Why We Need a Long Term Exchange Rate Target
Kaveh Pourvand, 22 February 2013
Various Civitas publications have argued that a devaluation of sterling is required to boost manufacturing exports. See, for example, this piece by John Mills Is the pound over-valued? or number five of David Green’s ten-point plan for a modern industrial policy. The rationale is simple: increasing exports will reduce Britain’s large trade deficit, help rebalance the economy towards manufacturing and thereby help set the country back on the road to prosperity. In this entry, I want to argue that a one-off spontaneous devaluation, such as has occurred to Sterling in the last few years, is unlikely to be very effective in boosting exports. To gain the benefits of low inflation, policymakers need to create confidence in the long term value of a currency. Similarly, confidence in the long term exchange value of sterling is needed if we are to gain the benefits of a more competitive exchange rate.
This insight may go some way in explaining the puzzle that Martin Weale, member of the Bank of England’s Monetary Policy Committee, outlined in a recent speech in Warwick. The sterling effective rate fell by 25 per cent between 2007 and 2008. While it had recovered somewhat by the start of 2013, it was still 20 per cent less than its value six years ago. Yet Dr Weale points out that the performance of British exports has been comparatively lacklustre over this period. They have increased by only around 2 per cent, while imports have fallen by only 4 per cent. He offers several explanations for this but one strikes me as particularly pertinent:
‘One obvious source of uncertainty is whether the competitive exchange rate will persist…. Indeed several of the businesses I have visited have told me that they are reluctant to devote substantial resources to competing against imports because they are concerned that the competitive advantage gained by the United Kingdom after 2008 might not last.’
It is only in idealised economic models that producers increase output in response to price changes instantly. In the real world, substantial increases in output often only occur after long term investments are made. It is perfectly understandable that businesses are reluctant to invest on the basis of a weak pound that they don’t know will last. The UK has no official exchange rate target that the government has gotten behind. The two other countries that may have gained most from a competitive exchange rate are Germany and China. In both cases, their currencies are valued lower than what they would be under open currency markets and this is the result of deliberate government policies. Consequently, businesses and investors in those countries can have confidence in the long run value of their currency.
Membership of the Euro effectively functions as a competitive trade policy for Germany. In 2010 Boris Schlossberg, director of currency research at Foreign Exchange Germany, said that the Deutsche Mark could be the equivalent of $2.00 to one Deutsch Mark if it still existed, compared to $1.41 to one euro at the time. This is represents a 42% discount, giving German exporters a huge cost advantage. Were Germany outside the Euro, its trade surplus would force an appreciation of its currency. However, the presence of less export competitive countries in the single currency, like Portugal or Greece, allays this pressure. As one economist neatly puts it: ‘On balance, the effect of the euro is to keep the German exchange rate undervalued at the expense of forcing overvaluation on peripheral members.’
Chinese intervention in currency markets is far more overt. China maintains the value of Renminbi simply by purchasing vast amounts of US government bonds. This prevents the dollar from weakening relative to the Renminbi. China is said to hold around 8% of publicly held US debt. In both cases, official policy supports the exchange rate policy. Germany is, for better or worse, committed to the Euro and the Chinese government has shown a long running commitment to a competitive currency.
This suggests that if we are to reap the benefits of a competitive devaluation here in the UK, the government has to show a long-term commitment to maintaining a competitive exchange rate. There are a couple caveats worth mentioning. The government should be careful not to target an exchange rate that is too low, which would damage Britain’s reputation with other countries and may encourage retaliatory devaluations that wipe out any gains achieved. Though perhaps, As John Mills has argued, Britain’s significance in the world economy is little enough now that other countries won’t feel particularly concerned if Britain devalues significantly. Nevertheless, it seems wise to stipulate that any exchange rate target should aim to balance our current account. Rather than run persistent surpluses that create equivalent debts in other countries, as Germany and China have been accused of doing.
Second, an exchange rate policy alone is not a substitute for a comprehensive industrial policy. Germany’s export economy is also built on a strong finance system, comprehensive skills policy, cost competitiveness and so forth. However, an intelligently designed and executed currency policy can help greatly to boost manufacturing.