5
202 NEWECONOMY i - 4New Economy Kickina the KEVIN GARDINER UK -kt at Morgan Stanley International. He is writing in a pencmal capacity currency Gabit Forget the currency’s value, it’s the quality of our products that counts. t is now obvious to all but the most finnly- tenured practitioners that the economics profession has done post-war politicians a profound disservice. When faced with ma- jor policy issues, we have often asked the wrong questions in the wrong way. Nowhere is the disappointing evolution of the macroe- conomic research programme more evident than in discussion of the balance of payments and the UK’s industrial decline, where the exchange rate plays a central role in many The sheer diversity of the economic cli- mates this downtrend has weathered might have warned against looking for easy solu- tions. But economistshave searched for a pol- icy panacea - a single, causal variable which, if manipulated with sufficient expertise, would solve the apparent manufacturing malaise. For many, the exchange rate is public enemy number one. Admittedly, even hardened sceptics would find it difficult to argue that a sharp analyses. Every post-war administra- tion - from Attlee to Major - has been hampered in its quest for sustainable economic growth by a balance of pay- ments crisis. More often than not the performance of the manufacturing account has been to blame. The steady decline in the ra- tio of manufactured exports to “the pound is more sinned against than sinning. In the longer term, sterling does not cause trends in the real economy, i t reflects them.” change in the value of the pound will have no impact whatsoever on the real econ- omy - one reason commenta- tors failed to foresee the pre- sent boomlet is that they over- looked the short-term stimu- latory effect on the manufac- turing sector of sterling’s fall from ERM grace. But the strongest argument against viewing the exchange rate as imports has been clearly visible for decades - it certainly didn’t start in 1979 - and well- documented (see Chart right-hand page). This decline has withstood any number of fiscal and mon-etary policy regimes, and sailed irr-everently through the most high- falutin’experiments with socialcontracts and libertarianism. the latest in a long line of holy grails can be stated quickly and simply: the pound is more sinned against than sinning. In the longer term, sterling does not cause trends in the real economy, it reflects them. Cause and correlation This subtle point is easily overlooked. The 1070-3535/94/040202 + 05 508.00/0 <c’ THE DRYDEN PRESS

Kicking the currency habit: Forget the currency's value, it's the quality of our products that counts

Embed Size (px)

Citation preview

Page 1: Kicking the currency habit: Forget the currency's value, it's the quality of our products that counts

202 NEWECONOMY i - 4New Economy

Kickina the KEVIN GARDINER

UK -kt at Morgan Stanley International. He is writing in a pencmal capacity

currency Gabit Forget the currency’s value, it’s the

quality of our products that counts.

t is now obvious to all but the most finnly- tenured practitioners that the economics profession has done post-war politicians

a profound disservice. When faced with ma- jor policy issues, we have often asked the wrong questions in the wrong way. Nowhere is the disappointing evolution of the macroe- conomic research programme more evident than in discussion of the balance of payments and the UK’s industrial decline, where the exchange rate plays a central role in many

The sheer diversity of the economic cli- mates this downtrend has weathered might have warned against looking for easy solu- tions. But economists have searched for a pol- icy panacea - a single, causal variable which, if manipulated with sufficient expertise, would solve the apparent manufacturing malaise. For many, the exchange rate is public enemy number one.

Admittedly, even hardened sceptics would find it difficult to argue that a sharp

analyses. Every post-war administra-

tion - from Attlee to Major - has been hampered in its quest for sustainable economic growth by a balance of pay- ments crisis. More often than not the performance of the manufacturing account has been to blame.

The steady decline in the ra- tio of manufactured exports to

“the pound is more sinned against than sinning. In the longer term, sterling

does not cause trends in the real economy,

i t reflects them.”

change in the value of the pound will have no impact whatsoever on the real econ- omy - one reason commenta- tors failed to foresee the pre- sent boomlet is that they over- looked the short-term stimu- latory effect on the manufac- turing sector of sterling’s fall from ERM grace. But the strongest argument against viewing the exchange rate as

imports has been clearly visible for decades - it certainly didn’t start in 1979 - and well- documented (see Chart right-hand page). This decline has withstood any number of fiscal and mon-etary policy regimes, and sailed irr-everently through the most high- falutin’ experiments with social contracts and libertarianism.

the latest in a long line of holy grails can be stated quickly and simply: the pound is more sinned against than sinning. In the longer term, sterling does not cause trends in the real economy, it reflects them.

Cause and correlation This subtle point is easily overlooked. The

1070-3535/94/040202 + 05 508.00/0 <c’ THE DRYDEN PRESS

Page 2: Kicking the currency habit: Forget the currency's value, it's the quality of our products that counts

KICKING THE CURRENCY HABIT- ~~ 203

devoting much of its research budget in this area to the sterile art of econometric modelling.

