What does the strength of the pound really mean for manufacturing?

Posted on 8 Dec 2022 by Joe Bush

The end of September saw the pound fall to a record low against the dollar. Despite the well reported negative consequences in the mainstream media, John Mills, economist and Founder of The John Mills Institute for Prosperity, claims that such an event could result in a silver lining, and growth opportunities for UK manufacturing.

Speaking in the days following the pound’s devaluation, John highlighted the UK’s historic national obsession with policies that lead to an overvalued pound which have contributed to driving down manufacturing productivity, creating an unproductive and low growth economy.

He also identified that a lower value pound represents an opportunity to boost manufacturing and for the government to make UK exports more competitive and increase the profitability of our domestic manufacturing sector. This would encourage investors to site new manufacturing plants and operations in the UK rather than elsewhere. The Manufacturer Editor, Joe Bush, caught up with John to find out more.

John Mills, economist and Founder of The John Mills Institute for Prosperity
John Mills, economist and Founder of The John Mills Institute for Prosperity

Why has the UK traditionally had an obsession with a strong pound?

JM: We’ve had this ethos for a few hundred years, going back to before the days of the gold standard. There’s always been a general perception that the stronger the pound, the better off the economy. In fact, when you analyse it, the reverse is true. A higher pound actually makes us less competitive, which means there is lower growth in exports and less investment. That results in lower living standards and lower productivity gains.

This perception was reinforced by the inflationary problems we had in the 1970s. Between 1977 and 1982 the exchange rate for the pound rose by about 70%. No wonder manufacturing (mostly operating in highly price sensitive international markets) as a percentage of UK GDP, went into a steep decline. At this higher exchange rate, swathes of manufacturing investments became unprofitable.

Despite all the efforts to increase UK productivity, this is the reason why we’ve slipped down the international rankings. Something like 30 countries now have higher living standards than the UK, whereas 150 years ago, we were the preeminent country.

Policies introduced to stabilise the economy in response to the inflation of the 1970s, resulted in a rising exchange rate. This was not replicated in the east; countries in that part of the world got exchange rates down. The imbalance we’ve seen ever since has meant that economies in the east have grown significantly faster than those in the west. Our growth rate has steadily fallen and, if we’re not careful, we’ll have no growth at all for the next five to ten years.

What have been the consequences of an overvalued pound on UK manufacturing?

It’s been disastrous; manufacturing as a percentage of GDP has fallen from around 30% in 1970 to less than ten now. We’ve lost share of world trade and for a highly competitive market, like the one for manufactured goods, we’ve suffered as a result.

In addition, there is a cultural problem, as well as one based around competitiveness and economics. Other countries enjoy much stronger manufacturing lobbies than we do in the UK. A look at the history of Germany, for example, will show that they’ve always had a very competitive exchange rate; the Bundesbank and big export companies have always insisted on that remaining the case, which was the basis on which the Euro was set up.

In the UK there’s never been that drive from industry to make sure that we have a competitive pound. Rather, industry has been prepared to accept the services view of the world, which is very strong in the UK and represents approximately five percent of GDP export surplus.

We’re good at services, helped by all manner of natural advantages such as our language, geography, legal system, universities and training. But because services is so dominant, it tends to set the economic climate. Services can live quite happily with $1.50 to the pound, but unfortunately, that exchange rate is completely lethal for manufacturing.

A further problem is that it’s more difficult to increase productivity and sell abroad in the services sector than it is in manufacturing. Therefore, if there is an over reliance on services, a large balance of payments deficit can result, which then leads to the levels of inflation like we currently have and a weak economy.

strong pound

How could a more competitive pound impact UK manufacturing and how could businesses take advantage?

All the evidence is that the lower the pound, the more competitive, relatively speaking, exports become and the better the balance of payments. I think the recent strengthening of the pound (following the recent dramatic fall) won’t be reflected in an improvement in the balance of payments; far from it.

If the pound had stayed down, it would have made a lot of competitive difference. Generally speaking, the lower the pound, the faster the growth of the economy. Therefore, what we have right now is a policy choice on the level at which we try and get the pound to settle. In terms of what our economic targets should be, currently it’s to try and keep inflation at two percent. A better target, in my view, would be for the Bank of England to maintain an exchange rate to produce enough investment to get our growth rate to two and a half or three percent per annum. Unfortunately, that’s a very long way from where the present government or opposition are. Right across the political spectrum, it’s not something that’s being considered.

However, it’s crucial that we get the rate of business investment up. Currently, the total amount of investment in the UK, including R&D, is approximately 17% of GDP. The global average is about 25%, and in places like China, it’s over 40%. It’s that investment that can really make the difference. Further to that, however, there are particular types of investment, particularly around mechanisation, power and technology, which produce very high rates of return. It’s these that really drove the first Industrial Revolution.

