employment. But a generation of UK policy-makers and commentators have swallowed a very different doctrine. For them the overriding requirement is to meet the inflation target.
Although they embraced sterling depreciation in 2007-8, the British policy establishment has never quite gone the full monty. The conflict with the inflation target is one of the reasons. Another is the fear that a policy of deliberately encouraging much weaker sterling simply wouldn't work. What counts for competitiveness, and hence for trade performance and GDP growth, is the so-called real exchange rate, that is to say, the nominal rate adjusted for inflation.
There are plenty of examples of countries devaluing the nominal rate only to find domestic inflation taking off so that, within a short time, the real exchange rate is back to where it was, thereby giving no advantage but leaving the country with a higher rate of inflation.
Yet there are counter-examples. In 1931, when the UK came off the Gold Standard, it was able to reduce the real exchange rate significantly. This happened again when we exited the ERM in 1992. On the last occasion, when the pound fell by 25pc in 2007-8, most of the gain was initially retained, although about half has now been lost.
Most significantly for the case against further sterling weakness, since that recent sterling drop, the performance of net trade has been disappointing and there is a danger that a further sharp fall could be counter-productive, because the sensitivity of exports to price could be very low, and delayed, whereas the sensitivity of consumers to squeezes on their real incomes could be great, and immediate.
So there would be risks in encouraging sterling lower.
But there are always risks in economic policy. The current approach of encouraging a housing market and consumer-led recovery is about the riskiest of the lot.
Our obligations to our G7 partners rule out an avowed policy of targeting the exchange rate but that still leaves much room for manoeuvre. Such obligations have not prevented Japan from "accepting" a 20pc fall in the yen last October and outside the G7 umpteen countries, including China and Switzerland, have adopted policies for the exchange rate.
With a new Governor soon to take office and with a policy of greater flexibility on the inflation target already in place it is time to take Mills' arguments seriously. Otherwise, we could soon be back to the traditional British pattern of a recovery which is already doomed from the start.
Roger Bootle is managing director of Capital Economics.
roger.bootle@capitaleconomics.com