This hasty resort to the technical toolbox, combined with the failure to distinguish between cause and ef- fect, is characteristic of the degeneration of the overall macroe- conomic research programme. While

monetarist debate illustrates the way econo- mists often confuse cause and effect. The Cambridge economist Lord Kaldor noted that the money supply tends to grow rapidly around Christmas each year, but that this doesn’t necessarily mean the surge in the money supply causes Christmas - quite the opposite.

But instead of informing the exchange rate debate, the economics profession has com- pounded its substantive error by making the procedural mistake of

devaluation can work. But like an ath- lete whose speed is

devalua tion-driven boom usually masks a less impressive un-

I derlying perform- ance. To maintain the enhanced speed, con- tinuing fixes are needed.

Moreover, de- valuation is a zero- sum game - not

10 boosted by drugs, a

1950 19% IW 1569 1974 1983 1% IPn ai

must have something to do with industrial performance. After all, a high value for ster- ling makes British goods and workers more expensive in the international market place.

When looking for possible reasons for fall- ing market share there can be few more obvi- ous places to start than the foreign exchanges. Provided there is plenty of spare capacity, how better to stimulate demand, output and employment than to engineer a lower ex- change rate?

In the short term,

Page 3: Kicking the currency habit: Forget the currency's value, it's the quality of our products that counts

204 NEW ECONOMY

Common sense When analysing such episodes, econometri- cians have usually been able to idenhfy the short-term linkages which common sense suggests exist - a statistically significant cor- relation between upward movements in the currency and deteriorations in manufactur- ing performance, and vice versa. But the sat- isfying nature of the econometric process itself, and the apparent precision of the esti- mated coefficients, has often tempted econo- mists to place unwarranted long-term policy emphasis on such misleading correlations.

In practice, sharp rises in the pound have followed episodes in which it has been weak. Viewed in the longer term, it is more difficult to see a strong pound as the prime mover behind Britain’s manufacturing decline. More often than not, changes in the value of sterling seem to have been linked to changing condi- tions in the domestic economy, suggesting at the very least that causation can run in both directions.

Indeed, the longer-term trend in the ex- change rate has been downwards, not up- wards. In the past few decades, s terhg has not even been ’correlated’ with economic per- formance in the way received wisdom sug- gests. In 1960 the pound was worth roughly Yen 1,ooO or DM12.00 or almost US$3.00. In 1994, it is worth roughly Yen 150, or Dh42.50, or US$1.50. If industrial success went hand in hand with a low exchange rate, the UK would be streets ahead. The reality is that the UK has lagged behind. In the past three decades, the growth rate of UK manufacturing output has been just one-sixth that of Japanese manufac- turing, and roughly half the growth rates of German and American industry. The UK’s industrial shortcomings cannot be explained neatly in terms of the level of the exchange rate. Common sense seems to have led us astray.

Getting real We are, of course, cutting a comer or two

here. The econometricians will argue that their multivariate analysis allows them to correct for factors excluded from this simplis- tic analysis, and which may be responsible for the apparently perverse correlation. More important, it is the real (inflation-adjusted) exchange rate that ought to matter. And if UK d a t i o n has been faster than inflation over- seas, the real position of UK industry may not have improved at all despite the fall in the nominal exchange rate.

To be fair, most proponents of the view that the pound has been public enemy number one have had some measure of the real ex- change rate in mind. And on closer inspection we may yet find the expected negative corre- lation between a declining manufacturing sector and a rising real exchange rate.

But the UK’s real exchange rate, in terms of prices or costs, has not been trending up- wards. Although the real exchange rate dur- ing the 1980s was, on average, much higher than in the 1970s, the latter levels were histori- cally low. Indeed, indices of relative unit wage costs compared with Germany have probably never been lower than they are in 1994.

But even long-term analyses that take on board these refinements still suggest the ex- change rate has played only a marginal role in influencing UK trade in the post-war period. If the UK stiU has payment problems in spite of relatively inexpensive labour input, the textbooks have some explaining to do.

Volatility Some people will argue that it is not the level of the exchange rate but the volatility of the currency which matters. Currency volatility, they will say, makes it difficult for companies to budget and market their products.

In the short term this must be true, and it would be foolish to ignore the potentially damaging impact on business such financial uncertainty can wreak. Again, however, it is difficult to prove that, in the days when ster- ling was much more stable than now, trade

Page 4: Kicking the currency habit: Forget the currency's value, it's the quality of our products that counts

KICKING THE CURRENCY HABJT 205

performance was significantly better than it has been of late. Indeed, the Chart earlier seems to suggest the steepness of the UK’s manufacturing decline abated during the mid 1980s, a period characterised by considerable exchange rate volatility.

Better, not cheaper Perhaps the question economists should have been asking is: can the UK hope simply to price itself into lasting economic success?

To date, Britain has competed most inten- sively against its industrialised partners in Europe, and against the United States and Japan. But increas- ingly, the UK will be competing with, for example, Chinese manufacturers which have at their disposal technology little dif- ferent from that available to UK pro- ducers and whose workers sell their time for as little as a dollar or two an hour. Can this longer-term competitive game be won by trying to

securing cheaper products and workers. But the ideal may be a more expensive manufac- turing sector producing things people actu- ally want to buy. Product differentiation, rather than average prices and costs, may hold the key.