These elements are all part of manufacturing, but the weaker manufacturing is, the less benefit there is from this sort of investment, and the slower the growth rate. So, by driving manufacturing forward it will increase regular investment.

Will the benefits of a lower pound on manufacturing mean negative trade-offs elsewhere?

Of course, no economic policy is without its downsides, and certainly any policy of a lower exchange rate means higher import prices. Whether that actually adds to inflation is a moot point. I was always brought up to believe that it would, but when you look at the international figures, the evidence would suggest something different.

A striking example was when the UK came out of the Exchange Rate Mechanism (ERM) in 1992. A year previous the inflation rate was around six percent, and despite some politicians claiming it would be a disaster to come out of the ERM, inflation actually went down, dropping to around one percent in 1993/94.

Following that we had 15 years of growth through to 2008 at a reasonable rate. That shows, first of all, that inflation doesn’t necessarily follow from devaluation. But also, if we’re trying to get the percentage of GDP from investment to something like 25% (from 17% currently) to keep pace with the rest of the world, then we need to shift eight percent of consumption into investment.

That means we need to find the resources to do that i.e., via savings from government, borrowing from abroad, the corporate or household sector. It’s not easy, but it’s possible, and there are plenty of other countries that have achieved it.

Maintaining a competitive pound will require a combination of two things; first of all, everything on the supply side needs to be in place – better education and training, infrastructure, longer-term capital, etc. Second, we also need to make sure that’s balanced by having enough competitiveness on the demand side, to make sure that we’ve got a reasonable amount of exports and investment flowing from that. An iron rule of economics is that if you’re losing your share of trade, then the economy will grow more slowly than the world average; that’s been the UK’s problem for a long time.

Would a more competitive pound benefit all manufacturers, both large and small?

A more competitive exchange rate would benefit manufacturing businesses of all sizes. Economies of scale mean that larger manufacturing businesses are able to bring down their unit cost for manufactured goods. However, that’s much more difficult for smaller manufacturing businesses. For that reason, a more competitive exchange rate could actually be more impactful for smaller manufacturers – it will boost their margin on goods that they sell internationally.

Plus, many smaller manufacturers have also historically put off international expansion because of the costs of exporting. A lower exchange rate would give many such companies the nudge they need to start selling abroad, and the fact that it will be more profitable to sell abroad will help offset the upfront costs of setting up all the administration that is needed in order to do so.

Are these goals achievable with such a negative perception of a lower valued pound?

It’s going to be a hard sell for sure. Devaluation has got a very bad name, partly because when we have devalued in the past, it has tended to be at times of crisis (sometimes of our own making when the exchange rate has been too high). If you ask the average person in the UK whether they would like a strong or a weak pound, their reply will inevitably be for the former.

That creates a tricky starting point for politicians who have been persuaded by the arguments addressed here. The problem is that if we go with public opinion and get the pound as strong as possible, then we’re going to end up going down the path that we’ve trodden before, where we continue to lose our share of world trade. We will have lower and less profitable investment in manufacturing, productivity will decrease and income will stagnate, in turn leading to political instability, and I’m concerned that’s where we’re heading.

This situation is even more serious now because of the heavy costs that are coming down the track around climate change, health and social care, pensions, increased military expenditure and further interest charges as a result of increased debts. With all these headwinds against us, we need to drive as much economic growth as we can to offset this.

Most of the costs heading our way will hit the public sector; that means taxes will go up and living standards will go down. That’s not where the government, of any hue, wants to be.

What needs to be done?

First and foremost we need a debate where the academic and practical policy world engage about the pros and cons of this sort of policy. Currently, that isn’t happening. If you talk to anyone about the exchange rate, the response will be that it’s fixed by the market and there’s nothing we can do. It’s like the weather, you just have to put up with it.

I don’t believe that’s the case, particularly if you look around the world at policies that have been pursued by other countries. A very striking example is China which devalued its currency by about 75% between 1980 and the mid-1990s. The result was that they could produce more or less any goods at around half the price of that in the west. Unsurprisingly, their economy grew very rapidly, whereas ours languished. Manufacturing declined in the west, whereas it advanced at huge speed in the east.

So, a lower exchange rate would undoubtedly make the pound more competitive. There would also need to be settled government policy; we’re not going to attract investors if they believe that the pound will go back up, so we need consistency.

We will also need all the complementary policies on the supply side in place; education, training etc, because it’s the two together that really make the difference. We also need to raise the prestige of manufacturing and get it from where it is at the moment (about ten percent of GDP) to around 15%.

At the current level the economy will never get rid of the very serious imbalance it has currently; we’ll never get the traditional, industrial red wall areas of the country back to a reasonable level, where they have enough to sell to the rest of the world. And we’ll never close the gap between London and the South East, and the rest of the country, so there’s a huge amount at stake, and it’s not an exaggeration to say that a more competitive pound would help to steer us out of the economic crisis.

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