Some succeed This suspicion is strengthened by a quick look at the composition of Britain’s trade. The Table below compares trade performance in 1993 and 1983 in selected categories of manu- facturing activity. Performance is shown in

~ ~

UK success stories are in diverse sectors UK trade performance in selected sectors: ratio ofexports to imports (OTS basis)

1983 1993

Drink and Tobacco 1.54 1.53

Pharmacuticals 2.28 1.83 Yam, fabrics 0.55 0.65 Iron, steel 1.06 1.24 Power generating equipment 1.58 1.52 Office machinery 0.68 0.81 Road vehicles 0.54 0.58 Telecommunications, hi-fi 0.52 0.89 Clothing 0.54 0.48 Footwear 0.23 0.33 Furniture 0.53 0.59 TOTAL manufacturing 0.89 0.91 (ex. drink & tobacco)

Organic chemicals 1.33 1.40

match Chinese suppliers cost for cost, and price for price? Shouldn’t the focus be on products where price and cost are not the most important determinant of trade? Better, perhaps, to let the naturally low-cost produc- ers specialise in mass production while Brit- ain looks elsewhere.

After all, the ideal in commercial strategy is to have a product which is so attractive that customers want it almost irrespective of price - whether because of its image or its reputa- tion for quality and reliability. This is why the business schools, rather than the economic faculties, may have most to teach us about competitiveness. Economists focus on rela- tive prices and costs, and think in terms of

terms of relative value - the ratio of exports to imports. This can be a more meaningful way of summarising structural trade per- formance than the crude arithmetic bal- ance.

The most striking thing is that perform- ance seems to vary tremendously, both across industries and through time. This di- versity in UK trade performance seems to hint at ’bottom-up’

reasons for the overall weakness, rather than at any single macroeconomic constraint on trade.

Britain does well in price-sensitive areas such as chemicals and steel, in R&D-intensive areas such as pharmaceuticals and aerospace production, in investment goods industries such as power-generation equipment, and in consumer products such as processed drink and tobacco. If these industries can live with the level and volatility of sterling, the struc- ture of interest rates, financial ‘short-temism’ and corporate taxation, why can’t others? And if the exchange rate is such a problem, why have so many Japanese and US compa- nies decided to use the UK as a base from

Page 5: Kicking the currency habit: Forget the currency's value, it's the quality of our products that counts

206 NEW ECONOMY

which to attack the Continental market, thereby boosting UK trade performance in car production, data-processing equipment and consumer electronics?

These are more important questions than those most post-war economists have been aslung. But for the time being, the search for a macroeconomic panacea persists. This is fos- tering, even now, a fascination with the re- sults of simplistic ’what if‘ exercises con- ducted on poorly-specified econometric mod- els. It also fosters, in the pub- lic arena, a tendency to avoid pa&l questions. At a major conference in 1992 on the im- pending national ‘economic disaster’, organised by a leading national newspaper, not one participant sug- gested poor economic per- formance was connected to

Conclusion None of the above means a dire prognosis for the UK economy - quite the opposite. The current business cycle may be both strong and durable. Recent figures suggest that even the trade constraint, the problem that a grow- ing UK economy usually leads to a rising and unsustainable trade deficit which therefore puts a limit on how fast policy makers dare let the economy grow, may be slightly looser

than we have been exDectine.

”If these industries can live with the level and volatility of sterling,

the stntcture of interest rates, financial

‘short-termism’ and corporate taxation, why can’t others?”

their individual companies’ - ”

This decade’s friendlier la- bour market demography may translate into bigger and more meaningful falls in unemployment than is gen- erally anticipated. Yes, the cheap exchange rate is play- ing its short-term role in the recovery. But the underlying cause is the fact that industry

product ranges or marketing. Many blamed the recession on the ERM.

ERM and inflation Government advisers’ advocacy of participa- tion in the ERM, despite Britain’s chronic trade weakness, becomes less puzzling if you believe long-term economic performance re- ally has little to do with the level of the ex- change rate - though it follows logically that the ERM’s usefulness as a counter-inflation- ary weapon must be relatively limited too. Financial stability under the auspices of the Bundesbank can be defended as an end in its own right.

Ln retrospect, perhaps the policymakers’ real mistake was to overlook how far ster- hg’s true status as a dependent, rather than independent, variable would upset their plans. The pound was expelled from the ERM because the UK recession undermined it. That recession had little to do with price or cost competitiveness and it began before Britain joined the ERM.

is belatedly learning the %ot- tom up’ lesson, and is slowly getting better at making things people want to buy.

The exchange rate is an important eco- nomic indicator, and we should watch it care- fully. But its importance is derived from its being a consequence, not a cause, of economic performance. There is no more comprehen- sive an index of our standing on the interna- tional stage than the value of our currency. A strong industrial sector goes hand in hand with a strong exchange rate - and vice versa o